Carpenter Technology Corp

NYSE:CRS

Earnings Call Transcript 2018-Q2

[Operator]

Good morning, and welcome to the Carpenter Technology Corporation Second Quarter Fiscal 2018 Financial Results Conference Call. [Operator Instructions]. Please note, this event is being recorded.

I would now like to turn the conference over to Brad Edwards, Investor Relations. Please go ahead.

[Brad Edwards, MD, Brainerd Communicators]

Thank you, Operator. Good morning, everyone, and welcome to Carpenter's earnings conference call for the second quarter ended December 31, 2017. This call is also being broadcast over the Internet along with presentation slides. Please note, for those of you listening by phone, you may experience a time delay in slide movement. Speakers on the call today are Tony Thene, President and Chief Executive Officer; and Damon Audia, Senior Vice President and Chief Financial Officer.

Statements made by management during this earnings presentation that are forward-looking statements are based on current expectations. Risk factors that could cause actual results to differ materially from those forward-looking statements can be found in Carpenter's most recent SEC filings, including the company's report on Form 10-K for the year ended June 30, 2017, Form 10-Q for the quarter ended September 30, 2017, and the exhibits attached to those filings.

Please also note that in the following discussion, unless otherwise noted, when management discusses sales or revenue, that reference excludes surcharge. When discussing operating income, that reference excludes pension earnings, interest and deferrals, or EID. When referring to operating margins, that is based on sales excluding surcharge and operating income, excluding pension EID.

I will now turn the call over to Tony.

[Tony Thene, President, CEO & Director]

Thank you, Brad, and good morning to everyone on the call today. We'll begin with an update of our safety performance on Slide 4. Our total case incident rate, or TCIR, was 1.0 for the first half of fiscal year 2018, which puts us on track for our best fiscal year performance in the last decade and likely, the best performance in Carpenter history.

In addition, our PEP organization worked the months of November and December with 0 recordable injuries, which reinforces our message that a 0-injury workplace is attainable. While TCIR is how we measure our safety results, our safety performance goes well beyond this lagging indicator as we continue to invest in our future by developing our employees and focusing more on leading indicators.

Almost a year ago, we launched a new safety strategy focused on three key areas, leadership, systems and engagement. Our leadership development program teaches skills to our leaders to help them actively listen and understand their team members. As for systems and engagement, we implemented an extensive human performance program that reinforces tools, practices and methods to reduce or eliminate errors in safety, quality and manufacturing. The engagement efforts have helped to empower every employee to stop any activity that they consider unsafe. Our safety culture has progressed to the point where, instead of just measuring results, we are focused more on leading indicators and systemic prevention.

Let me give you some examples. So far this year, our employees have identified and implemented 637 hand-safe solutions, which has led to a 55% reduction in hand injury cases year-to-date, issued 3,179 stop cards with detailed actions assigned and tracked to closure and conducted 3,742 one-on-one employee safety reviews. Each employee has a voice and plays a part in the safety culture, and we want to ensure there are constructive conversations with their supervisors throughout the year.

We are clearly seeing positive results from our efforts, and we remain passionate about our goal of 0 injuries.

Now let's turn to Slide 5 and cover our second quarter performance. Our second quarter results reflect continued momentum in what has proven to be a strong first half performance for fiscal year 2018. Let me cover some areas I believe are worth highlighting. In the Aerospace and Defense end-use market, our largest market, at 53% of total sales in the quarter, we continue to see substantial growth. More specifically, this quarter represents the fourth consecutive quarter of year-over-year sales growth, up 11%. Our total backlog for Aerospace and Defense is up 12% sequentially, marking our sixth consecutive quarter of growth, and year-over-year backlog is up 45% in this market.

In the SAO segment alone, Aerospace and Defense bookings are up 44% year-over-year and 20% sequentially. Our medical end-use market, accounting for 9% of total sales in the quarter, had the highest quarterly sales on record, up 11% sequentially and 48% year-over-year.

We have won significant share in orthopedic and cardiology submarkets. This growth is due in part to major OEMs valuing Carpenter's industry-leading comprehensive suite of products.

For the energy end-use market, the recovery in North American oil and gas appears to be strengthening. Activity at our Amega West business is increasing and several critical macro conditions currently point toward improved operating conditions during calendar year 2018.

Looking at our 2 business segments, we continue to drive improved performance. SAO operating margin was 15%, which marks the fourth consecutive quarter of margins at or above 15% and is the highest mark for a second quarter since fiscal year 2014, as we continue to drive a richer mix of products through the facilities. Improving our cost productivity remains a major focus item, but we could have done better in terms of yield-related cost in the quarter. PEP operating income was up 42% sequentially, driven by solid performance from Dynamet and Amega West, which posted its second consecutive profitable quarter since the beginning of the oil and gas downturn.

Last quarter, I communicated that we completed our final OEM oil and gas qualifications for our Athens facility, giving us access to most of the drilling and completions market. This quarter, we recorded another significant achievement when we submitted qualification packages to the major OEMs for engine disks and rain-quality materials that are projected to account for approximately 75% of the total aerospace VAP material expected to be produced at Athens. This is a significant milestone for the facility and is clearly well-timed, as mill bookings for our Aerospace engine submarket were up 20% sequentially.

We see OEMs projecting significant increases in engine build rates for calendar year 2018, approximately 150% for the LEAP and 100% for the gear turbo fan as examples. We are also seeing more frequent expedited orders from our key customers, without which engine deliveries would not proceed as scheduled. The current supply chain for specialty metal alloys is effectively at capacity, with lead times expanding quickly. Given the current demand conditions across the aerospace supply chain, we are actively working with key OEMs who recently have exhibited a much greater sense of urgency to work with us to achieve the final approvals for our state-of-the-art Athens facility.

In addition to the growth that Athens will afford us, we also continue to focus on strengthening our long-term growth profile through strategic investments in areas that we believe can fundamentally change the future of our business. We've talked on prior calls about the strategic push into additive manufacturing, giving us tremendous disruptive potential. In addition to additive manufacturing, we are also placing strategic emphasis on our soft magnetic solutions portfolio. This commitment to investing in our future was strengthened by the recent U.S. tax reform. Damon and I will speak more on this in a few minutes.

Let's move to Slide 6, and the end-use market update. Beginning in Aerospace and Defense, our largest market, sales ex surcharge were up 2% sequentially and up 11% compared to last year. In the engine submarket, we saw the highest level of quarterly bookings since fiscal year 2015. The engine submarket continues to present solid growth opportunities for Carpenter, given our diversified solution portfolio and participation on all the new engine platforms. The high-end materials we have developed and produced, combined with our solutions-based approach to serving our customers, puts us in a very strong position to gain market share and grow our presence across the industry.

Moving on to our fastener submarket. Sales were up 2% year-over-year and down 4% sequentially. While fastener demand patterns remained uneven quarter-to-quarter, we remain excited about this submarket given our continued leadership position in the underlying demand as demonstrated by the airframe build rate targets widely communicated.

In our structural business, growth is being driven by material we have in critical applications on key platforms like the A320 and the 737. Additionally, we continue to work with customers on further applications and uses for our advanced solutions like opportunities for additive production of critical parts using our proprietary high-stream stainless portfolio. In our aerospace distribution submarket, we benefit from leadership positions with key distributors given the breadth of our portfolio and our quality and delivery levels. This submarket has seen robust performance, again, tied to overall, the aerospace demand environment. Finally, revenues in our defense submarket increased both sequentially and year-over-year due to program-specific demand.

Moving to the energy market, which includes our oil and gas and power generation submarkets. Energy sales were flat on a sequential basis and up 7% compared to last year. Higher rental and replacement activity at Amega West continues to offset declines in power generation sales.

Looking at the oil and gas submarket, sales were up 3% on a sequential basis. For the same sequential period, the North American directional and horizontal rig count declined by 2%. The outperformance of our results in this submarket compared to the rig count speaks to our continued success, increasing our market share in North America. The growth in oil and gas revenues, both sequentially and year-over-year, has been driven by steady improvement in rental and replacement activity at our Amega West business. While activity remains more heavily weighted on the rental side, we are beginning to see an uptick in replacement orders.

As I mentioned earlier, we believe the recovery in the oil and gas market is strengthening. While the North American directional and horizontal rig count has flattened recently, several macro conditions are supporting the recent rise in crude prices and point to an improving operating environment for the market in calendar year 2018. These include balancing our supply and demand given OPEC extension of its production cut and a sharp decrease in global inventory levels. Large service providers are signaling that spending budgets for North America are expected to increase in 2018 versus last year. The outlook for international market is also expected to show signs of improvement, but as of today, demand levels remain subdued. Overall, we see an improving environment for North American drilling in calendar year 2018 and remain well positioned to gain additional market share.

In the power generation submarket, sales were down, both sequentially and year-over-year, due to industry-wide challenges in the industrial gas turbine, or IGT, market. Despite an aging fleet, that is due for refurbishment, the replacement cycle continues to be extended, which is impacting order timing for the entire industry.

Moving to transportation. Sales were down 3% sequentially as the continued strength in the heavy-duty truck market partially offset lower sales for materials application in the North American light vehicle market. On a year-over-year basis, transportation sales were up 3%, again, due to higher sales in the heavy-duty truck category. The strength in the heavy-duty truck market appears to be gaining momentum, and we're seeing stronger order activity with several key customers. While North American light vehicle production is expected to be down in calendar year 2018, global production is expected to rise, and we're focused on leveraging the strength of our solutions portfolio and capturing further share, particularly overseas. It's worth noting that our applications are more heavily weighted to the light truck segment of the market where demand is expected to be stronger compared to the passenger sedan segment.

The overall transportation market is one that is expected to undergo significant disruption in the coming years as the industry shifts its focus and devotes significant resources to electrification. We believe our soft magnetic application can help address many critical design challenges and current unmet needs of OEMs. I'll speak more about this in a few minutes.

Moving on to the medical market. Sales were up 11% on a sequential basis and 48% compared to last year as we further capitalize on strong demand for our titanium materials and continue to benefit from reduced lead time due to capacity gains in certain facilities. Conditions at the distributor level continue to strengthen, and we are making notable progress on the solutions front at the OEM level.

In the industrial and consumer end-use market, sales were down 2% sequentially but were up 19% on a year-over-year basis. This year-over-year increase was driven by continued strength in select industrial applications as well as higher consumer sales.

Now I'll turn it over to Damon for the financial review.

[Damon Audia, SVP & CFO]

Thank you, Tony. Good morning, everyone. Turning to Slide 8, and the income statement summary. As Tony mentioned, we delivered solid operating performance on our fiscal second quarter, marked by healthy year-over-year gains across all end-use markets with sequential performance largely in line with our plan. The underlying fundamentals of our business continue to improve. Our second quarter performance was driven by continued strong execution of our commercial strategy and the ongoing implementation of the Carpenter Operating Model, combined with improving market conditions across multiple end-use markets. Net sales in the second quarter were $488 million, or $416 million excluding surcharge. Sales excluding surcharge increased $5.7 million on a sequential basis on approximately 5% lower volume as we benefited from improved mix mainly associated with our medical as well as Aerospace and Defense end-use markets. On a year-over-year basis, sales excluding surcharge increased 13% on a similar gain in volume.

Sales rose across all five of our end-use markets, with 3 of our markets posting double-digit increases and again, exceptionally strong performance in the medical end-use market as we continue to gain share in a strengthening market. SG&A expenses increased by $1 million on a sequential basis and were in line with our expectations at approximately $45 million. We expect our SG&A expense to be at the higher end of our range of $45 million to $47 million on a quarterly basis during the balance of fiscal year 2018.

Operating income as a percent to sales was 9.9% in the quarter when excluding pension EID. This was effectively flat compared to the 10.3% in the first quarter. The higher margins associated with the richer mix sold in the quarter was offset by temporary headwinds related to a raw material surcharge lag that I will elaborate on in a moment. Compared to the 5.7% in the second quarter of last year, the 9.9% this quarter reflects the improving market conditions that helped deliver increased volume coupled with the ongoing strategy to improve our mix.

Overall, the results in the quarter in the first half of our fiscal year reflect the successful execution by our commercial team in further penetrating our targeted markets and capitalizing on rising demand trends for our solutions combined with our consistent focus on managing our cost, improving our manufacture processes and unlocking capacity through the implementation of the Carpenter Operating Model.

Our effective tax rate for the second quarter was negative 173%. The income tax benefit reported includes a net discrete tax benefit of $66 million mainly associated with the impact of the U.S. tax reform, which I will cover later. Adjusting for this special item, our tax rate in the quarter would have been 23% compared to 34% in the first quarter of fiscal year 2018 and 16% in last year's second fiscal quarter. We reported net income of $92 million in the second quarter or $1.92 per share, which reflects the income tax benefit of $66 million I mentioned a moment ago. Excluding the impact of the special item, adjusted diluted earnings per share would have been $0.55 for the quarter, which was up from $0.49 in the first quarter of fiscal year 2018 and $0.15 in the second quarter of last year.

Now turning to Slide 9. Free cash flow in the second quarter was negative $11 million, representing a significant improvement from negative $45 million in the first quarter. Our free cash flow performance in the quarter was in line with our expectation and reflects the increase in inventory of $35 million as we continue to strategically align inventory levels with the opportunities we see across our end-use market as indicated by our growing backlog.

Given current demand levels and the status of the implementation of the Carpenter Operating Model, we expect our full year inventory reduction to come in around the low-end of our initial targeted range of $30 million to $50 million versus fiscal year-end 2017. We spent $27 million in capital expenditures during the quarter, in line with $29 million spent in the first quarter of fiscal year 2018 as we ramp up our investments in key growth initiatives.

Our liquidity position remains strong. As of December 31, we have $406 million of total liquidity, including $21 million of cash and $385 million of availability under our credit facility. We continue to maintain a healthy balance sheet supporting our financial flexibility as we invest in our growth initiatives while strategically managing our capital allocation.

Now turning to Slide 10, and our SAO segment results. SAO delivered another strong quarter with net sales of $406 million or $332 million excluding surcharge, representing an increase of $6 million or 2% on a sequential basis. On a year-over-year basis, sales excluding surcharge were up $44 million or 15%. The sequential increase reflects strong execution of our solutions-focused strategy and improving conditions across many of our end-use markets. Operating income was $50 million in the second quarter, which was effectively flat sequentially but up $14 million compared to the prior year second quarter. The execution of our commercial strategy, Carpenter Operating Model and improving market conditions contributed to SAO's best second quarter in 4 years and the best first half performance in 4 years as well. Operating margin was 15% similar to Q1 and up year-over-year due to the successful execution of our commercial program driving higher sales as well as notable traction in driving improved plant productivity.

The current quarter results for SAO include some unplanned impacts from a raw material surcharge lag, which we estimate to be about a $3 million impact to operating income. Normally, we are able to match the price we pay for certain critical raw materials with the surcharge revenue we charge our customers. However, for some customers, we do have a lag on the timing of surcharge formulas. Therefore, when raw material prices move quickly, like we saw in Q2 and into January, we will experience a variance. As such, based on current raw material prices, we expect this surcharge lag impact to persist into Q3.

Over extended period of time, these variances neutralize themselves. Regarding the outlook for SAO, we continue to see strong demand trends across the majority of our end markets, as reflected in the considerable growth in our backlog that Tony spoke about earlier. We currently expect operating income to increase 10% to 15% on a sequential basis as we capitalize on our solutions-driven commercial model combined with the benefits of the Carpenter Operating Model.

Now turning to Slide 11, and the PEP segment overview. On a year-over-year basis, PEP sales increased 26% or $22 million to $105 million, as a result of the continued strong demand for our titanium solutions at Dynamet coupled with higher sales into the energy end-use market. On a sequential basis, sales rose approximately $4 million, which is reflective of stronger titanium and energy market demand. This was PEP's fifth consecutive profitable quarter, with the highest operating margin percentage since the fourth quarter of 2015, while Amega West achieved its second consecutive profitable quarter. Overall, this was strong performance from our PEP segment. The team has leveraged the Carpenter Operating Model's ability to unlock capacity in constrained areas which subsequently allowed the commercial team to capitalize on the robust demand for our titanium products in the medical as well as Aerospace and Defense end-use markets.

Looking at the third quarter, we continue to see very strong demand for our products. Unfortunately, in mid-January, we experienced a fire at our Washington, Pennsylvania Dynamet facility. Fortunately, no one was injured, and the team mobilized quickly to address our customer needs. The Dynamet team has established interim processing options to continue to serve our customers with the least disruption as possible.

Although the event has created some challenges, it only affects around 10% of Dynamet's revenue and the other products are running without any issues. Over the long term, we do not expect this to have a significant impact to our results as we will work hard and fast to restore optimal service to our customers, and our insurance coverage should help minimize the financial impact. However, for the third quarter, we expect to incur net cost in the range of $4 million to $5 million related to this issue.

The majority of those costs are related to asset write-offs, cleanup and restoration costs. Although there may be some continued costs into our fourth quarter, we would expect them to be much less.

I want to take a moment to say thank you to the Dynamet team. The team's actions during this event are clear examples of our values and our strategy. The team first focused on the safety of the people to ensure no one was hurt and then immediately began working around the clock to identify solutions for our customers. Our vision of being an irreplaceable solution provider was evident through this process to me, to Tony and to our customers.

As you would expect, the team will continue to work diligently until business returns to normal. Also, one last point related to our PEP business. Absent the fire, the noneffective businesses are anticipated to be up around 10% sequentially, given the strong demand we see ahead.

Turning now to Slide 12, and the discussion of the recent U.S. federal tax legislation and its impact on Carpenter. As I mentioned earlier, as a result of the legislation, during the second quarter we recorded a $66 million discrete tax benefit. The benefit recorded was primarily due to the remeasurement of our net deferred tax liability at the reduced corporate rate. The recent tax legislation lowers the U.S. federal corporate income tax rate from 35% to 21%. Since we have a fiscal year that spans calendar years 2017 and 2018, there will be a phase-in for our fiscal year 2018. We currently expect our effective tax rate when considering state, local and international taxes to be in the range of 25% to 28% for the balance of fiscal year 2018.

In fiscal year 2019, we currently expect our overall annual effective tax rate will be in the range of 24% to 26%. In addition, based on our current estimates, we expect that over the next 4.5 years, through fiscal year 2022, the recent tax legislation will reduce our cash taxes by approximately $90 million to $100 million. The cash savings represents a significant opportunity to increase our investment with particular emphasis on targeted core growth areas including additive manufacturing and our soft magnetic solutions portfolio, which Tony will discuss in a few moments. Our capital expenditures for this fiscal year are planned to increase from $120 million to $135 million, with the increase being equivalent to the fiscal year 2018 cash tax savings.

We believe increasing our level of investment in core growth areas with attractive and large long-term growth potential is critical as we continue to execute our plan to transform Carpenter and become an increasingly critical supply chain partner to our customers. At the same time, these incremental investments do not take us off of our trajectory of continuing to deliver strong free cash flow to strengthen our balance sheet and provide direct returns to our shareholders.

Now I'll turn the call back over to Tony.

[Tony Thene, President, CEO & Director]

Thank you, Damon. A primary component of our transformation has been solidifying our position as an irreplaceable partner for our customers. Achieving that goal is dependent not just on our capabilities and teams today but on continuing to innovate and strengthen our solutions portfolio to address the future of our industry and our markets. This strategic mandate will position us at the forefront of enabling customer success in the years ahead.

I've spoken on prior calls about a sharp focus on additive manufacturing, given its tremendous disruptive potential and the many attractive growth opportunity it presents across each of our end-use markets. Today, our customers are increasingly exploring additive manufacturing as they seek a higher level of performance for their products, given the growing premium being placed on light weighting, strength to weight, corrosion resistance, heat resistance, improved design and other performance requirements. We bring extensive knowledge in critical areas including powder flowability, process control and next-generation alloy development.

Through a combination of existing capabilities, capital investment and strategic partnerships, we believe we can provide customers with solutions from concept through design and ultimately, to manufacturing that can take the performance of their products to the next level.

To accelerate our advancement in this space and to provide our customers the solutions they will need to win, we are finalizing our plans to establish an additive manufacturing technology center. This is a critical step to help us evolve in a rapidly changing environment and will provide our customers an opportunity to leverage this innovative technology and our expertise. As excited as we are about additive manufacturing, we are equally passionate about our growing position in soft magnetics. Soft magnetics are not new to Carpenter. In fact, our advanced soft magnetics portfolio, including our Hypocore family, has an industry-leading position in avionics while also being utilized in consumer electronic devices including smartphones and smartwatches. The existing potential in the aerospace and consumer electronics market already makes this a very attractive growth area for us.

We believe significant additional growth opportunities will come with the projected sharp rise in electrical vehicle, or EV, sales over the coming years. Similar to the aviation and smart device market, we are already delivering solutions to our customers. EVs deal with a variety of critical design challenges and unmet needs that Carpenter can and will address.

For the EV market, these include driving versus charge range, size and weight reduction, improved performance and reduced charging time to get vehicles back onto the road. Our proven products can help the EV OEMs address their challenges. Whether they are looking for longer range or improved performance, we have solutions for them. We provide what we believe to be the highest induction alloy solution in the world, allowing designers the flexibility to reduce or reconfigure the size of power units without sacrificing performance.

To continue to capitalize on our strength in the aerospace and consumer electronics areas and to win in the growing EV space, we have chosen to increase our capacity and capability for soft magnetics. This investment of $100 million to be made over the next few years will provide us incremental capacity to serve our growing customers and win new customers who want the performance benefits of our soft magnetics solutions can bring to their products. Similar to our strategic focus on additive manufacturing, we believe the soft magnetic space offers strong, long-term growth potential for Carpenter, based not only on the market's growth rate but also on our proven technology.

Now let's turn to Slide 15, and my closing comments. As we close out the first half of fiscal year 2018, our results demonstrate the success we have had in transforming Carpenter as we continue to execute on our strategic plan and position the company for long-term growth. We continue to drive opportunities for expanding our market position as seen in our consistent backlog growth as we deepen our relationships with customers, demonstrate our value to new ones and unlock additional applications for our solutions.

For example, in the Aerospace and Defense market, the diversity of our submarket is a competitive differentiator, and we remain well positioned to take advantage of the steep and attractive engine platform ramp underway. The breadth of our exposure across multiple platforms and applications continues to make Carpenter a powerful supply chain partner and key contributor to the industry's success.

In the medical market, the power of our solutions approach is evident. OEMs and channel partners also see value in our market-facing strategy, which provides a single focal point to represent all Carpenter products and solutions.

In the energy market, conditions in the oil and gas submarket continue to show signs of improvement, and we are focused on building upon our share gains to date. We're achieving success in implementing the Carpenter Operating Model. Early wins have given us the confidence to look deeper into our operations to identify and secure opportunities for additional manufacturing efficiencies and unlock further incremental capacity at our facilities.

The financial benefits of the Carpenter Operating Model are not linear, and we will have variability from quarter-to-quarter. The point to make is that there are still opportunities in front of us to increase capacity in markets that are growing quickly and sustainably lower our operating cost.

As I mentioned earlier, this quarter marked a significant milestone in our progress on obtaining the necessary aerospace qualifications for our Athens facility. We have submitted qualification packages for the majority of the materials we expect to run through Athens that require these stringent qualifications. There is no doubt that more work is required as our team works closely with the OEMs to obtain customer-specific qualifications. But given current aerospace market conditions, we see an amplified level of interest from our customers to fast-track these efforts.

Turning to the U.S. tax reform. Carpenter's 128-year-old history is built on metallurgical expertise, a diverse solutions portfolio, strong brand recognition across attractive end-use markets and a commitment to innovation that enables customer success.

Today, over 90% of the products we manufacture are made in the United States, and approximately 30% of our sales are to customers outside of the U.S. In addition, we have demonstrated our ability to generate positive annual free cash flow and have invested heavily in our U.S. manufacturing operations over the last decade. In short, we are a profitable enterprise with a bright future and a demonstrated commitment to U.S. manufacturing. This positions us very well to take advantage of the tax reform. As Damon mentioned earlier, we expect the recent tax reform will reduce our cash taxes by approximately $90 million to $100 million over a five-year period. We intend to use the savings to invest back into our business by increasing our base level of capital investment over the same 5-year period.

Our investments will focus on key growth areas such as additive manufacturing and soft magnetics, as I mentioned earlier. We firmly believe the investments we make in the coming years in these areas will further strengthen our foundation for long-term sustainable growth and deliver increasing value to shareholders for years to come.

This is an exciting time to be associated with Carpenter technology. Our safety performance has improved significantly as we embrace the idea that our most important value is to ensure that no employee is injured. The markets we serve are robust, and our solutions-based commercial approach is driving share gain and new applications. We have introduced a new language on our manufacturing shop floors and it is called the Carpenter Operating Model. Although we have realized tangible success to date, additional value is in front of us with increasing opportunities. We have exciting new products and technologies on the horizon.

We are moving forward on critical qualifications at our Athens facility, that when complete, will provide vital capacity and a lead-time advantage to a tightening aerospace market and a recovering energy market. We are investing in key growth areas, and the recent tax reform allows us to accelerate those investments. These investments will strengthen our current workforce and add new jobs in the future.

And most importantly, as a collective workforce, we are changing our culture to one that values safety above all else, that is innovative, that is forward-leaning and that is performance-based.

Thank you for your attention, and I'll turn it back to the operator to field your questions.

[Operator]

[Operator Instructions]. Our first question comes from Gautam Khanna with Cowen and Company.

[Gautam Khanna, Cowen and Company]

A couple of questions. First on SAO, you mentioned the raw material volatility. Could you elaborate on what specifically -- how much of a damper that was on EBIT in the quarter? And was that more -- something that affected the cost position of the company versus the price and effect? Or was it actually not stimulative to demand?

[Damon Audia, SVP & CFO]

Yes, I think [indiscernible] yes, Gautam, no impact on demand. As Tony alluded to in his remarks, demand remained very strong for us in the quarter. The impact was to our cost base. And as I tried to elaborate in my scripted remarks, there's a timing difference with a subset of our customers here, given the cause that we incurred the nickel or the cobalt in, and then when we subsequently surcharge or what price of the surcharge they pay against, so again, for a small percentage of these customers, given that nickel and cobalt was pretty volatile in our second quarter and into January, it created that timing disconnect which impacted our quarter by about $3 million. So if you just added that back to the -- to SAO's margins or to the SAO OI, you sort of see what it would look like under a more normalized percent or idea.

[Gautam Khanna, Cowen and Company]

Okay. And then the fire at Dynamet, does that have any impact on the ability to deliver product in fiscal Q3? Or what is that $4 million to $5 million operating impact? Does it -- is it something related to lack of ability to deliver? Or is it just the cost of fixing things? And is that insured?

[Damon Audia, SVP & CFO]

Yes. So, Gautam, so the fire impact is about 10% of Dynamet's revenue, the product is about 10%. So 90% of Dynamet's running sort of normal, no issues on the customer. The team is working to find alternative ways, so it may be moving products to different parts of the Carpenter facilities. There may be some outsourcing for part of the process. And that's when we talked about, so I'll call it a more costly process to deliver on the customers. But again, there should be relatively minimal impact over the next couple of quarters as we work to deliver the customers' products. The net $4 million to $5 million that I referred to is effectively -- a lot of that is sort of the period cost. So we have some asset write-offs. Again, there was some equipment in the building damaged, so we have to write that down.

There is some restoration cost and some cleanup cost. So that's what we sort of expect in this quarter as we move into the profit or the incremental cost of servicing the customers, that will subside over the next couple of quarters. As I alluded to in my remarks, we expect the impact in Q4 to be significantly less. And then the last point to your question is, we do have insurance. We would expect the overall cost of this to be relatively minimal, basically down to our deductible. But the timing of that insurance recovery may not match the cost that we're incurring here in Q3 or into Q4.

[Gautam Khanna, Cowen and Company]

Last question just on fastener demand. You mentioned the order rate picked up a little bit sequentially. What are you seeing across the various end markets for aerospace fastener demand by alloy type, the titanium, the nickel alloy and stainless?

[Tony Thene, President, CEO & Director]

Good morning, Gautam, this is Tony. From our standpoint, we just continue to see variability in that market, but I can say that the titanium fastener is stronger than the nickel.

[Operator]

Our next question is from Chris Olin with Longbow Research.

[Christopher Olin, Longbow Research]

I want to make sure I understand the third quarter guidance for the SAO segment. I think you said up 10% to 15% sequentially. Would I be adding back the $3 million surcharge from the previous quarter on top of that? And then, is there -- how do I think about the surcharge effect for the current quarter?

[Damon Audia, SVP & CFO]

Yes, so Chris, again, as we alluded to, we're in the month of January -- or we just finished the month of January. So we sort to had to make an estimate on what the surcharge on this lagged component of these customers could be, again depending on where nickel and cobalt and a few other commodities were to move over the next month, so that would have an influence. But in answer to your question, we sort of looked at the $3 million as part of that 10% to 15%, so it's sort of baked in, and to the extent it was less than $3 million, we have moved a little bit up. But if it was up more than $3 million, we'd move a little down.

[Tony Thene, President, CEO & Director]

Yes, Chris, to clarify, I think that we believe we're going to have the same market conditions in the third quarter as we had in the second. So you're going to see that same type of negative impact or close to it.

[Christopher Olin, Longbow Research]

Is there a seasonal aspect to the demand in the third quarter? I would assume that you guys saw somewhat of an uptick in terms of volumes and revenues.

[Tony Thene, President, CEO & Director]

I think the seasonal argument is history, right? Because manufacturing facilities, as I said in my opening remarks, are effectively full. So we're running 100% across all of our production centers. So the increase in capacity we get or the differences in quarters will be based on our productivity and, quite frankly, the number of days in the quarter. So seasonality just is not applicable in today's market.

[Christopher Olin, Longbow Research]

Okay. And then just the last question on that. Athens, in terms of that impact on the EBIT number or margins, has that changed at all? And maybe an update on where that is on operating rate perspective right now? I apologize if you already said it.

[Tony Thene, President, CEO & Director]

No, it's a good question. I think a lot of people have some questions, and maybe I'll elaborate just a little bit more on Athens because that is a significant milestone for us, the fact that we are able to deliver qualification packages to the OEMs on the majority of the material that will go through Athens. I think there's just a couple of points that I want to make. First, the qualification process at each OEM is unique. And each one of them is at a different point in the time line when it comes to qualifying Athens. I think, secondly, as we all know, these qualifications are for aerospace jet engines, so by design, the process is painstaking and detailed. But if you take a step back and having said that, there's a couple of points that I'd like to repeat that I said in my comments is that we have seen an increase in expedited orders in this last quarter.

Carpenter has stepped up to work with those customers. We understand, had we not stepped up, that engine deliveries would have been negatively impacted. So we have stepped up and will continue to do that. As I said, lead times across the industry are increasing. I can tell you on our key products in this supply chain, we've seen increases in lead times up to 20%, and we believe we're the best in the industry, so we think the others are seeing the same type of increases. As I said, backlog is up, bookings are up. So from where we stand right now, we are actively engaged with every one of the OEMs. We have ongoing regular technical calls and active exchange of information. But where we sit today and what we see, the best I can tell you is that I think it's possible for some of those packages to be approved by the end of this fiscal year.

And I'd say we would be hopeful that most would be approved by the end of this calendar year. But I think it is a real stretch to say that you're going to get any margin from those specific aerospace VAP materials in this fiscal year. Now what's important is that, if you remember last quarter, we said that we have now obtained all of our approvals for oil and gas, and that is the recovery market. So I think you'll see increased activity at Athens based on the oil and gas recovery. I hope that answered your question.

[Operator]

[Operator Instructions]. Our next question comes from Josh Sullivan with Seaport Global.

[Joshua Sullivan, Seaport Global Securities]

Just on the soft magnetics market. Obviously, you're making a big investment here. Can you quantify that market opportunity maybe today and then what it looks like in 3 years? And I guess, what are the gating factors for maybe achieving some of those targets? Do you need a new design cycle from the OEMs or any qualifications?

[Tony Thene, President, CEO & Director]

Well, a couple of things here. I mean, this is a market that we've been in, I think you all know, over the last several decades. We supply into that market now with our Hypocore suite of products. And I think it's important to say that this is the premium electrical material that we produce. If you ask what's the size of the market, if you look at the addressable market, that means $2.5 billion. Now our base is approximately $50 million, very, very high, very high margins. We believe over the next couple of years we can easily double the size of that, if not more.

[Joshua Sullivan, Seaport Global Securities]

And then I'd take that -- I mean, that's higher margin kind of worked from your base? Is that true?

[Tony Thene, President, CEO & Director]

That's correct.

[Joshua Sullivan, Seaport Global Securities]

And then just on the $100 million investment. Do you think that will be a greenfield-type operation? Or is that going to be an expansion of your current assets?

[Tony Thene, President, CEO & Director]

It will be an expansion of our current assets, so it would be -- it will go in one of our existing facilities. And it's going to have a time line of about 2.5 to possibly 3 years. I think it's fair to say this is a different type of capital investment than when you're talking about rotary quality disk material that takes a long time to order, to install and then to qualify. Remember, we started the Athens process 7 years ago when we're -- here. These are assets that qualification times are short. We're doing it today. And you have paybacks that are easily 2x the cost of capital. And if you look at our upside and how this market could go, it could be even higher.

[Operator]

And our next question comes from Phil Gibbs with KeyBanc Capital Markets.

[Philip Gibbs, KeyBanc Capital Markets]

The question I had was on the jet engine sales and any color on what you could provide in terms of the growth year-on-year on those sales? And then secondarily, oil and gas?

[Tony Thene, President, CEO & Director]

Okay. So thanks for the question, Phil. On the jet engine side, if you take a look at first half of fiscal year versus first half of fiscal year '17, jet engine revenue was up 8%.

[Philip Gibbs, KeyBanc Capital Markets]

Base sales were up 8% first half over first half?

[Tony Thene, President, CEO & Director]

Correct. And then on oil and gas -- sorry, go ahead.

[Philip Gibbs, KeyBanc Capital Markets]

No, you were going there.

[Tony Thene, President, CEO & Director]

Yes, and then to your question on oil and gas, yes, we see some positive moves there from what we're hearing from the exploration and production companies. Several of those has announced increases to their budget 12% to 16% for 2018. We expect North American onshore to receive the majority of that capital versus the offshore.

[Philip Gibbs, KeyBanc Capital Markets]

And then the growth in your sales there, maybe over the same timeframe as you provided on the engine side?

[Tony Thene, President, CEO & Director]

If I look at -- on the oil and gas side, energy was up 6 -- 7% year-over-year.

[Philip Gibbs, KeyBanc Capital Markets]

That's just oil and gas?

[Tony Thene, President, CEO & Director]

That's energy in total because if you look at oil and gas by itself, it was 60% year-over-year, sorry. But you had a big decrease in power generation year-over-year as you're aware of.

[Philip Gibbs, KeyBanc Capital Markets]

And then the medical sales, I think surprised us particularly, given some of the comments one of your competitors were making about the market. Maybe anything you could provide us in terms of what you're seeing there? And how you've been able to sort of walk the trend? I think you've got growth there and top line of almost 50% year-on-year to date?

[Tony Thene, President, CEO & Director]

Yes, that's a great story. That's about 9% of our market, very strong margins. I think what's important there is where you play. So we're in orthopedic and the cardio solutions. Those are the areas that we're focused on. We've stepped in when some other folks have left the market. The additive manufacturing push has helped us because we sell our wire into that. So I think this is a real testament to the new commercial approach that we've had, and that specific medical commercial team going out and talking to customers that either have been underserved or we've not served at all. And I'd also say on the distribution side, we stepped in there and working with our key distributors to support this market. It's a real growth market for us.

[Philip Gibbs, KeyBanc Capital Markets]

Okay, I appreciate that. And I have just a question on the cost environment. I know you did put an electrode surcharge maybe several weeks ago. Maybe timing or cadence of when you may feel the impact on just the cost base from that? And I know alloys have risen and refractories have risen, freight has risen, so trying to couch how to think about some of that in the model right now and just the business environment overall?

[Damon Audia, SVP & CFO]

Yes Phil, I mean, the cost for the graph of electrodes, it's going to phase in, and we are already experiencing some of that here in January, again depending on the supply contracts we had and the volume of what we were purchasing from these different suppliers. It's going to sort of phase in, so it's not -- there's no linear or simple answer to that, but it's already starting.

[Philip Gibbs, KeyBanc Capital Markets]

And then my last question is on the inventory. I think you've guided to something down, maybe on a cash basis, $100 million for the balance of the year. Should we think about that as an equal phase in, in Q3 and Q4?

[Damon Audia, SVP & CFO]

No, Phil, again I think you'll see a little bit -- I think it will be more pronounced in Q4 as you historically see that being our -- generally our strongest sellout quarter.

[Operator]

Our next question comes from Jeremy Kliewer with Deutsche Bank.

[Jeremy Kliewer, Deutsche Bank AG]

Just a question on -- you mentioned the lead times are increasing for some of your engine components. And then, are you guys locked in for contractual pricing? Are you able to also scooch up some of your revenues to match the increase in lead times?

[Tony Thene, President, CEO & Director]

Yes, so we have a majority, I would say, of our -- in that high-end area is based on contracts. But we also have opportunities on shipments that are transactional in nature, and we will take advantage of this type of market.

[Jeremy Kliewer, Deutsche Bank AG]

All right. And then on your kind of year-over-year growth for the last 12 months, how much of that was organic versus being acquired through your peer's acquisition?

[Tony Thene, President, CEO & Director]

It was effectively 100% organic. We've not really had -- the sales that we've had through peers to date are really not material.

[Operator]

This concludes our question-and-answer session. I would like to turn the conference back over to Brad Edwards for any closing remarks.

[Brad Edwards, MD, Brainerd Communicators]

Thanks, Austin, and thanks, everyone, for joining us today for the second quarter conference call. We look forward to speaking with all of you again on our third quarter call. Thanks, and have a great day.

[Operator]

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.