Carpenter Technology Corp

NYSE:CRS

Earnings Call Transcript 2021-Q4

[Operator]

Hello and welcome to the Carpenter Technology Corporation Fourth Quarter Fiscal 2021 Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today's presentation there will be an opportunity to ask questions. [Operator Instructions] Please note, today's event is being recorded. I will now turn the conference over to Brad Edwards, Investor Relations. Mr. Edwards, please go ahead.

[Brad Edwards, Investor Relations]

Thank you, operator. Good morning, everyone, and welcome to the Carpenter Technology earnings conference call for the fiscal 2021 fourth quarter and full year ended June 30, 2021. 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 Tim Lain, 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 Technology's most recent SEC filings, including the company's report on Form 10-K for the year ended June 30, 2020, Form 10-Q for the quarters ended September 30, 2020, December 31, 2020, and March 31, 2021, and the exhibits attached to those filings.

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

I will now turn the call over to Tony.

[Tony Thene, President and Chief Executive Officer]

Thank you, Brad, and good morning to everyone on the call this morning. Let's begin on Slide 4, a review of our safety performance. For fiscal year 2021, our total case incident rate was 0.6, marking the best fiscal year safety performance on record.

Today, Carpenter Technology is one of the safest manufacturing companies in the United States. However, our ultimate goal is a zero-injury workplace. The continued progress we made in fiscal year 2021 was due to our focus on fundamental safety programs, including hand safety, human performance, leadership development and employee engagement activities.

In fiscal year 2022, we plan to build upon the momentum and take our next step towards a zero-injury workplace. Now, let's turn to Slide 5 and a review of the fourth quarter.

Our fourth quarter results finished ahead of our expectations. The results reflect our efforts to position ourselves to capitalize on the emerging recovery and market opportunities. While the recovery remains in the early stages and varies by end-use market, we are encouraged by the market signals we are seeing.

We saw demand conditions improve sequentially across our major end-use markets, including Aerospace and Defense and Medical. During the quarter, we continued to execute a strategy focused on driving liquidity, strengthening key customer relationships and advancing our manufacturing capabilities. We generated free cash flow of $43 million and for the full-year delivered free cash flow of $132 million, quite an accomplishment when many in the industry burn through cash during the market downturn.

We finished the fiscal year with $582 million in total liquidity, including $287 million in cash. Customer engagement around Athens remains high as we continue to broaden our capabilities and customer base. Notably, we received another important qualification during the quarter. The Athens facility will be a competitive differentiator for Carpenter Technology as industry build rates rise and lead times begin to extend.

In addition, I'm excited to share that our hot strip mill at our Reading campus recently completed its commissioning. The timing for the strip mill coming online is ideal. As prior to the pandemic and now into the recovery, we have seen and continue to see steady growth from existing applications, like high-temperature engine gaskets, fasteners and electrification applications, including motor-stack laminations for auxiliary power units and generators.

The mill significantly strengthens our soft magnetics capabilities and production capacity at a time when electrification is increasingly disrupting major end-use markets. The higher frequency motors being used for electrification requires thinner strip, which is more challenging to produce. As these markets grow, enhanced thin, flat-rolled product capabilities would become increasingly critical to overall system performance.

The productivity, quality and consistency of our new hot strip mill will create an advantage for Carpenter Electrification, motor stacks assembled from the thin laminations. We are already producing materials to support new [eviation] [ph] motors that are in the process of FAA certification.

We are also producing products for sensors and resistors that are now in newer more advanced electric vehicle electronic systems. Now, let's move to Slide 6 and the end-use market update. As I mentioned earlier, we are seeing increasing signs of recovery across our end-use markets. We continue to believe the worst is behind us. And that demand conditions across end-use markets will further improve as we move through fiscal year 2022.

Our Aerospace and Defense market sales were up 21% sequentially, and a growing number of our customers are pointing to further demand acceleration in early calendar year 2022. Activity in the defense submarket continues to be strong and we are generating increased interest in our advanced materials as customers source for new programs.

In the medical end-use market, sales were up 22% sequentially. Elective procedures volumes increased in the fourth quarter as patient sentiment and hospital capacity continue to improve due to higher global vaccination rates. Conditions continue to vary by region depending on COVID-19 concerns and the impact on procedures.

Results in our orthopedic and cardiology submarkets were also strong and we began to see increased stocking activity in the distribution channels. Looking ahead, our customers expect order rates and backlog to show further improvement in the current quarter as the overall market continues to ramp in support of the ongoing recovery in elective surgeries. It is predicted that orthopedic procedures will reach 85% to 90% of pre-pandemic levels in the coming quarter.

Cardiovascular procedures will reach 80% to 85% of pre-pandemic levels. Although, the emergence of the delta variant could soften the elective surgeries increase in some areas. We had been delivering consistently strong growth in our medical end-use market prior to the pandemic and believe it will return to being one of our fastest-growing markets post-pandemic.

In the transportation end-use market, sales were up 25% sequentially and 111% compared to last year. The global light vehicle production forecast for calendar year 2021 remains robust. And we achieved record shipments for heavy-duty truck applications in the quarter due to increasing demand for our exhaust valve solutions. We continue to see market share growth opportunities in both the light vehicle and heavy-duty truck submarkets and continue to further penetrate key market adjacencies, including off-road, marine and aftermarket.

Now moving to the energy end-use market. In the U.S. oil and gas submarket, we are seeing initial signs of recovery, but the pace is measured. The international markets have largely stabilized and the outlook is becoming more positive. As a reminder, the prior year fourth quarter results included our Amega West business that was divested early in fiscal year 2021. In the power generation submarket, we are working closely with customers as the maintenance upgrade cycle continues.

Lastly, for the industrial and consumer end-use market, sales were up 21% on both a sequential and year-over-year basis. Growth for both periods was driven by historically high demand for our semicon solutions, recovery in industrial distribution as well as increased consumer electronics demand.

Now, I will turn it over to Tim for the financial review.

[Timothy Lain, Chief Financial Officer]

Thanks, Tony. Good morning, everyone. I'll start on Slide 8, the income statement summary. Net sales in the fourth quarter were $421.6 million, and sales excluding surcharge totaled $348.1 million. Sales excluding surcharge increased 17% sequentially on 27% higher volume. Compared to the fourth quarter a year ago, sales decreased 7% on flat volume. As Tony covered in his review of the end-use markets, we continue to see signals of improving demand conditions across most of our end-use markets.

SG&A expenses were $47.9 million in the fourth quarter, up $6 million from the same period a year ago and relatively flat sequentially. The year-over-year increase reflects higher amortization costs related to the ERP system that was placed in service during fiscal year 2021 and higher accruals related to certain incentive compensation programs. These items were partially offset by the actions we took to reduce costs, including the elimination of certain salary positions late last fiscal year.

The current quarter's operating results included $58.2 million of special items, which include the following. First, $52.2 million of LIFO decrement charges, about $48 million of this charge is included in the SAO segment's results with the remainder or $4 million related to our Dynamet business within the PEP segment. The LIFO decrement charge is due to our significant reduction of inventory. As required, we recorded a non-cash charge to reflect the liquidated historical LIFO layers that are well above current inventory costs.

Second, $2.9 million of COVID-19 costs, which are in line with the $2.7 million of COVID-19 costs incurred in our recent third quarter; as a reminder, these costs include direct incremental operating costs, such as outside services to execute enhanced cleaning protocols, isolation pay for employees potentially exposed to COVID-19 and additional personal protective equipment and other operating supplies necessary to maintain our operations, while keeping employees safe against possible exposure.

Third, the current quarter special items include about $3 million of restructuring and asset impairment charges. The restructuring and asset impairment charges, including inventory write-downs, are associated with executing the near final steps against our planned actions to reduce costs and narrow focus in our additive business unit within our PEP segment.

The operating loss was $70.7 million in the current quarter. While excluding the impact of the special items, I just highlighted, adjusted operating loss was $12.5 million in the current quarter compared to $8.9 million in the prior year period and $29.7 million in the third quarter of fiscal year 2021. Again, the current quarter's results exceeded the expectations we set at the beginning of the quarter and reflect the impact of higher-than-anticipated shipments, coupled with our continued focus on cost controls.

Our effective tax rate for the fourth quarter was 27.7%. Earnings per share for the quarter was a loss of $1.18 per share, when excluding the impact of special items, adjusted earnings per share was a loss of $0.28 per share.

Now turning to Slide 9 and our SAO segment results. Net sales for the quarter were $361.5 million or $289.9 million excluding surcharge. Compared to the fourth quarter last year, sales excluding surcharge decreased 6% on 3% higher volume. Sequentially, sales excluding surcharge increased 18% on 28% higher volume.

The sequential sales improvement reflects higher sales across all end-use markets other than energy. The largest contributor to the sequential sales growth was aerospace and defense, where sales were up 20% sequentially. Other than energy, all other end-use markets reported sales up sequentially 20% or higher.

SAO reported an operating loss of $47.3 million for the current quarter. The same quarter a year ago, SAO's operating income was $5.3 million and in the third quarter of fiscal year 2021, SAO reported an operating loss of $9.9 million. It's important to note that the current quarter's operating results for SAO include $47.9 million related to the LIFO decrement charge I mentioned earlier and also include $2.1 million of COVID-19 costs. When excluding those 2 items, SAO would have reported operating income of $2.7 million.

Again, excluding the impact of the LIFO decrement and COVID-19 costs, the sequential improvement in operating income performance is due primarily to the higher sales. Also of note, excluding the impact of the non-cash LIFO decrement charge, SAO reduced inventory by $47 million in the current quarter and for the full fiscal year 2021, SAO reduced inventory by $193 million.

Looking ahead, we expect that demand conditions across most end-use markets will continue to improve. Based on current expectations, we anticipate SAO will generate a similar sequential operating income performance in the first quarter of fiscal year 2022. For clarity, I want to highlight a couple of key points in this guidance. First, this estimate includes similar sequential COVID-19 related costs in the upcoming first quarter. And second, we do not expect any further LIFO liquidation impacts at this time.

The anticipated results, taking into account our continued focus on managing costs closely as activity levels begin to normalize as the broader market recovery takes shape, and we execute against our planned annual maintenance shutdowns, which are critical to ensure our operations can meet future anticipated demand.

Now, turning to Slide 10 and our PEP segment results. Net sales excluding surcharge were $75.6 million, which were essentially flat from the same quarter a year ago and up 16% sequentially. It's important to note that sales were essentially flat year-over-year, despite the fact that the same quarter of last year included sales associated with our Amega West business that was divested in the first quarter of fiscal year 2021. The year-over-year growth, excluding Amega West was driven primarily by growth in our additive sales as well as improving demand conditions in our distribution business.

The sequential increase in sales reflects increased demand for titanium materials used in the aerospace and defense, and medical end-use markets. In addition, our additive business drove a sequential increase in sales as demand conditions continue to improve. In the current quarter, PEP reported an operating loss of $2.3 million. This compares to an operating loss of $8.4 million in the same quarter a year ago, and an operating loss of $3.3 million in the third quarter of fiscal year 2021.

For clarity, the current quarter's results include a $4.3 million LIFO decrement charge associated with our Dynamet business unit. Excluding that LIFO decrement charge, operating income for the current quarter would have been $2 million. The sequential operating results reflect the favorable impacts of higher volumes.

The year-over-year results reflect the benefits of the portfolio actions we have taken over the last several quarters, particularly focused on reducing cost in our additive business unit and the divestiture of Amega West business earlier this fiscal year. As we look ahead, we believe that demand conditions will continue to improve in the coming quarters.

With that said, given some of the same dynamics that SAO faces, some planned summer shutdowns in Q1 for both us and our customers, we currently anticipate PEP will generate operating results of breakeven to a $2 million loss in our upcoming first quarter. Also, as I mentioned for SAO, the PEP guidance includes COVID-19 costs, largely in line with the fourth quarter.

Now, turning to Slide 11 and a review of free cash flow. In the current quarter, we generated $75 million of cash from operating activities and a total of $250 million for the full fiscal year. As you can see within the cash flow generated from operations, we continue to reduce inventory. In the current quarter, we drove a $57 million reduction.

For all of fiscal year 2021, we reduced inventory by just under $240 million. Moving down, we funded the minimum required pension contributions to our qualified pension plans of $20 million as planned for fiscal year 2021. In the fourth quarter, we spent $22 million of capital expenditures and finished the year with just over $100 million of capital expenditures.

We finished the year with lower capital spending than expected, largely as a result of our concentrated efforts to complete the hot strip mill project and the lack of availability of contractors and other resources to start certain projects. We also continue to fund a constant dividend to our shareholders, which we consider as part of our free cash flow.

We continue to highlight that we have paid a regular dividend to our shareholders despite the market headwinds. This was an important signal to our shareholders of our conviction in the long-term outlook for our business as well as our desire to continue to return value to our shareholders.

With those details in mind, we generated $43 million of free cash flow in the quarter and $132 million for the year. From a liquidity perspective, we ended the current quarter with total liquidity of $582 million, including $287 million of cash and $295 million of available borrowings under our credit facility.

With that, let's move to Slide 12 to talk about selected fiscal year 2022 guidance. We're providing the selected information to help for modeling the current fiscal year. Depreciation and amortization is expected to increase from $124 million in fiscal year 2021 to $135 million in fiscal year 2022. The increase reflects a full year of amortization related to the new ERP system that we implemented in fiscal year 2021 as well as a full year of depreciation for the hot strip mill that was recently placed in service.

We expect to spend about $125 million in capital expenditures in fiscal year 2022. At this level, we'll spend the required amounts for maintenance type CapEx, but this also allows us opportunities to make targeted investments in growth areas as well as expand capacity in certain constrained flow paths.

Moving to minimum required pension contributions. In fiscal year 2021, as I mentioned, we contributed $20 million to our qualified pension plans. With the enactment of the American Rescue Plan Act of 2021 in March of 2021, our minimum pension contributions are effectively eliminated for fiscal year 2022. For non-cash net pension expense as a result of favorable asset returns and slightly higher discount rates, we expect net pension expense to decline by $21 million and move from $13 million of net pension expense to net pension benefit of $8 million in fiscal year 2022. For clarity, the fiscal year 2021 number on the slide excludes $11.4 million of pension settlement charges recorded in fiscal year 2021.

Next, interest expense is estimated to increase from $33 million in fiscal year 2021 to $41 million in fiscal year 2022. The increase is driven largely by lower capitalized interest due to the completion of several large multiyear projects in the current fiscal year.

Lastly, the effective income tax rate. For fiscal year 2021, our reported effective tax rate was about 23%. However, when excluding the impact of special items, the fiscal year 2021 rate was about 29%. For fiscal year 2022, we expect the effective rate to be 28% to 30%.

With that, I will turn the call back over to Tony.

[Tony Thene, President and Chief Executive Officer]

Thanks, Tim. Let's turn to Slide 14 in my closing remarks. The last year has been a challenging, but successful year for Carpenter Technology. In navigating the pandemic, we have strengthened our company to best capitalize on the coming recovery. With respect to our facilities and employees, fiscal year 2021 was the safest in the history of the company, despite operating in unprecedented conditions. In terms of managing our business, we moved quickly to execute various portfolio initiatives and cost reduction programs, which will deliver between $60 million and $70 million in annualized cost savings.

In addition, we have been relentlessly implementing the Carpenter operating model across key work centers and have secured notable productivity gains. We also focused on driving liquidity and finished the fiscal year 2021 with total liquidity of $582 million including $287 million in cash. Our enhanced operations and strong financial position will provide us with increased flexibility as we look to best capitalize on market opportunities and the overall recovery as it continues to take shape.

We also expect to benefit from our Athens facility, as the incremental capacity it offers the aerospace market as production levels rise and industry capacity begins to tighten. We have meaningfully expanded and strengthened key customer relationships during the downturn. We have worked closely with our customers to address their changing material needs and production schedules, and demonstrated that Carpenter Technology is both a critical solutions provider as well as a valued business partner.

We remain a market leader in our core business, where we have provided mission-critical solutions to the world's largest industries for more than 130 years. In addition, we have invested in emerging areas like our soft magnetic portfolio, as electrification is a major trend moving forward.

As I said last quarter, the worst is behind us and the recovery has started. And while different recovery timelines across our end-market will continue to influence our shorter-term quarter-to-quarter performance, we are excited about the mid-term and longer-term outlook.

Thank you for your time. And now, I will turn it over to the operator to take your questions.

[Operator]

Yes, thank you. At this time, we will begin the question-and-answer session. [Operator Instructions] And the first question comes from Gautam Khanna with Cowen.

[Gautam Khanna, Cowen]

Yeah, so thanks. Good morning, guys.

[Tony Thene, President and Chief Executive Officer]

Yeah, good morning.

[Gautam Khanna, Cowen]

I was wondering, at SAO there was mention of some closeouts in the quarter, benefiting sales and profits. Any way you can quantify that?

[Tony Thene, President and Chief Executive Officer]

Not to the exact number, Gautam. But we just wanted to mention that there was some of that a year ago when we work with our customers to delay some shipments. We trued that up in this quarter here. So not overall significantly material, but it was one of the drivers to higher sales in the quarter.

[Gautam Khanna, Cowen]

Okay. And the commentary around the fiscal Q1 SAO being similar to Q4. I was curious, what are you seeing in the aerospace like backlogs, where are you seeing demand picking up? Is it engines, is it fasteners, is it structures? How can you characterize sort of what's been going on in that channel?

[Tony Thene, President and Chief Executive Officer]

Well, I can say, if you look forward and why we're confident is a couple of data points. Overall, our total backlog is up 20% sequentially. And that's across all of our end-use markets, different percentages, but all of our end-use markets, the backlog is increasing.

Bookings sequentially were up 14%. Some markets higher than that. For example, in medical that had very strong bookings in the quarter and lead times are extending across the board as well. So, as you look at all those things start to come together, it gives you a very positive outlook. Now, it's fair to say that not all customers are at the same point.

We have some customers that are ordering right now for immediate needs. We have other customers that are telling us, “Hey, I have got another 30, 60, 90 days of inventory I need to burn through.” So they're all at different points in time. But as I said, overall, when you take a look at lead times, bookings and backlogs and orders, it points to a pretty clear signal that we're moving forward.

[Gautam Khanna, Cowen]

And any meaningful differences between engines, fasteners and structural components?

[Tony Thene, President and Chief Executive Officer]

In terms of sales, sales backlog?

[Gautam Khanna, Cowen]

In terms of demand or orders, demand lead times?

[Tony Thene, President and Chief Executive Officer]

Yeah, sales, on the sales side, engines were strong, they were up 26% sequentially. Fasteners were down a bit. But as you all know, that can be up and down. But if you look at it from a backlog standpoint, all of the submarkets in aerospace was up except structural, which was flat quarter-over-quarter. And then, if you look at bookings, we had bookings were up slightly in aerospace and some mixing differences inside the submarkets.

[Gautam Khanna, Cowen]

Okay. And lead-times in general, I imagine the fastener lead-times are short, but how are they trending in engines?

[Tony Thene, President and Chief Executive Officer]

I would, if I remember correctly, yeah, if I remember correctly, last quarter I said that engines for us were about 10 to 12 weeks. We track pretty closely with the others in the industry, maybe a couple of weeks here or there difference. And if you look at this quarter, lead times roughly are extended 50%, 60%. So several weeks push out on the lead times.

And I've said this, Gautam, every quarter. That's going to continue. Prior to the pandemic, we were at roughly 52 weeks. And here we are, I say 10 to 12, last quarter, you're in the high teens, maybe this quarter. That's going to continue to increase as more and more customers start placing those increased orders.

[Gautam Khanna, Cowen]

Yes, thank you very much. I appreciate it.

[Tony Thene, President and Chief Executive Officer]

Yeah, thanks, Gautam. Have a good day.

[Gautam Khanna, Cowen]

Thank you.

[Operator]

Thank you. Thank you. [Operator Instructions] And the next question comes from Michael Leshock with KeyBanc Capital Markets.

[Michael Leshock, KeyBanc Capital Markets]

Hey guys, good morning.

[Tony Thene, President and Chief Executive Officer]

Yeah, good morning.

[Michael Leshock, KeyBanc Capital Markets]

So, first, I just wanted to ask about your current inventory levels. Do you feel comfortable with where they're at now? Or should we expect further destocking in the first quarter? Or do you see any benefit from inventory absorption going forward?

[Tony Thene, President and Chief Executive Officer]

Yeah, it's a good question. Thanks for asking. I think that we spent the last year really diving deeper into the Carpenter operating model, to get our inventories at a lower rate overall. So when you look at days on hand overall, we want that number to be lower going forward.

Prior to the pandemic, we consciously moved our inventories up, because again we were at 52 week lead-times. We wanted to supply our customers. We were melting non-stop, right? And we invested in our customers and put that into inventory. We were allowed to balance that more during this pandemic.

So as we go forward, I do not see us going back to those higher inventory levels, because we've taken some corrective actions. Now, will every quarter be a step down? No. You could see quarters over the next year or two, where we build a little bit of inventory, because of some specialized situation. But overall, going forward, our inventories will stay flat, and we believe that we still have some opportunity to take them down over a longer period with - hopefully, that helps out.

[Michael Leshock, KeyBanc Capital Markets]

Yeah, that's helpful. And then, on different platforms, do you see some platforms that are destocking more or less than others within aerospace, whether that be by platform or by product. But I just want to know what opportunities do you see are there to ship more upon the recovery, given some of the supply chain inventory levels?

[Tony Thene, President and Chief Executive Officer]

Well, as you know, we're on all of the platforms. So whichever ones are coming back quicker or slower for us, the demand is still there. So like I said, if you just take a look at the lead times in the backlog and the bookings across the entire aerospace industry right now, that's pretty compelling data that says we're moving forward in this recovery.

I do think it's important to note that over the next couple of quarters, even when I say that you have the positive trend moving forward, it could be lumpy in the aerospace market. You could see a quarter where engines are down a couple of points going forward. And that's nothing to be alarmed about. I think if you look at it year-over-year though, you're going to see positive increases going forward.

And what we are saying on the call today lines up spot on to what you're hearing from other manufacturers in the industry that have released earnings recently or talked external recently. So I think we're right in line with what you're hearing other people in the industry saying.

[Michael Leshock, KeyBanc Capital Markets]

Got it. Appreciate the color. Thanks, guys.

[Operator]

Thank you. And this concludes the question-and-answer session. I now like to turn the conference back over to Brad Edwards for any closing comments.

[Brad Edwards, Investor Relations]

Thanks, Keith. Thank you, everyone, for joining us today for our earnings conference call. We look forward to speaking with all of you again in the near future. Enjoy the rest of your day and have a great summer.

[Operator]

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