Carpenter Technology Corporation (NYSE:CRS) Q1 2021 Earnings Conference Call

October 22, 2020 10:00 AM ET

Company Participants

Brad Edwards � Investor Relations

Tony Thene � President and Chief Executive Officer

Tim Lain � Vice President and Chief Financial Officer

Conference Call Participants

Gautam Khanna � Cowen

Josh Sullivan � The Benchmark Company

Phil Gibbs � KeyBanc Capital Markets

Chris Olin � Tier4 Research

Operator

Good morning and welcome to the Carpenter Technology Corporation First Quarter
Fiscal 2021 Conference Call. All participants will be in a listen-only mode.
[Operator Instructions] After today's presentation, there will be an opportunity to
ask questions. Please note, this event is being recorded.

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

Brad Edwards

Thank you, operator. Good morning, everyone, and welcome to the Carpenter
Technology earnings conference call for the fiscal 2021 first quarter ended
September 30, 2020. 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, 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, and the exhibits attached to
that filing.

Please also note that in the following discussion, unless otherwise noted, when
management discusses 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

Thank you, Brad, and good morning to everyone. As we always do, let's start with a
review of our safety performance on Slide number 4. Our total case incident rate or
TCIR was 0.4 in the first quarter. This marked our lowest quarterly TCIR rate ever
recorded. In addition, we achieved our first official injury-free month in the
company�s 131 year history during the month of September. A zero-injury workplace
is possible and we look forward to achieving our next milestone on our way to zero.

Before moving on, I want to take a minute to recognize and thank all of our
employees for their ongoing hard work and commitment during these unprecedented
times. All of our facilities remain open and operating safely, which is a
tremendous accomplishment. Our team has done a remarkable job of building on our
core safety value and protecting each other and the communities we�re operating in,
while at the same time staying focused on serving our customers.

Now let's turn to Slide 5 and review the first quarter. Our first quarter operating
performance was in line with our previous guidance as demand headwinds across their
end-use markets continue to be the driving factor. Given the current environment,
demand weakness is difficult to offset. However, as I stated before, our primary
focus is staying cash flow positive. We have taken significant actions which
enabled us to continue our strong cash generation performance in Q1.

In the first quarter, we generated $63 million of free cash flow and ended the
first quarter with over $600 million in total liquidity, including $219 million of
cash. In addition, we completed a bond offering that extended our maturities
profile and provides us additional financial flexibility as we navigate the current
environment. We have ample liquidity to continue managing through the COVID-19
pandemic.

In the first quarter, we completed the divestiture of our Amega West oil and gas
business and took additional restructuring actions in our additive business unit to
streamline operations and reduce costs. At the same time, we are pushing forward
with our long-term growth initiatives and balancing our actions to ensure that we
emerge in an even stronger market position with our customers.

This includes our Athens facility, which remains a key long-term growth driver and
differentiator for Carpenter Technology. We continue to collaborate with customers
and make progress on achieving key additional qualifications for the facility. In
addition, we further strengthen our capabilities in critical emerging technologies.
Most recently, there's a launch of our Carpenter Electrification brand.
Electrification is a rapidly growing area of focus across our end-use markets. And
we believe our material solutions can help customers drive enhanced performance for
the products. Our new hot strip mill installation is nearing completion, which will
enable us to further excel in our capabilities in this emerging area.

Now let's move to Slide number 6 and the end-use market update. Let me spend a
little more time than usual on this slide as I anticipate, most of the questions
will be focused on market dynamics, especially in the Aerospace and Defense end-use
market. Starting with the Aerospace and Defense end-use market, and specifically
the aerospace sub-market, the supply chain continued to adjust to revise forward
build rates and a lowered demand environment. Most supply chains continue to be
over inventory and OEMs continued the process of adjusting inventory levels across
the supply chain during the quarter.

Individual customers reported ongoing destocking at various rates. Many customers

continue to report refusals of obligations throughout the supply chain and several
customers, especially in Europe had longer than normal extended shutdowns. We
continue to closely with all of our customers and finalized commercial discussions
with many, regarding forward sales arrangements. Lower depressed levels we
continued to secure and support areas of real demand.
Cancellation and deferral request while not altogether behind us did decline in the
quarter. Direct bookings were relatively flat, no stock shipment activity declined
as customers had lowered consumption requirements versus stock contracts. In our
fiscal second quarter, we expect customers to continue to work through destocking
requirements. While we have seen an uptick of demand activity in some limited
areas, most customers continue to report significant amounts of inventory.

At the extreme, some customers report over 12 months of inventory at the current
shipment levels for certain parts. On the other end, some customers are beginning
to discuss restocking at very limited levels. During our second quarter, we are
continuing to support near-term customer needs and are also in negotiation with key
customers, developing mutually beneficial outcomes in both the mid and long-term.

As credit has become an increasing concern with some of our customer base. We are
also closely monitoring and adjusting to customer financial situations as
necessary. Concerning our defense sub-market, we continue to see steady activity
standing in contrast to commercial aerospace.

Many of our customers involved in commercial aerospace are also involved in defense
and some customer locations report defense work as the main activity that is
currently sustaining their operations. Some of the defense programs we support are
seeing increased activity and we are working to support these accordingly. We
continue to be involved in new platform design and prototyping and remain excited
about our long-term growth.

Let's turn to our Medical end-use market. From a macro perspective, as it relates
to trends in elective procedures, hospitals reported a gradual recovery of
procedures beginning of fiscal Q1 if recovery expected to continue. Medical device
companies acknowledged this gradual return of elective surgeries during fiscal Q1,
but are continuing to manage inventory levels downwards and only reordering
necessary materials to replace critical needs.

We expect destocking efforts to level off within our fiscal Q2 at both OEMs and
distributors that support the medical device market. In the Transportation end-use
market, sales increased 42% sequentially, but we're down on a year-over-year basis.
Global light-duty vehicle production rebounded across most global markets.

In North America, we believe the light vehicle market is currently on track to

recover and come close to reaching pre-pandemic levels in calendar year 2021.
Overall, competencies returning to the supply chain and we believe we can benefit
given the unique value, our high temperature solutions deliver.

In the heavy-duty trucks sub-market, we began to see signs of recovery of

historical low levels due in part to cyclical timing, but also increased freight
demand. Now moving to the Energy end-use market, where conditions in North America
remain challenged and drilling activity is at severely depressed levels.
International market has held up better due to longer project cycle lead time or
current activity levels are low.

In the power generation sub-market within Energy. We are seeing some signs of
increased activity related to a delayed maintenance cycle, but a potential uptick
remains in the early stages. Lastly, for the Industrial and Consumer end-use
market, sales were up both year-over-year and sequentially. Industrial sales were
driven by continued strong demand for our semiconductor and control applications.

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

Tim Lain

Thank you, Tony. Good morning, everyone. I'll start on Slide 8, the income
statement summary. Net sales in the first quarter were $353 million and sales
excluding surcharge, totaled $307 million. Sales excluding surcharge decreased 18%
sequentially on 8% lower volume, compared to the first quarter a year ago, sales
decreased 37% on 29% lower volume.

As Tony covered in his review of the end-use markets, the results reflected ongoing
demand impacts driven by COVID-19 headwinds in our key end-use markets of Aerospace
and Defense and Medical. This was partially offset by increased sequential demand
in transportation, as North American vehicle production rebounded, albeit off a low
base from the COVID-19 related shutdowns in Q4.

As we've mentioned, since the beginning of the pandemic, we continue to actively

manage our production schedules and focus on accelerating a targeted inventory
reduction program. While the reduction in inventory drives near-term cash flow
generation, which I'll talk about shortly, it negatively impacts our operating
income performance.

SG&A expenses were $42.3 million in the first quarter, down $11 million from the
same period a year ago, and flat sequentially. The lower year-over-year SG&A
expenses primarily reflect the impacts of restructuring actions, including the
elimination of salary positions, salary furloughs, as well as the impact of remote
working conditions that reduce certain administrative costs such as travel and
entertainment.

The current quarter�s operating results includes $17.9 million of special items.
This includes $10 million of restructuring charges, including severance costs, non-
cash asset impairment charges and lease acceleration costs. These costs are
principally associated with actions that we initiated in the current quarter to
reduce costs and streamline operations in our additive business unit.

The special items also includes $7.9 million in COVID-19 related costs, included in
these costs are direct incremental operating costs, including 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 and costs necessary to maintain the operations while keeping the
employees safe against possible exposure.

The COVID-19 costs in the current quarter also include $3.1 million of costs
associated with a customer bankruptcy, resulting from the COVID-19 pandemic. The
operating loss was $48.8 million in the quarter. When excluding the impact of the
special items, adjusted operating loss was $30.9 million, compared to operating
income of $59.8 million in the prior year period and an adjusted operating loss of
$10.7 million in the fourth quarter of fiscal year 2020.

Again, the current quarter�s results reflect the impact of significantly lower
volume combined with the targeted inventory reduction. Our effective tax rate for
the first quarter was 28.6%. The income tax benefit was below our full year tax
rate guidance as a result of the discrete tax impact of the special items, as well
as $1.2 million discrete tax charge associated with certain stock-based
compensation awards vesting in the quarter. Earnings per share for the quarter was
a loss of $0.98 per share, when excluding the impacts of special items, adjusted
earnings per share was a loss of $0.58 per share.

Now turning to Slide 9 and our SAO segment results. Net sales for the quarter were
$300.7 million, or $254.8 million excluding surcharge. Compared to the first
quarter of last year, sales excluding surcharge decreased 35% on 28% lower volumes.
Sequentially, sales excluding surcharge decreased 17% on 6% lower volume. The
results reflect ongoing demand headwinds in Aerospace and Defense as the supply
chain continues to deal with the near-term reductions in OEM build rates. This is
partially offset by stronger shipments and transportation as North American
production returned from COVID-19 related shutdowns and by higher demand in certain
industrial applications,

SAO reported an operating loss of $18.6 million for the current quarter. The same
quarter a year ago, SAO�s operating income was $81 million and in the fourth
quarter of fiscal year 2020, SAO generated $5.3 million of operating income. A
year-over-year reduction in operating income primarily reflects the impacts of
lower volume, as well as the negative income statement impact of reducing
inventory.

To note, during the quarter SAO reduced inventory by approximately $73 million,
sequentially, the lower operating income results is principally the result of lower
volume as well as the impact of an unfavorable product mix due to the pronounced
decline in Aerospace and Defense. In addition, the current quarter�s results
reflect approximately $7.3 million of direct incremental costs associated with our
efforts to protect our facilities and employees against COVID-19. And as I
mentioned earlier, also includes $3.1 million of cost associated with a customer
bankruptcy directly resulting from COVID-19.

Looking ahead, we expect demand conditions across most end-use markets will remain
challenged in our upcoming second quarter of fiscal year 2021. As we have stated
before, we anticipate that the demand environment across our key end-use markets
will stabilize and begin to recover as we enter the second half of our fiscal year
of 2021. In response to current market conditions, we continue our focus on
managing costs and further enhancing our liquidity position via working capital
management. Based on current expectations, we expect SAO to generate an operating
loss of approximately $18 million to $23 million in the second quarter of fiscal
year 2021. This estimate includes $3 million to $4 million of COVID-19 related
costs in the quarter.

Now turning to Slide 10 and our PEP segment results. Net sales, excluding surcharge
were $61.2 million, which were down 43% from the same quarter a year ago and down
20% sequentially. The year-over-year decline in sales was driven by the impacts of
lower demand as a result of COVID-19, particularly in Aerospace and Defense,
Medical and Distribution. Additionally sales and the energy end-use market declined
as a result of our exit of the Amega West oil and gas business.

The sequential decline in sales follows the themes covered in the market summary.
Ongoing near-term demand pressures in Aerospace and Defense and Medical are due
primarily to the impacts of the global pandemic and its impact on aircraft OEM
build rates and medical elective procedures. The bright spot was in our
distribution business, where we fell a sequential increase in sales off the
relatively low bates. In the current quarter PEP reported an operating loss of $3.6
million, this compares to an operating loss of $8.4 million in the fourth quarter
of fiscal year 2020, and an operating loss of $2 million in the same quarter last
year.

The sequential operating results reflect the unfavorable impacts of lower volume
driven primarily by COVID, offset by some savings realized from the actions we
initiated over the last several quarters, both in our additive business unit and
the recent divestiture of our Amega West oil and gas business. The approach to
reducing costs in additives has been bounced and that we recognized the importance
of being innovative in this business and remain excited about its long-term future
prospects. With that approach in mind, we took action to rationalize our footprint
and infrastructure, and we have identified areas where we can reduce costs without
affecting our ability to capitalize on the anticipated long-term growth
opportunities. As we look ahead, we currently anticipate PEP will generate an
operating loss of $3 million to $5 million in our upcoming second quarter.

Now turning to Slide 11 and a review of free cash flow. In the current quarter we
generated $88 million of cash from operating activities. This cash generation was
driven by improvements in working capital, primarily inventory. Within the quarter,
we decreased inventory by $85 million with a bulk of the inventory reduction coming
from SAO. This reduction is substantial and the result of considerable effort
throughout the organization to accelerate targeted inventory reduction programs
across our facilities.

It's worth noting that we also reduced inventory by $117 million in the fourth
quarter of fiscal year 2020. That's a reduction of over $200 million of inventory
in the last two quarters. We remain in constant communication with our key
customers to ensure that we maintain the appropriate inventory and lead times are
aligned as demand patterns change. In the first quarter, we've spent $33 million on
capital expenditures. We remain on track to spend about $120 million in capital
expenditures for fiscal year 2021 as planned.

As a reminder, within the $120 million planned for fiscal year 2021, it�s the
completion of the multi-year $100 million hot strip mill project to support growing
demand for our soft magnetics materials. Tony will speak to the importance that
this new hot strip mill, we�ll have to further enhance our leading position in the
emerging area of electrification. We are also nearing the completion of a large
scale ERP system implementation that is expected to be operational in the second
half of this fiscal year.

In addition, as I mentioned previously, we completed the divestiture of our Amega

West oil and gas business. We are pleased that we could complete this transaction
and realize $18 million of proceeds in our current quarter. With those highlights
in mind, we generated $63 million of free cash flow on the quarter. From a
liquidity perspective, we ended the current quarter with a total liquidity of $613
million, including $219 million of cash and $394 million of available borrowings
under our credit facility.

The increased liquidity reflects the cash flow generation in the quarter, as well
as the debt refinancing we completed in the quarter, in which we issued $400
million of notes and use the proceeds to repay the $250 million of notes that were
due to mature in July of 2021. For reference the net incremental cost of
extinguishing the notes of $8.2 million is included in our reported interest
expense for the quarter and it's treated as a special item net of tax, when
calculating adjusted EPS.

Our focus on the liquidity is essential in the near-term, as we work our way
through the temporary market disruptions brought on by COVID-19 in our end-use
markets. Our thoughtful approach to capital allocation over the years, as well as
the actions we have taken since the onset of the pandemic have been critical and
will enable us to exit this latest challenge even stronger than we entered.

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

Tony Thene

Thanks, Tim. Moving to Slide number 13. Our key priorities in the near-term
continue to be safeguarding our facilities and employees, maintaining the liquidity
and working closely with our customers. While our near-term focus is centered on
the execution of those priorities, you cannot turn a blind eye to our future, and
the future needs of our customers. During this long history, Carpenter Technology
has weathered many downturns, both cyclical and macroeconomic driven, and each time
emerged on the other side, a stronger company.

Despite these unprecedented times, we believe we have that opportunity again.

Today, we remain focused on innovation and creating unique solutions that address
evolving industry trends and customer material requirements. To that end during the
first quarter, we launched our Carpenter Electrification brand. Electrification is
an exciting trend that is changing the way we live in and move around our world.
Part of this movement involves electric motors and generators, which are replacing
combustion engines in vehicles. This is where Carpenter Electrification plays a
significant role.

We foresee a rapid increase in the use of electric motor and generator systems in a
wide variety of mobility applications. The electric motor is now a well established
technology for passenger cars. Electric vehicles have been rapidly gaining in
popularity over the last five years and are now a reliable alternative to internal
combustion engines. This trend is beginning to take hold in other markets as well,
new commercial aircraft already using more onboard electricity to power their
systems than ever before.

We have seen an increase in hybrid and electric aircraft designs and prototypes
over the last few years. In addition, we see similar trends in the defense industry
and other markets that rely on mobility and miniaturization, such as drones,
autonomous robot and consumer electronics applications. In cars, aircraft, and
other mobility applications, size and weight are always issues that must be
considered for overall performance.

Vehicle designers are increasingly turning to more powerful and efficient motors,
that must also be small and light. Improve system designs and new technologies that
will deliver the performance improvements needed for future applications. New
designs are using advanced state of the art materials to achieve optimal
performance. Our high induction, high formability and low loss soft magnetic alloys
are delivering performance benefit, miniaturization and product development
flexibility.

As product manufacturers push the boundaries of performance for electrification,

they need stronger technology partners. Applications and testing support are
increasingly important, as companies work to optimize their product designs. They
also need a reliable and streamlined supply chain and partners that can scale with
them from prototype to production. With our high performance soft magnetic alloy
portfolio, technical expertise and advanced production capabilities, Carpenter
Electrification is uniquely positioned to help electronics, motor and vehicle OEM,
bring new electrification solutions to the world.

With the technology and market demand that had backdrop, we remain excited about
the completion of the hot strip mill installation on our Reading campus. This
project once completed later this fiscal year will provide us with significant
capability and critical capacity to service this growing opportunity.

Now let's turn to the next slide with my closing comments. Our first quarter
performance was as anticipated, given volume and cost headwinds related to COVID-
19, as well as our focus on driving and preserving liquidity in the near-term.
Looking ahead, we expect market conditions will remain largely challenging, but do
anticipate some recovery in the second half of fiscal year 2021. We've chosen not
to simply sit back and wait for market conditions to improve. Better we continue to
actively manage our organization and align our cost structure and business
activities with evolving in used market conditions.

We've taken significant action since the start of the pandemic to reduce costs and
generate cash flow. These actions include accelerating working capital improvements
via the Carpenter operating model, executing our targeted portfolio actions,
including idling and divesting underperforming businesses, as well as reducing
cost, we position eliminations, temporary furlough and hiring freezes among many
other actions. With a bulk of our growth investments, largely completed, we are
also able to significantly reduce capital expenditures beginning of fiscal year
2021. These actions has been critical to maintain our healthy balance sheet and
provide ample liquidity to weather the near-term challenges created by the
pandemic.

Despite the challenges related to COVID-19, today we remain an established supply

chain partner and often one of only a few providers, especially solutions that
enabled mission critical performance. We are a leader in our industry today and are
committed to remaining a leader for decades to come. In the face of these
unprecedented times, we reaffirm that we expect to generate positive free cash flow
and positive adjusted EBITDA in fiscal year 2021. We have taken and will continue
to take the necessary steps to position corporate technology to be an even stronger
company on the other side of this pandemic.

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

Question-and-Answer Session

Operator

Thank you. We will now begin the question-and-answer session. [Operator

Instructions] And the first question will come from Gautam Khanna with Cowen.
Please go ahead.

Gautam Khanna

Hi, good morning guys. Thanks for the details.

Tony Thene

Good morning, Gautam.

Gautam Khanna

I wanted to just maybe ask you to expand on your comments about kind of the various
levels of channel inventory? We have some customers with a year's worth and some
that are restocking. Is there any broad trends you can characterize, maybe if you
could talk about engine oriented applications versus fast versus other areas, or if
there is anything you can expand upon?

Tony Thene

Yeah, Gautam, this is Tony. There's really no more additional color there, that
cuts across all of our customers. So I wouldn't classify this, the engine customers
are the ones that have greater inventory or not. We see variations across whether
it's engines, fastener, structural or distribution business in aerospace. So really
no difference there Gautam.

Gautam Khanna
Okay. And you know, you guys have talked about how in the second half of the fiscal
year, so the March quarter, you'll start to see demand recover. What grounds that
view and just curiously, do you have order visibility? Do you have you � what gives
you that conviction?

Tony Thene

Well, we are very close to our customers spend a lot of time, obviously with our
customers. So we have a good line of sight on what we think is going to happen in
the second half. And in fact, we just reaffirmed that internally are going through
customer by customer, market by market. So I don't think you're going to see a 50%
increase in your second half Gautam. I don't think anybody's saying that, but I do
think that you'll see an uptick in the third and the fourth quarter. Keep in mind
that the first and second quarter has been obviously extremely long. So yes, we're
fairly confident that we'll see an uptake in the second half.

Gautam Khanna

I'm sorry to keep belaboring the point, but just to be clear on, magnitude, right
now, obviously we're in a destocked period. So it looks like sales levels are below
underlying consumption by the end customers. What it should be anyway? Is the right
way to think about where the aerospace ex-surcharge sales will shake out, once we
get through destocking as 30% or 40% below, what you guys did in fiscal 2019, so we
get back to some level obviously below where we were because production rates are
down. I'm just curious like in terms of gauging the magnitude of the potential
recovery, is that where we should think level out kind of 60%, 70% of where they
were pre-COVID to the production rates are down by that level? Or is there some
sort of offset to that I can share or otherwise or downside to that because of�

Tony Thene

Yes, Gautam. Tough question, obviously. And it's the question that most people are
asking. If you just take a look at this quarter on a year-over-year basis,
Aerospace is down 45% to 50%. So when does that come back, is it two quarters, is
it three, four quarters? I can tell you this that might help you, if you take a
look at what we think the second half of the year is going to be, you're probably
in that 10% to 15% for a year in that team, a type of recovery that I think you'll
see it. I think it's going to be a gradual improvement from there.

Gautam Khanna

Got it. Like 10% to 15% above where we are now. They're about.

Tony Thene

Yes. I think that's reasonable. Yes.

Gautam Khanna

Okay. And just last one for me, any changes as you talked about coming to better
more mutually beneficial kind of agreements with customers over the mid and long-
term, I just am curious what types of things is Carpenter advocating for the kind
of minimum � quantity guarantees? Is it better price seem, this is � what are the
types of things that you guys are advocating for to kind of, what would you
consider better terms?

Tony Thene
Yes, it's a good question. We have great relationships with our customers and it
really hasn't been what our Carpenter Technology is reaching out to them and
dictating this is what we require, in many cases, they're giving us ideas as well.
They understand that the good market is going to come back. There is no one we're
talking to that said, well, Aerospace is never going to come back.

So everyone understands that the market is going to come back, everyone still
believes in the macro trend. And they know that Carpenter Technology is only one of
a couple of companies that can supply them the materials they need. So it is a very
� it's a mutual respect type of relationship and what we're looking for and what
they are, in many cases very happy to do, let's extend that contract for a period
of time, or let's increase the share that we have on that contract. So it's those
types of items that we're looking for Gautam. And quite frankly, don't get a lot of
pushback in that area.

Gautam Khanna

Thank you very much, Tony. Appreciate it.

Tony Thene

Yes. Thank you, sir.

Operator

The next question will come from Josh Sullivan with The Benchmark Company. Please
go ahead.

Josh Sullivan

Hey, good morning.

Tony Thene

Good morning, Josh.

Josh Sullivan

On the refusal of service, that you mentioned at the aerospace customers for Q3 in
prepared marks. What is the tempo of those here in Q4? Does it the same page as Q3
or this is either decelerated or accelerated here?

Tony Thene

Well, I made that comment, that's across, I would say that across all the supply
chain, it's not just Carpenter Technology. I mean, you can � I'm sure you've heard
many times when you have this type of drastic slow down, everyone's trying to
conserve cash and many people are trying not to take shipment. So that's happening
across the entire supply chain across every level, that is � that's pretty well
known. From our standpoint, it's much like the answer I just gave, Gautam, which we
work very closely with our customers trying to get to a win-win. And then
specifically for us, we've seen that type of activity slow down quite a bit and
believe the majority of that's behind us right now.

Josh Sullivan

Got it. And then just on the medical exposure. How do you think that the restocking
takes place? You're going to be a snapback as those elective surgeries come back,
we might see COVID research here. What are you thinking about the restocking on the
medical side and the time, you know, that?

Tony Thene

I think that Josh actually a really good question. In my remarks I talked about how
we saw an increase in surgery in procedures, but not necessarily a one for one, as
far as our supply to them, which tells you that those medical device companies and
others in the supply chain or decreasing their inventories, everybody's looking to
conserve cash. What we're getting prepared for is that I think you could see a
deeper recovery than in the second half as opposed to what you would normally see,
because I just don't think there is a one for one right now. I think people are
still trying to protect their inventory, especially as we get to most everyone else
that the calendar year is the end of their fiscal year. And they're being extra
cautious there. So a long way of answering your question to say yes, I think that
the spike that you'd see in shipments or demand let's say, or medical could be a
little steeper than maybe other markets

Josh Sullivan

Got it. And then just on the inventory draw down between the components where raw
materials finished, where are you focused right now? And maybe how should we see
that progress? Is it just that second half 10%, 15% kind of looks like if you just
walk us through some of the components there and some of the changing dynamics?

Tony Thene

Well, there is three big components of raw materials work in process and finished
goods, we look at all of those. And I think it's important to note that this
inventory draw down, that we're having is not an approach and said, taking
inventory out at all costs. It's a very disciplined approach based on our lean
manufacturing philosophy. And that is as you well know, just six months ago, we
were running at 100% and trying to make as much as possible.

So in many cases, yes, we produced inventory or future dates knowing that I was
never going to shut down the front-end of my process that had 50 weeks lead times.
So our inventory got a little higher than what we would have liked through from �
when you're looking at it from the manufacturing point of view. So this has given
us an opportunity to continue to work on our productivity and balance our plant and
take out that inventory become more balanced. Inventory in many cases is attracted
to productivity because it keeps you from working on the right thing.

So this has been a very surgical if you will, inventory reduction, I think there's
still more that we can do, but obviously, we're not going to take out these level
of inventory for the next four or five, six quarters. There will be a time where
there were balanced. I think the important thing is Josh, as when you see demand
come back, we're not going to put ourselves in a position where you'll have to see
a significant inventory build to support that we're going to get down to these
levels. We're locking in our productivity and we'll be able to maintain these types
of relative levels, even when you see the demand pick up over the next several
quarters.

Josh Sullivan

That's very helpful. And then just one last one, you've talked about you're pushing
into the electric world, can you talk a little bit about your special alloys there?
How do those compare to the current market offering? Is there any way to quantify
some of the special attributes that�s very power or some metric while you think
Carpenter's going to be successful in those markets?

Tony Thene

I appreciate you asking that question because we think this is really important for
us. We have our core business that is going to grow over the next several decades,
just because of the macro trends. But what we're trying to do is look at other
areas of growth in areas that we're already participating in, but we can take it to
the next level. And if I could take a step back, in this what we call soft
magnetics and running an electric motor, the real key there is that your � the
material that you're using that soft magnetic material, it's magnetizing and
demagnetizing, on and off. And that's what creates the rotation in the motor. And
that's what creates the ultimate power. The material that you use is really
important because that material will take the magnetic response or what I said in
my prepared comments, the induction.

So the higher the induction materials that leads to a better performing motor, that
leads to a motor with higher power, higher torque, higher speed. All at the same
time, making that motor smaller and lighter, which is really important for electric
vehicles, our proprietary product, hyper-coal does all those, and it is rated as
the best in the industry right now. So that's why we have a lot of interest for
that product.

Now, remember, Josh, even before the pandemic, Carpenter Technology was the leader
in this area when it came to auxiliary power units in aerospace. We're just taking
it to the next level, as the market continues to grow with the electrification of
the world. We're moving closer to the customer by not just making material, but
moving into stack production and quite frankly, being pulled by our customers to
get even more involved.

And now as Tim mentioned in his remarks, finishing up the almost $100 million
project in our Reading campus to put in a hot strip mill, which will increase the
capacity, but more importantly, the capability to produce that product at a lower
cost than we do now. And hopefully even, we�ll attract more and more business that
way. It's a big market today and it's a market that could be three to four times
bigger over the next five to 10 years. So I really appreciate the question that
allows us to talk about something that can really be an earnings accelerator for
Carpenter Technology over the next year.

Josh Sullivan

Got it. Thanks for the comments.

Operator

[Operator Instructions] The next question will come from Phil Gibbs with KeyBanc
Capital Markets. Please go ahead.

Phil Gibbs

Hey, good morning, Tony and Tim.

Tony Thene

Yes, good morning.

Tim Lain
Good morning

Phil Gibbs

Tony, can you give us some color on your backlog, either they change sequentially
or year-over-year?

Tony Thene

Backlog was down about 18% sequentially that's across all of Carpenter, that's
total. Aerospace backlog was down 16% sequentially, on a year-over-year basis,
backlog was down about 40%, aerospace backlog was down a couple percentage points
higher than that.

Phil Gibbs

That's helpful. And then on aerospace engine specifically what was the either year-
over-year or sequential decline in engine revenues?

Tony Thene

If you look at engine, you remember last quarter sequentially, it was down 30%. Now
we get to this quarter, it's down another almost 40% year-over-year. For this
quarter, aero engine is down about 50%. Now, remember to � you're comparing to
periods a year ago that were at the high point � over the last five to 10 years, we
were at the high point so coming off the top, year-over-year 50% down.

Phil Gibbs

So you're saying year-over-year down 50?

Tony Thene

Yes, on aero engine.

Phil Gibbs

Okay. And then I just wanted to be clear on the networking capital side. So this
coming quarter, this December quarter, it sounds like it's going to be another
strong quarter of taking down your inventories, is that I got that. Just a simple
question on that and then I'll ask a part B, is that right?

Tony Thene

That's correct. Maybe not the same levels, but we do still see opportunity where
we'll be taking inventory out.

Phil Gibbs

So any way to handicap the impact to the P&L just from the loss absorption and in
this past quarter, I think you had an EBIT loss in SAO of north of $15 million. If
you weren't taking out inventory, just trying to gauge what that intrinsic profit
would have been? Would have been closer to break-even if you hadn't been taking out
inventory and losing absorption?

Tony Thene

Yes. I'll let Tim take that one on where he involved.

Tim Lain

Yes, Phil, I mean, I think that's a fair way of looking at it. It certainly would
have been closer to break-even or positive. I mean, it really is an absorption
impact, as you said. I mean, you've got fixed costs, but that don't go into
inventory. And you've also got the variable cost when you're running at lower
levels, have a larger impact on your P&L as you're bringing the inventory down. So
I think that's a fair estimate directionally of what it would look like this
quarter.

Phil Gibbs

Okay. So you had about a plus or minus $20 million hit from under absorption. And
then you're also saying you had about $3.5 million hit from COVID costs?

Tony Thene

COVID costs, we said we're about $7.3 million. We said included in that $7.3
million is a $3 million bankruptcy impact. So direct cost about four, so just to
clarify on that.

Phil Gibbs

So what are � so was that bankruptcy hit � was that bankruptcy hit in your numbers
you didn't strip it out?

Tony Thene

We added it back for adjusted EPS, but it's in the segment numbers that we were
reporting.

Phil Gibbs

Okay. And then on these COVID costs, what � can you just explain what these
actually are? And you may have done that, I apologize if you did.

Tony Thene

Yes. I mean, sure. We tried to give some high level, it's basically the cost of
keeping the facilities going that we wouldn't have, had it not been for COVID it's
things like the extra cleaning protocols that we've initiated rentals of equipment
and extra PPE for the people in the facilities. There's some aspect of, as people
suspect, they have been exposed to COVID-19 or paying them to stay home. And then
just kind of other operating supplies for just general protection in the current
environment.

Phil Gibbs

Thanks very much.

Operator

And the next question will come from Chris Olin with Tier4 Research. Please go
ahead.

Chris Olin

Hey, good morning guys. Thanks for taking the call.

Tony Thene

Good morning, Chris.

Chris Olin

I apologize, I got disconnected there for a second, so hopefully I'm not repeating
things if I do. Let�s just chalk it up to 2020, but I wanted to just follow up. I
heard the tail end of the magnetic Q&A session. And I just want to make sure I
understood how � I should think about the timeline. I guess, maybe you'd give me
numbers. I've just forgotten, but how do I think about � you were saying demand
could be five to 10 times greater and you mentioned earlier end markets that you're
looking at. When do we start thinking about those, call them green bananas turning
into real volume more than inflection starts. I guess, I'm asking � I was wondering
if there was any wiggle room in terms of the CapEx and a timeline for the hot strip
mill?

Tony Thene

Yes. And just to be clear on that, I said that the current available market to us
could be three to four times higher over the next five to 10 years. So not five to
10 times � three to four times higher than � so that's still a big number and I
think if you follow this for a long time, you're aware that we've been in this
market for quite some time on the APU side with aerospace. And it's just a way for
us that fairly broad, I mean, we're moving more and more towards electrification.
So, this just takes a proprietary product and now profits and increased equipment
into other markets like transportation, defense, and � so consumer electronics. So
we're getting earnings and revenue for this right now.

And I think over the next several quarters, you'll see that continue to increase. I
can't give you a specific time on when that might get to that triple, but I do
think it's over the next five years.

Chris Olin

Okay. So we're not waiting for anything like the new Tesla plant in Texas or
anything like that. It's just a gradual outlook of growth.

Tony Thene

I think it's a gradual outlook, but you read all of the source, I mean, more and
more companies are moving to this direction. I mean, you saw the announcement from
General Motors and what they're going to do, that's significant. Across aerospace,
how you could potentially see electric commercial flights, certainly a very small
scale. They're doing the testing that now this is going to touch a lot of areas,
drones and robotics. And I think we're really at the right point in time here to
capitalize on it.

And I think the most important point to make really, not only do we have the
expertise, we have a proprietary product. And we now within the next three, six
months, we'll have our new mill up and running, which is quite an accomplishment.
We're getting significant pull from our customers that want us to not only supply
that proprietary product, but want us to move further and closer to them in the
supply chain, whether that be in the building of stack, what we may or may not do
going forward in terms of motors. So it's a really exciting opportunity for us.
That is near-term and we'll get the bottom line in the near-term. It's not a decade
away.
Chris Olin

Okay. That makes sense. One of the � as you take the follow-up pretty closely with
the whole product approval process at Athens and I guess, I was wondering if
anything has changed since the COVID outbreak and kind of everybody got distracted,
like other issues, like has it slowed down or are you doing less work there, where
now maybe it pushes out some of the longer term opportunities?

Tony Thene

I wouldn't say that, I think the best word is that it�s different now, a
qualification process for a long, long time, it's a very face-to-face type of
process that customers visit your plant. You visit the customer, obviously with
travel restrictions that has been limited, but we deal with a very sophisticated
customer groups. So we found other ways to continue to push this process along. I
mean, I wouldn't say that we're at the exact speed that we were at prior to the
pandemic, but it has not slowed much.

Again because of the sophisticated customer base, they know that this market is
coming back and they know prior to the pandemic, this is a sort of market that
could not meet their demand. In other words, they couldn't build enough of the
engines prior to the pandemic. So they know how important that system and they
continue to push forward albeit in a different manner than we did before.

Chris Olin

If there is still low hanging fruits in terms of like, some big products out there,
a big volume products that could move the needle?

Tony Thene

Yes. There's still a couple of big � once got there first to get qualified for
sure.

Chris Olin

Okay. And then just the last question, I thought Tim said distribution orders or
demand picked up. I was wondering if that was just transportation related or did
that tie into, I thought he said, there were some areas of aerospace that were
getting better, just touch a little bit?

Tim Lain

Just to be clear, when I said distribution, I was talking in the PEP business unit
that segment. We've got a distribution business within our PEP segment. And I think
Chris, that you're right at the comment, distribution is tied pretty significantly
to transportation. So as the automakers returned to work, they saw a spike in
demand.

Chris Olin

Great. Thanks for all the info and the color, guys.

Operator

Ladies and gentlemen, this concludes our question-and-answer session. I would like
to turn the conference back over to Brad Edward for any closing remarks.
Brad Edwards

Thanks Chad. Thanks everyone for joining us today on our first quarter fiscal 2021
conference call. We look forward to speaking with all of you on our second quarter
call. Thanks again, and have a great day.

Operator

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