Carpenter Technology Corp (CRS) 2006 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Carpenter Technology's third-quarter 2006 earnings conference call. My name is Janelle and I will be your coordinator for today. At this time, all participants are in a listen-only mode. We will be facilitating a question-and-answer session towards the end of this conference call. (OPERATOR INSTRUCTIONS).

I would now like to turn the presentation over to your host for today's call, Mr. Jaime Vasquez, Vice President and Treasurer. Please proceed, sir.

Good morning. Welcome to our conference call for the period ended March 31, 2006, the third quarter of Carpenter's fiscal year. This call is also being broadcast over the Internet.

With me today are Bob Torcolini, Chairman, President, and Chief Executive Officer; Mike Fitzpatrick, Vice Chairman; and Terry Geremski, Senior Vice President, Finance and Chief Financial Officer.

Some of Carpenter's statements will be forward-looking statements, which are based on current expectations. Risk factors that could cause actual results to differ materially from these forward-looking statements can be found in Carpenter's recent SEC filings, including the Company's June 30, 2005 10-K, subsequent forms 10-Q, and the exhibits attached to those filings.

During this conference call, we will be using abbreviations SAO to represent Specialty Alloys Operations, and EPG to represent our Engineering Products Group.

I will now turn the call over to Bob, who will start with a brief overview.

Thank you, Jaime, and good morning. Earlier today, we distributed a news release on the results of our third quarter and first nine months of fiscal year 2006. We are pleased to report the best quarterly sales and earnings in the Company's history.

For the quarter, record sales were led by the performance in the aerospace market which accounted for 43% of total quarterly revenue. Sales also benefited from favorable conditions in most end-use markets.

While we're pleased with the strength of our topline growth, we are even more encouraged by our ability to grow profitability. We're achieving enhanced margins by focusing on higher-value products, reducing the sale of less profitable products, and by relentlessly focusing on cost through lean and variation reduction. Our goal is to develop a business operating model that enables us to earn in excess of our cost of capital through all phases of an economic cycle.

Now, let me provide you with some detail on Carpenter's consolidated third-quarter sales, first by product type, and then by end-use market. Sales of our specialty alloys increased 50% from a year ago to $202 million, a record level for any quarter. The increase was driven by strong demand from the aerospace market for our specialty alloys used in the manufacture of jet engine components and airframe structural components. Specialty alloy results also benefited from increased sales to the power generation and energy markets in addition to higher base prices.

Our stainless steel sales were $136 million, or essentially flat with the third quarter a year ago. In the quarter, increased revenue from the sale of higher-value stainless steel products and base price increases were offset by reduced sales to the industrial and automotive markets and our strategy not to pursue lower-margin business.

Sales of our titanium alloys increased 57% to $47 million, also a record for any quarter. The rise in sales reflected higher prices, particularly as a result of the escalation in raw material costs, a better product mix, and increased demand. Sales of titanium should continue to benefit from both the increase in the number of aircraft being built and by the specific models being ordered. The new wide-body aircraft such as the Airbus A380 and Boeing 787 typically a require greater use of lighter-weight materials such as titanium. Also benefiting titanium sales is our continued growth in both the domestic and foreign medical markets.

Sales of ceramics and other material increased 4% from the third quarter a year ago to $26 million. The increase is primarily attributable to demand from the aerospace market for ceramic cores used in the casting of turbine blades for jet engines and diesel engine fuel injectors for the heavy truck market.

By end-use markets, sales to the aerospace market increased 80% from the same quarter a year ago to $182 million. This was the ninth consecutive quarter of increased sales to the aerospace market, and was a record for any quarter.

Demand for our aerospace materials should remain strong. The airline monitors' latest forecast calls for 920 commercial aircraft to be delivered in 2007, or 15% more than 2006. Deliveries are projected to increase another 7% in 2008 when 985 aircraft are expected to be delivered. To put demand in perspective, Boeing and Airbus delivered 833 aircraft in 2001, the peak of the last cycle. The mix of airplanes scheduled for the delivery should also expand demand for our materials, as the next generation of aircraft are using more lighter-weight materials.

Sales to the medical market were $36 million or 40% higher than a year ago and also a record for any quarter. Sales benefited from a better mix of higher-value materials and growth in the international markets. The increase also reflected the impact of a significant rise in titanium costs.

Sales to the power generation market increased 30% to $23 million from a year ago, excluding the sales from a divested business. Sales benefited from new bills and maintenance activity of industrial gas turbines and pricing actions.

Sales to the consumer market of $55 million increased 6% from a year ago. Demand from the electronic, sporting goods, and housing markets have helped to sustain sales near historically high levels.

Sales to the automotive and truck markets were $46 million, a 7% decrease from the third quarter a year ago. Increased sales of ceramic cores used in the manufacture of diesel fuel injectors were more than offset by lower sales of specialty alloy and stainless steel used in engine components and general applications.

Industrial sector sales decreased 10% from the third quarter a year ago to $84 million. Increased demand from the energy market were offset by reduced sales to capital equipment manufacturers.

Now I will provide an overview of our business units. Starting with SAO, third-quarter sales increased 28% from a year ago to $346 million, a quarterly record for SAO. Our richer product mix and base pricing actions primarily drove this growth.

Volume this quarter was flat with a year ago. Increased shipments to the aerospace and power generation markets were offset by reduced shipments to the automotive and industrial market. Sales of bar products increased 7% from the third quarter a year ago. Pricing actions and a more favorable product mix as a result of increased shipments to the aerospace and energy markets more than offset a 12% decline in bar shipments. The lower bar shipments primarily reflected reduced demand from the automotive and industrial markets.

Sales of coil products increased 17%. A better product mix resulting from our continued focus to rationalize the sale of marginally profitable products, and a 4% increase in shipments contributed to the sales gain.

Our forged bar and billet product sales increased 85% from a year ago. The primary drivers were a 40% increase in shipments to the aerospace and power generation markets, increased international sales, and higher selling prices.

At Dynamet, which primarily sells titanium products, third-quarter sales increased 65% from a year ago to $45 million, a record level for any quarter. The increase reflected higher selling prices, particularly as a result of rising raw material costs, a better product mix, and continuing strength in the aerospace and medical markets. Dynamet's business should continue to benefit from robust demand for our new aircraft and the larger mix of wide-body aircraft which requires significantly more titanium. Also, Dynamet's growth in the domestic and international medical markets should further aid its performance.

For the engineered products group, sales of $26.3 million in the third quarter compared to $31.9 million in the quarter a year ago. However, last year's third-quarter sales included $6.2 million from Carpenter Special Products, which was divested in the fourth quarter of 2005. Certech, which produces ceramic cores used in the casting of turbine blades and diesel engine fuel injectors, experienced solid demand from the truck and aerospace markets.

Now I would like to turn the call over to Terry.

Thank you, Bob. As Bob mentioned, sales in the third quarter reached a record $426 million, an increase of 25% from the third quarter a year ago. Results benefited from increased sales of higher value products, especially to the aerospace, medical, and power generation market and higher base selling prices. Adjusted for surcharge revenue, sales this quarter increased by 26% compared to a year ago.

Gross profit in the third quarter increased to $124 million or 29.1% of sales. This was a 46% increase from a year ago, when gross profit totaled $85 million or 24.9% of sales. The 420 basis point increase in the gross profit margin is attributable to a richer product mix, higher base prices, and better operating efficiencies achieved through lean initiatives and variation reduction.

In the third quarter of fiscal 2006, selling and administrative expenses of $32 million were 7.5% of sales compared to $29 million or 8.4% of sales in the same quarter a year ago. We continue to diligently manage costs and expect that selling and administrative expenses in fiscal 2006 will be near the same level as a year ago.

As a result of the increase in gross profit margin and selling and administrative expenses that increased only marginally, operating income increased 63% to $92 million from $57 million last year. This was the highest level of quarterly operating income in Carpenter's history. As a percentage of sales, operating income expanded by 520 basis points this quarter to 21.7% of sales from 16.5% last year.

Interest expense for the quarter was $5.9 million, unchanged from a year ago. Other income was $4.0 million compared to $2.4 million in the third quarter a year ago. The increase primarily reflected higher interest income from increased balances of invested cash.

As a result of the strong operating performance, Carpenter generated record quarterly net income which totaled $60.8 million or $2.32 per diluted share. This compares to net income of $35.3 million or $1.38 per diluted share in the quarter a year ago.

Turning to the balance sheet, accounts receivable were $35 million higher than a year ago, due primarily to the increased level of sales. However, days sales outstanding were reduced to 46 days from 49 days at the end of the third quarter a year ago.

Inventories of $262 million were $38 million higher than a year ago. The strength of orders for higher-value materials, many of which have longer throughput times, were largely responsible for the inventory increase. In many cases, actual physical stocks of inventory were reduced, although inventory values increased.

For the quarter, free cash flow was $53 million versus $46 million in the quarter a year ago. Despite higher working capital requirements, we continue to estimate free cash flow to be in excess of $150 million for fiscal 2006. This amount is after dividends and after capital expenditures which are protected to be in the low $20 million range.

I will now turn the call back to Bob for concluding remarks.

Thanks, Terry. The third quarter highlighted the operating leverage created through our business operating model. Very favorable market conditions led to the best results in Carpenter's history. Despite volatility and order patterns characteristic of a tight supply chain, we expect to report year-over-year operating improvement for the fourth quarter of fiscal 2006.

Now that we have Carpenter well-positioned, we're turning our focus to the future. During the past quarter, Mike Fitzpatrick joined the Company as Vice Chairman from the Board of Directors. He's leading a team of dedicated internal and external resources focused on evaluating alternatives to further improve long-term shareholder value. We're excited about the opportunities in front of us, and will provide more details at the appropriate time.

I would like to thank all of the people at Carpenter for their collective efforts toward delivering this record quarterly performance. We will now open the call to analyst and investor questions.

(OPERATOR INSTRUCTIONS) Mark Parr, KeyBanc Capital Markets.

I see the market had a very good reaction to your earnings, and I think it's deserved. Congratulations on a tremendous result.

Thank you.

Can you break down pricing versus volume on the revenue side for us, please?

Yes, quite simply, Mark, the volume component was relatively small. Less than 5% of the balance was price and mix.

Okay. Does that reflect anything related to capacity utilization of the existing operations?

Well, I think that what you heard in the call and what you saw in the press release is that what we really are focusing on are really the high-value products. And the high-value products are strongly being demanded right now by the aerospace, the medical side, and even some other sectors as well, including the high-end automotive. And all of those products are in pretty good demand. And as a result, across the industry, I think those products also are enjoying improved pricing.

Also these are intrinsically high raw material kind of component material -- a lot of nickel, a lot of cobalt and things like that -- and of course, the titanium. So I think what you're seeing in that is the price associated with those materials and the demand profile for those.

Okay, terrific -- I really appreciate that. One other question. If you look at the mix of anticipated aircraft deliveries into '07 and '08 -- let's just say that 15% -- or let's say 10% is a good number over the next two to three years. What should be a sustainable corresponding run rate of growth for Carpenter's products serving that mix?

(multiple speakers) I guess what I am getting at is 80% growth is probably not sustainable -- or maybe it is? I don't know. It just seems awfully strong.

Mark, I think it's hard to really project that for a lot of different reasons, because I think what we're looking at it is not just the underlying demand of aircraft builds. There are other components of what's going on with aerospace, including spares, which is revenue passenger miles traveled, freight that is being hauled. There's a military component as well.

And then, of course, you have the supply chain aspects of that, gearing up, if you will, for some of the production. Typically, raw materials are very early in the cycle. And so we typically precede some of those deliveries. So even though we don't have any A380s or 787s really being delivered or slated to be delivered, the materials need to be procured early enough and components made -- not only for test articles, but for some of the first items.

So I think it's a little early for us to be able to predict that because of all of those factors that are going on. I think it would be hard for us to do that. I think what is important to us and probably to most everyone is what is the underlying growth rate that we see with new aircraft builds? And that looks pretty good for the next at least five to seven years.

Okay, terrific. Well, I will pass it on, but congratulations -- tremendous quarter.

Matt McGeary, Sentinel Asset Management.

Could you just flesh out -- you mentioned a couple of times exposure to industrial -- your industrial markets is a little bit weak -- industrial and auto -- auto is understandable. Could you just explain to me -- is the industrial weakness due to specific exposures you have, or is it part of your effort to the cull out some of the less-profitable business?

Matt, it's a little of both. I'm speaking specifically about the industrial side, and it's particularly in the specialty alloys business. This is our core business. One -- as you mentioned, we do and we have been looking at marginal business, marginally profitable business. And we have systematically been decreasing our participation in that area. So therefore when we compare it to the third quarter a year ago, that will give us a little bit of a volume downside.

In addition to that, there are some major components typically related to capital spending that we would be selling into some of those capital spending areas, and some of the customers that are there typically would be involved with large projects and they would purchase for those projects, and those projects may not repeat. And also, they may find themselves in an inventory position that they might just be adjusting the inventory. So I would say those are the two major components contributing to the industrial side.

And then on the capacity, I think Mark had a question about capacity. I'm just trying to understand, if your volumes are sort of flattish, can I assume that your capacity utilization levels are also consistent? And where do you stand right now? I'm trying to sort of nail down what you need to do on the CapEx front going forward over the next couple of years?

Let me see -- I'll try to answer that in three parts. First of all, Matt, on the capacity side, it varies by product. In other words -- and we have answered this in the past. In areas like titanium, we are very, very good on capacity, and the capacity additions that we have made and will continue to make are relatively low capital spending. So we have been matching, if you will, not only our today capacity, which we are well in excess of demand, but even tomorrow's capacity. And we're planning to make sure we're well ahead of that curve.

On some other products, obviously as we have indicated, in things like stainless steel, our participation is lower today than it was a year ago. So on some of the ability to produce more stainless steel should we elect to do that, we're in plenty good shape. And also I mentioned previously that some of the finishing capacity that we utilize to make stainless steels and other kinds of materials are also able to be used to make some of the other kinds of products that we make, some of the high nickel alloys. So on the finishing side, some of that is fungible.

On the melting side of our business, that's where the capacity isn't completely fungible. And I think I also mentioned at the last call that we increased our vacuum induction melting capacity. We had four furnaces. We were not operating them all. We now are operating all of those furnaces. And we have also recently added -- we had two idle ESR furnaces that were idle. We have modernized and computerized those. And we are also planning to add a couple of more VAR furnaces, which would bring our total to 19. And that is really done in anticipation for some of the demand that we anticipate seeing in the out years.

So that's kind of how we are addressing that situation. But we are in pretty good shape from the standpoint of having the capacity to finish particularly the specialty alloys and the titanium products.

Okay, great. And just lastly, you mentioned Mr. Fitzpatrick, is it -- coming on Board to look at alternatives to increase shareholder value, I think, is the words you used. To put it mildly, you guys have done a pretty good job increasing shareholder value the last couple of years. Is everything on the table here? I mean, are you looking at every and all option? Or are you sort of constrained to few different avenues that you're thinking about?

I would say that what we're trying to do is fully understand the opportunity space that's out there for us and that is really what Mike is leading together with a group of internal executives together with one of the leading consulting firms. And I would have to say that we are looking at all options in terms of how can we grow long-term shareholder value at Carpenter. And I think it is -- all of the things we talked on the past. Obviously, we are looking at things like what makes sense for us from an acquisition standpoint, but it's certainly not restricted to that.

So having Carpenter be part of a larger metals organization at some point is not off the table?

I would have to say that our first priority is to both organically and strategically grow Carpenter.

Chris Olin, FTN Midwest Securities.

Can you talk a little bit about your outlook on the titanium raw material input costs? Are you seeing any kind of alleviation on sponge and scrap right now?

I guess, Chris, it's probably a one-word answer -- high. Titanium has escalated pretty dramatically over the past couple of years. And I think you articulated that one of the issues is the availability of scrap and sponge. And the market remains rather tight, but I think it's been well chronicled that there is some new sponge capacity coming on board, both here in the States and abroad, both in Asia and in the former Soviet Union.

So I think that there will be higher availability of those materials in the not-so-distant future. But the demand remains very, very strong for titanium, not just for aerospace, but for medical and even for the chemical process industry as well.

Okay, and it looks like nickel is going to continue to trend up here. Any concerns on surcharges being able to pass through, or what are you seeing there?

In terms of your question of surcharges, no; they work well in terms of being able to pass through the fluctuation in raw material costs. Nickel is up rather substantially in the recent weeks. And I think again, we understand why that is going on, because of some of the issues with the major producers. And I think there's a little bit of nervousness in the market around that.

Michael Gambardella, JPMorgan.

Bob, in just the last three years, Carpenter's stock is up tenfold. And while Carpenter has certainly done well in the metals space in terms of stock performance, it's not the only stock that has gone up a lot. And I was just wondering, when you are looking at acquisitions out there with these stock prices running up, whether it's a potential public or private company -- can you give us a feel for asking prices? And are you hitting a lot of resistance there, because people's expectations for companies that they want to sell has just gone sky high?

Mike, I think -- again, on a prior conference call, we had a similar discussion. And one of the things that -- no one can deny that valuations right now are rather high, especially in the metals space, because as you pointed out, a lot of metal companies have enjoyed much better performance, and as a result their market caps are at all-time highs. And I would say -- even as you have pointed out in the private sector, it increases expectations. The other thing is, there's a lot of private equity money out there which is competing, if you will, for some of the same aspects.

So I think that accurately reflects the conditions that are out there. I still think it's important to define a strategy and to really evaluate what are good strategic fits with a today Carpenter and a tomorrow Carpenter. And I think that we just need to assess the financial viability of any of those options that are out there, and determine whether or not it will really fit our goal of really providing that shareholder value.

I can only say that it just may be a case where the valuations that are there are more reflective of longer-term earning capability of these companies. So we will need to monitor that quite closely.

Are most of the potential acquisitions you're looking at -- would you categorize them as businesses or products that Carpenter doesn't have right now?

Mike, I think it's really too early to tell and comment on that. Today, we have a breadth of materials, both metals and nonmetals. And one of the things that we had said is that we want to be a broader materials company. So that leaves us a pretty wide-open landscape. And we're fairly early in our process trying to prioritize that. And it would be premature for me to comment on it.

And last question just on the quarter, on the great results -- you mentioned earlier that the vast majority of the outperformance in the earnings this quarter came from price and some mix as opposed to volume. In terms of the pricing impact, can you give us a feel for how much of the pricing benefit occurred from changes in long-term, say, annual fixed-price contracts versus just spot business price increase?

Mike, it's really a combination of both. I think in prior calls we have talked about contracts. And some of the contracts that have been renewed have been renewed, as we mentioned -- double-digit kind of increases. So what we're seeing is the roll-forward of some of that kind of pricing activity.

Having said that, there is also what you pointed out -- the transactional or the spot price business that is present in the titanium side and in the specialty alloy side. So that is a strong driver.

The other thing that I also want to mention is that we often refer to what we have been benefiting in terms of our lean and variation reductions. So there is a cost savings in there as well that is driving some bottom-line profitability and some margin expansion. But of the price/mix, the price aspect is the larger of the two. And it is as a result of what you pointed out -- contracts that have now been re-established at higher pricing and also the effective transactional pricing.

Would you say in this quarter contract was a bigger benefit than the spot on prices?

I think they're both. I mentioned earlier that across all of Carpenter, approximately 35% of our business is contract. And so that's a good proxy for you could be assured that those contracts are all renewed at significantly higher numbers and then there's probably another at least more-than-equal portion of that that's on the transactional side that's benefiting from some of the same.

And most of the contracts roll over at the end of the calendar year?

They're a combination of calendar year and midyear, I would say, would be the two predominant times. So it would be a December and a June event.

Leo Larkin, Standard & Poor Equity Research.

Could you give us guidance for CapEx and DD&A in '07?

Leo, this is Terry. The CapEx is probably going to be in the low 20s. And that is for the balance of this fiscal year. And D&A -- approximately $50 million, just under that.

Okay. Barring acquisitions, let's say, going forward, would it still be the case that CapEx will probably continue to trail depreciation?

This is Bob, Leo. I would say, yes, trailing depreciation, but higher than the levels that we have been historically at. As Terry just pointed out, low 20s, I would venture to say that we're going to be above that, but certainly trailing depreciation.

Okay, and one final question -- and I know you're considering various alternatives with the amount of cash you have, but what about a supplemental or special dividend?

Those are all of the kinds of alternatives that we're considering.

[Fran Okineski], [Frieze Associates].

Congratulations on a great quarter. I was actually going to ask you about pricing, but Mr. Gambardella took care that for me. But perhaps you guys could maybe talk about any new end-market demand drivers that we could see in 2006 or in 2007 above and beyond aerospace, which seems to be doing quite well? You guys do a good job of breaking out your product classifications. But are there any new drivers that we haven't really picked up on that could potentially benefit Carpenter that we would be talking about in the upcoming quarters that could bode well for demand and profitability?

Okay, Fran, I would say that the markets that we are seeing some good activity in going forward right now is medical and energy. I would say that if you look at the participation that we have historically had in medical, I think the medical space is more and more designing with the kinds of materials that we at Carpenter here are making, are good at making, if you will. And so the medical space is very interesting to us. And of course, energy -- and given the global energy situation that we have and the exploration and production side of energy are often using materials that are [in severe] service. And we're seeing again more opportunity in those [too]. So I would say those would be probably two that we're looking with some optimism in the years ahead.

How do they compare in terms of just overall operating private contribution, if you would go as far as saying -- are they better than aerospace or some of the higher profitable contributors?

Generally, Fran, these are all fairly high value. When we refer to things as high value, they typically have higher selling prices, obviously, because of intrinsic raw materials and also the difficulty with which to make them. So our high-value products typically carry higher margins than, let's say, the more mainstream products. So as we look to participate in these particular materials and markets, we obviously are looking to make more money from these kinds of products. Relatively speaking, they could be the same or less than or greater than each other, depending on which product it is and specifically how critical it is and how difficult it is to make.

Mark Parr, KeyBanc Capital Markets.

Bob, how close are you to contemplating an additional [rotoforge] operation?

Not necessary in terms of our capabilities, Mark. Our rotary forge was put in 1983, and it's the largest one here in the U.S. -- or it was the largest one here in the U.S., and we have plenty of capacity there. So we're not in any way constrained there.

And at this time, there are no more questions in queue. I would like to turn the call back over to the speaker for closing remarks.

Thank you very much. We would like to thank all of you for your interest in Carpenter, and we look forward to talking with you at our next quarterly conference call. Thank you very much and goodbye.

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Have a great day.