Carpenter Technology Corp (CRS) 2017 Q2 法說會逐字稿

Good morning and welcome to the Carpenter Technology second-quarter 2017 earnings conference call.

(Operator Instructions)

Please note, this event is being recorded.

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

Thank you, operator. Good morning, everyone, and welcome to Carpenter's earnings conference call for the second quarter ended December 31, 2016. This call is also being broadcast over the Internet, along with presentation slides. Please note, for those of you listening by phone you may experience a time delay in slide movement. Speakers on the call today are Tony Thene, President and Chief Executive Officer; and Damon Audia, Senior Vice President and Chief Financial Officer.

Statements made by Management during this earnings presentation that are forward-looking statements are based on current expectations. Risk factors that could cause actual results to differ materially from those forward-looking statements can be found in Carpenter's most recent SEC filings, including the Company's September 30, 2016 10-Q 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 discussing operating income, that reference excludes pension, earnings interest in deferrals, or EID, and special items. When referring to operating margins, that is based on sales excluding surcharge and operating income excluding pension EID and special items. I'll now turn the call over to Tony.

Thank you, Brad, and good morning to everyone on the call. Let's begin on slide number 4 with an update on our safety performance. Year to date in FY17, our total case incident rate, or TCIR, stands at 2, which is down compared to the TCIR of 2.2 for FY16. I know we can do better. We are pushing through to the next level of improvement in our safety performance. To achieve the next level of improvement, it is necessary to drive fundamental changes to our safety culture. The transformation I am referring to requires an interdependent safety culture, with all employees engaged in the process. A critical component of this change is developing the capabilities of middle and front-line management so they understand what good looks like.

Key capabilities are tied directly to our operating model, including setting appropriate standards, intervening when standards are not met, problem solving, active listening, and engaging the total workforce in improvement. The cultural transformation to an interdependent safety culture across the entire organization will be the key to achieving further improvement in our safety performance. Achieving our goal of a zero-injury workplace is fundamental to our values and will require the engagement of all of our employees.

Turning to slide number 5 and a summary of our second-quarter results. Overall, we delivered an improved second quarter, with notable sequential growth on the back of strong execution, a [richer] product mix, and an improving environment across several of our end-use markets. Our aerospace and defense market experienced increased demand in the engine sub-market given the growing ramp-up of the new engine platforms.

Our energy market continued to see ongoing signs of the recovery, as the North American directional and horizontal rig count increased 30% on a sequential basis, which translated to an increase in activity levels at our Omega West business. The improvement is off a low base. But it appears that the industry, at least in the US, is beginning to show signs of improving conditions. The strengthening demand in the oil and gas sub-market, coupled with our sharp focus on managing coast resulted in our Omega West business improving operating income by 23% sequentially. Although that business is still in an operating loss position, its improved results help the overall PEP segment achieve positive operating income for the first time in six quarters.

During the second quarter, we continued to advance our transformation plan aimed at best positioning Carpenter to execute against the growth opportunities across our market, generate improved margin, and deliver sustainable long-term growth. This plan includes the ongoing implementation of the Carpenter operating model, which continues to deliver cost efficiencies and productivity enhancements.

In our SAO segment, we have reduced our variable operating expenses by 6% for the same quarter a year ago and 3% sequentially. As referenced, our internal goal is to reduce FAO variable operating costs by at least 3% net inflation annually. Last quarter, we began implementing the Carpenter operating model across our PEP facilities and expect future improvement, not only in cost reduction but also productivity enhancement that should drive additional capacity.

On the commercial side, we have repositioned Carpenter as a solutions provider and realigned our sales team to be market focused rather than product focused. This reformulated strategy in commercial approach is gaining traction with our customers. And strong execution by the commercial team, and an improving market landscape, is helping to drive backlog growth. In fact, in the second quarter, our backlog increased sequentially by approximately 20%.

Looking forward, we see continued momentum for bookings, coupled with improving market indicators for the back half of the year. We're focused on positioning in our operations to pursue a range of attractive growth opportunities by expanding our capabilities. This strategic mandate is reflected in our titanium powders acquisition that we announced earlier this morning. This transaction provides Carpenter with immediate entry into the titanium powder market. It strengthens our additive manufacturing presence and expands our capabilities as a solutions provider for our customers. I'll talk more about the acquisition in a few minutes. Lastly, and critically important, is that we are in a solid financial position, and our balance sheet remains strong, with no meaningful near-term obligations.

Let's move to slide 6 and the end-use market update. Our aerospace and defense market delivered a solid second-quarter performance. Sales ex-surcharge were up 15% sequentially, and relatively flat on a year-over-year quarter basis. To give you a little more insight, let's look at a couple of the aerospace sub-markets. We experienced strong sequential and year-over-year quarter demand in our engine sub-market related to the ramp of the new engine platforms, up 31% and 19%, respectively. We remain confident that the overall growth potential of our engine sub-market remains strong, given our participation on the new platforms as well as the projected build rate and backlog numbers coming from the engine and aircraft manufacturers.

Inventory consolidation in the supply chain continues to impact our fastener business, which is up slightly on a sequential basis, but down year over year. While we remain cautious, we are beginning to see positive signals in the market, and the long-term growth prospects remain healthy, given our strong, narrow-body market share in the OEM's expected build rates.

Conditions in the structural and distribution sub-markets are slightly better in the second quarter on a sequential basis, but are below the year-ago quarter. Visibility here remains somewhat challenged, given the transactional nature of the business. We remain cautiously optimistic moving forward, as we are seeing some improved activity levels in this sub-market.

Lastly, our defense sub-market revenues were up on a sequential basis due to increases in select programs, as well as market share gains, although sales were relatively flat on a year-over-year basis. In total, the second-quarter performance in our aerospace and defense end-use market highlights the benefits our broad product portfolio. I'll speak more about our position in aerospace and defense and the related sub-markets shortly.

Our energy market is made up of two primary sub-markets; oil and gas, and power generation. In total, energy sales were up 5% sequentially, with the oil and gas sub-market up 2% and the power generation sub-market up 10%. On a year-over-year quarter basis, sales were also up 5% as strong power-generation sales offset lower oil and gas sales. In the oil and gas sub-market, we are seeing some indications that customers are beginning to make critical replacement orders. And we continue to see improved rental activity in select regions, including the Permian Basin where we have worked hard to gain market share and strengthen our position as a reliable and high-value add partner.

While the North American directional and horizontal rig count remains down on a year-over-year basis, it increased 30% on a sequential basis. As we have stated previously, the North American directional and horizontal rig count is a leading indicator for our business. So the strong sequential growth also gives us optimism moving forward.

Of course it is important to note that it is still very early in the recovery. And although activity levels are increasing, the improvement is coming off an historical low base. While some hurdles remain, we are encouraged by the positive trends and development we are seeing in the market, and by our conversations with our customers. As I stated previously, we place strategic emphasis on enhancing our competitive position and deepening our customer relationships during a downtime. Today, we believe we are in a solid position to realize market share gains as activity and volume levels increase. Finally, our outlook for the power-generation sub-market remains robust, given our industrial gas turbine, or IGT, market position and the forward demand we see in the replacement market.

Moving now to transportation, where revenues were down sequentially and year over year, primarily due to ongoing weakness in the heavy-truck market. We expect the heavy-truck market will continue to be challenging in the near term, as it works through a cyclical downturn. As we navigate this challenging environment, our strategic focus is on strengthening our competitive position and product offerings.

On the light-vehicle side, revenue was impacted by decreased production of select customer programs, as OEMs work to rebalance their inventories. We currently believe this trend is largely behind us. While North America light-vehicle production is projected to be down versus record levels last year, it remains in attractive market for Carpenter. And we are focused on continuing to strengthen our customer relationships.

Overall, we remain well positioned in the transportation market, given that our solutions help address evolving engine design and performance requirements. We have strong industry relationships and are one of the few advanced materials suppliers whose product portfolio helps address the critical challenges facing OEMs.

Moving to medical. On a sequential basis, medical sales were up a very healthy 9%, due primarily to continued strong interest for our high-end titanium, nickel, and cobalt solutions, as well as additional progress we have made shifting our customer base to more direct OEM relationships. Medical sales were down year over year, due to the ongoing impact of distributor and OEM inventory correction for select product groups. We believe this trend has moderated, as evidenced by recent booking rates, as well as conversations with our customers. Looking ahead, we anticipate further growth opportunities for our higher-end products, particularly on the titanium side, as we capture incremental market share.

Lastly, sales in the industrial and consumer end-use market were flat, on a sequential basis, due to improvement in select industrial applications. This was offset by lower consumer revenues due to seasonality patterns as well as timing of certain program launches.

The consumer sub-market is quickly becoming very exciting for us as our capabilities address critical needs in the electronics market, expanding battery life, durability, and shielding, which are all areas of increasing customer focus. Last quarter, we launched CarTech Hypocore alloy, the first in what will be a continuing series of new solutions to advance our clear leadership position in the high-performance electrical steel arena. With the drive towards miniaturization and embedded digital technology, our suite of soft magnetic solutions is enabling next-generation electrical machines and electromagnetic devices to be designed smaller and to be more efficient at higher frequencies while generating less heat.

Carpenter is a leader in multiple attractive end-use markets, due to the diversity of our offerings, our sole focus on premium specialty alloys, as well as in various customer needs and challenges that our solutions address. We view this end-use market diversity as a significant differentiating strength. Of course, our largest end-use market, accounting for over 50% of our sales in the second quarter, is aerospace and defense. The fundamental long-term growth drivers of the aerospace market remain strong. And Carpenter has differentiated the market position, given the breadth of our revenue streams.

Let's move to slide 7, and a more detailed look at our broad aerospace capabilities. Today, Carpenter has broad participation in the aerospace market, fueled by our specialty-alloy focus, strong customer relationships, and product diversity across multiple attractive industry sub-markets. The long-term growth potential of the aerospace market is demonstrated by a number of critical long-term projections, including steady growth in passenger miles, as well as the build range, provided by the engine and aircraft manufacturers.

As I mentioned, Carpenter has content across the new engine platforms, including [elite] engine and the geared turbofan. Both are projecting increases in deliveries for the next-generation engines in calendar-year 2017, with GE stating it will deliver more than 5X as many elite engines compared to 2016. Pratt & Whitney, currently expects to increased its geared turbofan production from 138 engines in 2016 to a range of 350 to 400 in calendar-year 2017. We have content on each of these new engine platforms, and stand to benefit from the sharp uptick in projected deliveries in calendar-year 2017. In terms of the aircraft OEMs, both Boeing and Airbus have strong long-term outlooks for aircraft build rates based on continued growth in global passenger traffic.

The engine and airplane build rates are important indicators by our future growth in aerospace, as we have broad industry participation and leadership positions across multiple sub-markets including engines, fasteners, and structural. The diversity of our product portfolio is a key competitive differentiator. And our specialty-alloy focus positions us to address evolving material needs facing the aerospace industry today and in the future. Whether an engine needs to run hotter to drive fuel efficiency, or reduced weight is required, or more corrosion-resistant material is needed, Carpenter provides solutions that enable our customers to address their challenges.

In the engine sub-market, a number of industry dynamics, including higher temperature and pressure, present growth opportunities for our [rings] and disk solutions while we also see increasing application demands for bearings and other products. OEMs are also looking for higher value-add products in the fastener market, both on the airframe and engine side, where today we are the market leader. And in structural, the focus on reduced weight and increased corrosion resistance is driving interest and usage of our specialty solutions and applications.

As part of our market-focused commercial strategy, we are in close collaboration with our aerospace customers and have launched new engine, structural, and avionics products this year to help meet the material requirements. Moving forward, we will continue to align our solution portfolio against current and future customer needs. This commitment is clearly demonstrated by the addition of titanium powder capabilities, which strengthens our ability to meet high-demand technology applications and needs in the aerospace market.

Overall, the aerospace market has strong long-term growth potential, given the industry dynamics with respect to engine and aircraft [build ring]. The diversity of our offerings in our market leadership puts Carpenter in solid position to capitalize on the many growth opportunities we see in the future. Now I'll turn the call over to Damon for the financial review.

Thank you, Tony. Good morning, everyone. Turning to slide 9 and the income statement summary. As Tony noted, we delivered a solid quarter in sequential net sales increasing across the majority of our end-use markets, most notably, our aerospace and defense segment, which represents 54% of our net sales in the quarter. The performance in this end-use market demonstrates the strength of our diversified aerospace product offerings, and that we are also well positioned to take advantage of the ramp-up in the new engine production in the years ahead.

Overall, net sales in the second quarter were $427 million, or $367 million excluding surcharge. Sales excluding surcharge increased 8% sequentially, reflecting the solid performance of our aerospace and defense market, as well as the improving demand in our energy business from the increased order activity related to the industrial gas turbine replacement cycle.

On a year-over-year basis, net sales excluding surcharge decreased $13 million, or 3%, on 6% lower volume due to the decline in the oil and gas portion of our energy end-use market, which had a volume decline of 31%, as well as a decline in our industrial and consumer end-use market, driven primarily by its exposure to the oil and gas markets. The year-over-year performance was also influenced by a decline in our transportation business, primarily due to demand trends in the heavy-truck category.

SG&A expenses were up $2.5 million on a sequential basis. SG&A expenses during the second quarter included a number of expenses related to our office and personnel relocations and other expenses that aren't necessarily incurred ratably throughout the year. Going forward, we would expect our SG&A to be more in line with our historical spend.

Operating income, as a percent of sales, when excluding pension EID and special items, was 5.7%, which was more than double the 2.6% reported in the first quarter. On a year-over-year basis, operating margin was down from the 7.7%, with the volume declines more than offsetting the cost savings associated with the execution of the Carpenter operating model.

Our effective tax rate for the second fiscal quarter was 15.7%, compared to a negative 17% in the first quarter, and 23.8% in last year's second fiscal quarter. The lower tax rate in the quarter was influenced by a tax benefit recognized in connection with the repatriation of earnings from one of our foreign subsidiaries. We continue to expect our full-year tax rate, excluding special items, to be in the range of 28% to 30%.

We recorded a net income of $7 million in the second quarter, or $0.15 per share. This performance represents a significant improvement versus the first quarter, with a $0.23 sequential increase in adjusted earnings per share.

Now, turning to slide 10. Free cash flow in the second quarter was negative $57 million, due primarily to the impact of our voluntary pension plan contribution of $100 million that we made back in October. Excluding the net tax effective pension plan contribution, which amounted to about $61 million outflow in the quarter, free cash flow was approximately $4 million during the quarter. This will be our seventh quarter of positive free cash flow out of the past eight quarters.

In the quarter, we increased inventory by $41 million, up from increases of $33 million in the first quarter and $2 million in the second quarter last year. The normal seasonal inventory increase was further magnified in the quarter as a result of the overhang from the lower sales in our first-quarter in several end-use markets. At this point, we continue to expect inventory to be flat at year-end 2017, compared to 2016 levels, as we work through the inventory in the second half of our fiscal year.

The working capital Other line was a positive $56 million during the quarter, which primarily reflects the cash tax benefit that we realized associated with the voluntary contribution made this quarter. Capital expenditures for the second quarter were $19 million, as compared to $27 million in the first quarter and in line with the $20 million in CapEx reported last year. We remain committed to taking a disciplined approach to managing our capital expenditures, as we seek to balance our maintenance capital needs against market conditions and our plans to strategically invest in our infrastructure to ensure we can capitalize on our growth opportunities across our end markets.

Turning to slide 11. Overall, our balance sheet and liquidity remain very strong. As of December 31, we had $492 million of total liquidity, including $23 million of cash and $469 million of borrowings available under our revolving credit facility. We have no significant debt maturities until FY22. In addition, with the $100 million voluntary pension contribution made in October, we don't expect to have any significant required pension contributions until FY20. Since we have no near-term calls on our free cash flow, we are well positioned to accelerate our growth through key opportunistic acquisitions, like the titanium powder transaction announced earlier today, which Tony will elaborate on in a moment.

Also, although we already maintain an investment-grade credit rating, we will continue to focus on strengthening our balance sheet, mainly through our pension-plan funded status, which will also help reduce income statement volatility as the funded status improves. At the same time, we remain committed to delivering direct returns to our shareholders via our quarterly dividend program. Looking ahead, we remain focused on driving free cash flow and closely managing our capital as we balance maintaining strong liquidity with strategic investments in our business and continued shareholder returns.

Turning to slide 12 and our SAO segment results. Net sales, excluding surcharge, were $288 million, representing an increase of $22 million versus the first quarter and a decrease of $11 million compared to last year's second quarter. The sequential increase in sales reflects stronger mix achieved across all of our end-use markets, which more than offset slightly lower volume.

Operating income was almost $36 million in the quarter up by approximately $11 million sequentially, and down by $6 million compared to last year's second quarter. Operating margin was 12.4% in the quarter, which was up compared to operating margin of 9.4% during the first quarter. This improvement was driven by improved mix across our end-use markets, as well as the continued improvements from the Carpenter operating model. Operating margin was down versus the 13.9% in the same quarter last year, due to 6% lower volume, partially offset by the improvements in our variable manufacturing costs related to the Carpenter operating model.

Our progress is evident in the reduction of our variable manufacturing costs, which decreased by 6% on a year-over-year basis. Our ongoing implementation of the Carpenter operating model is aimed at identifying additional channels to drive efficiency gains and reduce waste in our production and distribution processes. We believe the steps we are taking, which represent a broad and permanent cultural shift across the organization, will serve to increase customer service and strengthen our competitive position, and drive margin enhancement over the long term.

Looking at the third quarter in SAO, we expect continued strengthening across our end-use markets, given our booking levels and the demand indicators in the marketplace, as well as the traditional seasonal increase. On the cost side, we expect the continued execution of the Carpenter operating model to drive further efficiencies in operating margin expansion when taken in conjunction with the $3 million of savings associated with the pension freeze, and shift to the defined-contribution plans starting in the third quarter. As such, based on current market conditions, we expect operating income at SAO to be up approximately 20% on a sequential basis.

Now turning to slide 13 and the PEP segment overview. As Tony noted, this was our first profitable quarter since the fourth quarter of FY15, due to the improving oil and gas environment, the early benefits of the Carpenter operating model in this segment, as well as improved performance in our titanium business. On a year-over-year basis, PEP reported a sales decline of $2.2 million to $83 million, mainly due to the lower volumes related to the energy end-use market.

On a sequential basis, sales increased by $4.7 million, due primarily to increased rental activity in oil and gas, as well as higher demand for our titanium products. As Tony mentioned, we are encouraged by the further signs of recovery in the oil and gas market, as well as the increased activity we are seeing in our PEP businesses. However, it is still early in the recovery.

We will continue to work to enhance our customer relationships, and work to best position ourselves for success as the markets continue to strengthen. For our third fiscal quarter, we expect PEP to deliver further improvements in operating performance given the ongoing, albeit modest, recovery in the oil and gas demand as well as higher-than-market demand for our titanium products. Based on current market conditions, we expect PEP's operating income to almost triple compared to the $800,000 reported in the second quarter.

Turning now to slide 14, and an update on our full-year guidance items we provided on our last call. We continue to expect depreciation amortization to be at $120 million for the full year. In addition, we expect interest expense to be approximately $32 million.

With our largest defined-benefit plan being frozen effective December 31 of 2016, pension expense for the full year will be approximately $48 million. Of this, $31 million was incurred in the first half of our fiscal year. In addition to the $17 million of pension expense in the second half of the fiscal year, our defined-contribution costs will increase by approximately $5 million to reflect the shift of the defined-contribution plan versus defined-benefit plan. Also our guidance reflects the $100 million voluntary contribution made to our defined-benefit pension plan in October.

As I stated earlier, our full-year effective tax rate is expected to be in the range of 28% to 30% for the year. Finally, given the announced titanium powder acquisition, we have reduced our capital expenditure for the year to $100 million to reflect the elimination of the capital we had allocated for the construction of our planned titanium powder facility. Now I'll turn the call back over to Tony.

Thank you, Damon. Moving to slide number 16. Previously, I have talked to our strategy to become a leading solutions provider to our customers, an irreplaceable partner in the supply chain. We are focused on multiple growth enablers that will support and accelerate this strategy. For example, on our Athens campus, we have a super-alloy powder facility that is currently producing high-quality powder metals. We are working on the qualification process for this facility necessary to achieve its intended purpose of producing disk-quality powder for rotating components in aerospace jet engines.

Also in Athens we continue to progress on the VAP qualifications. As planned, we expect the submission of desired VAP qualifications to occur in calendar-year 2017. The timing and pace of the OEM approvals will be dictated by our customers, who continue to be actively involved.

And today we announced our agreement to acquire the assets of Puris, LLC, the leading producer of titanium powder for added manufacturing and other applications. This is a strategic transaction that provides us with immediate entry into the rapidly expanding titanium powder market. It advances our position in additive manufacturing, a key future growth area for our industry, and it strengthens our capabilities as a solutions provider for our customers. As a result of the transaction, we will enter the titanium-powder market significantly earlier than we previously planned, and we'll reduce our planned capital expenditures for the year, as Damon discussed.

The transaction brings industry-leading technology and processes for the production of titanium powder, additive manufacturing assets, a talented team, an attractive intellectual property portfolio, and established customer relationships across several of our key end-use markets. The immediate addition of titanium powder to our portfolio is significant, given the current and anticipated demand expected to come from the additive manufacturing industry.

We continue to transition Carpenter into a solutions provider and market-focused Company. We believe the expansion of a powder and additive manufacturing capability, together with our focus on premium alloys and broad commercial reach, positions us to strengthen the value we provide our customers and deliver against their growing needs. We will continue to evaluate strategic opportunities like this one that enable our organization to significantly strengthen our production and process capabilities, and enable us to drive success for our customers.

Now let's turn to slide number 17, and my closing comments. In the second quarter, we generated a notable sequential improvement in operating results driven by strong execution and improving conditions in several of our end-use markets. In aerospace, we experienced solid demand for the new engine platforms and remain well positioned to further benefit as the platform ramp continues. We remain cautiously optimistic about the oil and gas market, and are continuing to control what we can by strengthening our customer relationships and positioning ourselves to win market share.

And our realigned commercial team continues to forge deeper relationships with key customers and, combined with improving market conditions, is driving backlog growth for the first time in a year. The Carpenter operating model continues to be rolled out across our entire organization. And we are identifying and locking in additional costs and productivity gain. The success we are having here, generating operating leverage, will set the stage for continued margin enhancement.

We also continue to expand our solutions portfolio and capabilities to strengthen our market position in a number of important growth areas, including titanium powder and additive manufacturing. We believe these strategic actions strengthen our competitive position across the attractive end-use markets we serve, and set the foundation for sustainable long-term growth in revenues and profitability as volumes recover. And we have maintained our strong balance sheet position. We are making steady progress, quarter by quarter, in building a stronger and more profitable Carpenter.

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

(Operator Instructions)

Gautam Khanna, Cowen and Company.

Thank you. A couple questions, first, with the aerospace business up quite a bit sequentially, it sounded like not only the areas are picking up, as you mentioned, how much were engines up in the quarter? Are there any specific platforms that you can attribute it to? What do you think explains the surge?

Good morning, Gautam; this is Tony. The pickup was really across all of the platforms. I think I said in my speaker notes, in fact, that engines were up significantly sequentially as well as year over year.

What do you mean by significantly? If it was up 15% sequentially with the other pieces relatively down below that rate, what are we talking about, like 30%, 40%?

Let's go one by one. If you look at fasteners, we had just a slight uptick on fasteners. If you look at some of the other markets, we saw nice increases; on the engine side alone we were up 31% on a sequential basis and 19% on a year-over-year basis.

Okay. And do you think there is some catch-up of deferrals? Is this a sustained rate that we are going to be at? I just wonder what broke the log jam, because if you look at production, it hasn't really changed that much on a sequential basis so (multiple speakers) what is --?

Right. If you remember, our sequential quarter was quite low. So we came off a low bottom there. I think you are always going to have some ups and downs in the aerospace market. But if you look to our next quarter, I would tell you that where I stand right now, the engines will be higher in our next quarter than they were in this quarter we just completed.

Okay. And then maybe just a nit question, with all the pension changes, what is the ongoing pension EID expense? And if you could remind us of what the benefit to the segment average profits -- the segment EBIT is in the various segments from the changes to the pension, just sequentially?

Gautam, EID is going to -- as you know, that will be re-measured every year at the end of our fiscal year. So it is hard to give you a forecast for 2018 and beyond.

Sequentially for us, EID in the second quarter was just about $6 million; that will be the EID component going forward for Q3 and Q4 as well. So you will see no change there. Sequentially, for the service cost or the defined benefit plan versus the DC, that is about a $3 million sequential pickup in our third quarter versus our second quarter.

Is that mostly in SAO?

Yes.

Okay, and so the 20% increase in operating income, is that excluding the $3 million pickup in SAO, just from pension?

No. That would include it.

Okay. And then one other one on this acquisition that you announced. What are the immediate opportunities it provides? And can you talk a little bit about the company you are acquiring's customer base. What kind of contracts do they have either on GTF or what have you? Where are they? And where can you take it?

It is a relatively young company. If you know anything about Puris, a very solid group of owners. We will retain basically all of the employees. Many of their customers today are customers of ours right now. And areas that you will be looking at is primarily on additive manufacturing but also thermal spray, medical coating, near-net shape, et cetera.

Do they bring a position on any of these engines that are ramping right now: LEAP 1A, 1B, PW 1000, et cetera?

No.

Okay. Thank you. I will turn it over. I appreciate it.

Thank you.

Phil Gibbs, KeyBanc Capital Markets.

Good morning, Tony, Damon, Brad.

Morning, Phil.

Congrats on the progress.

Thank you.

I had a question on the mix. The mix in the second quarter was a lot higher than we were anticipating, and maybe even you were anticipating, probably a couple months ago. What really drove that? And then in terms of the base pricing per pound, particularly for SAO, should we expect that to moderate a bit as the sales growth becomes a little bit more broad-based into your seasonal strength?

Yes, Phil, so two things really drove the increased mix. One is aerospace engines, of course. That was up, as I told Gautam, up 31% sequentially.

The other thing was power generation. We had higher power generation sales than what we expected probably when we had announced the last time.

And in terms of your thought process with it continuing into the back half here? Should we expect the mix to normalize a bit, maybe to where it was in the last couple quarters or take an average of the last couple quarters? Just wondering how to think about that.

I would probably take an average. As we look forward, I think the mix is going to be strong, like I said earlier. We see aerospace engines being up again next quarter. As you well know, there is going to be some movement from quarter to quarter. But I think for the most part, we will be close to where we are at now.

Okay. And, Damon, why is the interest expense poised to go higher into the end of the year based on where your full-year guidance is?

Phil, we have a swap in there right now that we can't really record the benefit or the loss. In our $28 million we had last year, we had gains that reduced the underlying interest expense to the $28 million. Right now, where interest rates are, we can't forecast what it is going to be for the second half of the year. So, effectively, if it stays where it is, interest expense will come down a little bit from the $32 million.

Okay.

Phil, this is Tony again, if I could just follow up real quick when we talked about mix because you are hitting on a good point. As we look forward, there are so many moving parts. It doesn't take a whole lot to move the mix.

And that's why -- hopefully you will see in our slides that Damon presented, we gave a lot more guidance this quarter than we ever have in the past. And that is the primary reason, to try to make sure we stay on course to what we think the next quarter is going to be. And we don't leave you guessing about what the mix may or may not be.

I appreciate that -- a lot more helpful in terms of the details than normal, which we appreciate. A lot of good color in there.

In terms of the acquisitions, I think you made a comment, Damon, that you are going to be balancing capital allocation between keeping a strong balance sheet but also wanting to keep an eye on some tuck-ins. I think you just said acquisitions in general. Are you thinking about tuck-ins or something bigger? How should we think about, in terms of the size of the deals that you are going to be targeting?

There is nothing specific, Phil, that we're talking about. The statement more was for us as we look at the balances. Tony talks about growing the Business here, being more of a solutions provided to the customers.

We are looking at different product lines. We are looking at different forms. We are looking at the build versus buy, as you would expect us to do. And Puris is an example of that, that we had talked about the building of a titanium powder. But upon research we were able to identify a great company that gave us access to the market faster, and has allowed us to buy that marketplace position sooner than building it.

We will continue to do that. There is nothing specific that we will point to today. But we are continually looking at those opportunities as we look to grow the Business longer term.

Are you putting that titanium investment on hold right now? Or are you just trying to make a more measured entry with that investment, given the fact that you [took] the CapEx down?

We are not doing anything at Athens. We had not started the construction of the facility down there. So that plant is on hold right now.

Okay. I appreciate that. Thanks so much.

(Operator Instructions)

Jorge Beristain, Deutsche Bank.

This is Jorge Beristain with Deutsche Bank. Good morning, and congrats on the results. I had a question about the decision to buy versus build on the powder facility. Could you give us any color on what kind of multiples were paid for that asset, either on a trailing or forward basis?

Yes, Jorge, we are not going to go into the transaction details more than what we have disclosed. For us, we view it was an appropriate price for us to access the markets over the timeline versus what we were investing to the build that we had talked about previously and the duration for us to get into the market with qualified powder. But we are not going to go into any more specifics than that.

Okay. Are you sensing that you are taking share in fasteners? We just had some color from another company that was saying fasteners were down. You guys are up a bit sequentially. Is there anything to take away from that?

I think we are holding our own on the fastener side. We noted that it was up. It was only up slightly.

And keep in mind we have multiple customers and multiple product types. We have titanium, nickel, and stainless. So depending on what you hear in the market, it is always not one for one for us. Again, I think it is important to note that the sequential increase was slight.

Okay, and then last question, on the aerospace revenue exposure you have, could you just give us a big-picture of what your exposure is on narrow body as a percent of that aerospace pie, and specifically on Next-Gen engines? Because clearly you guys are not showing the same destock effects we are seeing in the other parts of the supply chain. And so I'm just trying to understand how unique your leverages are to narrow and Next-Gen engines. Thanks.

I would say, Jorge, we are balance for the most part on narrow versus wide body. We are across all the platforms. What might be helpful to you, if you take a look at our aerospace revenue, so aerospace and defense only, 40% is engines, roughly. That is a long-term average. If you look at this quarter, it was in the high 40%s.

Okay. So then you've just benefited, like you said, for that surge in engines that was really on the Next-Gen engines, and that is the differentiator versus a lot of other suppliers we're seeing that might be more air frame focused?

I guess you could say that. We are very focused on airframe as well. We still have some increases on the structural side. And what is very interesting is on the avionics side as well. So, those are some good growth avenues for us also.

Okay. Thank you.

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

Thanks, operator, and thanks, everyone, for joining us today. Have a great day.

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