Carpenter Technology - Earnings Call - Q2 2020

Transcript

Speaker 0

Good morning, and welcome to the Carpenter Technology's Second Quarter Fiscal twenty twenty Earnings Conference Call. All participants will be in listen only mode. Please note this event is being recorded. I would now like to turn the conference over to Brad Edwards, Investor Relations. Please go ahead.

Speaker 1

Thank you, operator. Good morning, everyone, and welcome to the Carpenter Technology earnings conference call for the fiscal second quarter ended December 3139. 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 Tain, President and Chief Executive Officer and Tim Lane, 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 ks for the year ended June 3039, Form 10 Q for the quarter ended September 3039, and the exhibits attached to those filings. Please also note that in the following discussion, unless otherwise noted, when management discusses sales or revenue, that reference excludes surcharge. When referring to operating margins, that is based on operating income and sales, excluding surcharge. I will now turn the call over to Tony.

Speaker 2

Thank you, Brad, and good morning to everyone on the call today. Let's begin on Slide four and a review of our safety performance. Our total case incident rate, or TCIR, stands at 1.3 through the second quarter of fiscal year twenty twenty. Our employees are the face of our safety program. They are the most knowledgeable about the workplace and know how to make it safer.

Their engagement and promotion of our safety system is essential for our success. While TCIR is our primary measure of performance, we continue to see improvements in our leading indicators. For instance, when we look at our total injuries, which include first aid treatment cases, our injury frequency rate has improved seventeen percent year over year. In addition, proactive activities such as reporting of near misses and safety stops have increased by forty four percent. The emphasis we have placed on improving our safety culture has resulted in a reduced severity of injuries, which is a direct result of our employees' involvement and engagement.

We are confident that continued focus on ongoing investment in our safety systems will deliver our ultimate goal of a zero injury workplace. Now let's turn to Slide five and a review of the second quarter performance. Our second quarter results demonstrate our ability to deliver consistent year over year earnings growth and drive backlog expansion while generating record performance at SAO. This past quarter marked our twelfth consecutive quarter of year over year sales and earnings growth. It also marked the twelfth consecutive quarter of year over year backlog growth as we continue to execute at a high level.

Our solutions help customers address critical performance requirements, and this is driving expanded sales opportunities and share gains across our end use markets. At SAO, we are driving a richer product mix, which contributed to record second quarter operating income. This marked the second consecutive quarter of record operating income performance at SAO. In addition, our deliberate mix shift, the benefit of our Athens facility and productivity improvements resulted in adjusted operating margin of 19.9% during the second quarter. This is the fifth consecutive quarter in which FAO adjusted operating margin was above 18%.

In the Aerospace and Defense end use market, sales increased 19% year over year and backlog was up 14% compared to last year. Our sales and backlog performance in the aerospace and defense end use market demonstrate the benefits of our broad solution portfolio, our strong presence across attractive submarkets and participation on almost all the major platforms. In addition, customer activity and dialogue at Athens remained high, and we received four additional VAP approvals during the second quarter. Sales in the medical end use market, which accounts for approximately 9% of total company revenue, increased 13% compared to last year as our high value solutions continue to capitalize on strong demand patterns. Lastly, we continue to be committed to building on our strong core business by making strategic investments in critical emerging technologies.

These are areas that we believe will be significant in the future of our industry, and our investments will strengthen our long term position as a solutions provider and critical supply chain partner for our customers. I will touch more on this subject later in the presentation. Now let's move to Slide six and the end market update. Looking first at aerospace and defense, where sales increased 19% compared to last year. This is year over year growth in each of our aerospace submarkets.

The seven thirty seven MAX grounding and recent production halt is a major and ongoing development for the entire aerospace supply chain. While we are certainly not immune to the situation, we do believe we are well positioned to navigate the near term impact. I will provide more detailed comments on this topic shortly. Moving on to the medical end use market, where sales were up 13% year over year. This growth was due to share gains primarily in the orthopedic and dental submarkets.

It is clear our solutions bring significant value to customers as we are winning market share, and our deepened OEM relationships are unlocking incremental opportunities for our high value applications. Capacity expansion projects at Dynamet are nearing completion, which will allow us to further capitalize on the strong forward demand indicators we see in this end use market. We see ongoing strong demand for applications across many of our submarkets, including orthopedics, cardiology and dental. In the transportation end use market, sales were up 4% compared to last year. In the light vehicle submarket, there's increasing demand in North America for local content and high temperature resistant alloys.

We are capitalizing on these demand patterns with our high temperature bar and strip solutions that are specifically designed to address increasing engine performance requirements. Now moving to the energy end use market and our oil and gas and power generation submarkets. Total energy sales declined 26% year over year. The oil and gas market is facing significant headwinds in North America as operators have reduced drilling activity, idled equipment and continue to operate with a focus on managing free cash flow. The North American directional and horizontal rig count fell 9% sequentially and was down 23% compared to last year.

The oil and gas submarket accounts for only 5% of total company revenue. Given the ongoing challenges facing the oil and gas business, especially in North America, we initiated restructuring actions at our Amega West business during the second quarter. In the industrial and consumer end use market, revenues were down 18% year over year, as sales declined mainly due to reduced infrastructure activity and some volatility in the semiconductor market. It is also important to note that our sales into the industrial submarket continue to be impacted by portfolio prioritization as we further shift our production to higher value solutions. Now let's move to Slide seven, where I will update you on the seven thirty seven MAX discussion.

Over the last several years, we have worked hard to refine our strategic vision, which is to be a preferred solutions provider of mission critical products and an irreplaceable partner in the supply chains we participate. I've mentioned several times in the past that the breadth of our solutions portfolio is a strategic advantage. That advantage is evident today as the supply chain manages through the seven thirty seven MAX disruption. More than half of our total revenue is generated from the aerospace and defense end use market, which, as you know, is an attractive margin business. However, we also provide key solutions in other strategic end use markets such as medical, industrial and consumer, and transportation.

Important to note that across every one of these end use markets, we participate in the top 1% of the value pyramid, high end specialty alloy products that address critical application performance requirements. In our aerospace and defense market, we participate in rich submarkets, such as engines, fasteners, structural and defense, with exposure on practically all commercial platforms. We believe our diverse industry participation from an application and submarket standpoint is an important differentiator when compared to other aerospace supply chain participants. As such, this portfolio breadth provides opportunities to partially mitigate disruptions in the market, such as the current seven thirty seven MAX issue over the next couple quarters. With that said, it's clear that the supply chain reaction to the recent seven thirty seven MAX developments remains in a state of flux.

We are working closely with our customers to understand their material needs and evaluate how their reaction to the seven thirty seven MAX production halt will ultimately impact our production plans. Of course, every customer is different. For instance, we know of certain customers that already anticipated the latest negative news to some degree and adjusted their projected requirements. We've also seen certain customers reporting a high need for spares and asking for urgent spot support. To be clear, when I speak of the need for spares, I'm referring to older engines which are still in service and are running longer.

Of course, are many supply chain participants who are still evaluating how they want to proceed as they look to balance near term reduced requirements against the need to maintain production rate readiness. This is a critical concept to manage as production capacity in this complex supply chain can easily and effectively be turned off and on. Finally, there are participants that did not anticipate the recent news. Having built ahead, they are now expressing reduced near term requirements. That takes us to the ultimate question.

What is the anticipated impact of Carpenter Technology due to the seven thirty seven MAX disruption? Carpenter Technology provides specialty materials to our customers, who in turn use that material to forge and manufacture parts that are ultimately used in the production of aircraft and related components. This makes it more difficult for us to specifically identify which platform or application each pound of material that we sell will be used in. However, we know our customers well and can make certain assumptions. Those assumptions are based on where we believe our customers are positioned in the supply chain and what portion of their business is allocated to each aircraft platform, as well as where they might be leading or lagging actual demand.

With that framework in mind and based on what we know today, we estimate the net impact for our SAO segment in the third quarter to be approximately $10,000,000 of operating income. Let me offer a few points of clarification. The estimate is not exact, but rather represents the average of a range based on varying time assumptions. The estimated financial impact is a net impact number. In other words, it is our estimated gross impact less an estimate of any mitigating actions.

And finally, this estimate is for SAO Q3 only and may not be relevant to other periods. Assuming this estimated net impact, SAO operating income in Q3 is projected to be similar to the results delivered in Q2. The result would be a record third quarter for SAO despite the negative impact of the seven thirty seven MAX disruption. I think that speaks to the earnings strength of SAO. For our PEP segment, we estimate that the net impact in Q3 will be between $1,500,000 and $2,500,000 in operating income.

The same clarifications I just made apply to the PEP segment estimate as well. Obviously, the fourth quarter is less clear. We would expect that the gross impact will be higher, but we also have more opportunity to exercise the mitigating actions. That being said, it is possible that the fourth quarter net impact is similar to what I just communicated for the third quarter. As I mentioned, the exposure we are referring to is net of actions we anticipate will reduce the disruption impact.

Those actions in the near term include redeploying capacity to non-seven 37 MAX demand for firm orders currently in our backlog. This would include firm orders for the broader aerospace and defense market as well as high value applications across our other end use markets, including transportation, medical, energy, and industrial and consumer end use markets. In some cases, the long lead times we have seen due to the ramp in aerospace demand over the last several years have been limiting our ability to capitalize on sales opportunities in other markets. We believe we may be able to be more flexible in these high value areas by redeploying our capacity as the aerospace supply chain digests the seven thirty seven MAX production situation. While the ongoing seven thirty seven MAX situation is certainly a major development, we continue to believe in the strong, long term underlying fundamentals of the aerospace market.

Seven thirty seven MAX situation clearly presents challenges for the overall aerospace supply chain. However, we believe we are better positioned than many other companies to weather this situation. We will continue to evaluate the situation, stay in close contact with our customers, and execute initiatives aimed at partially offsetting the negative impact of the seven thirty seven MAX disruption. Now I'll turn it over to Tim for the financial review.

Speaker 3

Thanks, Tony. Good morning, everyone. I'll start on Slide nine, the income statement summary. Net sales in the second quarter were $573,000,000 and sales excluding surcharge were 471,200,000.0 Sales excluding surcharge grew 5% year over year on 7% lower volume, driven by double digit growth in our aerospace and defense and medical end use markets. Demand levels remain strong as total backlog grew 7% year over year, again driven by strength in Aerospace and Defense.

This quarter marked the twelfth consecutive quarter of year over year backlog growth. SG and A expenses were $55,300,000 in the second quarter, up roughly $4,000,000 from the same period a year ago. The increase is primarily due to the ongoing investments in additive manufacturing. Going forward, we expect SG and A expenses to be relatively flat or about $55,000,000 per quarter for the balance of the year. Operating income was $55,000,000 in the quarter compared to $55,400,000 in the prior year period.

Operating income in the current second quarter includes $2,300,000 of restructuring charges related to footprint and cost structure of that business to reflect current market conditions. Last year's second quarter included $1,200,000 of acquisition related costs associated with the LPW transaction. Excluding these special items, operating income was $57,300,000 in the current quarter and $56,600,000 in the same quarter last year. Operating income excluding special items as a percentage of sales was 12.2 percent in the quarter. Our effective tax rate for the second quarter was 23.2%.

We currently expect the effective tax rate to be 23% to 25% for the balance of the year. Net income for the quarter was $38,800,000 or $0.79 per diluted share. When adjusted for the restructuring charges, adjusted earnings per share was $0.83 for the quarter. Adjusted EPS grew 9% year over year, marking the twelfth consecutive quarter of year over year earnings growth. Now turning to Slide 10 and a review of free cash flow.

Free cash flow in the second quarter was negative $35,000,000 Within the quarter, we increased inventory by $57,000,000 We expect to reduce inventory in the second half of our fiscal year, consistent with our historic pattern of building inventory in the first half with a follow on reduction in inventory in the second half of the fiscal year. In the second quarter, we spent $47,000,000 on capital projects. We expect to spend $170,000,000 in capital expenditures for fiscal year twenty twenty, consistent with our prior guidance. Within the $170,000,000 there are several large multi year projects. First, the $100,000,000 hot strip mill being constructed on our Reading, PA campus.

This investment is being made to provide enhanced capacity and capabilities related to our soft magnetics portfolio and is expected to be completed in the summer of this year. Second, in the third quarter of fiscal year twenty twenty, we will complete the capacity expansion projects for our Dynamet titanium business, allowing us to capture emerging growth for our high value titanium solutions in the medical market. Finally, we recently completed our emerging technology center. In early December, we held a grand opening to showcase the facility that is located on our Athens, Alabama campus. Tony will provide some more commentary on this project later in the presentation.

Finishing up this slide, our liquidity position remains strong. As of the close of the current quarter, we had $3.00 $5,000,000 of total liquidity, including $30,000,000 of cash. As we have consistently said, our financial position is important as it allows us the flexibility to invest in our future growth and return value to shareholders. Now turning to Slide 11 and our SAO segment results. Net sales for the quarter were $483,000,000 or $382,500,000 excluding surcharge.

Sales excluding surcharge increased 7% year over year on 8% lower volume. The results reflect strong demand in the aerospace and defense and medical end use markets combined with continued improvement in our product mix. The improvement was partially offset by the ongoing weakness in the energy market and our portfolio rationalization efforts in the industrial and consumer market. Sequentially, sales excluding surcharge decreased 3% on 6% lower volumes. SAO operating income was $76,300,000 for the second quarter with adjusted operating margin of 19.9%.

The same quarter a year ago, SAO's operating income was on record for SAO. We continue to surpass prior financial performance due to the coupling of improving year over year product mix and creating incremental capacity being manufacturing improvements. The current quarter's results were negatively impacted by a pronounced surcharge lag. As a reminder, for most of our business, the impact of changes in raw materials is passed through to our customers via surcharges. A portion of our business has a surcharge mechanism that is not aligned with how we buy raw materials and therefore creates a surcharge lag.

The surcharge lag is only significant in periods of sharply changing raw material prices. Over the last several quarters, the surcharge lag has been in the range of 1,000,000 to $2,000,000 and has not had a significant impact on earnings. In the current quarter, given a sharp increase in nickel prices, the surcharge lag resulted in an unfavorable impact in operating income of about 4,000,000 In terms of the outlook for the upcoming third quarter, we continue to see strong demand in most of our key end use markets. As Tony mentioned in his comments, we are currently evaluating opportunities to mitigate the impact of the seven thirty seven MAX disruption in our third quarter. Based on feedback from our customers and what we now know, we expect that we will be able to partially mitigate the near term impacts of this disruption and still deliver similar operating income in Q3 relative to Q2 for SAO.

Now turning to Slide 12 and our PEP segment results. Net sales excluding surcharge were $104,100,000 which were down $5,000,000 from Q2 of fiscal year twenty nineteen. In the current quarter, PEP generated operating income of $400,000 Dynamet continued to experience strong demand for titanium products, predominantly in the aerospace and defense and medical end use markets in the second quarter. The current quarter's results for Dynamet were slightly below expectations. However, with the completion of the expansion projects, we expect to capture additional medical market opportunities in the second half of the fiscal year.

The ongoing challenges in the oil and gas industry, especially in North America, continue to negatively impact Amega West operating income. As I mentioned earlier, we took action in the second quarter to rationalize the footprint and cost structure of that business based on the current market environment. We will continue to evaluate strategic options for Amega West going forward as the market evolves. The additive manufacturing business generated similar sequential losses in the current quarter and we continue to view additive as a long term investment in an emerging market. As we look ahead to the third quarter, we expect PEP to deliver operating income similar to the second quarter.

Our estimate for Q3 includes the expected impact of seven thirty seven MAX disruption on PEP. Further, the downturn in the energy market, specifically in the Permian Basin is expected to continue. Oil and gas customers are continuing to moderate investments. We will also continue to invest strategically in additive manufacturing as this platform is critical for our long term growth strategy. I'll now turn the call back over to Tony.

Thanks, Tim. Let's move

Speaker 2

to Slide 14. As I noted earlier, over half of our revenue comes from the aerospace and defense end use market. The long term fundamentals of the aerospace market are robust, and Carpenter Technology is well positioned to capitalize on the future growth, especially with the ramp up of our facility in Athens, Alabama. But the seven thirty seven MAX issue is a reminder that disruptions in the complex aerospace supply chain will occur from time to time. At Carpenter Technology, we want to be well prepared to medicate such disruptions as well as build out businesses that will accelerate our revenue and earnings growth.

With that in mind, we continue to operate with a focus on driving near term earnings growth while also investing for the future in order to position Carpenter Technology for sustainable long term growth. We are doing this in three distinct areas as portrayed on the slide. First, investing in emerging technologies such as additive manufacturing to ensure our place as an irreplaceable solutions provider in the years to come. Second, identifying attractive market adjacencies for our solutions such as soft magnetics that will strengthen our capabilities to capitalize on future disruptive trends. And third, expanding our capacity and capability to meet strong forward demand patterns in our medical end use market, which is one of our fastest growing markets.

Let me start with additive manufacturing. I firmly believe that the future of our industry and our customers' material needs are going to be meaningfully impacted by additive manufacturing. Our strategy over the last several years has been to build a leading end to end additive manufacturing platform by combining the foundation of our long history of powder metallurgy capabilities and expertise with capabilities acquired through several strategic acquisitions. The capstone of our additive manufacturing journey to date was the completion of our Emerging Technology Center, or ETC, on our Athens campus. The ETC demonstrates our end to end platform by managing a complete production cycle under one roof and in one location of making metal powder, producing parts via additive manufacturing, finishing the parts and shipping the finished parts to customers.

Another area where we continue to invest for future growth is soft magnetics to capitalize on the growing number of electrification initiatives being pursued by major OEMs. We are leveraging our existing proprietary alloys and developing solutions for this rapidly developing market that includes not only electric vehicles, but also other electrification initiatives in markets such as aerospace and defense. The construction of our hot strip mill on our Reading campus remains on track as we look to expand our existing soft magnetics capabilities and capacity. And lastly, the capacity expansion projects at our Dynamic facilities. The medical end use market has been one of our fastest growing markets, given consistent strong demand for our high value solutions.

The capacity expansion at Dynamet will enable us to further capitalize on the demand for our solutions, which are becoming increasingly recognized and used in the development of new medical applications. To summarize, these growth areas, additive manufacturing, soft magnetics and increased titanium capacity, are strategic extensions of our core business and critical to accelerating our earnings growth and remain a solutions provider for our customers in the years and decades to come. Now let's turn to the next slide and my closing comments. In closing, let me summarize the key takeaways from today's call. Number one, we continue to deliver consistent year over year earnings growth and backlog expansion.

The second quarter was our twelfth consecutive quarter of year over year earnings and sales growth and our twelfth consecutive quarter of year over year backlog growth. Number two, SAO delivered another record quarterly operating income with adjusted operating margins of 19.9%. We see strong potential for further margin expansion at SAO given our ongoing mix shift to higher value applications, the benefits of our Athens facility and continued productivity improvement through the Carpenter operating model. Number three, customer engagement at Athens remains high given the critical incremental capacity we can offer the aerospace industry. We continue to progress on obtaining the stringent VAP qualifications and received four additional qualifications during our second quarter.

Number four, the long term demand signals in aerospace and defense remain robust, with a current backlog close to 13,000 aircraft, which represents seven to eight years of production. In addition, our broad platform exposure and leading position across multiple attractive aerospace submarkets offer strong future growth opportunities. Number five, our medical end use market continues to deliver meaningful year over year growth as our high value solutions are fulfilling emergent demand, and we are consistently driving sales in excess of market growth rates. Number six, we continue to operate with a focus on driving near term earnings growth while also investing for the future in our position Carpenter Technology for sustainable long term growth. These investments include additive manufacturing, soft magnetics and the titanium capacity expansion.

Number seven, our balance sheet remains strong and we have no significant near term financial obligations. This gives us the continued flexibility to invest in our future growth and best position Carpenter Technology for increasing returns to shareholders. And number eight, while the supply chain disruption caused by the seven thirty seven MAX will have a near term impact, we believe we are well positioned to manage the situation. We have a diverse range of applications across other end use markets. We have a broad solution portfolio across multiple attractive aerospace submarkets.

We participate on almost every commercial aerospace platform, and we have opportunities to redeploy capacity to capitalize on the growth opportunities in markets other than aerospace. Seven thirty seven MAX disruption is the highest profile topic in aerospace industry today, and rightly so. However, we are optimistic that an appropriate solution will be agreed to, and the aircraft will return to service. Without question, there will be a near term impact to earnings. We have given you guidance estimates for our next two quarters with the understanding that the situation can change quickly.

But the long term earnings potential of Carpenter is intact. The seven thirty seven MAX disruption does not change that. We remain excited about the future of Carpenter Technology. We believe the execution of our strategy will continue to enhance our long term sustainable growth profile and will result in increasing returns for our shareholders and customers for years to come. Thank you for your interest, and I'll turn it back to the operator to field your questions.

Speaker 0

The first question is from Josh Sullivan of The Benchmark Company. Please go ahead.

Speaker 3

Good morning.

Speaker 4

Are they willing to negotiate? How aggressive do you need to be to get them to take that capacity?

Speaker 2

Well, good morning, Josh. I think the point is here we have orders from customers in different markets that today we cannot fit into our near term schedule. So this isn't a point of us going out and trying to find, quote, new business. This is business that we have in front of us that now allows us to pull that forward and satisfy that customer.

Speaker 4

Customers are taking that inventory without any price concessions or anything along those lines?

Speaker 2

We don't have any reason to do price concessions.

Speaker 4

Got it. And then just as far as the VAP qualifications go, where do you stand on the total number expected? I know some are more important than others. Maybe where do you stand on a percentage basis of the total business needing VAP approvals?

Speaker 2

With the four this quarter, that puts us at 19. So I would say that's well over half of our way there. As you know, not every qualification is of equal weight. Obviously, the four that we received this quarter are meaningful, but there are still a couple large ones out there that we are working through. And many times, I've said this before, I would take progress on a very substantial qualification before I might take a final qualification on another one, if that makes sense.

So we received four qualifications this month, but just as importantly, we moved the ball down the field substantially on a couple other very significant ones for us that I think you'll see us start to announce over the next couple of quarters.

Speaker 4

Got it. And then just switching over to the Pet business. On the medical side, obviously some great growth. One, is there any opportunity to vertically integrate there? And then two, the utilization versus the margin dynamic with this new capacity coming on, how leverageable is that?

How should we think about that as it gets filled here over the next year?

Speaker 2

Let me take the second part first. We've timed this expansion in our Dynamet facility primarily due to medical, and we're really on the razor's edge, so to speak. In many cases, you build the capacity before the demand. We are actually both of those simultaneously. So our customers are asking for that material right now.

It is a relatively complex expansion because we are expanding not just both of our facilities, but we are moving some equipment between the facilities. So that makes just another level of complexity. So the answer there is we are trying to expand and move equipment at the same time that we're trying to deal with, in some cases, significant increase in demand. That is the challenge right now. And to be very transparent, I think the team is doing a very nice job, but I think we need to go faster.

And we have customers that are standing beside us right now, but at the end of the day, they want more material. And we need to up our game a bit there to push this expansion across the line and get them the material they so much desire.

Speaker 4

Appreciate it. I'll get back

Speaker 2

to The first part of your question of vertical integration, I think that really might come from a I think that's where the additive manufacturing comes into play. I don't want to talk I don't have a lot of information I'd share with you at this time, but I think there are opportunities for us in the vertical integration side around the AM business that we're building. The

Speaker 0

next question is from Phil Gibbs of KeyBanc Capital Markets. Please go ahead.

Speaker 5

Hey, good morning.

Speaker 2

Good morning, Phil.

Speaker 5

Hey, Tony, what was the backlog growth overall year on year? I think you said Aerospace and Defense is 14%, but what was the overall number? And then also, you give us a feel for what your jet engine sales were year on?

Speaker 2

You got it. So the overall backlog growth was 7%. So it's a little lower than it's been the last couple of quarters. As you might guess, what's pushing that number down is energy business. The backlog has decreased substantially year over year.

And also, our transportation business was down a bit as well. That's a business for us that is quite critical for us, but at times we have an issue of fitting that into the schedule. From an engine I think you asked the engine sales year over year, they were up year over year by 17.5% and up 4% sequentially.

Speaker 5

Okay. And then just a general kind of view here as we think about your Aerospace and Defense businesses in its entirety. You gave a nice breakout here between Engines, Faster, Structural and Defense. But if I think about just aftermarket or call it MRO versus OEM within that whole portfolio, any sense and or feel? Is it an equal split?

Are you heavier on the OE side? Just trying to think through this as the market's gonna be in flux for a few quarters.

Speaker 2

It is not an equal split. I would say we're more dependent on the OEM versus the aftermarket. I'd rather not give you the exact breakout, but I would say the majority is OEM.

Speaker 5

Okay. That's helpful. I appreciate it, guys. Thanks so much.

Speaker 2

Yes. Thank you.

Speaker 0

The next question comes from Gautam Khanna of Cowen and Company. Please go ahead.

Speaker 6

Hey, good morning guys.

Speaker 2

Good morning, Gautam.

Speaker 6

Hey. Couple questions. So just on the sequential EBIT impact that you talked about at SAO of 10,000,000, so flat sequentially. That's net. So what is sort of what's your estimate of the gross impact, if you will, before the mitigation?

And what happens to the 4,000,000 of out of phase surcharges? Does that ever come back? Is that included in the 10,000,000 net? Any granularity there would be helpful.

Speaker 2

Okay. I'll start with the first one and let Tim take on the two different questions and two separate issues. We made a conscious decision, Gautam, and I'm not surprised you're the one to ask this question. We made a conscious decision to say it's not the best thing for us to do to talk about what our content is per platform, right, which gets into your question about what's gross and what's net and trying to really bifurcate all of that out. Obviously, we have assumptions and we have marks for each one of those platforms to be able to get you to the number that we did.

For us, we thought it was best to give you that net number and really give you some clarity of what the impact was going to be for the quarter. We spent quite a bit of time on that, quite frankly. And I'd rather just stick to that going forward as opposed to saying what's the gross amount, what is the net amount. I think it is fair to point out that because of the longer cycle products that we make, the production cycle is quite long. Obviously, the impact in Q3 is going to be less because those products are already in production cycle.

Our contracts, for the most part, allow us to not accept changes to that cycle once it has been started. But then once we get to the second quarter sorry, the fourth quarter, our fiscal fourth quarter, that dynamic changes a little bit, right? So the gross impact will increase. But as I said on the call, it also gives us an opportunity now to adjust milk schedules to go after some other business. So didn't answer your question directly there, but hopefully you understand that's really the way we've decided to guide on this very important issue going forward.

And I'll give it back to Tim to talk about the lag.

Speaker 3

Yes, Gotham on the lag. As I said in my remarks, it generally hasn't been a big driver of profitability one way or the other. It's been about $1,000,000 or two We did have that big spike in nickel prices early in the quarter. So assuming nickel prices normalize here and stay where they are, yes, there may be some return of that favorable lag, but that's kind of all built into our numbers for Q3.

Speaker 2

And Gautam, I'll just add. As you all know, you can do the math. I mean, dollars $0.01 earnings per share is only about $600,000 of operating income for us. So it doesn't take a whole lot to get to $01 a share, and SAO came in a bit below our guidance, and that was really one of the main factors. The lag was a little bit more negative than what we anticipated, and our shipments were a little bit like those last couple of days of the quarter with the holidays.

There's a couple of shipments that we didn't get out. That was really the main the two main drivers for a relatively small miss in SAO from our stand versus our guidance, I should say.

Speaker 6

Yes. No, I agree. And then just so I understand, have the customers have your customers in the forging supply chain conveyed to you what their plans are for the June? Or is this truly in flux? Like, you're you know, you just don't know.

They haven't they haven't given you a number because we're hearing all kinds of things from the supply chain as they report. I'm just curious how fluid the situation is. And then relatedly to a prior question on pricing in other markets, should we be concerned that as other suppliers like yourselves look to backfill capacity that's been freed up from lower max volume, that there is a bit of a price degradation as you pursue those marginal those other markets because everyone's trying to do it at the same time. Any perspective

Speaker 2

Listen, I'll take the second one first. We do not anticipate that, and we do not anticipate taking that approach. We see this as a long term approach. This is a short term issue the way we see it, albeit a significant one. So it's not about price concessions in the near term.

It doesn't make sense to us. That's not the business that we're in. And I think the relationships we have with our customers are very strong, and we understand that. And we want to have a long term relationship with the customer. So I do not see that dynamic in the market.

To your customer question, there's can think about it this way. Our customers are in about every situation you can be in. Like we said, there are some that have been very much more, I'll say, aggressive looking forward, anticipating what this might be, and they've made some adjustments to their requirements. And those are built in. Those are built into our guidance today.

There are others that, although they're making these adjustments, they pivoted a bit and said, Hey, we have a need over here. Can we move some of our quote capacity to that area? We still see some urgent spot requests. There are other customers, Gotham, that are still working through this and understanding how they want to handle it. I've I've listened to a couple earnings calls prior to ours and listened to the management team speak.

And it's a very important point that you said you can't turn this capacity on and off like a light switch. So a lot of them are really trying to think, hey, I can't take this production down to zero because if I do, I can't get it back fast enough when this demand comes back. So there's a nice chunk of customers that are wrestling with that very difficult question right now. Of course, there's a couple that have built a little bit more inventory than what they would like, and we're working with them on an individual basis to mitigate that for them. I can say that the majority of our contracts do have some flexibility clauses that we and it defines when a customer can and can't make a change.

For the most part, we do not accept changes once that product has started production or if it's in finished goods. But again, we prefer a long term relationship, and we work with each of our customers on a one on one basis to try to help them manage through this process effectively just like we're trying to.

Speaker 6

And one last one, if I may. Just at the PEP segment, Boeing announced the 7 87 rate cut to 10 at some point in early twenty twenty one. When would you a, like, is there any ballpark you can give us on the magnitude of the impact to PAP Dynamet and when you might feel it? Because I know it's a big titanium fastener platform. And wondering when that starts to kick in and how that informs your view on the June.

Speaker 2

We've taken into consideration. So the guidance that we have given you takes into consideration all those factors. Now, I've not given a specific number of what the how that impacts us for July. I would say this when you think about Dynamet. And a lot of people, rightly so, think about DynaMed as an aerospace business.

And that's true. And it's a very good business for us, and we're very appreciative to have it. But DynaMed is a medical business as well, and over 50% of our revenues are coming from medical in DynaMed. And that's a bit of a mind shift that not everyone has really caught on to yet. So I hope that helps.

Thanks, guys.

Speaker 0

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

Speaker 1

Thanks, Kate, and thanks, everyone, for joining us today on our second quarter earnings call. We look forward to speaking with all of you on our third quarter call in April. Have a great day.

Speaker 0

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