Background and General

Carpenter is engaged in the manufacturing, fabrication, and distribution of specialty metals. We primarily process basic raw materials such as nickel, cobalt, titanium, chromium, iron scrap and other metal alloying elements through various melting, hot forming and cold working facilities to produce finished products in the form of billet, bar, rod, wire, narrow strip, special shapes and hollow forms in many sizes and finishes. We also produce certain metal powders. Our sales are distributed directly from our production plants and distribution network as well as through independent distributors.

Our discussions below in this Item 2 are based upon the more detailed discussions about our business, operations and financial condition included in our Annual Report on Form 10-K for the fiscal year ended June 30, 2008, under Item 8 thereof. Our discussions here focus on our results during or as of the three-month and six-month periods ended December 31, 2008 and the comparable periods of fiscal year 2008, and, to the extent applicable, on material changes from information discussed in that Form 10-K or other important intervening developments or information. These discussions should be read in conjunction with that Form 10-K for detailed background information.

Unless specifically stated otherwise, all discussions of operating results reflect continuing operations.

Raw Material Pricing and Product Mix

The volatility of the costs of raw materials has impacted our operations over the past few years. We, and others in our industry, generally have been able to pass cost increases on certain materials through to our customers using surcharges that are structured to recover increases in raw material costs. In the last several years, as raw material prices have escalated, surcharges have become an increasingly significant component of our net sales, which had a dilutive effect on our gross margin and operating margin percentages as described later in this discussion. Generally, the formula used to calculate a surcharge is based on published prices of the respective raw materials for the previous month. A portion of our raw material purchases is based on published prices from two months prior, rather than the previous month, which creates a lag between surcharge revenues and corresponding raw material costs recognized in costs of sales. Except for the usually modest effect of the lag, the surcharge mechanism protects our net income on such sales. We value most of our inventory utilizing the last-in, first-out ("LIFO") inventory costing methodology. Under the LIFO inventory costing method, changes in the cost of raw materials and production activities are recognized in cost of sales in the current period even though these materials may have been acquired at potentially significantly different values due to the length of time from the acquisition of the raw materials to the sale of the processed finished goods to the customers. In a period of rising raw material costs, the LIFO inventory valuation normally results in higher costs of sales. Conversely, in a period of decreasing raw material costs, the LIFO inventory valuation normally results in lower costs of sales.

A portion of our business consists of sales to customers under firm price sales arrangements. Firm price sales arrangements involve a risk of profit margin fluctuations particularly as raw material prices have been volatile. Firm price sales arrangements generally include certain annual purchasing commitments and consumption schedules agreed to by the customers at selling prices based on raw material prices at the time the contracts are consummated. In order to effectively reduce the risk of fluctuating profit margins on these sales, we enter into commodity forward contracts to purchase certain critical raw materials necessary to produce the related products sold. If a customer fails to meet the volume commitments or the consumption schedule deviates from the agreed upon terms of the firm price sales arrangements, the Company may need to absorb the gains or losses associated with the commodity forward contracts on a temporary basis. Gains or losses associated with commodity forward contracts are deferred and recognized in earnings as the inventory is sold. Since we value most of our inventory under the LIFO costing methodology, the gains and/or losses associated with commodity forward contracts may not impact the same quarter that the firm price sales contracts revenue is recognized and comparisons of gross profit from quarter to quarter may be impacted.

We produce hundreds of grades of materials, with a wide range of pricing and profit levels depending on the grade. In addition, our product mix within a period is subject to the fluctuating order patterns of our customers as well as decisions we may make to participate in certain lower margin business in order to utilize available capacity. While we expect to see positive contribution from a more favorable product mix in our margin performance over time, the impact by period may fluctuate, and period-to-period comparisons may vary.

Net Pension Expense

Based on the decline in the market value of the securities in our defined benefit pension plans as of June 30, 2008, the Company will experience a pre-tax net pension expense during fiscal 2009 of $20.1 million. This is a non-cash expense that is being amortized equally for each quarterly period during the fiscal year. The pension expense equates to a year-to-year difference in reported earnings of $0.28 per share, with a second quarter year-to-year pre-tax impact of $5.9 million or $0.08 per share and a six-month year-to-year pre-tax impact of $11.8 million or $0.16 per share.

Operating Performance Overview

For the quarter ended December 31, 2008, we reported income from continuing operations of $29.8 million or $0.68 per diluted share, compared with income from continuing operations for the same period a year earlier of $57.1 million or $1.16 per diluted share. For the six months ended December 31, 2008, we reported income from continuing operations of $55.6 million or $1.26 per diluted share, compared with income from continuing operations for the same period a year earlier of $112.5 million or $2.25 per diluted share. In both cases, the lower earnings in the current period reflect lower sales levels, higher operating costs, the impacts of pricing pressures experienced during the current year and the generally prevailing adverse economic conditions that became more severe from the middle of calendar year 2008. Notwithstanding the declines in our earnings during the current periods, we believe we are in a solid position to operate profitably over the near-term during this downturn and that the long-term prospects in our key markets of aerospace, energy and medical remain strong. Through the current downturn, our management will continue to act aggressively to cut costs and conserve cash.

As the domestic and international economies softened, we have taken actions to reduce our costs. These actions include the restructuring of several layers of our upper management and otherwise improving our operations in response to lower demand anticipated during the next few quarters

Results of Operations - Three Months Ended December 31, 2008 vs. Three Months Ended December 31, 2007

Net Sales

Net sales for the three months ended December 31, 2008 were $361.8 million, which was an 18 percent decrease over the same period a year ago. Adjusted for surcharge revenue, sales decreased 13 percent. Overall, pounds shipped were 10 percent lower than the second quarter a year ago.

Geographically, sales outside the United States decreased 14 percent from the same period a year ago to $130.3 million. The sales decline primarily reflects weakness in Europe. International sales represented 36 percent of total sales for the quarter ended December 31, 2008 compared to 34 percent for the quarter ended December 31, 2007.

Sales by End-Use Markets

Our sales are to customers across a diversified list of end-use markets. The
table below includes comparative information for our estimated sales by end-use
markets:



                               Three Months Ended
                                  December 31,            $              %
           ($ in millions)      2008         2007      Decrease      (Decrease)
           Aerospace         $    154.7    $  168.6   $    (13.9 )           (8 )%
           Industrial              88.6       105.9        (17.3 )          (16 )
           Energy                  41.2        54.2        (13.0 )          (24 )
           Automotive              25.3        47.1        (21.8 )          (46 )
           Consumer                26.8        39.5        (12.7 )          (32 )
           Medical                 25.2        27.5         (2.3 )           (8 )

           Total net sales   $    361.8    $  442.8   $    (81.0 )          (18 )%

The following table includes comparative information for our estimated net sales by the same principal end-use markets, but excluding surcharge revenues:

                                                   Three Months Ended
                                                      December 31,               $               %
($ in millions)                                     2008          2007        Decrease        Decrease
Aerospace                                        $    116.6     $  121.8     $     (5.2 )           (4 )%
Industrial                                             62.1         69.1           (7.0 )          (10 )
Energy                                                 34.5         41.5           (7.0 )          (17 )
Automotive                                             18.8         33.3          (14.5 )          (44 )
Consumer                                               20.2         26.1           (5.9 )          (23 )
Medical                                                21.0         22.6           (1.6 )           (7 )

Total net sales excluding surcharge revenues     $    273.2     $  314.4     $    (41.2 )          (13 )%

Sales to the aerospace market decreased 8 percent from the second quarter a year ago to $154.7 million. Excluding surcharge revenue, sales decreased 4 percent from the second quarter a year ago on flat volume. The sales results principally reflect lower demand for materials used in jet engines, while sales for fastener applications have remained strong. The steady shipment volume performance reflects strengthening in our customer positions despite weakening market demand.

Industrial market sales decreased 16 percent from the second quarter a year ago to $88.6 million. Adjusted for surcharge revenue, sales decreased approximately 10 percent as a result of a 4 percent decrease in shipment volume. The results reflect lower sales of materials used in valves and fittings, fasteners and wire rod, partially offset by stronger demand for products used in welding and general industrial applications.

Sales to the energy market of $41.2 million reflected a 24 percent decrease from the second quarter of fiscal year 2008. Excluding surcharge revenue, sales decreased 17 percent from a year ago on lower shipment volume of 20 percent. Most of the decline experienced in the energy market reflects softer demand in the oil and gas exploration sector as excess inventory continues to build up in our customer base and in the overall supply chain. Power generation sector sales and shipments fell somewhat as demand weakened in the U.S. for high-end industrial gas turbines using our materials.

Sales to the medical market decreased 8 percent to $25.2 million from a year ago. Adjusted for surcharge revenue, sales decreased 7 percent, while volumes increased 9 percent. The coupling of strong shipment volume with a sales revenue decline reflects strength in demand for materials used in joint replacements and surgical instruments in the current period and lower titanium raw material prices compared to last year.

Sales to the consumer market decreased 32 percent to $26.8 million from a year ago. Adjusted for surcharge revenue, sales decreased 23 percent with shipment volume lower by 19 percent. The decline reflects lower sales in all sectors, led by housing and electronics.

Automotive market sales decreased 46 percent from the second quarter a year ago to $25.3 million. Excluding surcharge revenue, sales decreased 44 percent on 33 percent lower shipment volume. The continuing weakness in the automotive market has not abated as OEMs in the U.S. implement more plant closings and global auto makers reduce production.

Sales by Product Class

The following table includes comparative information for our net sales by major
product class:



                                 Three Months Ended
                                    December 31,            $             %
           ($ in millions)        2008         2007      Decrease      Decrease
           Special alloys      $    174.6    $  238.5   $    (63.9 )        (27 )%
           Stainless steels         131.9       144.9        (13.0 )         (9 )
           Titanium products         35.0        38.6         (3.6 )         (9 )
           Other materials           20.3        20.8         (0.5 )         (2 )

           Total net sales     $    361.8    $  442.8   $    (81.0 )        (18 )%

The following table includes comparative information for our net sales by the same major product class, but excluding surcharge revenues:

                                                  Three Months Ended
                                                     December 31,             $              %
($ in millions)                                    2008         2007       Decrease       Decrease
Special alloys                                  $    121.5    $  156.1    $    (34.6 )         (22 )%
Stainless steels                                      97.0        99.5          (2.5 )          (3 )
Titanium products                                     35.0        38.6          (3.6 )          (9 )
Other materials                                       19.7        20.2          (0.5 )          (3 )

Total net sales excluding surcharge revenues    $    273.2    $  314.4    $    (41.2 )         (13 )%

Sales of special alloys products decreased 27 percent from a year ago to $174.6 million. Adjusted for surcharge revenue, sales decreased 22 percent on a 14 percent decrease in shipment volume. The sales decrease principally reflects the decline in demand from the aerospace and energy markets.

Sales of stainless steels decreased 9 percent from a year ago to $131.9 million. Excluding surcharge revenue, sales decreased 3 percent on 9 percent lower shipment volume. The decrease resulted primarily from reduced shipments of materials used in the automotive, industrial and consumer markets.

Sales of titanium products decreased 9 percent from a year ago to $35.0 million on 10 percent higher volume. The coupling of a sales revenue decrease with a shipment volume increase reflects the impact of significantly lower titanium prices together with increased demand for titanium products especially in the medical and aerospace end-use markets.

Gross Profit

Our gross profit in the second quarter decreased 35 percent to $75.9 million, or 21.0 percent of net sales (27.8 percent of net sales excluding surcharges), as compared with $116.1 million, or 26.2 percent of net sales (36.9 percent of net sales excluding surcharges), in the same quarter a year ago. The lower gross profit was primarily due to lower shipment volumes along with higher manufacturing costs, pricing pressures, the timing impact of raw material hedges and other negatives from the low price of nickel.

Our surcharge mechanism is structured to recover increases in raw material costs, although generally with a lag effect. While the surcharge generally protects the absolute gross profit dollars, it does have a dilutive effect on gross margin as a percent of sales. The following represents a summary of the dilutive impact of the surcharges on gross margin for the comparative three-month periods:

                                                             Three Months Ended
                                                                December 31,
    (in millions)                                             2008          2007
    Net sales                                              $    361.8      $ 442.8
    Less: surcharge revenues                                     88.6        128.4

    Net sales excluding surcharges                         $    273.2      $ 314.4


    Gross profit                                           $     75.9      $ 116.1


    Gross margin                                                 21.0 %       26.2 %


    Gross margin excluding dilutive effect of surcharges         27.8 %       36.9 %

In addition to the impact of the surcharge mechanism, fluctuations in raw material prices (combined with fluctuations in inventory levels) have impacted our gross profit from quarter to quarter. We estimate that the effect of such combined fluctuations positively impacted gross margin by 40 basis points when comparing gross margin for the recent quarter with the prior year's quarter. We estimate that the lag effect of the surcharge mechanism positively impacted gross margin by approximately 90 basis points during the quarter ended December 31, 2008, compared to approximately 150 basis points during the prior year's quarter.

The biggest contributor to the reduction in gross profit in the current versus the prior year's quarter, however, is lower shipment volumes. Manufacturing costs were higher than the prior year, but have improved as compared with our first quarter performance, as we have worked through the equipment start-up issues we were experiencing a few months ago. In addition, we also experienced during the second quarter the negative timing impact associated with hedge contracts, as well as other negatives from the current low price of nickel, neither of which was significant during the comparable period of fiscal year 2008.

Selling, General and Administrative Expenses

Selling, general and administrative expenses of $36.2 million were 10.0 percent of net sales (13.2 percent of net sales excluding surcharges) as compared with $36.6 million or 8.3 percent of net sales (11.6 percent of net sales excluding surcharges) in the same quarter a year ago. The relatively total flat levels of selling, general and administrative expenses reflect an increase in the net pension expense during the recent quarter that served to offset reductions in compensation expense, outside services and travel-related expenses.

Interest Expense

Interest expense for the quarter was $3.8 million, as compared with $5.3 million in the same quarter in the prior year. The decrease in interest expense is attributable to reductions in our outstanding debt and increased amounts of capitalized interest associated with several large construction projects, during the current versus the prior year's quarter.

Other Income, Net

Other income for the recent quarter was $6.5 million as compared with $12.1 million in the second quarter a year ago. The decrease was due to reduced interest income partially offset by foreign exchange gains. In addition, the recent quarter includes $6.0 million related to funds received under the Continued Dumping and Subsidy Offset Act of 2000 (the "Act") as compared with $8.2 million in the same period a year ago

Income Taxes

Our tax provision for the recent quarter was $12.6 million, or 29.7 percent of pre-tax income, versus $29.2 million, or 33.8 percent, for the same quarter a year ago. The income tax provision for the recent quarter was favorably impacted by the retroactive extension of the research and development tax credit, which was partially offset by the reduction in tax-exempt interest earned during the recent quarter as compared to the same period a year ago.

Business Segment Results

Following the divestiture during fiscal year 2008 of our ceramics and metals shapes businesses, which historically comprised our Engineered Products Operations segment, we have two reportable business segments: Advanced Metals Operations ("AMO") and Premium Alloys Operations ("PAO").

The following table includes comparative information for our net sales by business segment:

                                     Three Months Ended
                                        December 31,               $             %
      ($ in millions)                 2008          2007        Decrease      Decrease
      Advanced Metals Operations   $    253.0      $ 313.4     $    (60.4 )        (19 )%
      Premium Alloys Operations         112.1        132.6          (20.5 )        (16 )
      Intersegment                       (3.3 )       (3.2 )         (0.1 )         (3 )

      Total net sales              $    361.8      $ 442.8     $    (81.0 )        (18 )%

The following table includes comparative information for our net sales by business segment, but excluding surcharge revenues:

                                                   Three Months Ended
                                                      December 31,                $              %
($ in millions)                                    2008           2007         Decrease       Decrease
Advanced Metals Operations                      $    193.4       $ 224.2      $    (30.8 )         (14 )%
Premium Alloys Operations                             83.1          93.4           (10.3 )         (11 )
Intersegment                                          (3.3 )        (3.2 )          (0.1 )          (3 )

Total net sales excluding surcharge revenues    $    273.2       $ 314.4      $    (41.2 )         (13 )%

Advanced Metals Operations ("AMO") Segment

Net sales for the quarter ended December 31, 2008 for the AMO segment decreased 19 percent during the quarter ended December 31, 2008 to $253.0 million, as compared with $313.4 million in the same quarter a year ago. Excluding surcharge revenues, net sales decreased 14 percent on 14 percent lower shipment volume from a year ago. Both the sales and shipment volume decrease reflect lower demand in the automotive, industrial and consumer markets.

Operating income for the AMO segment was $31.2 million or 12.3 percent of net sales (16.1 percent of net sales excluding surcharge revenues) in the recent quarter, as compared with $44.5 million or 14.2 percent of net sales (19.8 percent of net sales excluding surcharge revenues) in the same quarter a year ago. The decrease in operating income principally reflects lower shipment volume and the impacts of higher operating costs and pricing pressures.

Premium Alloys Operations ("PAO") Segment

Net sales for the quarter ended December 31, 2008 for the PAO segment decreased 16 percent to $112.1 million, as compared with $132.6 million in the same quarter a year ago. Excluding surcharge revenues, net sales decreased 11 percent on 8 percent lower shipment volume from a year ago. Both the sales and shipment volume decrease was due to lower demand, particularly in the oil and gas sector of our energy end use market.

Operating income for the PAO segment was $19.3 million or 17.2 percent of net sales (23.2 percent of net sales excluding surcharge revenues) in the recent quarter, compared with $39.6 million or 29.9 percent of net sales (42.4 percent of net sales excluding surcharge revenues) in the same quarter a year ago. The decrease in operating income principally reflects lower volume as well as the negative timing impacts from raw material hedges and an unfavorable shift in product mix during the recent quarter as compared to the same period in the prior year.

Results of Operations - Six Months Ended December 31, 2008 vs. Six Months Ended December 31, 2007

Net Sales

Net sales for the six months ended December 31, 2008 were $775.4 million, which was a 13 percent decrease from the same period a year ago. Adjusted for surcharge revenue, sales decreased 8 percent. Overall, pounds shipped were 6 percent lower than a year ago.

Geographically, sales outside the United States decreased 6 percent from a year ago to $283.1 million. The sales decline reflects the weakening of sales to customers in Europe and Asia Pacific. International sales represented 37 percent of total sales for the six months ended December 31, 2008 compared to 34 percent for the six months ended December 31, 2007.

Sales by End-Use Markets

Our sales are to customers across a diversified list of end-use markets. The
table below includes comparative information for our estimated sales by end-use
markets:



                                 Six Months Ended
                                   December 31,           $            %
             ($ in millions)      2008       2007     Decrease      Decrease
             Aerospace         $    312.0   $ 330.8   $   (18.8 )         (6 )%
             Industrial             192.1     217.0       (24.9 )        (11 )
             Energy                  94.6     102.0        (7.4 )         (7 )
             Automotive              61.2     104.1       (42.9 )        (41 )
             Consumer                62.4      78.4       (16.0 )        (20 )
             Medical                 53.1      58.6        (5.5 )         (9 )

             Total net sales   $    775.4   $ 890.9   $  (115.5 )        (13 )%

The following table includes comparative information for our estimated net sales by the same principal end-use markets, but excluding surcharge revenues:

                                                  Six Months Ended
                                                    December 31,             $              %
($ in millions)                                    2008        2007       Decrease       Decrease
Aerospace                                       $    232.1    $ 236.5    $     (4.4 )          (2 )%
Industrial                                           132.4      138.1          (5.7 )          (4 )
Energy                                                78.4       78.6          (0.2 )          -
Automotive                                            44.6       71.1         (26.5 )         (37 )
Consumer                                              44.2       51.5          (7.3 )         (14 )
Medical                                               43.4       49.4          (6.0 )         (12 )

Total net sales excluding surcharge revenues    $    575.1    $ 625.2    $    (50.1 )          (8 )%
. . .