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 and narrow strip 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 nine-month periods ended March 31, 2009 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. In addition, we may experience significant fluctuations in our quarterly income statement if inventory quantities change, in relation to the prior quarter, at the same time that raw material costs fluctuate. During our recent third quarter, we reduced inventories in a period of deflating raw material prices, which resulted in negative impacts.

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, we will experience a pre-tax net pension expense during fiscal year 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 estimated difference in reported earnings of $0.28 per share, with a third quarter year-to-year pre-tax impact of $4.7 million or $0.06 per share and a nine-month year-to-year pre-tax impact of $16.6 million or $0.22 per share.

Restructuring Charges

During the three months ended March 31, 2009, we recorded $2.1 million of restructuring charges associated with the closure our manufacturing facility in the United Kingdom ("UK"), which we announced in March 2009. The closure is expected to reduce our fixed costs and to utilize existing production capacity more efficiently with an ongoing profit improvement estimated at about $2.0 million per year. The manufacturing operations in the UK will wind down during the next several months with final closure targeted for June 30, 2009 and a total earnings impact of approximately $9.0 million in the current fiscal year. The charges recorded in the quarter ended March 31, 2009 consisted principally of employee severance costs and other exit costs.

Operating Performance Overview

For the quarter ended March 31, 2009, we reported income from continuing operations of $13.1 million or $0.30 per diluted share, compared with income from continuing operations for the same period a year earlier of $50.5 million or $1.05 per diluted share. For the nine months ended March 31, 2009, we reported income from continuing operations of $68.7 million or $1.56 per diluted share, compared with income from continuing operations for the same period a year earlier of $163.0 million or $3.29 per diluted share. In both cases, the lower earnings in the current period reflect lower sales levels, higher operating costs and the generally prevailing adverse economic conditions that became more severe from the middle of calendar year 2008. Our revenue decline this quarter reflected continued slowness in global industrial activity. Low oil prices have reduced demand in our energy end-use market, which had been a key growth driver in recent years. Also, demand in aerospace slowed significantly in the current quarter.

We continue to take appropriate actions to reduce manufacturing and other costs in order to adjust to the lower production levels. We also made considerable progress in reducing inventory levels during the quarter.

Results of Operations - Three Months Ended March 31, 2009 vs. Three Months Ended March 31, 2008

Net Sales

Net sales for the three months ended March 31, 2009 were $330.0 million, which was a 35 percent decrease over the same period a year ago. Adjusted for surcharge revenue, sales decreased 24 percent. Overall, pounds shipped were 31 percent lower than the third quarter a year ago.

Geographically, sales outside the United States decreased 37 percent from the same period a year ago to $111.8 million. The sales decline primarily reflects weakness in Europe for products in the aerospace, energy and automotive end-use markets. The decline also reflects a weakness in Canada for products used in oil and gas applications. International sales represented 34 percent of total sales for the quarter ended March 31, 2009 compared to 35 percent for the quarter ended March 31, 2008.

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
                                  March 31,               $               %
          ($ in millions)      2009         2008      (Decrease)      (Decrease)
          Aerospace         $    146.7    $  207.4   $      (60.7 )          (29 )%
          Industrial              79.1       110.5          (31.4 )          (28 )
          Energy                  35.0        54.8          (19.8 )          (36 )
          Medical                 28.4        34.6           (6.2 )          (18 )
          Consumer                20.7        44.7          (24.0 )          (54 )
          Automotive              20.1        54.4          (34.3 )          (63 )

          Total net sales   $    330.0    $  506.4   $     (176.4 )          (35 )%

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
                                                        March 31,                 $                 %
($ in millions)                                     2009          2008        (Decrease)        (Decrease)
Aerospace                                        $    116.5     $  140.8     $      (24.3 )            (17 )%
Industrial                                             62.7         73.7            (11.0 )            (15 )
Energy                                                 29.7         40.5            (10.8 )            (27 )
Medical                                                24.3         28.7             (4.4 )            (15 )
Consumer                                               16.9         31.0            (14.1 )            (45 )
Automotive                                             16.6         37.7            (21.1 )            (56 )

Total net sales excluding surcharge revenues     $    266.7     $  352.4     $      (85.7 )            (24 )%

Sales to the aerospace market decreased 29 percent from the third quarter a year ago to $146.7 million. Excluding surcharge revenue, sales decreased 17 percent from the third quarter a year ago on 17 percent lower shipment volume. The sales decline reflects the continued impact of a reduction in airplane build schedules and lower overall passenger miles, compounded by excess inventory in the jet engine supply chain. In addition, in the aerospace fastener segment, we observed for the first time, a weakened demand for nickel-based and titanium fasteners.

Industrial market sales decreased 28 percent from the third quarter a year ago to $79.1 million. Adjusted for surcharge revenue, sales decreased approximately 15 percent as a result of a 27 percent decrease in shipment volume. The results reflect competitive pricing pressures in more commodity-oriented applications and reduced overall demand for materials used in valves, fittings, fasteners, and general industrial applications.

Sales to the energy market of $35.0 million reflected a 36 percent decrease from the third quarter of fiscal year 2008. Excluding surcharge revenue, sales decreased 27 percent from a year ago on lower shipment volume of 43 percent. The decline in energy sales principally reflected lower oil and gas exploration activity in the face of weak demand for oil as the recession deepens. Drilling rig activity continues to decline and there is substantial excess inventory in the supply chain. Declining market demand and high customer inventory are also beginning to affect sales to the power generation sector as customers are continuing to struggle to obtain financing for these large pieces of equipment in the current credit markets.

Sales to the medical market decreased 18 percent to $28.4 million from a year ago. Adjusted for surcharge revenue, sales decreased 15 percent, while volumes increased 5 percent. The strong shipment volume reflects higher demand in orthopedic implant and medical instrument applications, while the revenue decline reflects the impact of lower titanium costs and a leaner mix of products. Demand is driven primarily by steady increases in the number of implant procedures in the U.S., Japan and the EU.

Sales to the consumer market decreased 54 percent to $20.7 million from a year ago. Adjusted for surcharge revenue, sales decreased 45 percent with shipment volume lower by 39 percent. The decline reflects lower sales across all sectors, led by housing and electronics as consumers continue to be cautious in today's economic environment of tighter credit and high unemployment.

Automotive market sales decreased 63 percent from the third quarter a year ago to $20.1 million. Excluding surcharge revenue, sales decreased 56 percent on 57 percent lower shipment volume. Sharply lower consumer spending and tighter credit continue to suppress auto sales, resulting in the further deterioration in production rates.

Sales by Product Class

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



                               Three Months Ended
                                   March 31,               $               %
         ($ in millions)        2009         2008      (Decrease)      (Decrease)
         Special alloys      $    179.7    $  268.4   $      (88.7 )          (33 )%
         Stainless steels         103.4       170.5          (67.1 )          (39 )
         Titanium products         33.2        48.2          (15.0 )          (31 )
         Other materials           13.7        19.3           (5.6 )          (29 )

         Total net sales     $    330.0    $  506.4   $     (176.4 )          (35 )%

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

                                                   Three Months Ended
                                                        March 31,                 $                 %
($ in millions)                                     2009          2008        (Decrease)        (Decrease)
Special alloys                                   $    137.5     $  165.7     $      (28.2 )            (17 )%
Stainless steels                                       82.6        119.7            (37.1 )            (31 )
Titanium products                                      33.2         48.2            (15.0 )            (31 )
Other materials                                        13.4         18.8             (5.4 )            (29 )

Total net sales excluding surcharge revenues     $    266.7     $  352.4     $      (85.7 )            (24 )%

Sales of special alloys products decreased 33 percent from a year ago to $179.7 million. Adjusted for surcharge revenue, sales decreased 17 percent on a 22 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 39 percent from a year ago to $103.4 million. Excluding surcharge revenue, sales decreased 31 percent on 35 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 31 percent from a year ago to $33.2 million on 24 percent lower volume. The results reflect the impact of significantly lower titanium prices together with decreased demand for titanium products used in the aerospace end-use market, which was only partially offset by a marginal increase in demand in the medical market.

Gross Profit

Our gross profit in the third quarter decreased 55 percent to $49.2 million, or 14.9 percent of net sales (18.4 percent of net sales excluding surcharges), as compared with $108.5 million, or 21.4 percent of net sales (30.8 percent of net sales excluding surcharges), in the same quarter a year ago. The lower gross profit was primarily due to lower demand resulting in lower shipment volumes. The volume reductions coupled with major reductions in inventory levels put downward pressure on our production levels and resulted in negative fixed costs impacts. We have worked to reduce labor costs in line with the lower production levels. However, we are buying much less nickel and other raw materials now, when prices are lower, which then required expensing of higher costs raw materials purchased earlier in the year which also has a negative effect on gross profit.

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
                                                                  March 31,
    (in millions)                                             2009          2008
    Net sales                                              $    330.0      $ 506.4
    Less: surcharge revenues                                     63.3        154.0

    Net sales excluding surcharges                              266.7        352.4


    Gross profit                                                 49.2        108.5


    Gross margin                                                 14.9 %       21.4 %


    Gross margin excluding dilutive effect of surcharges         18.4 %       30.8 %

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 negatively impacted gross margin by 300 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 190 basis points during the quarter ended March 31, 2009, compared to a negative impact on gross margin of approximately 10 basis points during the prior year's quarter.

Selling, General and Administrative Expenses

Selling, general and administrative expenses of $31.0 million were 9.4 percent of net sales (11.6 percent of net sales excluding surcharges) as compared with $33.8 million or 6.7 percent of net sales (9.6 percent of net sales excluding surcharges) in the same quarter a year ago. Excluding the impact of changes in net pension expense discussed above, expenses improved by 12 percent over last year's third quarter principally as a result of reductions in costs associated with compensation expense, outside services and travel-related expenses.

Interest Expense

Interest expense for the quarter was $3.9 million, as compared with $5.1 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 $2.7 million as compared with $3.7 million in the third quarter a year ago.

Income Taxes

Our tax provision for the recent quarter was $1.8 million, or 12.1 percent of pre-tax income, versus $22.8 million, or 31.1 percent, for the same quarter a year ago. The lower tax rate results from applying certain research and development tax credits to our lower taxable income level as well as the impact of the reversal of certain unrecognized tax benefits due to the lapse of certain statutes of limitations. These items were partially offset by an increase in the valuation allowance related to state net operating loss carryforward deferred tax assets.

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             $               %
                                        March 31,             Increase /      Increase /
    ($ in millions)                 2009          2008        (Decrease)      (Decrease)
    Advanced Metals Operations   $    227.7      $ 361.9     $     (134.2 )          (37 )%
    Premium Alloys Operations         104.2        146.8            (42.6 )          (29 )
    Intersegment                       (1.9 )       (2.3 )            0.4            (17 )

    Total net sales              $    330.0      $ 506.4     $     (176.4 )          (35 )%

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

                                                    Three Months Ended                 $                 %
                                                         March 31,                Increase /         Increase /
($ in millions)                                     2009            2008          (Decrease)         (Decrease)
Advanced Metals Operations                       $    185.8        $ 261.6       $       (75.8 )            (29 )%
Premium Alloys Operations                              82.8           93.1               (10.3 )            (11 )
Intersegment                                           (1.9 )         (2.3 )               0.4               17

Total net sales excluding surcharge revenues     $    266.7        $ 352.4       $       (85.7 )            (24 )%

Advanced Metals Operations ("AMO") Segment

Net sales for the quarter ended March 31, 2009 for the AMO segment decreased 37 percent during the quarter ended March 31, 2009 to $227.7 million, as compared with $361.9 million in the same quarter a year ago. Excluding surcharge revenues, net sales decreased 29 percent on 33 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 $11.2 million or 4.9 percent of net sales (6.0 percent of net sales excluding surcharge revenues) in the recent quarter, as compared with $44.9 million or 12.4 percent of net sales (17.2 percent of net sales excluding surcharge revenues) in the same quarter a year ago. The decrease in operating income reflects lower shipment volume coupled with the negative fixed cost impacts related to our inventory reduction efforts.

Premium Alloys Operations ("PAO") Segment

Net sales for the quarter ended March 31, 2009 for the PAO segment decreased 29 percent to $104.2 million, as compared with $146.8 million in the same quarter a year ago. Excluding surcharge revenues, net sales decreased 11 percent on 25 percent lower shipment volume from a year ago. Both the sales and shipment volume decreases were due to lower demand, particularly in our energy end use market.

Operating income for the PAO segment was $15.2 million or 14.6 percent of net sales (18.4 percent of net sales excluding surcharge revenues) in the recent quarter, compared with $34.3 million or 23.4 percent of net sales (36.8 percent of net sales excluding surcharge revenues) in the same quarter a year ago. The decrease in operating income principally reflects lower shipment volume, the negative timing impacts from raw material hedges and the negative effects of our inventory reduction efforts.

Results of Operations - Nine Months Ended March 31, 2009 vs. Nine Months Ended March 31, 2008

Net Sales

Net sales for the nine months ended March 31, 2009 were $1,105.4 million, which was a 21 percent decrease from the same period a year ago. Adjusted for surcharge revenue, sales decreased 14 percent. Overall, pounds shipped were 15 percent lower than a year ago.

Geographically, sales outside the United States decreased 17 percent from a year ago to $394.8 million. The sales decline reflects the weakening of sales to customers in Europe, Canada and Asia Pacific. International sales represented 36 percent of total sales for the nine months ended March 31, 2009 compared to 34 percent for the nine months ended March 31, 2008.

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:



                              Nine Months Ended
                                  March 31,              $               %
          ($ in millions)     2009        2008       (Decrease)      (Decrease)
          Aerospace         $   458.5   $   538.0   $      (79.5 )          (15 )%
          Industrial            271.2       327.5          (56.3 )          (17 )
          Energy                129.6       156.8          (27.2 )          (17 )
          Consumer               83.2       123.2          (40.0 )          (32 )
          Medical                81.6        93.2          (11.6 )          (12 )
          Automotive             81.3       158.5          (77.2 )          (49 )

          Total net sales   $ 1,105.4   $ 1,397.2   $     (291.8 )          (21 )%

. . .