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, manganese, chromium, molybdenum, 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. Unlike many other specialty steel producers, we operate a worldwide network of service/distribution centers. These service centers, located in the United States, Canada, Mexico, Asia and Europe, allow us to work more closely with customers and to offer various just-in-time stocking programs. As a result, we often serve as a technical partner in customizing specialty metals or in developing new ones.

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, 2009, under Item 8 thereof. Our discussions here focus on our results during or as of the three-month period ended September 30, 2009 and the comparable period of fiscal year 2009, and, to the extent applicable, on material changes from information discussed in that Form 10-K or other important intervening developments or information that we have reported on Form 8-K. These discussions should be read in conjunction with that Form 10-K for detailed background information and with any such intervening Form 8-K.

Impact of Raw Material Prices and Product Mix

The volatility of the costs of raw materials has impacted our operations over the past several 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. 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 are 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. However, surcharges have had a dilutive effect on our gross margin and operating margin percentages as described later in this discussion.

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 when raw material prices are 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 arrangements are established. In order to 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 reclassified to earnings/loss when earnings are impacted by the hedged transaction. Because 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 period that the firm price sales contracts revenue is recognized and comparisons of gross profit from period to period 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

Net pension expense below includes the net periodic benefit costs related to both our pension and other postretirement plans. The current quarter's results include non-cash net pension expense of $0.21 per diluted share versus $0.06 per diluted share in the same quarter last year. The following is a summary of the classification of net pension expense included in our statements of operations for the three months ended September 30, 2009 and 2008:

                                                         Three Months Ended
                                                           September 30,
       (in millions)                                     2009          2008
       Cost of sales                                  $      11.2    $     3.0
       Selling, general and administrative expenses           4.1          2.1

       Total pension expense                          $      15.3    $     5.1

Net pension expense is determined annually based on beginning of year balances, and is recorded ratably throughout the fiscal year, unless a significant re-measurement event were to occur. A significant increase in net pension expense during fiscal year 2010 is expected due to the decline in the market value of the assets held by the plans as of June 30, 2009. We currently expect that the total net pension expense for fiscal year 2010 will be $61.1 million as compared with $25.0 million in fiscal year 2009.

Operating Performance Overview

For the quarter ended September 30, 2009, we reported a loss of $(9.3) million or $(0.21) per diluted share, compared with income for the same period a year earlier of $25.8 million or $0.58 per diluted share. We believe that our revenue level has bottomed this quarter and will likely improve quarter-to-quarter over the balance of the year. While we predict the pace of the economic recovery will vary considerably among markets, we are seeing balanced inventories in certain segments of our business including aerospace engines, power generation and automotive.

We continue to take appropriate actions to reduce costs in all areas, improve our manufacturing efficiencies and respond to recovery within all of our markets. We will also continue our investment in key emerging markets, research and development and new market initiatives to drive long-term growth and value creation.

Results of Operations - Three Months Ended September 30, 2009 vs. Three Months Ended September 30, 2008

Net Sales

Net sales for the three months ended September 30, 2009 were $233.7 million, which was a 44 percent decrease over the same period a year ago. Adjusted for surcharge revenue, sales decreased 38 percent. Overall, pounds shipped were 30 percent lower than the first quarter a year ago.

Geographically, sales outside the United States decreased 53 percent from the same period a year ago to $71.9 million. The reduction reflects declines in energy, aerospace and automotive demand, especially in Europe. International sales represented 31 percent of total sales for the quarter ended September 30, 2009 compared to 37 percent for the quarter ended September 30, 2008.

Sales by End-Use Markets

Our sales are to customers across diversified end-use markets. During the current quarter, we changed the manner in which sales are classified by end-use market so that we could better evaluate our sales results from period to period. In order to make the discussion of net sales by end-use market meaningful, we have reclassified the prior year's quarter sales by end-use market balances to conform to the current year presentation. The table below includes comparative information for our estimated sales by end-use markets:

                             Three Months Ended
                               September 30,             $                %
         ($ in millions)      2009         2008      (Decrease)       (Decrease)
         Aerospace         $    102.9    $  157.6   $      (54.7 )           (35 )%
         Industrial              50.4        99.8          (49.4 )           (49 )
         Energy                  12.1        53.4          (41.3 )           (77 )
         Medical                 25.5        29.2           (3.7 )           (13 )
         Consumer                23.4        36.0          (12.6 )           (35 )
         Automotive              19.4        37.7          (18.3 )           (49 )

         Total net sales   $    233.7    $  413.7   $     (180.0 )           (44 )%

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
                                                September 30,               $                  %
($ in millions)                               2009          2008        (Decrease)         (Decrease)
Aerospace                                  $     81.1     $  115.5     $      (34.4 )             (30 )%
Industrial                                       42.2         67.5            (25.3 )             (37 )
Energy                                            9.3         44.0            (34.7 )             (79 )
Medical                                          20.9         23.3             (2.4 )             (10 )
Consumer                                         18.4         24.4             (6.0 )             (25 )
Automotive                                       16.0         27.2            (11.2 )             (41 )

Total net sales excluding surcharge
revenues                                   $    187.9     $  301.9     $     (114.0 )             (38 )%

Sales to the aerospace market decreased 35 percent from the first quarter a year ago to $102.9 million. Excluding surcharge revenue, sales decreased 30 percent from the first quarter a year ago on 22 percent lower shipment volume. The sales decline reflects the lower airplane build levels, reductions of inventory in the supply chain and a less favorable mix of products. Supply chain inventory for jet engine materials appears to be in better balance, and we anticipate that it will result in order activity more closely tied to usage. Fastener demand continues to be soft with excess inventory remaining at manufacturers and distributors and a longer lead time to builds.

Industrial market sales decreased 49 percent from the first quarter a year ago to $50.4 million. Adjusted for surcharge revenue, sales decreased approximately 37 percent as a result of a 27 percent decrease in shipment volume. The decline in sales and volumes reflects continuing weak manufacturing demand and the impacts of lower pricing.

Sales to the energy market of $12.1 million reflected a 77 percent decrease from the first quarter a year ago. Excluding surcharge revenue, sales decreased 79 percent from a year ago on lower shipment volume of 81 percent. Excess inventories in the supply chain continue to exacerbate an already weak demand for materials in oil and gas exploration. Inventory levels serving the power generation market have become more stable, which we anticipate should result in increased demand for our products.

Sales to the medical market decreased 13 percent to $25.5 million from a year ago. Adjusted for surcharge revenue, sales decreased 10 percent, while shipment volumes increased 15 percent. Shipment volume increases reflect higher demand for materials used for implant procedures and our improved position in medical instrument applications, while the revenue decline is attributable to lower shipment volume and material costs of titanium and a less favorable mix of products.

Sales to the consumer market decreased 35 percent to $23.4 million from a year ago. Adjusted for surcharge revenue, sales decreased 25 percent with shipment volume lower by 16 percent. The decline reflects lower sales primarily in the housing and electronics segments.

Automotive market sales decreased 49 percent from the first quarter a year ago to $19.4 million. Excluding surcharge revenue, sales decreased 41 percent on 21 percent lower shipment volume. As expected, domestic auto production increased in the first fiscal quarter due to the impact of incentive programs and a new model year. Supply chain inventory has been significantly reduced, which we anticipate should lead to more demand pull-through for materials.

Sales by Product Class

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



                              Three Months Ended
                                September 30,             $                %
        ($ in millions)        2009         2008      (Decrease)       (Decrease)

        Special alloys      $    120.8    $  205.2   $      (84.4 )           (41 )%
        Stainless steels          74.0       144.9          (70.9 )           (49 )
        Titanium products         26.8        41.8          (15.0 )           (36 )
        Other materials           12.1        21.8           (9.7 )           (45 )

        Total net sales     $    233.7    $  413.7   $     (180.0 )           (44 )%

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

                                             Three Months Ended
                                                September 30,               $                  %
($ in millions)                               2009          2008        (Decrease)         (Decrease)

Special alloys                             $     88.2     $  137.7     $      (49.5 )             (36 )%
Stainless steels                                 61.0        101.3            (40.3 )             (40 )
Titanium products                                26.8         41.8            (15.0 )             (36 )
Other materials                                  11.9         21.1             (9.2 )             (44 )

Total net sales excluding surcharge
revenues                                   $    187.9     $  301.9     $     (114.0 )             (38 )%

Sales of special alloys products decreased 41 percent from a year ago to $120.8 million. Adjusted for surcharge revenue, sales decreased 36 percent on a 27 percent decrease in shipment volume. The sales decrease principally reflects the decline in demand in the aerospace and energy markets.

Sales of stainless steels decreased 49 percent from a year ago to $74.0 million. Excluding surcharge revenue, sales decreased 40 percent on 32 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 36 percent from a year ago to $26.8 million on 27 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 first quarter decreased 74 percent to $19.2 million, or 8.2 percent of net sales (10.2 percent of net sales excluding surcharges), as compared with $73.7 million, or 17.8 percent of net sales (24.4 percent of net sales excluding surcharges), in the same quarter a year ago. The lower gross profit was primarily due to reduced demand levels and correspondingly higher volume-related costs. The margin was also adversely affected by a less favorable mix of products, including lower demand for premium alloys for energy and aerospace applications, and the portion of higher net pension expense included in costs of sales.

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
                                                               September 30,
   (in millions)                                            2009           2008

   Net sales                                              $   233.7       $ 413.7
   Less: surcharge revenues                                    45.8         111.8

   Net sales excluding surcharges                         $   187.9       $ 301.9


   Gross profit                                                19.2          73.7


   Gross margin                                                 8.2 %        17.8 %


   Gross margin excluding dilutive effect of surcharges        10.2 %        24.4 %

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 160 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 negatively impacted gross margin by approximately 120 basis points during the quarter ended September 30, 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 $32.5 million were 13.9 percent of net sales (17.3 percent of net sales excluding surcharges) as compared with $33.4 million or 8.1 percent of net sales (11.1 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 10 percent over last year's first quarter. The improvement reflects the actions we have taken to reduce headcount and spending across the business beginning last fiscal year.

Interest Expense

Interest expense for the quarter was $4.3 million, as compared with $4.5 million in the same quarter in the prior year. The decrease in interest expense is attributable to reductions in our outstanding debt, partially offset by lower capitalized interest costs associated with several large construction projects, during the recently-ended quarter versus the prior year's quarter.

Other Income, Net

Other income for the recent quarter was $1.5 million as compared with $3.9 million in the first quarter a year ago. The reduction primarily reflects lower interest income as cash investment rates have significantly declined since the prior year, especially in the conservative sectors in which we currently invest our excess cash.

Income Taxes

Income taxes in the recent first quarter was a benefit of ($6.8) million, or 42.2 percent of pre-tax loss versus $13.9 million of expense, or 35.0 percent of pre-tax income, in the same quarter a year ago. The increase in the effective tax rate for the three months ended September 30, 2009 was primarily due to the greater impact that our permanent differences had on our effective tax rate as a result of lower pre-tax income in the current quarter versus the same quarter a year ago.

Business Segment Results

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              $                %
                                    September 30,            Increase /       Increase /
  ($ in millions)                2009           2008         (Decrease)       (Decrease)

  Advanced Metals Operations   $   175.3       $ 295.2      $     (119.9 )           (41 )%
  Premium Alloys Operations         59.3         121.2             (61.9 )           (51 )
  Intersegment                      (0.9 )        (2.7 )             1.8              67

  Total net sales              $   233.7       $ 413.7      $     (180.0 )           (44 )%

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

                                             Three Months Ended                 $                  %
                                                September 30,               Increase /         Increase /
($ in millions)                             2009             2008           (Decrease)         (Decrease)

Advanced Metals Operations                $   145.7         $ 216.4        $      (70.7 )             (33 )%
Premium Alloys Operations                      43.1            88.2               (45.1 )             (51 )
Intersegment                                   (0.9 )          (2.7 )               1.8                67

Total net sales excluding surcharge
revenues                                  $   187.9         $ 301.9        $     (114.0 )             (38 )%

Advanced Metals Operations ("AMO") Segment

Net sales for the quarter ended September 30, 2009 for the AMO segment decreased 41 percent to $175.3 million, as compared with $295.2 million in the same quarter a year ago. Excluding surcharge revenues, net sales decreased 33 percent on 24 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 (loss) income for the AMO segment was $(2.6) million or 1.5 percent of net sales (1.8 percent of net sales excluding surcharge revenues) in the recent quarter, as compared with $19.2 million or 6.5 percent of net sales (8.9 percent of net sales excluding surcharge revenues) in the same quarter a year ago. The decrease in operating income reflects lower shipment volume and a weaker product mix.

Premium Alloys Operations ("PAO") Segment

Net sales for the quarter ended September 30, 2009 for the PAO segment decreased 51 percent to $59.3 million, as compared with $121.2 million in the same quarter a year ago. Excluding surcharge revenues, net sales decreased 51 percent on 50 percent lower shipment volume from a year ago. Both the sales and shipment volume decreases were due to lower demand, particularly in our aerospace and energy markets.

Operating income for the PAO segment was $7.9 million or 13.3 percent of net sales (18.3 percent of net sales excluding surcharge revenues) in the recent quarter, compared with $28.9 million or 23.8 percent of net sales (32.8 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 negative impacts from the less favorable mix of products shipped during the recently-ended quarter compared to the same period a year ago.

Liquidity and Financial Condition

We have the ability to generate cash to meet our needs through cash flow from operations, management of working capital and the availability of outside sources of financing to supplement internally generated funds. We believe that our cash and cash equivalents of approximately $375 million as of September 30, 2009, together with cash generated from operations and available borrowing capacity of approximately $188 million under our credit facilities, will be sufficient to fund our operating activities, planned capital expenditures, current maturities of long-term debt totaling $20.0 million and other obligations for the foreseeable future. We are currently engaged in negotiations to renew our credit facilities. We continue to closely monitor our accounts receivable and other financial exposures.

During the three months ended September 30, 2009, our free cash flow, as defined under "Non-GAAP Financial Measures" below, was $17.8 million as compared to $12.7 million for the same period a year ago. The positive cash flow result in the recent first quarter would have been essentially flat on an operating basis without the receipt of a tax refund from prior year overpayments.

Capital expenditures for plant, equipment and software were $11.3 million for the three months ended September 30, 2009 as compared with $35.8 million for the same period a year ago. We expect to finish the fiscal year with about $50 million of capital expenditures.

Dividends during the three months ended September 30, 2009 were $8.0 million as compared with $7.9 million in the same period last year and were based on quarterly amounts of $0.18 per share of common stock for dividends paid in each of the three month periods ended September 30, 2009 and 2008.

Non-GAAP Financial Measures

The following provides additional information regarding certain non-GAAP financial measures that we use in this report. Our definitions and calculations of these items may not necessarily be the same as those used by other companies.

Net Pension Expense Per Diluted Share



                                                       Three Months Ended
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