Background and General

We are 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 our own worldwide network of service/distribution centers. These service centers, located in the United States, Canada, Mexico, Europe and Asia allow us to work more closely with customers and to offer various just-in-time stocking programs. We are also a manufacturer and service provider of high-precision components for measurement while drilling ("MWD") and logging while drilling ("LWD"), drill collars, stabilizers and other down-hole tools used for directional drilling. MWD and LWD technology is used to ensure critical data is obtained and transmitted to the surface to monitor progress of the well.

On February 29, 2012, following approval of the acquisition by the U.S. Federal Trade Commission ("FTC"), we completed the acquisition of Latrobe Specialty Metals, Inc. ("Latrobe") through the merger of a wholly-owned subsidiary of the Company with and into Latrobe (the "Latrobe Acquisition"). In connection with the Latrobe Acquisition, former owners of Latrobe received 8.1 million shares of Carpenter stock. In addition, pursuant to the terms of the related merger agreement, Carpenter paid $11.5 million in cash at closing, net of $2.5 million of cash acquired, in addition to a payment of approximately $154 million in order to pay off Latrobe debt. A key benefit of the Latrobe Acquisition is a substantial increase in production which will increase Carpenter's capacity to meet strong customer demand for premium products. As a condition of the FTC approval, Carpenter entered into a consent decree (the "Consent Decree") to transfer certain assets and technical knowledge to Eramet S.A and its subsidiaries, Aubert & Duval and Brown Europe (collectively, the "Transferees"), which will allow the Transferees, as a group, to become a second manufacturer of two specific alloys in order to provide customers with a supply alternative in the marketplace. The alloys have minimal sales impact and will cause no material change to the economics of the Latrobe Acquisition. As part of the Consent Decrees, Carpenter agreed to transfer certain assets as well as fund the cost of acquiring assets in an amount up to approximately $5.0 million; Carpenter recorded a charge for this liability in the quarter ended March 31, 2012.

In August 2012, we announced that we have commenced a process to sell the Latrobe and Mexico distribution businesses. As of December 31, 2012, we have not met the criteria to qualify to report these businesses as held for sale or discontinued operations. If successful, we intend to eventually reinvest the proceeds from the sales of the businesses in other, more strategic businesses.

As part of our overall business strategy, we have sought out and considered opportunities related to strategic acquisitions and joint collaborations aimed at broadening our offering to the marketplace. We have participated with other companies to explore potential terms and structure of such opportunities and we expect that we will continue to evaluate these opportunities.

Our discussions below in this Item 2 are based upon the more detailed discussions about our business, operations and financial condition included in Item 8 of our 2012 Form 10-K. Our discussions here focus on our results during or as of the three-month and six-month period ended December 31, 2012 and the comparable periods of fiscal year 2012, and, to the extent applicable, on material changes from information discussed in the 2012 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 the 2012 Form 10-K for detailed background information and with any such intervening Form 8-K.

Changes to Segment Reporting

In January 2012, we changed our reportable segments, beginning with our second quarter results of fiscal year 2012, to align with a new operating model in which our integrated steel mill operations are managed distinctly from the collection of other differentiated business unit operations. In addition, during the first quarter of fiscal year 2013, we moved the Specialty Steel Supply ("SSS") business acquired in connection with the Latrobe Acquisition from the Latrobe segment to the Performance Engineered Products segment. We now have three reportable segments, Specialty Alloys Operations ("SAO"), Latrobe and Performance Engineered Products ("PEP"). Previously, the Company's reportable segments consisted of Premium Alloys Operations, Advanced Metals Operations and Emerging Ventures.

The SAO segment is comprised of Carpenter's major premium alloy and stainless steel manufacturing operations. This includes operations performed at mills primarily in Reading, Pennsylvania and the surrounding area, South Carolina, and the new premium products manufacturing facility being built in Limestone County, Alabama. The combined assets of the SAO operations are managed in an integrated manner to optimize efficiency and profitability across the total system.

The Latrobe segment is comprised of the operations of the Latrobe business acquired effective February 29, 2012. The Latrobe segment provides management with the focus and visibility into the business performance of these newly acquired operations. The Latrobe segment also includes the results of Carpenter's distribution business in Mexico, which is being managed together with the Latrobe distribution business. As the Latrobe business becomes integrated with Carpenter, its results will likely be combined and reported together with the SAO business segment sometime in the future.

The PEP segment is comprised of Carpenter's differentiated operations. This includes the Dynamet business, the Carpenter Powder Products business, the Amega West business and the SSS business that was acquired in connection with the Latrobe Acquisition. The businesses in the PEP segment are managed with an entrepreneurial structure to promote speed and flexibility, and drive overall revenue and profit growth.

In conjunction with the segment reporting changes, we also made a few modifications to our supplemental end-use market and product class reporting. For end-use market reporting, Aerospace end-use market sales was broadened to incorporate Aerospace and Defense. Industrial and Consumer end-use market sales were combined as Industrial and Consumer. The Automotive end-use market was broadened to Transportation to reflect sales in non-automotive markets like marine. All distribution businesses sales are being reported as a separate end-use market called Distribution. For product class reporting, sales of powder metal products were broken out and a new category of Alloy and Tool Steels was added. The changes are intended to better segregate growth areas of premium products such as high temperature nickel-based special alloys, titanium products and powder metals, while also reflecting the product classes and businesses gained through the Latrobe Acquisition. All prior period information has been reclassified to conform to the fiscal year 2013 presentation.

Impact of Raw Material Prices and Product Mix

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.

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 major raw 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 which correlates to the prices we pay for our raw material purchases. However, a portion of our surcharges to customers may be calculated using a different surcharge formula or may be based on the raw material prices at the time of order, which creates a lag between surcharge revenue and corresponding raw material costs recognized in costs of sales. The surcharge mechanism protects our net income on such sales except for the lag effect discussed above. However, surcharges have had a dilutive effect on our gross margin and operating margin percentages as described later in this report.

Approximately 25 percent our net sales are 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. 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. 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. 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, changes in the cost of raw materials and production activities are recognized in cost of sales in the current period attempting to match the most recently incurred costs with revenues. Gains or losses on the commodity forward contracts are reclassified from other comprehensive income together with the actual purchase price of the underlying commodities when the underlying commodities are purchased and recorded in inventory. To the extent that the total purchase price of the commodities, inclusive of the gains or losses on the commodity forward contracts, are higher or lower relative to the beginning of year costs, our costs of goods sold reflect such amounts. Accordingly, the gains and/or losses associated with commodity forward contracts may not impact the same period that the firm price sales arrangements revenue is recognized, and comparisons of gross profit from period to period may be impacted. These firm price sales arrangements are expected to continue as we look to strengthen our long-term customer relationships by expanding, renewing and in certain cases extending to a longer term, our customer long-term arrangements.

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 on participation in certain products based on available capacity, including the impacts of capacity commitments we may have under existing customer agreements. 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, as we define it 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 $17.1 million, or $0.21 per diluted share, versus $9.8 million, or $0.13 per diluted share, in the same quarter last year. Net pension expense for the six months ended December 31, 2012 was $34.3 million, or $0.42 per diluted share, as compared with $19.7 million, or $0.27 per diluted share, during the six months ended December 31, 2011. See the section "Non-GAAP Financial Measures" below for further discussions of these financial measures.

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 occurs. We currently expect that the total net pension expense for fiscal year 2013 will be $68.3 million as compared with $42.1 million recorded in fiscal year 2012.

Net pension expense is recorded in accounts that are included in both the cost of sales and selling, general and administrative expenses lines of our Consolidated Statements of Income. The following is a summary of the classification of net pension expense for the three months and six months ended December 31, 2012 and 2011:

                                                  Three Months Ended         Six Months Ended
                                                     December 31,              December 31,
($ in millions)                                   2012          2011        2012         2011
Cost of sales                                   $    12.8     $     7.2    $   25.6     $   14.5
Selling, general and administrative expenses          4.3           2.6         8.7          5.2
Net pension expense                             $    17.1     $     9.8    $   34.3     $   19.7

The service cost component of net pension expense represents the estimated cost of future pension liabilities earned associated with active employees. The pension earnings, interest and deferrals expense is comprised of the expected return on plan assets, interest costs on the projected benefit obligations of the plans, and amortization of actuarial gains and losses and prior service costs. The following is a summary of the components of net pension expense during the three months and six months ended December 31, 2012 and 2011:

                                             Three Months Ended        Six Months Ended
                                                December 31,             December 31,
($ in millions)                               2012         2011        2012        2011
Service cost                                $     9.1     $    6.2    $   18.3     $ 12.5
Pension earnings, interest and deferrals          8.0          3.6        16.0        7.2
Net pension expense                         $    17.1     $    9.8    $   34.3     $ 19.7

Latrobe Acquisition Impacts

We closed the Latrobe Acquisition on February 29, 2012. After ten months of ownership, the Latrobe results remain strong and we continue to exceed our plan for operational synergies track ahead of our deal economics. The net accretion from Latrobe's operating results offset by a higher share count, contributed $0.05 and $0.12, respectively per diluted share for the three months and six months ended December 31, 2012. This accretion excludes the synergies realized on our existing SAO business. These measures below have not been determined in accordance with U.S. GAAP. See further discussion of these measures in the "Non-GAAP Financial Measures" discussion below.

Operating Performance Overview

For the quarter ended December 31, 2012, we reported net income attributable to Carpenter of $33.0 million, or $0.62 per diluted share, compared with income attributable to Carpenter for the same period a year earlier of $23.6 million, or $0.52 per diluted share. The results principally reflect the addition of the Latrobe business, which continues to outperform expectations for operational synergies and the benefits of our continued strong product mix. At the same time, the results reflect the weaker demand for lower value mill product lines and destocking in the titanium medical supply chain.

There are several initiatives that will have an impact on our results this fiscal year, including costs associated with the following: (i.) the start-up of our Athens, Alabama premium products manufacturing facility, (ii.) manufacturing footprint optimization opportunities, and (iii.) an inventory reduction initiative. See below for further discussion of these costs. During the three months and six months ended December 31, 2012, these initiatives impacted our operating margin excluding surcharge by 0.6 percent ($2.5 million) and 0.5 percent ($4.1 million), respectively and negatively impacted our diluted earnings per share by $0.03 per diluted share and $0.05 per diluted share, respectively.

In the first quarter of fiscal year 2012, we announced our plans to construct a new 400,000 square foot state-of-the-art manufacturing facility in response to strong customer demand for premium products primarily in the fast-growing aerospace and energy industries. We expect that the new facility will ultimately be capable of producing approximately 27,000 tons per year of additional premium product and be operational by April 2014. The facility is being built on a 230 acre greenfield site located in Limestone County, Alabama at a total cost of approximately $500 million. The new facility will include forge, re-melting and associated finishing and testing capabilities and will play a key role in further developing our capabilities in the production of our premium products. During the three months and six months ended December 31, 2012, we incurred facility start-up costs of $1.3 million and $2.2 million, respectively. We currently expect that the facility startup costs will amount to approximately $6.0 million in fiscal year 2013.

We are currently evaluating opportunities with respect to manufacturing footprint optimization principally as a result of the Latrobe Acquisition and other changes we believe are necessary to manage our business as an integrated steel mill operation. In August 2012, we announced plans to close our wire production facility in Orangeburg, South Carolina and move certain assets as we expand the Wauseon, Ohio facility acquired in connection with the Latrobe Acquisition. We are currently evaluating other, smaller consolidation opportunities related to the Latrobe acquisition and continue to evaluate opportunities to optimize the broader footprint of our mill assets. Total costs incurred in connection with the footprint optimization were approximately $0.2 million and $0.3 million, respectively, during the three months and six months ended December 31, 2012. We currently expect to incur approximately $3.0 million in costs related to the footprint optimization activities during fiscal year 2013.

In connection with the Latrobe Acquisition, we initiated a third party consulting study to identify opportunities to potentially reduce inventory levels across our integrated mill system, including Latrobe. Our inventory turns performance is below average as compared with peers in our industry, with Latrobe at even lower average turns than our SAO business. The consulting study was completed in the quarter ended December 31, 2012 and we believe there are potential opportunities to reduce inventory levels and improve our inventory turns performance from historical levels. Specific action plans have been developed, and we expect to see the benefits of improvements in our inventory performance during the second half our fiscal year 2013. During the three months and six months ended December 31, 2012, we incurred $1.0 million and $1.6 million, respectively, of costs associated with the inventory reduction initiative which consists of consulting costs associated with the study. We estimate that we will incur approximately $3.0 million of total consulting fees to develop and execute our inventory reduction initiative during fiscal year 2013 and expect this project to continue through fiscal year 2015.

Results of Operations - Three Months Ended December 31, 2012 vs. Three Months Ended December 31, 2011

Net Sales

Net sales for the three months ended December 31, 2012 were $533.5 million, which was a 24 percent increase over the same period a year ago. Excluding surcharge revenue, sales increased 30 percent. Overall, pounds shipped were 28 percent higher than the second fiscal quarter a year ago. Excluding the Latrobe impact, our recent second quarter net sales excluding surcharge revenues increased 5 percent on 2 percent higher volume. Net sales excluding surcharge revenues in our SAO segment increased 7 percent on 1 percent higher volume, while net sales excluding surcharge revenues in our PEP segment increased 13 percent on 6 percent lower shipment volume. The results reflect our continued deliberate actions to grow premium products and strengthen overall product mix.

Geographically, sales outside the United States increased 11 percent from the same period a year ago to $158.1 million. International growth was led by 30 percent growth in Asia-Pacific sales, 49 percent increase in Canada sales and 3 percent increase in European sales. Growth in Asia-Pacific was led by sales into aerospace end markets. Growth in Canada and Europe were led by increased demand for materials used for aerospace and oil and gas applications. Total international sales in the quarter represented 30 percent of total net sales, compared with 33 percent in the prior year. Excluding the impact of Latrobe, total international net sales in the current quarter represented 34 percent of total net sales.

Sales by End-Use Markets



We sell to customers across diversified end-use markets. The table below
includes comparative information for our estimated sales by end-use markets:



                            Three Months Ended           $              %
                               December 31,          Increase       Increase
($ in millions)              2012         2011      (Decrease)     (Decrease)
Aerospace and defense     $    250.3     $ 192.2     $    58.1           30  %
Industrial and consumer        111.6       105.0           6.6            6
Energy                          79.5        61.3          18.2           30
Medical                         26.6        31.7          (5.1 )       (16)
Transportation                  31.8        31.4           0.4            1
Distribution                    33.7         9.5          24.2          255
Total net sales           $    533.5     $ 431.1     $   102.4           24  %

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

                                     Three Months Ended             $               %
                                        December 31,            Increase         Increase
($ in millions)                      2012          2011        (Decrease)       (Decrease)
Aerospace and defense             $    194.6     $   142.6      $    52.0            36  %
Industrial and consumer                 85.4          75.8            9.6            13
Energy                                  69.0          51.7           17.3            33
Medical                                 24.2          28.2           (4.0 )        (14)
Transportation                          24.2          22.5            1.7             8
Distribution                            33.3           9.5           23.8           251
Total net sales excluding
surcharge revenues                $    430.7     $   330.3      $   100.4            30  %

Sales to the aerospace and defense market increased 30 percent from the second quarter a year ago to $250.3 million. Excluding surcharge revenue, sales increased 36 percent from the second quarter a year ago on 83 percent higher shipment volume (or up 10 percent on 8 percent higher shipment volume excluding Latrobe). Demand for super-alloy engine materials remains strong due to higher build rates and initial pull through for new engine programs. Demand for nickel and stainless fastener material increased year-over-year for the tenth consecutive quarter while shipments of titanium fastener material set a new second quarter record, up slightly from the very strong year-ago period. The addition of Latrobe's structural, bearing and other complementary products also contributed to the year-to-year growth rate.

Industrial and consumer market sales increased 6 percent from the second quarter a year ago to $111.6 million. Excluding surcharge revenue, sales increased 13 percent on an 8 percent increase in shipment volume (or up 4 percent on 1 percent lower shipment volume excluding Latrobe). This market remains more sensitive to economic uncertainty which is reflected in the powder metals portion of the PEP segment and value products within Latrobe. Carpenter's strategy to focus on specialized, premium and ultra-premium niche applications with strategically important customers has offset overall demand softness in more commodity type products and distributor channels.

Sales to the energy market of $79.5 million reflected a 30 percent increase from the second quarter a year ago. Excluding surcharge revenue, sales increased 33 percent from a year ago on higher shipment volume of 23 percent (or up 6 percent excluding Latrobe). Demand growth for material used in oil and gas applications outpaced weaker demand for power generation materials. Despite lower North American rig activity, demand for Carpenter materials used in oil and gas drilling increased as Amega West remained strong by expanding its footprint and gaining share. In addition, there are a significant number of wells that have been drilled and still require completions, which is leading to growth of Ultra-Premium products. Build schedules at major industrial gas turbine manufacturers are pointing toward stronger second half growth in that sector after temporary slowness in this area.

Sales to the medical market decreased 16 percent from a year ago to $26.6 million. Excluding surcharge revenue, sales decreased 14 percent on lower shipment volume of 21 percent (relatively unchanged without Latrobe). Uncertainty surrounding pending legislative impacts and economic sentiment continues to affect short term demand for medical materials. In addition, as largely seen in the PEP segment results, continued inventory destocking within the titanium distribution supply chain is being influenced by falling titanium prices.

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