TMCnet News
CARPENTER TECHNOLOGY CORP - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) Background and General Our discussions below in this Item 7 should be read in conjunction with our consolidated financial statements, including the notes thereto, included in this annual report on Form 10-K. 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 and distribution centers. These service and distribution 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 also manufacture and rent down-hole drilling tools and components used in the oil and gas industry. In fiscal year 2014 we completed the construction of a new 400,000 square foot state-of-the-art manufacturing facility in Limestone County, Alabama in response to anticipated strong customer demand for premium products primarily in the fast-growing aerospace and defense and energy industries. We produced 1,000 tons of saleable products in the fourth quarter of fiscal year 2014 and are making progress on internal and customer qualifications. We ultimately expect the facility will be capable of producing approximately 27,000 tons per year of premium products in the future. The new facility includes forge, remelting and associated finishing and testing capabilities and will play a key role in further developing our capabilities in the production of our premium products. As part of our overall business strategy, we have sought out and considered opportunities related to strategic acquisitions and joint collaborations as well as possible business unit dispositions 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. Business Trends Selected financial results for the past three fiscal years are summarized below: Fiscal Year ($ in millions, except per share data) 2014 2013 2012 Net sales $ 2,173.0 $ 2,271.7 $ 2,028.7 Net sales excluding surcharges (1) $ 1,782.8 $ 1,839.3 $ 1,569.6 Operating income excluding pension earnings, interest and deferrals ("pension EID") expense(1) $ 233.8 $ 264.6 $ 225.4 Net income $ 132.8 $ 146.5 $ 121.6 Diluted earnings per share $ 2.47 $ 2.73 $ 2.53 Purchases of property, equipment and software $ 349.2 $ 310.2 $ 157.8 Free cash flow (1) $ (147.8 ) $ (159.3 ) $ (58.8 ) Pounds sold (in thousands) (2) 290,388 273,724 235,532 19 -------------------------------------------------------------------------------- Table of Contents -------------------------------------------------------------------------------- (1) See the section "Non-GAAP Financial Measures" below for further discussion of these financial measures. (2) Includes specialty and titanium alloys, stainless steel and powder materials. Our sales are across a diversified list of end-use markets. The table below summarizes our estimated sales by market over the past three fiscal years: Fiscal Year 2014 2013 2012 % of % of % of ($ in millions) Dollars Total Dollars Total Dollars TotalAerospace and defense $ 980.7 45 % $ 1,067.0 47 % $ 901.2 44 % Industrial and consumer 481.6 22 474.3 21 478.1 24 Energy 310.4 14 337.3 15 287.0 14 Transportation 150.1 7 138.8 6 142.2 7 Medical 112.6 5 113.2 5 141.1 7 Distribution 137.6 6 141.1 6 79.1 4 Total net sales $ 2,173.0 100 % $ 2,271.7 100 % $ 2,028.7 100 % The table below shows our net sales by major product class for the past three fiscal years: Fiscal Year 2014 2013 2012 % of % of % of ($ in millions) Dollars Total Dollars Total Dollars Total Special alloys $ 917.0 42 % $ 989.9 43 % $ 931.4 47 % Stainless steels 643.6 30 638.8 28 637.3 31 Alloy and tool steel 240.4 11 255.7 11 108.6 5 Titanium products 157.7 7 155.0 7 156.6 8 Powder metals 48.6 2 60.4 3 64.3 3 Distribution and other 165.7 8 171.9 8 130.5 6 Total net sales $ 2,173.0 100 % $ 2,271.7 100 % $ 2,028.7 100 % 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. 20 -------------------------------------------------------------------------------- Table of Contents 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, 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 of 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 net periodic benefit costs are determined annually based on beginning of year balances and are recorded ratably throughout the fiscal year, unless a significant re-measurement event occurs. The following is a summary of the of net periodic benefit costs for the years ended June 30, 2014, 2013 and 2012: 21 -------------------------------------------------------------------------------- Table of Contents Years Ended June 30, ($ in millions) 2014 2013 2012 Pension plans $ 49.0 $ 59.5 $ 38.3 Other postretirement plans 11.1 9.3 3.8 Net periodic benefit costs $ 60.1 $ 68.8 $ 42.1 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 ("pension EID") 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. Net pension expense is recorded in accounts that are included in both the cost of sales and selling, general and administrative expenses based on the function of the associated employees. The following is a summary of the classification of net pension expense for the years ended June 30, 2014, 2013 and 2012: Years Ended June 30, ($ in millions) 2014 2013 2012 Cost of sales Service cost $ 28.2 $ 28.8 $ 21.0 Pension earnings, interest and deferrals 14.2 22.9 10.2 $ 42.4 $ 51.7 $ 31.2 Selling, general and administrative expenses Service cost $ 7.9 $ 8.1 $ 5.7 Pension earnings, interest and deferrals 7.6 9.0 5.2 $ 15.5 $ 17.1 $ 10.9 Net pension expense $ 57.9 $ 68.8 $ 42.1 Historically, we capitalized only the service cost component of net pension expense related to manufacturing employees. Beginning in the quarter ended December 31, 2013, we began to capitalize the portion of pension EID expense related to current manufacturing employees in inventory. The impact of this change resulted in a reduction of pension EID expense of $2.2 million during the quarter ended December 31, 2013. The tables above include the impact of making this change during the quarter ended December 31, 2013 and as such pension EID expense included in cost of sales was reduced by $2.2 million. We will continue to expense the portion of pension EID expense related to inactive manufacturing employees as a period cost in cost of sales. For the years ended June 30, 2014, 2013 and 2012, the amount of pension EID expense included in cost of sales related to inactive manufacturing employees was $9.5 million, $13.3 million and $6.1 million, respectively. The amounts included in the net pension expense table above do not include the impact of any amounts capitalized in beginning and ending inventories except for the impact of the $2.2 million additional pension expense capitalized in inventory discussed above. As of June 30, 2014 and 2013, amounts capitalized in gross inventory were $9.2 million and $8.7 million, respectively. Operating Performance Overview For the three years leading up to fiscal year 2014 we increased earnings before adjusted interest, taxes, depreciation and amortization (Adjusted "EBITDA") an average of $91 million per year. Fiscal year 2014 proved to be a challenge. Our sales mix was negatively impacted by weak demand for the ultra-premium products used in our key end use markets of aerospace and energy. In this context, we responded to the areas we could impact. More specifically, we grew volume in medical, transportation and industrial and consumer markets, we lowered our Specialty Alloys Operations variable cost per ton, improved the trajectory of our Performance Engineered Products business and reduced our selling, general and administrative expenses by 7 percent. The net result was that we delivered $382 million of Adjusted EBITDA, a decrease of 6 percent as compared to the prior year. 22 -------------------------------------------------------------------------------- Table of Contents During fiscal year 2014 we completed some important strategic growth enabling initiatives in the following areas: † We completed the construction and start-up of our new Limestone County, Alabama facility. The facility produced 1,000 saleable tons primarily for the aerospace and energy markets in the fourth quarter of fiscal year 2014. This facility will support growing demand from our customers while opening up opportunities in new markets. We are making progress on internal and customer qualifications. † We completed a superalloy powders multi-level agreement with Pratt & Whitney which includes a technical assistance agreement and long-term powder supply agreement. As a result of the agreement we began construction of a superalloy powder facility in Limestone County, Alabama. † Due to the steady increases in customer demand for titanium fastener material, we added titanium wire line capacity. † We started construction and are near completion of a new production facility in China. We negotiated multiple customer long-term agreements which are key to our future growth. In summary, in fiscal year 2014 we showed agility in a difficult context and now start, what we believe will be strengthening demand cycle, with over $380 million of Adjusted EBITDA and the capacity to support growth. Results of Operations - Fiscal Year 2014 Compared to Fiscal Year 2013 For fiscal year 2014, we recorded net income of $132.8 million, or $2.47 per diluted share, compared with net income of $146.1 million, or $2.73 per diluted share, a year earlier. Our fiscal year 2014 results reflect the impact of the decrease in demand for our materials used in aerospace and energy which was partially offset by increased volumes from lower value materials. The impact of the unfavorable mix was partially offset by reductions in variable cost per ton in our Specialty Alloys Operations and reduction in overall selling, general and administrative costs. Net Sales Net sales for fiscal year 2014 were $2,173.0 million, which was a 4 percent decrease from fiscal year 2013. Excluding surcharge revenues, sales were 3 percent lower than fiscal year 2013 on 6 percent higher volume. The decrease in sales combined with higher shipment volume reflects an unfavorable shift in product mix. Geographically, sales outside the United States decreased 9 percent from fiscal year 2013 to $635.1 million. International sales as a percentage of our total net sales represented 29 percent and 31 percent for fiscal year 2014 and fiscal year 2013, respectively. Sales by End-Use Markets We sell to customers across diversified end-use markets. The following table includes comparative information for our net sales, which includes surcharge revenues, by principal end-use markets which we believe is helpful supplemental information in analyzing the performance of the business from period to period: $ % Fiscal Year Increase Increase ($ in millions) 2014 2013 (Decrease) (Decrease)Aerospace and defense $ 980.7 $ 1,067.0 $ (86.3 ) (8 )% Industrial and consumer 481.6 474.3 7.3 2 Energy 310.4 337.3 (26.9 ) (8 ) Transportation 150.1 138.8 11.3 8 Medical 112.6 113.2 (0.6 ) (1 ) Distribution 137.6 141.1 (3.5 ) (2 ) Total net sales $ 2,173.0 $ 2,271.7 $ (98.7 ) (4 )% 23 -------------------------------------------------------------------------------- Table of Contents The following table includes comparative information for our net sales by the same principal end-use markets, but excluding surcharge revenues: $ % Fiscal Year Increase Increase ($ in millions) 2014 2013 (Decrease) (Decrease) Aerospace and defense $ 775.3 $ 832.5 $ (57.2 ) (7 )% Industrial and consumer 379.8 366.4 13.4 4 Energy 269.9 290.9 (21.0 ) (7 ) Transportation 118.0 106.6 11.4 11 Medical 103.5 103.7 (0.2 ) - Distribution 136.3 139.2 (2.9 ) (2 ) Total net sales excluding surcharge revenues $ 1,782.8 $ 1,839.3 $ (56.5 ) (3 )% Sales to the aerospace and defense market decreased 8 percent from fiscal year 2013 to $980.7 million. Excluding surcharge revenue, sales decreased 7 percent on 1 percent lower shipment volume. The results reflect weakness in demand for our premium materials used in engine applications offset by improving demand for materials used in structural components and increased demand for materials used in titanium fasteners. The fiscal year 2014 results were impacted significantly by supply chain destocking in the first half of our fiscal year. Industrial and consumer market sales increased 2 percent from fiscal year 2013 to $481.6 million. Excluding surcharge revenue, sales increased approximately 4 percent on 16 percent higher shipment. The results reflect strong demand for lower value materials used in plant and equipment applications as wells as materials used in bridge infrastructure projects. The shift in unfavorable mix was a result of soften demand for materials used in the more premium products used in high end valves and fittings and electronics applications. Sales to the energy market of $310.4 million reflected an 8 percent decrease from fiscal year 2013. Excluding surcharge revenue, sales decreased 7 percent on 12 percent lower shipment volume. The results reflect demand softness in materials used in oil and gas completions as well as the power generation sector. These declines were partially offset by a moderate increase in sales, particularly rentals through our Amega West oil and gas business. Transportation market sales increased 8 percent from the fiscal year 2013 to $150.1 million. Excluding surcharge revenue, sales increased 11 percent on 18 higher shipment volumes. The results reflect the impacts of growth in demand for our materials as a result of increasing North American vehicle sales and strong demand for materials used in next generation of fuel delivery systems. Sales to the medical market decreased 1 percent to $112.6 million from fiscal year 2013. Adjusted for surcharge revenue, sales were flat on 10 percent higher shipment volume. The results reflect the impacts of lower titanium scrap prices during most of the fiscal year, which negatively impacted order patterns for our materials. During the second half of the fiscal year we began to see improving demand for materials used in orthopedics and surgical devices and more normalized buying patterns by distributors as supply chain inventory levels appeared to stabilize. Distribution sales decreased 2 percent from the same period a year ago to $137.6 million. Excluding surcharge revenue, sales decreased 2 percent from the same period a year ago. 24 -------------------------------------------------------------------------------- Table of Contents Sales by Product Class The following table includes comparative information for our net sales by major product class: $ % Fiscal Year Increase Increase ($ in millions) 2014 2013 (Decrease) (Decrease) Special alloys $ 917.0 $ 989.9 $ (72.9 ) (7 )% Stainless steels 643.6 638.8 4.8 1 Alloy and tool steel 240.4 255.7 (15.3 ) (6 ) Titanium products 157.7 155.0 2.7 2 Powder metals 48.6 60.4 (11.8 ) (20 ) Distribution and other 165.7 171.9 (6.2 ) (4 ) Total net sales $ 2,173.0 $ 2,271.7 $ (98.7 ) (4 )% The following table includes comparative information for our net sales by the same major product class, but excluding surcharge revenues: $ % Fiscal Year Increase Increase ($ in millions) 2014 2013 (Decrease) (Decrease) Special alloys $ 666.3 $ 706.0 $ (39.7 ) (6 )% Stainless steels 548.7 543.1 5.6 1 Alloy and tool steel 198.4 210.9 (12.5 ) (6 ) Titanium products 157.7 155.0 2.7 2 Powder metals 48.6 55.9 (7.3 ) (13 ) Distribution and other 163.1 168.4 (5.3 ) (3 ) Total net sales excluding surcharge revenues $ 1,782.8 $ 1,839.3 $ (56.5 ) (3 )% Sales of special alloys products decreased 7 percent in fiscal year 2014 as compared with a year ago to $917.0 million. Excluding surcharge revenue, sales decreased 6 percent on a flat shipment volume. The results reflect an unfavorable shift in product mix due to lower demand for Aerospace engine and fastener material as compared to the year ago period. Sales of stainless steels increased 1 percent in fiscal year 2014 as compared with a year ago to $643.6 million. Excluding surcharge revenues, such sales increased by 1 percent on 14 percent higher shipment volume. The year over year results reflect increased volumes in transportation and industrial and consumer markets combined with an unfavorable shift in product mix from the same period last year. Sales of alloy and tool steel decreased 6 percent in fiscal year 2014 on 2 percent lower shipment volume. Sales of titanium products increased 2 percent as compared with fiscal year 2013 on 8 percent higher shipment volume. Sales of powder metals decreased 20 percent in fiscal year 2014 on 17 percent lower shipment volume. 25 -------------------------------------------------------------------------------- Table of Contents Gross Profit Gross profit in fiscal year 2014 decreased to $398.9 million, or 18.4 percent of net sales (22.4 percent of net sales excluding surcharges), from $433.5 million, or 19.1 percent of net sales (23.6 percent of net sales excluding surcharges), for fiscal year 2013. The results reflect a weaker product mix and incremental costs associated with our new Alabama facility partially offset by a reduction in variable production costs. In addition, the fiscal year 2014 results were impacted by approximately $8.0 million of additional weather related expenses due to severe weather in the Northeast where the majority of our operations are centered. Our surcharge mechanism is structured to recover increases in raw material costs, although generally with a lag effect. While the surcharge generally protects the absolute gross profit dollars, it does have a dilutive effect on gross margin as a percent of sales. The following represents a summary of the dilutive impact of the surcharges on gross margin for fiscal years 2014 and 2013. See the section "Non-GAAP Financial Measures" below for further discussion of these financial metrics. Fiscal Year ($ in millions) 2014 2013 Net sales $ 2,173.0 $ 2,271.7 Less: surcharge revenue 390.2 432.4 Net sales excluding surcharges $ 1,782.8 $ 1,839.3 Gross profit $ 398.9 $ 433.5 Gross margin 18.4 % 19.1 % Gross margin excluding dilutive effect of surcharges 22.4 % 23.6 % Selling, General and Administrative Expenses Selling, general and administrative expenses in fiscal year 2014 were $186.9 million, or 8.6 percent of net sales (10.5 percent of net sales excluding surcharges), compared to $200.8 million, or 8.8 percent of net sales (10.9 percent of net sales excluding surcharges), in fiscal year 2013. The decrease in selling, general and administrative expenses in fiscal year 2014 compared to fiscal year 2013 is primarily due to lower incentive compensation and a reduction in pension EID during the current year. Prior year included restructuring related costs of $2.9 million due to a reduction in salaried headcount as well as costs associated with respect to manufacturing footprint optimization activities and inventory reduction initiative costs. Operating Income Our operating income in fiscal year 2014 decreased to $212.0 million as compared with $232.7 million in fiscal year 2013. The fiscal year 2014 results reflect the impacts of a weaker product mix, incremental costs associated with our new Alabama facility and costs associated with severe weather in the Northeast where the majority of our operations are centered resulting in an additional $8.0 million of energy related expenses in the third quarter of fiscal year 2014. These impacts were partially offset by a reduction in variable production costs and lower selling, general and administrative expenses. Operating income has been significantly impacted by the pension EID portion of our net pension expense, which may be volatile based on conditions in the financial markets. The following presents our operating income and operating margin, in each case excluding the impact of surcharges on net sales and excluding the impacts of pension EID expense from operating income. We present and discuss these financial measures because management believes removing the impacts of raw material surcharges from operating margin provides a more consistent and meaningful basis for comparing results of operations from period to period. See the section "Non-GAAP Financial Measures" below for further discussion of these financial measures. 26 -------------------------------------------------------------------------------- Table of Contents Fiscal Year ($ in millions) 2014 2013 Net sales $ 2,173.0 $ 2,271.7 Less: surcharge revenue 390.2 432.4 Consolidated net sales excluding surcharge $ 1,782.8 $ 1,839.3 Operating income $ 212.0 $ 232.7 Pension earnings, interest & deferrals 21.8 31.9 Operating income excluding pension earnings, interest and deferrals $ 233.8 $ 264.6 Operating margin excluding surcharge and pension earnings, interest and deferrals 13.1 % 14.4 % In addition to the impact of the surcharge mechanism and pension EID expense, fluctuations in raw material prices (combined with fluctuations in inventory levels) and the lag effect of the surcharge mechanism have impacted our operating income from year to year. We estimate that the effect of such combined fluctuations positively impacted our operating margin by approximately 100 basis points during fiscal year 2014 and positively impacted our operating margin by approximately 10 basis points during fiscal year 2013. Interest Expense Fiscal year 2014 interest expense of $17.0 million decreased 19.0 percent from $21.0 million in fiscal year 2013. The decrease of $4.0 million is due to $8.3 million of higher capitalized interest in connection with the increased spending attributable to the construction of our Alabama manufacturing plant offset by higher interest costs of $4.3 million. The increase in interest costs is due to higher outstanding debt levels in fiscal year 2014 as compared in fiscal year 2013 principally as a result of the February 2013 issuance of $300.0 million of 4.45% notes due March 2023 which is partially offset by the $100.0 million 6.625% notes that matured in May 2013. Other Income, Net Other income for fiscal year 2014 was $1.4 million as compared with $5.1 million a year ago. The results reflect the decrease in earnings in the funding mechanisms for certain non-qualified retirement plans and the negative impacts in foreign exchange losses for the current period as compared to the same a year ago. The year ago period also reflects a gain of $1.9 million in connection with the dissolution of the strategic partnership with Sandvik Materials Technology. Income Taxes Our effective tax rate (income tax expense as a percent of income before taxes) for both fiscal years 2014 and fiscal year 2013 was 32.4 percent. The tax rates for both periods were lower than the statutory rate of 35 percent, primarily due to benefits associated with the domestic manufacturing deduction and the research and development credits. See Note 16 to the consolidated financial statements in Item 8, "Financial Statements and Supplementary Data" for a full reconciliation of the statutory federal tax rate to the effective tax rates. 27 -------------------------------------------------------------------------------- Table of Contents Business Segment Results Summary information about our operating results on a segment basis is set forth below. For more detailed segment information, see Note 19 to the consolidated financial statements included in Item 8, "Financial Statements and Supplementary Data". The following tables include selected information by business segment: % Fiscal Year Increase Increase (Pounds sold, in thousands) 2014 2013 (Decrease) (Decrease) Specialty Alloys Operations 282,914 264,606 18,308 7 % Performance Engineered Products 12,248 13,451 (1,203 ) (9 ) Intersegment (4,774 ) (4,333 ) (441 ) (10 ) Consolidated pounds sold 290,388 273,724 16,664 6 % $ % Fiscal Year Increase Increase ($ in millions) 2014 2013 (Decrease) (Decrease)Specialty Alloys Operations $ 1,741.6 $ 1,823.5 $ (81.9 ) (4 )% Performance Engineered Products 498.6 520.1 (21.5 ) (4 ) Intersegment (67.2 ) (71.9 ) 4.7 7 Total net sales $ 2,173.0 $ 2,271.7 $ (98.7 ) (4 )% $ % Fiscal Year Increase Increase ($ in millions) 2014 2013 (Decrease) (Decrease)Specialty Alloys Operations $ 1,344.6 $ 1,388.5 $ (43.9 ) (3 )% Performance Engineered Products 496.6 513.7 (17.1 ) (3 ) Intersegment (58.4 ) (62.9 ) 4.5 7 Total net sales excluding surcharge revenues $ 1,782.8 $ 1,839.3 $ (56.5 ) (3 )% Specialty Alloys Operations Segment Net sales in fiscal year 2014 for the Specialty Alloys Operations ("SAO") segment were $1,741.6 million, as compared with $1,823.5 million in fiscal year 2013. Excluding surcharge revenues, sales decreased 3 percent from a year ago. The fiscal year 2014 net sales reflected 7 percent higher shipment volume as compared to fiscal year 2013. The decrease in sales combined with higher shipment volumes reflects an unfavorable shift in product mix as a result of continued challenging market conditions. Operating income for the SAO segment in fiscal year 2014 was $232.7 million, or 13.4 percent of net sales (17.3 percent of net sales excluding surcharge revenues), compared to $268.5 million, or 14.7 percent of net sales (19.3 percent of net sales excluding surcharge revenues), for fiscal year 2013. The decrease in operating income reflects the impacts of a weaker product mix and the $8.0 million of additional weather related expenses in the third quarter of fiscal year 2014 partially offset by cost control in the current period as compared to the same period a year ago. 28 -------------------------------------------------------------------------------- Table of Contents Performance Engineered Products Segment Net sales for fiscal year 2014 for the Performance Engineered Products ("PEP") segment decreased 4 percent to $498.6 million as compared with $520.1 million for fiscal year 2013. Excluding surcharge revenues, net sales decreased 3 percent. The results reflected softness in demand as a result of challenging market conditions, particularly in the aerospace and energy markets during the first half of this fiscal year. In addition, sales of powder metal products and sales from our distribution businesses were impacted by sluggish industrial activity. This was partially offset by sales growth resulting from strengthening demand for our titanium fastener material, better penetration in the medical orthopedic market and increased sales into the oil and gas exploration market in the second half of the fiscal year 2014. Operating income for the PEP segment for fiscal year 2014 was $45.5 million, or 9.1 percent of net sales, as compared with $45.2 million, or 8.7 percent of net sales for fiscal year 2013. The results reflect the impacts of lower sales levels in fiscal year 2014 compared to the same period a year ago offset by the positive impacts of improvements in the manufacturing processes and cost reduction initiatives. Results of Operations - Fiscal Year 2013 Compared to Fiscal Year 2012 For fiscal year 2013, we reported net income of $146.1 million, or $2.73 per diluted share, compared with income of $121.2 million, or $2.53 per diluted share, a year earlier. Our fiscal year 2013 results reflect a trend of improving revenue during the second half of the fiscal year as well as the full year inclusion of the Latrobe business. Net Sales Net sales for fiscal year 2013 were $2,271.7 million, which was a 12 percent increase from fiscal year 2012. Excluding surcharge revenues, sales were 17 percent higher than fiscal year 2012 on 16 percent higher volume. The full year inclusion of the Latrobe business in fiscal year 2013 contributed $266.1 million of the year over year increase in net sales. Geographically, sales outside the United States increased 5 percent from fiscal year 2012 to $696.4 million. International sales as a percentage of our total net sales represented 31 percent and 33 percent for fiscal year 2013 and fiscal year 2012, respectively. Sales by End-Use Markets We sell to customers across diversified end-use markets. The following table includes comparative information for our net sales, which includes surcharge revenues, by principal end-use markets which we believe is helpful supplemental information in analyzing the performance of the business from period to period: $ % Fiscal Year Increase Increase ($ in millions) 2013 2012 (Decrease) (Decrease) Aerospace and defense $ 1,067.0 $ 901.2 $ 165.8 18 % Industrial and consumer 474.3 478.1 (3.8 ) (1 ) Energy 337.3 287.0 50.3 18 Transportation 138.8 142.2 (3.4 ) (2 ) Medical 113.2 141.1 (27.9 ) (20 ) Distribution 141.1 79.1 62.0 78 Total net sales $ 2,271.7 $ 2,028.7 $ 243.0 12 % 29 -------------------------------------------------------------------------------- Table of Contents The following table includes comparative information for our net sales by the same principal end-use markets, but excluding surcharge revenues: $ % Fiscal Year Increase Increase ($ in millions) 2013 2012 (Decrease) (Decrease) Aerospace and defense $ 832.5 $ 668.8 $ 163.7 24 % Industrial and consumer 366.4 346.7 19.7 6 Energy 290.9 246.1 44.8 18 Transportation 106.6 104.0 2.6 2 Medical 103.7 125.7 (22.0 ) (18 ) Distribution 139.2 78.3 60.9 78 Total net sales excluding surcharge revenues $ 1,839.3 $ 1,569.6 $ 269.7 17 % Sales to the aerospace and defense market increased 18 percent from fiscal year 2012 to $1,067.0 million. Excluding surcharge revenue, sales increased 24 percent on 47 percent higher shipment volume. The aerospace and defense results reflect strength in commercial aerospace as build rates remain high as well as demand growth for proprietary materials for structural application. The addition of the Latrobe aerospace products contributed $135.6 million to the year over year growth in net sales. Industrial and consumer market sales decreased 1 percent from fiscal year 2012 to $474.3 million. Excluding surcharge revenue, sales increased approximately 6 percent on 2 percent higher shipment. The market is sensitive to economic conditions which were challenging particularly in the second half of our fiscal year 2013. Our strategy has been to focus on specialized, high value niche applications with strategically important customers. The addition of the Latrobe industrial and consumer net sales contributed $27.4 million to the year over year growth in net sales. Sales to the energy market of $337.3 million reflected an 18 percent increase from fiscal year 2012. Excluding surcharge revenue, sales increased 18 percent on 10 percent higher shipment volume. The sales results reflect the market penetration in certain segments of the oil and gas markets as well as our international expansion in addition to the inclusion of the Specialty Steel Supply business acquired in connection with the Latrobe acquisition. The full year inclusion of the Latrobe business contributed $37.6 million to the year over year growth in net sales. This growth was partially offset by a decline in drilling alloys, which was impacted by destocking and low growth in North American rig count. Transportation market sales decreased 2 percent from the fiscal year 2012 to $138.8 million. Excluding surcharge revenue, sales increased 2 percent on flat shipment volume. The results reflect North American fuel efficiency standards requiring automobiles to become lighter and engines to operate at higher temperatures offset by continued weakness in Europe and softer demand for materials used in valves, exhaust and other automotive components. Sales to the medical market decreased 20 percent to $113.2 million from fiscal year 2012. Adjusted for surcharge revenue, sales decreased 18 percent due on 15 percent lower shipment volume. As largely seen in the PEP segment results, continued inventory destocking within the titanium distribution supply chain was influenced by falling titanium prices. Sales to the distribution market increased 78 percent to $141.1 million from fiscal year 2012. The increase is primarily attributable to the addition of Latrobe distribution business which globally sources and distributes corrosion resistant steels, tool steels and powder metals for a wide range of industries. The full year inclusion of the Latrobe distribution business contributed $63.3 million to the year over year growth in net sales. 30 -------------------------------------------------------------------------------- Table of Contents Sales by Product Class The following table includes comparative information for our net sales by major product class: $ % Fiscal Year Increase Increase ($ in millions) 2013 2012 (Decrease) (Decrease) Special alloys $ 989.9 $ 931.4 $ 58.5 6 % Stainless steels 638.8 637.3 1.5 - Alloy and tool steel 255.7 108.6 147.1 135 Titanium products 155.0 156.6 (1.6 ) (1 ) Powder metals 60.4 64.3 (3.9 ) (6 ) Distribution and other 171.9 130.5 41.4 32 Total net sales $ 2,271.7 $ 2,028.7 $ 243.0 12 % The following table includes comparative information for our net sales by the same major product class, but excluding surcharge revenues: $ % Fiscal Year Increase Increase ($ in millions) 2013 2012 (Decrease) (Decrease) Special alloys $ 706.0 $ 626.2 $ 79.8 13 % Stainless steels 543.1 512.4 30.7 6 Alloy and tool steel 210.9 85.7 125.2 146 Titanium products 155.0 156.6 (1.6 ) (1 ) Powder metals 55.9 59.7 (3.8 ) (6 ) Distribution and other 168.4 129.0 39.4 31 Total net sales excluding surcharge revenues $ 1,839.3 $ 1,569.6 $ 269.7 17 % Sales of special alloys products increased 6 percent in fiscal year 2013 as compared with a year ago to $989.9 million. Excluding surcharge revenue, sales increased 13 percent on a 9 percent increase in shipment volume. The sales results principally reflect the increased demand in our higher value alloys used in the aerospace and energy markets. The full year of the Latrobe business contributed $25.9 million of the year over year growth in net sales. Sales of stainless steels remained flat compared with fiscal year 2012. Excluding surcharge revenues, such sales increased by 6 percent on 1 percent higher shipment volume. The year over year results also reflect the $54.8 million from the full year inclusion of the Latrobe business. Sales of alloy and tool steel increased 135 percent in fiscal year 2013 on 272 percent higher shipment volume. The results primarily reflect the full year inclusion of the Latrobe business which contributed $139.4 million of the year over year increase in net sales. Sales of titanium products decreased 1 percent as compared with fiscal year 2012 on 1 percent lower shipment volume. The results reflect lower demand in the titanium distributor channel, including sales to medical market. Sales of powder metals decreased 6 percent in fiscal year 2013 on 10 percent lower shipment volume. The results reflect unfavorable performance in Europe. 31 -------------------------------------------------------------------------------- Table of Contents Gross Profit Gross profit in fiscal year 2013 increased to $433.5 million, or 19.1 percent of net sales (23.6 percent of net sales excluding surcharges), from $391.0 million, or 19.3 percent of net sales (24.9 percent of net sales excluding surcharges), for fiscal year 2012. The results reflect the impacts of higher volumes from the addition of the Latrobe business offset by higher net pension expense included in costs of sales during fiscal year 2013. Fiscal year 2012 results included $11.6 million of costs associated with acquisition inventory fair value cost adjustments in connection with the Latrobe Acquisition. Our surcharge mechanism is structured to recover increases in raw material costs, although generally with a lag effect. While the surcharge generally protects the absolute gross profit dollars, it does have a dilutive effect on gross margin as a percent of sales. The following represents a summary of the dilutive impact of the surcharges on gross margin for fiscal years 2013 and 2012. See the section "Non-GAAP Financial Measures" below for further discussion of these financial metrics. Fiscal Year ($ in millions) 2013 2012 Net sales $ 2,271.7 $ 2,028.7 Less: surcharge revenue 432.4 459.1 Net sales excluding surcharges $ 1,839.3 $ 1,569.6 Gross profit $ 433.5 $ 391.0 Gross margin 19.1 % 19.3 % Gross margin excluding dilutive effect of surcharges 23.6 % 24.9 % Selling, General and Administrative Expenses Selling, general and administrative expenses in fiscal year 2013 were $200.8 million, or 8.8 percent of net sales (10.9 percent of net sales excluding surcharges), compared to $169.2 million, or 8.3 percent of net sales (10.8 percent of net sales excluding surcharges), in fiscal year 2012. The increase in fiscal year 2013 is due to the additional overhead costs related to the Latrobe businesses, restructuring related costs activities and higher pension expense. Acquisition-Related Costs In connection with the Latrobe Acquisition, we incurred approximately $11.7 million of acquisition-related costs during fiscal year 2012. These costs represent direct incremental legal, accounting and investment banking fees incurred in connection with the Latrobe Acquisition as well as approximately $5.2 million of a liability for costs associated with the sale of certain Latrobe assets necessary to obtain FTC approval for the transaction. 32 -------------------------------------------------------------------------------- Table of Contents Operating Income Our operating income in fiscal year 2013 increased to $232.7 million as compared with $210.1 million in fiscal year 2012. Operating income has been significantly impacted by our pension earnings, interest and deferrals ("pension EID") portion of our net pension expense, which may be volatile based on conditions in the financial markets. The following presents our operating income and operating margin, in each case excluding the impact of surcharges on net sales and excluding the impacts of pension EID expense from operating income. We present and discuss these financial measures because management believes removing the impact of raw material surcharges from operating margin provides a more consistent and meaningful basis for comparing results of operations from period to period. See the section "Non-GAAP Financial Measures" below for further discussion of these financial measures. In fiscal year 2013, we incurred certain restructuring related costs of $5.5 million. These costs consisted of severance costs associated with a reduction in salaried headcount as well as costs associated with respect to manufacturing footprint optimization activities 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 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. The consulting study was completed in fiscal year 2013. Specific action plans were developed, and we began to see the benefits of improvements in our inventory performance during the second half of our fiscal year 2013. During fiscal year 2013, we incurred $2.5 million costs associated with the inventory reduction initiative which consists of consulting costs associated with the study. Fiscal Year ($ in millions) 2013 2012 Net sales $ 2,271.7 $ 2,028.7 Less: surcharge revenue 432.4 459.1 Net sales excluding surcharges $ 1,839.3 $ 1,569.6 Operating income $ 232.7 $ 210.1 Add back: Pension EID expense 31.9 15.3 Operating income excluding pension EID expense $ 264.6 $ 225.4 Operating margin excluding surcharges and pension EID expense 14.4 % 14.4 % In addition to the impact of the surcharge mechanism and pension EID expense, fluctuations in raw material prices (combined with fluctuations in inventory levels) and the lag effect of the surcharge mechanism have impacted our operating income from year to year. We estimate that the effect of such combined fluctuations positively impacted our operating margin by approximately 10 basis points during fiscal year 2013 and negatively impacted our operating margin by approximately 30 basis points during fiscal year 2012. Interest Expense Fiscal year 2013 interest expense of $21.0 million decreased 11.8 percent from $23.8 million in fiscal year 2012. Fiscal year 2013 interest expense includes $6.8 million of capitalized interest compared to $1.2 million in fiscal year 2012 offset by the net impact of a higher debt level albeit at a lower average interest rate. Interest on substantially all of our debt was at a fixed rate. 33 -------------------------------------------------------------------------------- Table of Contents Other Income, Net Other income for fiscal year 2013 was $5.1 million as compared with $2.3 million a year ago. The increase principally reflected positive impacts in the valuation of assets used to fund certain non-qualified retirement plans and the gain recorded in connection with the dissolution of the strategic partnership with Sandvik Materials Technology. Income Taxes Our effective tax rate (income tax expense as a percent of income before taxes) for fiscal year 2013 was 32.4 percent as compared to 35.5 percent in fiscal year 2012. The fiscal year 2013 tax rate was lower than the statutory rate of 35 percent, primarily due to the benefits associated with the domestic manufacturing deduction and the research and development credit. The fiscal year 2012 tax rate was higher than the statutory rate of 35 percent, primarily due to non-deductible acquisition expenses associated with the Latrobe Acquisition. See Note 16 to the consolidated financial statements in Item 8, "Financial Statements and Supplementary Data" for a full reconciliation of the statutory federal tax rate to the effective tax rates. Business Segment Results Summary information about our operating results on a segment basis is set forth below. For more detailed segment information, see Note 19 to the consolidated financial statements included in Item 8, "Financial Statements and Supplementary Data". The following tables include selected information by business segment: % Fiscal Year Increase Increase (Pounds sold, in thousands) 2013 2012 (Decrease) (Decrease) Specialty Alloys Operations 264,606 227,805 36,801 16 % Performance Engineered Products 13,451 14,182 (731 ) (5 ) Intersegment (4,333 ) (6,455 ) 2,122 33 Consolidated pounds sold 273,724 235,532 38,192 16 % $ % Fiscal Year Increase Increase ($ in millions) 2013 2012 (Decrease) (Decrease) Specialty Alloys Operations $ 1,823.5 $ 1,672.0 $ 151.5 9 % Performance Engineered Products 520.1 444.9 75.2 17 Intersegment (71.9 ) (88.2 ) 16.3 18 Total net sales $ 2,271.7 $ 2,028.7 $ 243.0 12 % 34 -------------------------------------------------------------------------------- Table of Contents $ % Fiscal Year Increase Increase ($ in millions) 2013 2012 (Decrease) (Decrease) Specialty Alloys Operations $ 1,388.5 $ 1,207.4 $ 181.1 15 % Performance Engineered Products 513.7 439.2 74.5 17 Intersegment (62.9 ) (77.0 ) 14.1 18 Total net sales excluding surcharge revenues $ 1,839.3 $ 1,569.6 $ 269.7 17 % Specialty Alloys Operations Segment Net sales in fiscal year 2013 for the Specialty Alloys Operations ("SAO") segment were $1,823.5 million, as compared with $1,672.0 million in fiscal year 2012. Excluding surcharge revenues, sales increased 15 percent from a year ago. The fiscal year 2013 net sales reflected 16 percent higher shipment volume as compared to fiscal year 2012. The results reflect the inclusion of the Latrobe acquisition in February 2012. Excluding the Latrobe manufacturing operations net sales in fiscal year 2013 for the SAO segment were $1,547.4 million, as compared with $1,566.6 million in fiscal year 2012. Excluding surcharge revenues, sales increased 4 percent from a year ago. The fiscal year 2013 net sales reflected 1 percent lower shipment volume as compared to fiscal year 2012. The results reflect growth attributable to our premium and ultra-premium products offset by the impact of lower order intake activity. Operating income for the SAO segment in fiscal year 2013 was $268.5 million, or 14.7 percent of net sales (19.3 percent of net sales excluding surcharge revenues), compared to $236.3 million, or 14.1 percent of net sales (19.6 percent of net sales excluding surcharge revenues), for fiscal year 2012. The results reflect the inclusion of the Latrobe acquisition in February 2012. Excluding the Latrobe manufacturing operations operating income for the SAO segment in fiscal year 2013 was $218.9 million, or 14.1 percent of net sales (18.7 percent of net sales excluding surcharge revenues), compared to $229.4 million, or 14.6 percent of net sales (20.4 percent of net sales excluding surcharge revenues), for fiscal year 2012. The decrease in operating income reflects the negative impacts of an unfavorable shift in product mix as well as increased manufacturing costs related to lower production levels. Performance Engineered Products Segment Net sales for fiscal year 2013 for the Performance Engineered Products ("PEP") segment increased 17 percent to $520.1 million as compared with $444.9 million for fiscal year 2012. The results reflect the inclusion of the Latrobe acquisition in February 2012. Excluding the Latrobe distribution operations net sales for fiscal year 2013 for the PEP segment increased 4 percent to $378.8 million as compared with $365.7 million for fiscal year 2012. Excluding surcharge revenues, net sales increased 4 percent. Operating income for the PEP segment for fiscal year 2013 was $45.2 million, or 8.7 percent of net sales, as compared with $48.2 million, or 10.8 percent of net sales for fiscal year 2012. The results reflect the inclusion of the Latrobe acquisition in February 2012. Excluding the Latrobe distribution operations operating income for the PEP segment for fiscal year 2013 was $36.5 million, or 9.6 percent of net sales, as compared with $44.1 million, or 12.1 percent of net sales for fiscal year 2012. The results reflect weakening of demand in the Titanium distributor channel including medical, continued softness in our European powder tool steel business and higher costs on the Amega West business associated with investments in future growth. 35 -------------------------------------------------------------------------------- Table of Contents Liquidity and Financial Resources We ended fiscal year 2014 with $120.0 million of cash, a decrease of $137.5 million from fiscal year 2013. During fiscal year 2014 our cash from operations was $239.6 million as compared with $188.5 million in fiscal year 2013. Our free cash flow, which we define under "Non-GAAP Financial Measures" below, was negative $147.8 million as compared to negative $159.3 million for the same period a year ago. The increase in free cash flow in fiscal year 2014 as compared with the prior year reflects a reduction in pension contributions from $6.3 million in fiscal year 2014 as compared to $144.9 million in fiscal year 2013 principally as result of the $75.0 million of discretionary pension contributions included in fiscal 2013 which significantly reduced the minimum contributions that were required in fiscal year 2014. This positive impact was offset by lower earnings, unfavorable working capital levels, principally as a result of increased inventory levels necessary to support the Alabama facility start-up, and significantly higher capital spending largely related to the Alabama facility construction in fiscal year 2014. Capital expenditures for plant, equipment and software were $349.2 million in fiscal year 2014, as compared with $310.2 million for the same period a year ago. In fiscal year 2015 we currently expect capital expenditures to be approximately $120 million plus any remaining Alabama spending. Accordingly, we expect capital expenditures of $160 million to $175 million in fiscal year 2015, exclusive of any capital expenditures related to special growth projects and opportunities. Dividends for the fiscal year 2014 were $38.5 million, as compared with $38.3 million in the prior year, and were paid at the same quarterly rate of $0.18 per share of common stock in both periods. For fiscal years 2014, 2013 and 2012, interest costs totaled $32.1 million, $27.8 million and $25.0 million, respectively, of which $15.1 million, $6.8 million and $1.2 million, respectively, was capitalized as part of the cost of plant, equipment and software. During the fiscal year 2014, we made $6 million in cash contributions to our qualified pension plans, and expect to contribute $16 million of cash contributions to our pension plans during fiscal year 2015. Over the next five years, current estimates indicate that we will contribute about $139 million to our pension plans, based on the laws in effect for pension funding as of June 30, 2014, and subject to market returns and interest rate assumptions. In February 2013, we issued $300 million of 4.45% senior notes due 2023. We used the net proceeds from the issuance of the Notes to repay in full $100 million in aggregate principal amount of our senior unsecured notes due May 2013. We used the remaining net proceeds from the issuance of the Notes for general corporate purposes, which included discretionary pension contributions, additions to working capital and capital expenditures. Our next debt payment is scheduled in fiscal year 2018 in the amount of $55.0 million. 36 -------------------------------------------------------------------------------- Table of Contents During the fiscal year 2014, we identified an error in the classification of amounts reported in previously reported Statements of Cash Flows. The classification error is related to the reporting of purchases of property, equipment and software that should be adjusted for amounts not yet paid in cash as of the balance sheet date, which were previously incorrectly reflected as cash used in investing activities and cash provided from operating activities. The discussion above reflects prior reported amounts that have been revised. For more detailed on the revision to statement of cash flows information, see Note 2 to the consolidated financial statements included in Item 8, "Financial Statements and Supplementary Data". We have demonstrated 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 generally target minimum liquidity, consisting of cash and cash equivalents added to available borrowing capacity under our credit agreement, of $150 million. Our revolving credit facility (the "Credit Agreement") contains a revolving credit commitment of $500 million and expires in June 2018. As of June 30, 2014, we had $8.2 million of issued letters of credit under the Credit Agreement. The balance of the Credit Agreement ($491.8 million) remains available to us. The available borrowings together with cash on hand of $120.0 million results in total liquidity of approximately $612 million as of June 30, 2014. From time to time during the year ended June 30, 2014 we have borrowed under our Credit Agreement and subsequently repaid any outstanding borrowings prior to June 30, 2014. The weighted average daily borrowing under the Credit Agreement during the year ended June 30, 2014 was approximately $4.1 million with daily outstanding borrowings ranging from $1.0 million to $40.0 million during the fiscal year 2014. We evaluate liquidity needs for alternative uses including funding external growth opportunities as well as funding consistent dividend payments to stockholders. Over the last several years, we declared and paid quarterly cash dividends of $0.18 per share. We have historically authorized share repurchase programs. As of June 30, 2014, we had cash and cash equivalents of approximately $48 million held at various foreign subsidiaries. Our global cash deployment considers, among other things, the geographic location of our subsidiaries' cash balances, the locations of our anticipated liquidity needs and the cost to access international cash balances, as necessary. The repatriation of cash from certain foreign subsidiaries could have adverse tax consequences as we may be required to pay and record U.S. income taxes and foreign withholding taxes in various tax jurisdictions on these funds to the extent they were previously considered permanently reinvested. From time to time, we evaluate opportunities to repatriate cash from foreign jurisdictions. Our current plans consider repatriating cash only at levels that would result in minimal or no net adverse tax consequences in the near term. From time to time, we may make short-term intercompany borrowings against our cash held outside the United States in order to reduce or eliminate any required borrowing under our Credit Agreement. We are subject to certain financial and restrictive covenants under the Credit Agreement, which, among other things, require the maintenance of a minimum interest coverage ratio (3.50 to 1.00 as of June 30, 2014). The interest coverage ratio is defined in the Credit Agreement as, for any period, the ratio of consolidated earnings before interest, taxes, depreciation and amortization ("EBITDA") to consolidated interest expense for such period. The Credit Agreement also requires the Company to maintain a debt to capital ratio of less than 55%. The debt to capital ratio is defined in the Credit Agreement as the ratio of consolidated indebtedness, defined as total long-term debt added to outstanding capital lease obligations and outstanding letters of credit, to consolidated capitalization, defined as consolidated indebtedness added to total equity. As of June 30, 2014, the Company was in compliance with all of the covenants of the Credit Agreement. The following table shows our actual ratio performance with respect to the financial covenants, as of June 30, 2014: Actual Covenant Requirement Ratio Consolidated interest coverage 3.50 to 1.00 (minimum) 23.12 to 1.00 Consolidated debt to capital 55% (maximum) 29% 37 -------------------------------------------------------------------------------- Table of Contents We continue to believe that we will maintain compliance with the financial and restrictive covenants in future periods. To the extent that we do not comply with the covenants under the Credit Agreement, this could reduce our liquidity and flexibility due to potential restrictions on borrowings available to us unless we are able to obtain waivers or modification of the covenants. Non-GAAP Financial Measures The following provides additional information regarding certain non-GAAP financial measures. Our definitions and calculations of these items may not necessarily be the same as those used by other companies. Net Sales and Gross Margin Excluding Surcharges This report includes discussions of net sales and gross margin as adjusted to exclude the impact of raw material surcharges, which represent financial measures that have not been determined in accordance with U.S. GAAP. We present and discuss these financial measures because management believes removing the impact of raw material surcharges from net sales and gross margin provides a more consistent basis for comparing results of operations from period to period for the reasons discussed earlier in this report. See our earlier discussion of gross profit for a reconciliation of net sales and gross margin excluding surcharges to net sales as determined in accordance with U.S. GAAP. Net sales and gross margin excluding surcharge revenues is not a U.S. GAAP financial measure and should not be considered in isolation of, or as a substitute for, net sales and gross margin calculated in accordance with U.S. GAAP. Operating Income and Operating Margin Excluding Surcharges and Pension EID Expense This report includes discussions of operating income and operating margin as adjusted to exclude the impact of raw material surcharges and pension EID expense, which represent financial measures that have not been determined in accordance with U.S. GAAP. We present and discuss these financial measures because management believes removing the impact of raw material surcharges from net sales provides a more consistent and meaningful basis for comparing results of operations from period to period for the reasons discussed earlier in this report. In addition, management believes that excluding pension EID expense from operating income and operating margin is helpful in analyzing our operating performance particularly as pension EID expense may be volatile due to changes in the financial markets. See our earlier discussion of operating income for a reconciliation of operating income and operating margin excluding pension EID expense to operating income and operating margin determined in accordance with U.S. GAAP. Operating income and operating margin excluding surcharges and pension EID expense is not a U.S. GAAP financial measure and should not be considered in isolation of, or as a substitute for, operating income and operating margin calculated in accordance with U.S. GAAP. 38 -------------------------------------------------------------------------------- Table of Contents Free Cash Flow The following provides a reconciliation of free cash flow, as used in this annual report, to its most directly comparable U.S. GAAP financial measures. Fiscal Year ($ in millions) 2014 2013 2012 Net cash provided from operating activities $ 239.6 $ 188.5 $ 146.2 Purchases of property, equipment and software (349.2 ) (310.2 ) (157.8 ) Dividends paid (38.5 ) (38.3 ) (33.7 ) Proceeds from disposals of plant and equipment 0.3 1.2 1.2 Proceeds from sale of equity method investment - 7.9 - Capital contribution to equity method investment - - (1.8 ) Purchase of subsidiary shares from noncontrolling interest - (8.4 ) - Acquisition of businesses, net of cash acquired - - (12.9 ) Free cash flow $ (147.8 ) $ (159.3 ) $ (58.8 ) Management believes that the presentation of free cash flow provides useful information to investors regarding our financial condition because it is a measure of cash generated which management evaluates for alternative uses. It is management's current intention to use excess cash to fund investments in capital equipment, acquisition opportunities and consistent dividend payments. Free cash flow is not a U.S. GAAP financial measure and should not be considered in isolation of, or as a substitute for, cash flows calculated in accordance with U.S. GAAP. Adjusted Earnings before Interest, Taxes, Depreciation and Amortization (Adjusted EBITDA) The following provides a reconciliation of adjusted EBITDA, to its most directly comparable U.S. GAAP financial measures. Fiscal Year ($ in millions) 2014 2013 2012 ADJUSTED EARNINGS BEFORE INTEREST, TAXES, DEPRECIATION AND AMORTIZATION (ADJUSTED EBITDA) Net income $ 132.8 $ 146.5 $ 121.6 Interest expense 17.0 21.0 23.8 Income tax expense 63.6 70.3 67.0 Depreciation and amortization 111.9 104.1 83.8 Other income, net (1.4 ) (5.1 ) (2.3 ) EBITDA $ 323.9 $ 336.8 $ 293.9 Net pension expense 57.9 68.8 42.1 Adjusted EBITDA $ 381.8 $ 405.6 $ 336.0 Management believes that adjusted EBITDA is helpful in analyzing the operating performance. Our definitions and calculations of these items may not necessarily be the same as those used by other companies. Adjusted EBITDA is not a measure of liquidity or profitability and should not be considered as an alternative to net income, operating income, net cash provided by operating activities or any other measure determined in accordance with U.S. GAAP. 39 -------------------------------------------------------------------------------- Table of Contents Critical Accounting Policies and Estimates The preparation of the consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. On an on-going basis, we evaluate our estimates, including those related to bad debts, customer claims, inventories, goodwill, intangible assets, income taxes, pensions and other postretirement benefits, contingencies and litigation, environmental liabilities and derivative instruments and hedging activities. We believe the following are the critical accounting policies and areas affected by significant judgments and estimates impacting the preparation of our consolidated financial statements. Allowance for Doubtful Accounts We maintain an allowance for doubtful accounts for estimated losses resulting from the failure of our customers to make required payments. We perform ongoing credit evaluations of our customers and monitor their payment patterns. Should the financial condition of our customers deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. Inventories Inventories are stated at the lower of cost or market. The cost of inventories is primarily determined using the LIFO method. Costs include direct materials, direct labor and applicable manufacturing overhead and other direct costs. Under the LIFO inventory valuation 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 and other costs may have been incurred at significantly different values due to the length of time of our production cycle. The prices for many of the raw materials we use have been volatile. Since we value most of our inventory utilizing the LIFO inventory costing methodology, rapid changes in raw material costs have an impact on our operating results. In a period of rising prices, cost of sales expense recognized under LIFO is generally higher than the cash costs incurred to acquire the inventory sold. Conversely, in a period of declining raw material prices, cost of sales recognized under LIFO is generally lower than cash costs incurred to acquire the inventory sold. Since the LIFO inventory valuation methodology is designed for annual determination, interim estimates of the annual LIFO valuation are required. We recognize the effects of the LIFO inventory valuation method on an interim basis by estimating the expected annual LIFO cost based on cost changes to date. These projections of annual LIFO inventory valuation reserve changes are updated quarterly and are evaluated based upon material, labor and overhead costs. 40 -------------------------------------------------------------------------------- Table of Contents Pension and Other Postretirement Benefits The amount of the pension expense, which is determined annually, is based upon the value of the assets in the pension trusts at the beginning of the fiscal year as well as actuarial assumptions, such as the discount rate and the expected long-term rate of return on plan assets. The assumed long-term rate of return on pension plan assets is reviewed at each year end based on the plan's investment policies, an analysis of the historical returns of the capital markets and current interest rates. Based on the current funding level, the allocation policy for pension plan assets is to have approximately 60% in return seeking assets and 40% in liability matching assets. Return seeking assets include domestic and international equities and high yield bond funds. Liability matching assets include long duration bond funds. As the funding level of the plans improves in increments of 5%, assets will be shifted from return seeking to liability matching in increments of 4% as a de-risking strategy. The discount rate plan is determined by reference to the Bond:Link interest rate model based upon a portfolio of highly rated U.S. corporate bonds with individual bonds that are theoretically purchased to settle the plan's anticipated cash outflows. The fluctuations in stock and bond markets could cause actual investment results to be significantly different from those assumed, and therefore, significantly impact the valuation of the assets in our pension trusts. Changes in actuarial assumptions could significantly impact the accounting for the pension assets and liabilities. If the assumed long-term rate of return on plan assets was changed by 0.25 percent, the net pension expense would change by approximately $2.8 million. If the discount rate was changed by 0.25 percent, the net pension expense would change by approximately $2.9 million. Long-Lived Assets Long-lived assets are reviewed for impairment and written down to fair value whenever events or changes in circumstances indicate that the carrying value may not be recoverable through estimated future undiscounted cash flows. The amount of the impairment loss is the excess of the carrying amount of the impaired assets over the fair value of the assets based upon estimated future discounted cash flows. We evaluate long-lived assets for impairment by individual business unit. Changes in estimated cash flows could have a significant impact on whether or not an asset is impaired and the amount of the impairment. Goodwill Goodwill is not amortized, but instead is tested for impairment, at least annually at the reporting unit level. Potential impairment is identified by comparing the fair value of a reporting unit to its carrying value, including goodwill. The fair value is estimated based principally upon discounted cash flow analysis. If the carrying value of the reporting unit exceeds its fair value, any impairment loss is measured by comparing the carrying value of the reporting unit's goodwill to its implied fair value. The discounted cash flow analysis for each reporting unit tested requires significant estimates and assumptions related to cash flow forecasts, discount rates, terminal values and income tax rates. The cash flow forecasts are developed based on assumptions about each reporting unit's markets, product offerings, pricing, capital expenditure and working capital requirements as well as cost performance. The discount rates used in the discounted cash flow are estimated based on a market participant's perspective of each reporting units weighted average cost of capital. The terminal value, which represents the value attributed to the reporting unit beyond the forecast period, is estimated using a perpetuity growth rate assumption. The income tax rates used in the discounted cash flow analysis represent estimates of the long-term statutory income tax rates for each reporting unit based on the jurisdictions in which the reporting units operate. Historically, we have conducted our annual goodwill impairment test as of June 30 for our reporting units, other than the reporting units acquired in connection with the Latrobe Acquisition (Latrobe Manufacturing, Latrobe Distribution and Specialty Steel Supply ("SSS"), which were tested for impairment annually as of February 28. In the fourth quarter of fiscal year 2014, we changed the annual impairment testing date for the Latrobe Distribution and SSS reporting units to June 30, which was considered a change in accounting principle. The change to the goodwill impairment testing date is preferable. The change in accounting principle did not accelerate, delay or cause a goodwill impairment charge. In addition, to reflect the continued integration of the Latrobe Manufacturing operations into the Company's SAO segment the discrete financial information at the Latrobe Manufacturing level ceased to be available during the fourth quarter of fiscal year 2014; therefore, effective April 1, 2014, the SAO segment is the reporting unit for goodwill impairment testing purposes. We performed a goodwill impairment test for the SAO segment at June 30, 2014. As a result of the change in the annual impairment testing date, goodwill was also tested for impairment at the Latrobe Distribution and SSS reporting units at June 30, 2014. As a result of the impairment testing completed as of June 30, 2014 and February 28, 2014, we have determined that there was no goodwill impairment. 41 -------------------------------------------------------------------------------- Table of Contents As of June 30, 2014, we had six reporting units with goodwill recorded. As discussed above, goodwill associated with our SAO segment is tested annually for impairment at the SAO segment level and represents 76 percent of our total goodwill. All other goodwill is associated with our PEP segment, which includes 5 reporting units with goodwill recorded. The PEP reporting units with goodwill are: Latrobe Distribution, Specialty Steel Supply, Dynamet, Amega West Services and Carpenter Powder Products. As of June 30, 2014, the fair value of all the reporting units, with the exception of Carpenter Powder Products ("Powders"), substantially exceeded the carrying value. The Powders reporting unit's fair value exceeded the carrying value by 5 percent as of June 30, 2014. The goodwill recorded related to Carpenter Powder Products as of June 30, 2014 was $3.4 million. The powder business has performed below expectations over the last several quarters. The discounted cash flows analysis for the powders reporting unit includes assumptions related to our ability to increase volume, improve mix, expand product offering and implement opportunities to reduce costs over the next several years. Environmental Expenditures Environmental expenditures that pertain to current operations or to future revenues are expensed or capitalized consistent with Carpenter's capitalization policy for property, plant and equipment. Expenditures that result from the remediation of an existing condition caused by past operations and that do not contribute to current or future revenues are expensed. Liabilities are recognized for remedial activities when the remediation is probable and the cost can be reasonably estimated. Recoveries of expenditures for environmental remediation are recognized as assets only when recovery is deemed probable. Most estimated liabilities are not discounted to present value, but estimated assets are measured on a discounted basis. For one former operating facility site, due to the routine nature of the expected costs, the liability for future costs is discounted to present value over 20 years. Income Taxes Deferred income taxes result from temporary differences in the recognition of income and expense for financial and income tax reporting purposes, or differences between the fair value of assets acquired in business combinations accounted for as purchases for financial reporting purposes and their corresponding tax bases. Deferred income taxes represent future tax benefits (assets) or costs (liabilities) to be recognized when those temporary differences reverse. We evaluate on a quarterly basis whether, based on all available evidence, we believe that our deferred income tax assets will be realizable. Valuation allowances are established when it is estimated that it is more likely than not that the tax benefit of the deferred tax assets will not be realized. The evaluation includes the consideration of all available evidence, both positive and negative, regarding historical operating results including recent years with reported losses, the estimated timing of future reversals of existing taxable temporary differences, estimated future taxable income exclusive of reversing temporary differences and carryforwards, and potential tax planning strategies which may be employed to prevent an operating loss or tax credit carryforward from expiring unused. Future realization of deferred income tax assets ultimately depends upon the existence of sufficient taxable income within the carryback, carryforward period available under tax law. Management determines whether a tax position should be recognized in the financial statements by evaluating whether it is more likely than not that the tax position will be sustained upon examination by the tax authorities based upon the technical merits of the position. For those tax positions which should be recognized, the measurement of a tax position is determined as being the largest amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement. Interest and penalties on estimated liabilities for uncertain tax positions are recorded as components of the provision for income taxes. 42 -------------------------------------------------------------------------------- Table of Contents Derivative Financial Instruments Our current risk management strategies include the use of derivative instruments to reduce certain risks. The critical strategies include: (1) the use of commodity forward contracts to fix the price of a portion of anticipated future purchases of certain raw materials and energy to offset the effects of changes in the costs of those commodities; and (2) the use of foreign currency forward contracts to hedge a portion of anticipated future sales denominated in foreign currencies, principally the Euro and Pound Sterling, in order to offset the effect of changes in exchange rates. The commodity forwards and foreign currency forwards have been designated as cash flow hedges and unrealized net gains and losses are recorded in the accumulated other comprehensive loss component of stockholders' equity. The unrealized gains or losses are reclassified to the income statement when the hedged transaction affects earnings or if the anticipated transactions are no longer expected to occur. We have used interest rate swaps to maintain a certain level of floating rate debt relative to fixed rate debt. Interest rate swaps have been designated as fair value hedges. Accordingly, the mark-to-market values of both the interest rate swap and the underlying debt obligations were recorded as equal and offsetting gains and losses in the interest expense component of the consolidated statement of income. We have also used forward interest rate swaps to manage the risk of cash flow variability associated with fixed interest debt expected to be issued. We evaluate all derivative instruments each quarter to determine that they are highly effective. Any ineffectiveness is recorded in our consolidated statement of income. We also use foreign currency forward contracts to protect certain short-term asset positions denominated in foreign currency against the effect of changes in exchange rates. These positions do not qualify for hedge accounting and accordingly are marked-to-market at each reporting date through charges to other income and expense. New Accounting Pronouncements For information with respect to new accounting pronouncements and the impact of these pronouncements on our consolidated financial statements, see Note 20, Recent Accounting Pronouncements, to Notes to Consolidated Financial Statements included in Item 8, "Financial Statements and Supplementary Data". Off Balance Sheet Arrangements We had no off balance sheet arrangements during the periods presented. Contractual Obligations At June 30, 2014, we had the following contractual obligations and other commercial commitments and contingencies: Fiscal Year ($ in millions) Total 2015 2016 2017 2018 2019 Thereafter Long-term debt (1) $ 605.0 $ - $ - $ - $ 55.0 $ - $ 550.0 Estimated interest payments(2) 222.0 30.2 30.2 30.2 29.5 26.4 75.5 Operating leases 34.2 9.6 7.2 4.2 2.7 2.4 8.1 Pension plan contributions(3) 265.8 15.5 53.0 39.1 24.3 6.6 127.3 Accrued post-retirement benefits(4) 181.3 15.5 16.4 17.2 17.9 18.4 95.9 Purchase obligations (5) 231.2 231.2 - - - - - Pension benefits (6) 34.7 3.8 3.8 3.3 3.2 3.1 17.5 Total $ 1,574.2 $ 305.8 $ 110.6 $ 94.0 $ 132.6 $ 56.9 $ 874.3 43 -------------------------------------------------------------------------------- Table of Contents -------------------------------------------------------------------------------- (1) Refer to Note 8 of Notes to Consolidated Financial Statements included in Item 8. "Financial Statements and Supplementary Data". (2) Estimated interest payments for long-term debt were calculated based on the applicable rates and payment dates. No interest payments are included for any potential borrowings under our revolving credit facility. (3) Pension plan contributions represent required minimum contributions for plan years beginning January 1, 2013. These amounts were calculated based on actuarial valuations as prescribed by pension funding regulations in the United States effective June 30, 2014. Estimated fiscal year contributions have been included through fiscal year 2025. The actual required pension contributions in future periods may be different. (4) Postretirement benefits for certain plans are paid from corporate assets. There is no guarantee that future payments will be paid from corporate assets rather than plan assets. Estimated fiscal year postretirement benefit payments have been included through fiscal year 2024. (5) We have entered into purchase commitments primarily for various key raw materials and equipment purchases at market related prices, all made in the normal course of business. The commitments include both fixed and variable price provisions. We used June 30, 2014 raw material prices for commitments with variable pricing. (6) Pension benefits for certain plans are paid from corporate assets. There is no guarantee that future payments will be paid from corporate assets rather than plan assets. Market Sensitive Instruments and Risk Management See "Item 7A. Quantitative and Qualitative Disclosures About Market Risk" for discussion of market sensitive instruments and associated market risk for Carpenter. Contingencies Environmental We are subject to various federal, state, local and international environmental laws and regulations relating to pollution, protection of public health and the environment, natural resource damages and occupational safety and health. Although compliance with these laws and regulations may affect the costs of our operations, compliance costs to date have not been material. We have environmental remediation liabilities at some of our owned operating facilities and have been designated as a potentially responsible party ("PRP") with respect to certain third party Superfund waste disposal sites and other third party owned sites. Additionally, we have been notified that we may be a PRP with respect to other Superfund sites as to which no proceedings have been instituted against us. Neither the exact amount of remediation costs nor the final method of their allocation among all designated PRP's at these Superfund sites has been determined. The liability for future environmental remediation costs is evaluated on a quarterly basis. We accrue amounts for environmental remediation costs that represent our best estimate of the probable and reasonably estimable costs related to environmental remediation. During fiscal years 2014 and 2013, we increased the liability for a company-owned former operating site by $0.7 million and $0.3 million, respectively. The liabilities recorded for environmental remediation costs at Superfund sites, at other third party-owned sites and at company-owned current or former operating facilities remaining at June 30, 2014 and 2013, were $15.5 million and $14.8 million, respectively. 44 -------------------------------------------------------------------------------- Table of Contents Estimates of the amount and timing of future costs of environmental remediation requirements are inherently imprecise because of the continuing evolution of environmental laws and regulatory requirements, the availability and application of technology, the identification of currently unknown remediation sites and the allocation of costs among the PRP's. Based upon information currently available, such future costs are not expected to have a material effect on our financial position, results of operations or cash flows over the long-term. However, such costs could be material to our financial position, results of operations or cash flows in a particular future quarter or year. Other We are defending various routine claims and legal actions that are incidental to our business, and we are subject to contingencies that are common to our operations, including those pertaining to product claims, commercial disputes, employment actions, employee benefits, compliance with domestic and foreign laws, personal injury claims, patent infringement and tax issues. Like many other manufacturing companies in recent years, from time to time, we have been named as a defendant in lawsuits alleging personal injury as a result of exposure to chemicals and substances in the workplace. We provide for costs relating to these matters when a loss is probable and the amount of the loss is reasonably estimable. The effect of the outcome of these matters on our future results of operations and liquidity cannot be predicted because any such effect depends on future results of operations and the amount and timing (both as to recording future charges to operations and cash expenditures) of the resolution of such matters. While it is not feasible to determine the outcome of these matters, we believe that the total liability from these matters will not have a material effect on our financial position, results of operations or cash flows over the long-term. However, there can be no assurance that an increase in the scope of pending matters or that any future lawsuits, claims, proceedings or investigations will not be material to our financial position, results of operations or cash flows in a particular future quarter or year. Forward Looking Statements This Annual Report on Form 10-K contains various "Forward-looking Statements" pursuant to the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995. These statements, which represent our expectations or beliefs concerning various future events, include statements concerning future revenues, earnings and liquidity associated with continued growth in various market segments and cost reductions expected from various initiatives. These forward-looking statements are subject to risks and uncertainties that could cause actual results to differ from those projected, anticipated or implied. The most significant of these uncertainties are described in this Form 10-K and they include but are not limited to: (1) the cyclical nature of the specialty materials business and certain end-use markets, including aerospace and defense, industrial and consumer, medical, transportation and energy, or other influences on Carpenter's business such as new competitors, the consolidation of competitors, customers and suppliers or the transfer of manufacturing capacity from the United States to foreign countries; or political or economic instability, (2) the ability of Carpenter to achieve cash generation, growth, profitability, cost savings, productivity improvements or process changes; (3) the ability to recoup increases in the cost of energy, raw materials, freight or other factors; (4) domestic and foreign excess manufacturing capacity for certain metals; (5) fluctuations in currency exchange rates; (6) changes in legal and regulatory requirements, including export and import controls, tax laws and regulations, tariffs and trade duties; (7) the valuation of the assets and liabilities in Carpenter's pension trusts and the accounting for pension plans; (8) possible labor disputes or work stoppages; (9) the potential that our customers may substitute alternate materials or adopt different manufacturing practices that replace or limit the suitability of our products; (10) the ability to successfully acquire and integrate acquisitions; (11) the availability of credit facilities to Carpenter, its customers or other members of the supply chain; (12) the ability to obtain energy or raw materials, especially from suppliers located in countries that may be subject to unstable political or economic conditions; (13) Carpenter's manufacturing processes are dependent upon highly specialized equipment for which there may be limited alternatives if there are significant equipment failures; and (14) Carpenter's future success depends on the continued service and availability of key personnel, including members of the executive management team, management, metallurgists and other skilled personnel and the loss of these key personnel could affect Carpenter's ability to perform until suitable replacements are found. Any of these factors could have an adverse and/or fluctuating effect on 45 -------------------------------------------------------------------------------- Table of Contents Carpenter's results of operations. The forward-looking statements in this document are intended to be subject to the safe harbor protection provided by Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Carpenter undertakes no obligation to update or revise any forward-looking statements. |