Carpenter Technology Corporation (CRS) Earnings Call Transcript & Summary

Good morning, and welcome to the Carpenter Technology Corporation First Quarter Fiscal 2021 Conference Call. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Brad Edwards with Investor Relations. Please go ahead.

Thank you, operator. Good morning, everyone, and welcome to the Carpenter Technology earnings conference call for the fiscal 2021 first quarter ended September 30, 2020. This call is also being broadcast over the Internet along with presentation slides. Please note, for those of you listening by phone, you may experience a time delay in slide movement. Speakers on the call today are Tony Thene, President and Chief Executive Officer; and Tim Lain, Vice President and Chief Financial Officer. Statements made by management during this earnings presentation that are forward-looking statements are based on current expectations. Risk factors that could cause actual results to differ materially from those forward-looking statements can be found in Carpenter Technology's most recent SEC filings, including the company's report on Form 10-K for the year ended June 30, 2020, and the exhibits attached to that filing. Please also note that in the following discussion, unless otherwise noted, when management discusses sales or revenue, that reference excludes surcharge. When referring to operating margins, that is based on operating income and sales, excluding surcharge. I will now turn the call over to Tony.

Thank you, Brad, and good morning to everyone. As we always do, let's start with a review of our safety performance on Slide #4. Our total case incident rate, or TCIR, was 0.4 in the first quarter. This marked our lowest quarterly TCIR rate ever recorded. In addition, we achieved our first official injury-free month in the company's 131-year history during the month of September. A 0-injury workplace is possible. And we look forward to achieving our next milestone on our way to 0. Before moving on, I want to take a minute to recognize and thank all of our employees for their ongoing hard work and commitment during these unprecedented times. All of our facilities remain open and operating safely, which is a tremendous accomplishment. Our team has done a remarkable job of building on our core safety value and protecting each other and the communities we operate in while, at the same time, staying focused on serving our customers. Now let's turn to Slide 5 and review the first quarter. Our first quarter operating performance was in line with our previous guidance as demand headwinds across our end-use markets continue to be the driving factor. Given the current environment, the demand weakness is difficult to offset. However, as I have stated before, our primary focus is staying cash flow positive, and we have taken significant actions, which enabled us to continue our strong cash generation performance in Q1. In the first quarter, we generated $63 million of free cash flow and ended the first quarter with over $600 million in total liquidity, including $219 million of cash. In addition, we completed a bond offering that extended our maturities profile and provides us additional financial flexibility as we navigate the current environment. We have ample liquidity to continue managing through the COVID-19 pandemic. In the first quarter, we completed the divestiture of our Amega West oil and gas business and took additional restructuring actions in our additive business unit to streamline operations and reduce costs. At the same time, we are pushing forward with our long-term growth initiatives and balancing our actions to ensure that we emerge in an even stronger market position with our customers. This includes our Athens facility, which remains a key long-term growth driver and differentiator for Carpenter Technology. We continue to collaborate with customers and make progress on achieving key additional qualifications for the facility. In addition, we have further strengthened our capabilities in critical emerging technologies, most recently through the launch of our Carpenter Electrification brand. Electrification is a rapidly growing area of focus across our end-use markets, and we believe our materials solution can help customers drive enhanced performance for the product. Our new hot strip mill installation is nearing completion, which will enable us to further excel in our capabilities in this emerging area. Now let's move to Slide #6 and the end-use market update. Let me spend a little more time than usual on this slide as I anticipate most of the questions will be focused on market dynamics, especially in the Aerospace and Defense end-use market. Starting with the Aerospace and Defense end-use market and specifically the aerospace submarket, the supply chain continued to adjust to revise forward build rates in a lowered demand environment. Most supply chains continue to be over inventory, and OEMs continued the process of adjusting inventory levels across the supply chain during the quarter. Individual customers reported ongoing destocking at various rates. Many customers continue to report refusals of obligations throughout the supply chain and several customers, especially in Europe, had longer-than-normal extended shutdowns. We continue to work closely with all of our customers and finalize commercial discussions with many regarding forward sales arrangements. Though at depressed levels, we continued to secure and support areas of real demand. Cancellation and deferral requests, while not altogether behind us, did decline in the quarter. Direct bookings were relatively flat, while stock shipment activity declined as customers had lower consumption requirements versus stock contracts. In our fiscal second quarter, we expect customers to continue to work through destocking requirements. While we are seeing an uptick of demand activity in some limited areas, most customers continue to report significant amounts of inventory. At the extreme, some customers report over 12 months of inventory at the current shipment levels for certain parts. On the other hand, some customers are beginning to discuss restocking, though at very limited levels. During our second quarter, we are continuing to support near-term customer needs and are also in negotiation with key customers developing mutually beneficial outcomes in both the mid and long term. As credit has become an increasing concern with some of our customer base, we are also closely monitoring and adjusting to customer financial situations as necessary. Concerning our defense submarket, we continue to see steady activity standing in contrast to commercial aerospace. Many of our customers involved in commercial aerospace are also involved in defense. And some customer locations report defense work as the main activity that is currently sustaining their operations. Some of the defense programs we support are seeing increased activity, and we are working to support these accordingly. We continue to be involved in new platform design and prototyping and remain excited about our long-term growth. Let's turn to our medical end-use market. From a macro perspective, as it relates to trends in electric procedures, hospitals reported a gradual recovery of procedures beginning in fiscal Q1 with recovery expected to continue. Medical device companies acknowledged this gradual return of elective surgeries during fiscal Q1, but are continuing to manage inventory levels downwards and only reordering necessary materials to replace critical needs. We expect destocking efforts to level off within our fiscal Q2 at both OEMs and distributors that support the medical device market. In the transportation end-use market, sales increased 42% sequentially, but were down on a year-over-year basis. Global light-duty vehicle production rebounded across most global markets. In North America, we believe the light vehicle market is currently on track to recover and come close to reaching prepandemic levels in calendar year 2021. Overall, confidence is returning to the supply chain, and we believe we can benefit given the unique value our high-temperature solutions deliver. In the heavy-duty truck submarket, we began to see signs of recovery off historical low levels due in part to cyclical timing but also increased freight demand. Now moving to the energy end-use market, where conditions in North America remain challenged and drilling activity is at severely depressed levels. International market has held up better due to longer project cycle lead times, but current activity levels are low. In the power generation submarket within energy, we are seeing some signs of increased activity related to a delayed maintenance cycle, but a potential uptick remains in the early stages. Lastly, for the industrial and consumer end-use market, sales were up both year-over-year and sequentially. Industrial sales were driven by continued strong demand for our semiconductor and control applications. Now I'll turn it over to Tim for the financial review.

Thank you, Tony. Good morning, everyone. I'll start on Slide 8 with the income statement summary. Net sales in the first quarter were $353 million, and sales, excluding surcharge, totaled $307 million. Sales, excluding surcharge, decreased 18% sequentially on 8% lower volume. Compared to the first quarter a year ago, sales decreased 37% on 29% lower volume. As Tony covered in his review of the end-use markets, the results reflected ongoing demand impacts driven by COVID-19 headwinds in our key end-use markets of Aerospace and Defense and medical. This was partially offset by increased sequential demand in transportation as North American vehicle production rebounded, albeit off a low base, from the COVID-19-related shutdowns in Q4. As we have mentioned since the beginning of the pandemic, we continue to actively manage our production schedules and focus on accelerating a targeted inventory reduction program. While the reduction in inventory drives near-term cash flow generation, which I'll talk about shortly, it negatively impacts our operating income performance. SG&A expenses were $42.3 million in the first quarter, down $11 million from the same period a year ago and flat sequentially. The lower year-over-year SG&A expenses primarily reflect the impacts of restructuring actions, including the elimination of salary positions, salary furloughs as well as the impact of remote working conditions that reduced certain administrative costs, such as travel and entertainment. The current quarter's operating results include $17.9 million of special items. This includes $10 million of restructuring charges, including severance costs, noncash asset impairment charges and lease acceleration costs. These costs are principally associated with actions that we initiated in the current quarter to reduce cost and streamline operations in our additive business unit. The special items also includes $7.9 million in COVID-19-related costs. Included in these costs are direct incremental operating costs, including outside services to execute enhanced cleaning protocols, isolation pay for employees potentially exposed to COVID-19 and additional personal protective equipment and other operating supplies and costs necessary to maintain the operations while keeping the employees safe against possible exposure. The COVID-19 costs in the current quarter also include $3.1 million of costs associated with a customer bankruptcy resulting from the COVID-19 pandemic. The operating loss was $48.8 million in the quarter. When excluding the impact of the special items, adjusted operating loss was $30.9 million compared to operating income of $59.8 million in the prior year period and adjusted operating loss of $10.7 million in the fourth quarter of fiscal year 2020. Again, the current quarter's results reflect the impact of significantly lower volume, combined with a targeted inventory reduction. Our effective tax rate for the first quarter was 28.6%. The income tax benefit was below our full year tax rate guidance as a result of the discrete tax impact of the special items as well as a $1.2 million discrete tax charge associated with certain stock-based compensation awards vesting in the quarter. Earnings per share for the quarter was a loss of $0.98 per share. When excluding the impacts of special items, adjusted earnings per share was a loss of $0.58 per share. Now turning to Slide 9 and our SAO segment results. Net sales for the quarter were $300.7 million or $254.8 million excluding surcharge. Compared to the first quarter last year, sales, excluding surcharge, decreased 35% on 28% lower volume. Sequentially, sales, excluding surcharge, decreased 17% on 6% lower volume. The results reflect ongoing demand headwinds in Aerospace and Defense as the supply chain continues to deal with the near-term reductions in OEM build rates. This was partially offset by stronger shipments in Transportation as North American production returned from COVID-19-related shutdowns and by higher demand in certain industrial applications. SAO reported an operating loss of $18.6 million for the current quarter. The same quarter a year ago, SAO's operating income was $81 million and in the fourth quarter of fiscal year 2020, SAO generated $5.3 million of operating income. The year-over-year reduction in operating income primarily reflects the impacts of lower volume as well as the negative income statement impacts of reducing inventory. To note, during the quarter, SAO reduced inventory by approximately $73 million. Sequentially, the lower operating income result is principally the result of lower volume as well as the impact of an unfavorable product mix due to the pronounced decline in Aerospace and Defense. In addition, the current quarter's results reflect approximately $7.3 million of direct incremental costs associated with our efforts to protect our facilities and employees against COVID-19, and as I mentioned earlier, also includes $3.1 million of costs associated with a customer bankruptcy directly resulting from COVID-19. Looking ahead, we expect demand conditions across most end-use markets will remain challenged in our upcoming second quarter of fiscal year 2021. As we have stated before, we anticipate that the demand environment across our key end-use markets will stabilize and begin to recover as we enter the second half of our fiscal year 2021. In response to current market conditions, we continue our focus on managing costs and further enhancing our liquidity position via working capital management. Based on current expectations, we expect SAO to generate an operating loss of approximately $18 million to $23 million in the second quarter of fiscal year 2021. This estimate includes $3 million to $4 million of COVID-19-related costs in the quarter. Now turning to Slide 10 and our PEP segment results. Net sales, excluding surcharge, were $61.2 million, which were down 43% from the same quarter a year ago and down 20% sequentially. The year-over-year decline in sales is driven by the impacts of lower demand as a result of COVID-19, particularly in Aerospace and Defense, Medical and distribution. Additionally, sales in the energy end-use market declined as a result of our exit of the Amega West oil and gas business. The sequential decline in sales follows the themes covered in the market summary. Ongoing near-term demand pressures in Aerospace and Defense and Medical are due primarily to the impacts of the global pandemic and its impact on aircraft OEM build rates and medical elective procedures. The bright spot was in our distribution business, where we saw a sequential increase in sales off a relatively low base. In the current quarter, PEP reported an operating loss of $3.6 million. This compares to an operating loss of $8.4 million in the fourth quarter of fiscal year 2020 and an operating loss of $2 million in the same quarter last year. The sequential operating results reflect the unfavorable impacts of lower volume, driven primarily by COVID, offset by some savings realized from the actions we initiated over the last several quarters, both in our additive business unit and the recent divestiture of our Amega West oil and gas business. The approach to reducing cost in additives has been balanced in that we recognize the importance of being innovative in this business and remain excited about its long-term future prospects. With that approach in mind, we took actions to rationalize our footprint and infrastructure, and we have identified areas where we can reduce costs without affecting our ability to capitalize on the anticipated long-term growth opportunities. As we look ahead, we currently anticipate PEP will generate an operating loss of $3 million to $5 million in our upcoming second quarter. Now turning to Slide 11 and a review of free cash flow. In the current quarter, we generated $88 million of cash from operating activities. This cash generation was driven by improvements in working capital, primarily inventory. Within the quarter, we decreased inventory by $85 million, with the bulk of the inventory reduction coming from SAO. This reduction is substantial and the result of considerable effort throughout the organization to accelerate targeted inventory reduction programs across our facilities. It's worth noting that we also reduced inventory by $117 million in the fourth quarter of fiscal year 2020. That's a reduction of over $200 million of inventory in the last 2 quarters. We remain in constant communication with our key customers to ensure that we maintain the appropriate inventory and lead times are aligned as demand patterns change. In the first quarter, we spent $33 million on capital expenditures. We remain on track to spend about $120 million in capital expenditures for fiscal year 2021 as planned. As a reminder, within the $120 million planned for fiscal year 2021 is the completion of the multiyear $100 million hot strip mill project to support growing demand for our soft magnetics materials. Tony will speak to the importance of this new hot strip mill will have to further enhance our leading position in the emerging area of electrification. We are also nearing the completion of a large-scale ERP system implementation that is expected to be operational in the second half of this fiscal year. In addition, as I mentioned previously, we completed the divestiture of our Amega West oil and gas business. We are pleased that we could complete this transaction and realized $18 million of proceeds in our current quarter. With those highlights in mind, we generated $63 million of free cash flow in the quarter. From a liquidity perspective, we ended the current quarter with a total liquidity of $613 million, including $219 million of cash and $394 million of available borrowings under our credit facility. The increased liquidity reflects the cash flow generation in the quarter as well as the debt refinancing we completed in the quarter in which we issued $400 million of notes and used the proceeds to repay the $250 million of notes that were due to mature in July of 2021. For reference, the net incremental cost of extinguishing the notes of $8.2 million is included in our reported interest expense for the quarter and is treated as a special item, net of tax, when calculating adjusted EPS. Our focus on liquidity is essential in the near-term as we work our way through the temporary market disruptions brought on by COVID-19 in our end-use markets. Our thoughtful approach to capital allocation over the years as well as the actions we have taken since the onset of the pandemic have been critical and will enable us to exit this latest challenge even stronger than we entered. With that, I will turn the call back over to Tony.

Thanks, Tim. Moving to Slide #13. Our key priorities in the near term continue to be safeguarding our facilities and employees, maintaining liquidity and working closely with our customers. While our near-term focus is centered on the execution of those priorities, we cannot turn a blind eye to our future and the future needs of our customers. During its long history, Carpenter Technology has weathered many downturns, both cyclical and macroeconomic driven, and each time emerged on the other side a stronger company. Despite these unprecedented times, we believe we have that opportunity again. Today, we remain focused on innovation and creating unique solutions that address evolving industry trends and customer material requirements. To that end, during the first quarter, we launched our Carpenter Electrification brand. Electrification is an exciting trend that is changing the way we live in and move around our world. Part of this movement involves electric motors and generators, which are replacing combustion engines in vehicles. This is where Carpenter Electrification plays a significant role. We foresee a rapid increase in the use of electric motor and generator systems in a wide variety of mobility applications. The electric motor is now a well-established technology for passenger cars. Electric vehicles have been rapidly gaining popularity over the last 5 years and are now a reliable alternative to internal combustion engines. This trend is beginning to take hold in other markets as well. New commercial aircraft are already using more onboard electricity to power their systems than ever before. We have seen an increase in hybrid and electric aircraft designs and prototypes over the last few years. In addition, we see similar trends in the defense industry and other markets that rely on mobility and miniaturization, such as drones, autonomous robots and consumer electronics applications. In cars, aircraft and other mobility applications, size and weight are always issues that must be considered for overall performance. Vehicle designers are increasingly turning to more powerful and efficient motors that must also be small and light. Improved system designs and new technologies will deliver the performance improvements needed for future applications. New designs are using advanced state-of-the-art materials to achieve optimal performance. Our high induction, high permeability and low loss soft magnetic alloys are delivering performance benefits, miniaturization and product development flexibility. As product manufacturers push the boundaries of performance for electrification, they need stronger technology partners. Applications and testing support are increasingly important as companies work to optimize their product designs. They also need a reliable and streamlined supply chain and partners that can scale with them from prototype to production. With our high-performance soft magnetic alloy portfolio, technical expertise and advanced production capabilities, Carpenter Electrification is uniquely positioned to help electronics, motor and vehicle OEMs bring new electrification solutions to the world. With the technology and market demand as a backdrop, we remain excited about the completion of the hot strip mill installation on our Reading campus. This project, once completed later this fiscal year, will provide us with significant capabilities and critical capacity to service this growing opportunity. Now let's turn to the next slide and my closing comments. Our first quarter performance was as anticipated, given volume and cost headwinds related to COVID-19 as well as our focus on driving and preserving liquidity in the near term. Looking ahead, we expect market conditions will remain largely challenging, but do anticipate some recovery in the second half of fiscal year 2021. We have chosen not to simply sit back and wait for market conditions to improve, rather we continue to actively manage our organization and align our cost structure and business activities with evolving end-use market conditions. We've taken significant actions since the start of pandemic to reduce costs and generate cash flow. These actions include accelerating working capital improvement via the Carpenter Operating Model; executing on targeted portfolio actions, including idling and divesting underperforming businesses as well as reducing cost through position eliminations, temporary furlough and hiring freezes among many other actions. With the bulk of our growth investments largely completed, we are also able to significantly reduce capital expenditures beginning in fiscal year 2021. These actions have been critical to maintain our healthy balance sheet and provide ample liquidity to weather the near-term challenges created by the pandemic. Despite the challenges related to COVID-19, today, we remain an established supply chain partner and often one of only a few providers of specialty solutions that enable mission-critical performance. We are a leader in our industry today and are committed to remaining a leader for decades to come. In the face of these unprecedented times, we reaffirm that we expect to generate positive free cash flow and positive adjusted EBITDA in fiscal year 2021. We have taken and will continue to take the necessary steps to position Carpenter Technology to be an even stronger company on the other side of this pandemic. Thank you for your interest, and I'll turn it back to the operator to field your questions.

[Operator Instructions] And the first question will come from Gautam Khanna with Cowen.

I wanted to just maybe ask you to expand the comments about kind of the various levels of channel inventory. We have some customers with a years' worth and some that are restocking. Is there any broad trends you can characterize? Maybe if you could talk about engine-oriented applications versus fasteners versus other airframe? Or if there's anything you can expand upon?

Yes. Gautam, this is Tony. Yes, there's really no more additional color there. That cuts across all of our customers. So I wouldn't classify it as the engine customers are the ones that have greater inventory or not. We see variations across whether it's engines, fasteners, structural, our distribution business in Aerospace. So really no difference there, Gautam.

Okay. And you guys have talked about how in the second half of the fiscal year, so the March quarter, you'll start to see demand recover. What grounds that view? I'm just curious, like do you have order visibility? Do you have -- what gives you that conviction?

Well, we are very close to our customers, spend a lot of time, obviously, with our customers. So we have a good line of sight on what we think is going to happen in the second half. And in fact, we just reaffirmed that internally going through it customer by customer, market by market. So I don't think you're going to see a 50% increase in the second half, Gautam, I don't think anybody's saying that. But I do think that you'll see an uptick in the third and the fourth quarter. Keeping in mind that first and second quarter have been obviously extremely low. So yes, we're fairly confident that we'll see an uptick in the second half.

And I'm sorry to keep belaboring the point. But just to be clear on magnitude, right now, obviously, we're in a destocked period. So it looks like sales levels are below underlying consumption by the end customers, what it should be, anyway. Is the right way to think about where the Aerospace, ex surcharge, sales will shake out once we get through destocking as 30% or 40% below what you guys did in fiscal '19? So we get back to some level, obviously, below where we were because production rates are down. I'm just curious, like in terms of gauging the magnitude of the potential recovery, is that where we should think things level out, kind of 60%, 70% of where they were pre-COVID because the production rates are down by that level? Or is there some sort of offset to that, whether it be share or otherwise? Or downside to that because of...

Really, really -- yes, Gautam tough question, obviously, and it's the question that most people are asking. If you just take a look at this quarter on a year-over-year basis, Aerospace is down 45% to 50%. So when does that come back? Is it 2 quarters? Is it 3, 4 quarters? I can tell you this that might help you, if you take a look at what we think the second half of the year is going to be, you're probably in that 10% to 15% -- or you're in that teen, you're -- that type of recovery that I think you'll see. And I think it's going to be a gradual improvement from then on.

Got it. Like 10% to 15% above where we are now, thereabouts?

Yes. I think that's reasonable. I think that's reasonable, yes.

Okay. And just last one for me. Any changes -- as you talked about coming to better -- more mutually beneficial kind of agreements with customers over the mid and long term, just I'm curious what types of things is Carpenter advocating for? Is it kind of minimum quantity guarantees? Is it better pricing? Is it -- what are the types of things that you guys are advocating for to kind of -- what would you consider better terms?

Yes. It's a good question. We have great relationships with our customers. And it really hasn't been where Carpenter Technology is reaching out to them indicating this is what we're requiring. In many cases, they're giving us ideas as well. They understand that the market is going to come back. There's no one we're talking to that said, "Well, aerospace is never going to come back." So everyone understands that the market is going to come back. Everyone still believes in the macro trend. And they know that Carpenter Technology is only one of a couple of companies that can supply the materials they need. So it is a very -- it's a mutual respect type of relationship. And what we're looking for and what they're, in many cases, very happy to do is let's extend that contract for a period of time or let's increase the share that we have on that contract. So it's those types of items that we're looking for, Gautam, and quite frankly, don't get a lot of pushback in that area.

The next question will come from Josh Sullivan with The Benchmark Company.

I just -- on the refusal of service that you mentioned at the aerospace customers for Q3, just in the prepared remarks there, what is the tempo of those here in early Q4? Is it the same pace as Q3? Or are those incidences either decelerated or accelerated here?

Well, I made that comment, that's across -- we're saying that across all of the supply chain. It's not just Carpenter Technology. I mean you can -- I'm sure you've heard it many times, when you have this type of drastic slowdown, everyone's trying to conserve cash and many people are trying not to take shipments. So that's happening across the entire supply chain, across every level. That's pretty well known. From our standpoint, it's much like the answer I just gave Gautam is we work very closely with our customers trying to get to a win-win. And then specifically for us, we've seen that type of activity slow down quite a bit and believe the majority of that is behind us right now.

Got it. Got it. And then just on the medical exposure, how do you think that the restocking takes place? Is it going to be a snapback as those elective surgeries come back if we might see COVID research here? Just what are you thinking about the restocking on the medical side and the timing of it?

I think that -- Josh, that's a really good question. In my remarks, I talked about how we saw an increase in surgery, in procedures, but not necessarily a one-for-one as far as our supply to them, which tells you that those medical device companies and others in the supply chain are decreasing their inventories. Everybody is looking to conserve cash. What we're getting prepared for is that I think you could see a steeper recovery than in the second half as opposed to what you would normally see because I just don't think there's a one-for-one right now. I think people are still trying to protect their inventory, especially as we get to most -- everyone else that the calendar year is the end of their fiscal year, and they're being extra cautious on it. So a long way of answering your question is to say, yes, I think that the spike that you've seen in shipments or demand, let's say, for Medical could be a little steeper than maybe other markets.

Got it. And then just on the inventory drawdown, between the components and where raw materials finish, where are you focused right now? And maybe how should we see that progress since -- just as that second half, 10%, 15% kind of looks like? If you can just walk us through some of the components there and some of the changing dynamics?

Well, the 3 big components of raw materials work in process and finished goods. We look at all of those. And I think it's important to note that this inventory drawdown that we're having is not an approach, let's say, take inventory out at all cost. It's a very disciplined approach based on our lean manufacturing philosophy. And that is, as you well know, just 6 months ago, we were running at 100% and trying to make as much as possible. So in many cases, yes, we have produced inventory for future dates knowing that I was never going to shut down the front end of my process that had 50-week lead times. So our inventory got a little higher than what we would have liked through -- from -- when you're looking at it from lean manufacturing point of view. So this has given us an opportunity to continue to work on our productivity and balance our plant and take out that inventory to become more balanced. Inventory, in many cases, is a detractor to productivity because it keeps you from working on the right thing. So this has been a very surgical, if you will, inventory reduction. I think there's still more that we can do. But obviously, we're not going to take out these global inventories for the next 4, 5, 6 quarters. There will be a time where they were balanced. I think the important thing is, Josh, is when we see demand come back, we're not going to put ourselves in a position where you'll have to see a significant inventory build to support that. We're going to get down to these levels. We're locking in our productivity, and we'll be able to maintain these types of relative levels even when we see the demand pick up over the next several quarters.

Got it. No, that's very helpful. And then just one last one. You talked about your push into the electric world. Can you talk a little bit about your special alloys there? How do those compare to the current market offering? And is there any way to quantify some of the special attributes, weight, power or some metric why you think Carpenter is going to be successful in those markets?

Yes. I appreciate you asking that question because we think this is really important for us. We have our core business that is going to grow over the next several decades just because of the macro trends. But what we're trying to do is look at other areas of growth in areas that we're already participating in, but we can take it to the next level. And if I could take a step back, in this, what we call, soft magnetics, running an electric motor, the real the real key there is that you're -- the material that you're using, that soft magnetic material, is magnetizing and demagnetizing on and off. And that's what creates the rotation in the motor, and that's what creates the ultimate power. The material that you use is really important because that material will dictate the magnetic response or, what I said in my prepared comments, the induction. So the higher the induction materials, that leads to a better performing motor, that leads to a motor with higher power, higher torque, higher speed. All at the same time, making that motor smaller and lighter, which is really important for electric vehicles. Our proprietary product hyperscope does all those, and it is rated as the best in the industry right now. So that's why we have a lot of interest for that product. Now remember, Josh, even before the pandemic, Carpenter Technology was the leader in this area when it came to auxiliary power units in aerospace. We're just taking it to the next level. As the market continues to grow with the electrification of the world, we're moving closer to the customer by not just making the material but moving into stack production, and quite frankly, being pulled by our customers to get even more involved. And now, as Tim mentioned in his remarks, finishing up the almost $100 million project in our Reading campus to put in a hot strip mill, which will increase the capacity, but more importantly, the capabilities to produce that product at a lower cost than we do now and hopefully even attract more and more business that way. It's a big market today, and it's a market that could be 3 to 4x bigger over the next 5 to 10 years. So I really appreciate the question that allow us to talk about something that can really be an earnings accelerator for Carpenter Technology over the next year.

[Operator Instructions] The next question will come from Phil Gibbs with KeyBanc Capital Markets.

Tony, can you give us some color on your backlog, either to change sequentially or year-over-year?

Backlog was down about 18% sequentially. That's across all of Carpenter, that's total. Aerospace backlog was down 16% sequentially. On a year-over-year basis, backlog was down about 40% on. Aerospace backlog was down a couple of percentage points higher than that.

That's helpful. And then on aerospace engines, specifically, what was the either year-over-year or sequential decline in engine revenues?

If you look at engine, you remember last quarter, sequentially, it was down 30%. Now we get to this quarter, it's down another almost 40% year-over-year. For this quarter, aero engine is down about 50%. Now remember to back -- you're comparing to periods a year ago that were at the high point. Over the last 5 to 10 years, you were at the high point. So we're coming off the tops, but year-over-year, 50% down.

So you're saying year-over-year down 50%?

Yes. On aero engine.

Okay. And then I just wanted to be clear on the net working capital side. So this coming quarter, this December quarter, it sounds like it's going to be another strong quarter of taking down your inventories. Is that -- I got that. Just a simple question on that, and then I'll ask a Part B. Is that right?

That's correct. Maybe not at the same levels, but we do still see opportunity where we'll be taking inventory out.

So any way to handicap the impacts to the P&L just from the lost absorption in this past quarter? I mean I think you had an EBIT loss in SAO of north of $15 million. If you weren't taking out inventory, just trying to gauge what that intrinsic profit would have been, would it have been closer to breakeven if you hadn't been taking out inventory and losing absorption?

Yes. I'll let Tim take that one on him being involved.

Yes. Phil, I mean, I think that's a fair way of looking at it. It certainly would have been closer to breakeven or positive. I mean it really is an absorption impact, as you said. I mean you've got fixed costs that don't go into inventory. Then you've also got the variable costs when you're running at lower levels, have a larger impact on your P&L as you're bringing the inventory down. So I think that's a fair estimate directionally of what it would look like this quarter.

Okay. So you had about a plus or minus $20 million hit from under absorption. And then you're also saying you had about a $3.5 million hit from COVID costs.

The COVID costs we said were about $7.3 million, we said. And included in that $7.3 million is a $3 million bankruptcy impact. So the right cost is about $4 million. So just to clarify on that.

So what -- so was that bankruptcy hit in your numbers, you didn't strip it out?

We added it back for adjusted EPS, but it's in the segment numbers that we reported.

Okay. And then on these COVID costs, what -- can you just explain what these actually are? You may have done that, I apologize if you did.

Yes. I mean, sure, we tried to give some high level. It's basically the cost of keeping the facilities going that we wouldn't have had it not been for COVID. It's things like the extra cleaning protocols that we've initiated, rentals of equipment and extra PPE for the people in the facilities. There's some aspect of, as people suspect they have been exposed to COVID-19, we're paying them to stay home. And then just kind of other operating supplies for just general protection in the current environment.

And the next question will come from Chris Olin with Tier4 Research.

I apologize, I got disconnected there for a second. So hopefully, I'm not repeating anything. If I do, let's just chalk it up to 2020. But I wanted to just follow up. I heard the tail end of the magnetic Q&A session, and I just want to make sure I understood how the -- I should think about the time line. I guess, maybe you've given numbers I've just forgotten, but how do I think about the -- you were saying demand could be 5 to 10x greater, and you mentioned earlier the end markets that you're looking at. When do we start thinking about those, call them, green bananas turning into real volume or the inflection starts? I guess I'm asking because if I was wondering if there was any big element in terms of the CapEx and the time line for the hot strip mill.

Yes. And just to be clear on that, I said the current available market to us could be 3 to 4x higher over the next 5 to 10 years. So not 5 to 10x higher, 3 to 4x higher over the next 5 to 10 years.

Okay. I apologize.

Yes. So that's still a big number. And I think if you followed us for a long time, you're aware that we've been in this market for quite some time on the APU side with aerospace, and this is just a way for us to fairly broaden that. As you know, I mean we're moving more and more towards the electrification. So this just takes proprietary products and now process and increased equipment into other markets like transportation, defense and so -- and consumer electronics. So this -- we're getting earnings and revenue for this right now. And I think over the next several quarters, you'll see that continue to increase. I can't give you a specific time on when that might get to that triple, but I do think it's over the next 5 years.

Okay. So we're not waiting for anything like the new Tesla plant in Texas or anything like that? It's just a gradual outlook of growth?

I think it's a gradual outlook. But you read all of the stories, I mean more and more companies are moving to this direction. I mean you saw the announcement from General Motors and what they're going to do, that's significant. Across aerospace, how you could potentially see electric commercial flights, certainly at a very small scale. They're doing the testing that now. This is going to touch a lot of areas, drones and robotics. And I think we're really at the right point in time here to capitalize on it. And I think the most important point to make really is not only do we have the expertise, we have a proprietary product. And we now -- within the next 3, 6 months, we'll have our new mill up and running, which is quite an accomplishment. We're getting significant pull from our customers that want us to not only supply that proprietary product, but want us to move further or closer to them in the supply chain, whether that be in the building of stack, what we may or may not do going forward in terms of motors. So it's a really exciting opportunity for us. That is near term, and we'll hit the bottom line in the near term. It's not a decade away.

Okay. That makes sense. One of the issues I used to follow pretty closely with the whole product approval process at Athens. And I guess I was wondering if anything has changed since the COVID outbreak and kind of everybody got distracted by other issues. Like has it slowed down? Are you doing less work there where now maybe it pushes out some of the longer term opportunities?

I wouldn't say that -- I think the best word is that it's different now. The qualification process for a long, long time is a very face-to-face type of process. The customer visits your plant, you visit the customer. Obviously, with the travel restrictions, that has been limited. But we deal with a very sophisticated customer group. So we've found other ways to continue to push this process along. I mean I wouldn't say that we're at the exact speed that we were at prior to the pandemic, but it has not slowed much, again, because of the sophisticated customer base. They know that this market is coming back, and they know prior to the pandemic, this is a sold-out market that could not meet their demand. In other words, they couldn't build enough engines prior to the pandemic. So they know how important that fiscal is and we'll continue to push forward, albeit in a different manner than we did before.

Is there still low-hanging fruits in terms of like some big products out there, big volume products that could move the needle?

Yes. There's still a couple of big ones out there for us to get qualified for sure.

Okay. And then just the last question. I thought Tim said distribution orders or demand picked up. I was wondering if that was just transportation related. Or did that tie into -- I thought you said there were some areas of aerospace that were getting better. Just curious what drove that.

Yes. Just to be clear, when I said distribution, I was talking in the PEP business unit, in our PEP segment. We've got a distribution business within our PEP segment. And I think, Chris, that you're right at the comment, distribution is tied pretty significantly to transportation. So like the automakers returned to work, they saw a spike in demand.

Ladies and gentlemen, this concludes our question-and-answer session. I would like to turn the conference back over to Brad Edwards for any closing remarks.

Thanks, Chad, and thanks, everyone, for joining us today on our first quarter fiscal '21 conference call. We look forward to speaking with all of you on our second quarter call. Thanks again, and have a great day.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.