UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
(Mark One)
ý | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the fiscal year ended June 30, 2016
OR
o | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the transition period from to
Commission File Number 1-5828
CARPENTER TECHNOLOGY CORPORATION
(Exact name of registrant as specified in its charter)
Delaware | 23-0458500 | |
(State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification No.) | |
P.O. Box 14662 Reading, Pennsylvania | 19610 | |
(Address of principal executive offices) | (Zip Code) | |
610-208-2000 |
(Registrant’s telephone number, including area code) |
Securities registered pursuant to Section 12(b) of the Act:
Common Stock, $5 Par Value | New York Stock Exchange | |
Title of each class | Name of each exchange on which registered | |
Securities registered pursuant to 12(g) of the Act: None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
Yes ý No o
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
Yes o No ý
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to the filing requirements for at least the past 90 days.
Yes ý No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files)
Yes ý No o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer x | Accelerated filer o | Non-accelerated filer o | Smaller reporting company o | |||
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes o No ý
The aggregate market value of the registrants’ voting common stock held by non-affiliates at December 31, 2015 was $1,415,149,138, based on the closing price per share of the registrant’s common stock on that date of $30.27 as reported on the New York Stock Exchange.
As of August 12, 2016, 46,612,582 shares of the registrant’s common stock were outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Selected portions of the Company’s fiscal year 2016 definitive Proxy Statement are incorporated by reference into Part III of this Report.
TABLE OF CONTENTS
Page Number | |||
PART I
Item 1. Business
(a) General Development of Business:
Carpenter Technology Corporation, incorporated in 1904, is engaged in the manufacturing, fabrication and distribution of specialty metals. As used throughout this report, unless the context requires otherwise, the terms “Carpenter”, “Company”, “Registrant”, “Issuer”, “we” and “our” refer to Carpenter Technology Corporation.
(b) Financial Information About Segments:
We are organized in two reportable business segments: Specialty Alloys Operations (“SAO”) and Performance Engineered Products (“PEP”). See Note 18 to our consolidated financial statements included in Item 8. “Financial Statements and Supplementary Data” for additional segment reporting information.
(c) Narrative Description of Business:
(1) General:
We develop, manufacture and distribute cast/wrought and powder metal stainless steels and special alloys including high temperature (iron-nickel-cobalt base), stainless, superior corrosion resistant, controlled expansion alloys, ultra-high strength and implantable alloys, tool and die steels and other specialty metals, as well as cast/wrought titanium alloys. We also manufacture and rent down-hole drilling tools and components used in the oil and gas industry.
We provide material solutions to the changing needs of the aerospace and defense, energy, transportation, medical and industrial and consumer industries. We have continued to increase our global manufacturing capacity as well as expand our operations to provide customers with solutions to today’s changing materials challenges.
Reportable Segments
The SAO segment is comprised of the Company’s major premium alloy and stainless steel manufacturing operations. This includes operations performed at mills primarily in Reading and Latrobe and surrounding areas in Pennsylvania, South Carolina and Alabama. The combined assets of the SAO operations are being managed in an integrated manner to optimize efficiency and profitability across the total system.
The PEP segment is comprised of the Company’s differentiated operations. This segment includes the Dynamet titanium business, the Carpenter Powder Products business, the Amega West business, the Specialty Steel Supply business and the Latrobe and Mexico distribution businesses. The businesses in the PEP segment are managed with an entrepreneurial structure to promote speed and flexibility, and drive overall revenue and profit growth.
(2) Raw Materials:
Our business depends on continued delivery of critical raw materials for our day-to-day operations. These raw materials include nickel, cobalt, chromium, manganese, molybdenum, titanium, iron and scrap containing iron and nickel. Some of the sources of these raw materials, many of which are international, could be subject to potential interruptions of supply as a result of political events, labor unrest or other reasons. These potential interruptions could cause material shortages and affect availability and price. We have arrangements with certain vendors to provide consigned materials at our manufacturing facilities available for our consumption as necessary.
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We have long-term relationships with major suppliers who provide availability of material at competitive prices. Purchase prices of certain raw materials have historically been volatile. We use pricing surcharges, indexing mechanisms, base price adjustments and raw material forward contracts to reduce the impact of increased costs for the most significant of these materials. There can be delays between the time of the increase in the price of raw materials and the realization of the benefits of such mechanisms or actions that could have a short-term impact on our results and could affect the comparability of our results from period to period.
(3) Patents and Licenses:
We own a number of United States and international patents and have granted licenses under some of them. In addition, certain products that we produce are covered by patents held or owned by other companies from whom licenses have been obtained. The duration of a patent issued in the United States is between 14 and 20 years from the date of filing a patent application or issuance of the patents. The duration of patents issued outside of the United States vary from country to country. Generally, patent licenses are structured to match the duration of the underlying patent. Although these patents and licenses are believed to be of value, we do not consider our business to be materially dependent upon any single such item or related group of such items.
(4) Seasonality of Business:
Our sales are normally influenced by seasonal factors. Historically, our sales in the first two fiscal quarters (the respective three months ending September 30 and December 31) are typically the lowest — principally because of annual plant vacation and maintenance shutdowns by us, as well as by many of our customers. However, the timing of major changes in the general economy or the markets for certain products can alter this historical pattern.
The chart below summarizes the percent of net sales by quarter for the past three fiscal years:
Quarter Ended | 2016 | 2015 | 2014 | ||||||
September 30, | 25 | % | 25 | % | 23 | % | |||
December 31, | 25 | 24 | 23 | ||||||
March 31, | 25 | 26 | 26 | ||||||
June 30, | 25 | 25 | 28 | ||||||
100 | % | 100 | % | 100 | % | ||||
(5) Customers:
On a consolidated basis, we are not dependent upon a single customer, or a very few customers, such that the loss of any one or more particular customers would have a materially adverse effect on our consolidated statement of income. One customer, Alcoa Inc., accounted for approximately 13 percent of net sales for the year ended June 30, 2016. No single customer accounted for 10 percent or more of net sales during fiscal years 2015 and 2014. Approximately 22 percent of the accounts receivable outstanding at June 30, 2016 is due from two customers, Alcoa Inc. and Precision Castparts Corporation. Approximately 17 percent of the accounts receivable outstanding at June 30, 2015 is due from one customer, Alcoa Inc. See Note 18 to our consolidated financial statements included in Item 8. “Financial Statements and Supplementary Data” for additional information.
(6) Backlog:
As of June 30, 2016, we had a sales backlog of orders excluding surcharge, believed to be firm, of approximately $306 million, substantially all of which is expected to be shipped within fiscal year 2017. Our backlog of orders excluding surcharge as of June 30, 2015 was approximately $435 million.
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(7) Competition:
Our business is highly competitive. We supply materials to a wide variety of end-use market sectors and compete with various companies depending on end-use market, product or geography. We are leaders in specialty materials for critical applications with over 125 years of metallurgical and manufacturing expertise. A significant portion of the products we produce are highly engineered materials for demanding applications. There are less than ten companies producing one or more similar products that we consider our major competitors for our high value products used in demanding applications, particularly in our Aerospace and Defense and Energy end-use markets. These products are generally required to meet complex customer product specifications and often require the materials to be qualified prior to supplying the customer orders. Our experience, technical capabilities, product offerings and research and development efforts that we have in our niche markets represent barriers to existing and potential competitors.
For other products, there are several dozen smaller producing companies and converting companies that are also competitors, as well as several hundred independent distributors of products similar to those distributed by us. Additionally, numerous foreign companies produce various specialty metal products similar to those produced by us. Furthermore, a number of different products may, in certain instances, be substituted for our finished products.
(8) Research, Product and Process Development:
Our expenditures for company-sponsored research and development were $16.3 million, $18.7 million and $18.5 million in fiscal years 2016, 2015 and 2014, respectively. We believe that our ability to be an innovator in special material development and manufacturing processes has been and will continue to be an important factor in the success of the Company. Our worldwide staff of expert metallurgists, research and development scientists, engineers and service professionals work closely with our customers to identify and provide innovative solutions to specific product requirements.
(9) Environmental Regulations:
We are subject to various stringent 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. Management evaluates the liability for future environmental remediation costs on a quarterly basis. We accrue amounts for environmental remediation costs representing management’s best estimate of the probable and reasonably estimable costs relating to environmental remediation. For further information on environmental remediation, see the Contingencies section included in Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the notes to our consolidated financial statements included in Item 8. “Financial Statements and Supplementary Data”.
Our costs of maintaining and operating environmental control equipment were $13.5 million, $14.8 million and $13.3 million for fiscal years 2016, 2015 and 2014, respectively. The capital expenditures for environmental control equipment were $0.7 million, $0.5 million and $2.2 million for fiscal years 2016, 2015 and 2014, respectively. We anticipate spending approximately $3 million on major domestic environmental capital projects over the next five fiscal years. This includes approximately $1 million in fiscal year 2017. Due to the possibility of future regulatory developments, the amount of future capital expenditures may vary from these estimates.
(10) Employees:
As of June 30, 2016, our total workforce consisted of approximately 4,500 employees, which included approximately 125 production employees in Washington, Pennsylvania who are covered under a collective bargaining agreement which expires on August 31, 2016, and approximately 440 employees in Latrobe, Pennsylvania who are covered under a collective bargaining agreement which expires August 1, 2017.
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(d) Financial information about foreign and domestic operations and export sales:
Sales outside of the United States, including export sales, were $569.9 million, $646.8 million and $635.1 million in fiscal years 2016, 2015 and 2014, respectively. Long-lived assets held outside of the United States were $28.0 million, $30.0 million and $27.5 million as of June 30, 2016, 2015 and 2014, respectively. For further information on domestic and international sales, see Note 18 to our consolidated financial statements included in Item 8. “Financial Statements and Supplementary Data”.
(e) Available Information:
Our Board of Directors has adopted a Code of Ethics for the Chief Executive Officer and Senior Financial Officers of Carpenter Technology Corporation, which is also applicable to our other executive officers. There were no waivers of the Code of Ethics in fiscal year 2016. The Code of Ethics and any information regarding any waivers of the Code of Ethics are disclosed on Carpenter’s website at www.cartech.com. Our annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 are available free of charge through our website as soon as reasonably practicable after we electronically file such material with, or furnish such material to, the Securities and Exchange Commission (“SEC”). Our website and the content contained therein or connected thereto are not intended to be incorporated into this Annual Report on Form 10-K.
The public may read and copy any materials the Company files with the SEC at the SEC’s Public Reference Room at 100 F Street, N.E., Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC also maintains an Internet site that contains reports, proxy and other information regarding issuers that file electronically. Such information can be accessed through the Internet at www.sec.gov.
Item 1A. Risk Factors
There are inherent risks and uncertainties associated with all businesses that could adversely affect operating performances or financial conditions. The following discussion outlines the risks and uncertainties that management believes are the most material to our business. However, these are not the only risks or uncertainties that could affect our business. Certain risks are associated specifically with our business, industry or customer base, while others have a broader effect.
The demand for certain products we produce may be cyclical.
Demand in our end-use markets, including companies in the aerospace and defense, energy, transportation, medical and industrial and consumer markets, can be cyclical in nature and sensitive to general economic conditions, competitive influences and fluctuations in inventory levels throughout the supply chain. As such, our results of operations, financial condition, cash flows and availability of credit could fluctuate significantly from period to period.
A significant portion of our sales represents products sold to customers in the commercial aerospace and defense and energy markets. The cyclicality of those markets can adversely affect our current business and our expansion objectives.
The commercial aerospace and defense market is historically cyclical due to both external and internal market factors. These factors include general economic conditions, airline profitability, consumer demand for air travel, varying fuel and labor costs, price competition and international and domestic political conditions such as military conflict and the threat of terrorism. The length and degree of cyclical fluctuation can be influenced by any one or combination of these factors and therefore are difficult to predict with certainty. A downturn in the commercial aerospace and defense industry would adversely affect the demand for our products and/or the prices at which we are able to sell our products; our results of operations and financial condition could be materially adversely affected.
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The energy market has also been historically cyclical, principally as a result of volatile oil prices. Due to the prolonged weakness in oil and gas drilling and exploration activity oil prices have been depressed. The decline in oil prices has negatively impacted the demand for our products used in our Energy and Industrial and Consumer end-use markets. Our future success requires us to, among other things, expand in key international energy markets by successfully adding to our customer base, distribution channels and product portfolio. The outlook for oil prices remains uncertain. The duration of the current low price environment or further deterioration in prices could further adversely affect the demand for products, which could impact our results of operations and financial condition.
Any significant delay or inability to successfully expand our operations in a timely and cost effective manner could materially adversely affect our business, financial condition and results of operations.
Over the last few years, we have undertaken capital projects associated with expanding our production capacity and capability, including our state-of-the-art manufacturing facility in Athens, Alabama and our adjacent superalloy powder facility. These projects place a significant demand on management and operational resources. Our success in expanding our operations in a cost effective manner depends upon numerous factors including the ability of management to ensure the necessary resources are in place to properly execute these projects, our ability to obtain the necessary internal and customer qualifications to produce material from the facility and our ability to operate the facility to maximize the potential opportunities with minimal impacts to our existing operations. If we are not able to achieve the anticipated results from our capital expansion projects, or if we incur unanticipated excess costs, our results of operations and financial position may be materially adversely affected.
Periods of reduced demand and excess supply as well as the availability of substitute lower cost materials can adversely affect our ability to price and sell our products at the profitability levels we require to be successful.
Additional worldwide capacity and reduced demand for our products could significantly impact future worldwide pricing which would adversely impact our results of operations and financial condition. In addition, continued availability of lower cost, substitute materials may also cause significant fluctuations in future results as our customers opt for a lower cost alternative.
We change prices on our products as we deem necessary. In addition to the above general competitive impact, other market conditions and various economic factors beyond our control can adversely affect the timing of our pricing actions. The effects of any pricing actions may be delayed due to long manufacturing lead times or the terms of existing contracts. There is no guarantee that the pricing actions we implement will be effective in maintaining the Company’s profit margin levels.
We rely on third parties to supply certain raw materials that are critical to the manufacture of our products and we may not be able to access alternative sources of these raw materials if the suppliers are unwilling or unable to meet our demand.
Costs of certain critical raw materials, such as nickel, cobalt, chromium, manganese, molybdenum, titanium, iron and scrap containing iron and nickel have been volatile due to factors beyond our control. We are able to mitigate most of the adverse impact of rising raw material costs through raw material surcharges, indices to customers and raw material forward contracts, but changes in business conditions could adversely affect our ability to recover rapid increases in raw material costs and may adversely affect our results of operations.
In addition, the availability of these critical raw materials is subject to factors that are not in our control. In some cases, these critical raw materials are purchased from suppliers operating in countries that may be subject to unstable political and economic conditions. At any given time, we may be unable to obtain an adequate supply of these critical raw materials on a timely basis, at prices and other terms acceptable to us, or at all.
If suppliers increase the price of critical raw materials or are unwilling or unable to meet our demand, we may not have alternative sources of supply. In addition, to the extent that we have quoted prices to customers and accepted customer orders for products prior to purchasing necessary raw materials, or have existing contracts, we may be unable to raise the price of products to cover all or part of the increased cost of the raw materials to our customers.
The manufacture of some of our products is a complex process and requires long lead times. As a result, we may experience delays or shortages in the supply of raw materials. If unable to obtain adequate and timely deliveries of required raw materials, we may be unable to timely manufacture sufficient quantities of products. This could cause us to lose sales, incur additional costs, delay new product introductions or suffer harm to our reputation.
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Regulations related to conflict minerals could adversely impact our business.
The SEC has promulgated final rules mandated by the Dodd-Frank Act regarding disclosure of the use of tin, tantalum, tungsten and gold, known as conflict minerals, in products manufactured by public companies. These rules require due diligence to determine whether such minerals originated from the Democratic Republic of Congo (the “DRC”) or an adjoining country and whether such minerals helped finance the armed conflict in the DRC. The Company timely filed its annual conflict minerals report required by the rules on June 1, 2016. There will be costs associated with complying with these disclosure requirements going forward, including costs to determine the origin of conflict minerals used in our products. In addition, the implementation of these rules could adversely affect the sourcing, supply and pricing of materials used in our products. Also, we may face disqualification as a supplier for customers and reputational challenges if the due diligence procedures we continue to implement do not enable us to verify the origins for all conflict minerals or to determine that such minerals are DRC conflict-free.
We provide benefits to active and retired employees throughout most of our Company, most of which are not covered by insurance; and thus, our financial condition can be adversely affected if our investment returns are insufficient to meet these obligations.
We have obligations to provide substantial benefits to active and retired employees, and most of the associated costs are paid by the Company and are not covered by insurance. In addition, certain employees are covered by defined benefit pension plans, with the majority of our plans covering employees in the United States. Many domestic and international competitors do not provide defined benefit plans and/or retiree health care plans, and other international competitors operate in jurisdictions with government sponsored health care plans that may offer them a cost advantage. A decline in the value of plan investments in the future, an increase in costs or liabilities or unfavorable changes in laws or regulations that govern pension plan funding could materially change the timing and amount of required pension funding. A requirement to accelerate or increase pension contributions in the future could have a material adverse effect on our results of operations and financial condition.
The extensive environmental, health and safety regulatory regimes applicable to our manufacturing operations create potential exposure to significant liabilities.
The nature of our manufacturing business subjects our operations to numerous and varied federal, state, local and international laws and regulations relating to pollution, protection of public health and the environment, natural resource damages and occupational safety and health. We have used, and currently use and manufacture, substantial quantities of substances that are considered hazardous, extremely hazardous or toxic under worker safety and health laws and regulations. Although we implement controls and procedures designed to reduce continuing risk of adverse impacts and health and safety issues, we could incur substantial cleanup costs, fines and civil or criminal sanctions, third party property damage or personal injury claims as a result of violations, non-compliance or liabilities under these regulatory regimes required at our facilities.
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 or similar 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. From time to time, we are a party to lawsuits and other proceedings involving alleged violations of, or liabilities arising from, environmental laws.
When our liability is probable and we can reasonably estimate our costs, we record environmental liabilities in our financial statements. However, in many cases, we are not able to determine whether we are liable, or if liability is probable, in order to reasonably estimate the loss or range of loss which could result from such environmental liabilities. Estimates of our liability remain subject to additional uncertainties, including the nature and extent of site contamination, available remediation alternatives, the extent of corrective actions that may be required, and the number and financial condition of other PRP’s, as well as the extent of their responsibility for the remediation. We adjust our accruals to reflect new information as appropriate. Future adjustments could have a material adverse effect on our results of operations in a given period, but we cannot reliably predict the amounts of such future adjustments. Future developments, administrative actions or liabilities relating to environmental matters could have a material adverse effect on our financial condition, cash flows or results of operations.
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Our manufacturing processes, and the manufacturing processes of many of our suppliers and customers, are energy intensive and generate carbon dioxide and other “Greenhouse Gases”, and pending legislation or regulation of Greenhouse Gases, if enacted or adopted in an onerous form, could have a material adverse impact on our results of operations, financial condition and cash flows.
Political and scientific debates related to the impacts of greenhouse gas emissions on the global climate are prevalent. Regulation or some form of legislation aimed at reducing the greenhouse gas emissions is currently being considered both in the United States and globally. As a specialty alloy manufacturer, we will be affected, both directly and indirectly, if proposed climate change legislation, such as use of a “cap and trade”, is enacted. Such legislation could have a material adverse impact on our results of operations, financial condition and cash flows.
Product liability and product quality claims could adversely affect our operating results.
We produce ultra-high strength, high temperature and corrosion-resistant alloys designed for our customers’ demanding applications particularly in our Aerospace and Defense, Energy and Medical end-use markets. Failure of the materials that are included in our customers’ applications could give rise to substantial product liability claims. There can be no assurance that our insurance coverage will be adequate or continue to be available on terms acceptable to us. We have a complex manufacturing process necessary to meet our customers’ stringent product specifications. We are also required to adhere to various third party quality certifications and perform sufficient internal quality reviews to ensure compliance with established standards. If we fail to meet the customer specifications for their products, we may be subject to product quality costs and claims. These costs are generally not insured. The impacts of product liability and quality claims could have a material adverse impact on the results of our operations, financial condition and cash flows.
Our business subjects us to risks of litigation claims, as a routine matter, and this risk increases the potential for a loss that might not be covered by insurance.
Litigation claims relate to the conduct of our currently and formerly owned businesses, including claims pertaining to product liability, commercial disputes, employment actions, employee benefits, compliance with domestic and federal laws, personal injury, patent infringement and tax issues. Due to the uncertainties of litigation, we can give no assurance that we will prevail on claims made against us in the lawsuits that we currently face or that additional claims will not be made against us in the future. The outcome of litigation cannot be predicted with certainty, and some of these lawsuits, claims or proceedings may be determined adversely to us. The resolution in any reporting period of one or more of these matters could have a material adverse effect on our results of operations for that period. We can give no assurance that any other matters brought in the future will not have a material effect on our results of operations, financial condition and cash flows.
A portion of our workforce is covered by collective bargaining agreements and union attempts to organize our other employees may cause work interruptions or stoppages.
Approximately 125 production employees at our Dynamet business unit located in Washington, PA are covered by a collective bargaining agreement. This agreement expires in August 2016. Approximately 440 production employees at our Latrobe business unit located in Latrobe, Pennsylvania are covered by a collective bargaining agreement. This agreement expires in August 2017. There can be no assurance that we will succeed in concluding collective bargaining agreements with the unions to replace those that expire. From time to time, the employees at our manufacturing facility in Reading, Pennsylvania, participate in election campaigns or union organizing attempts. There is no guarantee that future organization attempts will not result in union representation.
Our manufacturing processes are complex and depend upon critical, high cost equipment for which there may be only limited or no production alternatives.
It is possible that we could experience prolonged periods of reduced production due to unplanned equipment failures, and we could incur significant repair or replacement costs in the event of those failures. It is also possible that operations could be disrupted due to other unforeseen circumstances such as power outages, explosions, fires, floods, accidents and severe weather conditions. We must make regular, substantial capital investments and changes to our manufacturing processes to lower production costs, improve productivity, manufacture new or improved products and remain competitive. We may not be in a position to take advantage of business opportunities or respond to competitive pressures if we fail to update, replace or make additions to our equipment or our manufacturing processes in a timely manner. The cost to repair or replace much of our equipment or facilities would be significant. We cannot be certain that we will have sufficient internally generated cash or acceptable external financing to make necessary capital expenditures in the future.
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A significant portion of our manufacturing and production facilities are located in Reading and Latrobe, Pennsylvania and Athens, Alabama, which increases our exposure to significant disruption to our business as a result of unforeseeable developments in these geographic areas.
It is possible that we could experience prolonged periods of reduced production due to unforeseen catastrophic events occurring in or around our manufacturing facilities in Reading and Latrobe, Pennsylvania and Athens, Alabama. As a result, we may be unable to shift manufacturing capabilities to alternate locations, accept materials from suppliers, meet customer shipment needs or address other severe consequences that may be encountered. Our financial condition, cash flows and results of operations could be materially adversely affected.
We rely on third parties to supply energy consumed at each of our energy-intensive production facilities.
The prices for and availability of electricity, natural gas, oil and other energy resources are subject to volatile market conditions. These market conditions often are affected by political and economic factors beyond our control. Disruptions or lack of availability in the supply of energy resources could temporarily impair the ability to operate our production facilities. Further, increases in energy costs, or changes in costs relative to energy costs paid by competitors, has affected and may continue to adversely affect our profitability. To the extent that these uncertainties cause suppliers and customers to be more cost sensitive, increased energy prices may have an adverse effect on our results of operations, financial condition and cash flows.
We consider acquisitions, joint ventures and other business combination opportunities, as well as possible business unit dispositions, as part of our overall business strategy, that involve uncertainties and potential risks that we cannot predict or anticipate fully.
From time to time, management holds discussions with management of other companies to explore such aforementioned opportunities. As a result, the relative makeup of the businesses comprising our Company is subject to change. Acquisitions, joint ventures and other business combinations involve various inherent risks. Such risks include difficulties in integrating the operations, technologies, products and personnel of the acquired companies, diversion of management’s attention from existing operations, difficulties in entering markets in which we have limited or no direct prior experience, dependence on unfamiliar supply chains, insufficient revenues to offset increased expenses associated with acquisitions, loss of key employees of the acquired companies, inaccurate assessment of undisclosed liabilities, difficulties in realizing projected efficiencies, synergies and cost savings, and increases in our debt or limitation on our ability to access additional capital when needed.
Our business may be impacted by external factors that we may not be able to control.
War, civil conflict, terrorism, natural disasters and public health issues including domestic or international pandemic have caused and could cause damage or disruption to domestic or international commerce by creating economic or political uncertainties. Additionally, the volatility in the financial markets could negatively impact our business. These events could result in a decrease in demand for our products, affect the availability of credit facilities to us, our customers or other members of the supply chain necessary to transact business, make it difficult or impossible to deliver orders to customers or receive materials from suppliers, affect the availability or pricing of energy sources or result in other severe consequences that may or may not be predictable. As a result, our business, financial condition and results of operations could be materially adversely affected.
We believe that international sales, which are associated with various risks, will continue to account for a significant percentage of our future revenues.
Risks associated with international sales include without limitation: political and economic instability, including weak conditions in the world’s economies; difficulty in collecting accounts receivable; unstable or unenforced export controls; changes in legal and regulatory requirements; policy changes affecting the markets for our products; changes in tax laws and tariffs; and exchange rate fluctuations (which may affect sales to international customers and the value of profits earned on international sales when converted into dollars). In addition, we will need to invest in building our capabilities and infrastructure to meet our international growth goals. Any of these factors could materially adversely affect our results for the period in which they occur.
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We value most of our inventory using the LIFO method, which could be repealed resulting in adverse effects on our cash flows and financial condition.
The cost of our inventories is primarily determined using the Last-In, First-Out (“LIFO”) method. 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. Generally in a period of rising prices, LIFO recognizes higher costs of goods sold, which both reduces current income and assigns a lower value to the year-end inventory. Recent proposals have been aimed at repealing the election to use the LIFO method for income tax purposes. According to these proposals, generally taxpayers that currently use the LIFO method would be required to revalue their LIFO inventory to its First-In, First-Out (“FIFO”) value. As of June 30, 2016, if the FIFO method of inventory had been used instead of the LIFO method, our inventories would have been approximately $98 million higher. This increase in inventory would result in a one-time increase in taxable income which may be taken into account over the following several taxable years. The repeal of the LIFO method could result in a substantial tax liability which could adversely impact our cash flows and financial condition.
We depend on the retention of key personnel.
Much of our future success depends on the continued service and availability of skilled personnel, including members of our executive management team, management, metallurgists and production positions. The loss of key personnel could adversely affect our ability to perform until suitable replacements are found.
We could be adversely impacted if our information technology (“IT”) and computer systems do not perform properly or if we fail to protect the integrity of confidential data.
Management relies on IT infrastructure, including hardware, network, software, people and processes, to provide useful information to conduct our business and support assessments and conclusions about operating performance. Our inability to produce relevant and/or reliable measures of operating performance in an efficient, cost-effective and well-controlled fashion may have significant negative impacts on our future operations. In addition, any material failure, interruption of service, or compromised data security could adversely affect our operations. Security breaches in our information technology could result in theft, destruction, loss, misappropriation or release of confidential data or intellectual property which could adversely impact our future results.
We are in the process of implementing a new enterprise resource planning system and problems with the design or implementation of this system could interfere with our business and operations.
We are engaged in a multi-year implementation of a new global enterprise resource planning (ERP) system. Our ERP system is being designed to accurately maintain books and records, record transactions, provide important information to our management and prepare our financial statements. The implementation of the new ERP system has required, and will continue to require, the investment of significant financial and human resources. Any disruptions, delays or deficiencies in the design and implementation of the new ERP system could adversely affect our financial condition and results of operations.
The carrying value of goodwill and other intangible assets may not be recoverable.
Goodwill and other long-lived assets including property, plant and equipment and other intangible assets are recorded at fair value on the date of acquisition. We review these assets at least annually for impairment. Impairment may result from, among other things, deterioration in performance, adverse market conditions, adverse changes in applicable laws or regulations and a variety of other factors. Any future impairment of goodwill or other long-lived assets could have a material adverse effect on our results of operations.
Item 1B. Unresolved Staff Comments
None.
10
Item 2. Properties
The principal locations of our primary domestic integrated mills in our SAO segment are located in Reading and Latrobe, Pennsylvania and Athens, Alabama. In addition, SAO manufactures large diameter hollow bar in Orwigsburg, Pennsylvania and Elyria, Ohio and operates a mini mill manufacturing stainless steel bar and wire in Hartsville, South Carolina. The principal locations for PEP businesses include titanium alloy production facilities located in Washington, Pennsylvania and Clearwater, Florida, powder products manufacturing facilities in Bridgeville, Pennsylvania; Athens Alabama and Woonsocket, Rhode Island and a facility in Houston, Texas for manufacturing of machined components used in the drilling, exploration and production of oil and gas. The PEP segment also includes domestic leased warehouses and service centers located in Houston, Texas; San Antonio, Texas; Midland, Texas; Oklahoma City, Oklahoma; Casper, Wyoming; Lafayette, Louisiana; West Alexander, Pennsylvania; Vienna, Ohio; Chicago, Illinois; Pinehurst, Texas and Mobile, Alabama. The PEP segment includes one owned service center in White House, Tennessee.
The Reading, Hartsville, Washington, Bridgeville, Orwigsburg, Elyria, Woonsocket, Latrobe, Houston and Athens facilities are owned. The Clearwater facility is owned, but the land is leased.
We also own or lease manufacturing facilities, distribution centers, service centers and sales offices in a number of foreign countries, including Sweden, Canada, Singapore, China, Mexico, Taiwan, the United Arab Emirates, the United Kingdom and Belgium.
Our corporate offices, located in Wyomissing, Pennsylvania, are leased. In February 2016, we announced plans to move the corporate offices to Philadelphia, PA. We currently expect to move prior to the end of calendar 2016.
Our plants, customer service centers, and distribution centers were acquired or leased at various times over several years. There is an active maintenance program to ensure a safe operating environment and to keep facilities in good condition. In addition, we have an active capital spending program to replace equipment as needed to keep it technologically competitive on a worldwide basis. We believe our facilities are in good condition and suitable for our business needs.
Item 3. Legal Proceedings
From time to time, we are a party to lawsuits and other proceedings involving alleged violations of, or liabilities arising from, environmental laws. 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 or similar 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. 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.
In addition, from time to time, we are a party to certain routine claims and legal actions and other contingent liabilities incident to the normal course of business which pertain to litigation, product claims, commercial disputes, employment actions, employee benefits, compliance with domestic and foreign laws, personal injury claims, patent infringement and tax issues. Based on information currently available, the ultimate resolution of our known contingencies, individually or in the aggregate and including the matters described in Note 10 to the consolidated financial statements in this Form 10-K, is not expected to have a material adverse effect on our financial position, cash flows or results of operations. 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.
See the “Contingencies” section included in Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operation”, and the “Contingencies and Commitments” section included in Note 10 to our consolidated financial statements included in Item 8. “Financial Statements and Supplementary Data”, included in this Form 10-K, the contents of which are incorporated by reference to this Item 3.
Item 4. Mine Safety Disclosures
Not applicable.
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Item 4A. Executive Officers of the Registrant
Listed below are the names of our corporate executive officers, including those required to be listed as executive officers for SEC purposes, each of whom assumes office after the annual organization meeting of the Board of Directors which immediately follows the Annual Meeting of Stockholders.
Tony R. Thene was appointed President and Chief Executive Officer effective July 1, 2015. Since joining Carpenter in January 2013, Mr. Thene served as the Senior Vice President and Chief Financial Officer. Mr. Thene joined Carpenter after 23 years with Alcoa Inc., a leading producer of primary and fabricated aluminum, holding various management positions.
Damon J. Audia was appointed Senior Vice President and Chief Financial Officer effective October 19, 2015. Mr. Audia joined Carpenter from The Goodyear Tire & Rubber Company where he worked for ten years and most recently served as Senior Vice President of Finance for the company's North America division.
David L. Strobel was appointed Senior Vice President and Chief Technology Officer effective July 13, 2015. Since joining Carpenter in 1983, Mr. Strobel has held numerous positions of increasing responsibility, including Vice President - Manufacturing, Vice President - Technology and Senior Vice President - Global Operations. Mr. Strobel retired from the Company in August 2016.
Joseph E. Haniford was appointed Chief Operating Officer effective June 30, 2016. Since joining Carpenter in July 2015, Mr. Haniford served as Senior Vice President - Specialty Alloys Operations. Mr. Haniford joined Carpenter from EnTrans International where he was responsible for all operations as the company's Chief Operating Officer and was a member of the Board of Directors. Prior to EnTrans International, Mr. Haniford worked for Alcoa, Inc. for more than 30 years in various executive leadership positions.
Assumed Present Position | ||||||
Name | Age | Position | ||||
Tony R. Thene | 55 | President and Chief Executive Officer | July 2015 | |||
Damon J. Audia | 45 | Senior Vice President and Chief Financial Officer | October 2015 | |||
David L. Strobel | 55 | Senior Vice President and Chief Technology Officer | July 2015 | |||
Joseph E. Haniford | 57 | Chief Operating Officer | June 2016 | |||
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PART II
Item 5. Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Our common stock is listed on the New York Stock Exchange (“NYSE”) and traded under the symbol “CRS”. The following table sets forth, for the periods indicated, the high and low prices for our common stock as reported by the NYSE:
Fiscal Year 2016 | Fiscal Year 2015 | |||||||||||||||
Quarter Ended: | High | Low | High | Low | ||||||||||||
September 30 | $ | 41.25 | $ | 29.18 | $ | 64.69 | $ | 44.98 | ||||||||
December 31 | $ | 37.18 | $ | 27.55 | $ | 53.12 | $ | 41.43 | ||||||||
March 31 | $ | 36.18 | $ | 23.99 | $ | 49.73 | $ | 34.28 | ||||||||
June 30 | $ | 38.16 | $ | 28.74 | $ | 45.42 | $ | 34.80 | ||||||||
Annual | $ | 41.25 | $ | 23.99 | $ | 64.69 | $ | 34.28 | ||||||||
The range of our common stock price on the NYSE from July 1, 2016 to August 12, 2016 was $32.44 to $40.46. The closing price of the common stock was $36.62 on August 12, 2016.
We have paid quarterly cash dividends on our common stock for over 120 consecutive years. We paid a quarterly dividend of $0.18 per share of common stock during each quarter of fiscal years 2016 and 2015.
As of August 12, 2016, there were 2,332 common stockholders of record.
Information regarding Securities Authorized for Issuance under Equity Compensation Plans is set forth in Item 12 hereto “Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters”.
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Cumulative Total Stockholder Return
The graph below compares the cumulative total stockholder return on our common stock to the cumulative total return of the S&P MidCap 400 Index, the most widely used index for mid-sized companies, and our Peer Group, for each of the last five fiscal years ended June 30, 2016. The cumulative total return assumes an investment of $100 on June 30, 2011 and the reinvestment of any dividends during the period. Our Peer Group consists of the companies in the Russell Materials and Processing Growth Index. We believe the companies included in our Peer Group, taken as a whole, provide a more meaningful comparison in terms of product offerings, markets served, competition and other relevant factors. The total stockholder return for the peer group is weighted according to the respective issuer’s stock market capitalization at the beginning of each period.
6/11 | 6/12 | 6/13 | 6/14 | 6/15 | 6/16 | |||||||||||||||||||
Carpenter Technology Corporation | $ | 100.00 | $ | 84.10 | $ | 80.37 | $ | 114.16 | $ | 70.91 | $ | 61.70 | ||||||||||||
S&P Midcap 400 | $ | 100.00 | $ | 97.67 | $ | 122.27 | $ | 153.12 | $ | 162.92 | $ | 165.09 | ||||||||||||
Russell Materials & Processing Growth | $ | 100.00 | $ | 89.57 | $ | 111.20 | $ | 143.43 | $ | 145.31 | $ | 139.78 | ||||||||||||
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Issuer Purchases of Equity Securities
In October 2014, the Company’s Board of Directors authorized a share repurchase program up to $500.0 million of the Company's shares of Common Stock over two years. The shares of Common Stock may be repurchased from time to time at our discretion based on capital needs of the business, general market conditions and market price of the stock. The timing or amount of the shares to be repurchased cannot be assured. The share repurchase program may be discontinued at any time. As of June 30, 2016, $251.6 million of the $500.0 million remained available for future purchases.
Item 6. Selected Financial Data
Five-Year Financial Summary
in millions, except per share data
(Fiscal years ended June 30,)
2016(a)(c) | 2015(b)(c) | 2014 | 2013(d) | 2012(d)(e) | ||||||||||||||||
Summary of Operations: | ||||||||||||||||||||
Net sales | $ | 1,813.4 | $ | 2,226.7 | $ | 2,173.0 | $ | 2,271.7 | $ | 2,028.7 | ||||||||||
Operating income | $ | 51.6 | $ | 111.5 | $ | 212.0 | $ | 232.7 | $ | 210.1 | ||||||||||
Net income | $ | 11.3 | $ | 58.7 | $ | 132.8 | $ | 146.5 | $ | 121.6 | ||||||||||
Net income attributable to Carpenter | $ | 11.3 | $ | 58.7 | $ | 132.8 | $ | 146.1 | $ | 121.2 | ||||||||||
Financial Position at Year-End: | ||||||||||||||||||||
Cash and cash equivalents | $ | 82.0 | $ | 70.0 | $ | 120.0 | $ | 257.5 | $ | 211.0 | ||||||||||
Total assets | $ | 2,794.3 | $ | 2,902.6 | $ | 3,053.7 | $ | 2,878.6 | $ | 2,625.7 | ||||||||||
Long-term debt, net of current portion | $ | 611.3 | $ | 603.8 | $ | 600.5 | $ | 599.9 | $ | 303.8 | ||||||||||
Per Common Share: | ||||||||||||||||||||
Net earnings: | ||||||||||||||||||||
Basic | $ | 0.23 | $ | 1.11 | $ | 2.48 | $ | 2.75 | $ | 2.55 | ||||||||||
Diluted | $ | 0.23 | $ | 1.11 | $ | 2.47 | $ | 2.73 | $ | 2.53 | ||||||||||
Cash dividend-common | $ | 0.72 | $ | 0.72 | $ | 0.72 | $ | 0.72 | $ | 0.72 | ||||||||||
Weighted Average Common Shares Outstanding: | ||||||||||||||||||||
Basic | 48.1 | 52.6 | 53.3 | 52.9 | 47.1 | |||||||||||||||
Diluted | 48.2 | 52.7 | 53.6 | 53.2 | 47.5 | |||||||||||||||
(a) Fiscal year 2016 included $22.5 million of excess inventory write-down charges, $12.5 million of goodwill impairment charges and $18.0 million of restructuring and impairment charges including of $7.6 million of impairment of intangible assets and property, plant and equipment and $10.4 million of restructuring costs related primarily to an early retirement incentive and other severance related costs. See Note 2 in the Notes to the Consolidated Financial Statements included in Item 8 “Financial Statements and Supplementary Data” of this report.
(b) Fiscal year 2015 included $29.1 million of restructuring costs related principally to workforce reduction, facility closures and write-down of certain assets. See Note 2 in the Notes to the Consolidated Financial Statements included in Item 8 “Financial Statements and Supplementary Data” of this report.
(c) The weighted average common shares outstanding for fiscal years 2016 and 2015 included 5.5 million and 0.9 million less shares, respectively, related to the share repurchase program authorized in October 2014. During the year ended June 30, 2016 and 2015, we repurchased 3,762,200 shares and 2,995,272 shares, respectively, of common stock for $123.9 million and $124.5 million, respectively.
(d) The weighted average common shares outstanding for fiscal years 2013 and 2012 included an additional 8.1 million and 2.7 million, respectively, shares issued in connection with the Latrobe acquisition.
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(e) Fiscal year 2012 included $11.7 million of acquisition-related costs incurred in connection with the Latrobe acquisition that was consummated on February 29, 2012.
See Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for discussion of factors that affect the comparability of the “Selected Financial Data”.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
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 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.
As part of our overall business strategy, we have sought out and considered opportunities related to strategic acquisitions, divestitures 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 structures of such opportunities and expect that we will continue to evaluate these opportunities.
While we prepare our financial statements in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”), we also utilize and present certain financial measures that are not based on or included in U.S. GAAP (we refer to these as “Non-GAAP financial measures”). Please see the section “Non-GAAP Financial Measures” below for further discussion of these financial measures, including the reasons why we use such financial measures and reconciliations of such financial measures to the nearest U.S. GAAP financial measures.
16
Business Trends
Selected financial results for the past three fiscal years are summarized below:
Fiscal Year | ||||||||||||
($ in millions, except per share data) | 2016 | 2015 | 2014 | |||||||||
Net sales | $ | 1,813.4 | $ | 2,226.7 | $ | 2,173.0 | ||||||
Net sales excluding surcharge revenue (1) | $ | 1,572.6 | $ | 1,811.8 | $ | 1,782.8 | ||||||
Operating income | $ | 51.6 | $ | 111.5 | $ | 212.0 | ||||||
Operating income excluding pension earnings, interest and deferrals (“pension EID”) expense (1) | $ | 70.9 | $ | 121.0 | $ | 233.8 | ||||||
Net income | $ | 11.3 | $ | 58.7 | $ | 132.8 | ||||||
Diluted earnings per share | $ | 0.23 | $ | 1.11 | $ | 2.47 | ||||||
Purchases of property, equipment and software | $ | 95.2 | $ | 170.5 | $ | 349.2 | ||||||
Free cash flow (1) | $ | 138.6 | $ | 74.4 | $ | (147.8 | ) | |||||
Pounds sold (in thousands) (2) | 242,560 | 277,482 | 290,388 | |||||||||
(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.
As a result of the realignment of the commercial team during fiscal year 2016, we changed the manner in which sales are classified by end-use market so that we could better evaluate our sales results from period to period. In order to make the discussion of sales by end-use market meaningful, we have reclassified the fiscal year 2015 and 2014 sales by end-use market to conform to the fiscal year 2016 presentation.
Our sales are across a diversified list of end-use markets. The table below summarizes our sales by market over the past three fiscal years:
Fiscal Year | |||||||||||||||||||||
2016 | 2015 | 2014 | |||||||||||||||||||
($ in millions) | Dollars | % of Total | Dollars | % of Total | Dollars | % of Total | |||||||||||||||
Aerospace and defense | $ | 981.5 | 54 | % | $ | 1,053.8 | 48 | % | $ | 1,006.8 | 47 | % | |||||||||
Energy | 130.6 | 7 | 285.6 | 13 | 309.9 | 14 | |||||||||||||||
Transportation | 160.6 | 8 | 171.0 | 7 | 153.5 | 7 | |||||||||||||||
Medical | 121.5 | 7 | 129.4 | 6 | 117.6 | 5 | |||||||||||||||
Industrial and consumer | 300.9 | 17 | 450.0 | 20 | 447.6 | 21 | |||||||||||||||
Distribution | 118.3 | 7 | 136.9 | 6 | 137.6 | 6 | |||||||||||||||
Total net sales | $ | 1,813.4 | 100 | % | $ | 2,226.7 | 100 | % | $ | 2,173.0 | 100 | % | |||||||||
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Impact of Raw Material Prices and Product Mix
We value most of our inventory utilizing 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 cost of sales. Conversely, in a period of decreasing raw material costs, the LIFO inventory valuation normally results in lower cost of sales.
The volatility of the costs of raw materials has impacted our operations over the past several years. We, and others in our industry, generally have been able to pass cost increases on major raw materials through to our customers using surcharges that are structured to recover increases in raw material costs. Generally, the formula used to calculate a surcharge is based on published prices of the respective raw materials for the previous month which correlates to the prices we pay for our raw material purchases. However, a portion of our surcharges to customers may be calculated using a different surcharge formula or may be based on the raw material prices at the time of order, which creates a lag between surcharge revenue and corresponding raw material costs recognized in cost 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 and/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 cost of goods sold reflects 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 net periodic benefit costs for the years ended June 30, 2016, 2015 and 2014:
Years Ended June 30, | ||||||||||||
($ in millions) | 2016 | 2015 | 2014 | |||||||||
Pension plans | $ | 50.9 | $ | 34.5 | $ | 49.0 | ||||||
Other postretirement plans | 2.9 | 10.0 | 11.1 | |||||||||
Net periodic benefit costs | $ | 53.8 | $ | 44.5 | $ | 60.1 | ||||||
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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”) 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.
During the year ended June 30, 2016, we offered an early retirement incentive to certain employees. As a result of the incentive, $9.4 million was paid from the Company's qualified pension plan consisting of various personnel-related costs to cover severance payments.
During the year ended June 30, 2015, in connection with a restructuring plan, we reduced approximately 200 salaried positions. As a result, $8.3 million was paid from the Company's qualified pension plan consisting primarily of various personnel-related costs to cover severance payments and medical coverage.
Net pension expense is recorded in accounts that are included in both the cost of sales and selling, general and administrative expenses based on the function of the associated employees. The following is a summary of the classification of net pension expense for the years ended June 30, 2016, 2015 and 2014:
Years Ended June 30, | ||||||||||||
($ in millions) | 2016 | 2015 | 2014 | |||||||||
Cost of sales | ||||||||||||
Service cost | $ | 28.1 | $ | 29.3 | $ | 28.2 | ||||||
Pension earnings, interest and deferrals | 13.2 | 5.0 | 14.2 | |||||||||
41.3 | 34.3 | 42.4 | ||||||||||
Selling, general and administrative expenses | ||||||||||||
Service cost | 6.4 | 7.3 | 7.9 | |||||||||
Pension earnings, interest and deferrals | 6.1 | 4.5 | 7.6 | |||||||||
Curtailment gain | — | (1.6 | ) | — | ||||||||
12.5 | 10.2 | 15.5 | ||||||||||
Net pension expense | $ | 53.8 | $ | 44.5 | $ | 57.9 | ||||||
As of June 30, 2016 and 2015, amounts capitalized in gross inventory were $10.6 million and $9.5 million, respectively.
Operating Performance Overview
Fiscal year 2016 was a successful year for Carpenter related to numerous changes made in how we operate as a company, including:
• | We strengthened our Carpenter team by adding experienced external talent and promoted internal talent into critical roles. |
• | We defined our strategy as a solutions provider helping our customers solve their most challenging problems and giving them competitive advantage. |
• | We reorganized our commercial team to be market focused versus product focused. We are aggressively seeking avenues to deepen customer relationships and expand the participation of our high-end specialty alloys across the most critical applications. |
• | We launched the Carpenter Operating Model. The Carpenter Operating Model is unlocking manufacturing efficiencies and commercial opportunities, while also driving further improvements in working capital efficiency and capital spending discipline. |
These strategic initiatives are aimed at enabling our organization to not only overcome the near term cyclical challenges but also better position Carpenter to generate growth and improve margins over the long-term.
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Results of Operations — Fiscal Year 2016 Compared to Fiscal Year 2015
For fiscal year 2016, we reported net income of $11.3 million, or $0.23 per diluted share, compared with net income of $58.7 million, or $1.11 per diluted share, a year earlier. Our fiscal year 2016 results reflect operating cost improvements driven by the implementation of the Carpenter Operating Model which were more than offset by the impact of lower volumes principally in our Energy, Industrial and Consumer and Aerospace and Defense end-use markets and non-cash impairment charges related to certain assets in the Company’s oil and gas businesses within the Performance Engineered Products (“PEP”) segment. The non-cash impairment charges consist of:
• | Excess inventory write-down charges totaling $22.5 million |
• | Goodwill impairment charges totaling $12.5 million |
• | Impairment of intangible assets and property, plant and equipment charges totaling $7.6 million |
In addition, the Company recorded $10.4 million of restructuring charges consisting primarily of an early retirement incentive offered to certain employees funded by the Company’s pension plan.
Net Sales
Net sales for fiscal year 2016 were $1,813.4 million, which was a 19 percent decrease from fiscal year 2015. Excluding surcharge revenue, sales were 13 percent lower than fiscal year 2015 on 13 percent lower volume. The results reflect weakness in demand for materials used in the Energy end-use market which also affected order patterns for customers in the Industrial and Consumer end-use market.
Geographically, sales outside the United States decreased 12 percent from fiscal year 2015 to $569.9 million. The decrease is primarily due to sales to Asia and Canada in the Energy and Industrial and Consumer end-use markets. In addition, sales to Europe decreased in the Aerospace and Defense, Energy, Medical and Industrial and Consumer end-use markets. A portion of our sales outside the United States are denominated in foreign currencies. The impact of fluctuations in foreign currency exchange rates resulted in a $9.5 million decrease in sales during the fiscal year 2016 compared to fiscal year 2015. International sales as a percentage of our total net sales represented 31 percent and 29 percent for fiscal year 2016 and fiscal year 2015, 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 revenue, by principal end-use markets. We believe this is helpful supplemental information in analyzing the performance of the business from period to period.
Fiscal Year | $ Decrease | % Decrease | |||||||||||||
($ in millions) | 2016 | 2015 | |||||||||||||
Aerospace and defense | $ | 981.5 | $ | 1,053.8 | $ | (72.3 | ) | (7 | )% | ||||||
Energy | 130.6 | 285.6 | (155.0 | ) | (54 | )% | |||||||||
Transportation | 160.6 | 171.0 | (10.4 | ) | (6 | )% | |||||||||
Medical | 121.5 | 129.4 | (7.9 | ) | (6 | )% | |||||||||
Industrial and consumer | 300.9 | 450.0 | (149.1 | ) | (33 | )% | |||||||||
Distribution | 118.3 | 136.9 | (18.6 | ) | (14 | )% | |||||||||
Total net sales | $ | 1,813.4 | $ | 2,226.7 | $ | (413.3 | ) | (19 | )% | ||||||
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The following table includes comparative information for our net sales by the same principal end-use markets, but excluding surcharge revenue:
Fiscal Year | $ Increase (Decrease) | % (Increase) Decrease | |||||||||||||
($ in millions) | 2016 | 2015 | |||||||||||||
Aerospace and defense | $ | 823.1 | $ | 823.5 | $ | (0.4 | ) | — | % | ||||||
Energy | 115.3 | 245.0 | (129.7 | ) | (53 | )% | |||||||||
Transportation | 136.8 | 130.9 | 5.9 | 5 | % | ||||||||||
Medical | 114.5 | 118.5 | (4.0 | ) | (3 | )% | |||||||||
Industrial and consumer | 265.2 | 358.3 | (93.1 | ) | (26 | )% | |||||||||
Distribution | 117.7 | 135.6 | (17.9 | ) | (13 | )% | |||||||||
Total net sales excluding surcharge revenue | $ | 1,572.6 | $ | 1,811.8 | $ | (239.2 | ) | (13 | )% | ||||||
Sales to the Aerospace and Defense market decreased 7 percent from fiscal year 2015 to $981.5 million. Excluding surcharge revenue, sales were flat on similar shipment volume. The results reflect stronger demand for materials used in structural applications and an increase in sales of engine materials as a result of additional activity across the new platforms offset by a decrease in sales of titanium fastener material. In addition, we are experiencing strength in our defense related sales with continued spending on supported programs.
Sales to the Energy market of $130.6 million reflected a 54 percent decrease from fiscal year 2015. Excluding surcharge revenue, sales decreased 53 percent on 50 percent lower shipment volume. The results reflect the impact of low oil and gas prices and slowing demand, which has significantly reduced drilling and exploration activity. The North American average directional rig count, a leading indicator of drilling activity, decreased 53 percent from the same period a year ago.
Transportation market sales decreased 6 percent from fiscal year 2015 to $160.6 million. Excluding surcharge revenue, sales increased 5 percent on 3 percent lower shipment volume. The results reflect a strengthening mix for our materials used in engine, valve and fuel system materials. Low fuel prices drove up sales for vehicle platforms with higher Carpenter material content. In addition, sales of light trucks increased from the year ago period.
Sales to the Medical market decreased 6 percent to $121.5 million from fiscal year 2015. Excluding surcharge revenue, sales decreased 3 percent on 2 percent lower shipment volume. The results reflect pricing pressures on transactional business for titanium and stainless steel materials.
Industrial and Consumer market sales were $300.9 million for fiscal year 2016. Excluding surcharge revenue, sales decreased 26 percent on 22 percent lower shipment volume. The results reflect decreased demand for materials used in capital equipment and industrial components due in part to the drilling and exploration activity.
Distribution sales decreased 14 percent from the same period a year ago to $118.3 million. Excluding surcharge revenue, sales decreased 13 percent from the same period a year ago.
Gross Profit
Gross profit in fiscal year 2016 decreased to $255.9 million, or 14.1 percent of net sales from $318.3 million, or 14.3 percent of net sales for fiscal year 2015. During the year ended June 30, 2016, we recorded a $22.5 million excess inventory adjustment in our oil and gas businesses within the PEP segment due to the prolonged weakness in oil and gas businesses. Excluding the impacts of the excess inventory write-down and surcharge revenue, our gross margin in fiscal year 2016 was 17.7 percent as compared 17.6 percent in the same period a year ago. The results reflect lower operating costs driven by the implementation of the Carpenter Operating Model which were offset by lower volume principally in our Energy and Industrial and Consumer end-use markets compared to the same period a year ago.
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Our surcharge mechanism is structured to recover increases in raw material costs, although in certain cases with a lag effect as discussed above. While the surcharge generally protects the absolute gross profit dollars, it does have a dilutive effect on gross margin as a percent of sales. The following represents a summary of the dilutive impact of the surcharge on gross margin excluding the impact of the excess inventory write-down. We present and discuss these financial measures because management believes removing the impact of these items provides a more consistent and meaningful basis for comparing results of operations from period to period. See the section “Non-GAAP Financial Measures” below for further discussion of these financial measures.
Fiscal Year | ||||||||
($ in millions) | 2016 | 2015 | ||||||
Net sales | $ | 1,813.4 | $ | 2,226.7 | ||||
Less: surcharge revenue | 240.8 | 414.9 | ||||||
Net sales excluding surcharge revenue | $ | 1,572.6 | $ | 1,811.8 | ||||
Gross profit | $ | 255.9 | $ | 318.3 | ||||
Excess inventory write-down | 22.5 | — | ||||||
Gross profit excluding the excess inventory write-down | $ | 278.4 | $ | 318.3 | ||||
Gross margin | 14.1 | % | 14.3 | % | ||||
Gross margin excluding surcharge revenue and excess inventory write-down | 17.7 | % | 17.6 | % | ||||
Selling, General and Administrative Expenses
Selling, general and administrative expenses in fiscal year 2016 were $173.8 million, or 9.6 percent of net sales (11.1 percent of net sales excluding surcharge revenue), compared to $177.7 million, or 8.0 percent of net sales (9.8 percent of net sales excluding surcharge revenue), in fiscal year 2015. Selling, general and administrative expenses decreased due to lower salaries and benefits of $5.6 million primarily as a result of the restructuring actions taken in fiscal year 2015, lower variable compensation expense of $3.1 million partially offset by consulting costs of $4.2 million related to the Business Management Office (BMO) and strategic business review. The BMO is focused on profit optimization, operating cost improvement and inventory reductions.
Restructuring and Asset Impairment Charges
During fiscal year 2016, we incurred $18.0 million of restructuring and asset impairment charges. This included $7.6 million of non-cash impairment charges to write down property, plant and equipment and other intangible assets. The remaining $10.4 million consisted primarily of an early retirement incentive that resulted in a reduction of approximately 130 production and maintenance positions.
During fiscal year 2015, we incurred $29.1 million of restructuring charges. We implemented a reduction of approximately 200 salaried positions resulting in a charge of $12.7 million consisting primarily of various personnel-related costs to cover severance payments, medical coverage and related items. We also exited the ultra-fine grain materials development program resulting in a charge of $13.4 million during fiscal year 2015. In addition, we announced the closure of a facility resulting in a charge of $3.0 million to reflect the write-down of certain property and equipment. The actions taken in fiscal year 2015 aimed to yield approximately $30 million of fixed costs savings were realized in fiscal year 2016.
Activities undertaken in connection with the fiscal years 2016 and 2015 restructuring plans are complete.
Goodwill Impairment Charge
The Company’s Amega West Services (“Amega”) and Specialty Steel Supply (“SSS”) reporting units within the PEP Segment have been significantly impacted by the prolonged weakness in oil and gas drilling and exploration activity driven by depressed oil prices. As a result, during the fiscal year 2016 we recorded an impairment charge of $12.5 million which represents the entire balance of the goodwill recorded for these reporting units.
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Operating Income
Our operating income in fiscal year 2016 decreased to $51.6 million, or 2.8 percent of net sales as compared with $111.5 million, or 5.0 percent in net sales in fiscal year 2015. Excluding surcharge revenue, pension EID and special items, operating margin was 8.5 percent for the fiscal year 2016 and 8.6 percent for the same period a year ago. The decrease in the operating margin reflects lower volume principally in our Energy and Industrial and Consumer end-use markets partially offset by operating cost improvements and overhead cost reductions compared to the same period a year ago.
Operating income has been significantly impacted by our pension EID, which may be volatile based on conditions in the financial markets, as well as other special items. The following presents our operating income and operating margin, in each case excluding the impact of surcharge on net sales, pension EID, the excess inventory write-down, restructuring and asset impairment charges, goodwill impairment and other special items. We present and discuss these financial measures because management believes removing the impact of these items provides a more consistent and meaningful basis for comparing results of operations from period to period. See the section “Non-GAAP Financial Measures” below for further discussion of these financial measures.
Fiscal Year | ||||||||
($ in millions) | 2016 | 2015 | ||||||
Net sales | $ | 1,813.4 | $ | 2,226.7 | ||||
Less: surcharge revenue | 240.8 | 414.9 | ||||||
Net sales excluding surcharge revenue | $ | 1,572.6 | $ | 1,811.8 | ||||
Operating income | $ | 51.6 | $ | 111.5 | ||||
Pension EID | 19.3 | 9.5 | ||||||
Operating income excluding pension EID | 70.9 | 121.0 | ||||||
Special items: | ||||||||
Excess inventory write-down | 22.5 | — | ||||||
Restructuring and asset impairment charges | 18.0 | 29.1 | ||||||
Goodwill impairment | 12.5 | — | ||||||
Consulting costs | 9.3 | 5.1 | ||||||
Operating income excluding pension EID and special items | $ | 133.2 | $ | 155.2 | ||||
Operating margin | 2.8 | % | 5.0 | % | ||||
Operating margin excluding surcharge revenue, pension EID and special items | 8.5 | % | 8.6 | % | ||||
Interest Expense
Fiscal year 2016 interest expense was $28.0 million compared to $27.7 million in fiscal year 2015. We have used interest rate swaps to achieve a level of floating rate debt to fixed rate debt. Interest expense for fiscal 2016 includes net gains from interest rate swaps of $2.6 million compared with $2.9 million of net gains from interest rate swaps for the fiscal year 2015.
Other Expense (Income), Net
Other expense for fiscal year 2016 was $2.1 million as compared with other income of $5.3 million a year ago. The results reflect negative impacts in foreign exchange losses of $2.7 million for the current period compared to the same period a year ago. The fiscal year 2015 results include a $4.4 million favorable legal settlement.
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Income Taxes
Our effective tax rate (income tax expense as a percent of income before taxes) for fiscal year 2016 was 47.4 percent as compared to 34.1 percent in fiscal year 2015. The fiscal year 2016 tax rate includes the impact of non-cash goodwill impairment charges, a portion of which is non-deductible for tax purposes, as well as a tax charge of $2.8 million recorded due to a change in business strategy for one of our foreign subsidiaries that resulted in a change in our intent with regard to the indefinite reinvestment of the foreign earnings for this subsidiary. The fiscal year 2016 tax rate also includes net tax benefits of $0.8 million primarily for additional research and development credits as a result of the December 2015 enactment of the Protecting Americans from Tax Hikes Act of 2015. Income tax expense in the prior year includes a net tax charge of $1.6 million for the unfavorable impact of bonus depreciation on domestic manufacturing benefits, net of additional research and development credits as a result of the enactment of the Tax Increase Prevention Act of 2014.
As of June 30, 2016, we had $106.5 million of indefinitely reinvested foreign earnings for which we had not provided deferred income taxes.
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 18 to the consolidated financial statements included in Item 8, “Financial Statements and Supplementary Data”.
The following table includes comparative information for volumes by business segment:
Fiscal Year | Increase (Decrease) | % Increase (Decrease) | ||||||||||
(Pounds sold, in thousands) | 2016 | 2015 | ||||||||||
Specialty Alloys Operations | 234,296 | 269,550 | (35,254 | ) | (13 | )% | ||||||
Performance Engineered Products | 11,626 | 15,262 | (3,636 | ) | (24 | )% | ||||||
Intersegment | (3,362 | ) | (7,330 | ) | 3,968 | 54 | % | |||||
Consolidated pounds sold | 242,560 | 277,482 | (34,922 | ) | (13 | )% | ||||||
* Pounds sold data for PEP segment includes Dynamet and Carpenter Powder Products businesses only.
The following table includes comparative information for net sales by business segment:
Fiscal Year | $ Increase (Decrease) | % Increase (Decrease) | |||||||||||||
($ in millions) | 2016 | 2015 | |||||||||||||
Specialty Alloys Operations | $ | 1,481.0 | $ | 1,796.6 | $ | (315.6 | ) | (18 | )% | ||||||
Performance Engineered Products | 358.7 | 497.7 | (139.0 | ) | (28 | )% | |||||||||
Intersegment | (26.3 | ) | (67.6 | ) | 41.3 | 61 | % | ||||||||
Total net sales | $ | 1,813.4 | $ | 2,226.7 | $ | (413.3 | ) | (19 | )% | ||||||
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The following table includes comparative information for our net sales by business segment, but excluding surcharge revenue:
Fiscal Year | $ Increase (Decrease) | % Increase (Decrease) | |||||||||||||
($ in millions) | 2016 | 2015 | |||||||||||||
Specialty Alloys Operations | $ | 1,239.6 | $ | 1,373.5 | $ | (133.9 | ) | (10 | )% | ||||||
Performance Engineered Products | 357.9 | 496.5 | (138.6 | ) | (28 | )% | |||||||||
Intersegment | (24.9 | ) | (58.2 | ) | 33.3 | 57 | % | ||||||||
Total net sales excluding surcharge revenue | $ | 1,572.6 | $ | 1,811.8 | $ | (239.2 | ) | (13 | )% | ||||||
Specialty Alloys Operations Segment
Net sales in fiscal year 2016 for the SAO segment decreased 18 percent to $1,481.0 million, as compared with $1,796.6 million in fiscal year 2015. Excluding surcharge revenue, sales decreased 10 percent from a year ago. The fiscal year 2016 net sales reflected 13 percent lower shipment volume as compared to fiscal year 2015. The results reflect weakness in the Energy and Industrial and Consumer end-use markets compared to the prior year same period.
Operating income for the SAO segment in fiscal year 2016 was $176.9 million, or 11.9 percent of net sales (14.3 percent of net sales excluding surcharge revenue), compared to $155.2 million, or 8.6 percent of net sales (11.3 percent of net sales excluding surcharge revenue), for fiscal year 2015. The increase in operating income reflects operating cost improvements driven by the implementation of the Carpenter Operating Model, an insurance recovery benefit of $4 million and a favorable shift in product mix.
Performance Engineered Products Segment
Net sales for fiscal year 2016 for the PEP segment were $358.7 million as compared with $497.7 million for fiscal year 2015. Excluding surcharge revenue, net sales were decreased 28 percent. The results reflect decreased net sales primarily due to the current weakness in the Energy end-use market.
Operating loss for the PEP segment for fiscal year 2016 was $5.5 million, or 1.5 percent of net sales, as compared with operating income of $39.1 million, or 7.9 percent of net sales for fiscal year 2015. The results reflect the impact of the weak Energy end-use market due to limited drilling activity.
Results of Operations — Fiscal Year 2015 Compared to Fiscal Year 2014
For fiscal year 2015, we reported net income of $58.7 million, or $1.11 per diluted share, compared with net income of $132.8 million, or $2.47 per diluted share, a year earlier. Our fiscal year 2015 results reflect the impact of increasing sales by 2 percent in a challenging market environment which was more than offset by the weakness in the oil and gas businesses, increased operating costs and the restructuring plan implemented in the third quarter of fiscal year 2015.
Net Sales
Net sales for fiscal year 2015 were $2,226.7 million, which was a 2 percent increase from fiscal year 2014. Excluding surcharge revenue, sales were 2 percent higher than fiscal year 2014 on 4 percent lower volume. The results reflect sales increasing in the Aerospace and Defense, Medical and Transportation end-use markets, partially offset by the weakness in the Energy end-use market due to weak market conditions. The increase in sales combined with lower shipment volume reflects a favorable shift in product mix.
Geographically, sales outside the United States increased 2 percent from fiscal year 2014 to $646.8 million. International sales as a percentage of our total net sales represented 29 percent for both fiscal years 2015 and 2014.
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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 revenue, 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 (Decrease) | % Increase (Decrease) | |||||||||||||
($ in millions) | 2015 | 2014 | |||||||||||||
Aerospace and defense | $ | 1,053.8 | $ | 1,006.8 | $ | 47.0 | 5 | % | |||||||
Energy | 285.6 | 309.9 | (24.3 | ) | (8 | )% | |||||||||
Transportation | 171.0 | 153.5 | 17.5 | 11 | % | ||||||||||
Medical | 129.4 | 117.6 | 11.8 | 10 | % | ||||||||||
Industrial and consumer | 450.0 | 447.6 | 2.4 | 1 | % | ||||||||||
Distribution | 136.9 | 137.6 | (0.7 | ) | (1 | )% | |||||||||
Total net sales | $ | 2,226.7 | $ | 2,173.0 | $ | 53.7 | 2 | % | |||||||
The following table includes comparative information for our net sales by the same principal end-use markets, but excluding surcharge revenue:
Fiscal Year | $ Increase (Decrease) | % Increase (Decrease) | |||||||||||||
($ in millions) | 2015 | 2014 | |||||||||||||
Aerospace and defense | $ | 823.5 | $ | 795.0 | $ | 28.5 | 4 | % | |||||||
Energy | 245.0 | 269.7 | (24.7 | ) | (9 | )% | |||||||||
Transportation | 130.9 | 120.5 | 10.4 | 9 | % | ||||||||||
Medical | 118.5 | 107.8 | 10.7 | 10 | % | ||||||||||
Industrial and consumer | 358.3 | 353.5 | 4.8 | 1 | % | ||||||||||
Distribution | 135.6 | 136.3 | (0.7 | ) | (1 | )% | |||||||||
Total net sales excluding surcharge revenue | $ | 1,811.8 | $ | 1,782.8 | $ | 29.0 | 2 | % | |||||||
Sales to the Aerospace and Defense end-use market increased 5 percent from fiscal year 2014 to $1,053.8 million. Excluding surcharge revenue, sales increased 4 percent on 2 percent higher shipment volume. The results reflect an increase in sales of fastener materials and a stronger demand for engine materials, partially offset by lower demand for structural and defense materials.
Sales to the Energy end-use market of $285.6 million reflected an 8 percent decrease from fiscal year 2014. Excluding surcharge revenue, sales decreased 9 percent on 9 percent lower shipment volume. The results reflect demand softness in materials used in oil and gas drilling and completions in the second half of fiscal year 2015. Also, North American average directional and horizontal rig count decreased 46 percent from the prior year. These declines were partially offset by a moderate increase in power generation sales.
Transportation end-use market sales increased 11 percent from fiscal year 2014 to $171.0 million. Excluding surcharge revenue, sales increased 9 percent on 5 percent higher shipment volume. The results reflect a strengthening mix for our materials used in engine fasteners, valve and fuel system materials. Low fuel prices drove up sales for vehicle platforms with higher Carpenter material content. In addition, sales of light trucks increased from the year ago period. Also, fiscal year 2015 backlog is experiencing growth due to an improved mix compared to fiscal year 2014.
Sales to the Medical end-use market increased 10 percent to $129.4 million from fiscal year 2014. Excluding surcharge revenue, sales increased 10 percent on 13 percent higher shipment volume. The results reflect strength in demand for materials used for surgical instruments, as well as increased sales of titanium materials used in orthopedic implant procedures. However, the medical market pricing environment remains extremely competitive.
Industrial and Consumer end-use market sales were $450.0 million for fiscal year 2015. Excluding surcharge revenue, sales increased 1 percent on 14 percent lower shipment volume. The results reflect a favorable shift in product mix related to high-end consumer electronics and industrial capital goods.
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Distribution end-use market sales decreased 1 percent from the same period a year ago to $136.9 million. Excluding surcharge revenue, sales decreased 1 percent from the same period a year ago.
Gross Profit
Gross profit in fiscal year 2015 decreased to $318.3 million, or 14.3 percent of net sales (17.6 percent of net sales excluding surcharge revenue), from $398.9 million, or 18.4 percent of net sales (22.4 percent of net sales excluding surcharge revenue), for fiscal year 2014. The results reflect a stronger product mix which was more than offset by higher operating costs, unfavorable cost absorption as a result of reducing inventory and incremental depreciation expense due to the Athens facility which was placed into service late in fiscal year 2014.
Our surcharge mechanism is structured to recover increases in raw material costs, although in certain cases with a lag effect as discussed above. While the surcharge generally protects the absolute gross profit dollars, it does have a dilutive effect on gross margin as a percent of sales. The following represents a summary of the dilutive impact of the surcharge on gross margin for fiscal years 2015 and 2014. We present and discuss these financial measures because management believes removing the impact of these items provides a more consistent and meaningful basis for comparing results of operations from period to period. See the section “Non-GAAP Financial Measures” below for further discussion of these financial measures.
Fiscal Year | ||||||||
($ in millions) | 2015 | 2014 | ||||||
Net sales | $ | 2,226.7 | $ | 2,173.0 | ||||
Less: surcharge revenue | 414.9 | 390.2 | ||||||
Net sales excluding surcharge revenue | $ | 1,811.8 | $ | 1,782.8 | ||||
Gross profit | $ | 318.3 | $ | 398.9 | ||||
Gross margin | 14.3 | % | 18.4 | % | ||||
Gross margin excluding surcharge revenue | 17.6 | % | 22.4 | % | ||||
Selling, General and Administrative Expenses
Selling, general and administrative expenses in fiscal year 2015 were $177.7 million, or 8.0 percent of net sales (9.8 percent of net sales excluding surcharge revenue), compared to $186.9 million, or 8.6 percent of net sales (10.5 percent of net sales excluding surcharge revenue), in fiscal year 2014. Selling, general and administrative expenses decreased from the same period last year primarily due to lower depreciation and amortization expense of $4.3 million, lower variable compensation expense of $3.5 million, a reduction in pension EID expense of $3.1 million and lower severance of $1.6 million compared to prior year. These favorable items were partially offset by consulting costs of $5.1 million in fiscal year 2015 related to the BMO and strategic business review.
Restructuring and Asset Impairment Charges
During fiscal year 2015 we incurred $29.1 million of restructuring charges. We implemented a reduction of 200 salaried positions resulting in a charge of $12.7 million consisting primarily of various personnel-related costs to cover severance payments, medical coverage and related items. We also exited the ultra-fine grain materials development program resulting in a charge of $13.4 million during the fiscal year. In addition, we announced the closure of facilities resulting in a charge of $3.0 million to reflect the write-down of certain inventory, property and equipment and related items.
Activities undertaken in connection with the restructuring plan were complete by the first quarter of fiscal year 2016.
Operating Income
Our operating income in fiscal year 2015 decreased to $111.5 million as compared with $212.0 million in fiscal year 2014. The results reflect a strengthening product mix and lower selling, general and administrative expenses more than offset by higher operating costs, incremental depreciation expense due to the Athens facility which was placed into service in fiscal year 2014 and restructuring charges.
27
Operating income has been significantly impacted by our pension EID, which may be volatile based on conditions in the financial markets as well as other special items. The following presents our operating income and operating margin, in each case excluding the impact of surcharge on net sales, pension EID, restructuring and asset impairment charges and special items. We present and discuss these financial measures because management believes removing the impacts of these items provides a more consistent and meaningful basis for comparing results of operations from period to period. See the section “Non-GAAP Financial Measures” below for further discussion of these financial measures.
Fiscal Year | ||||||||
($ in millions) | 2015 | 2014 | ||||||
Net sales | $ | 2,226.7 | $ | 2,173.0 | ||||
Less: surcharge revenue | 414.9 | 390.2 | ||||||
Net sales excluding surcharge revenue | $ | 1,811.8 | $ | 1,782.8 | ||||
Operating income | $ | 111.5 | $ | 212.0 | ||||
Pension EID | 9.5 | 21.8 | ||||||
Operating income excluding pension EID | 121.0 | 233.8 | ||||||
Special items: | ||||||||
Restructuring and asset impairment charges | 29.1 | — | ||||||
Consulting costs | 5.1 | — | ||||||
Weather-related costs | — | 8.0 | ||||||
Operating income excluding pension EID and special items | $ | 155.2 | $ | 241.8 | ||||
Operating margin | 5.0 | % | 9.8 | % | ||||
Operating margin excluding surcharge revenue, pension EID and special items | 8.6 | % | 13.6 | % | ||||
Interest Expense
Fiscal year 2015 interest expense of $27.7 million increased 63 percent compared to $17.0 million in fiscal year 2014. The increase in interest expense is due to capitalized interest of $2.7 million during the year ended June 30, 2015 compared to $15.1 million the same period a year ago which primarily reflects the impact of placing a significant amount of the assets, attributable to the construction project at our Athens manufacturing plant, in service late in fiscal year 2014. This is offset by net gains from interest rate swaps of $2.9 million as compared to $0.0 million in fiscal year 2014. We have used interest rate swaps to achieve a level of floating rate debt to fixed rate debt.
Other Income, Net
Other income for fiscal year 2015 was $5.3 million as compared with $1.4 million a year ago. The year ended June 30, 2015 includes a $4.4 million favorable legal settlement.
Income Taxes
Our effective tax rate (income tax expense as a percent of income before taxes) for fiscal year 2015 was 34.1 percent as compared to 32.4 percent in fiscal year 2014. 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. The fiscal year 2015 tax rate includes net tax charges of $1.6 million for the unfavorable impact of bonus depreciation on domestic manufacturing benefits recorded in the prior year, net of additional research and development credits as a result of the December 2014 enactment of the Tax Increase Prevention Act.
As of June 30, 2014 we had $128.4 million of indefinitely reinvested foreign earnings for which we had not provided deferred income taxes. Due to the authorization of the $500.0 million share repurchase program in October 2014, we changed our intent with regard to the indefinite reinvestment of a portion of the foreign earnings of one of our foreign subsidiaries for fiscal year 2014 and prior years. As a result of this change, we repatriated approximately $38 million during the third quarter of fiscal year 2015 with minimal tax cost. The remaining balance of unremitted foreign earnings continues to be indefinitely reinvested.
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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 18 to the consolidated financial statements included in Item 8, “Financial Statements and Supplementary Data”.
The following table includes comparative information for volumes by business segment:
Fiscal Year | Increase (Decrease) | % Increase (Decrease) | ||||||||||
(Pounds sold, in thousands) | 2015 | 2014 | ||||||||||
Specialty Alloys Operations | 269,550 | 282,914 | (13,364 | ) | (5 | )% | ||||||
Performance Engineered Products | 15,262 | 12,248 | 3,014 | 25 | % | |||||||
Intersegment | (7,330 | ) | (4,774 | ) | (2,556 | ) | (54 | )% | ||||
Consolidated pounds sold | 277,482 | 290,388 | (12,906 | ) | (4 | )% | ||||||
* Pounds sold data for PEP segment includes Dynamet and Carpenter Powder Products businesses only.
The following table includes comparative information for net sales by business segment:
Fiscal Year | $ Increase (Decrease) | % Increase (Decrease) | |||||||||||||
($ in millions) | 2015 | 2014 | |||||||||||||
Specialty Alloys Operations | $ | 1,796.6 | $ | 1,741.6 | $ | 55.0 | 3 | % | |||||||
Performance Engineered Products | 497.7 | 498.6 | (0.9 | ) | — | ||||||||||
Intersegment | (67.6 | ) | (67.2 | ) | (0.4 | ) | (1 | )% | |||||||
Total net sales | $ | 2,226.7 | $ | 2,173.0 | $ | 53.7 | 2 | % | |||||||
The following table includes comparative information for our net sales by business segment, but excluding surcharge revenue:
Fiscal Year | $ Increase (Decrease) | % Increase | |||||||||||||
($ in millions) | 2015 | 2014 | |||||||||||||
Specialty Alloys Operations | $ | 1,373.5 | $ | 1,344.6 | $ | 28.9 | 2 | % | |||||||
Performance Engineered Products | 496.5 | 496.6 | (0.1 | ) | — | ||||||||||
Intersegment | (58.2 | ) | (58.4 | ) | 0.2 | — | |||||||||
Total net sales excluding surcharge revenue | $ | 1,811.8 | $ | 1,782.8 | $ | 29.0 | 2 | % | |||||||
Specialty Alloys Operations Segment
Net sales in fiscal year 2015 for the SAO segment increased 3 percent to $1,796.6 million, as compared with $1,741.6 million in fiscal year 2014. Excluding surcharge revenue, sales increased 2 percent from a year ago. The fiscal year 2015 net sales reflected 5 percent lower shipment volume as compared to fiscal year 2014. The increase in sales combined with lower shipment volumes reflects a favorable shift in product mix despite challenging market conditions.
Operating income for the SAO segment in fiscal year 2015 was $155.2 million, or 8.6 percent of net sales (11.3 percent of net sales excluding surcharge revenue), compared to $232.7 million, or 13.4 percent of net sales (17.3 percent of net sales excluding surcharge revenue), for fiscal year 2014. The decrease in operating income reflects the impacts of a strengthening mix which was more than offset by the operational issues, higher operating costs and incremental depreciation expense related to our Athens facility.
29
Performance Engineered Products Segment
Net sales for fiscal year 2015 for the PEP segment were $497.7 million as compared with $498.6 million for fiscal year 2014. Excluding surcharge revenue, net sales were flat. The results reflect increased net sales of powder products and sales of titanium bar and wire products which was offset by lower rentals and sales of down-hole drilling tools due to the weakness in the Energy end-use market.
Operating income for the PEP segment for fiscal year 2015 was $39.1 million, or 7.9 percent of net sales, as compared with $45.5 million, or 9.1 percent of net sales for fiscal year 2014. The results reflect the impacts of the weak market conditions in the oil and gas businesses experienced during the second half of fiscal year 2015, partially offset by improved performance in the titanium and powder products businesses.
Liquidity and Financial Resources
We ended fiscal year 2016 with $82.0 million of cash, an increase of $12.0 million from fiscal year 2015. During fiscal year 2016 our cash from operations was $256.9 million as compared with $282.6 million in fiscal year 2015. Our free cash flow, which we define under “Non-GAAP Financial Measures” below, was positive $138.6 million as compared to positive $74.4 million for the same period a year ago. The increase in free cash flow reflects significantly lower capital spending levels largely related to the winding down in capital expenditures associated with the construction of our Athens, Alabama facility. Capital expenditures for property, equipment and software were $95.2 million for fiscal year 2016 as compared to $170.5 million for the fiscal year 2015. In fiscal year 2017, we expect capital expenditures to be approximately $120 million.
During fiscal year 2016, we used $123.9 million to purchase 3,762,200 shares of common stock pursuant to the terms of the share repurchase program authorized by our Board of Directors in October 2014. To date we used $248.4 million to purchase 6,757,472 shares.
Dividends for the fiscal year 2016 were $34.8 million, as compared with $37.9 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 the years ended June 30, 2016, 2015 and 2014, interest costs totaled $29.9 million, $30.4 million and $32.1 million, respectively, of which $1.9 million, $2.7 million and $15.1 million, respectively, were capitalized as part of the cost of property, plant, equipment and software.
During fiscal year 2016, we made no cash contributions to our qualified pension plans, and are required to make cash contributions of $0.7 million to our pension plans during fiscal year 2017. Over the next five years, current estimates indicate that we will be required to make about $216.6 million of cash contributions to our pension plans, based on the laws in effect for pension funding as of June 30, 2016, and subject to market returns and interest rate assumptions.
We have demonstrated the ability to generate cash to meet our needs through cash flows 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 $150.0 million. Our syndicated revolving credit agreement (“Credit Agreement”) contains a revolving credit commitment of $500.0 million and expires in June 2018. As of June 30, 2016, we had $7.1 million of issued letters of credit. The balance of the Credit Agreement ($492.9 million as of June 30, 2016) remains available to us. As of June 30, 2016, we had total liquidity of approximately $575 million, including $82.0 million of cash and cash equivalents. From time to time during the year ended June 30, 2016 we have borrowed under our Credit Agreement and subsequently repaid any outstanding borrowings prior to June 30, 2016. The weighted average daily borrowing under the Credit Agreement during the year ended June 30, 2016 was $15.3 million with daily outstanding borrowings ranging from $0.0 million to $50.8 million.
We evaluate liquidity needs for alternative uses including funding external growth opportunities, share repurchases 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.
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As of June 30, 2016, we had cash and cash equivalents of approximately $35 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, 2016). 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 and non-cash net pension expense (“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 percent. The debt to capital ratio is defined in the Credit Agreement as the ratio of consolidated indebtedness, as defined therein, to consolidated capitalization, as defined therein. As of June 30, 2016, 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, 2016:
Covenant Requirement | Actual Ratio | |
Consolidated interest coverage | 3.50 to 1.00 (minimum) | 10.23 to 1.00 |
Consolidated debt to capital | 55% (maximum) | 36% |
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 modifications of the covenants.
Non-GAAP Financial Measures
The following provides additional information regarding certain non-GAAP financial measures that we use in this report. Our definitions and calculations of these items may not necessarily be the same as those used by other companies.
Net Sales and Gross Margin Excluding Surcharge Revenue and Special Items
This report includes discussions of net sales as adjusted to exclude the impact of raw material surcharge and the resulting impact on gross margins, as well as the excess inventory write-down, 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 surcharge from net sales and cost of sales provides a more consistent basis for comparing results of operations from period to period for the reasons discussed earlier in this report. In addition, management believes that excluding the excess inventory write-down from gross profit and gross margin is helpful in analyzing our operating performance as the excess inventory write-down is not indicative of ongoing operating performance. Management uses its results excluding these amounts to evaluate its operating performance and to discuss its business with investment institutions, the Company's board of directors and others. See our earlier discussions of “Gross Profit” for reconciliations of net sales and gross margin, excluding surcharge revenue and the excess inventory write-down, to net sales as determined in accordance with U.S. GAAP. Net sales and gross margin excluding surcharge revenue and the excess inventory write-down 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 Surcharge Revenue, Pension EID and Special Items
This report includes discussions of operating income and operating margin as adjusted to exclude the impact of raw material surcharge revenue, pension EID, the excess inventory write-down, restructuring and asset impairment charges, goodwill impairment and other special items 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 surcharge from net sales and cost of 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
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EID, the excess inventory write-down, restructuring and asset impairment charges, goodwill impairment and other special items from operating income and operating margin is helpful in analyzing our operating performance particularly as pension EID may be volatile due to changes in the financial markets and the excess inventory write-down, restructuring and asset impairment charges, goodwill impairment and other special items are not indicative of ongoing operating performance. Management uses its results excluding these amounts to evaluate its operating performance and to discuss its business with investment institutions, the Company's board of directors and others. See our earlier discussion of operating income for a reconciliation of operating income and operating margin excluding pension EID, the excess inventory write-down, restructuring and asset impairment charges, goodwill impairment and other special items to operating income and operating margin determined in accordance with U.S. GAAP. Operating income and operating margin excluding surcharge revenue, pension EID, the excess inventory write-down, restructuring and asset impairment charges, goodwill impairment and special items 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.
Adjusted Earnings Per Share
The following provides a reconciliation of adjusted earnings per share, to its most directly comparable U.S. GAAP financial measures:
($ in millions, except per share amounts) | Income Before Income Taxes | Income Tax Benefit (Expense) (a) | Net Income | Earnings Per Diluted Share | ||||||||||||
Year ended June 30, 2016, as reported | $ | 21.5 | $ | (10.2 | ) | $ | 11.3 | $ | 0.23 | |||||||
Special Items | ||||||||||||||||
Excess inventory write-down | 22.5 | (7.8 | ) | 14.7 | 0.31 | |||||||||||
Restructuring and asset impairment charges | 18.0 | (5.7 | ) | 12.3 | 0.26 | |||||||||||
Goodwill impairment | 12.5 | (3.2 | ) | 9.3 | 0.19 | |||||||||||
Consulting costs | 9.3 | (3.3 | ) | 6.0 | 0.13 | |||||||||||
Income tax item | — | 2.8 | 2.8 | 0.06 | ||||||||||||
Impact of tax law change | — | (0.8 | ) | (0.8 | ) | (0.02 | ) | |||||||||
Total impact of special items | 62.3 | (18.0 | ) | 44.3 | 0.93 | |||||||||||
Year ended June 30, 2016, as adjusted | $ | 83.8 | $ | (28.2 | ) | $ | 55.6 | $ | 1.16 | |||||||
($ in millions, except per share amounts) | Income Before Income Taxes | Income Tax Benefit (Expense) (a) | Net Income | Earnings Per Diluted Share | ||||||||||||
Year ended June 30, 2015, as reported | $ | 89.1 | $ | (30.4 | ) | $ | 58.7 | $ | 1.11 | |||||||
Special Items | ||||||||||||||||
Restructuring and asset impairment charges | 29.1 | (10.2 | ) | 18.9 | 0.36 | |||||||||||
Consulting costs | 5.1 | (1.8 | ) | 3.3 | 0.07 | |||||||||||
Legal settlement | (4.4 | ) | 1.5 | (2.9 | ) | (0.06 | ) | |||||||||
Impact of tax law change | — | 1.6 | 1.6 | 0.03 | ||||||||||||
Total impact of special items | 29.8 | (8.9 | ) | 20.9 | 0.40 | |||||||||||
Year ended June 30, 2015, as adjusted | $ | 118.9 | $ | (39.3 | ) | $ | 79.6 | $ | 1.51 | |||||||
(a) The income tax effect of the special items was determined using a normalized effective income tax rate of 35 percent unless the item had specific discrete income tax impacts such as certain nontaxable goodwill and asset impairment charges and impacts of tax law changes.
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Management believes that the presentation of earnings per share adjusted to exclude the impacts of the excess inventory write-down, restructuring and asset impairment charges, goodwill impairment and other special items is helpful in analyzing the operating performance of the Company, as these costs are not indicative of ongoing operating performance. Management uses its results excluding these amounts to evaluate its operating performance and to discuss its business with investment institutions, the Company's board of directors and others. Our definitions and calculations of these items may not necessarily be the same as those used by other companies. Adjusted earnings per share is not a U.S. GAAP financial measure and should not be considered in isolation of, or as a substitute for, earnings per share calculated in accordance with U.S. GAAP.
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) | 2016 | 2015 | 2014 | |||||||||
Net cash provided from operating activities | $ | 256.9 | $ | 282.6 | $ | 239.6 | ||||||
Purchases of property, equipment and software | (95.2 | ) | (170.5 | ) | (349.2 | ) | ||||||
Dividends paid | (34.8 | ) | (37.9 | ) | (38.5 | ) | ||||||
Proceeds from disposals of plant and equipment and assets held for sale | 1.4 | 0.2 | 0.3 | |||||||||
Proceeds from sale of equity method investment | 6.3 | — | — | |||||||||
Other | 4.0 | — | — | |||||||||
Free cash flow | $ | 138.6 | $ | 74.4 | $ | (147.8 | ) | |||||
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, treasury stock repurchases 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.
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. We also use the FIFO and average cost methods. As of June 30, 2016 and 2015, $118.4 million and $154.9 million of inventory, respectively, was accounted for using a method other than the LIFO method.
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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.
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 percent in return seeking assets and 40 percent in liability matching assets. Return seeking assets include domestic and international equities and diversified loan funds. Liability matching assets include long duration bond funds. As the funding level of the plans improves in increments of 5 percent, assets will be shifted from return seeking to liability matching in increments of 4 percent as a de-risking strategy. The plan discount rate 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 $2.5 million. If the discount rate was changed by 0.25 percent, the net pension expense would change by $4.0 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. 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 unit's 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.
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Two of the Company’s reporting units, Amega West Services (“Amega”) and Specialty Steel Supply (“SSS”), have been significantly impacted by the prolonged weakness in oil and gas drilling and exploration activity driven by depressed oil prices. Given weak market conditions, depressed customer orders, reporting units results lower than expectation, we performed an interim impairment test during the third quarter of fiscal year 2016. In connection with the interim impairment test for Amega and SSS, we also performed an interim goodwill impairment test for the Latrobe Distribution reporting unit, for which results have been below expectations for the last several quarters. As a result of the goodwill impairment testing completed in the third quarter of fiscal year 2016, we determined that the goodwill associated with Amega and SSS was impaired and recorded an impairment charge of $12.5 million which represents the entire balance of the goodwill recorded for these reporting units. No other impairment was identified at the interim impairment testing date.
As of June 30, 2016, we had four remaining reporting units with goodwill recorded. Goodwill associated with our SAO reporting unit is tested at the SAO segment level and represents 80 percent of our total goodwill. All other goodwill is associated with our PEP segment, which includes 3 reporting units with goodwill recorded.
As of June 30, 2016, the fair value of the SAO and Latrobe Distribution reporting units exceeded the carrying value by approximately 10 percent and 20 percent, respectively. The goodwill recorded related to the SAO and Latrobe Distribution reporting units as of June 30, 2016 was $195.5 million and $14.0 million, respectively. The discounted cash flows analysis for the SAO and Latrobe Distribution reporting units includes assumptions related to our ability to increase volume, improve mix, expand product offerings and continue to implement opportunities to reduce costs over the next several years. For purposes of the discounted cash flow analysis for the SAO and Latrobe Distribution reporting unit’s fair value, we used a weighted average cost capital of 10.5 and 11.5 percent, respectively, and a terminal growth rate assumption of 3 percent.
The estimate of fair value requires significant judgment. We based our fair value estimates on assumptions that we believe to be reasonable but that are unpredictable and inherently uncertain, including estimates of future growth rates and operating margins and assumptions about the overall economic climate and the competitive environment for our business units. There can be no assurance that our estimates and assumptions made for purposes of our goodwill and identifiable intangible asset testing as of the time of testing will prove to be accurate predictions of the future. If our assumptions regarding business projections, competitive environments or anticipated growth rates are not correct, we may be required to record goodwill and/or intangible asset impairment charges in future periods, whether in connection with our next annual impairment testing or earlier, if an indicator of an impairment is present before our next annual evaluation.
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. Most estimated liabilities are not discounted to present value due to the uncertainty as to the timing and duration of expected costs. 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 assuming a discount rate of approximately 3 percent and 4 percent as of June 30, 2016 and 2015, respectively.
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 or carryforward period available under tax law.
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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.
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 use 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 are 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 or liability 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 19, 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.
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Contractual Obligations
At June 30, 2016, we had the following contractual obligations and other commercial commitments and contingencies:
Fiscal Year | ||||||||||||||||||||||||||||
($ in millions) | Total | 2017 | 2018 | 2019 | 2020 | 2021 | Thereafter | |||||||||||||||||||||
Long-term debt (1) | $ | 605.0 | $ | — | $ | 55.0 | $ | — | $ | — | $ | — | $ | 550.0 | ||||||||||||||
Estimated interest payments (2) | 161.6 | 30.2 | 29.5 | 26.4 | 26.4 | 26.4 | 22.7 | |||||||||||||||||||||
Operating leases | 40.3 | 10.2 | 8.6 | 6.1 | 4.9 | 3.8 | 6.7 | |||||||||||||||||||||
Pension plan contributions (3) | 599.7 | 0.7 | 50.5 | 46.0 | 64.2 | 55.2 | 383.1 | |||||||||||||||||||||
Accrued post-retirement benefits (4) | 145.3 | 13.7 | 14.1 | 14.3 | 14.5 | 14.7 | 74.0 | |||||||||||||||||||||
Purchase obligations (5) | 140.2 | 140.2 | — | — | — | — | — | |||||||||||||||||||||
Pension benefits (6) | 34.2 | 3.3 | 3.2 | 3.2 | 3.4 | 3.5 | 17.6 | |||||||||||||||||||||
Total | ||||||||||||||||||||||||||||