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. Unless specifically stated otherwise, all discussions of operating results reflect continuing operations.

Carpenter is engaged in the manufacturing, fabrication, and distribution of specialty metals. We primarily process basic raw materials such as nickel, cobalt, titanium, manganese, chromium, molybdenum, iron scrap and other metal alloying elements through various melting, hot forming and cold working facilities to produce finished products in the form of billet, bar, rod, wire and narrow strip in many sizes and finishes. We also produce certain metal powders. Our sales are distributed directly from our production plants and distribution network as well as through independent distributors. Unlike many other specialty steel producers, we operate our own worldwide network of service/distribution centers. These service centers, located in the United States, Canada, Mexico and Europe, allow us to work more closely with customers and to offer various just-in-time stocking programs. As a result, we often serve as a technical partner in customizing specialty metals or in developing new ones.

Business Trends and Strategic Priorities

Selected financial results for the past three fiscal years are summarized below:



                                                                     Fiscal Year
(in millions, except per share data)                       2009         2008         2007
Net sales                                                $ 1,362.3    $ 1,953.5    $ 1,839.0
Net sales excluding surcharges                           $ 1,055.2    $ 1,369.0    $ 1,316.7
Income from continuing operations                        $    47.9    $   200.5    $   215.2
Net income                                               $    47.9    $   277.7    $   227.2
Diluted earnings per share from continuing operations    $    1.08    $    4.12    $    4.09
Diluted earnings per share                               $    1.08    $    5.70    $    4.32
Purchases of property, equipment and software            $   116.3    $   118.9    $    47.1
Free cash flow                                           $    11.2    $   213.4    $   202.3
Pounds sold (in thousands)*                                167,040      223,460      229,072

* includes specialty and titanium alloys, stainless steel and powder materials

Market conditions were challenging throughout the latter half of fiscal year 2009, as the recent economic downturn was broader and more severe than the last downturn that we experienced in 2002-2003. The resulting weak global manufacturing activity affected demand throughout our customer base, including our higher value products, which significantly impacted our results of operations. Despite these prevailing difficult economic conditions, we achieved our financial goal of generating positive free cash flow for fiscal year 2009. We believe this achievement demonstrates our ability to manage effectively through the recent downturn.

In response to the challenges of the economic downturn, we have taken steps to stabilize our operations, including the following:

• Reduced production hours by 30 to 40 percent and eliminated over 300 positions;

• Reduced selling, general and administrative spending;

• Reduced inventory levels; and

• Tightened control over credit and receivables.

At the same time, we continue to take action to create a strong base from which we can quickly respond to increased demand when markets begin to recover. In this respect we have:

• Protected the core capabilities of our workforce;

• Completed the capacity expansion for our premium melt program;

• Invested in new products and research and development;

• Advanced new marketing programs that will grow our customer base; and

• Focused resources on international growth opportunities.

Our commitment to drive growth and operational excellence will yield results as volumes return to more normal levels.

Our sales are across a diversified list of end-use markets. The table below summarizes our estimated sales by market over the past three fiscal years.

                                                   Fiscal Year
          ($ in millions)        2009                 2008                 2007
          Aerospace         $   579.3    42 %    $   744.4    38 %    $   683.1    37 %
          Industrial            326.6    24          465.4    23          476.7    26
          Energy                149.9    11          229.5    12          158.4     9
          Medical               108.7     8          132.1     7          124.2     7
          Consumer              103.4     8          169.0     9          173.6     9
          Automotive             94.4     7          213.1    11          223.0    12

          Total net sales   $ 1,362.3   100 %    $ 1,953.5   100 %    $ 1,839.0   100 %

The table below shows our net sales by major product class for the past three fiscal years:

                                                    Fiscal Year
         ($ in millions)          2009                 2008                 2007
         Special alloys      $   694.6    51 %    $ 1,019.8    53 %    $   902.8    50 %
         Stainless steels        460.1    34          668.1    34          667.4    36
         Titanium products       141.4    10          180.6     9          188.2    10
         Other materials          66.2     5           85.0     4           80.6     4

         Total net sales     $ 1,362.3   100 %    $ 1,953.5   100 %    $ 1,839.0   100 %

Impact of Raw Material Prices and Product Mix

The volatility of the costs of raw materials has impacted our operations over the past several years. We, and others in our industry, generally have been able to pass cost increases on certain materials through to our customers using surcharges that are structured to recover increases in raw material costs. Generally, the formula used to calculate a surcharge is based on published prices of the respective raw materials for the previous month. A portion of our raw material purchases are based on published prices from two months prior, rather than the previous month, which creates a lag between surcharge revenues and corresponding raw material costs recognized in costs of sales. Except for the usually modest effect of the lag, the surcharge mechanism protects our net income on such sales. However, surcharges have had a dilutive effect on our gross margin and operating margin percentages as described later in this discussion.

We value most of our inventory utilizing the last-in, first-out ("LIFO") inventory costing methodology. Under the LIFO inventory costing method, changes in the cost of raw materials and production activities are recognized in cost of sales in the current period even though these materials may have been acquired at potentially significantly different values due to the length of time from the acquisition of the raw materials to the sale of the processed finished goods to the customers. In a period of rising raw material costs, the LIFO inventory valuation normally results in higher costs of sales. Conversely, in a period of decreasing raw material costs, the LIFO inventory valuation normally results in lower costs of sales.

A portion of our business consists of sales to customers under firm price sales arrangements. Firm price sales arrangements involve a risk of profit margin fluctuations particularly when raw material prices are volatile. Firm price sales arrangements generally include certain annual purchasing commitments and consumption schedules agreed to by the customers at selling prices based on raw material prices at the time the arrangements are established. In order to reduce the risk of fluctuating profit margins on these sales, we enter into commodity forward contracts to purchase certain critical raw materials necessary to produce the related products sold. If a customer fails to meet the volume commitments (or the consumption schedule deviates from the agreed upon terms of the firm price sales arrangements), the Company may need to absorb the gains or losses associated with the commodity forward contracts on a temporary basis. Gains or losses associated with commodity forward contracts are reclassified to earnings/loss when earnings are impacted by the hedged transaction. Because we value most of our inventory under the LIFO costing methodology, the gains and/or losses associated with commodity forward contracts may not impact the same period that the firm price sales contracts revenue is recognized and comparisons of gross profit from period to period may be impacted.

We produce hundreds of grades of materials, with a wide range of pricing and profit levels depending on the grade. In addition, our product mix within a period is subject to the fluctuating order patterns of our customers as well as decisions we may make to participate in certain lower margin business in order to utilize available capacity. While we expect to see positive contribution from a more favorable product mix in our margin performance over time, the impact by period may fluctuate, and period-to-period comparisons may vary.

Net Pension Expense (Income)

Net pension expense (income) below includes the net periodic benefit costs
(credits) related to both our pension and postretirement plans. The following is
a summary of the classification of net pension expense (income) included in our
statements of income during fiscal year 2009, 2008 and 2007:



                                                                      Fiscal Year
(in millions)                                                   2009     2008       2007
Cost of sales                                                  $ 12.0   $ (3.7 )    $ 1.5
Selling, general and administrative expenses                      8.6      3.6        3.7
Pension settlement charges included in restructuring charges      4.4       -          -

Total pension expense (income)                                 $ 25.0   $ (0.1 )    $ 5.2

Net pension expense (income) is determined annually, based on beginning of the year balances. Net pension expense (income) increased significantly during fiscal year 2009 principally due to the decline in market value of the securities held by the plans as of June 30, 2008.

Results of Operations - Fiscal Year 2009 Compared to Fiscal Year 2008

For fiscal year 2009, we reported income from continuing operations of $47.9 million, or $1.08 per diluted share, compared with income from continuing operations of $200.5 million, or $4.12 per diluted share, a year earlier. Continued weak global manufacturing activity affected demand throughout our customer base, and especially in our higher margin markets of energy and aerospace.

Net Sales

Net sales for fiscal year 2009 were $1,362.3 million, which was a 30 percent decrease from fiscal year 2008. Excluding surcharge revenues, sales were 23 percent lower than a year earlier.

Geographically, sales outside the United States decreased 27 percent from a year ago to $477.0 million. International sales remained fairly consistent as a percentage of our total net sales, representing 35 percent and 34 percent for fiscal year 2009 and fiscal year 2008, respectively.

Sales by End-Use Markets

Our sales are to customers across diversified end-use markets. During fiscal year 2009, we changed the manner in which sales are classified by end-use market so that we could better evaluate our sales results from period to period. In order to make the discussion of net sales by end-use market meaningful, we have reclassified the fiscal year 2008 sales by end-use market balances to conform to the fiscal year 2009 presentation. The following table includes comparative information for our estimated net sales by principal end-use markets:

                                   Fiscal Year            $             %
            ($ in millions)     2009        2008      Decrease       Decrease
            Aerospace         $   579.3   $   744.4   $  (165.1 )         (22 )%
            Industrial            326.6       465.4      (138.8 )         (30 )
            Energy                149.9       229.5       (79.6 )         (35 )
            Medical               108.7       132.1       (23.4 )         (18 )
            Consumer              103.4       169.0       (65.6 )         (39 )
            Automotive             94.4       213.1      (118.7 )         (56 )

            Total net sales   $ 1,362.3   $ 1,953.5   $  (591.2 )         (30 )%

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

                                                      Fiscal Year              $              %
($ in millions)                                    2009         2008       Decrease        Decrease
Aerospace                                        $   446.8    $   520.5    $   (73.7 )          (14 )%
Industrial                                           242.1        306.1        (64.0 )          (21 )
Energy                                               124.9        171.4        (46.5 )          (27 )
Medical                                               91.1        109.7        (18.6 )          (17 )
Consumer                                              77.9        113.1        (35.2 )          (31 )
Automotive                                            72.4        146.9        (74.5 )          (51 )

Total net sales excluding surcharge revenues     $ 1,055.2    $ 1,367.7    $  (312.5 )          (23 )%

Sales to the aerospace market decreased 22 percent from fiscal year 2008 to $579.3 million. Excluding surcharge revenue, such sales decreased 14 percent on 13 percent lower shipment volume. The sales decline reflects the continued impact of a reduction in airplane build schedules and lower overall passenger miles. Excess inventory in jet engines and fasteners also contributed to the lower volumes in fiscal year 2009.

Industrial market sales decreased 30 percent from fiscal year 2008 to $326.6 million. Adjusted for surcharge revenue, such sales decreased approximately 21 percent as a result of a 24 percent decrease in shipment volume. The results reflect competitive pricing pressures in more commodity-oriented applications and reduced overall demand for materials used in valves, fittings, fasteners, and general industrial applications as customers are purchasing limited quantities on an as-needed basis.

Sales to the energy market of $149.9 million reflected a 35 percent decrease from the fiscal year 2008. Excluding surcharge revenue, such sales decreased 27 percent from a year ago on lower shipment volume of 37 percent. The decline in energy sales and shipment volumes principally reflected lower oil and gas exploration activity in the face of weak demand for oil. Declining market demand and high customer inventory have also reduced shipments and sales levels to the power generation sector.

Sales to the medical market decreased 18 percent to $108.7 million from a year ago. Adjusted for surcharge revenue, such sales decreased 17 percent, while volumes increased 4 percent. The strong shipment volume reflects higher demand in orthopedic implant and medical instrument applications, while the revenue decline reflects the impact of lower titanium costs and a leaner mix of products. Demand is driven primarily by steady increases in the number of implant procedures in the U.S., Japan and the EU.

Sales to the consumer market decreased 39 percent to $103.4 million from a year ago. Adjusted for surcharge revenue, such sales decreased 31 percent with shipment volume lower by 25 percent. The decline reflects lower sales across all sectors, led by housing and electronics as customers and distributors attempt to conserve cash in light of credit availability concerns.

Automotive market sales decreased 56 percent from the fiscal year 2008 to $94.4 million. Excluding surcharge revenue, such sales decreased 51 percent on 46 percent lower shipment volume. Sharply lower consumer spending and tighter credit continued to suppress auto sales, resulting in the further deterioration in production rates. Lower inventory levels in the supply chain reflect customers with demand focused on spot purchases of material with short lead times.

Sales by Product Class

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



                                    Fiscal Year            $             %
           ($ in millions)       2009        2008      Decrease       Decrease
           Special alloys      $   694.6   $ 1,019.8   $  (325.2 )         (32 )%
           Stainless steels        460.1       668.1      (208.0 )         (31 )
           Titanium products       141.4       180.6       (39.2 )         (22 )
           Other materials          66.2        85.0       (18.8 )         (22 )

           Total net sales     $ 1,362.3   $ 1,953.5   $  (591.2 )         (30 )%

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

                                                      Fiscal Year              $              %
($ in millions)                                    2009         2008       Decrease        Decrease
Special alloys                                   $   499.2    $   647.1    $  (147.9 )          (23 )%
Stainless steels                                     349.8        458.4       (108.6 )          (24 )
Titanium products                                    141.4        180.6        (39.2 )          (22 )
Other materials                                       64.8         81.6        (16.8 )          (21 )

Total net sales excluding surcharge revenues     $ 1,055.2    $ 1,367.7    $  (312.5 )          (23 )%

Sales of special alloys products decreased 32 percent in fiscal year 2009 as compared with a year ago to $694.6 million. The sales decrease principally reflects the decline in demand from the aerospace and energy markets.

Sales of stainless steels decreased 31 percent as compared with a year ago. Excluding surcharge revenues, such sales decreased by 24 percent on 28 percent lower shipment volume. The decrease resulted primarily from reduced shipments of materials used in the automotive, industrial and consumer markets

Sales of titanium products decreased 22 percent as compared with a year ago on 10 percent lower shipment volume. The results reflect the impact of significantly lower titanium prices and decreased demand for titanium products used in the aerospace end-use market, which was partially offset by an increase in demand in the medical end-use market.

Gross Profit

Gross profit in fiscal year 2009 decreased to $207.2 million, or 15.2 percent of net sales (19.6 percent of net sales excluding surcharges), from $457.2 million, or 23.4 percent of net sales (33.4 percent of net sales excluding surcharges), a year ago. The results primarily reflected the reduced demand levels and related manufacturing inefficiencies associated with the lower volume.

Our surcharge mechanism is structured to recover increases in raw material costs, although generally with a lag effect. While the surcharge generally protects the absolute gross profit dollars, it does have a dilutive effect on gross margin as a percent of sales. The following represents a summary of the dilutive impact of the surcharges on gross margin for fiscal years 2009 and 2008:

                                                                Fiscal Year
   (in millions)                                            2009           2008
   Net sales                                              $ 1,362.3      $ 1,953.5
   Less: surcharge revenues                                   307.1          585.8

   Net sales excluding surcharges                         $ 1,055.2      $ 1,367.7

   Gross profit                                           $   207.2      $   457.2

   Gross margin                                                15.2 %         23.4 %

   Gross margin excluding dilutive effect of surcharges        19.6 %         33.4 %

In addition to the impact of the surcharge mechanism, fluctuations in raw material prices (combined with fluctuations in inventory levels) have impacted our gross profit from year to year. We estimate that the effect of such combined fluctuations negatively impacted gross margin by 50 basis points when comparing gross margin for fiscal year 2009 with the prior year. We estimate that the lag effect of the surcharge mechanism positively impacted gross margin by approximately 100 basis points during fiscal year 2009, compared to a positive impact on gross margin of approximately 40 basis points during fiscal year 2008.

Selling, General and Administrative Expenses

Selling, general and administrative expenses in fiscal year 2009 were $133.8 million, or 9.8 percent of net sales (12.7 of net sales excluding surcharges), compared to $163.6 million, or 8.4 percent of net sales (12.0 percent of net sales excluding surcharges), in fiscal year 2008. Excluding the impact of changes in net pension expense discussed above, expenses improved by 22 percent over fiscal year 2008. The reduction reflects the $21.0 million charge for a legal matter that was recorded in the fourth quarter of fiscal year 2008 in addition to reductions in variable compensation and actions taken to reduce headcount and spending across the business.

Restructuring Charges

During fiscal year 2009, we recorded $9.4 million of restructuring charges associated with the closure of our metal strip manufacturing facility in the United Kingdom ("UK"). The closure is expected to reduce our fixed costs and to utilize existing production capacity more efficiently. The charges recorded consisted principally of pension settlement charges from the elimination of a U.K. defined benefit pension plan, certain asset write-downs, payments of employee severance costs and other exit costs.

Interest Expense

Fiscal year 2009 interest expense of $16.1 million decreased 22 percent from $20.5 million in fiscal 2008. Interest on substantially all of our debt was at a fixed rate. The decrease in interest expense is attributable to the reductions in outstanding debt related to current year repayments, as well as a $1.7 million increase in the amount of interest capitalized associated with ongoing construction projects during fiscal year 2009 as compared with fiscal year 2008.

Other Income, Net

Other income for fiscal year 2009 was $15.1 million as compared with $24.2 million a year ago. The decrease principally reflected lower returns on invested cash balances which were partially offset by the favorable impacts of foreign exchange in fiscal year 2009 as compared with fiscal year 2008.

Income Taxes

Our effective tax rate (income tax expense as a percent of income before taxes) for fiscal year 2009 was 24.0 percent as compared to 32.6 percent in fiscal year 2008. The fiscal year 2009 tax rate was more favorable than the statutory rate of 35 percent, primarily due to the following items. We recorded a reduction in income tax expense in the amount of $3.5 million or 5.6 percent of pre-tax income related to research and development tax credits. In addition, there was a reduction in income tax expense in the amount of $3.3 million or 5.2 percent which was primarily due to the reversal of certain unrecognized tax benefits due to the lapse of certain statutes of limitations. These items were partially offset by an increase in tax expense in the amount of $4.6 million or 7.4 percent related to additional valuation allowance on deferred tax assets for state net operating losses. Our lower taxable income level generated a more significant impact on the effective tax rate for these items.

The fiscal year 2008 tax rate was also more favorable than the statutory rate of 35 percent, primarily due to the following items. We recorded a reduction in income tax expense of $2.3 million, or 0.8 percent of pretax income, reflecting the reversal of valuation allowances that had been recorded against state net operating loss carryforwards in prior years. Under Statement of Financial Accounting Standards No. 109, valuation allowances should be reviewed each year and an assessment must be made as to the likelihood of recovery of those deferred taxes. Based on the then-current year and forecasted taxable income in certain jurisdictions, we determined that it was appropriate to reverse a portion of this valuation allowance in fiscal year 2008. We recognized a benefit of $5.7 million, or 1.9 percent of pretax income, in connection with the domestic manufacturing deduction, which was part of the American Jobs Creation Act of 2004 allowing a special deduction for qualified manufacturing activities. The Act also provided for a two-year phase-out of the existing extraterritorial income exclusion deduction. As a result, we recognized an increase in income tax expense year over year, reflecting the phase-out of the deduction in 2007, and the repeal in 2008.

See Note 20 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 22 to the consolidated financial statements included in Item 8. - "Financial Statements and Supplementary Data."

Advanced Metals Operations ("AMO") Segment

Net sales in fiscal year 2009 for the AMO segment were $957.4 million, as compared with $1,390.7 million in fiscal year 2008. Excluding surcharge revenues, sales decreased 24 percent from a year ago. The fiscal year 2009 net sales reflected a reduction in pounds shipped of 26 percent as compared to fiscal year 2008. Both the sales and shipment volume decreases primarily reflect lower demand in the automotive, industrial and consumer markets.

Operating income for the AMO segment in fiscal year 2009 was $34.1 million, or 3.6 percent of net sales (4.5 percent of net sales excluding surcharge revenues), compared to $188.7 million, or 13.6 percent of net sales (19.0 . . .