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Management's Discussion of Results of Operations (Excerpts)

For purposes of readability, Zenith attempts to strip out all tables in excerpts from the Management Discussion. That information is contained elsewhere in our articles. The idea of this summary is simply to review how well we believe Management does its reporting. Also, this highlights what Management believes is important.

In our Decision Matrix at the end of each article, a company with 0 to 2 gets a "-1", and 3 to 5 gets a "+1."

On a scale of 0 to 5, 5 being best, Zenith rates this company's Management's Discussion as a 5.


Background and General

We are engaged in the manufacturing, fabrication and distribution of specialty 
metals. We primarily process basic raw materials such as nickel, cobalt, 
titanium, manganese, chromium, molybdenum, iron scrap and other metal alloying 
elements through various melting, hot forming and cold working facilities to 
produce finished products in the form of billet, bar, rod, wire and narrow 
strip in many sizes and finishes. We also produce certain metal powders. Our 
sales are distributed directly from our production plants and distribution 
network as well as through independent distributors. Unlike many other 
specialty steel producers, we operate our own worldwide network of service 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.

Our discussions below in this Item 2 are based upon the more detailed 
discussions about our business, operations and financial condition included in 
Item 7 of our 2017 Form 10-K. Our discussions here focus on our results during 
or as of the three-month period ended September 30, 2017 and the comparable 
periods of fiscal year 2017, and to the extent applicable, on material changes 
from information discussed in the 2017 Form 10-K and other important 
intervening developments or information that we have reported on Form 8-K. 
These discussions should be read in conjunction with the 2017 Form 10-K for 
detailed background information and with any such intervening Form 8-K.

Impact of Raw Material Prices and Product Mix

We value most of our inventory utilizing the last-in, first-out (“LIFO”) 
inventory costing method. 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 potentially have 
been acquired at 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 30 percent of our net sales are sales to customers under firm 
price sales arrangements. Firm price sales arrangements involve a risk of 
profit margin fluctuations, particularly when raw material prices are volatile. 
In order to reduce the risk of fluctuating profit margins on these sales, we 
enter into commodity forward contracts to purchase certain critical raw 
materials necessary to produce the related products sold. Firm price sales 
arrangements generally include certain annual purchasing commitments and 
consumption schedules agreed to by the customers at selling prices based on raw 
material prices at the time the arrangements are established. If a customer 
fails to meet the volume commitments (or the consumption schedule deviates from 
the agreed-upon terms of the firm price sales arrangements), the Company may 
need to absorb the gains or losses associated with the commodity forward 
contracts on a temporary basis. Gains or losses associated with commodity 
forward contracts are reclassified to earnings/loss when earnings are impacted 
by the hedged transaction. Because we value most of our inventory under the 
LIFO costing methodology, changes in the cost of raw materials and production 
activities are recognized in cost of sales in the current period attempting to 
match the most recently incurred costs with revenues. Gains or losses on the 
commodity forward contracts are reclassified from other comprehensive income 
(loss) 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. We currently expect that the total net 
periodic benefit costs for fiscal year 2018 will be $14.0 million as compared 
with $48.2 million in fiscal year 2017.

In September 2016, we announced changes to retirement plans we offer to certain 
employees. The decision was consistent with addressing costs and actively 
managing the business. Benefits accrued to eligible participants of our largest 
qualified defined benefit pension plan and certain non-qualified pension plans 
were frozen effective December 31, 2016. Approximately 1,900 affected employees 
were transitioned to the Company’s 401(k) plan that has been in effect for 
eligible employees since 2012, when the pension plan was closed to new 
entrants. We recognized the plan freeze in the three months ended September 30, 
2016 as a curtailment, since it eliminated the accrual for a significant number 
of participants for all of their future services. We also made a voluntary 
pension contribution of $100.0 million to the affected plan in October 2016.

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.

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 three months ended September 30, 2017 and 2016:


Operating Performance Overview

The first quarter of fiscal year 2018 was our best first quarter in four years 
as continued execution of our commercial and manufacturing strategies and 
improving market conditions drove solid operational performance. Our 
solutions-focused approach is helping drive a stronger product mix. We are 
continuing to generate cost savings driven by the organization-wide 
implementation of the Carpenter Operating Model. In addition, the conditions 
across most of our end-use markets are continuing to improve, including in the 
Aerospace and Defense end-use market where engine demand remains strong as the 
new platform ramp continues and we are also benefiting from our broad 
participation in other attractive Aerospace sub-markets.

Results of Operations — Three Months Ended September 30, 2017 vs. Three Months 
Ended September 30, 2016

For the three months ended September 30, 2017, we reported net income of $23.4 
million, or $0.49 earnings per diluted share. This compares with net loss for 
the same period a year earlier of $6.2 million, or $0.13 loss per diluted 
share. Excluding special items, earnings per share would have been $0.08 loss 
per diluted share for the three months ended September 30, 2016. The current 
period results reflect the impact of higher sales and improved product mix 
across most of our end-use markets and lower operating costs through the 
ongoing implementation of the Carpenter Operating Model.

Net Sales

Net sales for the three months ended September 30, 2017 were $479.8 million, 
which was a 23 percent increase over the same period a year ago. Excluding 
surcharge revenue, sales increased 21 percent on a 17 percent increase in 
shipment volume from the same period a year ago. The results primarily reflect 
the impact of stronger demand for materials primarily used in the Aerospace and 
Defense, Industrial and Consumer and Medical end-use markets.

Geographically, sales outside the United States increased 32 percent from the 
same period a year ago to $159.9 million for the three months ended September 
30, 2017. The increase is primarily due to net sales to Europe in the Aerospace 
and Defense and Medical end-use markets, Asia Pacific in the Aerospace and 
Defense end-use market and Canada in the Energy end-use market. 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 $1.1 
million increase in sales during the three months ended September 30, 2017 
compared to the three months ended September 30, 2016. International sales 
represented 33 percent and 31 percent of total net sales for the three months 
ended September 30, 2017 and 2016, 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:

Sales to the Aerospace and Defense end-use market increased 25 percent from the 
first quarter a year ago to $258.6 million. Excluding surcharge revenue, sales 
increased 24 percent from the first quarter a year ago on a 25 percent increase 
in shipment volume. The results reflect the impact of stronger demand for 
materials used in aerospace engines and an increase in sales of structural and 
defense applications driven by specific programs.

Sales to the Energy end-use market of $32.0 million reflect a 13 percent 
increase from the first quarter a year ago. Excluding surcharge revenue, sales 
increased 12 percent from a year ago on 43 percent higher shipment volume. The 
results reflect increased rental activity demand keeping pace with slow oil and 
gas market expansion partially offset by weaker demand for materials used in 
power generation applications.

Transportation end-use market sales increased 4 percent from the first quarter 
a year ago to $36.7 million. Excluding surcharge revenue, sales were flat on 6 
percent lower shipment volume from the first quarter a year ago. The results 
reflect the impact of improved demand as a result of heavy duty truck 
production offset by continued softness in North American passenger car 
production.

Medical end-use market sales increased 56 percent from the first quarter a year 
ago to $38.3 million. Excluding surcharge revenue, sales increased 45 percent 
on 22 percent higher shipment volume from the first quarter a year ago. The 
results reflect improved market positioning and the positive impact of supply 
chain inventory rebuilding within orthopedic and cardiology sub-markets.

Industrial and Consumer end-use market sales increased 27 percent from the 
first quarter a year ago to $84.4 million. Excluding surcharge revenue, sales 
increased 21 percent on an 11 percent increase in shipment volume. The results 
reflect the impact of stronger demand for consumer electronic applications and 
an increase in industrial components due in part to a moderate increase in 
recovery of oil and gas activity partially offset by weaker demand for sporting 
goods applications.

Gross Profit

Our gross profit in the first quarter increased 86 percent to $85.6 million, or 
17.8 percent of net sales as compared with $46.0 million, or 11.8 percent of 
net sales in the same quarter a year ago. Excluding the impact of surcharge 
revenue, our gross margin in the first quarter was 20.9 percent as compared to 
13.5 percent in the same period a year ago. The current quarter results reflect 
higher sales and improved product mix across most end-use markets and operating 
cost efficiencies compared to the same period a year ago.

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 the comparative three month period. See the section “Non-GAAP Financial 
Measures” below for further discussion of these financial measures.

Selling, General and Administrative Expenses

Selling, general and administrative expenses of $43.9 million were 9.1 percent 
of net sales (10.7 percent of net sales excluding surcharge) as compared with 
$44.6 million and 11.5 percent of net sales (13.1 percent of net sales 
excluding surcharge) in the same quarter a year ago.

Operating Income

Our operating income in the recent first quarter was $41.7 million or 8.7 
percent of net sales as compared with $1.4 million or 0.4 percent of net sales 
in the same quarter a year ago. Excluding surcharge revenue, pension EID and 
special items, operating margin was 10.3 percent for the most recent quarter as 
compared with 2.6 percent a year ago. The increase in our operating margin for 
the first quarter of fiscal year 2018 reflects the impacts of higher sales and 
improved product mix across most end-use markets combined with operating cost 
efficiencies 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 special 
items. The following presents our operating income and operating margin, in 
each case excluding the impact of surcharge revenue on net sales and other 
special items. We present and discuss these financial measures because 
management believes removing these items provides a more consistent and 
meaningful basis for comparing ongoing results of operations from period to 
period. See the section “Non-GAAP Financial Measures” below for further 
discussion of these financial measures.


Interest Expense

Interest expense for the three months ended September 30, 2017 was $7.2 million 
compared with $7.3 million in the same period a year ago. We have used interest 
rate swaps to achieve a level of floating rate debt to fixed rate debt where 
appropriate. Interest expense for the three months ended September 30, 2017 
includes net gains from interest rate swaps of $0.2 million compared with $0.4 
million of net gains from interest rate swaps for the three months ended 
September 30, 2016. Capitalized interest reduced interest expense by $0.5 
million for the three months ended September 30, 2017 and $0.2 million for the 
three months ended September 30, 2016.

Other Income, Net

Other income for the three months ended September 30, 2017 was $0.7 million as 
compared with other income of $0.6 million for the three months ended September 
30, 2016.

Income Taxes

Income tax expense in the recent first quarter was $11.8 million, or 33.5 
percent of pre-tax income compared with $0.9 million, or 17.0 percent of 
pre-tax loss in the same quarter a year ago.

In October 2016, the Company made a voluntary pension contribution of $100.0 
million that was announced in connection with the plan freeze. As a result of 
the planned pension contribution, income tax expense in the three months ended 
September 30, 2016 included a discrete tax charge of $2.1 million due to 
reduced tax benefits for domestic manufacturing claimed in prior periods.

Business Segment Results

We have two reportable business segments: SAO and PEP.


Three Months Ended Specialty Alloys Operations Segment

Net sales for the quarter ended September 30, 2017 for the SAO segment 
increased 26 percent to $396.8 million, as compared with $315.1 million in the 
same quarter a year ago. Excluding surcharge revenue, net sales increased 22 
percent on 17 percent higher shipment volume from a year ago. The results 
reflect the impact of higher demand driven by improving market conditions 
across most of our end-use markets compared to the prior year quarter.

Operating income for the SAO segment was $50.5 million or 12.7 percent of net 
sales (15.5 percent of net sales excluding surcharge revenue) in the recent 
first quarter, as compared with $25.0 million or 7.9 percent of net sales (9.4 
percent of net sales excluding surcharge revenue) in the same quarter a year 
ago. The increase in operating income reflects higher volume combined with 
continued operating cost improvements driven by the implementation of the 
Carpenter Operating Model compared to the prior year quarter.

Performance Engineered Products Segment

Net sales for the quarter ended September 30, 2017 for the PEP segment 
increased 28 percent to $100.7 million, as compared with $78.5 million in the 
same quarter a year ago. Excluding surcharge revenue, net sales of $100.5 
million increased 28 percent from a year ago. The results reflect an increase 
in sales primarily in the Energy and Medical end-use markets.

Operating income for the PEP segment was $5.3 million or 5.3 percent of net 
sales in the recent first quarter, compared with operating loss of $2.8 million 
or 3.6 percent of net sales in the same quarter a year ago. The results reflect 
the increasing demand for titanium products combined with ongoing improvements 
in our oil and gas businesses and cost reduction initiatives.

Liquidity and Financial Resources

During the three months ended September 30, 2017, we used cash from operating 
activities of $7.4 million compared to cash provided from operating activities 
of $4.1 million in the same period a year ago. Our free cash flow, which we 
define under “Non-GAAP Financial Measures” below, was negative $44.9 million as 
compared to negative $31.0 million for the same period a year ago. The decrease 
in cash from operating activities and free cash flow reflects higher working 
capital levels, principally increased inventory, to support improving demand 
conditions.

Capital expenditures for property, equipment and software were $28.9 million 
for the three months ended September 30, 2017 as compared to $26.6 million for 
the same period a year ago. In fiscal year 2018, we expect capital expenditures 
to be approximately $120 million.

Dividends during the three months ended September 30, 2017 and 2016 were $8.6 
million and $8.5 million, respectively, and were paid at the same quarterly 
rate of $0.18 per share of common stock in both periods.

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 of $150 million, consisting of cash and cash 
equivalents added to available borrowing capacity under our Credit Agreement. 
Our Credit Agreement contains a revolving credit commitment of $400.0 million, 
which expires in March 2022. As of September 30, 2017, we had $6.1 million of 
issued letters of credit and $3.3 million of borrowings under the Credit 
Agreement. The balance of the Credit Agreement ($390.6 million) remains 
available to us. As of September 30, 2017, we had total liquidity of $415.5 
million, including $24.9 million of cash and cash equivalents. From time to 
time during the three months ended September 30, 2017 we have borrowed under 
our Credit Agreement. The weighted average daily borrowing under the Credit 
Agreement during the three months ended September 30, 2017 was approximately 
$5.9 million with daily outstanding borrowings ranging from $0.0 million to 
$29.4 million during the period.

We believe that our cash and cash equivalents of $24.9 million as of September 
30, 2017 and available borrowing capacity of $390.6 million under our credit 
facilities will be sufficient to fund our cash needs over the foreseeable 
future.

During the three months ended September 30, 2017, we made pension contributions 
of $4.2 million to our qualified defined benefit pension plans. We currently 
expect to make approximately $2.6 million of contributions to our qualified 
defined benefit pension plans during the remainder of fiscal year 2018.

As of September 30, 2017, we had cash and cash equivalents of approximately 
$23.1 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 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 September 30, 2017). 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%. 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 September 
30, 2017, the Company was in compliance with all of the covenants of the Credit 
Agreement.

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

This report includes discussions of net sales as adjusted to exclude the impact 
of raw material surcharge and the resulting impact on gross margins, which 
represent financial measures that have not been determined in accordance with 
accounting principles generally accepted in the United States of America (“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. 
Management uses its results excluding these amounts to evaluate its operating 
performance and to discuss its business with investment institutions, our Board 
of Directors and others. See our earlier discussion of “Gross Profit” for a 
reconciliation of net sales and gross margin, excluding surcharge revenue to 
net sales as determined in accordance with U.S. GAAP. Net sales and gross 
margin excluding surcharge revenue 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 
and 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 EID and 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. 
Management uses its results excluding these amounts to evaluate its operating 
performance and to discuss its business with investment institutions, our Board 
of Directors and others. See our earlier discussion of operating income for a 
reconciliation of operating income and operating margin excluding pension EID 
and 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 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

Management believes that the presentation of earnings per share adjusted to 
exclude the special items is helpful in analyzing the operating performance of 
the Company, as these items are not indicative of ongoing operating 
performance. Our definitions and calculations of these items may not 
necessarily be the same as those used by other companies. Management uses its 
results excluding these amounts to evaluate its operating performance and to 
discuss its business with investment institutions, our Board of Directors and 
others. 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

Management believes that the presentation of free cash flow provides useful 
information to investors regarding our financial condition because it is a 
measure of cash generated which management evaluates for alternative uses. It 
is management’s current intention to use excess cash to fund investments in 
capital equipment, acquisition opportunities and consistent dividend payments. 
Free cash flow is not a U.S. GAAP financial measure and should not be 
considered in isolation of, or as a substitute for, cash flows calculated in 
accordance with U.S. GAAP.

Contingencies

Environmental

We are subject to various federal, state, local and international environmental 
laws and regulations relating to pollution, protection of public health and the 
environment, natural resource damages and occupational safety and health. 
Although compliance with these laws and regulations may affect the costs of our 
operations, compliance costs to date have not been material. We have 
environmental remediation liabilities at some of our owned operating facilities 
and have been designated as a PRP with respect to certain third party Superfund 
waste-disposal sites and other third party-owned sites. We accrue amounts for 
environmental remediation costs that represent our best estimate of the 
probable and reasonably estimable future costs related to environmental 
remediation. During the three months ended September 30, 2017, no additional 
accruals were recorded. The liabilities recorded for environmental remediation 
costs at Superfund sites, other third party-owned sites and Carpenter-owned 
current or former operating facilities remaining at September 30, 2017 and June 
30, 2017 were $16.1 million and $16.1 million, respectively. Additionally, we 
have been notified that we may be a PRP with respect to other Superfund sites 
as to which no proceedings have been instituted against us. Neither the exact 
amount of remediation costs nor the final method of their allocation among all 
designated PRPs at these Superfund sites have been determined. Accordingly, at 
this time, we cannot reasonably estimate expected costs for such matters. The 
liability for future environmental remediation costs that can be reasonably 
estimated is evaluated on a quarterly basis.

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 PRPs. Based upon information 
currently available, such future costs are not expected to have a material 
effect on our financial position, results of operations or cash flows over the 
long-term. However, such costs could be material to our financial position, 
results of operations or cash flows in a particular future quarter or year.

Other

We are defending various routine claims and legal actions that are incidental 
to our business, and that are common to our operations, including those 
pertaining to product claims, commercial disputes, patent infringement, 
employment actions, employee benefits, compliance with domestic and foreign 
laws, personal injury claims and tax issues. Like many other manufacturing 
companies in recent years we, from time to time, have been named as a defendant 
in lawsuits alleging personal injury as a result of exposure to chemicals and 
substances in the workplace such as asbestos. We provide for costs relating to 
these matters when a loss is probable and the amount of the loss is reasonably 
estimable. The effect of the outcome of these matters on our future results of 
operations and liquidity cannot be predicted because any such effect depends on 
future results of operations and the amount and timing (both as to recording 
future charges to operations and cash expenditures) of the resolution of such 
matters. While it is not feasible to determine the outcome of these matters, we 
believe that the total liability from these matters will not have a material 
effect on our financial position, results of operations or cash flows over the 
long-term. However, there can be no assurance that an increase in the scope of 
pending matters or that any future lawsuits, claims, proceedings or 
investigations will not be material to our financial position, results of 
operations or cash flows in a particular future quarter or year.

Critical Accounting Policies and Estimates

A summary of other significant accounting policies is discussed in our 2017 
Form 10-K Item 7. “Management’s Discussion and Analysis of Financial Condition 
and Results of Operations”, and in Note 1, Summary of Significant Accounting 
Policies, of the Notes to our consolidated financial statements included in 
Part II, Item 8 thereto.

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.

As of June 30, 2017, we had four reporting units with goodwill recorded. 
Goodwill associated with our SAO reporting unit is tested at the SAO segment 
level and represents approximately 75 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, 2017, the fair value of the SAO exceeded the carrying value by 
approximately 20 percent. The goodwill recorded related to the SAO as of June 
30, 2017 was $195.5 million. The discounted cash flows analysis for the SAO 
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 SAO’s fair value, we used a weighted average cost capital of 10 
percent 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.


Quantitative and Qualitative Disclosures about Market Risk

We use derivative financial instruments to reduce certain types of financial 
risk. Firm price sales arrangements involve a risk of profit margin 
fluctuations particularly as raw material prices have been volatile. As 
discussed in Note 10 to the consolidated financial statements included in Part 
I, Item 1 of this Quarterly Report on Form 10-Q, “Financial Statements”, 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 products sold under the firm price sales arrangements. 
If a customer fails to perform its obligations under the firm price sales 
arrangements, we may realize losses as a result of the related commodity 
forward contracts.

We are actively involved in managing risks associated with energy resources. 
Risk containment strategies include interaction with primary and secondary 
energy suppliers as well as obtaining adequate insurance coverage to compensate 
us for potential business interruption related to lack of availability of 
energy resources. In addition, we have used forwards and options to fix the 
price of a portion of our anticipated future purchases of certain energy 
requirements to protect against the impact of significant increases in energy 
costs. We also use surcharge mechanisms to offset a portion of these charges 
where appropriate.

Fluctuations in foreign currency exchange rates could subject us to risk of 
losses on anticipated future cash flows from our international operations or 
customers. Foreign currency forward contracts are used to hedge certain foreign 
exchange risks.

We use interest rate swaps to achieve a level of floating rate debt relative to 
fixed rate debt where appropriate. Historically, we have entered into forward 
interest rate swap contracts to manage the risk of cash flow variability 
associated with fixed interest debt expected to be issued.

All hedging strategies are reviewed and approved by senior financial management 
before being implemented. Senior financial management has established policies 
regarding the use of derivative instruments that prohibit the use of 
speculative or leveraged derivatives. Market valuations are performed at least 
quarterly to monitor the effectiveness of our risk management programs.

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.

The status of our financial instruments as of September 30, 2017 is provided in 
Note 10 to the consolidated financial statements included in Part I, Item 1, 
“Financial Statements” of this Quarterly Report on Form 10-Q. Assuming either 
of the following occurred on September 30, 2017, (a) an instantaneous 10 
percent decrease in the price of raw materials and energy for which we have 
commodity forward contracts, or (b) a 10 percent strengthening of the U.S. 
dollar versus foreign currencies for which foreign exchange forward contracts 
existed, our results of operations would not have been materially affected in 
either scenario.