Management’s Discussion of Liquidity and Capital Resources

We have maintained the ability to generate cash to meet our needs through cash flow from operations, management of working capital and the flexibility to use outside sources of financing to supplement internally generated funds.

Free cash flow, defined as net cash provided before financing activities but after dividends and excluding the purchases and sales of marketable securities, was $88.4 million in fiscal 2004 versus $80.2 million a year ago. Free cash flow in the current year was after a $25 million voluntary contribution to a VEBA trust that funds post-retirement medical expenses.

Our cash flow from operations was $94.1 million for fiscal 2004 and $92.2 million a year ago. Accounts receivable, after adjusting for the effects of the receivables purchase facility, were $40.5 million higher than a year ago due to the increased level of sales. However, days sales outstanding were reduced to 49 days from 54 days a year ago. Inventories of $185.0 million were $4.3 million higher than a year ago also due to the increased level of sales. Capital expenditures for plant, equipment and software were $8.0 million during fiscal 2004 versus $8.5 million and $26.7 million for fiscal 2003 and 2002, respectively. Included in the prior year cash flow was an $18.3 million tax refund and $8.5 million proceeds on the sale of businesses.

In May 2003, we issued $100 million of 10-year senior unsecured notes with a coupon of 6.625 percent. Proceeds from the sale of the notes were used to redeem approximately $90 million of our 9 percent debentures due 2022. The refinancing eliminated a mandatory sinking fund requirement of $5 million annually between 2004 and 2021. The debentures were callable at a price of 103.82 percent plus accrued interest through the redemption date. The remaining proceeds were used for general corporate purposes. In connection with the early redemption, a special charge of $4.5 million was recorded, including the price paid above par, unamortized discount and debt issuance costs. In addition, we paid $0.9 million in fees associated with the debt issuance.

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In December 2003, we purchased $20 million of previously issued, 6.95 percent Series A Medium Term Notes due June 2005 on the open market. In connection with the early redemption, a special charge of $1.5 million was recorded, including unamortized issue costs associated with these Notes.

In September 2003, we increased the commitments under our unsecured revolving credit facility from $125 million to $150 million. The revolving credit facility, which had an initial term of five years, will expire in November 2006.

Also in September 2003, we decided not to renew our $75 million, 364-day unsecured credit facility. The decision was made in conjunction with the decision to increase our revolving credit.

On September 3, 2002, our lenders and we amended the credit facility. The amendment reduced the minimum coverage under the EBITDA-to-interest covenant for the trailing four quarterly periods ended September 30, 2002, December 31, 2002 and March 31, 2003. Thereafter, the covenant reverted to the original terms under the credit facility.

In addition to the EBITDA-to-interest covenant, we are required to maintain a total debt to total capital ratio below 55 percent. As of June 30, 2004, we are in compliance with all covenants.

At June 30, 2004, we had approximately $2.2 million in outstanding foreign currency loans and $10.8 million of issued letters of credit under the revolving credit facility. The balance of the revolving credit facility ($137 million) was available to us. In addition to this facility, we had $50 million available to us under an Accounts Receivable Purchase Facility.

In December 2001, Carpenter and CRS Funding Corp., a wholly owned consolidated Special Purpose Entity, entered into a $75 million three-year accounts receivable purchase facility (“Purchase Facility”) with an independent financial institution. In March 2003, we reduced this facility to $50 million. As of June 30, 2004, there is no utilization of the facility.

For the years ended June 30, 2004, 2003 and 2002, interest cost totaled $23.8 million, $31.1 million, and $34.9 million, of which $0.1 million, $0.1 million, and $0.3 million, respectively, were capitalized as part of the cost of plant, equipment and software.

A component of our debt refinancing strategy is to maintain a certain level of floating rate debt relative to our fixed rate debt. In order to achieve this targeted level, we use interest rate swaps. These instruments will obligate us to pay a swap counterparty either a floating rate of interest in return for us receiving a fixed rate of interest or obligate us to pay a fixed rate of interest in return for us receiving a floating rate of interest. At June 30, 2004, and 2003, we had entered into interest rate swaps with a notional principal amount of $100 million and $86.0 million, respectively.

Net debt (see page 25 for Carpenter’s definition), defined as total debt net of cash and marketable securities and including amounts outstanding under our Purchase Facility, was reduced to $249.7 million at June 30, 2004 or 31.7 percent of capital. This net debt level was $106.6 million lower than a year ago. Cash and marketable securities at June 30, 2004 was $105.4 million versus $53.5 million a year ago.

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We believe that our current financial resources, both from internal and external sources, will be more than adequate to meet our foreseeable needs. At June 30, 2004, we had approximately $187 million available under our credit facilities.

Non-GAAP Financial Measures

The following tables provide additional information regarding certain non-GAAP financial measures. Our definitions and calculations of these items may not necessarily be the same as those used by other companies.

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 apply excess cash to the repayment of debt when economically feasible.

Net cash provided from operations includes the addition of depreciation and amortization to net income. The level of purchases of property, equipment and software was considerably lower than the level of depreciation and amortization in fiscal years 2002 through 2004, due primarily to the significant level of capital expenditures in fiscal years 1997 through 2001. The current level may not be indicative of future purchase levels.

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Management believes that the presentation of net debt provides useful information to investors regarding our financial condition because accumulated cash is expected to be used for debt repayment until a targeted debt to capital ratio is achieved.

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, restructuring, 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 impacting the preparation of our consolidated financial statements:

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 evaluation on our customers. Should the financial condition of our customers deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.

Inventories are stated at the lower of cost or market. The cost of inventories is determined primarily using the last-in, first-out (LIFO) method. We write down our inventory for estimated obsolescence or unmarketable inventory equal to the difference between our cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. If actual market conditions are less favorable than those projected by management, additional inventory writedowns may be required.

Our prepaid pension asset on the balance sheet is primarily a result of the overfunded status of Carpenter’s General Retirement Plan and the historical recording of pension credits on our consolidated statement of operations. The amount of the pension credit or expense, which is determined annually, is based upon the value of the assets in the pension trust at the beginning of the fiscal year as well as actuarial assumptions, such as discount rate and 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. The plan’s current allocation policy is to have approximately 60 percent U.S. and international equities and 40 percent fixed income. The discount rate for the U.S. plan is determined by reference to Moody’s AA corporate bond index. 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 trust. 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 1 percent, the net pension expense would change by approximately $7.0 million. If the discount rate was changed by 0.25 percent, the net pension expense would change by approximately $1.9 million.

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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 is not amortized, but instead is tested for impairment, at least annually. Potential impairment is identified by comparing the fair value of a reporting unit to its carrying value, including goodwill. The fair value is estimated based upon discounted cash flow analysis and the use of market multiples. 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.

Environmental expenditures that pertain to current operations or to future revenues are expensed or capitalized consistent with Carpenter’s capitalization policy for property, plant and equipment. Expenditures that result from the remediation of an existing condition caused by past operations and that do not contribute to current or future revenues are expensed. Liabilities are recognized for remedial activities when the remediation is probable and the cost can be reasonably estimated. Recoveries of expenditures for environmental remediation are recognized as assets only when recovery is deemed probable. Estimated liabilities are not discounted to present value, but estimated assets are measured on a discounted basis.

Our current risk management strategies include the use of derivative instruments to reduce certain risks. The critical strategies include: (1) the use of commodity options 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 forwards and options 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. These derivatives have been designated as cash flow hedges and unrealized net gains and losses are recorded in the accumulated other comprehensive income (loss) component of stockholders’ equity. We evaluate all derivative instruments each quarter to determine that they are highly effective. Any ineffectiveness is recorded in our consolidated statement of operations. If the anticipated future transactions are no longer expected to occur, unrealized gains and losses on the related hedges would be reclassified to the consolidated statement of operations.

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We have entered into purchase commitments primarily for various key raw materials at market related prices, all made in the normal course of business. The purchase commitments covered by these agreements aggregate approximately $233.2 million, substantially all of which relates to fiscal 2005.

In addition, we had $10.8 million of outstanding letters of credit as of June 30, 2004.

Market Sensitive Instruments and Risk Management

We use derivative financial instruments to reduce certain types of financial risk. Raw material cost fluctuations for our Specialty Metals Segment are normally offset by selling price adjustments, primarily through the use of surcharge mechanisms and base price adjustments. Firm price sales contracts involve a risk of profit margin decline in the event of raw material increases. We reduce this risk on certain raw materials by entering into commodity forward contracts on a portion of our requirements, which are effective hedges of the risk.

We use forwards and options to fix the price of a portion of anticipated future purchases of certain energy to offset the effects of changes in the costs of these commodities.

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

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.

The status of our financial instruments as of June 30, 2004, is provided in note 10 to the consolidated financial statements included in Item 8. “Financial Statements and Supplementary Data”. Assuming on June 30, 2004 (a) an instantaneous 10 percent decrease in the price of raw materials and energy for which we have commodity forward contracts, our

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results of operations would not have been materially affected, (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, (c) a 10 percent increase in our annual interest rate on short-term debt, our results of operations would not have been materially affected, and (d) a 10 percent decrease in the market value of investments in corporate-owned life insurance, our results of operations would not have been materially affected.

Contingencies

Environmental

We are subject to various federal, state, local and foreign 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 our costs of operations, compliance costs to date have not been material. We have environmental remediation liabilities at some of our owned operating facilities and have been designated as a potentially responsible party (“PRP”) with respect to certain third-party Superfund waste disposal sites and other third party owned sites. Additionally, we have been notified that we may be a PRP with respect to other Superfund sites as to which no proceedings have been instituted against us. Neither the exact amount of remediation costs nor the final method of their allocation among all designated PRPs at these Superfund sites have been determined. The liability for future environmental remediation costs is evaluated by management on a quarterly basis. We accrue amounts for environmental remediation costs that represent management’s best estimate of the probable and reasonably estimable costs related to environmental remediation. During fiscal 2004, an additional $0.6 million was accrued related to three of our Superfund sites. During fiscal 2003, an additional $1.75 million was accrued for one of our current operating facilities and for a manufacturing site of a former subsidiary of Talley Industries, Inc. Also related to the former Talley subsidiary site, $2.25 million was established as the fair value of land received as part of the settlement in a bankruptcy proceeding of a claim under an indemnification agreement. This amount was included in other assets on the Consolidated Balance Sheet. The liabilities recorded for environmental remediation costs at Superfund sites, at other third party-owned sites and at Carpenter-owned current or former operating facilities remaining at June 30, 2004, 2003 and 2002, were $6.7 million, $6.8 million and $5.8 million, respectively. The estimated range at June 30, 2004 of the reasonably possible future costs of remediation at Superfund sites, at other third party-owned sites and at Carpenter-owned current or former operating facilities is between $6.7 million and $11.1 million.

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. However, such costs could be material to our financial position, results of operations or cash flows in a particular future quarter or year.

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Other

We are also defending various claims and legal actions, and are subject to contingencies that are common to our operations, including those pertaining to product claims, commercial disputes, employment actions, employee benefits, personal injury claims and tax issues. We provide for costs relating to these matters when a loss is probable and the amount 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, management believes that the total ultimate liability will not have a material effect on our financial position, results of operations or cash flows. However, such costs could be material to our financial position, results of operations or cash flows in a particular future quarter or year.

Future Outlook

We expect to build on the momentum generated in fiscal 2004 by intensifying our efforts in lean and variation reduction. We also expect additional benefits from our strategy to price products and services for the value delivered to our customers and from our initiative to reduce complexity by eliminating less profitable products. We anticipate that our fiscal 2005 operating performance will also benefit from strong demand across our major end-use markets, including aerospace.

In fiscal 2005, we expect that our net pension expense will be reduced to $2.4 million or $.01 per diluted share. This compares to an adjusted full year net pension expense of $16.1 million or $.42 per diluted share in fiscal 2004. The reduction in expense from fiscal 2004 reflects several factors including higher returns on assets in our largest pension plan, an increase in the discount rate to 6.25 percent from 6.0 percent as a result of a higher interest rate environment and the full-year favorable effects of Medicare Part D. Our largest pension plan remains well funded, and as in prior years, we are not required to make a cash contribution to the plan.

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Forward-looking Statements

This Form 10-K contains various “Forward-looking Statements” pursuant to the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. These statements, which represent our expectations or beliefs concerning various future events, include statements concerning future revenues and continued growth in various market segments. These forward-looking statements are subject to risks and uncertainties that could cause actual results to differ from those projected, anticipated or implied. The most significant of these uncertainties are described in this Form 10-K. They include but are not limited to: 1) the cyclical nature of the specialty materials business and certain end-use markets, including aerospace, power generation, automotive, industrial and consumer, all of which are subject to changes in general economic and financial market conditions; 2) our ability to ensure adequate supplies of raw materials and to recoup increased costs of electricity, natural gas, and raw materials, such as nickel, through increased prices and surcharges; 3) domestic and foreign excess manufacturing capacity for certain alloys that we produce; 4) fluctuations in currency exchange rates, resulting in increased competition and downward pricing pressure on certain of our products; 5) the degree of success of government trade actions; 6) fluctuations in capital markets that could impact the valuation of the assets in our pension trusts and the accounting for pension assets; 7) the potential cost advantages that new competitors or competitors who have reorganized through bankruptcy may have; 8) the transfer of manufacturing capacity from the United States to foreign countries; 9) the consolidation of customers and suppliers; and 10) the potential that our customers may substitute alternate materials or adopt different manufacturing practices that replace or limit the suitability of our products. Any of these factors could have an adverse and/or fluctuating effect on our results of operations. The forward-looking statements in this document are intended to be subject to the safe harbor protection provided by Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. We undertake no obligation to update or revise any forward-looking statements.