ESCO Technologies Inc (ESE) 2004 Q3 法說會逐字稿

Welcome to the ESCO third-quarter conference call. Today's call is being recorded. With us today are Vic Ritchie, Chairman and CEO; Chuck Kretschmer, President and COO; and Gary Muenster, Vice President and CFO. And now to present the forward-looking statement and for introductions I would like to turn the call over to Ms. Pat Moore, Director Investor Relations.

Good morning, everyone. Statements made during this call regarding the results and timing of real estate sales; the level of contribution from each segment; the success and timing of technology integration efforts; the ability to differentiate the Company and the AMR markets; future fiscal 2004 revenues, EBIT, EPS and earnings; long-term success of the Company; and other statements which are not strictly historical are forward-looking statements within the meaning of the Safe Harbor provisions of the federal securities laws.

Investors are cautioned that such statements are only predictions and speak only as of the date of this call. The Company's actual results in the future may differ materially from those projected in the forward-looking statements due to risks and uncertainties that exist in the Company's operations and business environment including, but not limited to, the risk factors referenced in the Company's press release issued today which as an exhibit to the Company's Form 8-K filed today. The Company disclaims any intent or obligation to update these forward-looking statements.

In addition, during this call the Company may discuss some non-GAAP financial measures in describing the Company's operating results. A reconciliation of these measures to their most comparable GAAP measures can be found in the above-mentioned Form 8-K and accompanying press release on the Company's website at ESCOTechnologies.com under the links "Investor Relations", "financial reports" and "SEC filings". I'll now turn the call over to Vic Ritchie.

Good morning and welcome to our third-quarter conference call. As I indicated in our release, I'm very pleased with our third-quarter results both financially where we posted record earnings and operationally (indiscernible) largely completed our repositioning activities with the sale of the Microsep businesses and had a successful startup of our filtration manufacturing in Juarez. All of our segments contributed to a solid third quarter. I will comment further before we close the call, but first Gary Muenster, our CFO, will provide some commentary on the third-quarter financials. Gary?

Thanks, Vic. Good morning, as noted in the release, our operating results were very strong and the quarter. Sales increased approximately 19 percent over prior year with all 3 segments contributing to the growth. Communications and tests increased approximately 30 percent each and filtration was up 6 percent. The co-op market remains very strong in communications and the overall test business is seeing solid results driven by 2 large chamber projects in Europe and continuing strength in Asia. GAAP earnings increased nearly threefold to 90 cents a share as the prior year results included the charges from the repositioning activities begun in 2003.

Operational EPS of 84 cents a share increased 65 percent during the third quarter as compared to the prior year. One of the major drivers of the operational EPS growth was the strength of the communications segment. Not only did the sales increase contribute to the earnings growth, but the sales mix and significant cost reductions relating to component parts contributed as well.

As Vic mentioned, during the third quarter we completed the sale of the Microsep businesses which generated approximately 23 million of cash. As part of the transaction the Company recognized a gain on the sale of approximately 1.9 million primarily driven by a 1.1 million tax benefit realized as a result of the final purchase price allocation. Overall Microsep contributed 6 cents a share to the third-quarter GAAP results.

Our June 30 balance sheet remains very strong with a cash position of $57.5 million and only $500,000 of debt. From continuing operations we generated approximately $3.5 million of free cash flow during the third quarter and 22.9 million year-to-date. During the third quarter later than anticipated cash receipts from 2 large customers and the timing of payments to subcontractors within the communications segment negatively impacted this free cash flow. These timing issues will result in a significantly higher cash flow amount being realized during the fourth quarter.

Also during the third quarter we made a voluntary cash contribution of $900,000 to our pension fund. This contribution will reduce future administrative and insurance costs related to the pension plan. With respect to the facility that we recently closed in Puerto Rico, we are continuing to actively market the property but have not had any meaningful offers to date. We are incurring some mothball cost to carry this property and as a result we are exploring alternatives to expedite its disposal and convert it to cash.

As noted in this release, the Board has extended our stock repurchase authorization through September 2006. Our strong cash position along with our available credit capacity will allow us to continue to fully fund our internal development program and will provide adequate financial resources to achieve our acquisition objectives. As such we expect to be actively repurchasing our stock in the open market during the fourth quarter.

We raised our operational guidance for the year by 25 cents on the upper end and 30 cents on the lower end based on the strength of our 9 month results and the additional visibility we have regarding the fourth quarter. We now estimate our operational EPS to be in the range of $2.80 to $2.85 per share, up from the 2.50 to 2.60 per share previously communicated.

Finally on the governance front, we continue working diligently on the implementation of the 404 certification requirements of Sarbanes-Oxley. We continue to feel that we are in excellent shape to be in full compliance well before the required deadline which for ESCO is September 30, 2005. I'll be happy to address any specific financial questions during the Q&A later and now I'll turn it back over to Vic.

Thanks, Gary. A few comments before we take questions. I recognize that the third-quarter results were better than most of your expectations and they were in fact better than our own. The primary driver on the up side was in communications where we made better than anticipated progress on our 2 new IOU programs, Idaho Power Phase I and our program at Bangor Hydro. Puerto Rico Electric Power Authority also provided some up side in the quarter.

As we indicated in the business outlook section of the release, our current expedition from a revenue and earnings perspective is that the fourth quarter will look very much like the third. With the repositioning actions complete our number one focus is accelerating the growth of the business both organically and through acquisitions. If I have any frustration it's not with the number or quality of our growth opportunities, but rather the pace. In any case, we have good opportunities in each of our segments. I'll briefly characterize our most prominent growth opportunities. And while I would welcome the opportunity to talk about them at great length, competitive considerations would suggest that a top-level view of our initiatives makes more sense.

In filtration we have both new products and programs in the medical device area which should contribute significantly in a reasonable near-term. In tests we're continue to develop our Asian presence. And of course, the Boeing job which we announced last week will provide some lift over the out years and we are actively considering a couple of smaller acquisition candidates.

In the communications business where we currently see the most organic opportunity we have significantly increased our investment in sales, project management and product enhancements. We are also looking at acquisitions both product extensions like we did with CIC's prepayment capability and, more significantly, we're continuing to pursue opportunities which would provide direct access to automatic meter reading for water and gas. We have resumed shipments of our SecurVision product which should also help the communications segment.

From an end market perspective, in filtration we're just starting to see some recovery in the commercial aerospace side. In tests the end markets appear solid. And in communications the IOU and co-op interest and activity remains encouraging. So as I said earlier, we're focused on accelerating growth and we're finalizing our '05 outlook which we will communicate with the year-end release. In addition to growth, we also continue to work hard on our costs and competitive positioning. So with that I'd be glad to answer any questions you may have.

(OPERATOR INSTRUCTIONS) Steve Sanders, Stephens Inc.

A couple questions on the communications side. Year-to-date orders are up about 24 percent, I think that's essentially the small utility business. Does that market feel like it will support solid double-digit growth through '05?

Yes, I think our current view, Steve, is it certainly should. We've seen good acceleration over the past couple years, as you know, and we've not seen any softening in that market at all. As far as the penetration level, that overall market is only penetrated about 30 percent. So, I think there's plenty of room -- plenty of headroom for growth there.

Okay. And Gary, how much of that million in currency benefit flows to the bottom line roughly?

Very little, I would say less than 50,000.

Okay. And then a follow-up on the component cost reductions, can you just expand on that a little bit for the communications side and let us know if those are sustainable?

Yes, what we did and with all our businesses we work hard on cost reductions. We really worked hard on the modules that we make over the past year and we're starting to see the results of that. So that's 1 reason the margins went up in the third quarter as we fully realized that. And it's just a matter of not only working the specific components on the board, but also, as you know, we subcontract manufacture those products. So we're looking for cost reductions from that perspective and additional people to do that type of manufacturing for us.

But yes, this is not a onetime deal. We've now been able to bake that into the underlying cost of the project.

Thanks, Vic. It looks like the market is going to give you a nice birthday present today. Congratulations on a good quarter.

Thank you.

James Gentile, Sidoti & Co.

Looking at the filtration margin expectations for the fourth quarter, you said you're getting a 1 to 2 percent sequential expansion from the 14.5 you showed in the third quarter. Is that true?

Yes.

Is that 16 percent-ish sustainable next year for the entire year? Given the cost changes that you've made and how much essentially is the variable volume there going to drive it in the first half of the year which presumably is a little weaker than the second half?

You're right on, James; the mix is going to impact the sustainability of that run rate. I think as we've mentioned in the past, the volume drivers on the commercial aerospace side obviously is we keep the volumes up as they are in the second half of the year in commercial aerospace it brings a lot of margin along with it because it covers a lot of the fixed cost. So contingent upon the sustainability of the revenue there, that's a factor; and also the contributions evident in the second half of the year from the project that we call out specifically in previous releases, the T700 deicing valve, the defense aerospace product at VACCO, that has a large contribution in Q3 and Q4 as well and obviously we're working on future prospects they're so there are some variables that impact that threshold of sustainability for the foreseeable future. We don't see anything dropping tremendously though.

Okay. And Vic mentioned that you got some contribution from Puerto Rico which we haven't heard in a while. How much exactly was that?

On the PREPA contract?

Yes.

It was up sequentially a little over $2 million.

And that's one -- that's just my way of trying to explain a little bit of the surprise in the third quarter in that we've had that project laid out and it's been running along at a fairly steady level for some number of quarters. And they just had a desire to get more installed in the third quarter than what we anticipated. But the project continues to run nicely.

Fantastic. And you mentioned that the Phase I Idaho contract -- that was obviously a very small almost beta test for you guys. The fact that you kind of emphasized Phase I, does that indicate that potentially they're considering moving forward into further phases with you all given the first quarter of deployment?

Well, a couple of things. The one reason we called it out specifically, even though it wasn't a huge contract is because the way the revenues is recognized on that we thought we wouldn't recognize that until the fourth quarter; it actually was done in the third quarter. So that was really we called it out specifically. As far as the core of your question, their intent all along has been to run that system for some period of time and their current view is probably 9 to 12 months before they make the decision to move forward. So it was really a smooth installation. I think they're very happy with the results that they're getting, but they still do plan to run that for some period of time before making a decision to go forward.

Great. Well, you guys, as always, make some of us look smarter than we actually are.

Patrick Forkin (ph), Rockhouse Research.

Good morning and congratulations on the quarter and the execution of the repositioning plan. Gary, on the EBIT margins for communications, it looks like they for the quarter were up to about 31 percent which looks like 800 basis points over where they had been historically. And your guidances were pretty much that state-level in Q4 here. Can you give me a sense of how much of that is coming from the mix with the co-ops versus just buying the components better?

I would say when you look at PPL in particular and you see in the quarter alone we dropped about 12 million of sales out of there and then you can see that incrementally in the same period the sales are up. And so if you were to look at just that factor alone, the margin that we previously communicated, Patrick, is in the neighborhood of 8 to 10 percent higher on the gross margin side. So as the mix changes you can kind of do the math off of that stripping out PPL, looking at the growth in the co-op at about a 10 percent differential. And I would say the component savings -- we don't want to show our hand specifically, but that's probably worth in this quarter 2 or 3 points of margin.

Okay, very good. And Vic, could you talk about some of the drivers for sort of the rapid growth on the co-op side here?

Yes, I think it's a couple of things, Pat. I've talked a number of times, we did change the way we went to market a couple years ago and doing more through reps and distributors. And I think that has been one thing that has really been helpful, and I think a lot of it too is just market acceptance. You get more systems deployed; people get more comfortable with it -- being a real advantage of having a system line that. I can't point to any one thing other than just market acceptance and we do have a wider distribution network than what we had in the past. 3, 4 or 5 years ago we were selling direct, and that's a difficult thing to do with co-ops. So we've been able to hook up with some really solid distribution channels and partners that have helped accelerate that.

Okay. And is there anything new on the competitive front in the co-op business like with Hunt or Itron? Are you seeing more or less or are you winning more or less from either one of those guys?

I would say Itron has never been a big player on the co-op side just because the technologies they currently use. Hunt has still been very active, they have remained a good competitor but I would say we are still winning an equal share with what we have in the past.

Okay, very good. Congratulations again.

(OPERATOR INSTRUCTIONS) Jason Simon, JMP Securities.

I apologize if these questions are redundant, I had to hop off. First thing is component cost, such a huge jump in margins that we saw during the quarter. Could you explain exactly where the cost savings came from?

Again, what we have done is go through and look at the module that we're making and you have to remember that we do subcontract manufacture this product and so some of it has been how we bought the components, the type of leverage we have been able to get with as well as our subcontract manufacturers. It is really more evident here than what you would typically see but as we talk a lot about, we do focus a lot on cost both material cost, labor costs, where we manufacture so it is not unusual for us to do. It is just that it has manifested itself in a much higher level when you are able to do the types of volumes that we did in the third and the fourth quarter here.

Keeping with communications, a quick update on the PPL acceptance test, where that stands and how it is progressing?

So far so good. I don't want to get into a lot of specifics just because we're working with that customer and we will let them talk specifically about that but I would say we are really on track with that. We have been happy with the way the deployment has gone and the operation of the system. I think that the customer would say the same thing.

Are you still fully staffed at PPL or have you scaled back somewhat?

No, we haven't scaled back. What we have done over the past year really is incrementally increased the number of people that we have dedicated to these types of projects. We want to be well-prepared for the next investor-owned utility and in fact, we have a fairly small staff on site at PPL. We only have 5 people up their everyday and then we support the rest of it out of St. Louis. We really have, as I mentioned in my opening comments, we have increased the number of program management, engineering folks that we have onboard because we want to be prepared to really hit the ground running as we get new deployments. I think that is one reason that we have had success with Idaho Power and Bangor Hydro because we did have the people in place that had the experience so that when we had a contract we were able to get those done very effectively and very efficiently.

And just on SecurVision I was expecting to see probably better revenues this quarter than -- I guess than what you posted. Are we to see a ramp, an acceleration in Q4 as we expected in the June quarter?

I expected to see the same and it was really just a matter of getting the product turned back on with our major customer. That has happened now and we are delivering the product. So I think we're back on track there.

Okay. And then how is it looking on the acquisition front?

Frustratingly slow. There's a lot of opportunities out there. As you know, we are very conservative, very deliberate about what we're going to do because we do want to spend our money wisely. There are a lot of opportunities out there but they take a lot longer than you want them to and you don't always work on your own time frame. But there are opportunities out there; it's just a matter of us getting them done.

Thanks very much.

(OPERATOR INSTRUCTIONS) Steve McNeil, Genis (ph) & Assoc.

I just wanted to get a sense for the -- in terms of Bangor and Idaho, what's the threshold of breaking contracts like that out in the future or should we expect that things would be lumped together along with the other co-op business?

Well, both of those we have broken out separately because they were investor-owned utilities. And I think what we will look at doing is as we get additional investor-owned utilities I think people are interested in that and people need to be aware of those and so we'll continue to break those out versus with each of the cooperatives because at any quarter we may enter a business with 8 or 10 or 12 or more co-ops. And so I don't think there's a lot of benefit to breaking those out separately. But an investor-owned utility, particularly if there's potential follow-on, we'll continue to break those out.

All right. And Bangor and Idaho margins, are those closer to what we saw at PPL or closer to what you're seeing on the co-op side?

Steve, they're going to fall closer to the co-op side. With the scalable size of those things they tend to not get the same economics as a 100 million plus contract would, so it's at the high end of the scale.

Okay.

What really drives that is the volume. If a customer comes in and wants to buy 1 million meters versus a couple hundred thousand or 10,000 then we get some real volume and advantage by doing that.

Okay. And then, Gary, what's the free cash flow situational look like for the rest of the year? You kind of hinted that we'd have a strong fourth quarter relative to the third quarter. But 23 million year-to-date, can you maybe walk us through that a little bit?

Yes, generally, Steve, when you look at the balance sheet you'll see receivables are substantially higher than the previous quarter and payables are lower and what basically happens there is when we come to the end of a couple contracts there's usually some retention in the contract where there's a little holdback until the final acceptance comes through and a few things were expected to be received in mid-June and they came in in July. And so from a balance sheet point in time perspective obviously the cash didn't come through. So a substantial portion of that has already come through. And on the payables side we don't have that same relationship with our subcontractors. We can't stretch them out contractually. So those 2 timing issues basically fixed themselves in July and August. So with that said, the run rate for the first half of the year, you can put it into the second half of the year and put about a 25 percent factor on that. So how the math works is it should be in the neighborhood of $15 million.

For the fourth quarter?

Yes.

Okay.

Steve, if I could back up one question real quickly. One other thing that does have an impact on our margins on the communication side is what our real role is. Some contracts where we manage the installation like we did at PPL, we're not able to put as large a wrap on the installation as we are the product that we provide. So that's probably the largest thing beyond the volume that impacts those margins. So for most of the co-ops and certainly with these 2 larger investor-owned utilities we did not manage the installation so that helps improve the margins as well.

Sure, okay. And then lastly, it seems like your -- I think in your corporate presentation you had talked about your financial goals for '05 and they seem relatively unambitious given the performance of the business this year. And I realize perhaps the numbers are a little outdated, but you're talking about 0.5 billion in revenue, $2.50 to $3 in earnings on 13 percent EBIT margin. So I guess when the fourth quarter gets released we'll probably expect those numbers to change dramatically up?

First of all, they didn't seem that pedestrian 4 years ago.

I think you've executed very well, that's clear.

I understand. Our plan is at this next press release to provide some update as well as some insight into '05. And as we think about that, I think the thing that needs to be remembered is there's going to be some impact on acquisitions in '05 and beyond, some impact of the investor-owned utilities in '05 and beyond and what we're trying to do is take a thoughtful approach over the next 3 or so months prior to that next release to really understand what the right goals are for us. But we will be sharing those in the next release.

Okay. Thanks, guys. Have a good day.

That concludes today's questions. I'll now turn the conference over to Mr. Richey.

Thank you a lot, everyone. And again, thanks to the Board and our shareholders for their support as we work through the execution of our repositioning plan. We do remain fully committed to delivering increased shareholder value over the long-term and we firmly believe we have the platform, opportunities and people to deliver. Thank you.

That concludes today's conference. Thank you for attending.