ESCO Technologies Inc (ESE) 2006 Q3 法說會逐字稿

Good day and welcome to the ESCO third quarter conference call. Today's call is being recorded. With us today are Vic Richey, Chairman and CEO, and Gary Muenster, Senior Vice President and CFO. And now to present the forward-looking statement and for introductions, I would now like to turn the call over to Ms. Pat Moore, Director of Investor Relations. Please go ahead ma'am.

Good afternoon, everyone. Statements made during this call regarding the future levels and timing of revenue contributions from each segment and operating unit, results of the recent Nexus and Hexagram acquisitions, the timing, ultimate value and quantity of products, software and services to be ordered and accepted under the Company's contract with PG&E, growth in the electric gas and water AMR markets and of the Company's AMR business, the Company's receipt, timing and size of electric IOU contracts, the impact of the federal energy bill, fiscal 2006 revenues, cash, EBIT, EBIT margin, sales, EPS, SG&A, capital spending and amortization of capitalized software development costs, corporate operating expenses, the success, timing and cost of product and software development efforts, effective tax rates, the longer-term success, revenues and earnings 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 is in an exhibit to the Company's 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, ESCOTechnologies.com, under the link investor relations, financial results and SEC filings.

I'll now turn the call back over to Vic.

Thanks, Pat. Good afternoon and welcome to our fiscal 2006 third quarter conference call. I'll be providing some comments on our results and outlook, but prior to that, Gary is going to spend a few minutes covering our financial performance. Gary?

Thanks, Vic. As noted in the release, our third-quarter EPS was $0.42 a share and was favorably impacted by a research tax credit recognized in the current quarter. The prior-year third quarter was $0.47 a share and was favorably impacted by the true-up of estimated foreign sourced income.

If we normalize the tax rate at 38% in both periods, which is what we previously expected and guided to in our second-quarter release, the comparable EPS amounts for the third quarters would have been $0.38 in '06 and $0.35 in '05. This reflects a 9% increase in EPS, which is more consistent with the 10% increased noted in pre-tax earnings.

Additionally, the current year third-quarter results included $2.1 million of intangible asset amortization and stock option expensing not reflected in the 2005 results.

Operationally, our third-quarter results were at the higher end of our internal expectations on both an EBIT and EPS basis. The filtration margins were higher than expected due to the increased sales volume at all three operating units, as well as a more favorable sales mix. The test margins were higher than expected as a result of better execution on larger projects. The communication margins were consistent with our previous expectation.

Our balance sheet remains exceptionally strong, as we ended the quarter with over 35 million in cash and no debt outstanding. Our operations generated over $14 million of cash during the quarter, which was higher than our previous expectation, and was driven by the timing of several large receipts coming in earlier than projected, as well as some vendor invoicing happening later than expected.

Excluding the amounts spent on acquisitions, we expect to generate approximately $25 million of cash this year, which includes the ongoing capital spending for the TNG software project, as well as our normal level of capital spending.

Our entered orders were consistent with our plan and our backlog remained solid at June 30th, as we generated nearly $364 million in orders year-to-date. This includes $15 million of acquired backlog from Nexus and Hexagram.

One particular bright spot with the orders was the receipt of $5 million in follow-on business for the T-700 program at VACCO.

As I've noted in previous calls, EBIT within the communication segment will continue to be impacted by our investment in SG&A. The majority of this spending is the result of our outlook for the AMR business and is being spent on marketing, new product development and program management to enhance our ongoing pursuit of several additional IOU opportunities. As we close out fiscal '06, we expect to maintain this level of investment in Q4 as we continue to introduce new products, features and software enhancements to our overall AMR product offering.

In March, we began amortizing the TNG capitalized software, since version 1.5 became commercially available and was delivered to an electric utility customer. As we continue to make solid progress on this significant software program, I want to remind you that, in addition to the amortization of this current version of TNG, the soon-to-be-completed versions are expected to be commercially available in stages throughout fiscal '07, and during this time we will begin to amortize the costs related to these later versions over the remainder of the original seven-year amortization period. This should result in an annual amortization expense in the range of 7 to $8 million.

Regarding PG&E, although we cannot currently recognize revenue on this contract, we continue to incur additional indirect costs, such as engineering and R&D, associated with this contract and other IOUs in the pipeline, which are reflected in the P&L in '06.

Moving on to the balance sheet, inventories decreased nearly $3 million in the quarter, primarily as a result of significant increase in Q3 communication sales and progress payment receipts at VACCO. Other assets increased compared to March 31st due to the additional capitalized software expenditures related to the ongoing development of higher versions of TNG.

In closing, we've narrowed our earnings guidance by raising the lower-end of the previous EPS range, and we now believe the full year should close out between $1.10 and $1.15.

I'll be happy to address any specific questions during the Q&A. Now I will turn it back over to Vic.

Thanks, Gary. I'm going to spend the bulk of my time discussing activities in the communication segment, because that's where we're focused in the context of step changing our operating performance.

Having said that, the management teams at our test and filtration businesses are delivering solid results, and we expect that to continue as they work a range of opportunities to further expand their contribution.

In terms of third-quarter accomplishments, I'm encouraged by the strong bookings in filtration and the improving margins in test.

Turning to communications, I thought it would be worthwhile to recap the key elements of our strategy to deliver significant and sustained performance improvement.

First and foremost, we're focused on our performance at PG&E, where the recent PUC approval in California opened the door to move forward on this very important project. Based on a kickoff meeting that I attended at PG&E after PUC approval, I believe that our customer is comfortable with our progress and is anxious to move forward. PG&E is in the process of finalizing its deployment schedule, which in turn will give us the visibility we need to develop our '07 outlook.

The performance of our recently acquired advanced metering business is also a central component of our component -- of our communication segment growth plan. At Nexus we've had two consecutive quarters of strong orders, which should begin to deliver in '07, and we continue to see adequate opportunities for sustaining this growth.

At Hexagram, in addition to their deployment at PG&E, we're seeing an acceleration of opportunities with the larger water utility customers. Our fixed network solution continues to gain traction in the marketplace, and I believe it will continue to do so as the conservation and customer care benefits that can be derived from the more frequent readings becomes better understood by customers. We also expect that our alliance with Neptune will accelerate our growth opportunities in the water market as a result of their extensive sales network.

The third major element of our growth outlook is the opportunities we currently see for additional electric IOU orders for our [coax] products.

Over the last few quarters we have mentioned our progress on a latter-stage pilot. Regarding that utility, I'm feeling positive about our competitive position. The customer is entering their budgeting process, and based on our most recent inputs, if they receive approval we would expect deliveries to ramp up in the second half of '07. There are several other electric IOUs where we expect decisions in the next six to 12 months where I believe we are well positioned.

The final key element for sustained growth in our communications business is our new product development program, where we're working on, among other things, the integration of our prepaid metering technology and in-home display and interfaces with smart thermostats.

I hope I've provided some insight into how we intend to capitalize on the opportunities we have in the advanced metering markets. We're poised to be a major contributor in satisfying utility customers' requirements for energy conservation, improved customer care, and better overall economics. We remain convinced that we can translate this in sustainable and significantly improved shareholder value.

Finally, let me make a few comments on the organizational change we announced in the release. Chuck Kretschmer has decided he wants to take a different role at the Company. He has been and will continue to be an integral part of the management team, simply in a different capacity.

I'm very comfortable with the management team and operating structure we have in place across ESCO. Bruce Butler leads our RF shielding and test business and has for 11 years. Sam Chapetta, who currently heads PTI and has been with ESCO for 17 years, will take a larger role in the leadership of the filtration segment.

As some of you may know, we have a relatively new president at DCSI, [Bruce Philips]. We ensured that while we conducted the search for that position, that we identified an individual that would be capable of running the business that DCSI is today, and, more importantly, the business it will be in three to five years. I'm confident that Bruce is the right person to lead DCSI in the future.

Finally, the addition of Nexus and Hexagram not only brought key new technologies and products to ESCO, but also several excellent executives, including Harvey Michaels and Gary Moore, both of which are veterans of the industry.

With that I want to thank Chuck for the enormous contribution he's made to ESCO over the past 28 years, and I look forward to his contributions in the future.

I'd now be glad to answer any questions you may have.

(OPERATOR INSTRUCTIONS). Richard Eastman, Robert Baird.

Just a quick question regarding this IOU opportunity that you talked about. If it falls into place from a budgeting standpoint, and if they receive approval, second half of '07 would be the timing. Could you just clarify that comment? You make it sound -- have you been chosen as the technology vendor there?

Not officially, no.

But you feel that comfortable that you're right there in the running?

I think we're definitely right there in the running, yes.

Gary, just a quick question on the amortization on the software. Could you just walk back through that a little slower? We're now expensing some of the software development costs, and that's why our amortization jumped up, plus it will go up higher?

Right. Each of the releases, you have to think of those as a separate module, and each one of those has a capitalized cost, and it has a fixed amortization period. And the aggregate amortization period is seven years that began on March 1st. So version 1.0 and 1.5, the cumulative costs up through March 31st will be amortized over the full seven-year period. As we are incurring additional costs to get to 1.6, 2.0 and 3.0, those costs will begin amortization once we've crossed commercial viability here. And as that timetable moves out, the period becomes shorter.

For instance, if next March we were to issue something like a 2.0 at that point in time, we would have six years remaining on the amortization. And so you get a little bit of compression as you move out. So as the aggregate cost today, which is around $35 million, begins amortizing off, it's going to build up a little bit over time and bleed off over time through amortization. So you have to think of each of the versions, 1.0, 1.5, 1.6, 2.0 and 3.0, as separate amortizable events.

When you talk about them technically being ready for commercial viability, is that the same as saying we'll see some revenue from those?

Not necessarily, correct?

No, it means they can be sold. And they're in a situation -- they're in a structure that means it's fully functional and available for sale, as opposed to being beta tested and being debugged and that sort of thing.

If I could just jump in for a second. With PG&E, they ordered version 3.0. So that's why we won't be able to recognize revenue in that contract until that happens. But we have these interim releases that someone could buy and could operate a system on. But it doesn't have the full functionality that the PG&E contract requires.

So we'll be absorbing that cost without -- of all these versions without probably any revenue until next June, June of '07?

Yes. The only way that wouldn't be the case is if someone bought the system using one of the different versions. But that's not what we see happening today.

Steve Sanders, Stephens.

A question on PG&E. I realize we're still, it sounds like, a month or two away from having a good idea of what the implementation looks like there, but is it reasonable to think they'll start in the December quarter?

Their plan -- what they would like to do, and I think they're on track to do that, is to have some deployment in the first -- in our first quarter. So that would be late November early December. I think that will probably [be] a fairly limited number, but they do want to get some product in the field yet this calendar year.

And a couple of quarters ago, you put a $50-plus million number out there tied to the TNG development on the PG&E electric portion of the contract. Again, I know we're pushing a little bit here, but is that still a reasonable way to think about it for '07?

I'm sorry; for revenue, or --

For the electric portion of the PG&E contract in '07.

Yes, I don't -- that was the best information we had then. I'd hesitate to update that, just because we don't have a schedule, a firm schedule today. So we should have that here in the next 60 days or so, and I'd prefer to wait and see what that is rather than try to update you on something when I know I'll have better information.

Can you give us a general update on where you stand in terms of program managers, manufacturing, other infrastructure to support PG&E, and also additional large contracts? And the question here is really do you have any concerns at this point that other customers will pause because of the effort required to implement PG&E?

That's a good question, and I've had that question asked of me by other customers, or potential customers I should say. And it does break down in a couple of pieces.

We -- when we won the PPL contract a number of years ago, we made a conscious decision then to start investing more in program management. So we've brought along a number of people. We've hired people. We've got them in place where they could learn on that project, where they could learn on some of the other projects that we have, so that when we got to this position -- which we were, obviously, hoping and planning would be the position where we would have multiple opportunity -- we'd be in a position to execute on those. I would say that our program management team today is in very good stead. They're managing a lot of projects. People forget that we have probably 150 customers or so out there with co-ops, maybe even more than that these days, and they effectively manage those as well as some of the larger investor-owned utilities.

We have a dedicated team at PG&E, led by Kevin Cornish, a fellow that has been out there for a couple of years. He started with us probably four years ago; good background there. He's done a good job. We've brought in additional people that have been working that project really since we started bidding it well over a year ago. So we've got a good team in place there.

We have other people that have been working some of these other opportunities on a full-time basis. So I feel good about the program management group that we have in place. I think we'd put it up against anybody's. So I don't have a big concern there.

And as far as manufacturing capacity, again, I think, getting these relationships in place with the larger subcontract manufacturers has been key, and they're performing very well, as well as one of the legacy vendors that we've been working with. So again, that capacity issue should not be an issue at all.

So I've been having that conversation with folks, people seem to be buying into it, but really I think a lot of that is because we're able to get people in front of them and say, this is going to be your program management, this is the people that are going to surround them. So, we haven't seen any indication that that's going to cause a pause with potential customers.

On the other IOU that you talked about potentially in the second half of '07, is the decision timeline something that we should expect news on before calendar year-end, or how should we think about that?

It would certainly be before calendar year-end.

On the test business, you're at 12% year-to-date EBIT margin, something in that ballpark, but you kept the guidance for the year, I think, around 11%. Did you have an unusually strong quarter? I know there was some commentary about mix and execution. Anything that would -- beyond just being a little conservative about the fourth quarter?

The biggest thing was that we did have a very strong sales quarter on the component side. And I think, as we've talked about before, I hate to use the mix term, but it really is the mix term in that business. Because those components carry a much higher gross margin than the chamber business itself does. So, we don't see that we're going to necessarily have that strong of a sales quarter on the component side in the fourth quarter, so that's the reason it's normalized back to 11%.

Last question on the communications orders -- any large orders in there that are noteworthy, anything slip, anything that impacted that this quarter?

There's still a couple of things that are in the pipeline that we have a high degree of confidence we'll book in the fourth quarter. There's nothing individually in there that we called out like we have in the past, where we had the Florida Power and Light LCT order and the TXU add-on that we announced in the second quarter. It was nothing in the 5 million -- individual $5 million range this quarter.

John Quealy, Canaccord Adams.

A couple of questions. First, on the IOU, you mentioned that you're feeling more comfortable with that. Can you comment -- I realize we're under pressure a little bit -- but can you comment in terms of the competition there? A fixed network? Is that competitors, or PLC competitors? Can you give us any characterization of who the final guys are at the table?

The only thing I'd feel comfortable saying is that they are looking at an advanced metering system, rather than just an AMR system.

If you could go into the Neptune a little bit more, especially if you can give us the outlook on Neptune -- obviously, a big meter and AMR provider, and now hooking up and getting a little bit deeper relationship with Hexagram. From their perspective, Hexagram gives them the fixed network capability a little bit different -- in a little bit different fashion. Can you comment on the sort of pros and cons for each of you folks for that relationship?

Really what it came down to was we wanted to have a better opportunity to get to more customers. As you know, you get behind the very large water utilities, which we continue to pursue and, I think, can do fairly effectively -- it's such a fragmented market. And to do that with the limited number of sales folks that we have is going to be very difficult.

So what Neptune brings to us is a lot of people calling on individual utilities. They've got a long history with some of these customers. They've got very good access, and it's something that would take much longer for us to do effectively and efficiently.

What we bring to them is they don't have a fixed network. And the conversations we had with them, they said that historically, 2 or 3% of their customers, potential customers would talk about a fixed network. And they saw that accelerating, and they thought that that was going to be more in the 10 to 15% range in the fairly near future. So they wanted to have a quality product to satisfy those customers with, because at the end of the day, the majority of their revenue is derived from selling the meters. So this gave them an opportunity to sell more of those utilizing a fixed network, one that they're comfortable with, and it gave us more feet on the street, if you will, to sell our product.

Just two more questions. I think perhaps a quarter or two ago, when Hexagram was announced, we talked about some pretty good opportunities organically in the water market. We're seeing some of those. Some of your competitors are saying that water should pick up a little bit. Also in gas, I think, was an opportunity for you folks. Can you comment on the relative order flow? Obviously, electric continues to have some good momentum. But can you comment on those other two markets, if you could?

The water market is, I would say, very solid right now. There's a number of active proposals out there that we, along with other people, are pursuing. So I would say the water market -- we're seeing a lot of acceleration there. And I think between what we're seeing on the large projects, as well as the benefit of having the Neptune agreement in place, I think we're going to do very well there.

The gas, we see that more in conjunction with some of the things we're doing on the electric side, but there are certainly some opportunities there as well. But I would say of the two, we're seeing probably more activity on the water side.

Lastly, on Nexus, how is the whole meter data management/software product offering going? Obviously it sounds like a good quarter for the second in a row out of Nexus. Are you starting to see some "unconventional" competitors come into that software/meter data management side, or is it still the core guys that you've come up against for the last couple of years there?

It's still the core guys. There are two or three -- three kind of major competitors out there that are in pursuit, and everybody has a slightly different set of products to offer. But we have had two really good quarters. I think they're the two biggest quarters that Nexus has ever had. And again, the PPL project, I think, is key to that. But they've also won some other pretty significant orders as well. So we're feeling good about what they have there and getting it out to more people, in conjunction with not only our offerings at DCSI and Hexagram, but also really we -- set over top of some of the other competitive systems as well, and we'll continue to do that and support those customers.

Patrick Forkin, Tejas Securities.

I was wondering if you could update us on TXU, if there's been any changes in the landscape there. And it looks like you did some decent business with them in Q3. But what's your best assessment as to what their program is, in terms of total endpoints going forward here?

What they said is they've got 3.1, 3.2 million meters, and they've said that they're going to do 2 million of those with PPL. I think they have -- are due to start deploying some of those before too long. And that would leave, assuming they go forward with the rest of it, an opportunity for us of 1 million, 1.2 million endpoints. And we don't see any reason that over time we wouldn't fulfill that order.

They're very happy with what we're doing down there. We've got a couple hundred meters in place, they're reading very well; performing very well. So again, I think I said last time our plan is to keep them very happy and perform on what we're asked to perform on, and be there to support their needs, whatever they end up being.

And in California, outside of PG&E, could you characterize your involvement with the other two IOUs, and maybe where they're at in the process?

I don't think that there's been a tremendous amount of progress by the other two utilities since our last call. We do remain involved with both of those and the processes are going forward. It's very hard to tell when those things are going to come to fruition. There doesn't seem to be the same [drive] at those utilities as there were at PG&E. I think they're taking a little bit more of a wait-and-see approach on what they're going to do. And I don't think that's necessarily a bad thing for us, honestly, because we're going to have some good success in California here pretty soon.

Lastly, on the water side, it looks like there's potentially some fairly significant projects in Kansas City and Chicago. Are you guys involved in those proposals?

I would say that we're involved in all the major proposals that are currently underway.

David Smith, Citigroup.

Coming back to the question of capacity, (indiscernible) how Hexagram's capacity is, how it stood before the acquisition and then how it is today, in terms of maybe if it's impacting the order book?

I don't think it's having -- their capacity is having any impact on the order book. What I would say is they were well-positioned to execute on what they have. I think we brought some things that are going to help them in that regard. We have good manufacturing expertise within the Company. They have good manufacturing expertise there. But I think we should be able to leverage some of the things we're doing at DCSI with some of the subcontract manufacturers, to ensure that we have multiple sources and that we're able to meet the demands, not only of PG&E, but other customers we see coming onboard.

In terms of the bookings or ability that they were experiencing (indiscernible) PG&E, was there any slowdown or was there any hesitancy on the customer part?

No, I think -- well, I would say that one of the real benefits of them joining up with us is the customers see that as a positive. (multiple speakers) now I think they feel like there's a stronger company behind them than where there may have been before. And I can't say, because it didn't happen that way, but there was a potential, I think, that people could say -- well, they've got this big contract, and we're going to make sure that we're able to get our product as well. Now that they're part of ESCO, I think that will really benefit them.

Have they had any sizable wins other than PG&E since they've come onboard with you?

Yes, Corpus Christi is the other large project that we've been deploying.

Okay. Any sense of how the backlog activity is in Hexagram? Would that be just reflective of what we've seen in water, I guess?

Yes. I believe they've delivered all the gas work that they have at WPS. So the other backlog, in addition to what you have at PG&E, I believe, is all water.

And then on the Neptune alliance, is there any set period to that agreement? And also, do they -- does that in any way compete with their existing product? I know they were working on a base station product, but have they abandoned that?

The only product that they're currently selling, I think the plan is, is their drive-by system. So they do have a drive-by system that they sell. But they would be selling just our fixed network product. As far as the timing, it's one of these where I think there's a kickout clause over some period of time, but it's something that's going to be beneficial to both of us. It's kind of a long-term contract, but there's a kick-out clause if it doesn't work.

Is there any synergy or benefit to working in anything like gas and electric for Neptune or Roper specifically? Have you guys looked any further at that?

With Roper, really they don't have another metering business, so I don't think from that perspective that there would be.

So you kind of view that water meter business as a core to kind of growing maybe?

Yes.

That purchase program, is that just for share creep? Can we assume that?

Yes. I think that's the right way to think about it.

We put that in place just because the other one was expiring, and we just want to have it in place should we need it.

That TNG software product, has that shipped out? I'm not quite clear on that. Has that shipped out to any customers so far?

PG&E has 1.5, and they're using it in their small-scale test right now. So they are the main ones that have taken delivery. And it's deployed at another customer as well that we're working on kind of. We're letting them trial it, basically.

You guys haven't said who that other customer is?

No.

Last thing, just on this report that came out from FERC yesterday and the CPUC -- maybe just if you can give us a sense of what the regulatory environment is from your angle these days, as far as advanced metering goes.

The FERC report, I would say a couple of things about it. And I will tell you, it's about two inches thick and I haven't read every word of it, but I've done a pretty deep scan of it. A couple of things.

Number one, I think it was a very well researched document. I think they did a really nice job of capturing what's going on. One of the most encouraging things was the response rate they got from the survey that they sent out. I think anybody that's ever done this type of survey would be astounded by the fact that they got a 55% response rate. I think that's indicative of the interest that the utilities have, because I think they want to participate, and that's because they see it as the future. So that was very surprising to me, that they were able to get that type of response rate.

The other thing is it's very supportive of a lot of the things that we've been preaching over the last couple of years, in that a fixed network is really the future of this business. And if you're going to do demand response, you're going to do advanced metering, you've got to be able to access those meters when you want to access, and you've got to be able to do it on a very consistent basis. You need a robust communication network to do that with.

So, the fact that it's reinforcing a lot of the things that we've been saying about hourly rate and on demand rate is key. So, we are encouraged by that.

Also, the fact that the 6% penetration rate for advanced metering -- I think that bodes well for the future of the business as well. We talk about penetration rates a lot, and the fact that they're 20 to 30% overall, but that's for all metering. So if you start talking about really advanced meter and demand response, the fact that it is as low as it is is good for us.

The other interesting thing in there, I thought, was this is one of the first times where kind of an outside third party has talked about the cost benefit of doing a system like this. And the fact that they talk about the cost being roughly $1.25 to $1.75 per customer per month, and that the benefit is far in excess of that, that's the first time that I at least have seen in a document like this where they talked about the fact that you could get an internal rate of return of 15 or 20%.

So, all those things and all those facts that come out of this document are encouraging to us, and it's going to be harder for people, harder for the states, for the state regulators, to ignore a document like this. So, I would say I was very happy to see that come out yesterday.

That's very helpful. Thanks a lot.

James Gentile, BB&T Capital.

We see Hexagram kind of wedged in the more order market now with Neptune, Badger, Itron. Could you kind of articulate the fixed network systems' competitive advantages versus those players? I know you did the short hop with Badger, and now you're allying with Neptune. It just kind of seems that these are interesting kind of complementary yet competitive alliances.

The difference, I would say, is what we're doing with the Badger system is the short-hop system. So it's only going to be used in instances where we have the electric meter that's there, and there's the gas meter close by or water meter that's close by. And it gives us the ability to bring that back.

We've always said that our longer-term plan is to have different meters that we can interface to. So, we have that alliance with Badger; we'll continue that -- not to say that we can't do the same type of approach with the Hexagram system.

Then if you look at the fixed network, what that's done for us is given us the opportunity to do things like we're doing at PG&E, where they're interested in having a couple of different networks, but also gives us an opportunity to go into standalone water, standalone gas. And the core technology that we use, because it's a licensed technology, there's some real advantages to that versus some of the unlicensed product. So, we like the core technology. I think that's one of the things that attracted Neptune to our approach. They thought the core technology was a little bit better than some of the other folks that were out there, so that was key. The other piece where you can kind of draw a differentiation as well is the Neptune -- I'm sorry -- the Hexagram water system is going to be for areas where it is standalone, and a lot of times that's going to be with the investor on utilities.

Nobody pays attention to filtration anymore, but --

We do.

-- it still remains a third of your business and a reasonable contributor to operating profit. Could you kind of articulate the kind of intermediate-term view of that business, A? And B, within those businesses, what makes us excited about the growth prospects there?

We do pay attention to the filtration business; we just don't get any questions about it, so we don't spend a lot of time talking about it on the calls.

But the business -- I would say the filtration business overall is in a very solid position. If you look at the pieces of it, probably the fastest-growing -- the fastest-growing these days is really our commercial aerospace. And what's happened at PTI over the past year and a half has really been great. And they're at historic profit margin levels right now. And the growth -- kind of the comeback of the recovery of the commercial aerospace market has been key to that. We've done a good job -- those guys have done a good job on ensuring that we got our costs in line, and that we performed on the products that we have, both on the aerospace and industrial filtration side.

The VACCO business -- we talk about the defense spares, and they've softened up a bit. But, as Gary mentioned earlier, we have been able to recover that T-700 business, which is one of the big things that had fallen out of this year. So we have a couple of contracts here that look really good.

On the automotive -- on the Filtertek side, we've got a couple of new products that we've introduced in Europe that are getting some traction. We have a pleated fuel filter over there, and we also won our first job with an Asian automaker this past quarter. So there's a lot of good things going on there as well.

Is it safe to say that the new programs into 2007 will be derived from the Filtertek platforms, in terms of your language that --

I would say that the new products this next year, that would be the case, although we did win a couple of new products on the Crew Exploration Vehicle at VACCO. As you may remember, we do a little space work out there, a good bit of space work actually. And historically it's been on the Space Shuttle. As the Space Shuttle is kind of tapering off, they're coming out with the new system, which is the Crew Exploration Vehicle. And because of the legacy we have with NASA and the engineering talent that we have out there, we've been able to win, I guess, two or three new projects on that vehicle already.

Chris Kotowicz, A.G. Edwards.

Wanted to follow-up on the California Public Utility Commission. Did you guys get a sense that the tone in general, just in dealing not just with PG&E, but other customers, not even just in California, changed after that was approved? Was that kind of like a ho-hum, didn't really expect it not to go forward response?

No -- that's a good question. I would say the tone changed a little bit, because I think a lot of people were surprised. And that's talking about -- investors I don't think were, because they've been very close to it. But some of the customers, I believe, potential customers, were a little surprised, just because it was such a big contract, and because it was such a big move for California and such a positive move. So I would say that there was a little change in mood among people, that they were a bit surprised.

So probably the tone is a little bit more favorable, or a little less -- I won't say skepticism, but concern about how this unfolds?

I don't think there's any concern about how it unfolds. I think it's a little more positive maybe than it was before.

On the gas versus the electric side, obviously, the gas doesn't have the amortization, the software development issue to the extent, if at all, that the electric side has. I know it's early, and you said that PG&E is still working through their deployment, but do you have anything -- is there any difference in kind of the pace of deployment as you see it today on the gas versus the electric side?

I don't think in the near term. They only have -- there's 4 million gas meters they're going to deploy, so I think the plan has always been to get that completed a little bit before they do the electric side. But I believe once they go get started and they go into a territory, they'll kind of build a territory out. In fact, that is the plan. As I mentioned, I was out there a couple of weeks ago, and the plan is kind of do it a territory at a time. And obviously, because of the installation portion of it, they don't want to go revisit places. So they'll deploy the electric at the same time as they deploy the gas.

Okay. A question on the comment in the press release about the integration of technologies. Should we read anything in there about taking Hexagram's RF technology and utilizing that maybe more broadly on the electrical side, even though that wasn't necessarily the major reason for the purchase?

Certainly one of the things that we've always said is we want to give the customer what they want. And Hexagram has developed, in a small basis thus far, the ability to do electric AMR, and we're going to continue that process. I think there are going to be opportunities or instances where that makes sense. And so we want to make sure that we have a full suite of products so that we can give the customer what they want. Again, that's the reason we're working with partners like Badger and Neptune, and now having Hexagram in-house, because customers are going to have preferences, and we want to be able to give them what they want.

Fair enough. Good quarter.

(OPERATOR INSTRUCTIONS). Stuart Bush, RBC Capital Markets.

Actually, all of my questions have been answered, but good quarter. Thanks a lot.

Richard Eastman, Robert Baird.

Just to clarify, Vic, as you move forward on PG&E, the accounting varies between gas and electric. And as you've seen the deployment schedule -- as the deployment schedule was originally laid out, the gas portion was going to start shipping kind of in the October/December timeframe. Does that still seem reasonable with the revenue recognition on that project also in that timeframe?

Right. Again, their current plan -- their current plan, at least they've told us, is to do something in the late November/December timeframe. And if they do it with the gas -- or electric, they'll do it with the gas as well, and we'll immediately start recognizing revenue on the Hexagram piece of that.

So the deployment isn't front-end on the gas side, front-end loaded on the gas side? It will come in conjunction with the electric?

Correct.

Also, the question I have, too, is when I look at Hexagram's revenue run rate in this quarter, does that include anything from PG&E?

I believe -- if it does, it's less than 250,000. They're doing a small-scale test out there as well, so it's a nominal number.

So that 7 million kind of quarterly run rate is essentially Corpus Christi and whatever base business they have?

The largest customer in the quarter was less than $1 million. So it's a collection of a dozen to 20 customers, with the largest being probably 800,000.

Do you have visibility today -- I have to go back; I'm not in the office -- but if I look at the Corpus Christi business and the base business, do you have visibility, excluding PG&E, at the $30 million revenue rate through your '07?

Yes. When we looked at the -- when we were doing the due diligence, and now that we own them, we basically look at the business with and without, so that we can really -- as we're looking at making SG&A investments, we want to make sure that we have rightsized the Company, so that if PG&E did not happen with the PUC approval, that we wouldn't have been overstacked and had to take some corrective action. So, we look at the Company, obviously, in the aggregate, but the two pieces of it are how we monitor it. So we'll be able to basically address the margin with and without PG&E to see how the absorption works on that.

Just one point of clarification, and maybe I'm the only one who heard it this way -- we don't have a plan for '07 established yet, much less at a $30 million run rate. I would say that as we talked about the acquisition, that's certainly where we see the business being able to perform. But as of today, we don't have the backlog in place to deliver that level of sales exclusive to PG&E.

That was the question. Thank you. Just the last thing is, when I look at the comm orders in the quarter, how does the co-op market look from an order standpoint?

I think it was pretty consistent with what we had seen in the last quarter, so we've not seen any significant change there.

That does conclude today's question-and-answer session. At this time I'll turn the call back over to Mr. Vic Richey for any additional or closing remarks.

I don't really have anything else to say other than I appreciate your interest and we will talk to you next quarter.

This does conclude today's call.