ESCO Technologies Inc (ESE) 2011 Q4 法說會逐字稿

Good day, everyone, and welcome to the ESCO fourth quarter 2011 conference call. Today's call is being recorded.

With us today are Vic Richey, Chairman and CEO, and Gary Muenster, Vice President and CFO. And now, to present the forward-looking statement, I would like to turn the call over to Kate Lowrey, Director, Investor Relations.

Thank you.

Statements made during this call regarding the timing and amounts of fiscal 2012, 2013, and beyond, expected results including sales, EPS, and profit, the timing and uncertainty of developments in connection with the SoCalGas project, new product developments, spending on the smart grid initiatives, future growth opportunities, success in domestic and international markets, favorable pacts positions, and other statements which are not strictly historical are forward-looking statements within the meaning of the Safe Harbor provisions of the federal security laws. These statements are based on current expectations and assumptions, and actual results 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 an exhibit to the Company's Form 8-K filed today. We undertake no duty to update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise.

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 fourth quarter and fiscal 2011 results press release issued today and found on the Company's website at www.escotechnologies.com under the link Investor Relations.

Before I turn it over to Gary to cover the financials, I'm going to share a few high-level thoughts. Given today's macroeconomic situation, in general, coupled with some of the challenges we're seeing in the smart grid space in particular, I'm really very pleased with our 2011 results. Moreover, our abilities show continued improvement in 2012 and significant growth in 2013 and beyond, is both gratifying and a testimony to our operating group's management throughout the Company. It truly has required a team effort to deliver these results and more importantly, to position the Company for continued success going forward.

With that, I will turn it over to Gary.

Thanks, Vic.

EPS in Q4 was $0.57 compared to $0.89 in the prior year, and for the full year, we reported EPS of $1.95 compared to $1.68. As communicated throughout the year and consistent with our original operating plan, we expected Q4 sales EBIT and EPS to be lower than Q4 of fiscal 2010 as a result of significantly lower sales of USG products to PG&E and New York City, as these contracts are nearly completed.

During Q4 of 2011, combined sales to PG&E and New York City were $7 million compared to $35 million in Q4 the prior year, reflecting a $28 million decrease. For the full year, the combined sales on these 2 projects were $42 million compared to $83 million in fiscal 2010, reflecting a $40 million decrease. The impact of these decreases was mitigated by significant increases in sales and EBIT within filtration and test during both Q4 and for the full year. In spite of the lower sales to these 2 customers, we were still able to grow full year consolidated sales 14%, and we increased full-year EPS 16% over fiscal 2010.

During Q4, we had a couple of clean-up items I'd like to touch on. First, we wrote off approximately $6.5 million of RF electric inventory that we determined was now obsolete, as our next generation RF electric products are currently being offered for sale. This non-cash write-off hit cost of sales and temporarily lowered gross margins by 3.5 percentage points. Gross margin would have been approximately 39% in Q4 absent this charge.

Next, as part of purchase accounting standards, on an annual basis, we are required to evaluate the projected earn-out liability related to our extensible acquisition, and through this process, we recognized a gain of approximately $6.6 million in Q4, which is reflected in other income. On the tax side, we reported a better than expected effective tax rate as several favorable events impacted the fourth quarter rate, and a few of these items are expected to have a favorable impact going forward.

Overall, filtration and test clearly were the growth winners in fiscal to 2011, followed by a very strong year from Doble. Filtration sales increased 39% for the year, with tests being up 28%. Doble sales increased 13% for the year and came in at nearly $103 million, the first time in their 90 plus year history that they broke the $100 million mark in sales. In addition, Doble contributed over 22% of EBIT in spite of approximately $6 million of incremental smart grid investments made in 2011.

USG, in total, increased 2011 sales nominally despite the size of the PG&E and New York City headwind. We were very pleased with our 2011 entered orders, as we booked $676 million in new orders compared to $669 million last year. In addition, we increased our 2011 SoCalGas bookings to over $20 million as of September 30, and subsequent to fiscal year-end, we have had significant follow-on order activity.

On the cash flow and balance sheet front, we are very pleased with the $76 million of cash generated by operating activities during the year, as well as our solid capital structure and available liquidity. Our net debt outstanding decreased to approximately $90 million with a comfortable leverage ratio of 1.36.

Regarding our outlook for fiscal 2012 and 2013, we are pleased to report that we are expecting reasonable growth next year and significant growth over the next several years in spite of the runoff of our 2 largest contracts. We expect the SoCalGas project, which begins its initial network installation and software deployment in fiscal 2012, to ramp up significantly in 2013 as they begin the installation of the high-volume metering endpoints. While facing the final impact of the wind down from PG&E and New York, which drops off approximately $40 million of sales during fiscal 2012 compared to 2011, we are still anticipating sales growth in the low to mid-single digits in fiscal 2012, followed by greater than 15% sales growth in fiscal 2013 when compared to fiscal 2012, as SoCalGas ramps up significantly.

EPS is expected to grow faster than sales as we gain significant profit leverage on these additional deliveries. Our fiscal 2012 EPS is expected to grow between 5% and 10%, followed by EPS growth well over 25% in fiscal 2013 when compared to fiscal 2012. This growth is led by the SoCal project, but is supplemented by above average growth at Doble, driven by its new products and international expansion. And further expanded by filtration and test, which are expected to deliver sales and profit growth in the mid-single digits for the next several years. We expect to show this EPS growth while continuing to invest significantly, yet prudently in our ongoing smart grid initiatives.

I do want to point out that as we have experienced in the past, we expect sales and EPS to be more heavily weighted in the second half of fiscal 2012 when compared to fiscal 2011. I'll be happy to address any specific questions on the Q&A, and I'll turn it back over to Vic.

Thanks, Gary. As I commented in the release, I'm pleased with the way we ended the year, as we closed out fiscal 2011 at the top end of both our sales and EPS ranges.

Since Gary covered most of the operating highlights, I'd like to focus my comments on the future, but before I leave 2011, I'd like to emphasize one key point. With all of the significant sales swings and profit volatility surrounding large AMI projects today, on our projects or being experienced by our competitors, when I look at our results, our growth opportunities, and our future, I'm convinced that our 3 segment strategy and in-market diversity is clearly a strength that differentiates us in the market and allows us multiple paths to grow in whether the economics snore.

So, let's being with SoCal. I'm pleased to report that the project is going well in the early stages and that our relationship to customer is very strong. This sentiment was validated over the past few weeks as SoCal increased its scope of the project with us, and as a result, increased the total value of the project. We are extremely pleased that this customer has this level of confidence in us and our product to have expanded their commitment this early in the program.

On the Doble side of USG, I continue to be impressed with the management team's progress in getting new products to the market and how well they are managing their international growth. They've added several key members to their already impressive management team, and results are apparent in their financials and in their outlook for growth. A testament to our new products and solutions is the fact that we were oversubscribed by large electric utilities requesting to service as beta sites for these solutions, and many of these customers are working with us on getting these products to market quickly.

Aclara continues to make progress with its new products as well. As with Doble, we enhanced our senior management team last year and have added a new dimension to our go-to-market strategy in gas, water, and co-ops that I believe will result in significant growth in these markets over the next several years.

Our international strategy at Aclara continues to be a key focus area as we move to expand our project in Mexico, and we see great opportunities in Brazil and Asia for our products and services as well. Our software continues to make significant inroads in the AMI marketplace, as we are now deployed at over 50 large IOU customers in North America. [Whether it be] management, customer presentment, enablement, and conservation.

On the M&A front, I can't say much in particular other than our pipeline of opportunities is quite strong. We continue to look across all 3 platforms, but our focus remains in USG. We will remain prudent and disciplined in our approach, but with our low leverage and favorable price in our credit facility, we can't afford to be more aggressive. I'm pleased to show growth in 2012, as today's overall economic situation is challenging, and I appreciate the fact that not everybody's experiencing the same near-term growth. After we have passed a modest growth in 2012, we have significant growth prospects over the next 2 to 5 years, across all 3 business segments.

My longer-term enthusiasm is supported by the recent strategic planning updates, which allow me to be optimistic about the opportunities in front of us, both domestically and international. I remain excited about our market leadership positions in all of our end markets, as well as what I see ahead of us in the way of new business opportunities. Within a smart grid area in particular, I remain enthused with the success of our wide-ranging technology offerings and our new product road map.

In summary, I believe our multi-segment strategy will allow us to remain in a favorable operating position across the Company with ample opportunities for growth, and we will continue prudently investing in the Business to ensure our long-term success. With that, I'd be glad to answer any questions.

Thank you very much.

(Operator Instructions)

Carter Shoop, KeyBanc.

Good afternoon. I wanted to ask a few questions here on the SoCalGas contract. Can you help us understand what the subsequent orders were after the quarter closed, how big those were? And then, also what you're expecting for the revenue contribution in 2012, 2013 and 2014 from SoCalGas?

I think we have project -- I think we entered about $20 million so far in the SoCal project, and we anticipate the sales next year to be roughly at that level. And then, we will have pretty significant ramp up in 2013 and 2014. Those numbers aren't totally firmed up yet, but I would say certainly 2013 would be north of $50 million, and the following year I would say probably another 10% to 20% higher than that.

And, then the follow-on, the subsequent (inaudible).

Yes, the follow-on, the contract that we talked about. We haven't entered that contract yet, but we did, as I mentioned, sign a supplemental contract, which is primarily for services under that contract.

Okay. So, when you are talking about the new orders since the quarter closed, that is what you were referring to?

No. That new contract has been signed, but it hasn't been entered yet.

Okay. So when we look at the Business excluding SoCalGas, it looks like your implied 2013 guidance suggests that sales will increase call it, high single digits to low double digits range in 2013. Can you walk through a couple of those drivers? It sounds like expectations are higher for Doble and also for the international AMI business. Can you give us a little bit more sense on what is driving that confidence?

Yes. Actually, it really is across the Business, as I mentioned. Certainly, Doble is a big driver of that. We're introducing a couple of new products here over the next 12 months, which we think will take hold and significant sales in 2013. As well as a couple of new offices for them, which I think will expand. Their footprint allows to have more sales and services from that perspective.

Filtration business and the test business both are assumed to grow. And, I say assumed that I mean, I think we have good insight into where that growth is going to come from, more in the high single digits versus what we have seen in some past years.

The international business at Aclara is going to be primarily focused again in South America where we think we have some solid opportunities for growth there.

Maybe just one follow-up question on that. On Doble, I think everyone on the call understands the investments you are making internationally, but I think it is difficult to quantify that from our side here. When we look at that revenue opportunity and the growth there, is like $10 million a reasonable way to think about that incremental growth coming in the 2013 year on Doble?

No. I think, Carter, it's going to be more than that. I think $12 million. As Vic said, we have some beta testings going on here at the start, and so, the real significant ramp probably won't happen until February or March.

We will get about three-quarters of the big pop on the new products that we are doing, but the growth from 2012 to 2013 is significantly north of 10%. It's not 20%, but it is in the, probably, mid double-digit range. I think you'd be comfortable taking that up somewhere in the neighborhood of 15% going from fiscal 2012 to 2013 because you'll get the full-year impact of the new products, and you will have rolled through the international sales offices that we have in the plan today will get a full-year of revenue being recognized out of that. So, 2013 is a big year for Doble.

Great, that's helpful. Thank you.

John Quealy, Canaccord Genuity

Good afternoon. This is Mark Segal for John. When you look at the USG business next year, can you talk about how you are viewing other contracts of size versus how you expect the book and ship business, just in terms of the growth outlook there?

Well, our view for -- or at least we've put in our plan is to not have any additional big contracts in the plan. It's really going to be executing on what we have, getting a strong start in SoCal, and then it's going to be the smaller water and gas contracts. And, another solid year from the co-ops.

I don't think we should let it pass without saying, we had a really solid year with the co-ops this year, well north -- north of $100 million with co-ops. We think will be able to do that again next year, and as you all know, that's a good, solid profitable business for us and has provided a good base for us for a long time.

Okay, and then, staying within USG. Can you talk a bit about the continued investment in that business next year? Obviously, 2011 saw a bit of elevated expense, do you expect that to repeat or perhaps taper a bit into 2012?

It's going to taper; it's certainly not going to go away. With what we have going at SoCalGas, there is going to be continued investments there, and then getting the Doble products through beta testing, there will be some incremental investment there. But, I would say it's going to be probably half of what it was this year.

Okay. Then lastly, can you talk a bit just based on what you are seeing so far about opportunities emerging throughout 2012 or perhaps into 2013 in Brazil and China on the metering side?

Right. I'd say there's good opportunities in Brazil. Everything is developing slower than what we thought it was going to. What we have done to try to make sure we really capitalize on that is to open it an office there.

We have got a number of full-time employees there now, and we're working with some partners to try to make sure that as that does develop, which I think is probably going to be more -- at least the latter part of 2012 and into 2013. We still are convinced it's going to be a solid market and I think we are doing the right things to ensure that we are well-positioned to get, hoping, more than our fair share of that business. John, is a little more genuous.

We have a good relationship with 2 partners there and have been working there. It is a matter of working through them, making sure that we are well-positioned, that when that does take off we are there and well-positioned, which I think we will be. Because when it takes off I think it has the opportunity at least to take off in a big way.

We do have some product on the ground there; it's working very well. So, it's really a matter of getting those customers, primarily the government, to move forward with that. And, we do think we've got the best solution as it relates to large scale deployments there because it's a powerline based system, and I think that's going to be the majority of what is deployed there. It is really with both of these it's going to be an issue of timing and then the rate and pace of deployment.

Thanks so much.

Ben Schuman, Pacific Crest Securities.

Good evening, guys. Can you help us quantify a little bit the added service component to the SoCalGas contract both in terms of revenue and incremental margins?

Yes. I would say it's probably going to be less than 10% of the overall contracts. We are talking somewhere north of $25 million. It probably won't be as profitable as the core business because it is more of a service component but it is going to be a very -- a profitable piece of business as well.

Then along those lines, when that business starts to ramp up in 2013, can you give us any color in terms of what that could do to the EBIT margins? Are we going to see the traditional top line leverage that we have seen in that USG business in the past or is there some pricing pressure that can offset that?

There's a couple of things that work in our favor as the volumes go up, obviously. Because we outsource manufacture, we get to leverage that sales contribution more significantly than you would say, for instance, in the filtration business where that kind of volume increase, you'd have to do some capacity things. What generally happens in these things is you ramp up the curve, you certainly cover your fixed costs. And, as Vic said, a couple of years out when you're banging out $50 million and $75 million more in sales, you're not adding a lot of people underneath that to support it. We use the word incremental margin.

I think the right way to think about that next step up the sales volume ladder is to think of it at about it at 42% to 45% incremental gross margin. And, you might have 1 point or 2 underneath it that dissipates that, so it's substantial when it falls down to the EBIT side.

When you start getting into the volumes we are looking at within just the Aclara piece of USG, you start to get yourself into the high teens and low 20s at EBIT, and Doble is already there. They did 22 this year, and you get some favorable leverage there off the growth talked about earlier. When you pull those 2 together, if you were as forward thinking as 14, you're going to be into the 20s at some level at the EBIT contribution side.

Okay, great. And then just one more if I may. Can you talk to the pipeline for the new RF electric product? Are you anticipating any material traction with that product any time soon?

I think where we do have that product focused is really more in a municipal market. We are not actively pursuing large investor-run utilities with that. So, it will be with the municipals and the combination utilities where we will look to deploy that.

Great, thank you.

Steve Sanders, Stephens.

Hey, guys. Good afternoon.

First, a question on Doble. You obviously finished the year strong. You've got some new products out there, a big focus on international expansion. Maybe you could talk a little bit about how the new products differ from what Doble's traditionally delivered. And what signals you are getting in terms of the new products and the new customers that give you confidence that we are going to continue to see this acceleration there.

Yes. We aren't getting specifics for competitive reasons. But, certainly we have significantly upgraded the current products. We have a lot more capability, a lot more functionality.

In addition to that, we are getting much more heavily involved in subsidization automation side of that. With some of the dissolved gas analyzers, so I'd we're taking one more step in getting deeper into the utilities And, we are able to do that because of the relationships we have with the utilities.

I had mentioned, we have a lot of people as we started talking about some of these products and looking for beta sites, that we were way over subscribed on people that really wanted to participate in that. These are products I think once they are developed and proven out, we will get into the field and people will be you know really -- they are chomping at the bit to get a hold of them.

The other area that we are working hard is a lot of our products today are really offline testers where you have to take the transformers or devices offline and do the testing. We have sold a good bit of online testing, but that is a product area that's, let's say in its infancy, but its not nearly as well developed as the offline testers are. That is an area where we have a major thrust. We have had a lot success selling those products into Asia, particularly into China. And, a lot more interest in doing that in US as well.

Okay, thanks for that.

Then, Vic, I think you talked a little bit about Brazil. You talked about the fact that you're not making any big deals into your guidance. Can you touched on CFE and Mexico specifically. And then also talk about whether there is the potential for some large gas and water deals that could be incremental?

First with CFE, we are completing that deployment there. They are flushing that out; it is working well. The functionality that they requested is there, so I'd say it's performing well. We are in a little bit of a lull period now before we're working with them on what might be the next potential deployment.

So, I think that CFE will end up deploying a number of technologies, whether that's 2 or 3, whatever, I'm not sure. It's certain there is a big role for our product because in the less dense areas, in particular, it's very well suited. And now, as we've talked about some of these others calls, it has been proven. We can go to the field and say, look, here is what you asked it to do, it is doing it, and it's doing it very reliably.

We think there is going to be good long-term opportunities for us there. And, I've already forgotten the other part of your question because I was talking so much.

It was just whether there is the potential for a large gas or water deal over the next 12 to 18 months to be incremental to what you're talking about now?

Yes, I'm sorry. I would say probably the best opportunity there, at least for s significant deal, would be on the gas side. We've identified probably a half a dozen, not SoCal's because there are not any more SoCal's out there really, but in the 1 million plus range that we are in the early stages of working.

I think the real opportunities got teams working those pretty hard. And, is that 12 to 18 months? I think there certainly is a likelihood for some of those to start taking place then. But, I will tell you that, again, today we don't have those baked into our forecast, so if we are able to be successful on something like that, then that would be an upside of what we are currently projecting.

Okay, good. Then, Gary, a couple of clean-up questions. You talk about the $6.6 million of other income, but the line item is $4.1 million, can you just close that gap for us? And then also, maybe, shed a little bit more light on your second half stronger than first half. I assume we are not going back to the 2010 pattern, but give us a little more direction there?

Yes, on the first part, Steve, relative to the OIOD stuff, there is some situations in there where we have taken some severance charges. We've had some other things where we've abandoned a few assets, some manufacturing equipment that was probably in the 30 to 40-year-old stage, and so we disposed of some assets. And, we had some situations with some newer products that we brought in, or newer equipment that we brought in that we expensed as opposed to capitalizing. So, I would say severance and leaving a little bit of asset in some foreign locations behind, and that sort of thing is probably the expense side that offsets the $6.6. Nothing of substance individually, just a bunch of little noise level stuff.

And, then relative to 2012, I'd say it's not going to be as steep as we had in fiscal 2010 where we did $0.02 in the first quarter and $0.90 in the fourth. I'd say the best way to think about it is, in fiscal 2011 we did about 45% of our EPS in the first half, and this year it will be about 30% of our EPS will be in the first half. So, it's not going to start out at a $0.02 kind of thing, but it is going to be lower than Q1 was of fiscal 2011, but not as severely as low as 2010. If you looked at 30% of your combined EPS in sum of Q1 and Q2, I think you will be in the right ballpark, how that curve looks sloped.

Okay, thank you very much.

Okay.

Sean Hannan, Needham & Company.

Good evening. So, I was looking to see if I could perhaps get you, Vic or Gary, to elaborate at least a little bit on some of the projects that you have ongoing in filtration and test in terms of where do we stand with some of the larger projects today? What remains?

And then, if you can further detail how some of the growth is actually being driven in some of those businesses, and with particular consideration to the degree of momentum you see from those businesses, kind of, what you have acquired?

I'd say the good news, at least -- in both businesses, but let's talk about tests first. The good news is, right now it's not a big project-driven growth that we're seeing. Certainly, we have had some benefit with the project we are doing with the Air Force and satellite chamber. That is going to be completed in the first quarter, maybe the second quarter of this year.

But, there aren't any huge contracts that are really driving the growth there. The biggest contracts we have are $4 million, maybe $5 million contracts. What's happened is we have a lot more traction with some of our smaller projects and so, $3 million or $4 million projects. A lot of the components, the MRIs we've got a lot faster growth internationally than what we had anticipated.

So, while we do have good solid projects like a big satellite test chamber that we are doing in Argentina or a large automotive chamber we're doing in Turkey. But, again, those are $4 million or $5 million projects. What has really made that business grow, is the breadth of applications that we have. And, the systems business that we entered in a little over 1 year ago, we starting winning some substantial projects there. So, the good thing about the growth we are seeing there is it's not tied to a $20 million project with General Motors or a $20 million project with Boeing, which is what we had in the past.

I would say the underlying momentum there is really strong, particularly in Asia. As we continue to talk about, that market does continue to grow. We are seeing more strength now in South America than what we saw a couple of years ago.

A lot of the government projects have been driving this growth as well. So, the funds are there for some of those things as they look to have more development in country that needs supportive projects like ours.

I'd say pretty much the same thing on the filtration side, in that we have just been successful in getting on more airframes than we have been in the past. I think the addition of Crissair has really has been key. They are performing at, or actually a little above, the projections we had for them when we acquired them. So it's really, again, the momentum in the aerospace business, and I think if you talk to any aerospace business today, they see good strength. And, we are participating in that in a larger way than we have in the past.

The fellow that runs that business, Sam Chapetta, has done a nice job of working those 3 businesses together. So as we have opportunities, and there are some, where we can go in and bid either 2 or 3 of the companies together on some of these more complex projects, we have been able to do that.

Thanks, Vic. Since you just brought up Boeing, maybe if we can talk about that side of the business or at least as it pertains to filtration. When you think about Boeing and perhaps Boeing and Airbus together with the platforms you're on because there are a number of platforms that are now really ramping. Can those customers effectively ramp in excess of 10%, or how should we think about the commercial side of that filtration business today and it's traction?

I think the production schedules for those companies are pretty readily available. And, we don't see anything that is going to change that significantly today. So, as those businesses continue to be successful, we will ride along with them.

We are fortunate, or whatever you want to call it, that we were able to finally get on Airbus product because that has given us an opportunity to play with both of those major prompts. I think they both do have strong opportunities going forward. Having Crissair on board, who already had a good position with Airbus, has helped as well. I see both of those companies as doing well going forward, and fortunately, we are on a number of airframes participating in that.

Okay. Then, lastly, when you look at your business development efforts on the utility side, I realize a little bit earlier you were talking about hey look, we are not looking for the mega projects. But, I believed that you had seen a number of utilities, some large, some international that particularly being referenced to you for your gas solution. Just looking to see if we can do a quick update around what's being actively pursued?

Do we have some scenarios where there are 1 million endpoint and upsize deployment opportunities? And, what stage are discussions are? Let's say, what are some of those discussions with those utilities?

Yes, as I mentioned a bit ago, they are probably on the gas side is the opportunities for the biggest, one pop kind of deals. There is probably a half a dozen of those, 1 million points or larger that we're actively having discussions with customers. Our hope is somewhere in the next 12 to 18 months, some of those will start to transpire.

I think, having a reference customer, as what we have in California with PG&E and now with SoCal starting to roll out, positions us very well with these larger customers. I think it would be more difficult for them to rationalize going with a competing technology when they can go and see the 2 largest gas deployment of there utilizing our products.

Also, we do have some discussions with some larger water customers. But again, those are more in the hundreds of thousands of endpoints range. As you know, the water market's really more made up of 30,000, 40,000, 50,000 endpoint customers. Some of the larger cities are starting to look at those types of things. And again, I think the having the reference customers like New York City and City of San Francisco and Boston, and those types of deployments that we have already been successful really put us in a good position there.

Thanks so much.

Paul Coster, JPMorgan.

Thank you for taking my questions. Perhaps I can start by just examining the fourth quarter gross margins a little bit. Can you just talk us a little bit through why these were quite low on a historical basis?

And then moving forward to fiscal year 2012, how should we shape that? It sounds like by the end of the year we should be expecting an excess of 40% percent, should it ramp during the year?

Yes, I'll say relative to the fourth quarter. As I mentioned, we took that -- an opportunity to clean up some of the inventory that was more legacy driven on the RF electric product and that was about $6.5 million. That was worth about 3.5 points of margin in the quarter. If you set that aside, you're back up at 38 or 39. We if we use that, as what I'd call the operational gross margin for Q4.

It was a little bit lower than historical run rate. And, I'd say for 2 reasons primarily driving it is the VACCO business, which historically has a lot of space content, and the higher margin things that came through from the historical Project Constellation were not in this quarter at the levels they were in the past. If you set aside VACCO, that's probably worth close to a full-point of margin as last year in the fourth quarter. They did mid-40s on the gross margin and in this one they did about 39 to 40.

The impact of VACCO into the group is worth about -- on the space business, is worth about a point. Set aside the nonrecurring charge and look at it on an operational basis, and really I would say VACCO is the main driver.

And then, the secondary driver is just the volume decrements of PG&E and New York going away. Those are high margin things. When they are not in the population, the margin's temporarily impacted by that as well.

So, as we jump forward, and we don't have the negative comps going forward on PG&E and New York City because they have basically, essentially gone away. You'll have a much more normalized gross margin rate that I think we are very comfortable speaking to in the 40% range again.

You obviously excellent visibility into the SoCal revenues as the year progresses and then into fiscal year 2013. Do you have the same degree of confidence around the gross margin for that project or just the service, but the products as well?

Yes. We've got very good insight into that. These are pretty standard products who already made them. We had to do some work on different meter types and that type of thing, but we're very confident with the product itself. And, most of them are very standard products, so we are in good shape there.

The filtration and test businesses had a tremendous year, but the guidance suggests that there's a pretty significant deceleration into fiscal year 2012. What ultimately accounts for that?

I don't think -- we're not projecting deceleration in that. We are anticipating some additional growth next year in both of those businesses over and above what was -- were very strong years. Test had the best year they have ever had this year. We are anticipating an even better year next year.

I get that. I said the deceleration in the growth rate. It's going from very high double digits --.

Test grew 28% this year.

And, you had filtration up also very significantly -- (multiple speakers).

Yes. I would say within test, the 28% obviously, as Vic said, it was the best year in our history. And, as we're migrating, these large contract scenarios to what I'd call a grouping of smaller contracts embedded in fiscal 2011, is the large contract, as Vic said, with the Air Force for a satellite test chamber down at Cape Canaveral. That was about $11.5 million of revenue in 1 year and a very high margin.

So, we thought that thing was going to take 1.5 years, possibly 2 years to deliver, but the execution on that project was outstanding, and we were able to get the entire project in this year. That is a big driver of what you see impacting test in fiscal 2011 versus 2012.

We will still show top line growth, but the top line growth is going to be the aggregation a of bunch of $2 million and $3 million and $4 million projects instead of the $11 million, $12 million, and $13 million projects we've had historically. What we like about the 28% growth for the fiscal year is that it reset the baseline.

Okay, so, what was historically in the test business, one would think of it as $150 million to $160 million business. I think the right way to think of it now is $170 million to $180 million business. So, we've re-baselined the business there with the global expansion and, as Vic said, the broadening of the product offering.

We are going to go back to what I'd say is the historical growth rates of mid-to-upper single digits as we stair step across. Now with that said, if we are fortunate enough to get another $10 million or $12 million single project, then it will accelerate, but I would say that the re-baseline of what the scale of that business is should be is the positive take away from this.

Okay, last question. Heading into 2009, we obviously experienced a cyclical downturn as clearly risks around government or into the neuro-European oriented businesses at the moment. To what extent, comparing and contrasting, is today different from say the end of 2008?

I think we have better insight into the specific projects, the backlog that we have, and where we are going to see the growth. I think going into that timeframe, there was a lot more uncertainty, not that these aren't uncertain times. But, if you look at the projects that we have, look the customer that we, look at the countries they are located in, I don't anticipate as much volatility as we had then.

Okay, thank you.

Jeremy Hellman, Divine Capital Markets.

Hey, guys. Can you hear me okay?

Yes.

I just wanted to go back to CFE for a moment, if I could and understand with the guidance you've put out for 2012 and 2013, if you are assuming any contributions from CFE, and if so, any quantifications you are willing to provide around that?

Yes, I won't go into any quantification. We're not projecting anything in 2012. We are assuming that we are going to get another award that will deliver in 2013.

Okay.

It would be more in a size of what have already entered, though. We are not looking, we are not anticipating a huge ramp up there. Not that there's not the opportunity for that, but that's not the assumption we have in our forecast.

Okay and then similarly, where are you with respect to what you've done in Colombia? Does that got any follow-up potential?

I think it has some good follow-up potential. We are about done with the current contract that we have, but we anticipate having something, I believe, toward the end of next year in Colombia as well. That's a project that's going very well. As you can imagine, the funding is always a bit of an issue there. But, I think we will have some additional orders there as well.

Okay, thanks, guys.

Craig Irwin, Wedbush Securities.

Evening, gentlemen. Thank you for taking my questions.

So, as we look out at the overall landscape of USG that you address, you have a pretty good penetration into a number of different channels, Doble, the old Aclara business, the RF products. Is there anything that you might see as an opportunity from an M&A side out there that you might want to buy? Or is there anything that you see as potentially missing from the portfolio or something that would enhance your competitiveness if you were to develop these products for your existing customer base?

Yes, a couple of things. Obviously, I'm not going to talk specific about M&A opportunities because to the extent we can keep ourselves that would be better. As I've said previously, we are very comfortable with our core AMI products. And so as we look to expand that, we look for opportunities to add functionality, whether that be software, whether it be some hardware, to augment the things that we can offer to the grid and to automate the grid, those are opportunities that we look for.

What I always tell people as -- that are out looking for businesses for us and our internal guys, is that we'd like to find the next Doble. And by that I mean, another company of that size, profitability that has a niche that supports existing customers. Those companies are out there, we are aware of some, and those are the kinds of companies that I think would be a good addition for us. Because you have an opportunity to significantly grow the Business, but not have some of the volatility you see with these large AMI deployments. We are very committed to the AMI business, and obviously, think we've got good positioning there.

We are making good progress, but it does introduce volatility. I mean, just look at it, last year versus this year PG&E and New York City, and we dropped off $40 million in 1 year. So, that is something you have to replace and then start over. So, we continue to look for opportunities for companies that are more like the Doble business model that would help us to further penetrate the customers that we have. We really like the utilities space, and we remain committed to providing them with more products and services.

How would you characterize your overall level of activity level right now? Would you say that it's higher in the current environment than maybe 1 or 2 years ago? Or, would you say that the relative opportunities might not be as high as several years ago?

I say the reality is that it's probably higher than it was a couple of years ago. There are companies out there that are looking for an exit strategy or looking for a strong partner. And, as Gary and I both mentioned, I think we are well-positioned to take advantage of that because of the low leverage ratio we have, the access to capital that we have. The fact that we are a fairly profitable business. It puts us in a good position.

Banks are taking a lot of heat right now for not lending money. They want to lend money, but they want to lend to somebody they are pretty sure they are going to get it paid back from. And, I we think a very high candidate for them, and we have had a lot of the discussions with our banks and there very willing to work with us as we find opportunities. I like the financial position we are in because I think it does put us in a very strong position as some of these opportunities come to fruition.

Plus, Craig, I will add one other thing. The valuations are stabilizing a little bit besides the overall equity markets being all out of control.

I think sellers expectations have rationalized as well, and that's where, as Vic said in his commentary, we can be a little more aggressive because people aren't looking for the top -- top penny to scrape off this thing. I think we are having a lot more rational discussions with sellers, which keeps the pipeline a lot more robust, as opposed to a couple of years ago where people thought 12 and 13 times EBITDA was the minimum what they would take in some of these folks we talked to. I think the overall environment is very comfortable for us right now to be aggressive.

Great, moving on to the R&D budget. Can you discuss with us whether or not you expect significant incremental spending in the R&D line this year. And maybe give us some color on your top priorities as far as R&D spending in fiscal 2012?

I will give you the dollar amount, and I will let Vic give you the statistic allocation of that. When we put our planning process together, we think of this as a 7% to 8% of sales type expenditure. As the sales are expected to increase next year and the year after, I think the dollar amount is going to move up a little bit next year and maybe a little bit higher as we see that.

As Vic said in commentary earlier, that the smart grid expenditures that were $10 or $11 million last year probably are going to be half that. So, I would say nominally the dollars will go up. But if you think of it as that 7.5% of sales for the foreseeable future, is probably the right way to think of the dollars, and I will let Vic give you the allocation.

Again, the primary areas where we are focused today are the Doble products, with some significant new products coming out, a significant upgrade to what they already have. And then, working with the Aclara products as well, particularly on the software side. And, then what we are doing, I don't guess you'd necessarily call it R&D, but some of the development work we are doing in support of the SoCal project, are the biggest areas that we're working.

Great, and then last question, if I may, is a little bit more of a housekeeping question. Tax rates have been a little bit volatile over the last couple of years. I guess in 2009 you were about 22%, 2010, 36% and 2011 back to 32%. Can you talk about the fourth quarter tax rate coming in at 23%? What drove that lower tax rate and what your expectations are for 2012 and 2013?

Yes, I would say going forward that's the easier one to answer is going forward. I think it will be -- think of it in the 33% or 34% range going forward is the right way to do it. So, looking the at the volatility historically, I'll say 2 things.

One is a compliment to our tax group. They are extremely focused on finding opportunities to mitigate or minimize our tax liabilities because it is real money. And, they manage one of the larger operating budgets in the Company because our tax off our pretax is a pretty substantial dollar amount. So their tax, or their focused with mitigating that.

Part of the opportunistic things they do, is to make sure that we fully exploit the legal means to do this with things such as a research credit, domestic production deductions. As well as on the foreign side, maximizing the favorable impact of our foreign tax holding companies.

So, as we have grown this Business more internationally, we set up over the last year a very structured international tax group via a tax holding company based in Luxembourg. So, as a result of that in the fourth quarter, we were able to realize some tax benefits, foreign tax credits, that sort of thing, related to the profitability we are now experiencing internationally, which in the aggregate has brought in a lower rate.

The other thing that worked in our favor was we had a couple liabilities from a few years ago, primarily related to Doble, where we had thought we had a little bit of a tax situation, but the statute of limitations expired. We were able to defend our position, so we had part of our uncertain tax positions came back through the P&L to the tune of about $400,000 to $500,000.

We are always going to have volatility. I think that's a tribute to our tax groups, that they do shake the low hanging fruit out as well as the more aggressive stuff. I don't want to apologize for the volatility because it is real money in most cases.

I would say going forward, 33%-ish is the right way to think about it. That's lower than our average rate has been over the past few years because I think these permanent items that we put in place primarily on the foreign side are going to save us money. The biggest challenge we have is to try to make sure we have enough credits in place with the things, like the research credit, to mitigate the impact that the state tax has worked against you. I think our tax group is doing a great job contributing to the overall EPS contribution.

Thank you, and thanks again for taking my questions.

Okay, Craig.

Andrew Storm, Cortina.

Hey, guys. Thank you.

I'm just curious, earlier this year, you had talked about some deals with -- or working with the Japanese utilities. Understandably that went off the table with the earthquake, but we are getting past that; they are going into rebuilding and we've heard a lot about their energy problems, their power problems. I'm curious, where are we in terms of that? Are you seeing them come back, and is that in guidance?

It's definitely not in guidance, just because I think there is certainly still volatility there. They are starting to talk again. We feel very strong that we have a role to play there. But, it is so uncertain that we would not put that in our guidance today. But, we will continue to discuss opportunities with them going forward.

Okay, and I wasn't sure -- had you'd already won an RFP that was just canceled because of the earthquake or was it earlier stages then that?

It was earlier stages than that. Where we ended right before that was when we had been approved for sale into Japan. So, we had been through all the testing, do the lab testing, some field testing; it was approved for sale. But, they had not formally sent out an RFP for our project.

Okay, great. Thank you.

Steve Sanders, Stephens.

Thanks for taking the follow-up. Vic, coming back to the macro, I think the last time I saw the actual direct European sales number, it was in the 10-K and it was about 6%. Maybe, you could just get us a sense of what your direct European exposure is in terms of a run rate, and whether in the past month or so, or how you thought about it relative to your guidance in terms of Europe playing out in 2012?

Almost all of that, Steve, is the test business. There is a little bit with Airbus and with Doble. But, the primary driver there is the test business.

And again, we feel pretty good about where we are at there. We've been in Europe for a long time, and we've got some, I would say consistent customers there. Whether it be Nokia, people that want our filters, and in Europe we're talking about our RF filters. Doble has a good set of customers there. Some of that, they have a big service contract with the UK utility.

We keep a good eye on it, but I'm not as concerned about that as a lot of businesses would be just because of the longevity we have there and the types of products that we're selling there.

Okay and then in terms of the total, is it still 10% or less in terms of the run rate?

I think this year, Steve, in 2011 it will be around that, if not a little higher, because, just as a reminder CFE, -- what's that -- are you only talking Europe? I'm sorry.

Just Europe.

I would say that what we have there is pretty consistent. I don't see a significant change there.

Okay, perfect. Thanks, guys.

(Operator Instructions)

Carter Shoop, KeyBanc.

Just one more follow-up. When we look at your implied guidance for 2013, it looks like the implied margin on that business is a lot less than what we have seen historically on an incremental basis. Is there anything going on in 2013 on the OpEx side or gross margin side that we should be aware of, or are you being conservative on the EPS guidance for 2013? Thanks.

Yes, I would say it would be the latter. It is 2013. The point we are trying to get across here, obviously, is that we do see significant growth in 2013. We want to make sure we get that on the table with folks so they understand that.

We have a great deal of confidence that, that level of sales and profitability is going to come through, but we don't have it tied out to the last penny. There's nothing that we anticipate being a significant change to what we've seen in the business today. It is not a big -- capital expenditure that is anticipated or anything like that. We're just trying to make sure that we don't get too far ahead of ourselves.

I would just add to that, Carter, to Vic's point that we are being conservative, I would just focus on the point that we say more than 25% in 2013 versus 2012. There's more upside to it than downside based on the baseline that we are putting in place today because of the distance that we are out. We are very comfortable saying more than 25%. That should allow you to think that the actual number would be above that.

At this time with no further questions in queue, I would like to turn the call back to today's speakers for any additional or closing remarks.

Okay. Thanks very much for your interest, and we will be talking to you next quarter. Thank you.

This does conclude today's conference. We thank you for your participation.