ESCO Technologies Inc (ESE) 2014 Q3 法說會逐字稿

Presentation

Good day, and welcome to the ESCO third quarter 2014 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 of Investor Relations. Please go ahead.

Thank you. Statements made during this call regarding 2014 Q4 EPS from continuing operations as adjusted, future growth, profitability and revenue, sales, market share, product development acquisitions, the schedule and cost of the Crissair move, share repurchases 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.

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 will be included as an exhibit to the Company's Form 8-K to be filed. 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 press release issued today and found on the Company's website at www.escotechnologies.com under the link Investor Relations.

Now I will turn the call over to Vic.

Thanks, Kate, and good afternoon. Let me start by saying that I believe the current quarter and our nine-month results show that ESCO has firmly positioned itself for a more stable and predictable future. Combined with the strength of our balance sheet, we have a tremendous amount of financial flexibility, which creates additional opportunities for growth.

I firmly believe our core businesses continue to present us with long-term organic growth opportunities that when supplemented with our M&A strategy create an exciting outlook for ESCO over the next several years.

As we reported in a separate release today, I'm please to announce that we've added a new independent board member, in addition to the two others we announced in May. We're very fortunate to find such experienced executives to add to our already strong board.

Additionally, Jim Woods announced he'll be retiring from the board in October after a long successful run. We sincerely appreciate his many contributions and his guidance over the past 13 years.

Moving on to Q3 performance, we again exceeded the profit and cash flow commitments compared to our earlier expectations. This was the result of a really strong quarter in the test segment, lower than expected SG&A spending across the Company and a favorable tax rate.

Clearly the significant increase in our orders and backlog remains a real bright spot for the year, as I believe it validates strength and the leadership positions we hold in our various end markets. This strong market presence positions our core businesses to gain market share and to maintain our increased profitability in the future. Gary and I recently visited all the domestic operations and came away with a positive outlook for the balance of the year, as well as validating our view of future growth opportunities.

Within the filtration segment, we remain bullish on our growth and profitability, which is being driven by recently announced aerospace program wins, coupled with having some sizeable programs moving toward production, also the consolidation of Crissair and Canyon is progressing on schedule and on budget. And looking forward to next year, we're excited to see the preliminary EBIT projections coming out of that combined operation.

The test business had back to back quarters of greater than $50 million in orders, which bodes well for the significant sales increase expected in Q4. The outlook contains several large projects, which are on track and are expected to deliver solid profitability.

Doble had another solid quarter as they delivered 21% EBIT on increased sales. We continue to see a significant uptick in the market interest related to Doble's recently introduced products and solutions, including dobleARMS. We recently won a large contract with SoCal Edison to implement our ARMS solution.

Doble's international strategy continues to show success, evidenced by the recent win as with Saudi National Grid, which creates an exciting opportunity for us in that region. We see this win as a potential catalyst for several other opportunities in the area.

So to wrap up, the remainder of the year is on track and I remain optimistic about our growth prospects, both short term and longer term. Our priorities remain simple and straightforward. Execute and deliver our commitments in the core business, maintain our focus on new product developments supporting organic growth and supplement our existing plan with accretive acquisitions around our core business. This will be supported by our strong balance sheet, our rigorous planning process and our attention to the allocation of capital.

I will now turn it over to Gary to discuss the financials and we'll then be glad to answer any questions you have.

Thanks, Vic. With the Aclara sale being completed in Q2, Aclara's financials are presented as discontinued operations in the attached release. You'll see there was no disc op activity in Q3. Consistent with our previous communications, the Q3 and year to date results are being reported on the basis of EPS from continuing operations as adjusted and my commentary will follow that format.

As a reminder, the fiscal 2014 results discussed here exclude the non-recurring charges to complete the exit and relocation of Crissair's Palmdale, California operation into the Canyon Engineering facility in Valencia, California.

As Vic said, the process remains on track and is expected to be completed at the end of the fiscal year at a cost of approximately $2 million or $0.05 a share. We've spent about $700,000 through June 30th. The 2013 adjusted items were identified on a quarterly basis throughout the prior year and are described in the financial tables attached to this release.

During our May call, we expected Q3 EPS from continuing operations as adjusted in the range of $0.36 to $0.41 a share. We beat the top end of our range by $0.03 as we delivered $0.44 a share on a comparable basis. The increased earnings were the result of solid operating performance across the segments, effective cost management resulting in lower than expected SG&A spending, and a slightly better than expected effective tax rate, which resulted from additional research credits and foreign tax credits being realized. I'll call out a few highlights from the release to allow you to better understand the underlying results.

Q3 sales increased 12% over the prior year with all three segments contributing. The test business led the group with a 23% increase in sales, followed by filtration sales increasing 7% and Doble's 4% increase. Adjusted EBIT dollars increased 11% on this 12% increase in sales, which contributed to the EPS growth.

The test business delivered above average EBIT growth, which demonstrates the earning power of our lowered cost structure, resulting from last year's restructuring actions. Doble's Q3 EBIT of 21% was slightly below Q3 of the prior year, primarily due to additional sales and marketing costs incurred related to several new products, which are being introduced throughout 2014.

Filtration's EBIT came in slightly below prior year due to higher engineering startup costs being incurred at PTI as several of our new aerospace program wins are in the early stages of development and/or low rate initial production. These NRE costs, which drive significant increases in future years' revenues, are coupled with the additional inefficiencies being realized by operating in the two facilities at Crissair and Canyon, which are being consolidated into one.

So at the bottom line, in Q3 of this year, we reported $0.44 of EPS from continuing operations as adjusted, which compares to $0.33 in Q3 of 2013. This reflects a 33% increase in EPS on a 12% increase in sales.

On the cash flow and balance sheet front, we generated $23 million of cash from continuing operations during the first nine months of this year. As part of our capital allocation strategy related to share repurchases, we spent $4 million on buybacks through June 30th and another $5 million through July 31st for a total of $9 million in the last four months.

We expect to continue to opportunistically repurchase shares in the open market during Q4. We continue to be supported by a strong balance sheet as our net debt balance was $8 million at June 30th.

A significant highlight of both Q3 and our nine months was the strength of our entered orders. During Q3, we recorded $150 million in orders for a 1.15 book to bill and a resulting backlog of $293 million. All three segments reported very strong orders in both the quarter and year to date periods, which bodes well for our future and continues to support our growth expectations.

We are most proud of the fact that from an EBIT, EPS, cash flow and orders perspective, fiscal 2014 is playing out at or above our original expectations and we expect that to continue in the fourth quarter.

As noted in the release, we do expect a solid fourth quarter and therefore we have moved our EPS expectations for 2014 towards the high end of our EPS range. We expect Q4 EPS from continuing operations as adjusted to be in the range of $0.44 to $0.48 a share. And I'll be happy to address any specific financial questions and I'll turn it back over to Vic.

Okay. We'd like to answer any questions you have at this time.

(Operator Instructions) Jim Giannakouros, Oppenheimer.

Good quarter. On your filtration segment, just thinking high level about your current OE versus aftermarket mix, I think that your recent platform win keeps your OE percentage of mix kind of where it is now, roughly two-thirds or so. Correct me if I'm wrong. How should we be thinking about that going forward as far as your mix, maybe providing upside to operating margin, particularly if aftermarket over time represents a higher percentage of sales?

Yes, I think you're thinking about it the right way as of now. I mean obviously we do work to get more of the after market business, but I think that's just going to be kind of a slow process. I don't see that changing dramatically over a two year period or something like that. But as we get more and more of these products or platforms are on to mature, then that's where we have the opportunity to get more of the aftermarket business.

And once you're on a platform, what's been your experience in retaining aftermarket sales? Is there anything contractual there or --? I'm basically looking is it one or two years with a high degree of certainty that you're going to retain after market? Or is it much longer than that?

It's much longer. It's very, very unusual for you to lose the aftermarket. You have to understand that for these aero lines or aircraft manufacturers, either one, to second source something is an expensive process, it's a long process. So what we always talk about is once you're on a platform unless you really screw up, then you're kind of on it for the duration. Once you win a program, we really assume that we're going to get all of that aftermarket business going forward and that's been our experience as well.

And two quick ones if I may on your other segments. You said Doble there were sales and marketing costs that were a bit higher in 3Q. Should we expect similar spend in 4Q?

Yes. Similar dollars and then I think you'll obviously see a revenue increase there as well, so I think when you pull that forward, pull the revenue up a little bit, hold that spin the same, you should get back to the 22% to 23% EBIT margin just because of the leverage we'll get off of the additional sales. And then going into 2015 you should see that drop a little bit.

And part of that, just so you understand what we're doing, is some of the international opportunities we're going after and obviously that's more expensive. There's more travel cost, those types of things. But I mean obviously that's something we need to do to be able to tap that international market, further penetrate those markets more so than we have. And we're having success doing that. So I think it's money well spent.

Understood. And the last one, if I may, on test. You guys had a good quarter, good growth. Do you have line of sight or any -- can you guide a little bit on what you're seeing as far as your project pipeline? It is a lumpy segment, but how should we be thinking about that near term?

It can be a bit lumpy, but I would say that the insight that we have through the fourth quarter and certainly through the first and even into going into the second half of next year is pretty solid. I'd say it's consistent or maybe a little bit better than what we've historically seen. There's a couple of large projects out there, which we don't assume that we would get that would provide a little more significant upside.

Kevin Maczka, BB&T Capital Markets.

First question, if I can start on some of the aero programs that you've won over the last few quarters, PTI and Crissair. I think maybe the A350 is the biggest there, but based on the customer build schedules, can you just give us little bit of an update there on how to think about that going forward? When does that start to really move the needle more for you in terms of revenue? Is that more of a 2015 or 2016 type event as you roll all these new programs forward?

Yes, that's the right way to look at it, Kevin. If you look at -- let me give you two data points. One is our content for playing. Obviously A350 is the largest contribution per aircraft and that's about 130,000 per unit on the OEM side. And what they're publishing in all the airline monitor and all the other things that come out of the TL report for directional guidance there is they expect that to get up to about 110 planes a year by 2017.

And so sitting here where we are today, obviously it doesn't go from zero to 110 just step function. So I think if you model that out going up to 50 planes a year next year and 75 or 80 planes in 2016 and then put yourself up to the 117. So that's kind of the glide path of the development of the revenue profile there.

And when you look at some of the other things, the next one I'll talk about is the -- that we announced was the Commack, which is the Chinese C919. Our content on is about 10,000 a plane and that really kicks in in earnest in 2017 as well.

The Embraer, the E2, the ERJ upgrade we're talking about, we do about 40,000 per aircraft on the OEM side of that. And that kicks off in earnest in late 2017, early 2018. And the build rates they're looking at there are in the high double-digits, 50 to 90 a plane. So I think stepping into 2015 and 2016 you're going to see nice organic growth and in 2017 when all those programs are running at what they think is close to annual stable run rates, I think that's where you'll see the step function change.

And then in terms of the engineering and new product development costs associated with these programs and others that you're bidding on and hope to win, I guess for the existing ones that you've already won, are there some engineering costs that roll off and go away next year? Or is this just kind of part of doing business from here on out as you're trying to develop new products and win new programs?

Yes, I mean the biggest one is the A350. I mean that's the only one I would that has substantial engineering costs. And all these others have some, but they kind of pale in comparison to A350. So that should be completed some time this next year, first half of this next year as far as the A350. And then the others will be there, but they'll be smaller amounts.

So it is the price of doing business, as I mentioned before. You go through this phase, and we've been working on the A350 now for about four years. Because you go through this phase so that you get to the part where we have full delivery of 100 units a year for the next 20 years or whatever the case may be. So it's kind of the price of being in that business.

Kevin, let me add something to Vic's comment there. Obviously on the NRE upfront you're incurring that startup design work with very little revenue. Again, see because we're not in full scale production. And so that will stabilize and fall into a category that's called recurring engineering or sustaining engineering, so it drops off significantly, but it doesn't go to zero. And I'll use the Boeing 737 as an example. The thing's been flying for 30-something years, so obviously all the NRE is decades ago.

But we still trim off the product a little bit and probably spend $40,000 or $50,000 a year on sustaining engineering, just keeping the product current. So you will see a step down in the future, but it won't go to zero because the sustaining aspect of that, which is 10% or 15% of what you spend up front. But that's priced into the product, so it kind of becomes invisible when you have the revenue sitting on top of it.

And hopefully in the couple of years there'll be a new major platform that we can go after, because we want to spend the NRE because that's how you get on the new programs. So it's one of those things where you've got some ebbs and flows in it, but there's always going to be some level of engineering required.

Well, I guess on that point then, as we get out into the second half of next year, is there any way to ballpark what type of these upfront costs do drop off? And in terms of other new programs, things like the A350 don't come around every month or quarter.

That's for sure.

Can you comment on what else is new and exciting that you're after there?

Well, I think we just got through the rash of them that are out there now. There's a few programs that are on the horizon, but I don't think we're really in a position to say which ones we think are going to go forward and which aren't. As far as the specifics on how much is going to roll off, we're in the throes, well, I guess week after next we'll have everybody in for a first look at 2015 or actually second look at 2015. I think we'll have a little more insight by the end of the year on what that spend profile is going to look like.

And then just finally from me, can you remind me, on the Crissair Canyon consolidations, it sounds like that's on track for the end of September. What was the cost savings planned when that's fully implemented?

Yes, it's less than a one-year payback. So we're spending in round terms, it'll be about $2 million. Obviously the majority of that hits in the fourth quarter when we physically do the move. So if you pegged it at $2 million, the savings will be greater than that. So as we -- and to Vic's commentary when he talked about the EBIT profile of the contribution coming out of that joined entity, it will be meaningful next year.

Sean Hannan, Needham & Company.

David Roldan for Sean Hannan actually. So wondering if you could elaborate on the progress with the ARMS software within the Doble business? How many pilots are you in today? How many more do you think you can recognize this year? Have there been any kind of incremental big picture impacts, the story there? Any color you can shed there?

Yes, a couple of things. We've got eight pilots under our -- or, not pilots, but eight beta sites out there that are all performing well. We think those are going to turn into real projects at some point. We're not looking to add anymore sites like that. For instance, in the near term we're really looking at selling the product now, which we've had some success with.

And additionally, we've added some people and added some of the other marketing costs that we mentioned earlier to support that both domestically and internationally. And I think we've been in front of probably 50 or so customers talking about this and it's been a high level of interest.

One issue -- not an issue, but one thing about this product is because it sold at a higher level in the organization than where we've typically sold our boxes and some of the other solutions, we have to have people that can go in at that level and we've been fortunate to get some people that have been customers in the past at pretty senior level in organizations that have come to work for us to go out and sell the products.

So for me to have some pretty senior level people out of the utilities that want to come sell this product, that says a lot to me about how much success we're going to have because these are people that are used to operating at those levels and are going to call on people that were at their level to talk about a very impressive piece of software.

And then on the M&A front, without naming names, are there any candidates you're in active discussions with? And if it were to be international, are there potential geographies that are more interesting to you than others?

Well, currently we are -- obviously we can't give a lot of detail, but we are talking with several companies. These things always take longer than we think they're going to, but we do have some things that we're actively looking at. As far as whether domestic or international, we won't go into that, but if we were going to look at international opportunity, I think that we'd be very comfortable either in Europe or Asia. Probably nothing in South America at this point in time that we'd be looking at.

(Operator Instructions) Jon Tanwanteng, CJS Securities.

Can you talk about the Saudi Arabia win a little bit more and what that means for growth in the region?

Yes, and what we're really doing there, this initial contract, which we think will be potentially a multi-year contract, is really do an assessment of their transformers in their old labs. So this is a little bit different -- well, I mean something that we do, but to do a project this large just on this is kind of unusual. So what they're doing is looking to analyze the help that their grid, if you will, at least as it relates to transformers and our ability to test those transformers.

And then a longer end, to train their people to do the testing, to understand that. And then what hasn't been considered yet is any hardware that would be sold in conjunction with that, which I think over time will certainly be a good opportunity for us.

In addition, there's -- Saudi kind of leads the way in that area, that part of the country. And so I think it was really key that we got them onboard first. So we're in active discussions with other utilities in the area, which I think now that we see what Saudi Arabia's going to be doing, that maybe they'll fall in behind that.

So it's a little bit of a two-step process in that we're going to go in and do this assessment and it's not a short-term deal. I mean we're in for a year and it's probably going to take longer, a good bit longer than that to do the total assessment, get their people trained and then hopefully equip them to go out and support and test the health and welfare of their system on their own as they go forward.

And then you had some nice bookings in the test business. Can you comment on the traction and reception you're getting for the newer protection products there?

You talking about the MP products?

Yes.

Yes, we've had some good wins here in the US and then I'd say more importantly -- (inaudible) more importantly, but equally important we have won a couple of jobs in Asia as well, places in the Korea, Taiwan, those places have a great deal of interest in this technology.

So not big wins, we're talking less than $5 million, but those are nice, profitable jobs and also it kind of gets our foot in the door with some customers. So once we can get some facilities built there, it's much easier to get customers to come over, look at that, understand it and see the benefit of doing that.

And then I'm not sure if you commented on this before, but just with regards to M&A and the repurchases, what's the ideal capital structure for the Company following those actions?

Better than it is now. I'll start there. Obviously it's not our goal to run debt free, so as Vic said, let me kind of address it mathematically first. We publicly stated that we're looking to keep about 40% of our free cash flow in the return to shareholders, so a combination of the dividend, which we have in place, which is about $8 million a year, and then we'll do the share repurchases at levels greater than that until we start adding some debt to the balance sheet. But the deals we're looking at are not hundreds of millions of dollars of debt.

So our goal is to get to a capital structure that generates the best return on invested capital and so I think the mix with debt being as cheap as it is right now, the deals we're looking at are accretive. I think if we get to a point where we have 15% or 20% debt to capital, that's certainly comfortable.

We kind of come at it the other way and say what's our leverage ratio? We're not looking to get 3 times levered by any stretch. So somewhere between 1 times levered and 2 times levered is extremely comfortable, as long as it comes through with the end result being an increase on the return on invested capital.

So if you think of our structure as less than 2 times levered and you can kind of back into the equity relationship in that regard.

At this time I show no further questions. I'd like to turn the call back to Vic Richey, Chairman and CEO, for final remarks.

Before we wrap up, I just want to remind everybody that we'll be hosting an analyst and investor day on September 9th in New York City and we'd enjoying having you attend. You'll be able to meet and talk with our senior operating executives, which I'm certain you'll find worthwhile. So thank you to everyone. I look forward to talking to you after year-end.

Thank you, ladies and gentlemen. This concludes today's conference. Thank you for participating. You may now disconnect.