ESCO Technologies Inc.

Good day and welcome to the Q1 2021 ESCO Earnings Conference Call. Today and number 39's call is being recorded. With us today are Vic Ritchie, Chairman and CEO, Gary Monster, Vice President and CFO. And now, to present the forward-looking statement, I would like to turn the call over to Kate Lurie, Director of Investor Relations. Please go ahead.

Thank you. Statements made during this call regarding the amounts and timing of 2021 and beyond revenues, COVID impacts and recovery expected as a result of COVID vaccines, EPS, adjusted EPS, EBITDA, adjusted EBITDA, new products, margins, cash, shareholder value, the timing of Block 5 orders, Success in completing additional acquisitions 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, aka 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 the most comparable GAAP measures found in the press release issued today and found on the company's website at www.sgotechnologies.com under the link Investor Relations. Now I'll turn the call over to Vic.

Thanks, Kate. Before we get into the financials, I'll provide a brief update on today's COVID environment. We continue monitoring the situation on a regular basis, and our primary goals remain the same. Stay ahead of the curve, provide a safe working environment, and protect the health of our employees. The decisive actions we've taken and the operating protocols we've implemented since the start of the pandemic We're done with a clear focus, which was to protect our strong financial condition, to deliver products and services in support of our customers, all while keeping our employees safe and healthy. Our solid operating results in Q1, coupled with our strong liquidity position, demonstrates that the measures we've taken will allow us to successfully navigate through this challenge. Our actions will benefit ESSA going forward as things continue to move toward a more normal state. And I'm confident that our disciplined approach to operating the business will result in our continued success throughout the balance of fiscal 21. While Gary will provide the financial details, I'll offer a top-level comment by noting that while our Q1 A&D sales were lower than prior year due to COVID's impact on commercial aerospace, our portfolio diversity allowed us to overcome this headwind as we substantially increased our adjusted EPS from prior year due to the strong performance from our other operating units. Our Navy business remains strong and well-funded. Our test business continues to outperform with increased margins, and our USG business saw some meaningful calendar year-end spending across the utility customer base. Coupled with the cost reduction actions we recently implemented, USG delivered an adjusted EBITDA margin of nearly 25%, up from approximately 19% in the prior year's Q1. We are fortunate to have strong and experienced leadership teams across the company who continue to demonstrate their ability to effectively manage costs to meet changing market demands. Our teams are actively addressing the challenges of today while continuing to focus on being even stronger tomorrow. ESCO will continue to benefit from our leadership positions in several niche markets where we deliver a set of unique and highly technical products and solutions specifically designed to meet our customer needs. This makes it difficult for our solutions to be replaced by alternative sources. The fundamentals of our portfolio remain strong, and our goal remains the same, to create long-term shareholder value. Now I'll turn it over to Gary.

Thanks, Vic. I'll briefly touch on the financial results as laid out in the press release. Navigating today's COVID world, our number one financial priority remains the same, maintaining our substantial liquidity. As I said from the start of the pandemic, when challenging times pop up unexpectedly, cash is king. I'm extremely pleased with the significant cash flow we generated in Q1, as normally our first quarter is the weakest quarter of the year when it comes to cash generation. Following up on the strong cash flow performance of the past year, We kicked off fiscal 21 with a record amount of cash flow, resulting in a free cash flow conversion ratio of 127% of net earnings. Clearly, our working capital initiatives are taking hold across the company, and while impressive today, we have set larger goals for the future. Today, we have approximately $740 million of liquidity at our disposal between cash on hand and available credit capacity, while carrying a modest leverage ratio of 0.38. In the release, we called out a couple of discrete items which are described in detail and are excluded from the calculation of adjusted EBITDA and adjusted EPS in both Q1 periods. I'll briefly touch on a few comparative highlights. We reported adjusted EPS of 55 cents a share, which increased 12 cents, or 28 percent, From the 43 cents we reported in prior year Q1, the 55 cents also exceeded the consensus estimate of 45 cents. Given the backdrop of today's COVID operating environment, I'm pleased to report that we delivered Q1 adjusted EBITDA of over $29 million, which is approximately 4.5% higher than Q1 of last year, despite the noted sales decline in A&D that Vic mentioned related to softness within commercial aerospace, which historically is one of our most profitable operating units. Total sales in Q1 decreased $9 million compared to Q1 of last year, but Navy and space sales were up $4 million in A&D, which helped to mitigate the decline in commercial aerospace, and test and USG sales were up a combined $2 million. Despite the noted increase in USG's Q1 sales resulting from the release of some pent-up demand, Doble continues to expect some near-term deferrals of project deliverables and maintenance work as many utility customers, both domestic and international, are continuing their COVID protocols, reflecting the various mandates restricting on-site personnel at customer locations. Consistent with their earlier communications, we believe the back half of 21 will be stronger than the first half, and as vaccine rollouts continue to accelerate, This should allow available customers to return to a more normal operating environment. We took several cost reduction actions recently, and as a result, we increased our Q1 gross margin by 150 basis points to 39.4% and reduced our SG&A spending by nearly 3%. These favorable outcomes were achieved despite adding the recent ATM acquisition in October, which is not fully operating at capacity during its transition to CRIS Air, and despite our continued spending on R&D and new product development to benefit our future. Amortization of intangibles, interest expense, and tax expense as a percent of pre-tax income also decreased in Q1 as we look at all costs in spending similarly. Entered orders were solid as we booked $158 million in new business and ended the quarter with a backlog of $512 million, with a book-to-bill of 97%. As we move forward throughout 21, I'll remind you that our DOD business, led by our participation on the Block 5 contract for additional Virginia-class submarines, where we booked several large orders during fiscal 20, will be delivering products against these large multi-year programs, which will mathematically reduce the optics of our book-to-bill going forward. As we work through the year, COVID will continue to bring along some uncertainty, which makes it difficult to predict how our near-term operations will be affected using our normal forecasting methodologies. And as a result of this uncertainty, we will continue our current protocol of not providing finite EPS guidance for the balance of the year. Consistent with our November communications, from a directional perspective, we can point to several areas where we see positive momentum. Our commercial aerospace and our utility end markets are showing some degree of customer stabilization, which supports our current outlook, suggesting movement towards recovery in the second half of 21. Increasing distribution of the COVID vaccine is anticipated to benefit and accelerate the recovery of commercial air travel and utility spending, with customers resuming more normal buying patterns. While we solidly beat Q1, we still expect the first half of 21 to be slightly down compared to the first half of 20. And the outlook for the second half of 21 is expected to be a favorable comparison to the second half of fiscal 20, given the various elements of recovery that we are anticipating. We expect to show growth in fiscal 21 adjusted EBITDA and adjusted EPS compared to fiscal 20. with adjusted EBITDA and adjusted EPS reasonably consistent with that reported in 2019. If we complete any additional acquisitions during the year, it is expected they will contribute to these expectations. And with that, I'll turn it back over to Vic.

Thanks, Gary. I won't spend much time recapping the first quarter. The commentary and release captures my perspective. But I will offer some qualitative comments about our end markets, our expectations for the balance of the year. Starting with our A&D segment, while we're seeing some signs of modest recovery in commercial aerospace, we expect continued softness over the next three to six months. We are seeing some stabilization in OEM build rates and increasing airline passenger traffic and flight miles, evidenced by the fact that quite a few air carriers are bringing more of their item fleet back into service, and daily TSA passenger boarding numbers are moving in the right direction. Just as we saw in Q1, the defense portion of our A&D business is and will continue to remain strong for the foreseeable future, given our backlog and platform positions. We also see the current situation in the aerospace market as an opportunity for ESCO, and we continue to look at suppliers or competitors where we may be able to provide assistance via partnering or through an acquisition. Our test business delivered a really solid Q1 by significantly beating our internal expectations and delivering an EBIT margin of nearly 13% versus 11% last Q1. Test outlook remains solid given the diversity of its served markets. While USG had a really strong first quarter coupled with a favorable sales mix driving a solid EBIT margin, we did not expect ESG's Sales outlook, we do expect it to be soft for Q2 before returning to more normal levels in the second half of the year. As the COVID vaccine gets more widely distributed throughout the utility service personnel, we expect the USG market to come back online more quickly as they can relax under today's social distancing guidelines. Utility service personnel can return to their normal site visit routines. We continue to communicate with and support our utility customers remotely, and our client service engineers are doing a really good job capitalizing on their relationships with their utility counterparts to provide real-time solutions. This has been accomplished through a lot of creative means and positions available for success when the current site restrictions are eased. I'm pleased with the enthusiasm surrounding USG's pipeline of new products and solutions, and we continue to see NRG's and markets improving as new investments in renewable energy are increasing in both wind and solar. Our new solar product introductions have been growing far better than anticipated, and we expect that trend to continue. Moving on to M&A, we continue to evaluate several opportunities, and we'll continue taking a prudent and deliberate approach. We expect to take action on these opportunities for our business as we have in the past. Our board is supportive of our M&A strategy, and our current balance sheet provides us with plenty of liquidity to allow us to add to our existing portfolio. Regarding our recent acquisition of ATM, I'm pleased to report the integration into our Chris Air facility in Valencia, California is on track and should be completed within the next two to three months. We should further improve ATM's contribution margin. So to wrap up, we delivered a solid first quarter. from both the cash flow and earnings standpoint. As we move through fiscal 21, our plan is to continue to focus on the fundamentals and look for opportunities to leverage our infrastructure through M&A to create additional operating efficiencies and ensure we're well positioned for long-term success. So with that, I'll be glad to take any questions.

At this time, I would like to remind everyone, in order to ask a question, please press star 1 on your telephone keypad. Again, to ask a question, please press star 1 on your telephone. Our first question comes from the line, Tommy Moll of Steppens. Sir, your line is open.

Good afternoon, and thanks for taking my questions.

Sure.

I wanted to start off on the utility end market. It sounds like into calendar year end, there was some good activity there. And then as we look at the current quarter, maybe there's some softness, but then opportunity beyond. I think that's the way you've framed it up qualitatively. So any anecdotes you can give there on the puts and takes would be helpful.

Thank you. Sure, Tommy. And you got it exactly right. So in the fourth quarter, we often will get some of this kind of money that they want to spend before year-end, and we've had a little bit more of it this year than typical. I guess it's not surprising because the spending has been somewhat restrained over the past six months or so. Our second quarter is always the softest quarter for Doble, and so that's not going to be different this year. But I think it's about even with what we saw last year in the second quarter, so not really concerned. That's what our expectations are. And we do think, you know, going into the second half, it should pick back up to more normal levels because, as we've said before, you can delay this testing, but you can't delay it forever. And so my hope is, as we said in our prepared statements, is more and more utility folks get vaccinated that they'll allow more on-site, you know, visits and support and that type of thing. But, yeah, the way you stated it is very consistent with what we see.

Okay. All right. Thank you for that. And I guess for a follow-up, I'll hit on the directional outlook that you've given, really just to make sure we're tracking correctly what you've communicated on the first half, compare, and the second half, compare. Just want to make sure, does that apply to both revenue and EBITDA? And then anything you want to call out maybe in terms of margin differences first quarter, first fiscal quarter into second fiscal quarter that you want to make sure just to remind folks of would be helpful as well.

Okay. Tommy, I'll take the last part of the question first because that's the easiest. We expect the margin in the back half of the year to be meaningfully higher than the first half of the year. And that's a combination. If you look back at our last probably five years, it's that same correlation well before COVID. And it's a function of two things. One, the revenue in the back half of the year has been consistently more heavily weighted. So because the fixed cost coverage ratio there, you know, we tend to have very strong Q4 margin contributions, and usually Q3 is the second strongest. So that is going to continue. So as you think of kind of general correlation of how we're looking at this, you know, historically, when I say historically, I'm talking about, you know, 20, 19, and 18 going backwards. It's kind of in the ballpark of a 40%, 60%, meaning 40% of the revenue and profit came in the first half and 60 in the back. It's probably just a few points different. So You know, if you were putting it somewhere in the neighborhood of $35,000, $65,000, you know, somewhere in that range, you would get yourself from a weighting perspective, depending on how you modeled out what your end goal is there. So then you could just kind of carry that up to the revenue side because, again, you know, we're looking at the same kind of relationship at 35% to 38% in the first half with the balance coming in the year. So hopefully that helps you directionally.

Certainly does. Thank you, and I'll turn it back.

Thank you. Again, to ask a question, please press star 1 on your telephone. Next question from the line of John Tan Wang Tang of CJS. Your line is now open.

Hi, good afternoon, gentlemen. Thank you for taking my questions and a nice quarter. Thank you. You mentioned, I think, that your expectations for the year were mostly unchanged, but just given the strength that you saw in Q1, is there maybe a slightly more positive bias to the year? you know, just given what you've seen so far, or is there maybe something coming up that, you know, is a little bit more negative than what you thought, you know, before you finished Q1?

Well, just given an environment we're in right now, you know, we're four months into the year, and I really would hesitate to make any big changes. I mean, we did have a great first quarter. I mean, I think some of that was probably at the expense of the second quarter, to be honest. But, you know, if we get something done on the acquisition front or if you know, the markets open up a little bit quicker, then obviously there is a potential for upside. But I would hesitate to make any bold statements, you know, here in the middle of February, to be honest.

Okay, great.

Thank you, Michael.

Go ahead, John. Just a step further. Just our commentary about we're seeing signs pointing in the right direction, but those signs haven't finalized themselves or put themselves in a finite bucket yet. So, you know, where we started the year, you know, we had a pretty – you know, decent plan based on the visibility that we had. Again, not consistent with our past planning protocols. And when you look at it today, yeah, we're off to a good start. But I think the visibility window we have today kind of runs in three-month cycles instead of nine-month cycles. So, you know, we have pretty good clarity on the next quarter we're sitting in. But back half of the year, you know, we're still taking a cautious approach. You know, there's probably enough balance there to protect the downside. But, We don't want to commit this early in the year, and that's been our protocol for years, not to come out in February and raise the guidance while you still have, as Vic said, eight and a half or nine months of time left. So I think we're off to a really good start. We have enough protection, but until the year gets more mature, we're probably not going to comment other than directionally on the recovery and the signs of recovery that we're seeing.

Okay, fair enough. Thank you for that. And I just wanted to talk a little bit more about the commercial aerospace business. Are you getting any indication at this point that, you know, they're preparing to ramp up production just given the boardings, given that they're taking, you know, their planes out of idle sleep? Or are they still maybe burning up inventory that they have on hand? Just, you know, are they telling the supply chain to, you know, get ready for more coming?

They haven't yet. I mean, you know, we see some signs of it, but nobody's called and said, hey, you need to, to make sure you're ready for this big ramp up. We track all the indicators pretty closely and I would say that while things seem pretty solid, we've not got any indication anybody's going to pull anything forward at this point.

John, I think the only clarity we've obtained since the last time we spoke was if you look at the OEM side of it, the build rate certainty was completely uncertain. We didn't know because the customer didn't know if they were going to build 10 planes or two planes or 20 planes. And I'd say that we're getting a little more clarity as you get through this stuff, that we're getting a reasonable narrowing of that variability in the build rate. So, you know, we don't have to throw a dart at the wall and say, hey, Boeing might be building 20 or they might be building two. Now we're talking about, you know, a deviation of two or three planes a month. So that helps us, you know, get comfortable with things, but it certainly doesn't, to a fixed point, it doesn't give us the... the visibility that says, you know, let's rehire people and start spending money. I'd say on the aftermarket side, what we track is, as Vic said, the TSA boarding profile, who's putting planes back in service and that sort of thing. And, you know, I want to remind people that even if a plane's half full, it's still flying. And so TSA boardings are one indicator of what's driving the aftermarket. It's really a combination of that and plane miles, not just passenger miles. So that's stabilized for us as well. I mean, it's still down significantly, but, again, we're seeing signs directionally that that looks like it's going to come back faster than the OEM side.

Yeah, and one that's very anecdotal, but, you know, if you look at the TSA numbers, and so they've been tracking, you know, since probably December at about 40%, 38% to 40% of the previous year. But then if you look at the three days after the first of the year, the first three days of 2021, they jumped up like 55%. And the only thing I draw from that is people are ready to travel. They really want to travel. And if you look at vacation bookings and cruise bookings and all that, those are very strong. So I don't think there's any doubt that there's a strong desire there for people to get back The traveling and traveling by air, but it's and I think that that the vaccine is going to make a huge difference when you know a lot more people are able to get access to that.

Got it OK, thank you. We don't talk about it too much. Can you talk about the pipeline for tests? My impression was that there are some larger projects that got deferred out of last year's because just because of the COVID situation are those now close to releasing or are they still in a holding pattern? Just kind of talk about the environment there in demand that you're seeing.

I think, you know, the very large ones I think are still in a bit of a holding pattern. But, you know, we're seeing a lot of great activity in the smaller chambers, and here I'm talking, you know, $1 to $4 or $5 million of chambers. So that's really been strong. I mean, the pipeline that we see today is as strong as it was when we were entering last year. And we're seeing a lot, particularly in China. It's been a really great market for us. but I'd say that the test market, or I should say that the test end markets remain, you know, pretty strong. So that's an area, if you look at the results over the past, you know, 9, 12 months, I mean, that's held up very nicely, and we've not seen anything that's going to change that. And so my hope is that, you know, in some near term, some of these large ones will start, freeing up. But again, we don't need those to kind of make the forecast that we have out there today.

Got it. Okay. My last one is just any update on the CFO replacement, Gary? I know you're a hard act to follow.

Yeah, actually, I've been getting specifics, but I've been very pleased with the quality of people that are showing a true interest in this. And, you know, we've been working this hard and we get into a lot of detail, but I think that, you know, it will be really good candidates we have. And so I think that's something that we'll be able to get done here in the next quarter. So I think Gary will still be here for the next call for sure. But, you know, it will be a very orderly transition. He's committed to stay as long as he needs to to make sure that whoever does replace him will, you know, be well schooled in what to do around here. But, again, I've been very impressed with the quality of people we've been able to attract.

Great. Thank you very much.

Thank you. Next question from the line of John. Sir, your line is now open.

I thought you referred to in your commentaries that there might have been some borrowing from the second quarter into the first quarter. Did I hear that properly? If so, what businesses did you borrow from?

Yeah, I would say that just what we saw particularly in the test, I'm sorry, in the utility market, I think they had such a strong first quarter, and my assumption is some of that probably got pulled out of the second quarter into the first quarter.

Okay, that's in the utility market. And one question, regarding the tempo of the billings in aerospace and defense, how – Does that second half in A&D follow that 40-60 model, or is it tilted more one way or the other?

Well, I think if you look at the A&D market, you know, you're going to see a little bit more, a little more tilting to the back end because, again, if I just focus on the large programs in that group, large meaning, you know, getting an order over $10 million, it's primarily around the submarines and the space business. So, We're in negotiations on the next pool, if you will, of Block 5. And so we would expect not many orders on Block 5 and Q1 and Q2 because, again, we got $100 million last year. So we should pick up another lot on the back end of this year. And then within the space program at Boeing, the space launch system, the Artemis program, SLS, we're in negotiations as we have been. If you get that, it's a cadence of when they release the core stage numbers, and I think that should give us a nice book to build in the back half of the year. So we're burning off backlog in the first half on the large programs. We'll replenish that, and my guess or prediction for the ordered book to build for the year will be fight to a tie, which to me is a home run when you're burning off $100 million of running start from last year. So the profile looks pretty good, and that's why I wanted to emphasize the cadence of this. The book-to-bill is important, but it's really the sustaining of the backlog number as it burns off and it gets replenished in different quarters. So it's really just a mathematical kind of rejiggering of the quarterly profile, but the year looks great.

Got it. Got it. Thank you.

Thank you again. To ask a question, please press star 1 on your telephone. Again, to ask a question, please press star 1 on your telephone.

Okay, so I think we've got all the questions that are out there answered, so I appreciate everybody's interest, and we'll talk to you again next quarter. Thank you.

Thank you, and that concludes today's call. Thank you, everyone, for participating. Give me an OO disconnect.