ESCO Technologies Inc.

Good day, and thank you for standing by. Welcome to the third quarter 2022 ESCO Technologies earning call. At this time, all participants are in a listen-only mode. After the speaker's presentation, there will be a question and answer session. To ask a question during the session, you will need to press star 1 1 on your telephone. You will then hear an automated message advising you your hand is raised. Please be advised that today's conference is being recorded. On the call today, we have Vic Ritchie, Chairman and CEO, Chris Tucker, Senior Vice President and CFO. And I would now like to hand the conference over to your first speaker today, Kate Lowry, Vice President of Investor Relations. Kate, you now have the floor.

Thank you. Statements made during this call, which are not strictly historical, are forward-looking statements within the meaning and the safe harbor provisions of the federal securities laws. These statements are based on current expectations and assumptions, and the 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 8K to be filed. We undertake no duty to update or revise any forward-looking statements, except as may be required by applicable laws or regulations. 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.esco-technologies.com under the link Investor Relations. Now I'll turn the call over to Vic.

Thanks, Kate, and thanks, everybody, for joining today's call. I'd like to start off with a thank you to our global teams. We continue to experience challenging operating conditions today, all of our end markets, but the teams are working tirelessly to deliver for our customers. We did see the benefits of this hard work during the quarter, with reported sales increasing by over 20%. This is the second quarter in a row of sales growth in excess of 20%. This strong top line growth translated to the bottom line, with reported earnings per share up over 50%, and adjusted earnings per share up 33%. I would say strong performance indeed. The other key highlight for the quarter was our ongoing order strength. During the third quarter, we saw orders increase by 25%, and backlog ended at $707 million. As we mentioned in the press release, this is a record level of backlog for us. It's great to be setting with record backlog. It indicates healthy end markets and gives us some visibility as we plan for next year. We also are managing high levels of past due backlog, and this is something we're very focused on bringing down. In general, we still see supply chain issues as a key driver of our past due backlog situation. It's mostly focused on our utility and aerospace businesses. The teams have this in focus, and we're proactive with our customer base to make sure they address any issues. Visibility is somewhat limited as to when this will clear up. Our main focus will remain on doing everything in our power to get customers the products they want when they want them. Crystal will get into some financial details in a few minutes, but I did want to offer some top-level commentary about each of our business segments. Starting with A&D, where we had a really nice quarter. Sales and margins both increased nicely. Orders also remained strong with 16% growth compared to last year's third quarter. As we look across this business, we continue to see good trends with commercial aerospace, Navy, and space all doing well. Just a few weeks back, we attended a Farmer Air show outside of London. It was encouraging to see the event so well attended. The show was very positive for us, and we continue to be well positioned in this market. As mentioned before, past due backlog is something we're watching closely for the A&D business. Supply chain challenges are persistent, and we had hoped that past dues would be normalized by now. But in spite of this, we're still achieving good results at A&D. Next is utility group, but we also had a strong quarter. If you exclude the acquisition impact, we had sales growth of nearly 17%, and that was after a very strong performance in Q2. So it looks like this business has finally shaken off the market softness we saw through the pandemic and is starting to ramp up. When you add in the acquisitions, the growth is up over 40%. We're excited about what the acquisitions bring to the table for ESCO. And N22 is shaping up to be a really transformable year for the Utility Solutions Group. Let's turn now to the test business. We continue to see really great sales momentum. This is the second quarter in a row with sales growth in excess of 20%. We have a global footprint and a broad product offering selling into strong markets. So it's really been a powerful combination for us. Even with the strong sales performance, we have continued to grow backlogged. Order activity remains elevated, and the team continues to win business around the world. Overall, through the first nine months, we attracted to the plan we communicated last November. The third quarter was important as we needed to see sales and earnings improvement ramp up, and we were able to get that done. We're in good position and pushing hard to close out the year successfully. As you know, we still have a lot to get done here in the fourth quarter. The teams have this in sharp focus as we come down the stretch. And looking beyond this year, it's clear we're setting up a strong foundation for 23 and beyond. So I'll turn it over to Chris.

Thanks, Vic. Once again, we'll have a chart presentation for you, and I'll walk through the material in those charts. We'll start on chart number three, which summarizes the Q3 results on a consolidated basis. It's great to have a chart like this when we have all the arrows pointing upward this quarter. You can see the strong performance here with orders and sales up 25% and 21% respectively, adjusted EBIT dollars up 34%, and adjusted EPS up 33%, all very strong numbers. I'll go through the segment results in a moment, but we had a strong sales growth across all three businesses with organic growth of nearly 14% and acquisitions adding another seven points of growth. On the margin side, we had adjusted EBIT up 1.4 points as we continue to see good leverage on the sales increases. We do continue to see significant inflation unfavorably impacting margins, but the teams across the company are doing a good job managing cost reduction efforts and price increases to help offset these impacts. If you go to the next chart, we can take a quick look at cash flow and capital allocation. Operating cash flow is lagging so far this year, We are investing in working capital as the business grows. We see this in accounts receivable and inventory balances, somewhat offset by accounts payable. Capital expenditures are up this year, driven by the first quarter building purchase at NRG. And share purchases year to date are just shy of $20 million. This represents our first share buybacks in a number of years and a good restart to this program. Acquisition spending is up, driven by the NECO deal that was closed in the first quarter. On the next chart, We have details for the aerospace and defense business. Really solid quarter here with 8% sales growth, the biggest growth coming from the commercial aerospace customers at PTI and Mayday. The Navy and space markets also saw nice growth, which was driven by VACO and Globe. On the margin side, we saw really nice improvement with adjusted EBIT margins up almost three points as Westland, Mayday, and Globe all delivered nice improvements compared to last year's third quarter. Moving to chart six, utility solutions group, we had order growth here of 34% and sales growth of 41%. If you exclude the impact of acquisitions, the growth was 9% and 17% respectively, very strong numbers. Year-to-date sales growth for USG excluding acquisitions is 12%. And as Vic mentioned, we are hoping that this business is coming into a period of more consistent growth as utility customers invest in their infrastructure. Adjusted EBIT margins here were up over a point as leverage from the growth more than offset the impact from acquisitions. Chart 7 is the final business we'll discuss, which is test. As Vic mentioned here, two quarters in a row of sales growth in excess of 20%, but orders even better, up 32%. This business has hit a sweet spot of growth with pretty broad growth across end markets and geographies. The adjusted EBIT margins were up a tenth to 14.1%. We continue to battle some operational headwinds here, but expect the year to close out nicely, especially from a margin perspective. Our last chart is chart number eight, where I'll quickly cover guidance. We have tightened up the full year guidance range to a range of $3.12 to $3.18 per share, which represents more than 20% growth compared to 2021. You'll recall that we laid out initial guidance of $310 to $320 per share back in November, and we continue to track to this range. As Vic mentioned, this comes from a lot of hard work by everyone across the company as we meet the many challenges that the current economy is presenting. A lot of the inflation and supply chain challenges have been more severe than anticipated, so we feel good about being on track to deliver within the initial guidance range of earnings per share. With that, I'll turn it back over to Vic.

Thanks, Chris. Since I touched on quite a few of my thoughts earlier in my commentary, I'll just offer a few more comments before we move into Q&A. You saw the numbers from Chris, but overall, we had a really good first nine months of fiscal 22. We see good momentum across all three business segments in spite of the ongoing difficulties that come in this current operating environment. We hear a lot these days about the economy and fears of a deep recession. Certainly, we watch that very closely and be ready to act appropriately wherever the economy goes from here. But the continued orders and backlog strength are reassuring. I feel very confident in saying that the outlook for ESCO is positive. A few of our end markets are really just getting going with their recovery from the pandemic, and we think that that has to run away, even if the broader economy is a bit slower. As I said, we'll watch this closely, but overall, we're very optimistic. With that, I think we're ready for Q&A.

Thank you. At this time, we will conduct the question and answer session. As a reminder, to ask a question, you will need to press star 11 on your telephone and wait for your name to be announced. Please stand by. Our first question is coming from Tommy Mall with Stevens. Tommy, please go ahead with your question.

Good evening, and thanks for taking my questions.

Hey, Johnny.

I wanted to start on DOBL. It looks like another strong quarter. That makes at least a couple in a row now. And maybe even sequentially, it looks like it was flat to even higher in the quarter you just reported. I guess there's some consistency here coming out of the pandemic when in prior periods there was some volatility there. So if you wrap it all together, does it feel like you've hit a pretty good run rate here for Doble? Or would you point to factors that are still, at least on the revenue side, holding you back where there could be a potential for another step change higher from this new level that you've hit the last couple quarters?

Thanks. Sure. Sure. So, I mean, I think there's always opportunity here. I mean, as we've talked about some past calls, we've, you know, took the time during COVID to do some significant product development at Doble and at NRG as well as Morgan Schaefer. And so, you know, coming out of the pandemic, we think that we should have a pickup of those new products. And, you know, I think we have developed some things and kind of a step function better than what, we've had in the past and what competition has. And so I think there's not a governor on this, and therefore we should be able to get some additional growth as we go forward, particularly in the next year. And even with the acquisitions, and we talked about some of the growth we had there, but as you know, the European economy has been a little more challenged than the U.S., and you're dealing with what's going on with Ukraine. And so I think as those businesses are incorporated, I think we'll see a little more pick up. European market as well.

Yeah, and one thing I would add, Tommy, you kind of mentioned incremental things. I mean, one thing we do see there is that the supply chain challenges are still pretty acute. So the last couple of quarters, we've probably had six to seven million each quarter, each quarter end, and kind of what we would call past due backlog there, where we've got the orders but can't get the product to the customers because of supply chain issues. certainly we expected that would be a little better by now. So we're really kind of seeing a lot of challenges on the supply chain front, and hopefully that will continue to work itself out as we move forward, and that can allow us to execute in the business a little bit better. But I can tell you month to month we continue to be doing a lot of kind of hand-to-hand combat there to manage different issues that flare up across the supply base.

So you anticipated my follow-up question, which was, going to be on the past due backlog that you've mentioned a couple times now. You don't historically guide on cash flow, but maybe you could talk qualitatively versus what you had planned at the beginning of the fiscal year. Have these issues gotten worse? Were there some unanticipated items that arose? And then as you look forward, I feel like I got to ask the question, how much visibility do you have? I mean, this has been a tricky issue for plenty of high-quality companies in this challenging environment. So if that forward visibility is limited, knowing that would be helpful. But whatever you could share there would be appreciated.

Yeah. What I would say is that we talked a little bit and quantified in the Q1 numbers about kind of how much past due we had and how much that cost us. We haven't really done that the last couple quarters, but I would tell you it did get bigger from Q1 to Q2. From Q2 to Q3, kind of stable, so not a big increase. So I would say the problem really isn't getting worse. But I would say we would hope that things would have gotten a little better by now or that some of these pressures would have started to ease. So I think what you're finding is, you know, we don't have a lot of things that are six or nine or 12 months past due. You know, we're getting things out the door eventually. They're just a little slower. And then you get to the next month and some other issue kind of arises. So, you know, as I said, we just kind of have to battle through it month to month. As far as visibility on, you know, when it gets better and how that all kind of rolls into the numbers, it's It is hard to say. I mean, I wouldn't want to say we've got a crystal ball that says it all gets better, you know, September 30th or whatever date you want to pick. So I think visibility is tough to get on that front. But, you know, we continue to work it hard. And I think, you know, we feel good about what we've delivered here the last couple quarters in spite of some of those challenges. And so we'll continue to kind of push to do that.

Yeah, if I could just add, I mean, one real benefit of having – the orders that we've had and the backlog that we have is it gives us some flexibility. I mean, in a number of places, we've not been able to get certain components. We've not been able to get some outside processing done. So we've been able to kind of move around what we're going to deliver. So the fact that we've been having as many challenges that we've had and we've still been able to get the you know, hit our numbers, I think is a testament to people's flexibility, to be honest. But having that backlog makes a big difference because it does give us the opportunity to pull some things in.

I appreciate it, and we'll turn it back. Thank you.

All right. Thank you, Tommy. Our next question comes from John Franzip from Sedoti. John, go ahead with your question.

Good afternoon, Dick and Chris, and thanks for taking the questions. I guess I'm curious a little bit about the order intake. What's your sense of how much there is that's still deferred spending that's kind of flowing through the booking profile, or are customers now spending based on their current market expectations?

Yeah, I would say the vast majority of it is, you know, just kind of people are buying what they need. I'd say the place where we're seeing a little bit of pent-up demand is in our test business on the medical side. You know, I think that was, there was not as much of that capital spending going on during the pandemic because they were focused on other things. And then the other thing is, you know, we do a good bit of sales to the test labs. And so they're playing a little catch-up now because they had kind of put a lot of their capital expenditures on hold. And we've seen, you know, good, pick up there, and it's really across the board. We've seen that in the U.S., we've seen it in China, we've seen it in Europe. And so, you know, while I talked a little bit about the European economy on the utility side, we've seen that pick up from an order perspective, and particularly we've seen it pick up with the test business and the test houses. I'd say there's a little bit of that on the utility side, but I think for the utility side, it's just kind of getting back to more normalized order rates.

And you mentioned in your remarks concerns about recession. Where would you see that first in your order book? Any particular business that would stand out?

I would say probably test. I think as we look at the business, and I wouldn't say we were trying to express concern about the recession as much as just acknowledging that there's a lot of chatter out there about it. I think from our perspective, the utility business and the A&D business have some unique and good characteristics about where they are in their cycles right now that should give us hopefully pretty good foundation to move forward from. But I think in the test business, if you saw a big slowdown in some kind of overall business activity and capital and that kind of stuff, you could see a quicker impact there. I'd say that's probably where we'd expect to see it first.

Great. And one more, if I may. Of the organic growth that is up at least 7% year over year, how much of that was volume versus pricing? How are you getting pricing?

Yeah, we're getting price overall. I mean, when you look at, you know, it kind of nets out overall to about 3% or so on the revenue line, and the rest would be volume. Again, you've got places where you're kind of getting more than that, obviously, and you've got places where you're not getting any because of LTAs and things like that. So it's kind of a lot of different circumstances that drive that overall number, but we estimate it would be in that range.

Great. Thanks. I'll get back into the queue for now. Thank you.

Thank you very much. We have one more question, and that is coming from John Tanwen Ting of CJS Securities. John, go ahead with your question.

Hi. Thanks for taking my questions. I actually wanted to follow up on the last one regarding security. inflation. Is the net pricing improving as we go forward? Are you starting to see any moderation at all or maybe a pickup in your ability to pass price through? Or should we expect that margin to remain the same as we go forward here?

Yeah, I mean, I think we've thought a few times as we've moved through this year that we saw maybe that inflation was going to settle in a little bit, but then it kind of continues to rear its ugly head. So I wouldn't say we've seen a slowdown in inflation, but we would expect continue to drive price as we move forward so that we can get a little more favorability in that price cost equation generally i think we feel good about where we are year to date we're kind of covering the issues we see with price but um you know we need to do a little better than that so yeah john we would expect moving forward that'll continue to get a little bit better okay great and it's great to see you guys um doing repurchases again it's been a while i think since we saw that um just a one a question about your

priority for capital allocation, is it seeing repurchases a sign of not much in the M&A pipeline, or are you still active there and put more of a balance than anything else?

We still want to continue to make acquisitions. We had a couple of things 13 months ago. We did something in the first quarter. So there are still opportunities there. I can tell you I mentioned a Farnborough Air show earlier, and, you know, unfortunately I've spent the vast majority of my time there sitting in a conference room talking to investment bankers and other folks about opportunities. And so we certainly have a full court press out there still on that. I think there's some opportunities there. But, as you know, we're very judicious about that, and we've been asked some things that got away from us, but there are a lot of opportunities out there. So we're not pulling in. you know, our horns as far as looking for good acquisitions.

Okay, great. And then one final one for me, just the climate bill that's making its way through Congress, it's got a big focus on renewables and the grid. I'm wondering if there's anything in there for NRG or Doble or anything like that that would make a difference to you guys.

Yeah, I mean, the NRG business, we don't break that out separately, but they're going gangbusters right now. We anticipate that that should help even more, right? So there's been some puts and takes this year where they're going to allow some of these imported solar panels, and that kind of got pushed out where that's not an issue. But I think within this bill, there are things that certainly are going to help that business.

Yeah, and I would also say, John, even in the double business that's maybe not directly into renewables the way NRG is, we still expect a good impact there as the grid gets kind of, remade and modernized and, you know, gets more renewables added in, that's going to drive testing requirements as these new assets are commissioned and such. And so we think that's good for our business as well. So, yeah, we, you know, maybe not anything in those bills that directly, you know, drives spend of our products, but we think it absolutely drives the whole market and is going to benefit us. Okay.

If I could sneak one more in there, maybe attacking the double question from another angle. Are you back to where you were at 2019 levels in the legacy Doble business yet? Or is there still more room to recover there?

So we project that by the end of this year we'll be close but not quite there. So within $5 million on the revenue line. So pretty close but not quite there. So obviously we would get there next year would be the plan. Got it. Thank you, guys. You bet.

Yeah.

As a reminder, if you have a question, you can press star one one on your telephone and wait for your name to be announced. It appears we have no more questions, so I'd like to now turn it back over to Vic Ritchie for closing remarks.

Okay, we'll end the call now then. So thanks, everybody, for dialing in. I look forward to talking to you on our next call.