Good day, and welcome to the ESCO First Quarter 2014 Conference Call. Today's call is being recorded. With us today are Vic Richey, Chairman and CEO; Gary Muenster, Vice President and CFO. And now to present the forward-looking statement, I'd like to turn the call over to Kate Lowrey, Director of Investor Relations. Please go ahead..

Thank you.

Statements made during this call regarding the Aclara divestiture process, 2014 EPS from continuing operations as adjusted, quarter's sales and EBIT growth, margin, EBIT, the schedule and cost of the Crissair move, the benefits from previous consolidations 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 we 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'll turn the call over to Vic..

Thanks, Kate. Good afternoon. We have two major subjects to discuss this afternoon, one which we can talk about; the first quarter performance and our 2014 outlook. The other is the Aclara sale where we can only provide limited insight given where we are in the process. Let's talk about the Aclara process first.

We continue to work very diligently to get a deal signed and now it's in close. I initially hoped to have this completed by now but given the complexity of the business and its resulting impact on the transaction, the process is taking longer than anticipated.

As I said before, we're really committed to get the best deal for our shareholders not the quickest deal. Even if we can't say anymore at this time, I can assure you that we're continuing to make progress and getting this done is a high priority for me and our management team.

Moving on to our Q1 performance, I'm obviously very pleased to have a quarter play out that has exceeded our projections across the board with every company contributing.

There was a lot of good activity in the Filtration segment since we last spoke, including several nice program wins through our aerospace and space business, coupled with having sizable programs moving toward production. Both of these bode well for our future growth.

Consolidation of Crissair Canyon Engineering is progressing on schedule and on budget. Also through its first six months, Canyon has beaten [ph] the initial acquisition forecast. The Test business, while a little soft on orders in the first quarter, exceeded its projections on all other financial metrics.

The facility consolidation completed last year has been a good [ph] business. We anticipate a strong second quarter in orders resulting from several projects from Q1.

Built by an exceptionally solid quarter and more importantly, we're seeing significant uptick in market interest going into Doble new and developed products as well as nice momentum in our international markets. The remainder of the year continues to be solid although it's never without challenges.

We did have a lot of reorganization and cost reductions last year to enhance our future growth and to protect our profitability. We are seeing the improved results we expected. Our priorities are simple; execute and deliver our commitments in a core business. And once the Aclara divestiture is completed, preempt our focus on growth.

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

Thanks, Vic. Consistent with our fiscal year-end earnings release, Aclara's financials for Q1 are presented as discontinued operations in the P&L and assets held for sale on the balance sheet.

The '14 guidance provided in November was based on EPS from continuing operations as adjusted, and therefore the Q1 results are presented in a consistent format and my commentary will follow as such.

As a reminder, the 2014 EPS from continuing operations as adjusted excludes the nonrecurring charges to complete the exit and relocation of Crissair's Palmdale operation into the Canyon Engineering facility in Valencia. The move is expected to be completed by fiscal year end and a cost of approximately $2 million or $0.05 a share.

The 2013 items were identified throughout the prior year on a quarterly basis and are noted in the footnotes to the tables of the attached release. Our November expectations for Q1 EPS from continuing operations as adjusted were in the range of $0.24 to $0.29 a share.

We beat the top end of our range by $0.05 as we delivered $0.34 a share on a comparable basis. As Vic said, the increase in earnings was the result of solid performance across all three operating segments. I'll call out a few highlights from the release to allow you to better understand the underlying results.

Q1 sales increased $14 million or 13% over prior year with all three segments contributing. Filtration increased 20%, Test increased 9% and Doble 6%. We're also pleased to see gross margin percentages increase to 40.3% in the current quarter compared to 39.6% in Q1 of last year.

In calling out our Q1 highlights, the $4.5 million increase in our adjusted EBIT and our increase in EBIT margins to 11.8% from 9.1% in the prior year is noteworthy. Doble's EBIT margin of 26% was higher than expected and was favorably impacted by strong sales mix between hardware and services.

Test's EBIT margin nearly doubled from prior year reflecting the impact of last year's facility consolidation and Filtration came in slightly below prior year due to changes in sales mix within the respective quarters at PTI, coupled with the additional cost of currently operating in the two facilities at Crissair in Canyon which, as we said, are being consolidated into one.

So at the bottom line in Q1 of this year, we reported $0.34 of EPS from continuing operations as adjusted which compares to $0.24 in Q1 of the prior year. This reflects a 42% increase in EPS on a 13% increase in sales.

On the cash flow and balance sheet front, we continue to be supported by a strong balance sheet as our net debt balance was approximately $143 million. Our leverage ratio remains low with continued favorable pricing on our debt.

On a continuing operations basis we recorded $114 million in orders for a 0.91 book to bill ratio and a resulting backlog of $261 million. Our order profile on a quarterly basis throughout the remainder of '14 remains strong and continues to support our growth expectations.

The management continues to see strong growth across the company in '14 and as noted in the release, our expectations for '14 are consistent with the guidance presented in November. EPS from continuing operations as adjusted is expected to remain in the range of $1.50 to $1.60 a share.

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

Thanks, Gary. We'll be glad to open up to answer any questions you have now..

Thank you. (Operator Instructions). Our first question is from Kevin with BB&T Capital Markets. Please go ahead..

Thank you. A couple of questions but can we start with margins, maybe for Gary. If you look at utility Filtration margins and the incremental we had, in utility we've had sales up less than 2 million but been up more than 2.

Was there something going on with the mix there was more favorable because obviously the dropdown there was a lot more impressive than we would have thought? And the same but opposite question on Filtration where sales were up 9 million but we have less $1 million dropdown?.

Yes. On the Doble side, Kevin, obviously when we talk about mix we have a spread of hardware units that we sell and some of our legacy products carry significant margins because there's not a whole lot of additional engineering or costs involved that they're incremental.

So when you can move the disproportionate share of some of our protection suite of products that are not the new things, which obviously have some engineering attached to them, you get a significant margin contribution to put numbers around it, but we have certain hardware products that we sell that are 65% and 67% gross margins.

So depending on which individual units you sell out of our suite of products, you can get 2 or 3 points of margin differential on some of those things. So it really is a mix of some of the higher margin products that we've sold where we sold more of those, what I'll call legacy products in this quarter versus last year.

And so that obviously impacts the mix. When you look at Filtration, there's a differential between OEM and aftermarket and there's a differential between some of the new products that are coming onto market.

For instance, on the – as Vic said in his prepared remarks, there are some large programs that are coming into initial stages of production, so the primary one is the Airbus A350.

As you come out of the development stage and you're in preproduction and what they call low rate initial production, you're selling hardware in some cases at a loss because there is a nonrecurring incremental engineering component at these low rates.

So if you're selling, for instance, $1 million or $750,000 worth A350, you're going to be selling that at negative margins. As you get that up into production run rates, you're going to see a significant increase there. So, we had some A350 sales in the quarter which obviously had a negative margin, so therefore it brings down the total.

We had a little bit of a change between aftermarket and OEM in the two comparable quarters. And also last year we had some foreign sales to a Japanese customer which had significantly higher margins through that distribution channel. So it truly is a mixed situation.

And I would say it's primarily embedded at PTI, the space business, came in at a higher margin. Crissair standalone came in at a higher margin and then when you put the extra facility on the small scale of Canyon prior to consolidation, its margin is not at the average obviously of the company. So we did in the single digits at Canyon.

So when you put that against the whole, it obviously dilutes the total. So it really is a mixed situation both at Doble. There's a contribution margin on these older products and it's a mix situation to PTI that we're confident throughout the rest of the year will rationalize themselves closer to the annual guidance we provided..

All right, very helpful, Gary, and so again just to kind of summarize that.

In both cases, Doble and Filtration, do you expect that to kind of normalize and that's why we have a flattish guide for the year and that's unchanged?.

Yes. We don't expect as much as we would like to see Doble banging out 25% and 26% margins. That product mix will not be sustainable in the same relationship throughout the year because the service business tends to be more backend weighted at the end of the year.

And so as you look through the succeeding quarters, 2, 3 and 4, you'll see a more normalized low 20s type EBIT margin contribution to bring us to where we see it. And at PTI, I'll call them out separate. Their margin was in the mid teens and normally they're in the 20s.

Once the A350 gets a little more volume through there and some of these other new programs that Vic talked on the business jets in the regional and that sort of thing, they carry better margins than start-up programs. You'll see PTI reverting back to 18 to 20 versus the 15 or 16, so those really are timing/mix-related deliverables..

Got it.

And on that front, Gary, on some of the new program wins and the A350, can you give a little bit more color around that? Can you call out any others by name and maybe talk about timing and magnitude?.

I think on a broad scale with the A350 obviously we announced several years ago because that's a gigantic program in hundreds of millions of dollars ranges over the next 15 or 20 years.

The other ones I can't specifically say who the customer is other than to characterize two of them as business jet providers, so pretty sure you can figure out who the business jet providers are and the other is centered around the regional jet providers of which again there's only a few of them who knows to put them in scale, size.

On the regionals, those are between $75 million and $100 million programs over the next 10 or 12 years. And on the business jet, sized two projects. They range between $20 million and $45 million over the expected fleet production.

So very, very good wins that we'll start ramping up here over the next several years, as Vic said, to support our growth outlook..

In an (indiscernible), Gary, or at least in aggregate, there is some ramp happening this year. These are not – I know they're multiyear things but these are not ramping in the out years, they're ramping this year..

No. I would say one of the business jet opportunities ramps in the back half but it will be a nominal contribution in Q4. A350 is the most eminent ramp.

And I'd put the regional jet players probably in the back half of '15 to early '16 and then the business – the second business jet contribution will be the same thing, second half of '15 into early '16. So it's a nice opportunity to see a step change in revenue as you go beyond '15 to support our growth..

Okay, got it.

And then just finally from me, can you piggyback on that and anything you can say on the space side, any trend of note in the SLS program or others?.

This is Vic. I'd say it's been pretty solid. We've not seen any specific – significant uptick or softness, so it's been a nice steady business for us over the past two years. And we've got pretty good insight for at least the next two years what this will be. So that turned into a real nice solid state business for us..

Okay, got it. Thank you..

Our next question is from Sean Hannan with Needham & Company. Please go ahead..

Yes. Thank you.

Can you hear me?.

Yes..

Good evening. I want to see if we could get some clarification around the movement that you had that you pulled forward from fiscal second quarter into the first, how much moved? And what segment was that specific to? And then have a little bit more in terms of follow-up questions, specifically around Doble. Thanks..

Well, we had a little bit, Sean, across each of the businesses just to kind of put some relative scale on that and obviously to support the bottom line, you have to pull through at the top line. So, I would say across the Filtration segment if you pegged it as somewhere between 500,000 and 750,000, it'd be okay.

On Test, it would be between 250,000 and 500,000. And on Doble, it would be between 500,000 and 1 million..

Okay. And then specifically on Doble, I'm trying to get an understanding of that 6% growth. It's positive, not a huge number I think that your general aspirations would be for something, a little bit higher.

I know that there are some aspects of that business – there's a little bit of a transitional period as we have some new products kind of on the horizon as well as getting accepted, et cetera.

So just trying to get a sense from you, can you share your assessment of how the business performed and what contributed to that performance result? And how you expect that, as we move through the year, in the aggregate to really grow from these levels?.

Yes, this is Vic. I would say that what you'll see and we talked about the new products we built and are starting to roll those out. That's a slow process. You start with a small number I think over time.

I think the two things that you'll see as we go throughout the year and the exact timing always holds us back, and what you'll see over the course of the year is number one, we'll get more traction and continue to get more traction on those new products.

And then the other thing particularly in the second half of the year so the average (indiscernible) international markets we're really starting to drive it through. So those are really the two pieces.

So the guidance we put out going into the year on the type of growth anticipated from Doble, we've not seen anything that's changed our outlook on that..

Okay. And specific to the ARMS product, I think that that's one of the new products you folks are looking for some traction with and it feels like you were good beyond beta testing there and that's more or less in the rearview mirror and you're now moving more so into pilots.

Is there a way that you can elaborate on the activity with ARMS, how many utilities are now in or about to enter pilot and how do you expect this to contribute to that '14 guidance you previously provided, and if there are any perhaps acceleration that occur in that uptake? Thanks..

I think we got eight clients that are currently in or already in the pilot line stage or moving to the pilot line stage. I'd say the best opportunity for acceleration for them is some big international opportunity we're looking at.

I think we can do a lot more domestically as well, but we're trying to make sure that we have deployments really in all of our major markets. So, as I said, we've got those (indiscernible) I think we'll have some established internationally before the end of the year as well. But that project overall has gone very well.

We've got great response from utilities that have seen it and seen it demonstrate. So, we still have all the high hopes for that project..

Great. Thanks so much for the color..

Our next question is from Jon from CJS Securities. Please go ahead..

Hi, guys. Thanks for taking my questions..

Hi, Jon.

How are you doing?.

Test segment margins were down a bit from, I guess, Q3 and Q4 of last year despite the facility consolidation.

Just wondering what went into that?.

I mean it's really (indiscernible) by volume. If you look, I think the fourth quarter last year did 59 million and we did about 30 this time. So the reality is we did much better than – we did better than we thought we were going to do in the fourth quarter. And the first quarter is always a little soft in Test and it's only driven by volume..

Okay.

And then how do you see the timing of revenues in Test this year? I mean if you're going to divest Crissair, it sounds like that would be the lumpiest business left over?.

As far as the trends on the growth for the rest of the year, it's going to be backend loaded as it typically it. So we'll see a good strong fourth quarter like we had last year and the first half of the year will be softer than the second half of the year..

Okay..

Just to put numbers around there, Jon, we always – as Vic said the first quarter from a revenue perspective just because of where it falls on the calendar for most of our customers, being in that mid to upper 30s tends to be the first quarter profile, our first quarter profile, fourth quarter calendar profile.

And then we expect it to step up into the mid 40s. And so the nice part is as you step up from that 39 into the mid 40s, obviously you don't have a variable G&A that comes along with that. So the direct margin pretty well falls to the bottom line there. So you see a nice step change in Q2.

And then when you advance that into Q3 and you move yourself above 50, so let's call that the low 50s in Q3, that's where you'll see the margin above the mean because of that volume throughput that comes through.

So comparable to last year, we did about 49 million or 50 million in Q3 of '13 and we pulled through above 14.5% and that was still in the midst of the restructuring. So as you pull that kind of revenue through which is consistent in Q3, that's where we'll see the leverage off the facility consolidation.

And then as you go into Q4 you start to see it in the mid to upper 50s. And again, consistent with our Q4 of last year where we had a monstrous sales quarter, so the profile of the revenue is higher in each of the quarters as you see here.

And then with the lower costs, you'll see margins leverage our expansion coming off of the lower cost structure in that same revenue profile..

Okay, great. That's helpful. And then maybe if you can, just a little bit more color on the Aclara process.

What needs to be finished? What's the biggest holdup? When can we kind of look forward to moving past that and then moving on to – what are you going to do with the cash and proceeds?.

Yes, obviously we can't give a lot of detail on where we're at. Obviously we've been at this for quite a while so I think we've made a lot of progress and we hope to be a in a position to announce that.

Just call us offline, we'll do that, but I can't give you any more guidance on that other than we're working hard and we're trying to get it done as quickly as we can..

Okay.

Then I guess on that, can you talk a bit about the acquisition pipeline, how soon after maybe the close of the divestiture do you think you could close an acquisition?.

Well, we've had, I'm going to say the full team or we've got most of staff working on this process. The operating guys still continue to look for opportunities, identified some things. We've kind of been holding the days [ph] we get through this process.

But I can assure you that the day after we sign this, we'll be turning to that and hopefully get some things done pretty quickly..

Okay, great. Thank you very much..

The next question is from Chip Moore with Canaccord Genuity. Please go ahead..

Thanks. Hi, folks. You gave some good color there on the A350 program is that it's a ramp here and then some other platforms to follow. Can you talk maybe a little more broadly of the longer term pipeline there, what's out there that hasn't been decided yet? How's the competitive environment? Thanks..

Yes, as you know with the aerospace business it's not like you get five new platforms a year anything like that. We have identified a number of things that see more on the business jet and the regional jet front and we'll continue to see some significant upgrades.

The large players Boeing and Airbus don't have anything in their near-term pipeline but some of these others will. Also we've identified some international opportunities – kind of nontraditional international opportunities that we're pursuing as well.

I think there will be some good opportunities there and that's kind of the way this aerospace business is. And as Gary mentioned earlier we have projects this year that will start delivering in a couple of years from now (indiscernible) for a number of years.

So it's just a matter of making sure that we got I would say our sales pipeline go through the next number of years just as a result of the programs that we're on from years ago and a one more recently. And so it's a matter of staying on top of new ones as they come out.

From a competitive standpoint I think that the companies have all done a good job of making sure they've identified the right partners to work with and kept the right engineering staff in place to ensure that we can perform well expected of companies like this.

And then the other thing is if you go in and look at the specific growth and profitability of Crissair, for instance, we're already seen with the Canyon, both of those companies have benefited greatly as being part of a larger company.

And they've gotten an opportunity – one opportunity as a result to be able to say, hey, we're part of this large footprint business which is part of ESCO which is a larger business. So, I would say we'll from a competitive standpoint it's been improved as a result for both of those companies in particular being part of a larger organization.

And in fact we've even kind of told PTI (indiscernible) as well.

So when we go to the Paris Air Show, for instance, you go to (indiscernible) later in the summer, we're able to show a presence to these aerospace vendors because that's important to us because they're talking about working with the company for 20 years on some of these projects and want to make sure that the conference is going to be around these novel sets..

Perfect, thanks. I appreciate it..

The next question is from Jim Giannakouros with Oppenheimer. Please go ahead..

Hi, guys. I'm sorry if I missed it but Doble I think you mentioned in your prepared remarks soft quarter.

I'm sorry, what did you attribute that to?.

No, Doble did not have a soft quarter. The only thing that I said was a soft quarter was the Test business orders were soft this quarter..

Got it, sorry about that, okay. Real question then I had was Filtration.

When thinking just longer term, are you thinking that you're going to take this Filtration business to areas outside of commercial aerospace and NASA? And if you do have an eye on those end markets, I mean – how should we be thinking about how that would impact your growth profile and especially that 20% EBIT margin that we've come to appreciate out of that segment?.

Jim, I would say that what we've done over the past five years is really refocus our filtration and fluid flow business on aerospace and space. We think there's a lot of opportunities there for us into nice niche markets. We were able to achieve good margins.

Historically and if you'd follow ESCO years ago, we had some other markets that we participated in such as our (indiscernible), the more industrial flavor. And quite honestly the margins aren't as good to the competition, it's a lot worst. The engineering requirements aren't as strong.

So we really like this filtration and fluid flow business but I think we're really going to be successful in sticking to the niche what we've got compared to (indiscernible) where we got to carry our expertise and we will bring those markets to bear..

Understood and I agree. Thank you, guys..

Yes, I would say, Jim, just one thing. I would add while we're sticking to the aerospace business, we have the expansion, particularly PTI where PTI used to be strictly hydraulic fluid and (indiscernible).

We understand that (indiscernible) and the fuel filters and so the test for doing it in the same market would have the same characteristics and the same margins..

(Operator Instructions). We have a question from Craig Irwin with Wedbush Securities. Please go ahead..

Good evening, gentlemen..

Hi, Craig..

I know everyone wants to talk about where you're going to redeploy the capital from Aclara and what sort of organic opportunities there are for you. But really Aclara is still a very important asset until it's off the balance sheet.

To not ask about the processes others have, can you maybe update us on the major issue that Aclara was facing as a headwind? Our checks showed that the deployment of the collectors was a serious issue for SoCal in the initiation of this project.

They thought they were going to get access, the right to waive for Caltrans and other utilities but just didn't materialize. Can you update us on where you're seeing spend operationally in that process since you still do only the assets and this is not related to the actual sale and SoCal also discusses some of these things in public.

Can you maybe give us an update on where that is, what the solutions are and how this impacts timing?.

Yes, let me give you a general answer and then I want to kind of drill in to make sure I understood some of your questions as it related to where there were some problems with deployment. I think I know what you're saying but I'll try to answer it. If it's not correct, then we'll talk about it more.

Let me say first, I was just at SoCal two weeks ago and met with the CEO of SoCal. I can say they could not happier with what's going on with Aclara deployment. I mean we're on schedule, on budget, we got a great relationship at all levels of the organization.

The reiterates that we're getting in Aclara, on this project, are well above what the contractual requirements are. So it's been thus far, knock on wood, a great success. Having said that, I mean you don't have a project that's one like this that is having some hiccups. We've had some which every company would on a project like this.

The great thing is we've got a great customer who bodes well with them. We've worked through all of the issues and I can just tell you we made a lot of customer visits over my career and this one is a really good one. So maybe what you were talking about. So that's kind of general. I'd be glad to give you any more color that you want.

But maybe what you were talking about is when SoCal first started deploying the data collectors, I think there was a thought that they would be able to access the points if they had trouble accessing.

So I would say early on in a project and I'm talking early last year there was a little slower deployment of those endpoints and what have been anticipated.

Fortunately, SoCal went ahead and made the decision to deploy the endpoint because it wasn't an issue with those, it was just a matter of they had to find the right place to deploy those and gain access to that. So with that, no problems with the performance of the product at all.

There was some delay in getting some of those – getting access to some of the places where we wanted them out. But that's really what the issue was and has been but as far as I know there has not been an issue now because we're actually ahead of deployment schedule from what was in the contract..

Great, that's really good to hear.

The next thing I wanted to ask if we take a look at Aclara and specifically the SoCal contract, based on where you would be tracking if you were on the original deployment schedule and I know you said you're slightly ahead of it but I'm going to guess it's generally accurate; sort of indicate there's something like $100 million in gross margin left to be earned on this contract by a buyer.

Now having known ESCO for a number of years, I know that there's also a large number of other customers out there with specific interest in this technology.

Can you maybe walk us through how you would present this for your potential buyers in a due diligence process? And whether or not you believe the trough [ph] that we're seeing in smart grid activity is maybe impacting the process or if this is just really – actually I want to stay away from the process, sorry, but if this is maybe something that you look at and say, man, I wish we could maybe own a business like this five years from now..

Yes, let me piggyback just a minute and remind people why we made the decision that we made. And it's not because Aclara is not a good business, it's a solid business. It got great technology, it got great people, it got a market position.

The real problem we have is for a public company our size the volatility that you have on a quarter-to-quarter and year-to-year basis is very hard for us to deal with, because it is – while it's a business of long-term contracts the issue is it's pretty hard to predict quarter-to-quarter.

And so what we were experiencing over the past year and particularly even longer than that was we were having a hard time predicting exactly when that was going to happen. And so as a result, we had as everybody knows (indiscernible) earnings effectively and I think that would have an impact on our stock price, on our ability to predict the earnings.

So that's really the reason we made this decision. When I think about the smart grid market overall, I think it's a good market. I mean it's something that – I do think it's a little slow right now. I don't think there's any secret there. I mean look at what's going on with everybody who is playing here and there is some softness.

But I'd say long term, this is a great market because the business cases that people have conducted whether (indiscernible) they make a lot of sense. I can assure you if they did make a lot of sense, PUCs would be approved then.

So it is something that over time I think it will be a very solid market here and the problem is for a company our size, it's just a difficult market to be in.

But I think if you look at our underlying performance that remains a business, you can see that now we have a business that is a bit more predictable, profitable and we'll take those findings and we'll redeploy them in more businesses like that..

Excellent. Congratulations on the broad progress in your three businesses that you've committed to for the longer term..

Thanks..

(Operator Instructions)..

Okay. It doesn't appear we have any other questions, so I'll appreciate everybody's interest this afternoon..

Thank you..

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