Kate Lowrey - Director of Investor Relations Victor L. Richey - Chairman, Chief Executive Officer, President and Chairman of Executive Committee Gary E. Muenster - Chief Financial Officer, Principal Accounting Officer, Executive Vice President and Director.

James Giannakouros - Oppenheimer & Co. Inc., Research Division Kevin R. Maczka - BB&T Capital Markets, Research Division David Rold - Needham & Company, LLC, Research Division Jonathan Tanwanteng - CJS Securities, Inc..

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; Gary Muenster, Vice President and CFO. And now to present the forward-looking statements, 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 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 on 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 a 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..

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'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. 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 '14 results discussed here include the -- or exclude the nonrecurring 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 30.

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 3 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 2 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 9 months of this year.

As part of our capital allocation strategy related to share repurchases, we spent $4 million on buybacks through June 30 and another $5 million through July 31, for a total of $9 million in the last 4 months. We continue to opportunistically -- I'm sorry, 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 30. A significant highlight of both Q3 and our 9 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 3 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 '14 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 per share.

And I'll be happy to address any specific financial questions, and I'll turn it back over to Vic..

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

[Operator Instructions] And our first question is from Jim Giannakouros with Oppenheimer..

On your Filtration segment, just thinking high level about your current OE versus aftermarket mix. I think that your recent platform wins keeps your OE percentage of mix kind of where it is now, roughly 2/3 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 aftermarket business. But I think that's just going to be kind of a slow process. I don't see that changing dramatically over a 2-year period or something like that.

But as we get more and more of these products or platforms rolling to mature, then that's where we have the opportunity to get more of the aftermarket business..

And -- okay, thanks.

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 1 or 2 years with a high degree of certainty that you're going to retain aftermarket, or is it much longer than that?.

It's much longer. I mean, it's very, very unusual for you to lose the aftermarket. They -- you have to understand that for these airlines or aircraft manufacturers, either one, the second source of it 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. So we -- once you won 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..

Got it. And 2 quick ones if I may. On your other segments, you said Doble, they were -- sales and marketing cost, they were a bit higher in 3Q.

Should we expect similar spend in 4Q?.

Yes. Similar dollars. And I think you'll obviously you see a revenue increase there as well. So I think when you pull that forward, pull the revenue up a little bit, pull that spend the same, you should get back to the 22% to 23% EBIT margin just because the leverage we'll get off the additional sales.

And then going into '15, 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 costs, 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, and we're having success doing this, so I think it's money well spent..

Understood. And 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 us 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 to the first, and even 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 with provide a little more significant upside..

Our next question is from Kevin Maczka with BB&T Capital Markets..

First question. If I can start on some of the aero programs that you 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 a 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 '15 or '16 type event as you roll all of these new programs forward?.

That's a right way to look at it, Kevin. If you look at -- let me give you 2 data points. One is our content for plane. 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 0 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 -- we announced was the COMAC, which is the Chinese C919. Our content on that 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 '17, early '18. And the build rates they're looking at there are in the high double digits, $50,000 to $90,000 a plane. I think stepping into '15 and '16 you're going to see nice organic growth.

And in 2017, when all those programs are running on what they think is close to annual stable run rates, I think that's where you'll see the step function change..

Got it. That's great, Gary.

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, the -- I mean the biggest one, the A350, I mean that's the only one I'd say that has substantial engineering cost. All these others have some, but they kind of pale in comparison to the A350. So that should be completed sometime 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's -- it is a price of doing business as I mentioned before. You go through this phase, and we've been working on the A350 now for about 4 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, that startup design work with very little revenue again since 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 0. And I'll use the Boeing 737 as an example. That thing has 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 0 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 revenues sitting on top of it..

And hopefully the next couple of years, there will be a new major platform that we can go after. Because we want to spend the NRE because that's on the new programs. So it's one of those things where you've got ebbs and flows, and 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. Can you....

It's for sure..

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

Well I think we just got to the rash of them that are out there now. There's few programs that are on a horizon, but I think we're really in a position to say which ones we think are going to go forward, and which ones aren't.

As far as the specifics on how much is going to roll off, we're in the throes, but I guess week after next we'll have everybody in for first look at '15, or actually second look at '15. 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..

Okay. And then just finally from me, can you remind me on the Crissair, Canyon consolidation? 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 1-year payback. So we're spending in round terms, it will 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..

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

David Rold on for Sean Hannan actually.

So wondering if you could elaborate on the progress of 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? Had there been any kind of incremental big picture impact of the story there? Any color you can shed there?.

A couple of things. We've got 8 pilots -- not pilots, but 8 beta sites out there, they're all performing well. We think there's going to turn into real projects at some point. We're not looking to add any more 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.

Additionally, we've added some people and 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 issue, but one thing about this product is because it's sold at a higher level in the organization then what we've typically sold our boxes in some of those some of the other solutions, we had to have people that can go in that level and we've been very fortunate to get some people that have been customers in the past and 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 at 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 they're going to call on people that are used to operating at those and are going to call on people that were at their level to talk about a piece of a very impressive piece of software..

Okay. And then on the M&A front.

Without naming name, is there -- are there any candidates you're in active discussions with? And if it would be international, is there -- or are there potential geographies that are more interesting for you than others?.

Well, currently we are talking -- we're -- 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 are going to, but we do have some things we're actively looking at, as far as whether domestic or international, I won't go into that.

But if we're 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] Your next question is from Jon Tanwanteng with CJS Securities..

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

Yes, what we're really doing there, this initial contract which we think will be potentially a multiyear contract, is really do an assessment of their transformers and their oil labs. So this a little bit different -- well, 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 bring -- to analyze the health of their -- grid if you will at least as it relates to transformers and ability to test those transformers. In the longer end to train, there are people to do the testing to understand that.

And then what's -- 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 is -- Saudi kind of leads the way in that area, that part from the country, and so I think it was really key that we got them on board first.

So we're active discussions with other utilities in the area, which I think now that they see what Saudi Arabia is going to be doing that there may be following behind it. It's a little bit of a 2-step process in that we're going to go in and do this assessment. And it's not a short-term deal, we're in it for a year. It's probably going to take longer.

Can be a bit longer than they have 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..

Okay, great. And then you had some nice bookings in the Test business.

Can you comment on the traction of the reception you're getting for the newer protection products there?.

You're talking about the EMP products?.

Yes..

Yes, we've had some good wins here in the U.S. And then I'd say more importantly -- more importantly, but equally important, we have won a couple of jobs in Asia as well. You know, places in Korea, Taiwan, those kind -- 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 come over, look at that, understand it and see the benefit of doing that..

Okay, great. And then I'm not sure 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 that -- 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. 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 3x levered by any stretch.

So somewhere between 1x levered and 2x 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 -- if you think of our structure as less than 2x levered, then 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..

Okay, before we wrap up, I just want to remind everybody that we'll be hosting the Analyst and Investor Day on September 9 in New York City. And we enjoy having you attend. You'll be able to meet and talk to our senior operating executives which I'm certain you'll find worthwhile. So thanks, 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..