Vic Richey - Chairman & CEO Gary Muenster - CFO Kate Lowrey - IR.

Sean Hannan - Needham & Company Drew Lipke - Stephens Inc. Pete Lucas - CJS Securities.

Good day, and welcome to the ESCO First Quarter 2018 Earnings 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 would like to turn the call over to Kate Lowrey, Director of Investor Relations. Please go ahead..

Thank you.

Statements made during this call regarding amounts and timing of 2018 and beyond EPS, adjusted EPS, adjusted EBITDA, EBITDA, EBIT, EBIT margin, gross non-cash depreciation and amortization from recent acquisitions, tax rate and benefits of the new tax bill, repatriation of foreign cash, profitability, sales, cash flow, orders, success of new products, success in completing additional acquisitions, plant cost production activities and other statements which are not strictly historical, are forward-looking statements within the meaning of the safe harbor provisions of the federal securities laws.

These statements are based on current expectations and assumptions, and actual results may differ materially from those projected in the forward-looking statements due to risks and uncertainties that exist in the company’s operations and business environment, including but not limited to the risk factors referenced in the company’s press release issued today, which will be included as an exhibit to the company’s Form 8-K to be filed.

We undertake no duty to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. In addition, during this call, the company may discuss some non-GAAP financial measures in describing the company’s operating results.

A reconciliation of these measures to the 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, and good afternoon. As noted in the release and as Gary will describe in more detail, I’m pleased with the way we started the year as our Q1 adjusted EPS came in at the top of our guidance range, and our orders and cash flow were well above our November expectations.

As reflected in our Q1 results, ESCO realized significant benefits from the recently enacted tax bill, which factors the ongoing EPS and cash flow benefits driven by these lower rates. Now I’ll turn it over to Gary for his financial comments..

Thank you, Vic. I'm also pleased with our Q1 results on both a GAAP and adjusted basis.

Given the large GAAP EPS impact for the one-time gain resulting from the true up of our deferred tax liabilities, netted against the GAAP P&L charges related to accumulated foreign earnings and cash repatriation charges, I will focus my commentary in Q1 and for the full year on an adjusted EPS and adjusted EBITDA basis.

These are more relevant measures of our operating performance when compared to expectations and to prior year. Before I comment on the Q1 details, I’ll recap the raising of our full year EPS outlook as noted in the release to help reconcile this to our November view.

At the start of the year, and before anyone could estimate the impact of the then pending tax reform narrative, we set our original financial goals on a GAAP basis and centered our discussion of expected operating performance around EBITDA, which at the start of the year is expected to be in the range of $141 million to $143 million, reflecting an increase of 15% to 17% over prior year we also set our full year EPS guidance on a GAAP basis, reflecting a range of $2.30 to $2.40 a share, with Q1 expected to come in between $0.28 and $0.33 a share.

We also describe the timing of several large project related items that were impacting our first half results compared to prior year’s first half, which are driving our back half waiting.

Given Q1’s one-time tax reform benefit and the non-cash items resulting from our recent M&A activities, coupled with the announced cost reduction actions we're taking in USG and filtration to improve ongoing earnings and cash flow, our GAAP reporting for 2018 becomes a bit less comparable.

So we'll continue to focus on adjusted EBITDA and adjusted EPS operating results, consistent with how we reported in fiscal ’17. As noted in the release, we are raising our GAAP EPS to $3.55 to $3.65 a share. And we're raising our adjusted EPS to $2.65 to $3.75 a share. We feel at this point it's prudent to maintain our adjusted EBITDA expectations.

Now touching on a few of the financial highlights in Q1. We reported adjusted EPS of $0.33 is at the top end of our guidance. This was led by stronger than expected performance in filtration and USG, with Test and Technical Packaging reporting generally on plan.

Sales exceeded expectations by $8 million, with all four operating segments reflecting these gains, with the clear leaders being Doble and Vanguard. Compared to prior year, sales increased $27 million, with $18 million of the increase coming from acquisitions and $9 million, or 6%, being organic.

We recorded $24 million of EBITDA in the quarter, which drove this EPS to the high end of our range. And cash flow from operating activities was $18 million, also well above expectations. And this was driven by strong cash collections across the company.

This cash flow allowed us to pay down debt by $15 million and reinforced our view that our significant cash generating capabilities over the balance of the year, as well as our credit capacity and available liquidity, have us well positioned to continue to execute our strategy.

Additionally, while still being quantified, we’re confident that our lower US federal tax rates going forward will allow us to generate a meaningful amount of additional cash flows as a result of our lower tax liabilities.

We plan to repatriate a significant amount of the $30 million of foreign cash on hand at December 31, to pay down current debt, thus realizing a favorable interest rate arbitrage and lowering our leverage ratio from the current 2.1.

And finally, entered orders were $200 million in Q1, reflecting a book to bill of 1.5x, and increasing the backlog by $27 million or 7% from the start of the year. Test orders were $58 million on top of last year's $200 million, which brought their backlog to $136 million at 12/31.

This provides us confidence in their ability to achieve the back half of the year financial commitments it made. Turning to our guidance for the balance of the year, the short answer is this.

We remain on track to meet our financial commitments for the balance of the year, and we feel we have sufficient protection and contingencies to protect us from any unforeseen risks.

Additionally, I'm confident that our current backlog and program delivery profile, supports this outlook I'll be happy to address any specific questions when we get to the Q&A. And now I’ll turn it back over to Vic..

Thanks, Gary. As we entered fiscal ’18, and we spoke last, I was confident that all our businesses were in solid financial condition, with solid growth opportunities. Sitting here today, I continue to feel the same confidence. Considering our Q1 performance, I feel we’re well positioned to deliver our projected results.

While we're not immune to challenges, we're - but with that said, I strongly believe the breadth and diversity of our end markets and the specific niches which we operate in, provide us with the protection to mitigate a lot of these pressures.

I like the position we’re in across our various businesses and anticipate that we can achieve our longer term, steady growth rates. As noted in the release, our second quarter EPS is lighter than anticipated as a couple of large programs previously projected in Q2 will now be completed in the second half of the year.

This included ship set of Navy valves that had their customer acceptance date pushed to Q3, and a couple of large chamber projects and tasks, which have a different delivery profile than originally planned.

Additionally, in USG, our fiscal Q2 ending March 31, represents the first quarter for the budget spending for the majority of our customers, and therefore historically, this calendar quarter tends to be the lowest spending quarter for utilities within the year. I’ll provide a few specific thoughts and comments on the individual businesses.

In filtration, we continue to expect solid results in ’18, and I remain comfortable with our outlook for 6% to 7% growth in adjusted EBITDA in the segment compared to prior year.

All of our served markets remain strong, as the Virginia Class Sub program continues on track, commercial aerospace backlog continues to grow, Mayday’s MRO market is showing early strength, and our space programs, led by SLS, continue to progress nicely.

Our Technical Packaging group’s future continues to improve as a result of our scale and leadership positions across several growth markets and geographies. Our domestic performance and outlook are very strong, as we recently extended our cash program through 2020, and have numerous multi-year programs in our own backlog, or soon to be entered.

In USG, we delivered solid performance in Q1, led by Doble and Vanguard. And we continue to see solid growth opportunities across the global platform, including hardware, software and services. Our distributor network rationalization is essentially complete.

Through this process, we've identified several meaningful operational and financial benefits where we can reduce USG’s operating cost and expand future margins. Through these cost reduction initiatives, we plan to take a charge in Q2 of approximately $2 million to $3 million.

Considering a gain of cost savings from these actions are meaningful, the payback is essentially one year. At Test, we beat our Q1 sales plan, hit our profit targets and remain committed to our 13% EBIT margin expectations for the year.

Q1 orders were a highlight of Test performance again, as we booked nearly $60 million in new business and I’m not seeing a slowdown in Q2, as January was a very strong order month. I'm also pleased to see the diversity of the end markets where we’re winning this new business.

In Q1 for example, we booked large orders for satellites testing facilities, automotive related to antenna test facilities, electric vehicle, motor testing chambers in China, and several large projects related to the developing 5G market.

So in summary, I can say we feel pretty good about the growth opportunities we have across all of our businesses and I see tangible avenues for additional growth in future years. Regarding M&A, the pipeline remains robust and we have several opportunities in process, which would supplement the filtration and utility segments.

Acquisitions remain a key component of our ability to meet our longer term growth targets. We certainly have the balance sheet capacity to do more M&A and we’ll remain disciplined in our approach.

Our focus remains constant to continue to improve our operational performance and to execute on our growth opportunities, both organically and through acquisitions. I’ll now be glad to answer any questions you have..

[Operator Instructions] Our first question comes from the line of Sean Hannan with Needham & Company. Your line is now open..

Yes. Thanks for taking the question here. Good evening. So wanted to see if I could dig into two areas for USG. First, wanted to see if we could get perhaps a little bit more detail in terms of the momentum that you're seeing with new products. We typically hit this and this is something that you touched on a little bit earlier.

But if it's possible to get a little bit more of an explicit understanding of what's driving incremental dollars and perhaps if there's a way to rank order on what’s pushing that then within the USG group. That would be the first question I have for you tonight..

Sure. So we look at specific new products, I mean the personal controller we call it (duckie). We continue to have a lot of success with that. We had a big year with that last year and I think the momentum is remaining - continuing this year. We introduced the new kind of high end tester last year, the M7000.

And so that is getting good traction so far this year. So those are two primary ones at Doble itself. And then of course the other thing which is really helping us with the growth this year is the addition of the new businesses with both Vanguard and then NRG. They're providing good growth opportunities, as well as Morgan Schaffer.

So we just have a bigger arsenal I guess if you will, as well as making some significant investments at Doble, which are really paying benefits. And we’ll continue to do that. I mean in that type of business, you never kind of get to declare victory.

it's just you're going to keep upgrading products as you have the opportunity and that’s something we’ll continue to do to make sure we stay ahead of the competition. .

Okay, that’s helpful. And then as a follow on within the USG group, you provided some commentary in terms of energy product deliveries being delayed, partly as a consequence of the ambiguity around tax reform. How do we think about the timing of that layering in here either after 2Q and four here in ’18.

Not sure if I had heard that detail on the call..

Yes, it was interesting. I mean like immediately after the tax reform passed, people understood what was in there, the orders really picked back up. So we don't think it's going to have a meaningful impact on the year.

There’ll be some, but fortunately the management team there said okay, we're going to be a little short there so we’ve got to do something about it. So we did some cost trimming there to make sure that we're able to hold our margins. So this is not a long term issue.

It was really - and quite honestly, kind of caught us by surprise that - because the first two months of the quarter are pretty strong from an order perspective. And then we saw really the Brexit and as we dug in to like figure out there were some real concerns by customers that some of the incentives were going to go away.

Once they didn’t, then the order activity picked right back up..

And Sean, to put some numbers around that profile that Vic was alluding to with the kind of January or December slowdown there, it did start picking back up in January. But from a quarterly revenue profile as that lays out, obviously you don't book an order and ship it the next week.

So in Q1 in the actuals, we did about $8.5 five million of revenue in NRG and that goes up a little bit in Q2 to about 9, 9.2. But then in Q3, that will jump to around 12 and in Q4, it's up around 14.

So that profile that you see there is where you see the little pause in the order book in December, relaunches in January and then the products have about a 60 to 90 day delivery profile on the back end of that.

So going from 8.5 to 14 in the fourth quarter profile should give you a little bit of understanding of why the back half waiting is the way it is..

Okay. And that’s actually helpful, Gary because it segues into the last question I’ve got for you for the moment. When we think about that back end of the year, now we have kind of the profile, the first half setup.

We think about the back end, 3Q versus 4Q, how should we think about what’s remaining there in terms of your allocation third quarter, fourth quarter revenues, earnings profile. Any general sense of how that might look? Thanks so much for taking the questions here tonight folks. .

Yes, and it follows along with the revenue. Obviously when you get that kind of incremental revenue up there, you're covering the fixed costs pretty substantially. So the $8.5 million, that’s a $32 million, $33 million dollar annualized profile, and that's not how the company is built. It’s a 40 something million.

And so when you put the back up - I’m sorry? (Indiscernible). Oh, okay..

Yes, sorry. I was looking in terms of aggregate cross segments..

I thought you were staying still with USG. I apologize. .

All right. That’s my fault..

And so now you know how USG is profiled. Okay. So if you look across the platform within filtration, it moves up as it has in the past in the back half of the year because we have the large shipments of macro relative to the Virginia Class and then at Westland. We won that program on the SLP and you have the revenue shipping in the back there.

So Q4 will be very strong in filtration. The packaging business has a little bit of seasonality. So it will be up in the back half. Just as it has for the last five or six years, its biggest quarter will be Q4. So if you look at the profile from last Q4 to this, will be up a little bit in revenue, which will pull the profit through.

And then consistent with the NRG conversation, the entire USG profile continues to support that waiting in the back half, with again Q4 being the most dominant. So there’s a lot of generalities, but I think you can kind of get a flavor as to A, why we have confidence in the back half and because most of the things are in backlog.

And as you look at the fixed costs, we're lowering them. So as the revenue comes across at a higher level, you win even bigger than you have in the past..

So for second half, revenue is split between third quarter, fourth quarter.

Is it kind of a 40 to 60?.

Yes. I’d say Q3 to Q4, Q4 is about 10% higher than Q3 on revenue. So if you profile it off the way we started at 120 - or I’m sorry, 173, you move up a little bit in Q2 and substantially in Q3 and then 10% higher than Q3 as you migrate to Q4 for all those reasons I just indicated..

Very helpful. Thanks so much folks. .

Thank you. Our next question comes from the line of Drew Lipke with Stephens. Your line is now open..

Yes, good afternoon guys. Thank you for taking the question.

So with Westland and VACCO, do you expect to see any maybe incremental timing delays or shipment delays just as a result of the ongoing continuing resolution? Is there any risk there to the back half of the year in your opinion?.

We already assumed that in our forecast. That is a frustrating thing to say the least, but we've kind of assumed that that was going to continue throughout the year. So if they do get their act together and this is turned back on, the needle might be able to have a little acceleration, but we’re certainly not counting on that..

Okay. So any additional ….

I should also say, I mean really where that impacts is really just at Westland. It really doesn't have an impact at VACCO for the most part because those are Westland submarines. Those things have been scheduled for a long time. So we've been delivering those, even through this time period.

So really the risk that we have is at Westland and we think we've captured that in the forecast we have out there..

Okay, that's helpful. And then in filtration and then looking at aerospace and commercial aerospace there, can you talk about the trends you're seeing on both the commercial OEM side and then on the commercial aftermarket? I think you kind of call that strength in the aftermarket in the orders there. .

Yes. I'd say there's not really any change from what we've seen over the past year or so. The buying remains solid. I mean so much of that is our backlog that we really don't have a lot impact. That’s the only place we've seen anything as the schedule moves around a little bit on our A350, but I think generally it's playing out as proposed.

But the other thing is, we are having some strength as we mention either - I don’t remember it was in the press release or the script here earlier. But the MRO market at Mayday is picking up some there. So we are seeing some aftermarket growth there, which is obviously good.

And that's not something they were really involved in that much prior to our acquisition of them. But we're really sensing some good activity there. .

And on A350, I know it's an important platform for you, there's been some kind of mixed commentary through the channel, some talking about destocking associated with that program. Others are talking or pointing to the fact that we're stepping up to a rate of 10 per month at the end of ’18.

What are you guys seeing specifically on that platform?.

Yes. I think they're generally on track now. I mean it’s been a little bit of a rocky road getting there, but it looks like - and the other thing you’ve got to remember is they buy our product pretty far in advance. It’s more a long lead item. So we've not seeing - we don't think this will be an issue for that project.

I think we’ve been pretty conservative in this year in our forecasting as well..

Okay. And then overall, on Technical Packaging, sales were up 11% there. Good performance in the quarter.

Can you kind of elaborate on what that was attributable to, and then kind of the outlook for the remainder of the year within Packaging?.

You want to take that? Go ahead..

Okay. Again on that, with the - we split up into two conversations, one on the domestic side and one on the international side. We’re seeing a disproportionate share of strength on the domestic side. As Vic mentioned, the cash program got renewed. So that's really going well. So that added a little bit to the contribution.

We’ve won four or five reasonably sizable for that business, $1.5 million to $2 half million is a good time - or a good sized contract. So we picked up some new business over the last year and a half that we've been in pursuit of for a year before that. And so we're starting to see that coming through.

So obviously of that - the increase you see there, it's a little bit more heavily weighted domestically. So the legacy tech business. And then within the European side of the business at Plastique, which we bought a year and a half, two years ago, we see nice strength there. There’s some additional medical stuff coming through.

We built the new clean room, very state of the art in the UK. We're seeing volumes increasing there. And the investment we made in the plant expansion last year, we’re seeing some of the volumes come through there. So absent of that increase you see there, it's about 60/40 domestic to international. So we're pleased to see that growth. .

And I think usually that’s kind of a GDP plus type of growth business.

I mean should we see something accelerate above GDP growth this year or how should we think about that?.

Yes. I think for this year, that’s probably the right way to think about it because if you remember in the November conversation where we had - as our razor company over there at Gillette, kind of internally have in sourced their packaging to try to compete with the mail order folks and that sort of thing, the internet folks.

And so we had a little headwind there, but we're still showing growth and that's why I say it's - as you look forward on the medical side, I think our medical device and our medical and pharmaceutical kind of (units) are going to grow faster than GDP.

But this year I’m told that the GDP just is a little bit of head wind that we had maybe comparable downturn in the Gillette business this year that we talked about in November..

Yes. If you remember when we bought that business, the primary reasons we did it were really two primary reasons. One was to get into Europe and we didn’t have a presence there and the other one was to get in the medical business and it is more probable that our underlying businesses.

It’s one of those little chicken and egg things in that when we win a medical customer saying we want your business and trust us we’re going to build something and assume that we can build it. And so what we had to do is go ahead and put the facility in place, putting the room in place to be able to support those customers.

And now that we've done that, we're starting to get a lot of interest and I think we won maybe three medical jobs there so far, and we think that will - over time, will accelerate and improve profitability of that business as well. .

9That’s helpful. Thanks guys. Best of luck..

Thank you. [Operator instructions]. Our next question comes from the line of Jon Tanwanteng of CJS Securities. Your line is now open..

Yes. Hi. It’s Pete Lucas for John. You said it was - you mentioned it earlier talking about still trying to quantify in terms of the tax benefits.

But any more detail you can give us on the one-time tax benefit for the quarter?.

Yes. I’d say, if you look back at our year end 10-K and the annual report there, we had a substantial deferred tax liability. And so without getting into the accounting side of it, the liability gets revalued from roughly 35% down to 25%.

And the reason it's 25%, with us being a September 30 year end, we have kind of a unique application of the effective rate, because it's 35% for Q1 and it's 21% for Q2, three and four, and it's weighted by number of days.

And so our headline rate, if everything was equal, would be 24.5% this year because of that Q1 because they signed it basically effective January 1. So what's nice is as you go into next year, you step that down to kind of the blended 21, at least the statutory number is 21, then you've got the pluses and minuses around that.

So we'll get one more that will take of that, but we won't get the one time item. It will become the effective rate going forward because what we did in Q1 here on the true up is mark that down or adjusted it down with a favorable benefit to the 21%. So the big one time item is done.

And then the go forward way to think about it is for the back half or back three quarters, we’re at that 24.5 with some other 1% or 2% around it. And then as go into next year, the effective rate as a going comparable concern there moves closer to 21. So we get another favorable - and that's cash and earnings favorability as we step into ’19 as well..

Very helpful.

And in terms of the run rate for cost reductions you’re getting it from USG and PTI, are those separate from acquisition synergies?.

Yes. I mean that would be - that’s just because we’re going to have to take some cost out or have that ability as a result of some of the consolidation we have underway. So that’s in addition to what we're getting from synergies..

And to tie that off, that - if you remember, we announced we're exiting one of the industrial markets at PTI, one of the lower margin businesses we have. And unfortunately there’s going to be some people that have to be severed there and then some equipment disposed of and things like that.

So that is really a function of exiting a lower margin business that we announced in our segment of the business we announced in November. So it’s just cleaning up behind that. .

Great. Helpful. And as far as the tech business, any impacts you're seeing from the flu season? Last time this happened, I think you saw a bit of a bump.

Is that something you're seeing and you’re incorporating that into expectations?.

We really have not seen anything there. I think we see that that's going to be a little later in the year because they’ll be restocking because they buy these things pretty far in advance. And so unfortunately I don't think they've burned them all yet, but that's something we may see in the next couple of months as they burn their inventory down. .

And the last one for me. The book to bill on the Test segment was pretty great at 1.55 times. How should we think about that on a forward basis? I know you mentioned momentum continuing there. And just any thoughts on that. .

I wouldn’t count on it being quite that high every quarter. But it’s - they've had a really good run. I mean a lot of it has been where you see them above a 1.0 usually or one time it’s usually some of the larger jobs. As I mentioned, we've had some real success over the past 15 months of landing some of these larger jobs.

And there seem to be a lot of activity out there between defense contractors. The EV market in China is really strong, some of the automotive opportunities. And so there's been a number in ENP job. We won an ENP job earlier this year - earlier this month I should say.

So it's been nice and strong and then 5G of course is the other one where we’re - a lot of people because that impacts everybody, from the chip manufacturer to the device manufacturers to the carriers. And so as that rolls out over the next couple of years, we think we’ll be very successful there. .

And let me add something just to the math around the optics of the ratio. The orders are going to still be kind of strong, but now you start getting the denominator, start shipping. And so all this stuff that we have in back logs are going to see a pretty significant sales ramp.

So you're still going to see dollars of orders that look strong, but you're going to see - in Q3 to Q4, you're going to see an inverse relationship because you're shipping the stuff you have. So your sales are going to be greater than your orders because of the back half profile.

So the math of the ratio will be below one in the back half, but the dollars to dollars will still be very attractive..

And I think people don’t understand, need a little more insight on how this stuff rolls out, I mean not only the second half of the year, but a lot of these large jobs will actually be delivered in ’19. So I’m obviously happy about the impact it’s going to have in ’18, but the real thing I'm happy about, it gives us some protection going into ’19.

And it's not like we're done entering orders. So I think we'll have a good strong year this year. But a lot of these big projects that I kind of detailed earlier, the majority of that work ships in next year. .

Very helpful. Thank you. .

Thank you. I'm showing no further questions at this time. I would like to turn the call back over to Vic Richey, the company's chairman and CEO for closing remarks. .

Okay. Well, thanks everybody for calling in today and I look forward to talking to you in the next call. .

Ladies and gentlemen, thank you for your participation in today's conference. This concludes today’s program. You may now disconnect. Everyone, have a great day..