Earnings Call Transcript - ESE Q3 2023

Operator, Operator

Good day and thank you for standing by. Welcome to the Third Quarter 2023 ESCO Technologies' Earnings Call. Please be advised that today's conference is recorded. On the call today, we have Bryan Sayler, President and CEO; Chris Tucker, Senior Vice President and CFO. And now I would like to turn the conference over to our first speaker today, Kate Lowrey, Vice President of Investor Relations. Kate, you may now have the floor.

Kate Lowrey, Vice President of Investor Relations

Thank you. Statements made during this call 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, 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 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 Bryan.

Bryan Sayler, President and CEO

Thanks, Kate. Thanks, everyone, for joining today's call. We really appreciate you taking some time to get an update from ESCO this afternoon. Our year has gone really well through the first three quarters and I'm excited to talk to all of you about that. But before I do, I'd like to take a moment to thank all of our employees. ESCO has wrapped up a number of strong quarters with impressive top and bottom line growth. Our industries are growing, but it takes a dedicated and capable team to truly deliver on these positive industry trends. It hasn't been easy over the last few years, but our teams continue to show real commitment and dedication. Chris and I had a chance in July to visit most of our operating locations and it's always energizing to see the teams in action and to witness firsthand the success that they're achieving. The teams across the world are very engaged and they're winning. So it's fun to be in a strong culture like that. And again, I just want to say thanks to everyone at ESCO for their tremendous effort and support. With that, let me pivot over to the quarterly results. We had a really great third quarter with strong sales and earnings growth. Sales increased nearly 14% in the quarter, with positive trends continuing in most parts of our business. On top of that, we had nice margin expansion, which ultimately led to adjusted earnings per share growth of over 20%. We are very happy with this performance and excited that we have continued to exceed expectations through the first three quarters of FY '23. We have over $700 million of backlog now. So the outlook going forward remains positive. We did see orders drop compared to the prior third quarter of last year. Chris will take us through those details in a few minutes, but that's mostly an issue of timing and due to the lumpy nature of multiyear orders for certain parts of our business. Year-to-date, our book-to-bill ratio is over 100% and we're optimistic about our growth outlook as we look beyond 2023. Before Chris gets into the financial details, I did want to offer some top-level commentary about each of our business segments. Starting with A&D, where we had a solid quarter. Sales were up double-digit as we continue to see good momentum in the commercial and defense aerospace businesses. The aircraft components business certainly led the growth this quarter for A&D. The teams executed very well, but this continues to be the part of our business with the most challenges from a supply chain perspective. This continues to constrain the potential growth and contributes to some past-due backlog. The teams continue to manage this aggressively and we're delivering on the growth, but the challenges industry-wide persist. Orders for Aerospace & Defense were down in the quarter, but again that's mostly a timing issue with some large multiyear orders booked in Q3 of the prior year. The outlook here remains solid, with navy, commercial, and military aerospace all expected to drive future growth. Next up is the Utility Group, which had a really great quarter. Revenue growth was up over 30% in the quarter, and adjusted EBIT dollars grew by more than 50%. This business has seen a nice burst of growth in 2023. The core utility customer base continues to invest in their infrastructure, and we're seeing broad growth across all of our product lines with protection testing, condition monitoring, and offline testing, all delivering good growth. On the renewable side, growth continues to exceed even our expectations. 2023 will be a phenomenal year for NRG. The Inflation Reduction Act has provided long-term visibility for renewable infrastructure build-outs, and our USG teams that both Doble and NRG are beginning to see benefits from that activity. On the supply chain side, we've seen a big improvement at USG. And while our backlogs are elevated, very little of that is past-due. Finally, I'll touch on the test business, where we saw a sales decline again in the third quarter, which was in line with what we described during our last conference call. We've seen flattish results domestically as growth paused over last year's strength from Power Line Filters and test and measurement projects. Additionally, we've seen continued weakness in China, where business was significantly impacted as the economy opened back up after the pandemic. Unfortunately, we have not seen business pick up much since that time. The team here continues to do a great job and they increased our EBIT dollars in the third quarter despite the lower sales volume. This is good performance and positions us well to capture additional growth as these markets start to recover in the future. So to summarize, I would say it's been a great nine months to start 2023. It puts us on a good path overall as we drive to deliver on our targets for the full year, which we are increasing again this quarter. So now I'll turn it over to Chris to give some more financial highlights on the third quarter.

Chris Tucker, Senior Vice President and CFO

Thanks, Bryan. Everyone can follow along with the chart presentation. We'll start on Page 3, where we have the overall financial highlights. As you can see, we had another great quarter with sales up over 13%, adjusted EBIT up over 24%, and adjusted earnings per share up over 22%. We will go through the segment details in a minute, but on the sales side, the Utility Solutions Group delivered exceptional sales growth of over 30%, and Aerospace & Defense was also strong at 12% growth. Orders were down in the quarter. You can see they dropped by 16% to $213 million. Again, I will cover this in the segment details, but we had some tough comparisons with large items booked last year. The good news is that backlog still stands at over $700 million as of June 30. Moving on to Chart 4. We'll start to get into the segment details, beginning with Aerospace & Defense. Starting with orders, you can see the orders in the third quarter were down over 25%. We had some large orders in the space business last year which are the key driver to the decline. On the sales side, we are up 12%, with organic sales up 8% and the CMT acquisition adding 4 points of growth. The commercial and military aerospace businesses were the key drivers to the overall growth, and we continue to see good momentum there. Adjusted EBIT was up 4.5% in dollar terms, and margins were down 150 basis points as improvements from the commercial and military aerospace businesses were offset by margin erosion on some space development contracts. Next is Chart 5 and the Utility Solutions Group. Here, the performance was exceptional. Orders were up 15% with the renewables business leading that growth. Sales were up nearly 34%. And as you can see on the chart, the Doble services, offline testing, protection testing, and condition monitoring product lines all contributed. On the renewable side, with NRG, we once again saw explosive growth, 45% in the quarter. The top line performance for this group overall converted to a nice margin expansion with adjusted EBIT up 330 basis points. This improvement was driven by leverage on the higher sales growth and favorable impacts from price increases which more than offset inflationary headwinds. Next is Chart 6, where we have the Test business. A bit of a mixed story here. You can see orders were down nearly 35%. A big drop as last year we had significant order activity for test and measurement orders which did not repeat this year. We have also seen continuing weakness in China as the overall pace of business has been slow since the reopening from COVID earlier in the fiscal year. Sales were down 7%, but the good news here was that margins as EBIT dollars increased 3.5% even on the lower sales. This is a margin improvement of 150 basis points driven by cost reduction efforts as well as price increases. Next is Chart 7 and our cash flow highlights. We did see operating cash flow improvement in the third quarter compared to our first two quarters, but we are still running behind last year's operating cash flow amount of $42 million. Working capital increases from accounts receivable, inventory, and contract assets have been a cash headwind. And we've also seen sizable negative cash impact from higher taxes paid and interest paid. Capital expenditures are down approximately $9 million year-to-date. You'll recall that last year we had a building purchase at NRG and that's the main driver of this year's decrease. Acquisition spending is relatively flat with NEco acquired in fiscal '22 and CMT acquired in fiscal '23. And lastly is share repurchase, where we completed just over $12 million in buybacks this year compared to approximately $20 million through the first nine months last year. And the last chart is our guidance chart. You can see here that we are projecting adjusted earnings per share growth in the range of 13% to 15%. We put our initial guidance out in November of last year of $3.45 to $3.60 per share, and the midpoint of our guidance has gone up each quarter since then. We are now looking at a range of $3.62 to $3.68, good double-digit growth for the year coming after 24% adjusted earnings per share that we delivered in fiscal '22. This represents two strong years for ESCO and we are excited not only about the strong years in '22 and '23, but what comes next in '24 and beyond. So that concludes the financial update, and now I'll turn it back over to Bryan.

Bryan Sayler, President and CEO

Thanks, Chris. Since I touched on a number of my thoughts earlier, I will just offer a few more comments before we go to Q&A. You saw the numbers from Chris. So obviously, a great 2023 with very strong financial performance. The company is operating at a high level, and we continue to have confidence as we look to the future. We serve very strong end markets with well-established customers. We have great teams here at corporate and out of the businesses around the world. This forms a powerful combination, and we're excited about what's next for ESCO. Before Q&A, I did want to mention that we recently published our ESG report covering our 2022 activities. You can find this on the Corporate Citizenship section of our website. I would encourage you to go and take a look at the report. It's got a lot of good information on ESCO's ESG program overall. It also has a nice profile of our NRG business and their capabilities about helping to enable renewable energy. The team here put a lot of work into the report. We hope that you find it useful. So with that, we can start the Q&A.

Operator, Operator

Thank you. Our first question comes from Jonathan Tanwanteng at CJS.

Peter Lucas, Analyst

It's Peter Lucas for Jon. Can you talk a bit more about the Virginia-class timing shift? And does that impact when you expect to generate earnings and revenue from those orders?

Bryan Sayler, President and CEO

Sure. So what's happening right now on Virginia-class is there's a multiyear procurement process that's in place. We do expect that that's going to take a few more months. We would expect to get some Block 5 expansion orders in the near term, probably within the fourth quarter. And then we expect to see a pretty significant tranche of as many as 12 Virginia-class submarines at some time perhaps early next year. We are in a really good position on that project and so we don't think it's going to have any impact on our ability to generate earnings. We might see a modest expansion based upon some additional aspects of the submarines that they're going to be adding going forward.

Peter Lucas, Analyst

Very helpful. And then jumping to the supply chain issues. Can you give us a little more color on those? Is it your internal throughput, your suppliers, or parallel downstream partners? Where are you seeing the biggest issues there?

Bryan Sayler, President and CEO

Well, so we're really talking about the Aerospace & Defense business here at ESCO. The rest of our business seems to have largely recovered. Within the aerospace and defense industry, there's an industry-wide challenge right now with regard to supply chain. The biggest issue is that lower-tier suppliers are struggling, and that has a cascade effect. We're not able to replace suppliers very easily in this industry. And so that puts us in a position where we have to wait for products rather than swapping them out. So over in the Utility segment, for example, we were able to redesign circuit boards to be able to swap out components for more available types of memory chips or something similar. We don't have that luxury over at Aerospace & Defense. The good news is we are making good progress and we are driving the growth. But this is really an industry-wide challenge that many companies are facing. This was a big topic of discussion at the Paris Air Show back in June. I would say the industry consensus is it's going to take several more quarters to really unwind the challenge.

Peter Lucas, Analyst

And last one for me. Just an update on the M&A environment, what it looks like relatively? Is it more or less attractive compared to the past couple of quarters? And if acquisitions aren't out there, kind of talk about the priority in terms of capital allocation.

Chris Tucker, Senior Vice President and CFO

Sure. Yes. So the good news is it's improving. We're seeing more opportunities presently than we have for the last couple of quarters. And based on our market research and intelligence, we are seeing more opportunities that will be coming to market later this year. We do have a couple of good programs that we're engaged on, but I don't think we're close to getting anything done. We certainly don't want to comment on any details. But we feel pretty good about our opportunity to get some investment done in the near term.

Operator, Operator

Our next question comes from Tommy Moll at Stephens Inc.

Tommy Moll, Analyst

Bryan, I want to start on the A&D side of the business. What if any update can you provide from your review of that segment? And then specific to commercial, where the growth rates continue at rather elevated levels, if you look at the build plans and the content that you have spec-ed in, is there any reason to think that the growth momentum in the double-digit range, even if at a moderating rate from this year is unreasonable through your planning horizon?

Bryan Sayler, President and CEO

So listen, the build rates from Airbus and Boeing, in particular, continue to accelerate, and we're seeing a lot of that benefit in our aircraft businesses. And we feel like we're responding well to that and that we should have growth rates that are in the high single digits over the next year or two, maybe a touch higher in the shorter term. The biggest challenge for us will be continuing to work through the supply chain piece. And we continue to make progress there. But the orders keep piling up. And so we feel pretty good about where that business is headed.

Tommy Moll, Analyst

And then in terms of your review of the A&D portfolio, Bryan, any update you can provide there?

Bryan Sayler, President and CEO

Listen, first of all, we've got some great businesses there. We don't have any strategic announcements to make today. I think all the businesses are performing well. We do think that there are opportunities to expand on our position in some of those spaces, in particular, navy and commercial aerospace. And we're looking at ways to do that.

Tommy Moll, Analyst

Fair enough. I also wanted to ask about Utility or really Doble specifically. Another quarter with an impressive growth rate in the third quarter. It feels like you've hit a good operating cadence post-pandemic where there were some rough quarters there. What is favorably changing in terms of the underlying demand there? And then if you take a step back, pre-pandemic, even a number of years pre-pandemic, Bryan, I think it's fair to say that was probably a high single-digit kind of market opportunity to go after. Then there were some years leading into the pandemic where that dipped a little bit. Does it feel like in terms of the outlook going forward, there's been a reacceleration in terms of the growth rate of that opportunity?

Bryan Sayler, President and CEO

I think it's become clear to many that significant investments in grid infrastructure are essential for supporting the clean energy transition. This is a major factor driving the current expansion we are witnessing. The positive impacts of the Inflation Reduction Act and the Infrastructure Act are noteworthy, especially because they enable long-term investments rather than just short-term funding. We have a 10-year period ahead, which instills a lot of confidence in making substantial capital investments, fundamentally benefiting our business. Moreover, utility companies are increasingly recognizing the importance of managing their assets more intelligently. Our previous investments in enhancing our condition monitoring capabilities—both through acquisitions and organic development—are really paying off. The new products we've introduced over the past couple of years are gaining traction. Overall, while it's been challenging to predict developments in the renewable sector, every conversation we have seems to bring more good news. The key question moving forward is how we navigate the future. It’s evident that facilitating this transition will require trillions of dollars in global investment, and we stand to gain from these investments.

Operator, Operator

Our next question comes from John Franzreb at Sidoti & Company.

John Franzreb, Analyst

Congratulations on a great quarter. I'd like to start on the Test side of the business. You've kind of characterized that business as coming out of COVID. China has been an issue just getting in the door. Now China seems to be weakening in and of itself. Can you talk a little bit about what your expectations are in Test in China in the coming quarters? And has the competitive landscape changed in light of that demand environment?

Bryan Sayler, President and CEO

The Test business has been our strongest sector during the COVID period, showing growth while other areas faced challenges. We have successfully maintained a higher level of overall revenue. However, our operations in China have been somewhat difficult this year following an exceptional previous year, resulting in a significant year-over-year decline. Despite still making profits and producing goods, we are encountering some issues with demand and access to job sites. We believe this is due to fundamental economic conditions in China rather than competitive factors. Fortunately, this segment represents a smaller portion of our overall business and remains a reasonable part of our Test and Measurement division. In North America, our business has been relatively stable, with a slight shift towards Engineering and Construction work while wireless activities have decreased. We are observing ongoing engagement in the electric vehicle sector. Interestingly, our European business has performed robustly, likely influenced by security developments, including our significant presence in Finland as it joins NATO. Overall, we maintain an optimistic outlook for this business, even though we are currently experiencing steady revenue at the high end of what we have achieved in recent years.

John Franzreb, Analyst

Got it. Got it. That actually helped a lot. And going back to your utility comments to be sure. The renewable markets are doing well but more the traditional utility spend, it sounds like you're enthusiastic about the slope of that business going forward. Can you talk a little bit about what you're seeing as far as traditional utility spending? Is it pent-up demand that's coming back? Would you really see a fundamental long-term shift in the demand cycle on the utility side?

Bryan Sayler, President and CEO

I believe it's important to acknowledge that there was indeed pent-up demand. During the pandemic, utilities adopted a hands-off approach, prioritizing uptime and power generation over other activities. As we emerged from the pandemic, there was a need to make up for that inactivity. I think we've moved beyond that phase now, and there seems to be a change in how utilities view more advanced techniques. We have developed new products that meet their needs for digital testing and have enhancements for condition monitoring. We're witnessing significant activity in those areas. Utilities recognize that even with the ambitious net zero targets, significant growth is still expected, especially with the expansion of electric vehicles creating substantial demand. They are starting to see potential revenue streams from this and are making the necessary investments to provide the required services.

John Franzreb, Analyst

I understand. I have one final question regarding A&D. I believe there has been a rise in alternative suppliers among some of the lower-tier suppliers that may have necessitated recertification for their products. Is that true, or is the process just taking longer than anticipated? Could you clarify this for me?

Bryan Sayler, President and CEO

Well, it's going slower than expected. And I think when you think about it as an industry-wide phenomenon, just think about the people that are actually doing those recertifications; they're being inundated by requests. It's a very conservative industry that is very change-averse. So in a lot of cases, we really are put in a position where we don't have many choices. I mean, we have definitely design changes and we've made changes to material certifications and that sort of thing. I think the other thing I would point out is if we look at our past-due backlog, it's a small number of parts and programs that are driving a large piece of this overall past due. The meat and potatoes stuff that are going into 737, A320, that sort of thing, most of that is running along nicely. But a lot of our other programs are where you're seeing a lot of the past due. And those are programs of smaller quantities. And so the justification for going through a recertification program is less obvious.

Operator, Operator

Our next question is from Tommy Moll at Stephens Inc.

Tommy Moll, Analyst

Yes. I just wanted to make sure we hit on utility margin today. So thanks for letting me back in here. On an adjusted EBIT basis, you just reported a 23% which is a ZIP code where you've been before, if you go back far enough in history. But more recently, you haven't been there on any sustained basis. So I'm curious if there's anything onetime favorable in this quarter or if some of the recent margin improvement there feels like a more sustainable base that you can operate at?

Chris Tucker, Senior Vice President and CFO

Yes, Tommy, I wouldn't say there was anything particularly onetime in there. Again, we're just kind of obviously driving really nice leverage on the big growth. I think we did see a little bit of favorable mix that was kind of unfavorable earlier in the year, so that helped us slightly. But then, again, it's more just kind of price and cost management and those kinds of things. So listen, we're not going to be there every quarter at that level. But obviously, we're looking to drive back to the historical peaks as we go into '24 and beyond. So that's kind of how I'd answer it. Really nothing special, good leverage and we feel confident about the ability to drive the margins up as we go forward.

Operator, Operator

Thank you. I'm showing no further questions at this time. I would now like to turn the conference back to President and CEO, Bryan Sayler, for closing remarks.

Bryan Sayler, President and CEO

Well, thanks, everyone. It's been good to talk to you in this quarter and we'll look forward to talking to you again next quarter.

Chris Tucker, Senior Vice President and CFO

Thank you.

Operator, Operator

Thank you. This concludes today's conference call. Thank you for participating. You may now disconnect.