Earnings Call Transcript - ESE Q2 2022

Operator, Operator

Good day, and welcome to ESCO Technologies Second Quarter Earnings Conference Call. Today's call is being recorded. With us today are Vic Richey, Chairman and Chief Executive Officer; Chris Tucker, Vice President and Chief Financial Officer. And now to present the forward-looking statement, I would now turn the call over to Kate Lowrey, Vice President of Investor Relations. Please go ahead.

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 the 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. During today's call, we will be referring to a slide presentation that is currently available on the Investor Relations section of our website. Within the call, the charts are located in the download tab at the top right corner. Now, I'll turn the call over to Vic.

Vic Richey, Chairman and Chief Executive Officer

Thanks, Kate, and thanks, everybody, for joining today's call. I'd like to start off with a welcome to our new Board member, Jan Hess. We just finished up our Board meeting late last week and are really thrilled to be adding Jan to our Board. She brings a very broad skill set with decades of experience and leadership roles at Teledyne, a diversified industrial company. We're focused on technology development to meet customer needs and drive growth while bringing great perspective to our Board. She also has experience across many industries, including several of our core markets. Her knowledge and leadership will be a great asset for ESCO, and we're happy to have her on the team. I'd like to thank the entire Board for their ongoing support and commitment to ESCO. Now let's switch to a discussion of the second quarter. Overall, we saw the business continue to build momentum. All three businesses delivered organic sales growth in the quarter. With consolidated revenue growth of over 23% in the quarter, it's clear that we have nice top line momentum. We also had another great quarter of order growth, with a 34% increase in orders compared to last year's second quarter. Our backlogs continue to grow with an increase of over $75 million since the fiscal year started. The backlog at the end of March was a new record for ESCO, so we feel good about the outlook for the balance of fiscal '22 and expect good momentum as we head into '23. Chris will get into some of the financial details in a few minutes, but I'll start off with some top-level commentary about each of the business segments. Starting with A&D, where the quarter was a bit mixed. We continue to monitor the commercial aerospace business closely, and we're seeing some good growth from that market so far in 2022. It was another strong quarter for orders and revenue increased 30% over the prior year to reach the highest level since before the start of the pandemic. Some of this is from an easy comparison we had last year, but it's clear that travel is picking up, and that is helping drive recovery in our business. The Navy and Defense businesses had some declines in the quarter, but we see that more as timing and feel good about the outlook there. While there was revenue growth in the quarter, there are still margin and operational challenges in A&D. Past due backlog is something we're watching closely as supply chain challenges have not let up. So all of the operations teams are highly focused on managing these issues to support our customers. On the margin side, the bottom line is for A&D as we expect margins to improve as recovery continues and volumes build in the back half of the year. Let's turn now to the Test business, where we had a really great quarter. The sales growth strength continued with nearly 28% increase compared to last year's second quarter. We've seen great growth in the Americas and in Asia with the growth coming from several key industries and product lines. The other thing I'd like to highlight about the Test order is the margin performance. We talked a bit last quarter about how important it was to see the margin improvement in this business, and it really came through nicely in the second quarter. The team at Test continues to work the inflation challenges aggressively. It's definitely an ongoing battle, but nice to see the jump in margins after all their hard work. Similar to Test, we had a really solid quarter from the USG business as well. The underlying sales growth came in at over 35% in Q2; just phenomenal growth. When you add in the acquisition impact, the growth jumps to north of 60%. Great work by the teams there. We had a pretty weak quarter for Doble a year ago, so the comparisons were a bit easy, but I would say, we still saw the orders and sales momentum outpacing our expectations as the quarter closed out. I did want to comment on the acquisition integration status for Doble, Altanova, and Phenix. We just did a strategic review of these teams a few weeks ago, and they've really done a great job of analyzing the product portfolio to determine which products should be offered in our markets around the world. Clearly, the acquisitions have brought us some new capabilities, and now we have good visibility on our product roadmaps globally. It's a long process and it will be additional work as we move into execution mode, but we still see nice revenue synergies and are really happy with how the businesses are coming together. Overall, through the first six months of the year, we feel good about what we achieved, and we continue to be on track with the expectations we laid out back in November. It does require a step-up in EPS growth in the second half of the year. This is how our plan was laid out from the beginning of the year, and we've been working hard with all our subsidiary teams to make sure the plans are in place to deliver. You all know that the operating environment is very challenging right now, but we will continue pushing hard to deliver the year. Certainly, the backlogs are supportive of the second half projections, and we are committed to delivering for our customers. And now, I'll turn it over to Chris.

Christopher Tucker, Vice President and Chief Financial Officer

Thanks, Vic. I'll now discuss the financial results. We're using a slide deck this time, which you can view on the webcast or access from the Investor Relations section of our website, as Kate mentioned earlier. Starting with Chart #3, all key measures show impressive double-digit growth. Orders increased by 34% this quarter compared to the same quarter last year, and the book-to-bill ratio of 1.15x was strong due to broad strength across the business. We concluded with a record backlog of $671 million as of the end of March. Sales rose by 23.5%, consisting of 16.5% organic growth, with acquisitions contributing an additional 7%. We experienced strong sales growth, particularly in utilities, commercial aerospace, and the test group. The adjusted EBIT dollars increased by 17%. However, we did see a slight decline in margins, which we will discuss by segment. The A&D segment saw a small decrease, while Test and USG improved. The GAAP EPS was $0.59 during the same quarter last year, and adjusted EPS decreased to $0.56 due to a gain from the resolution of the Watertown building last year. This year, we had $0.01 in various adjustments, resulting in $0.65 this year compared to $0.56 last year, marking a 16% growth. Regarding cash flow, we are down year-to-date, with $23 million compared to over $57 million last year. Notable changes in the balance sheet include contract assets and liabilities; we have not yet received significant milestone payments this year as we did last year, which is just a timing issue and should level out moving forward. Inventory has also negatively impacted cash flow by approximately $18 million year-over-year. We're managing supply chain issues that force us to sometimes purchase larger quantities of parts or, in other cases, leave us with stranded inventory due to missing components for completing orders. Increased backlogs require us to bring in more inventory to address future demand. Capital expenditures have increased by about $7.5 million year-to-date due to the Q1 purchase of the NRG headquarters. We've spent $15.6 million on the NEco acquisition this year, while a year ago, we had the ATM acquisition for $6.7 million. In terms of share repurchase, we've spent around $18 million year-to-date, following reauthorization to spend $200 million on a new buyback program in November. Now, looking at segment performance, starting with A&D. Orders were up 7%, and backlog reached almost $397 million, reflecting nearly a 14% increase year-over-year. The commercial aerospace sector is showing a solid recovery, which drives these numbers. Sales growth in A&D was 3%, led by commercial aerospace, although the Navy business had mixed results with some growth in Globe and Westland while VACCO experienced declines. EBIT margins decreased to 17.1% from 20.7% a year ago due to the VACCO sales decline and some margin mix in commercial aerospace. For the Utility Solutions Group, we've seen fantastic performance with orders nearly doubling to 98% growth, including $27 million from the core Doble business and contributions from acquisitions and the renewable sector. Sales were up 62%, with good growth in the renewables market. Adjusted EBIT margins improved almost 4 points to 17.7% due to revenue leverage and price increases that countered wage and material inflation, although in-person events have incurred additional costs. In the Test business, orders rose by 25% to $55.4 million, with strong demand in medical shielding and positive order flow from test and measurement projects globally. Sales increased by 28% to $55.9 million, with power filter orders starting to move from backlog to sales. Margins rose over 2 points to 15.2%, driven by volume growth and price increases despite ongoing inflation challenges. As for our full-year guidance, we initially set a range of $3.10 to $3.20 per share. While we were slightly under expectations in the first quarter, we outperformed in the second quarter. Thus, we remain on track for the full year, maintaining our projection of solid growth of 25% to 35% for the third quarter, which equates to a range of $0.84 to $0.91. That summarizes the financial highlights, and I'll now hand it back to Vic.

Vic Richey, Chairman and Chief Executive Officer

Thanks, Chris. Since I touched on quite a few of my thoughts early in my commentary, I'll just offer two more comments before we move into Q&A. We feel good about the start to 2022, and we're excited about the forecast we have out there. Lots of growth coming as we move into the third quarter and beyond. We recently had our planning meetings with all the businesses. All the subsidiary teams have great product development programs that they're pursuing to deliver growth over the three-year planning horizon. The end markets we serve continue to recover and exhibit good growth characteristics over the short to medium term. Our portfolio is well positioned as we move forward. There continues to be uncertainty in the economy as the pandemic continues to evolve, but as always, we'll focus on serving customers well or managing our profitability and balance sheet to deliver higher returns for the shareholders. To close out the opening commentary, I'd just like to thank all of our employees for the tremendous efforts so far this year. We all know how challenging an operating environment is. There are lots of challenges to run an efficient operation right now. Supply chains continue to be unpredictable and getting certain operations fully staffed is also challenging. In spite of all that, our teams have persevered, and for that, I'm very grateful. I just want to extend a big thank you to the entire ESCO team. So with that, I think we're ready for Q&A.

Operator, Operator

Our first question comes from John Franzreb with Sidoti & Company.

John Franzreb, Analyst

I'd like to start with the supply chain issues you faced with the contractor in the previous quarter. I'm curious if those issues have continued into this quarter, and if so, to what extent.

Christopher Tucker, Vice President and Chief Financial Officer

Yes. What I would say, John, is that we did see those past due backlogs continue to increase. So we talked a little bit last quarter about missing some sales as a result of that. So that overhang is still there. I think we were able to kind of power through that and still obviously drive to the earnings and sales commitments we made. From our perspective, we're watching the supply chain closely and expect everybody is working to burn the past dues down as quickly as we can. Obviously, that's important to keep our customers happy. But we expect that's a challenge we're going to have for probably the balance of the fiscal year. Again, everybody has got plans to get those past dues down, but we did see an increase in the quarter, and we'll continue working down from here.

Vic Richey, Chairman and Chief Executive Officer

Yes, I'd just add. I think it's a cost disadvantage for sure because you don't know what's going to not show up from one day to the next. In addition to this normal supply chain, as you would think about with piece parts, in our Aerospace and Defense Group, we're really challenged on outside processing. A lot of the products we make require sending them out for some processing, and the lead times on the outside processing have increased dramatically. Products that we would typically get back in two weeks may now take 12 weeks. The good news is, we've dealt with those challenges and we do a lot of work around pulling some things in. We really do need to get that worked off, but we'll get that done over time for sure. Having that big backlog we have now is really helpful because you have a little more flexibility to pull things in if you need to do that.

John Franzreb, Analyst

Right. Great. And just to shift over to Altanova and Phenix, I'm wondering if you've identified any additional revenue synergies or cost-saving opportunities as you've kind of got to know the businesses a little bit better?

Vic Richey, Chairman and Chief Executive Officer

Yes, I think the biggest opportunities for us there are really doing some cross-selling. They've done a lot of really good work to go through in each of the product areas, look at the products to determine the best characteristics of each of those, and then working to make sure that we're selling the right products in the right areas. When we made the acquisition, part of our internal review was to identify the type of revenue synergies and other types of synergies we would be able to get. I have a lot of confidence that we'll be able to achieve those based on the work that's been done so far.

John Franzreb, Analyst

Okay. And just the legacy USG business, can you talk a little bit about the relative strength in the business and how much confidence you have in that persisting through the balance of the year? It seems like a really good comeback there at Doble and everything.

Vic Richey, Chairman and Chief Executive Officer

Yes, we were initially disappointed heading into the first quarter, but we have observed significant strength since then. Much of this is anecdotal as we survey our customers for their insights. Many are returning to the office, and the demand for test equipment has increased by about 40% compared to our previous survey. While I don’t anticipate a steady growth pattern, I believe the momentum is there and will continue throughout the year. The backlog in that segment is probably the strongest it has ever been, and we just need to maintain this momentum. We held our major customer conference in person this spring for the first time in a couple of years. Attendance was lower than in the past, yet it was still quite strong. Those who attended were very engaged and seemed excited about our initiatives. As mentioned in previous calls, we have launched several new products, which I believe are crucial in driving this momentum by providing updated offerings to our customers.

Christopher Tucker, Vice President and Chief Financial Officer

Yes. And I would just add that as Vic said, as we talk to the team there, they feel like sentiment is starting to improve a little bit. Some of the external forecasts they track on overall utility usage continue to increase. There seems to be a better overall outlook for demand, and we see that in some of the customer activity and interactions right now. As you mentioned, John, it's maybe not going to be perfectly linear, but we're hopeful to get to a more stable, steady growth output rather than the up and down we've seen throughout the pandemic.

John Franzreb, Analyst

Great. I'll get back in the queue.

Operator, Operator

Our next question comes from Jon Tanwanteng with CJS Securities.

Jonathan Tanwanteng, Analyst

My first one is on maybe just to dig a little deeper into Doble. I was wondering if the demand you're seeing so far has sustained into Q3. I think you suggested you might have number one and number two; is it some of that pent-up demand where they're just catching up to where they needed to be? Or is that more just a resumption of the demand you saw pre-pandemic?

Christopher Tucker, Vice President and Chief Financial Officer

I didn't hear your first question, but I'll answer the second one. I do think it's more just returning to normal. I'm not sure there's a huge amount of pent-up demand. With the test equipment, there's some discretionary nature to it, but it does seem like you're seeing a return to where it was prior to the pandemic. I think it's more something that's sustainable. If there were too much pent-up demand, I'd be concerned because that would create a bubble. We see this more as a recovery to the norm.

Jonathan Tanwanteng, Analyst

Got it. And the first part was just, have you seen that sustained through Q3 so far?

Christopher Tucker, Vice President and Chief Financial Officer

Honestly, we don't even have our first month yet, so it's hard for us to comment on kind of what we've seen in April so far. The only thing I would point out is that we are seeing some pretty big orders right now too for some of our lease renewals. We mentioned in the press release that we had one of the big DUC orders, which is the billable security offering. Those are great programs for us, but those also can be multimillion-dollar orders that sit in backlog for a while. You're not going to execute those things over anywhere from a year to all the way up to five years. We did see some pretty big of those in the quarter, which helped drive the orders. Again, that's a positive thing, but I just wanted to give you some color on what happened in the quarter.

Jonathan Tanwanteng, Analyst

Got it. That's helpful. My next question, just on the ability to meet those orders. I think you mentioned in the past quarter and maybe even before that Doble had some issues acquiring electronic parts. We know China has had lengthening lockdowns. I'm just wondering if you're able to actually meet that demand that you have now.

Victor Richey, Chairman and Chief Executive Officer

Yes, we'll be okay. I mean, like I mentioned earlier, we may be delivering a slightly different mix of products than what we had anticipated. But they’re working through these issues. They’re not significant, but there's a lot more work than they used to do.

Christopher Tucker, Vice President and Chief Financial Officer

Yes. When we reported last quarter, we mentioned that we had missed between $5 million and $8 million due to some past due backlogs, including Doble. Their contribution to that backlog increased in the second quarter. They typically operate with no past dues, as their products usually come in and go out quickly relative to orders. However, they are still experiencing some supplier issues, specifically with chips and other necessary components. While strong demand is helping sustain their revenues, the supply chain challenges are still causing some slight setbacks.

Jonathan Tanwanteng, Analyst

Okay. Great. Understood. And then, my last question, could you talk about your preference for share repurchases now versus potentially more M&A at this point?

Christopher Tucker, Vice President and Chief Financial Officer

Well, I think we always would prefer to make good acquisitions, and we'll continue to look for things there. I mean, I think we are a little more aggressive than we have historically on the stock. Because we didn't clean up our dilution for a number of years. We certainly want to do that. It's something we talk about every quarter. It really is based on what we see from opportunities for acquisitions. We review that on an ongoing basis. If we aren't able to achieve some of those things, then we'll look at being more aggressive on the buyback side.

Jonathan Tanwanteng, Analyst

How does the pipeline look now?

Victor Richey, Chairman and Chief Executive Officer

Pretty good. It seems like over the past few months it has picked up a bit; some interesting properties out there. Nothing that's going to close this week, but there's a number of things that we're working on.

Jonathan Tanwanteng, Analyst

Okay. Thank you, guys. I'll go back in queue.

Operator, Operator

Thank you. I'm currently showing no further questions at this time. I'd like to hand the conference back over to Mr. Richey for any closing comments.

Vic Richey, Chairman and Chief Executive Officer

Okay. I appreciate everybody's participation, and we'll end the call now. Thanks for dialing in. We look forward to talking to you in our next call.

Operator, Operator

Ladies and gentlemen, thank you for your participation. You may now disconnect. Everyone, have a wonderful day.