Earnings Call Transcript - ESE Q3 2022

Operator, Operator

Good day, and thank you for standing by. Welcome to the Third Quarter 2022 ESCO Technologies Earnings Call. At this time, all participants are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. Please be advised that today’s conference is being recorded. On the call today, we have Vic Richey, Chairman and CEO; Chris Tucker, Senior Vice President and CFO. And I would now like to hand the conference over to your first speaker today, Kate Lowrey, Vice President of Investor Relations. Kate, you 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 the 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 Vic.

Vic Richey, Chairman and CEO

Thanks, Kate, and thanks, everybody, for joining today’s call. I’ll start off by thanking our global teams. We continue to experience challenging operating conditions across all of our end markets that the teams are working tirelessly to deliver for our customers. We saw the benefits of this hard work during the quarter, with reported sales increasing by over 20%. This is the second consecutive quarter of sales growth in excess of 20%. This strong top-line growth translated to the bottom line, with reported earnings per share of over 50% and adjusted earnings per share up 33%. That is a strong performance indeed. The other key highlight for the quarter was our ongoing order strength. During the third quarter, we saw orders increase by 25%, and the backlog ended at $707 million. As we mentioned in the press release, this is a record level of backlog for us. Setting a record backlog indicates healthy end markets and provides visibility as we plan for next year. We are also managing high levels of past due backlog, which is something we are very focused on reducing. In general, we still see supply chain issues as a key driver of our past due backlog situation, primarily affecting our Utility and Aerospace businesses. The teams have this in focus, and we’re proactive with our customer base to address the issues. Visibility is somewhat limited, but as the wind clears up, our main focus will remain on doing everything we can to get customers the products they want, when they want them. Chris will discuss some financial details in a moment, but I wanted to offer some top-level commentary about each of our business segments. Starting with Aerospace & Defense, where we had a really solid quarter. Sales and margins both increased nicely. Orders remained strong with 16% growth compared to last year’s third quarter. As we look across this business, we continue to see good trends in Commercial Aerospace, Navy, and space—all doing well. Just a few weeks back, we attended the Farnborough Airshow outside of London. It was encouraging to see the event well-attended. The show was very positive for us, and we continue to be well-positioned in this market. As mentioned earlier, past due backlog is something we’re watching closely for the A&D business. Supply chain challenges are persistent, and we hoped that past dues would have normalized by now but, despite this, we’re still achieving good results at A&D. Next is the Utility Group, where we also had a strong quarter. Excluding the acquisition impact, we had sales growth of nearly 17%, after a very strong performance in Q2. This business seems to have finally overcome the market softness we saw during the pandemic and is starting to ramp up. When you add any acquisitions, growth is up over 40%. We’re excited about what the acquisitions bring to the table for ESCO, and 2022 is shaping up to be a transformational year for the Utility Solutions Group. Now, turning to the Test business, we continue to see really great sales momentum, marking the second consecutive quarter with sales growth in excess of 20%. We have a global footprint and a broad product offering, allowing us to sell into strong markets. This has proven to be a powerful combination for us. Even with a robust sales performance, we have continued to grow the backlog. Order activity remains elevated, and the team continues to win business around the world. Overall, through the first nine months, we are tracking to the plan we communicated last November. The third quarter is crucial as we need to see sales and earnings improvement ramp up, and we have been able to achieve that. We are in a good position and are pushing hard to close out the year successfully. As you know, we still have a lot to accomplish in the fourth quarter. The teams are maintaining a sharp focus as we approach the end of the year. Looking beyond this year, it's clear we are setting up a strong foundation for 2023 and beyond. Now, I’ll turn it over to Chris.

Chris Tucker, Senior Vice President and CFO

Thanks, Vic. Once again, we’ll have a chart presentation for you, and I’ll walk through the material in those charts. We’ll start on Chart number 3, which summarizes the Q3 results on a consolidated basis. It’s great to have a chart like this, as all the arrows are pointing upward this quarter. You can see the strong performance here with orders and sales up 25% and 21%, respectively. Adjusted EBIT dollars are up 34%, and adjusted EPS is up 33%. All very strong numbers. I’ll go through the segment results in a moment, but we had strong sales growth across all three businesses, with organic growth of nearly 14% and acquisitions adding another 7 points of growth. On the margin side, we had adjusted EBIT up by 1.4 points as we continue to see good leverage from the sales increases. While we do continue to face significant inflation negatively impacting margins, teams across the company are effectively managing cost reduction efforts and price increases to help offset these impacts. Moving to the next chart, we can take a quick look at cash flow and capital allocation. Operating cash flow is lagging so far this year as we are investing in working capital as the business grows. We see this reflected in accounts receivable and inventory balances, somewhat offset by accounts payable. Capital expenditures are up this year, driven by the building purchase at NRG and share repurchases year-to-date, which are just shy of $20 million. This marks our first share buybacks in a number of years, signaling a good restart to this program. Acquisition spending is also up, driven by the NEco deal that was closed in the first quarter. In terms of the Aerospace and Defense business, we had a really solid quarter with 8% sales growth led by Commercial Aerospace customers at PTI and Mayday. The Navy and Space markets also saw nice growth driven by VACCO and Globe. On the margin side, we saw an impressive improvement with adjusted EBIT margins up almost 3 points compared to last year’s third quarter. Moving to the Utility Solutions Group, we had order growth here of 34% and sales growth of 41%. Excluding the impact of acquisitions, the growth was 9% and 17%, respectively—very strong numbers. Year-to-date, sales growth for USG, excluding acquisitions, stands at 12%. As Vic mentioned, we are hopeful that this business is entering into a period of more consistent growth as Utility customers invest in their infrastructure. Adjusted EBIT margins here were up over 1 point as leverage from the growth more than offset the impact from acquisitions. Finally, in the Test business, as Vic mentioned, we have experienced two quarters of sales growth exceeding 20%, with orders even better, up 32%. This business has reached a point of growth characterized by broad development across end markets and geographies. The adjusted EBIT margins were up a tenth to 14.1%. While we continue to confront some operational headwinds, we expect to finish the year strongly, especially from a margin perspective. Now turning to guidance, we have tightened the full-year guidance range to between $3.12 and $3.18 per share, representing more than 20% growth compared to 2021. You'll recall we initially laid out guidance of $3.10 to $3.20 per share back in November, and we continue to stay on track within this range. As Vic highlighted, this reflects the hard work of everyone across the company as we navigate the numerous challenges posed by the current economy. Many of the inflationary pressures and supply chain challenges have been more severe than anticipated, so we feel good about being on track to deliver within the initial guidance range for earnings per share. With that, I’ll hand it back to Vic.

Vic Richey, Chairman and CEO

Thanks, Chris. Since I touched on quite a few thoughts earlier in my commentary, I’ll just offer a few more comments before we move to Q&A. As all the numbers from Chris indicate, we have had a really good first nine months of fiscal 2022. We see good momentum across all three business segments despite the ongoing challenges in the current operating environment. We hear a lot these days about the economy and fears of a deep recession. Certainly, we are monitoring this closely and are ready to respond appropriately to wherever the economy goes from here. With the continued strength in orders and backlog, I feel very confident in saying that the outlook for ESCO is positive. Some of our end markets are really just beginning their recovery from the pandemic, and we believe that there is potential for growth even if broader economies are slower. We will keep a close watch on this situation, but overall, we remain very optimistic. With that, I think we’re ready for Q&A.

Operator, Operator

Thank you. At this time, we will conduct a question-and-answer session. Our first question is coming from Tommy Moll with Stephens. Tommy, please go ahead with your question.

Tommy Moll, Analyst

Good evening, and thanks for taking my questions. I wanted to start on Doble. It looks like another strong quarter. That makes at least a couple in a row now. And maybe even sequentially, it looks like it was flat to even higher in the quarter you just reported. So I guess now there’s some consistency here coming out of the pandemic when in prior periods, there was some volatility there. So if you wrap it all together, does it feel like you’ve hit a pretty good run rate here for Doble, or would you point to factors that are still at least on the revenue side holding you back where there could be potential for another step change higher from this new level that you’ve reached in the last couple of quarters? Thanks.

Vic Richey, Chairman and CEO

Sure. So Tommy, I think there’s always opportunity here. As we’ve talked about in previous calls, we took the time during COVID to do some significant product development at Doble, as well as NRG and Morgan Schaffer. Coming out of the pandemic, we anticipate an uptick from those new products. I believe we have developed some offerings that are better than what we had in the past and what the competition has. So there isn't a cap on this potential, and we should be able to achieve additional growth as we move forward, particularly in the next year. Even with the acquisitions, we’ve discussed the growth we’ve had there, but as you know, the European economy has been somewhat more challenged than the U.S. due to the situation with Ukraine. So, as those businesses are integrated, I think we’ll see a bit more growth in the European market as well.

Chris Tucker, Senior Vice President and CFO

Yes. And one thing I would add, Tommy, you kind of mentioned incremental things. I mean, one aspect we are facing is that the supply chain challenges are still quite acute. Over the last couple of quarters, we probably had $6 million to $7 million each quarter in what we would call past-due backlog, where we’ve received orders but can’t deliver the product to the customers due to supply chain issues. We expected this to be improved by now, but we are really managing a lot of challenges on that front. Hopefully, these issues will start to resolve as we progress, allowing us to execute better in the business. But I can assure you, month-to-month, we continue to do a lot of hand-to-hand combat to address different issues that arise across our supply base.

Tommy Moll, Analyst

So you anticipated my follow-up question, which was going to be on the past due backlog that you’ve mentioned a couple of times now. And you don’t historically guide on cash flow, but maybe you could talk qualitatively versus what you planned at the beginning of the fiscal year. Have these issues gotten worse? Were there some unanticipated items that arose? And then as you look forward, I feel like I got asked the question, how much visibility do you have? This has been a tricky issue for plenty of high-quality companies in this challenging environment. So if that forward visibility is limited, knowing that would be helpful, but whatever you could share there would be appreciated.

Chris Tucker, Senior Vice President and CFO

Yes. I think what I would say is that we talked a little bit and quantified in the Q1 numbers about how much past due we had and how that cost us. We haven’t provided that level of detail in the last couple of quarters, but I would tell you it did get larger from Q1 to Q2. However, from Q2 to Q3, it has stabilized, so it’s not a big increase. I would say the problem isn't worsening. We had hoped that conditions would have improved by now, or that some of these pressures would have eased. We don’t have many items that are 6, 9, or 12 months past due; they’re just taking a little longer to ship. Each month, we face new issues that arise. So, it’s difficult to predict when conditions will improve, but we continue to work hard despite these challenges, and feel good about what we’ve delivered over the past few quarters.

Vic Richey, Chairman and CEO

Yes, if I could just add, one real benefit of having the orders and backlog we have is that it provides some flexibility. In several instances, we’ve been unable to acquire certain components and that hinders processing. However, we’ve been able to adjust our delivery schedules. The fact that we have dealt with these challenges and still met our targets speaks to the team's flexibility. Having a strong backlog certainly makes a difference, allowing us the opportunity to adapt our delivery plans.

Tommy Moll, Analyst

I appreciate it and I’ll turn it back. Thank you.

Operator, Operator

Thank you, Tommy. Our next question comes from John Franzreb from Sidoti. John, go ahead with your question.

John Franzreb, Analyst

Good afternoon, Vic and Chris. Thanks for taking the questions. I guess I’m curious a little bit about the order intake. What’s your sense of how much there is that’s still deferred spending that’s kind of flowing through the booking profile or customers now spending based on the current market expectations?

Vic Richey, Chairman and CEO

Yes. I would say the vast majority of it is just kind of people are buying what they need. The area where we see a little bit of pent-up demand is in our Test business on the medical side, as much of that capital spending was paused during the pandemic focused on other areas. We've also seen good pickup in sales to Test Labs, as they play catch up now that they’ve resumed capital expenditures. This is evident across the board, in the U.S., China, and Europe. Regarding the Utility side, we’ve noticed some recovery from an order perspective, particularly in the Test business and test houses. The Utility business is returning to more normalized order rates.

John Franzreb, Analyst

And you mentioned in your prepared remarks some concerns about the recession. Where would you see that first in your order book? Any particular business that would stand out?

Chris Tucker, Senior Vice President and CFO

I would say probably the Test business. I wouldn’t characterize what we’re seeing as concern about the recession; rather, it’s recognizing the anxiety that is prevalent right now. From our perspective, the Utility and A&D businesses have favorable characteristics and cycles that should provide a solid foundation as we move forward. However, in the Test business, if there were a significant slowdown in overall business activity and capital spending, that might result in a quicker impact there. That said, that is likely where we would see it first.

John Franzreb, Analyst

Great. And one more, if I may. Of the organic growth at least 7% year-over-year, how much of that was volume versus pricing? How are you managing pricing?

Vic Richey, Chairman and CEO

Yes. We are indeed seeing price increases overall. When you look at the net results, it averages out to about 3% on the revenue line with volume accounting for the rest. Of course, there are exceptions where some areas see greater increases or none at all due to long-term agreements and other factors. But overall, we estimate it falls within that range.

John Franzreb, Analyst

Great. Thanks. I’ll get back into the queue for now. Thank you.

Operator, Operator

Thank you very much. We have one more question, and that is coming from Jon Tanwanteng of CJS Securities. Jon, go ahead with your question.

Jon Tanwanteng, Analyst

Hi, thanks for taking my question. I wanted to follow-up on the prior question regarding inflation. Is the net pricing improving as we go forward? Are you starting to see any moderation at all or maybe a pickup in your ability to pass price through, or should we expect that margins remain the same as we go forward?

Chris Tucker, Senior Vice President and CFO

Yes. I mean, we’ve observed a few times throughout this year that inflation appeared it might stabilize, yet it keeps rearing its head. Thus, I wouldn't say we’ve seen a slowdown in inflation; however, we do expect to continue driving prices upward so that we can improve our price-cost equation. Overall, we feel positive about our year-to-date position. We’re addressing the issues we face with pricing, but we need to perform even better. So yes, Jon, we anticipate improvements moving forward.

Jon Tanwanteng, Analyst

Okay. Great. And it’s great to see you guys doing repurchases again. It’s been quite some time since we saw that. Just one question about your priority for capital allocation. Seeing repurchases at a time of limited M&A pipeline? Or are you still active there? Are you looking to maintain a balanced approach?

Vic Richey, Chairman and CEO

Jon, we still intend to pursue acquisitions. We completed a couple of transactions a few months ago and did something in the first quarter. So there are opportunities still out there. I can mention that during my time at the Farnborough Airshow, I spent a significant amount of time in meetings with investment bankers discussing potential opportunities. We have several prospects available. However, we are very selective and strategic, as there have been cases where opportunities slipped away. Nonetheless, we remain vigilant in seeking good acquisition opportunities.

Jon Tanwanteng, Analyst

Okay. Great. And then, one final question for me regarding the climate bill making its way through Congress. It focuses heavily on renewables and grid modernization. Is there anything in there for NRG or Doble that would impact you guys?

Vic Richey, Chairman and CEO

Yes. I mean, while we don’t break out the NRG business separately, they are performing exceptionally well right now. We anticipate that should all align positively. There have been some changes to the bill this year that would push out the allowance for imported solar panels, which is no longer an issue for us. Overall, I believe this bill will generally benefit our business.

Chris Tucker, Senior Vice President and CFO

Yes. And I would add that while the Doble business isn't directly involved in renewables like NRG, we expect to see positive effects as the grid undergoes modernization and the integration of more renewables. This will drive testing requirements for new assets, ultimately benefiting us. So while there might not be direct spending driven by these bills, we think it will greatly benefit the overall market.

Jon Tanwanteng, Analyst

Okay. If I could sneak one more in there. Regarding Doble, are you back to the 2019 levels in the legacy Doble business yet, or is it still somewhat in recovery?

Vic Richey, Chairman and CEO

We project that by the end of this year, we will be close, but not quite there—within $5 million on the revenue line, so fairly close. We anticipate reaching those levels next year.

Jon Tanwanteng, Analyst

Got it. Thank you, guys.

Vic Richey, Chairman and CEO

You bet.

Chris Tucker, Senior Vice President and CFO

Yes.

Operator, Operator

It appears we have no more questions. I would like to now turn it back over to Vic Richey for closing remarks.

Vic Richey, Chairman and CEO

Okay. We’ll conclude the call now. Thanks, everybody, for dialing in. I look forward to talking to you on our next call.

Chris Tucker, Senior Vice President and CFO

Thank you.