Earnings Call Transcript - ESE Q2 2020

Operator, Operator

Good day, and welcome to the Q2 2020 ESCO Technologies 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.

Kate Lowrey, Director of Investor Relations

Thank you. We issued a press release earlier today that will be referenced during the prepared remarks on this call. You can find a copy of our press release and our safe harbor statement regarding forward-looking statements made during this call in the Investors center of ESCO's website. During this call, the company may make forward-looking statements, which are inherently subject to risks and uncertainties, particularly given the unknown impact of the current COVID-19 pandemic and the company's response to these evolving circumstances. Actual results may differ materially from those projected in the forward-looking statements, and the company does not assume any duty to update forward-looking statements. Please refer to the company's press release for risk factors that may impact any forward-looking statements and for a reconciliation of any non-GAAP financial measures to their most comparable GAAP measures. Now, I'll turn the call over to Vic.

Vic Richey, Chairman and CEO

Thanks, Kate. Before I hand it over to Gary to discuss the second-quarter financials, I'll make a few comments on the current state of the company as well as our outlook for the future in light of the COVID-19 crisis. Given how much the world has changed since our last earnings call three months ago, I think it's important to share with you the details of how we're managing the business through this unprecedented time. As the pandemic spread across the globe during February and March, and as economic impacts started being felt in some of our businesses, we did what we do best: we took decisive action. The actions we've taken have a clear and precise focus, which is to protect our strong financial condition, secure the financial well-being of the company, and support business continuity. These measures will allow us to weather the storm while continuing to support our long-term strategy for profitable growth. In the past, we've demonstrated our operational excellence and our ability to effectively manage costs to meet challenging market demands. This challenging time will be no different as we're actively addressing today's business pressures by using all the tools at our disposal. The beauty of these current cost reduction initiatives is they're being implemented with minimal costs to achieve, thereby maintaining our flexibility to ramp up quickly should demand increase as customers, communities, and countries reopen their economies. Bottom line is we're controlling what is within our control and focusing on the near term without losing our vision for the future. I hope our comments today will leave investors with three clear messages about ESCO going forward: our diverse portfolio of strong, global businesses serving a wide range of nondiscretionary end markets provides us with the strength and resilience to continue to support our long-term growth outlook. Number two, our strong balance sheet and significant financial liquidity will allow us to effectively manage through this crisis and maintain the company's financial health and well-being. And finally, our deep and experienced leadership team has managed through and overcome many challenges in our 30-year history. I am confident we will emerge from this extraordinary time as an even stronger company. Today, we have very clearly defined priorities. First and foremost is the health and safety of our employees and our families, followed by a commitment to meet the needs of our customers and suppliers. Both of these will help support the business today and secure our future during this uncertain time. ESCO will benefit from the fact that we have developed leading positions in various niche markets with a set of unique and highly technical products and solutions specifically designed to meet our customers' needs, which makes it difficult to be replaced by alternative sources. Our continued investment in new products across all three segments and our staff of highly skilled engineering talent will continue to create new opportunities to provide value to our customers, which will drive our long-term growth. I firmly believe that our future will rise as our customers' communities recover and spending returns to more normal levels. To close out my comments before I hand it over to Gary, as we face the immediate and ensuing economic fallout of COVID-19, I believe we are well positioned to navigate the short-term challenges in front of us. Our fundamental approach to operating our business and our solid liquidity will be the cornerstone of our continued long-term success. Our employees are our most important asset. I want to say thank you to our manufacturing employees, leadership teams, and staff around the world for their hard work and dedication during this trying time, as you all demonstrated an extraordinary commitment to the success of ESCO. Now I'll turn it over to Gary.

Gary Muenster, Vice President and CFO

Thank you, Vic. I'll briefly cover the Q2 and year-to-date operating results, which we've laid out in the press release, then I'll share some comments on the guidance for the balance of the year. As Vic noted in his comments, our liquidity position is of the utmost importance to us during this challenging time. I'm extremely pleased with where we stand today, having nearly $700 million of dry powder at our disposal between cash on hand and available credit capacity, while carrying a modest leverage ratio of 0.92. I wish I could tell you that we saw this economic crisis coming late in 2019 when we extended our 5-year credit facility out to the year 2024 and increased our debt capacity by an additional $50 million at lower rates; or when we sold our Technical Packaging business and generated over $190 million of gross proceeds to significantly improve our cash and debt positions. But we didn't see it coming. We did not anticipate a pandemic as we executed both of these liquidity enhancements, as these were part of our normal financial strategy. I'm glad we did these things as they have bolstered our current financial position. I'll touch on a few Q2 highlights from the release. Sales increased 5%, led by our Aerospace & Defense segment, growing $16 million or 20%, driven by the addition of Globe's submarine businesses, coupled with strong aerospace sales at PTI and Crissair, and higher space sales at VACCO. Q2 A&D sales came in approximately $3 million ahead of plan. Test sales were relatively flat due to a three-week shutdown of our Chinese manufacturing facility in February, coupled with timing delays at several installation sites where personnel access was restricted due to COVID. Domestic chamber sales were relatively strong and on plan during the quarter, which nearly offset the installation site issues. USG sales were down due to the timing of various project deliverables as several large utility customers, both domestic and international, realigned their short-term maintenance and spending protocols to focus on uninterrupted power delivery during the global crisis. Entered orders were a bright spot in both Q2 and year-to-date, where we booked $466 million of new business and ended March with a record backlog of $565 million, which is up 25% from the start of the year. Our DoD business, led by our participation on the Block V contract for additional Virginia Class submarines, was the clear winner. During Q2, we generated $34 million of cash from continuing operations with free cash flow of $23 million, reflecting a 127% free cash flow conversion to net earnings during the quarter. Q2 and year-to-date adjusted EBITDA improved from the prior year, with Q2 reflecting a 17.4% margin despite the lower contribution from USG, which is our highest margin segment. Finally, Q2 adjusted EPS was $0.68 a share, down slightly from the $0.71 a share delivered in Q2 of 2019, which resulted from the noted COVID impact. To set the table for the balance of 2020, the COVID-19 global pandemic has introduced considerable uncertainty around the extent and duration of today's economic circumstances, which makes it difficult to predict how our future operations will be affected using our normal forecasting methodologies. As a result of this uncertainty, we're withdrawing our previously issued full-year guidance and will not provide guidance for Q3 at this time. To add some color to Vic's comments on our cost savings actions, we are focused on the right things, and we are pulling on all reasonable cost levers to maintain and optimize our cash flow and liquidity. Our focus is to prudently cut our deferred costs in the short term and focus on those costs that do not have a negative impact on our ability to meet increasing demand or growth in the future. Now I'll turn it back over to Vic.

Vic Richey, Chairman and CEO

Thanks, Gary. I will offer some qualitative comments about our end markets, but I will emphasize that today's situation is very fluid, and there are many unknowns, so my comments may change materially in the future. We recently completed a thorough review of our individual businesses as part of our April planning meetings to better frame our expectations of the impact of COVID-19 across and within our various operating units. Starting with the Aerospace & Defense segment, we expect to see a slowdown in commercial aerospace deliveries over the balance of the year. It's too early in the cycle to determine the sales and EBIT impact from the current industry downturn as it relates to future build rates and airline passenger miles. We are working with all of our aerospace customers to get a better picture of their demand and requirements over the coming quarters, but the situation continues to evolve daily. Our defense contract within Aerospace & Defense, both military aerospace and navy products, is expected to remain strong given its current backlog and the urgency of expected platform deliveries. Our aerospace supply chain partners continue to deliver necessary parts and services to us. In some cases where we see some weakness, we are working on bringing some of these products and services back in-house, such as machining and other capabilities we can replicate as a safety net. We also see this weakness in the aerospace market as an opportunity for ESCO. So, if we find suppliers or competitors experiencing financial or operational stress during this crisis, we may be able to provide assistance either through partnering or via acquisition at a reasonable price. Our Test business is expected to remain relatively solid over the balance of the year given the strength of its backlog and the strength of its served markets, including medical shielding and 5G and its related communications technologies. We expect USG's customer spending softness to continue through the next few months as they come out of their summer testing protocols and return to their more normal buying patterns. Once some of the social distancing guidelines are sorted out and utility service personnel can return to their normal site visit routines, we expect our service business to return to normal as it has been essentially on hold for the past few months. Utilities have the money to spend, and I'm certain that spending will return in the near future as maintenance spending cannot be delayed indefinitely without creating significant risk to grid safety, efficiency, or regulatory compliance. The critical need to maintain, repair, and improve the utilities' aging infrastructure is not reduced by this pandemic crisis. On a positive note, I'm really pleased with USG's pipeline of new products and solutions, especially related to cybersecurity and related asset hardening solutions. We introduced several new solutions at the Doble conference in March, and from customer feedback, both there and after the show, these products are being enthusiastically received. Moving on to M&A. Prior to COVID, we had a couple of actionable opportunities well down the path to completion, and we'll continue to evaluate several other actionable deals in the pipeline. When the time is right, we will take action on these opportunities to grow our businesses as we have in the past. Our Board is supportive of our M&A strategy, and our current balance sheet provides us with plenty of liquidity to allow us to add to our existing portfolio. In summary, we delivered a strong first half of the year. For the balance of the year, our plan is to hunker down while dust settles, work hard to control our costs while maintaining our critical workforce, develop contingency plans for multiple scenarios, and look for opportunities to leverage our infrastructure. We will survive and prosper. I'll now be glad to answer any questions you have.

Operator, Operator

First question comes from Robert McCarthy with Stephens.

Robert McCarthy, Analyst

So maybe the first thing is to talk about, in the quarter, the strong cash conversion you cited. Could you talk about some of the dynamics of that and how we should be thinking about that going forward?

Vic Richey, Chairman and CEO

Yes. I think, Rob, as we've talked in the past, it's a clear focus of ours to get that percentage up from where it's been historically. Some of the initiatives are taking hold. It really is kind of across-the-board focus on doing the things that are easy to do, which is making sure you're paying your vendors and that sort of thing on the appropriate timescale and also working on the receivable side and collecting some things. We're also doing some things within inventory, where we're not accepting inventory early and things like that. Those are the kind of basic things. But I'd say the other side of it comes on some of the contracting things we're doing across the DoD world. When we win these contracts, part of our negotiating strategy is to ask for larger downpayments upfront to minimize our investment in those programs. So we're successful with that. I'm sure you've seen some of the headlines where the DoD is increasing their progress payment flexibility in some cases, so we're starting to see some flow in from that. It's kind of across the board, but we're really pleased with our numbers. I don't think it's sustainable at 127% because you're going to have swings with quarterly volatility. But I think you're going to see, for the year, depending on how the back half plays out relative to our order book, pretty decent cash conversion in the back half of the year as well, again not at the 127%. What you're starting to see is some traction on the things we've been working on. As I said, six months ago, we're trying to turn around a battleship here with some of our customers, and we're seeing some progress. So hopefully, that's helpful.

Robert McCarthy, Analyst

No, it is. And maybe we can talk a little bit about your commercial aerospace exposure as a whole and just amplify your comments around it in terms of sizing the business and exposure, then just giving us some level of comfort or dynamics. Because, I mean, you know, we can start citing third parties, you get some pretty scary numbers pretty quickly because you're tied, obviously, ultimately to airline travel and movement. So just help us how you're thinking about that, not only in terms of near-term dynamics but also just how long you think we could be in this kind of choppy environment. And what is the implication for you all? Because clearly, you didn't see it in the quarter, which we understand. But it's important.

Gary Muenster, Vice President and CFO

Sure. So, Rob, overall, it's about 20% of our overall business. That gives me a lot of comfort in that 80% of our business is not associated with that. Commercial aerospace is still going to be a good business longer term. If you look at what happened after 9/11 or after 2008, sure, there was a downturn. But, you know, these things don't go to zero. People are still going to fly. People are still going to travel. These businesses are going to be fine over time. If you look at it in pieces, about 18% of our overall business is to OEMs, and the rest is the aftermarket, driven by flight miles. Obviously, the OEMs will be impacted to some level as well, but I don't think it's nearly as dramatic as the aftermarket will. As for recovery, I think we said to look at history and make some assumptions on that. Everything I'm hearing shows people are thinking it will take three to maybe five years to get back to 2019 levels. This is not something that's going to turn around in the next 18 months. Again, I don't think it's going to go down as far as some people may think. It's not like 95% of the flight tracks down, and we go down 95%. That's just not how it works. What we're doing is looking for opportunities, as I mentioned, to do some in-sourcing to try to fill that void. It will have an impact in the near term, but I think longer term, those are still good solid businesses.

Robert McCarthy, Analyst

And then finally, for me for now, USG. Could you just comment on some of the behavior you talked about with this kind of pushout of some of the deployments in terms of the switching of resources to other areas for full power for the utilities? I do think there was a comment in the press release about Doble and some struggles, either in the quarter or expected? Could you just amplify your comments around that?

Vic Richey, Chairman and CEO

Sure. With utilities, the utilities are pretty conservative. The most important thing for them to do right now is to keep power flowing, right? What we typically see in spring is taking substations offline, where they will do the testing and utilize our equipment and services, which would remind them they need to purchase new equipment. Instead, they've jumped past that piece and acted as if it's more like summertime. They have not been taking substations out of service to do some of the work. One thing that happens when they do that, they take more oil samples. Our oil labs have been running overtime, but that's not enough to make up the difference in product and service standpoint. This situation isn't sustainable. Everything we've heard, we're staying very close to our customers. We can't visit them right now, but we spend a lot of time on the phone with them. Everything they're saying indicates this is going to come back. We think we'll start to see good movement in the fourth quarter and certainly going into next year. Unlike airlines, where it's less clear, utilities will have to do this maintenance and testing. We think it'll be a much shorter duration dip for the utility business than what we might see in the airline business.

Operator, Operator

Next question will come from Jon Tanwanteng with CJS Securities.

Jon Tanwanteng, Analyst

Nice quarter. And also, Gary, echoing your comments, nice job on the sale of packaging, the refinancing, and even the action on the pension you mentioned in your press release—just all of that is very timely stuff ahead of what we're seeing. My first question is, you mentioned the utilities business servicing is not an option right now. How big was that business on a quarterly run rate? And is it actually going to zero at this point? Or is there still some minimal level of services going on?

Vic Richey, Chairman and CEO

With the service business itself, it's not a huge piece of our business. I don't have the exact number right in front of me, but it's not going to zero. There are critical areas, such as nuclear, that still have to be serviced. But we're talking around $25 million to $30 million, and certainly not going to zero. Even with performance in the last quarter, they were down but not to that level. It's critical to be careful when we talk about businesses dipping. They rarely go to zero unless you're in a retail business. Our businesses are impacted relatively. This service business will come back. I expect it will be back in the fourth quarter. We're hearing from some of the testing companies providing services to utilities that there's a lot of pent-up demand.

Jon Tanwanteng, Analyst

If you're running at $25 million to $30 million, maybe a year, how much is the run rate in April, for example?

Gary Muenster, Vice President and CFO

Again, as Vic mentioned, the seasonality of when they're allowing people out isn't ratable for all months. Normally, if we were in a routine cycle, it would be around $3 million to $4 million a month. Current reports are around $2.5 million to $3 million a month. So, we're seeing a dip at that level.

Jon Tanwanteng, Analyst

Just the same question regarding aerospace. What kind of run rates have you been seeing, split between OEM sales side and the filtration side, through the end of March and into April?

Gary Muenster, Vice President and CFO

One thing we do, as you know, is pay attention to details as part of our planning process. We track weekly shipping reports, which are typically tight. On a weekly basis, we're seeing around a $200,000 to $500,000 shortfall off numbers that can reach into millions. We had a great first half, ahead of plan, by around $2 million or $3 million. Now, currently, for the first five weeks of Q3, we're about $2.5 million behind plan. It's not going to zero. The beauty of our products is we receive orders for finite products. We're not selling just widgets. Our customers are taking the products they requested a little lighter, and some deliveries have been pushed back but not canceled.

Jon Tanwanteng, Analyst

Yes, it makes sense. Is that just the aftermarket? Or is that the entire aerospace business, considering the shortfall?

Gary Muenster, Vice President and CFO

On the weekly shipping, I view it through dollars, not a split between OEM and aftermarket. Our contribution of OEM and aftermarket is about an 80-20 split with 80% on the OEM side. That helps because they're still building claims, just not as many. The contracts we have are still being executed at 80-90% of planned deliverables.

Vic Richey, Chairman and CEO

It's important to remember that the only place we're seeing that impact is on commercial aerospace. Defense sales are still strong, and so are Navy and space sales. We're focusing on one area, and that's where we'll spend our time to bolster that business.

Jon Tanwanteng, Analyst

Just one last one, if I may. What's the schedule and timing for the Virginia orders, like Block V boat, to flow through to the P&L from backlog?

Gary Muenster, Vice President and CFO

It's multiyear. There won't be much sales this year as they're still producing. We’ll have some long lead material purchases this year, which will deliver some revenue. We booked about $105 million to $110 million of Block V; we'll probably deliver around $3 million to $5 million of that over the second half, with the rest carrying over. When you look at that backlog number of $565 million, 68%-70% will ship in the next 12 months, equating to about $385 million. The Virginia Class backlog at Globe has a longer timeline, which is one reason it's at 68%. It's why we find the long-term contracts in Navy business most attractive.

Operator, Operator

Next question comes from John Franzreb with Sidoti and Company.

John Franzreb, Analyst

I'd like to start with the Test segment. I'm getting different feedback as far as spending in that marketplace, in part because R&D is discretionary spend. I have some exact…

Vic Richey, Chairman and CEO

I couldn't quite understand you, but I think I know what you said. Some people are telling you that orders are really soft right now in the Test segment, while others say they are pretty strong. Is that what you are asking?

John Franzreb, Analyst

That's a good summation, yes.

Vic Richey, Chairman and CEO

Our Test business really is pretty solid. We've seen good orders in our Test business. Each segment serves various markets, including medical, components, absorbers, and others. Most of it is very dependable and not really discretionary. Many of our customers have long-term projects that must be completed. We haven't seen that level of variability yet. I think we're in great shape this year. We have a lot of backlog for next year and great growth opportunities. The diversity of end markets is what gives us stability. However, keep in mind that some of this is capital equipment, and that can face cuts. If they're not using our equipment, they'll likely have to go to a third-party test house, which most customers won't have the capability to do without our equipment.

John Franzreb, Analyst

On the commercial aerospace business, how much excess inventory do you think is in the channel for your products?

Gary Muenster, Vice President and CFO

Are you talking on our end or in relation to fleets that are parked?

John Franzreb, Analyst

Relative to how much you've delivered that hasn't been built yet.

Gary Muenster, Vice President and CFO

Our product is shipped usually going on an airplane within 90 days, so our inventory is not just sitting. We don't generally ship product with extended delivery delays. Distributors have probably around 30-45 days of inventory. That’s where we've seen the $2.5 million slowdown in the last five weeks, resulting from delivery timing complexities, particularly while they sort out their build rates.

John Franzreb, Analyst

On the utility service side of the business, is that seasonal spring and fall or similar to a turnaround season?

Vic Richey, Chairman and CEO

Typically, we see more activity in spring as utilities maintain power flow. But this spring, they're not doing that to keep power stable. This spring, they’re taking substations offline less than usual due to operational priorities. Ultimately, we think they’ll attempt to make up for it in either the fourth quarter of this year or the first quarter of next year.

John Franzreb, Analyst

Are there any changes in your capital spending plans for the year based on COVID?

Vic Richey, Chairman and CEO

We're taking a hard look at that. We’ve asked each segment to rejustify their capital plans. For example, we were planning to expand one of our plants in the second half of this year, we've put that on hold. There are some equipment buys that have been postponed. We’re doing everything possible to conserve cash.

John Franzreb, Analyst

Can you talk a bit about the tax rate trend in the quarter and expectations going forward?

Gary Muenster, Vice President and CFO

Last year, we similarly had an unusually low rate in Q2 due to strategic actions our tax group executed, and we saw the same effect this year. For a blended annual rate, it will be around the 24% range, similar to what we expected at the start of the year. To achieve that average, we may face 25%-26% tax rates in Q3 or Q4.

Operator, Operator

Next question comes from Robert McCarthy with Stephens.

Robert McCarthy, Analyst

Just a few follow-ups, if I may. I guess first, I mean, looking at your overall exposure, and I understand and respect the difficulty in forecasting given the COVID situation. However, we do not have that luxury. A lot of your businesses are cyclically resistant, and we've discussed your Navy, space, defense, and utility businesses. However, I want to focus on testing, which is more tied to CapEx among corporations. How cyclical do you think that will be? Could we see dramatic cuts there? What kind of color about volatility can you provide?

Vic Richey, Chairman and CEO

Today, I think that business is solid. It comes down to the end markets we're serving. The primary end markets are medical, industrial shielding, and 5G technology. Those sectors are very extendable, and we do have a good bit of recurring business. People are buying instruments like antennas and amplifiers regularly, which help stabilize our business. Where I think you may see volatility is in larger projects, but we typically don't rely heavily on a few large projects to meet our yearly numbers.

Gary Muenster, Vice President and CFO

We track what's called shippable new orders (SNO). Typically, for this year, we only have to book about $18 million to $19 million to meet our commitments. We basically have 83% of the materials needed for this year's commitments already at our disposal. That means we're positioned well to meet commitments without major issues.

Robert McCarthy, Analyst

If we're in a situation where you may be looking at M&A opportunities, what are your expectations? Are you bound to a specific size for deals now? I know niche and bolt-ons are the main strategy. But can you expand on the bid-ask expectations and your outlook on M&A? It's a notably tough time to do deals.

Gary Muenster, Vice President and CFO

We see good opportunities emerging. Some companies may need to sell, and some firms want to streamline their portfolios. We've said our management teams should identify the best opportunities and stay engaged in those discussions. There are chances down the line. Due diligence will be crucial for verifying forecasts; we need to ensure we're not buying into unfounded projections. We remain focused on acquisitions that have typical size rather than large deals, as we want to maintain a strong liquidity position.

Jon Tanwanteng, Analyst

For my follow-up question, can you quantify the cost reductions that you're looking at, perhaps in the aerospace business? I don't think you mentioned a specific amount.

Vic Richey, Chairman and CEO

We've not quantified all that yet. We have halted some actions, such as travel and other compensation measures. We haven't had to cut salaries yet. Our hope is to work around those challenges. We're still prioritizing and will make necessary decisions if required. However, we do not have a firm number on cost reductions yet.

Jon Tanwanteng, Analyst

I know you're involved in cabin air filtration. Do you think there could be increased demand or new products emerging related to hygiene and air purification on planes?

Vic Richey, Chairman and CEO

We've been asking that internally. The filtration of air on planes isn't as much the issue compared to close proximity with other passengers. N95 masks stop 95% of certain particles, while HEPA filters on airplanes exceed 99%. That's not the primary concern; it’s really about how close you sit to others. There may be an increase in the frequency of filter swaps, though we've developed some products with antibacterial materials.

Gary Muenster, Vice President and CFO

Some airlines are promoting their enhancements in HEPA filtration. They're marketing this to comfort passengers to ease their minds before they fly again.

Jon Tanwanteng, Analyst

I know you're not rushing to close M&A, but can you provide updates on specific opportunities and whether any may close in the near future?

Vic Richey, Chairman and CEO

We decided to halt one opportunity due to market conditions that prevented us from obtaining a clear forecast. Another deal is still in progress but moving slower than expected as we want to avoid undue risk. This isn't the right time for significant acquisition opportunities. We're focusing on identifying low-risk prospects.

Operator, Operator

We don't have any further questions. Presenters, please continue.

Vic Richey, Chairman and CEO

I appreciate everybody's interest today. Hopefully, we'll have a less eventful 90 days before we talk to you again. Thank you very much.

Gary Muenster, Vice President and CFO

Thanks.

Operator, Operator

This concludes today's conference call. Thank you, everyone, for your participation. You may now disconnect.