ESCO Technologies - Q4 2022

Transcript

Operator (participant)

Good day, thank you for standing by. Welcome to The Fourth Quarter 2022 ESCO Technologies Earnings Call. At this time, all participants are on a listen-only mode. After the speaker's presentation, there will be a question-and-answer session. To ask a question during the session, you will need to press star one, one on your telephone. You will then hear an automated message advising your hand is raised. Today's call is being recorded. On the call today, we have Vic Richey, Chairman and CEO, Chris Tucker, Senior Vice President and CFO, and Bryan Sayler, President, Utility Solutions Group. Now I would like to turn the conference over to your first speaker today, Kate Lowrey, Vice President of Investor Relations. Kate, you may now have the floor.

Kate Lowrey (VP)

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 their 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 thank everyone for joining today's call. We've got a lot to cover today, but I wanna start off by introducing everybody to Bryan Sayler. By now you've all seen a press release from September 12th and also the commentary from the release we issued today. Bryan's about to take over as CEO on January 1st and is joining us on today's call. I really feel good about our transition plan, and we thought this call would be a good chance for Bryan to say a few words and to start to engage in a quarterly earnings process. Well, let me turn it over to Bryan for a brief introduction.

Bryan Sayler (President of Utility Solutions Group)

Thanks, Vic, and hello to everyone on the call today. I'm really grateful to have a chance to talk to all of you. I know you've seen the details from the press release, but I am excited to be taking this step. I've been at ESCO for over 25 years. Vic and the team here have built a tremendous company during his time as CEO. I know I speak for the entire team when I say that we're all very thankful for his contributions over a 37-year career at ESCO. The company is in a very strong position, and I'm looking forward to engaging with the teams around the company as we work to continue our momentum and drive the growth of our business forward.

I'd also like to thank the Board of Directors for the confidence that they are showing by placing me in this role, and I'm very eager to get started. On a personal note, I am currently in the process of relocating to the St. Louis area as we speak, and will certainly be ready to hit the ground running by January 1st. I also look forward to engaging with all of you in the investment community. Once I get established here in St. Louis, I'll work with Kate and Chris to set up some investor outreach. There'll be a lot to focus on as I take over, and certainly meeting with investors will be a big priority. With that, I'll turn it back over to Vic.

Vic Richey (Chairman and CEO)

Okay, great. Thanks, Bryan. Let me say again how excited I am for the transition we have in front of us. I have the utmost respect for Bryan, and the full board is very confident as he takes over. Our succession planning process was rigorous, and Bryan is the right leader to move us forward. Congratulations, Bryan. With that, let me pivot into the quarterly results. We really had a tremendous finish to the year. In a lot of ways, this was a very challenging year. You've all heard a lot about the ongoing supply chain and labor challenges. At ESCO, we felt those pressures throughout the year, so it was tough sledding for much of the year. That makes it very gratifying to be on the call today announcing these record results. For the full year, we achieved many records.

Sales of $858 million, adjusted EPS of $3.21 a share, operating cash flow of $135 million, and a year-end backlog of $695 million, all record amounts. We had meaningfully improved financial contributions from all three segments and tremendous efforts by thousands of employees around the company. Our portfolio of businesses all have strong market positions, which is very evident from the numbers we put up this year. Across the company, we've seen favorable end market dynamics, and we feel really good about the long-term outlook for all three business platforms. Chris will get into some of the financial details in a few minutes, but I did wanna offer some top-level commentary about each of the business segments. Starting with A&D, where we had a great quarter.

Sales increased 30% and adjusted EBITDA were up over 60%. This business had a few tough years with big negative impact from the pandemic. 2022 represented a nice year of recovery for A&D, but we think the recovery still has room to run. The commercial aerospace markets have led to recovery with PTI, Crissair, and Mayday seeing significant order increases. We also have sizable Navy, space, and defense aerospace businesses in A&D, and those markets are also strong. This business is nicely diversified across different aerospace and defense markets, and we see good momentum as we move into 2023. Next is Utility Group, where we also had a strong quarter. This business was a little uneven in 2021 coming out of the pandemic. Over the last three quarters of fiscal 2022, we have really seen the business stabilize and strengthen.

It's clear that the North American utility customers have started spending again as they work to bolster capacity and to improve their infrastructure. Additionally, the renewable space continues to be a bright spot for us, and energy has now delivered two years in a row of sales growth in excess of 20%. The other exciting thing for the Utility Group is some of the new product launches that Bryan and the team have completed. In particular, the new Calisto R9 dissolved gas analyzer is a very exciting new product that's gaining good momentum in the marketplace. The supply chain issues have been difficult here, especially given the electronic components involved, but the teams have continued to work these issues and are able to deliver really strong growth in 2022.

Lastly, let's touch on the Test business, where we had a nice quarter of sales growth and EBIT margin expansion. Q4 sales were up 8% for Test, a good number given the significant growth we posted over the last several quarters. This business also has diversity in end markets, and we have seen strength across several different markets with healthcare, telecom, automotive, and data center customers all having high level of activity in 2022. The other good news for Test in Q4 was a margin expansion. An EBIT margin of 17% in Q4 is a really great number for this business, and I know the team is focused on continuing to drive margin improvement as we move forward. To summarize a bit, it really was a good year for ESCO on a number of fronts.

At the beginning of the year, we gave earnings per share guidance of $3.10-$3.20 a share. When that guidance was delivered, there was not an expectation that supply chain and labor challenges would be with us all year. That is really one of the reasons we feel so good about the year. We slightly exceeded EPS range in spite of the headwinds that were well beyond what we anticipated. It's a big testament to our employees across the company. Always, I'm very thankful for the tremendous effort to deliver this record year. Now I'll turn it over to Chris.

Chris Tucker (SVP and CFO)

As we have done the last few quarters, we're gonna use a chart presentation to walk through the financial results. Starting on Chart three, we have the overall financial highlights for the fourth quarter. As Vic mentioned, we had a great quarter, and this chart illustrates that very well. Sales were up nearly 25%. Adjusted EBIT was up over 50%, and adjusted EPS was up over 42%. A great growth quarter for ESCO. The chart does show orders down approximately 5%. That is a function of last year's fourth quarter acquisition of Altanova and Phenix. The acquired backlog came through as orders last year, so it makes for a pretty tough comparison. Overall, the order trends have remained robust, and our record year-end backlog of $695 million demonstrates the strength of the business.

The last thing I wanted to highlight on this chart was organic sales growth of 19%. Two of the three business platforms grew at over 20% organically to drive this very strong finish to 2022. Next, on chart four, we'll get into segment results, starting with A&D. A great finish to the year here as well, with nearly 30% sales growth and EBIT margins up over four points. Commercial aerospace recovery led to sales growth as we saw sales increase by 50% in this market. This was led by our PTI and Mayday subsidiaries. Beyond that, we still saw explosive growth from other parts of the business, with defense aerospace, navy, and space all up more than 20%.

The teams here have been managing a number of supplier and labor challenges, so it was great to see them work through those issues and deliver this quarter. On the next chart, we have the Utility Solutions Group, where we also had very strong sales performance. Organic sales growth was 21% overall, with high levels of activity from the electric utility customer base and the renewables business.

EBIT margins were down 6/10 of a point, as we did see some unfavorable mix here, but EBIT dollars were up 33%. The acquisition impact was favorable in the quarter, with Altanova and Phenix adding 16 points of growth. Going forward, these businesses will be folded into the base company, but we are very excited about the progress made with both acquisitions during their first year as part of ESCO. The last segment to talk about is Test.

A good finish to the year for this group with sales up 8% and EBIT margins up 1.7 points. Really nice margin expansion here as we saw solid leverage on the volume increase, and we also saw good impacts from pricing actions. Orders did drop for test during the quarter. Last year in Q4, we saw significant orders in the power filter product line, so that is the main driver of the decrease. We still have a 19% increase in backlog compared to prior year-end, so the business has some nice runway as we move into 2023. Next, on chart seven, we'll take a snapshot of the full year results. As you saw in the press release, it was a record year for ESCO on many fronts.

The sales performance was strong with a 20% increase driven by 13% organic and 7% from recent acquisitions. Adjusted EBIT margins expanded by 0.8 points and adjusted EPS was up 24% as we saw favorable impacts from volume leverage, price, and cost reductions, which more than offset the inflationary impacts of material and labor. Orders were up over 20%, resulting in $695 million year-end backlog with good growth from all three segments. Chart eight has the cash flow highlights. Operating cash flow increased to $135 million, a great result as we had lagged on cash flow through the first three quarters. Capital spending was up just over $5 million, and acquisition spending dropped significantly, with 2021 including ATM, Altanova, and Phenix, while 2022 included only the NECO acquisition.

We did restart a share repurchase program in 2022 and were able to buy back $20 million worth of stock during the year. Chart nine has full-year highlights for each of the segments. Not gonna read through every number here. Obviously for us, this is a really good-looking chart with lots of arrows pointing in the up direction. Double-digit increases of sales and EBIT for all three business segments. 2022 was a really a good year of recovery for both A&D and USG after the pandemic had negatively impacted those businesses in 2020 and 2021. For Test, we really had continued growth after good performance throughout the pandemic period. The last chart will be our guidance for 2023.

We are expecting another year of growth in 2023, with sales growth of 6%-8% and adjusted EBIT dollar growth of 10%-15%. In the press release, we detailed the growth expectations by segment. We expect A&D to lead the sales growth with low double-digit growth, followed by USG with mid-single digit growth and Test expecting low single digit growth. From an EPS perspective, we are planning for growth in the range of 8%-12%, slightly lower than the EBIT growth as we expect increases in interest expense given the current interest rate environment. Overall, we are looking at another year of nice growth after the great year we had in 2022. That concludes the financial update, and now I'll turn it back over to Vic.

Vic Richey (Chairman and CEO)

Thanks, Chris. Since I touched on it quite a few of my thoughts earlier, my commentary, I'll just offer a few more comments before we move into Q&A. You saw the numbers from Chris. Obviously a great year for ESCO with, and I'll say this for the last time, record financials on a number of fronts. Even better than that, the continued growth is being projected as we go into next year. The growth isn't over for ESCO, and we feel that the momentum is strong heading into 2023. The company's on very solid footing, and it's a good time for the leadership transition we discussed earlier.

Bryan is more than capable, and I know he'll do a great job as he moves into the CEO role. It's been a real honor for me to be the CEO at ESCO for the last 20 years, and I've really enjoyed my interactions with the investment community over that time. With that, we can start Q&A.

Operator (participant)

Thank you. As a reminder, if you would like to ask a question, please press star one one on your telephone. One moment while we compile a Q&A roster. Our first question will be coming from Jon Tanwanteng of CJS Securities. Your line is open.

Jon Tanwanteng (Managing Director)

Hi, guys. Thanks for taking my questions. Vic, first of all, congrats on your semi-retirement and Bryan on your promotion. Look forward to working with you. You guys didn't mention on the call, but congrats on a successful SLS launch. I know you had parts on there in that program.

Vic Richey (Chairman and CEO)

Oh, yeah.

Chris Tucker (SVP and CFO)

Thanks so much.

Jon Tanwanteng (Managing Director)

My first question, I was wondering if you could break out what the true year-over-year, I guess, order or bookings changes would have been if you normalized for the impact of Phenix and Altanova in USG business, because you put all that backlog in at once. I don't know if you could break out what it would look like just with that single quarters with the orders in those businesses.

Chris Tucker (SVP and CFO)

Yeah. It was worth about $25 million, John, of backlog that came in last year in Q4. We can do that math real quick, but that was the impact in the prior year numbers.

Jon Tanwanteng (Managing Director)

Okay. We, we can do that separately. I guess the other question is especially with the Test orders coming down, I know you mentioned that last year there was a, an unusual timing item, but is there any chance that you might be seeing a demand slowdown in any way, shape, or form just based on the headwinds you've seen in mobile device and a lot of your customers in the wireless businesses there?

Chris Tucker (SVP and CFO)

Yeah, I wouldn't say we would call it a slowdown from kind of broad economic impacts or anything. I would say that that power filter business was really seeing explosive growth a year ago that was driven by some specific data center build outs and things that are going on. That has moderated a little bit. I think as that whole, again, supply chain works to kind of get the data center build outs done, it's just taking a little longer. We're seeing that work stretch out a little bit. We're able to keep up with demand, but other parts of the supply chain aren't. We've seen that order book kind of slow down a little bit.

I wouldn't say we see any kind of broad weakness beyond that. We are still seeing some good activity on automotive same with some of the telecom stuff. We feel good there. We're also just in general coming up against higher comps and that's why if you look in the guidance, we kind of had a lower growth expectation in for them relative to the other two segments. Fundamentally, you know, just kind of as they've gotten this much bigger, this much faster, we expect the growth to be a little bit more moderate going forward. Vic, I don't know if you have anything else to add there.

Vic Richey (Chairman and CEO)

Yeah. No, I think that's all good. I agree with everything you said. Just back to the data centers for a minute. I mean, I think the long-term opportunity there is great. I mean, there's no sign that that's gonna slow down. If anything, I think it will continue to accelerate. As Chris alluded to, part of the problem was just people's ability to get the centers built. As anybody who's done any type of construction over the past year knows it's hard to get concrete, it's hard to get steel, it's hard to get a lot of those basic things as well as just getting the people to come do the work.

But look, I think the business, as you know, that's the one business that was not impacted during COVID, and so they continued to grow, and I think they will. And, you know, the inner orders we had this past year were, you know, a record by, you know, probably sixty million dollars. So it's been a good year for those guys.

Jon Tanwanteng (Managing Director)

Got it. Thanks for that color. Just to maybe follow on a little bit with that, just your general observations of the supply chain and how much better it's getting and how much more room or how much more, I guess, you want it to catch up before you feel comfortable with the supply and, you know, timing that's out there?

Vic Richey (Chairman and CEO)

It's a little spotty. I would say it's better than it was last quarter. I'd say we still have some issues on a component side. Outside processing at a couple of businesses, the A&D businesses has still been a bit of a challenge because most of those outside processors are very small businesses. I think some of them, as, you know, particularly the commercial aerospace business has picked back up, a lot of them have had a hard time keeping up with that growth. I'd say there, but it certainly is getting better. I'd say the other challenge though right now that is not getting better is workforce availability. That's an area where I think everybody's continuing to struggle a bit.

Jon Tanwanteng (Managing Director)

Got it. Thanks, Vic. I'll jump back in queue.

Vic Richey (Chairman and CEO)

Okay.

Operator (participant)

Thank you for your question. Again, if you would like to ask a question, please press star 1 1 on your telephone. One moment. I believe we have a follow-up question from Jon. One moment. Jon, your line is open. You can go ahead.

Jon Tanwanteng (Managing Director)

Great, thanks. I was wondering if you could talk about the unfavorable mix you saw in USG, kind of what went into that and what you're expecting of that business as you go forward.

Chris Tucker (SVP and CFO)

Yeah. The main driver there was the security business that we have. We call it the Doble DGA business as an acronym there. That's a business where we sell hardware kind of upfront, and then we get kind of a service revenue stream over multiple years on that. As that hardware goes out, that's a little bit lower margin. I would say a fair bit lower margin. You know, this utility is a high gross margin business, so it's still kind of mid-30s%, but well below the overall average there. That was really the main driver. We saw a lot of growth in that business with those hardware shipments in Q4 was a pretty big driver of the growth. That was the number one factor.

Vic Richey (Chairman and CEO)

Yeah. The good news with that business, though, is you usually get the cash up front. One reason our cash was as good as it was this year was largely driven by payments on those contracts.

Jon Tanwanteng (Managing Director)

Got it. That makes sense. I was wondering also if you could talk a little bit more about, you know, your capital allocation priorities going forward. Obviously, rates are going higher. You know, help me think about the M&A pipeline versus repurchases or the use of cash as you're looking ahead.

Chris Tucker (SVP and CFO)

Yeah, I think I would say, you know, pretty consistent framework that we're looking at as we head into 2023, John. You know, as we said, we did about $20 million of share repurchases in 2022. We'll probably target a similar amount for 2023 as we, you know, kind of get that program going again. Obviously the acquisitions is kind of the key piece there. If we see something bigger, you know, then we would maybe dial back. You know, to me, I think the pipeline is okay. We are seeing some things come through a little bit right now on the deal side. You know, again, I wouldn't characterize it as, you know, a totally stuffed pipeline or anything, but we do have a little bit of activity there.

Jon Tanwanteng (Managing Director)

Okay, great. Just a question on the EPS guidance for next year. What's the implied interest expense or interest rate that you're using to arrive at that?

Chris Tucker (SVP and CFO)

You know, on average for 2022, we had about 2% interest rate, and we're looking at something more, you know, in the 6%+ range for next year. We'll be a little bit better than that in Q1 for some of the three and six month money we had locked up coming into the quarter. Overall, as we get through the year, we're expecting it to be 6%+.

Jon Tanwanteng (Managing Director)

Okay, fair enough. I was wondering as you look at the A&D business, you know, it seems like that there's been a fairly good recovery as you mentioned. What's the limit for that business as you get towards a full recovery as maybe wide-body returns, international travel returns? How much better can it be than it was, I guess, before the pandemic? I know you've taken share, you know, through the past three years. Just help us understand what the upside is as we get to a full recovery.

Chris Tucker (SVP and CFO)

Well, I think we would say we feel like, you know, we had a couple of pretty tough years, and this was a nice kind of recovery, but we still have some legs to go there. I mean, I think it was certainly kind of single-aisle driven platforms that are kind of driving a lot of the sales growth that we put up this year. I think even with some of our businesses like Crissair and Mayday, if you compare them, you know, back to the 2019 levels, they're just, you know, they still got a fair bit to go to get there. Now, their order books have been pretty good, but it's been a little bit slower to materialize through the sales line.

The double aisle stuff is, again, I think still out in front of us from a sales perspective, and that we expect to kind of carry on for, you know, you're talking in years there, I think, before you get back to kind of prior peaks. As far as the overall single aisle, you know, the only thing I would say about that is, you know, if you hear kind of a lot of the commentary from the big OEMs out there, I think they're generally not quite the build rates they're trying to get to. If you look at those forecasts again, those still show pretty nice growth out over the next coming years.

Vic Richey (Chairman and CEO)

Yeah. I think another way to think about it is, you know, when we were really ramping that business up. When the pandemic hit, I mean, we had the best first quarter we'd ever had, and then the pandemic hit and, you know, kind of the bottom fell out. You know, I think if you go back and look at pre-pandemic, I mean, I think when it gets back to full recovery, we'll be, you know, above that.

You know, in addition to just that kind of that normal growth, I mean, we have, you know, won some additional projects, particularly on the space side. On the Navy side, with Westland really recovered nicely. You know, I think that longer term, and I'm not talking five years from now, I'm talking about over the next couple of years, I think we'll get back above the levels that we had going into the pandemic.

Jon Tanwanteng (Managing Director)

Okay, great. The same kind of question on just the USG business. Are your utility customers, you know, back towards where they were pre-pandemic, or is there more room to grow and kind of how much room there is?

Chris Tucker (SVP and CFO)

Yeah, I think the quick answer there is the domestic business is kind of back. You know, I think they're kind of back at the level they were previously. The, you know, European business is still not back, and the Asian business. I think we'll see some growth there over the next couple of years. As I mentioned in my prepared comments, you know, we have had some new product developments, which I think will add a little upside as well.

Jon Tanwanteng (Managing Director)

Understood. Thank you, everyone.

Chris Tucker (SVP and CFO)

Thanks, Jon.

Operator (participant)

Thank you for your question. As a reminder, if you would like to ask a question, please press star one one on your telephone. One moment while we prepare for our next question. Our next question will be coming from John Franzreb of Sidoti. Your line is open.

John Franzreb (Senior Equity Analyst)

Good afternoon, guys, and thanks for taking the questions. Just curious about the pricing versus cost equation. How much of headwinds is higher inflationary costs still impacting you? When do you expect to maybe be in an equilibrium with price increases kind of matching up to those higher input costs?

Chris Tucker (SVP and CFO)

Yeah, I would say by the fourth quarter, we kinda got ahead of that a little bit. I think you saw that in the Test margins. I think you saw that in the A&D margins as well. You know, even in the Utility side, I think we've done a good job on the price there to stay in front, but we talked about some of the mix issues there earlier that caused the margins to hold back a little bit. We would say in general that we feel like we've priced pretty well, and we're kinda favorable on that equation right now, John.

John Franzreb (Senior Equity Analyst)

Yeah. Great. When you think about the cadence of revenue for this year, how heavily weighted is it into the second half of 2023 relative to the first half as far as order deliveries are concerned?

Chris Tucker (SVP and CFO)

Yeah, I'd say the sales growth is a little bit more, it's not super back-end loaded from a growth perspective if you look at the year-over-year growth, so because of the backlog we're coming in with. From a margin and EBIT perspective, it's a little more back-end loaded. But, but fundamentally, we think the sales growth will be, you know, pretty even. You know, a little lower Q1, then a little higher Q2, Q3, and then maybe a little lower Q4, something like that.

John Franzreb (Senior Equity Analyst)

Got it. Just on the balance sheet, why not be more aggressive in paying down debt in a higher interest rate environment?

Chris Tucker (SVP and CFO)

You know, what you see in the September financials there, we had really strong cash flow really late in the year, so we ended up with pretty high cash and a little higher debt. We've already kind of fixed a lot of that here since we started fiscal 2023. We're definitely gonna be managing, you know, the debt pretty aggressively given the interest rate environment as we move forward.

John Franzreb (Senior Equity Analyst)

Okay. Thanks for taking my questions. Congratulations, guys.

Chris Tucker (SVP and CFO)

Thank you.

Operator (participant)

Thank you for your question. This concludes the Q&A session. I would like to turn the call back over to Vic Richey, Chairman and CEO, for closing remarks. Go ahead, sir.

Vic Richey (Chairman and CEO)

Okay. Thanks so much for everybody joining us. I look forward to Bryan and Chris talking to you next quarter.

Operator (participant)

This concludes.

Chris Tucker (SVP and CFO)

Thank you.

Operator (participant)

This concludes today's conference call. Thank you. You may all disconnect. Have a great rest of your evening.

Chris Tucker (SVP and CFO)

All right, I gotta run.