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Esco Technologies Inc (NYSE:ESE)
Q2 2021 Earnings Call
May 4, 2021, 5:00 p.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good day and welcome to the ESCO Q2 Conference Call. [Operator instructions]

With us today are Vic Richey, Chairman and CEO; Gary Muenster, who is retiring as Vice President and CFO and Chris Tucker, Senior 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. Statements made during this call regarding the timing of recovery and growth of our end market the amounts and timing of 2021 and beyond, revenues, COVID impacts and recovery expected as a result of COVID vaccines, recovery in commercial aerospace, adjusted EPS, adjusted EBITDA, cash, shareholder value, the timing of block five deliveries, excess and completing additional acquisitions, and other statements 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 wherever referenced in the company's press release issued today, which will be included as an exhibit to the company's form 8Lto be filed. We undertake no duty to update or revise any forward looking statements whether as a result of new information, future events or otherwise. 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.esco.technologies.com under the link, Investor Relations.

Now I'll turn the call over to Vic.

Vic Richey -- Chairman, Chief Executive Officer and President

Thanks, Kate. As you saw in a press release, we do have some management changes here, which we've been working on for some time. So we're hearing from Chris in a few minutes. In addition to that, we've got Dave Schatz here with us, who had recently replaced Alyson as our General Counsel. So before we get into the details of the quarter, I'd like to start off by introducing and welcoming Chris Tucker. He joined us a few weeks ago as the newest member of our executive management team. Chris will be serving as Senior Vice President and Chief Financial Officer replacing Gary who previously announced his retirement. Chris comes to us from Emerson, where he served in numerous financial leadership roles with increasing responsibilities over the years. He also led their Investor Relations Group for several years.

I'll turn it over to Chris to give you a little more background and all the experience, Chris.

Chris Tucker -- Senior Vice President and Chief Financial Officer

Hello everyone and thanks Vic for the introduction. It's great to join all of you today. I just wanted to take a minute, give a brief introduction to myself, before we jump into details of the Q2 performance. A lot of this was covered in the press release announcing my hiring a lot, but I'll provide a little more color here on the phone. As you know, I'm joining ESCO from Emerson, where I spent the last 24 years of my career. Emerson is a great company and I'd a great experience there. I started off in the Corporate Accounting and Finance team back in 1997 and finished up as the Group CFO for one of the few business platforms. And of course, there were several important stops in between those two bookends.

During my time there I had a chance to work on a variety of operational issues, business development opportunities and overall value creation strategies. I also lead the Investor Relations efforts for a few years during my tenure there, which was a good bit of training for calls like we're doing right now. My prior experiences have put me in a strong position as I transitioned to this new role. I'm very excited to be part of this team here at ESCO. Gary has been extremely helpful as we've worked together over the last few weeks and everyone from the corporate staff, to the Board of Directors has been collaborative and great to work with. ESCO is really great company and has a lot of exciting initiatives going on really across all the businesses. I'm excited to be here and start building on Gary's legacy of strong financial leadership as we move into the future.

With that, I'll turn it back over to Vic and Gary for a more detailed discussion of Q2 and the rest of the year.

Vic Richey -- Chairman, Chief Executive Officer and President

Thanks, Chris, and welcome to board. We'll look forward to working with you. I'd be remiss, if I didn't mention today's COVID environment. And how we continue manage and around this impact, on our aerospace consulting businesses.

I think our results demonstrate we're succeeding. Since beginning of the pandemic, our primary goal is remain the same. Provide a safe working environment and protect the health of our employees. And today, we're really encouraging our staff to fully vaccinated, for the benefit of all.

Our solid operating results in Q2 and for the first six months of the year, coupled with our increasing liquidity, demonstrate that the measures we've taken over the past 12 months have significantly mitigated COVID impact on earnings. And I believe will it allow us to continue successfully navigating through this challenge.

Our previous cost reduction actions, along with our enhanced focus on operational efficiency will benefit ESCO going forward as things continue to move forward in more normal state. And I'm confident that our disciplined approach to operating business will result in continued success, throughout the balance of the year.

While Gary will provide the financial details, I'll offer some top level commentary to set the tone. Our Q2 and year-to-date, AMD sales were significantly lower than prior year, due to COVID impact at commercial aerospace.

Our portfolio diversity allowed us to mitigate this headwind, as we're able to hold our ESCO consolidated adjusted EBITDA constant at $31 billion in Q2, compared to pre-COVID Q2 results from last year.

Additionally, we were able to increase our fiscal 21 year-to-date adjusted EBITDA and adjusted EPS from a prior year, despite a 6% decrease in sales. This improvement is delivered by solid contributions from other operating units and as a result of favorable sales mix, and meaningful cost reductions across the company.

From the segment level, there are several positives to report. Within AMD we're seeing signs of recovery in commercial aerospace. This past year board is continued increase, and more airlines are adding idle aircraft back into service.

Our navy and space businesses remain strong and well funded. And our outlook for, near-term growth opportunities continue to materialize in both of these areas. Our test business continues to outperform, as we saw sales growth in both Q2 and year-to-date, with increasing margins, as our project execution remained solid.

We expect this outlook remain positive, driven by the strength of the serve markets, including 5G. our USG business are reporting a solid for Q2 than originally projected report a solid first half of the year, from both the sales and adjusted EBIT perspective.

USD delivered an adjusted EBITDA margin of 26% for the first six months of the year, up from approximately 22% in the prior year's first half. This is a result of year-end spending cash in our first quarter, along with our lower cash and cost base.

Overall, the fundamentals of our portfolio are strong, and our goal remains the same to create long-term shareholder value.

Now I'll turn it over to Gary.

Gary Muenster -- Executive Vice President and Chief Financial Officer

Thanks, Vic. I'll briefly touch on the financial results, laid out in the press release. As we continue navigating through what we hope, is the near-end of COVID. Our number one financial priority remains the same, increasing and maximizing our liquidity to position us for future M&A growth, and increased investment in new products and solutions.

We have a rock solid balance sheet today. And we are poised to use it to our advantage. I'll highlight the significant cash we've generated this year, as we've set a record for cash flow during the first half is the highest in our history. We delivered free cash flow conversion at 134% of net earnings for the first six months. Clearly our working capital initiatives are producing solid results.

Today, we have approximately $760 million of liquidity at our disposal between cash on hand and available credit capacity, while carrying a modest leverage ratio 0.23. We fully realize that while this is a positive metric, it is not the ideal capital structure given the historically low cost of debt, and with that said, we're committed to putting our balance sheet to work.

One of our primary objectives in the near-term is to add leverage to fund acquisitions, with our focus directed at bringing on new businesses that provide an ROIC well in excess of our cost of capital. As we believe this return spread is a cornerstone of value creation.

In the release, we call about a couple of discrete items, which are described in detail and are excluded from the calculation of adjusted EBITDA and adjusted EPS in both years presented, so I will not repeat them here.

I'll now touch on a few comparative highlights noted in the release. We beat the consensus estimate of $0.55, as we reported Q2 adjusted EPS of $0.59 cents of share. This compares to $0.68 of share in the prior year Q2.

Considering Q2 of this year was influenced by the COVID operating environment, I'm pleased to report that we've delivered adjusted EBITDA of $31 million in the current period, which is equal to the $31 million we reported last year in Q2 pre-COVID. More impressively, this was achieved despite the noted sales decline in Q2 that Vic mentioned earlier.

Our Q2 adjusted EBITDA margin increased at 19% from 17% last year. Year-to-date our adjusted EBITDA increased over $60 million with an 18% margin up from 17% prior year today.

Over the past year, we took several cost reduction actions across the company, and as a result, we were able to increase our Q2 and year-to-date gross margins to 38.1% and 38.7%, respectively. We reduced our Q2 and year-to-date SG&A spending by 3% in both Q2 and year-to-date periods compared to prior year.

These favorable outcomes were achieved, despite including the acquisition of ATM in October, which has not yet at full operating capacity during its transition to Crissair. And it was done despite our continued spending on R&D, and new product development.

Amortization of intangibles and interest expense both decreased, while tax expense as a percent of pre-tax income increased in Q2 and the first half as we had several large tax strategies implemented last year, which benefited the 2020 competitive rates, but were not repeated in the current year.

Q2 orders were solid as we booked $176 million in new business and ended the quarter with a backlog of $522 million with a book-to-bill of 106%. A bright spot worth mentioning was the order volumes recorded in our commercial aerospace businesses, which grew their backlog $7 million during the quarter.

As we move through the balance of the year, I'll remind you that our DoD businesses led by our participation on the Block V contract for additional Virginia class submarines, where we booked several large orders during fiscal 2020 will be delivering products against those orders, which are multi-year programs, which will mathematically reduce the optics of our book-to-bill.

Consistent with our November communications and from a directional perspective, we can point to several areas where we see positive momentum. Our commercial aerospace and utility end markets are showing some degree of customer stabilization, which supports our current outlook suggesting a movement toward continue to recover in the second half of fiscal 2021. The increasing distribution of the COVID-19 vaccine is anticipated to benefit and accelerate the recovery of commercial air travel and utility spending, with customers resuming more normal buying patterns.

While we solidly beat Q2, and are ahead of our original plan at the halfway point, we still expect the second half of 2021 to be slightly favorable in comparison to the second half of fiscal 2020, given the various elements of recovery that we are anticipating. We expect to show growth in fiscal 2021 adjusted EBITDA, adjusted EPS as compared to fiscal 2020. With an adjusted EBITDA reasonably consistent with that was which was reported in 2019. If we complete any additional acquisitions during the year, it is expected that these would contribute to the expectations I've just mentioned.

And now, I'll turn it back over to Vic.

Vic Richey -- Chairman, Chief Executive Officer and President

Since that touched on quite a few of my thoughts or my commentary I'll offer a few qualitative comments about our end markets and our expectations for the balance of the year.

Starting with our A&D segment, as I mentioned, we're seeing some signs of modest recovery in commercial aerospace. We expect continued softness over the next three months. We're starting to see stabilization in the OEM build rates and increase in airline passenger traffic and flight miles. Just as we saw in Q1, the defense portion of our A&D business is and will remain strong for the foreseeable future, given our backlog and platform positions.

We also see the current situation, the aerospace market as an opportunity for ESCO, as we've been made aware of some situations where other suppliers or competitors are not fulfilling their customer requirements. And those customers have reached out to us to see if we can step down and satisfy their demands.

Our Test business delivered another really solid quarter by beating our internal expectations and delivering the EBIT margin of 13%. Test outlook remained solid, given the diversity of its serve markets. As I noted on the previous call, when USG had a really strong first quarter, we expected USG sales to be down in Q2, before returning to more normal levels in the second half of the year. And that's what we've seen. But the positive is increased margin contribution USG delivered in Q2 in year-to-date compared to prior year.

As the COVID vaccine gets more widely distributed throughout the utility service personnel, we expect USG market to come back online more quickly as they can relax them with today's social distancing guidelines and utility service personnel can return to their normal site visit route

We've recently visited with our USG management teams and I remain pleased with the enthusiasm surrounded their new products and solutions, and we continue to see energies and markets improving as the investments in renewable energy are increasing in both wind and solar. Our solar revenues have been growing far better than anticipated, and we expect that trend to continue.

Moving on M&A, we continue to evaluate several opportunities and we expect to take action on these opportunities to grow our businesses as we have in the past. Our board is extremely 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 business.

To wrap up, we delivered a solid second half and first quarter from both the cash flow and earnings standpoint. As we move through the second half of our fiscal 2021, Our plan is to continue to focus on the fundamentals and look for opportunities to leverage our existing cost structure through M&A, to create additional operating efficiencies, ensure we're well positioned for long-term success.

So with that, I'll be happy to take any questions.

Questions and Answers:

Operator

First question is coming from the line of Tommy Moll with Stephens. Your line is open.

Tommy Moll -- Stephens -- Analyst

Good afternoon, and thanks for taking my questions.

Vic Richey -- Chairman, Chief Executive Officer and President

Hi, Tom.

Tommy Moll -- Stephens -- Analyst

Vic, I wanted to start on A&D, sounds like you exceeded your internal expectations this quarter on the top and bottom lines. So any context you could give us there about what came in better than expected? And then a related follow on, as you look ahead. It sounds like there's -- there may be some structural benefit to your margins after some of the cost out last year, at the same time as the end markets recover presumably there would be some OpEx you'd look to layer back in. So what kind of incrementals should we be thinking about? Or what's the approach as you balance those competing considerations? Thank you.

Vic Richey -- Chairman, Chief Executive Officer and President

Sure. So on your first question, as far as what we saw in the A&D, we see a couple things, the non-commercial aerospace part of our business to space, the Navy, and the small amount of commercial aviation -- I'm sorry, our defense aviation, all we're a little better than what we anticipated. In addition to that, while the commercial aerospace is still a bit behind schedule and it is recovering, but we were able to get a good bit of non-recurring engineering from customers for some new product development. So that really helped. As a result, because it's not something we initially anticipated getting this quarter in this first half of the year. So obviously, those are the major things that we saw to the upside.

As far as your second question is, certainly, you saw in the leverage, I mean, particularly USG, where our sales were down, our margins were up pretty significantly. And that's really just a matter of the cost that we took out, really across the business in the second half of the year. And so what we have to do, I mean, when business starts to grow again, obviously, you're going to have to add some folks. But I do think we've kind of reset the bar on the cost structure. And we're going to be very, very diligent about any cost back. And I think we will be able to, as a result of that be able to have better margins than what we've seen in the past in some of these businesses.

Tommy Moll -- Stephens -- Analyst

Thank you, Vic. That's all helpful. Just as a follow up, I want to talk about balance sheet and M&A? It sounds like optimizing your capital structure and acquisitions are two sides of the same coin. So we fast forward to a natural comfort zone or an optimized balance sheet in your mind. What were the brackets around where you're comfortable with leverage? If you think about that without putting an exact timeframe around it, but just the most likely scenario to get from point A to point B is that probably one larger acquisition to think about it a longer dated time horizon with multiple deals. A context you could get us there and any more context on the pipeline how activities by fill expectations would be helpful as well? Thank you.

Vic Richey -- Chairman, Chief Executive Officer and President

Sure. So obviously, we can handle a good a bit of debt now we're not going to go out and do it too quickly or too large of acquisitions. I mean, typically, where we've been successful is, you know, larger acquisitions, somewhere between $20 million and $100 million, $150 million, something like that purchase price. And so that you would expect, that's what we'll continue to do. There are some opportunities out there that are bigger than -- I think we would have to take our hard look at those as well. But we think we've been pretty successful and integrating, smaller, middle sized businesses into in our portfolio, pipelines really strong. I mean, I'm surprised seems like we're getting a new book, every couple of days, or at least once a week. And so there's a lot of activity out there.

I think everybody's aware it's a very competitive market right now. So we work hard to try to get into areas before -- before there's an auction -- before there's an auction with a lot of strategic, at least. But the amount of money out there is pretty amazing right now. So I had thought going into the pandemic that maybe the multiples be coming down. And unfortunately, that's not what's happened. And so I think we have to be realistic about what we're going to do is we add to the business. We're probably looking a lot harder at returns now than maybe the multiples that we're paying is, that's what I think really makes most sense. And now -- we're looking for opportunities where we can really see some synergies in the businesses that we acquire.

Gary Muenster -- Executive Vice President and Chief Financial Officer

And Tommy, this is Gary. Let me add something to that, because that that philosophy is not going to change with me going away and Chris coming on. But the first part of your question on the comfort level, one thing we do for the board, as Vic mentioned that they're very supportive. I think I might have mentioned it to you, when we spoke after Q1 is we kind of keep a mathematical profile in front of them and just being this underleveraged. Today, we just had board meetings last week. And if we were to spend roughly $250 million and bring along $25 million of EBIT the 10 times obvious multiple, that would only put us at 1.5 times leverage into care that math exercise a step forward. If VIX posts were 2.5, we could spend another $230 million which together says we could spend $450 million and a 10x multiple only be levered up to 2.5, which I think from an ideal capital structure was not something that would be uncomfortable. That's not -- I'm not implying that's what we have in the pipeline. But just to put some posts around how this math carries forward.

It'd be ideal, if we could find $450 million to spend and bring along $45 million of EBITDA, but just really just calibrating 2.5 is something that would be extraordinarily comfortable for a company of our size.

Tommy Moll -- Stephens -- Analyst

Thank you both. All very helpful, and I will turn it back.

Operator

[Operator Instructions] Next question will be coming from the line of Jon Tanwanteng with CJS securities. Your line is open.

Pete Lucas -- CJS securities -- Analyst

Yes. Hi, it's Pete Lucas for John. You answered a lot of the questions previously, just wondered if you could kind of talk about how you look at potential infrastructure bill. All seems like would be positive for you. But just wondering -- wondering any specifics in there that you guys are focused on?

Vic Richey -- Chairman, Chief Executive Officer and President

Yeah, I mean, we've used that question a lot. It's so well defined right now. It's hard to say, I don't think there's a downside to those, that's for sure. I do think that some of the things will be going into renewable energy some of the things will be going into the grid. Those kinds of things, I think should -- should be have the potential to be very helpful to us. But, it is pretty ill to finance, it's probably the biggest area where we would see a positive impact. And the other thing I think, that we look at a lot is what the defense budget is, right? I mean, you get a bit of our business now as AMD. And it looks like that's holding up pretty well. And as we've talked about before, we really think more about it in the areas where we participate. So, looking at the Naval side of it, particularly submarines, which is where the vast majority of our -- much of our products goes. And that's really rock solid -- changing at all.

And then the other thing, obviously, look at from a budget perspective, is NASA. We have a great position on the SLS program and that appears to be very solvent as well. So, I think the infrastructure bill gets a lot of attention as it should and I think that will be helpful to us. But as we look at it, those other two budgets in many ways are just as important to us.

Pete Lucas -- CJS securities -- Analyst

Great. And last one from me. As far as the test business, competitor of yours was recently sold, just wondering if that's changed the competitive environment at all or anything special you're seeing there.

Vic Richey -- Chairman, Chief Executive Officer and President

No, the reality is we didn't compete with them a lot because they're really very focused on aerospace and defense. We do some of that. But I'd say that's a business -- it's a bit different than ours. We do some work with them. In fact, we're doing some work with them down and they will continue. They work more on the sensor side, I think we have a good bit more footprint on the chamber side and on the absorber side, and that's a place where we have teamed historically and hope to continue doing that going forward.

Pete Lucas -- CJS securities -- Analyst

Very helpful. Thank you.

Operator

Next question will be coming from the line of John Franzreb with Sidoti. Your line is open.

John Franzreb -- Sidoti -- Analyst

Good afternoon, guys. Just a follow-up on the test segment, you talked about it returned to more normalized level. Are we talking about normalized level pre-COVID or normalized level not what you do in the second half of fiscal 2020?

Vic Richey -- Chairman, Chief Executive Officer and President

The test -- I'm a little confused, I mean, are you talking about the test business or the aerospace business?

John Franzreb -- Sidoti -- Analyst

The test business.

Vic Richey -- Chairman, Chief Executive Officer and President

The test business has been pretty solid. I mean I think year-over-year we're within a couple million dollars -- I think we're up a couple million dollars thus far this year over last year. So, that -- is higher -- and the margins are higher for sure. So, I mean, if you look at the three segments, the test businesses been the one that's been least impacted by back COVID thus far.

John Franzreb -- Sidoti -- Analyst

And what's driving the margin improvement in test?

Vic Richey -- Chairman, Chief Executive Officer and President

Big day is project execution. We have some in mix. I mean we've been getting more EMP filters and more components. But I'd say the biggest -- and those carry higher margin than the underlying chamber business, but I'd say -- it's that and it's just project execution, just the overall process that they go through and execution on the large projects has improved over the past several years.

John Franzreb -- Sidoti -- Analyst

Okay. And in the USG, you said that the opening up post-COVID restrictions will be beneficial to the business. Are you starting to see any kind of pickup in order activity, be it spring-related turnaround easing or any kind of activity that backs up that thesis?

Vic Richey -- Chairman, Chief Executive Officer and President

Yes, at the activity level certainly has picked up, I think, for a couple of reasons. There's kind of entering the test season, if you will and that's when they typically start buying things. Then the people getting back to work, I mean, the issue is -- I'd say most utility that historically -- they've been doing more work from home than a lot of other in the markets and so as you're getting back into the office, that's really helped that activity as well.

John Franzreb -- Sidoti -- Analyst

Okay. And just -- yes, please go ahead.

Gary Muenster -- Executive Vice President and Chief Financial Officer

Hey, John. This is Gary. Sorry to interrupt. Just to supplement what Vic said, if you look at the Q2 order profile in the back of the release there, you'll see that the order book is up about 10% in Q2. So that's a precursor to the conversation that Vic just alluded to, which is evidence that the momentum starting there. Because it's generally a quick turn business in the backlog. It's not uncommon to get an order on Monday and ship it on Tuesday. So seeing that growth in Q2 is certainly beneficial.

John Franzreb -- Sidoti -- Analyst

Excellent. Thank you, Gary. And I guess, one last question. You kind of alluded to it, I think, in a response to another question about costs coming back. How much staffing do you think you still need to add this year? And in which segments do you think the most definitely you'll be bringing back?

Gary Muenster -- Executive Vice President and Chief Financial Officer

So, I would say, the areas where we'll probably be adding some folks and we're not talking large numbers, I can say. I think, the people have done a good job of managing this. But as some of the programs ramp up, particularly in the Navy side, there're some specific people we need to add there.

We're always looking to move our engineering workforce or add to our engineering workforce. And so, as things return to normal, and we're able to afford more that, I'm sure we added some folks in the technical areas as well.

John Franzreb -- Sidoti -- Analyst

Okay. But that's not going to be a large numbers, you're saying, overall.

Gary Muenster -- Executive Vice President and Chief Financial Officer

No, no. So, I mean, I think if we look at sheer numbers, what we'll see is, as sales pick up in commercial aerospace, we're going to have to add some direct labor people. But obviously, that funds itself. We wouldn't be adding those folks unless we had to work for them for formula.

John Franzreb -- Sidoti -- Analyst

Okay. Thank you very much. I appreciate you taking my questions.

Vic Richey -- Chairman, Chief Executive Officer and President

Thanks, John.

Operator

[Operator Instructions]

Vic Richey -- Chairman, Chief Executive Officer and President

Okay. So I think we're done. So I'm going to end the call by saying thanks to Gary and Alyson for their long term support at our value creating mission here at ESCO and for their passion and commitment to the company. You're both going to be missed. We were fortunate to have Chris and Dave to step in and help lead the company with continued success. So thanks to everybody. I look forward to talking to you in the next call.

Operator

[Operator Closing Remarks]

Duration: 31 minutes

Call participants:

Kate Lowrey -- Director of Investor Relations

Vic Richey -- Chairman, Chief Executive Officer and President

Chris Tucker -- Senior Vice President and Chief Financial Officer

Gary Muenster -- Executive Vice President and Chief Financial Officer

Tommy Moll -- Stephens -- Analyst

Pete Lucas -- CJS securities -- Analyst

John Franzreb -- Sidoti -- Analyst

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