ESCO TECHNOLOGIES INC annual report, FY2018

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ESCO Technologies Inc. — FY2018 Form 10-K

Business context and reporting period. ESCO is a diversified supplier of engineered products and services across aerospace and defense, electric utilities, wireless and electronics, healthcare, renewable energy, and packaging markets. It reports four segments: Filtration, Test, Utility Solutions Group (USG), and Technical Packaging. The fiscal year ended September 30, 2018; the filing also provides unaudited fourth-quarter results.

Financial performance and position

  • Revenue: FY2018 net sales were $771.6 million, up 12.5% from $685.7 million in FY2017. Segment sales were Filtration $286.8 million, Test $182.9 million, USG $214.0 million, and Technical Packaging $87.9 million.
  • Earnings: Net earnings were $92.1 million versus $53.7 million; diluted EPS was $3.54 versus $2.07. The FY2018 effective tax rate was negative 4.7%, largely reflecting a $24.4 million net benefit from U.S. tax reform. Adjusted diluted EPS, a non-GAAP measure excluding specified items, was $2.77 versus $2.22.
  • Operating results: Consolidated EBIT, a non-GAAP measure, was $96.8 million, up 14.3%; EBIT margin was 12.5% versus 12.4%. Segment EBIT rose in Filtration, Test, and USG, but declined in Technical Packaging. Interest expense increased to $8.8 million from $4.6 million.
  • Fourth quarter: Net sales were $231.1 million and net earnings were $28.5 million; diluted EPS was $1.09. Results were unaudited.
  • Cash flow and investment: Operating cash flow was $93.3 million, up from $67.3 million. Investing activities used $41.6 million, including $11.4 million for acquisitions; capital expenditures were $20.6 million and capitalized software expenditures were $9.5 million. Dividends paid totaled $8.3 million, or $0.32 per share.
  • Liquidity and debt: Cash was $30.5 million; total debt was $220.0 million, giving net debt of approximately $189.5 million. Working capital was $195.5 million versus $197.8 million. The $450 million revolving credit facility had approximately $204 million available, in addition to cash; the company reported covenant compliance.
  • Orders: Orders were $777.2 million, a 1.01x book-to-bill ratio. Backlog was $382.8 million, up 1.5% year over year; approximately 83% was expected to be completed in FY2019.

Material changes versus FY2017

  • Revenue growth was strongest in USG, up 31.8%, largely from acquisitions; Test rose 13.7%, Technical Packaging 6.0%, and Filtration 2.6%.
  • Recent acquisitions contributed materially to growth, including NRG, Morgan Schaffer, and Vanguard Instruments in USG, and Manta, acquired in March 2018 for $9.5 million. Acquisition-related amortization and higher interest expense also increased.
  • Debt declined by $55 million during FY2018; net cash used in financing activities was $66.4 million, compared with $156.8 million provided in FY2017.
  • U.S. tax reform drove a substantial nonrecurring tax benefit and makes reported earnings less directly comparable with the prior year. FY2018 also included $4.8 million of pretax restructuring charges, primarily for Doble office closures and Filtration’s exit from a low-margin market.

Outlook, risks, and unusual items

  • FY2019 outlook: Management expected consolidated organic sales growth in the mid-single digits: Filtration and Technical Packaging each 4%–6%, USG 5%–7%, and Test 3%–5%. Adjusted EPS guidance was $2.95–$3.05. Management expected higher taxes at an approximately 24% effective rate, increased depreciation and amortization, and interest expense similar to FY2018; revenue and adjusted EPS were expected to be weighted toward the second half.
  • Guidance excluded an expected approximately $7 million pretax gain from the October 2018 sale of Doble’s Watertown headquarters and approximately $4.5 million in pretax relocation and restructuring costs. The move and other consolidations were planned for FY2019.
  • Internal controls: Management and KPMG identified a material weakness in controls over the deferred-revenue general ledger account, involving the design and operation of controls used in revenue reconciliations. An adjustment, primarily affecting revenue and deferred revenue, was corrected before the statements were issued and was not material. KPMG gave an adverse opinion on internal control over financial reporting, while issuing an unqualified opinion on the financial statements. Management reported remediation steps but had not yet established that revised controls had operated effectively for a sufficient period.
  • Other risks: The filing highlights dependence on government funding and contract awards, sole- or limited-source suppliers, raw-material prices and availability, tariffs, currency and international-market exposure, acquisition integration, and customer/project timing. Some government contracts may be terminated for convenience. The company also remained guarantor of certain Aclara contracts after its 2014 sale; unreleased guarantees could expose it to damages if Aclara fails to perform. Environmental investigations and litigation were described as not expected by management to have a material adverse effect, but outcomes remain uncertain.
  • Accounting transition: The new revenue standard, effective October 1, 2018, was expected to accelerate recognition for certain Filtration and Technical Packaging contracts. The company estimated a roughly $5 million pretax increase to retained earnings and establishment of approximately $35 million in contract assets at adoption, with no expected cash-flow impact.

Important facts for investors to verify

  • How much of FY2018 revenue and earnings growth was organic versus acquisition-driven, and whether the acquisitions achieve expected returns.
  • Whether the deferred-revenue control weakness is fully remediated and whether subsequent reporting shows further corrections.
  • How FY2019 performance compares with the organic-growth and adjusted-EPS guidance, including the excluded gain and restructuring costs.
  • Debt repayment, interest-rate exposure, and the company’s ability to sustain cash generation and dividends while funding acquisitions and operations.
  • Potential exposure under remaining Aclara guarantees, and developments in environmental matters, litigation, supplier constraints, and government-program funding.