ESCO Technologies Inc. — Q3 FY2019 Form 10-Q
Reporting period: Three and nine months ended June 30, 2019; the quarter ended June 30 is the company’s fiscal third quarter. Amounts are in U.S. dollars. ESCO operates in Filtration/Fluid Flow, RF Shielding and Test, Utility Solutions Group (USG), and Technical Packaging.
Financial results and liquidity
| Metric | Three months 2019 | Three months 2018 | Nine months 2019 | Nine months 2018 |
|---|---|---|---|---|
| Net sales | $199.8M | $192.2M | $576.3M | $540.5M |
| Net earnings | $20.1M | $19.0M | $56.2M | $63.7M |
| Diluted EPS | $0.77 | $0.73 | $2.15 | $2.45 |
| EBIT margin | 13.4% | 13.3% | 13.1% | 10.4% |
| Operating cash flow | Not provided by quarter | $37.0M | $53.9M |
Third-quarter sales rose 4.0% and net earnings rose 5.5% year over year. For the first nine months, sales increased 6.6%, while reported net earnings fell 11.8%; the 2018 comparison included a substantial tax benefit from the Tax Cuts and Jobs Act. Gross margin was approximately 38.8% in the quarter versus 36.1% a year earlier, and 37.0% year to date versus 35.8%.
Segment performance was uneven. Third-quarter Filtration sales increased 19.2% and EBIT increased to $19.0M from $14.3M. Test sales declined 6.0%; USG declined 4.7%; Technical Packaging declined 2.3%. Year-to-date sales growth was led by Filtration, up 17.0%. Technical Packaging year-to-date EBIT declined to $3.3M from $5.4M, partly reflecting restructuring costs. USG year-to-date EBIT rose to $40.5M from $27.8M, including an approximately $8M gain on sale of a building.
Cash and cash equivalents were $39.0M at June 30, 2019, compared with $30.5M at September 30, 2018. Working capital was $250.5M, up from $195.5M. Operating cash flow declined year over year, which management attributed primarily to higher working-capital requirements. Capital expenditures were $26.5M and capitalized software spending was $6.2M for the nine months.
Total borrowings were $217.9M, including $20.9M classified as current; long-term debt was $197.0M. The company had approximately $225M of available credit-facility capacity, plus a $250M increase option subject to lender acceptance, and was in compliance with its debt covenants. Its credit facility matures December 2020. Management said cash from operations and facility borrowings should meet foreseeable capital and operating needs.
Comparability and material changes
ESCO adopted ASC 606 on October 1, 2018 using the modified retrospective method; 2018 comparative figures were not restated. Adoption increased opening retained earnings by $4.2M. The filing’s bridge shows that, compared with the prior accounting method, ASC 606 increased reported 2019 third-quarter sales by $4.0M and net earnings by $2.2M; for the first nine months, it increased sales by $9.8M and net earnings by $1.3M. Accordingly, reported year-over-year growth is not fully like-for-like.
Other notable items included an approximately $8M gain from the sale of Doble’s Watertown, Massachusetts building and land, as well as restructuring charges. Third-quarter other expenses included $1.2M of restructuring charges and derivative losses. Year-to-date results also included restructuring activity and gains or losses on derivatives.
Backlog was $432.5M at June 30, up from $382.8M at September 30, 2018; the company expected to recognize 83% of remaining performance obligations as revenue within the next 12 months. Nine-month new orders were $626.0M versus $588.9M a year earlier. On July 2, 2019, ESCO acquired Globe Composite Solutions, a supplier of composite products for defense and industrial customers; results will be included in Filtration.
Outlook, risks, and controls
Management maintained 2019 adjusted EPS guidance of $3.05–$3.10. This non-GAAP outlook excludes the pre-tax Doble building-sale gain and specified relocation, closure, consolidation, and other restructuring costs. The filing does not provide a GAAP EPS forecast.
Management cited continued softness in the renewable-energy market affecting NRG, and timing of projects and shipments affecting Test and Technical Packaging. Risks disclosed include government funding and contract timing or termination, market weakness, customer and supplier performance, raw-material availability and costs, interest and foreign-exchange movements, litigation, environmental matters, and acquisition integration. Management stated that claims and environmental matters were adequately reserved, insured, or not expected to have a material adverse effect.
Control issue: Disclosure controls were deemed ineffective at June 30, 2019 because of an unresolved material weakness in controls over the deferred-revenue general ledger account. Remediation procedures and training were being implemented but had not operated long enough to establish that the weakness was fully remediated.
ESCO expected to adopt the new lease standard on October 1, 2019 and preliminarily estimated balance-sheet additions of less than $30M, with no significant effect on operations or cash flows. No impairment charges were recorded during the reported periods.
Investor verification priorities
- Review the ASC 606 reconciliation and assess growth using the comparable prior-accounting figures, not only reported totals.
- Separate recurring operating performance from the Doble property-sale gain, restructuring costs, and tax-related items.
- Monitor operating cash conversion, contract assets, and working-capital needs; contract assets were $99.5M at June 30.
- Track remediation of the deferred-revenue control weakness and any related reporting or audit developments.
- Confirm the use of adjusted EPS guidance and its exclusions, and assess the Globe acquisition’s subsequent contribution and financing needs.