Good day and welcome to the Q4 2018 ESCO Technologies Incorporated Earnings 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 now like to turn the call over to Kate Lowrey, Director of Investor Relations. Please go ahead.

Thank you. Statements made during this call regarding the amounts and timing of 2019 and beyond, EPS, adjusted EPS, EBITDA, adjusted EBITDA, growth, profitability, sales, costs, productivity, tax rates, success in 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 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 whether as a result of new information, future events or otherwise. In addition, during the 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.escotechnologies.com under the link Investor Relations. Now, I'll turn the call over to Vic.

Thanks, Kate. Before I hand it over to Gary to discuss the specifics of the fourth quarter and our full year results, I want to make a couple of comments. I'm sure some of you were concerned about the big ramp-up we projected in the second half of the year, and particularly the expectations we set for the fourth quarter. I'm very happy we were able to manage this ramp and not only hit our numbers but exceed them which resulted in our fourth quarter being the strongest quarter in ESCO's history. Not only were the results good on a stand-alone basis, but I think it demonstrates the earning power of the business at higher volumes. With these higher volumes, two of our segments had EBIT margins in excess of 25% and our Test segment reported 17%, another all-time high. Our challenge is to continue to grow these businesses to better leverage the fixed overhead throughout the year. For the year on an operating basis, we finished $0.02 above the top end of our guidance range and $0.07 above consensus. In some areas we overachieve versus our expectations, in others we fall a bit short primarily due to sales timing and mix but our results are a testament supporting our multi-segment, multi-industry strategy. In addition to our solid earnings, another bright spot was cash generation. Cash from operating activities was almost $103 million. This excludes the pension contributions which allowed us to pay down debt to the point where our leverage ratio is well below 2 times. In addition to the financial results, we took a number of actions to further cut costs and enhance our competitiveness. In fiscal year '17, we made some fairly significant moves in our Test segment which brought fully in '18. In '18, for USG,…

Thanks, Vic. As we've done all year, I will focus my commentary on the as adjusted numbers as these are more relevant measures of our operating performance when compared to expectations and the prior year. As noted in the release, we closed out the fiscal year reporting adjusted EPS of $2.77 a share, which is $0.02 above the top of our expected range of $2.65 to $2.75. The $2.77 is also $0.07 above consensus estimates for the year and 25% above 2017's adjusted EPS of $2.22. As noted in our previous quarterly reports, we delivered solid operating results throughout the first 9 months of 2018 and stating the obvious, and as Vic noted, we delivered an extraordinary fourth quarter when measured on nearly all financial metrics. Simply put, this was our best record, best quarter on record. Comparing Q4 '18 to Q4 of last year, we increased sales 12%, increased adjusted EBIT 28%, increased adjusted EBITDA 23%, increased adjusted EPS by 54%, and increased cash flow from operating activities by 16%. These increased profit percentages are well above our sales increase, which clearly demonstrates the earning power we can deliver when we have quarterly sales at this level. Exceeding the top end of our expectations for Q4 and the year demonstrates that what we saw earlier in the year with our back half weighting and the Q4 significant volumes which impacted that second half weighting that it played out as expected. Which, this should provide some support for our 2019 sales and EPS profile, as noted in the business outlook section of the release. Now touching on a few specific segment highlights from Q4, Filtration sales increased 13%, while we delivered a 26% EBIT margin, which increased significantly over Q4 '17's EBIT margin of 22%, and this was led by…

Thanks, Gary. I want to provide a backdrop for 2019 forecast. You saw in the release, our operational forecast has us growing the top line approximately 5%, EPS growing 7% to 10%, and EBITDA increasing approximately 10%. I think it's really important to remember that all of this growth is organic. Also I'll point out that we benefited from a 22% adjusted tax rate in fiscal '18 versus our projected rate of 24% in fiscal '19. This rate differential resulted in approximately $0.07 a share of EPS headwind in '19. We certainly plan to remain aggressive on the M&A front and any success we have in this area will be additive to our results. In this area, we have several significant opportunities we're pursuing, which could provide an upside or as a minimum could cover any downward pressure should it arise. Obviously certainty and timing of these opportunities make it unwise to include in our base forecast. In addition to the restructuring of our packaging business in Europe, which I mentioned earlier, as Gary mentioned, we made the decision to our Doble facility in Watertown and relocate outside of Boston proper area. This decision was made for several reasons. It is additive to our GAAP earnings and provides us with approximately $12 million of cash after taxes, commissions and moving costs. Also it should help us in our recruiting and retention efforts by being located in an area with lower cost of living. The new facility will be purposeful for Doble, which should lower our operating cost, significantly enhance our productivity, and be a showcase for our customers. Over the past several years, we've made a lot of changes to the structure of our business. And while cost containment will always be a prime piece of our strategy, I think the heavy lifting is behind us. We plan now to put much more emphasis on our organic growth and this focus should help us meet our '19 numbers and assist us as we move into '20 and beyond. So in closing, our focus remains constant to continue to prove our operational performance and to execute our growth opportunities, both organically and through acquisitions, therefore enhancing shareholder value. We'll be glad to answer any questions you have now.

[Operator Instructions] And our first question comes from the line of Sean Hannan of Needham & Company. Your line is now open.

Yes, thanks very much. Thanks for taking the question here and good evening folks. The first question I want to see if I can get through here is, as you folks look at the range that you're providing for your segments for expected growth, and thank you very much for providing that. Could you talk a little bit about what some of the highlights might be in key contributors or what might be weighing against us, for example, I think NRG is a little bit of a headwind there within the USG segment? A little bit more detail if we could hear from you, Vic and Gary around that would be very helpful. Thanks.

Sure. I think we're seeing some decent growth really across the business. We are projecting growth that is obviously above GDP and above what we're seeing from our industrial competitors, but there are challenges obviously. First of all group is solid, that's a very predictable business, the Doble business is solid as well. We are having a few headwinds at NRG, I mean really the, I'd say just the pickup rate that we anticipate is not quite as strong as we thought it would be. I think it's probably a temporary thing and we're still very happy with the business and we've got some new products we're looking to introduce, which should help us in that area. But it's just a little more volatile in the short term than maybe we thought. But longer term, it's a great place to be and we continue to look for opportunities in the renewable space to add to that. Packaging business, we're going through that restructuring. I think it's going to really pay dividends. We're making some investments to make sure that we're more competitive. And then the Test business, they're coming off of a really strong year. They're going to have another strong year next year, but we are finishing up a couple of big projects that we had entered in the past couple of years. But fortunately, we're not depending on another big project to make our numbers for '19. They're really looking at a lot of smaller, $1 million to $3 million projects, which quite honestly usually work out better for us in each case, because we have lot less pass-through content in those smaller projects. But again, as I mentioned in the, in my comments, all the growth we will see in next year is organic. So if we are able to accelerate some of that or make an acquisition, then that will be some solid upside for the business.

And Sean, I'll add one thing on the efficiency side. If you recall a year or so ago when you came along with me, we toured the aerospace facilities and the impressive nature of the automation and what it's done for efficiency and manufacturing at Crissair in particular and PTI and VACCO secondarily, we continue to make those investments. We spent a little bit of money last year in fiscal '18 at Mayday to expand their capacity as well as improve their efficiency around the labor pool. So next time when all supported the sales side, I just wanted to remind you on the EBIT contributions that we're getting. We are not shy about investing in equipment that improves operational efficiency and you were able to see a couple of those things last year. We have some additional ones in place now that will benefit '19.

Sure. Understood, okay. And I suppose drawing off that, it sounds like, as we think about each of the segments here that there should be some degree of margin expansion across all of them for next year, maybe Test, not as much but or actually I think from your comments earlier, Vic, maybe we will see that. Can you just help to validate or comment on that part as we, kind of, drill down into the margin profile of each?

Yes, and each of our operational units, not just within the segment, but within the operating units as subsets of the segment we will see margin percentages increasing, in some cases nominally like at NRG because they are not, they are getting some level of growth, but it's not where we thought it would be. And then a little bit more substantial across the filtration aspect again with volumes increasing in the automation and that sort of thing. And then we will have a little bit of disruption for a couple months while we move the aircraft business from backward with the PTI. But once it gets settled in there and hopefully in the second quarter, you'll see back half efficiencies coming out of that. So each of the operating segments has some level of percentage EBIT margin improvement in '19 compared to '18.

And let's say one other area where it's a little unclear today and because we, as you know, we're always a little bit conservative about these things because we want to see them play out, but some of the acquisitions we made that were added to billable. As we get those more and more into the distribution network, we've seen some increases in sales already. And I think we'll get some increases in efficiency as their level of sales go up. If you look at a couple of those acquisitions, we significantly improved their profitability and they were already pretty profitable businesses. I think, getting inside a larger corporation with a little more knowledge on automation and some things like that is really starting to pay some dividends.

Okay, very helpful. And then last question here, I'll hop back in the queue. It sounds like or if I'm reading the way the wording is laid out here in the press release, it seems that you feel you might be very close to really bringing through some M&A acquisitions to close. And just wanted to get your viewpoints around that. Obviously, you mentioned that the pipeline looks fairly healthy. Just trying to get a sense of what we could potentially expect out of some additions there as tuck-ins to the portfolio? Thanks so much folks.

Sure. So the M&A is always very difficult to predict, as you know. Obviously in the fourth quarter -- our first quarter or the fourth fiscal quarters is technically pretty light, because there is lot of holidays and people typically are taking a lot of activity. Although, we are seeing some things that are at least going to start to coming to market during this time frame. So there are a number of things out there. We've looked at a number of things over the past year. Disappointed we weren't able to close on anything and it's primarily because some of the multiples of which has been really, kind of, much higher than what we were comfortable with. As you know, where we do a really good job is if we're able to find a problem in our own business, it's really looking to make sure that they go to the right type of partner or acquirer and then we were able to get in there before they go to auction. Having said that, we have won some in auctions as well. But there's a lot of activity there. I would say we will probably pick up more so after the first of the year, but we will remain aggressive there. And as you know our operating folks are not shy about pursuing these type of opportunities when they find them.

All right. And our next question comes from the line of Jon Tanwanteng from CJS Securities. Your line is now open.

Good afternoon. Nice quarter guys. Congratulations. You're moving a lot of facilities at once. Can you quantify the headwinds from an operational standpoint as they are implemented how much risk have you given yourself -- risk cushion have you given yourself and on the flip side how much savings are you counting toward in '19 in your guidance?

So, I'll let Gary answer that last half of it because I am going to draw a blank there. But we always put a contingency in place when we are making these types of moves. I mean, because there are things that pop up. Having said that, we've done a lot of this, for the good or bad, we've done a lot of it. So the folks have really done a very good job of understanding what needs to be done. We have people that we started deploying that really help us with this activity. They are internal people that have been through it before. So they were not kind of relearning how to do this every time. So my confidence level in getting these things done properly is very high. I would say over the past couple of years, we probably had four or five of these types of actions that we've taken and obviously everyone on this come in either on budget or under budget and on time. So I don't anticipate any significant problems here. And to the extent we have any issue, I think we’ve got contingency to cover that.

And Jon on the dollar side, the way we look at it is, we have a very rigorous or diligent process on how we time phase these things. I'll just address each one. For instance, on the Doble sale, we sold that the first week of October. The process is under way. So you were just up there and you saw that facility, it's a three-story building, I can't remember the square footage, but that's not something you move out of in 30 days. So we will gracefully move out of there across the '19 fiscal year continuum. And so we baked in, obviously, there is inefficiency when you're packing people and moving. But I think, we've done a good job of baking in where the inefficiency would come out. So the answer to your cost savings, you're not going to see a whole lot of cost savings in '19, because that process will probably take the majority of the year. But in '20, you will see a meaningful improvement by being out of an outdated very expensive facility to maintain in that sort of thing into, as Vic said, a very specifically well-built building that we will be renting. So I'd say '20 is the best way to think about that. On the packaging side in Europe, as everyone knows, we had to, unfortunately, do some of these things, again moving people, the time frame of the European severance programs and [indiscernible] and all that are not immediate. So there'll be a transitory period as that cost goes away. And I would say maybe by the fourth quarter, we'll start to see some realistic savings there. And as we said in the release, we will be spending about $1.5 million to $2 million. The payback is greater than that…

Okay. Do you have a dollar amount for a run rate? Do you plan to say that at all or is that to be determined some later?

Well, I'll just say, just because we don't want to really get commenting on 2020, but I would say that the payback across each of these continuums is roughly a year. So I think, if you think of talking about $2 million here and there, the payback of $2 million annually is not an unrealistic expectation.

Okay, great, thanks for the color on that. And then just one more for me. The cadence of the quarter that you have into '19, any large projects that are getting in any certain quarters, how should we expect that all to play out as we go through the year?

Yes, I'd say, because that's obviously one of the things that we pay a lot of attention to as well as we go through that. So this past year '18 that we just wrapped up was I would say, extraordinary to have the profile that we had. We mean that at the beginning of the year. But going in we certainly -- we understand some of those, as Vic mentioned in his prepared remarks, some of the concern the shareholders had relative to the way that stair-step look. So the good part of fiscal '19 is while it's still back half weighted, it's not of that nature that it was in '18. So to just put numbers around it, we were about 30% of our 277 happened in the first half and 70% hitting the back half. We're about, I'd say would be a lot closer to 40% to 60% versus the 30% to 70%. So it's still back half weighted, but the stair stepping is not as deep. Does that makes sense? So if you were to think of 38% to 40% of our pick, whatever your midpoint is be on our guidance and if you were to 38% to 40% in the first half versus 30% in first half of '18, you'd be pretty squared up.

[Operator Instructions] And our next question comes from the line of Liam Burke of B. Riley FBR. Your line is now open.

Thank you. Good evening, Gary, good evening, Vic. A lot of the emphasis on -- for the Company has been on improving or growing the ROIC. Your debt levels are down fairly low. How has it changed your capital allocation strategy or how you're valuing acquisitions as the ROIC begins to improve and how it becomes an increased discipline for the company?

I'll take the first part of that and then I'll let Vic address more of the strategic side and his thinking of valuation and that sort of thing. As I mentioned on whether it's restructuring or if we're putting in a piece of automation, or doing anything to a facility, we always had the backdrop of ROIC as kind of the guiding principle there. So taking that into the capital allocation policy, first and foremost, I want to remain consistent with Vic's emphasis on organic growth. We look at that first. So if we can do things that expand our opportunity to create sales and that might come through automation because it makes our cost structure lower, so therefore we can do a little bit more [indiscernible]. And the ROIC perspective and capital allocation, first and foremost, the money that we generate is intended to grow the business. Second -- and that's both top line and through efficiency. Second is, as we look at M&A, we do have a pretty rigorous structure that we look at and so we create this chart that we call the bull's-eye chart and in the center of it is dead center of the fairway. So we have a range of parameters that we can make work on valuations. So I'm just giving you a range that might be something like 10 or 11 times EBITDA. As you get into the second ring of that, it's a little less because what drives those circles that supports our required ROI. So we will stretch if we get to the center of the bull's eye. But that's kind of how we look at capital allocation. We're really not going to raise our dividend, at least it's nowhere in our near-term thinking. So beyond the internal investment for automation and growth, R&D for new products, I'd say, is second. And then acquisitions is the wild card that again has the ROIC focus and I will turn to Vic, how he thinks about the bull's-eye chart and what we're willing to spend.

Yes, I think the valuation will come from the company and while we have [indiscernible] we really focus on their comps where it's business we really had to have and we will pay up for that. And if their business need to be additive, if they're as center of the fairway, as Gary says and that's not something that we will stretch for. I think it's important to just remember that we're going to try to have a combined approach here and having the type of ordering and growth that we have or projected for this year at least, we understand that's how we want to be as a company. So we need to do one or two things. We need to grow faster organically and we spent a lot of times thinking about that, how we're going to do that, and what type of investments we need to make, but also looking at acquisitions. So we will then have a balanced portfolio. And often when it comes to acquisitions, it's really driven by what's available. And so, and that's one of the reasons we don't set firm targets on organic versus acquisition because we want to do what makes sense, what's presented and what was presented to us at that time.

Got it. And fourth quarter you converted backlog fairly nicely. As we go into 2019, you have longer-term contracts in place so it gives you a fair amount of visibility. But if I can even use Test as an example where it's going to move from more project-base to smaller, I guess, you mentioned $1 million to $3 million project. How much visibility do you have across the board in terms of non-project related or non-contract related business?

So, the good thing is as we go into this year, we do have a really precise backlog in Test and I think it's pretty equivalent to what it was last year. And, so we are not requiring to get those big projects to make it happen. As we kind of look at how we project that business, we can stratify because we've got the medical business, which runs at kind of certain level historically and we can project that pretty closely, components is another piece of it. The logistics business is another piece of it, and then what I would call the smaller chambers, which we have pretty good insight into that. So I think we're really left with a relatively small percentage of business that's I would say kind of unidentified, if you will, going into the year. But I would say it's not any different or not significantly different than it has been years past. So while we have burned off a couple of big projects, fortunately been able to grow the backlog in some of these smaller projects and so that's not a concern for us as of today.

And I'll add one thing to that, Liam, just on the math. As we look at the backlog, we look at obviously when the expected delivery dates are on that. So one of the metrics we pay a lot of attention to is what do we have in backlog today that supports the first half of the year, because our goal is to try to maintain a backlog level that's relatively close to 45% or 50% of our expectations for next year. So obviously there are some things that we have to book and ship, we'll get some aircraft orders in February that will ship in February that kind of thing which is quick turn. But starting the year at roughly $385 million of backlog is not a challenging percentage of our expected sales next year consistent with how we started '18 and how we started '17. So going into the year with about 50% roughly of your expected sales already in backlog and the conversion cycle we see gives us comfort in the ability to put our sales increased numbers out there.

And I'm not showing any further questions at this time. I would now like to turn the call back to Vic Richey for closing remarks.

Okay, well thanks to everyone for your questions, your interest and look forward to talk to you in the next call.

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program and you may all disconnect. Everyone have a great day.