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ESCO Technologies Inc. (NYSE:ESE)

F2Q09 (Qtr End 03/31/09) Earnings Call Transcript

May 5, 2009 5:00 pm ET

Executives

Pat Moore – Director, IR

Vic Richey – Chairman, CEO and President

Gary Muenster – EVP and CFO

Analysts

Steve Sanders – Stephens Inc.

Kevin Maczka – BB&T Capital Markets

Carter Shoop – Deutsche Bank

John Quealy – Canaccord Adams

Rob Mason – RW Baird

Stuart Bush – RBC Capital Markets

Richard Baxter – Ardour Capital

Operator

Good day and welcome to the ESCO’s Second Quarter Conference Call. Today’s call is being recorded. With us today are Vic Richey, Chairman and CEO, and Gary Muenster, Executive Vice President and CFO.

And now to present the forward-looking statement and for introductions, I’d now like to turn the call over to Ms. Pat Moore, Director of Investor Relations. Please go ahead, ma’am.

Pat Moore

Good afternoon everyone. Statements made during this call regarding the timing and amounts of fiscal 2009 expected results, sales, cash flow, EPS, future growth prospects, anticipated deliveries to our AMI customers, the success of AMI pilots, success in international markets, the receipt of additional space project awards, impact of the stimulus package, 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 is an exhibit to the company’s Form 8-K filed today. 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 their most comparable GAAP measures can be found in the fiscal 2009 second quarter results press release issued today, and found on the company’s website at escotechnologies.com under the link Investor Relations.

I will now turn the call over to Vic.

Vic Richey

Thanks, Pat. Before Gary gets into the specifics on the financials, I’d like to provide a few comments on the quarter and the year and also discuss our perspective surrounding our adjusted earnings guidance.

I’m very pleased with our second quarter results as we came in at the top end of our previously expected EPS range in a very challenging economy as all of our operating units delivered solid performance.

I strongly believe that our diversified end markets, driven by our three-segment approach, continue to pay strong dividends for us in the current business cycle. Certainly, we are not immune from challenges during these difficult times, but I feel our multi-segment approach gives us the resiliency to weather the storm.

In addition to our sales and EPS growth in the second quarter, I’m also very pleased to see our Q2 entered orders come in at with a book-to-bill greater than 1. All of our major AMI projects remain on track and we are executing the plan on the big three programs. The PG&E gas project is now over 3 million units on order worth $175 million.

New York City Water is at $21 million in firm orders, representing nearly one-third of the project. And Idaho Power orders grew over $6 million, representing nearly 25% of that project. Our co-op and muni orders remain on track, consistent with our original plan and our distribution partners continuing to provide us with the level of confidence that we’ll be able to deliver our plan.

Regarding our backlog, I’m going to remind you that our backlog only reflects the amount of purchase orders received and does not include the full contract value expected of each project.

As an additional data point, we are starting to see some positive signs with our utility customers. We base this on the impressive turnout we had at both the Doble Client Conference and the Aclara Users Group Conference, which were held over the past 45 days. Utility customer attendance was exceptional at both conferences and was consistent with historic levels, which I believe is indicative of the interest and the commitment we have from our customers through this trying time.

On the international front, we continue to make meaningful progress with our power activity and proof-of-concept work in both Latin America and Asia. While this process continued at a slow pace, we are making steady progress in getting these projects move from testing to deployment.

In fact, we had our first win at South America, where a smaller utility in Columbia has selected our Aclara PLS solution for system-wide deployment. While this deployment is not large in quantity, as it is less than 25,000 end points, it is very meaningful as a reference customer for other ongoing projects in that region. In addition to our electric AMI opportunities, we are now seeing several new and significant opportunities for our RF fixed network water AMI solutions in Latin America.

Lastly, on the international front, even though our LDIC acquisition has not performed according to plan given the very soft European economy, we are seeing a significant level of interest in LDIC products here in the US as we are cross-selling the LDIC products to the Doble sales and distribution channels.

I’ll now turn to the full year outlook. While we have continued to have – while we continue to have meaningful pockets of opportunity throughout the company and are cautiously optimistic about the balance of the year, I think it’s prudent to adjust our ’09 outlook given the uncertainties of the macro environment.

As you know, we have a very rigorous and detailed planning process with our operating units that regularly provide us with numerous touch points throughout the year. Through this process, we are able to maintain a high degree of visibility and confidence surrounding our near-term outlook. But because we are operating a rather unique business cycle, I believe a more conservative posture is warranted as we address our outlook. I would characterize this adjustment as a reflection of our conservative planning approach.

Our EPS adjustments reflect softer-than-anticipated commercial aerospace deliveries and lower sales of Doble’s hardware products. The Doble recurring service business remains rock solid, but the hardware side of the business has been slowed by the capital constraints at the utilities.

Since the Doble hardware is very critical to the overall maintenance and reliable performance of the electric grid, I’m confident that the slower hardware orders and sales are temporary in nature. In total, our overall business remains very solid and our current operating plan is well understood and appears achievable.

Regarding the stimulus package, there is a lot of activity going on, it’s moving very fast, and seems to be changing constantly. We are actively engaged in monitoring this process with dedicated internal people and resources, as well as participating with various industry groups in advancing our agenda and we are working with other AMI companies on these opportunities as well. We feel this is going to be a positive catalyst for our industry over the long term, but until it’s more clearly defined, the timing of any near-term benefit is a bit unclear.

As I wrap up my commentary, I’m going to point out that while we have confidence in our ability to achieve our financial goals, we are not standing idle. We continue to be aggressive in looking at all of our operating costs and we continue to work our ongoing contingency plans.

We have very seasoned management teams in place across the company who continue to make the hard decisions every day to ensure that we continue to return value to our shareholders. We are very fortunate to have these dedicated individuals in each of our operating units.

Lastly, I’d like to touch on an administrative matter. Several of our key managers have five and ten-year stock options, which are expiring throughout 2009. Significant number of shares have already been exercised with cash and more shares will be exercised over the next nine months.

It’s our corporate policy to allow limited stock sales periodically by our key executives, basically to cover the cash required to exercise the options and to cover the personal income taxes related to those shares. As a result, you will see some modest selling activity over the next few weeks to cover these options. But the net result is that the executive officers will in all cases own more net shares as a result of these transactions and we’ll continue to significantly exceed their mandated ownership requirements.

Now, I’ll turn it over to Gary for some brief financial comments.

Gary Muenster

Thanks, Vic. As noted in the release, EPS from continuing operations was $0.40 a share in Q2, which represents a 60% increase over the prior year second quarter EPS of $0.25. In addition, the $0.40 in Q2 represents an 80% increase in EPS sequentially over Q1 of ’09. Also sequentially during Q2, we increased sales approximately $7 million from Q1 and we were able to increase EBIT greater than $7 million in the same period, validating our cost control efforts along with a more favorable sales mix.

The $0.40 came in at the top end of our previous EPS guidance and was driven by additional sales of Aclara RF AMI products and higher sales at VACCO. Additionally, we were able to realize manufacturing cost efficiencies and other cost containment strategies put in place throughout test and filtration. During the quarter, we also sold the assets of Comtrak and received nearly $3.5 million in cash and recognized a modest accounting loss in discontinued operations.

On the cash side, while our cash flow was slightly negative in the quarter, it came in significantly better than expectations. The cash usage in Q2 was driven by our inventory build at Aclara to meet increased Q3 and Q4 sales demand, as well as to build safety stock to meet delivery schedules during the RF facility move later this year.

Cash was also impacted by slower-than-anticipated collections from one large international customer. While the payments have been slower than expected, this AR is not at risk as this is not a financially challenged customer.

While our Q2 performance was better than expected, I still want to point out that Q2, as with Q1, was impacted by our decision to continue spending R&D dollars at VACCO and Aclara RF on new product development and existing product enhancements to support future growth. The VACCO R&D spending continues to be made to ensure that we are in the best position possible to continue to win the additional space products – projects that are currently up for bid.

Regarding the balance sheet, I am very pleased with our capital structure and our available liquidity as our net debt outstanding at March 31st was approximately $180 million. This debt level, on top of our trailing EBITDA, results in a very comfortable 1.99 times leverage ratio. By getting below the 2.0 ratio, we further lowered our cost of borrowings as our spread over LIBOR decreased at this level to 57 basis points.

Regarding our current outlook for the balance of ’09, as Vic mentioned, we adjusted our outlook for ’09 to provide a more conservative view of our Q3 and Q4 expectations. We now expect 2009 operational EPS to be within the range of $2.37 to $2.47 a share. This equates to GAAP earnings, which includes intangible asset amortization and the Aclara RF facility exit move costs, which are expected to be around $0.05 a share, to be between $1.90 and $2 a share.

As I mentioned during the last call, it is not our preference to provide quarterly guidance since we regularly have several moving parts within our customer base, as well as other long-term contract deliveries, that can move a month or two around the quarter-end. But with that said, I will tell you that our fourth quarter will be higher than our third quarter.

I’d also like to point out that even with our more conservative outlook we continue to expect favorable sales and EPS comparisons for the total year of ’09 versus the total year of ’08. Assuming EPS comes in at the mid-point of our guidance; this would reflect an 8.5% EPS growth in a very challenging economy.

I’ll be happy to address any specific financial questions during the Q&A and now I’ll turn it back over to Vic.

Vic Richey

Thanks, Gary. That does wrap up our prepared comments. And now we’ll open the call to any questions you may have.

Question-and-Answer Session

Operator

Thank you. (Operator instructions) And we’ll go first to Steve Sanders with Stephens Inc.

Steve Sanders – Stephens Inc.

Good afternoon, everyone. First, just a question on stimulus. It looks the initial draft is skewed towards smaller projects. It seems like that would be a pretty significant benefit to you guys in 2010 if in fact that’s how it turned out. Is that a fair way to look at it?

Vic Richey

Yes, I would say Steve that the way it’s currently written – the key, those two cap out at a fairly low level, less than $20 million. And so, we would see more of that money going to the co-ops and municipals and those types of utilities and obviously, I think we are best positioned in that market of all of the competing technologies.

Steve Sanders – Stephens Inc.

And what are you hearing from kind of an insider’s perspective on the commentary? Clearly, there are some large projects that would like to go after bigger chunks for the funding. What’s your best guess at this point on how that plays out and what we ultimately end up with?

Vic Richey

Yes, I still think that what’s currently in place will probably hold together for a number of reasons. I think that they really do want to spread the wealth, if you will, to a larger number of utilities and as I’ve said previously, I think just from a PR perspective, it probably looks better if the government is providing a number of these things to the smaller co-operatives, municipals versus large investor-owned utilities because if they do that, they are only going to have a much more limited number that they can actually award.

Steve Sanders – Stephens Inc.

Right. And then, in kind of a related area, security has become a pretty high profile issue. Clearly, it’s been a high profile issue for the vendors and the utilities for many years. How comfortable are you guys with your current RF and PLS products as it relates to the current focus on security?

Vic Richey

Yes, as you can imagine – I mean, this is something that we’ve been working through over the years and most – every one of these projects will have some level of security requirements, testing, verification, certainly we went through that. Probably the most rigorous phase was with PG&E with both of our technologies and we have performed well there.

So, I think that we are in a pretty solid position there. There is a lot of activity underway with some of the standards committees where they are looking at cyber security because that has become more and more important and there maybe some changes that come out of that, but I don’t think there is anything inherent on our technology that’s going to give us any issues as that does get more clarified. But until it gets clarified, we won’t know the final answer, but I would say today we are pretty comfortable with our ability to meet those requirements.

Steve Sanders – Stephens Inc.

Okay. And then on the PG&E gas project, you’ve received orders for I think 3 million units, $175 million or so against 3.7 million [ph] potential and an incremental $50 million. Where do we stand in terms of shipments and I guess what I’m trying to figure out is it feels like at the current shipment rate that the projects winds down sometime during 2010 assuming that they don’t make a significant shift back toward electric installations and away from gas installations? So, I just wanted to get a sense of how you are looking at that project over the course of the next year and a half or so and how we should be thinking about that.

Gary Muenster

Steve, I’ll address the quantity issue and I’ll let Vic take care of how we are looking at the things. So, cumulative to date in number of units, we’ve sold and shipped 2.4 million units worth about $140 million against that 3 million and $175 million that you mentioned. So, you can do the math on that on what their yet-to-install rate is on that.

The way that rollout looks for the balance of the year, it should be relatively consistent with the volumes that you see in Q2. But I will point out also that there is some additional growth meters as we look at the fall-off in 2010. I don’t think it’s going to be as severe as everyone thinks because keep in mind that contract was signed in 2005 and there has been additional building activity going on out there.

So, if they are going to go forward with a complete installation then the ultimate number at the completion of that project will be greater or is expected to be greater than the numbers you have. So, the fall-off that you will see in 2010 is probably somewhere in the neighborhood of 20 million to 25 million off of the run rate in ’09 and not as steep as a lot of people might think because of the creation of growth meters as that service territory has expanded over the last four-and-a-half years. It’s a much larger service territory than it was when that contract was originally signed.

Steve Sanders – Stephens Inc.

Okay.

Vic Richey

Yes. And we are not making any assumptions on the electrometer. So, we are really focused on the gas meters today and I think Gary kind of doing a good job of capitalizing on when that rolls out.

Steve Sanders – Stephens Inc.

Okay. And then two quick ones. I think you talked last quarter about some push-outs on the Doble hardware side. I think it was something you mentioned along with commercial aerospace weakness as it relates to your guidance over the balance of the year. Can you just bring us up to date on Doble in – from the contacts, does it look like this issue is compounding or does it just look like you are going to be unable to catch up maybe what you lost over the first half of the year?

Vic Richey

Yes. I don’t think it’s really compounding. I mean, we’ve really seen – I think there is a lot of pent-up demand and I spent sometime with the client conference at the first part of April and talked to a number of customers, talked to our internal sales guys and I don’t think there is any doubt that the orders are going to start loosening up because the demand is there. I mean, they need the product, they want the product. In some cases, they have open purchase orders to – they have the ability to order product, but they are just not drawing against those purchase orders as of yet.

So, I don’t think this is a systemic issue as much as it is a timing issue. At the end of the day, it is capital equipment and it’s anywhere from $40,000 to $60,000 piece of equipment and that’s something if they can buy eight of them rather than 12 of them, that’s kind of the decisions that utilities have been making.

The other reason that I think it is a timing issue is I mentioned in my introductory comments, the recurring part of the business is just – is solid as it ever has been and so, I think the utilities are still quite enamored with the products or with the service they are getting from Doble. It is just that this is – they are taking a bit of a pause and then pause is probably even too strong of a term because people are still buying things, they just aren’t buying in the same quantity that they did before.

I think the other thing that is very important the way I remember is that even with us talking about the Doble’s sales being down, they are not down versus what they’ve been in the past. They are down versus what our expectations were. And so, I think we have built a good bit of growth into this year and the other thing that is important to remember is their EBIT contribution is still very significant.

Steve Sanders – Stephens Inc.

Okay. All right. Thank you very much.

Vic Richey

That’s just off business right now. The Boeing strike hurt us in the first quarter and we are seeing the travel – the flight miles are just not where they projected to be, the number of parked planes is a lot higher than it has been in the past. And so again, that’s come down from what our expectations were going to be, but again I think it’s important to remember a couple of things.

PTI, the business that has that is coming off their strongest year ever last year and the other thing is that management team has done such a good job of managing cost that even though their sales are pretty – are down pretty dramatically this year, dramatic probably an overstatement again, they are down significantly this year, but they are still delivering EBIT in the upper-teens. And so, they’ve done a really good job of managing the business.

Steve Sanders – Stephens Inc.

Okay. Thanks very much.

Vic Richey

You bet.

Operator

Our next question comes from Kevin Maczka with BB&T Capital Markets.

Kevin Maczka – BB&T Capital Markets

Hi guys.

Gary Muenster

Hi, Kevin.

Kevin Maczka – BB&T Capital Markets

I guess, I think a little more color if I could on the guidance. It sounds like you are taking about PTI and Doble hardware, kind of where the weakness is at least relative to your prior plan. I’m just wondering if you can quantify at all the significant decline at PTI versus the growth at VACCO. And also, is there anything in that guide-down related to the rest of utilities other than Doble or the – specifically, the muni business or even the test segment?

Vic Richey

The – I don’t want to get into a lot of specifics about versus what we thought and where we are at, but the – but you are right, I mean the two areas where we’ve seen the biggest downturn is with the Doble hardware and with PTI. The VACCO business is higher than what we anticipated. So, that’s all set. So, the test business is a little softer in the second half than we thought it was going to be, but it’s not a significant number. So – again, I’d say the area where we made the decision to take the guidance down was a result of Doble and PTI.

Kevin Maczka – BB&T Capital Markets

How about in absolute terms, Vic? Not necessarily relative to your expectation, but just in absolute terms in the quarter, can you tell us how much VACOO was up, how much PTI was down?

Gary Muenster

Yes. Actually, for the second quarter Kevin, VACCO was up over $2 million and PTI was down about $2.5 million. So, that’s where you see in compared to second quarter last, I think we are down $700,000. So, they almost offset each other dollar for dollar. And to Vic’s earlier point, the impressive sight of PTI, while their sales were down $2.5 million, the EBIT contribution was only down nominally and to Vic’s point, in the upper-teens, they basically were ringing right at 20% EBIT in the second quarter in spite of the lower sales.

Now, with the VACCO sales being up over $2 million, their margin contribution was down slightly and that’s in reference to the point that I wanted to make sure everyone was aware of that we are investing pretty substantially in that crew exploration vehicle to the tune over the course of the year, somewhere in the neighborhood of $1.5 million to $2 million in additional spending on that project.

So, I don’t want to say we are purposefully muting the EBIT contribution, but the point we are trying to make is there is a substantial revenue opportunity coming out of those programs based on the bidding proposal activity we are signing off on and this money we are spending on the R&D in spite of a challenging economy, we are not constraining them on their spending because I think the opportunities over the next three to ten years on this program are going to be substantial.

So, when you put that all together, you do see a little bit of compression in the filtration EBIT margins to the point on the test side, the sales as you saw in the charts are up nominally, but the EBIT contribution is up five times the sales increase. And again, that’s where these guys at the units have really taken a very hard look at the cost initiatives; we are really tightening down the screws on our manufacturing efficiencies and to see that type of margin contribution coming out of the test business, I think, is exceptional.

Vic Richey

Yes. I think I guess one other thing I’ll add because you did ask the question and I didn’t address, that was what we were seeing in the rest of – in the Aclara business and I would say it’s down only nominally from where we thought it was going to be.

Kevin Maczka – BB&T Capital Markets

That’s how it’s trending or it was trending in Q2, Vic or that’s how you see the rest of the –?

Vic Richey

That’s how we see it through the rest of the year.

Gary Muenster

And that’s compared to our original plan.

Kevin Maczka – BB&T Capital Markets

Okay. So, you haven’t seen any significant change in customer behavior? This is not a function of significant cancellations, or push-outs, or anything like that?

Vic Richey

No. Again – I mean, I think you have to look at our business in pieces a bit and that the co-op business has remained fairly strong, now we do have book and ships that we have to do the remainder of the year. So, if there is additional risk that’s where it would be, but – and being very close with our distributors and with their customers, that appears to be on track. Beyond that and you are really looking at the major deployments that we have that I can outline that would be in New York City, PG&E gas and Idaho Power.

So, those three are remaining on track. So, if you look at that and then you drop in some of the smaller municipals that we are also winning and delivering on, I would say overall the business is pretty much on track. Sure there is – I mean, we’ve not seen anybody cancel a project on us to date. So from that perspective, they’ve been behaving well.

Kevin Maczka – BB&T Capital Markets

Okay, great. Thanks guys.

Vic Richey

Okay.

Operator

Our next question will come from Carter Shoop with Deutsche Bank.

Carter Shoop – Deutsche Bank

Good afternoon. A couple of questions here. Maybe first on the stimulus, can you just in detail what you are doing to make sure that your utility customers capture a large portion of the stimulus funding here?

Vic Richey

Yes. We are doing a couple of things and the biggest thing is staying close to what is going on and there has been a lot more published more recently. We had some specific sessions at our Aclara customer conference, talking specifically about what we knew the activity that was underway.

We also have on our – on the Aclara’s website, the internal one they have for the customers; they update that on a regular basis to inform the customers of what’s going on. We’ve also been working with them to help think through the grant-writing process because that is a process that’s going to take place with a lot of this. So, what we are trying to do is just stay as close as we can to them, do as much of that for them as we can to make it easy because it’s not something they typically have had to do.

Carter Shoop – Deutsche Bank

Could you elaborate a little bit on you helping these munis and co-ops walk through the grant-making process? I mean, are you dedicating personnel for that? Do you expect –?

Vic Richey

We’ve got scorers tracking the – this. We have two full-time legislative affairs folks that are tracking on a real-time basis. They fellow that kind of runs our marketing communications group is responsible for updating the website, keeping that information up to date in front of the customers and he’s also looking for – or working with an outside grant writer to help in that process.

We’ve got – so I mean, I think that’s essentially it as far as – and then we are educating our sales force as well to make sure that as they are talking to folks they can help them through the process as well.

Carter Shoop – Deutsche Bank

Okay, that’s helpful. In regards to space contracts that are currently out for bid, can you just discuss the opportunity here over the next couple of years? I mean, is this something that can be $20 million, $30 million, $50 million opportunity by 2011?

Vic Richey

And you are talking about for the – through the stimulus bill?

Gary Muenster

No, for the (inaudible). I’ll address that, Carter, from the numbers side and I’ll let Vic kind of put the overview on what’s going on with the program. And these are long-life programs. Obviously, the – they are still trying to figure out what to do with the shuttle, should they fly it, should they retire, and that sort of thing.

So, what they are doing is they are accelerating a lot of the development work on the CEV because it’s pretty obvious that the shuttle is – in its aged condition is a bit challenging to fly. So, what they are doing is they are compressing a lot of what the plan was going to be over the next three to five years. And so, I would say in the last five months we’ve signed off on over $125 million in projects.

Now with that said, those are extended life programs. So, to your point, is it going to be $20 million in a given year? Probably not. With the front end of that, you do the development work that you get paid for. Then you do the prototyping work and then you do all the production work.

So, it really is a ramp that I think you’ll start seeing revenues of any significance in 2011 migrating up, maybe somewhere out – five, six years out, it could be at those levels. But the profitability is strong because there are not a whole lot of vendors that can provide these products; there is really only two or three. And we’ve been winning an inordinate share of those because of our legacy products on the shuttle. So, it’s a very large contracting opportunity for VACCO in the aggregate, but I think spreading it over the number of years would be a better way for you to look at it, but it’s very large.

Carter Shoop – Deutsche Bank

Okay, that’s helpful. Thanks. In regards to linearity in – particularly for orders, can you discuss kind of where you were three months ago and talk about how orders progressed throughout the quarter? I’m trying to understand if orders maybe slightly behind where you thought they were each month of the quarter or if the softness is more of a recent phenomenon?

Gary Muenster

I would say throughout the quarter the orders came in generally on plan and maybe even a little bit higher when you look at the filtration side of it because there were some additional orders that we had assumed in the second half of the year that came in earlier.

So, I’d say within utility solutions, we were on track, especially on the co-op side of the business, and as we alluded to in the commentary, we stay very close to our distribution channels and so, we have a pretty high level of visibility on the customers that are in the order pipeline. So, when we make commitments for the second half of the year, as Vic said, we still have to book some orders and ship it, but the majority of that stuff for the co-ops is simplistic product that’s already in inventory. So, if we did get an order later than expected, we can still ship it within the period.

So, I’d say the order book held together. It wasn’t the last-minute push in the last two weeks to get 75%, it was nothing like that. And it’s shaping up the same for Q3. We feel confident based on the utility solutions group on where we are going with PG&E and Idaho and New York, and our distribution channels seem to be on the order book holding together relative to the original plan. So, that feels pretty solid.

Test always has its volatility because these chambers can be so large that a customer may tell you, you are getting the order in March and it slips two weeks and it becomes April for a $2 million, but generally the things that we had expected to happen are happening. Some things are moving to the right, but nothing of great concern and filtration. I think we came in a little bit better than our plan on the order book.

So, I think in total, the way it wrapped up with the $157 million or so in orders, I’d say we were pleased and it probably came in $2 million to $5 million better than we had expected last time we spoke.

Carter Shoop – Deutsche Bank

Okay, that’s helpful. Last question here in regards to the international opportunity. I was hoping that you guys could give us a little bit of an update on how your pilots are progressing in Latin America and also discuss some of the prospects for a large volume win in Latin America or Japan.

Vic Richey

Yes. Continuing – as I mentioned in the intro, continuing to make good progress there. It’s never as quick as you want, but I would say the performance that we are seeing with the pilots that we currently have in place are good. We were encouraged with a small win that we won in Columbia. That was our first win there. It’s a small deployment, it’s a full deployment.

And as I mentioned, the water thing is the other thing that is pretty exciting. We do have a – I’m not going to get into any details, but a couple of water pilots in Latin America as well that we’ve recently put in place. And so, we are excited about that as well. That’s fairly new news I would say in that we didn’t see that opportunity and so, we started to spend a lot more time down there.

So, I would say that we are still very bullish on South America and really timing is the issue. As far as the large deployment, I mean that really is the question. We met with the international team last week and talked about that and this is a very hard thing to characterize. I mean, I would certainly hope that we are going to have something more substantial in 2010 than we are seeing this year.

I don’t think – and I think I’ve mentioned this before, I don’t think it’s going to be a case where utility is going to say, okay, we are going to buy 5 million end points and off we go. They are going to say, we are going to deploy in this city for a 200,000 end points and another city for 0.5 million end points. So, I think it’s still – even though they start to going to deployment; it’s going to be much more incremental than what we see with some of the domestic customers.

Carter Shoop – Deutsche Bank

Could you possibly give us an update on how many pilots you currently have going and how many points that entails, if you have that information with you?

Vic Richey

Yes, we currently have – we have about seven pilots going in Latin America and I would say the total number of end points is under 100,000.

Carter Shoop – Deutsche Bank

Great. Thanks a lot.

Vic Richey

Okay.

Operator

Our next question comes from John Quealy with Canaccord Adams.

John Quealy – Canaccord Adams

Good evening, guys. A couple of questions. First, when we look at USG EBIT margins moving forward, do deployment schedules at PG&E or it looks like New York water is ramping bookings quarter-on-quarter, how should we think about EBIT margins moving forward for that business? You got all the way up to almost 22% last year in the Q4 period. How does that look this year?

Gary Muenster

I think it should trend about the same, John. I think – obviously, when you look at where we need to be at the end of the year versus we are now, we obviously have to increase our sales volume and once we do that, you start to see the incremental margins follow the sales because obviously we are not going to be ramping up G&A ratably. So, what you are going to start seeing in Q3 and Q4 is basically the gross margins essentially falling through to EBIT.

And so, two things are working in our favor. The volume increase and second is, on the New York City water project, all water projects in general tend to carry inherently higher gross margins than the gas and certainly the electric too. So, as we get higher volumes of water projects, whether it’s New York or Kansas City or Corpus Christi, whatever, the gross margins there are in the neighborhood of 8% to 10% higher. Still it’s not the largest percentage of the total Aclara volume, but as that mix changes it will favorably pull through the EBIT margins.

So, as you look at Q3 and Q4 percentage wise, it should be reasonably consistent to even slightly higher than we had last year because last year we did not have the same volume of water. So, it’s trending positive.

John Quealy – Canaccord Adams

That’s good. And then also, just on Doble, if we can just go back and revisit it, I’m thinking about last quarter where it sounded like we had a couple of bigger customers push out year-end spending. Is that basically what you are seeing again, these customers not coming back? I thought at that time that you guys had a pretty conservative handle on when those bigger customers would come back and quite frankly, I think you had a sort of right in the mark for the year quite frankly. So, what’s happening in Doble just to cause you to lower guidance just a bit?

Gary Muenster

Yes, I would say that what we are seeing now is more – was a couple of things. They aren’t big customers like we had in the first quarter. This suggests a lot of the smaller customers aren’t buying at the same level we thought and so, if you’ve got two big customers that change your buying behavior versus ten smaller customers who do that, you kind of come out at the same place. So, we just – where we thought at the end of the first quarter that some of the smaller customers would continue to buy as they had in the past, that hasn’t happened. So, we’ve seen more softness there than what we had anticipated.

The other thing is we are being hurt somewhat from a pricing perspective on our international business because as the dollar strengthened against some of the other currencies; we’ve got more price pressure than we have in the past. And then the third thing I would say, I mentioned in my opening remarks is the LDIC acquisition, we anticipated better performance from that than we’ve gotten. Really the economy in Europe, our timing wasn’t the best. I mean, it’s simple as that. We bought the business and that economy has gotten exceptionally soft and their sales have been impacted as a result.

We still think it was the right thing to do, it’s a good acquisition, good technology, I think we will be able to sell a lot of that internationally and a lot of it now domestically. We had a special session on their products at the client conference in April and it was exceptionally well attended and a lot of people were very excited about what they saw. So, I still think it was good acquisition, but just quite frankly, it’s not meeting what we had anticipated the – what we had anticipated into the first year.

John Quealy – Canaccord Adams

Okay. And then just two final ones. Under the USG group for power line, I think you said co-op was strong, but it remains one of your risks as you look into the back half of ’09 being proactively conservative, if I can use that term. For that business, as you look out for the remaining six months, do you think that’s a grower this year, Vic, or how do you characterize DCSI this year?

Vic Richey

Yes, the way we have that is flat year-over-year from a co-op perspective.

John Quealy – Canaccord Adams

And then the last thing, just a little bit more sort of qualitative macro thought if you will. We are seeing a lot of discussion on the federal level about licensed versus unlicensed and Smart Grid, not just in metering, but in other places. Obviously, you’ve got great history on the license side. Now, can you talk about how you think that argument moves forward and then, how USG is positioned, however it comes across and comes from the Feds?

Vic Richey

Yes, we’ve got much more involved on the standard committees than we have in the past. In fact, we have a number of internal resources, as well as some outside resources that are involved in that. We are going to make sure that everybody has a full understanding of what that really means as they go the standards. And I think we are going to be well positioned as you go through the process.

I don’t think that people are going to say, here is a one-size-fits-all. I think there are opportunities for a number of different technologies to be successful. And so, while the standards committees I think have a job to do and I think they are going to do that, I think there a number of different places on the grid where the standards are going to be different because they really have different applications.

And so, I think what we’ve done is just to make sure that we’ve got people in place to make sure we do a good job of educating all of the consumers and the shareholders in this activity.

John Quealy – Canaccord Adams

Great, thanks.

Operator

Our next question comes from Rob Mason with RW Baird.

Rob Mason – RW Baird

Hi, Vic, Gary. I wondered if you could just go through a similar margin discussion that you did on the USG group, but do so for the filtration segment just given that you have some mix possibly moving around and also your development costs. I’m not sure if those will fluctuate as we go through the second half of the year, but some margin perspective for the second half?

Gary Muenster

Are you talking about second quarter specifically first and foremost or?

Rob Mason – RW Baird

Looking forward. But – I mean, if you could frame it against the second quarter, that would, I guess be, helpful.

Gary Muenster

How about I address it for the year, and I think make a lot more efficient than you kind of back into how the second half looks for the total. I think on the filtration side, in the aggregate, the EBIT margin probably will be down in the neighborhood of 1%. Last year, we did 18.2%. So, somewhere in the neighborhood of 17.2%, I think is a fair way to think about that.

So, looking at where we were in the second quarter, we were at 16%. So, you can see how the volume and the mix is going to impact the second half of the year, and as we’ve talked in the past, when you at the second half of the year, we have a large recurring delivery at VACCO on this Virginia class submarine valve that we sell. It’s a very significant product, several million dollars worth of product, it always ships in the second half of the year and it has nice margins associated with it.

And so, the second half of the year, obviously coming off of where we started and where we are in Q2 is driven by the mix, as well as the volume. So, putting that somewhere in the neighborhood of low-17s I think is the right way to think about it.

On the test side, last year we did about 9.5% EBIT and I think we are going to be kind of in the neighborhood of 11% to maybe a point over that, 11.1%, 11.2%. So, I think what you are seeing there is favorable mix as well. But also, you are seeing a very effective cost containment program being managed through the test business globally.

As Vic said on the Doble business in Europe, test has impacted on some of the international content as well. Asia is very strong, Europe is very soft, domestic is fighting to a tie, so the nice part of Asia being the strongest; it has really good margins right now. And so, that mix works in our favor and the exceptional cost management disciplines that the test guys are working through, that is paying dividends for us. So, you are going to see expansion there.

And then on utility solutions, I think we kind of walked through the pieces. We should see that higher in the aggregate in ’09 versus ’08 as the Aclara RF business, which is the big, big grower this year, works in our favor. And it carries a higher margin than power line because power line has the drag from the TNG amortization. So – and the water content at Aclara RF works in our favor.

So, those are really the catalysts that give us confidence that we are going to see this 6% to 10% growth in earnings driven by that mix in the second half. I think we do have visibility and I think we’ve dialed in the right amount of risk.

Rob Mason – RW Baird

Okay. Thanks, Gary. It’s helpful. And Vic, it sounds like test was more or less on track, just your commentary around orders, it was also absent from any adjustments that you may have made to your guidance or it sounds like it was. So, the idea though that quarters are trending lower or have in the first half year-over-year, we are still thinking that test has a good chance to be flat, possibly up this year despite it is a tough comparison. Is that still the thinking and then maybe the lower orders, maybe portend a lower 2010 or at least a slower start to 2010?

Gary Muenster

Rob, let me put one thing out before kind of – just on the number side before Vic gives you kind of his global thinking on it. Keep in mind that the NATRIP project, the big automotive chamber in India, there are a series of chambers we are doing in India, that order was booked last year and that was $17 million and half of the deliveries occur in the second half of this year.

So, that’s already in backlog and we can call that $8 million or $9 million in the second half of the year. So, that gives us confidence in the back half of the year because it’s already there, it’s on track, and we are already starting the front-end work on that thing.

And so, we don’t need to book a whole lot of things to get the second half performance because that, while you do see the order trend in the first half of the year a little bit down, a big chunk of the second half performance is already in backlog. And Vic, I don’t know if you want to add to it.

Vic Richey

Yes, I think that’s certainly the biggest driver. I mean, we still do with that business – as you know, we do a lot of book and ship within the year, so I can’t say it’s not without risk, but we’ve been through the details of that and fortunately in light of the things that, particularly in Asia, are kind of government-sponsored projects, and as I think we all know, all the governments right now are spending money to just to try to keep the economies moving forward.

Rob Mason – RW Baird

Okay. And maybe just last question. Do you have any update that you can give us on Toronto in terms of timing there or expectations of when we might start to see that project begin?

Vic Richey

I think just probably – I don’t think we have anything baked in this fiscal year. So, that contract process has been a bit slower than what we thought. So, we don’t have anything in this year. So, that would be incremental going into 2010.

Rob Mason – RW Baird

Okay. Thank you.

Operator

Our next question comes from Stuart Bush with RBC Capital Markets.

Stuart Bush – Capital Markets

Hi, good afternoon guys. First on the OpEx side, you mentioned that you would keep R&D on for VACCO. Do you expect any additional rationalization from the expense side or what is it going to take besides just product mix and flow through to get the greater uplift on the bottom line kind of the back half of the year?

Gary Muenster

I think it’s mostly driven by volume, Stuart. I mean – the ramp-up in the second half of the year, there is some military applications that we have on some of the aircraft product lines at VACCO that are working as well, and that Virginia class submarine valve that I referred to earlier is a – depends on when we actually complete it, but to kind of give you a relative perspective, looking at VACCO in particular, this second quarter they did about $10 million or $10.5 million in sales and in Q4, it’s roughly $13 million. And so, you – obviously, that’s roughly 30%.

So, when you start to see that kind of incremental volume coming through with their gross margins north of 40%, that’s where you get a little bit of the uplift. And also at PTI on the commercial aerospace, some of their – while we are in a very soft period and compared to last year, we are down 10% or a little bit more than that, we are seeing a little bit of order strength in the second half of the year and we are seeing some deliveries in Q3 and Q4 that give us confidence that the volume pull-through covering the fixed costs will also work in our favor.

And while we don’t talk much about the packaging business, the residual packaging business left over from Filtertek, that has – year-over-year, while you hate to think of it as seasonality, the third and fourth quarters there are relatively strong as well. And to put a number on that, they did about $3.5 million in sales in Q2 and they are about $5.5 million in Q4 and clearly understand where that’s coming from. Those contracts are in backlog, the performance of that again is driven by volume. And when you see sales volume coming through at 5.5% there, we do rationalize G&A and that will be a 20% EBIT business at that kind of sales volume.

And so, it kind of gets lost because it really doesn’t make sense being in there, but we don’t have a better place for it at the moment because of its small size. But we’ve spent a lot of time with the operating units looking at their monthly forecast, looking at their backlog, looking at the products that need to book and ship and the ones they have in backlog, and we feel good about where we are in filtration going into the second half of the year.

Stuart Bush – Capital Markets

So for the whole business, we should expect not additional cost-cutting measures to be implemented for the year?

Vic Richey

I would say what we always try to do and I mean – is run a pretty lean business. And so, typically – I don’t remember the last time we went in and just said, okay, here is a huge cut we are going to take. I mean, every business we have is a different business. I think the operating managers with review from us take the actions proactively.

So – or is there going to be continual cost-cutting throughout the year? I’m sure there will be and we are looking and – people always think of people as part of that or as the only piece of that. And while, unfortunately, that is a key part of it, there is also lot of other costs that we look at and our guys are getting down to the nickels, looking at material costs, looking at scrap efficiencies, looking at every place, whether it be travel or any of the other expenses.

And so, we will continue to have very tight cost management activities throughout the business. But I think the things that need to be done we have in focus and are doing those as necessary. In addition, when we kind of saw this thing softening up the end of last year, we did say to all of the operating guys, you need to put some contingency plans in place so that if your business falls off 10% you know what to do; if it falls off 15%, you know what to do.

And so, a lot of those contingency plans have been executed and we have additional contingency plans if the year doesn’t kind of unfold the way we clearly think that it will now. So, we don’t have any huge reductions or cost containment plans planned, but we are going to do what’s prudent for the business.

Stuart Bush – Capital Markets

Okay, great. Can you guys give us an update on SoCal Edison with their AMI gas opportunity and anything that we should expect to see developments out of there?

Vic Richey

Yes, really nothing that you can’t see on the public filings and I think the plan is currently for them to get closer to a vendor selection sometime early summer. And then I think it goes for final approval in the fall. So, obviously, we don’t have anymore insight than what’s public information.

Stuart Bush – Capital Markets

Sure. But is it likely they would be able to make a vendor selection before it gets final approval?

Vic Richey

I would be surprised if they didn’t and the reason for that would be what they are going to have to do is with all of these large projects, you have people that come out and say, well, we want to make sure that the technology is going to work, we want to make sure you get the business case, we want to make sure that we are – that the consumers are going to be serviced well.

And so, as part of that process, I think that unless you can say to the – those people, well, here is a vendor that we had, here is the experience they have, here is where they have proven technology, here is where the payback has been received, then I think it’s going to be very difficult for them to have those kind of discussions.

I can’t say 100% that’s the way it’s going to be, but that’s typically what’s happened in the past. I mean, even if you look at some of the other large deployments, those decisions have been made and then the vendor themselves to kind of support and being joined in with those discussions that utility has whether it be the public utility commission or which it be some of the consumer advocacy groups.

Stuart Bush – Capital Markets

Okay. And if you can just lay out for us what projects for the AMI electric bids outside of PG&E you are currently working on and what proportion that makes up for your 2009 utility solutions segment?

Vic Richey

Yes, if you look at 2009, we are not pursuing – we don’t have anything in the forecast that we don’t already have in backlog other than the co-operatives.

Vic Richey

So, there are no large electric bids that we are counting on winning and delivering this year to make our forecast. It’s solely focused on the co-operatives.

Stuart Bush – Capital Markets

And so, that would be upside if anything did come in the tail end of the year?

Vic Richey

That’d be correct.

Stuart Bush – Capital Markets

Okay. Thanks a lot guys.

Vic Richey

Sure.

Operator

(Operator instructions) Our next question will come from Richard Baxter with Ardour Capital.

Richard Baxter – Ardour Capital

Yes. First question is Doble. What’s the – I guess the breakdown between like service and products?

Vic Richey

It’s almost exactly 50-50.

Richard Baxter – Ardour Capital

Okay. And then I guess for US and international?

Vic Richey

It’s probably 70% domestic – 75% domestic and the rest would be international.

Richard Baxter – Ardour Capital

Okay. And then I guess another question on the stimulus for the – and I guess the visibility into the sales cycle for the munis and co-ops, do you see them looking at the stimulus bill as accelerating an existing project, or just looking to accelerate – or like pull forward something they haven’t started yet?

Vic Richey

I think it’d be a mixture. I mean, most of the people that would be making decisions in the next 12 months are already actively looking at projects I would say. But I think it does give us another arrow in the quiver, if you will, as we go talk to people and say, hey, here is an opportunity where we may be able to get some of this and by the way, that money does run out at the end of 2010, at least that’s the current plan. So, people want to access that money, then that may require them to move a little faster than what they had anticipated in the past.

And it’s also important to remember that one area where we are really going to aggressively go after things is we have a very large deployment base, particularly with the co-ops and the munis and they are our additional products that we have to offer them that we feel they should be able to acquire under some of these stimulus grants rather than all of them just being brand new deployments. (inaudible) – find a new one.

Richard Baxter – Ardour Capital

Can you elaborate on what some of the new products and services –?

Vic Richey

Some of the things like the capacitors, bank switchers – switching units that we have, and probably the biggest one is the demand response unit that we have. Also some of the software products, most of our Aclara Software products have been historically sold to investor-owned utilities and maybe an opportunity there with the co-operatives as well.

Richard Baxter – Ardour Capital

Okay, great. Thank you.

Operator

That concludes today’s questions and I’d like to turn the call back over to Vic Richey.

Vic Richey

Okay. Well, I appreciate the interest – continued interest and good questions today. And we’ll talk to you next quarter.

Operator

That concludes today’s conference. Thank you for attending.

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Source: ESCO Technologies Inc. F2Q09 (Qtr End 03/31/09) Earnings Call Transcript
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