ESCO Technologies: Bound to Fall?

Jul.25.08 | About: ESCO Technologies (ESE)

ESCO Technologies, Inc. (NYSE:ESE) has three product lines.

The first is their communications segment [DCSI], which accounted for 37% of revenue in 2007, manufactures two-way power line communication systems, including meter modules and equipment for central stations and substations known as advanced Metering Instruments [AMI] and Advanced Meter Reading [AMR].  DCSI is considered by management and analysts to be Esco’s growth segment.

The second business segment is their filtration business [PTI], which accounts for 36% percent of revenue, declining over the past few years.  PTI is a supplier of filtration products serving the commercial aerospace, military aerospace and various industrial markets. The industrial markets include chemical processing, automotive and mobile equipment. Products include filter elements, assemblies, modules, indicators and other related components. 

ESE’s third business segment offers software and support services to the electric utility industry.  

Focusing on the communications segment, ESE employs a technology DCSI, which is over 40 years old.  As a result they transmit around 7 bits per second. Significantly less then that of larger competitors, Silver Spring, Landis & Gyr, Itron, Celnet, etc. Why is this significant, people who follow the company and the business know that bits per second define the effectiveness of the product.  For example Silver Spring Networks (SSN a private company) transmits roughly 100 kilobits a second and Itron is near 60 kilobits per second.  The more data per second the higher the probability of the device showing up on the utility’s network and be communicable (essentially the AMI device doing its job).  ESE has a competitive advantage in selling to utilities needing reading devices over a large geographic area.  Generally utilities have responded that they are looking for devices capable of transmitting data as fast as possible. 

In November 2005, DCSI entered into a contract to provide equipment, software and services to Pacific Gas & Electric [PG&E] in support of the electric portion of PG&E’s Advanced Metering Infrastructure [AMI] project. The contract value was initially expected to total approximately $310 million over a five-year period; however, during the third quarter of fiscal 2007, PG&E announced its plans to request proposals from a small group of vendors in order to evaluate such vendors’ ability to address potential future functionality requirements for the electric portion of its service territory currently included in DCSI’s contract. 

ESE currently has contracts to ship 188,000 RF electric modules to PG&E, which according to company guidance should all be shipped in FY08/ beginning of FY09. This totals roughly $12m in revenue. Less then 10% of the total contract, ($310m) discussed by management earlier. 

Management has focused investors on the company’s growth attributable to AMI/AMR product wins, especially that of PG&E.  Management made comments in May to the effect that they are well positioned to win the remaining PG&E contract. So if we take the announced wins – including “trial”/pilot program - ESE announced it was chosen to participate in an AMI pilot program at Baltimore Gas & Electric [BG&E], which is a 1.2m electric/gas end-point utility; plus the announced win of $68m NYC water AMI program (5 year project, deployment to begin late CY08); finally, an award by Idaho Power to complete deployment of 500k end-points – a $25m 3-yr contract to begin in CY09.  

In recent days, there has been a precipitous fall in ESE’s share price. Attendants at the summer meeting of the National Association of Regulatory Utility Commissions [NARUC] in Portland, OR complete channel checks.  The buzz, a couple of reports published if you have a Bloomberg terminal, is that Silver Spring Networks (SSN – a private company), has been awarded a contract to deploy 150,000 electric end-points at PG&E and that PG&E is going to award the remaining contract to Silver Spring – not ESE.  Why is this significant?  

It undermines management’s credibility, given their strong conference in the May press release relating to expectations of future PG&E awards.  Additionally ESE is trading at 14x EV/EBITDA and 2.7 EV/EBITDA.  Their use of free cash flow – indicates they may have to do an issuance to raise capital (pure speculation based on FCF analysis).   Yes, ESE is strong in providing services to small utilities; but orders can be lumpy, as such I can’t imagine analysts will continue to publicize strong growth for ’09 without the opportunity to win PG&E contracts justifying a 21x P/E multiple.   

Current bull analysts on the stock publish a price target between 45-48, based on 22-25x CY-09 EPS of 2.25 compared to a 14x-20x historical P/E trading rage, with peak P/Es of 22x-24x generated with larger AMI contract wins, or when interest in AMI is elevated. These estimates take into account the announced wins (by the way the announcement of the NY Water contract comes out to about $22m a year in revenue, which is less then 3% of total revenue.) 

When looking for shorts in this volatile market, I like to find leveraged companies, with high multiples, for which Wall Street analysts have set high expectations. If such companies have business segments with muted growth (and are not entering cycles of increased interest and capital flow), and diminished potential in the growing segment AMI, company should trade towards the lower end of its historic NTM P/E range.  

Given my assumptions on gross margin, and announced contract rollouts, I don’t see the company growing with the industry at 20x-25x.  The newly awarded $68m NYC water contract is meaningless to bottom line without the SSN award as it is awarded over 3 years and comes out to no more then 3% of revenue. As such I believe we could see a return to a 16-18 multiple in the near future, which would translate to a mid 30 stock price. 

Obviously if reports confirm that the possible PG&E revenue has indeed been lost, I’d expect continued pressure on future earnings potential for ESE. This is a decisively qualitative report and as such I would encourage everyone to work their own assumptions and dig deeper into the valuation and if unfamiliar with the company, you will need to learn about the differences in technologies.

Disclosure: Author holds a short position in ESE