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 or forward-looking statements within the meaning of the safe harbor provisions of the Federal Securities Law. 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 this 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'll 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 standalone 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 challenges 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, and 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 excluding defined contributions, which allowed us to pay down debt to a point where our leverage ratio is well below 2 x. In addition to the financial results, we took a number of actions to further cut costs and enhance our competitiveness.
In fiscal year 2017, we made some fairly significant moves in our Test segment, which bore fruit in 2018. In 2018, for USG, we worked to leverage our excellent distribution network at Doble, which allowed us to shut down four small international offices and right-size our workforce in Watertown. Additionally, we began the move of VACCO's aircraft product business to consolidate it into operations at PTI. This allows us to better utilize available space that we own in Oxnard and reduce our rented space in South El Monte. The aircraft products are also better aligned with the core PTI business and should enhance our ability to accelerate growth in that product line. Continuing in this vein, we have announced our intention to reduce the European footprint of our packaging business.
We'll be shutting down our headquarters facility in Tunbridge Wells and relocating these activities to our existing plants in Nottingham and Poland. The majority of the costs associated with this action will hit our first half of 2019. In addition to a reduction in cost, we think by operating from two facilities, some level of enhanced productivity will be achieved. So before I turn it over to Gary, I'll wrap up by saying we had a very solid year of financial performance and taken a number of proactive steps to enhance our cost competitiveness, which I believe should accelerate our future growth.
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-$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 nine 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 quarter on record.
Comparing Q4 2018 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 in 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 they delivered a 26% EBIT margin, which increased significantly over Q4 2017's EBIT margin of 22%, and this was led by the strength of our commercial aerospace and navy businesses. Test increased sales 16%, which resulted in a 17% EBIT margin on this volume and with a favorable sales mix. The 17% margin also reflects the lower cost structure and operational improvements that we implemented over at Test over the past two years, as Vic mentioned. Within USG, sales increased 7% as Doble and Morgan Schaffer sales increased significantly, while NRG sales into the renewable market declined compared to Q4 of 2017. The group's Adjusted EBIT margin was 29% compared to 23% in Q4 of 2017, with the margin contribution following the related sales delta, as I mentioned.
As noted in the release, we also took some additional cost actions within USG to improve operational efficiency, and we've excluded these when calculating our adjusted amounts. Additionally, and as noted in the release, subsequent to fiscal year-end, we sold Doble's headquarters campus to a developer for $17.5 million cash, and later in fiscal 2019, we will be relocating to a more cost-efficient building in Marlborough, Massachusetts, where we will consolidate our two operations into one facility. The building sale resulted in a pretax gain of approximately $7 million, which we will recognize in Q1. So for a final comment on the year, I'm also really pleased with our cash flow from operating activities for the year. As this created a reasonably low level of debt and coupled with our remaining credit capacity and available liquidity, this has us well positioned to effectively execute on our M&A strategy.
So in closing, before I pass over to Vic, I'll be happy to address any questions when we get to the Q&A.
Thanks, Gary. I want to provide a backdrop for our 2019 forecast. As you saw in the release, our operational forecast has us growing top line approximately 5%, EPS growing 7%-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 2018 versus our projected rate of 24% in fiscal 2019. This rate differential resulted in approximately $0.07 a share of EPS headwind in 2019. 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 sell our Doble facility in Watertown and relocate outside of the 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 a lower cost of living. The new facility will be purpose-built for Doble, which should lower our operating costs, 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 2019 numbers and assist us as we move into 2020 and beyond. So in closing, our focus remains constant to continue to improve our operational performance and to execute on our growth opportunities both organically and through acquisitions, therefore enhancing shareholder value. We'll be glad to answer any questions you have now.
Ladies and gentlemen, if you have a question at this time, please press the star and then the number one key on your telephone keypad. If your question has been answered or you wish to remove yourself from the queue, please press the pound key. To prevent any background noise, we ask that you please place your line on mute once your question has been stated. 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. 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. Well, I think we're seeing some decent growth really across the business. We are projecting growth that I'd say is obviously above GDP and above what we're seeing from our industrial competitors, but there are challenges, obviously. The Fluid Flow 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, I would say just the pickup rate that we anticipate is not quite as strong as we thought it would be. I think that'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 involved in the short term than maybe we thought.
The longer term, it's a great place to be, and we continue to look for opportunities in the renewable space to add to that. The packaging business, we're going through that restructure, and I think that'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 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. Unfortunately, we're not depending on another big project to make our numbers for 2019. They're really looking at a lot of smaller $1 million-$3 million projects, which, quite honestly, usually work out better for us in any case because we have a lot less pass-through content in those smaller projects.
Again, as I mentioned in my comments, all the growth that we're seeing next year is organic. If we are able to accelerate some of that or make an acquisition, then that would 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 and we toured the aerospace facilities and the impressive nature of the automation and what it's done for efficiency in 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 2018 at Mayday to expand their capacity as well as improve their efficiency around the labor pool. So Vic's comments are all supportive of the sales side, and I just want 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, and we have some additional ones in place now that'll benefit 2019.
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?
Yeah. I mean, each of our operational units, not just within the segment but within the operating units as subsets of the segment, we'll see margin percentages increasing, in some cases nominally, like in an NRG, because 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 and automation and that sort of thing. And then we will have a little bit of disruption for a couple of months while we move the aircraft business from VACCO to 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 2019 compared to 2018.
Yeah. And I'd say one other area where it's a little unclear today, and of course, as you know, we're always a little bit conservative about these things because we want to see them play out, but for some of the acquisitions we made that were added to Doble, as we get those more and more into their 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. But if you look at a couple of those acquisitions, we've significantly improved their profitability, and they were already a pretty profitable business. So I think getting inside a larger corporation with a little more knowledge on automations and 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 that 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've 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 it augments the portfolio. Thanks so much, folks.
Sure. So the M&A is always very difficult to predict, as you know, and obviously, the fourth quarter or our first quarter, the fourth fiscal quarters, is typically pretty light because it's a lot of holidays and people typically aren't taking a lot of activity, although we are seeing some things that are at least going to start to come into 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. At this point, we weren't able to close on anything, and it's primarily because some of the multiples have just 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 properly owned business that's really looking to make sure that they go to the right type of partner or acquirer, and then we're able to get in there before they go to auction. Having said that, we have won some at auction as well, but there's a lot of activity there. I'd say we'll probably pick up more so after the first of the year, but we'll remain aggressive there. And as you know, our operating folks are not shy about pursuing these types 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. Great quarter, guys. Congratulations.
Thanks, Jon.
You're moving a lot of facilities at once. Can you quantify the headwinds from an operational standpoint as they're implemented? How much risk cushion have you given yourself? And on the flip side, how much savings are you counting towards in 2019 in your guidance?
So I'll let you answer that last half up because I'm kind of drawing a blank there, but we always put a contingency in place when we're 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 the bad, and we've done a lot of it. I think the folks that have really done a very good job of understanding what needs to be done. We have people that we've started deploying that really help us with this activity. They're internal people that have been through it before so that we're not kind of relearning how to do this every time. So my confidence level on 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 I would say every one of them has come in either on budget or under budget and on time. I don't anticipate any significant problems here. To the extent that we have any issues, I think we've got contingency to cover that.
Yeah. And Jon, on the dollar side of it, the way we look at it is we have a very rigorous or diligent process in how we time phase these things, so I'll just address each one. For instance, on the Doble sale, we sold that the first week of October. The process is underway. 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 2019 fiscal year continuum. And so we baked in obviously, there's 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 to answer the cost savings, you're not going to see a whole lot of cost savings in 2019 because that process will probably take the majority of the year, but in 2020, you will see a meaningful improvement by being out of an outdated, very expensive facility to maintain and that sort of thing into, as Vic said, a very specifically well-built building that we'll be renting. So I'd say 2020 is the best way to think about that. On the packaging side in Europe, as everyone knows who has had to, unfortunately, do some of these things where you're moving people, the time frame of the European severance programs and garden leave 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.
As we said in the release, we'll be spending about $1.5 million-$2 million. The payback is greater than that when you get into the facility. The payback is about a year to a year and a quarter. And then when you get to the things that we're doing with the VACCO aircraft move, obviously, when you're dealing with a sensitive customer like that, you have to have all the approvals in place and all that, which we're in the process of getting. But because that size of the revenue is about $9 million or $10 million that'll be moving, and so to make sure we don't break the supply chain, we will build ahead, and so we will build some advanced inventory.
So physically, the move will only take a couple of days, but the preparations for the move will take 60-90 kind of days. So I think in the second half of 2019, you'll see the benefit coming out of the Filtration group by that geography move in there. So I think we've done a really good job of capturing the delay and disruption costs across those three platforms, but I would really think of it more beneficial as the impact it's going to have in fiscal 2020 when it's kind of "clean" as you go across because that's really how we look at it. We do an ROIC on every one of these things, and we make sure that the payback's reasonable and we're doing it for the right reasons.
And then we're not going to talk about 2020 at this point, but I think as we get to that point, you'll see meaningful margin improvements there.
Okay. Do you have a dollar amount for a run rate? Do you plan to save it all, or is that to be determined and shown later?
Well, I'll just say it this way 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. 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 from me. The cadence of the quarters as you head into 2019, any large projects that are hitting in any certain quarters, how should we expect that all to play out as we go through the year?
Yeah. 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, 2018, that we just wrapped up was, I would say, extraordinary to have the profile that we had. We knew that at the beginning of the year, but going in, we certainly we understand some of those, Vic mentioned his prepared remarks, some of the concern the shareholders had relative to the way that stair step looked. So the good part of fiscal 2019 is, well, it's still back half weighted. It's not of the nature that it was in 2018. So to just put numbers around it, we were about 30% of our $277 happened in the first half and 70% hit in the back half.
We're about, I'd say, would be a lot closer to 40%-60% versus the 30%-70%. So it's still back half weighted, but the stair stepping is not as steep, if that makes sense. So if you were to think of 38%-40% of our pick whatever your midpoint is going to be on our guidance, and if you were to say 38%-40% in the first half versus 30% in first half of 2018, you'd be pretty squared up.
Okay. Great. Thank you.
You bet.
Ladies and gentlemen, as a reminder, if you have a question at this time, please press the star and then the number one key on your telephone keypad. If your question has been answered or you wish to remove yourself from the queue, please press the pound key. To prevent any background noise, we ask that you please place your line on mute once your question has been stated. 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 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 on 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 have 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 of advice to our customers.
From an 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 bullseye 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 valuation. So I'm just giving you a range. It might be something like 10x or 11x EBITDA. As you get into the second ring of that, it's a little less because what drives those circles is the accretion that supports our required ROI.
So we will stretch if you get to the center of the bullseye, but that's kind of how we look at capital allocation. We're really not going to raise our dividend, at least 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'll turn to Vic, how he thinks about that bullseye chart and what we're willing to spend.
Yeah. No, I mean, I think that the valuation really comes down to the company. While we have some organizations that we really focus on their comps where it's business we really have to have, and we'll pay up for that. If there are businesses that we think could be additive that aren't as center of the fairway, as Gary says, then that's not something that maybe we'll 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 organic growth that we have or projected for this year, at least. We understand that's not where we want to be as a company, so we need to do one of two things.
We need to grow fast organically, and we spend a lot of time 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're really going to have a balanced portfolio. Often, when it comes to acquisitions, it's really driven by what's available. That's one reason we don't set firm targets on organic versus acquisition because we want to do what makes sense with what's presented to us at the 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-based to smaller, I guess you mentioned $1 million-$3 million projects, 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 we go into this year, we do have a really pretty solid backlog in Test, and everything's pretty equivalent to what it was last year. And so we're not requiring to get those big projects to make it happen. But as we kind of look at how we project that business, we kind of stratify because we've got the medical business, which runs at kind of a certain level historically, and we can project that pretty closely. Components are another piece of it. We've got acoustics business, which is another piece of it. And then what I would call kind of the smaller chambers, which we have pretty good insight into that. So then you are really left with a relatively small percentage of the 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 in years past. So while we have burned off a couple of big projects, fortunately, we've 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. And 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's some things that we have to book and ship. We'll get some aircraft orders in February that'll 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 2018 and how we started 2017.
Going into the year with about 50%, roughly, of your expected sales ready in backlog and the conversion cycle we see gives us comfort in the ability to put our sales increase numbers out there.
Great. Thank you, Vic, and thank you, Gary.
Thank you very much.
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 answers, and I look forward to talking to you on 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.