Good day and welcome to the ESCO Q2 conference call. Today's call is being recorded. With us today are Vic Richey, Chairman and CEO, Gary Muenster, who is retiring as Vice President and CFO, and Chris Tucker, Senior Vice President and CFO. And now, to present the forward-looking statement, I would 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 timing of recovery and growth of our end markets, the amounts and timing of 2021 and beyond revenues, COVID impacts and recovery expected as a result of the COVID vaccine, recovery in commercial aerospace, adjusted EPS, adjusted EBITDA, cash, shareholder value, the timing of Block V deliveries, success in completing additional acquisitions, and other statements which are not strictly historical are forward-looking statements within the meaning of the safe harbor provisions of the Federal Securities Laws.
These statements are based on current expectations and assumptions, and actual results may differ materially from those projected in the forward-looking statements due to risks and uncertainties that exist in the company's operations and business environment, including but not limited to the risk factors referenced in the company's press release issued today, which will be included as an exhibit to the company's Form 8-K to be filed. We undertake no duty to update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise. In addition, during 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. As you saw in the press release, we do have some management changes here which we've been working on for some time. So you'll be hearing from Chris in a few minutes. In addition to that, we've got David Schatz here with us who recently replaced Alyson as our General Counsel. So before we get into the details of the quarter, I'd like to start off by introducing and welcoming Chris Tucker, who joined us a few weeks ago as a newest member of our executive management team. Chris will be serving as Senior Vice President and Chief Financial Officer, replacing Gary, who previously announced his retirement. Chris comes to us from Emerson, where he served in numerous financial leadership roles with increasing responsibilities over the years. He also led their Investor Relations Group for several years.
I'll turn it over to Chris to give you a little more background on his experience. Chris?
Hello everyone, and thanks, Vic, for the introduction. It's great to join all of you today. I just wanted to take a minute and give a brief introduction of myself before we jump into details of the Q2 performance. A lot of this was covered in the press release announcing my hiring, but I'll provide a little more color here on the phone. As you know, I'm joining ESCO from Emerson, where I spent the last 24 years of my career. Emerson's a great company, and I had a great experience there. I started off in the corporate accounting and finance team back in 1997 and finished up as the Group CFO for one of their two business platforms. And of course, there were several important stops in between those two bookends.
During my time there, I had a chance to work on a variety of operational issues, business development opportunities, and overall value creation strategies. I also led the investor relations effort for a few years during my tenure there, which was a good bit of training for calls like we're doing right now. My prior experiences have put me in a strong position as I transition to this new role. I'm very excited to be part of Vic's team here at ESCO. Gary has been extremely helpful as we've worked together over the last few weeks, and everyone, from the corporate staff to the board of directors, has been collaborative and great to work with. ESCO is really a great company and has a lot of exciting initiatives going on really across all the businesses.
I'm excited to be here and start building on Gary's legacy of strong financial leadership as we move into the future. With that, I'll turn it back over to Vic and Gary for a more detailed discussion of Q2 and the rest of the year.
Thanks, Chris, and welcome aboard. We look forward to working with you. I'd be remiss if I didn't mention today's COVID environment and how we continue managing around its impact on our aerospace and utility businesses. I think our results demonstrate we're succeeding. Since the beginning of the pandemic, our primary goal has remained the same: provide a safe working environment and protect the health of our employees. And today, we're really encouraging our staff to get fully vaccinated for the benefit of all. Our solid operating results in Q2 and for the first six months of the year, coupled with our increasing liquidity, demonstrate that the measures we've taken over the past 12 months have significantly mitigated COVID's impact on our earnings, and I believe will allow us to continue successfully navigating through this challenge.
Our previous cost reduction actions, along with our enhanced focus on operational efficiency, will benefit ESCO going forward as things continue to move toward a more normal state. I'm confident our disciplined approach to operating the business will result in continued success throughout the balance of the year. While Gary will provide the financial details, I'll offer some top-level commentary to set the tone. While our Q2 and year-to-date A&D sales were significantly lower than prior year due to COVID's impact on commercial aerospace, our portfolio diversity allowed us to mitigate this headwind as we were able to hold our ESCO consolidated Adjusted EBITDA constant at $31 million in Q2 compared to the pre-COVID Q2 results from last year. Additionally, we were able to increase our fiscal 2021 year-to-date Adjusted EBITDA and Adjusted EPS from a prior year despite a 6% decrease in sales.
This improvement was delivered by solid contributions from our other operating units and as a result of favorable sales mix and meaningful cost reductions across the company. From the segment level, there are several positives to report. Within A&D, we're seeing signs of recovery in commercial aerospace as passenger boardings continue to increase and more airlines are adding idle aircraft back into service. Our Navy and Space businesses remain strong and well-funded, and our outlook for near-term growth opportunities continue to materialize in both of these areas. Our Test business continues to outperform as we saw sales growth in both Q2 and year-to-date, with increasing margins as our project execution remains solid. We expect Test outlooks to remain positive, driven by the strength of its served markets, including 5G.
Our USG business, while reporting a softer Q2 than originally projected, reported a solid first half of the year from both the sales and adjusted EBIT perspective. USG delivered an adjusted EBITDA margin of 26% for the first six months of the year, up from approximately 22% in the prior year's first half. This is a result of year-end spending captured in our first quarter, along with our lower cost base. Overall, the fundamentals of our portfolio remain strong, and our goal remains the same: to create long-term shareholder value. Now I'll turn it over to Gary.
Thanks, Vic. I'll briefly touch on the financial results laid out in the press release. As we continue navigating through what we hope is the near end of COVID, our number one financial priority remains the same: increasing and maximizing our liquidity to position us for future M&A growth and increased investment in new products and solutions. We have a rock-solid balance sheet today, and we are poised to use it to our advantage. I'll highlight the significant cash we've generated this year, as we've set a record for cash flow during the first half, which is the highest in our history. We delivered free cash flow conversion at 134% of net earnings for the first six months. Clearly, our working capital initiatives are producing solid results.
Today, we have approximately $760 million of liquidity at our disposal between cash on hand and available credit capacity, while carrying a modest leverage ratio of 0.23. We fully realize that while this is a positive metric, it is not the ideal capital structure given the historically low cost of debt. With that said, we are committed to putting our balance sheet to work. One of our primary objectives in the near term is to add leverage to fund acquisitions, with our focus directed at bringing on new businesses that provide an ROIC well in excess of our cost of capital, as we believe this return spread is a cornerstone of value creation.
In the release, we called out a couple of discrete items, which are described in detail and are excluded from the calculation of Adjusted EBITDA and Adjusted EPS in both years presented, so I will not repeat them here. I'll now touch on a few comparative highlights noted in the release. We beat the consensus estimate of $0.55 as we reported Q2 Adjusted EPS of $0.59 a share. This compares to $0.68 a share in the prior year Q2. Considering Q2 of this year was influenced by the COVID operating environment, I'm pleased to report that we delivered Adjusted EBITDA of $31 million in the current period, which is equal to the $31 million we reported last year in Q2 pre-COVID. More impressively, this was achieved despite the noted sales decline in Q2 that Vic mentioned earlier.
Our Q2 adjusted EBITDA margin increased to 19% from 17% last year. Year-to-date, our adjusted EBITDA increased to over $60 million with an 18% margin, up from 17% prior year-to-date. Over the past year, we took several cost reduction actions across the company, and as a result, we were able to increase our Q2 and year-to-date gross margins to 38.1% and 38.7%, respectively. We reduced our Q2 and year-to-date SG&A spending by 3% in both Q2 and year-to-date periods compared to prior year. These favorable outcomes were achieved despite including the acquisition of ATM in October, which is not yet at full operating capacity during its transition to Chris' era. It was done despite our continued spending on R&D and new product development.
Amortization of intangibles and interest expense both decreased, while tax expense as a percent of pre-tax income increased in Q2 and the first half as we had several large tax strategies implemented last year, which benefited the 2020 comparative rates but were not repeated in the current year. Q2 orders were solid as we booked $176 million in new business and ended the quarter with a backlog of $522 million with a book-to-bill of 106%. A bright spot worth mentioning was the order volumes recorded in our commercial aerospace businesses, which grew their backlog $7 million during the quarter.
As we move through the balance of the year, I'll remind you that our DoD businesses, led by our participation on the Block 5 contract for additional Virginia-class submarines, where we booked several large orders during fiscal 2020, will be delivering products against those orders, which are multi-year programs, which will mathematically reduce the optics of our book-to-bill. Consistent with our November communications and from a directional perspective, we can point to several areas where we see positive momentum. Our commercial aerospace and utility end markets are showing some degree of customer stabilization, which supports our current outlook, suggesting a movement towards continued recovery in the second half of fiscal 2021. The increasing distribution of the COVID-19 vaccine is anticipated to benefit and accelerate the recovery of commercial air travel and utility spending, with customers resuming more normal buying patterns.
While we solidly beat Q2 and are ahead of our original plan at the halfway point, we still expect the second half of 2021 to be slightly favorable in comparison to the second half of fiscal 2020, given the various elements of recovery that we are anticipating. We expect to show growth in fiscal 2021 Adjusted EBITDA, Adjusted EPS, as compared to fiscal 2020, with an Adjusted EBITDA reasonably consistent with that which was reported in 2019. If we complete any additional acquisitions during the year, it is expected that these would contribute to the expectations I just mentioned. Now I'll turn it back over to Vic.
Since I touched on quite a few of my thoughts earlier in my commentary, I'll offer a few qualitative comments about our end markets and our expectations for the balance of the year. Starting with our A&D segment, as I mentioned, we're seeing some signs of modest recovery in commercial aerospace, but we expect continued softness over the next three months. We're starting to see stabilization in the OEM build rates and increase in airline passenger traffic and flight miles. Just as we saw in Q1, the defense portion of our A&D business is and will remain strong for the foreseeable future, given our backlog and platform positions.
We also see the current situation in the aerospace market as an opportunity for ESCO, as we've been made aware of some situations where other suppliers or competitors are not fulfilling their customer requirements, and those customers have reached out to us to see if we can step in and satisfy their demands. Our test business delivered another really solid quarter by beating our internal expectations and delivering an EBIT margin of 13%. Test outlook remains solid, given the diversity of its served markets. As I noted on a previous call, when USG had a really strong first quarter, we expected USG sales to be down in Q2 before returning to more normal levels in the second half of the year, and that's what we've seen. But the positive is increased margin contribution USG delivered in Q2 and year-to-date compared to prior year.
As the COVID vaccine gets more widely distributed throughout the utility service personnel, we expect the USG market to come back online more quickly as they can relax some of today's social distancing guidelines, and the utility service personnel can return to their normal site-visit routines. We recently visited with our USG management teams, and I remain pleased with the enthusiasm surrounding their new products and solutions. We continue to see NRG's end markets improving as new investments in renewable energy are increasing in both wind and solar. Our solar revenues have been growing far better than anticipated, and we expect that trend to continue. Moving on to M&A, we continue to evaluate several opportunities, and we expect to take action on these opportunities to grow our businesses as we have in the past.
Our board is extremely supportive of our M&A strategy, and our current balance sheet provides us with plenty of liquidity to allow us to add to our existing business. To wrap up, we delivered a solid second half and first quarter from both a cash flow and earnings standpoint. As we move through the second half of our fiscal 2021, our plan is to continue to focus on the fundamentals and look for opportunities to leverage our existing cost structure through M&A to create additional operating efficiencies and ensure we're well-positioned for long-term success. With that, I'll be happy to take any questions.
At this time, I would like to remind everyone, in order to ask a question, "please press star one" on your telephone's keypad. Again, to ask a question, "please press star one" on your telephone's keypad. First question coming from the line of Tom Moll with Stephens. Your line is open.
Good afternoon, and thanks for taking my questions.
[audio distortion] Hey Tom.
Vic, I wanted to start on A&D. Sounds like you exceeded your internal expectations this quarter on the top and bottom lines. Any context you could give us there about what came in better than expected? Then a related follow-on. As you look ahead, it sounds like there may be some structural benefit to your margins after some of the cost out last year. At the same time, as the end markets recover, presumably there would be some OpEx you'd look to layer back in. What kind of incrementals should we be thinking about, or what's the approach as you balance those competing considerations? Thank you.
Sure. So on your first question, as far as what we saw in the A&D, I see a couple of things. The non-commercial aerospace part of our business, the space, the Navy, and the small amount of commercial aviation or I'm sorry, of defense aviation we have all were a little better than what we anticipated. In addition to that, while the commercial aerospace is still a bit behind schedule and it is recovering, but we were able to get a good bit of non-recurrent engineering from customers for some new product development. So that really helped as a result because it's not something we had initially anticipated getting this quarter and this first half of the year. So I would say those are the major things that we saw to the upside. As far as your second question, certainly, you saw the leverage.
I mean, particularly USG, where our sales were down, our margins were up pretty significantly. And that's really just a matter of the cost that we took out really across the business in the second half of the year. And so what we have to do I mean, when the business starts to grow again, obviously, we're going to have to add some folks. But I do think we've kind of reset the bar on the cost structure, and we're going to be very, very diligent about adding any cost back. And I think we will be able to, as a result of that, be able to have better margins than what we've seen in the past in some of these businesses.
Thank you, Vic. That's all helpful. Just as a follow-up, I wanted to talk about balance sheet and M&A. It sounds like optimizing your capital structure and acquisitions are two sides of the same coin. So if we fast-forward to a natural comfort zone or an optimized balance sheet in your mind, where are the brackets around where you're comfortable with leverage? And if you think about that without putting an exact time frame around it, but just the most likely scenario to get from point A to point B, is that probably one larger acquisition? Should we think about it a longer-dated time horizon with multiple deals? Any context you could give us there, and any more context on the pipeline, just how active it is. Buy-sell expectations would be helpful as well. Thank you.
Sure. So obviously, we can handle a good bit of that now. We're not going to go out and do it too quickly or too large of acquisitions. I mean, typically, where we've been successful is larger acquisitions somewhere between $20 million and $100 million, $150 million, something like that purchase price. And so we'd expect that's what we'll continue to do. There are some opportunities out there that are bigger. I mean, I think we would have to pick our hard look at those as well. But I think we've been pretty successful in integrating smaller, middle-sized businesses into our portfolio. Pipeline's really strong. I mean, I'm surprised. Seems like we're getting a new book every couple of days or at least once a week. And so there's a lot of activity out there. I think everybody's aware. It's a very competitive market right now.
So we work hard to try to get into areas before there's an auction, before there's an auction with a lot of strategics, at least. But the amount of money out there is pretty amazing right now. And so I had thought going into the pandemic that maybe the multiples would be coming down. And unfortunately, that's not what's happened. And so I think we have to be realistic about what we're going to do as we add to the business. We'll probably look in a lot harder at returns now than maybe the multiples that we're paying because that's what I think really makes the most sense at the end of the day. I'm looking for opportunities where we can really see some synergies in the businesses that we acquire.
And tell me this, Gary. Let me add something to that because the philosophy is not going to change with me going away and Chris coming on. But the first part of your question on the comfort level, one thing we do for the board, as Vic mentioned, they're very supportive. And I think I might have mentioned it to you when we spoke after Q1, is we kind of keep a mathematical profile in front of them. And just being this under-leveraged today, we just had board meetings last week. And if we were to spend roughly $250 million and bring along 25 million of EBITDA, it would be a 10x EBITDA multiple. That would only put us at 1.5x leverage.
To carry that math exercise a step forward, if Vic's posts were 2.5, we could spend another $230 million, which together says we could spend $450 million at a 10x multiple and only be levered up to 2.5, which I think from an ideal capital structure is not something that would be uncomfortable. I'm not implying that's what we have in the pipeline, but just to put some posts around how this math carries forward, it'd be ideal if we could find $450 million to spend and bring along $45 million of EBITDA. But really, just calibrating 2.5 is something that would be extraordinarily comfortable for a company of our size.
Thank you both. All very helpful, and I will turn it back.
And again, ladies and gentlemen, please feel free to "press star one" if you have questions. Next question will be coming from the line of Jon Tanwanteng with CJS Securities. Your line is open.
Yes. Hi. It's Pete Lucas for John. You answered a lot of the questions previously. Just wondered if you could kind of talk about how you look at potential infrastructure bill? All seems like would be positive for you, but just wondering any specifics in there that you guys are focused on?
Yeah. I mean, we get that question a lot. It's so ill-defined right now, it's hard to say. I don't think there's any downside to us, that's for sure. I do think that some of the things will be going into renewable energy, some of the things will be going into the grid. Those kind of things, I think, should have the potential to be very helpful to us. But it is pretty ill-defined. It's probably the biggest area where we would see a positive impact. I mean, the other thing I think that we look at a lot is what the defense budget is, right? I mean, a good bit of our business style is A&D, and it looks like that's holding up pretty well. And as we've talked about before, I mean, we really think more about it in the areas where we participate.
So we're looking at the naval side of it, particularly submarines, which is where the vast majority of our or much of our product goes. And that's really rock solid. And I don't anticipate that changing at all. And then the other thing, obviously, we look at from a budget perspective is NASA. We have a great position on the SLS program, and that appears to be very solid as well. So I think the infrastructure bill gets a lot of attention as it should. I think that will be helpful to us. But as we look at it, those other two budgets, in many ways, are just as important to us.
Great. Last one from me. As far as the test business, a competitor of yours was recently sold. Just wondering if that's changed the competitive environment at all or anything special you're seeing there.
No. The reality is we didn't compete with them a lot because they're really very focused on aerospace and defense. We do some of that. But I'd say that that's a business that's a bit different than ours. We do some work with them. In fact, we're doing some work with them now, and that will continue. They work more on the sensor side. I think we have a good bit more of a footprint on the chamber side and on the absorber side. And that's a place where we have teamed historically, and we hope to continue doing that going forward.
Very helpful. Thank you.
Bye.
Next question will be coming from the line of John Franzreb with Sidoti. Your line is open.
Good afternoon, guys. Just to follow up on the test segment, you talked about it turning to more normalized level. Are we talking about normalized level pre-COVID or normalized level in line with what you're doing in the second half of fiscal 2020?
I'm a little confused because, I mean, are you talking about the test business or the aerospace business?
The test business.
The test business has been pretty solid. I mean, I think year-over-year, we're within $2 million. I think we're up $2 million thus far this year over last year. So the margin's higher. And the margin's higher, for sure. So I mean, if you look at the three segments, the test business has been the one that's been least impacted by COVID thus far.
What's driving the margin improvement in test, Vic?
I'd say the big thing is project execution. We have some in the mix. I mean, we've been getting more EMP filters and more components. But I'd say the biggest and those carry a higher margin than the underlying chamber business. So it's that, and it's just project execution. I think just the overall process that they go through in the execution on the large projects has improved over the past several years.
Okay. In USG, you said that the opening up post-COVID restrictions will be beneficial to the business. Are you starting to see any kind of pickup in order activity, be it the spring-related turnaround season or any kind of activity that backs up that thesis?
Yeah. I'd say the activity level certainly has picked up, I think, for a couple of reasons. They're kind of entering the test season now, if you will, and so that's when they typically start buying things. And then just people getting back to work. I mean, the issue is, I'd say, most utilities have historically been doing more work from home than a lot of other end markets. And so as they're getting back into the office, that's really helped that activity as well.
Okay. And just regarding.
[crosstalk]. Go ahead
Sorry to interrupt. Just to supplement what Vic said. If you look at the Q2 order profile in the back of the release there, you'll see that the order book is up about 10% in Q2. So that's a precursor to the conversation that Vic just alluded to, which is evidence that the momentum's starting there. Because it's generally a quick-turn business. The backlog, it's not uncommon to get an order on Monday and ship it on Tuesday. So seeing that growth in Q2 is certainly beneficial.
Excellent. Thank you, Gary. And just one last question. You kind of alluded to it, I think, in response to another question about costs coming back. How much staffing do you think you still need to add this year, and in which segments do you think the most staffing will be bringing back?
So I would say the areas where we'd probably be adding some folks and we're not talking large numbers, like I said. I think the people have done a good job of managing this, but as some of the programs ramp up, particularly on the Navy side, there's some specific people we need to add there. We're always looking to improve our engineering workforce or add to our engineering workforce. And so as things return to normal and we're able to afford more of that, I'm sure we'll be adding some folks in the technical areas as well.
Okay. But that's not going to be a large number, you're saying, overall?
No. I don't think so. I mean, I think if you look at sheer numbers, what we'll see as sales pick up on the commercial aerospace side, we're going to have to add some direct labor people. But obviously, that funds itself. We wouldn't be adding those folks unless we had to work for them formally.
Okay. Thank you very much. I appreciate you taking my questions.
Thanks, John.
And again, if you wish to ask a question, "please press star one" on your telephone's keypad.
Okay. So I think we're done. So I'm going to end the call by saying thanks to Gary and Allison for their long-term support of our value-creating mission here at ESCO and for their passion and commitment to the company. They're both going to be missed, but we're fortunate to have Chris and Dave to step in and help lead the company to continued success. So thanks to everybody, and I look forward to talking to you in the next call.
This concludes today's ESCO Q2 conference call. Thank you, everyone, for your participation. You may now disconnect.