ESCO Technologies Inc. (ESE) Earnings Call Transcript

Welcome to the ESCO Technologies' Signature Management & Power Acquisition Conference Call. With us today are Bryan Sayler, President and CEO; Chris Tucker, Senior Vice President and CFO. And now to present the forward-looking statement, I will turn the call over to Kate Lowrey, Vice President of Investor Relations.

Thank you. Statements made in this release regarding future growth, growth strategy, expectations, beliefs and benefits resulting from the acquisition and other statements which are not strictly historical are considered forward-looking statements within the meaning of the safe harbor provisions of the federal securities laws. There is no assurance that the acquisition will be consummated and there are a number of risks and uncertainties that could cause actual results to differ materially from the forward-looking statements made herein. The risks and uncertainties in connection with such forward-looking statements related to the acquisition include but are not limited to, the ability and timing to consummate the acquisition, including obtaining the required regulatory approvals and financing to fund the acquisition, ESCO's ability to promptly and effectively integrate the business after the acquisition has closed and ESCO's ability to obtain expected cost savings and synergies of the acquisition, operating costs, customer loss and business disruption, including difficulties maintaining relationships with the employees, customers or suppliers of the acquired business that may be greater than expected following the confirmation of the acquisition and other risks and uncertainties described in Item 1A, Risk Factors of ESCO's annual report on Form 10-K for the year ended September 30, 2023. Now I'll turn the call over to Bryan.

Thanks, Kate and thanks, everyone, for joining today's call. We're here today to discuss ESCO's planned acquisition of Signature Management & Power, which is a subsidiary of Ultra Maritime. We will be working from a set of call charts, which are available on the Investor tab of our website. Before we begin, I'd like to thank the large team of people on both sides of the transaction who have been working diligently throughout this process. Through an intensive process of diligence and discovery, ESCO and our Board of Directors have come to the conclusion that this transaction meets all of our stated M&A goals and will meaningfully advance our strategy to increase shareholder value by delivering highly engineered solutions in rapidly growing end markets. To the management, employees of Ultra Maritime, Signature Management & Power, we look forward to you joining our team of more than 3,000 employees who are dedicated to accomplishing our common mission to make the world more reliable, safe and secure. We'll get started on Slide #3. Adding SM&P to the ESCO portfolio extends our capabilities to support the Navy's mission to protect its ships from a wide range of threats while at sea. SM&P is the leading provider of signature power and management solutions for submarines and surface ships for the U.S. and U.K. naval defense markets. They bring a number of key technologies and intellectual property, which are essential to safely managing onboard power, while minimizing the risk of detection by acoustic, magnetic and electrical field sensors. The business includes both OEM and aftermarket solutions across a wide range of naval defense applications. SM&P has a long history as a supplier to shipbuilders in both the U.S. and U.K. for many decades and has a strong track record of revenue growth with an attractive margin profile and it provides ESCO with additional exposure to a rapidly growing end market. Let's go to Slide #4 and talk about the deal metrics. We're paying a total of USD 550 million for the business, which includes tax benefits worth approximately $30 million to ESCO. On an adjusted basis, the transaction will represent a multiple of approximately 11x the calendar year 2024 expected EBITDA for the business. The transaction is subject to regulatory approval in both the U.S. and the U.K. We do not expect there to be any major challenges to approval and anticipate a closing date in the first quarter of our fiscal 2025, which begins in October. We are paying for the deal in cash and have committed financing already in place. This will increase our leverage ratio to approximately 3x EBITDA at closing but we have a clear path to reducing that leverage to approximately 2x by the end of fiscal 2025 through the application of operating cash flows from the combined business. This deal is the result of the ESCO strategic planning process that we have discussed with you in the past. It continues our shift towards high-growth end markets by adding complementary technologies and capabilities, which align with our existing customers' stated mission focus areas. We expect the acquisition to be accretive to revenue growth, adjusted EBITDA margins and earnings, excluding onetime acquisition costs and related amortization. Let's go to Slide 5 and talk a little bit more about the business. As we mentioned, SM&P is focused on technical solutions for the U.S. and U.K. naval defense markets and has existing content on nearly every operational platform. These systems are designed in from the conception of the ship and do require maintenance throughout the life cycle. At the bottom of the slide, you can see some of the breakdowns. The business is 90% sole source due to SM&P's unique capabilities and IP portfolio. There are some technical applications that benefit the broader defense industry but 85% of the business is focused on Navy applications. There is a strong aftermarket component to the business, which results in approximately 34% recurring revenue. The business is just about evenly split between the U.S. and U.K. The business has outstanding revenue visibility due to the predictability of Navy programs and currently has a funded backlog of approximately $350 million, which represents 2 years of coverage of the calendar year 2024 expected revenue of $175 million. Additionally, the business has been awarded another $100 million in contracts, which are not yet fully government funded and are likely to move into backlog in the near term. Given the current projections of naval investments, we currently estimate the growth to be at least 12% compounded annually over the next few years. Let's switch to Slide 6 and discuss the business' technologies. There are 2 major product lines which exist on both sides of the pond. Signature Management is a set of technologies which improve the stealth characteristics of the ship to prevent detection by underwater sensors and mines. These technologies include modifying the magnetic, electrical and acoustic signature of the vessel through active and passive techniques. The business has been a leader in this space for more than 30 years. Power management and control as a set of technologies which enable the onboard power and propulsion systems to operate with high reliability under the most extreme conditions that may be present during conflict at sea. The business has been a trusted supplier of these systems on U.S. and U.K. submarines and surface ships for more than 50 years. As part of ESCO, these businesses will continue to invest in development of critical IP to serve the current and future needs of the U.S. and U.K. navies in an increasingly complex and dynamic competitive environment. Moving to Slide 7, let's talk about the transaction's benefits. From an ESCO strategy perspective, this transaction expands our focus on high-margin, high-growth end markets while adding additional scale to our Aerospace & Defense portfolio. From our customers' perspective, this enables them to leverage a single trusted supplier that is focused on innovation, quality and superior customer service. The transaction builds on our existing shipset content for Virginia class and Columbia class submarines, while adding shipset content for Arleigh Burke destroyers and future builds of Ford-class aircraft carriers. SM&P expands our international presence with substantial content on the Astute and Vanguard replacement submarine platforms. We will also gain substantial growth from the next-generation AUKUS SSN-A submarine platform, which is currently in development in the U.K. From a shareholder perspective, this deal is accretive to our overall revenue growth and EBITDA margins. We expect that the acquisition will be accretive to ESCO adjusted EPS in the first year post closing, excluding onetime acquisition costs and related amortization. To illustrate this beneficial change in mix, let's go to Slide 8. As you can see here, the addition of SM&P increases our A&D segment to just over 50% of our overall portfolio. Within A&D, Navy is already the fastest-growing part of the portfolio today and it will now represent nearly 50% of our A&D business. We see this as a very favorable overall mix change with SM&P coming in with 3 years projected compound growth of at least 12% and EBITDA margins in the mid-20s. Slide 9 will illustrate how SM&P complements our existing Navy portfolio. On this diagram of a typical submarine platform, ESCO's existing content is highlighted with blue text, while the additional content from SM&P is overlaid with gold text. As you can see, ESCO already has a substantial amount of content which are focused on the stealth aspects of the bow. SM&P takes this to another level. Let's go to Slide 10 to discuss how the transaction meets our stated M&A goals. We've been very thoughtful and deliberate about the enterprise-level strategy for ESCO. We want to acquire businesses which have a leadership position in a business or a market where we already have a presence. As a leader in naval defense, SM&P clearly meets those criteria. We prefer businesses with a high degree of technology-driven IP products and services. Again, SM&P clearly meets that criteria. We look for businesses with demonstrated financial performance and predictable revenue streams in high-growth markets. SM&P easily clears these hurdles with 90% sole-source revenue, EBITDA margins in the 20s and a projected growth rate in excess of 12%. The combination of SM&P and ESCO's existing naval business provides complementary and synergistic capabilities, which OEM and aftermarket customers will come to appreciate. We'll conclude the presentation on Slide #11. The addition of SM&P strengthens ESCO's already compelling investment story. We have a well-tested operating model with demonstrated performance and a strong track record. We serve technology-oriented end markets with long-term organic growth trajectories. Our exposure to commercial and defense aerospace will continue to drive value as build rates increase to meet projected demand increases over the next 2 decades. Our increased exposure to Navy submarines will drive substantial growth as both the U.K. and the U.S. continue to make fleet investments to counter geopolitical threats worldwide. Our Utility Solutions business will continue to benefit from increased investments in the utility infrastructure as worldwide demand for electrification places increasing demand on an aging grid, as society strives towards net zero targets in the coming decades. ESCO is executing on our stated plan to supplement organic growth with strategic M&A. SM&P is a prudent investment which allows us to achieve our strategic objectives, while maintaining leverage inside 3x with a clear line of sight to a leverage ratio of 2x. We continue to maintain our focus on returns, with a high degree of alignment between management and shareholders. In summary, ESCO is a good investment, which will be strengthened by the actions that we are taking to grow the portfolio and increase our exposure to end markets with compelling growth for decades to come. With that, we can open up the call for Q&A.

[Operator Instructions] Our first question comes from Tommy Moll with Stephens Inc.

Bryan, you talked about a revenue outlook in the low double digits in terms of the CAGR for the next few years. I presume a lot of that is on conversion of the backlog. But any of the inputs to that outlook that you could provide would be helpful. And then also, if we just zoom out a bit and look either beyond that 3-year horizon or maybe back at some of the historical performance of this business, what kind of growth rates could you use to anchor us for your other -- those frameworks?

Thanks, Tommy. Yes, the growth that we're projecting in the first 3 years is partly from a conversion backlog. But this is a business that has a lot of forward-looking growth opportunities, particularly with the Vanguard replacement program that they're a key part of over in the U.K. with additional content on U.S. ships. And then they're part of this SSN-A program, which will be a big part of that overall growth story. ESCO is taking a conservative posture with regard to the forecast of this business. We're saying it's probably at least 12%. It could be quite a bit more. And we would anticipate that, that would be sustainable throughout that 5-year window that we kind of think about as our planning window.

That's helpful, Bryan. And a related follow-up there on the go-to-market here. What, if any, kind of sales synergy opportunities, do you see -- even if beyond the 3- or 5-year planning window, just -- if you've got a sizable existing business with the U.S. Navy, for example, now you go to market with a much larger business. What kind of synergy opportunities could we contemplate here?

So we have built some amount of synergies into our 5-year plan but I want to be clear that, that is not really the basis for this deal. The intrinsic growth that we see and the margins here are sufficient to justify this on an economic basis. But we do have synergies built in. A lot of that is really related more to SG&A leverage over time, doing a good job on the sales and marketing side of kind of selling a larger portfolio. We do think that there could be some potential for cross-selling and up selling down the road between the U.S. and the U.K. But of course, that's really subject to both governments' willingness to exchange critical IP that is really national security protected. So we can't -- we didn't make any assumptions there because we really -- but as part of the overall AUKUS program, we anticipate that there will be increased sharing between those 2 governments.

Last question for me and I'll turn it back. Just stepping back to a broader portfolio discussion. So you're at 3x pro forma leverage line of sight to 2x by the end of next fiscal year. I presume that's entirely on an organic basis once this transaction is closed. But I also wonder now that you've clearly demonstrated an appetite to acquire in the A&D space, I presume that appetite would also apply to the Utility space. Does this news potentially open the aperture from a divestiture standpoint, to enable you to acquire even more aggressively in one of these other priority areas? Or is it premature to think about that today?

Well, so I do think it's a little bit premature to be thinking about that at the moment. However, let me answer your first question first. Yes, we certainly have an appetite to grow our Utility business, as well as our A&D business. We think these are both businesses that have exemplary long-term macro growth trajectories, okay? The fundamental markets that they serve are going to grow for decades to come at much better than normal rates. So we do intend to continue to be aggressive in the space. We're comfortable at the 3x leverage. And at that point, we're not in a position where we have to do anything either on the acquisition or the divestiture side, nor are we prevented from taking any action that we wish to take.

Our next question comes from Jon Tanwanteng with CJS.

I was just wondering if you could compare the per boat or per vessel content in the business compared to your existing Navy business. And kind of how that flows through and exposures to relative U.K. and U.S. geographies?

Yes. I would say that on the U.S. side for Columbia and Virginia class, the business adds some content there, it's substantially less than the numbers that we have communicated about -- we have about $45 million of content on each Virginia Class now. It's a lower number than that. We do not currently have content on things like Arleigh Burke or on the aircraft carriers. And so that's a big add for us. Over in the U.K., we don't have substantial content on Vanguard replacement or Astute or on SSN-A. So that's certainly a big add for us. But listen, their content on those vessels would exceed our content on Virginia class today.

And then what kind of production rate is implicit in the forecast for that growth? I know that the Navy plans to increase Virginia to in excess of 2 a year but I was wondering if you could shed some light on what is the assumption underlying the growth both in the U.S. and in the U.K.

Sure. So I think you're really asking about the U.K. build rates because I think you probably know what the build rates are here in the U.S. quite a bit. Listen, there are currently 4 Vanguard replacement vessels that are in the pipeline. And there will be -- they're still wrapping up kind of the Astute program right now and then they are anticipating something like 8 to 12 of the SSN-A that will go to sea in the 2030s. I think what's different about the -- about SM&P compared to our current business is that the SM&P content goes into the ship very early in the process before the hull is closed, whereas the ESCO current content, the exterior hull content, that goes on outside of the vessel later in overall stage. So in terms of where the revenue flows in the overall build process, SM&P's revenue flows much more -- much sooner. So when you look at published dates, on what to expect for when you might see Vanguard replacement or SSN-A being put to sea, you kind of got to back off of that by a few years to see where our revenue would fall.

Got it. That's helpful. Could you talk about the recurring revenue component? What does that consist of?

Yes. So a lot of this equipment are -- so think of it as -- if you look at the photographs that are on Page 6 of the -- what you'll see there is a lot of rack-mounted types of equipment. So those large rack systems will go into the submarine or the surface ship, right? And then inside of those racks are modular power supplies and other devices, instrumentation, which is hot swappable in the field. And so over time, some of those things will wear out and have to be replaced or will malfunction because of extreme conditions that they've been put under. And so there is a pretty robust replacement cycle on that equipment.

Got it. And then finally, just can you talk about the cash flow profile of the business before financing costs? Just help us understand what kind of cash flow generates.

Yes. I mean I think it's -- the cash profile is very good. I mean they -- in some of these big contracts, they operate in kind of a prepayment environment where they get funded a lot upfront. Frankly, it keeps the working capital quite low, even negative. And where they are in some of these big programs that are kind of early in the development phase, they are getting a lot of that upfront funding. So we see a cash profile that's quite good.