UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

(MARK ONE)

 

xQUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2018

 

OR

 

¨TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM ______ TO ______

 

COMMISSION FILE NUMBER 1-10596

 

ESCO TECHNOLOGIES INC.

(Exact name of registrant as specified in its charter)

 

MISSOURI 43-1554045
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
   
9900A CLAYTON ROAD  
ST. LOUIS, MISSOURI 63124-1186
(Address of principal executive offices)  (Zip Code)

 

(314) 213-7200

(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes x No ¨

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (Section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes x No ¨

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer x Accelerated filer ¨
Non-accelerated filer ¨ (Do not check if a smaller reporting company) Smaller reporting company ¨
Emerging growth company ¨  

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨  No x

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

Class   Shares outstanding at July 31, 2018
Common stock, $.01 par value per share   25,910,828

 

 

 

 

 

 

PART I. FINANCIAL INFORMATION

 

ITEM 1. FINANCIAL STATEMENTS

 

ESCO TECHNOLOGIES INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(Dollars in thousands, except per share amounts)

 

    Three Months Ended
June 30,
 
    2018     2017  
             
Net sales   $ 192,223       171,189  
Costs and expenses:                
Cost of sales     122,805       108,856  
Selling, general and administrative expenses     39,910       38,453  
Amortization of intangible assets     4,605       4,085  
Interest expense, net     2,243       1,213  
Other (income) expenses, net     (656 )     1,160  
Total costs and expenses     168,907       153,767  
                 
Earnings before income taxes     23,316       17,422  
Income tax expense     4,297       4,777  
Net earnings   $ 19,019       12,645  
                 
Earnings per share:                
Basic - Net earnings   $ 0.73       0.49  
                 
Diluted - Net earnings   $ 0.73       0.49  

 

See accompanying notes to consolidated financial statements.

 

2

 

 

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(Dollars in thousands, except per share amounts)

 

    Nine Months Ended
June 30,
 
    2018     2017  
             
Net sales   $ 540,496       478,735  
Costs and expenses:                
Cost of sales     346,911       307,149  
Selling, general and administrative expenses     122,813       107,104  
Amortization of intangible assets     13,615       11,548  
Interest expense, net     6,464       2,752  
Other expenses (income), net     992       (184 )
Total costs and expenses     490,795       428,369  
                 
Earnings before income taxes     49,701       50,366  
Income tax (benefit) expense     (13,983 )     15,837  
Net earnings   $ 63,684       34,529  
                 
Earnings per share:                
Basic - Net earnings   $ 2.46       1.34  
                 
Diluted - Net earnings   $ 2.45       1.33  

 

See accompanying notes to consolidated financial statements.

 

3

 

 

ESCO TECHNOLOGIES INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(Unaudited)

(Dollars in thousands)

 

    Three Months Ended
June 30,
    Nine Months Ended
June 30,
 
    2018     2017     2018     2017  
                         
Net earnings   $ 19,019       12,645       63,684       34,529  
Other comprehensive income (loss), net of tax:                                
Foreign currency translation adjustments     (6,865     4,796       (2,740     2,981  
Net unrealized (loss) gain on derivative instruments     (62     81       93       (23 )
Total other comprehensive (loss) income, net of tax     (6,927     4,877       (2,647     2,958  
Comprehensive income   $ 12,092       17,522       61,037       37,487  

 

See accompanying notes to consolidated financial statements.

 

4

 

 

ESCO TECHNOLOGIES INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(Unaudited)

(Dollars in thousands)

 

    June 30,
2018
    September 30,
2017
 
ASSETS                
Current assets:                
Cash and cash equivalents   $ 43,259       45,516  
Accounts receivable, net     164,100       160,580  
Costs and estimated earnings on long-term contracts, less progress billings of $43,769 and $64,099, respectively     39,180       47,286  
Inventories     145,596       124,515  
Other current assets     17,861       14,895  
Total current assets     409,996       392,792  
Property, plant and equipment, net of accumulated depreciation of $113,831 and $99,650, respectively     134,704       132,748  
Intangible assets, net of accumulated amortization of $87,494 and $73,879, respectively     345,874       351,134  
Goodwill     381,420       377,879  
Other assets     6,977       5,891  
Total assets   $ 1,278,971       1,260,444  
                 
LIABILITIES AND SHAREHOLDERS’ EQUITY                
Current liabilities:                
Current maturities of long-term debt   $ 20,000       20,000  
Accounts payable     49,830       54,789  
Advance payments on long-term contracts, less costs incurred of $54,295 and $59,772, respectively     29,841       22,451  
Accrued salaries     26,597       32,259  
Current portion of deferred revenue     37,082       28,583  
Accrued other expenses     36,672       36,887  
Total current liabilities     200,022       194,969  
Pension obligations     21,976       30,223  
Deferred tax liabilities     63,292       86,378  
Other liabilities     24,427       21,956  
Long-term debt     242,000       255,000  
Total liabilities     551,717       588,526  
Shareholders’ equity:                
Preferred stock, par value $.01 per share, authorized 10,000,000 shares            
Common stock, par value $.01 per share, authorized 50,000,000 shares, issued 30,534,786 and  30,468,824 shares, respectively     305       305  
Additional paid-in capital     290,106       289,785  
Retained earnings     574,192       516,718  
Accumulated other comprehensive loss, net of tax     (29,955 )     (27,308 )
      834,648       779,500  
Less treasury stock, at cost: 4,623,958 and 4,635,622 common shares, respectively     (107,394 )     (107,582 )
Total shareholders’ equity     727,254       671,918  
Total liabilities and shareholders’ equity   $ 1,278,971       1,260,444  

 

See accompanying notes to consolidated financial statements.

 

5

 

 

ESCO TECHNOLOGIES INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(Dollars in thousands)

 

    Nine Months Ended
June 30,
 
    2018     2017  
Cash flows from operating activities:                
Net earnings   $ 63,684       34,529  
Adjustments to reconcile net earnings to net cash provided by operating activities:                
Depreciation and amortization     28,350       23,023  
Stock compensation expense     3,864       4,130  
Changes in assets and liabilities     (18,239 )     (24,977 )
Effect of deferred taxes     (23,086 )     (577 )
Change in deferred revenue and costs, net     8,785       4,863  
Pension contributions     (9,414 )     (2,317 )
Other     -       (5,202 )
Net cash provided by operating activities     53,944       33,472  
                 
Cash flows from investing activities:                
Acquisition of businesses, net of cash acquired     (11,445 )     (162,268 )
Additions to capitalized software     (7,118 )     (6,213 )
Capital expenditures     (15,539 )     (23,055 )
Proceeds from sale of land     -       1,184  
Proceeds from life insurance     -       2,307  
Net cash used by investing activities     (34,102 )     (188,045 )
                 
Cash flows from financing activities:                
Proceeds from long-term debt     53,000       213,000  
Principal payments on long-term debt     (66,000 )     (58,000 )
Dividends paid     (6,205 )     (6,190 )
Other     (2,886     (21 )
Net cash (used) provided by financing activities     (22,091 )     148,789  
Effect of exchange rate changes on cash and cash equivalents     (8     480  
Net decrease in cash and cash equivalents     (2,257 )     (5,304 )
Cash and cash equivalents, beginning of period     45,516       53,825  
Cash and cash equivalents, end of period   $ 43,259       48,521  
                 
Supplemental cash flow information:                
Interest paid   $ 6,333       2,404  
Income taxes paid (including state and foreign)     4,343       20,421  

 

See accompanying notes to consolidated financial statements.

 

6

 

 

ESCO TECHNOLOGIES INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

1. BASIS OF PRESENTATION

 

The accompanying consolidated financial statements, in the opinion of management, include all adjustments, consisting of normal recurring accruals, necessary for a fair presentation of the results for the interim periods presented. The consolidated financial statements are presented in accordance with the requirements of Form 10-Q and consequently do not include all the disclosures required for annual financial statements by accounting principles generally accepted in the United States of America (GAAP). For further information, refer to the consolidated financial statements and related notes included in the Company’s Annual Report on Form 10-K for the fiscal year ended September 30, 2017.

 

The Company’s results for the three and nine-month periods ended June 30, 2018 are not necessarily indicative of the results for the entire 2018 fiscal year. References to the third quarters of 2018 and 2017 represent the fiscal quarters ended June 30, 2018 and 2017, respectively.

 

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities. Actual results could differ from those estimates.

 

2. ACQUISITION

 

On March 14, 2018, the Company acquired the assets of Manta Test Systems Inc. (Manta), a North American utility solutions provider located in Mississauga, Ontario, Canada, for a purchase price of $9.5 million in cash. Manta has annualized sales of approximately $8 million. Since the date of acquisition, the operating results for Manta have been included as a product line of Doble Engineering Company within the Company’s USG segment. Based on the preliminary purchase price allocation, the Company recorded approximately $0.4 million of accounts receivable, $1.1 million of inventory, $0.2 million of property, plant and equipment, $0.4 million of accounts payable and accrued expenses, $3.5 million of goodwill, $1.2 million of tradenames and $3.5 million of amortizable intangible assets consisting of customer relationships with a weighted average life of 13 years.

 

3. EARNINGS PER SHARE (EPS)

 

Basic EPS is calculated using the weighted average number of common shares outstanding during the period. Diluted EPS is calculated using the weighted average number of common shares outstanding during the period plus shares issuable upon the assumed exercise of dilutive common share options and vesting of performance-accelerated restricted shares (restricted shares) by using the treasury stock method. The number of shares used in the calculation of earnings per share for each period presented is as follows (in thousands):

 

7

 

 

    Three Months
Ended June 30,
    Nine Months
Ended June 30,
 
    2018     2017     2018     2017  
                         
Weighted Average Shares Outstanding - Basic     25,900       25,815       25,862       25,756  
Dilutive Options and Restricted Shares     150       210       180       219  
                                 
Adjusted Shares - Diluted     26,050       26,025       26,042       25,975  

  

4. SHARE-BASED COMPENSATION

 

The Company provides compensation benefits to certain key employees under several share-based plans providing for performance-accelerated restricted shares (restricted shares), and to non-employee directors under a non-employee directors compensation plan.

 

Performance-Accelerated Restricted Share Awards

Compensation expense related to the restricted share awards was $0.9 million and $3.1 million for the three and nine-month periods ended June 30, 2018, respectively, and $1.0 million and $3.3 million for the corresponding periods of 2017. There were 316,544 non-vested shares outstanding as of June 30, 2018.

 

Non-Employee Directors Plan

Compensation expense related to the non-employee director grants was $0.3 million and $0.8 million for the three and nine-month periods ended June 30, 2018, respectively, and $0.3 million and $0.8 million for the corresponding periods of 2017.

 

The total share-based compensation cost that has been recognized in the results of operations and included within selling, general and administrative expenses (SG&A) was $1.2 million and $3.9 million for the three-and nine-month periods ended June 30, 2018, respectively, and $1.3 million and $4.1 million for the three and nine-month periods ended June 30, 2017. The total income tax benefit recognized in results of operations for share-based compensation arrangements was $0.2 million and $0.9 million for the three and nine-month periods ended June 30, 2018, respectively, and $1.2 million and $2.2 million for the three and nine-month periods ended June 30, 2017, respectively. As of June 30, 2018, there was $8.9 million of total unrecognized compensation cost related to share-based compensation arrangements. That cost is expected to be recognized over a remaining weighted-average period of 2.1 years.

 

5. INVENTORIES

 

Inventories consist of the following:

 

(In thousands)   June 30,
2018
    September 30,
2017
 
             
Finished goods   $ 30,960       28,127  
Work in process     57,155       43,750  
Raw materials     57,481       52,638  
Total inventories   $ 145,596       124,515  

 

8

 

 

6. GOODWILL AND OTHER INTANGIBLE ASSETS

 

Included on the Company’s Consolidated Balance Sheets at June 30, 2018 and September 30, 2017 are the following intangible assets gross carrying amounts and accumulated amortization:

 

(Dollars in thousands)   June 30
2018
    September 30,
2017
 
Goodwill   $ 381,420       377,879  
                 
Intangible assets with determinable lives:                
Patents                
Gross carrying amount   $ 973       928  
Less: accumulated amortization     773       750  
Net   $ 200       178  
                 
Capitalized software                
Gross carrying amount   $ 68,876       63,007  
Less: accumulated amortization     39,757       34,382  
Net   $ 29,119       28,625  
                 
Customer relationships                
Gross carrying amount   $ 185,055       181,891  
Less: accumulated amortization     45,066       37,364  
Net   $ 139,989       144,527  
                 
Other                
Gross carrying amount   $ 5,316       5,373  
Less: accumulated amortization     1,899       1,383  
Net   $ 3,417       3,990  
Intangible assets with indefinite lives:                
Trade names   $ 173,149       173,813  

 

The changes in the carrying amount of goodwill attributable to each business segment for the nine months ended June 30, 2018 is as follows:

 

(Dollars in millions)   USG     Test     Filtration     Packaging     Total  
Balance as of September 30, 2017     250.2       34.1       73.7       19.9       377.9  
Acquisition activity     3.8       -       -       -       3.8  
Foreign currency translation     (0.1 )     -       -       (0.2     (0.3 )
Balance as of June 30, 2018   $ 253.9       34.1       73.7       19.7       381.4  

 

7. BUSINESS SEGMENT INFORMATION

 

The Company is organized based on the products and services that it offers, and classifies its business operations in four reportable segments for financial reporting purposes: Filtration/Fluid Flow (Filtration), RF Shielding and Test (Test), Utility Solutions Group (USG) and Technical Packaging. The Filtration segment’s operations consist of PTI Technologies Inc. (PTI), VACCO Industries (VACCO), Crissair, Inc. (Crissair), Westland Technologies Inc. (Westland), Mayday Manufacturing Co. and its affiliate Hi-Tech Metals, Inc. (collectively referred to as Mayday). The companies within this segment primarily design and manufacture specialty filtration products, including hydraulic filter elements used in commercial aerospace applications, unique filter mechanisms used in micro-propulsion devices for satellites and custom designed filters for manned and unmanned aircraft; manufacture elastomeric-based signature reduction solutions for the U.S. Navy; and manufacture landing gear components for the aerospace and defense industry. The Test segment’s operations consist primarily of ETS-Lindgren Inc. (ETS-Lindgren). ETS-Lindgren is an industry leader in providing its customers with the ability to identify, measure and contain magnetic, electromagnetic and acoustic energy. The USG segment’s operations consist primarily of Doble Engineering Company (Doble), Morgan Schaffer Inc. (Morgan Schaffer), and NRG Systems, Inc. (NRG). Doble provides high-end, intelligent diagnostic test solutions for the electric power delivery industry and is a leading supplier of partial discharge testing instruments used to assess the integrity of high voltage power delivery equipment. Morgan Schaffer provides an integrated offering of dissolved gas analysis, oil testing, and data management solutions for the electric power industry. NRG designs and manufactures decision support tools for the renewable energy industry, primarily wind. The Technical Packaging segment’s operations consist of Thermoform Engineered Quality LLC (TEQ) and Plastique Limited and Plastique Sp. z o.o. (together, Plastique). The companies within this segment provide innovative solutions to the medical and commercial markets for thermoformed packages and specialty products using a wide variety of thin gauge plastics and pulp.

 

9

 

 

Management evaluates and measures the performance of its reportable segments based on “Net Sales” and “EBIT”, which are detailed in the table below. EBIT is defined as earnings before interest and taxes.

 

    Three Months
Ended June 30,
    Nine Months
Ended June 30,
 
 (In thousands)   2018     2017     2018     2017  
NET SALES                                
Filtration   $ 69,721       71,179       195,531       198,869  
Test     45,034       37,544       123,368       109,738  
USG     55,489       42,059       157,942       110,287  
Technical Packaging     21,979       20,407       63,655       59,841  
Consolidated totals   $ 192,223       171,189       540,496       478,735  
                                 
EBIT                                
Filtration   $ 14,292       11,945       35,056       34,296  
Test     5,902       4,885       13,797       11,076  
USG     11,528       8,477       27,805       25,585  
Technical Packaging     2,505       2,433       5,355       5,660  
Corporate (loss)     (8,668 )     (9,105 )     (25,848 )     (23,499 )
Consolidated EBIT     25,559       18,635       56,165       53,118  
Less: Interest expense     (2,243 )     (1,213 )     (6,464 )     (2,752 )
Earnings before income taxes   $ 23,316       17,422       49,701       50,366  

 

Non-GAAP Financial Measures

 

The financial measure “EBIT” is presented in the above table and elsewhere in this Report. EBIT on a consolidated basis is a non-GAAP financial measure. Management believes that EBIT is useful in assessing the operational profitability of the Company’s business segments because it excludes interest and taxes, which are generally accounted for across the entire Company on a consolidated basis. EBIT is also one of the measures used by management in determining resource allocations within the Company as well as incentive compensation. A reconciliation of EBIT to net earnings is set forth in Item 2, Management’s Discussion and Analysis of Financial Condition and Results of Operations – EBIT.

 

The Company believes that the presentation of EBIT provides important supplemental information to investors to facilitate comparisons with other companies, many of which use similar non-GAAP financial measures to supplement their GAAP results. However, the Company’s non-GAAP financial measures may not be comparable to other companies’ non-GAAP financial performance measures. Furthermore, the use of non-GAAP financial measures is not intended to replace any measures of performance determined in accordance with GAAP.

 

10

 

 

8. DEBT

 

The Company’s debt is summarized as follows:

 

(In thousands)   June 30,
2018
    September 30,
2017
 
Total borrowings   $ 262,000       275,000  
Short-term borrowings and current portion of long-term debt     (20,000 )     (20,000 )
Total long-term debt, less current portion   $ 242,000       255,000  

 

The Company’s existing credit facility (“the Credit Facility”) matures December 21, 2020. The Credit Facility includes a $450 million revolving line of credit as well as provisions allowing for the increase of the credit facility commitment amount by an additional $250 million, if necessary, with the consent of the lenders. The bank syndication supporting the facility is comprised of a diverse group of nine banks led by JPMorgan Chase Bank, N.A., as Administrative Agent.

 

At June 30, 2018, the Company had approximately $180 million available to borrow under the Credit Facility, and a $250 million increase option subject to lender approval, in addition to $43.3 million cash on hand. At June 30, 2018, the Company had $262 million of outstanding borrowings under the Credit Facility in addition to outstanding letters of credit of $8.3 million. The Company classified $20.0 million as the current portion of long-term debt as of June 30, 2018, as the Company intends to repay this amount within the next twelve month period; however, the Company has no contractual obligation to repay such amount during the next twelve month period.

 

The Credit Facility requires, as determined by certain financial ratios, a facility fee ranging from 12.5 to 27.5 basis points per year on the unused portion. The terms of the facility provide that interest on borrowings may be calculated at a spread over the London Interbank Offered Rate (LIBOR) or based on the prime rate, at the Company’s election. The facility is secured by the unlimited guaranty of the Company’s material domestic subsidiaries and a 65% pledge of the material foreign subsidiaries’ share equity. The financial covenants of the Credit Facility include a leverage ratio and an interest coverage ratio. The weighted average interest rates were 3.17% and 2.97% for the three and nine-month periods ending June 30, 2018, respectively, and 2.11% and 1.90% for the corresponding periods of 2017. At June 30, 2018, the Company was in compliance with all debt covenants.

 

9. INCOME TAX EXPENSE

 

The third quarter 2018 effective income tax rate was 18.4% compared to 27.4% in the third quarter of 2017. The income tax benefit for the first nine months of 2018 was $14.0 million compared to income tax expense of $15.8 million for the first nine months of 2017. The effective income tax rate for the first nine months of 2018 was (28.1%) compared to 31.4% for the first nine months of 2017. H.R. 1, Tax Cuts and Jobs Act (“TCJA”), was signed into law on December 22, 2017. The total impact of the TCJA in the third quarter and first nine months of 2018 was a net expense of $0.1 million and a net benefit of $24.3 million, respectively. The impacts were as follows: First, the Company’s 2018 federal statutory rate decreased from 35.0% to 24.5% which required an adjustment to the value of its deferred tax assets and liabilities. This adjustment ($30.3 million provisional amount recorded in the first quarter of 2018 and $0.4 million provisional amount in the third quarter of 2018) favorably impacted the third quarter and year-to-date effective tax rate by 1.5% and 61.7%, respectively. Second, the TCJA subjected the Company’s cumulative foreign earnings to federal income tax ($4.1 million provisional amount of which $2.9 million was recorded in the first quarter of 2018, $0.7 million was recorded in the second quarter of 2018, and $0.5 million in the third quarter of 2018) which unfavorably impacted the third quarter and year-to-date effective tax rate by 2.1% and 8.2%, respectively.

 

In the first quarter of 2018, the Company recorded a $2.3 million provisional estimate of the income tax effects of the future repatriation of the cumulative earnings of its foreign subsidiaries which unfavorably impacted the year-to-date effective tax rate by 4.7%. An additional $7.5 million pension contribution for the 2017 plan year was approved during the second quarter of 2018 increasing the value of the deferred tax liability by $1.0 million (provisional amount). This favorable adjustment, net of the $0.3 million unfavorable impact to the 2017 Domestic Production Deduction, favorably impacted the year-to-date effective tax rate by 1.6%. An accounting method change was filed with the 2017 tax return which resulted in an additional deferred tax liability to be adjusted as a result of the TCJA. A favorable adjustment, net of the $0.3 million unfavorable impact to the 2017 Domestic Production deduction, favorably impacted the third quarter and year-to-date effective tax rate by 2.9% and 1.4%, respectively. The income tax expense in the third quarter and first nine months of 2018 was favorably impacted by return to provision true-ups decreasing the third quarter and year-to-date effective tax rate by 1.4% and 0.7%, respectively. In 2017, the Company elected to adopt Accounting Standards Update No. 2016-09, Improvements to Employee Share-Based Payment Accounting, resulting in income tax expense in the third quarter and nine months of 2017 being favorably impacted by additional tax benefits on share-based compensation that vested during the quarter decreasing the effective tax rate by 5.2% and 1.8%, respectively. Income tax expense in the third quarter and nine months of 2018 was also favorably impacted by additional tax benefits on share-based compensation that vested during the quarter decreasing the effective tax rate by 1.9% and 0.9%, respectively.

 

Staff Accounting Bulletin No. 118 (SAB 118) was issued by the SEC effective December 22, 2017. SAB 118 allows registrants to record provisional amounts of the income tax effects of the TCJA where the information necessary to complete the accounting under ASC Topic 740 is not available but the amounts are based on reasonable estimates. SAB 118 permits registrants to record adjustments to its provisional amounts during the measurement period (which cannot exceed one year).

 

11

 

 

In the first and second quarter of 2018, the Company recorded reasonable provisional estimates of the TCJA income tax effects. During the third quarter of 2018, the Company collected and analyzed additional information needed to compute the Company’s deferred tax assets and liabilities. However, these amounts remain provisional as the Company needs more time to collect and analyze information primarily related to the federal impact on the value of state deferred tax assets and liabilities. The income tax effects of subjecting the Company’s cumulative foreign earnings to federal income tax also remains provisional as the Company needs more time to collect and analyze the cumulative balance of earnings subject to the tax and the amount of foreign tax credit that is available to offset the tax.

 

Since the TCJA subjected the Company’s cumulative foreign earnings to U.S. tax, repatriation of those earnings generally provides that no additional federal tax will be imposed. However, the permissible amount of repatriation can be restricted by local law and a repatriation can result in tax expense due to local country withholding tax, U.S. state tax, and changes in foreign exchange rates. The Company is evaluating these considerations to determine the amount of its foreign subsidiaries’ cumulative earnings it intends to indefinitely reinvest.

 

The TCJA includes a tax on global intangible low-taxed income (“GILTI”). The Company expects it will be subject to this tax. At its January 10, 2018 meeting, the FASB staff indicated that companies should make and disclose a policy election as to whether they will recognize deferred taxes for basis differences expected to reverse as GILTI or whether they will account for GILTI as period costs if and when incurred. Because there are interpretative questions associated with the approach that involves recognizing deferred taxes, the Company is in the process of evaluating and will make the accounting policy election during the SAB 118 measurement period.

 

10. SHAREHOLDERS’ EQUITY

 

The change in shareholders’ equity for the first nine months of 2018 is shown below (in thousands):

 

Balance at September 30, 2017   $ 671,918  
Net earnings     63,684  
Other comprehensive (loss)     (2,647
Cash dividends     (6,205 )
Stock compensation plans     504  
Balance at June 30, 2018   $ 727,254  

 

12

 

 

11.RETIREMENT PLANS

 

A summary of net periodic benefit expense for the Company’s defined benefit plans for the three and six-month periods ended March 31, 2018 and 2017 is shown in the following table. Net periodic benefit cost for each period presented is comprised of the following:

 

  

Three Months

Ended June 30,

  

Nine Months

Ended June 30,

 
(In thousands)  2018   2017   2018   2017 
Defined benefit plans                    
Interest cost  $821    737    2,461    2,438 
Expected return on assets   (975)   (942)   (2,924)   (2,978)
Amortization of:                    
Prior service cost   -    -    -    3 
Actuarial loss   548    683    1,644    1,871 
Net periodic benefit cost  $394    478    1,181    1,334 

 

12.DERIVATIVE FINANCIAL INSTRUMENTS

 

Market risks relating to the Company’s operations result primarily from changes in interest rates and changes in foreign currency exchange rates. The Company is exposed to market risk related to changes in interest rates and selectively uses derivative financial instruments, including forward contracts and swaps, to manage these risks. During 2016, the Company entered into several forward contracts to purchase pounds sterling (GBP) to hedge two deferred payments due in connection with the acquisition of Plastique. During the first quarter of 2018, the Company entered into three interest rate swaps with a notional amount of $150 million to hedge some of its exposure to variability in future LIBOR-based interest payments on variable rate debt. In addition, the Company’s Canadian subsidiary Morgan Schaffer enters into foreign exchange contracts to manage foreign currency risk as a portion of their revenue is denominated in U.S. dollars. The Company expects hedging gains or losses to be essentially offset by losses or gains on the related underlying exposures. All derivative instruments are reported in either accrued expenses or other receivables on the balance sheet at fair value. For derivative instruments designated as cash flow hedges, the gain or loss on the derivative is deferred in accumulated other comprehensive income until recognized in earnings with the underlying hedged item. The interest rate swaps entered into during the first quarter of 2018 were not designated as cash flow hedges and, therefore, the gain or loss on the derivative is reflected in earnings each period.

 

The following is a summary of the notional transaction amounts and fair values for the Company’s outstanding derivative financial instruments by risk category and instrument type as of June 30, 2018:

 

(In thousands)  

Notional

amount

   

Fair

Value

(US$)

   

Float

Rate

   

Fix

Rate

 
Forward contracts     700     GBP (80 )                
Forward contracts     9,250     USD (199 )                
Forward contracts     600     EUR 10                  
Interest rate swap     150,000     USD 227       2.09 %     1.80 %
Interest rate swap *     150,000     USD 760       N/A       2.09 %
Interest rate swap **     150,000     USD 955       N/A       2.24 %

 

*This swap represents a forward contract and will be effective in November 2018.

**This swap represents a forward contract and will be effective in November 2019.

 

13.FAIR VALUE MEASUREMENTS

 

The accounting guidance establishes a three-level hierarchy for disclosure of fair value measurements, based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date, as follows:

 

·Level 1 – inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets.
·Level 2 – inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.
·Level 3 – inputs to the valuation methodology are unobservable and significant to the fair value measurement.

 

Financial Assets and Liabilities

The Company has estimated the fair value of its financial instruments as of June 30, 2018 and September 30, 2017 using available market information or other appropriate valuation methodologies. The carrying amounts of cash and cash equivalents, receivables, inventories, payables, debt and other current assets and liabilities approximate fair value because of the short maturity of those instruments.

 

13

 

 

Fair Value of Financial Instruments

 

The Company’s forward contracts and interest rate swaps are classified within Level 2 of the valuation hierarchy in accordance with FASB Accounting Standards Codification (ASC) 825, as presented below as of June 30, 2018:

 

(In thousands)   Level 1     Level 2     Level 3     Total  
Assets (Liabilities):                                
Forward contracts and interest rate swaps   $ -       1,673     $ -       1,673  

 

Valuation was based on third party evidence of similarly priced derivative instruments.

 

Nonfinancial Assets and Liabilities

 

The Company’s nonfinancial assets such as property, plant and equipment, and other intangible assets are not measured at fair value on a recurring basis; however they are subject to fair value adjustments in certain circumstances, such as when there is evidence that an impairment may exist. No impairments were recorded during the three and nine-month periods ended June 30, 2018.

 

14.NEW ACCOUNTING STANDARDS

 

In March 2017, the FASB issued ASU 2017-07, Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost, which updates ASC 715, Compensation – Retirement Benefits. This update permits only the service cost component of net periodic pension and postretirement expense to be reported with other compensation costs, while all other components are required to be reported separately in other deductions, outside any subtotal of operating income. These updates are effective for fiscal years beginning after December 15, 2017, with early adoption permitted, and must be adopted on a retrospective basis. The updates change presentation only and will not impact the Company’s results of operations.

 

In August 2017, the FASB issued ASU 2017-12, Targeted Improvements to Accounting for Hedge Activities, which updates ASC 815, Derivatives and Hedging. This update is intended to amend the hedge accounting model to enable entities to better align the economics of risk management activities and financial reporting. The updates eliminate the requirement to separately measure and report hedge ineffectiveness and simplify hedge documentation and effectiveness assessment requirements. These updates are effective for fiscal years beginning after December 15, 2018, with early adoption permitted, and must be adopted using a modified retrospective approach. These updates are not expected to materially impact the Company’s results of operations.

 

In February 2016, the FASB issued ASU No. 2016-062, Leases (Topic 842), which, among other things, requires an entity to recognize lease assets and lease liabilities on the balance sheet and disclose key information about leasing arrangements. This standard will increase an entities’ reported assets and liabilities. The standard is effective for fiscal years beginning after December 15, 2018 and mandates a modified retrospective transition period for all entities. The Company is currently assessing the impact of this standard on its consolidated financial statements and related disclosures.

 

In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers, (ASU 2014-09) which requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. This guidance has been further clarified and amended. The new standard will be effective for annual reporting periods beginning after December 15, 2017, and interim periods within those annual periods. The standard permits the use of either the retrospective or cumulative effect transition method. The Company has selected the cumulative effect method of transition to the new standard. Because the new standard impacts the Company’s business processes, systems and controls, we developed a project plan to guide the implementation. This project plan included analyzing the standard’s impact on our contract portfolio, comparing our historical accounting policies and practices to the requirements of the new standard, and identifying differences from applying the requirements of the new standard to our contracts. We developed internal controls to ensure that we adequately evaluated our portfolio of contracts under the five-step model to ensure proper assessment of our operating results under ASU 2014-09. We reported on the progress of the implementation to the Audit Committee and the Board of Directors on a regular basis during the project’s duration. The adoption of ASU 2014-09 will have one primary impact on our portfolio of contracts and our Consolidated Financial Statements which is that more of our contracts within our Filtration and Technical Packaging segments will recognize revenue and earnings over time as the work progresses versus at a single point of time. This standard will not change the total revenue or operating earnings recognized, only the timing of when those amounts are recognized. The Company is currently in the process of finalizing the effect that ASU 2014-09 will have on its consolidated financial statements and related disclosures.

 

14

 

 

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

RESULTS OF OPERATIONS

 

References to the third quarters of 2018 and 2017 represent the three-month periods ended June 30, 2018 and 2017, respectively.

 

OVERVIEW

 

In the third quarter of 2018, sales, net earnings and diluted earnings per share were $192.2 million, $19.0 million and $0.73 per share, respectively, compared to $171.2 million, $12.6 million and $0.49 per share, respectively, in the third quarter of 2017. In the first nine months of 2018, sales, net earnings and diluted earnings per share were $540.5 million, $63.7 million and $2.45, respectively, compared to $478.7 million, $34.5 million and $1.33 per share, respectively, in the first nine months of 2017.

 

NET SALES

 

Net sales increased $21.0 million, or 12.3%, to $192.2 million in the third quarter of 2018 from $171.2 million in the third quarter of 2017. Net sales increased $61.8 million, or 12.9%, to $540.5 million in the first nine months of 2018 from $478.7 million in the first nine months of 2017. The increase in net sales in the third quarter of 2018 as compared to the third quarter of 2017 was due to a $13.4 million increase in the USG segment, a $7.5 million increase in the Test segment and a $1.6 million increase in the Technical Packaging segment, partially offset by a $1.5 million decrease in the Filtration segment. The increase in net sales in the first nine months of 2018 as compared to the corresponding prior year period was due to a $47.7 million increase in the USG segment, a $13.6 million increase in the Test segment and a $3.8 million increase in the Technical Packaging segment, partially offset by a $3.3 million decrease in the Filtration segment.

 

-Filtration

 

In the third quarter of 2018, net sales of $69.7 million were $1.5 million, or 2.0%, lower than the $71.2 million in the third quarter of 2017. Net sales decreased $3.3 million, or 1.7%, to $195.5 million in the first nine months of 2018 from $198.9 million in the first nine months of 2017. The sales decrease in the third quarter of 2018 compared to the third quarter of 2017 was mainly due to a $4.7 million decrease in net sales at VACCO due to lower shipments of its defense spares products and a $1.6 million decrease in net sales at PTI due to lower aerospace assembly and industrial/automotive shipments, partially offset by a $2.2 million increase in net sales at Mayday due to higher aerospace shipments, $1.8 million increase in net sales at Crissair due to higher aerospace shipments and $0.9 million increase in net sales at Westland. The sales decrease in the first nine months of 2018 compared to the first nine months of 2017 was primarily due to a $6.2 million decrease in net sales at PTI due to lower aerospace assembly and industrial/automotive shipments, a $6.0 million decrease in net sales at VACCO due to lower shipments of its defense spares products and a $3.8 million decrease in net sales at Westland due to timing of shipments on government programs, partially offset by an $12.9 million increase in net sales at Mayday and Crissair due to higher aerospace shipments.

 

15

 

 

-Test

 

In the third quarter of 2018, net sales of $45.0 million were $7.5 million, or 19.9%, higher than the $37.5 million recorded in the third quarter of 2017. Net sales increased $13.6 million, or 12.4%, to $123.4 million in the first nine months of 2018 from $109.7 million in the first nine months of 2017. The increase in the third quarter and first nine months of 2018 compared to the corresponding periods of 2017 was primarily due to higher sales from the segment’s U.S. operations due to the timing of test and measurement chamber projects.

 

-Utility Solutions Group (USG)

 

Net sales increased $13.4 million, or 31.9%, to $55.5 million in the third quarter of 2018 from $42.1 million in the third quarter of 2017. Net sales increased $47.7 million, or 43.2%, to $157.9 million in the first nine months of 2018 from $110.3 million in the first nine months of 2017. The increase in the third quarter of 2018 compared to the third quarter of 2017 was mainly due to the sales contributions from the NRG, Morgan Schaffer and Vanguard Instruments acquisitions. The increase in the first nine months of 2018 compared to the first nine months of 2017 was mainly due to the sales contributions from NRG, Morgan Schaffer and Vanguard Instruments and new products and software solutions at Doble.

 

-Technical Packaging

 

In the third quarter of 2018, net sales of $22.0 million were $1.6 million, or 7.7%, higher than the $20.4 million in the third quarter of 2017. Net sales increased $3.8 million, or 6.4%, to $63.7 million in the first nine months of 2018 from $59.8 million in the first nine months of 2017. The increase in the third quarter and first nine months of 2018 compared to the corresponding periods of 2017 was primarily due to the increase in net sales from Plastique driven by fluctuations in currency ($2.5 million for the first nine months of 2018) and increased shipments to new customers.

 

ORDERS AND BACKLOG

 

Backlog was $425.5 million at June 30, 2018 compared with $377.1 million at September 30, 2017. The Company received new orders totaling $201.1 million in the third quarter of 2018 compared to $182.2 million in the third quarter of 2017. Of the new orders received in the third quarter of 2018, $85.9 million related to Filtration products, $37.9 million related to Test products, $57.8 million related to USG products, and $19.5 million related to Technical Packaging products. Of the new orders received in the third quarter of 2017, $77.6 million related to Filtration products, $38.0 million related to Test products, $46.3 million related to USG products, and $20.3 million related to Technical Packaging products.

 

The Company received new orders totaling $588.9 million in the first nine months of 2018 compared to $532.0 million in the first nine months of 2017. Of the new orders received in the first nine months of 2018, $219.1 million related to Filtration products, $144.2 million related to Test products, $168.0 million related to USG products, and $57.6 million related to Technical Packaging products. Of the new orders received in the first nine months of 2017, $207.1 million related to Filtration products, $138.3 million related to Test products, $118.9 million related to USG products, and $67.7 million related to Technical Packaging products.

 

SELLING, GENERAL AND ADMINISTRATIVE EXPENSES

 

Selling, general and administrative (SG&A) expenses for the third quarter of 2018 were $39.9 million (20.8% of net sales), compared with $38.5 million (22.5% of net sales) for the third quarter of 2017. For the first nine months of 2018, SG&A expenses were $122.8 million (22.7% of net sales) compared to $107.1 million (22.4% of net sales) for the first nine months of 2017. The increase in SG&A in the third quarter and first nine months of 2018 compared to the corresponding periods of 2017 was mainly due to an increase in the USG segment due to the Company’s recent acquisitions (NRG, Morgan Schaffer and Vanguard Instruments) and additional sales and marketing expenses to support future revenue growth, and at Corporate (higher professional fees including acquisition expenses).

 

16

 

 

AMORTIZATION OF INTANGIBLE ASSETS

 

Amortization of intangible assets was $4.6 million and $13.6 million for the third quarter and first nine months of 2018, respectively, compared to $4.1 million and $11.5 million for the corresponding periods of 2017. Amortization expenses consist of amortization of acquired intangible assets from acquisitions and other identifiable intangible assets (primarily software). The increase in amortization expense in the third quarter and first nine months of 2018 compared to the corresponding periods of 2017 was mainly due to an increase in amortization of intangibles related to the Morgan Schaffer, NRG and Mayday acquisitions.

 

OTHER EXPENSES (INCOME), NET

 

Other income, net, was $0.7 million in the third quarter of 2018 compared to other expenses, net, of $1.2 million in the third quarter of 2017. The principal component in other income, net, in the third quarter of 2018 was a gain on derivative instruments of $0.5 million. There were no individually significant items in other (income) expenses, net, in the third quarter of 2017.

 

Other expenses, net, was $1.0 million in the first nine months of 2018 compared to other income, net, of $0.2 million in the first nine months of 2017. The principal components in other expenses, net, in the first nine months of 2018 were $2.1 million of charges primarily related to the USG segment restructuring activities, including the Doble facility consolidations, partially offset by gains on derivative instruments. The restructuring charges mainly related to severance and compensation benefits, professional fees and asset impairment charges related to abandoned assets. The principal component in other income, net, in the first nine months of 2017 was $0.4 million of income related to death benefit insurance proceeds from a former subsidiary.

 

EBIT

 

The Company evaluates the performance of its operating segments based on EBIT, and provides EBIT on a consolidated basis, which is a non-GAAP financial measure. Please refer to the discussion of non-GAAP financial measures in Note 7 to the Consolidated Financial Statements, above. EBIT was $25.6 million (13.3% of net sales) for the third quarter of 2018 compared to $18.6 million (10.9% of net sales) for the third quarter of 2017. For the first nine months of 2018, EBIT was $56.2 million (10.4% of net sales) compared to $53.1 million (11.1% of net sales) for the first nine months of 2017.

 

The following table presents a reconciliation of EBIT to net earnings.

 

(In thousands)  

Three Months Ended

June 30,

   

Nine Months Ended

June 30,

 
    2018     2017     2018     2017  
Consolidated EBIT   $ 25,559       18,635       56,165       53,118  
Less: Interest expense, net     (2,243 )     (1,213 )     (6,464 )     (2,752 )
Plus (Less): Income tax     (4,297 )     (4,777 )     13,983       (15,837 )
Net earnings   $ 19,019       12,645       63,684       34,529  

 

-Filtration

 

EBIT in the third quarter of 2018 was $14.3 million (20.5% of net sales) compared to $11.9 million (16.8% of net sales) in the third quarter of 2017. EBIT in the first nine months of 2018 was $35.1 million (17.9% of net sales) compared to $34.3 million (17.2% of net sales) in the first nine months of 2017. The increase in EBIT in the third quarter compared to the third quarter of 2017 was mainly due to an increase at Crissair, Mayday and Westland due to higher sales volumes partially offset by a decrease in EBIT at VACCO and PTI due to the lower sales volumes mentioned above. The increase in EBIT in the first nine months of 2018 compared to the first nine months of 2017 was mainly due to an increase at Mayday and Crissair due to higher sales volumes partially offset by a decrease in EBIT at Westland, PTI and VACCO due to lower sales volumes as mentioned above. In addition, EBIT in the first nine months of 2018 included $0.5 million of restructuring charges at PTI related to the exit of the low margin industrial/automotive market, which were recorded in the second quarter of 2018. These charges consisted primarily of severance and compensation benefits and asset impairment charges.

 

-Test

 

EBIT in the third quarter of 2018 was $5.9 million (13.1% of net sales) compared to $4.9 million (13.0% of net sales) in the third quarter of 2017. EBIT in the first nine months of 2018 was $13.8 million (11.2% of net sales) compared to $11.1 million (10.1% of net sales) in the first nine months of 2017. The increase in EBIT in the third quarter and first nine months of 2018 compared to the corresponding prior year periods was primarily due to the increased sales volumes mainly from the segment’s U.S. operations.

 

17

 

 

-Utility Solutions Group

 

EBIT in the third quarter of 2018 was $11.5 million (20.8% of net sales) compared to $8.5 million (20.2% of net sales) in the third quarter of 2017. EBIT in the first nine months of 2018 was $27.8 million (17.6% of net sales) compared to EBIT of $25.6 million (23.2% of net sales) in the first nine months of 2017. The increase in EBIT in the third quarter and first nine months of 2018 compared to the corresponding periods of 2017 was mainly due to the higher sales volumes as well as the EBIT contribution from the recent acquisitions of NRG, Morgan Schaffer and Vanguard Instruments. In addition, EBIT in the first nine months of 2018 was negatively impacted by $1.9 million of charges recorded in the second quarter of 2018 related to closing the Doble facilities in Norway and China consisting mainly of employee severance and compensation benefits, professional fees, and asset impairment charges.

 

-Technical Packaging

 

EBIT in the third quarter of 2018 was $2.5 million (11.4% of net sales) compared to $2.4 million (11.9% of net sales) in the third quarter of 2017. EBIT in the first nine months of 2018 was $5.4 million (8.4% of net sales) compared to $5.7 million (9.5% of net sales) in the first nine months of 2017. The decrease in EBIT as a percent of net sales in the third quarter of 2018 and the decrease in EBIT in the first nine months of 2018 compared to the corresponding periods of 2017 was mainly due to product mix at Plastique including lower margin projects.

 

-Corporate

 

Corporate costs included in EBIT were $8.7 million and $25.8 million in the third quarter and first nine months of 2018, respectively, compared to $9.1 million and $23.5 million in the corresponding periods of 2017. The decrease in Corporate costs in the third quarter of 2018 compared to the third quarter of 2017 was mainly due to the $0.5 million of gains on derivative instruments recorded in the third quarter of 2018. The increase in Corporate costs in the first nine months of 2018 compared to the corresponding periods of 2017 was primarily due to higher professional fees and an increase in amortization of intangible assets related to recent acquisitions.

 

INTEREST EXPENSE, NET

 

Interest expense was $2.2 million and $6.5 million in the third quarter and first nine months of 2018, respectively, and $1.2 million and $2.8 million in the corresponding periods of 2017. The increase in interest expense in the first nine months of 2018 compared to the corresponding period of 2017 was mainly due to higher average outstanding borrowings ($263 million compared to $189 million) and higher average interest rates (2.97% vs. 1.90%) as a result of the additional borrowings to fund the Company’s recent acquisitions.

 

INCOME TAX EXPENSE

 

The third quarter 2018 effective income tax rate was 18.4% compared to 27.4% in the third quarter of 2017. The income tax benefit for the first nine months of 2018 was $14.0 million compared to income tax expense of $15.8 million for the first nine months of 2017. The effective income tax rate for the first nine months of 2018 was (28.1%) compared to 31.4% for the first nine months of 2017. H.R. 1, Tax Cuts and Jobs Act (“TCJA”), was signed into law on December 22, 2017. The total impact of the TCJA in the third quarter and first nine months of 2018 was a net expense of $0.1 million and a net benefit of $24.3 million, respectively. The impacts were as follows: First, the Company’s 2018 federal statutory rate decreased from 35.0% to 24.5% which required an adjustment to the value of its deferred tax assets and liabilities. This adjustment ($30.3 million provisional amount recorded in the first quarter of 2018 and $0.4 million provisional amount in the third quarter of 2018) favorably impacted the third quarter and year-to-date effective tax rate by 1.5% and 61.7%, respectively. Second, the TCJA subjected the Company’s cumulative foreign earnings to federal income tax ($4.1 million provisional amount of which $2.9 million was recorded in the first quarter of 2018, $0.7 million was recorded in the second quarter of 2018, and $0.5 million in the third quarter of 2018) which unfavorably impacted the third quarter and year-to-date effective tax rate by 2.1% and 8.2%, respectively.

 

In the first quarter of 2018, the Company recorded a $2.3 million provisional estimate of the income tax effects of the future repatriation of the cumulative earnings of its foreign subsidiaries which unfavorably impacted the year-to-date effective tax rate by 4.7%. An additional $7.5 million pension contribution for the 2017 plan year was approved during the second quarter of 2018 increasing the value of the deferred tax liability by $1.0 million (provisional amount). This favorable adjustment, net of the $0.3 million unfavorable impact to the 2017 Domestic Production Deduction, favorably impacted the year-to-date effective tax rate by 1.6%. An accounting method change was filed with the 2017 tax return which resulted in an additional deferred tax liability to be adjusted as a result of the TCJA. A favorable adjustment, net of the $0.3 million unfavorable impact to the 2017 Domestic Production deduction, favorably impacted the third quarter and year-to-date effective tax rate by 2.9% and 1.4%, respectively. The income tax expense in the third quarter and first nine months of 2018 was favorably impacted by return to provision true-ups decreasing the third quarter and year-to-date effective tax rate by 1.4% and 0.7%, respectively. In 2017, the Company elected to adopt Accounting Standards Update No. 2016-09, Improvements to Employee Share-Based Payment Accounting, resulting in income tax expense in the third quarter and nine months of 2017 being favorably impacted by additional tax benefits on share-based compensation that vested during the quarter decreasing the effective tax rate by 5.2% and 1.8%, respectively. Income tax expense in the third quarter and nine months of 2018 was also favorably impacted by additional tax benefits on share-based compensation that vested during the quarter decreasing the effective tax rate by 1.9% and 0.9%, respectively.

 

Staff Accounting Bulletin No. 118 (SAB 118) was issued by the SEC effective December 22, 2017. SAB 118 allows registrants to record provisional amounts of the income tax effects of the TCJA where the information necessary to complete the accounting under ASC Topic 740 is not available but the amounts are based on reasonable estimates. SAB 118 permits registrants to record adjustments to its provisional amounts during the measurement period (which cannot exceed one year).

 

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In the first and second quarter of 2018, the Company recorded reasonable provisional estimates of the TCJA income tax effects. During the third quarter of 2018, the Company collected and analyzed additional information needed to compute the Company’s deferred tax assets and liabilities. However, these amounts remain provisional as the Company needs more time to collect and analyze information primarily related to the federal impact on the value of state deferred tax assets and liabilities. The income tax effects of subjecting the Company’s cumulative foreign earnings to federal income tax also remains provisional as the Company needs more time to collect and analyze the cumulative balance of earnings subject to the tax and the amount of foreign tax credit that is available to offset the tax.

 

Since the TCJA subjected the Company’s cumulative foreign earnings to U.S. tax, repatriation of those earnings generally provides that no additional federal tax will be imposed. However, the permissible amount of repatriation can be restricted by local law and a repatriation can result in tax expense due to local country withholding tax, U.S. state tax, and changes in foreign exchange rates. The Company is evaluating these considerations to determine the amount of its foreign subsidiaries’ cumulative earnings it intends to indefinitely reinvest.

 

The TCJA includes a tax on global intangible low-taxed income (“GILTI”). The Company expects it will be subject to this tax. At its January 10, 2018 meeting, the FASB staff indicated that companies should make and disclose a policy election as to whether they will recognize deferred taxes for basis differences expected to reverse as GILTI or whether they will account for GILTI as period costs if and when incurred. Because there are interpretative questions associated with the approach that involves recognizing deferred taxes, the Company is in the process of evaluating and will make the accounting policy election during the SAB 118 measurement period.

 

TCJA moved the U.S. to a federal tax system that will no longer tax dividends from foreign corporations to U.S. corporations. The cost of transitioning to this new tax system is a deemed repatriation of cumulative foreign earnings, the “Foreign Earnings Toll Charge”, the estimated tax cost of which was recorded in the first quarter and trued up during the second and third quarters of 2018. The actual repatriation of foreign earnings triggers foreign dividend withholding taxes and U.S. state taxes, the estimated cost of which was recorded in the first quarter and trued up during the second and third quarters of 2018.

 

During the three-month period ended June 30, 2018, there were no material changes in the unrecognized tax benefits. The Company does not anticipate a material change in the amount of unrecognized tax benefits in the next twelve months.

 

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CAPITAL RESOURCES AND LIQUIDITY

 

The Company’s overall financial position and liquidity remains strong. Working capital (current assets less current liabilities) increased to $210.0 million at June 30, 2018 from $197.8 million at September 30, 2017. Inventories increased by $21.1 million during this period mainly due to a $10.7 million increase within the Filtration segment primarily to support new aerospace platforms, a $4.3 million increase within the Test segment and a $4.2 million increase within the USG segment to support revenue growth in the fourth quarter of 2018. Costs and estimated earnings in excess of billings on long-term contracts decreased $8.1 million in the first nine months of 2018 mainly due to ETS-Lindgren ($7.3 million) related to timing of projects.

 

Net cash provided by operating activities was $53.9 million and $33.5 million in the first nine months of 2018 and 2017, respectively. The increase in net cash provided by operating activities in the first nine months of 2018 as compared to the first nine months of 2017 was driven by higher earnings and lower working capital requirements.

 

Capital expenditures were $15.5 million and $23.1 million in the first nine months of 2018 and 2017, respectively. The decrease in the first nine months of 2018 was mainly due to a decrease in machinery and equipment at Plastique ($3.6 million) and VACCO ($1.8 million). In addition, the Company incurred expenditures for capitalized software of $7.1 million and $6.2 million in the first nine months of 2018 and 2017, respectively.

 

Credit Facility

 

At June 30, 2018, the Company had approximately $180 million available to borrow under its bank credit facility, a $250 million increase option subject to lender approval, and $43.3 million cash on hand. At June 30, 2018, the Company had $262 million of outstanding borrowings under the credit facility in addition to outstanding letters of credit of $8.3 million. Cash flow from operations and borrowings under the Company’s credit facility are expected to meet the Company’s capital requirements and operational needs for the foreseeable future. The Company’s ability to access the additional $250 million increase option of the credit facility is subject to acceptance by participating or other outside banks.

 

New Accounting Standards

 

In March 2017, the FASB issued ASU 2017-07, Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost, which updates ASC 715, Compensation – Retirement Benefits. This update permits only the service cost component of net periodic pension and postretirement expense to be reported with other compensation costs, while all other components are required to be reported separately in other deductions, outside any subtotal of operating income. These updates are effective for fiscal years beginning after December 15, 2017, with early adoption permitted, and must be adopted on a retrospective basis. The updates change presentation only and will not impact the Company’s results of operations.

 

In August 2017, the FASB issued ASU 2017-12, Targeted Improvements to Accounting for Hedge Activities, which updates ASC 815, Derivatives and Hedging. This update is intended to amend the hedge accounting model to enable entities to better align the economics of risk management activities and financial reporting. The updates eliminate the requirement to separately measure and report hedge ineffectiveness and simplify hedge documentation and effectiveness assessment requirements. These updates are effective for fiscal years beginning after December 15, 2018, with early adoption permitted, and must be adopted using a modified retrospective approach. These updates are not expected to materially impact the Company’s results of operations.

 

In February 2016, the FASB issued ASU No. 2016-062, Leases (Topic 842), which, among other things, requires an entity to recognize lease assets and lease liabilities on the balance sheet and disclose key information about leasing arrangements. This standard will increase an entities’ reported assets and liabilities. The standard is effective for fiscal years beginning after December 15, 2018 and mandates a modified retrospective transition period for all entities. The Company is currently assessing the impact of this standard on its consolidated financial statements and related disclosures.

 

In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers, (ASU 2014-09) which requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. This guidance has been further clarified and amended. The new standard will be effective for annual reporting periods beginning after December 15, 2017, and interim periods within those annual periods. The standard permits the use of either the retrospective or cumulative effect transition method. The Company has selected the cumulative effect method of transition to the new standard. Because the new standard impacts the Company’s business processes, systems and controls, we developed a project plan to guide the implementation. This project plan included analyzing the standard’s impact on our contract portfolio, comparing our historical accounting policies and practices to the requirements of the new standard, and identifying differences from applying the requirements of the new standard to our contracts. We developed internal controls to ensure that we adequately evaluated our portfolio of contracts under the five-step model to ensure proper assessment of our operating results under ASU 2014-09. We reported on the progress of the implementation to the Audit Committee and the Board of Directors on a regular basis during the project’s duration. The adoption of ASU 2014-09 will have one primary impact on our portfolio of contracts and our Consolidated Financial Statements which is that more of our contracts within our Filtration and Technical Packaging segments will recognize revenue and earnings over time as the work progresses versus at a single point of time. This standard will not change the total revenue or operating earnings recognized, only the timing of when those amounts are recognized. The Company is currently in the process of finalizing the effect that ASU 2014-09 will have on its consolidated financial statements and related disclosures.

 

Acquisitions

 

On March 14, 2018, the Company acquired the assets of Manta Test Systems Inc. (Manta), a North American utility solutions provider located in Mississauga, Ontario, Canada, for a purchase price of $9.5 million in cash. Manta has annualized sales of approximately $8 million. Since the date of acquisition, the operating results for Manta have been included as a product line of Doble within the Company’s USG segment.

 

During the second quarter of 2018, the Company paid a deferred payment of $1.6 million in connection with the 2016 acquisition of Plastique.

 

Dividends

 

A dividend of $0.08 per share, totaling $2.1 million, was paid on April 18, 2018 to stockholders of record as of April 3, 2018. Subsequent to June 30, 2018, a quarterly dividend of $0.08 per share, totaling $2.1 million, was paid on July 19, 2018 to stockholders of record as of July 5, 2018.

 

OUTLOOK

 

Management’s current expectations for 2018 remain consistent with the details outlined in the Business Outlook presented in previous releases. Management expects 2018 GAAP EPS in the range of $3.55 to $3.65 per share and Adjusted EPS in the range of $2.65 to $2.75 per share, adjusting for the 2018 incremental net tax benefits resulting from U.S. Tax Reform and the 2018 cost reduction charges in the USG and Filtration segments.

 

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CRITICAL ACCOUNTING POLICIES

 

Management has evaluated the accounting policies used in the preparation of the Company’s financial statements and related notes and believes those policies to be reasonable and appropriate. Certain of these accounting policies require the application of significant judgment by Management in selecting appropriate assumptions for calculating financial estimates. By their nature, these judgments are subject to an inherent degree of uncertainty. These judgments are based on historical experience, trends in the industry, information provided by customers and information available from other outside sources, as appropriate. The most significant areas involving Management judgments and estimates may be found in the Critical Accounting Policies section of Management’s Discussion and Analysis and in Note 1 to the Consolidated Financial Statements contained in the Company’s Annual Report on Form 10-K for the fiscal year ended September 30, 2017.

 

OTHER MATTERS

 

Contingencies

 

As a normal incident of the business in which the Company is engaged, various claims, charges and litigation are asserted or commenced against the Company. Additionally, the Company is currently involved in various stages of investigation and remediation relating to environmental matters. In the opinion of Management, the aggregate costs involved in the resolution of these matters, and final judgments, if any, which might be rendered against the Company, are adequately reserved, are covered by insurance, or would not have a material adverse effect on the Company’s results from operations, capital expenditures, or competitive position.

 

FORWARD LOOKING STATEMENTS

 

Statements contained in this Form 10-Q regarding future events and the Company’s future results that reflect or are based on current expectations, estimates, forecasts, projections or assumptions about the Company’s performance and the industries in which the Company operates are considered “forward-looking statements” within the meaning of the safe harbor provisions of the Federal securities laws. These include, but are not necessarily limited to, statements about: the amount and timing of future sales, revenues, cash flows, Adjusted EPS and EPS; the adequacy of the Company’s credit facility and the Company’s ability to increase it; the outcome of current litigation, claims and charges; income taxation of foreign earnings and the future repatriation, reinvestment or distribution of foreign earnings; future income tax liabilities and effective tax rate; timing of the repayment of the current portion of the Company’s long-term debt; changes in the amount of unrecognized tax benefits; the recognition and timing of costs related to share-based compensation arrangements; returns on retirement plan assets; estimates or projections made in connection with the Company’s accounting policies; market risks relating to the Company’s operations and changes in interest rates; the extent to which hedging gains or losses are offset by losses or gains on related underlying exposures; the Company’s ability to hedge against or otherwise manage them through the use of derivative financial instruments; the impact of ASU 2017-12 which amends the hedge accounting model to enable entities to better align the economics of risk management activities and financial reporting; and any other statements contained herein which are not strictly historical. Words such as expects, anticipates, targets, goals, projects, intends, plans, believes, estimates, variations of such words, and similar expressions are intended to identify such forward-looking statements.

 

Investors are cautioned that such statements are only predictions and speak only as of the date of this Form 10-Q, and the Company undertakes no duty to update them except as may be required by applicable laws or regulations. The Company’s actual results in the future 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 those described in Item 1A, “Risk Factors,” of the Company’s Annual Report on Form 10-K for the fiscal year ended September 30, 2017, and the following: the impacts of natural disasters on the Company’s operations and those of the Company’s customers and suppliers; the timing and content of future contract awards or customer orders; the appropriation, allocation and availability of Government funds; the termination for convenience of Government and other customer contracts or orders; financial exposure in connection with Company guarantees of certain Aclara contracts; weakening of economic conditions in served markets; the success of the Company’s competitors; changes in customer demands or customer insolvencies; competition; intellectual property rights; technical difficulties; the availability of selected acquisitions; delivery delays or defaults by customers; performance issues with key customers, suppliers and subcontractors; material changes in the costs and availability of certain raw materials; labor disputes; final analysis of the impacts of the TCJA; changes in U.S. tax laws and regulations; other changes in laws and regulations including but not limited to changes in accounting standards and foreign taxation; changes in interest rates; costs relating to environmental matters arising from current or former facilities; uncertainty regarding the ultimate resolution of current disputes, claims, litigation or arbitration; and the integration of recently acquired businesses.

 

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

Market risks relating to the Company’s operations result primarily from changes in interest rates and changes in foreign currency exchange rates. The Company is exposed to market risk related to changes in interest rates and selectively uses derivative financial instruments, including forward contracts and swaps, to manage these risks. During 2016, the Company entered into several forward contracts to purchase pounds sterling to hedge two deferred payments due in connection with the acquisition of Plastique. During the first quarter of 2018, the Company entered into three interest rate swaps with a notional amount of $150 million to hedge some of its exposure to variability in future LIBOR-based interest payments on variable rate debt. In addition, the Company’s Canadian subsidiary Morgan Schaffer enters into foreign exchange contracts to manage foreign currency risk as a portion of their revenue is denominated in U.S. dollars. All derivative instruments are reported on the balance sheet at fair value. For derivative instruments designated as cash flow hedges, the gain or loss on the respective derivative is deferred in accumulated other comprehensive income until recognized in earnings with the underlying hedged item. The interest rate swaps entered into during the first quarter of 2018 were not designated as cash flow hedges and, therefore, the gain or loss on the derivative is reflected in earnings each period. There has been no material change to the Company’s market risks since September 30, 2017. See Note 12 to the Consolidated Financial Statements in Item 1 of this Report for a summary of the Company’s outstanding derivative financial instruments as of June 30, 2018. Refer to the Company’s Annual Report on Form 10-K for the fiscal year ended September 30, 2017 for further discussion about market risk.

 

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ITEM 4. CONTROLS AND PROCEDURES

 

The Company carried out an evaluation, under the supervision and with the participation of Management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as of the end of the period covered by this report. Based upon that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of that date. Disclosure controls and procedures are controls and procedures that are designed to ensure that information required to be disclosed in Company reports filed or submitted under the Securities Exchange Act of 1934 (the “Exchange Act”) is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. There has been no change in the Company’s internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) during the period covered by this report that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

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PART II. OTHER INFORMATION

 

ITEM 6. EXHIBITS

 

Exhibit Number   Description   Document Location
         
3.1(a)   Restated Articles of Incorporation   Exhibit 3(a) to Form 10-K for the fiscal year ended September 30, 1999
         
3.1(b)   Amended Certificate of Designation, Preferences and Rights of Series A Participating Cumulative Preferred Stock of the Registrant   Exhibit 4(e) to Form 10-Q for the fiscal quarter ended March 31, 2000
         
3.1(c)   Articles of Merger effective July 10, 2000   Exhibit 3(c) to Form 10-Q for the fiscal quarter ended June 30, 2000
         
3.1(d)   Amendment of Articles of Incorporation effective February 5, 2018   Exhibit 3.1 to Form 8-K filed February 7, 2018
         
3.2   Bylaws   Exhibit 3.2 to Form 8-K filed February 7, 2018
         
4.1   Specimen revised Common Stock Certificate   Exhibit 4.1 to Form 10-Q for the fiscal quarter ended March 31, 2010
         
4.2   Amended and Restated Credit Agreement dated as of December 21, 2015 among the Registrant, the Foreign Subsidiary Borrowers from time to time party thereto, the Lenders from time to time party thereto, JP Morgan Chase Bank, N.A. as Administrative Agent, and Bank of America, N.A., BMO Harris Bank, N.A., SunTrust Bank and Wells Fargo Bank, National Association as Co-Documentation Agents   Exhibit 4.1 to Form 8-K filed December 23, 2015
         
4.3   Amendment No. 1 to December 21, 2015 Credit Agreement, effective September 30, 2016   Exhibit 4.4 to Form 10-K for the fiscal year ended September 30, 2016
         
4.4   Amendment No. 2 to December 21, 2015 Credit Agreement, effective May 15, 2017   Exhibit 4.4 to Form 10-Q for the fiscal quarter ended June 30, 2017
         
31.1   Certification of Chief Executive Officer relating to Form 10-Q for period ended June 30, 2018   Filed herewith
         
31.2   Certification of Chief Financial Officer relating to Form 10-Q for period ended June 30, 2018   Filed herewith
         
32   Certification of Chief Executive Officer and Chief Financial Officer relating to Form 10-Q for period ended June 30, 2018   Filed herewith
         
101.INS   XBRL Instance Document*   Submitted herewith
101.SCH   XBRL Schema Document*   Submitted herewith
101.CAL   XBRL Calculation Linkbase Document*   Submitted herewith
101.DEF   XBRL Definition Linkbase Document*   Submitted herewith
101.LAB   XBRL Label Linkbase Document*   Submitted herewith
101.PRE   XBRL Presentation Linkbase Document*   Submitted herewith

 

* Exhibit 101 to this report consists of documents formatted in XBRL (Extensible Business Reporting Language). The financial information contained in the XBRL – related documents is “unaudited” or “unreviewed”.

 

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SIGNATURE

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

  ESCO TECHNOLOGIES INC.
   
  /s/ Gary E. Muenster
  Gary E. Muenster
  Executive Vice President and Chief Financial Officer
  (As duly authorized officer and principal accounting and financial officer of the registrant)

 

Dated: August 8, 2018

 

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