Good day, and welcome to the ESCO Second Quarter 2014 Conference Call. Today's call is being recorded. With us today are Vic Richey, Chairman and CEO; Gary Muenster, Vice President and CFO. And now to present the forward-looking statement, I would like to turn the call over to Kate Lowrey, Director of Investor Relations. Please go ahead.

Thank you. Statements made during this call regarding the total cash we received in connection with the Aclara sale, 2014 EPS from Continuing Operations as adjusted, future growth, profitability and revenue, the schedule and cost of the Crissair move, and other statements which are not strictly historical, are forward-looking statements within the meaning of the Safe Harbor provisions of the federal securities laws. These statements are based on current expectations and assumptions, and actual results may differ materially from those projected in the forward-looking statements, due to risks and uncertainties that exist in the company's operations and business environment, including, but not limited to, the risk factors referenced in the company's press release issued today, which will be included as an exhibit to the company's Form 8-K to be filed. We undertake no duty to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. In addition, during this call, the company may discuss some non-GAAP financial measures in describing the company's operating results. A reconciliation of these measures to their most comparable GAAP measures can be found in the press release issued today and found on the company's website at www.escotechnologies.com, under the link Investor Relations. Now I'll turn the call over to Vic.

Thanks, Kate, and good afternoon. Let me start with a brief comment on the sold Aclara, which was wrapped up at the end of March. I'm pleased with the paid cash proceeds resulting from transaction, as the total cash generated as expected to be north of $155 million and result in a very favorable liquidity position. Completing the transaction, positions us for a more stable and predictable future. If you combine with the strength of our balance sheet, it creates additional opportunities for growth given our financial flexibility. Our remaining businesses continue to present us with long-term organic growth opportunities. That when supplemented with our M&A strategy, create an exciting outlook for ESCO over the next several years. As we reported in a separate release today, I'm pleased to announce that we've added 2 new independent board members. We are fortunate to have experienced and seasoned board, and these additions further enhance our depth. We're imbibing a wealth of the industry perspective to ESCO and are excited to capitalize on our experience. Moving on to our Q2 performance. For the third consecutive quarter, we've exceeded our profit and cash flow commitments compared to our earlier guidance. This is a result of another strong quarter in Filtration segment and lower-than-expected SG&A spending across the company. Within the Filtration segment, we remain bullish on our growth and profitability, which is being driven by the recently announced aerospace program wins, coupled with having some sizable programs moving toward production. The consolidation of Crissair and Canyon Engineering is progressing on schedule and on budget. And through the first 6 months of this year, Canyon continues to beat its internal -- it's initial acquisition forecast. Looking forward to next year, we're excited to see the projections coming out of the combined Crissair and Canyon operation.…

Thanks, Vic. With the sale of Aclara being completed in Q2, Aclara's financials are presented as Discontinued Operations in the attached released. I remind you that once Aclara was put into Discontinued Operations last year, depreciation and amortization were no longer expensed. On the cash side, through March 31, we've collected approximately $140 million of proceeds related to the transaction, and we expect another $15 million in cash to be received within the next 60 days related to the specific Aclara receivables and other working capital adjustments. Additionally, we generated $15 million of cash from continuing operations during the first 6 months of the year. Consistent with our previous communications, the Q2 and year-to-date results are being reported based on EPS from Continuing Operations as adjusted. And therefore, my commentary will follow as such. As a reminder, the '14 results discussed here exclude the nonrecurring charges to complete the exit and relocation of Crissair's Palmdale, California operation into the Canyon Engineering facility in Valencia. As Vic said, the move is on track and we expect it to be completed by the end of the year at a cost of approximately $2 million or $0.05 a share. And to date, we've spent about $500,000. The 2013 adjusted items were identified throughout the prior year on a quarterly basis and are noted in the financial tables attached to the release. During the February call, we expected Q2 EPS from Continuing Operations as adjusted in the range of $0.27 to $0.32 a share. We beat the top end of our range by $0.04, as we delivered $0.36 a share on a comparable basis. As Vic noted, the increase in earnings was the result of better-than-expected Filtration performance and lower SG&A spending. I'll call out a few highlights from the release to allow you…

Okay. We'd be happy to answer questions you have.

[Operator Instructions] And our first question is going to come from Jon from CJS Securities.

Corporate expenses and SG&A were pretty low in the quarter. Can you give us a little more detail on what went into that and the run rate we can expect going forward?

Yes. I think, Jon, with the effort that we were expending on the Aclara transaction, we pretty well had everything else on hold. So, normally, we're looking at some M&A opportunities. We have some diligence activities going on and things like that. And then, I'd say, normal ordinary course of business where we're spending money on certain things, I would say we were all pretty well on lockdown in getting the Aclara transaction down. So that's why it was a little lighter than one would expect. So I think if you looked at the first quarter, that would be what I refer to as a little bit more normalized run rate relative to what you should be able to see there. So I think if you use that and kind of in the neighborhood of $5.5 million to $6 million, would probably be the right way to think about that. So it's more of a timing thing than anything.

And then just on the new capital return strategy. Just on a relative basis, can you give us more color on how much you've actually spent in the past as a percentage of free cash flow just on dividends or buybacks, that kind of thing?

The dividends has been pretty well fixed since we initiated -- and it's ballpark $8 million, I think, it's about $8.4 million. And so we expect that to remain the same. So if you look historically, we've been in and out of the buybacks scenario. We bought back $15 million over the last 2 years. And so going forward, I think, really, the south for aspect of it is if you look at free cash flow going forward. And if we were to use a number of $40 million to $50 million and you put 40% against that, and you have $8 million on dividends, the balance would be -- how you should think about share repurchases going forward. So $40 million, 40%, $16 million. So you'd be somewhere in the neighborhood of $8 million to $10 million on that map.

And these are just, so you know, I mean, this is not that different to what we've done historically based on what Gary said. We just thought it would be helpful for people to kind of understand how we were thinking about that. And of course, the wild card will be what we do on the M&A side. I mean, obviously, you can say 60% for the other piece of it. And I'd say the real consistent piece is your going to be in the dividend. And what we'd make, as far as investment and new product development and then the rest of it is kind of driven by what's available in the market from an M&A perspective to be augmented with the share repurchase as appropriate.

Got it. That's very helpful. And then can you just give us an update on the M&A pipeline and what you're seeing out there?

Yes. It's -- as Gary mentioned earlier, we pretty much have it by a lockdown until 30, 60 days ago. But there are opportunities out there, [indiscernible] we have kind of formal protegees that you use the operating units, as well as getting aggressive, very corporate, I guess. So there are opportunities out there. As you know, things are expensive these days and so we want to make sure that we take a very disciplined approach when we start to add to the company through M&A. But there are good opportunities out there.

And then our next question is going to come from John Quealy out of Cannacord Genuity.

So, first, the question, so the 2 new independent directors was that motivation more internally, just sort of best practice or was there some ISS/activist pressure, or how did that come about with the first time...

So this is a process we actually started before we had decided to sell Aclara. So we have started down the path because we had a pretty small board, we thought it was time to start adding to the board. As -- a lot of the folks we had on the board for a long time, which is a great thing. We just thought it was time to bring on some additional people with the additional experiences. And particularly, we wanted to have somebody with utility experience. Because while we had -- when we sold Aclara, we still are very interested in the utility space and thought that having some expertise was good there. Now, once we made that decision to sell Aclara, we put that on hold because we started -- we thought it was kind of unfair to bring people on board in the middle of that process. And so once we got to the -- closer to the finish line, we reenergized that and we're able to bring these guys on. So I'd say it's more just -- we wanted to have a broader board with some additional experiences. That was what really drove that decision. And then as you may remember, we unfortunately lost a board member about 6 months, what's been...

A year now.

About a year ago now, and so that really accelerated. In fact, we were looking at 1 initially, and maybe 2, really needed to add. So even with these guys on, we still have a reasonably small board.

Yes. Okay. That's fair. And then so looking at Filtration, it continues to do really well. You mentioned the secular uptick. Talk to us qualitatively, if you would, Vic, do you think that macro had longer legs than you thought before? I can imagine that potentially influences M&A decisions at the right price, but just give us a litmus test on Aerospace Filtration, especially at this point.

Yes. I would say it does continue. It has continued to improve over the last couple of years. As you know, both Boeing and Airbus have the longest and biggest backlog that they've had in quite some time. The other thing that's encouraging to me is we already had a couple of programs that were moved into production. And with the recent wins that we've talked about before, that gives us more legs. As you now, in this business, with the aerospace business, it's a matter of getting the one near the airframes. Because once you get an airframe, unless you're really screwed up, you get to keep that position. So you really do need a good mix of the legacy programs, as well as new programs. We've been able to do that. We'll continue to do that. In short, it's a good business. I mean, it's just really a long-term good business. And we see that when we were just out there a couple of weeks ago. And then some of these programs started on a production escrow, we'll see some better growth. And what we have seen in the last couple of years as these programs go into production, that's where you really start getting an incremental growth.

Okay. And then, lastly, so the remaining small debt on the balance sheet now, of course, to the current isle, do you wait for acquisition to do something with that debt or you just pay it down, Gary, how should we think about that? You're clearly underlevered here.

Right. And this is about the ideal capital structure. We acknowledged that, and that's why we're being aggressive on the M&A side. As Vic said, we're looking at a lot of opportunities. We are going to generate cash in the back half of the year. So the reason it's moved up to current, we don't have a mandatory payment due. It's really more just the accounting to reflect this. We don't really have to write any checks to pay that $40 million off. But between the buyback and the M&A activity, we would expect free cash flow to pay that down, and then acquisitions and buybacks to bump it back up. And, over time, again, we were not looking to just blow the balance sheet with a tremendous amount of debt. But I think, over time, we're going to maintain a very prudent capital structure. But for right now, I assume, jump ahead to the next quarter. If we don't have an acquisition done by the next quarter, you'll just see that debt lower than it is today.

And then our next question is going to come from Nick Prendergast from BB&T Capital Markets.

I just had a question on your Test margins. They came in lower than expected and you gave a pretty good explanation of that. I know that segment is typically pretty volume sensitive and it's usually back-end loaded. So do you see kind of volumes kind of sequentially increasing here in Q3 and Q4, and maybe margins are recovering through a more normalized level or is there going to be some carryover of these low-margin projects?

No. I think what you're going to see a nice uptick looking -- if you look at the profile back in fiscal '13, it's going to be very similar to that. So we did $41 million in revenue in Q2. That should be north of $46 million in Q3. And there will be fewer of the large chambers in there that have all the construction pass through content. So you should see margins getting up into the low- to mid-teens there with that volume and the mix change favorably. And then in Q4, you'll see a big pop from some of these orders that we booked in Q2, or the order profile will be in the low- to mid-50s in Q4. And with that kind of volume, you'll have very similar margins to what you had in Q4 of 2013, which were 17%. So you could expect 17% of that volume comes through, and we've demonstrated that last year that the volume will pull that overhead absorption through. So it will be back-end loaded as it was in the past. And I think if you go back a couple of years, it's the same kind of profile and the mix is favorable as well.

Got it. That's extremely helpful. And then, obviously, your debt profile would play a large part in any of your M&A. How much do you have available under your revolver?

The gross revolver is for $450 million, and then we have the accordion which is $250 million. So on the piece that we're actually carrying on the revolving side, we have $40 million of debt against that and we have $7 million or $8 million of letters of credit outstanding that count against that. So in round terms, counting the domestic cash we have on hand, I'd comfortably say we have $400 million immediately available. And that if we were to do an acquisition, that's what the accordion is for, we could draw against that if we chose to. Just hypothetical, if we had a $250 million deal, we could pull the accordion into it and keep the revolver intact. So we have a lot of flexibility sitting there on the checkbook.

And then our next question is going to come from Jim Giannakouros from Oppenheimer.

I'd like to attack on to the that margin question, basically, for the USG and the Filtration segments. I know that you're -- on Filtration your tracking a little lower than I think what I had anticipated 19.5%, 20% or so normalized given just some start-up costs, et cetera in the first half of this year. How should we be thinking about the second half run rates for USG and Filtration?

On the USG side, you'll see a little bit of an uptick relative to the volumes there. So if you look at Q2, we get about 25 million. I think we're comfortable in Q3 putting that up at about $28 million to $29 million in revenue. And kind of keeping it in, keeping the EBIT margin in the low-20s. I think, somewhere between 20% and 22%. Again, the mix influences that. So I'm comfortable with that. And then if you remember, last year, in Q4, we had a step up to about 30 million in Q4. We expect to be pretty close to that. So it should be pretty comparable looking both on dollars of revenue and percentages of margin at the EBIT side. So I think Q4 is going to look a lot like Q4 last year in the Doble business. And then on the Filtration side, again, with the announcement that we put out on the 4 or 5 new programs wins we have, we're spending a lot of start-up money on that to get some of the engineering wrapped up in the development stage, and that's burned through. So you won't have that same level of cost hitting in Q3 and Q4. It's still be some there, but not at the magnitude it's at. So you'll see the margin step up greater than a point there. So I think we did about 17%, 18% there. You'll see that grow up a full point. And then in Q4, you'll see it north of 20 with a nice pop in revenue there. And that's really going to be a function of catching up on some of the commercial aerospace products that we're going to be selling, as well as VACCO delivering a big piece of the Virginia-class submarine valve that we do every year. And that will pull through some favorable margins in Filtration. So we feel pretty good about the back half of the year. As Vic said, we're just solid on all the operating units within the last month and we took a hard scrub of that in advance of this call, and we feel pretty comfortable with the back half of the year.

[Operator Instructions]

Okay. It looks like we're finished. So I appreciate everybody's interest today and we'll talk to you next quarter.

Thank you, ladies and gentlemen. This concludes today's conference. Thank you for participating, you may now disconnect.

Thank you.