Vic Richey

Mi: Please tell us something about yourself.

VR: After graduating from college I spent several years in the US Army as an intelligence officer before beginning my business career in the defence business – at that time part of Emerson Electric. In 1990 Emerson spun off its defence businesses as ESCO. Over the years at ESCO I held several positions at the corporate and subsidiary level in marketing and management, with both domestic and international responsibility. In 2002 I was named CEO of ESCO, and in 2003 was also named Chairman.

Please tell us about Esco Technologies. How did the company come to be involved in three such different sectors (utility communications systems, filtration products and shielding and test products)?

ESCO, headquartered in St Louis, Missouri, manages 25 operating units throughout North America, South America, Europe and Asia. The company, whose common stock is traded on the New York Stock Exchange, has a market capitalisation in excess of $1.3 billion, with annual revenues greater than $450 million. We employ approximately 2500 people in ten countries. ESCO’s major operating units include Distribution Control Systems Inc., Filtertek, Inc., VACCO Industries, PTI Technologies Inc., ETS-Lindgren and Comtrak Technologies. Recent acquisitions have added Hexagram, Inc. and Nexus Energy Systems. ESCO was created in 1990 through a spin-off from Emerson. At the time of the spin-off, approximately 90% of ESCO’s business was with military and defence customers – the remainder involved providing engineering services and load control products to the electric utility industry.

Today the company primarily supplies products and services to commercial and industrial customers. At the time of the spin-off, ESCO was focused primarily on system-level defence projects, competing against large contractors such as General Dynamics, Raytheon, Northrop Grumman and Boeing. These projects required major capital investments, and had a significant amount of financial and execution risk associated with them. In the early 1990s ESCO’s management team quickly determined that the defence marketplace was not going to be a successful place to do business long term, and began its plan of conversion.

The transition from being primarily a defence contractor to a commercial and industrial supplier began in earnest in 1992 with the first commercial filtration acquisition, and was completed in 1999 with the divestiture of the last major defence subsidiary. The transformation process included the acquisition of over ten businesses and the divestiture of  our major subsidiaries. ESCO believed that this change in strategic direction, via a systematic conversion of the business composition, was in the best interests of its shareholders. New commercial markets were identified and targeted which utilised many of the core technologies, engineering designs and manufacturing expertise which were employed in the defence businesses. As a result of this transformation, two new business segments were created – Filtration/Fluid Flow and RF Sheilding & Test.

At the time of the spin-off, ESCO had a small Filtration/ Fluid Flow business which served the defence and aerospace market. In 1990, this business had approximately $15 million in sales. ESCO management targeted this segment as its first growth platform; through acquisitions and supported by solid organic growth, this business segment generated approximately $175 million in sales in 2005 and diversified out of the defence market by serving automotive, medical, aerospace and industrial markets. A similar approach was taken in the RF Shielding & Test segment. What began as a $20 million business serving a small portion of the defence market is today a $130 million provider of sophisticated products and services to the electronic, wireless, automotive and aerospace markets. ESCO is the market share leader, and manufactures products and provides services around the world in support of its broad customer base. The third segment of the company, known as the Communications segment, started as the only nondefence entity which was included in the spin-off.

The core technology of this business at the time of the spin-off allowed electricity utility customers to communicate across their existing power lines with load control devices installed inside the customer’s home. The purpose of this product was to lower the peak electricity demand of the utility by cycling off certain appliances in the home, such as hot water heaters, pool pumps and air conditioners, for short intervals. This segment had sales of approximately $10 million at the time of the spin-off. In the mid 1990s, the core technology was adapted and enhanced to provide additional functionality capable of performing automatic meter reading and advanced metering. Today ESCO is a market share leader, with sales of $138 million in 2005.

And the recent acquisitions of Hexagram and Nexus – why were they made?

In fiscal 2006, ESCO made two complementary acquisitions within the Communications segment which not only provided additional functionality, but also doubled the served market of this segment. One of the acquired companies (Hexagram) produces hardware and software to provide advanced metering services to gas and water utilities using advanced RF technology. The second acquisition, NEXUS, is a software company which allows utilities to use the metering data much more effectively, and also allows the utility to communicate directly with its customers via web-based tools.

It seems that utility communications is the largest slice of your business. How did this happen?

Actually, the Filtration sales were larger in 2005 than our utility communications business – but given our recent acquisitions, major contract wins at PG&E and overall market growth, our expectation is that Communications will become the largest segment in 2007 and beyond. The growth we have experienced is a combination of overall adoption rates, our investment in product functionality and acquisitions.

Your recent financial results show ep s is short of the estimates – apparently because sales of your amr solution have not been as good as anticipated. Why is this, and what are you doing to turn things around?

As I mentioned in my last conference call after our first quarter press release, the earnings numbers fell short of expectations due to the timing of sales, primarily with sales to co-ops. Despite the timing issue, our co-op orders were very strong in the first quarter and we continue to feel bullish about our future.

Are you planning any more acquisitions in the shortish term, and if yes, in which market sector?

Our primary focus for acquisitions is in the utility Communications segment, particularly on the software side and/or internationally. However, we continue to look for ‘tuck in’ opportunities in the other two segments.

Are you planning to sell off any of the companies you presently own? If yes, which one(s) and why?

As part of our strategic planning process we regularly evaluate our business mix, but we see tremendous benefit to a multi-segment business.

Are you intending to expand the utility communications business outside the Americas?

To date we haven’t done much because we have been quite busy on the domestic front. We are currently evaluating what approach we should take to address international expansion. There appear to be good near-term opportunities in Europe and Asia. In the longer term, Asia and South America should become very involved in advanced metering. As I mentioned earlier, we do a good bit of international business through our other segments, and therefore we understand the risks and opportunities in this type of expansion. We will most likely undertake the approach of strategic partner or acquisition versus starting a ‘greenfield’ operation.

What sort of market share does the utility communications business command?

If you’re talking about installed base with all systems, including drive-by systems, we would be less than 20%. However, we have won most of the large IOU contracts in the past few years that have gone with a fixed network technology, including PREPA, Pennsylvania Power& Light, Wisconsin Public Service, TXU and more recently, Pacific Gas & Electric.

What other plans for the future do you have for the utility communications business?

We will continue to add functionality to our core products, look to leverage our recent acquisitions and look for additional opportunities to acquire complementary companies or technologies. How much of an emphasis is placed on r&d at esco technologies? (with particular reference to the utility communications section).
R&D and new product development are very important to us and our engineering expenditures have been in the 7-8% of sales range over the past several years – heavily weighted to the utility Communications segment.

Where does most of the production of the utility communications products take place, and why?

On the electric side we subcontract all of our production in the Communications segment. Basically what is being manufactured is a printed circuit board, which many companies are capable of making. On the gas and water side, Hexagram does some manufacturing and subcontracts some. This approach allows us to focus on the engineering and project management side of the business, and transfers the overhead associated with the manufacturing of the product to a third party. When we have fluctuations in demand due to project startup or completion, we don’t have to deal with the ‘bricks and mortar’ and people issues. Also, thanks to their worldwide purchasing power, these large subcontract manufacturers are able to leverage their vendors to provide us with competitive prices. It’s a win-win situation.

Thank you for your input.