ESCO
Annual Report 2007

Plain-text annual report

E S C O TE Ch nOlOg iE S inC. 2 0 0 7 A n n u Al REpO R T E S C O TE Ch nOlOg iE S inC. 2 0 0 7 A n n u Al REpO R T C o m m u n i C at i o n S F i lt r at i o n r F S h i e l d i n g & t e S t Contents Letter To Shareholders 23 Financial Statements 1 3 4 6 Company Overview Communications Filtration 8 RF Shielding & Test 10 Commitment To Communities 11 Financial Section 12 Management’s Discussion and Analysis 28 Notes to Consolidated Financial Statements 43 Accountability Reports 46 Five-Year Financial Summary 47 Market Performance 48 Shareholders’ Summary 49 Management and Directors E S C O TE Ch nOlOg iE S inC. 2 0 0 7 A n n u Al REpO R T To Our Shareholders Fiscal 2007 was a challenging year for ESCO and included events. On the positive side, our operating performance many positive developments along with a few negative was strong across all three business segments, and we real- ized sales growth of 10 percent or more in five of our eight operating units. Hexagram clearly was our biggest success, as we more than doubled their sales to nearly $50 million and ex- panded our product offering with the successful launch of our fixed-network RF AMI electric solution. At DCSI, sales to COOP customers which represent the core strength of our business base increased 15 percent to nearly $95 million. Additionally, we are pleased with the continued strength of our aerospace- related businesses (PTI and VACCO) which combined for nearly 15 percent top line growth along with a meaningful operat- ing margin expansion. While more expensive and longer in development than originally planned, we are pleased with the current operational status of our next generation AMI software, TWACS NG. On the negative side, PG&E’s decision to reevaluate the electric AMI requirements, along with a slower than originally Victor L. Richey, Alyson S. Barclay, and Gar y E. Muenster planned deployment, certainly was the biggest disappointment My perspective on the current position and outlook for the in 2007. Additionally, while progress on the TWACS NG software individual segments of our business is as follows: development continues going well, the delayed delivery and In the Communications segment, 2007 was a solid year for us resulting revenue deferral was disappointing. Lastly, the 2007 in terms of positioning ESCO for significant growth. This segment arbitration loss in the Test segment related to a long completed continues to offer the best opportunity to deliver meaningful government project negatively impacted that segment’s operat- increases in shareholder value over the next few years. ing performance. In September, we announced the strategic integration of the Summarizing 2007, despite the challenges we faced, ESCO Communications segment to take full advantage of our broad showed resiliency and delivered year-over-year improvement both range of product offerings. This action allows ESCO to present at the top and bottom line, and most importantly, positioned our- customers with a more focused customer-facing organization selves for substantial growth in 2008 and beyond. Additionally, that will bring together a comprehensive suite of unique products the November 2007 sale of a portion of Filtertek along with the and services providing proven technologies and industry leader- acquisition of Doble has allowed us to strategically reposition ship while offering seamless, integrated solutions that have not ourselves by adding a high margin growth business, which is previously existed in the marketplace. Customer reaction to this complementary to our Communications segment, while exiting a integration and the rollout of our “hybrid” solution which offers lower margin slower growth business. The cash proceeds from the a mix of power-line based and RF based AMI technologies has divestiture will be used to partially fund the Doble acquisition. been very favorable. The investments we continue to make in new products, software, Today, we have the most capable, proven AMI technologies and acquisition partners, have positioned us for significantly available in the market which can be deployed to satisfy even the improved financial performance. This growth will provide the largest IOU customer’s requirements, whether used for electric, opportunity to increase long-term shareholder value, which is gas or water utility applications. With that said, we will never our primary mission. stand still when it comes to new product development, evidenced 1 E S C O TE Ch nOlOg iE S inC. 2 0 0 7 A n n u Al REpO R T To Our Shareholders I believe we have the financial strength and flexibility, as well as the right products and technolo- gies, to effectively achieve our growth plans in 2008 and beyond. new testing standards continues at an unprecedented level. Our expanding international presence is a primary source of our growth as electronics manufacturers continue establishing new product development centers in the Far East, and therefore, we will continue to expand our presence near these customers to capture this growing demand. My confidence in our ability to cap- ture a majority of this growth is based on our leadership position, expanding international presence, and superior technology. Additionally, we remain committed to managing our cost struc- by the continued investments we made in 2007. We increased ture in this segment to better leverage our growth as evidenced our Company-wide spending on research and development to by the consolidation of our acoustics business in Austin, Texas, $33 million compared to $26 million in 2006, with AMI related resulting in a 40,000 square foot reduction in floor space. product solutions leading the way. In Filtration, we expect continued solid financial performance In Communications, our new product development has been in our aerospace related businesses although our growth outlook focused on meeting customer needs and includes several prod- remains somewhat modest compared to our 2007 growth. This ucts that will provide functionality “behind the meter.” These segment continues to provide a solid foundation for our business new products include interfaces with smart thermostats and while generating a significant amount of cash. Our favorable multiple-function in-home displays which will allow utilities cost structure allows us to earn above average returns which and their customers to better manage how and when energy is supports our commitment to invest in this segment via drop-in used. Our full suite of products provide the information neces- acquisitions such as Wintec. sary to allow the utilities to gain greater insight into and better The divestiture of Filtertek makes us a more strategically control over the management of their energy resources, which focused higher margin business with a much improved growth is the core tenet of AMI. profile. Additionally, this divestiture fully supports our stated Additionally, we expect to continue our market-leading posi- strategy of continuing to concentrate our investments in our tion with COOP and Municipal customers that have provided a fastest growing, highest margin Communications segment. stable revenue platform for the last few years. On the interna- Overall, I believe we have the financial strength and flexibil- tional front, we expanded our focus by adding senior business ity, as well as the right products and technologies, to effectively development staff to address the fast moving dynamics currently achieve our growth plans in 2008 and beyond. I am grateful that being seen in numerous countries outside of North America. The we have solid management teams in place across the Company international AMR / AMI opportunities are substantial, and we who understand our mission and are fully committed to deliver- feel we have the appropriate resources and product offerings in ing exceptional results. place to capitalize on these. In closing, I want to thank our customers for the opportunity Lastly, we are excited about the addition of Doble Engineering to serve them, our employees for their effort and dedication, our Company. Doble will allow us to further penetrate the electric Board of Directors for their leadership and guidance, and our utility market by leveraging its strong brand recognition and shareholders for their support and confidence. superior customer service. Along with the additional resources that ESCO will provide to grow this business, Doble is expected to capture more than its fair share of the electric utilities’ substan- tial investments in the areas of grid management, grid reliability, and optimal asset utilization. Victor L. Richey Moving to the Test segment, we continue to see solid growth Chairman, Chief Executive Officer, and President prospects as the introduction of new electronic products and November 29, 2007 2 E S C O TE Ch nOlOg iE S inC. 2 0 0 7 A n n u Al REpO R T Company Overview ESCO Technologies Inc. is a worldwide manufacturer of highly engineered products operating in three business segments: Communications The primary companies of the Communications segment, DCSi, hexagram and nexus Energy Software, provide market and technology leadership, employing the highest caliber, proven Two-Way Fixed Network Advanced Metering Communication Systems (TWACS by DCSi® and hexagram Star®), with enter- prise software that stands apart in its ability to optimize what smart meter data can accomplish for utilities and their customers (nexus MDMS™). Our SecurVision® product line provides digital video surveillance and security functions for large commercial enterprises and alarm monitoring companies. Electric, Gas, and Water Utilities, Security Industry Filtration/Fluid Flow The com- panies in this segment design and manufacture specialty filtration products ranging from high volume medical components to unique filter mechanisms used in micro- propulsion devices for satellites. RF Shielding & Test The com- panies in the RF Shielding & Test segment are industry leaders in providing their customers with the ability to identify, measure and contain magnetic, electromagnetic and acoustic energy. Healthcare, Aviation, Space, Trans- portation, Consumer Appliance Healthcare, Electronics, Transportation north America Cedar Park, TX Cleveland, OH Durant, OK Glendale Heights, IL Hebron, IL Huntley, IL Juarez, Mexico Minocqua, WI Oxnard, CA South El Monte, CA St. Louis, MO Wellesley, MA Europe Eura, Finland Newcastle West, Ireland Plailly, France Stevenage, England ESCO Operations Markets Served South America São Paulo, Brazil Asia Beijing, China Tokyo, Japan 3 E S C O TE Ch nOlOg iE S inC. 2 0 0 7 A n n u Al REpO R T Automated Metering Infrastructure and Meter Data Management for Electric, Gas and Water Utilities Worldwide C ustomers of ESCO’s Communications segment get proven results with industry-leading advanced metering solutions that are innovative, fully customizable, and built using advanced RF- and PLC-based fixed- network technologies and leading meter data management software. A deep-rooted culture of improvement in the Communications segment companies drives them to exceed customer expectations. The segment’s three primary companies — DCSI, Hexagram, and Nexus Energy Software — work closely with municipal and investor-owned utilities worldwide through a unique integrated sales, marketing, and customer-service organization that allow them to respond quickly and effectively with cutting-edge solutions that meet the most exacting requirements. e n d u S e r S B e n e F i t ▲ Increase awareness of energy pricing and conservation ▲ Stabilize energy costs ▲ Improve interaction with utility companies ▲ Enable customer prepayment 4 e l e C t r i C PoWer utilitieS ProFit From reliaBle and ComPlete adVanCed metering inFraStruCture. ESCO’s Communications segment offers proven power line and radio frequency com- munication systems with full two-way access to and from the meter, providing useful information to utilities. With features such as load control, demand response, interval data, time-of-use, and critical peak pricing, customers of ESCO’s Communications segment benefit from reduced resource requirements, efficient and reliable meter data man- agement, reduced costs, and enabled innovation in business processes. B u s i n e s s s e g m e n t The versatile TWACS® IHD (In-Home Display), above left, from DCSI provides utilities with valuable end-customer information and supports applications from rate-change messaging to individual account monitoring. The device works via the existing TWACS infrastructure — an important market differentiator — and is an easy addition to exist- ing utility deployments. Nexus Energy Software provides utility and energy companies with value-added software solutions that unlock the power of advanced metering and energy information. Nexus’ applications are in use at more than 100 energy companies worldwide and help reduce capital, operating and resource costs and increase customer satisfaction, while supporting millions of customers, interac- tions, and transactions each year. V iSiOn > E n g i nE E Ri n g > i M A g i nA TiOn ga S Wat e r gaS utilitieS relY on FiXed-netWorK Water utilitieS dePend on adVanCed teChnologY For reliaBle data meter reading and leaK deteCtion ColleCtion. Flexible advanced-metering solutions from Hexagram, Inc. provide gas utilities with the decision-making infor- mation that they need to serve customers. Transmitters, designed to supplement nearly all gas meters, automatically collect readings on a customer-defined schedule and transfer the incremental data regularly to the utility. The informa- tion then is used by utili- ties to balance distribution records or to track individual consumption, leading to high- er customer satisfaction. teChnologieS. Water utilities use innovative metering technologies from Hexagram to improve customer service and enhance water-conservation efforts. Fixed-network solutions allow utilities to collect meter readings automatically and analyze them quickly to pinpoint in-home leaks as well as tamper or backflow conditions. Hexagram’s partner- ship with Gutermann International will take leak detection to the next level by helping utilities acquire and correlate acoustic readings to identify leak loca- tions on the water main. Hexagram’s STAR® Network AMI/AMR system delivers the right data in the right format to municipal and privately held gas, water, and electric utilities. u t i l i t i e S B e n e F i t ▲ Know and understand consumption patterns ▲ Implement demand- response programs ▲ Recapture lost revenues ▲ Improve customer service and communications 5 E S C O TE Ch nOlOg iE S inC. 2 0 0 7 A n n u Al REpO R T Engineered Filtration and Fluid Flow Products for the Aerospace, Medical, and Automotive Markets Worldwide E SCO’s Filtration and Fluid Flow segment, comprised of Filtertek, PTI Technologies and VACCO Industries, serves a diverse group of technically demanding markets such as automotive, air transport, medical and satellite communications. The applied level of innovation and commercial success into these markets is testament to their ability to turn vision into engineered solutions. Through the incorporation of cutting-edge technology they continue to stimulate imagination and shape the path forward. The success of the Filtration group has been historically demonstrated and will continue to be defined through the successful exploitation of new ideas, products and services. B u s i n e s s s e g m e n t e n d u S e r S B e n e F i t ▲ Reliability in aircraft, automo- tive and recreational vehicles ▲ Variety of entertainment provided by satellites ▲ Healthier lives through cleaner and safer water 6 ae r o S PaC e Filtration and Fluid FloW ProduCtS For SPaCe and airCraFt marKetS. Innovation as the corner- stone for success is best exhibited with the VACCO automated refueling mechanism aboard the Orbital Express mission. The VACCO solution provides the first ever U.S. on-orbit demonstra- tion of automated fuel transfer between two satellites. Closer to earth, similar successes can be found at PTI with the development of a wide range of products supporting the next generation of manned and unmanned aircraft from the Global Hawk to the Joint Strike Fighter to the Boeing 787. Life’s challenges often require unique solutions. The ability to rise to these challenges defines the Filtration group. Universally, Filtertek, PTI and VACCO are recog- nized globally as sources for the custom develop- ment of engineered solutions. Through their own efforts or through collaborative devel- opment with the OEM, they push the limits continually. With a com- mitment to cutting-edge projects and technologies; it is engineering that truly invents the future. Whether the goal is for greater operational efficiency as demanded by the automotive industry, the quality assurances essential to sustain life or the reliability required to sustain non-stop flight, the Filtration group prides itself on its ability to leverage its design experience and manufac- turing expertise to take invention to innovation. V iSiOn > E n g i nE E Ri n g > i M A g i nA TiOn m e d iC a l au t o m o t iV e mediCal, PharmaCeutiCal and Bio- CuStom Filtration For automotiVe PharmaCeutiCal Filtration. Critical medical applications require the highest level of product engineering and manu- facturing expertise. Whether it’s an at- home drug delivery device or an extracor- poreal circuit particulate filter supporting open heart surgery, patients and practi- tioners need the most advanced products possible. Recognizing this need, Filtertek remains at the forefront of emerging medical technologies, materials and manufacturing practices, and works to incorporate the most innova- tive ones in a broad spectrum of medical applications. manuFaCturerS and diStriButorS. Coming off the production line, each auto- mobile houses numerous filters designed to protect its fluid systems and keep them operating reliably. Automakers continue to promote longer vehicle life with lengthy warranty periods, bringing filtration to the forefront as a central design issue in new vehicle development. Understand- ing the vanguard of emerging automotive technologies such as alternative fuels, gas mileage improvements, and advanced power train development, allows Filtertek to support its automotive customers with continued ingenuity and flexibility. Filtertek has manufactured custom-engineered filters for major automobile manufacturers since the company was founded in 1965. Pioneering the all- plastic transmission filter, the company remains at the forefront of transmis- sion filter technology. i n d u S t r i e S B e n e F i t ▲ Innovative engineered filtration solutions ▲ Reliability of a proven product track record ▲ World-class quality control systems ▲ Value through operational efficiency 7 E S C O TE Ch nOlOg iE S inC. 2 0 0 7 A n n u Al REpO R T Detect, Measure and Manage Magnetic, Electromagnetic and Acoustic Energy for Customers in a Broad Range of Industries E TS-Lindgren comprises ESCO’s RF Shielding & Test segment. Within this segment, ETS-Lindgren is recognized as a global leader not only for the depth and quality of its products and services, but for its leader- ship role in the technical standards committees that drive RF shielding and test regulations. Suppliers of electronic products — from cell phones to aircraft — rely on ETS-Lindgren to provide innovative RF shielding and test solutions to measure product performance and ensure regulatory compliance. As products have increasing electronic content and operate in closer proximity, test demands have increased and markets requiring this testing have expanded. Markets served now include the electronic, automotive, aerospace, medical and, increasingly, wireless industries. e n d u S e r S B e n e F i t ▲ Availability of proven and reliable products ▲ One source for multiple RF shielding and test requirements ▲ Customized solutions to meet unique demands 8 t e St eleCtromagnetiC and radio Fre- quenCY meaSurement SYStemS. In today’s increasingly electronic envi- ronment, commercial and government regulations require electromagnetic compatibility (EMC) between products and within products — such as wireless hand-held devices with multiple capa- bilities. ETS-Lindgren designs, manu- factures and installs numerous types of enclosures for testing electronic prod- ucts to ensure electromagnetic compat- ibility. ETS-Lindgren engineers, through their leadership on standards commit- tees, impact the emerging regulations and creatively design test solutions. B u s i n e s s s e g m e n t ETS-Lindgren provided the first Over-the-Air wireless performance test system and con- tinues to set the indus- try standard with high quality, diverse test solutions. With rapidly emerging technolo- gies such as Wi-Fi and WiMAX™, its involve- ment in the standards committees and the flexibility of its wire- less test solutions, the company is poised to maintain its industry leadership. Innovative test solutions for the wireless (left) and medical (above left) industries are key to ETS-Lindgren’s success. Defense requirements are expanding in today’s aerospace and military markets. Long a trusted supplier, ETS-Lindgren is well known for its high per- formance microwave chambers, some of which are designed to test full size fighter aircraft. ETS-Lindgren’s microwave chambers (right) allow precise measurement for secure applications. V iSiOn > E n g i nE E Ri n g > i M A g i nA TiOn m e d iC a l aCo u S t i C Shielded and Sterile enCloSureS modular noiSe Control enClo- For magnetiC reSonanCe imaging. SureS For ProduCt qualitY teSting. Combining its RF shielding expertise with the desire to perform magnetic resonance imaging (MRI) scans during surgical pro- cedures, ETS-Lindgren developed the MRI Interventional Suite. This new technology provides the magnetic shielding required for the proper operation of the MRI scan while also providing a sterile environ- ment, thus eliminating the need to move the patient and potentially reducing mul- tiple surgeries. ETS-Lindgren is the leader in RF shielding for the medical industry with significantly more installations glob- ally than any other company. Acoustic testing is critical to verify a product design meets industry regulations and the desired audio quality is achieved. This is especially important for consumer products, from dishwashers to hearing aids, to name a few, to assure ideal sound transmission. The addition of Acoustic Systems, with its popular pre-engineered panels for flexible designs, expands ETS-Lindgren’s chamber offerings to new markets, including industrial and con- sumer products as well as the audiology service industry. Customers now have one source for EMC, MRI, and acoustic testing. Manufacturers of small electronic devices, such as cell phones, require quick and efficient testing to verify performance. ETS-Lindgren’s test cells are ideal for engineering design verification and pre-compliance measure- ments for quality control. i n d u S t r i e S B e n e F i t ▲ Vision and position to capture emerging RF shielding and test trends ▲ Engineering expertise ensures products that perform as expected ▲ Imagination provides innovative test solutions 9 E S C O TE Ch nOlOg iE S inC. 2 0 0 7 A n n u Al REpO R T Commitment to Communities I n 2007 the ESCO Technologies Foundation marked its first full year of operation as a charitable non-profit entity. Funding from the Company, as well as from many of our dedicated employees, ensured that the Foundation was able to support children and families in need in areas where the Company has operations throughout the United States. Some of the recipients of Foundation grants during the year are described below. As the Foundation grows, additional recipients will be considered for assistance. WellSPring Center For hoPe The Wellspring Center for angel on mY Shoulder ltd Headquartered in St. Germain, Hope, a non-profit organization located in the Chicago area, Wisconsin, this non-profit organization was founded with the promotes an individual’s right to be physically safe by providing hope of becoming the emotional backbone of people in the com- emotional support, advocacy and crisis intervention. A grant munity by improving the qualify of life for those who have been was made by the Foundation to further Wellspring’s work in afflicted with or affected by cancer. The Foundation’s grant educating the community regarding the signs and effects of assisted the organization in helping individuals, families and domestic violence. caregivers who demonstrated a need for support. reVitalization 2000, inC . Dedicated to reaching out to haBitat For humanitY During 2007, the Foundation sup- disadvantaged kids in the Ville neighborhood of St. Louis, ported Habitat for Humanity (HFH) organizations in DuPage Revitalization 2000, Inc. (R2K) was given a grant by the County, Illinois and St. Louis. HFH is dedicated to eliminating sub- Foundation for two programs. The Claver Works Program pro- standard housing and the St. Louis HFH took on the challenge of vides training and supervision for students to do part-time lawn building 25 houses in 2007. In addition to the Foundation’s finan- and gardening work, giving them the opportunity to learn a cial assistance, ESCO employees and family members volunteered skill and the responsibility of work commitments as well as a to work on one of the houses during two days of the build cycle. small income opportunity. With the funding, R2K was able to ESCO corporate employees hung siding and installed porches, and offer this program throughout the summer to area students. a group of DCSI employees painted the interior. Pictured below The Foundation also funded the Botball Renaissance Program is Kristen Everett of ESCO’s Tax Department applying her newly once again. This program is an organized national robotics pro- learned circular saw skills as Mindy gram for youth in grades 7–12. With funding by the Foundation, Anderson, HFH Crew Leader, over- eight Ville students traveled to a regional Botball tournament at sees her work. Southern Illinois University. The students were mentored during the year by a group of dedicated employees from the Company’s DCSI subsidiary. WingS oF hoPe 2007 was the first year the Foundation has supported Wings of Hope (WoH). WoH was founded in St. Louis but reaches across the world. The organization retains older air- craft refurbished by volunteers to become life-saving transport. Volunteers also maintain the planes and fly the missions. ESCO Technologies Foundation funding was earmarked for transport missions relating to children needing emergency or specialized healthcare in the states where the Company has operations. To make a tax-deductible contribution or to learn more about the Foundation, please call 314-213-7277 or visit the Web site at www.escotechnologiesfoundation.org. 10 E S C O TE Ch nOlOg iE S inC. 2 0 0 7 A n n u Al REpO R T Financial Section Contents 12 Management’s Discussion and Analysis 23 Consolidated Statements of Operations 24 Consolidated Balance Sheets 26 Consolidated Statements of Shareholders’ Equity 27 Consolidated Statements of Cash Flow 28 Notes to Consolidated Financial Statements 43 Management’s Statement of Financial Responsibility 43 Management’s Report on Internal Control Over Financial Reporting 44 Reports of Independent Registered Public Accounting Firm 46 Five-Year Financial Summary 47 Market Performance 48 Shareholders’ Summary 49 Management and Board of Directors 11 Management’s Discussion and Analysis The following discussion should be read in conjunction with the Consolidated Financial Statements and Notes thereto. The years 2007, 2006 and 2005 represent the fiscal years ended September 30, 2007, 2006 and 2005, respectively, and are used throughout the document. introduction ESCO Technologies Inc. and its wholly owned subsidiaries (ESCO, the Company) are organized into three reporting units: Commu- nications, Filtration/Fluid Flow (Filtration), and RF Shielding and Test (Test). The Company’s business segments are comprised of the following primary operating entities: ▶ Communications: Distribution Control Systems, Inc. (DCSI), Hexagram, Inc. (Hexagram), acquired on February 1, 2006, Nexus Energy Software, Inc. (Nexus), acquired on November 29, 2005, and Comtrak Technologies, L.L.C. (Comtrak), ▶ Filtration: PTI Technologies Inc. (PTI), VACCO Industries (VACCO), and the Filtertek companies (Filtertek), ▶ Test: EMC Group companies consisting primarily of ETS-Lindgren L.P. (ETS) and Lindgren R.F. Enclosures, Inc. (Lindgren). The Communications unit is a proven supplier of special purpose fixed network communications systems for electric, gas and water utilities, including hardware and software to support advanced metering applications. DCSI’s Two-Way Automatic Communica- tions System, known as TWACS®, is currently used for automatic meter reading (AMR) and related advanced metering infrastructure (AMI) functions serving over 200 utilities, as well as having load management capabilities. Hexagram’s STAR® system, the premier wireless AMI system, delivers two-way and one-way operation on secure licensed radio frequencies for more than 100 utilities serving electric, gas and water customers. Nexus provides best-in-class utility data management solutions to more than 85 leading energy companies that add value to existing billing and metering infra- structure to allow both the utilities and their customers to better manage energy-driven transactions and decision making. Comtrak’s SecurVision® product line provides digital video surveillance and security functions for large commercial enterprises and alarm moni- toring companies. The Filtration unit develops, manufactures and markets a broad range of filtration products used in the purifica- tion and processing of liquids. These engineered filtration products utilize membrane, precision screen and other technologies to protect critical processes and equipment from contaminants. Major applications include the removal of contaminants in fuel, lubrica- tion and hydraulic systems, various health care applications, indus- trial processing, satellite propulsion systems, and oil processing. The Test unit is the industry leader in providing its customers with the ability to identify, measure and contain magnetic, electromag- netic and acoustic energy. 12 E S C O TE Ch nOlOg iE S inC. 2 0 0 7 A n n u Al REpO R T ESCO continues to operate with meaningful growth prospects in its primary served markets and with considerable financial flexibility. The Company continues to focus on new products that incorporate proprietary design and process technologies. Management is commit- ted to delivering shareholder value through internal growth, ongoing performance improvement initiatives, and selective acquisitions. highlights of 2007 Operations ▶ Sales, net earnings and earnings per share were $527.5 million, $33.7 million and $1.28 per share, respectively. ▶ Net cash provided by operating activities was $45.3 million. ▶ At September 30, 2007, cash on hand was $18.6 million. ▶ The Company received $49.1 million in orders from Pacific Gas & Electric (PG&E) related to its electric and gas AMI deployment. ▶ Successful deployment of upgraded TWACS system software called “TWACS NG” (formerly referred to as TNG) Version 1.6.3 at PG&E, with Version 2.0 delivered in October 2007. ▶ Hexagram received a $13.5 million order for a water AMR project in Kansas City, Missouri. ▶ The Company repurchased $10 million or 265,000 shares of its common stock during 2007. Results of Operations nET SAlES (Dollars in millions) 2007 2006 Fiscal year ended Change Change 2006 2007 2005 vs. 2006 vs. 2005 Communications $197.6 156.2 138.0 26.5% 13.2 % Filtration 188.4 174.1 171.7 8.2% 1.4 % Test Total 141.5 128.6 119.4 10.0% 7.7 % $527.5 458.9 429.1 14.9% 6.9 % Communications The 26.5% or $41.4 million increase in net sales in 2007 as com- pared to the prior year was due to: an increase of $30.5 million at Hexagram; an increase of $6.5 million at DCSI; an increase in sales of $4.6 million at Nexus; partially offset by a $0.2 million decrease in sales of Comtrak’s video security products. The $30.5 million increase in sales of Hexagram’s RF AMI products in 2007 as compared to 2006 was due to: a $21.6 million increase in sales to PG&E related to their gas deployment; and a $3.1 million increase in sales from the advanced metering project in Kansas City, Missouri. In addition, Hexagram’s current year results represent twelve months of sales compared to eight months in the prior year. Management’s Discussion and Analysis The $6.5 million increase in sales of DCSI’s AMR products in 2007 as compared to 2006 was due to: a $14.7 million increase in sales to the electric utility cooperative (COOP) market; a $1.1 million increase in sales to Puerto Rico Electric Power Authority (PREPA); partially offset by $9.4 million of lower AMR product sales to investor owned utilities (IOUs). Sales to IOUs decreased in 2007 as compared to the prior year due to: a $21.0 million decrease in sales to TXU (Oncor), partially offset by increases in sales to: Duke Energy of $6.0 million, EDESur of $4.5 million, and Florida Power & Light of $2.6 million. The $18.2 million or 13.2% increase in net sales in 2006 as compared to 2005 was due to: the acquisitions of Hexagram and Nexus with sales of $18.6 million and $9.6 million, respectively; partially offset by an $8.6 million decrease in sales of Comtrak’s video security products; and $1.5 million of lower shipments of DCSI’s AMR products. The $1.5 million decrease in sales of DCSI’s AMR products in 2006 as compared to 2005 was due to: an increase in sales to TXU of $19.9 million and other IOUs of $3.0 million; offset by $16.2 million of lower COOP sales; and an $8.1 million decrease in sales to PREPA. Comtrak’s sales were $7.3 million, $7.5 million, and $16.1 million in 2007, 2006 and 2005, respectively. The decrease in sales in 2006 as compared to the prior year was due to an acceleration of ship- ments in 2005 to meet the customer’s schedule. Filtration Net sales in 2007 increased $14.3 million or 8.2% compared to the prior year primarily as a result of higher commercial aerospace shipments at PTI of $6.4 million; a sales increase of $4.9 million at VACCO driven by higher defense spares and T-700 shipments; and a net sales increase at Filtertek of $3.2 million driven primarily by higher commercial shipments. Net sales in 2006 increased $2.4 million or 1.4% compared to 2005 primarily as a result of higher commercial aerospace shipments at PTI of $5.6 million, a net sales increase at Filtertek of $3.3 million driven by higher commercial shipments, partially offset by lower defense spares and T-700 shipments at VACCO of $6.6 million. Test The net sales increase of $12.9 million or 10.0% in 2007 as compared to the prior year was mainly due to: a $10.6 million increase in net sales driven by project milestones on a large air- craft chamber and completion of other test chambers; a $3.2 mil- lion increase in net sales from the Company’s Asian operations; partially offset by a $0.9 million decrease in net sales from the Company’s European operations. The net sales increase of $9.2 million or 7.7% in 2006 as compared to 2005 was mainly due to: a $10.2 million increase in net sales from the Company’s U.S. operations driven by sales of additional test chambers and higher component sales, a $0.6 million increase in net sales from the Company’s Asian operations; partially offset by a $1.6 million decrease in net sales from the Company’s Euro- pean operations due to the prior year completion of several test chamber projects. ORDERS AnD BACKlOg New orders received in 2007 were $562.2 million, resulting in an order backlog of $288.1 million at September 30, 2007 as compared to an order backlog of $253.4 million at September 30, 2006. In 2007, the Company recorded $201.8 million of new orders related to Communications products, $214.9 million related to Filtration products, and $145.5 million related to Test products. See “CAPITAL RESOURCES AND LIQUIDITY - Pacific Gas & Electric” on page 17 for a discussion of PG&E contracts. The Company received orders totaling $49.1 million from PG&E under these agreements during 2007. During 2007, Hexagram received a $13.5 million order for a water AMR project in Kansas City, Missouri. In 2006, the Company recorded $187.5 million of new orders related to Communications products (including $19.0 million of new orders and $6.0 million of acquired backlog from Hexagram and $16.7 million of new orders and $9.0 million of acquired backlog from Nexus), $172.1 million related to Filtration products, and $119.6 million related to Test products. SElling, gEnERAl AnD ADMiniSTRATiVE EXpEnSES Selling, general and administrative expenses (SG&A) were $122.5 mil- lion, or 23.2% of net sales in 2007, $106.9 million, or 23.3% of net sales in 2006, and $84.2 million, or 19.6% of net sales in 2005. The increase in SG&A expenses in 2007 as compared to the prior year was primarily due to: a $4.8 million increase in SG&A related to Hexagram (due to a full twelve months of SG&A expenses compared to eight months included in the prior year); an increase of $4.3 mil- lion at DCSI mainly due to an increase in engineering head count; a $2.9 million increase related to Nexus (due to a full twelve months compared to ten months in the prior year) and an increase in soft- ware development head count; an increase of $2.1 million incurred in the Test segment primarily to support new growth opportunities in Asia; and an $0.8 million increase at Corporate mainly due to the increase in stock option expense. The increase in SG&A in 2006 as compared to the prior year was primarily due to: $7.5 million of SG&A expenses related to Nexus; $6.8 million of SG&A expenses related to Hexagram; $2.3 million of stock option expense and higher costs related to engineering and new product development. E S C O TE Ch nOlOg iE S inC. 2 0 0 7 A n n u Al REpO R T 13 Management’s Discussion and Analysis AMORTiZATiOn OF inTAngiBlE ASSETS Amortization of intangible assets was $10.7 million in 2007, $6.9 million in 2006 and $2.0 million in 2005. Amortization of intangible assets included $2.1 million and $2.7 million of amor- tization of acquired intangible assets related to the Hexagram and Nexus acquisitions in 2007 and 2006, respectively. The amortization of acquired intangible assets related to Hexagram and Nexus are included in the Corporate operating segment’s results. The remain- ing amortization expenses consist of other identifiable intangible assets (primarily software, patents and licenses). The Company recorded $6.2 million and $2.2 million in 2007 and 2006, respec- tively, related to DCSI’s TWACS NG capitalized software. OThER (inCOME) AnD EXpEnSES, nET Other (income) and expenses, net, were $2.5 million, $(2.8) million and $(1.6) million in 2007, 2006 and 2005, respectively. Other (in- come) and expenses, net, in 2007 consisted primarily of: $2.6 million of expenses within the Test segment related to the adverse arbitra- tion award related to the delivery and installation contract completed in 2005 for a shielded communication room in an international loca- tion; partially offset by $(1.4) million of royalty income. Other (income) and expenses, net, in 2006 consisted primarily of: a $(1.8) million non-cash gain representing the reversal of a liability related to an indemnification obligation with respect to a previously divested subsidiary; $(2.3) million of royalty income; partially offset by a $0.2 million charge related to the termination of a subcontract manufacturer. Other (income) and expenses, net, in 2005 consisted primarily of: $(2.2) million of royalty income; and a $0.5 million charge related to the termination of a supply agreement with a medical device customer. ASSET iMpAiRMEnT — 2005 In June 2005, the Company abandoned its plans to commercial- ize certain sensor products within the Filtration segment resulting in an asset impairment charge of $0.8 million to write off certain patents and a related licensing agreement. EARningS BEFORE inTEREST AnD TAXES (EBiT) The Company evaluates the performance of its operating segments based on EBIT, which the Company defines as earnings before interest and taxes. EBIT is not a defined GAAP measure. However, the Company believes that EBIT provides investors and Management with a valuable and alternative method for assessing the Company’s operating results. Management evaluates the performance of its operating segments 14 E S C O TE Ch nOlOg iE S inC. 2 0 0 7 A n n u Al REpO R T based on EBIT and believes that EBIT is useful to investors to demonstrate the operational profitability of the Company’s business segments by excluding interest and taxes, which are generally ac- counted for across the entire company on a consolidated basis. EBIT is also one of the measures Management uses to determine resource allocations and incentive compensation. (Dollars in millions) 2007 2006 Fiscal year ended Change Change 2006 2007 2005 vs. 2006 vs. 2005 Communications % of net sales Filtration % of net sales Test % of net sales $22.0 28.3 (22.3)% (27.1) % 38.8 11.1% 18.1% 28.1% (7.0)% (10.0) % 19.5 23.4 12.4% 11.2% 13.1% 1.2% 20.0% (12.9) % (1.9) % 22.4 15.0 14.4 10.2% 11.7% 10.2% (1.5)% (4.0)% 23.0 % 1.5 % 12.2 Corporate (17.8) (15.2) (11.4) 17.1% 33.3 % Total % of net sales $42.0 47.6 (11.8)% (23.2) % 8.0% 10.4% 14.4% (2.4)% (4.0) % 62.0 The reconciliation of EBIT to a GAAP financial measure is as follows: (Dollars in millions) 2007 2006 2005 EBIT Add: Interest income Less: Income taxes Net earnings Communications $42.0 0.7 47.6 1.3 62.0 1.9 (9.0) (17.6) (20.4) $33.7 31.3 43.5 The decrease in EBIT in 2007 as compared to 2006 was due to: a $10.8 million decrease at DCSI due to an increase in TWACS NG software amortization expense of $4 million, an increase of $4.3 million in SG&A expenses mainly due to an increase in engi- neering head count, an increase in PG&E program support costs and TWACS NG maintenance of $1.5 million, and higher shipping expense of $0.9 million; partially offset by an increase of $4.4 mil- lion in EBIT at Hexagram due to the increase in sales volumes related to the PG&E deployment. The decrease in EBIT in 2006 as compared to 2005 was due to: a $7.8 million decrease at DCSI due to changes in product mix gross margins (IOU vs. COOP), charges related to a terminated subcontract manufacturer, higher warranty costs and amortization of TWACS NG software; a $3.8 million decrease at Comtrak due to lower shipments; a $0.7 million loss at Nexus due to the timing of customer deployments and additional SG&A spending related to engineering and new product initiatives; partially offset by $1.8 million from Hexagram. Management’s Discussion and Analysis Filtration inTEREST inCOME EBIT increased in 2007 as compared to 2006 primarily due to: a $2.8 million increase at PTI due to higher commercial aerospace shipments; a $1.7 million increase at VACCO due to higher defense spares shipments; partially offset by a $0.6 million decrease at Filtertek due to increased raw material costs. EBIT decreased in 2006 as compared to 2005 primarily due to: a $4.3 million decrease at VACCO due to significantly lower defense spares shipments; a $1.4 million decrease at Filtertek partly due to increased material costs; partially offset by a $2.8 million increase at PTI due to higher shipments of aerospace products. The 2005 operating results for Filtertek included a $1.9 million gain related to the termination of a supply agreement with a medical device customer that was not repeated in 2006. Test The decrease in EBIT in 2007 as compared to 2006 was mainly due to: a $1.1 million decrease in EBIT from the Company’s European operations as a result of lower sales volumes and U.K. facility move costs; partially offset by a $0.4 million increase in EBIT from the Company’s Asian operations on the higher sales volumes. In addi- tion, the Company’s current year U.S. operations were negatively impacted by $2.6 million of total costs associated with the arbitra- tion judgment related to a 2005 U.S. Government project. The increase in EBIT in 2006 as compared to the prior year was mainly due to: a $2.1 million increase in EBIT from the Company’s U.S. operations driven by sales of additional test chambers and higher component sales; a $0.4 million increase in EBIT from the Company’s European operations; and a $0.3 million increase in EBIT from the Company’s Asian operations. Corporate Corporate office operating charges included in consolidated EBIT increased by $2.6 million in 2007 as compared to 2006 mainly due to: the 2007 absence of a $1.8 million non-cash gain recorded in 2006 related to an indemnification obligation with respect to a previously divested subsidiary; a $0.7 million increase in pre-tax stock option expense; $0.4 million of additional professional fees incurred to support a research tax project; partially offset by a $0.6 million decrease in pre-tax amortization of acquired intangible assets related to Nexus and Hexagram. Corporate office operating charges included in consolidated EBIT increased by $3.8 million in 2006 as compared to 2005 mainly due to: $2.7 million of pre-tax amortization of acquired intangible assets related to Nexus and Hexagram; $2.3 million of pre-tax stock option expense; partially offset by a $1.8 million non-cash gain representing the reversal of a liability related to an indemnification obligation with respect to a previously divested subsidiary. The “Reconciliation to Consolidated Totals (Corporate)” in Note 14 to the Consolidated Financial Statements represents Corporate office operating charges. Interest income was $0.7 million in 2007, $1.3 million in 2006 and $1.9 million in 2005. The decrease in interest income in 2007 and 2006 as compared to the prior year periods was due to lower aver- age cash balances on hand resulting from the 2006 acquisitions. inCOME TAX EXpEnSE The 2007 effective tax rate was 21.1% compared to 36.0% in 2006 and 31.9% in 2005. The decrease in the 2007 effective tax rate as compared to the prior year was due to: the favorable impact of the research tax credit reduced 2007 income tax expense by $4.4 million and the effective tax rate by 10.3%; resolution of certain tax exposure items reduced current year income tax expense by $2.3 million and the effective tax rate by 5.3%; the release of a portion of the valuation allowance on capital loss carryforward reduced income tax expense by $0.8 million and the effective tax rate by 1.8%; and the effect of deferring U.S. tax on foreign earn- ings and favorable adjustments to foreign tax accruals reduced 2007 tax expense by $1.1 million and the effective tax rate by 2.7%. During 2007, the Company determined that certain tax accounts had not been accurately recorded in the financial statements for fiscal years 2001 to 2006. The effect in any individual year was not material to the Company’s results of operations, financial position or cash flows. The Company recorded $1.3 million as a cumulative credit adjustment to tax expense to correct previously recorded tax accounts during the fourth quarter of 2007. The increase in the effective tax rate in 2006 as compared to the prior year was due to: the effect of the foreign earnings repatria- tion increased 2006 income tax expense by $2.4 million and the effective rate by 4.8%; the adoption of SFAS 123(R) increased tax expense by $0.7 million and the effective rate by 1.4%; the lower volume of profit contributions of the Company’s foreign operations (primarily Puerto Rico due to the lower sales to PREPA) adversely impacted the tax rate; partially offset by the effect of a favorable change in tax contingencies not related to the research tax credit which decreased tax expense by $1.4 million and the effective tax rate by 2.9% and the net effect of the research tax credit which favorably impacted tax expense by $2.5 million and the effective tax rate by 5%. Capital Resources and liquidity Working capital (current assets less current liabilities) increased to $141.2 million at September 30, 2007 from $131.4 million at September 30, 2006. During 2007, cash and cash equivalents decreased $18.2 mil- lion, primarily due to an increase in operating working capital requirements. The $19.2 million increase in accounts receivable at September 30, 2007 is mainly due to: $9.9 million related to the Communications segment and $5.7 million related to the Test E S C O TE Ch nOlOg iE S inC. 2 0 0 7 A n n u Al REpO R T 15 Management’s Discussion and Analysis segment, both due to timing and increased volume of sales. The $16.9 million increase in inventories at September 30, 2007 is mainly due to an $11.7 million increase within the Communica- tions segment primarily related to the PG&E deployment. Accounts payable increased by $15.1 million at September 30, 2007, of which $6.0 million related to the Test segment and $3.1 million related to the Communications segment, both due to the timing of vendor payments on the higher level of inventory. Net cash provided by operating activities was $45.3 million, $58.6 million and $68.6 million in 2007, 2006 and 2005, respec- tively. The decrease in 2007 is related to an increase in operat- ing working capital requirements. The decrease in 2006 is related to lower net earnings. Capital expenditures were $19.5 million, $9.1 million and $8.8 mil- lion in 2007, 2006 and 2005, respectively. The increase in 2007 compared to 2006 included: approximately $4 million of manufac- turing equipment for the More Energy project at Filtertek Ireland (Filtration segment); approximately $2 million for the Cedar Park facility expansion (Test segment); approximately $1 million for the DCSI facility expansion (Communications segment). There were no commitments outstanding that were considered material for capital expenditures at September 30, 2007. At September 30, 2007, intangible assets, net, of $77.2 million included $65.7 million of capitalized software. Approximately $58.6 million of the capitalized software balance represents software development costs on the TWACS NG software within the Communi- cations segment to further penetrate the IOU market. This software is being deployed to efficiently handle the additional levels of communications dictated by the size of the utility service territories and the frequency of meter reads that are required under time-of- use or critical peak pricing scenarios to meet the requirements of large IOUs. At September 30, 2007, the Company had approximately $2 million of commitments related to the development of TWACS NG versions 2.0 and 3.0 which is expected to be spent during the first quarter of fiscal 2008. The Company expects to spend up to ap- proximately $6 million in fiscal 2008 on TWACS NG. Amortization is on a straight-line basis over seven years and began in March 2006. The Company recorded $6.2 million and $2.2 million in amortization expense related to TWACS NG during 2007 and 2006, respectively. At September 30, 2007, the Company had an available net operating loss (NOL) carryforward for U.S. Federal tax purposes of approximately $35 million. This NOL will expire between 2019 and 2025, and will be available to reduce future Federal income tax cash payments. 16 E S C O TE Ch nOlOg iE S inC. 2 0 0 7 A n n u Al REpO R T The closure and relocation of the Filtertek Puerto Rico facility was completed in March 2004. The Puerto Rico facility is included in other current assets with a carrying value of $3.6 million at September 30, 2007. The facility is being marketed for sale. During 2005, the Company reached a settlement in the defense of a certain revenue-generating patent used in the Filtration business. Under the terms of the agreement, the Company received a cash payment of $1.5 million, and in 2005 the Company recognized a gain of $0.3 million, after deducting $0.2 million of professional fees related to the settlement. The unrecognized gain is being recorded on a straight-line basis in Other (income) and expenses, net, over the remaining patent life, through 2011. ACQuiSiTiOnS On August 10, 2007, the Company acquired the assets and certain liabilities of Wintec, LLC (Wintec) for a purchase price of $6 million. Wintec is engaged in the design, manufacture and sale of metallic elements, filters, and strainers for pneumatic/hydraulic applications and surface tension devices for propellant management fluid control with annual revenues of approximately $3.5 million. The assets acquired consist of accounts receivable, inventory and property, plant and equipment. The Company recorded approximately $5 mil- lion of goodwill in connection with the transaction. In addition, the Company recorded $0.2 million of amortizable intangible assets consisting of customer contracts and order backlog which are being amortized on a straight-line basis over periods ranging from nine months to seventeen months. The operating results for Wintec, since the date of acquisition, are included within VACCO in the Filtration segment. On February 1, 2006, the Company acquired the capital stock of Hexagram for a purchase price of approximately $66 million. The acquisition agreement also provides for contingent consideration of up to $6.3 million over a five-year period following the acquisition if Hexagram exceeds certain sales targets. During 2007, the Com- pany paid $1.3 million of contingent consideration. Hexagram is a radio-frequency (RF) fixed network AMI company headquartered in Cleveland, Ohio. Hexagram broadens the Company’s served market and provides an RF based AMI system serving primarily electric, gas and water utilities. The operating results for Hexagram, since the date of acquisition, are included within the Communications unit. The Company recorded approximately $51 million of goodwill and $3.5 million of trademarks as a result of the transaction. The Company also recorded $6.6 million of identifiable intangible assets consisting primarily of patents and proprietary know-how, customer contracts, and order backlog which are being amortized on a straight-line basis over periods ranging from six months to seven years. On November 29, 2005, the Company acquired Nexus through an all cash for shares merger transaction for approximately $29 million in cash plus contingent cash consideration over the four-year period Management’s Discussion and Analysis following the merger if Nexus exceeds certain sales targets. Nexus is a software company headquartered in Wellesley, Massachusetts. Nexus broadens the Company’s served market and provides software solutions that allow utilities to fully utilize the information produced by the Company’s AMI systems. The operating results for Nexus, since the date of acquisition, are included within the Communications unit. The Company recorded approximately $24 million of goodwill as a result of the transaction. The Company also recorded $2.7 million of identifiable intangible assets consisting of customer contracts and backlog value which are being amortized on a straight-line basis over periods ranging from one year to three years. All of the Company’s acquisitions have been accounted for using the purchase method of accounting, and accordingly, the respective purchase prices were allocated to the assets (including intangible assets) acquired and liabilities assumed based on estimated fair values at the date of acquisition. The financial results from these acquisitions have been included in the Company’s financial state- ments from the date of acquisition. pACiFiC gAS & ElECTRiC In November 2005, DCSI entered into a contract to provide equip- ment, software and services to Pacific Gas & Electric (PG&E) in support of the electric portion of PG&E’s Advanced Metering Infra- structure (AMI) project. Under this contract, equipment is purchased by PG&E only upon issuance of purchase orders and release authori- zations. These orders were initially expected to total approximately $310 million over a five-year period although significant future devel- opments explained in the following paragraph have impacted these expectations and the Company now expresses no opinion as to the amount of orders anticipated under the contract. Under the contract, PG&E continues to retain the right to purchase products or services from other suppliers for the electric portion of the AMI project. DCSI has agreed to deliver to PG&E versions of its newly developed TWACS NG software as it becomes available and is tested. Delivery of the final software version for which DCSI has committed was required in the fourth quarter of fiscal 2007 and is currently anticipated in the first quarter of fiscal 2008. The parties are negotiating an amendment to the current contract to conform to the parties’ performance, in- cluding DCSI’s anticipated software delivery date. In accordance with U.S. generally accepted accounting standards, the Company will defer all revenue related to DCSI’s arrangement with PG&E until all software is delivered and acceptance criteria have been met. The contract provides for liquidated damages in the event of DCSI’s late develop- ment or delivery of hardware and software, and includes indemnifica- tion and other customary provisions. The contract may be terminated by PG&E for default, for its convenience and in the event of a force majeure lasting beyond certain prescribed periods. The Company has guaranteed the obligations of DCSI under the contract. If PG&E terminates the contract for its convenience, DCSI will be entitled to recover certain costs. During the third quarter of 2007, PG&E announced its plans to request information and proposals from a small group of vendors in order to evaluate such vendors’ ability to address potential future functionality requirements for the electric portion of its service territory currently included in DCSI’s contract. In July 2007, PG&E issued requests for proposals (RFPs) to a group of vendors, includ- ing the Company, for PG&E’s electric requirements. Prior to PG&E’s issuance of this RFP, Hexagram agreed to provide 2,000 of its RF fixed network electric units for PG&E testing. Testing of Hexagram’s electric solution began in the fourth quarter of 2007. PG&E’s cur- rent activities will impact the timing and/or receipt of future orders from PG&E for its electric deployment and, until PG&E completes this evaluation and determines whether it will modify its AMI proj- ect plan, the Company cannot estimate the total value or the tim- ing of orders that may be received under the DCSI PG&E contract. In November 2005, Hexagram entered into a contract to provide equipment, software and services to PG&E in support of the gas util- ity portion of PG&E’s AMI project. Hexagram’s contract also provided PG&E the option to purchase an RF based electric product from Hexagram. The total anticipated contract revenue from commence- ment through the five-year full deployment is expected to be up to approximately $225 million excluding any potential purchases of Hexagram’s RF based electric product. As with DCSI’s contract with PG&E, equipment will be purchased only upon issuance of purchase orders and release authorizations, and PG&E will continue to have the right to purchase products or services from other suppliers for the gas utility portion of the AMI project. The contract provides for liquidated damages in the event of late deliveries, includes indem- nification and other customary provisions, and may be terminated by PG&E for default, for its convenience and in the event of a force majeure lasting beyond certain prescribed periods. The Company has guaranteed the performance of the contract by Hexagram. BAnK CREDiT FACiliTY Effective October 6, 2004, the Company entered into a $100 million five-year revolving bank credit facility with a $50 million increase option that has a final maturity and expiration date of October 6, 2009. The credit facility is available for direct borrowings and/or the issuance of letters of credit, and is provided by a group of six banks, led by Wells Fargo Bank as agent. The credit facility requires, as determined by certain financial ratios, a commitment fee ranging from 17.5 to 27.5 basis points per annum on the unused portion. The terms of the facility provide that interest on borrowings may be calculated at a spread over the LIBOR or based on the prime rate, at the Company’s election. The credit 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 limitations on leverage, minimum consoli- dated EBITDA and minimum net worth. E S C O TE Ch nOlOg iE S inC. 2 0 0 7 A n n u Al REpO R T 17 Management’s Discussion and Analysis At September 30, 2007, the Company had approximately $96.4 mil- lion available to borrow under the credit facility in addition to its $18.6 million cash on hand. At September 30, 2007, the Company had outstanding short-term borrowings of $2.8 million, and out- standing letters of credit of $3.6 million ($0.8 million outstanding under the credit facility). As of September 30, 2007, the Company was in compliance with all bank covenants. Cash flow from operations and borrowings under the bank credit facility are expected to provide adequate resources to meet the Company’s capital requirements and operational needs for the foreseeable future. Subsequent to September 30, 2007, the Company announced its intention to enter into a new credit facility led by National City Bank in connection with the acquisition of Doble Engineering Company. See “Subsequent Events” under Management’s Discussion and Analysis. ShARE REpuRChASES In August 2006, the Company’s Board of Directors authorized an open market common stock repurchase program for up to 1.2 mil- lion shares, subject to market conditions and other factors which covers the period through September 30, 2008. The Company repurchased $10 million or 265,000 shares in 2007 under this program. There were no stock repurchases during 2006. The Com- pany repurchased $25 million or 670,072 shares in 2005 under a previously authorized program. pEnSiOn FunDing REQuiREMEnTS The minimum cash funding requirements related to the Company’s defined benefit pension plans are approximately $0.5 million in 2008, approximately $1.75 million in 2009 and approximately $1.25 million in 2010. The Company made a voluntary cash contri- bution of $1.4 million in 2006. COnTRACTuAl OBligATiOnS SuBSEQuEnT EVEnTS The following table shows the Company’s contractual obligations as of September 30, 2007: (Dollars in millions) Payments due by period Contractual Obligations Long-Term Debt Obligation Capital Lease Obligations Operating Lease Obligations Purchase Obligations(1) Total Less than 1 year 1 to 3 years More 3 to 5 than years 5 years Total $ — — — — 0.9 0.3 0.4 0.2 — — 26.4 6.6 9.7 6.7 3.4 2.0 $ 29.3 2.0 8.9 — 10.1 — 6.9 — 3.4 (1) A purchase obligation is defined as a legally binding and enforceable agree- ment to purchase goods and services that specifies all significant terms. Since the majority of the Company’s purchase orders can be cancelled, they are not included in the table above. TWACS NG software development costs for version 2.0 and version 3.0 are included. The Company has no off balance sheet arrangements outstanding at September 30, 2007. On November 7, 2007, the Company announced an agreement to acquire the stock of Doble Engineering Company, headquartered in Watertown, Massachusetts, for $319 million in cash, subject to adjustment for differences in working capital and cash on hand at closing. The Company intends to fund the acquisition by a combina- tion of existing cash and borrowings under a new credit facility led by National City Bank. The transaction is expected to close in the quarter ending December 31, 2007. On November 26, 2007, the Company announced it had completed the sale of the filtration portion of Filtertek Inc. to Illinois Tool Works Inc. (ITW) for approximately $77.5 million in cash, subject to closing working capital adjustments. The Tek Packaging divi- sion of Filtertek is not included in the transaction. The net cash proceeds from the sale, estimated at $70 million after taxes and expenses, will be used to pay down a portion of the debt associ- ated with the Doble Engineering Company acquisition, mentioned above. The Company expects to record a gain on the sale for both financial reporting and tax purposes, with a portion of the tax gain being shielded from cash payments through the utilization of the Company’s existing capital loss carryforward which was generated from prior divestitures. OThER Management believes that, for the periods presented, inflation has not had a material effect on the Company’s results of operations. The Company is currently involved in various stages of investiga- tion and remediation relating to environmental matters. Based on current information available, Management does not believe the aggregate costs involved in the resolution of these matters will have a material adverse effect on the Company’s operating results, capital expenditures or competitive position. 18 E S C O TE Ch nOlOg iE S inC. 2 0 0 7 A n n u Al REpO R T Management’s Discussion and Analysis Market Risk Analysis MARKET RiSK EXpOSuRE Market risks relating to the Company’s operations result primar- ily from changes in interest rates and changes in foreign currency exchange rates. At September 30, 2007 and 2006, the Company had no obligations related to interest rate swaps. The Company is also subject to foreign currency exchange rate risk inherent in its sales commitments, anticipated sales, anticipated purchases and assets and liabilities denominated in currencies other than the U.S. dollar. The foreign currency most significant to the Company’s operations is the Euro. Net sales to customers out- side of the United States were $121.2 million, $103.0 million, and $103.8 million in 2007, 2006 and 2005, respectively. The Company hedges certain foreign currency commitments by purchasing for- eign currency forward contracts. The estimated fair value of open forward contracts at September 30, 2007 was not material. Critical Accounting policies The preparation of financial statements in conformity with GAAP requires Management to make estimates and assumptions in certain circumstances that affect amounts reported in the accompanying Consolidated Financial Statements. In preparing these financial statements, Management has made its best estimates and judg- ments of certain amounts included in the financial statements, giving due consideration to materiality. The Company does not believe there is a great likelihood that materially different amounts would be reported under different conditions or using different assumptions related to the accounting policies described below. However, application of these accounting policies involves the exer- cise of judgment and use of assumptions as to future uncertainties and, as a result, actual results could differ from these estimates. The Company’s senior Management discusses the critical accounting policies described below with the Audit and Finance Committee of the Company’s Board of Directors on a periodic basis. The following discussion of critical accounting policies is intended to bring to the attention of readers those accounting policies which Management believes are critical to the Consolidated Finan- cial Statements and other financial disclosure. It is not intended to be a comprehensive list of all significant accounting policies that are more fully described in Note 1 of Notes to Consolidated Financial Statements. REVEnuE RECOgniTiOn Communications Unit: Within the Communications unit, approxi- mately 95% of the unit’s revenue arrangements (approximately 35% of consolidated revenues) contain software components. Revenue under these arrangements is recognized in accordance with Statement of Position 97-2 (SOP 97-2), “Software Revenue Recognition,” as amended by SOP 98-9, “Modification of SOP 97-2, Software Revenue Recognition, with Respect to Certain Transac- tions.” The application of software revenue recognition requires judgment, including the determination of whether a software arrangement includes multiple elements and estimates of the fair value of the elements, or vendor-specific objective evidence of fair value (“VSOE”). Changes to the elements in a software arrangement, and the ability to identify VSOE for those elements could materi- ally impact the amount of earned and/or deferred revenue. There have been no material changes to these estimates for the financial statement periods presented and the Company believes that these estimates generally should not be subject to significant variation in the future. The remaining 5% of the unit’s revenues represent prod- ucts sold under a single element arrangement and are recognized when products are delivered to unaffiliated customers. Filtration Unit: Within the Filtration operating unit, approximately 80% of operating unit revenues (approximately 30% of consolidated revenues) are recognized when products are delivered (when title and risk of ownership transfers) or when services are performed for unaffiliated customers. Approximately 20% of operating unit revenues (approximately 5% of consolidated revenues) are recorded under the percentage-of- completion provisions of SOP 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts” because the Company manufactures complex products for aerospace and military customers under production contracts. The percentage-of- completion method of accounting involves the use of various esti- mating techniques to project costs at completion. These estimates involve various assumptions and projections relative to the outcome of future events over a period of several years, including future labor productivity and availability, the nature and complexity of the work to be performed, availability of materials, the impact of delayed performance, and the timing of product deliveries. These estimates are based on Management’s judgment and the Company’s substan- tial experience in developing these types of estimates. Changes in underlying assumptions/estimates may adversely affect financial performance if they increase estimated project costs at completion, or positively affect financial performance if they decrease estimated E S C O TE Ch nOlOg iE S inC. 2 0 0 7 A n n u Al REpO R T 19 Management’s Discussion and Analysis project costs at completion. Due to the nature of these contracts and the operating unit’s cost estimating process, the Company believes that these estimates generally should not be subject to significant variation in the future. There have been no material changes to these estimates for the financial statement periods presented. The Company regularly reviews its estimates to assess revisions in contract values and estimated costs at completion. Test Unit: Within the Test unit, approximately 50% of revenues (approximately 15% of consolidated revenues) are recognized when products are delivered (when title and risk of ownership transfers) or when services are performed for unaffiliated customers. Certain arrangements contain multiple elements which are accounted for under the provisions of EITF 00-21, “Revenue Arrangements with Multiple Deliverables.” The application of EITF 00-21 requires judg- ment as to whether the deliverables can be divided into more than one unit of accounting and whether the separate units of account- ing have value to the customer on a stand-alone basis. Changes to these elements could affect the timing of revenue recognition. There have been no material changes to these elements for the financial statement periods presented. Approximately 50% of the unit’s revenues (approximately 15% of consolidated revenues) are recorded under the percentage-of- completion provisions of SOP 81-1, “Accounting for the Performance of Construction-Type and Certain Production-Type Contracts” due to the complex nature of the enclosures that are designed and produced under these contracts. As discussed above, this method of accounting involves the use of various estimating techniques to project costs at completion, which are based on Management’s judgment and the Company’s substantial experience in develop- ing these types of estimates. Changes in underlying assumptions/ estimates may adversely or positively affect financial performance. Due to the nature of these contracts and the operating unit’s cost estimating process, the Company believes that these estimates generally should not be subject to significant variation in the future. There have been no material changes to these estimates for the financial statement periods presented. The Company regularly reviews its contract estimates to assess revisions in contract values and estimated costs at completion. inVEnTORY Inventories are valued at the lower of cost (first-in, first-out) or market value. Management regularly reviews inventories on hand compared to historical usage and estimated future usage and sales. Inventories under long-term contracts reflect accumulated production costs, factory overhead, initial tooling and other related costs less the portion of such costs charged to cost of sales and any unliquidated progress payments. In accordance with industry practice, costs incurred on contracts in progress include amounts relating to programs having production cycles longer than one year, and a portion thereof may not be realized within one year. inCOME TAXES The Company operates in numerous taxing jurisdictions and is subject to examination by various U.S. Federal, state and foreign jurisdictions for various tax periods. Additionally, the Company has retained tax liabilities and the rights to tax refunds in connection with various divestitures of businesses in prior years. The Company’s income tax positions are based on research and interpretations of the income tax laws and rulings in each of the jurisdictions in which the Company does business. Due to the subjectivity of inter- pretations of laws and rulings in each jurisdiction, the differences and interplay in tax laws between those jurisdictions, as well as the inherent uncertainty in estimating the final resolution of complex tax audit matters, Management’s estimates of income tax liabilities may differ from actual payments or assessments. While the Company has support for the positions taken on its tax returns, taxing authorities are increasingly asserting alter- nate interpretations of laws and facts, and are challenging cross jurisdictional transactions. Cross jurisdictional transactions between the Company’s subsidiaries involving transfer prices for products and services, as well as various U.S. Federal, state and foreign tax matters, comprise the Company’s income tax exposures. Manage- ment regularly assesses the Company’s position with regard to tax exposures and records liabilities for these uncertain tax positions and related interest and penalties, if any, according to the prin- ciples of SFAS No. 5, “Accounting for Contingencies.” The Company has recorded an accrual that reflects Management’s estimate of the likely outcome of current and future audits. A final determination of these tax audits or changes in Management’s estimates may result in additional future income tax expense or benefit. At the end of each interim reporting period, Management esti- mates the effective tax rate expected to apply to the full fiscal year. The estimated effective tax rate contemplates the expected jurisdiction where income is earned, as well as tax planning strategies. Current and projected growth in income in higher tax jurisdictions may result in an increasing effective tax rate over time. If the actual results differ from Management’s estimates, Management may have to adjust the effective tax rate in the interim period such determination is made. 20 E S C O TE Ch nOlOg iE S inC. 2 0 0 7 A n n u Al REpO R T Management’s Discussion and Analysis Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Deferred tax assets may be reduced by a valuation allowance if it is more likely than not that some portion of the deferred tax assets will not be realized. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The Company regularly reviews its deferred tax assets for recoverability and establishes a valuation allowance when Manage- ment believes it is more likely than not such assets will not be recovered, taking into consideration historical operating results, expectations of future earnings, tax planning strategies, and the expected timing of the reversals of existing temporary differences. gOODWill AnD OThER lOng-liVED ASSETS In accordance with SFAS 142, Management annually reviews goodwill and other long-lived assets with indefinite useful lives for impairment or whenever events or changes in circumstances indi- cate the carrying amount may not be recoverable. If the Company determines that the carrying value of the long-lived asset may not be recoverable, a permanent impairment charge is recorded for the amount by which the carrying value of the long-lived asset exceeds its fair value. Fair value is measured based on a discounted cash flow method using a discount rate determined by Management to be commensurate with the risk inherent in the Company’s current business model. The estimates of cash flows and discount rate are subject to change due to the economic environment, including such factors as interest rates, expected market returns and volatility of markets served. Management believes that the estimates of future cash flows and fair value are reasonable; however, changes in es- timates could result in impairment charges. SFAS 142 also requires that intangible assets with estimable useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with SFAS 144. pEnSiOn plAnS AnD OThER pOSTRETiREMEnT BEnEFiT plAnS The measurement of liabilities related to pension plans and other post-retirement benefit plans is based on Management’s assump- tions related to future events including interest rates, return on pension plan assets, rate of compensation increases, and health care cost trend rates. Actual pension plan asset performance will either decrease or increase unamortized pension losses that will af- fect net earnings in future years. Depending upon the performance of the equity and bond markets in 2008, the Company could be required to record a charge to equity. In addition, if the discount rate was decreased by 25 basis points from 6.25% to 6.00%, the projected benefit obligation for the defined benefit plan would increase by approximately $1.0 million and result in an additional after-tax charge to shareholders’ equity of approximately $1.0 mil- lion. The discount rate used in measuring the Company’s pension and postretirement welfare obligations was developed by matching yields of actual high-quality corporate bonds to expected future pension plan cash flows (benefit payments). Over 500 Aa-rated, non-callable bonds with a wide range of maturities were used in the analysis. After using the bond yields to determine the present value of the plan cash flows, a single representative rate that resulted in the same present value was developed. Other Matters COnTingEnCiES As a normal incident of the businesses in which the Company is engaged, various claims, charges and litigation are asserted or com- menced against the Company. In the opinion of Management, final judgments, if any, which might be rendered against the Company are adequately reserved, covered by insurance, or are not likely to have a material adverse effect on its financial statements. QuAnTiTATiVE AnD QuAliTATiVE DiSClOSuRES ABOuT MARKET RiSK Market risks relating to the Company’s operations result primar- ily from changes in interest rates and changes in foreign currency exchange rates. At September 30, 2007 and 2006, the Company had no obligations related to interest rate swaps. See further discussion in “Management’s Discussion and Analysis — Market Risk Analysis” regarding the Company’s market risks. COnTROlS AnD pROCEDuRES The Company carried out an evaluation under the supervision of and with the participation of Management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effec- tiveness 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 are effective. 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 is recorded, processed, summarized and reported within time periods specified in the Securities and Exchange Commission’s rules and forms. There have been no significant changes in the Company’s internal controls or in other factors during the period covered by this report that have materially affected, or are reasonably likely to materially affect those controls and procedures. E S C O TE Ch nOlOg iE S inC. 2 0 0 7 A n n u Al REpO R T 21 Management’s Discussion and Analysis new Accounting pronouncements In June 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109” (FIN 48). FIN 48 prescribes a recogni- tion threshold and measurement process for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 is effective for fiscal years begin- ning after December 15, 2006. The Company estimates that the adoption of FIN 48 will result in an increase to the opening balance of retained earnings as of October 1, 2007 in the range of zero to $5 million for income tax benefits not previously recognized. In September 2006, the FASB issued SFAS No. 158, “Employer’s Accounting for Defined Benefit Pension and Other Postretire- ment Plans” (SFAS 158), which amends SFAS 87 and SFAS 106 to require recognition of the overfunded or underfunded status of pension and other postretirement benefit plans on the balance sheet. Under SFAS 158, gains and losses, prior service costs and credits, and any remaining transition amounts under SFAS 87 and SFAS 106 that have not yet been recognized through net periodic benefit cost will be recognized in accumulated other comprehen- sive income, net of tax effects. The measurement date — the date at which the benefit obligation and plan assets are measured — is required to be the Company’s fiscal year-end, which is the date the Company currently uses. SFAS 158 is effective for publicly held companies for fiscal years ending after December 15, 2006. The Company adopted the provisions of SFAS 158 as of September 30, 2007 and recorded a pre-tax credit of $0.9 million to accumulated other comprehensive income in equity. In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (SFAS 157), which defines fair value in generally accepted accounting principles and expands disclosures about fair value measurements. This Statement is effective for financial state- ments issued for fiscal years beginning after November 15, 2007. The adoption of SFAS 157 is not expected to have a material impact to the Company’s financial position or results of operations. Forward-looking information Statements regarding future events and the Company’s future results that are based on current expectations, estimates, forecasts and projections about the Company’s performance and the industries in which the Company operates, the Company’s ability to utilize NOLs, adequacy of the Company’s credit facilities and future cash flows, estimates of anticipated contract costs and revenues, the timing, amount and success of claims for research credits, the timing and success of software development efforts and resulting costs, accep- tance by PG&E of the final version of DCSI’s TWACS NG software, the 22 E S C O TE Ch nOlOg iE S inC. 2 0 0 7 A n n u Al REpO R T anticipated value of the PG&E contract, timing of closing the Doble acquisition, the outcome of current litigation, claims and charges, recoverability of deferred tax assets, continued reinvestment of foreign earnings, the impact of FIN 48 and SFAS 157, future costs relating to environmental matters, share repurchases, investments, sustained performance improvement, performance improvement initiatives, growth opportunities, new product development, the Company’s ability to increase shareholder value, acquisitions, and the beliefs and assumptions of Management contained in the Letter to Our Shareholders (pages 1-2), and Management’s Discussion and Analysis and other statements contained herein which are not strictly historical are considered “forward-looking statements” within the meaning of the safe harbor provisions of the Federal securities laws. Words such as expects, anticipates, targets, goals, projects, intends, plans, believes, estimates, variations of such words, and similar expressions are intended to identify such for- ward-looking statements. Investors are cautioned that such state- ments are only predictions, speak only as of the date of this report, and the Company undertakes no duty to update. The Company’s actual results in the future may differ materially from those project- ed 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 under “Item 1A. Risk Factors” in the Company’s Annual Report on Form 10-K for the fiscal years ended September 30, 2007 and the following: actions by the California Public Utility Commission; PG&E’s Board of Directors or PG&E’s management impacting PG&E’s AMI projects; the timing and success of DCSI’s software development efforts; the timing and content of purchase order releases under the PG&E contracts; and DCSI’s and Hexagram’s successful performance of the PG&E contracts; satisfaction of closing conditions to the Doble acquisi- tion; the timing and execution of real estate sales; termination for convenience of customer contracts; timing and magnitude of future contract awards; weakening of economic conditions in served markets; the success of the Company’s competitors; changes in cus- tomer demands or customer insolvencies; competition; intellectual property rights; technical difficulties; the availability of selected acquisitions; the timing, pricing and availability of shares offered for sale; delivery delays or defaults by customers; performance issues with key customers, suppliers and subcontractors; material changes in the costs of certain raw materials; the successful sale of the Company’s Puerto Rico facility; collective bargaining and labor disputes; changes in laws and regulations including but not limited to changes in accounting standards and taxation requirements; costs relating to environmental matters; litigation uncertainty; and the Company’s successful execution of internal operating plans. Consolidated Statements of Operations (Dollars in thousands, except per share amounts) Years ended September 30, Net sales Costs and expenses: Cost of sales Selling, general and administrative expenses Amortization of intangible assets Interest income, net Other (income) and expenses, net Asset impairment Total costs and expenses Earnings before income tax Income tax expense Net earnings Earnings per share: Basic: Net earnings Diluted: Net earnings Average common shares outstanding (in thousands): Basic Diluted See accompanying Notes to Consolidated Financial Statements. 2007 2006 2005 $ 527,537 458,865 429,115 349,891 122,502 10,705 (744) 2,455 — 300,309 106,882 6,872 (1,286) (2,814) — 281,654 84,241 1,973 (1,900) (1,550) 790 484,809 409,963 365,208 42,728 9,015 $ 33,713 48,902 17,622 31,280 $ 1.30 $ 1.28 1.22 1.19 63,907 20,363 43,544 1.71 1.66 25,865 26,387 25,718 26,386 25,511 26,306 E S C O TE Ch nOlOg iE S inC. 2 0 0 7 A n n u Al REpO R T 23 2007 2006 $ 18,638 36,819 102,994 83,816 11,520 67,871 25,264 34,063 1,345 50,984 24,251 10,042 260,350 207,257 5,543 48,767 101,076 5,184 5,497 46,089 86,312 1,444 160,570 139,342 82,293 78,277 70,588 68,754 149,466 77,242 10,772 $ 576,107 143,450 59,202 10,031 488,694 Consolidated Balance Sheets (Dollars in thousands) Years ended September 30, ASSETS Current assets: Cash and cash equivalents Accounts receivable, less allowance for doubtful accounts of $638 and $798 in 2007 and 2006, respectively Costs and estimated earnings on long-term contracts, less progress billings of $3,881 and $4,405 in 2007 and 2006, respectively Inventories Current portion of deferred tax assets Other current assets Total current assets property, plant and equipment: Land and land improvements Buildings and leasehold improvements Machinery and equipment Construction in progress Less accumulated depreciation and amortization Net property, plant and equipment Goodwill Intangible assets, net Other assets See accompanying Notes to Consolidated Financial Statements. 24 E S C O TE Ch nOlOg iE S inC. 2 0 0 7 A n n u Al REpO R T Consolidated Balance Sheets (Dollars in thousands) Years ended September 30, liABiliTiES AnD ShAREhOlDERS’ EQuiTY Current liabilities: Short-term borrowings and current maturities of long-term debt Accounts payable Advance payments on long-term contracts, less costs incurred of $20,314 and $19,532 in 2007 and 2006, respectively Accrued salaries Current portion of deferred revenue Accrued other expenses Total current liabilities Long-term portion of deferred revenue Pension obligations Deferred tax liabilities Other liabilities Long-term debt Total liabilities 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 29,159,629 and 29,030,995 shares in 2007 and 2006, respectively Additional paid-in capital Retained earnings Accumulated other comprehensive income (loss), net of tax Less treasury stock, at cost (3,416,966 and 3,166,026 common shares in 2007 and 2006, respectively) Total shareholders’ equity See accompanying Notes to Consolidated Financial Statements. 2007 2006 $ 2,844 — 54,634 39,496 3,408 15,114 25,239 17,961 119,200 6,411 8,029 18,522 8,462 — — 7,367 13,932 3,569 11,531 75,895 7,458 13,143 3,750 12,014 160,624 112,260 — — 292 243,131 226,759 6,303 290 236,390 193,046 (2,070) 476,485 427,656 (61,002) (51,222) 415,483 $ 576,107 376,434 488,694 E S C O TE Ch nOlOg iE S inC. 2 0 0 7 A n n u Al REpO R T 25 Consolidated Statements of Shareholders’ Equity (In thousands) Years ended September 30, Common Stock Amount Shares Additional Paid-In Capital Retained Earnings Accumulated Other Comprehensive Income (Loss) Treasury Stock Total Balance, September 30, 2004 14,149 $142 221,711 115,963 (3,698) (26,502) 307,616 Comprehensive income: Net earnings Translation adjustments Minimum pension liability, net of tax of $1,372 Comprehensive income Stock options and stock compensation plans, net of tax benefit of $(3,032) Purchases into treasury 100 percent stock dividend — — — — — — — — — 43,544 — — — 680 — — 43,544 680 (2,548) — (2,548) 41,676 222 — 14,368 1 6,606 — 144 — — — — (144) — — — 53 6,660 (24,928) (24,928) — — Balance, September 30, 2005 28,739 287 228,317 159,363 (5,566) (51,377) 331,024 SAB 108 Cumulative effect adjustment — — — 2,403 — — 2,403 Comprehensive income: Net earnings Translation adjustments Minimum pension liability, net of tax of $(1,103) Comprehensive income Stock options and stock compensation plans, net of tax benefit of $(3,173) — — — — — — — — — 31,280 — — — 1,448 — — 31,280 1,448 2,048 — 2,048 34,776 292 3 8,073 — — 155 8,231 Balance, September 30, 2006 29,031 290 236,390 193,046 (2,070) (51,222) 376,434 Comprehensive income: Net earnings Translation adjustments Minimum pension liability, net of tax of $(1,622) Comprehensive income SFAS 158 adjustment, net of tax of $(358) Stock options and stock compensation plans, net of tax benefit of $(828) Purchases into treasury — — — — — 129 — — — — — — 2 — — — — — — 6,741 — 33,713 — — — — — — — 4,252 3,558 — 563 — — — — — — — 33,713 4,252 3,558 41,523 563 227 6,970 (10,007) (10,007) Balance, September 30, 2007 29,160 $292 243,131 226,759 6,303 (61,002) 415,483 See accompanying Notes to Consolidated Financial Statements. 26 E S C O TE Ch nOlOg iE S inC. 2 0 0 7 A n n u Al REpO R T Consolidated Statements of Cash Flow (Dollars in thousands) Years ended September 30, Cash flows from operating activities: Net earnings Adjustments to reconcile net earnings to net cash provided by operating activities: Depreciation and amortization Stock compensation expense Changes in operating working capital Effect of deferred taxes on tax provision Pension contributions — Change in deferred revenue and costs, net Other Net cash provided by operating activities Cash flows from investing activities: Acquisition of businesses, net of cash acquired Capital expenditures Additions to capitalized software 2007 2006 2005 $ 33,713 31,280 43,544 22,176 5,299 (37,663) 12,873 9,339 (474) 45,263 (8,250) (19,503) (30,094) 17,303 4,790 1,162 3,596 (1,350) 1,133 712 58,626 (91,968) (9,117) (27,977) 12,184 2,649 (4,634) 15,221 — 396 (804) 68,556 — (8,848) (8,342) Net cash used by investing activities (57,847) (129,062) (17,190) Cash flows from financing activities: Proceeds from long-term debt Principal payments on long-term debt Net increase in short-term borrowings Purchases of common stock into treasury Excess tax benefit from stock options exercised Proceeds from exercise of stock options Other — — 2,844 (10,007) 73 1,843 (350) 52,000 (52,000) — — 1,569 2,761 (1,559) — (519) — (24,928) — 3,037 3,247 Net cash (used) provided by financing activities (5,597) 2,771 (19,163) Net (decrease) increase in cash and cash equivalents Cash and cash equivalents at beginning of year (18,181) 36,819 (67,665) 104,484 32,203 72,281 Cash and cash equivalents at end of year $ 18,638 36,819 104,484 Changes in operating working capital: Accounts receivable, net Costs and estimated earnings on long-term contracts, net Inventories Other current assets Accounts payable Advance payments on long-term contracts, net Accrued expenses Supplemental cash flow information: Interest paid Income taxes paid (including state, foreign & AMT) See accompanying Notes to Consolidated Financial Statements. $ (18,775) (10,175) (16,627) (11,877) 15,138 (3,959) 8,612 (10,029) 3,047 1,822 737 7,675 594 (2,684) $ (37,663) 1,162 $ 109 3,731 456 10,768 8,910 (1,916) (4,358) (1,856) (3,156) 2,468 (4,726) (4,634) 33 6,269 E S C O TE Ch nOlOg iE S inC. 2 0 0 7 A n n u Al REpO R T 27 notes to Consolidated Financial Statements 1. Summary of Significant Accounting policies A. pRinCiplES OF COnSOliDATiOn The Consolidated Financial Statements include the accounts of ESCO Technologies Inc. (ESCO) and its wholly owned subsidiaries (the Company). All significant intercompany transactions and accounts have been eliminated in consolidation. Certain prior year amounts have been reclassified to conform with the 2007 presentation. B. BASiS OF pRESEnTATiOn Fair values of the Company’s financial instruments are estimated by reference to quoted prices from market sources and financial institutions, as well as other valuation techniques. The estimated fair value of each class of financial instruments approximated the related carrying value at September 30, 2007 and 2006. C. nATuRE OF OpERATiOnS The Company has three industry operating units: Communications, Filtration/Fluid Flow (Filtration), and Test. The Communications unit is a proven supplier of special purpose communications systems for electric, gas and water utilities, including hardware and software to support advanced metering applications. The Filtration unit devel- ops, manufactures and markets a broad range of filtration products used in the purification and processing of liquids and gases. The Test unit is an industry leader in providing its customers with the ability to identify, measure and contain magnetic, electromagnetic and acoustic energy. D. uSE OF ESTiMATES The preparation of financial statements in conformity with account- ing principles generally accepted in the United States of America (GAAP) requires Management to make estimates and assumptions, including estimates of anticipated contract costs and revenues utilized in the earnings process, that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. E. REVEnuE RECOgniTiOn Communications Unit: Within the Communications unit, approxi- mately 95% of the unit’s revenue arrangements (approximately 35% of consolidated revenues) contain software components. Revenue under these arrangements is recognized in accordance with State- ment of Position 97-2 (SOP 97-2), “Software Revenue Recognition,” as amended by SOP 98-9, “Modification of SOP 97-2, Software Rev- enue Recognition, with Respect to Certain Transactions.” The unit’s software revenue arrangements generally include multiple products and services, or “elements” consisting of meter and substation hard- ware, meter reading system software, program management support during the deployment period and software support (post-contract customer support, “PCS”). These arrangements typically require the Company to deliver software at the inception of the arrangement 28 E S C O TE Ch nOlOg iE S inC. 2 0 0 7 A n n u Al REpO R T while the hardware and program management support are delivered over the contractual deployment period. Software support is provided during deployment and subsequent thereto. The software element included in such arrangements is essential to the functionality of the hardware and, therefore, the hardware is considered to be software-related. Hardware is considered a specified element in the software arrangement and vendor-specific objective evidence of fair value (“VSOE”) has been established for this element. VSOE for the hardware element is determined based on the price when sold sepa- rately to customers. These revenue arrangements are divided into separate units of accounting if the delivered item(s) has value to the customer on a stand-alone basis, there is objective and reliable evidence of the fair value of the undelivered item(s) and delivery/ performance of the undelivered item(s) is probable. For multiple ele- ment arrangements, revenue is allocated to the individual elements based on VSOE of the individual elements. The application of these principles requires judgment, including the determination of whether a software arrangement includes multiple elements and estimates of the fair value of the elements. The VSOE of the fair value of undelivered elements is determined based on the historical evidence of stand-alone sales of these elements to customers. Hardware revenues are generally recognized at the time of shipment or receipt by customer depending upon contract terms. VSOE generally does not exist for the software element; therefore, the Company uses the residual method to recognize revenue when VSOE exists for all other undelivered elements. Under the residual method, the fair value of the undelivered elements is deferred and the remain- ing portion of the arrangement fee is recognized as revenue. SOP 97-2 requires the seller of software that includes post-contract customer support (PCS) to establish VSOE of the undelivered ele- ment of the contract in order to account separately for the PCS revenue. The Company determines VSOE by a consistent pricing of PCS and PCS renewals as a percentage of the software license fees or by reference to contractual renewals, when the renewal terms are substantive. Revenues for PCS are recognized ratably over the maintenance term specified in the contract (generally in 12 monthly increments). Revenues for program management support are recog- nized when services have been provided. The Company determines VSOE for program management support based on hourly rates when services are performed separately. In November 2005, DCSI and Hexagram entered into arrangements with a large utility company to provide software, program manage- ment services, training and PCS that includes an option for the customer to purchase a significant quantity of hardware over an initial deployment period of approximately five years and subse- quently over the remaining initial contract term of up to fifteen years. The software, program management services and training will be delivered over the initial hardware deployment period of approximately five years. PCS will be provided at no charge during the first year of the initial deployment period, after which it will be provided over subsequent annual periods throughout the contract term if the customer chooses to continue PCS. Because the program notes to Consolidated Financial Statements management services are based on a fixed price per month rather than on a time and materials basis, the Company is unable to es- tablish VSOE for the program management services in this arrange- ment. The Company is able to establish VSOE for the PCS based on contractual renewal rates that are consistent with other arrange- ments and for the training based on pricing when sold separately. For the DCSI arrangement, the pricing for the optional hardware includes a discount that the Company has determined to be more- than-insignificant. In accordance with applicable software revenue recognition guidance, the Company will defer all revenue related to the DCSI arrangement until all software is delivered and acceptance criteria have been met. At that time, revenue otherwise allocable to the software, program management services, training and initial bundled PCS will be reduced by the rate of the significant incremen- tal discount offered on the hardware products. The portion of the arrangement consideration allocated to the significant incremental discount will be recognized ratably over the discount period (up to twenty years) similar to a subscription. The remaining arrange- ment consideration will be recognized ratably over the period the program management services will be performed (the initial deploy- ment period of approximately five years). Additional annual fees are payable in each subsequent year that PCS is provided and will be recognized over the respective PCS period. The amount paid by the customer for optional purchases of hardware during the deployment period related to both the DCSI and Hexagram arrangements will be recognized upon delivery and acceptance, if applicable, assuming all other revenue recognition criteria have been met. Approximately 5% of unit revenues are recognized when products are delivered (when title and risk of ownership transfers) or when services are performed for unaffiliated customers. Products include the SecurVision® digital video surveillance systems. Filtration Unit: Within the Filtration operating unit, approximately 80% of operating unit revenues (approximately 30% of consolidated revenues) are recognized when products are delivered (when title and risk of ownership transfers) or when services are performed for unaffiliated customers. Approximately 20% of operating unit revenues (approximately 5% of consolidated revenues) are recorded under the percentage-of- completion provisions of SOP 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts.” Products accounted for under SOP 81-1 include the design, development and manufacture of complex fluid control products, quiet valves, manifolds and systems primarily for the aerospace and military mar- kets. For arrangements that are accounted for under SOP 81-1, the Company estimates profit as the difference between total estimated revenue and total estimated cost of a contract and recognizes these revenues and costs based on units delivered. The percentage- of-completion method of accounting involves the use of various techniques to estimate expected costs at completion. Test Unit: Within the Test unit, approximately 50% of revenues (approximately 15% of consolidated revenues) are recognized when products are delivered (when title and risk of ownership transfers) or when services are performed for unaffiliated customers. Certain arrangements contain multiple elements which are accounted for under the provisions of EITF 00-21, “Revenue Arrangements with Multiple Deliverables.” The multiple elements generally consist of materials and installation services used in the construction and installation of standard shielded enclosures to measure and contain magnetic and electromagnetic energy. The installation process does not involve changes to the features or capabilities of the equipment and does not require proprietary information about the equipment in order for the installed equipment to perform to specifications. There is objective and reliable evidence of fair value for each of the units of accounting, as a result, the arrangement revenue is al- located to the separate units of accounting based on their relative fair values. Typically, fair value is the price of the deliverable when it is regularly sold on a stand-alone basis. Approximately 50% of the unit’s revenues (approximately 15% of consolidated revenues) are recorded under the percentage-of- completion provisions of SOP 81-1, “Accounting for the Performance of Construction-Type and Certain Production-Type Contracts” due to the complex nature of the enclosures that are designed and produced under these contracts. Products accounted for under SOP 81-1 include the construction and installation of complex test chambers to a buyer’s specifications that provide its customers with the ability to measure and contain magnetic, electromagnetic and acoustic energy. As discussed above, for arrangements that are accounted for under SOP 81-1, the Company estimates profit as the difference between total estimated revenue and total estimated cost of a contract and recognizes these revenues and costs based on either (a) units delivered or (b) contract milestones. If a reliable measure of output cannot be established (which applies in less than 8% of Test unit revenues or 2% of consolidated rev- enues), input measures (e.g., costs incurred) are used to recognize revenue. Given the nature of the Company’s operations related to these contracts, costs incurred represent an appropriate measure of progress towards completion. The percentage-of-completion method of accounting involves the use of various techniques to estimate expected costs at completion. These estimates are based on Management’s judgment and the Com- pany’s substantial experience in developing these types of estimates. F. CASh AnD CASh EQuiVAlEnTS Cash equivalents include temporary investments that are readily convertible into cash, such as Eurodollars, commercial paper and treasury bills with original maturities of three months or less. g. ACCOunTS RECEiVABlE Accounts receivable have been reduced by an allowance for amounts that the Company estimates are uncollectible in the future. This estimated allowance is based on Management’s evaluation of the fi- nancial condition of the customer and historical write-off experience. E S C O TE Ch nOlOg iE S inC. 2 0 0 7 A n n u Al REpO R T 29 notes to Consolidated Financial Statements h. COSTS AnD ESTiMATED EARningS On lOng-TERM COnTRACTS Costs and estimated earnings on long-term contracts represent unbilled revenues, including accrued profits, accounted for under the percentage-of-completion method, net of progress billings. i. inVEnTORiES Inventories are valued at the lower of cost (first-in, first-out) or market value. Inventories under long-term contracts reflect accumulated production costs, factory overhead, initial tooling and other related costs less the portion of such costs charged to cost of sales and any unliquidated progress payments. In accordance with industry practice, costs incurred on contracts in progress include amounts relating to programs having production cycles longer than one year, and a portion thereof will not be realized within one year. J. pROpERTY, plAnT AnD EQuipMEnT Property, plant and equipment are recorded at cost. Depreciation and amortization are computed primarily on a straight-line basis over the estimated useful lives of the assets: buildings, 10-40 years; machinery and equipment, 5-10 years; and office furniture and equipment, 5-10 years. Leasehold improvements are amortized over the remaining term of the applicable lease or their estimated useful lives, whichever is shorter. K. gOODWill AnD OThER lOng-liVED ASSETS Goodwill represents the excess of purchase costs over the fair value of net identifiable assets acquired in business acquisitions. The Company accounts for goodwill as required by Statement of Financial Accounting Standards (SFAS) 142, “Goodwill and Other Intangible Assets.” Management annually reviews goodwill and other long-lived assets with indefinite useful lives for impairment or whenever events or changes in circumstances indicate the carry- ing amount may not be recoverable. If the Company determines that the carrying value of the long-lived asset may not be recoverable, a permanent impairment charge is recorded for the amount by which the carrying value of the long-lived asset exceeds its fair value. Fair value is measured based on a discounted cash flow method using a discount rate determined by Management to be commensu- rate with the risk inherent in the Company’s current business model. Other intangible assets represent costs allocated to identifiable intangible assets, principally capitalized software, patents, trade- marks, and technology rights. See Note 4 regarding goodwill and other intangible assets activity. l. CApiTAliZED SOFTWARE The costs incurred for the development of computer software that will be sold, leased, or otherwise marketed are charged to expense when incurred as research and development until technological feasibility has been established for the product. Technological feasibility is typically established upon completion of a detailed program design. Costs incurred after this point are capitalized on a project-by-project basis in accordance with SFAS No. 86, “Ac- counting for the Costs of Computer Software to be Sold, Leased or 30 E S C O TE Ch nOlOg iE S inC. 2 0 0 7 A n n u Al REpO R T Otherwise Marketed.” Costs that are capitalized primarily consist of external development costs. Upon general release of the product to customers, the Company ceases capitalization and begins amortiza- tion, which is calculated on a project-by-project basis as the greater of (1) the ratio of current gross revenues for a product to the total of current and anticipated future gross revenues for the product or (2) the straight-line method over the estimated economic life of the product. The Company generally amortizes the software development costs over a three- to seven-year period based upon the estimated future economic life of the product. Factors considered in deter- mining the estimated future economic life of the product include anticipated future revenues, and changes in software and hardware technologies. The carrying values of capitalized costs are evaluated for impairment on an annual basis to determine if circumstances exist which indicate the carrying value of the asset may not be recoverable. If expected cash flows are insufficient to recover the carrying amount of the asset, then an impairment loss is recognized to state the asset at its net realizable value. M. iMpAiRMEnT OF lOng-liVED ASSETS AnD lOng-liVED ASSETS TO BE DiSpOSED OF Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to dispose. n. inCOME TAXES Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Deferred tax assets may be reduced by a valuation allowance if it is more likely than not that some portion or all of the deferred tax assets will not be realized. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The Company regularly reviews its deferred tax assets for recoverability and establishes a valuation allowance when Management believes it is more likely than not such assets will not be recovered, taking into consideration historical operating results, expectations of future earnings, tax planning strategies, and the expected timing of the reversals of existing temporary differences. O. RESEARCh AnD DEVElOpMEnT COSTS Company-sponsored research and development costs include research and development and bid and proposal efforts related to the Company’s products and services. Company-sponsored product notes to Consolidated Financial Statements development costs are charged to expense when incurred. Customer- sponsored research and development costs incurred pursuant to contracts are accounted for similar to other program costs. Customer-sponsored research and development costs refer to certain situations whereby customers provide funding to support specific contractually defined research and development costs. As the Company incurs costs under these specific funding contracts, the costs are “inventoried” until billed to the customer for reimburse- ment, consistent with other program costs. Once billed/invoiced, these costs are transferred to accounts receivable until the cash is received from the customer. All research and development costs incurred in excess of the contractual funding amount, or costs incurred outside the scope of the contractual research and develop- ment project, are expensed as incurred. p. FOREign CuRREnCY TRAnSlATiOn The financial statements of the Company’s foreign operations are translated into U.S. dollars in accordance with SFAS 52 “Foreign Currency Translation” (SFAS 52). The resulting translation adjust- ments are recorded as a separate component of accumulated other comprehensive income. Q. EARningS pER ShARE Basic earnings per share is calculated using the weighted average number of common shares outstanding during the period. Diluted earnings per share is calculated using the weighted average number of common shares outstanding during the period plus shares issu- able upon the assumed exercise of dilutive common share options and vesting of performance-accelerated restricted shares using the treasury stock method. The number of shares used in the calculation of earnings per share for each year presented is as follows: (In thousands) 2007 2006 2005 Weighted Average Shares Outstanding — Basic Dilutive Options and performance- accelerated restricted stock 25,865 25,718 25,511 522 668 795 Adjusted Shares — Diluted 26,387 26,386 26,306 Options to purchase 602,731 shares at prices ranging from $36.07 - $54.88 were outstanding during the year ended September 30, 2007, but were not included in the respective computation of diluted EPS because the options’ exercise price was greater than the average market price of the common shares. Options to purchase 264,430 shares at prices ranging from $42.99 - $54.88 were out- standing during the year ended September 30, 2006, but were not included in the respective computation of diluted EPS because the options’ exercise price was greater than the average market price of the common shares. Options to purchase 34,967 shares at prices ranging from $35.18 - $50.26 were outstanding during the year ended September 30, 2005, but were not included in the respective computation of diluted EPS because the options’ exercise price was greater than the average market price of the common shares. These options expire in various periods through 2013. Approximately 14,000, 9,000 and 36,000 restricted shares were outstanding but unearned at September 30, 2007, 2006 and 2005, respectively, and, therefore, were not included in the respective years’ computations of diluted EPS. R. ShARE-BASED COMpEnSATiOn Prior to October 1, 2005, the Company accounted for its stock op- tion plans using the intrinsic value method of accounting provided under APB Opinion No. 25, “Accounting for Stock Issued to Employ- ees,” (APB 25) and related Interpretations, as permitted by FASB Statement No. 123, “Accounting for Stock-Based Compensation,” (SFAS 123) under which no compensation expense was recognized for stock option grants. Accordingly, share-based compensation for stock options was included as a pro forma disclosure in the financial statement footnotes for periods prior to fiscal 2006. Effective October 1, 2005, the Company adopted the fair value recognition provisions of FASB Statement No. 123(R), “Share-Based Payment,” (SFAS 123(R)) using the modified-prospective transition method. Results for prior periods have not been restated. The Company provides compensation benefits to certain key employ- ees under several share-based plans providing for employee stock options and/or performance-accelerated restricted shares (restricted shares), and to non-employee directors under a non-employee directors compensation plan. S. COMpREhEnSiVE inCOME (lOSS) SFAS 130, “Reporting Comprehensive Income” requires the Company to report separately the translation adjustments of SFAS 52 defined above, and changes to the minimum pension liability, as compo- nents of comprehensive income or loss. Management has chosen to disclose the requirements of this Statement within the Consolidated Statements of Shareholders’ Equity. Accumulated other comprehensive income (loss) as shown on the consolidated balance sheet of $6.3 million and $(2.1) million at September 30, 2007 and 2006, respectively, consisted of $8.8 mil- lion and $4.5 million related to currency translation adjustments; $(2.5) million and $(6.6) million related to the minimum pension liability, respectively. T. DEFERRED REVEnuE AnD COSTS Deferred revenue and costs are recorded for products or services that have not been provided but have been invoiced under con- tractual agreements or paid for by a customer, or when products or services have been provided but the criteria for revenue recogni- tion have not been met. If there is a customer acceptance provi- sion or there is uncertainty about customer acceptance, revenue and costs are deferred until the customer has accepted the product or service. At September 30, 2007, approximately $12 million of deferred costs are included within other current assets on the consolidated balance sheet. E S C O TE Ch nOlOg iE S inC. 2 0 0 7 A n n u Al REpO R T 31 notes to Consolidated Financial Statements Deferred revenue also includes the long-term portion of unearned income related to two intellectual property agreements. The amount is being amortized into income on a straight-line basis over the remaining patent life through 2011. The current portion of approxi- mately $0.6 million is included in the current portion of deferred revenue on the consolidated balance sheet. u. nEW ACCOunTing STAnDARDS In June 2006, the FASB issued FASB Interpretation No. 48, “Ac- counting for Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109” (FIN 48). FIN 48 prescribes a recognition threshold and measurement process for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 is effective for fiscal years begin- ning after December 15, 2006. The Company estimates that the adoption of FIN 48 will result in an increase to the opening balance of retained earnings as of October 1, 2007 in the range of zero to $5 million for income tax benefits not previously recognized. In September 2006, the FASB issued SFAS No. 158, “Employer’s Accounting for Defined Benefit Pension and Other Postretirement Plans” (SFAS 158), which amends SFAS 87 and SFAS 106 to require recognition of the overfunded or underfunded status of pension and other postretirement benefit plans on the balance sheet. Under SFAS 158, gains and losses, prior service costs and credits, and any remaining transition amounts under SFAS 87 and SFAS 106 that have not yet been recognized through net periodic benefit cost will be recognized in accumulated other comprehensive income, net of tax effects. The measurement date — the date at which the benefit obligation and plan assets are measured — is required to be the Company’s fiscal year-end, which is the date the Company currently uses. SFAS 158 is effective for publicly-held companies for fiscal years ending after December 15, 2006. The Company adopted the provisions of SFAS 158 as of September 30, 2007 and recorded a pre-tax credit of $0.9 million to accumulated other comprehensive income in equity. In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (SFAS 157), which defines fair value in generally accepted accounting principles and expands disclosures about fair value measurements. This Statement is effective for financial state- ments issued for fiscal years beginning after November 15, 2007. The adoption of SFAS 157 is not expected to have a material impact to the Company’s financial position or results of operations. 2. Acquisitions On August 10, 2007, the Company acquired the assets and certain liabilities of Wintec, LLC (Wintec) for a purchase price of $6 million. Wintec is engaged in the design, manufacture and sale of metallic elements, filters, and strainers for pneumatic/hydraulic applications and surface tension devices for propellant management fluid control with annual revenues of approximately $3.5 million. The assets acquired consist of accounts receivable, inventory and property, plant and equipment. The Company recorded approximately $5 mil- lion of goodwill in connection with the transaction. In addition, the Company recorded $0.2 million of amortizable intangible assets consisting of customer contracts and order backlog which are being amortized on a straight-line basis over periods ranging from nine months to seventeen months. The operating results for Wintec, since the date of acquisition, are included within VACCO in the Filtration segment. On February 1, 2006, the Company acquired the capital stock of Hexagram, Inc. (Hexagram) for a purchase price of approximately $66 million. The acquisition agreement also provides for contin- gent consideration of up to $6.25 million over the five-year period following the acquisition if Hexagram exceeds certain sales targets. During 2007, the Company paid $1.3 million of contingent consider- ation. Hexagram is an RF fixed network AMI company headquartered in Cleveland, Ohio. Hexagram broadens the Company’s served market and provides an RF based AMI system serving primarily electric, gas and water utilities. The operating results for Hexagram, since the date of acquisition, are included within the Communications unit. The Company recorded $6.6 million of amortizable identifiable intangible assets consisting primarily of patents and proprietary know-how, customer contracts, and order backlog which are being amortized on a straight-line basis over periods ranging from six months to seven years. On November 29, 2005, the Company acquired Nexus Energy Soft- ware, Inc. (Nexus) through an all cash for shares merger transac- tion for approximately $29 million in cash plus contingent cash consideration over the four-year period following the merger if Nexus exceeds certain sales targets. Nexus is a software company headquartered in Wellesley, Massachusetts. Nexus broadens the Company’s served market and provides software solutions that allow utilities to fully utilize the information produced by the Company’s AMI systems. The operating results for Nexus, since the date of acquisition, are included within the Communications unit. The Company recorded $2.7 million of identifiable intangible assets consisting primarily of customer contracts and order backlog which are being amortized on a straight-line basis over periods ranging from one year to three years. In connection with the acquisition of Nexus, the Company acquired approximately $13 million of net operating loss carryforward that will expire between 2017 and 2025 and is subject to a Section 382 limitation. All of the Company’s acquisitions have been accounted for using the purchase method of accounting and accordingly, the respective purchase prices were allocated to the assets (including intangible assets) acquired and liabilities assumed based on estimated fair values at the date of acquisition. The financial results from these acquisitions have been included in the Company’s financial state- 32 E S C O TE Ch nOlOg iE S inC. 2 0 0 7 A n n u Al REpO R T notes to Consolidated Financial Statements ments from the date of acquisition. Pro forma financial information related to the Hexagram and Nexus acquisitions was not presented as it was not significant to the Company’s results of operations. None of the goodwill recorded as part of the Nexus or Hexagram acquisitions is expected to be deductible for U.S. Federal or state income tax purposes. 3. Asset impairment In June 2005, the Company abandoned its plans to commercial- ize certain sensor products within the Filtration segment resulting in an asset impairment charge of $0.8 million to write off certain patents and a related licensing agreement. 4. goodwill and Other intangible Assets Included on the Company’s Consolidated Balance Sheets at Septem- ber 30, 2007 and 2006 are the following intangible assets gross carrying amounts and accumulated amortization: (Dollars in millions) Goodwill: Gross carrying amount Less: accumulated amortization Net Intangible assets with determinable lives: Patents Gross carrying amount Less: accumulated amortization Net Capitalized software Gross carrying amount Less: accumulated amortization Net Other Gross carrying amount Less: accumulated amortization Net 2007 2006 $ 158.4 8.9 $ 149.5 152.4 8.9 143.5 $ 17.9 14.7 $ 3.2 $ 83.4 17.7 $ 65.7 $ 9.9 5.1 $ 4.8 17.6 13.9 3.7 55.2 10.0 45.2 9.5 2.8 6.7 The changes in the carrying amount of goodwill attributable to each business segment for the years ended September 30, 2007 and 2006 are as follows: (Dollars in millions) Communications Filtration Test Balance as of September 30, 2005 Acquisitions $ — 39.8 29.1 (Hexagram and Nexus) 74.6 — — Balance as of September 30, 2006 Acquisitions Balance as of September 30, 2007 74.6 0.8 39.8 5.2 29.1 — $75.4 45.0 29.1 Amortization expense related to intangible assets with determin- able lives was $10.7 million, $6.9 million and $2.0 million in 2007, 2006 and 2005, respectively. The increase in amortization expense in 2007 as compared to the prior year was due to the Company’s TWACS NG software. The Company recorded $6.2 million and $2.2 million of amortization expense related to DCSI’s TWACS NG software in 2007 and 2006, respectively. Patents are amortized over the life of the patents, generally 17 years. Capitalized software is amortized over the estimated useful life of the software, gener- ally three to seven years. Estimated intangible assets amortization for fiscal year 2008 is approximately $14 million. Intangible asset amortization for fiscal years 2009 through 2012 is estimated at approximately $16 million to $19 million per year. The increase in intangible asset amortization is related to the additional costs associated with the TWACS NG software. 5. Accounts Receivable Accounts receivable, net of the allowance for doubtful accounts, consist of the following at September 30, 2007 and 2006: (Dollars in thousands) Commercial 2007 2006 $ 97,714 81,986 U.S. Government and prime contractors 5,280 1,830 Total $102,994 83,816 Intangible assets with indeterminable lives: Trademarks $ 3.5 3.5 6. inventories The Company performed its annual evaluation of goodwill and intan- gible assets for impairment during the fourth quarter of fiscal 2007 and concluded no impairment existed at September 30, 2007. Inventories consist of the following at September 30, 2007 and 2006: (Dollars in thousands) Finished goods Work in process — including long-term contracts Raw materials Total 2007 2006 $22,211 12,834 17,660 13,211 28,000 24,939 $67,871 50,984 E S C O TE Ch nOlOg iE S inC. 2 0 0 7 A n n u Al REpO R T 33 notes to Consolidated Financial Statements 7. property, plant and Equipment Depreciation expense of property, plant and equipment for the years ended September 30, 2007, 2006 and 2005 was $11.5 million, $10.4 million and $10.1 million, respectively. The Company leases certain real property, equipment and machinery under noncancelable operating leases. Rental expense under these operating leases for the years ended September 30, 2007, 2006 and 2005 was $7.8 million, $7.3 million and $6.3 million, respectively. Future aggregate minimum lease payments under operating leases that have initial or remaining noncancelable lease terms in excess of one year as of September 30, 2007 are: (Dollars in thousands) Years ending September 30: 2008 2009 2010 2011 2012 and thereafter Total 8. income Tax Expense $ 6,639 5,428 4,238 3,516 6,619 $26,440 The components of income before income taxes consisted of the following for the years ended September 30: (Dollars in thousands) 2007 2006 2005 United States Foreign $37,051 43,920 52,543 5,677 4,982 11,364 Total income before income taxes $42,728 48,902 63,907 The principal components of income tax expense from continuing operations for the years ended September 30, 2007, 2006 and 2005 consist of: (Dollars in thousands) 2007 2006 2005 Federal Current (including Alternative Minimum Tax) $ (6,419) 3,571 874 11,473 10,291 15,313 1,051 2,066 2,673 2,414 (518) (21) Deferred State and local: Current Deferred Foreign: Current Deferred Total 34 E S C O TE Ch nOlOg iE S inC. 2 0 0 7 A n n u Al REpO R T The actual income tax expense from continuing operations for the years ended September 30, 2007, 2006 and 2005 differs from the expected tax expense for those years (computed by applying the U.S. Federal corporate statutory rate) as follows: 2007 2006 2005 Federal corporate statutory rate 35.0% 35.0% 35.0% State and local, net of Federal benefits 2.8 Foreign — Puerto Rico Foreign — Other Foreign earnings repatriation Research credit SFAS 123(R) Change in tax contingencies Release of valuation allowance Other, net (0.6) (2.1) — (10.3) 3.8 (5.3) (1.8) (0.4) 2.4 0.5 (0.5) 4.8 (5.0) 1.4 (2.9) — 0.3 2.4 (4.6) (1.6) — — — — — 0.7 Effective income tax rate 21.1% 36.0% 31.9% During 2007, the Company determined that certain tax accounts had not been accurately recorded in the financial statements for fiscal years 2001 to 2006. The effect in any individual year was not material to the Company’s results of operations, financial position or cash flows. The Company recorded $1.3 million as a cumulative credit adjustment to tax expense to correct previously recorded tax accounts during the fourth quarter of 2007. The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and liabilities at September 30, 2007 and 2006 are presented below. (Dollars in thousands) Deferred tax assets: 2007 2006 Inventories, long-term contract accounting, contract cost reserves and others $ 3,828 Pension and other postretirement benefits 3,339 Net operating loss carryforward — domestic 12,311 Net operating loss carryforward — foreign 3,092 Alternative Minimum Tax credit carryforward Capital loss carryforward Other compensation-related costs and other cost accruals Research credit carryforward Total deferred tax assets Deferred tax liabilities: 1,858 5,449 5,103 2,895 3,306 7,381 779 7,888 11,285 15,178 13,979 6,635 56,501 47,805 Plant and equipment, depreciation methods, acquisition asset allocations, and other (38,780) (17,028) 1,510 1,213 1,854 (666) 392 (71) Net deferred tax asset before valuation allowance $ 9,015 17,622 20,363 Less valuation allowance Net deferred tax assets 17,721 30,777 (10,979) (10,276) $ 6,742 20,501 notes to Consolidated Financial Statements Management believes that, based on the Company’s historical pretax income, together with the projection of future taxable income, and after consideration of the valuation allowance, it is more likely than not that the Company will realize the benefits of the net deferred tax assets existing at September 30, 2007. In order to realize this net deferred tax asset, the Company will need to generate future taxable income of approximately $19 million. At September 30, 2007, the Company had an available net operating loss (NOL) for U.S. Federal tax purposes of approximately $35 million. This NOL will expire between 2019 and 2025 and will be available to reduce future Federal income tax cash payments. The Company anticipates being able to utilize the NOL carryforward to reduce future Federal income tax cash payments. The Company has established a valuation allowance of $7.9 million against the capital loss carryforward generated in 2004, as such loss carryforward may not be realized in future periods. In addition, the Company has established a valuation allowance against certain NOL carryforwards in foreign jurisdictions which may not be realized in future periods. The valuation allowance established against the foreign NOL carryforwards was $3.1 million and $2.9 million at Sep- tember 30, 2007 and 2006, respectively. The Company classifies its valuation allowance related to deferred taxes on a pro rata basis. The Company completed its analysis of available research credits for fiscal years 2000 through 2006 and recorded total research credit claims, net, of $5.6 million. The Company expects the net research credits related to fiscal year 2007 to be approximately $1.4 million. The expiration of the research credits is between 2020 and 2027. The Company anticipates being able to utilize the research credits to reduce future Federal and state income tax cash payments. No deferred taxes have been provided on the accumulated unremit- ted earnings of the Company’s foreign subsidiaries as of September 30, 2007. The Company’s intention is to reinvest these earnings indefinitely. In the event these foreign entities’ earnings were dis- tributed, it is estimated that U.S. taxes, net of available foreign tax credits, of approximately $3.2 million would be due, which would correspondingly reduce the Company’s net earnings. On October 22, 2004, the American Jobs Creation Act (the “AJCA”) was signed into law. The AJCA includes a deduction of 85% of cer- tain foreign earnings that are repatriated, as defined in the AJCA. In 2006, the Company recognized a charge of $2.4 million for the accrual of income taxes associated with the repatriation under the AJCA of approximately $39.5 million of foreign earnings. During 2006, the Company adopted the provisions of SEC Staff Accounting Bulletin No. 108 and recorded $2.4 million as a cumulative state tax expense adjustment to 2006 beginning retained earnings. The Company operates within multiple taxing jurisdictions and is subject to audit in these jurisdictions. These audits can involve complex issues which may require an extended period of time to re- solve. The Company regularly reviews its potential tax liabilities for tax years subject to audit. Changes in the Company’s potential tax liability occurred during the year ended September 30, 2007, and may occur in the future as the Company’s assessment changes based on examinations in various jurisdictions and/or changes in tax laws, regulations and case law. Accordingly, the Company’s estimate of in- come tax liabilities may differ from actual payments or assessments. 9. Debt At September 30, 2007 and 2006, there were $2.8 million and zero outstanding borrowings under the revolving credit facility, respectively. Effective October 6, 2004, the Company entered into a $100 million five-year revolving bank credit facility with a $50 mil- lion increase option that has a final maturity and expiration date of October 6, 2009. The credit facility is available for direct borrow- ings and/or the issuance of letters of credit, and is provided by a group of six banks, led by Wells Fargo Bank as agent. At Septem- ber 30, 2007, the Company had approximately $96.4 million avail- able to borrow under the credit facility in addition to $18.6 million cash on hand. At September 30, 2007, the Company had outstand- ing letters of credit of $3.6 million ($0.8 million outstanding under the credit facility). The credit facility requires, as determined by certain financial ratios, a commitment fee ranging from 17.5 to 27.5 basis points per annum 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 finan- cial covenants of the credit facility include limitations on leverage, minimum consolidated EBITDA and minimum net worth. During 2007 and 2006, the maximum aggregate short-term borrow- ings at any month-end were $9 million and $47 million, respec- tively; the average aggregate short-term borrowings outstanding based on month-end balances were $1.7 million and $3.9 million, respectively; and the weighted average interest rates were 6.24%, 5.25%, and not applicable in 2005. The letters of credit issued and outstanding under the credit facility totaled $0.8 million and $0.8 million at September 30, 2007, and 2006, respectively. Subsequent to September 30, 2007, the Company announced its in- tention to enter into a new credit facility led by National City Bank in connection with the acquisition of Doble Engineering Company. See further discussion in Note 16 “Subsequent Events” in the Notes to the Consolidated Financial Statements. E S C O TE Ch nOlOg iE S inC. 2 0 0 7 A n n u Al REpO R T 35 notes to Consolidated Financial Statements 10. Capital Stock The 29,159,629 and 29,030,995 common shares as presented in the accompanying Consolidated Balance Sheets at September 30, 2007 and 2006 represent the actual number of shares issued at the respec- tive dates. The Company held 3,416,966 and 3,166,026 common shares in treasury at September 30, 2007 and 2006, respectively. In August 2006, the Company’s Board of Directors authorized an open market common stock repurchase program for up to 1.2 mil- lion shares, subject to market conditions and other factors which covers the period through September 30, 2008. The Company repurchased 265,000 shares during 2007 under this program. There were no stock repurchases during 2006. The Company repurchased 670,072 shares in 2005 under a previously authorized program. 11. Share-Based Compensation The Company provides compensation benefits to certain key employees under several share-based plans providing for employee stock options and/or performance-accelerated restricted shares (restricted shares), and to non-employee directors under a non- employee directors compensation plan. During fiscal 2004, the Board of Directors authorized and the shareholders approved, the 2004 Incentive Compensation Plan, which states, in part, that on February 5, 2004, there shall be 2,000,000 shares added to the authorized shares allocated for the grant of stock options, stock appreciation rights, performance-accelerated restricted stock, or other full value awards. Of these, shares up to 600,000 may be utilized for performance-accelerated restricted stock or other full value awards. At September 30, 2007, the maximum number of full value shares available for issue under the 2004 Incentive Compensation Plan and the 2001 Stock Incentive Plan was 600,000 and 270,502 shares, respectively. Stock Option plans The Company’s stock option awards are generally subject to graded vesting over a three-year service period. All outstanding options were granted at prices equal to fair market value at the date of grant. The options granted prior to September 30, 2003 have a ten- year contractual life from date of issuance, expiring in various pe- riods through 2013. Beginning in fiscal 2004, the options granted have a five-year contractual life from date of issuance. Beginning with fiscal 2006 awards, the Company recognizes compensation cost on a straight-line basis over the requisite service period for the entire award. Prior to fiscal 2006, the Company calculated the pro forma compensation cost using the graded vesting method. The fair value of each option award is estimated as of the date of grant using a Black-Scholes option pricing model. The weighted average assumptions for the periods indicated are noted below. Expected volatility is based on historical volatility of ESCO’s stock calculated over the expected term of the option. The expected term was calculated in accordance with Staff Accounting Bulletin No. 107 using the simplified method for “plain-vanilla” options. The risk-free rate for the expected term of the option is based on the U.S. Treasury yield curve in effect at the date of grant. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants in 2007, 2006 and 2005, respectively: expected dividend yield of 0% in all periods; expected volatility of 27.3%, 28.0% and 23.5%; risk-free interest rate of 4.6%, 4.6% and 3.9%; and expected term of 3.50 years, 3.50 years and 3.58 years. Information regarding stock options awarded under the option plans is as follows: October 1 Granted Exercised Cancelled September 30, At September 30, Reserved for future grant Exercisable FY2007 FY2006 FY2005 Estimated Weighted Avg. price $26.60 $45.71 $21.56 $40.59 Shares 1,387,348 296,280 (101,683) (23,004) Estimated Weighted Avg. Price $ 20.48 $ 44.63 $ 15.95 $ 35.77 Shares 1,324,548 328,080 (232,371) (32,909) Estimated Weighted Avg. Price $ 13.63 $ 35.55 $ 10.94 $ 24.96 Shares 1,356,094 376,200 (388,340) (19,406) 1,558,941 $30.35 1,387,348 $ 26.60 1,324,548 $ 20.48 878,238 951,066 1,146,741 1,428,032 $21.99 753,415 $ 16.46 755,612 $ 12.29 36 E S C O TE Ch nOlOg iE S inC. 2 0 0 7 A n n u Al REpO R T longer performance period as it is not probable the performance condition will be met. The restricted share award grants were valued at the stock price on the date of grant. Pre-tax compensation expense related to the restricted share awards was $1.5 million, $1.5 million and $1.9 million for fiscal years ended September 30, 2007, 2006 and 2005, respectively. The following summary presents information regarding outstanding restricted share awards as of September 30, 2007 and changes dur- ing the period then ended: Options Outstanding Weighted- Nonvested at October 1, 2006 Number Outstanding at Sept. 30, 2007 Average Weighted Average Exercise Price Remaining Contractual Life Granted Vested Cancelled Weighted Shares Avg. Price 155,730 $34.33 63,530 $45.75 (51,200) $24.60 (4,000) $34.80 notes to Consolidated Financial Statements The aggregate intrinsic value of options exercised during 2007, 2006 and 2005 was $2.4 million, $7.9 million and $12.4 million, respectively. The aggregate intrinsic value of stock options out- standing and exercisable at September 30, 2007 was $12.3 million. The weighted-average contractual life of stock options outstand- ing at September 30, 2007 was 3.0 years. The weighted-average fair value of stock options granted in 2007, 2006, and 2005 was $12.25, $12.17, and $11.28, respectively. Summary information regarding stock options outstanding at September 30, 2007 is presented below: Range of Exercise Prices $ 5.39 - $10.72 $12.64 - $14.52 $17.29 - $32.32 $35.18 - $42.10 $42.99 - $54.88 Range of Exercise Prices $ 5.39 - $10.72 $12.64 - $14.52 $17.29 - $32.32 $35.18 - $54.88 201,426 268,486 186,455 303,630 598,944 2.0 years 4.5 years 1.7 years 2.0 years 3.6 years $ 7.19 $13.76 $23.51 $35.31 $45.20 1,558,941 3.0 years $30.35 Exercisable Options Outstanding Number Exercisable at Sept. 30, 2007 201,426 268,486 186,455 294,699 951,066 Weighted Average Exercise Price $ 7.19 $13.76 $23.51 $38.64 $21.99 performance-accelerated Restricted Share Awards The performance-accelerated restricted shares (restricted shares) vest over five years with accelerated vesting if certain performance targets are achieved. In these cases, if it is probable that the per- formance condition will be met, the Company recognizes compen- sation cost on a straight-line basis over the shorter performance period; otherwise, it will recognize compensation cost over the longer service period. Compensation cost for the majority of the outstanding restricted share awards is being recognized over the Nonvested at September 30, 2007 164,060 $41.77 non-Employee Directors plan The non-employee directors compensation plan provides to each non-employee director a retainer of 800 common shares per quarter. Compensation expense related to the non-employee director grants was $0.8 million, $1.0 million and $0.7 million for the years ended September 30, 2007, 2006 and 2005, respectively. The total share-based compensation cost that has been recognized in results of operations and included within SG&A was $5.3 million, $4.8 million and $2.6 million for the years ended September 30, 2007, 2006 and 2005, respectively. The total income tax benefit recognized in results of operations for share-based compensation arrangements was $1.2 million, $1.2 million and $1.0 million for the years ended September 30, 2007, 2006 and 2005, respectively. The Company has elected to use tax law ordering rules when calculating the income tax benefit associated with its share-based payment arrangements. In addition, the Company elected to use the simplified method of calculating the pool of excess tax benefits available to absorb tax deficiencies recognized subsequent to the adoption of SFAS No. 123(R)-3, “Transition Election related to Accounting for the Tax Effects of Share-Based Payment Awards.” As of September 30, 2007, there was $10.2 million of total unrecog- nized compensation cost related to share-based compensation arrangements. That cost is expected to be recognized over a weighted-average period of 3.0 years. E S C O TE Ch nOlOg iE S inC. 2 0 0 7 A n n u Al REpO R T 37 notes to Consolidated Financial Statements pro Forma net Earnings The following table provides pro forma net earnings and earnings per share had the Company applied the fair value method of SFAS 123 for the year ended September 30, 2005: Pro forma (Unaudited) (Dollars in thousands, except per share amounts) Net earnings, as reported Add: stock-based employee compensation expense included in reported net earnings, net of tax Less: total stock-based employee compensation expense determined 2005 $43,544 1,165 under fair value based methods, net of tax (3,476) Pro forma net earnings Net earnings per share: Basic — as reported Basic — pro forma Diluted — as reported Diluted — pro forma $41,233 $1.71 1.62 1.66 1.57 The Company adopted Statement of Financial Accounting Standards No. 158, “Employer’s Accounting for Defined Benefit Pension and Other Postretirement Plans” (SFAS 158) as of September 30, 2007. SFAS 158 requires an employer to recognize the overfunded or underfunded status of a defined benefit postretirement plan as an asset or liability in its statement of financial position and to recog- nize changes in that funded status in the year in which the changes occur through comprehensive income. As a result of adopting the provisions of SFAS 158, the Company recorded a pre-tax credit of $0.9 million to accumulated other comprehensive income in equity as of September 30, 2007. The Company uses a measurement date of September 30 for its pension and other postretirement benefit plans. The Company has an accrued benefit liability of $0.7 million and $1.8 million at September 30, 2007 and 2006, respectively, related to its other postretirement benefit obligations. All other information related to its postretirement benefit plans is not considered material to the Company’s results of operations or financial condition. The following tables provide a reconciliation of the changes in the pension plans and fair value of assets over the two-year period ended September 30, 2007, and a statement of the funded status as of September 30, 2007 and 2006: 12. Retirement and Other Benefit plans (Dollars in millions) Pension Benefits 2007 2006 Substantially all domestic employees are covered by the defined contribution pension plan maintained by the Company. Effective December 31, 2003, the Company’s defined benefit plan was frozen and no additional benefits will be accrued after that date. As a result, the accumulated benefit obligation and projected benefit obligation are equal. These frozen retirement income benefits are provided to employees under defined benefit pay-related and flat- dollar plans, which are noncontributory. The annual contributions to retirement plans equal or exceed the minimum funding requirements of the Employee Retirement Income Security Act or applicable local regulations. In addition to providing retirement income benefits, the Company provides unfunded postretirement health and life insurance benefits to certain retirees. To qualify, an employee must retire at age 55 or later and the employee’s age plus service must equal or exceed 75. Retiree contributions are defined as a per- centage of medical premiums. Consequently, retiree contributions increase with increases in the medical premiums. The life insurance plans are noncontributory and provide coverage of a flat dollar amount for qualifying retired employees. Effective December 31, 2004, no new retirees are eligible for life insurance benefits. Reconciliation of benefit obligation Net benefit obligation at beginning of year $ 48.2 50.2 Service cost Interest cost Actuarial (gain) loss Plan amendments Gross benefits paid — — 2.7 (2.9) (1.8) — 2.6 (2.9) 0.1 (1.8) Net benefit obligation at end of year $ 46.2 48.2 (Dollars in millions) Pension Benefits 2007 2006 Reconciliation of fair value of plan assets Fair value of plan assets at beginning of year $ 35.1 Actual return on plan assets Employer contributions Gross benefits paid 4.7 0.2 (1.8) Fair value of plan assets at end of year $ 38.2 32.7 2.6 1.6 (1.8) 35.1 38 E S C O TE Ch nOlOg iE S inC. 2 0 0 7 A n n u Al REpO R T notes to Consolidated Financial Statements (Dollars in millions) Funded Status Pension Benefits 2007 2006 Funded status at end of year $(8.0) (13.1) Unrecognized prior service cost — Unrecognized net actuarial (gain) loss — 0.1 10.1 Accrued benefit cost (8.0) (2.9) Amounts recognized in the Balance Sheet consist of: Current liability Noncurrent liability Accrued benefit cost (0.2) — (7.8) — — Additional minimum liability Intangible asset Accumulated other comprehensive income (before tax effect) — — — Accrued benefit liability (8.0) (2.9) (10.3) 0.1 10.2 (2.9) present value was developed. The expected long-term rate of return on plan assets assumption was determined by reviewing the actual investment return of the plans since inception and evaluat- ing those returns in relation to expectations of various investment organizations to determine whether long-term future returns are expected to differ significantly from the past. The following weighted-average assumptions were used to determine the net periodic benefit cost for the pension plans: Discount rate Rate of increase in compensation levels Expected long-term rate of 2007 2006 2005 5.75% 5.25% 6.00% n/A N/A N/A return on assets 8.25% 8.25% 8.25% The following weighted-average assumptions were used to determine the net periodic benefit obligations for the pension plans: Amounts recognized in Accumulated Other Comprehensive Income consist of: Net actuarial loss Prior service cost 5.0 — 0.1 — Discount rate Rate of increase in compensation levels 2007 2006 6.25% 5.75% n/A N/A Accumulated Other Comprehensive Income $5.1 — The following table provides the components of net periodic benefit cost for the plans for the years ended September 30, 2007, 2006 and 2005: Pension Benefits (Dollars in millions) 2007 2006 2005 Service cost Interest cost $ — 2.7 — 2.6 Expected return on plan assets (2.8) (2.7) Net actuarial (gain) loss Net periodic benefit cost Defined contribution plans Total 0.4 0.3 3.6 $ 3.9 0.4 0.3 2.9 3.2 — 2.6 (2.9) 0.2 (0.1) 2.4 2.3 The discount rate used in measuring the Company’s pension obligations was developed by matching yields of actual high- quality corporate bonds to expected future pension plan cash flows (benefit payments). Over 500 Aa-rated, non-callable bonds with a wide range of maturities were used in the analysis. After using the bond yields to determine the present value of the plan cash flows, a single representative rate that resulted in the same The assumed rate of increase in compensation levels is not applicable in 2007, 2006 and 2005 as the plan was frozen as of December 31, 2003. The asset allocation for the Company’s pension plans at the end of 2007 and 2006, the Company’s acceptable range and the target allocation for 2008, by asset category, follows: Target Acceptable Percentage of Plan Assets at Year-end Range Allocation Asset Category Equity securities Fixed income Cash/cash equivalents 2008 60% 40% 0% 2007 2006 50-70% 30-50% 0-5% 69% 29% 2% 66% 32% 2% The Company’s pension plan assets are managed by outside invest- ment managers and assets are rebalanced when the target ranges are exceeded. Pension plan assets consist principally of marketable securities including common stocks, bonds, and interest-bearing de- posits. The Company’s investment strategy with respect to pension assets is to achieve a total rate of return (income and capital ap- preciation) that is sufficient to accomplish the purpose of providing retirement benefits to all eligible and future retirees of the pension plan. The Company regularly monitors performance and compliance with investment guidelines. E S C O TE Ch nOlOg iE S inC. 2 0 0 7 A n n u Al REpO R T 39 notes to Consolidated Financial Statements EXpECTED CASh FlOWS 14. Business Segment information Information about the expected cash flows for the pension and other postretirement benefit plans follows: (Dollars in millions) Pension Benefits Other Benefits Expected Employer Contributions — 2008 $ 0.2 0.1 Expected Benefit Payments 2008 2009 2010 2011 2012-2016 2.4 2.5 2.6 2.7 $15.0 0.1 0.1 0.1 0.1 0.3 13. Other Financial Data Items charged to operations during the years ended September 30, 2007, 2006 and 2005 included the following: (Dollars in thousands) 2007 2006 2005 Salaries and wages (including fringes) $137,999 119,286 100,372 Maintenance and repairs 5,545 4,719 3,897 Research and development (R&D) costs: Company-sponsored $ 25,357 20,043 16,829 Customer-sponsored 7,618 6,323 5,687 Total R&D $ 32,975 26,366 22,516 Other engineering costs 9,082 9,069 7,763 Total R&D and other engineering costs $ 42,057 35,435 30,279 As a % of net sales 8.0% 7.7% 7.1% Customer-sponsored R&D is defined in Note 1(O) of Notes to Con- solidated Financial Statements. A reconciliation of the changes in accrued product warranty liabil- ity for the years ended September 30, 2007, 2006, and 2005 is as follows: (Dollars in thousands) 2007 2006 Balance as of October 1 $1,422 1,487 Additions charged to expense 1,771 2,357 2005 2,147 1,108 Deductions (1,732) (2,422) (1,768) Balance as of September 30 $1,461 1,422 1,487 The Company is organized based on the products and services that it offers. Under this organizational structure, the Company has three reporting units: Communications, Filtration and Test. The Communications unit is a proven supplier of special purpose fixed network communications systems for electric, gas and water utili- ties, including hardware and software to support advanced metering applications. DCSI’s Two-Way Automatic Communications System, known as TWACS®, is currently used for automatic meter reading (AMR) and related advanced metering infrastructure (AMI) functions serving over 200 utilities, as well as having load management capa- bilities. Hexagram’s STAR® system, the premier wireless AMI system, delivers two-way and one-way operation on secure licensed radio frequencies for more than 100 utilities serving electric, gas and water customers. Nexus provides best-in-class utility data manage- ment solutions to more than 85 leading energy companies that add value to existing billing and metering infrastructure to allow both the utilities and their customers to better manage energy-driven transactions and decision making. Comtrak’s SecurVision® product line provides digital video surveillance and security functions for large commercial enterprises and alarm monitoring companies. The Filtration unit’s primary operations consist of: PTI Technologies Inc. (PTI), VACCO Industries (VACCO) and the Filtertek companies (Filtertek). PTI and VACCO develop and manufacture a wide range of filtration products and are leading suppliers of filters to the commercial and defense aerospace, satellite and industrial markets. Filtertek develops and manufactures a broad range of high-volume, original equipment manufacturer (OEM) filtration products at its facilities in North America, South America and Europe. Each of the components of the Filtration segment is presented separately due to differing long-term economics. Test segment operations represent the EMC Group, consisting primarily of ETS-Lindgren L.P. (ETS) and Lindgren R.F. Enclosures, Inc. (Lindgren). The EMC Group is princi- pally involved in the design and manufacture of EMC test equip- ment, test chambers, and electromagnetic absorption materials. The EMC Group also manufactures radio frequency (RF) shielding products and components used by manufacturers of medical equip- ment, communications systems, electronic products, and shielded rooms for high security data processing and secure communica- tion. Accounting policies of the segments are the same as those described in the summary of significant accounting policies in Note 1 to the Consolidated Financial Statements. In accordance with SFAS 131, the Company evaluates the per- formance of its operating units based on EBIT, which is defined as: Earnings Before Interest and Taxes. Intersegment sales and transfers are not significant. Segment assets consist primarily of customer receivables, inventories, capitalized software and fixed assets directly associated with the production processes of the segment. Segment depreciation and amortization is based upon the direct assets listed above. 40 E S C O TE Ch nOlOg iE S inC. 2 0 0 7 A n n u Al REpO R T notes to Consolidated Financial Statements nET SAlES (Dollars in millions) Year ended September 30, Communications PTI VACCO Filtertek Filtration subtotal Test Consolidated totals 2007 $197.6 52.7 37.2 98.5 188.4 141.5 $527.5 2006 156.2 46.4 32.3 95.4 174.1 128.6 458.9 2005 138.0 40.7 38.9 92.1 171.7 119.4 429.1 CApiTAl EXpEnDiTuRES (Dollars in millions) Year ended September 30, 2007 2006 2005 Communications $ 7.0 PTI VACCO Filtertek Filtration subtotal Test Corporate 0.4 0.6 7.4 8.4 4.0 0.1 3.4 0.2 1.0 3.8 5.0 0.7 — 9.1 1.9 1.0 0.7 4.0 5.7 1.2 — 8.8 No customers exceeded 10% of net sales in the periods presented. Consolidated totals $ 19.5 EBiT (Dollars in millions) Year ended September 30, Communications PTI VACCO Filtertek Filtration subtotal Test Reconciliation to consolidated 2007 $ 22.0 9.4 7.8 6.2 23.4 14.4 2006 28.3 6.6 6.1 6.8 19.5 15.0 2005 38.8 3.8 10.4 8.2 22.4 12.2 totals (Corporate) (17.8) (15.2) (11.4) Consolidated EBIT Add: interest income 42.0 0.7 Earnings before income tax $ 42.7 47.6 1.3 48.9 62.0 1.9 63.9 iDEnTiFiABlE ASSETS (Dollars in millions) Year ended September 30, Communications PTI VACCO Filtertek Filtration subtotal Test Reconciliation to consolidated totals (Corporate assets) 2007 $ 151.6 32.5 16.8 68.6 117.9 72.0 2006 97.9 32.0 15.7 62.9 110.6 50.3 234.6 229.9 Consolidated totals $576.1 488.7 2005 52.4 36.7 19.7 91.5 147.9 80.7 142.8 423.8 Corporate assets consist primarily of goodwill, deferred taxes, acquired intangible assets and cash balances. DEpRECiATiOn AnD AMORTiZATiOn (Dollars in millions) Year ended September 30, 2007 2006 2005 Communications $ 10.3 PTI VACCO Filtertek Filtration subtotal Test Reconciliation to consolidated totals (Corporate) 1.4 0.8 6.2 8.4 1.3 2.2 Consolidated totals $ 22.2 5.0 1.5 0.7 6.0 8.2 1.3 2.0 1.5 0.7 6.2 8.4 1.4 2.8 17.3 0.4 12.2 gEOgRAphiC inFORMATiOn net sales (Dollars in millions) Year ended September 30, 2007 2006 2005 United States $406.3 355.9 325.3 Europe Far East Other 45.9 38.0 37.3 40.2 36.1 26.7 56.0 29.6 18.2 Consolidated totals $527.5 458.9 429.1 long-lived assets (Dollars in millions) Year ended September 30, 2007 2006 2005 United States Europe Other Consolidated totals $ 54.6 14.0 9.7 $ 78.3 51.3 10.6 6.9 68.8 50.3 10.9 6.0 67.2 Net sales are attributed to countries based on location of customer. Long-lived assets are attributed to countries based on location of the asset. E S C O TE Ch nOlOg iE S inC. 2 0 0 7 A n n u Al REpO R T 41 notes to Consolidated Financial Statements 15. Commitments and Contingencies At September 30, 2007, the Company had $3.6 million in let- ters of credit outstanding as guarantees of contract performance. As a normal incidence of the businesses in which the Company is engaged, various claims, charges and litigation are asserted or commenced against the Company. With respect to claims and litigation asserted or commenced against the Company, it is the opinion of Management, that final judgments, if any, which might be rendered against the Company are adequately reserved, covered by insurance, or are not likely to have a material adverse effect on its financial condition or results of operation. 16. Subsequent Events On November 7, 2007, the Company announced an agreement to acquire the stock of Doble Engineering Company, headquartered in Watertown, Massachusetts, for $319 million in cash, subject to adjustment for differences in working capital and cash on hand at 17. Quarterly Financial information (unaudited) closing. The Company intends to fund the acquisition by a combina- tion of existing cash and borrowings under a new credit facility led by National City Bank. The transaction is expected to close in the quarter ending December 31, 2007. On November 26, 2007, the Company announced it had completed the sale of the filtration portion of Filtertek Inc. to Illinois Tool Works Inc. (ITW) for approximately $77.5 million in cash, subject to closing working capital adjustments. The Tek Packaging divi- sion of Filtertek is not included in the transaction. The net cash proceeds from the sale, estimated at $70 million after taxes and expenses, will be used to pay down a portion of the debt associ- ated with the Doble Engineering Company acquisition, mentioned above. The Company expects to record a gain on the sale for both financial reporting and tax purposes, with a portion of the tax gain being shielded from cash payments through the utilization of the Company’s existing capital loss carryforward which was generated from prior divestitures. As discussed in Note 8 to the Consolidated Financial Statements, there is a valuation allowance established against the capital loss carryforward as of September 30, 2007. (Dollars in thousands, except per share amounts) First Quarter Second Quarter Third Quarter Fourth Quarter Fiscal Year 2007 Net sales Net earnings (loss) Basic earnings (loss) per share: Net earnings (loss) Diluted earnings (loss) per share: Net earnings (loss) 2006 Net sales Net earnings Basic earnings per share: Net earnings Diluted earnings per share: Net earnings $ 98,813 129,068 137,523 162,133 527,537 (1,381) 9,618 8,854 16,622 33,713 (.05) .37 .34 .65 1.30 $ (.05) .36 .33 .64 1.28 $90,586 122,884 123,626 121,769 458,865 2,204 7,343 11,163 10,570 31,280 .09 .29 .43 .41 1.22 $ .08 .28 .42 .40 1.19 During 2007, the Company determined that certain tax accounts had not been accurately recorded in the financial statements for fiscal years 2001 to 2006. The effect in any individual year was not material to the Company’s results of operations, financial position or cash flows. The Company recorded $1.3 million as a cumulative credit adjustment to tax expense to correct previously recorded tax accounts during the fourth quarter of 2007. 42 E S C O TE Ch nOlOg iE S inC. 2 0 0 7 A n n u Al REpO R T Management’s Statement of Financial Responsibility The Company’s Management is responsible for the fair presentation of the Company’s financial statements in accordance with account- ing principles generally accepted in the United States of America, and for their integrity and accuracy. Management is confident that its financial and business processes provide accurate information on a timely basis. Management, with the oversight of ESCO’s Board of Directors, has established and maintains a strong ethical climate in which the Company’s affairs are conducted. Management also has established an effective system of internal controls that provide reasonable as- surance as to the integrity and accuracy of the financial statements, and responsibility for the Company’s assets. KPMG LLP, the Company’s independent accountants, reports directly to the Audit and Finance Committee of the Board of Directors. The Audit and Finance Commit- tee has established policies consistent with newly enacted corporate reform laws for auditor independence. In accordance with corporate governance listing requirements of the New York Stock Exchange: ▶ A majority of Board members are independent of the Company and its Management. ▶ All members of the key Board committees — the Audit and Fi- nance, the Human Resources and Compensation and the Nominat- ing and Corporate Governance Committees — are independent. ▶ The independent members of the Board meet regularly without the presence of Management. ▶ The Company has a clear code of ethics and a conflict of inter- est policy to ensure that key corporate decisions are made by individuals who do not have a financial interest in the outcome, separate from their interest as Company officials. ▶ The charters of the Board committees clearly establish their respective roles and responsibilities. ▶ The Company has an ethics officer and an ombudsman hot line available to all domestic employees and all foreign employees have local ethics officers and access to the Company’s ombudsman. The Company has a strong financial team, from its executive leader- ship to each of its individual contributors. Management monitors compliance with its financial policies and practices over critical areas including internal controls, financial accounting and report- ing, accountability, and safeguarding of its corporate assets. The internal audit control function maintains oversight over the key areas of the business and financial processes and controls, and reports directly to the Audit and Finance Committee. Additionally, all employees are required to adhere to the ESCO Code of Business Conduct and Ethics, which is monitored by the ethics officer. Management is dedicated to ensuring that the standards of financial accounting and reporting that are established are maintained. The Company’s culture demands integrity and a commitment to strong internal practices and policies. The Consolidated Financial Statements have been audited by KPMG LLP, whose report is included herein. Victor L. Richey Chairman, Chief Executive Officer, and President Gary E. Muenster Senior Vice President and Chief Financial Officer Management’s Report on internal Control Over Financial Reporting The Company’s Management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in the Securities Exchange Act Rule 13a-15(f)). Our internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accor- dance with generally accepted accounting principles in the United States of America. Because of its inherent limitations, any system of internal control over financial reporting, no matter how well designed, may not prevent or detect misstatements due to the possibility that a control can be circumvented or overridden or that misstatements due to error or fraud may occur that are not detected. Also, because of changes in conditions, internal control effectiveness may vary over time. Management assessed the effectiveness of the Company’s internal control over financial reporting as of September 30, 2007 using cri- teria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Com- mission (COSO) and concluded that the Company maintained effective internal control over financial reporting as of September 30, 2007 based on these criteria. Our internal control over financial reporting as of September 30, 2007, as well as our assessment of the effectiveness of our internal control over financial reporting as of September 30, 2007, have been audited by KPMG LLP, an independent registered public ac- counting firm, as stated in the report which is included herein. Victor L. Richey Chairman, Chief Executive Officer, and President Gary E. Muenster Senior Vice President and Chief Financial Officer E S C O TE Ch nOlOg iE S inC. 2 0 0 7 A n n u Al REpO R T 43 Report of independent Registered public Accounting Firm The Board of Directors and Shareholders ESCO Technologies Inc.: each of the years in the three-year period ended September 30, 2007, in conformity with U.S. generally accepted accounting principles. We have audited the accompanying consolidated balance sheets of ESCO Technologies Inc. and subsidiaries (the Company) as of September 30, 2007 and 2006, and the related consolidated state- ments of operations, shareholders’ equity and cash flows for each of the years in the three-year period ended September 30, 2007. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to ob- tain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to pre- viously present fairly, in all material respects, the financial position of ESCO Technologies Inc. and subsidiaries as of September 30, 2007 and 2006, and the results of their operations and their cash flows for As discussed in Notes 1 and 12 to the consolidated financial statements, the Company adopted Statement of Financial Accounting Standards No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, as of September 30, 2007. Additionally, as discussed in Note 1 to the consolidated financial statements, the Company adopted Statement of Financial Accounting Standards No. 123(R), Share- Based Payment, effective October 1, 2005 and, as discussed in Note 8 to the consolidated financial statements, the Company changed its method of quantifying errors in 2006. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of ESCO Technologies Inc.’s internal control over financial reporting as of September 30, 2007, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Com- mission (COSO), and our report dated November 29, 2007, expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting. St. Louis, Missouri November 29, 2007 44 E S C O TE Ch nOlOg iE S inC. 2 0 0 7 A n n u Al REpO R T Report of independent Registered public Accounting Firm The Board of Directors and Shareholders ESCO Technologies Inc.: We have audited management’s assessment, included in the ac- companying Management’s Report on Internal Control Over Financial Reporting, that ESCO Technologies Inc. (the Company) maintained effective internal control over financial reporting as of Septem- ber 30, 2007, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). ESCO Technolo- gies Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assess- ment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards required that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted account- ing principles. A company’s internal control over financial report- ing includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and the receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projec- tions of any evaluation of effectiveness to future periods are sub- ject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, management’s assessment that ESCO Technologies Inc. maintained effective internal control over financial report- ing as of September 30, 2007, is fairly stated, in all material respects, based on criteria established in Internal Control — Integrated Framework issued by COSO. Also, in our opinion, ESCO Technologies Inc. maintained, in all material respects, effective internal control over financial reporting as of September 30, 2007, based on criteria established in Internal Control — Integrated Framework issued by COSO. We also have audited, in accordance with the standards of the Pub- lic Company Accounting Oversight Board (United States), the con- solidated balance sheets of ESCO Technologies Inc. and subsidiaries as of September 30, 2007 and 2006, and the related consolidated statements of operations, shareholders’ equity and cash flows for each of the years in the three-year period ended September 30, 2007, and our report dated November 29, 2007, expressed an un- qualified opinion on those consolidated financial statements. St. Louis, Missouri November 29, 2007 E S C O TE Ch nOlOg iE S inC. 2 0 0 7 A n n u Al REpO R T 45 Five-Year Financial Summary (Dollars in millions, except per share amounts) 2007 2006 2005 2004 2003 For years ended September 30: Net sales Net earnings from continuing operations Net earnings (loss) from discontinued operations — Net earnings (loss) before accounting change Net earnings (loss) Earnings (loss) per share: Basic: Continuing operations Discontinued operations — Cumulative effect of accounting change, net of tax Net earnings (loss) Diluted: Continuing operations Discontinued operations — Cumulative effect of accounting change, net of tax Net earnings (loss) As of September 30: Working capital Total assets Long-term debt Shareholders’ equity $527.5 33.7 33.7 33.7 1.30 — 1.30 1.28 — 1.28 141.2 576.1 — $415.5 458.9 31.3 — 31.3 31.3 1.22 — — 1.22 1.19 — — 1.19 131.4 488.7 — 376.4 429.1 43.5 — 43.5 43.5 1.71 — — 1.71 1.66 — — 1.66 197.2 423.8 — 331.0 422.1 37.8 (2.1) 35.7 35.7 1.47 (0.09) — 1.38 1.42 (0.08) — 1.34 165.2 402.4 0.4 307.6 396.7 26.7 (66.5) (39.7) (41.1) 1.05 (2.62) (0.06) (1.63) 1.02 (2.53) (0.06) (1.57) 120.5 393.4 0.5 275.4 See Note 2 of Notes to Consolidated Financial Statements for discussion of acquisition activity. Common Stock Market price ESCO’s common stock and associated preferred stock purchase rights (subsequently referred to as common stock) are listed on the New York Stock Exchange under the symbol “ESE.” The following table summarizes the high and low prices of the common stock for each quarter of fiscal 2007 and 2006. Quarter First Second Third Fourth 2007 2006 high $49.28 49.20 52.41 43.50 low 41.88 40.67 34.73 29.63 High $50.75 52.76 58.03 58.42 Low 32.57 43.84 47.65 45.30 ESCO historically has not paid cash dividends on its common stock. Management continues to evaluate its cash dividend policy. There are no current plans to initiate a dividend. 46 E S C O TE Ch nOlOg iE S inC. 2 0 0 7 A n n u Al REpO R T Market performance Russell 2000® Peer Group ESCO Technologies Inc. The adjacent graph presents a comparison of the cumulative total shareholder return on the Company’s common stock as measured against the Russell 2000 Index and a peer group (the “2007 Peer Group”). The Company is not a component of the 2007 Peer Group, but it is a component of the Russell 2000 Index. The measurement period begins on September 30, 2002 and measures at each Septem- ber 30 thereafter. These figures assume that all dividends, if any, paid over the measurement period were reinvested, and the starting value of each index and the investments in the Company’s common stock were $100 at the close of trading on September 30, 2002. $350 300 250 200 150 100 ESCO Technologies Inc. Russell 2000 Index 2007 Peer Group ESCO Technologies inc. Russell 2000 Index 2007 Peer Group 9/02 9/03 9/04 9/05 9/06 9/07 9/02 9/03 9/04 9/05 9/06 9/07 $100 140.15 209.78 310.03 285.08 205.82 100 136.50 162.12 191.23 210.20 236.14 100 136.29 168.38 196.60 226.06 294.15 The 2007 Peer Group is the same peer group included in the performance graph in last year’s proxy statement and designated the “2006 Peer Group”. The 2007 Peer Group is comprised of six companies, which correspond to the Company’s three indus- try segments as follows: Filtration/Fluid Flow segment (36% of the Company’s 2007 total revenue) — Pall Corporation and Clarcor Inc.; Communications segment (37% of the Company’s 2007 total revenue) — Badger Meter Inc., Itron Inc. and Roper Industries Inc.; and Test segment (27% of the Company’s 2007 total revenue) — Tektronix Inc. In calculating the composite return of the 2007 Peer Group, the return of each company comprising the 2007 Peer Group is weighted by (a) its market capitalization in relation to the other companies in its corresponding Company industry segment, and (b) the percentage of the Company’s 2007 total revenue repre- sented by its corresponding Company industry segment. E S C O TE Ch nOlOg iE S inC. 2 0 0 7 A n n u Al REpO R T 47 Shareholders’ Summary ShAREhOlDERS’ AnnuAl MEETing inVESTOR RElATiOnS The Annual Meeting of the shareholders of ESCO Technologies Inc. will be held at 9:30 a.m. Wednesday, February 6, 2008, at the Company’s Corporate headquarters, 9900A Clayton Road, St. Louis, Missouri 63124. Notice of the meeting and a proxy statement were sent to shareholders with this Annual Report. Additional investor-related information may be obtained by contacting the Director of Investor Relations at (314) 213-7277 or toll free at (888) 622-3726. Information is also available through the Company’s web site at www.escotechnologies.com or via e-mail to pmoore@escotechnologies.com. CERTiFiCATiOnS TRAnSFER AgEnT AnD REgiSTRAR Pursuant to New York Stock Exchange (NYSE) requirements, the Company submitted to the NYSE the annual certifications, dated February 23, 2007 and February 27, 2006, by the Company’s chief executive officer that he was not aware of any violations by the Company of NYSE’s corporate governance listing standards. In addition, the Company filed with the Securities and Exchange Commission the certifications by the Company’s chief executive officer and chief financial officer required under Section 302 of the Sarbanes-Oxley Act of 2002 as exhibits to the Company’s Forms 10-K for its fiscal years ended September 30, 2007 and September 30, 2006. 10-K REpORT A copy of the Company’s 2007 Annual Report on Form 10-K filed with the Securities and Exchange Commission is available to shareholders without charge. Direct your written request to the Investor Relations Department, ESCO Technologies Inc., 9900A Clayton Road, St. Louis, Missouri 63124. The Form 10-K is also available on the Company’s web site at www.escotechnologies.com. Shareholder inquiries concerning lost certificates, transfer of shares or address changes should be directed to: Registrar and Transfer Company 10 Commerce Drive Cranford, NJ 07016-3572 1 (800) 368-5948 E-mail: info@rtco.com CApiTAl STOCK inFORMATiOn ESCO Technologies Inc. common stock shares (symbol ESE) are listed on the New York Stock Exchange. There were approximately 2,700 holders of record of shares of common stock at November 15, 2007. inDEpEnDEnT REgiSTERED puBliC A CCOunTing FiRM KPMG LLP 10 South Broadway, Suite 900 St. Louis, Missouri 63102 48 E S C O TE Ch nOlOg iE S inC. 2 0 0 7 A n n u Al REpO R T heading Management and Board of Directors ExECuTivE OffiCERS victor l. Richey Chairman, Chief Executive Officer, & President Alyson S. Barclay Vice President, Secretary & General Counsel gary E. Muenster Senior Vice President & Chief Financial Officer CORpORATE STAff Charles J. Kretschmer Vice President Deborah J. hanlon Vice President Human Resources OpERATing ExECuTivES David f. Atkinson President Filtertek Inc. Bruce E. Butler President ETS-Lindgren LP Sam R. Chapetta Filtration Group Vice President & President PTI Technologies Inc. Martin flusberg President Nexus Energy Software, Inc. William M. giacone Vice President & General Manager — Lindgren ETS-Lindgren LP Antonio E. gonzalez President VACCO Industries Bruce S. Kessler Executive Vice President & General Manager Distribution Control Systems, Inc. Kent A. Marty General Manager Comtrak Technologies, LLC Sam A. Mazzola President Tek Packaging gary l. Moore President Hexagram, Inc. Bruce A. phillips Group President Communications BOARD Of DiRECTORS James M. McConnell 2 Retired President & Chief Executive Officer Instron Corp. James M. Stolze 2 Vice President & Chief Financial Officer Stereotaxis, Inc. victor l. Richey 1 Chairman, Chief Executive Officer, & President larry W. Solley 3,4 Retired Executive Vice President Emerson Electric Co. Donald C. Trauscht 1,2,3,4 (Lead Director) Chairman BW Capital Corp. James D. Woods 3 Chairman Emeritus & Retired Chief Executive Officer Baker Hughes Inc. Bryan Sayler Senior Vice President & General Manager — ETS ETS-Lindgren LP Committee Membership 1 Executive Committee 2 Audit and Finance Committee 3 Human Resources and Compensation Committee 4 Nominating and Corporate Governance m o c . c n i g n i l d n a w . w w w O M , s i u o l . t S , . c n i s e t a i c o s s A & g n i l d n a W : n g i s e D E S C O TE Ch nOlOg iE S inC. E S C O TE Ch nOlOg iE S inC. 2 0 0 7 A n n u Al REpO R T 2 0 0 7 A n n u Al REpO R T 49 Cover3 ESCO Technologies Inc. 9900A Clayton Road St. Louis, MO 63124 www.escotechnologies.com 

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