MTS Systems Corp
Q3 2008 Earnings Call Transcript

Published: 5 Aug 2008

[Operator:]

(Operator Instructions) Good day and welcome to the MTS Systems Third Quarter Conference Call. Today's conference is being recorded. At this time I would like to turn the conference over to Ms. Sue Knight. Please go ahead.

[Sue Knight:]

Thank you, Doris. Good morning, and welcome to MTS Systems' Fiscal 2008 Third Quarter Investor's Teleconference. Joining me on the call today is Laura Hamilton, Chief Executive Officer. I want to remind you that statements made today, which are not of historical fact, should be considered forward-looking statements as defined by the Private Securities Litigation Reform Act of 1995. Future results may differ materially from these statements depending upon risks, some of which are beyond Management's control. A list of such risks can be found in the Company's latest SEC Forms 10-Q and 10-K. The Company disclaims any obligation to revise forward-looking statements made today based on future events. This presentation may also include reference to financial measures, which are not calculated in accordance with Generally Accepted Accounting Principles or GAAP. These measures may be used by Management to compare the operating performance of the Company over time. They should not be considered in isolation or as a substitute for GAAP measures. I am pleased now to turn the teleconference over to Laura who will update you on our third quarter results.

[Laura Hamilton:]

Thanks, Sue. Good morning, and thank you for joining our call today. You know we have had a really active quarter, and we have a lot of good news to talk about today. I am going to do three things with you; I am going to take you through our headlines; our perspective on the quarter's results by segment, which is really the details of orders, and then I am going to talk to you about globalization and the opportunity for our business. Then we will go back to Sue who'll take you through the financial details. Today we have seven headlines, which seems like quite a few. Three are about the operations of the business, three are about announcements that we have made throughout the quarter, and our fourth headline is about -- or our last headline is about our guidance. Let us start from the top. With respect to operations, our number one headline is 6% orders growth, which is strong. If you consider the economy, and you consider our first half orders, we are sitting at an 18% year-to-date growth rate and maintaining a strong backlog, and we are really pleased about this. Our second headline is that Test is improving. We delivered record $92 million in revenue, which is up 8% over last year. With this increased volume and cost containment, this has resulted in a 28% increase in EBIT. At 36.6% gross margin rate, it is still lower than desired, but we are on track to complete these projects by the end of the fiscal year. Our third headline continues to be about our sensors business and how the momentum continues. Given the economic situation, sensors continue to have outstanding performance. Sensors also booked record revenue of $25 million, which was 24% growth. They also saw a 24% growth in EBIT. Our next three headlines are around the announcements we have made throughout the quarter. Our first is related to our acquisition of SANS Group. This is about a $25 million Chinese electro-mechanical and static-hydraulic testing company, and we are really excited about the strategic fit. First, SANS is going to help us accelerate our growth in China. Their extensive sales and service networks will change our footprint overnight in China. Second, the SANS product offering is going to help us accelerate our growth in other emerging geographies. We still expect to close in the fourth quarter, our fiscal fourth quarter, and we will provide more details upon closing. Our second announcement in the quarter was our announcement of the divestiture of the nano-indentation product line. I think you are all very aware that we are maintaining a focus on our core markets and those opportunities which provide the best opportunity for us, for market leadership, and profitable growth. Unfortunately, the nano-indentation product line has limited synergies with the rest of our businesses, but we really do believe that Agilent will be a leader in nanoscale imaging, measurement, and manipulation and can leverage our product offerings for their customers. We are excited because we think this is a win all the way around. We received a $13 million purchase price, which resulted in a $0.14 gain per share, net of taxes. And our third announcement in the quarter was the announcement of our accelerated share purchase program -- an agreement that we entered into with JP Morgan Chase where we purchased 700,000 shares on the open market. This created immediate value for our shareholders at favorable market prices. The cost is about $25 million, which we funded with cash on hand, and has still left us with a healthy cash position of $120 million at quarter end. Our last headline is about our guidance. We have raised our earnings per share guidance. Our new range is $2.65 to $2.70. This includes $0.14 for the gain on Nano, but it also reflects that operating results are expected to be at or just above the high end of our previous guidance. In addition, we have said that revenue is expected to be in the mid to upper end of our range, which was $455 million to $465 million. So let us talk for minute about MTS' Q3, and I think we have to start by talking about the economy. I am going to start with a quote by Robert Kubarych, Chief US Economist at Unicredit Global Research. Quote

[Sue Knight:]

Thank you, Laura. Laura has addressed the orders results for the year and the quarter, so I'll start with revenue. Revenue increased to 11% in the quarter to a $117 million, which was driven by an increase in both segments. The growth included 4 points of organic growth and 7 points due to favorable currency as the US dollar continued to weaken relative to the Euro and the Japanese Yen. Test revenue was $92 million, 8% higher than last year and record volume for the business. The growth included 5 points from currency. North America and Asia were up and Europe was flat based on the timing and mix of projects and backlog. The quarter also had a higher percentage of revenue from custom projects compared to last year and last quarter. From a market perspective, ground vehicles and infrastructure increased and aero was less than the prior year, which is similar to the results in the second quarter. Sensors revenue growth was very healthy at 26%. They also had a record revenue this quarter. At $24.5 million, organic growth of 14% and favorable currency contributed 12 points compared to the same period last year. Geographic demand resulted in 15% growth in North America, 26% growth in Europe and 42% growth in Asia, which has our smallest volume of the three locations. Moving from revenue to gross margins. Margin dollars increased 15% to $47 million, on 11% revenue growth. As a rate-to-revenue, gross margin of 40% was an increase of 1 point compared to 39% last year. Both segments contributed to the year-over-year rate increase. Test gross margin increased by $3 million or 10% on 8% revenue growth. The margin rate increased 70 basis points, primarily due to increased factory and engineering utilization on higher volume and lower warranty costs. These benefits were partially offset by a higher volume of custom versus standard products compared to last year, which is slightly lower margin rates. Additional progress was made this quarter on our custom development projects that have suppressed the Test margin rate for the last several quarters. With the possible exception of a couple of projects that have been slowed down due to customer delays, all of the remaining projects are expected to achieve customer acceptance by the end of the fourth quarter. In summary, we are very pleased with the year-over-year improvement in Test, particularly the progress on these custom development projects. Sensors delivered a 29%, or $3 million increase in gross margin dollars on 26% revenue growth. The margin rate was up more than a point to 56% based on strong volumes. Moving to earnings from continuing operations. The gross margin increase of $6 million was partially offset by $2 million of additional operating expenses. $1.4 million or 70% of the increase, was due to the negative impact of the US dollar weakness on foreign expenses. Cost containment actions remain in place in Test to offset the lower than expected gross margin rate for the year, while operating expenses in Sensors are as planned. The net effect of the gross margin contribution and operating expenses in the quarter increased earnings from continuing operations by $3 million or 27%. As a percent of revenue, EBIT from continuing operations increased 1.6 points to 12.3% compared to 10.7% last year. Next comment is relative to discontinued operations. The sale this quarter of the net assets of the Nano Instruments product line were just over $13 million, and the operating loss is recorded as the discontinued operation. The operating loss net of tax for the quarter was up 700,000, or $0.04 of earnings per share. And the after-tax gain on the sale was $2.5 million or $0.14 earnings per share as Laura previously mentioned. Together, they contributed positive earnings in the quarter. Tax expense for the quarter was $4.3 million or 28% of revenue, compared to $2.4 million or 20% last year. The year-over-year increase in the rate was driven by the impact of having more significant tax benefits in 2007, primarily from R&D credits and the impact of export transactions. On a full-year basis, we continue to expect the tax rate to be in the 29% to 30% range. Earnings per share from continuing operations increased 23% to $0.64, compared to $0.52 last year. The $0.12 increase was a combination of improved business performance, a little bit on the net interest line and $0.03 from a lower share count, which was partially offset by a higher tax rate which had a negative impact of about $0.06. Net income increased 28% including the discontinued operations impact, and the associated earnings per share increased 35%, including the one-time benefit of the Nano Instruments product line sale. The last topic for today is cash. We ended the quarter with $120 million in cash, a decrease of $9 million from last quarter. Operating cash flow was $9 million, net of the $6 million or 7% increase in working capital, associated with the higher revenue this quarter. Capital expenditures were $1.9 million. We also funded the accelerated share repurchase program for about $25 million. And the net proceeds from the Nano sales were also reflected in the cash balance, which was $12 million. Our global cash continues to be conservatively invested in bank deposits, treasuries and money market funds, which is a comment that I'll continue to reinforce on a quarterly basis. That is the end of our prepared comments. I will now turn the meeting back over to the moderator for your questions.

[Operator:]

(Operator Instructions) And our first question comes from John Franzreb from Sidoti & Company.

[John Franzreb:]

Good morning Laura and Sue.

[Laura Hamilton:]

Good morning.

[Sue Knight:]

Hi, John.

[John Franzreb:]

My first question is the Nano business. The operating loss, I think you said it was $0.04. That is for the first three quarters -- is that correct?

[Sue Knight:]

Just let me double-check the year-to-date, John, versus the quarter. The impact in the quarter was $0.04, and the nine-month impact was $0.02.

[John Franzreb:]

-- was $0.02. Great. Okay. And the acquisition of SANS, can you talk a little bit about what your margin expectations are for the business? Will it be a contributor to EPS or not, once complete?

[Sue Knight:]

John, we really haven't provided any financial details associated with the transaction at this point, but we will do so as soon as we close the deal.

[Laura Hamilton:]

This is Laura. The one thing we have said is it is a healthy business.

[John Franzreb:]

I am just wondering if it is going to be accretive to margins? Is your expectations of it will be, will this be a drag on margins? What should I be thinking about once it is rolled in?

[Laura Hamilton:]

We are going to do detail at that level once we close.

[John Franzreb:]

As far as you are raising your numbers, how much of that is the exclusion of the Nano business built into increasing your EPS estimates?

[Laura Hamilton:]

Not really. Well the $0.14 is -- $0.14 we have added, and then the rest of it is operating results. And you are saying is it really getting rid of a loss?

[John Franzreb:]

Exactly.

[Laura Hamilton:]

I know that -- that not really is. No, it is really about the business at a net income level.

[John Franzreb:]

Okay. The gross margin -- I mean, it sounds to me that the cost overruns in the custom projects due to customer delays, is what I think I heard you say, Sue, will spill into 1Q '09. Did I hear that properly or no?

[Sue Knight:]

We do have two projects that could delay final acceptance. Not because we are not ready, but we just need the customer to provide us a final acceptance, and they have had some site delays. So I do not expect there to be material cost issues associated with that. I think our cost estimates currently reflect it. It is just a matter of us being able to say we have passed ownership final ownership from MTS to the customer.

[John Franzreb:]

Okay. One last question, and I will get back into queue. The Sensor business is posting some stellar results. Laura, I think you kind of referenced steel several times in your prepared remarks as a primary driver. I am wondering what the exposure is to the paper market? We had two companies here last night pre-announce on the paper equipment side and actually the paper providing side, what the Sensor exposure is a) to that market, and b) what kind of growth expectations, if I am reading you properly, that you expect Sensors to get from the steel market?

[Laura Hamilton:]

So this is the part at the end where I said it is really hard to use application examples in Sensors because there are so many. So, what I am really trying to do is everybody knows that wood is down because construction is down. So I am just trying to say, but don't forget that steel is up and plastics is still strong. So overall, we felt -- we've already felt the effects of wood; wood being related to paper, and so I don't think that that's going to -- and it is a small segment for Sensors. But all of these segments are relatively small, and you add them all up and we have a great business. It is part of why we have a great business is because we are really good at these niches. So no one segment is going to drive Sensors up or down.

[John Franzreb:]

But hopefully drive them up.

[Laura Hamilton:]

Well, a lot them drive them up, but it takes them all to drive them up.

[John Franzreb:]

Okay, thanks. I will get back into the queue.

[Operator:]

We will go next from Liam Burke from Janney Montgomery Scott.

[Liam Burke:]

Laura, Sue, how are you today?

[Sue Knight:]

Good, Liam.

[Laura Hamilton:]

Hi, Liam.

[Liam Burke:]

Sue, in terms of the tax rate, you gave us for the full year what you expect it to be. Now you have a lot of overseas activity. If I am looking on an ongoing basis, what's the amount of overseas activity? Could we expect a lower than normal tax rate, and I define that in the 30% or below?

[Sue Knight:]

No, less than a 30% tax rate is not what you can expect going forward. I think, as we have talked in the past, if you look at US Statutory rate, we would have about 35% tax rate, but when you adjust for the German tax rate at 30%, you consider the permanent re-investment status change that we made in the second quarter associated with Japan. And our increasing contents in China, we would expect to be a couple of points less than 35%, but not consistently below 30%. The rate that we are experiencing this year had a tremendous amount of benefit from the one-time cash repatriation impact in Japan in the second quarter.

[Liam Burke:]

Great, thank you. And in terms of overseas, you mentioned the tax benefit from repatriating the cash. Do you still have a significant balance overseas?

[Sue Knight:]

Yes. The majority of our cash is still overseas. It is in Europe, and we are looking at whether we have opportunities to bring some of that cash back on a cost effective way, but I haven't concluded that yet.

[Liam Burke:]

Thank you.

[Operator:]

(Operator Instructions) We will go next to Mike Hamilton from RBC.

[Mike Hamilton:]

Good morning.

[Laura Hamilton:]

Good morning.

[Mike Hamilton:]

Laura, could you take a couple of minutes giving your assessment of anything you are seeing over global economies in terms of changes in the sales cycle, knowing that that covers an awful lot of ground, but just kind of from a high level, if you are seeing anything -- any changes in your…?

[Laura Hamilton:]

Yes. I think what we definitely see -- what we can see sometimes is that activity, which would mean our pipeline of opportunity, continues, but it is slower to close. So we do see those delays. Toyota is a great example. They freeze capital, and it doesn't mean that absolutely nothing gets approved, but it means that it takes a lot longer to get approval, and that they are a little bit more in a wait-and-see as opposed to driving ahead on their original project schedule. And what is interesting, Korea is probably the other good example of, clearly there is a recession, and it stopped capital spending. One of the other changes then in the order pattern is that you stop buying capital equipment, and you try to do more with what you have, which means then you make -- we go after the business in service and upgrades. We have done some rebuilds instead of new equipment sales. And that is what I keep calling, "Working the base business hard." If they are not buying big pieces of equipment, they need help somehow, and we need to be able to do that. So I would say Korea and Japan, and Detroit we felt for so long, we don't rely on the big three to buy a lot in the US.

[Mike Hamilton:]

Thanks. My other question, any products in the pipeline worth noting? New products or adjustments to products?

[Laura Hamilton:]

I would say, we talked a little bit about that we are capitalizing software. And this is a significant investment for us. It is not a new product, but it is going to be a very different capability when we finish this software platform. And that is going to be coming out over time, so that won't be a big bang, which is a part of the approach. But it is really leveraging -- we have this applications breadth, and what we are also doing is pulling it together and leveraging it like only MTS can in this investment. This year, we launched the beginning parts of our landmark load frame platform, and have had very positive response. And we will continue to introduce the remaining product families in that. And then we talked a little bit about we are in the pilot stage, and we are completing three pilots this year on basically this integration of physical testing -- or the optimization of physical testing and modeling. And we will continue to invest in that. The other part is that some of these projects that we are working on are moving forward -- our capability and some of our high-end offerings. The custom project issues are really investment in performance in some of these platforms.

[Mike Hamilton:]

Thanks, and thanks for the detail of the discussion today.

[Laura Hamilton:]

Great.

[Operator:]

(Operator Instructions) We will now take a follow-up question from John Franzreb from Sidoti & Company.

[John Franzreb:]

Hi. It has been a year now since the custom projects has kind of weighed on the margins. Is your expectation that the Test margin can return to what it was in -- I guess it was the March of '07 timeframe when we had a 43% gross margin for the business, once these projects are gone?

[Laura Hamilton:]

No, I don't think we think we are going to get back to that -- that was a peak. And so, a couple of things we would say, we think that Test can get back to more of the average that we had been running at before, but you have to average Test margins because quarterly margins are so variable and mix is big. Mix will always move our margins a few points. So that is a hard thing to model, but that is what we are working to return to.

[Mike Hamilton:]

And what was -- remind me, Sue, was the average then of Test, would you recall the average?

[Sue Knight:]

Well if you look over the last several years, the average would be in the 39% to 40% range.

[Mike Hamilton:]

39% to 40%. Okay, compared to the current 36%?

[Sue Knight:]

Yes.

[Mike Hamilton:]

And you touched on that the mix is a big issue. Can you give us a sense at how much, what you call standard products, as a percentage of sales?

[Sue Knight:]

Let us see. We talk about the business in terms of 50% customs and then 50% everything else which is standards and service. So, I would say that the margins for standards and service are comparable and then custom is lower.

[Mike Hamilton:]

Okay. Okay. And one last question. Can you give me a breakdown in Test for the quarter? What was ground vehicle, what was infrastructure, and what was aerospace? Just on a percentage basis would be fine.

[Sue Knight:]

Are you looking at orders?

[Laura Hamilton:]

On what line?

[Mike Hamilton:]

Revenue, please?

[Sue Knight:]

Alright, just a little math.

[Mike Hamilton:]

Okay.

[Sue Knight:]

The ground vehicle was just over 50%; aero was about 10%. And be careful, because aero can swing with the programs.

[Mike Hamilton:]

Right. So the balance would be…?

[Sue Knight:]

So the balance would be infrastructure. Yes.

[Mike Hamilton:]

Great. Thanks a lot.

[Sue Knight:]

You are welcome.

[Operator:]

And it appears we have no further questions. Ms. Hamilton, I will turn the call back over to you for any additional or closing remarks.

[Laura Hamilton:]

Okay. No, I would say once again, we are pleased with the quarter. We are pleased with our progress, and we think we are well positioned as we move forward. Thanks for participating today.

[Operator:]

Ladies and gentlemen, that does conclude today's conference. We thank you for your participation, and hope you have a great day.

[Laura Hamilton:]

Thank you