MTS Systems Corp
Q2 2015 Earnings Call Transcript

Published: 10 May 2015

[Operator:]

Welcome to the MTS Systems Second Quarter 2015 Earnings Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Mr. Andy Cebulla.

[Andy Cebulla:]

Thank you, Joe. Good morning and welcome to MTS' FY '15 Second quarter investor teleconference. Joining me on the call today is Jeff Graves, President and Chief Executive Officer and Jeff Oldenkamp, Senior Vice President and Chief Financial Officer. I want to remind you that statements made today which are not a 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 on the company's latest SEC forms 10Q and 10K. 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. It should not be considered in isolation or as a substitute for GAAP measures. A reconciliation of any non-GAAP measures to nearest GAAP measure can be found in the company's earnings release. Jeff will now begin his update on the Second quarter results.

[Jeff Graves:]

Thank you, Andy and good morning, everyone. Thank you for joining us for our Second quarter investor call. We appreciate having the opportunity to discuss our financial results for the quarter and to update you on our outlook for FY '15. First, let me remind you about the nature of our two business units. This may be particularly helpful for those newer to following our company. The larger of our two businesses is Tests which provides highly engineered testing systems and services largely to R&D and product development groups within automotive, aerospace, energy and infrastructure OEMs worldwide. This business is fueled by our customers spending on new products and these markets are growing in response to strong macroeconomic drivers which we believe will be sustained for years to come. This market opportunity sets us apart from many other companies. Our second business unit is Sensors which provides products that are essential for automating heavy industrial equipment and increasing the precision and safety of heavy vehicle systems that utilize hydraulic controls. These sensor markets are directly tied to industrial capacity utilization and heavy equipment demand. With this backdrop, I'll start with the headlines. There are three key takeaways for the quarter. First, the orders, revenue and earnings per share results for the second quarter of our FY '15 were strong, with revenues from organic growth up 5% or 12% on a constant currency basis and earnings per share up 54%, both in line with our expectations and reflecting well on our internal initiatives to improve operating efficiencies in our Test business. This was delivered in spite of significantly greater headwinds from foreign currency in the quarter, the implications of which I'll discuss in a few moments. Second, our orders growth, backlog and test opportunity pipeline remained very strong this quarter, at or near record levels, reflecting continued strength of our major markets around the world. However, we believe the significant strengthening of the U.S. dollar is aiding our competitors from Europe and Japan and is having an impact on pricing opportunities for our more standardized solutions, driving our mix of business to be richer in our more complex test solutions than we had originally planned when the year began. These more customized products are often unique in nature and, therefore, more highly differentiated in our test markets. So while our order and backlog mix is improving sequentially, the rate of change is less than we had originally planned for the year. The third and final key message today is that given the significant headwinds resulting from the strengthening of the U.S. dollar and the continued higher mix of custom orders in our test business, we're adjusting our revenue and earnings per share guidance for the full year downward. The revised guidance range for revenue is $565 million to $580 million. And our revised earnings per share range is $3 to $3.20. Now, normally, following the headlines for the quarter, I would move into a more detailed discuss on each business unit. But this quarter, before doing this, I want to provide a little more detail regarding the impact of the significant increase in the value of the U.S. relative to the euro and the yen and what it had on the financial performance of our company. While this is a common topic for most companies this quarter, each company is somewhat unique in the impact based upon its cost and revenue profile. So I want to help investors understand what this means specifically to MTS. First, there is a direct impact we feel from currency which results from translating our revenue and earnings at our non-U.S.-affiliated locations into U.S. dollars. There is also the direct impact from transaction gains and losses we experience as the euro and yen devalue which we offset to some degree in the short term with our hedging efforts. We typically combine these items into what we refer to as the direct impact of currency. However, we also experience two indirect effects from currency, particularly when the change in relative value occurs very quickly as it has over the last few months. First, the stronger dollar has had an impact on price competitiveness, particularly for our standard products. Some of our largest materials testing competitors are located in Europe and Japan and, in certain cases, we're seeing a negative effect on our win rates in these product categories, in spite of our strong new product portfolio which we launched over the last six months because we produce and price the majority of our products based on the U.S. dollar, our products have become relatively more expensive than some of our locally sourced competitors. While we're still maintaining our market share, this effect of price pressure has resulted in slower growth in materials test sales than we had originally planned and a reduction in our ability to price our newest product entries at the targets we had envisioned at the beginning of the year. The second indirect impact from currency is the resulting shift in the ratio of our custom versus standard orders or, in other words, the mix of our product sales. As I just mentioned, because of the changes in currency values, our standard product business dominated by materials testing is not growing as rapidly as we had expected when the year began. However, we're still able to compete and win the more highly customized testing systems because of our superior technology offerings. This is causing a shift in the mix of custom versus standard order flow relative to what we had expected when the year began, that is when the euro and yen were roughly 15% to 20% higher relative to the dollar. I'll provide more context on how these currency impacts specifically affected our guidance in a few minutes. With that, I'll now review orders in more detail for the quarter. Total company orders of $159 million decreased 3%, but were up 5% on a constant currency basis. Drilling down one level, Test orders were up 1% and up 7% on a constant currency basis. Sensor orders were down 18%, but down only 7% on a constant currency basis, driven primarily by order timing. Even with the full currency effects included, our backlog once again ended at near record levels of $324 million, an increase of $20 million or 7%, to the prior year and up 3% on a sequential quarterly basis. All of the increase was expectedly test-driven given the comparative short lead times for our sensor products. Thus, we begin our third quarter with $20 million more in backlog than the prior year. Looking forward, we continue to see strength in our core markets with the Test opportunity pipeline sitting at a new record high level of $924 million at the end of the quarter, again, even with all the negative currency effects included in that number. We're very pleased with this continuing demand profile as it demonstrates the strength of our core Test markets around the world, reflecting continued investments of our OEM customers, note they are making a new automotive, aerospace and infrastructure products. Now I'll provide you with some additional context on orders by business unit. As I mentioned, sensor orders in the quarter declined 18% and 7% on a constant currency basis. The main drivers of the softness were currency and the timing of large blanket orders from certain customers which negatively impacted the orders comparison by $4 million. Also, for comparative purposes, the second quarter last year was a record quarter for Sensors resulting from the high level of customer blanket orders. We believe the decline in blanket orders is not an indication of declining business, but rather the result of order timing. From a market perspective, the industrial segment was down 19%. 9% of the decrease was from lower blanket orders that I previously mentioned and steel markets in Asia remain soft, impacting the order rate in the quarter. On a bright note, industrial orders in China were very strong as we continue to grow our customer base in China by expanding the applications for our sensors beyond the traditional steel market. New applications include plastic injection molding machines, rubber molding machines for the Chinese automotive tire market and food and beverage machines primarily for more precise fillings of cans and bottles. All these applications benefit from our precision measurement sensors to improve industrial machine performance and safety. We continue to be excited about our growth prospects in China as these OEMs develop more sophisticated machinery and equipment for domestic use and for export. Moving on to the mobile hydraulics markets for sensors orders were down 21%. The majority of the decrease was from reduced blanket orders that I mentioned previously. Additionally, U.S. orders for mobile hydraulics were down 8%, primarily driven by softness in the agriculture equipment segment. Despite the down quarter, we believe the general outlook for mobile hydraulics for the remainder of the FY '15 and beyond looks positive. This is supported by strong construction markets, particularly in the U.S. Although orders in the first half of the year were down, over the long term, mobile hydraulics market remains the fastest growing sensor market, as our OEM customers continue to put a priority on developing smart machines for their end customers. Next, let's review the sensor orders from a geographic perspective. Asia was up 2% and up 17% on a constant currency basis. As I mentioned previously, China orders were very strong in the quarter, up 6% and up an exceptional 19% on a constant currency basis. In the Americas orders were down 19%, all of which was the result of blanket order timing. Europe declined 24% or 7% on a constant currency basis, also driven by the timing of blanket orders. Next, I'll spend a few minutes on our Test order results. Test orders in the quarter were $135 million, up 1% in absolute terms, but up 7% on a constant currency basis. The overall order increase was driven currency basis. The overall order increase was driven specifically by large custom projects which were $47 million in the quarter, compared to $19 million in Q2 of last year. The large orders were in the civil seismic and ground vehicle areas in Asia and were associated with highly customized test systems. The investments reflect ongoing demand for increased testing capacity for automotive durability, as well as substantial investments in aerodynamic wind tunnel capabilities. These four orders were all from existing customers which demonstrates the continued confidence our customers have in MTS to deliver high quality technically advanced equipment. Although large orders tend to drive quarter-to-quarter variability, this is an unusually high amount of large orders for a quarter. Geographically, Asia was very strong for the quarter, up 81% and up 89% on a constant currency basis, driven by the four large orders in the quarter I previously mentioned. Another bright spot in Asia was China, where orders were up 16%, driven by strength in the ground vehicles market associated with lab expansions to enhance capabilities for durability and performance testing, as well as higher orders in the materials market, driven specifically by strong sales for civil engineering dynamic test systems. Europe was down 44% for the quarter and down 30% on a constant currency basis. The decrease was driven by several factors, including delayed government procurements, softness in the capital investment spending rates in the energy sector, as well as slowing of capital investments in base business orders in the ground vehicles market. Americas orders were down 47%, primarily driven by nonrecurring large custom orders in the prior year, as well as specific project delays due to the dramatic drop in oil and gas prices which has now affected the capital spending of energy-related laboratories. As in prior quarters, we continue to experience a high mix of custom or engineered order volume. Customer orders increased 6%, while standard product orders were down 10% on a comparative basis to the prior year, driven largely, we believe, by the currency effects discussed previously. Next, I'd like to spend a few minutes discussing our Test Services business. Our Service business gained momentum this quarter. The gains were masked by the negative impact from foreign currency. Within the quarter, service orders declined 2% compared to prior year, from $23 million to $22 million dollars on an absolute currency basis, but increased a solid 7% on a constant currency basis. Geographically, the American orders grew 25% from large refurbishment projects and increased account penetration. European orders were down 33% and down 20% on a constant currency basis driven by sales cycle timing from multiyear contracts. Asia orders were flat, but up 10% on a constant currency basis. As we mentioned in the prior quarter conference call, our service engineers continue to be redirected to support the installation of an unusually high level of large complex custom projects. This drain on resources in the short term continues to negatively impact our service order growth. However, we expect this effect to decline in the future as we continue to expand our service teams and our product mix returns to a more balanced mix of standard and custom projects. Given the positive reception we have experienced by our customers in our service offerings and our large and rapidly growing installed base of test equipment worldwide which is now well over $4 billion and rising, we believe our opportunity for sustained profitable growth in Test Services remains excellent and that orders will further accelerate as our workforce expands and as we work through the high demand for custom test systems. We're continuing to add field service engineers to support the Service business and help drive future growth. Finally, I'd like to comment on the Test opportunity pipeline, as it is the best indicator we have for future growth. As I previously mentioned, at the end of the second quarter, our 12-month pipeline of opportunity stood at a record $924 million, up 1% compared to the prior year, up slightly on a sequential quarterly basis. On a constant currency basis, the opportunity pipeline was up 4% at the end of the second quarter. This high level of identified opportunities for future sales is reflective of the healthy continuing demand we see for testing capability in R&D and new product development by our customers worldwide across our automotive, aerospace, infrastructure and advanced material market segments. This visibility into future demand builds confidence in our ability to deliver sustained growth going forward. Now I'd like to turn the call over to Jeff Oldenkamp for some additional financial detail on the quarter. Jeff.

[Jeff Oldenkamp:]

Thank you, Jeff. My remarks today will summarize our Second quarter results based on a year-over-year comparison. Second quarter revenue of $144 million increased 5%, but was impacted by the strengthening of the U.S. dollar. On a constant currency basis, revenue was up 12%, driven by the high level of backlog at the beginning of the quarter in both businesses. Looking more specifically at revenue by business, Sensors revenue of $25 million was down 5%, but was up 8% on a constant currency basis. Regionally, Asia delivered excellent growth of 16%, while Europe was down 12% and the Americas was down 4%. On a constant currency basis, Asia and Europe were up 33% and 6%, respectively. The strong performance in Asia reflects continued growth in China which drove the majority of the increase. Moving on to Test, revenue of $119 million increased 7% and grew 13% on a constant currency basis. The strong performance primarily resulted from the high-level backlog at the beginning of the quarter. We were pleased with our ability to turn our high level of custom backlog. This resulted from the continued improvement in our manufacturing operations which are progressing as planned and providing significant improvement in the flow-through of projects in the factory. Test backlog ended the quarter at $311 million, a record high for Test. Today, custom backlog as a percent of total backlog decreased in the quarter to approximately 75%. This will continue to have a negative impact on margins for the remainder of the year as we work through the custom backlog. Moving on to the rest of the P&L, gross margin was $57 million, an increase of 2% on 5% higher revenue. As a rate to revenue, gross margin declined 110 basis points, to 39%, driven by a higher mix of custom projects and tests. Sensors gross margin was down 4% to $14 million on lower volume, while the gross margin rate was relatively flat and remained at a healthy 54%. We expect the margin rates to stay in the mid-50% range going forward. Test gross margin of $43 million was up 4% from higher value, while the gross margin rate declined 110 basis points. This result largely reflects the impact of the high custom mix in backlog. My next topic operating expenses. Operating costs decreased $4 or 10% to $39 million and were 27% of revenue, within our normalized range of 27% to 29%. R&D expense declined $1 million. Approximately half of the decrease was due to the capitalization of costs associated with software development activities and roughly half resulted from lower variable expense. Selling costs decreased $2 million, attributed to the favorable impact of currency translation and lower variable expense. G&A expense decreased $1 million compared to the prior year, driven by a reduced professional services expense, lower variable compensation expense and a favorable impact from currency translation. EBIT increased 41% to $17 million, resulting from the previously mentioned higher gross margins in Tests and lower operating expenses in both businesses. EBITDA as a rate to revenue improved 3.1 points to 11.9%. My next topic is taxes. The tax rate in the quarter was 31%, within the expected range, but down 4% from the rate in the same quarter last year. The decrease in the tax rate resulted from a change in the geographic mix of income before taxes and changes in certain foreign tax rates. In future quarters, we expect the tax rate to remain in the low to mid-30% range. Earnings per share improved 54% to $0.77, compared to $0.50 in the prior year. This was largely driven by higher Test gross margin and lower operating expenses that I just mentioned. As previously mentioned, currency has had a negative impact on the business thus far and we anticipate that to continue, given the current rates. If Q2 was adjusted for translation and transaction losses, EPS would have been up approximately 64%. Finally, I'll conclude my remarks with a summary on cash. The cash balance remains strong at $61 million and the net debt level is $10 of debt. In the quarter, cash increased $6 million. Operating cash flow was very strong at $23 million. This was driven by strong earnings and a slight improvement in our working capital requirements. We paid out $5 million in dividends, spent $14 million to purchase approximately 187,000 shares and spent $5 million on capital expenditures. That concludes my remarks for today. I will turn the call back to Jeff for his final comments. Thank you.

[Jeff Graves:]

Thanks, Jeff. Now I'd like to provide you more context for our revised full-year revenue and EPS guidance ranges. We continue to see positive market momentum and confirmation of the favorable long-term global macro trends that we've discussed in prior quarters. We believe this is supported by the record test opportunity pipeline, the large order flow during our second quarter and the continued high level of quoting activity in both the Test and Sensors businesses. Further, we feel good about the near-record level of backlog for the company which will help drive results for the remainder of our fiscal year and beyond. Lastly, we're very pleased with the operational improvements we've made in our Test business, enabling us to more efficiently turn the high level of custom backlog to support the growing businesses. These factors, as well as the strategic initiatives we're pursuing in both Test and Sensors business provide us well for the long term. However, as I mentioned in the headlines, we're lowering our full-year revenue guidance range to $565 million to $580 million and our earnings per share guidance range to $3 to $3.20. This represents flat to 3% growth in revenue compared to FY '14 and flat to 6% growth in earnings per share. The majority of the decrease in revenue guidance was driven by the strengthening of the U.S. dollar, relative to the euro and the yen. The direct impacts from currency I mentioned earlier, accounting for approximately 70% of the reduction in revenue and 40% of the reduction in earnings per share. The majority of the remaining decrease in revenue and earnings guidance resulted from the indirect impacts we felt from currency that I mentioned earlier which were increased price competitiveness and a shift in product mix from plan. In other words, the ratio of custom versus standard orders in Test relative to what we had originally anticipated for the year. From an end market perspective, our markets remain healthy, meaning, we see no substantial slowing of demand for our products. However, since these custom orders typically have a lower margin rate, as we turn the orders into revenue, it will have a negative impact on Test margins. While we expect this pricing pressure and higher mix to now continue through the balance of the year, it is fully reflected in our updated guidance. As usual, we're not providing specific guidance for the quarter. But based upon the profile and our backlog and the visibility we have in our orders pipeline, we expect our revenue and earnings to be somewhat evening split between the third and fourth quarter. We will continue to focus on enhancing our product capabilities to maintain our technology leadership position in both of our businesses, improve our Test operations to more efficiently turn the high level of custom backlog and scale our operations to support the growing business and to develop new products and sensors to propel continued growth. Despite the setback in our growth rate for FY '15 from currency effects, with the long-term macro trends that we see that support growth for both of our businesses, we remain bullish about our long-term prospects for sustained growth and profitability improvements into the future. That concludes my prepared remarks. I'll turn the call back to you, Joe, for handling the Q&A session.

[Operator:]

[Operator Instructions]. We will take our first question from Jim Ricchiuti with Needham & Company.

[Jim Ricchiuti:]

Jeff, wanted to just go a little more deeply into the margin issues in the Test business. This indirect impact that you're talking about, the increased competitiveness that you're seeing from some of your European, Japanese competition, that's not something you anticipate changing, I assume in the near term. Your maintaining share, what kind of a headwind has it really provided in terms of the impact, negative impact on gross margins. How significant has it been?

[Jeff Graves:]

Well, Jim, I would tell you that it affects our anticipated mix for the rest of the year. We launched some great new products late last year and early in the first half this year, specifically in the mid-serials test arena and in some of our simple test systems. We had planned on some faster growth than which we all right seeing right now. So while we're not losing traction certainly and we're able to maintain our margins within those product categories, the growth in volume, the overall growth in volume is just lower than we had planned. So while it's moving in the right direction, it certainly is - we had anticipated a much stronger tick up in the second half of the year. And we attribute it simply to the currency effects on price competitiveness. It's, if we guess who we're losing business to and we look at where their origins and their costs are most likely from, it's largely euro- and yen-denominated and it's causing it. So while we're gaining ground and we feel good about the new products, they're just not growing as fast as we would have thought. And it's somewhat understandable. From a customer standpoint, they suddenly got a 15%, 20% price break due to currency. So it's something we'll be fighting. I love the performance of our new standard products, they're great products. We make a large percentage of them in our China factories. So we're seeing good traction in China. We had anticipated seeing greater traction outside of China where we sell through our U.S. channels. And it's just not gaining as much traction as fast as we would have liked. On the bright side, our customized or more highly engineered products, customers continue, in spite of the dollar, to be able to justify MTS simply due to our technology and the strength of our relationship with them, our knowledge of their labs, things that are, that they're very hesitant to walk away from. So we see a large stickiness in that business. It's growing nicely, the end demand. But it's simply our standard products aren't gaining traction as fast as we would have liked due to the current - basically due to pricing headwinds driven by currency.

[Jim Ricchiuti:]

Are you seeing it in any other areas of your standard Test business outside of material?

[Jeff Graves:]

You have to drill down real hard to see that, so it's a minor effect. I would tell you, the simpler the system, the more, the more pricing is a factor. And while they love the technology, beyond a certain price differential, customers will place the order elsewhere. But you have to drill pretty far down to see it in any other market segments. It's primarily materials testing.

[Jim Ricchiuti:]

Now, these large orders that you talked about, the $46.5 million, is the margin profile of that business consistent with some of the custom test margins that you normally see?

[Jeff Graves:]

I would tell you, Jim, in the quarter, those projects we landed are ones that we have done very similar things before that in other parts of the world. So at that scale, everything gets customized to a certain extent. But I was actually quite pleased with the quality of those projects. I think the four big ones we landed are all quite good ones. And there again, they're in two main areas. They're in automotive, as we see a continued investment by automotive OEMs around the world in new products. And it's both durability testing and performance testing wind tunnel. So it's delightful business. We've done it a lot in the past and it's some of our very best technology. It is customized to some extent, but we've done a lot of the basic work in the past. So we tell you it's on the good end. You've got to look project by project. It's probably on the better end of margins for that product category, still lower than our standard product margins, though.

[Jim Ricchiuti:]

Okay. And last question before I jump back in the queue. Just it looks like you're, perhaps in a position now where you could go after more of the service opportunity that you've discussed in the past. You're adding field service engineers. Is there some near-term negative impact on margins as you staff up there?

[Jeff Graves:]

It'll be kind of continuing what it's been, Jim. I mean, we're staffing as quickly as we can. We're up probably 5% on the year in terms of overall headcount in services. We continue to hire. We're really, at this rate, limited by the training. I mean, our customers expect a high degree of proficiency by our service techs when they go in. So there is good and bad news in this high custom backlog that we're shipping is, it does take some of those very experienced guys, some of their time, to go help with the installation. But the very good news in the long term, Jim, is the more customized the machine is, the more we're likely to win services business in the long term. And it's a delightful business. So our customers, encouragingly, they're very open to it. They're very happy about it. They want to see us do more of it. The only headwind is really the amount of time our guys are having to spend helping install some of this unique customized product that we're shipping right now. So terrific long-term. It's a little bit of a headwind in the short term. And again, my apology that the currency masks some of the progress we're making. But I felt really good about the orders progress in the quarter, given that our guys are stretched. I think we're seeing as much customer strength as I would have anticipated.

[Operator:]

[Operator Instructions]. And we currently don't have any others in the queue, so will take a follow-up from Jim.

[Jim Ricchiuti:]

Moving to the Sensor business, can you elaborate on the blanket orders that you talked about? Where were they centered, Jeff and in what areas? And how quickly do you see, perhaps, that turning?

[Jeff Graves:]

It's primarily U.S. and Western Europe, Jim, driven. And there was a piece of it in the, funny enough, in the medical field where we have seen one of our customers have to drop out for FDA reasons and they're back in the market and there had been a bit of overstocking. So we saw a delay in placing blanket orders there. Those are coming through now, so we're pleased with that. The only market that really remains a little bit softer from a blanket order standpoint than I would like is the precision ag market. It'd be great if that were a bit stronger than it has been. I think that's a bit of a legacy issue from the last 12 months. I think they, if you follow those guys, they had to bring production down a lot and they had placed some pretty large blanket orders. So we see these coming in largely in the third quarter, some of which have arrived now and some of which we anticipate arriving in the third quarter. If you took out currency effects, Jim and you took out the timing of the blanket orders, we were actually up in the quarter and we felt good about the remainder of the business. And I would tell you, Jim, the area that I'm just particularly thrilled about is China. I think, have effect for both business, but Sensors had a terrific quarter in China. And I think we're tip of the iceberg there in terms Chinese industrial equipment manufacturers and machine makers that use civil hydraulics. I think their use of sensors is right at its infancy. So we're seeing really nice year-over-year growth there. So China's really good for us. It's good for the Test business as well. It's been a real success story. Europe and the U.S., lag a little bit in the quarter, but most of that was blanket purchase order issues on timing there. So and again, if you took that effect out, we would have grown in the quarter.

[Jim Ricchiuti:]

Got it. And then just to go back to OpEx. In the second half, your OpEx as a percent of revenues, I think you may have given a little bit of color on that, I just want to make sure I got that straight. What are you looking at in terms of operating expense as percent of revenue?

[Jeff Graves:]

We're on the low end of our operating range there, Jim, historically. So Jeff will let you have it on a future level.

[Jeff Oldenkamp:]

Yes, we say we historically will be in that 27% to 29% range from an OpEx standpoint.

[Jeff Graves:]

Jim just one last comment on OpEx. I mean, that's really where you start seeing the benefit from our productivity initiatives and efficiency drive in test. We're consistently now quarter over quarter able to handle a lot more volume, even of our customized products through our engineering and manufacturing workforce. So while we're growing that workforce, our revenue's growing more quickly. So you see us on the low end of our historical range. And I would expect those productivity benefits to continue to really pay benefits over the rest of the year.

[Operator:]

[Operator Instructions]. We will take our next question from Dan [indiscernible] with Invicta Capital.

[Unidentified Analyst:]

Just on the services business, just looking at the trends here in the margins, is there anything we should read into on the gross margin side on services as the, I guess mix moves more towards the annuity side of the business versus the break-and-fix?

[Jeff Graves:]

Well, certainly in the short term, break-and-fix business is always very lucrative for most companies. So it's historically driven, very good margin performance because it's a fairly dire situation when that happens. What we're actively trying to move customers to are multiyear service agreements which gives us much more of an ability to plan our cost structure, to execute things. Obviously, superimposed on that will be for still a break-and-fix business. But the rationale for driving folks on long-term contracts is generally to get away from a break-and-fix kind of mentality. So, Jeff, do you want to comment any more on [indiscernible]?

[Jeff Oldenkamp:]

Yes. No, my only other comment is, in the quarter our gross profit was relatively flat with the prior year. And year over year, the decrease you're seeing in margins is really due to the drag from the headcount additions this year.

[Unidentified Analyst:]

And then just on the backlog, I guess, what's the best way to think about what a 12-month backlog number would be like as a percentage of total backlog?

[Jeff Graves:]

You mean the flow-through to revenue?

[Unidentified Analyst:]

Yes.

[Jeff Graves:]

Is that what your question is, Dan, a flow-through to revenue from backlog?

[Unidentified Analyst:]

Right, say 12 months.

[Jeff Oldenkamp:]

So, Dan, in the K, we state generally, when you look at the backlog, roughly about 70% of it flows into revenue over a 12-month time span.

[Unidentified Analyst:]

Okay. And that's fairly consistent where it stands today to where it was a year ago?

[Jeff Graves:]

That's correct.

[Operator:]

[Operator Instructions]. This question comes from Matt Sherwood with Cooper Creek Partners.

[Matt Sherwood:]

Just have a quick question on the mix, the custom mix. I guess are you sort of back - you had suggested that there's some weakness in some of the standard orders, yet, the backlog sort of remains at very high levels. Are you sort of backfilling towards custom mix or do you just let the market dictate, hey, if there's lots of custom orders coming in, we'll just take them?

[Jeff Graves:]

Yes, it's much more market-driven, Matt. I would tell you, we have very long relationships with the key OEMs around the world and we're highly disinclined to pass on a critical order for them. It's truly great business. Our standard products' going to be higher-margin business. But it's still great business. It sets new standards for testing in the world. It brings a lot of efficiencies to their labs. So we're highly inclined to try to take those orders and keep those customers happy. It's the way we've grown our business for almost 50 years now. So whether you look at automotive OEMs around the world, this particular quarter we did really well with the automotive OEMs out of Asia, both in Japan and China. Just terrific quarters. And I think that's why they come to MTS, they can count on us to meet their needs when the time is right. And so it wasn't a backfilling operation with the drag on our standard products, it was, hey, these were the order timing our customers wanted and we want to be there for them. So I continue to say our end markets range from solid to strong and you see it in automotive, you see it in aerospace. You see it in civil seismic. I think the need and you look at the Nepal disaster and the collapse of infrastructure there, you see an ongoing need, particularly in the emerging markets where they haven't had the most advanced building designs to reduce those kind of catastrophes and the impact on life. Our machines help building designers deal with that, to design more earthquake-resistant buildings. So I was quite pleased in the quarter with our civil seismic business and with our automotive business and particularly out of Asia. So there was no drive to backfill orders. It was just that was the timing that these large orders demanded and that's what we took.

[Matt Sherwood:]

So you're sort of building towards the future.

[Jeff Graves:]

Yes.

[Matt Sherwood:]

Just quick question on the sort of margins on the different businesses. Has the margins on custom deteriorated relative to what they were previously or the margins on standard? Or is it just purely that there's more custom relative to standard and the mix has shifted rather than the margins on each segment of the backlog has--?

[Jeff Graves:]

Yes, I got you, Matt. It's dominated by the mix effect. I mean, certainly, there's puts and takes order by order, especially in the large customer arena, there's puts and takes on margin on each job. But on generally, the overwhelming effect you see in our P&L is due to the product mix. It's not due to margin degradation, per se, it's due to product mix effects. Not that there isn't some gives and takes with each quarter on profitability of projects, there are. But it's predominantly you can think of it as a mix effect. And our stated guidance simply was with the strength of our new product offerings and standard products, we're winning more business, we just thought we would win it faster in the second half than what we now project and we attribute that largely to price competitiveness. So things are moving in the right direction, it's just a bit slower and a bit frustrating when it's a factor that's largely out of your control like that.

[Matt Sherwood:]

Yes, it sounds frustrating. And then in terms of custom, do you have - I mean, if you, like if it's totally custom where you haven't done a system before, how much visibility do you have around the margin profile of that business? In other words, is it just sort of - because if you haven't done it before there might be more uncertainty around the cost profile.

[Jeff Graves:]

Sure. So we work with our customers, in the customer arena, we work with our customers for two, sometimes more than two years in advance of a PO being placed, to basically do some co-design work or some collaboration around what the project needs to do. And as we do that, we develop an assessment of risk and cost on the project. So undoubtedly, the normal cycle is you work it until engineer to engineer, they think they've got just a great solution and then on the customer side, they go back and their budget gets squeezed a bit and things. So we end up at what we believe is an acceptable margin by the end of the sale process, by the time the PO is placed. And undoubtedly, Matt, in those cases, it drives a brand new standard of testing technology in the world. So it's a great thing for sustaining our brand market position as a leader in testing. The margins on those highly customized jobs, not only are they probably lower than the standard products, but there's more risk around them. We've done some first-of-a-kind things where, to actually perform as a customer wants it to, we've had to embed more cost. We're becoming much more predictable on that basis now. I feel really good about that. We're working not real hard. So there's not as many surprises. But all in all, those projects tend to carry a lower margin than our standard product offerings do.

[Matt Sherwood:]

Okay. And do you have a sense of what percentage of the backlog is custom? Is there a way it's defined, like those large orders you got, the $15 million you referenced, are they all custom? Or do just sort of how would you characterize that?

[Jeff Graves:]

Yes. And bear in mind, Matt, when I say it's custom, it can be - that really represents a range of engineered content from what we call engineered-to-order which is slightly customized, to fully customized first-of-a-kind stuff. So if you put all that, lump all that in one category, we peaked out last quarter we believe and correct me if I'm wrong, so last quarter over 80% in terms of our percentage of custom in backlog, okay. Now we see that dropping. So as I mentioned, the trend's moving in the right direction from a margin standpoint, we like that. So now you'd say it's more like 75%, kind of mid-70s, down from the low 80s, in a quarter. And the issue for the second half of the year is we would have modeled that dropping much faster in the second half than what we actually believe we're going to see, driven by, frankly, by these pricing headwinds driven by currency. So it's not that the ratio isn't moving in the right direction and I am very pleased about that, it's just frustratingingly slower than we would have planned.

[Matt Sherwood:]

Yes. I guess just final one, in terms of the sort of currency headwinds on the competitiveness, I guess, assuming the currencies don't just snap back, how do you combat that? It sounds like it really affects the standard products to sort of continue to shift your backlog back towards more standardization.

[Jeff Graves:]

Yes. So there are a couple of things we do. And number one, we do have and it is much more important in the test business because that's much more where our costs are either in dollars or in R&D in China which is somewhat still related to the dollar. So it's much more important in our Test business that we address that on a long-term basis if the euro and yen were to continue to devalue. And you really go about it in two ways. One, obviously, is shifting your manufacturing if you can. We have to be careful about that because of the sensitivity around our supply chain and the quality of our product. Our customers don't like to take risk when it comes to the quality of a test machine in an R&D environment. I mean, if you look at how critical these machines are to a new product development lab, for example, in automotive, they're trying to squeeze their new product development cycle down as far as they can. They absolutely can't stand down time. They've got to have the highest quality machine they can buy and the highest precision machine. So we're very sensitive about our supply chain versus some other industries where you can move manufacturing around a bit more easily. So we take that very seriously. The obvious thing that all companies are doing that are subjected to this right now is we're driving cost control. So we're driving internal productivity initiatives for engineering and manufacturing. We're trying to get more and more efficient at what we do. The other big impact we can have on our and cost is standardization of design. Even in custom projects, we can work to standardize subassemblies and things within the project that can help us reduce the amount of engineering time and cost, if you will. So that's really what we're going after, Matt, first is internal productivity and design manufacturing productivity initiatives. We will look at our manufacturing footprint over time if we believe these changes are permanent. We'll look at it because we don't want to be aced out based simply on currency effects. Our customers don't want that. We don't want that. Right now, I would call it a headwind. I wouldn't call it a gale. I would call it a headwind. And I believe the storm will abate at some point. But we're taking it very seriously.

[Operator:]

[Operator Instructions]. And it seems as we have no further questions in the queue. I would like to turn the conference back of her two Dr. Jeffrey Graves for any additional or closing remarks.

[Jeff Graves:]

Thanks, Joe. And thank you all for participating on our call today. We look forward to updating you on our progress again next quarter. Thanks and have a great day.

[Operator:]

That concludes today's conference call. We thank you for your participation.