MTS Systems Corp
Q3 2015 Earnings Call Transcript

Published: 8 Aug 2015

[Operator:]

Please stand by. We’re about to begin. Good day, everyone, and welcome to the MTS Systems Third Quarter 2015 Earnings Conference Call. As a reminder, today’s conference is being recorded. And at this time, I’d like to turn the conference over to Andy Cebulla, Treasurer and Head of Investor Relations. Please go ahead, sir.

[Andy Cebulla:]

Thank you, Aaron. Good morning and welcome to MTS’ Fiscal 2015 third 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 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. A reconciliation of any non-GAAP measures to the nearest GAAP measure can be found in the company’s earnings release. Jeff will now begin his update on our third quarter results.

[Jeffrey Graves:]

Thank you, Andy; and good morning, everyone. Thank you for joining us for our third quarter investor call. We appreciate having the opportunity to discuss our financial results for the quarter and to update you on our outlook for fiscal 2015. 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 Test, 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 deadlines. There are three key takeaways for the quarter. First, we were pleased with the orders growth in the quarter. Overall, orders grew 3% but were up an impressive 10% on a constant currency basis. We continue to see good order activity in all geographic regions with both Europe and Asia posting double-digit orders growth on a constant currency basis, while Americas was relatively flat in the quarter. We were also pleased with orders growth in our Test services business which grew 11% on a constant currency basis. On the negative side, the order mix continues to be skewed toward more highly custom projects rather than shorter cycle orders. I’ll discuss the impact this has on our business in a minute. Second, we were disappointed with our revenue growth in the quarter, particularly in our test segment, given the strong backlog position. We continue to be challenged with a high level of slower turning custom projects in our test backlog. This has put a strain on available engineering resources, resulting in delays in revenue timing and lower revenue growth than we anticipated for the third quarter. However, with continued strong orders performance we ended the quarter with another record level of backlog, positioning us well for accelerated growth in the future. With the sustained customer interest in our technology, our primary focus in the test business is to drive efficiency improvements in order to more quickly convert our strong backlog. We are confident in our ability to implement these improvements and to realize higher revenue growth in future quarters. The third key message today is that we are reaffirming our revenue and earnings per share guidance range for the full year, with revenue of $565 million to $580 million and earnings per share of $3 to $3.20. However, as I just mentioned, we were not able to convert our backlog as quickly as we had anticipated in the third quarter due to the engineering resource constraints. And our order mix continues to be more heavily weighted toward custom projects. Although our order volume and backlog remained strong, these two factors are causing delays in revenue timing that will push revenue into fiscal 2016. Based upon this, we would expect to be at the low end of our guidance range for both revenue and earnings per share for the full year. With that, I’ll now review orders in more detail for the quarter. Total company orders of $154 million increased 3%, but were up 10% on a constant currency basis. Drilling down one level, test orders were up 4% and up 9% on a constant currency basis. Sensor orders were down 1%, but up 13% on a constant currency basis. Even with the full currency effects included, backlog ended at a new record level of $343 million, an increase of $33 million or 11% compared to the prior year, and up 6% 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 fourth quarter with $33 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 healthy $873 million at the end of the quarter. We’re very pleased with this continuing demand profile as it demonstrates the strength of our core test markets around the world, reflecting the continued investments our OEM customers are making in 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 1%, but were up an impressive 13% on a constant currency basis. We received two large blanket orders in the quarter which contributed 8 points to the growth rate. Even without these blanket orders, the Sensor business still grew a solid 5%, excluding the impact from foreign currency. From a market perspective, the industrial segment was flat compared to the prior year with substantial negative effects of currency being largely offset by the higher order volumes we received in the quarter. On the positive side, we saw strong demand driven by wind energy and OEM business across several market segments in Europe. The weakening of the euro resulted in our European customers’ industrial machines being relatively less expensive than their competitors, which drove their sales and in turn fueled our sensor growth in Europe. We also saw strength in the wood and plastic segment in the US. These strengths were offset by weakness in oil-and-gas-related-markets worldwide, driven by low oil prices, and weakness in the steel markets and other heavy industrial markets in China. We believe this is related to the weak manufacturing environment in China over the last several months. Moving onto the mobile hydraulics market for sensors, orders are relatively flat, down 2%. Strength in construction and the material handling markets were offset by weakness in agriculture and mining, as well as the negative effects of currency. Despite the lack of growth in the quarter, we believe the general outlook for the mobile hydraulics market for the remainder of our fiscal year 2015 and beyond looks positive. This is supported by strong construction markets, particularly in the U.S. We continue to believe that over the long-term the 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 order results from a geographic perspective. All areas except China were up double digits in local currency. America’s orders were up 18%, driven by a large blanket order. Europe orders were down 4%, but up 19% on a constant currency basis, with strength in wind energy and industrial OEM accounts, as I mentioned previously. Asia, excluding China, was down 7%, but was up 11% on the constant currency basis. China orders were weak in the quarter, down 26% and down 14% on the constant currency basis driven by a general slowing in the Chinese economy. Despite the down quarter, we continue to be excited about our growth prospects in China in the long-term. Specifically, we believe we have opportunities due to the consolidation of some steel manufacturers in China as well as opportunities related to the plastics market. Next, I’ll spend a few minutes on our test order results. Test orders in the quarter were $127 million, up 4% in absolute terms and up a strong 9% on a constant currency basis. The overall order increase was driven by large custom projects, which were $21 million in the quarter compared to $13 million in Q3 of last year. The large orders were in the ground vehicle area in Asia and were associated with highly customized test systems which will be used to develop advanced chassis systems for safety, comfort and handling in new automobiles. These two orders occurred in existing customer accounts and demonstrate the continued confidence our customers have in MTS to deliver high-quality technically-advanced testing equipment. Looking ahead for the automotive market, we anticipate continued strength with automotive handling and aerodynamics being areas where we expect to see sustained demand as our customers continue to invest in new advanced testing systems worldwide. Geographically for our test business, Asia broadly was strong for the quarter, up 12% and up 14% on a constant currency basis, driven by the two large orders in the quarter I mentioned previously. Another bright spot we saw in Asia was the substantial investments in durability and tire testing capabilities in the ground vehicle market. For China specifically, we continue to see competitive pressure in our materials testing business, and a general slowing of the capital spending market for our test products. With recent efforts by the Chinese government to increase liquidity, we anticipate a more favorable climate in the future with China remaining a key growth market for our test products in the years ahead. Europe was down 4% for the quarter but up 18% on a constant currency basis for our test business. We were pleased with this performance, given the currency headwinds on our products, which demonstrated our test technology strength with our key customers in this region. In the Americas, orders were down 7%, as we faced tough comps from last year. This was primarily driven by non-recurring investments in durability test systems in the ground vehicles market, and a decrease in government-funded projects year-over-year. We did see some positive traction from contract test labs in the materials market in the U.S. as they expanded capacity for increased testing of aerospace composite materials. Next, I’d like to spend a few minutes discussing our test services business. As I previously mentioned, our test services business gained momentum this quarter. The gains were once again masked by the negative impact from foreign currency. Within the quarter, test service orders were up a modest 1% compared to the prior year at $20 million on an absolute currency basis, but increased an impressive 11% on a constant currency basis. Geographically, the Americas orders grew 16% from large refurbishment projects and increased account penetration. Asia orders increased 7% but were up 17% on a constant currency basis. European orders were down 16% or up 4% on a constant currency basis. Although our service engineers continue to be re-directed to support the installation of the unusually high-level of large complex custom projects, we believe our increased service headcount is now beginning to have a positive impact on the orders result. We continue to receive a positive reception from our customers with regard to our service offerings. Our large and continually growing installed base of test equipment worldwide, which is over $4 billion and rising, continues to provide us with an opportunity for sustained profitable growth in our test services business. We believe that orders will further accelerate as our workforce expands and becomes more efficient, and as we work through the high demand for custom test systems. We are continuing to add field service engineers as quickly as we can to support the service business and help drive future growth. Finally, I’d like to comment on the test opportunity pipeline, as it’s a good indicator for future growth. As I mentioned previously, at the end of the third quarter, our 12-month pipeline of opportunities stood at $873 million, down 2% compared to the prior year and down 5% on a sequential quarterly basis. On a constant currency basis, the opportunity pipeline was up 2% year-over-year. The decrease in the pipeline on a sequential basis was driven by winning the two large orders late in the quarter that I previously mentioned and the deferral of another large custom order to outside the next 12 months. Although, the pipeline is down slightly on a sequential basis, it remains at historically very high levels. These identified opportunities for future sales are reflective of the healthy continuing demand we see for expanded and enhanced testing capability in R&D, and new product development by our customers worldwide across automotive, aerospace, infrastructure and advanced materials 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 our CFO, Jeff Oldenkamp for some additional financial detail on the quarter. Jeff?

[Jeffrey Oldenkamp:]

Thank you, Jeff. My remarks today will summarize our third-quarter results based on a year-over-year comparison. Third-quarter revenue of $134 million decreased 8%, but once again was impacted by the strengthening of the U.S. dollar. On a constant currency basis, revenue was down 2% driven by lower than expected revenue in Test, due to engineering capacity constraints that Jeff previously mentioned. Looking more specifically at revenue by business, Sensors revenue of $24 million was down 10%, but was up 3% on a constant currency basis. All regions were down. Europe was down 12%. The Americas was down 10%. And Asia was down 7%. On a constant currency basis, Europe and Asia were up 9% and 8% respectively. The strong performance in Europe was driven by short-cycle orders which were up 19% year-over-year on a constant currency basis. And the revenue growth in Asia was backlog-driven. Moving onto Test, revenue of $109 million decreased 7% and decreased 3% on a constant currency basis. As we have discussed previously, revenues in the short-term continue to be impacted by product mix in our test business. Our test backlog continues to have a higher percentage of custom, engineered-to-order projects than is typical. This put a strain on available engineering resources to work on the increased level of customized products, limiting the amount of progress we were able to make, resulting in a delay in revenue timing in the quarter. The good news is that the work remains in backlog for revenue recognition in coming quarters. Another bright spot was the performance of the Service business. On a GAAP basis, Service revenue increased 3% but on a constant currency basis, revenue increased 12% in the quarter, reflecting continued success in growing our Service business. Test backlog ended the quarter at $327 million, another record high for test. Custom backlog as a percentage of total backlog remained flat at approximately 75%. This will continue to have a negative impact on margins for the remainder of the year and into fiscal 2016 as we work through the custom backlog. Moving onto the rest of the P&L. Gross margin was $53 million, a decrease of 8%, driven by 8% lower revenue. As a rate to revenue gross margin was flat at 40%. Sensors gross margin was down 10% to $13 million on lower volume, while the gross margin rate was flat and remained at a healthy 55%. We expect the margin rates to stay in the mid-50% range going forward. Test gross margin of $40 million was down 7% from lower volumes and the negative impact from currency, while the gross margins remained flat at 36%. Lower volume negatively impacted the margin rate by approximately 50 basis points. However, these negative impacts were offset by productivity improvements in our manufacturing operations. My next topic is operating expenses. Operating costs decreased $3 million, or 6% to $38 million, and were 28% of revenue, within our normalized range of 27% to 29%. R&D expense declined $0.5 million, due to the capitalization of costs associated with software development activities. Selling cost decreased approximately $2 million. Approximately $1.5 million of the decrease was attributable to the favorable impact of currency translation, $1 million resulted from a lower commission expense due to the timing of revenue recognition, and $1 million was from lower restructuring costs. These decreases were partially offset by $1 million in higher compensation expense and slightly higher head count, as well as higher professional services. G&A expense was flat compared to the prior year, as an approximately $600,000 favorable impact of currency translation was offset by increased miscellaneous costs, including higher bad debt, as well as higher professional services and recruiting fees. EBIT decreased 12% to $15 million, primarily resulting from the previously mentioned lower gross margins in Test, which were partially offset by lower operating expenses. EBITDA as a rate to revenue decreased 50 basis points to 11.4%. My next topic is taxes. The tax rate in the quarter was 29%, slightly lower than the expected range, but up a 11% from the rate in the same quarter last year. The rate in the prior year was favorably impacted by a $2.6 million benefit associated with US R&D tax credits, which favorably impacted the rate by approximately 15 points. Excluding the impact in the prior year from the R&D tax credits, the tax rate in the current quarter decreased 4 points. The decrease primarily resulted from a more favorable geographic mix of earnings in the quarter. In future quarters, we expect the tax rate to remain in the low 30% range. Earnings per share decreased 22% to $0.72 compared to $0.92 in the prior year. This was largely driven by the favorable tax benefit and lower EBIT in Test that I just mentioned. In addition, currency continued to have a negative impact on the business. If Q3 was adjusted for translation and transaction losses, EPS would have been approximately $0.08 higher. Finally, I’ll conclude my remarks with a summary on cash. The cash balance remained strong at $53 million and the net debt level is now $17 million of net cash. In the quarter, cash decreased to $8 million. Operating cash flow was very strong at $36 million. This was driven by strong earnings and an improvement in our working capital requirements, specifically a reduction in our receivables. We reduced our debt by $35 million in the quarter, paid out $4 million in dividends, spent $4 million on capital expenditures, and spent $3 million to repurchase approximately 32,000 shares. That concludes my remarks for today. I will turn the call back to Jeff for his final comments. Thank you.

[Jeffrey Graves:]

Thanks, Jeff. Now, I would like to conclude my remarks with more context for our full-year revenue and EPS guidance ranges. We continue to see confirmation of the favorable long-term global macro trends and steady market momentum that we discussed in prior quarters. We believe this is supported by the strong test opportunity pipeline, the large order flow during our third quarter, and the continued high level of quoting activity in both Test and Sensors businesses. Further, we feel good about the record level of backlog for the company, which will help drive the results for the remainder of our fiscal year and beyond. These key factors, as well as the strategic initiatives we are pursuing in both testing and sensors position us well for the long-term. As I mentioned in the headlines, we are reaffirming our revenue and earnings per share guidance range for the full-year with revenues of $565 million to $580 million and earnings per share of $3 to $3.20. This represents flat to 3% growth in revenue, compared to fiscal 2014, and flat to 6% growth in earnings per share, including all currency effects. However, due to the engineering resource constraints and continued high custom order mix that I discussed previously, we expect to be at the lower-end of this guidance range for both revenue and earnings per share. We are addressing the engineering resource constraints as quickly as possible, and we are working diligently to improve the order flow in our factories to allow us to convert the high level of backlog. We will also continue to focus on enhancing our product capabilities and maintain our technology leadership position in both of our businesses, and develop new products and sensors to further propel our growth. With the long-term macro trends that we see supporting growth for both of our businesses, we remain bullish about our long-term prospects for sustained growth and profitability improvements. That concludes our prepared remarks. I’ll turn the call back to you, Aaron, for the Q&A session.

[Operator:]

Thank you. [Operator Instructions] And we’ll take our first question from John Franzreb with Sidoti & Company.

[John Franzreb:]

Good morning, guys.

[Jeffrey Graves:]

Good morning, John.

[Jeffrey Oldenkamp:]

Good morning, John.

[John Franzreb:]

Impressive quarter, especially in the backlog and order scenario. Jeff, you mentioned that the backlog, a lot of its lower turns, so that’s problematic in the fourth quarter. But you’re also optimistic about the future revenue being a higher growth rate. Can you discuss why - the composition of the backlog looks like today that makes you so optimistic about a higher growth rate?

[Jeffrey Oldenkamp:]

Well, fundamentally, John, quarter-over-quarter here we continue to build backlog. I mean, we’re up $33 million year-over-year in terms of backlog as we finished up Q3 and our pipeline looks really strong. The only issue we have really right now at all is that the orders that are out there that we’re winning are more of this custom nature. And they, by slow turning, as you’re aware, they can take anywhere from 12 to 24 months and beyond to really flow through into revenue, so it’s a long process. They are wonderful projects. They are great engineering projects. They are great for our brand. They are great for our services opportunity in the future. But they turn more slowly into revenue. So that’s why I say, we quarter-over-quarter consistently are winning a disproportionate amount of share in the market, I believe. Our backlog is growing and that eventually turns into revenue. It’s just the timing. Historically, John, we would have said, we run at between 60% and 70% of orders are custom, probably more towards the 60-ish than 70. And right now, we are 75% and holding. As we look at the pipeline going forward, there’s reasons for optimism in terms of the mix improving. As we exited Q3, we saw some uptick in our standard products, which would be lovely to have. But it - but one data point doesn’t make a trend, we have to wait and see if that’s sustained or not. So we remain bullish on the overall demand out there for our products. It’s very good worldwide across our market space with upward trends. It’s just the mix continues be a drag on the business in terms of revenue.

[John Franzreb:]

So is this an event that’s going to play out through most of next year also given the timing of the deliveries, Jeff?

[Jeffrey Oldenkamp:]

Well, I tell you, John, it seems every quarter I sit here and say, yes, we’ve got a few more quarters of it. Yes, I would say, at this point, John, I don’t think we are going to see dramatic shifts in the short-term. I think you will see a gradual rebounding of our standard products as a ratio of this custom. But right now, the world wants these custom projects. And I - customers seem to be focusing their fire power, if you will, in terms of purchasing on these machines that can make a real huge difference to their business. So it’s not bulk testing, standardized testing, and stuff, it is very specialized high-end testing that can really move their new products forward. And what that means to us are custom products. So, again, it’s lovely for technology. And, John, I would tell you, it provides a marvelous opportunity in the future for our services business, because we’re in a unique position to take care of this equipment over its lifetime, which can be 20 to 30 years. So I love that all of those aspects. What I don’t love is that, it turns slowly into revenue out of backlog, and the margins generally are lower than our standard products. So we are working on both those things. We are hiring like crazy. We’ve added over 50 engineers during this fiscal year and we still have open reps. We are investing in productivity tools for them. We are working Lean initiatives to drive more productivity in engineering, particularly right now in engineering. But it’s a little bit of an uphill battle, given our backlog. Maybe I over-killed your question, but that’s the full color.

[John Franzreb:]

Well, you helped me in that we can segue into the Test segment. The gross margin profile has been under pressure in that segment for a while. What is it going to take to get that thing that segment back up to the historical 50% gross margins that they used to record?

[Jeffrey Oldenkamp:]

Yes, John, I think the - if you look at the historical norms, it was probably more like a 40-ish number, but driven by the mix between services and products. Obviously, we hope to grow services faster than products going forward, and we would hope there would be some upside on that. What’s the overwhelming issue in the gross margin, John, is simply the mix of the product. It’s - our custom products can be 10 points lower than our standard product offerings. And…

[John Franzreb:]

I’m sorry, Jeff. Jeff, I meant to say services. I misspoke before, I’m…

[Jeffrey Oldenkamp:]

Oh, I’m sorry.

[John Franzreb:]

…the service gross. That was my fault.

[Jeffrey Oldenkamp:]

Yes. Yes, yes, yes. Okay, thanks for clarifying, John. No, in terms of services, I mean, we love the orders growth. I mean, the value proposition is there, clearly customers want the - want our services. The issue really with margins there, John, is that, we are hiring a lot of people and we’ve got a manpower drag through the less productive folks. So we’ve been bringing them in. And you see that now reflected in this orders growth rate. I think the number we cited was 11% on a constant currency basis being up this quarter. So that puts us back in double-digit growth range, again, for the first time in several quarters. And that’s a direct reflection of the number of people we have on - in our OEM shops now taking care of equipment and landing new orders. The drag is twofold. Number one, the guys are still working on installing the higher amount of custom product. But the main drag on margins is the manpower issue. We’ve hired a lot of new folks and it’s just a drag on the P&L.

[John Franzreb:]

Okay. One last question, and I’ll make it short. Is there any one-time items we should be expecting in the fourth quarter? Be it tax or anything else, because my back of the envelope math based on the tax rate, Jeff just said before it puts the gross margin really low on a consolidated basis for the company. I just want to make sure I’m not missing anything.

[Jeffrey Oldenkamp:]

Yes, John, I’ll take that question. I mean, there is no one-time items in the Q4. And Q4 is really driven off the conversion of the large custom backlog into revenue at the lower margins.

[John Franzreb:]

Okay. I’ll get back into queue. Thank you, guys.

[Jeffrey Graves:]

Okay. Thanks, John.

[Operator:]

And we’ll go next to Jim Ricchiuti with Needham & Company.

[James Ricchiuti:]

Hi, thanks. Good morning. I just wanted to follow up on that. How should we think about operating expense as well in Q4? I mean, clearly, there is a more negative mix shift that’s going to hold back your gross margins. But it sounds like your OpEx too will have to be higher just in light of where you are going in terms of the low-end of your earnings guidance?

[Jeffrey Oldenkamp:]

Yes. So, Jim, looking at OpEx, our guidance range is always, what we communicate is 27% to 29%. This quarter we came in at 20% - 28%. We would expect it to be at the high-end of that range in Q4 from an OpEx standpoint.

[James Ricchiuti:]

Okay. And given the backlog in the pipeline, you probably have some sense as to how some of that converts over the next couple of quarters. The shift that we’re seeing, the more shift toward more custom in the current quarter, is that something we should also assume in the early part of the next fiscal year as well?

[Jeffrey Graves:]

Yes, Jim, I would expect that trend to continue. It’s holding pretty steady right now in terms of orders we are landing. Our custom mix is holding pretty standard at this elevated level compared to history. It had ticked down a little bit and now it’s kind of in a steady state mode. So I would expect that now to continue into 2016.

[James Ricchiuti:]

Okay. And had, just given the concerns people have about China, Jeff, I was - I just wonder, if you’d elaborate a little bit more about what you are seeing in the business there? And to the extent that there are any tough compares coming up with respect to your business in China over the next couple of quarters. Is there anything we should be aware of just in general in both Test and Sensor, how should we think about that part of the business?

[Jeffrey Graves:]

Yes, Jim, I would tell you, I think in Sensors, we’ve already seen it. I think Sensors has been swimming upstream for the last, at least, the last quarter, or a couple of quarters in China, I would have to go back and look at the numbers in the prior quarter. But they feel it almost immediately. When the industrial machine in China slows down, they feel it almost immediately. So they are getting a lot of new design in wins and being placed in new products, but the overall demand has been soft in China and particularly in the quarter. And as you know, that’s a short cycle business. They’ve done a great job controlling costs and margins are hanging in there. But overall, revenue has been disappointing in China for sensors. Test is interesting, because we sell into very long-term markets there that are R&D driven. And the Chinese seem absolutely determined, if I could generalize, they seem absolutely determined to upgrade their products that they manufacture as a country. And so they’ve been pretty persistent in spending money in universities and at Chinese OEM levels to improve their products. Now that said, we did see flattish performance in the quarter in China for Test, and that’s unusual for us. I mean, usually we’re ticking up almost double-digits over there, particularly in automotive. But I wouldn’t expect to see it go highly negative. I think they will cling to investments in R&D and product development and only cut those expenses as a last resort. I mean, we may see some push-outs in time, but I would expect, again, if you look over the next couple of years, China will remain a very strong market for us in our Test business, particularly, as it relates to automotive and aerospace and advanced products for Test. I just think they are determined to become a world-class economy.

[James Ricchiuti:]

Got it. And you alluded to this, Jeff, but bringing on more resources - engineering resources, the additions that you’ve made, have they been mostly in Q2, Q3, or have they been spread out over the course of the fiscal year thus far?

[Jeffrey Graves:]

Yes, we’ve been recruiting all year, Jim. In reality, our standards are very high for engineers, because we have to be capable of doing first of the kind machines in an R&D environment, so very demanding on an engineer’s technical capabilities. So we’ve been looking all year. The hiring was very much back-end loaded, though. I mean, we did a little in Q1. We hunted a lot, we landed a little in Q1. We landed more in Q2, and we landed quite a lot more in Q3. So we will begin seeing the impact of their efforts here going forward. So I’m very pleased with the quality of the folks we have. It’s just the demand for engineers in the general economy right now is pretty high, and our standards are very high. So it was very back-end loaded.

[James Ricchiuti:]

So with respect to that, does the - is there some productivity headwinds that you’d expect over the next couple of quarters, and that improves as we look out over the course of fiscal 2016?

[Jeffrey Graves:]

Yes, sure. There is going to be some training and acclimating to do, Jim. All of these guys aren’t right out of school. I mean, we’ve hired a number of folks that have very seasoned careers, so their learning curves are shorter. But still they have to get used to the MTS systems and ways dealing with our custom base. So there is a learning curve. So I would expect some productivity headwinds for a couple of quarters as they really ramp-up to speed. And then we’ll be feeling the benefits in the coming year. So we’ll get some benefit in Q4. I mean, that’s why we’re anticipating our revenue turns to be better. But I think we’ll really see a lot more of that traction after a couple quarters. That pushes into kind of Q2 and Q3 of 2016.

[James Ricchiuti:]

Okay. And you mention, you still have open reps. Does the - is the bulk of the hiring done? Or do you anticipate having to do a fair amount…?

[Jeffrey Graves:]

Yes, in our core engineering functions, Jim, the bulk of the hiring’s done. We’ll add individuals here and there but as I mentioned, we hired over 50 engineers this year. And we’ve still got some open reps but they’re becoming very selective in certain disciplines. So it’s the - we’re down to a limited number now. Now, the exception to that really is our field service engineers. We continue to hire those people around the world as much as we can find them and get them up to speed, so because the services demand is very high. Engineering, I think we’ve pretty much got the bulk of the hiring behind us, and down to selective additions.

[James Ricchiuti:]

And then, that’s not a net number, is it? I mean, that’s a number you’re bringing on. But I assume you’re also, folks move around as well. Have you had much attrition?

[Jeffrey Graves:]

Well, certainly we have had some attrition. The engineering market heated up, especially here in the Minneapolis area it heated up over the last year, and very well. So we did see a little bit of attrition. We’ve also had some high profile companies in this area really be struggling right now. And have been able to pick up some really good engineering talent there. So yes, it is a net number, by the way. That is a net number. So we’re up substantially. And it was fairly backend loaded in this year.

[James Ricchiuti:]

Got it. Okay. Thank you.

[Jeffrey Graves:]

Thanks, Jim.

[Operator:]

And we’ll go next to Liam Burke with Wunderlich.

[Liam Burke:]

Thank you. Good morning, Jeff.

[Jeffrey Graves:]

Good morning, Liam.

[Liam Burke:]

Jeff, on the sensor side. You did have slightly higher gross margins. Jeff Oldenkamp mentioned in his prepared statements that the levels would be similar to that. But the bottom line is you had lower volume and you were able to eke out higher year-over-year margins. What was in that number that allowed you to do that on lower production volume?

[Jeffrey Graves:]

Well, remember that, it may be lower revenues based on currency effects. But we’re actually running at very high volumes right now. So, Jeff, you want to comment on that?

[Jeffrey Oldenkamp:]

Yes. Liam, I mean, it’s really driven off the mix in the industrial segment within the sensors business. We were helped by currency but the big driver of the margins within sensors is driven off the industrial mix.

[Liam Burke:]

Okay. And then on the tests, you said product mix was still heavily weighted towards the custom side. You were able to get flat year-over-year margins, relatively flat year-over-year margins. You mentioned productivity improvements within the segment. Could you give us a little detail on where you were able to get those improvements?

[Jeffrey Graves:]

Yes, what we’re focused on, Liam, very heavily is we’ve invested in, and we’ve been very public about this. We’ve been investing in our IT systems now for the last couple years real heavily. And it’s now a matter of getting all the engineers using the systems and getting the productivity benefits that come along with that. So better linkage between the engineering work flow, and operations and the supply chain. So it’s kind of standard tools that a high-end engineering company would use. In our case, we run an SAP backbone and we continue to upgrade that. And hire and train folks into that environment. And now it’s a matter of really driving that for productivity and predictability in the business. As I mentioned, the modeling, our custom backlog as it turns into revenue is a fairly complex thing to model the actual turn into revenue. And these systems will help us tremendously in the future do that. So not only from an efficiency standpoint, but I think from a predictability standpoint we’ll see benefits over the next few years in this.

[Liam Burke:]

So are you at the early stages of actually getting, reaping the benefits of the IT system in place? And then having the engineers actually use it?

[Jeffrey Graves:]

Yes. So what we’ve - so what I would tell you very specifically is, we’ve got everybody using the system now. And we’re learning more and more of the power of the system and what it can do. We’ve always invested in design tools themselves. We continue to do that, and that’s standard fare. But in terms of using a sophisticated ERP system and better communication and a linkage between engineering, manufacturing, everyone is now on the same system. Everybody’s using it and it’s a matter of familiarity and usage. Basically experience with the system now. So they’ve done the hard work of getting on it. And now it’s a matter of actually using it with this full range of custom projects that we have.

[Liam Burke:]

Great. Thank you, Jeff.

[Jeffrey Graves:]

Thanks, Liam.

[Operator:]

And we’ll go next to Ben Hearnsberger with Stephens.

[Ben Hearnsberger:]

Hey, thanks for taking my question. Jeff, I wanted to ask about the comment you made. You said that you saw an uptick in standard orders exiting Q3. Was this a significant uptick? Can you give us the driver there and has it persisted in early Q4?

[Jeffrey Graves:]

Yes, I mean, it’s probably the early days yet to say if it’s persisted or not, Ben. But we were encouraged as we moved through Q3 to go from this slog of custom orders and add it up. I don’t mean to downplay this, they’re wonderful orders. I mean, these are engineering marvels. They’re great systems. They’re tremendous for our business in the long-term. But we continue to desire to see a better mix, a historical mix of standard to custom products. We began to see a trend - we began to see some rays of sunshine in that as we moved through June. And basically selling more standard product, but we didn’t want to overplay it in this call because one month doesn’t make a quarter, it doesn’t make a trend. So as we look into the pipeline, I would tell you we see a relatively constant mix of opportunities out there. Now, that’s short cycle business can change fast and we could continue to see growth. I just don’t want to over play it. I think we have to see another quarter of the trend improving in order to take it to the bank. But I was at least encouraged as we ended the quarter and I wanted to share that.

[Ben Hearnsberger:]

Well, did the June trend continue into July?

[Jeffrey Graves:]

It looks like it’s held pretty steady. We didn’t go backwards. So it wasn’t just an uptick and a retreat. So that, from what we can understand with the order flow right now. And we’re just closing out July right now. It looks like it held pretty steady. So it’s one step forward and we’d hold a gain. So we just need to see that continuing to step forward now.

[Ben Hearnsberger:]

Got it. And I know that the custom orders are good business and they help increase your installed base. And it gives you the service opportunity later. But are there any - I guess what are the levers that you have available to influence the mix at all, if you do? If you did - maybe if there’s pricing and custom. Or anything you can do to somewhat influence that mix.

[Jeffrey Graves:]

Well, it’s - I tell you, Ben, it’s always easy to raise prices and drive demand downward. You can always do that and drive a preferred mix that way. And we do look at pricing very regularly. On these custom jobs, the sales process is often a one to two year or more process. So the - we work through these iterations with customers and they try to align their budgets to what we’re giving them as estimates and quotes. So what we feel by the end of a sale or when we take an order, is really the accumulation of a couple of years of effort. And a lot can change in two years. You can have parts prices changing. You can have currency effects. You can have a lot. So in the short term, driving price changes on custom projects tends to be difficult if you value your customer relationship. So I would love to take a purely numbers approach and say - yes, we’re going to take prices up and drive the mix to be better. I’m sure that would drive an improved mix. It may also drive total volumes down. And our customer relationships are 40 or more year old relationships with the premier automotive and aerospace OEMs in the world. As well as leading universities around the world. We really value that. That’s one of our long-term pillars of this company. So it’s a very tricky process on the custom end of things. Standard products are a little bit more easy to drive. You can drive a lot more short-term behaviors and things. So we continue to look at pricing across the board. So long-winded answer to your question, we continue to look for pricing opportunities in our custom business wherever we can wring more value out, or reduce risk if it’s a first time job. And I think we are moving in that direction. It’s just a pace issue.

[Ben Hearnsberger:]

Sure. And then on the standard orders, I know at the end of last quarter or during last quarter, you started to see some increased price competitiveness overseas against some competitors operating in local currency. I’m assuming that’s persisted. Maybe you can just speak to that environment and how it’s played out in the…

[Jeffrey Graves:]

Yes. It has, but again, we operate in a good industry. The - in terms of the price competitiveness right now, what I would tell you is we’re seeing some traction in our new products, which we had expected. Now going into this fiscal year, we would hope to be able to have priced those a little bit higher. With the currency effects, we weren’t able to do that. But we still, they generally are very good margin products, very competitive technically. And we continue to get traction in that. So when we see a stabilization of our standard product offerings now generally driven by our new products that are out there that have very good margins associated with them. In terms of pricing, I think there were some opportunistic taking advantage of the currencies earlier in the year because they swung so quickly that basically customers could reap a benefit by changing a purchase order on a standard product. But I think things have stabilized and we continue to work into a pretty healthy environment. And our new products are getting traction. So I’m encouraged by that.

[Ben Hearnsberger:]

Okay. That’s helpful. And then my last question, is it fair to say that you see a similar mix in your opportunity pipeline that you see in your current backlog?

[Jeffrey Graves:]

Yes, the mix. Yes, I would tell you, Ben, I mean from a distance it’s really pretty similar. We may be starting to see some - and again, I don’t want to oversell it. We may be starting to see some improvement in our standard products. In the pipeline, if you took a snapshot today, you would say that. You’d say we see standard products getting a little bit stronger going forward. And we did end the quarter on a good note in the month of June. And we see that kind of holding now in July. So as I look forward, again, I think there’s reason to be very hopeful in terms of an improving mix. But again, I’m very cautious. One data point does not make a trend. So we’ve got to see it recurring.

[Ben Hearnsberger:]

Sure. So if we look at longer term maybe over the next year or so, if this mix holds, would the idea be that we’d see similar gross margins within the test business but for maybe some improvement driven by the productivity initiatives you guys have in place?

[Jeffrey Graves:]

Yes. You’re correct. If everything held steady as we see it right now, you’d see this kind of margin mix if you would impacted only by these productivity improvements that were driving. And I think those can be meaningful. But it’s - but yes. That - your summary’s absolutely correct. What we hope to see is all of that plus a mix improvement in our orders win rate here. Okay?

[Ben Hearnsberger:]

Can you frame up for us, Jeff, how meaningful the productivity initiatives could be? Are we talking a point, are we talking multiple two to five points, three to five points? If possible, if you could just frame it up and give us a sense for that.

[Jeffrey Graves:]

Sure. Jeff, you want to comment on that?

[Jeffrey Oldenkamp:]

Yes, Ben. I mean, when we look at it again, we are in the early stages of that operations and engineering. So when we look at it over time, we’ve disclosed we’d like to see margin improve two points over the next four years. And a lot of that’s going to come from the productivity improvements.

[Ben Hearnsberger:]

Got it. All right, gentlemen. Well, thank you very much.

[Jeffrey Graves:]

Thanks, Ben.

[Operator:]

And we’ll go back to John Franzreb with Sidoti & Company.

[John Franzreb:]

Yes, Ben covered most of my points pretty well. But just, Jeff, on the pricing or the ability to get pricing in custom test, is it a function of your customers are willing to walk away from a job? Or is there competitive landscape so challenging that you just can’t improve the margin profile of your custom jobs?

[Jeffrey Graves:]

Yes, here’s exactly how it works, John. On these customized jobs or even highly engineered products that are - a degree a customization, you literally work through that process with your customer for a couple years. More and more, they like the features that you put into the product and it rolls up to a certain cost that we expressed as price for budgetary purposes. And that process really iterates a lot over a couple year period. So what it really means is you end up at a price point after a couple years, and then the engineering team you’ve been working with and the customer finally goes back to their management, and says this is the capital I need. At that point, it’s very - it’s tricky for them to bring in a lot of heavy competition because a lot of the machine is customized around our technology. So what we see if the number is simply way out of bed for what they can spend, they just put off the purchase. They just push it off. They may restart the whole two-year cycle again. They –if ever we talk about things pushing out of our 12 month pipeline, it’s generally that. We’ve gone back with some pricing that the customer just says, whoa, that’s much different than I can really afford when I go to my management. And it pushes it out in time. It’s rarely that we’re neck and neck with somebody else, frankly speaking. Very rarely that we’re neck and neck with somebody and it comes down to a few bucks at the end of a bid. Can I remember, these are generally multi-million dollar purchase orders. So they’re capital dollars our customs are spending. They require several management levels of approval. And that approval comes near the very end of the process. And if we lose, it generally means something is pushed out in time. Okay? We occasionally do lose to our global competitors. I’m not saying we don’t do that. And it, but obviously, we don’t have - it’s still a fairly fragmented market. But the more general case is the one I just described to you.

[John Franzreb:]

Got it. Okay. That’s it. That’s all I have for follow-up. Thank you, guys.

[Jeffrey Graves:]

Okay. Thanks, John.

[Jeffrey Oldenkamp:]

Thanks, John.

[Operator:]

And that does conclude the question-and-answer portion of today’s call. I’d like to hand the call back over to Jeff Graves for any comments or closing remarks.

[Jeffrey Graves:]

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

[Operator:]

And this does conclude today’s conference, everyone. Thank you for your participation and you may now disconnect.