MTS Systems Corp
Q3 2014 Earnings Call Transcript

Published: 5 Aug 2014

[Operator:]

Good day, and welcome to the MTS Systems Third Quarter 2014 Earnings Conference Call. Today's conference is being recorded. And at this time, I would like to turn the conference over to Sue Knight, Chief Financial Officer. Please go ahead.

[Susan E. Knight:]

Thank you, Anthony. Good morning, and welcome to MTS Systems Fiscal 2014 Third Quarter Investor Teleconference. Joining me on the call today is Jeff Graves, President and Chief Executive 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 in the company's latest SEC Forms 10-Q and 10-K. The company disclaims any obligation to revise forward-looking statements made today based on future events. This presentation may also include reference to financial measures, which are not calculated in accordance with generally accepted accounting principles, or GAAP. These measures may be used by management to compare the operating performance of the company over time. They should not be considered in isolation or as a substitute for GAAP measures. 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 A. Graves:]

Thanks, Sue, 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 2014. Before I discuss the results for the quarter, let me remind you about the nature of our 2 business units. This may be particularly helpful for those newer to following our company. The larger of our 2 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 customer 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 equipments 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, which have only recently begun to show signs of life within a slowly improving economy. Fortunately, in spite of a fairly tepid macroeconomic environment, the growth in what some refer to as smart machines as a percentage of the overall market is growing more rapidly, and therefore, providing accelerated growth opportunities for our sensors beyond simple GDP-driven market expansion. This is exciting, and we believe sustainable in the years ahead. With this backdrop, I'll now comment on the quarter. There are 3 key messages for the quarter. First, the momentum in orders that we saw in the first half of our fiscal year continued in our third quarter as we delivered 15% orders growth and set a new record high in backlog of $310 million. I'll provide you with additional orders-related information in a moment. Second, as previously announced, we acquired Roehrig Engineering in June. They are the leader in testing systems, utilizing electric and electromagnetic actuation technology primarily in the ground vehicle market. This acquisition is a good example of our focus on adding small, technology-rich acquisitions to broaden our market offerings and further enhance our technology leadership. They will supplement our organic growth prospects, helping us to attain our goal of delivering annual double-digit revenue growth in the future. We're very excited to have the Roehrig team be a part of MTS. Third, we're proud of the orders, backlog, revenue, EPS and cash flow growth in the quarter that resulted from increases in both Test and Sensors. At the same time, we were challenged by operational inefficiencies in Test associated with growing the business, which negatively impacted gross margin. We experienced higher overtime, rework and other organizational inefficiencies from the significant level of people, process and system changes that are underway. We're aggressively working to improve our product and service flow through organizational restructuring and business process improvement. While I'm confident these growing pains can and will be resolved, we believe it will take us another quarter or 2 to work through these issues. Thus, we've updated our full year revenue guidance range to $570 million to $580 million, and EPS guidance range to $300 -- $3.20 to $3.30 (sic) [$3.35] per share. Now I'd like to talk more about our orders, backlog and opportunity pipeline. Our markets and our commercial successes were very strong again this quarter as our total company orders growth was 15%. Orders of $150 million included growth in both Sensors and Tests. Excluding currency, orders growth was 14%. Overall, we were very pleased with the broad-based global demand for both our products and our services. This quarter -- this third quarter performance has contributed to our excellent 11% year-to-date orders growth in what is broadly characterized as a tepid global economic environment. Approximately 2/3 of the order growth in the quarter was attributable to base orders, those are orders less than $5 million. And the remaining 1/3 was from large order increases. Backlog of $310 million was a new record high following the record that was set in the second quarter. Backlog increased 10% year-over-year, fueled by strong orders in both businesses, and sequentially, backlog was up 2%. Now I'll provide you with some additional context on orders and backlog by business. Beginning with our Sensors business, orders were very good again this quarter. We delivered 8% growth, which has doubled the estimated average market growth rate of 4%. Excluding currency, third quarter growth was 6%. Also noteworthy for our Sensors business is our 14% year-to-date order growth, which reflects both our customers' initiatives to design and build more productive and intelligent machines, and our investments in product and sales capacity to take advantage of these market trends worldwide. For example, while China is currently only 15% of the Total Sensor business, our China growth rate in local currency was 32% in the quarter, a level similar to our year-to-date performance, driven by the investments we have been making in our technology and our sales force. Just in the last year, the number of customers we have in China has increased over 20% from approximately 330 to over 400. We believe this momentum will be sustained as China works to accelerate their adoption of Sensor technology. Next, let's look more specifically by market. Industrial sensor orders increased 6% in the quarter. The demand drivers included growth in fluid power globally, wood processing in the Americas and energy in Europe, which is similar to our results in the first half of the year. The distribution channel also remains strong and continues to reflect broad market demand in the Americas. Also exciting in the quarter was new, unique demand for tire press applications in both Europe and Asia, as these new and improved industrial machines require more precise position, measurement capability and support of new tire innovations. Moving to the mobile hydraulics market. Although less than 25% of the total Sensor business today, it continues to be an exciting and very rapidly growing segment for the future. Orders for mobile hydraulic sensors were up 18% in the quarter on strength of the U.S. market, as there was increasingly strong demand from OEMs and our fluid power cylinder partners for construction and agricultural applications. Europe's orders showed a similar pattern, however, these gains were largely offset by weaker demand in material handling equipment in that part of the world. We were also excited to get our first design wins for mobile hydraulic applications in China this quarter. While they were not yet material in revenue, they're the beginning of the intelligent machine trend in China and offer significant future sales potential. While Sensors is historically a short-cycle business, backlog at the end of the quarter was $18 million, an increase of 22%. This high level of backlog is comprised of approximately 1/3 blanket orders, which are scheduled to be delivered over the next several months; and 2/3 of quick turning business for our fourth quarter. This strong backlog position is a good sign of confidence in the machinery forecast by our customers. In short, for our Sensors business, our innovative products, our application knowledge and expanded sales coverage, along with the strengthening market trends, enable us to remain bullish about the growth prospects for Sensors as we move into Q4 and our new fiscal year to follow. Next, I'd like to spend a few minutes on our Test business. Test orders were impressive again this quarter. Orders grew 17% to $123 million. Excluding currency, orders were up 16%. Base orders increased 11%, and large orders, again driven by Ground Vehicle demand, more than doubled to $13 million. The geographic spotlight was on Asia, where growth was 55% this quarter, more than offset declines in Europe and the Americas which faced tough year-over-year comparisons after strong investments by our customers last year. Again, this quarter, there was a drop in the deferral rate within our Test order opportunity pipeline to 49%. This is below our historical average rate in the mid-50% range, but we believe it's a strong signal that R&D capital spending rates, which is fueled by the overall level of business confidence in the need for new products, is strong. The $891 million pipeline was up 13% compared to the prior year, relatively flat on a sequential basis remaining at near record levels. Now I'll take a couple of minutes to provide a little more color in product and service order results for the Test business. First, Service. The momentum in our Services growth is continuing as we posted another quarter of strong double-digit gains. Orders of $20 million were up 11%, and growth year-to-date is 14%. We're also very excited to announce that we have won our first multiyear lab management contract that includes equipment health monitoring of both MTS and non-MTS equipment. It highlights the value of our expanded service offerings to our customers, the power of our enhanced Echo equipment monitoring capability and the changes underlying our focus on creating the intelligent lab of the future. Moving to Test products. Orders of $103 million were up 18% driven by gains in Ground Vehicles and Structures, while Materials was flat in the quarter. In Ground Vehicles, orders increased 23%, which was great news given the very strong performance over the last 6 quarters. Both of the large orders we mentioned previously totaling $13 million were in Ground Vehicles in Asia. And base order growth was also solid. Our customers' investment priorities remain focused on developing next-generation technology, improving vehicle ride and handling and improving environmental conditions by reducing CO2 emissions while improving fuel efficiency. Our Test expertise and product offerings position us well to help our customers reduce their new product development cycle time and improve the quality of their vehicle testing. In the Materials Test segment, orders were flat this quarter. We experienced some order delays from contract Test labs, pending confirmation of their customer testing contracts, as well as some government funding constraints in the U.S. and Canada. From a mix perspective, we also saw a business mix change from standardized products to more engineered content that's been evident in our opportunity pipeline. This change reflects increasing demand for complex, high-temperature testing of metals and composites. This is a favorable trend for our Materials Testing business. Last but not least is our Structures segment. It's the smallest of our 3 markets for Test and also the most volatile on a quarter-to-quarter basis because of its large custom order composition. Third quarter orders increased 75% to $14 million from significant wins in China aerospace. Our aero opportunities are excellent, and we're well positioned to support the global aero market, in particular, the emerging market in China. With this quarter's order performance, our Test backlog, which represents booked orders that are not yet delivered, ended the quarter at $292 million, exceeding last quarter's record high by $6 million and setting a new Test record. Backlog growth year-over-year was 9%. Included was 9% growth to $264 million of product backlog. Our service backlog of $28 million increased 16%. All of the service backlog growth was attributable to annual or multiyear service contracts, which is a major initiative for us this year. This growth affirms that we're delivering value from our service initiatives. To wrap up this discussion on Test orders, the 17% growth in the third quarter and 10% growth year-to-date are great results in a challenging marketplace. This performance gives us continued confidence that the economic megatrends are in our favor, and we have the technological expertise and outstanding customer base to capture share in the Test business. Now I'd like to turn the call back to Sue for some additional financial detail on the quarter. Sue?

[Susan E. Knight:]

Thank you, Jeff. My remarks today will summarize our third quarter results based on a year-over-year comparison. As Jeff commented, third quarter revenue of $145 million was in our expected range and we were pleased with the 8% growth. Adjusting for currency, the growth was 7%. Both Test and Sensors delivered top line growth this quarter, as the beginning of period backlog was high and short-cycle orders received in the quarter were converted into revenue. Looking more specifically at revenue by business. Sensors revenue of $27 million was strongly up growing 11% compared to last year, and adjusting for currency, the growth was 9%. Regionally, all geographies had double-digit growth. The Americas increased 12%, and Europe and Asia were up 11% and 10%, respectively. Test revenue of $118 million increased 7%, and adjusting for currency, revenue was up 6%, and it was backlog-driven. Test revenue result reflects our efforts to re-prioritize engineering resources to work on the relatively high amount of custom and engineered to order work in backlog. We will continue to do so in the fourth quarter as well. Next, I will comment on the third quarter restructuring charge. In our second quarter call, we indicated that there was estimated to be up to $1 million of restructuring costs for a total of approximately $6 million year-to-date. The actual was $1.5 million for a total of $6.3 million. These actions were primarily related to a Test reorganization that will result in $7 million of annualized savings. Of the $1.5 million third quarter charge, $600,000 was in cost of sales, $800,000 in selling and $100,000 in G&A. Now moving on to the rest of the P&L, I will first explain the GAAP financial results, which includes the restructuring costs followed by a summary of the non-GAAP results, so the operating performance is clear. Including the $1.5 million pretax restructuring charge, gross profit of $58 million was up 6% compared to the prior year, and the gross margin rate as a percent of revenue was 39.7%. EBIT was $17 million, up 3%, and earnings per share of $0.92 increased 28% year-over-year. Now I'd like to transition to the non-GAAP operating results comparison. Gross margin on an operating basis was $58 million, increasing 7% on 8% revenue growth, and the gross margin rate was essentially flat at 40%. A slight rate improvement in Test was offset by a lower comparative rate in Sensors. More specifically, Sensors growth margin increased 3% to $15 million on 11% higher revenue. While the Sensors gross margin rate remains very strong at 54.7%, it was down 4 points from the prior year. A mix shift that includes more mobile hydraulic and certain lower margin industrial Sensors was the primary reason for the decline. We expect that this relative mix will continue in future quarters as we aggressively pursue the higher volume, mobile equipment applications and continue to implement design and manufacturing initiatives to increase margin results. Test gross margin increased 8% on 7% higher revenue. The gross margin rate increased 40 basis points compared to the prior year. This margin rate reflects the favorable impact of volume leverage and lower variable compensation expense, which was mostly offset by the high mix of custom backlog that impacted the rate by approximately 2 points, as well as operating inefficiencies associated with scaling our business operations for the current backlog and future growth prospects. We are working very hard to improve our efficiency, but we expect this to be a headwind for the next couple of quarters. My next topic is operating expenses. Expenses were up $1.2 million or 3% from higher selling cost. This increase was primarily attributable to the 17% order increase in Test in the third quarter. Generally speaking, sales commissions are paid on orders and not revenue. R&D and G&A expenses were flat compared to last year. And as a percent of revenue, operating expenses were 27%, which compares favorably to 28% last year. This rate was within our normalized range of 27% to 29%. EBIT increased 12% and all of the increase was attributable to Test. The gross margin increase was partially offset by the higher selling costs that I previously mentioned. The Test EBIT rate increased 1 percentage point compared to 10% last year, and Sensors remained strong at 21%, but down from 23%. Now I'd like to provide you with some context about our 18% tax rate in the quarter. The rate was favorably impacted by a benefit associated with new U.S. R&D tax credit guidance that was issued late last year. Having completed our analysis in the third quarter, we were able to realize a tax benefit of $2.6 million associated with fiscal years 2011 through 2013, which favorably impacted the rate by approximately 15 percentage points. This change will also result in an annualized tax rate benefit of approximately 2 points, assuming that the R&D tax credit, which is currently expired, is reinstated. Earnings per share was $0.92 on a GAAP basis and includes $0.07 from the restructuring cost and $0.17 from the R&D tax benefit. This compares to $0.72 in the prior year which is an increase of 28%. The growth is 14% when you exclude both the restructuring costs and the tax benefit. Finally, I'd like to conclude my remarks with a summary on cash. The cash balance remained strong at $57 million, and the net debt level is $8 million. In the quarter, cash increased $13 million driven by $25 million of operating cash flow. We paid out $5 million in dividends and spent $7 million on share purchases. Capital expenditures were $6 million, and $15 million was spent to acquire Roehrig Engineering, which was previously announced and mentioned by Jeff. Our year-to-date operating cash flow of $49 million compares favorably to $2 million in fiscal '13. We are pleased about the improvement in cash flow this year. That concludes my remarks for today. I'll turn the call back to Jeff for his final comments. Thank you.

[Jeffrey A. Graves:]

Thanks, Sue. Before going to Q&A, let me just clarify again as we put in the earnings release, our guidance range for the full year EPS is $3.20 to $3.35. I may have misspoke and said $3.30. It's actually $3.35. So the earnings release is correct. Just to clarify my statement here, $3.35 is the upper end of the guidance range. So with that, Anthony, we'll open it up for Q&A.

[Operator:]

[Operator Instructions] And we'll go first to Jim Ricchiuti at Needham & Company.

[James Ricchiuti:]

Just a question on the service portion of the business. Can you say what it represented in the quarter? And I don't know, Jeff or Sue, if you have the margins that you saw in service in the quarter?

[Susan E. Knight:]

On the total business, service represented about 13% of the revenue and the gross margin rate, and this information is in our Q, the gross margin rate was 40%. That was flat with the 40% we saw in the third quarter of fiscal '13, and it is typically our lowest margin quarter. Because when we have ratable contracts over a 12 or 24 months period, the work isn't necessarily performed ratably and we've got a lot of work flow in the third quarter, so that 40% is typical for Q3. And that puts us at a 42% rate year-to-date compared to a 43% rate in fiscal '13.

[James Ricchiuti:]

Got it. And you alluded to some operational inefficiencies and higher OTs to rework. Can you talk a little bit about how you see that improving? It looks like it's going to continue for the next 1 to 2 quarters. I wonder if you could just put a little bit more color around what's happening there?

[Jeffrey A. Graves:]

Sure, Jim. Let me take that, and then, Sue, if there's any detail you would like to add, you're welcome. So the only headwinds we really have, Jim -- we're very pleased with orders performance. Our markets are strong, we're winning a lot of business. The business that we're preferentially winning right now is the more customized or engineering-rich products, and those typically have a slightly lower gross margin. But I would tell you, they also fuel a lot of our learning, our R&D aspect and they're great for our brand, they help us fully penetrate a laboratory, so it's very good quality work all in. The challenge for us has been really the demand for engineers to execute the projects and the resulting inefficiencies. So we've had to redeploy a lot of engineering to execute those projects in the factory. At the same time, where we put in a lot of new IT tools over the last couple of years and we're just implementing those and are modifying our business processes to adapt to them. So it's kind of -- to use the overused phrase of a perfect storm, we've got -- at the same time, we've got some of the most complicated projects coming through our factory and history at the highest volumes in history, we're working on new business processes to fully use the IT tools we put in place. So all in, I would tell you the mix effect is truly unpredictable in the future. It's great to have customers ordering these things that we are particularly well positioned for. It's great. I hope that continues forever. In terms of the inefficiencies, we're guessing it's a couple of quarters to really fully implement the new business processes to use the IT tools we have in place and to adjust our engineering workforce to accommodate this higher engineering-content product. So that's -- all in, the couple of quarters is obviously rough guidance, but I would expect it to improve from here.

[Operator:]

[Operator Instructions] We'll go next to Liam Burke at Janney Capital Markets.

[Liam D. Burke:]

Jeff, you have restructuring charges this quarter. As you pass through 2014 looking into '15, do you anticipate a cleaner look in '15 on these expenses? And looking at how the order turnover will improve going into '15, it looks like, after the first quarter, it'll be a little cleaner.

[Jeffrey A. Graves:]

Yes, on the first bit of it, Liam, certainly. I mean, we knew coming into this year that we were doing -- we're going to do a lot of restructuring because of these IT tools we put in place. We had planned that. And as we work through the year, we had hoped it would be a couple of quarters. It ended up being a few quarters as we adapted the organization structure to use the tools. So it took a little bit longer, but we wanted to be thoughtful about it. So I would tell you, that's largely behind us. I would expect no significant restructuring from those changes in the future. The product mix is really interesting, because I've been surprised all year long at the -- just our success in winning these orders for the engineering-rich testing equipment, and it's been fairly astounding. I -- we had a good year -- a very good year on -- from order standpoint last year and it's just -- the momentum has continued as we go into this year and work through it. So -- and Ground Vehicles particularly has been very, very strong. So I don't have an ability to predict what customers are going to order. I would assume over time, it'll all go back to normal kind of historical averages. It's just the pace at which that happens, Liam. So it's lovely to be winning this business. It's terrific. I clearly -- our engineering expertise is highly valued in the market right now, so that's lovely. I hope that continues forever. And over the long term, as we move through next year and beyond, my guess is, at some point, it returns to the normal historical mix. We've invested in the past a lot of money in standard products and more products that are configured to order rather than engineered to order. So at some point, those will get increasing traction in the market and grow faster than the more customized products. But right now the demand is really on the customized end.

[Liam D. Burke:]

Great. And Sue, it looks like free cash flow bounced back nicely in the quarter. Do you anticipate full year being somewhat more normal for MTS rather than what you saw last year?

[Susan E. Knight:]

Clearly, we're on track to deliver a much different outcome in '14 than we did in '13, and I think we're very transparent about the headwinds we had last year with terms and conditions, as well as our mix that drove a much lower level of advance payments. But we're happy with the result year-to-date, and certainly, on a comparative basis, that's true.

[Operator:]

[Operator Instructions] And at this time, it appears we have no further questions in the phone queue. I'd like to turn the conference back over to Dr. Graves for any additional or closing remarks.

[Jeffrey A. Graves:]

Thanks, Anthony. So in conclusion, we've significantly increased our orders growth rate in the quarter and year-to-date for both businesses. We're proud of that accomplishment. It's a strong step on the path toward achieving our objective of double-digit revenue growth annually. Equally important, we must become operationally excellent as we grow. Our Test operational performance is not what we expected it to be in the quarter and the record backlog, level and mix will continue to challenge us in the short term. We're aggressively tackling underlying issues so we can successfully scale MTS and fully realize our potential. With this focus, I'm optimistic that these growing pains will begin to abate as we look to the year ahead. We look forward to speaking with you again next quarter. Thanks, and have a great day.

[Operator:]

And this does conclude today's presentation. We thank everyone for their participation.