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MTS Systems (NASDAQ:MTSC)

Q4 2012 Earnings Call

November 16, 2012 10:00 am ET

Executives

Susan E. Knight - Chief Financial Officer and Senior Vice President

Jeffrey A. Graves - Chief Executive Officer and Director

Analysts

John Franzreb - Sidoti & Company, LLC

Liam D. Burke - Janney Montgomery Scott LLC, Research Division

Michael A. Hamilton - RBC Wealth Management, Inc., Research Division

Chris McDonald - Kennedy Capital Management, Inc.

Operator

Good day, and welcome to the MTS Fourth Quarter 2012 Earnings Release Conference Call. Today's conference is being recorded.

And at this time, I'd like to turn the conference over to Ms. Sue Knight, CFO of MTS Systems. Please go ahead, ma'am.

Susan E. Knight

Thank you, Chris. Good morning, and welcome to MTS Systems Fiscal 2012 Fourth Quarter Investor Teleconference. Joining me on the call today is Jeff Graves, President and Chief Executive Officer.

I'd like to remind you that statements made today that are not historical facts 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.

The presentation may also include reference to financial measures that 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.

Jeff will now begin his update on our fourth quarter results.

Jeffrey A. Graves

Thank you, Sue. And good morning, everyone. Thank you for joining us today for our fourth quarter investor call. It's a pleasure to share our financial results for the fourth quarter of fiscal '12 and guidance for fiscal '13, with you. I'm also excited about the opportunity to discuss our $1 billion revenue goal.

For today's call, I'll first discuss the key takeaways for our business and provide some perspective on our end markets and fourth quarter orders. Sue will discuss the quarterly financials in more detail and provide some summary comments on the full year results. Following Sue's comments, I'll finish the call with our guidance for fiscal '13 and our strategy to achieve $1 billion in revenue on fiscal '18. We'll then open the call for your questions.

There are 4 key messages for today. First, we had another good quarter that was once again driven by our Test business. Despite continued softness in Sensors and headwinds from currency, we delivered double-digit orders growth and 5% revenue growth. Earnings per share were flat, reflecting continued aggressive investments in R&D and processes and systems to scale the business. Operating cash flow of $13 million net of the $8 million government settlement payment was very strong.

Second, we had an excellent full year in fiscal '12, achieving record highs in all of our major financial metrics, including orders, revenue, earnings per share from operations, operating cash flow and return on invested capital, or ROIC. Additionally, we had significantly improved our compliance and control environment, met our obligations under the administrative agreement and settled the government matters. I feel very good about this performance and our leadership team at MTS.

Third, our revenue and EPS growth for fiscal '12 was within our outlook range for the year, achieving 16% revenue growth and 14% growth in EPS from operations.

Fourth, while we remain cautious about the global economy and the fiscal challenges that many governments face around the world, we're forecasting 5% to 10% revenue and EPS growth in fiscal '13. This represents a solid continuation of our momentum on the heels of an excellent fiscal '12 and the next key step in meeting our $1 billion revenue objective for fiscal '18. Sue and I will discuss these topics in more detail beginning with Q4 orders.

Total company orders were up impressively to $147 million, 11% over last year. Adjusting for currency, orders increased 14%. Consistent with the year-to-date quarterly trend, the growth was driven by Test, which was up 15%. These results were partially offset by an 8% decline in Sensors. Backlog reached a record high of $299 million, up $10 million compared to the prior year.

Now I'll provide you with some additional color by business, and I'll begin with Sensors. Sensors orders were $23 million, down 8% as previously mentioned. Currency was the primary cause of the decline. Of the $1.9 million decline, 70% was currency-related. The remaining 30% difference was the net result of continued weak industrial demand in global energy, China steel and U.S. mobile hydraulics markets, partially offset by a strong European mobile hydraulic market in road building and agriculture machinery and stronger results in the U.S. medical market. In total, industrial orders declined 10% while mobile hydraulics orders were down -- or grew 11%. Regionally, Asia was down 1%, while Europe and the Americas declined 9% and 10%, respectively.

From a customer perspective, of the 2,500 customers that placed orders in Q4 with our Sensors business, which was 47% of our total customers, it was almost a 50-50 split between those who ordered more this quarter than last quarter and those who ordered less, a clear signal of the erratic and uncertain economy. On a positive note, orders from new customers and/or applications accounted for over $5 million this quarter.

While new customers generally do not order large quantities of sensors immediately, they generally collectively create a steady growth in demand over time as their new product platforms gain traction in the market. Backlog at the end of the quarter was $13.8 million, down 5% from last quarter. In summary, Sensors continues to be negatively impacted by currency and volume-related end customer demand. We continue to add new accounts, which are partial offset to the volume decline. Additionally, we believe these new wins will add to our long-term success as the global economy improves.

Now I'd like to spend a few minutes on Test. At $124 million, Test orders were up $16 million or 15%. Excluding currency, orders increased 17%. This quarter's results include one large $20 million seismic order in Asia. Base orders of $103 million were strong, but down slightly from $107 million in the prior year. Geographically, Asia was the bright spot once again this quarter, accounting for 56% of total orders in our Test business.

In addition to the large structures order, materials and ground vehicles were also strong in Asia, up 48% and 23%, respectively. China, comprising roughly 1/3 of our total Asian Test business, continues to be a very positive story with orders up 18% year-over-year, led by a strong materials testing market. MTS is well positioned in China and other emerging Asian markets, and we look forward to continued growth in this market.

The Americas orders were down 22% across all markets for our Test business, as our customers really focused their energies on their Asian development challenges. Meanwhile, Europe was up 2%, including a 7% point negative impact for currency. Excluding currency effects, 9% base order growth in Europe, driven largely by the materials market seem like a reasonable performance given Europe's severe economic fiscal uncertainties.

From a market perspective, ground vehicles declined 5% to $50 million. Materials was $43 million, a 15% increase. And structures grew 78% to $31 million, driven by the $20 million seismic order I previously mentioned. Within our ground vehicles market, strong demand for tire testing systems in Asia continues. Growth in materials was driven by global demand for our recently launched Criterion product family, which is being very well received and high temperature testing demand from contract Test labs to support aerospace and automotive OEM product development efforts.

In our structures market, we won, as previously stated, a key order for a seismic system that will be used for advanced earthquake research in Asia. Large-scale testing systems and methods are a real strength of MTS, and we were selected because of our proven capability and industry-leading offerings. With the tragic loss of life and property from earthquake and other mega storm-related events of recent years, we expect research in this area of civil construction to remain significant and the market for MTS products to remain strong for some time to come.

Backlog in test was $285 million, up 5% year-over-year and sequentially. It's a new record and a strong starting point for our fiscal '13. The Test pipeline, which is defined as orders that could close in the next 12 months, continues to be strong and is a leading indicator of our business. At $765 million, it's up 11% year-over-year and 5% on a sequential quarterly basis. The increases in base orders are good indication of the overall health of our Test business markets.

In summary, for our Test business, it was another strong quarter for orders despite some currency headwinds. Our backlog position and our robust pipeline indicate that Test is well positioned to have another good year in fiscal '13 barring a significant economic decline or disruption, as our customers need testing capability and capacity to meet the product requirements of an ever-changing world.

Now I'd like to turn the call back over to Sue to add further detail to the Q4 and full year fiscal '12 performance. Sue?

Susan E. Knight

Thank you, Jeff. My remarks today will summarize our fourth quarter results based on a year-over-year comparison. I will also provide a brief overview of over our full year results, and I'll begin with the fourth quarter.

Revenue in the quarter was $137.8 million, another strong quarter, with approximately $4 million lower than last quarter and typifies the variability in quarterly results that's driven by the nature of the test project-based business. Year-over-year revenue grew 5%, including a 3 percentage point unfavorable currency impact, primarily from the euro. Again this quarter, growth in Test was partially offset by a modest decline in Sensors that was driven by soft end customer demand.

On a segment basis, Sensors revenue of $24 million declined 10%, 6 percentage points of which was currency related. Geographically, Europe was down 17%, impacted by both market demand and currency. The Americas revenue was down 3%, and Asia was flat, which was an okay result given the overall sluggish global economy.

Test revenue of $114 million was very good on strong quarterly base orders and a high beginning of quarter backlog of $272 million. The year-over-year growth was over 8%, including a 3 percentage point negative currency impact. Geographic perspective, the Americas and Europe had significant increases, 37% and 17%, respectively. Test revenue in Asia declined 10%, driven by the completion timing of large custom projects, which does cause variability in the results when comparing a single quarter's performance. Overall, revenue results were within our expected range.

The next topic is gross profit. At $57 million, gross profit increased 1% on 5% revenue growth, impacted primarily by the volume decline in the higher-margin rate sensors business. Sensors was down $2.3 million or 16%, relatively strong performance in light of a 10% revenue decline. The gross profit in Test increased $3.2 million or 8%, which equals the revenue growth. The benefit of volume leverage was the offset by a mix impact and an increase in the number of technical and support service personnel as part of our service growth initiative.

The gross margin rate was 41.7%, down 1.3 percentage points compared to the prior year. The Sensors rate declined 3.5 points to 54%, which is still a very good margin rate. Approximately 2/3 of the decline was volume related and 1/3 was due to higher indirect factory expenses, including warranty and the year-end physical inventory adjustment. Test gross margin rate was essentially flat at 39.1% and within our normal range considering mix and volumes.

Moving on to operating expenses. Costs were $35.8 million, an increase of $500,000 over the prior year. Legal expenses declined approximately $2 million, due to the conclusion of the government investigation and settlement of the outstanding matters. This reduction was more than offset by our continued investments in processes and systems to increase productivity, enable our growth with expanded sales coverage and achieve scale to meet today's and future business requirements.

The Test revenue volume is almost 50% greater than it was only 2 years ago, and the backlog and opportunity pipeline remains strong, so these investments are critical. Additionally, R&D increased approximately $1.6 million or 36%, driven by Test programs. As a rate to revenue, operating expenses were 26%, down 0.009% on higher volumes and at the bottom of our expected range of 26% to 27%.

The next topic is EBIT. EBIT increased 2% to $21.6 million, less than the 5% revenue increase, due to the previously discussed lower gross margin rate in Sensors and slightly higher operating expenses. As a rate to revenue, the EBIT rate was very strong at 15.7%, relatively flat compared to last year's rate of 16.2%.

Tax rate in the quarter of 28.6% was lower than our typical quarterly rate, which is in the low- to mid-30% range, and lower year-over-year by about 1 percentage point. Approximately 2 percentage points related to the benefit of cash repatriation from higher tax rate jurisdiction, and the remaining variance from favorable geographic earnings mix. Earnings per share was $0.94, flat compared with the prior year. Revenue volume and mix contributed $0.06, which was offset by higher planned expenses of $0.10. A slightly higher share count had a $0.02 negative impact on earnings per share compared to the prior year, and a lower tax rate added $0.01 of additional earnings.

My last topic before I transition to a high-level summary of the full year is cash. The cash balance at the end of the quarter was $80 million, a decline of $66 million. Operating cash flow of $13 million was very good, net of the $8 million settlement payment to the U.S. government. Results include a $5 million decrease in working capital, primarily from a $7 million or 35% advance payment associated with the large $20 million order that Jeff previously discussed.

Capital expenditures and dividends were each $4 million. There were 2 large financing expenditures this quarter. The first, the $35 million for the previously announced accelerated share repurchase program and $40 million to pay off our debt. At this time, paying down the debt was a good use of a low-yield cash asset. Additionally in the fourth quarter, we established a new $100 million credit facility to replace the existing $75 million credit facility that was scheduled to expire in December. This gives us access to capital at attractive rates for the next 5 years to fund our growth as required.

Finally, I'd like to briefly recap the fiscal year from a financial perspective with 3 noteworthy messages. The first message is about our growth. We delivered very strong growth and record highs in orders, revenue, earnings per share from operations, which is non-GAAP, and operating cash flow despite a volatile global economic environment and net of investments needed for long-term growth. We attribute this success to our differentiated market offerings in both Sensors and Test and our investment several years ago having anticipated the energy, testing knowledge demand and emerging market mega trends, so we could rapidly respond to changing customer needs, particularly in China.

The second message is about our effective cash generation and deployment to achieve an impressive 25% return on invested capital, including the previously mentioned settlement charge. We generated a record $65 million of operating cash flow, which is almost 50% more than our historical best year ever.

We increased capital expenditures by about 50% to $16 million, making investments in productivity and scale. We returned cash to shareholders through a 20% dividend increase and a $35 million accelerated share repurchase program, and we repaid $40 million of borrowings, reducing our debt to 0.

Our third and final message is we achieved our beginning-of-year outlook for the year despite weaker-than-expected end market demand in Sensors. That included 16% revenue growth against the guidance outlook of low-double digit growth and 14% earnings per share growth from operations, compared to a low-double digit growth outlook. In summary, we are proud of what we've accomplished in fiscal 2012, thanks to the dedication and excellent work of our employees around the world.

That concludes my remarks. Now I'll turn the call back to Jeff for his final comments.

Jeffrey A. Graves

Thanks, Sue. Having executed to our commitments for fiscal '12, I'd like to fast forward to our longer-term goal for MTS, namely to become a $1 billion company. Since my arrival at MTS 6 months ago, I've traveled extensively to meet our key customers and our employees around the world. Most importantly, I've evaluated our business model to understand if we have the opportunities and competitive advantages to create sustainable growth and shareholder value over the long term. The answer is a resounding, yes.

I believe our 2 core businesses, sensors and Test, are serving markets that offer significant growth opportunities, and we have as our customers, the key long-term winners in these markets, most of whom we've known and supported for decades. Moreover, our key customers know MTS as a technology leader who understands them and is willing to invest for their future success. Given our excellent market position and the growing need for our products and services at the world, we've established a goal of delivering $1 billion in revenue by 2018. This goal has been fully endorsed by our Board of Directors, and our management team is committed to delivering it.

This $1 billion goal means that we'll move from being a cyclic company to one that is focused on growth, attaining a sustainable rate of over 10% compounded annual growth over the next few years. Our 3 priorities to achieve this goal are: Number one, accelerating innovation; two, capturing the opportunities in the rapidly changing emerging markets; and three, realizing the potential of the Test Services business. Achieving our $1 billion goal requires that some things remain the same, while other things change.

Unchanged will be our customer intimacy philosophy, which gives us unmatched insights to our key markets and allows us not anticipate the future needs of our key customers and our commitment to ensuring ethical behavior and corporate compliance every day. Also unchanged will be our determination to be the innovation leader in each of these markets, a reputation that we carry with great pride and one that is strongly associated with our MTS brand around the world. This culture of innovation is the cornerstone for our new mission statement with which every employee is aligned.

Very simply, our mission is to be the innovation leader in creating Test and measurement solutions to enable our customers' success. Our vision for MTS through innovation, create value to drive growth is embedded deeply in the DNA of our employees around the world. The essence of our mission and vision is unchanged from the past. Indeed, it's been with us since our founding almost 50 years ago. But stating it clearly and publicly is an effective way to tell the world what MTS is really about.

While many things will remain unchanged, there are some things that are changing as we transform the company to accelerate growth. First and foremost, we will accelerate our pace, as the pace of innovation, the pace of customer responsiveness and the pace of organizational change to respond to the rapidly changing marketplace in which our customers now operate.

Second, we'll leverage our outstanding market position, geographic footprint and installed base to generate more growth from Test Services and our expanded static testing product line. In Sensors, we'll capture the emerging market opportunities, particularly in China, and bring new technology solutions to solve our customers' measurement needs.

Third, we will invest more money in the near term, putting our strong balance sheet to work to hire, develop and expand our global talent base and build the processes, systems and infrastructure required to be a $1 billion global enterprise. While these investments are significant, given that our growth opportunities are largely organic in nature, we believe they will yield meaningful shareholder value in the future. I'm very confident about our ability to achieve this $1 billion goal and excited to be leading this transformation to accelerate growth at MTS.

Looking at fiscal '13, I'd like to spend a few minutes on our guidance for the fiscal year and provide a little more insight into the quarterly progress we anticipate. From a global economic perspective, like most companies, we're anticipating either a bust or a boom or rather a continuation of the slow growth environment that we experienced in fiscal 2012. We've proven that we can grow in these conditions as our customers continue to make capital equipment investments to enable their emerging market competitiveness and local infrastructure expansion, preserve and source synergy and develop innovative products for their evermore complex global customer base.

Of particular note, over the next few years, is accelerating the pace of change -- is the accelerating pace of change in the Chinese market, a particular strength for our company. While the growth of modern manufacturing infrastructure in China is commonly discussed and has helped MTS grow rapidly in China in recent years, China is now also experiencing rapid changes in their consumer marketplace with increased discretionary spending driving strong demand for new automobiles and the desire for expanded travel by air and high-speed rail. Product developments in all of these areas is robust in order to meet these demands. There's also a tremendous migration of the Chinese populace from farms to cities, requiring the construction of new high-rise buildings and other civil infrastructure to accommodate this influx.

This urbanization in the face of recent tragedies from earthquakes and related seismic and mega storm events has created a much greater demand for research and building design and construction in China. MTS is well positioned to respond to this need as the long recognized leader in civil seismic testing systems and methods. Additionally, China aspires to export products that meet global performance standards, which is creating sensor opportunities as more technically sophisticated machinery is now produced. And we expect these trends to continue both within China and more broadly in the developing nations, and the support continuation of order growth in our core businesses in the new year and beyond.

Thus, our outlook for revenue growth compared to fiscal '12 is 5% to 10%. While the single largest variable underlying the range is the global economy and what it will actually do, the fundamental growth drivers for MTS remain intact and very positive. As this is the first year of our plan to achieve $1 million in revenue in 2018, it will take some time to build up to the compounded annual growth rate of 11% that's inherent in that longer-term plan.

Regarding earnings per share, our outlook is 5% to 10% growth compared to fiscal '12, which is the same as the revenue growth range. We're using the incremental benefit of volume leverage to accelerate critical investments, which I've previously discussed. Capital spending is expected to increase from $16 million or 3% of revenue to $25 million or 4% of revenue in fiscal '13. The primary increases are for Test services' delivery and sales support, IT systems and Sensors manufacturing automation, which are the key to enabling us to achieve our growth goals. These initiatives began in fiscal '11 and '12 timeframe and are well underway. A lower share count from the accelerated share repurchase program, slightly lower tax rate and lower interest expense as a result of paying off our debt, all contribute to the earnings growth outlook.

I'd also like to share some context about our financial profile by quarter. We do not expect the growth to be linear throughout the year. In particular, and despite of record beginning backlog of $299 million, we expect first quarter revenue growth will be modest at 1% to 3% due to the timing of Test custom projects and the continuation of soft economy for Sensors and markets. This modest growth combined with accelerated investment pace will result in earnings per share of $0.72 to $0.82 in the first quarter of the year. We do expect the second half of the year to be stronger than the first half and slightly more skewed to the second half of the year than in previous years, with 52% to 54% of the full year revenue compared to 51% in fiscal '12. This is due to test customer delivery schedules and order timing and an anticipated stronger second half global economy.

Similarly, we anticipate earnings per share in the second half of the year will be 55% to 57% of the full year based on volume and timing of investment spending. This compares to 55% in the second half of fiscal '12. Overall, our experience in fiscal '12 and our robust opening backlog position, give us confidence in our outlook at this time. However, as always, we'll be closely monitoring our markets for changing conditions so that we can make adjustments as required. We look forward to updating you on our progress as the year progresses. It's an exciting time at MTS.

That concludes my prepared remarks. Chris, I'll turn the call back over to you to start our Q&A.

Question-and-Answer Session

Operator

[Operator Instructions] And we'll take our first question from John Franzreb of Sidoti & Company.

John Franzreb - Sidoti & Company, LLC

Jeff, I applaud you for reinstituting the guidance, and I really want to start right there, because if I just do some simple math, it looks like on a sequential basis, that revenues in Q1 will be pretty similar to what we just had in Q4, but the profit profile is substantially lower. It sounds to me that you're signaling that it's all expense related and not mix-related. Is that the case and how much more of incremental expenses are we looking at?

Jeffrey A. Graves

Yes, John, you got it right on the button. So our revenue is -- we're projecting up modestly from Q4. So we said 1% to 3%. EPS drop is entirely due to our investments for growth.

John Franzreb - Sidoti & Company, LLC

So if I kind of quickly annualize that, we're looking like an $8 million headwind from investments in fiscal 2013, is that a ballpark-type number?

Susan E. Knight

John, I think that's at the high-end, we're looking at $6 million to $8 million.

Jeffrey A. Graves

Yes, annualizing the Q1 level, John, is probably too aggressive. So to Sue's point, it drops throughout the year. It's front-end loaded because of hiring and training needs.

John Franzreb - Sidoti & Company, LLC

Got it. I didn't quite catch the order book number for Asia in total. How much was up for the company year-over-year, Sue, when you said that or Jeff have kind of said it. Whats was that number again?

Susan E. Knight

For the year, John, or the quarter?

John Franzreb - Sidoti & Company, LLC

For the quarter.

Susan E. Knight

Let me just look back at the number. At the company level, we didn't talk about total Asia. Test was the big driver for Asia, was -- no, we didn't highlight that number.

John Franzreb - Sidoti & Company, LLC

Okay. You said that China was up 18%. I guess what I was going to drill down to is why was America so weak in the order bookings?

Jeffrey A. Graves

Yes, we were -- we've been talking a lot about that as well, John. It's weaker than you'd probably expect this from kind of macroeconomic factors. But our conclusion, and it's just based on what we're -- just from discussions with customers, is they're really focusing most of their invesment around growth in Asia. And because that's where the consumer base is growing, that's where a lot of the spending is and the new product needs are. So they could very well be American companies, but they're growing over there and that's where most of their investments. So it's where a lot of our sales are. So I view it that way. I think America's economy was much like the headline said. But if you look at their investment profile, it was just more driven by their investments in Asia.

John Franzreb - Sidoti & Company, LLC

Okay. And sticking to the geographic theme here, you talked about the opportunity pipeline. Is it equally strong in Test in Europe? Or is there any concerns about the Europe spend rate right now?

Jeffrey A. Graves

Well, it's a little complicated because we've got some very global customers that are spending a lot of money in Asia, but they are headquartered in Europe. So we classify our orders based on the geographies that the first order is received at. And so we can call it Asian, it could still be driven out of Europe. I think our customers are certainly facing big headwinds in Europe like everybody is from a production standpoint, and capacity utilization is off. But from an R&D standpoint, the markets we play in are very, very strong. So Europe for us has still been a good story because they continue to invest in product development and R&D over there.

John Franzreb - Sidoti & Company, LLC

Great. One last question. What was the shares at the end of the quarter? What's the current share count standing at right now?

Susan E. Knight

About 15.8 million.

Operator

And we'll take our next question from Liam Burke from Janney Capital Markets.

Liam D. Burke - Janney Montgomery Scott LLC, Research Division

Jeff, part of your growth, or one of the pieces in your growth strategy, are the Test Services business for -- to support a fairly extensive embedded base. Could you give us a sense on what the -- or how do you feel it did on a start-up basis in 2012 and what's the outlook for 2013?

Jeffrey A. Graves

Liam, I would tell you, we run today $65 million in what we call services today, which is a combination of parts and services we provide. And frankly, we're definitely the person they call when they have an extreme issue. And we go in and help them or there's a unique part type. That's about 15% of our revenue if you do the math. What we believe that number really should be, frankly, if we were pursuing services in a way that we should like many companies do, is about 30%. So that number as a percentage of revenue should be 30%. If you look at our growth, that $65 million should be north of -- well north of 100, probably north of $150 million if we're actually doing it right and realizing the services from our installed base. So we've got a tremendous opportunity. We have to approach it differently, which we've organized ourselves to do now and we have to hire and train a lot of field engineers to go after it, which we're in the process of doing. We started actually back in '12 -- in fiscal '12 and will continue aggressively in '13. We've estimated, Liam, and just as a rough number to calibrate you, our customers are spending probably -- for our $3.5 billion installed base of equipment, they're spending probably $0.5 billion of expense revenue a year to service the equipment. We capture a very small percentage of that. And so that's really our target. That's what we're going after and training our service folks to do. And we're also designing our equipment for serviceability now and really embracing this whole services model, which I think is largely untapped from the past year.

Liam D. Burke - Janney Montgomery Scott LLC, Research Division

So do you anticipate being able to make any progress towards getting more of that $500 million market -- in 2013, excuse me.

Jeffrey A. Graves

'13 yes, it will be, but it certainly won't be linear. I mean, we've got our -- I just met with 2 teams of people coming through for training the last couple of weeks and it's -- our equipment is very technical, and it requires a lot of training and there's a pretty steep learning curve. So -- and we'll certainly see an improvement in '13. I can't give you a number. We'll see an improvement in '13 on a percentage basis of revenue. And obviously, revenues were up, so that's good. But the real benefits, Liam, I would expect in year 2 and 3. I think by the third year, the progress will be very clear and you'll see what kind of a growth rate we're on.

Liam D. Burke - Janney Montgomery Scott LLC, Research Division

Okay. Great. Thanks, Jeff. And on the Sensors side, you've discussed, in 2013, you'd expect that to be weak as well, as it had been in 2012. Is there any particular geography or application that you see weakness? Or is it just across the board?

Jeffrey A. Graves

Well, I can tell you, in my time, the industrial equipment business certainly hit the skids first and those are things like plastic injection molding machines and steel processing equipment, things like that. So that's been down with the overall economy. The mobile hydraulics piece is again, you've probably read the headlines around the big heavy equipment manufacturers, they've all slowed down, which means their pace of introducing new platforms has slowed down, and that's really what drives our Sensors sales. Clearly, we're making a lot of progress on landing new customers and getting designed in the products, but those products have to move into production and be sold and that's really what slowed down. It was disappointing last year. I can tell you, we had hoped for a better growth in the second half of the year. In retrospect, I feel pretty good about being flat. Aero was down slightly but -- and we held gross margins nicely in that business but -- the guys really reacted fast on the cost side and we're able to hold gross margins reasonably well. But the real problem there is on volume and we just need the economy to cooperate a bit more. So I would tell you it became, by the end of the year, broader based. We would anticipate this year is the same kind of environment in the first half of the year. In the second half, I think we'll see some improvement, based on our product adoption rates. We are landing a lot of new customers and particularly in Asia, where a lot of the manufacturing is happening now. We're seeing the Asians move from wanting to compete on price in their marketplace to compete more on technology, and then because of that, they're adapting our sensors. And that's -- it's a big, big focus of our investment around sales force and sales support, is in China specifically in the Asian marketplace.

Operator

[Operator Instructions] And we'll go next to Mike Hamilton of RBC.

Michael A. Hamilton - RBC Wealth Management, Inc., Research Division

Jeff, wondering if you could spend a little time on your feelings of components of your growth targets. What your view is on what's going to be required in taking market share or what your view is on new market activity? Obviously, you're talking a pretty healthy step up here in the outlook relative to a very long history for this company.

Jeffrey A. Graves

Yes, absolutely, Mike, and I only just hit the major components. The services thing I talked to with John and Liam on their prior questions. But again, I look at that, and truly, I think 2x to 3x growth in our services revenue from what we saw on '12 is very doable when you fast forward over the next 5 years. We have an installed base and the relationship with our customers where they would really prefer us to be doing the servicing, but we have to be staffed for it, equipped for it. We've got to have the IT infrastructure, which is often overlooked in terms of scheduling and part availability. We have to have all that in place, and that's why we're making the capital investments and the people investments we're making right now. So I think services will certainly be a cornerstone, an absolute cornerstone of our business and it's been done in many industries by many companies, extremely doable. Because I can tell you from talking to our customers firsthand, they would prefer us to do it a lot of times, but we just aren't really equipped and priced competitively to do it today. So we will participate much more significantly in that business. Our core markets, when you just walk across our end markets, you've got automotive, you've got aerospace, materials -- advanced materials that go into those products. In spite of a weak economy around the world, there is a huge proliferation of new products required because where the buying is occurring is in new geographies. So you've got more Chinese folks, Indian folks, Brazilians, that suddenly have disposable income that want to buy cars and they want to travel to see their relatives or travel out of the country. So aerospace, high-speed rail, new automotive, all of that drives R&D spending and product development. So our customers, to put words in their mouth, they look at us and say, yes, the economy may not be good, I may not be selling a lot of volume, but if I want to be positioned for future sales I better have the products that these folks want to buy. And then they need our test equipment to test those products. So fundamentally, I love the businesses we're in. I love the R&D and product development focus we have and we have a reputation for them. So all of our core businesses, I think, are positioned for growth because of the emerging markets. If you put on top of that the energy scarcity and the drive for more fuel-efficient vehicles and aircraft, you enhance that growth rates further and you add in areas like oil and gas where they're much more concerned now about testing how they drill and how they refine these products for safety and environmental concerns. It all drives the need for test. And then we see emerging markets, energy and infrastructure, those elements are really driving a great need for R&D and product development around the world. And then I'll add 2 more quick comments, Mike, and then shut up and let you ask another question if you like. But the civil seismic thing is really an interesting occurrence and it makes a lot of sense when you look backwards. You look at the tragedies that occurred in the last 7 years around earthquakes and tsunamis and tidal waves, floods, that's destroyed civil infrastructure. And you look at where the migration patterns are in the world, like for example in China, that's mirrored in India and elsewhere where you've got vast migration of people into cities. I heard numbers in the last couple of weeks of -- well, I can tell you from my own discussions in China, they're putting up a new high rise every 5 days. High rise means over 50 stories, every 5 days. You got estimated populations of a 20-plus million in China migrating to cities every year, creating a city the size of New York every single year. Therefore, they're very concerned, as they should be, about the stability of their buildings. Are they building things that are resistant to these earthquakes and flooding. Because you've seen in the press what's happened in the past and that problem just gets magnified. So they're making the smart investments in R&D in the design of buildings and materials that go into those buildings, and we're selling a lot of equipment to support it. So I'm really excited about our position in that market globally, not just in China, but these tragedies have struck everywhere in the world and we're in a position to really help out with that problem by selling them equipment that will saves lives. And then you switch to the Sensors side of the business. There is a -- if the volume comes back because of the economy, there's a good pent-up demand for more automated machinery. Our sensors go in to help automate it in a very rugged, robust way. So when the world needs more plastic injection molding or steel processing equipment, things like that, we are designed in, increasingly designed in every day and positioned to meet the demand. And then the mobile hydraulics thing in Sensors is we're really excited about because people that drive heavy -- safe -- heavy equipment that are concerned about both safety and efficiency. It can be in agriculture or earthmoving or heavy cranes, those people need smart systems. And at the heart of a smart system is our sensor that goes in a mobile hydraulic cylinder. And so that, again, we're getting design wins to a lot of those platforms. Unfortunately, the lead time is long because the platforms have to go into production and the end markets are still weak. So I'm really excited about the products we have. We're in an increasingly good cost position in Sensors. I'm just frustrated by the economy. If you look at we had a record year last year, and that was in spite of tremendous headwinds in our Sensors business. So I look at all that and say yes, $1 billion is a big goal, but we've certainly got the horsepower. We've got the technology base, the customer base and the market exposure to deliver it. So pending some calamity in the world, I feel very, very comfortable with setting the goal and being very public about it.

Operator

And we'll turn next to John Franzreb of Sidoti & Company.

John Franzreb - Sidoti & Company, LLC

Yes, you actually put up the growth rate and revenue stream over the past couple of years. I'm curious, Jeff, if the company is capacity constrained. Some of the spend that you're talking about is on the bricks and mortar?

Jeffrey A. Graves

No. No, we're fine, John, on that piece. Our investment is to make our operations more efficient. And again it's clearly -- updating our IT systems, updating our infrastructure. In the Sensors business, it's certainly automation and manufacturing to have more output from the factory because if you run the map on our Sensors business, we'll be -- again, by 2018, we'll be producing at least 3x the number of Sensors in each one of these plants than we are today, and automation is a key component of that. It's going very well, and we continue to make a lot of progress there. On the Test side of the business, it's really around productivity and efficiency of our IT systems and putting on front-end systems that help our sales force both identify and quote opportunities more quickly and making our engineers more productive through configuration tools and things like that. So it's -- basically, it's what's required for scale and productivity in the business, John. It's not brick and mortar, we're fine.

John Franzreb - Sidoti & Company, LLC

More feet on the street?

Jeffrey A. Graves

Yes, certainly. The other part of our investment is hiring -- I would tell you, it's a kind of 3 categories, but sales and sales support -- then again we sell to a very technical customer base within our customers, we sell to engineers largely. So our sales people are engineers. We have significant sales support requirements for providing engineering data and technical discussions, dialogue with customers around the world, so we're expanding that. And we also obviously, as I said, we're hiring a lot of service folks. We call them field service engineers. And again, it's a very technical position that requires 1 year or 2 to get good at. So there's an incubation period, but those are the folks who really call on customers every day to keep their equipment running better and better.

John Franzreb - Sidoti & Company, LLC

Do you have any sense of how many people you'll be adding this fiscal year, Jeff?

Jeffrey A. Graves

Oh, John, I would tell you it'll be at least in the range of a couple of hundred folks.

Operator

And up next is Chris MacDonald of Kennedy Capital.

Chris McDonald - Kennedy Capital Management, Inc.

Could you share the assumption relative to the tax rate and then also maybe comment on the potential impact if the R&D tax credit is extended.

Susan E. Knight

So typically our annualized tax rate is in the low 30%, and that range is driven by geographic mix primarily. But the R&D tax credit that's currently expired could have a benefit next year if it's reintroduced in the legislature and approved. We would get a full year benefit in '13, and we would get a retroactive benefit associated with 3 quarters of fiscal '12. So year-over-year, that would give us about a 2 point -- 1 to 2 point improvement in the rate.

Chris McDonald - Kennedy Capital Management, Inc.

Okay. And that's not assumed in the guidance, I imagine?

Susan E. Knight

It's a pretty granular point. When we look at the overall tax rate range, we would say that we are assuming, at the low end, that it doesn't happen -- excuse me, at the high-end, it's not happening. At the lower end, it would be included in the outcome.

Chris McDonald - Kennedy Capital Management, Inc.

Okay. And then the $6 million to $8 million of incremental spending in the coming year on this growth initiative, maybe first, how much of that is -- from a year-over-year comparison perspective, how much of that is offset by the nonrecurring spending associated with legal and compliance that was incurred during fiscal 2012?

Susan E. Knight

Well, certainly, the nonrecurring settlement is different. But on an operating cost basis, the compliance expenditures that we had are ongoing. And then from a legal cost perspective, we should be down $1 million or so.

Chris McDonald - Kennedy Capital Management, Inc.

Okay. How does that $6 million to $8 million -- how is that spread over the 3 areas that you discussed, just innovation and generically emerging markets, then the services expansion?

Susan E. Knight

Now that's a level of detail that I'm not prepared to get into today. But I think you can be confident that we are spending in all 3 areas.

Chris McDonald - Kennedy Capital Management, Inc.

And how...

Jeffrey A. Graves

It gets a little tricky by what you call innovation. Certainly, our sales folks and sales support people are out working with customers to develop specific solutions with them. Either you could classify that as innovation, what I usually think of through is more basic R&D spending and things like this, which is up as well. But again, a lot of other expenses here are around sales, sales support and field service engineers to grow our services business. So we have a tremendous innovation machine internally already. And frankly, we'll tune and tweak it, but we don't need significant increases in people doing R&D work, frankly.

Chris McDonald - Kennedy Capital Management, Inc.

And just relative to the measuring in the services business, specifically, where it would seem like you did have pretty good granular data there, what systems and processes do you have in place to measure the return on that investment and what's your plan as far as maybe sharing that externally with just the progress that's being made given that the investment is pretty significant and it's certainly weighing on profitability next year?

Susan E. Knight

Best measure of our return on investment will be the top line growth in service.

Chris McDonald - Kennedy Capital Management, Inc.

Okay. And that's something that we can maybe track quarterly too?

Susan E. Knight

That information is available in our quarterly filings where we separate service as a line item.

Chris McDonald - Kennedy Capital Management, Inc.

Okay. And then just since it's a new area of emphasis, what's the historical experience relative to how quickly you might start to see a return on that investment? And when do you reach breakeven, if you will, or what's a payback period-type thought process to apply to that?

Jeffrey A. Graves

It's probably -- it's really kind of hard to estimate because it's around how fast are folks trained, how quickly can they go out and start realizing revenue. The margin in that business is among our highest margin businesses today. And we assume it will remain so as we grow it. I think there's a lot of good demand out there. But in terms of return, it's really hard to put a real specific number on.

Susan E. Knight

Yes. On the people aspect, it's 1 year for them to get to, I would say, up the learning curve far enough to start paying back that investment. On the capital, we expect to achieve hurdle rates well beyond our cost of capital in the service business in particular. And that's going to take a few years to generate that kind of result.

Operator

And there are no further questions at this time. I'd like to turn the conference back over to Dr. Graves for additional or closing remarks.

Jeffrey A. Graves

Thanks, Chris. And thank you, all, for participating on the call today. I'm very pleased about MTS's performance in fiscal '12 and believe we have a promising future. We've already begun working to accelerate our pace so that we can achieve our $1 billion revenue goal in 2018. I look forward to updating you on the progress in our future calls. Thanks and have a great day.

Operator

And this does conclude today's presentation. Thank you for joining, and have a nice weekend.

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