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Executives

Susan Knight – Chief Financial Officer

Laura Hamilton – Chairman, CEO

Analysts

John Franzreb – Sidoti & Company

Liam Burke – Janey Montgomery Scott

Michael Hamilton – RBC Capital Markets

Tim O'Toole – Delta Management

MTS Systems Corp. (MTSC) F4Q 2008 Earnings Call November 14, 1969 10:00 AM ET

Operator

Welcome to the MTS Systems fourth quarter and fiscal 2008 earnings conference call. (Operator Instructions) At this time I would like to turn the conference over to Miss Susan Knight.

Susan Knight

Welcome to MTS Systems fiscal 2008 and fourth quarter investor teleconference. Joining me on the call today is Laura Hamilton, Chair and Chief Executive Officer.

To begin, I want to remind you that statements made today which 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 Form 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 calculated in accordance with the 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 substitute for GAAP measures.

Laura will now begin our update on our fourth quarter and fiscal results.

Laura Hamilton

Thank you for joining us for the call. I'm sure you're anxious to jump right in given the economic turmoil we're in, so let me just start out with the outline for today. I'm going to start with headlines. I'll talk to you about the SANS acquisition, the '08 year, both the quarter and full year orders where I think that's the best opportunity to give you some insight about the business, then close out the year. I'm going to talk to you about the challenges and opportunities we face and about '09 guidance. Then I'm going to turn it back over to Sue who's going to take you through the financial details of the quarter and the full year.

We've got four headlines for the quarter, and the first is really very strong financial performance, and I really want to highlight top line growth. If you consider the tough economy that we've experienced, especially in the fourth quarter, and the fact that there was the beginning sensor slowdown, I think this gives a good indication that the test business is strong and the company in total ended the quarter and the year strong.

Our second highlight is gross margins. We experienced both sensors and test volume leverage and test has worked through the custom issue which means we've got both feet firmly on the ground as we enter '09.

We've completed the SANS acquisition which I'll tell you more about in a minute, but this was our first acquisition in 10 years and it's a great strategic fit.

And finally, a headline around guidance. You know there's unprecedented uncertainty and what we want to do today is to share our perspective, but we're not going to give you specific guidance at this time.

Let's start with SANS. You know this is a really good news story at MTS, is the acquisition of SANS. I think you're all aware this is a Chinese electro-mechanical and static hydraulic and testing company. SANS did approximately $30 million in revenue in FY '08.

We paid approximately $44 million to acquire them and closed the deal on September 28. We worked this for two years. Over these two years we've worked the strategic value, the cultural fit, the financial outlook, integration planning and at this point we have completed the deal.

Personally, I had the opportunity to participate in the day one ceremonies in China. It was great to see the employee pride that they had in their company and the success that they built over the last ten years. It was also very inspiring to share their excitement about becoming a part of MTS. They clearly see that becoming a part of MTS is a part of their long term future.

You know we faced a lot of challenges along the way over the last few years as we worked on this and we have been tested. But at the same time, what that means is that we are more confident than ever about the strategic fit. We see this as an opportunity to accelerate our growth in China through their extensive sales and service network.

In addition, we think this helps expand our product offerings for growth in other emerging geographies. So we're off to a great start. We will incur integration costs in '09 as planned but the financial results for SANS will be in line with general test results. It will be modestly accredited in year one, but that's kind of a caveat of a normal economy and right now, things are a little harder to predict.

What I'd like to do is shift to providing you with some insight about what's happening in our world by going through Q4 and full year orders. But before I do that, I want to remind you that MTS is about singles and doubles, and like the game of baseball, if you hit a lot of singles and a few doubles you get on base. If you get on base you score runs and if you score runs you ultimately with the game.

What I'm going to talk to you about is the myriad of singles and a few doubles that MTS does to generate the kind of year over year growth that we've been delivering. From a total company perspective, for fourth quarter we did $115 million in orders which was a 7% increase over last year. Four points of that was currency, three points, organic growth really driven this time by test.

The quarter was very similar to Q3 which was $117 million although it had a little bit more organic growth. That puts the company at four strong quarters in a row, and for what generally is termed a lumpy business, this is great results in tough times.

For the year, we're at $485 million up $64 million or 15% year over year. We're really proud of this kind of performance. Five points of that is currency which means that 10 points of organic growth. We saw growth in all three geographies, but it was really led by Europe and then the America's, and Asia was more flat and more of a mixed bag. And we'll talk about that more in each of the businesses.

We ended the year with backlog of $235 million, up $30 million or 15% of opening backlog as we enter '09. Again, this puts us in a strong position going forward.

Let's go to the segments and let's start with test for the quarter. At $92 million we are up 8% year over year, three points of currency, five points of organic growth. This year we had one large order over $5 million which was about the same as last year which means that this is growth in the base business which is strong for the quarter.

From a geographic perspective, the America's are up 14% which is really kind of hard to believe when you read all the news about the American economy. So it's hard to understand but you really have to pull it apart because this is the America's which means that part of this is about Brazil and Mexico which is about the passenger car OEM business.

It's also driven in part by the U.S. government, a little of increase in terms of service or overhaul business, as well as tier one and tier two suppliers for component test systems.

In Europe we were up 52% and while a piece of this is currency, it really was driven by the motor sports business, again which can be lumpy from quarter to quarter, but also driven by Eastern European passenger car investment.

Asia for the quarter was down 33%. And we have to break this into three parts. First, on a year over year basis, there was a large order last year that wasn't repeated this year in the quarter. Given the lumpiness, there is also a piece that's around the Japan and Korean economy and there is a slowdown there. This is in part offset by China being up.

If we look at the quarter by market, ground vehicles was up 81%. Remember ground vehicles is much more than Detroit passenger cars OEM's. First ground vehicles was driven by motor sport. Next, it was driven by passenger car investment in emerging geographies; business in Romania, Brazil, Mexico and China.

From a market perspective, infrastructure was actually down 44%, again for the quarter it's more due to the lumpiness of large seismic business last year. The base materials business was relatively flat year over year. And Aero on a quarterly basis was up 3%.

For the year, we did $390 million or 15% increase year over year. Five points of that is currency, ten points organic growth. This year we had six orders over $5 million each at a total $52 million versus last year's five orders totaling $41 million. That makes about three points of growth coming from orders greater than $5 million, which means the balance of the growth is in the base business. We think that's great evidence of the execution of our strategy.

On a geographic basis, America's are up 18%. Overall, Detroit was quiet although the tier one's were strong and there's a lot of good non U.S. business in the America's.

Europe was up for the year 25%, about half of that due to currency which means strong motor sports, passenger cars OEM's both in western and eastern Europe as well as infrastructure helped drive this growth.

And Asia, for the year netted a basic flat 2% up which was really a mixed bag. Korea and Japan are down following an incredibly strong year, but they're also feeling the effects of the economy. China was up $14 million to $39 million for the year. Our focus and investment in China has paid off.

If we look at the year for test by markets, ground vehicles is up 22%. Again it really wasn't about the spending of the big three in Detroit, but it was about passenger car investment broadly. It was also up $9 million due to motor sports. Emerging markets, eastern Europe, China, South East Asia and South America and the tier suppliers in North America were all a part of this. In addition, ground vehicles also includes construction which was a piece of this growth this year.

Infrastructure was up 12%. This is really driven by investment in emerging regions as well as upgrades in established regions, particularly driven by seismic. Aero overall was down 6% which was expected because there really are no large Aero programs that have been launched in the last one to two year.

But the Aero business does come from ongoing support for programs as well as, we continue to pursue business jet, regional jet and other smaller business. Our backlog ended at $235 million, up $30 million or 15% as we enter '09. In addition, the margin in backlog is up. Mix is improved as well as selling value and we have fewer development projects as we enter '09 and we have seen no signs of cancellations.

Let's shift to sensors. Sensors orders for Q4 came in at $23 million or a 5% increase. All of the increase was due to currency which says sensors was flat for the first quarter. It's the slowest quarter in many quarters and the softness does continue into '09. If we look at this by geography, it's really essentially the same across all geographies. America's were up slightly, Asia down slightly and Europe without currency was flat.

By applications, the change we're seeing in the quarter are really a slowing in plastics and rubber as well as steel. What does remain positive in the quarter is fluid power, mobile hydraulics and wind.

If we look at sensors for the year, we came in at $96 million which was an 18% increase for the year, half due to currency and half, 9% organic growth. We saw strong growth in all geographies for the year. America is up 7%, Europe up 22% although that's aided by currency, Asia up 24%, also with a currency piece.

From an applications perspective, what was strong for the year was fluid power, hazardous liquids, steel, mobile hydraulics and medical, but what was weak was wood, all year long, and then more recently plastic and rubber and then steel just beginning to show a slowdown. What's emerging for sensors is wind. Overall, sensors backlog remained flat.

So if we step back and just summarize FY '08, we had a great year. First, we addressed the test custom projects issues and have come out stronger because of it. We've improved a number of our processes. We've strengthened our capabilities. For example, our systems engineering, and we further developed measurement and simulation technology which will add value for customers in the years ahead.

Next, we completed a very challenging acquisition which both enhanced our business acumen as well as better positioned us in the world wide materials market. We also made good progress on many R&D programs across both businesses. We've strengthened our presence in emerging markets including China, India, Brazil and eastern Europe. And we built our backlog and maintained a healthy balance sheet.

Overall for FY '08 we delivered value to our three constituency groups; customer, employees and shareholders and we did this in a tough environment. But, the environment is even tougher now.

Let's move to challenges. You know today is very different than just 12 months ago, and actually today is different from only 12 weeks ago. You know, from a macro view, the global economy has slowed dramatically; part of it due to fundamentals, and part of it due to fears. The credit markets are strained despite government intervention and access to capital is uncertain. There is record volatility today.

We see evidence of this in our business. For example, in sensors, we see slowing demand in industrial manufacturing. Our customers are tightly managing inventory and their ordering patterns are changing. They're ordering in smaller quantities.

We see tighter credit conditions and cash flow affecting customer order patterns. In test, one Japanese ground vehicle OEM recently froze all capital expenditures over $2 million for two years. And we have Korean and Canadian customers who have awarded projects to MTS, but are now waiting to place the purchase order because they're waiting to see what will happen to currencies. Essentially, they lost some of their buying power over the last 12 weeks.

Chinese customers are in the same position. Again, in China we have been awarded jobs, but they're waiting to place the purchase order. We see lots of wait and see.

So the challenges we face ahead, we face weak economic trends affecting our customer spending. The duration and the depth are unknown. We face a strengthened U.S. dollar which effectively increases prices of our U.S. exports in Europe and Asia. Many customers are pausing, slowing or stopping sending amid uncertainty and given the fact that access to credit is unclear.

So we do face a number of challenges. But we also face a number of opportunities. There's been no change at the macro level in long term trends; energy, the environment and globalization. When you put energy and the environment together, it's creating redesign for efficiency and environmentally friendly and that means opportunities for sensors and test.

When you look at globalization, it's about capability building whether that means better machines or developing product development capability, that's our opportunity for sensors and test.

When we put these all together, energy, the environment, globalization and even combine it with economic implications, there is still significant investment. One example of this is wind. In Europe, by 2020 they're trying to get to 12% to 14% of all power from wind. The U.S. Department of Energy says that getting to 20% of our power from wind by 2030 is within reach but requires trillions of dollars of investment. Today, we're at less than 1% of our electricity from wind.

And while the boom has slowed somewhat, the issues of global warming and energy security have not. A research firm, New Energy Finance, estimates clean energy investment projects at $18 billion globally. This is opportunity for sensors and tests.

If we look at these in combination, another effect is fuel efficient transportation. Hyundai Motor Company reported they can meet the proposed U.S. fuel efficiency standard of 35 mpg by 2015, five year ahead of the deadline and they're going to do this by "building smaller cars using lighter materials as well as new engine and power train technologies'. Energy means new products which requires better simulation which is opportunity for MTS.

This week, we just booked a $2 million order from a Hyundai tier one supplier who has been required to get their testing capabilities up to Hyundai's expectations. Also, fuel efficient transportation is about alternative transportation methods. Europe's tram builders, Alston, Siemens, Skoda and CASS see the U.S. as one of few fast growing markets around.

In the second quarter of '08 pubic transport was up 5% and light rail jumped 12% for the quarter. If you consider the new Obama administration, and the possible infrastructure expansion that's being considered to help the economy through this slow down, trans could be building blocks of economic revival and fuel efficiency. Environment means new products, requires better simulation and opportunity for MTS.

If we look at globalization, whether it's Pepsi's recent announcement of a $1 billion investment in China, or China governments announced $586 billion spending on housing and infrastructure, China will be a long term players. Globalization means higher meeting world standards for products. That means higher performing industrial equipment. It means improved product development capabilities, opportunities for MTS.

So as we sit here and face challenges and opportunities, fundamentally there are two strategies for survival in this economic situation. At one end, there's hunker down. Then at the other end, it's double down. Right now, MTS is working with customers who are taking advantage of these trends.

In sensors, we're targeting new applications in wind, robotics, linear motors, sheet metal and mobile hydraulics. In test we're targeting wind and other energy areas, transportation and emerging geographies. One example would be that we're currently pursuing multiple rail opportunities in China. We're also targeting fuel efficient vehicles which means materials, full vehicle impact and aerodynamics.

MTS much also choose a strategy for the downturn. Our strategy is to be conservative and tightly control spending while also taking advantage of opportunity. As I said, MTS is about singles and doubles and we can take advantage of the opportunity to create more singles which will help offset some of the other weaknesses.

Over the next 12 to 24 months, we'll also look for opportunities to accelerate our strategic priorities where we can.

So let's close with guidance. What we've tried to do today is provide you with insight about our fourth quarter performance and our strength going into '09. We talked about leveraging a strong backlog position, our balance sheet, our applications and geographic breadth, our recent acquisition, and strong fundamentals.

We tried to provide a perspective about the challenges and opportunities we face. Its tough uncertain economy but exciting macro trends. And we've shared our strategy for weathering the tough economic times ahead to come out stronger than when we went in.

Given the unprecedented volatility, current we are not giving more precise guidance. We feel it's critical that our guidance be quality guidance if we give it. At this point, I'd like to turn it over to Sue.

Susan Knight

My discussion today will focus on revenue and margin for the fourth quarter, followed by a recap of the year. In addition I will discuss our cash position at year end. I'll start with the P&L for the quarter followed by annual results.

In the quarter, revenue growth was very strong. At $124 million, a year over year growth of 14% included 3% from favorable currency. Both test and sensors delivered double digit growth as did all three geographic regions.

Test revenue was $100 million, 13% higher than last year which was a new record for the business. Of the 13%, three points was attributable to currency. The quarter included 21% growth in the America's, 8% growth in Europe and 9% growth in Asia. This geographic growth in revenue differs from the orders growth trends that Laura just discussed as revenue is always more a reflection of what's in our backlog than what orders were booked in the quarter.

From a market perspective, ground vehicles grew 9% and infrastructure was up 36% driven by the large number of seismic projects in backlog this year. Aero, our smallest market was down 23% consistent with the full trend due to the completion of customer testing for a few large commercial aircraft last year.

Backlog declined approximately $8 million or 3%. Also in the fourth quarter, sensors revenue was $24 million, a 17% increase over the comparable period last year. The growth rate included ten points organic growth and seven points from currency. Backlog was down about $1 million or 9%. Geographic demand included a positive growth in all three regions; 7% America's, 20% Europe and 26% Asia.

Moving on to gross margin, margin dollars increased approximately $7 million or 15% primarily driven by the increased revenue volume of 14%. In addition, the rate to revenue increased 40 basis points to 43.3% from an improved test margin rate of 40%. Sensors was flat at 57%.

Test gross margin increased by $5 million or 15% on 13% top line growth. The margin rate of 40% compares very favorably to previous quarters this year of 36% and 37%. We made excellent progress towards the completion of our short list of custom development projects that have negatively impacted test margin rates in previous quarters.

Last quarter we communicated that we expected that all of the projects except for two that have been delayed due to customer site readiness would be done by the end of Q4. We expect that the customers' site will be ready such that we can achieve customer acceptance for these last two projects in the first quarter of 2009. In addition, the last project that was open as of September 30 was accepted in October.

The test margin range will continue to be variable from quarter to quarter driven by our low volume and high mix of custom and standard, and also our market mix. However, the reduced number of development projects in backlog and the enhanced risk in project management processes that have been put in place, will improve future annual margins compared to the 37% rate in 2008.

Finishing up the discussion of fourth quarter gross margins, gross margins were flat but impressive at 57%. Gross margin dollars increased 18% or $2 million on 17% revenue growth.

Summarizing the results of income from operations, the majority of the $7 million margin increase contributed to the bottom line as operating expenses were only up $600,000 or 2%. We delivered $21 million of income compared to $14.5 million last year, an increase of 45%. As a percent of revenue, the operating margin rate increased 330 basis points to approximately 17% in the current quarter.

On a segment basis, test achieved a 48% increase in income from $10.6 million to $15.7 million. Sensors also had income growth delivering a 36% increase from $4.2 million to $5.7 million. Segment results included income as a percent of revenue for test and sensors of 16% and 23% respectively.

Moving on to tax, tax expense for the quarter was $7.2 million or 35% on income before taxes and discontinued operations. This compares to $4.5 million last year, or a 26% rate. The rate in 2007 benefited from favorable tax legislation primarily from a reduction in the German tax rate from 38% to 30% which was a one time benefit last year on an adjusted deferred liability basis. We do get a continuing benefit going forward of that reduced rate. It's not a one time benefit in the quarter.

Net income increased 26% to $14.5 million while earnings per share growth was 32%. The $0.85 of earnings per share is a record quarter us which was very exciting to close out the year with.

The year over year increase of $0.21 was the combination of $0.20 from improved business performance, $0.05 due to favorable currency and $0.05 from a lower share count. These increases were partially offset by $0.09 due to the higher tax rate.

I'll wrap up the fourth quarter discussion with an update on cash. We finished the quarter with $114 million, a decrease of $6 million in the quarter. Operating cash flow was $3 million net of a $13 million non recurring cash outflow to fund our German pension obligation. It was our only pension commitment and we funded it with a low return cash asset in Germany that reduces annual expenses and improves our return on investment capital.

Capital expenditures in the quarter were $3 million. In addition, we borrowed $24 million against our $75 million credit revolver to make the first payments of $14 million to SANS. As previously communicated, the credit facility was put in place last December with very attractive terms for three reasons.

The first reason was to augment our North American cash position as the majority of our cash is overseas; second, to opportunistically acquisitions and third, for share purchases. We do expect additional borrowing in the first quarter of approximately $16 million for the additional SANS payment.

So that's the end of my comments on the fourth quarter, I'd now like to move to the total year. I'll talk about all the financial results except orders which Laura has already addressed.

Revenue grew 12% or $51 million to $461 million. The 12% growth included seven points of organic growth and five points of favorable currency. Test revenue increased 9% to $364 million of which four points were currency. For the year, revenue in the America's was up 14%, Asia increased by 18% and Europe declined by 4%.

The negative growth in Europe was due to timing of projects and backlogs as their orders were up 26% in the same period. From a market perspective the results were similar to the second and third quarters, with double digit increases in ground vehicles and infrastructure while Aero was down.

Sensors delivered 25% revenue growth to $96 million. The growth rate was a combination of 15% organic growth and ten points from currency. Europe, which is our largest market, increased 23%, and the America's were up 11%. Our smallest market in Asia for sensors achieved 23% growth driven by demand in China.

Moving to gross margins, the rate for the year was 41%, down one point from 2007 driven by the higher custom project costs that I've discussed during the first three quarters and our mix of projects in the test business.

Test margin rate declined two points from 39% to 37% while sensors increased their rate from approximately 56% to 57% on volume leverage.

Income from continuing operations grew 16% or $9 million on 12% revenue growth. $5 million of that increase was from sensors and $3 million from test. The operating margin rate was flat year over year at 13%.

Net interest income was approximately flat at $3 million. Taxes were up $3 million on higher income while the rate increased 50 basis points to 28%.

Earnings per share from continuing operations grew $0.44 for a very healthy 20%. Of the $0.44 increase $0.20 is from stronger business performance, $0.13 from favorable currency and $0.11 from a lower share count. In addition, the net impact of discontinued operations associated with the sale of the Nano Instruments Product line added $0.12 per share of earnings last year.

A couple more comments on cash, operating cash flow for the year was $30 million, less than the $40 million we typically generate due to the $13 million non recurring funding of the pension liability I spoke of earlier. During the year we spent $10 million on capital expenditures, $42 million on share purchases and $14 million for the initial SANS payment.

Our cash balance of $114 million around the world remains conservatively invested in bank depositions, treasuries, and money market funds.

In summary, I just shared with you a lot of numbers and information about the fourth quarter and the year, probably too many to remember. So here's a four point condensed financial synopsis of the year.

Number one; orders, backlog and revenue were strong, including a currency benefit in a challenging economy. Number two, operating income and earnings per share grew faster than revenue. Number three, good cash flow and cash allocation, and number four, a very healthy balance sheet.

Thank you. That's the end of our prepared comments. I'll turn the meeting over for the Q&A session.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from John Franzreb – Sidoti & Company.

John Franzreb – Sidoti & Company

I want to start with the guidance. Piece this together for me. The backlog is relatively strong in both business and the order book as you pointed out has been great for four quarters, you suggested that gross margin in test is going to do nothing but improve in the coming quarters if nothing else just the elimination of some of those programs. Is the backlog that firm? Why wouldn't you have any kind of visibility in the year ahead?

Laura Hamilton

I think all the things you just said are definitely on our plus list and our backlog represents about half a year. If you just look at the last month or two of the world economy, you can't read the paper in the morning without getting bombarded with 20 more companies that are down and capital, so on the one hand we think we have all those strong points that you just made in the midst of incredible uncertainty.

So we considered how to give quality guidance and the range is just too broad to be of good use and we all need to see what the next few months brings.

John Franzreb – Sidoti & Company

October's done, we're into November, have your volumes or order book, has it dropped off substantially in the first quarter compared to the fourth?

Laura Hamilton

What we've said to you is that sensors softening started at the end of the fourth quarter and that it's continued. We believe our customers are working down inventory but to be able to decisively understand what's working down inventory and are new ordering patterns is too uncertain. And in test, I think we all know a month of test doesn't mean anything.

We have indications that some customers are placing orders and some customers are awarding them but not placing them, and others are implementing capital freezes. We have indications of all of those and that's I think similar to the general feeling outside that is, are people just taking a pause and everyone's waiting and we're all just going to resume?

It's back to depth and duration. How deep is this recession or whatever it is, and how long will it last? What we've decided is that from a company perspective, planning is the most important thing so we are working scenarios, we are being conservative on our spending, but we can't put a single stake in the ground or a band that says we can tell that we're going to land in this zone because we don't know. The top line is the most uncertain.

John Franzreb – Sidoti & Company

So essentially what you're saying is that the order book has fallen off meaningfully since the fourth quarter.

Laura Hamilton

No. Sensors is the smaller of the two businesses. We told you it was the leading indicator and we've seen some softening, so therefore there's a reason to be conservative, to think that something is happening, but to know what that is and how long that will be, nobody today can say really how long this is. What does this indicate?

In test, we just delivered an outstanding quarter and a month in test is not conclusive. But we have indications some are spending. There's clear opportunity. We have a pipeline and we've seen customers pause and they don't tell us "I'm going to pause for one week and then I'll get this order to you." They say, 'Just hold on for a minute". And we say, "Until when?" And they say, "Let's see."

I think we're no different than most people out there right now, saying, "Gee, what do you think?" So the trends are vey positive. We all know that money is going into energy and the environment, and we know that there are going to be stimulus packages and those play to some of our strengths. We don't know when the money is going to release.

It's just like the banks and the infusion in the banking system, and nobody knows when that's going to free up credit.

John Franzreb – Sidoti & Company

Given the visibility that you do have, why not just offer first guidance?

Laura Hamilton

Because I don't want to get in a pattern of quarterly guidance. We don't manage that way.

John Franzreb – Sidoti & Company

I just figured given the visibility numbers that you put out there, that would have been an easy alternative.

Laura Hamilton

No, I don't think that's valuable. You can turn our backlog to figure out the quarter.

John Franzreb – Sidoti & Company

You mentioned planning. Do you have a contingency plan if the environment continues to deteriorate? What are you thoughts along those lines?

Laura Hamilton

Absolutely we do. That's what I mean. Planning is the most important thing we can do right now. Planning, stay closer to our customers, close to our employees, so yes, we've done multiple scenario planning, and we're setting our sights on the more optimistic orders path, and setting our spending on a less optimistic path. We can be conservative in our spending until we see which way this plays out.

Operator

Your next question comes from Liam Burke – Janey Montgomery Scott.

Liam Burke – Janey Montgomery Scott

On the test product mix, obviously as you run through the customized projects modular will play a bigger role in product mix in 2009. Is there any sense you're getting, I mean it's a much shorter cycle and less predictable but with heavy dependence of suppliers, is there anything coming from what kind of feedback are you getting from the market on demand?

Laura Hamilton

First I think our backlog, going back to test, the custom growth was strong in '08 so our backlog still has custom in it. That's good. Our pipeline actually has a combination of shorter cycle turn stuff as well as still some potential big custom investment. So it's not that we're seeing that the entire custom world has just stopped.

I'll give you an example. In wind, everything that's happening, these turbines are just getting huge. They're putting them in places that are hard to get to. The blades are very, very big, moving at very high speeds, are dangerous if the fail. The wear and tear on these motors is incredible. That could be the need to stimulate real life would definitely be custom.

On the other hand, if you look at like I talked about Hyundai thinks that one of the ways to getting to a fuel efficient vehicle is materials. That's load frames. So we're still kind of going across the entire gamut.

If you think about generally capital spending, some companies are going to take the approach that the big capital just can't be afforded right now. Others are really actually saying, the best ROI projects are going to get funded. And we have customers coming back to us saying, "Help me do a better job of proving the ROI and the investment."

So then it's not necessarily big versus small. So I think we're going to see some of the capital moving towards smaller because you can get those approved better in tough times, but some of it is still going to be big choice investment about how do you change the game and come out of this stronger than you went in.

Liam Burke – Janey Montgomery Scott

The accounts receivable stepped up at end of the year. Is there some reason for that?

Susan Knight

Part of the increase was associated with the volume increase. We had a lot of September revenue and there's nothing problematic about our trends. We haven't seen any defaults, not much extension in terms of payment terms, so it's really driven by the strong revenue volumes that we had in the quarter, in September in particular.

Operator

Your next question comes from Michael Hamilton – RBC Capital Markets.

Michael Hamilton – RBC Capital Markets

I'd like to start with you assessment of how you're changing your views of risk management in the environment we're in and if there's anything structural that you're doing that's worth noting?

Laura Hamilton

I think one of our larger risks has been custom development and I think we've really worked that and how we approach that a lot in '08. I think a lot of risk generically for people today is credit which we think is a low risk for us, but we do think for our customers we need to understand credit risk as it relates to our customers. So I think we will be more focused on that.

Aside from the general economic risk that's probably the single biggest, and our way of managing that is scenario planning, taking actions early, and setting up triggers so that we have as early indication as possible which path we're on.

Michael Hamilton – RBC Capital Markets

Your sense as you look at the credit markets globally and some of the freezing you alluded to, if we roll back to '08 and if we had a similar situation, would there have been meaningful business not done because of the credit markets?

Laura Hamilton

It's a great question and I don't think we know that. I think it's not very clear to us which of our customers require access to credit and which ones do not, because you can't just say big versus small. So no, I don't think we have a good sense of that which is why we need to understand that one layer deeper this year.

Michael Hamilton – RBC Capital Markets

As you look at current backlog position, do you have imbalances that lead you to believe you can have some overhead absorption issues here going into '09?

Laura Hamilton

No. I think our backlog is good. It's strong. It's a good mix between our standard and our custom business across our geographies, across our markets. So that's good. I think we're really; our scenarios are much more about as we get through the backlog and whether or not, back to the depth and duration. So it's more a possibility than it is anything today.

Michael Hamilton – RBC Capital Markets

How are you prioritizing cash deployment as you look into '09?

Laura Hamilton

I think what we're working on, from a cash perspective, we think we are solid for multiple, multiple years and so I think cash deployment is a combination and we think we need to be conservative on spending, and we can start that right now. And, we need to opportunistically use our capital where we can.

One idea is for the right customer, we could extend credit terms. These are pretty standard things out there about what you do in these times, but we can use our balance sheet in the right way to accelerate our customers' progress and/or our strategy. So I don't think we have that fully articulated today, but I think we understand that it's an asset we have.

Michael Hamilton – RBC Capital Markets

Are you willing to go with this outlook on tax rate and CapEx for '09 or is that part of the umbrella of uncertainty?

Susan Knight

From a tax rate point of view I think if you look at '08 at 28%, we benefited about three points from the Japan repatriation and we had some other miscellaneous items. We guided for '08 and we'll guide for '09 the tax rate that you could expect it to be in the low 30%, somewhere between 31% and 35% range.

Laura Hamilton

I think on CapEx you can also say from our strategy, the two things that will affect Cap Ex, I'd say on a year over year basis, we would generally have run typical. On the one hand we'll be more conservative with things that maybe are a little more elective. On the other hand we'll look for opportunities to use this. So I'd say, net net I think it's fair to assume there are no dramatic changes.

Susan Knight

But a point of a lever we'll use as we look at our order pattern.

Michael Hamilton – RBC Capital Markets

I take it the balance sheet of SANS is on board and it looks to me like accrued liabilities is where you've got the payment that's remaining there on SANS. Is that accurate?

Susan Knight

The balance sheet that you're looking at as of the end of the fiscal year did not include SANS because the purchase occurred on day one of 2009. There's the $14 million initial payment that you're seeing on the balance sheet in other assets.

Michael Hamilton – RBC Capital Markets

Is there anything worth noting on where you'll skew the balance sheet over it?

Susan Knight

How SANS will affect the balance sheet?

Michael Hamilton – RBC Capital Markets

Right.

Susan Knight

No, I don't think they will have a material impact on the general company. We're still working on the transition and the opening balance sheet work. I think if you just look at SANS as an entity compared to MTS. We see opportunities for improvement in their working capital rate to revenue. They've been pretty generous with credit terms, and like I said, I'm a tightwad so we see opportunity there.

Operator

Your next question comes from Tim O'Toole – Delta Management.

Tim O'Toole – Delta Management

Everyone's focusing on the future and the economic backdrop and I will too, but I guess I'll start off with a nice job. You really had a good year.

I'll just go off of the SANS group, could you just talk about that a little bit? What kind of revenue run rate and as you look out the next couple of years, revenue synergies and profitability synergies, you also talked about cash flow on the working capital. That will take some time to implement from your neck of the woods to theirs, but could you talk a little bit about what you're buying and the cash flow dynamics?

Laura Hamilton

Let me start with what we're buying. We bought about a $30 million Chinese material testing company. What they do, one of our core businesses is material testing and SANS offering is just outside of our current offering. So their product offering is different, but very close and connected to the MTS offering, so very complimentary.

The first thing that we really see in terms of why buy SANS is that SANS has the sales and service network that covers all of China. So one of the things that I highlighted was the growth that we saw in China in '08 and that was all organic and that was MTS saying this is a priority and we drove investment and growth in China.

We can do that at one pace but what we think is that this will help accelerate that because just from an infrastructure they're already covering. The integration of SANS and MTS China is a very small overlap. It's not a big combine the two thing and completely integrate.

Tim O'Toole – Delta Management

It sounds like you're looking for lots of channel revenue synergies. Will you be able to bring some of their product line back here as well, is that part of the idea?

Laura Hamilton

Ultimately, but it's going to take awhile. To brand SANS product is a future decision, to go outside of China.

Tim O'Toole – Delta Management

What kind of cash flow margins on the $30 million and is that something that you can enhance by a couple of points or is the real idea here the revenue synergies that will evolve?

Laura Hamilton

The real idea is the revenue.

Tim O'Toole – Delta Management

What kind of cash flow margins have they done historically?

Laura Hamilton

We haven't really disclosed at this point. When you say cash flow margins, can you help me with that?

Tim O'Toole – Delta Management

EBITDA is what I would be looking at. Or you could go operating as well. Either one is an indicator.

Laura Hamilton

Their results are consistent with test.

Tim O'Toole – Delta Management

Obviously steel and other base metals and components and stuff that you incorporate in your equipment has been going up, and you've actually, the margins have actually been okay in the metal heavy side of the business. So you've obviously been getting some pricing, probably last year, maybe a little bit more this year. Could you talk about that a little bit? You may be getting pricing on sensors also, but that's margin enhancement and a little less material cost I would guess.

On the test side of the business, what kind of pricing action have you implemented? Have you announced being the fiscal year being the new year, and could you incorporate also some discussion of you probably have coming into this fiscal year you had steel at $700 a ton and somewhere in the middle of the year it went to a higher number, and it's probably backing off right now. Could you help me understand the amount of time it'll take to get some of the higher priced steel through your inventory and back to whatever the run rate is in the market today?

Susan Knight

I think I can help you but it will be a little different. First on sensors, they actually did see impact of their component prices increasing and what sensors does, is they're constantly improving technology and driving down costs. So I think what we saw throughout the year was a combination of the work they do helped offset those rising costs.

Tim O'Toole – Delta Management

So not much price action though for sensors?

Laura Hamilton

Normal price action. On the test side, what's more difficult about the test side is the length of the, we quote, and how long that quote is valid is really the key in the test side because if I quote today, and commit to this price in 12 months, then I'm assuming all the risk on the rising steel costs.

So one is about the timing of our quotes and how long they last and so we worked on that this year. One of the things we did this year was to state within the quote, "This assumes that steel or these kinds of costs are doing this," so within this range. So it's a combination of things that we do.

In addition, it's harder in this business to see the direct effect of steel because we don't buy steel. We buy machined parts, and there's value add and raw material costs so it's harder for us to see, but I think in general we saw this effect, and we've been offsetting it in part by cost reductions, other productivity enhancements as well as volume that we benefited from this year.

Tim O'Toole – Delta Management

So typical pricing action, 2% to 3% or something in test overall? Did you use any surcharge mechanism for steel.

Laura Hamilton

A little bit of surcharge in our standard business, but it's more of our business. You price in your cost estimate so it's more that we don't have to do surcharges as much as we say, "This quote reflects the high cost of steel."

Tim O'Toole – Delta Management

You talked about the German pension and enhancing that, I guess there was probably some regulatory requirements from time to time you said you could optimize. In North America are you on a pension plan or are you 401K at this point.

Laura Hamilton

401K

Tim O'Toole – Delta Management

So the only kind of pension has already been dealt with and that was the German piece?

Laura Hamilton

That's correct.

Tim O'Toole – Delta Management

That's an interesting and evolving topic.

Laura Hamilton

This is really an opportunity. Actually it's a good use of cash. It reduces the annual operating. You have an option to fund or not fund and it was definitely a better option to fund.

Tim O'Toole – Delta Management

The other thing I was curious about, what your plans are for cash. You've been a buyer of your own stock. Would you characterize your attitude here as continuing to be fairly aggressive? Are you going to back off and kind of as you will with the business and as your customers will with the business, see what transpires? What's your attitude there?

Laura Hamilton

I think we will maintain our overall philosophy which is we're a buyer at an attractive price and we'll continue to use that approach.

Tim O'Toole – Delta Management

It sounds like your timing was good in terms of putting together this debt package that's supporting the SANS acquisition, but what are the costs of the debt in terms of the spreads over whatever index, and what's the overall term on that debt? What's the duration of the arrangement?

Susan Knight

I can generally answer those questions. The revolver was established with a floating rate structure of LIBOR plus 45. Our average borrowing rate last year was about 2.7%. We did convert some of that to a four year fixed at about 4.7% and we will look at the next tranche of borrowing as to whether we should remain fixed or floating, to remain floating or go to fixed. We have those options. It's very attractive borrowing rates.

Tim O'Toole – Delta Management

Given that you fixed a chunk for four years, I guess that that looks approximately like the duration of the revolver arrangement that you put in place.

Susan Knight

That's correct.

Operator

You have a follow up question from John Franzreb – Sidoti & Company.

John Franzreb – Sidoti & Company

You touched on in your comments that currency is going to be an issue in the year ahead. At year end it looks like Euro dollar rate was $1.47 or so and current $1.27, how does that reprice your backlog? Do you have a sense of that?

Susan Knight

No. It's an okay question, I just don't know.

John Franzreb – Sidoti & Company

Maybe we'll look at it a different way. For the full year last year the Euro dollar was roughly $1.45 to $1.65. We're at that $1.27 level. What would be the potential impact on '08's numbers if you had to live with the $1.27 Euro dollar versus that $1.40, $1.50 benefit? Could you give a sense of the earnings impact at the current levels versus what you had a year ago.

Laura Hamilton

One of the things to remember about MTS and currency, it affects sensors, and let's just stick to the Euro for a minute. Sensors by themselves in Europe in local currency so the affect is the translation of their profits, and so X percent whatever the currency moves is how it would affect the translation.

In the test business we have some business in Europe and some business in Europe in Euro's. Once we have a contract we hedge and we do most of the spending on the project in U.S. dollars so it can have significant top line effect with no bottom line impact. So if you look for the company it's really about fundamentally about the top line, but we always show you organic versus currency anyway. But at the bottom line, it's really about a portion of sensors profit.

Susan Knight

I think the hedging for test is see, and we do that every day, every year. We're protecting our cash flow from order through billing and then we do balance sheet hedging as well to mitigate the risk of non functional currencies in AR and AP.

John Franzreb – Sidoti & Company

Did I hear you say that in the first quarter you're going to borrow an additional $16 million for SANS?

Laura Hamilton

Yes.

John Franzreb – Sidoti & Company

Can you remind me how much of your $114 million in cash is domestic?

Susan Knight

10%.

John Franzreb – Sidoti & Company

Would that suggest that you would be less active in share repurchases given that you're a little tight on cash and that you're a little concerned about maybe the fourth quarter and you want to reserve working capital a little bit?

Laura Hamilton

Our credit facility is $75 million and we've borrowed a little against that. We will look at our risk profile, our outlook for orders and how we want to allocate cash when the terms are opportunistically attractive as they are today. We're going to pull all the leverage we have because we do have an uncertain environment going forward, but today in my view, will continue to participate in share buy back.

John Franzreb – Sidoti & Company

Are you saying you'd borrow to repurchase the stock? Is that what I just heard?

Laura Hamilton

That's a possibility.

Operator

There are no further questions at this time. I'll turn the conference back over to you for any additional or closing remarks.

Laura Hamilton

I like what Tim said. It would really be nice to savor this great quarter and great year for one more day, but you know I just don't think we're going to have that luxury given the times ahead. I feel like with the questions on the call that we've had and the dialogue that we've had, I'm hoping you feel you have a much better understanding of what we see ahead and how we're going to manage through it.

I think we're on the right path and I hope you agree. Thank you.

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Source: MTS Systems Corp. F4Q 2008 Earnings Call Transcript
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