MTS Systems Corp. F1Q09 (Qtr. End 10/27/2008) Earnings Call Transcript

Jan.22.09 | About: MTS Systems (MTSC)

MTS Systems Corp. (NASDAQ:MTSC)

F1Q09 (Qtr. End 10/27/2008) Earnings Call

January 22, 2009 10:00 am ET

Executives

Sue Knight - VP and CFO

Laura Hamilton - Chairman and CEO

Analysts

John Franzreb - Sidoti & Company.

Liam Burke - Janney Montgomery Scott

Mike Hamilton - RBC

Tim O'Toole - Delta Management

Operator

Good day, everyone. Welcome to the MTS Systems first quarter 2009 Earnings Call.

(Operator Instructions).

Now, I'd like to turn the conference over to Ms. Sue Knight.

Sue Knight

Thank you, Jennifer. Good morning and welcome to MTS Systems fiscal 2009 first quarter investor teleconference. Joining me on the call today is Laura Hamilton, Chair and Chief Executive Officer.

I want to remind you that statements made today, which are not a historical fact, should be considered forward-looking statements as defined by the Private Securities Litigation Reform Act of 1995. Future results may differ materially from these statements depending upon risks, some of which are beyond management's control. A list of such risks can be found in the company's latest SEC Forms 10-Q and 10-K. The company disclaims any obligation to revise forward-looking statements made today based on future events.

This presentation may also include reference to financial measures which are not calculated in accordance with Generally Accepted Accounting Principles or GAAP. These measures may be used by management to compare the operating performance of the company overtime. They should not be considered in isolation or as a substitute for GAAP measures.

Laura will now begin her update on our first quarter results.

Laura Hamilton

Thank you, Sue. Good morning and thank you for joining our call. I think right now this is a time where we're all working hard to build understanding during these very tough times. Our goal for this call is to help provide insight wherever we can.

I'm going to start today's call with a headline, and then I'm going to go through the orders detail. We're going to shift the order a little bit, and Sue is going to continue through the financial details. We will then close with the business environment and the way forward.

Our headline is a fundamentally strong business execution for the quarter, but MTS is not immune to the world economic downturn.

Good business execution for the quarter. We really had a strong start to the year with a good business execution for the quarter. In particular, we're proud of our revenue, or net incomes and our earnings per share growth. We were proud of the fact that we offset softness in the Test gross margins with strong operating expense management.

Our company EBIT rate was held year-over-year despite both a drop in sensors volume as well as SANS startup costs. We maintained a strong balance sheet, which is going to be critical as we move forward and SANS is onboard. The integration is progressing as expected and there's been no change in our understanding of the strategic fit.

The second half of our headline though is MTS is not immune to the most recent changes in the world economy. In November and December, an already tough economy took an ugly turn for the worse. Europe and China were finally hit hard, while the US and Japan saw much deeper slides. MTS orders for the quarter were down 23%. While this is down from the second highest quarter on record for the company, it's still down. Both the challenges and the opportunities that we face are real.

Let's talk through orders for the quarter to help try to build some of this understanding. From a total company perspective, we experienced some slowness in October and November, but in December we saw dramatic change. Orders for the company were $95 million, down 23 points from last year. 1 point of the decline was from currency, 26 points of organic decline, and this was partially offset by 4 points picked up from the SANS acquisition.

At a macro level, worsening consumer confidence results in a drop in consumer demand, which in its turn resulted in a further reduction in manufacturing volumes worldwide. Add on top of this a lack of availability of capital and companies took swift action. Whether it was about inventory management, or quick productions in capital spending, everybody took actions in quarter one. The manufacturing decline has gone so deep that fundamentally there's been a bigger impact in R&D spending.

Our backlog for the company is $218 million, down 7% from the last quarter and 4% from the prior year. 9% of the decline is organic versus last year, and we are up five points because of SANS.

We've experienced one cancellation in the quarter, but we've also had several inquiries about the possibilities of slowing down delivery. Overall, this is a really very small percentage of our total backlog, and we feel that our backlog continues in a good position as we enter the second quarter.

Let's talk then specifically about Test orders. But before we do that, I'd like to provide you with a little bit more context before we go into the numbers. First, there is a lot of good information in this quarter, and we can help build understanding. But as we've said every quarter, we need to caution both you and us about drawing conclusions based on a single quarter in the Test business.

The quarter at $77 million was down 24% from last year. But last year, Q1 was our second highest quarter in history. If we would have been in 2008 and things would have maintained at that level, our expectation would've been that Test would come in around $100 million, not $125 million like we did last year at Q1.

All my numbers will still be quarter-over-quarter for the year. So Test at $77 million saw a 28% decline in the organic business, 1 point of currency decline, and this was offset in part by 5 point pick-up from SANS.

In the quarter we had no orders over $5 million. Just to give you more context, the last two years, which have been particularly strong years, we would have one to two orders for the quarter over $5 million. The slowdown in Test is primarily ground vehicles passenger car business. It's mainly custom. I'm going to talk about this in more detail when I get to the market section.

The decline in Test was across all geographies. From a mix perspective, custom was down about 50%, standard and aftermarket was down in mid single digits, and our service was up 20%.

From the geographic perspective, the Americas came in at $28 million, which was down 36%. Again, you have to go back to Q1 '08 for the Americas, which was the strongest quarter Americas had last year. In particular, what helped last year was ground vehicles motor sports, tier suppliers, tire and wheel and strong business in Brazil.

We expected some reduction in ground vehicles in the Americas this quarter, but the reduction was more than anticipated.

At the same time, we had expected that we were going to be able to offset some of this because we had a greater than $5 million infrastructure order tied to the US space program we were anticipating. This order was delayed due to uncertainty around the change in administration, which is a little bit different than just the change in the economy. Fundamentally in the Americas, infrastructure and aerospace were flat year-over-year.

In Europe we were down 15%. About half of that is currency, and the other half is organic. Fundamentally, this was driven by ground vehicles being down 20%, because, again, infrastructure and aero held flat.

In Asia we were down 15%. We were down 33% in the organic business. We had a 2 point pickup for currency and we had a 16 point pickup for the SANS acquisition. Again, if you go back to Q1 of '08, we had strong seismic business in Asia, which wasn't anticipated to repeat.

In addition, though, Japan and Korean economies are clearly in recession. We've seen postponement of major automotive programs, but critical orders are still being placed. For example, in Q1 '09, we received a $2 million road simulator order from a Korean ground vehicle supplier. China is growing, but more slowly.

From a market perspective, let's start with ground vehicles. Ground vehicles are down 45% from a very strong start last year. In November and December, what was a serious decline in the US, Korea and Japan spread to a worldwide problem, pulling in Europe and China, and going deeper everywhere else. We've seen postponement and cancellations of major automotive test programs in all geographies. We've also seen a slowing in motor sports. Part of it was expected, because we were coming off a peak in 2008, but part of it was unexpected, as we have seen a reduction in sponsorship money for the teams.

Infrastructure is down 4%, 20 points of that is organic, offset by a 16 point pick-up from the SANS acquisition. Infrastructure would be down though, because seismic is down after booking large orders last year. This quarter we've got zero on large orders in seismic, where last year we had $9 million worth of large orders. The Base Materials business has remained flat. Aero, our smallest segment and our smallest business, is up 8%. Again, no big programs, but strong baseline components and materials orders.

We don't usually talk about the opportunity pipeline, and I'm going to talk a little bit about it, but first let me explain what it is. Opportunity pipeline is about the opportunities that our sales force are pursuing. We measure this pipeline, based on the opportunities that are anticipated to close over the next 12 months.

What's interesting is the total opportunity pipeline in dollars has increased in the quarter. Quote activity level is high, but what is really important is to understand that anticipated close dates are being delayed. Those that are delayed beyond the 12-month window have come out of the pipeline number, but those within the 12-month window are pushing out into the latter part of the year.

In addition, the probability tied to the opportunities is more uncertain. We are carefully analyzing the changes in trends in our opportunity pipeline as we continue to move through the year.

Test backlog remains strong at $208 million. It's down 7% from Q4 of '08 and 12% without SANS. In summary for Test, the global recession has hit MTS in Q1. In particular, ground vehicle automotive was hit hardest, as you'd expect. Infrastructure and Aero are holding their own. Our diversity continues to remain an asset.

Let's talk about Sensors orders for a minute. Sensors orders came in at $18 million, which was an 18% decrease your over year. Two points of the decrease is due to currency, and 16 points are organic. October and November we saw some softening, and it was led predominantly by Asia, but by the end of December, all three geographies were down.

Interestingly, order patterns have changed. What we're seeing is smaller, more frequent, more just-in-time orders, predominantly driven by our customers' needs to tightly control their inventories due to cash management and uncertainty. By geography, the Sensors' Americas business saw a 9% decline.

Industrial machine OEMs that were down are predominantly plastics, wood, and metal forming. Energy and fluid power were actually up in the Americas. And mobile hydraulics, while it continues to be a very small percent of our business, was up 27%, which is interesting, because machines for residential construction continue to be down, but road construction and mining are up.

In Europe we saw a 22% decline. About half of this is currency, and the other half is organic. In Europe the industrial businesses that were weak were plastics and rubber, but industrial fluid power is up. Again, mobile hydraulics is small, but a good trend, up 22% for the year. Again, construction is slow, but there are other applications, like mobile cranes that continue to show opportunity.

In Asia we saw an 18% decline. This is our smallest percentage of the total mix of the Sensor business, but it is the largest total decline on an organic, non-currency basis. We saw a 30% reduction before currency, but it was offset by 12 points of positive currency effect driven by the yen. We've seen a significant slowdown in China steel and Japan plastics.

By application, I don't have numbers, but I can give you a general feel from an application perspective of what's up and what's down. In the Sensors business, we're seeing a decline where end markets are tied to consumer products and packaging, automotive, and residential construction, but we're seeing increases in areas like fluid power, energy, and mobile hydraulics. We maintain a positive market outlook for the future quarters in medical, food, and wind energy.

The Sensors backlog closed at $11 million, which is down 8 points from both the prior quarter and the prior year, so no significant change in the Sensors backlog. In summary, for Sensors orders, it's very similar to Test. We are experiencing the global recession, but our application and geographic diversity are strengths. We continue to pursue new applications whether it's marine, wind energy, or mobile hydraulics; and these are helping to offset slow areas.

I would like to turn this over to Sue to continue the financial details.

Sue Knight

Thanks, Laura. My discussion today will focus on revenue and earnings results for the first quarter. I will also discuss our cash flow and cash balance at the end of December, but I will begin with the P&L. In the quarter revenue growth was solid. At $117 million the year-over-year growth of 9%, included 9% organic growth and 3 points from SANS, which was partially offset by 3% due to currency.

Revenue increased in the Americas and Europe, but Asia was down due to weaker volume in both China and Japan. Test revenue was $97 million, which is 15% higher than last year. The 15% growth was made up of 15 points of organic growth from higher opening backlog, 4 points from SANS, and currency offset that 4 point contribution from SANS equally.

The quarter also included 15% growth in the Americas, 44% growth in Europe, and a 4% decline in Asia including SANS. Without the acquisition, Asia revenue declined 14%. As a reminder, revenue results by geography for Test are more reflective of backlog than they are of the current-quarter orders.

From a market perspective, all three markets had revenue growth in the quarter. Ground vehicles was up 5%, Aero increased 38%, and Infrastructure was up 27%, of which 12 points was attributable to SANS.

Moving to Sensors, Sensors revenue in the quarter was down 16%, negatively impacted by a decline in the incoming orders. Currency had a negative impact of 2 points, and the organic growth declined 14%. Geographic demand was similar to the orders profile with Americas down 9%, Europe down 7%, and Asia down 36%.

Moving on to gross margins, margin dollars increased approximately $1 million, or 2%. As the rate to revenue, margins declined 230 basis points, because the Test margin rate declined 150 basis points, and the higher-margin Sensor revenue was a smaller percentage of total revenue as compared to last year.

In Test there what were several factors that negatively impacted the margin rate this quarter, resulting in a 34.2% rate. In the organic Test business the margin rate declined 1 point from 35.7% to 34.7%, primarily due to a higher mix of lower-margin custom projects and higher material costs driven by steel and aluminum. These costs impacted longer cycle projects in backlog that were quoted well in advance of the escalating costs. We do expect improvement in future quarters from quotes that fully reflect today's costs.

In addition, SANS negatively impacted the rate by 0.5 point, resulting from the valuation of inventory at fair value associated with the acquisition. The business delivered 46% gross margins, which was reduced to 20% from the costs associated with that inventory valuation. The remaining cost in inventory of approximately $1 million is expected to be fully expensed in the second quarter.

Gross margin dollars in Test increased $3.2 million, or 11%, on 15% revenue growth. Excluding the impact of the SANS inventory markup, gross margin dollars increased 14%. Sensors' margins declined about 0.5 point from 56.8% to 56.4%. While revenue volume was lower by 16%, products mix was favorable and helped support the year-over-year rate comparison. Gross margin dollars declined $2.3 million, or 17%, on 16% less revenue.

Earnings, before interest and tax, increased 7% from $12 million to $12.8 million. Excluding SANS, EBIT increased 26%, or $3.1 million. As already discussed, SANS results in the quarter included inventory valuation costs of approximately $1 million, and sales were negatively impacted by the timing of revenue recognition based on contract terms.

In the quarter, SANS shipped $8 million worth of products, of which $3.3 million was recorded as revenue. We are adjusting our internal processes and contract terms to enable revenue recognition upon shipment instead of recognition on customer acceptance, but that will take us some time to resolve.

Operating expenses were up 4%, or $1.1 million, in the quarter. SANS expenses were $3 million, but when you compare the operating expenses of the organic business, expenses declined to 6%, or $1.9 million, to $29.3 million. We realized benefits of cost reductions in the quarter from our quick response to the early signs of the economic slowdown in our business. EBIT results for the quarter also include $900,000 of currency related gains.

Overall, the EBIT rate for the company was down slightly from 11.2% to 11.0%. The Sensors rate declined on 16% lower volumes. Operating expenses were flat. Test EBIT rate before SANS increased from 8.3% last year to 13.2%, driven by 12% higher volume and an 8% reduction in operating expenses. Including SANS, which had a loss in the quarter of $2.3 million, the Test EBIT rate was 10.3% or a year-over-year increase of 2 points.

Moving on to tax; tax expense for the quarter was $3.1 million compared to $4.4 million last year. The lower expense was due to a reduction in the tax rate in the quarter. Last year's was 35%. This year was 24%. These results include approximately $1 million of benefits associated with the US Government's retroactive reinstatement of the R&D tax credit in October. The legislation enabled us to record three quarters of benefits for fiscal 2008, during which time this credit had expired, but we expect future 2009 quarter tax rates to be in the normal range of 32% to 35%.

Net income increased 17% to $9.8 million, and earnings per share were up 21%, or $0.10, from $0.47 last year to $0.57 this year. The lower tax rate contributed $0.08 of the increase, and $0.03 was due to a lower share count.

I will finish the detailed discussion of the first quarter with a few comments on cash. We ended the quarter with $105 million, a decrease of $9 million. Operating cash flow was $6 million and first quarter is typically a low quarter for us due to our normal business cycle.

Capital expenditures were $3 million. In addition, as we communicated last quarter, we completed our borrowing for the SANS acquisition of $16 million against our credit facility. $4 million was spent in the quarter on share purchases, and an additional $19 million was paid for SANS. As a reminder, our cash remains invested in bank deposits, treasuries, and money market funds.

To conclude my remarks I have two summary comments. Yes, there were challenges in the quarter. Orders declined in both segments after a significant slowdown in December activity. Test margin rate was down, impacted by material costs, SANS startup, and a significantly higher custom mix as compared to last year. The Sensors EBIT rate was lower from the reduced volumes, but there are also many positives. From a growth perspective, 9% revenue growth, 17% net income growth, and an increase of 21% in earnings per share. SANS is a strategic acquisition. We're working through the startup aspects that are impacting the near-term financials. We're managing costs appropriately, given the changing topline outlook. Our cash, whether it's the balance or the operating cash flow, remains strong. Our $218 million of backlog gives us a good start for the second quarter.

Now, I would like to turn it back over to Laura for her concluding remarks.

Laura Hamilton

Thanks. Let's talk about the business environment and the way forward. I don't think we're going to share anything with you that's new news, but I think the severity of November and December is still very fresh and recent news, and it's something that we need to talk about, especially in the context of our business. So I think what's well known is that consumers have pulled back, whether it's due to credit, unemployment, the fear of unemployment, financial security, or just overall lack of confidence, consumers are buying less of everything, whether it's cars, flat-panel TVs, or in Motorola's experience, Motorola's cell phone volume has declined from 41 million phones in the fourth quarter of '07 to just 19 million phones in the fourth quarter of '08.

This consumer decline is triggering global manufacturing declines. My favorite quote comes from the Wall Street Journal, and they were talking about US global trade. What they said was, quote, two-thirds of the drop was in imports, which helps explain why so many countries dependent on trade with the US are suffering. Their exports, a key source of growth, are falling as spending by US consumers and companies continues to sour. China's December manufacturing shrank for the third month as export demand fell. Just this week it was announced that Chinese or Japanese exports plunged 35% in December, underscoring the drop in global demand for automobiles, electronics parts, and other products.

The US Manufacturing Index, which measures economic health, is at a 26-year low. US exports are no longer growing, and in December manufacturing activity in Euro-based countries contracted for the seventh straight month, the sharpest decline in 11 years. Eventually, manufacturing goes low enough that R&D is impacted. 2009 global R&D spending in inflation-adjusted dollars is expected to be flat. Capital spending is expected to be the hardest-hit category of R&D spending. However, the slowdown in R&D is expected to be more temporary in nature, because R&D and new products is the way forward for most companies.

Layer on top of this an extremely tight global credit market, lending capacity has been permanently reduced, stimulus packages have not yet had any measurable impact, and the loosening of credit is uncertain. So this is the brutal facts. But on the brighter side, and there is a brighter side, major investments in energy and environmentally friendly technology continue. The prevailing ambition of emerging geographies, and in particular, China and India, to offer world competitive products continues.

The timing of these things may change, but these priorities remain in place. These areas are the likely focus of worldwide stimulus packages. For example, the US is considering $30 billion of investment in energy, including investment in renewable technology, and $90 billion of investment in transportation, including rail.

There is more good news. Test and Sensors are niche businesses. We've talked a little bit about our analogy with baseball and that MTS is not a home-run company. We hit singles, and every now and then a double, but if you hit singles, you get on base. If you get on base, you score runs. And if you score runs, ultimately you win the game.

Our Sensors business offers an enabling technology. We have small penetration in most of our markets, and we are continuously innovating new solutions and applications for our customers. In the Test business we're used to tough business cycles, whether it's automotive, aerospace, or seismic. And we're used to managing many niches at once.

As our customers cope with these challenges, opportunities emerge. Fundamentally, MTS's strategies and long-term growth opportunities are still valid, but throughout 2009 much of this is going to sort out. How deep is this going to be, and how long? Our customers are figuring out how to position themselves for the future? How much of this is about resetting to new base levels and how much opportunity is really present as we set a new course?

So what is MTS's way forward? First, we're going to stay focused on our strategy and opportunities to strengthen our position. In our Sensors mobile hydraulics business, we're developing three new products to help our European customers to be ready to meet higher 2010 safety standards. We're going to leverage our strengths, our technical and applications expertise to win short-term strategic opportunities.

In Test we were just chosen by the National Renewable Energy Lab to partner with them in a cooperative research and development agreement to advance the state-of-the-art for wind turbine reliability testing. We're going to proactively help customers find alternative solutions for financing. Again, we're helping a customer right now secure third-party leasing to enable them to buy critical test equipment, while living within the constraints of their capital budgets.

We're going to maintain a focus on developing our people to manage and lead in an ambiguous and rapidly changing time. We're going to continue to manage costs according to the business outlook.

Finally, we're going to leverage our balance sheet. Right now, we're going to maintain this key measure of financial health. We're going to use it to create long-term value. Quarter-one performance feels good, all things considered. Now, this is a tough environment, but MTS is fundamentally a strong company. We have the flexibility to fine-tune our strategy to optimize our position in the market today, and when the economy starts to grow again.

Question-and-Answer Session

Operator

(Operator Instructions). We will hear first from John Franzreb with Sidoti & Company.

John Franzreb - Sidoti & Company.

Good morning, Laura and Sue.

Laura Hamilton

Good morning, John.

John Franzreb - Sidoti & Company.

Laura, it seems to me that given the bad fourth quarter, that the reset on the order book on an organic basis is around $90 million. It seems like you're kind of disappointed with that number, but since I've been following the firm, the worse number I've seen is around $70 million in incoming orders. Are your thoughts that we are resetting just to a $90 million threshold, or that the potential is that we could go much lower in Test, $70 million order flow?

Laura Hamilton

Good question, John. I think, as we tried to read the tea leaves of the world, I think we're feeling that November/December was pretty dramatic. At the same time, I don't think we believe that what we're currently in is going to rebound, so the idea like in the next 30 to 60 to 90 days things are going to change dramatically.

So I think we don't know, but I think that we are working through whether or not it's hard to say. We don't know. We're really looking across the board. Our current view of the world is that it's not going to take another dramatic turn down.

John Franzreb - Sidoti & Company.

Okay. Fair enough. This Sensor business, could you talk a little bit about the quarterly order trends in the first quarter on a monthly basis, if you will, and how it's playing out now in the January period?

Laura Hamilton

October and November started to slow, and December was more dramatic, but we do believe there was a lot of inventory management. We know, if you read the news generically, there were shutdowns, two weeks, three weeks. What's difficult to tell you what's happening yet is January's too early, because shutdowns went into the first week of January. So we're watching the rest of January and February to really sort through the inventory adjustment piece versus the new manufacturing levels.

John Franzreb - Sidoti & Company.

Okay. You mentioned in your comments about managing costs. Could you talk a little bit of what kind of cost savings initiatives you have in place? Or do you have a set of plans you'll put in place if the environment weakens further? What are your thoughts there?

Laura Hamilton

I think all the levers are pretty, and people know all the levers, and we're working them all, whether it's discretionary spending, slowing hiring, there are people and non-people implications, and we're going to continue to watch the kind of the business outlook and choose those according to the outlook.

John Franzreb - Sidoti & Company.

Okay. What is your CapEx budget for the year?

Sue Knight

Let's see. For the year, it's about $14 million.

Laura Hamilton

CapEx is an interesting one, where I think we have two choices. One is cut back, and one is accelerate. What I mean by accelerate, is that we can cut back on the nonessentials, like everybody is doing, and we will do that, but maybe we've got some opportunity to use some of our CapEx to invest, for example, right now you know we're capitalizing software. We think it's a very competitive product, and it's going to help strengthen our position in the market. One of the things we're exploring is can we accelerate that? It's small, but it would be one of the ways to use CapEx on our balance sheet as opposed to just completely pull back.

John Franzreb - Sidoti & Company.

Okay. I am going to get back to the queue.

Operator

And we will move next to Liam Burke of Janney Montgomery Scott.

Liam Burke - Janney Montgomery Scott

Thank you. Laura, Sue, good morning.

Liam Burke - Janney Montgomery Scott

Laura, you talked a bit about in the short term, customer buying patterns and how they have adjusted. How does that translate to your longer-term view of buying patterns? Is this going to persist, or do you see that going back to the old ways?

Laura Hamilton

In the Sensors business, I think the short order patterns are eventually going to loosen up and go back to optimized ordering patterns. How long we're going to be under extreme tight control, I don't know. That's how this whole thing plays out. In the Test business, I think, for some period of time larger capital expenditures are going to go through a much higher level of scrutiny, so it's going to take longer, because you're going to have more levels of authority having to sign off.

We're going to have to help our customers do a better job of defending their return on investments, which I think we can do. Eventually, as these R&D programs start kicking back in, I think, we'll get to more traditional ways of managing capital spending as well.

Liam Burke - Janney Montgomery Scott

Great. Thank you. Sue, in the past if you did get a large order, occasionally you would essentially take on all the expense until delivery. Then the rules changed a little bit, where you would get progress payments for orders. Now, with capital budgets of your client base being tightened up, is there any consideration of basically going back to the old ways of helping them or offsetting some of their CapEx constraints?

Sue Knight

Well, we are seeing changing conditions. I think Laura provided an example, where we have a customer who doesn't have the access to the capital that they need to make the purchase. So we're working with third-party lenders to finance those kinds of transactions. So then, we don't carry the assets and the customer doesn't carry the assets. When it comes to terms and conditions, we typically can demand a front-end loaded cash flow stream in our custom business.

There are larger orders. There are fewer choices as to where our customers can buy them, and thus the cash flow stream can be negotiated to our benefit. As we reduce the amount of large projects, which is what happened in Q1, we will see fewer advances. We will see pressure on the payment terms, because we have less leverage and we've got competition to consider when it comes to payment terms also. So, I think, we will see some pressure as it relates to working capital, but I think it's an asset for Unidentified Speaker, because we have the capacity to use it, to keep that order flow happening.

Liam Burke - Janney Montgomery Scott

Thank you.

Operator

We will hear next from RBC's Mike Hamilton.

Mike Hamilton - RBC

Good morning.

Laura Hamilton

Hi, Mike. Good morning.

Mike Hamilton - RBC

If we could, you've gone into more detail than you normally do. Would it be possible just to give the year-over-year December bookings?

Sue Knight

I don't have it in the room.

Laura Hamilton

We're all looking. We don't have it.

Sue Knight

You know, we typically don't give that level of detail.

Laura Hamilton

Actually, we don't. But just to be careful. I think we're talking more about Test than Sensors? Let's split them up.

Mike Hamilton - RBC

No. I'll go with what you think is the clearer picture, because I mean the difficulty in looking at that trend is, December is not always the most meaningful month anyway.

Laura Hamilton

Okay.

Mike Hamilton - RBC

I mean to some degree, what I'm looking for is, as clear a picture as you can give as to the magnitude of ramp that you have seen that gives some kind of ability to have a trajectory into the near-end months of calendar '09?

Laura Hamilton

Okay. Sensors, we saw a softening in October/November. What we experienced in December I think felt like, and we talked to our customers in Sensors, just a real dramatic inventory management on top of manufacturing shutdowns. So, I think, December was a time where you would use shutdowns to help slowdown your manufacturing volumes. So, December was more abrupt in Sensors, and the next few months are really critical for us to reestablish what this run rate is. We don't know yet, but we believe there was a multiple effect in the December number.

In Test, I actually believe, October and November were tracking along, according to what we had said, we were expecting more like $100 million. It was mid-November, December where we started. Toyota was going to experience their first loss in 70 years. So the November/December for Test was predominant, the relatively contained automotive issue hit Europe, hit China, hit Japan much more deeply, et cetera.

Now, it's not so much what's the December trend, as much as, everybody is going back and resetting their priorities. That's where we watch the pipeline, the opportunity pipeline, to say, which of these projects are now pushed out for three years, or two years? That's where the pipeline is more important to us than exactly the orders in December.

Mike Hamilton

In the near term, does Chinese New Year have the potential to be a bigger uncertainty than usual?

Laura Hamilton

I think it's the same thing, where you can use it to kind of take a longer layoff.

Mike Hamilton - RBC

Exactly.

Laura Hamilton

I think it won't be all of what hit the world in December. I think China is still adjusting to a reduction in US imports and figuring that out, but they've been adjusting to that now for a couple of months at this new level.

Mike Hamilton - RBC

If we could get into the detail on Test of motor sports area, which is kind of a unique business, where problems of the consumer is meeting, at least domestically, problems within the sport per se, if we see that be protracted, what happens to you in terms of mix and your thinking on business?

Laura Hamilton

This is a hard one. Motor sport is another one of those niches where you can have feast and famine, and we do. So we saw that we were at a peak in '08, but we didn't think it was going to drop off quickly. Motor sports, while they're getting less funding, still have a very high priority around, if you can give me another second per lap, it matters. So I think this is all still sorting out in terms of what are the priorities for motor sports over the next year. We're still in the sorting-it-out phase.

Mike Hamilton - RBC

Thanks. Then on the brighter side, could you comment, obviously, due to a lot of the other dynamics, some strong dynamics on the service side and what you see there and how you are posturing?

Laura Hamilton

On the brighter side, service was strong, but again, quarter-over-quarter, we are seeing two things. One, long service contracts are not being relet. Where people were having three-year contracts, they might be signing up six to 12 months. So there's mixed news on service. At the same time, as our customers let people go, they need more and more assistance. So it's in both sides.

So what are we doing? In both businesses where you've got segments or niches that are turning down, we're sorting through, what does it mean in those niches? Because nothing is turned off completely. So you support those, but you quickly redirect your resources to the niches that are continuing to have the funding.

So the way we do that is like this Sensors example. I mean very quickly they focus on the safety requirements for 2010 and helping their mobile hydraulics customers in Europe to be ready for that requirement, which might be slight design modification as opposed to a huge R&D program for a new platform.

In Test what it means is that we quickly mobilize our niche teams for maybe our more minor niches, where we quickly remobilize, look at what's the current priority is in those niches, and position ourselves to go after that. That is the way we work to offset those areas, steel, automotive, that are significantly down.

Mike Hamilton - RBC

Thank you for the insights.

Laura Hamilton

You are welcome.

Operator

[Fred Isingis] with Neuberger Berman has our next question.

Unidentified Analyst

Hi. Can you hear me?

Laura Hamilton

Pretty well.

Unidentified Analyst

Okay. I am at the airport, so have some background noise. You mentioned a little bit on working capital. I'm just wondering if you could give us a little more detail, as the business does slow, what we should expect in that regard. I mean, is it all negative, or I would imagine there would be some positives as the business does come down.

Sue Knight

Associated with less revenue, it would indicate that we would have less working capital dollars needed, but on the other hand, we will have to manage the pressure on working capital if customers extend terms, if we have fewer advances, because we have more standard business versus custom, which has been our profile over the last five or six quarters. So there's the inventory management aspect, which we think is an opportunity for us to work to offset any pressure in receivables, but if there is a significant shift in our business from custom to standard and service, you could expect our advance level to impact our cash flow.

Unidentified Analyst

What have we seen though in prior downturns in the Test business? I mean, can it be a generator of working capital? I mean, it doesn't sound that way.

Sue Knight

When I joined the company, it was the beginning of the early 2001/2002 downturn, and at that point we had opportunities in the balance sheet to monetize some of that because we were carrying very high rates of receivables and inventory and not very many advances. So I'm not sure I have an experience here that I can apply in this situation.

Laura Hamilton

I think that's a good answer. So previously, our working capital rate to revenue was much, much higher. So I think the main message is, we've worked it down to a much better overall rate to revenue, but we're going to have more pressure on that rate, as customers have more pressure, they manage their cash much more tightly, but we will continue to manage our assets if our business volumes change.

Sue Knight

I think the other comment that I would make is that there is opportunity to improve cash flow at SANS. This is a company who didn't focus on that aspect of managing their business, and I think some of the changes we've already made with terms and conditions and setting expectations relative to collections will help the results.

Unidentified Analyst

Okay. And the other question I had is do you expect to continue to repurchase shares through this period of uncertainty?

Sue Knight

Our 10b5 program is active, and at this point we see no reason to change that.

Unidentified Analyst

Okay. Great, thank you.

Sue Knight

You are welcome.

Operator

(Operator Instructions). We will hear next from [Jerry Leaver] of [Invista Capital].

Unidentified Analyst

Hi. Could you give us a sense of the business mix outlook in terms of your custom on the Test side, as well as the mix overall in terms of Sensor versus Test?

Laura Hamilton

Okay. In terms of Sensors and Test, I think that's the uncertainty. I think that's still yet to play out. In terms of the mix within Test, again, there's lots of uncertainty. I can just give you a little bit of here's the things that we're trying to manage through. On the one hand, when things reset in December, the thing that we experienced was we saw the biggest decline in our high dollar volume orders, because what did we do? You stop everything big, and those decisions have to be rethought. So our Q1 in Test, the custom decline was much more significant than the smaller order dollar decline. Our smaller orders, our standard aftermarket is our higher margin business typically. However, with the stimulus packages and wind energy, some of those bigger investments could come with larger-size orders. So it's hard to say from a mix perspective how this is all going to play out

Unidentified Analyst

I was just going to say I guess that where I'm going with this is kind of obviously, that mix issue makes your gross margin move around a lot. And I was trying to get a sense of where that might end up, at 38% level. Is the mix should stay similar? Or this is anomalously low because obviously last year you had a number (brusquely) over 40% the whole year.

Laura Hamilton

So from a backlog perspective, the first quarter returned more of our custom backlogs than our standard backlog. So I think the quarter was a little bit more skewed towards custom than the backlog is, slightly, not 25 points. The perspective orders, it's unclear which way the mix will go. Right now, our stronger order volume is more of the short cycle standard and aftermarket, but you layer in a couple of big custom orders, and then it can change. And timing is everything.

Unidentified Analyst

Okay. Thanks for that color. And just on the R&D side, obviously, you exhibited good cost control there in the December quarter. Is this level closer to $3 million a sustainable number? Or is this unusually low this quarter?

Laura Hamilton

I think our R&D was unusually low. We want to maintain our R&D. It's part of the future.

Unidentified Analyst

Great. Thank you.

Operator

We will move next to Tim O'Toole of Delta Management.

Tim O'Toole - Delta Management

Hi. Couple of things just to fill in some blanks. You went through a bunch of data earlier on, and I may have missed this, but in the inventory category from this last quarter, how much of the inventory number would've been attributable to SANS? I think you said you had to take the inventory markup, which isn't a surprise. And it sounded like you're done with that, working through the P&L aspect of it at the end of this upcoming quarter; is that correct?

Sue Knight

Yes, at the end of the upcoming quarter we expect to turn the rest of that fair value markup. On the balance sheet, $8 million of the inventory is attributable to SANS?

Tim O'Toole - Delta Management

About $8 million? Okay, great. In your orders number also, how much of that would have been SANS?

Sue Knight

$5.5 million.

Tim O'Toole - Delta Management

$5.5 million. Yes, I backed into something, same order of magnitude, but the precision is a little bit better, a little more helpful. Once you are through that inventory work-off and you've gone in there to look at it and kind of operate it yourselves after a couple of quarters or maybe a year, do you expect their gross margins to look roughly like your historic average on Test?

Sue Knight

I think that's a fair expectation. As I've said, in the quarter their margins were actually or 46%.

Tim O'Toole - Delta Management

All right. Okay.

Sue Knight

If you adjust for the fair value impact cost in the quarter. So low 40s I think is reasonable.

Tim O'Toole - Delta Management

Okay. That's great. So it may look more like your standard stuff versus your custom stuff?

Sue Knight

Yes, because the product line is more like our standard product offering in the infrastructure market than our portfolio of products, which for the organic Test business has a lot of custom in.

Tim O'Toole - Delta Management

Okay. That makes sense. But it also suggests or actually reinforces that you don't have to go in and fix something in terms of either the way they price or the way they do business?

Sue Knight

No, we did not buy a fixer-upper, but we're going to help them with cash.

Tim O'Toole - Delta Management

Right. Okay. I guess the mix question was a useful one. What does the mix in your current backlog look like? It sounded like you've burned a little higher custom mix out of backlog and that that's not replenishing because people, as you say, are on the sidelines. Does the mix in backlog get richer, if you will, as we go through time?

Sue Knight

So, the first quarter in Test turned more of the custom backlog than the standard backlog. So there was, again, a slight skew towards custom, which was a little bit different than the overall weighting of the backlog. Then as we add to the backlog, right now what we're adding is lower dollar volume business. What is unclear is what are we going to add for the rest of the year and what's the mix of that going to be?

Tim O'Toole - Delta Management

Right.

Sue Knight

Yes, I would say the quarter was more skewed towards custom than our backlog was.

Tim O'Toole - Delta Management

If you rewind to the last time the cycle rolled over, the '01/'02 timeframe, so you are going into or are you just coming through kind of the first quarter of whatever this is going to look like, we don't know how deep or how long or any of that stuff, but your backlog coverage is a little more than two times quarterly run rate or something on Test, just as a quick, rough benchmark?

Sue Knight

Yes.

Tim O'Toole - Delta Management

As we went through that last cycle, I'm guessing it declined, but maybe it didn't, what did backlog coverage decline to as a rough quarterly run rate? In other words, did two-to-one decline to one-and-a-half, or did it decline to one or something?

Sue Knight

I don't have that recollection that I could give you a quick answer with any granularity. I will say that I don't recall that it was dramatically different, because we always have some longer-term projects. It wouldn't have gone from two times a quarter to one times a quarter, but it would have been somewhere in between. So it's probably fair to continue to turn it roughly every six months, and then the key is what rate is, what's the turn of orders in revenue out?

Tim O'Toole - Delta Management

Right.

Sue Knight

And that's probably more significant than changing the rate to turn the backlog.

Tim O'Toole - Delta Management

Well then the other question I was trying to get some sense in terms of the dynamics. Again, if there's data that you haven't revisited for whatever it's been six or seven years, you may not be able to come up with an answer. If book to bill was, I don't know, rough numbers, I think I backed into 0.8 or 0.85 or something in Test. If it ran at something below 0.9 for a number of quarters, you'd wind up burning through backlog, and then both backlog and quarterly revenues would decline. I don't know if in lockstep, but in the same direction. That was leading me to wonder. This is kind of a two-part question, because you've already started taking some costs out on the OpEx lines. Have you defined how much kind of quarterly cost run rate you've already taken out? And where would you target OpEx to be once you are kind of done with this first go-around?

Sue Knight

Well, I think we are considering it a little differently than kind of a static look, because we are actively doing scenario planning as we consider our backlog for this in our incoming orders, and I see the operating expenses continuing to be a variable number, depending on our business scenario. So I wouldn't want to say Q1 is it and you can model that for the year. I think we will continue to adjust spending based on the business situation.

The other comment I will have about the last cycle. We've spent a lot of time looking at how that cycle played out versus what we're seeing now, and it really was quite different, because Sensors led the economic cycle and Test lagged. And now we're seeing it being impacted at the same time. We also had sequential geographic declines with the US leading, followed by Europe and America; and I think we're seeing much more of a coincident impact.

So I wouldn't line up the last time with this time and say that's what will happen, because I don't believe all the conditions are the same, that the outcome would be the same too.

Tim O'Toole - Delta Management

Oh, no. I certainly agree with that. It seems like, if you will, the time constant on this cycle is much shorter, we don't know what the other dynamics are, but it does seem like the time constant is much shorter. I guess we hope the recovery is much shorter also.

Laura Hamilton

That would be a good thing.

Tim O'Toole - Delta Management

Again it's probably a fluid situation, so you may not be able to answer this very concretely right now also, but have you sized on Test what a revenue breakeven level would be? Obviously, you would have a long ways to go from current run rate rates, but do you have a sense for that?

Laura Hamilton

We have a sense that we don't think that's our scenario. We got lots of scenarios between now and then, so I think we're a long way from that.

Operator

(Operator Instructions). We will take a follow-up question from John Franzreb.

John Franzreb - Sidoti & Company.

I was just wondering about the operating loss that SANS reported in the quarter. Are there any startup costs embedded in that? Could you just talk a little bit about that and the impact in the quarter?

Sue Knight

Well, we talked about the inventory valuation aspects, and in the quarter there were also expenses associated with things like opening balance sheet valuation, legal gets started, integration costs, and I would say they were about in the $0.5 million range or a little higher.

John Franzreb - Sidoti & Company.

And when do they do away?

Sue Knight

Well, some aspects of integration are done, and many aspects will continue. I think we would expect some costs associated with integration to be throughout 2009.

John Franzreb - Sidoti & Company.

Were most of those costs embedded in the operating line, or are they embedded in the SG&A line also, in the gross margin line?

Sue Knight

The inventory valuation would've been in the gross margin line. The remaining expenses, in operating expense.

John Franzreb - Sidoti & Company.

Okay. I think that's it. I think all my other questions have been addressed.

Laura Hamilton

Thanks John.

Sue Knight

Thanks John.

Operator

We have no further questions at this time.

Laura Hamilton

Thank you, Jennifer. I guess just in closing I would say again, I think, we're all really working hard to understand, and we really hope we met our objective in today's call. Thank you for participate participating.

Operator

Again, that does conclude today's conference. Thank you all for participating, and have a great day.

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