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MTS Systems (NASDAQ:MTSC)

Q2 2013 Earnings Call

May 07, 2013 10:00 am ET

Executives

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

Jeffrey A. Graves - Chief Executive Officer, President and Director

Analysts

John Franzreb - Sidoti & Company, LLC

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

Nigel Frankson

Operator

Good day, everyone, and welcome to today's MTS Systems Second Quarter 2013 Earnings Conference. Just as a reminder, today's call is being recorded. At this time, I would like to turn the conference over to your host for today, Ms. Sue Knight. Please go ahead, ma'am.

Susan E. Knight

Thank you, Sarah. Good morning and welcome to MTS Systems' fiscal 2013 second quarter investor teleconference. Joining me on the call today is Jeff Graves, President and Chief Executive Officer.

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

This presentation may also include reference to financial measures, which are not calculated in accordance with generally accepted accounting principles or GAAP. These measures may be used by management to compare the operating performance of the company over time. They should not be considered in isolation or as a substitute for GAAP measures.

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

Jeffrey A. Graves

Thank you, Sue, and good morning, everyone. Thank you for joining us for our second quarter investor call. We appreciate having the opportunity to discuss our financial results for the quarter and our outlook for the rest of the fiscal year.

In today's call, I'll first discuss key takeaways for the quarter followed by our orders and backlog results. Sue will then discuss the rest of the quarterly financials. Following Sue's comments, I'll provide an update on our outlook for fiscal '13 and our anticipated position as we enter our new fiscal year in October. We'll then open up the call for your questions.

There are 3 key takeaways today. First, we're pleased that we delivered orders growth in the quarter even though sensors markets remained tough and the Test order mix and late timing in the quarter were less favorable than expected. I'll explain the implications later in the remarks.

Second, in a period in which many companies are struggling to deliver top line growth, continuing strength in the markets for our Test segment, which is directly tied to global R&D spending, enabled us to deliver 6% top line revenue growth, fueled by 11% growth in Test. While we were pleased with our growth momentum, higher costs resulted in flat earnings per share. There were several cost puts and takes and Sue will provide more details in a few moments.

Third, based upon a delayed sensors market recovery and Test backlog in second half order timing, we've adjusted our revenue and earnings per share outlook for the full year. Having said that, we're very pleased to still expect a record year for orders, revenue and backlog driven by the macro trends in the test market. This outlook, combined with our ongoing productivity initiatives, position us well for a second half of the fiscal year and strong momentum as we enter our fiscal '14 in October.

Now before I go further, let me remind you about the nature of our 2 businesses and the market dynamics we're now experiencing. The larger of our 2 businesses is Test, which provides highly engineered testing systems and services to product development groups within automotive, aerospace, energy and infrastructure OEMs worldwide. This business is fueled by customers' R&D and development spending on new products and these markets are growing rapidly in response to strong macroeconomic drivers, which we believe will be sustained for several years to come. This market exposure sets us apart from many other companies.

Our second business is Sensors, which provides products that are essential for automating heavy industrial equipment and increasing the precision and safety of heavy vehicles systems that utilize hydraulic controls. These sensor markets are directly tied to industrial capacity utilization and heavy equipment demand, which have been in a multi-quarter trough, driven by ongoing sluggishness in the global economy. It's important to understand these distinct market forces as we discuss the growth opportunities and investment strategies that we're now following.

With this backdrop on our 2 businesses, I'll now provide more detail on the quarter. Total company orders were $138 million, up 2% over last year. Adjusted for currency, orders were up 3%. The recent quarterly trend by business continues as a 3% growth in Test was partially offset by a 6% decline in Sensors, which is the smaller of our 2 business. In the quarter, Sensors and Test were 17% and 83% of total orders respectively.

Backlog of $287 million was down 2% compared to the prior year as our operations investments continue to bear fruit, resulting in faster turns of our orders backlog.

I'll now provide you with some color on order patterns by business segment, and I'll begin with Sensors. The story for our second quarter in Sensors is a mirror reflection of the last several quarters. Overall, global market conditions are weak, particularly for mobile hydraulic applications. The one bright spot is that for the first time in the 4 quarters, we delivered a sequential quarterly increase. While 1 quarter is not enough to confirm a change in the trend, we're happy about the 7% increase, which was driven by North America and Europe. Asia declined sequentially, which was primarily attributable to the Chinese New Year in the second quarter.

Sensors orders were $24.1 million, down 6% year-over-year. Adjusted for currency, orders were down 4%. Industrial equipment orders declined 5%, driven by lower demand in 3 areas: North American recreational vehicles, Japanese plastics and China steel. Europe's flat result -- Europe's results were flat, delivering better year-over-year results than the other regions.

Mobile hydraulics orders remain weak, down 16%. An 11% growth in Europe, driven by material handling and construction equipment orders was more than offset by a 45% decline in North America. This decline was primarily related to 1 large OEM that is ordering 50% less than they did last year based on lowering mining and construction equipment demand. We're encouraged by the recent public statements by this OEM that markets are expected to improve going forward and we look forward to when these comments translate into firm orders for our Sensors products.

In summary, Sensors is a great business that remains under pressure based on soft market volume. We remain confident that our markets will recover, but the timing, which is tied to industrial demand for capacity expansion, remains elusive. Meanwhile, we're working aggressively to get spec into new machines worldwide. For example, within the quarter, we won application opportunities with 2 European cylinder manufacturers for pitch control on wind energy systems and a ship that's specifically designed for construction of offshore wind turbines. Additionally, we were selected as the sensor partner for a truck steering and suspension application at a European OEM. These are representative of the customer value we create with our precision measurement sensors.

Backlog in Sensors segment at the end of the quarter was $15.7 million, essentially flat year-over-year. Sequentially, backlog is up 6%, reflecting the uptick in orders this quarter. Our hope is that this strengthening in the market continues.

Next, I'll spend a few minutes on the test markets and orders. Overall, we're very pleased that our Test business continues to grow despite the sluggish global economy. As always, the nature of our business creates a lumpy profile from quarter-to-quarter, so I'll provide you with some context about what are the trends and where we are seeing variability due to timing.

Test orders in the quarter were $114 million, up 3%. Excluding currency, orders grew 5%. The order growth was base order-driven as large custom orders were flat at $5 million. I'll also note that base orders of $108 million were up 13% sequentially, following first quarter results of $96 million, reflecting in part the success of our new product introductions, which we expect will continue to be strong throughout the remainder of the year and into FY '14.

Similar to first quarter, we had good growth in 2 of our 3 markets for Test. Ground vehicles was up 31%, driven by R&D lab expansions in Asia. And materials grew 1% on the strength of static testing product demand in China. Structures was down $12 million or 47% on fewer large wind and seismic system orders, which are very lumpy quarter-to-quarter and year-to-year. Of particular note, we're pleased that the service orders were up 8% this quarter and 10% year-to-date, reflecting our focus on and investment in the aftermarket opportunities from our large installed base.

With that overview, I'd like to provide you with some additional color in each of the 3 test markets.

Beginning with ground vehicles. In addition to the previously mentioned R&D lab growth in Asia, we had strong aftermarket sales in the Americas as OEMs spent money to maintain their existing equipment. In Europe, we had a key motorsports win for $5 million for a new transmission test system. Globally, there was strong demand for tire testing systems, $10 million in total; and a damper and elastomer system, $5 million in total, driven by up-and-comers in Asia that are now rising to new levels of performance and global expansion of key Tier 1 suppliers.

Also, test line systems had a healthy quarter because our customers are making upgrade investments to more fully utilize their existing equipment, achieve productivity gains and solve specific problems related to regulations and new vehicle technology such as elastomer and advanced steering systems.

Next for Test is the materials market. At 1% growth, we continue to see some softness in the Americas due to government funding decreases, which directly affected the military and university laboratory spending in the quarter. Demand for static test materials testing systems was up 12%, particularly in China, but was offset by less demand for dynamic systems, which were down 19%. Since our business is lumpy, neither the static nor the dynamic growth rates suggest any trend, but simply a characterization of the second quarter orders.

And lastly, our structures market was down $12 million or 47%. In the Americas and Europe, the decline was due to the timing of wind applications while Asia was impacted by the relatively large aerospace order we received in the prior year, which provided a tough comparison this year. Also in aerospace, we're very pleased with orders for our new FlexDAC system, our new high-efficiency data acquisition system that we launched last year as well as recent U.S. and Korean automotive OEM and Tier 2 supplier wins.

Geographically, Test orders were up 16% in Asia, 1% in the Americas and down 11% in Europe. China and the emerging markets continued to provide outstanding growth opportunities for us and will remain a key focus for MTS in the quarters and years ahead.

While we had originally projected that full year orders would be more front-end loaded, the profile now indicates that it will be skewed to the second half of the year. Reflecting this order pattern and a higher backlog conversion rates revenue within the second quarter, Test backlog of $270 million was flat sequentially and down 3% year-over-year. With our factory efficiency investments gaining traction, we anticipate these higher conversion rates will be sustainable, but subject to mix considerations .

I'll comment in more detail later on the net effect of these order and revenue conversion factors on the full year.

My last comment in this section of my remarks is about the Test order pipeline. At $805 million, the pipeline remains strong and stable, providing us with excellent orders growth opportunities. We did experience delays with some larger projects in the second quarter, but they were typical for our Test business and there were fewer delays than in the first quarter, which we feel very good about. We're closely monitoring larger projects by analyzing customer trends, reconfirming budgets and managing the technical scope of pipeline opportunities to maximize our win rate and provide operations with accurate order timing information.

Now, I'd like to turn the call back to Sue for additional financial detail on the quarter. Sue?

Susan E. Knight

Thank you, Jeff. My remarks today will summarize our second quarter results based on a year-over-year comparison. And I'll start with revenue. Second quarter revenue was $136.9 million, which was a 6% increase. Similar to the first quarter, currency continues to have a 2-point negative impact. Excluding currency, revenue growth of 8% is recently good performance in light of the economic headwinds.

Again, this quarter, double-digit growth in Test was partially offset by a decline in Sensors.

Comparing results by segment. Sensors revenue of $23 million declined 12%. And excluding currency, revenue was down 10%. Europe, our largest market at 50% of the total business, was down modestly at 3%. North America and Asia were down 18% and 22%, respectively. On a market basis, revenue results tracked with the order pattern as customers generally continued to buy small quantities for short-term needs rather than committing to larger blanket orders for longer-term delivery.

Test revenue of $114 million was strong, up 11% compared to last year. This growth occurred on flat backlog of $276 million, evidence that we are achieving process improvement efficiencies from our productivity investments in Test operations.

Excluding currency, revenue was up 12%. Geographically, the revenue results in Test are always much more aligned with backlog than current quarter orders. Europe and Asia were up 25% and 16%, respectively, while the Americas was down 8%. Overall, we feel very good about the top line growth in Test.

The next topic is gross margin. At $54 million, gross margin was down 4% on higher revenue. Approximately $4 million of volume-related growth margin increase was more than offset by the impact of a 4-point decline in the gross margin rate. The lower mix of total company revenue from Sensors had an approximate 0.3 point negative impact. Additionally, the margins were down in both Sensors and Test, which resulted in a 39.4% rate to revenue compared to 43.7% in the prior year. In Sensors, gross margin declined $2.4 million to $12.6 million. Approximately 75% of the decline was volume related and 25% was mix related. Despite these impacts, the gross margin was strong at 54.8%, but down from 57.4% in the second quarter of last year.

In Test, gross margin of $41 million was flat on 11% higher revenue, impacted by a lower 36.3% margin rate. This is less than the 1 plus percentage rate improvement we expected compared to the almost 37% in the first quarter when we discussed it in our first quarter call. Compared to a strong gross margin rate of 40.2% last year, the rate is down almost 4 points and down 4.5 points considering the benefit of volume leverage.

In summary, the key drivers are -- I'll summarize them in 3 points. The first item, 3-points decline due to higher mix of lower margin, custom projects and cost increases on custom development projects. We had a very high custom mix this quarter, which accounted for 2.5 points of the decline from last year. Also, we had 5 "first of a kind" projects for wind and oil and gas energy applications and 1 ground vehicle system had cost adjustments in the quarter. While it is common to have some amount of custom project cost adjustments each quarter, it is unusual for us to have 5 development projects reach the testing and installation phases concurrently, which is when we typically see system design or performance issues. These projects will be completed over the next 6 to 9 months. Impact of these projects in the quarter was a negative impact on margin of 0.5 point.

The second category of impact on the margin rate in the quarter was 1 point from planned investments in productivity and growth initiatives, primarily service expansion. This was similar to what we saw in Q1.

The last point of variance was associated with over plan operational variances. In this category, the primary cost drivers were warranty, infrastructure spending and indirect engineering labor costs. The annualized warranty rate remains relatively low. On an annualized basis, it's less than 1%, but higher claims on a few systems and a greater-- a larger installed base have impacted the last quarter. Regarding infrastructure-related costs, facility and IT expenses were higher than planned based on the needs of our growing business. These costs are expected to moderate in the second half of the year. Looking forward, we do expect higher gross margin rate results in the second half of the year for Test and for the company.

Moving next to operating expenses. Costs were $38.3 million, down 2%. And as a percent of revenue, operating expenses were 28%, down 2.4% year-over-year on higher volume. Lower legal and consulting expenses, sales commissions and R&D were partially offset by people-related direct and indirect costs. Thus, operating expenses were slightly above our expected range of 26% to 27%, although for the full year we still expect those expenses to be in the 26% to 27% range.

Moving on to EBIT. At $14.7 million, EBIT declined approximately $2 million, driven by lower gross margins, net of lower operating expenses as previously discussed. Additionally, currency-related expenses were up $0.5 million, primarily because the 9% devaluation in the Japanese yen in the quarter was in excess of our hedging positions as it was quite unusual.

EBITDA as a percent of revenue was 10.7%, down 2.3 points, a disappointing result given our higher revenue.

Next subject is tax. The rate in the quarter was 23.8%, almost a 9 percent point -- percentage point year-over-year reduction. This difference was almost entirely due to the retroactive reinstatement of the U.S. R&D tax credit. The tax benefit was $1.3 million.

Earnings per share of $0.69 was flat compared to the prior year on a relatively flat share count.

Finally, I'd like to close with a few comments on cash. At the end of the quarter, the cash balance was $47 million, down slightly from $48 million last quarter. We used $1 million of operating cash flow, which was driven by $14 million of higher working capital requirement to enable Test revenue growth in the second quarter as well as our forecasted growth in the second half of the year. Receivables were the primary driver of the increase. We do expect strong collections in the third quarter as a result of that higher balance.

Additionally, capital expenditures were $6 million. And if you may recall, we accelerated the second quarter dividend payment into December in consideration of the change in the dividend tax rate, but there were essentially no second quarter impacts.

That concludes my prepared remarks for today. I'll turn the call back to Jeff for his final comments. Thank you.

Jeffrey A. Graves

Thanks, Sue. My final topic before we take questions is our revised outlook for the full year.

Our growth outlook for the second half of the year for Sensors has been tempered by our orders experienced in the second quarter and the delayed recovery in the end markets that several of our OEM customers have publicly communicated. Again, our Sensors business is directly tied to global capital equipment spending, which remains relatively weak.

In addition, while test markets remain robust, the timing and mix of backlog in the second half orders is now expected to shift more revenue into the fourth quarter of this year and into fiscal '14 than originally planned. In light of these conditions, we thoughtfully considered what actions are required to balance our investment needs with market dynamics. We've taken immediate action to curtail our discretionary spending globally. However, in light of strong test market tailwinds, we've also determined that it's critical for us to continue on with our productivity and growth investment initiatives that will enable us to accelerate innovation, capture the rich opportunities in the emerging markets and realize the potential of our services business. These initiatives drive meaningful, long-term value creation for our shareholders. In our view, the short-term earnings impact in fiscal '13 is well worth the longer-term sustainable growth and margin performance of our business in fiscal '14 and beyond.

Today, our view is that revenue will be $560 million to $570 million or 4% to 6% growth compared to the previous growth rate of 5% to 10%. Earnings per share are expected to be in the range of $3.30 to $3.70, down from the previous outlook of 5% to 10% growth. From a quarterly perspective, the conversion timing of the Test backlog is heavily skewed in the fourth quarter. Thus, third quarter revenue will be relatively flat compared to the second quarter, but lower costs will result in higher earnings. Including these revisions, we're now -- we are still expecting a record year of orders, revenue and ending backlog for the company. This backlog will then position us well for a very strong start in fiscal '14, and the macro trends are expected to drive momentum in future years.

That concludes my prepared remarks. And I'll turn the call to Sarah for the Q&A session.

Question-and-Answer Session

Operator

[Operator Instructions] Our first, from Sidoti & Company, we'll go to John Franzreb.

John Franzreb - Sidoti & Company, LLC

The services revenue was up 8% in the quarter, 10% year-to-date. Are you able to discern how much of this is the result of some of your new program initiatives?

Jeffrey A. Graves

I think-- well, it's a combination of factors, John. I mean, we have quarter-by-quarter a bigger installed base, frankly. But also the biggest driver is our hiring of resources, training of resources there are finally starting to get some traction so -- again, we've been at this for several quarters now of hiring and training people. As we've said, it takes a while for them to learn the technology and the products and we've now deployed them and we're starting to get some traction in the field. So I was quite pleased with 8% growth. I think that's terrific and we expect that momentum to do nothing but grow.

John Franzreb - Sidoti & Company, LLC

Okay. The gross margin in Test was weak. And Sue, you called down a couple of buckets there. I guess, I want to focus on the one that had to do with the custom projects. Again, is this a function of taking things in, say, the oil and gas segment. Is this part of your new program initiative? You seemed to imply that you expect the gross margin in Test to revert back to, call it, "historical norms," but I wonder if the incoming order book is such that the gross margins, maybe we should be thinking about them differently or not?

Jeffrey A. Graves

No, John, there's no change in our fundamental model. I mean, I'm really pleased with our penetration in some new, exciting areas like oil and gas and wind technology. We've got some really revolutionary equipment out there that's going into service right now. Unfortunately, when you do "first of a kind" stuff, there's often cost issues related to the last mile, if you will, of getting that equipment up and running. And many of those are driven by regulatory changes in health and safety kind of things in places -- in particular, these projects this quarter are largely in Europe, and many European regulations have changed over the 18 to 24 months that these products have been designed and being installed. So we see those costs at the end of the project. On the good news side, it drives our learning very quickly in these new exciting growth markets like oil and gas and wind. Unfortunately, there's a cost associated with that, which I almost think of as R&D-type costs. We learn as we go. But our chance of putting a benchmark project in a new growth market has been a model this company's followed for years and years and it's a real winner for us because then we set the standard for technology and expectations of the customer base and we have a technology edge then going forward. So -- but no change in the base model. This -- as Sue mentioned, this was an unusual quarter because we have 5 of these projects being installed right now and so the costs just happened to hit us in the quarter. Did that answer your question, John?

John Franzreb - Sidoti & Company, LLC

No -- yes, I mean, essentially what you're saying, Jeff, is that the gross margin profile, it just happened all these custom projects fell into the quarter, should revert back to norm. You're not addressing new markets that's kind of hurt the margin profile. Okay, okay.

Jeffrey A. Graves

No. In fact, I think the synergy market as an example is a really exciting one from a margin standpoint. I mean, it's -- they're very high value kind of applications for our customers. So they're willing to spend money on testing. So I'm really excited about that. We are being very deliberate in which of those -- these markets we choose for new projects and the energy market, I think, is a very, very exciting one. The oil and gas stuff, John, I would tell you is just tremendous. You look at the changes that have occurred in our country, in the United States, in the last couple of years with now talking about being energy independent. And what that really means from an infrastructure standpoint is a lot more exploration, transmission of these natural resources and all of that drives a need for reliable infrastructure, which our technology is great at testing. So I'm really excited about it. It will occasionally cost us money in the quarter from a margin standpoint, but it positions us beautifully from a, "first of a kind" offering out there that sets the standard for technology, which I think are difficult for others to compete with.

John Franzreb - Sidoti & Company, LLC

And Sue, can you remind me what the legal costs were that you incurred in fiscal 2012 that are not recurring this year?

Susan E. Knight

Those legal costs were associated with the government's investigation.

John Franzreb - Sidoti & Company, LLC

No, I know what they were associated with. What was the total tally last year?

Susan E. Knight

Well, the dollar amount of legal costs? I don't know that off the top of my head. I'll have to get back to you with that because I just can't recall it.

Operator

Up next, we'll hear from Liam Burke of Janney Capital Markets.

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

Jeff, you talked about a couple of design wins on the Sensors side. How quickly -- I mean, I know mobile hydraulic, just as a reference. Took a while for it to be designed in and then ultimately converted to revenue. How quickly do you anticipate design wins to start showing up on the revenue front here?

Jeffrey A. Graves

Liam, it's really frustrating because I can feel really good everyday coming in, looking at this litany of design wins that we have in Sensors. There really is an increasing demand out there for the technology and our technology is pretty compelling, both from a performance and cost standpoint. The frustrating thing to me is getting on a platform is just the first step. That platform has to sell and that sales process is strictly driven by capital investment for capacity in the world and it's frustratingly slow and difficult to get high visibility into. And part of the reason we had to change our guidance is we had expected the world to actually exhibit some kind of recovery in the second half of our fiscal year here and as we sit here today, I don't have enough visibility to say it's actually going to happen so that's why we had to bring our guidance down. It's really, really frustrating to not have direct visibility into that -- in demand. What I can tell you is we're getting designed into some really compelling platforms and I'll be really happy when the world gets stronger and those platforms sell from our customers.

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

Great. And you mentioned again 8% on the aftermarket growth in the quarter. Are -- is 1 particular region of the world, geographic region, doing better than others or are you seeing some uniform rollout of the initiative?

Jeffrey A. Graves

It's an interesting dynamic, Liam. Our installed base historically we've got $3.5 billion of installed equipment out there running. A disproportionate amount is in the U.S. and Western Europe because that's where the older infrastructure was installed. So we've got a lot of equipment with a lot of life in it running in those parts of the world. Obviously, some exciting growth in Asia. From a services standpoint, I think we're getting traction certainly in our installed base, which would be in the U.S. and Western Europe. But I'm equally excited in the emerging markets that they really need the service because they don't have the infrastructure yet. They really need the service for buying new equipment. They have to have the services right along with it. So I would tell you we're getting traction in all of our markets and I should have included Japan in our installed base. We've got a significant installed base in Japan as well. So as customers look to upgrade older equipment or shed costs within the laboratory by doing things more efficiently, we're there now to sell them that kind of service and that'll do nothing but grow in the future. So frankly, I was excited about 8% and that 10% growth year-to-date, and I think it's tip of the iceberg. I think we're going to have a lot of momentum in the coming quarters and years in our services segment.

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

Great. And Sue, accounts receivables stepped up during the quarter. Is there some reason for that?

Susan E. Knight

That's just timing of shipments, Liam. Periodically based on how shipments go out and revenue recognition on large projects occurs, it does affect the profile from quarter-to-quarter, but we watch the past due percentage and it's actually declined. So there's no risk in that regard. It's just a matter of turning it in the cash cycle.

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

Great. And your capital budget is near the same, you haven't changed that?

Susan E. Knight

We have not changed the capital budget for the year.

Operator

[Operator Instructions] We'll go next to Brown Advisory's Nigel Frankson.

Nigel Frankson

I have 2. First, really quick one. The tax rate for the rest of the year, we should assume to be 24%?

Susan E. Knight

No, I don't think we've ever had 24% from ongoing operations. This quarter was unique as it relates to the onetime benefit of the R&D tax credit. So you have to look at a more historical rate, which, for us, is in the low to mid-30% range.

Nigel Frankson

Got it. And the second question is I was hoping you could educate me on the value of your custom business. I knew there was margin risk there because the contracts are fixed-price contracts, so you inherently take on the risk of any cost overruns of the -- I knew the potential was there for this business to be a "lower than corporate average margin" business. But I'm surprised to learn, if I'm reading the press release correctly, that it's typically a "lower than corporate average" margin business. I would think anything that's a custom-made product is something you could charge a premium for. I'm curious as to why that's not a better business and why it's worth it for MTSC to chase that business?

Susan E. Knight

The custom business is still good business. It's just a relatively lower margin than either standard products or the service aftermarket business and there's a few reasons for that. One, custom does carry development risk. And this quarter, the 5 projects that I referenced are examples of that. They are fixed-priced contracts. We're designing things that haven't been made before and we carry that risk. Second thing to think about custom is when you don't make a specific piece of equipment often, you don't get the material volume benefits of large quantity, repeatable products as we do in the standard area. So margins are impacted there. And then there are many projects that have content that is more than sophisticated engineering, the design and sophisticated functional parts. When you think about a seismic system, for example, there's a lot of concrete that goes into the pit that is a basis for putting the system in and we can't mark up concrete like we can an engineering hour and those are just lower-margin projects by the nature of the content.

Jeffrey A. Graves

Nigel, at the heart of your question is a really important point for our business model, though. We have to be in this business of doing "first of a kind" projects in key growth markets. That's the way I'd look at this, is when we see a market that's going to grow around the world, we want to be the guy setting the standard for the new equipment. Because once we do that we can replicate the key components of that technology quite rapidly. We've done it in the automotive sector for years. I look at this energy market now with oil and gas and even wind and say we're the guys out there setting the standard based on our technology and our innovation. So it is very important. I look at that almost as a part of our R&D spend to be "first of a kind" in-key growth markets. That doesn't mean we do everything for everybody. But when we identify a market that's going to grow around the world, we want to be the guy setting the standard. And so even those margins might be slightly lower, it is essential in order to allow us to continue to grow the business. So walking away from those, you might feel good for a couple of quarters until everybody caught up with you and you were just competing on price. We compete largely on the value of our technology to our customers and so that's a key part of our business model.

Susan E. Knight

The other comment I would make about cost variances in custom, when you look at our total direct costs within the Test business, those variances on an annual basis run about 2%. In a good year, they're 1% and in a year where you've got a lot of development contact -- or content, it's 2.5%. But it's a relatively modest when you look at our total spend and the complexity and challenges with these highly customized systems. We work to make it be as small as possible, but we can't predict and know the timing on a quarterly basis.

Nigel Frankson

So when you say set the standard, are you effectively saying it's almost a market share grab that if you're the first there and you're doing it in a certain way, that process, repeat business with the same customer and perhaps their competitors and so forth?

Jeffrey A. Graves

Well, as an outcome, I believe it really does result in market share growth, Nigel, but the way to look at this really is, okay, there's a new demand. Take a large gas pipeline or oil pipeline and you think back to the disaster that happened in the Gulf of Mexico with oil leakage at a deep level. And so now there's a much larger interest in people having test machines and methods for measuring the quality of a pipe. A large oil and gas pipe, which is a very, very highly loaded system and the precision required is very high. We want to be the first of a kind out there, the first guy out there with the machines and the methods to do that kind of thing because we set the standards. Others will want to replicate that in our customer base because we've successfully done it for one party. So yes, it does result -- I believe it does result in market share growth clearly, but it allows us to continue to compete on a technology basis, rather than have the product just commoditized and compete on price because our history says that net-net all of the projects combined, our margin performance is outstanding, and as is with our payment plans, our cash flow in the business. So we want to replicate this model and continue growing it and our markets are strong, provided we picked them properly. So automotive, oil and gas, aerospace, those are some of our key markets out there and the materials testing that supports those markets.

Nigel Frankson

So the idea is just -- I want to repeat it so to make sure I have it right. So the idea is that you do the custom projects. It's a lower-margin business but you're fine with that because you develop new technologies that you can then use in other applications in the future and charge a premium for those because at that point in time it's proprietary, it's above and beyond what the competition has out there and it's effectively customer-funded R&D.

Jeffrey A. Graves

Yes. Fundamentally, you've got it. And as Sue mentioned, as the volumes grow and other customers buy this, our cost position in terms of supplier costs and things all get better. So yes, the "first of a kind project," you might take a margin hit for that. Still very good quality business, okay. It's not like many businesses where you give away the first few. We're still making very good margin on our first of a kind, but it sets the standard out there in our customer base and then as our volume grows we can drive our costs down and standardize componentry and gain share and margin as we grow.

Operator

And now, we'll go back to John Franzreb of Sidoti with a follow-up question.

John Franzreb - Sidoti & Company, LLC

Sure. Just to follow up on Nigel's thought. You said one of them was in oil and gas and I think you kind of called out to test the piping. Is that the kind of system you are actually making or was that an example? Are you doing valves? What are you testing in the oil and gas market or developing equipment to test in?

Jeffrey A. Graves

We're now shipping the first of a kind for a large oil piping, John. And this will be in a market developing and expanding, but there's a lot of interest right now and I would tell you we're doing similar things in the frac-ing arena with testing, drilling and piping to support drilling in the frac-ing market as well as how the rocks respond when you frac them. This whole energy segment for us is fantastic, and we're doing "first of a kind" work in everything from exploration to transmission of fossil fuels. And you look at the market out there and say, wow, it's growing. It's in our homeland here in the United States very quickly. And the concerns from an environmental and safety standpoint are very high, so it's a natural for us to be the leader in that kind of a segment and look at some sustained growth there. Then once the equipment's installed, it pulls our services right along with it. So that's the simple model and we are shipping a fantastic system within the next quarter here. It's getting ready to leave the factory and I believe it'll set the world standard for oil pipeline testing, frankly.

John Franzreb - Sidoti & Company, LLC

Jeff, I don't recall you having much exposure to oil and gas market at all.

Jeffrey A. Graves

It's been around, especially in the rock mechanics area, John, for a long time for oil drillers. But there's a tremendous interest now but just because of the changes in that end market that everybody sees. And it’s everything you get from exploration to transmission of fossil fuels.

John Franzreb - Sidoti & Company, LLC

Got it. Now, as far as adding any incremental fixed costs, where are we on that process? Are you happy with the way that the company's structured now? Are there more incremental costs coming in upcoming quarters?

Susan E. Knight

So, John, I commented about where we expect the operating expenses to be relative to revenue and that's as specific as we're going to get. Revenue growth, we see in the rate of 26% to 27%.

John Franzreb - Sidoti & Company, LLC

26% to 27%, right. Okay. So -- I mean, that kind of implies that you expect things to kind of flatline on the cost side from here on out, is that a fair assessment or no?

Susan E. Knight

John, you can do the math.

John Franzreb - Sidoti & Company, LLC

Okay. I guess one last question is on the Sensor side. We are starting to hear from some of the sensors companies that the order profile is moving on a sequential basis slightly positive. It seemed like you're having mixed results in that regard. Some businesses are down, some are up. What are your expectations as far as -- what are your customers telling you as far as their order patterns coming in the June quarter?

Jeffrey A. Graves

Well, again, John, we had our first quarter of growth in the Sensor business in 5 quarters. So that's great. One data point doesn't make a trend, but certainly, directionally it's a start. Two data points do, so if we can deliver another quarter of growth, you might say that the trend is upward. I was just very happy to see some improvement quarter-over-quarter. What our customers are saying publicly is same thing they're saying privately is, hey, things aren't getting worse and we can see some light at the end of the tunnel and we think things are going to get better. The disappointment for us is we really thought that would happen here in the second half. And until we see an orders flow, we're just going to be very cautious about saying it's here. So my personal opinion, which could change daily depending on the economic conditions here is yes, we've seen the worst of it and it's going to be upward from here, but it looks like it'll be a slow trek and we just have to keep pounding away. So I'd love to see the economy more robust and have that thing grow faster.

Operator

[Operator Instructions] We'll go next to Dan [indiscernible] with [indiscernible] .

Unknown Analyst

Can you just give us a sense as to where you guys are at in terms of the hiring process of the engineers and service personnel.

Jeffrey A. Graves

It's an ongoing process. So in every month, every quarter, we're hiring these guys, training them up and deploying them. It's nice to see that we're starting to get some benefit from the first folks that we hired, driving that 8% growth. That was really encouraging to me. So the model works. We have to just continue doing that. I wish it were a quicker process, but our equipment's very complex and there's a training period required so it'll be an ongoing effort. I really can't give you an end time. We're just going to continue investing in that direction. What we can do -- I would add, what we can do, Dan, is just measure our -- is just really be tight on our discretionary costs. So I'd put what you just asked about on service, that's a required cost for growth and we're spending money in that direction because we are -- the model works. We're seeing revenue growth and nice margins from that service growth, particularly addressing our installed base initially. Anything discretionary, we're tightening down on to make sure we're not getting out in front of ourselves there. But the investments for growth we're continuing and services is in that category.

Operator

And it appears we have no further questions at this time. Dr. Graves, I would like to turn the conference back over to you for additional remarks.

Jeffrey A. Graves

Thanks, Sarah. Well, thank you all for joining us today on our call. While the second quarter was more challenging than we expected, we're confident about our market opportunities and our growth prospects and strongly believe that our employees make a true difference for our customers everyday. We look forward to updating you again next quarter on our progress. Thank you again, and have a great day.

Operator

Again, that does conclude today's conference, and we thank you all for joining us.

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