MTS Systems Corporation F4Q09 (Qtr End 10/03/09) Earnings Call Transcript

| About: MTS Systems (MTSC)

MTS Systems Corporation (NASDAQ:MTSC)

F4Q09 Earnings Call

November 20, 2009 10:00 am ET


Susan E. Knight – Chief Financial Officer and Vice President

Laura B. Hamilton – Chair and Chief Executive Officer


John Franzreb - Sidoti & Company

Liam Burke - Janney Montgomery Scott LLC

Michael Hamilton - RBC Capital Markets


Good day and welcome to the MTS fourth quarter 2009 earnings release conference call. As a reminder, today’s conference is being recorded. At this time I’d like to turn the conference over to your host, Miss Sue Knight. Please go ahead, ma’am.

Susan E. Knight

Thank you, Amber. Good morning and welcome to MTS Systems fiscal 2009 fourth quarter investor teleconference.

Joining me on the call today is Laura Hamilton, Chair and Chief Executive Officer.

I’d like to remind you that statements made today, which are not a historical fact, could 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 references to financial measures which are not calculated in accordance with generally accepted accounting principles. These measures may be used by management to compare the operating performance of the company over time. It should not be considered in isolation or as a substitute for GAAP measures.

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

Laura B. Hamilton

Thanks Sue. Good morning, and thank you for joining our fourth quarter call. In today’s call we’re going to cover headlines, order summary, Sue will take you through the financial details, she’ll turn it back to me for a quick recap of ’09 and then we’ll do the look forward.

We have four headlines for fourth quarter. Our first headline is that Q4 orders are up 18% sequentially and although our fourth quarter included an extra week we were still up over Q3. We completed our previously announced fourth quarter workforce and cost reduction actions. We achieved our revenue and earnings per share outlook and we delivered positive operating cash flow and strong year end cash position.

At the end of the day, it was a good end to a really tough year. Let’s shift to orders to try to understand the environment today. From a total company perspective, orders were $96 million. Q4 was up 18% over Q3 and as we’ve said Q4 included an extra week. If we exclude it, the Q4 increase is attributable to the Test business.

Total company orders at $96 million were down 17% year-over-year, which is down 23% on an organic basis. We picked up 6 points from the SANS acquisition. Again, we’re pleased that Q4 orders are back to the Q1 level.

Backlog at $168 million was up 3 points from Q3. Essentially orders equals revenue in the fourth quarter. We’re finally seeing a smoothing out, albeit it’s at a new lower level of business. It’s our first quarter over quarter growth in 5 quarters, and while it’s down 29% or $67 million for last year, it’s still steady. But we will see the effect of this decline in the fiscal year ’10 revenue.

Backlog is up 4 points from the SANS acquisition.

Let’s talk about the external environment or the world of our customers. Right now there are four key drivers affecting our customers, the economy; energy; environment; and globalization predominantly in China. These four drivers are impacting the businesses of our customers in two key ways. First is economic reset. Our customers are seeing reduced profitability which is affecting and reducing their ability to invest. Therefore, companies are being more selective and they’re being slower to commit. We see a continued emphasis on cost reduction and the elimination of non-value added work. These four drivers are also affecting our customers because our customers are all trying to seek a bigger piece of a smaller pie. It means increased competition, which is driving an increased need for fresh products and fresh products faster. Our customers are using technology to differentiate, whether it’s around energy, environment or product performance. The environment is creating both pressure and opportunity, and we’ll talk more about this by business.

Let’s just [inaudible] Sensors business. At $16.5 million, Q4 orders for Sensors were essentially flat after adjusting for the extra week. Sensors backlog was up 8%. Generally speaking, customers are buying in small volumes to meet immediate, just in time demand. But backlog is up 8% or $1 million over Q3, really driven by a few larger purchase orders by a few customers. The customer environment for Sensors is something we should focus on. The environment is essentially stable, but the biggest issue affecting the environment is a lack of dramatic change in end market demand.

Lower overall profitability in the industrial market is driving a limited capacity investment. While customers have made big cuts, they are also carrying excess capacity, which means they’re going to be slow to ramp up. Energy and the environment are creating opportunity due to both changes in technology, as well as new applications like wind. China’s growth is a bright spot, whether we’re talking about steel, plastics or fuel storage. In some of the smaller markets like medical and some of the mobile hydraulics markets like road construction, material handling and agriculture, are fairing better than the industrial market.

We see areas that are stable but at much lower levels. Things related to consumer products, like the plastics industry; or automotive, like plastics and rubber; and metal forming; or residential and commercial construction, which translates into wood and construction machinery. We also see areas that are presenting more opportunity. For example, steel, whether it be new plants or mill upgrades. New opportunity in energy whether it be wind, oil and gas or power, and more opportunity in China and U.S. infrastructure investments.

Over the last 12 months, the industrial markets have been reported down at about 40% plus, but our Sensors business is down about 30%. We believe we’ve outperformed the market. This is attributable to two key areas, the first being new applications. Our focus on increasing performance while reducing cost enables access to a greater portion of the market. One example of this is in hydro turbines. MTS developed a new triple redundant Sensor to meet the requirements of this application. Once accomplished, this customer’s decision was driven by needs of programming and the elimination of recalibration. Other examples of this include marine steering, automated welding systems, polyurethane presses and refrigerant recovery systems.

The second area we attribute outperforming the market to is the ability to take market share. Our focus on increasing performance while reducing cost, together with our ability to maintain our customer support while others didn’t, has helped us to take share from competitors. One example of this is at [Arvade], an Italian steel mill, where we replaced a competitor’s encoder. We had to improve our product performance to meet their performance specifications, but then the customer’s decision was driven by total cost of ownership. Longer life, less recalibration and less mechanical protection was required with MTS Sensors. We offered a total lower cost of ownership.

Another example of taking share is at a Chinese tire press maker, who was having issues with potentiometer [sealings] due to heat and contamination. This customer worked with MTS to address these issues. Then our higher Sensor performance also enabled more precise control of the process for better quality.

And finally, at a high speed train OEM, we worked for the better part of two years on reliability and gaining qualification at this OEM, ultimately replacing another competitor’s product. In summary, it was a tough year, with significant decline in the first half and a stable second half. But we outperformed the market. We reset some new levels and we don’t expect quick market recovery. But new applications and our ability to take share position us well to capture the opportunity ahead. We’ve proven we have what it takes to win in any economic environment.

Let’s shift to the Test business. At $79 million, Q4 orders were up $13 million or 21% over the third quarter. We have to estimate the effect of the extra week in Test, but we’d say maybe about half of this is due to the extra week. We saw a 20% growth in the organic business and 12% growth in the SANS business. We’ve seen two consecutive quarterly increases, but this is off of a pretty scary low in the second quarter of $47 million.

Backlog was up 2% or $4 million from Q3. This is a small increase but it is the first quarterly increase in the last six quarters. It feels good to see an end to the decline. However, we are entering fiscal year ’10 with $67 million less in backlog than last year and that will be a challenge.

Let’s shift to the Test customer environment. Unlike Sensors, which is very steady right now, Test’s normal volatility is increasing. Like Sensors, a key factor in the environment is the lack of dramatic change in end market demand. Lower overall profitability at our customers is limiting capital investment and slowing decision making. We see increased competitiveness for our customers, which is driving a need for fresh products faster. Customers are making priority investments, they’re being funded, but ROI is critical.

Energy and the environment are driving the focus on improved fuel economy and alternative energy like wind and geothermal. And again, China’s growth is everybody’s opportunity, whether we’re talking about rail, infrastructure investment or the automotive industry. China was a particularly bright spot for Test this quarter.

And stimulus is creating more variability than ever. There’s a flurry of activity of wanting it, then there’s waiting for it, then there’s getting it and spending it. MTS’s fourth quarter was driven really by the infrastructure business versus the third quarter. Ground vehicles was essentially flat, but infrastructure was up 57%, driven by strong government and university spending, SANS increase and a $7 million seismic order in China. Aero was down 18% but this is just the episodic nature of aero.

Over the last 12 months, the auto industry was one of the hardest hit industries in this economic decline, which has really driven a change in our ground vehicles business, but it also affects our infrastructure materials business. Ground vehicles is down 50% year-over-year. And ground vehicles dropped from about 50% of our orders last year to about 35% of orders this year. Infrastructure, including SANS, was down 9% year-over-year and down 26% without SANS. Infrastructure orders were greater than ground vehicle orders this year, the first time in a long time. And aero was essentially flat.

Not surprisingly, when we include SANS, the Americas has gone from 39% of our mix to 32%, while Asia has gone from 30% to 40%. And custom orders are down 50%.

Test saw a dramatic first half sequential decline at about 20% followed by 35% in the first two quarters excluding SANS. This is followed by a positive upturn in the second half, seeing a 25% and about a 20% increase respectively. Interestingly, the second half was only up about $12 million from the first half, but this is really the result of the recession hitting very late in the first quarter. What we can conclude is that Q3 and Q4 was more stable than what we saw in the second quarter and order predictability, while still challenging, is improving slowly. What we can’t conclude is that orders growth will continue at 20% to 25% per quarter.

Remember, a typical swing for Test is kind of $10 to $20 million in a quarter, which is the nature of the business. And the current environment says that could be bigger.

It’s much more difficult to compare Test fiscal year ’09 performance to the market, because the data’s not really readily available. But we did respond quickly to the drop in the automotive demand. We established market development teams to capture opportunity in emerging areas like wind, rail, and other alternative energy sources. We targeted opportunity in tire rolling resistance, we improved our product cost and captured key wins in the year and are well positioned for fiscal year ’10.

We leveraged our expertise to win at important accounts like Chery Automotive in China and Rolls Royce in Europe. And we doubled our efforts in China to insure we were fully participating in their rapid expansion. Our applications expertise, real life simulation capabilities, and global presence, position us well for the opportunity ahead.

Now let me turn this over to Sue for the financial details.

Susan E. Knight

Thank you Laura. Today my summary will include perspective on both the fourth quarter and the full year. My fourth quarter comments will be a sequential comparison to third quarter. Overall the fourth quarter results were in line with our expectations. And then I’ll close with the company’s financial results for the full year.

Beginning with the sequential quarter revenue comparison, compared to Q3, revenue increased 3% to $94 million. Revenue growth by segment was 2% in Test and 11% in Sensors. Currency changes were not a material factor compared to Q3. Revenue was negatively impacted by lower opening backlog of $12 million, which was more than offset by a strong conversion to revenue due to a combination of the extra week this quarter, Test mix and operations performance improvement.

Moving on to gross margins, the sequential gross margin rate was down approximately 5 points to 33.3%, driven by severance costs and as expected the rate was constant on relatively flat revenue. Severance costs were $5 million in the quarter.

At the segment level, Sensors was flat at 55% and did not include any severance cost impact. Test was 28.9%. Severance costs reduced the rate in Test by 6.4 points.

Operating expenses were $35 million, up $5 million including $3.1 million of severance related costs. The other $2 million of increase was not part of our quarterly run rate, as we had expenditures to support cost reduction initiatives and higher legal costs.

In total, pretax severance costs in the fourth quarter were $8.1 million compared to $1.2 million in Q3. Approximately 130 employees were affected in all regions.

The tax rate in the quarter was 21.5%. That’s the benefit of six tax credits favorably impacted the rate on lower earnings.

Compared sequentially to Q3, earnings per share declined from $0.19 last quarter to a loss of $0.18. Severance costs in the fourth quarter impacted earnings per share by $0.33. The third quarter impact of severance cost was $0.04.

Now moving to the full year 2009, I’d like to spend a few minutes commenting on the year from a macro perspective. The question is no longer whether or not there’s been a recession. The question is how did we do during the last 12 months? Beginning with orders, both Test and Sensors began to see the impact of a significant reduction in capital equipment demand beginning in Q1. Organic orders declined 35% for the year, in the range of experience of other industrial companies and notwithstanding the higher automotive industry aspect of Test. SANS contributed 5 points of growth, so total company orders were down 30%. The order pattern in the last two quarters has been good, but orders still remain well below 2008 levels.

Moving on to revenue, record high beginning of year backlog of $235 million caused organic revenue to decline at 16%, roughly half of the 35% organic orders declined. SANS also added 5 points of growth, so total company revenue was down only 11%. This does not suggest that we have [skagged] the recession. It does say that we will feel the residual effect in 2010 as Test lags the decline and will also lag the recovery.

Moving on to EBIT, we achieved a 7% EBIT rate in the organic business despite the severe economic conditions. Severance costs of $12.1 million impacted the rate by approximately 3 points. Including year one SANS results, which included integration costs, the EBIT rate was 9%. Every quarter without severance we were profitable as we took timely cost actions in response to the rapidly changing market conditions. The organic EBIT of $40 million declined 37% or 2 times the revenue rate decline as we needed to consider preservation of critical capability, fixed structural costs and the need to balance both short and long term objectives.

We spent $12 million on severance costs to right size the company and reduce our structural costs. This cost will yield net savings before tax of $21 million of savings in 2010.

Moving on to cash, operating cash flow was $44 million driven by profitability and a reduction in the working capital requirement associated with lower revenue. Our cash balance is up $5 million to $119 million at year end. We spent $10 million on capital expenditures and $9 million on SANS, net of borrowings. Despite a tough economy, we maintained a strong cash position that enabled us to continue paying $10 million in dividends and $11 million in net share purchases.

We are very pleased that we were able to return cash to shareholders during a period when many companies couldn’t because they had to preserve cash to maintain adequate liquidity.

While our return on invested capital declined to 18% from 20% plus historically on reduced profitability, we did deliver positive returns.

In summary, our financial performance reflects both the economic times and our quick response to maintain operating profit, albeit less, and a healthy balance sheet.

Now I’d like to turn the call back over to Laura.

Laura B. Hamilton

Thanks Sue. So we are glad to put 2009 behind us, but we remain proud of what was accomplished. We did feel the full effect of the recession, but we feel we have successfully navigated through it. We maintained our commitment to customers. We aligned resources to our highest priority market needs. We completed the SANS integration. We’re profitable from operations excluding restructuring costs every quarter. And although painful, we made timely, necessary and targeted cost reductions to smartly rationalize expenses while improving customer experience globally, and positioning the company for the long term.

So let’s take a look forward. What we want to do is share our view of fiscal year ’10. The economic picture is mixed and you can find support for whatever you want to believe. On the not so pretty side, U.S. industrial capacity utilization is at 68%, a historic low. European sales of plastic and rubber manufacturing machinery are expected to plummet 30% due to weak auto and packaging demand.

On the rosy side, the World Steel Association predicts exceptionally strong consumption in China at 9% in 2010, recovering to 2008 levels. And Daimler announced a $4.5 billion German factory investment to expand the line up of compact cars. Our view is that given the many consumer, industry and government structural issues, it will take time to work through this. For our markets we believe that the Sensors industrial customers will be challenged by excess capacity and lower profitability. And capital equipment is one step removed from improvement in end user demand. We believe that Sensors ability to find new applications and markets continues to be key to our growth process.

In Test, we believe that customers will fund priority R&D capital projects. They’ll do this with a high level of scrutiny and they’ll do it more slowly. And there will be lots of competition. And we believe that emerging market opportunities will pay off, whether it be China, energy, rail or infrastructure.

So how do we think about the financial outlook for the year ahead? Let me provide you with a framework. We enter the year knowing that opening backlog is $67 million less than last year. It’s the lag in the Test business and it needs to flow through revenue. We know that 2009 net cost reduction actions will help offset this margin impact. We also enter the year though with current economic conditions that create a broad spectrum of possible order outcome. Customers’ financial situations, competition, stimulus, timing and mix all create a very broad range of possible outcomes, and we need to see how some of this plays out. We will keep you apprised each quarter.

In closing, we’re proud of what we’ve accomplished in fiscal year ’09. We’re pleased with our strong positioning to date and we are prepared to make the most of fiscal year ’10.

Thank you. This is the end of our prepared remarks and I’ll now turn this over to Amber for the Q&A.

Question-and-Answer Session


Thank you. (Operator Instructions) Your first question comes from John Franzreb - Sidoti & Company.

John Franzreb - Sidoti & Company

My first question is regarding the cost savings actions, especially relative to the commentary that you just said, Laura, and what’s in the press release about based on those actions and the drop in backlog that you look for operating margins to stabilize. Are you talking about operating margins stabilize compared to what you did for the full year or how you exited the fourth quarter? Because you provide a little bit of color as to the cost savings and margin expectations based on where you are right now.

Laura B. Hamilton

I think we didn’t say exactly what you were saying. What we’re saying is that we know that we’ve got this backlog effect on revenue and that the net cost savings that we achieved this year will help to offset the backlog reduction. So much of the margin rate that we’re going to achieve will be dependent on the overall volumes, so we haven’t given you expectations on that yet.

John Franzreb - Sidoti & Company

Do you expect the cost saving moves that you put in place to be incremental to the operating profit in the year ahead? Or do you expect them to help stabilize the profit environment in the year ahead?

Laura B. Hamilton

It’s hard to answer your question so the cost savings are real and the part you’re asking about is volume, and what we’re saying is the possible range of net volume is too broad. And that will have an effect on profitability rates. So I think we’re not answering your question.

John Franzreb - Sidoti & Company

Why are you unwilling to give earnings guidance in this environment when you reported numbers in the July timeframe? And it would seem given with what the order book was back then, that that would be a scarier environment. Why have you decided to pull back from giving the guidance now?

Laura B. Hamilton

So that’s a great question. Last time we gave you direction on halfway through the year, so I agree with you it was a harder time but at that point in time, we were only looking out six months. We had six months behind us. And what we said was if this continues, and then we said earnings would be about half, so we were directionally saying this is how it would play out. To do that today, there’s too many possible ways this could play out. It’s 12 months out and it’s so broad that it’s not meaningful. And that’s why we’re not.

John Franzreb - Sidoti & Company

Do you think it might be better to think about it on a quarterly basis? Do you have that kind of visibility?

Laura B. Hamilton

No. Quarterly is a different thing and we won’t do quarterly guidance. So you know the variability of the Test business, all of that, but I mean we really directionally we’re trying to help you see the year ahead and we are sharing with you as much of that as we can see. And right now, the economy, I mean we’ve said we believe it’s flat, but we recognize that lots of people have lots of different opinions about that. But even with that assumption, there’s too much variability to give you a meaningful range at this time.

John Franzreb - Sidoti & Company

In your prepared statements you mentioned something about competition and I think you alluded to pricing. Are you seeing project pricing come in substantially? Is that just a concern that has not yet materialized?

Laura B. Hamilton

Well, my reference was to our customers and the reference I made was that everybody’s seeking a bigger piece of a smaller pie. And I think that’s true for us and I think that’s true for our customers. And so it is challenging. Do we see across the board price impact? No. Do we see spot places where people may be using price to absorb excess capacity? Yes. And our customers are in the same competitive situation, which is actually creating opportunity for us. So it’s a good and a bad thing all at the same time.


Your next question comes from Liam Burke - Janney Montgomery Scott LLC.

Liam Burke - Janney Montgomery Scott LLC

Laura, you mentioned one large order for a seismic application for China. Behind that, how has the quote activity been across the board? Are you seeing more requests for proposals or less or how is that looking right now?

Laura B. Hamilton

I’d say that the fourth quarter activity was pretty good in comparison, 2 was really slow, 3 was picking up and 4 was better. Our pipeline’s up about 10% but remember the probability tends to be lower. But still, growing pipeline is good. And we are seeing a range of dollar size. So where in the Q2 we weren’t talking to many people about anything over $1 million, there’s more larger order activity than there was, but there wasn’t any before. More than zero.

Liam Burke - Janney Montgomery Scott LLC

Is there any particular geography? Is it weighted more heavily towards Southeast Asia or are you seeing any quote activity in Europe or the Americas?

Laura B. Hamilton

I’d tell you that China’s hot, Europe will probably start reinvesting sooner just because of the way they think about business, and the Americas is interesting because of government infrastructure and some potential stimulus. But stimulus is really a wild card. You know Japan has turned theirs off, other countries have said theirs is done and others are still considering turning it on. So stimulus is a wild card.

Liam Burke - Janney Montgomery Scott LLC

And Sue on the expense side, did you have any meaningful non-cash amortization of intangibles this year? And what was the total depreciation amortization number for the year?

Susan E. Knight

We had amortization associated with SANS of about $2.5 million. And your second question was about? Can you repeat it?

Liam Burke - Janney Montgomery Scott LLC

Total depreciation amortization for the year.

Susan E. Knight

Let me get you that number. $12 million.


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

Michael Hamilton - RBC Capital Markets

A couple of questions on activity dynamics. Are you seeing anything new in terms of what your customers are requesting out of you? And particularly in the area of financing?

Laura B. Hamilton

You know interestingly it hasn’t been a big change. You know we have a few anecdotal situations, but we had those before, too, where somebody might want to try to do a sale leaseback or something, so not significantly. Things that are different. What we talk about is that our customers need to be able to present a return on investment and we need to be better at helping them put that together.

One of the things in the automotive industry is the customer is really trying to improve the model, the model of the car, and there’s certain information demand requirements that we’re trying to help them meet so that they can improve the quality of the model and the prediction of the product performance. So that’s not new because of the economy, but that’s maybe more of newer. But economic wise, maybe a few customers say let’s talk about you managing my assets, but these are the same customers that have mentioned that five years ago and ten years ago. And it’s not worldwide, across the board.

Susan E. Knight

And Michael we do offer two options based on relationships that we’ve established for third party financing and different kinds of lease arrangements. We rarely if ever do first party because we’re still not that bank of Eden Prairie, but building on Laura’s comment there have been very few that have taken advantage of it. We did not see a dramatic change in demand associated with the last 12 months.

Michael Hamilton - RBC Capital Markets

I think the issues that you’ve ducked on still apply on this question, but you may have some ideas on ways to think about it and that’s what you see as your overhead run rate being as we go into 2010, given the restructuring actions that have been taken.

Laura B. Hamilton

In the fourth quarter our operating expenses were $35 million and we said $3 of that was restructuring related and we said $2 was non-recurring, because they were associated with some of our actions. So I would think of that as the high end of what we would expect going forward.

Michael Hamilton - RBC Capital Markets

You mentioned within that some legal expenses. Is there anything worth noting on a carry forward basis?

Laura B. Hamilton

No, not on a carry forward basis.

Michael Hamilton - RBC Capital Markets

In terms of thinking about backlog timing, how does that stack up with what we would have seen in times past?

Laura B. Hamilton

It’s a little difficult to compare to historical because mix is such a big factor. We do have less custom so therefore the backlog, when it has less custom, turns faster. We are working on operational efficiencies to improve our turns. So I think what we’d say is the mix is more towards a faster mix and we’re working on continuing to tweak it up a point here and there so that just from our ability to convert it to revenue. So to be more competitive, we get to shorten our delivery times is important.

Michael Hamilton - RBC Capital Markets

And historically that mix would imply more predictability in gross margin. Is that true in this environment?

Laura B. Hamilton

Well we’ve said that our margins shift around in Test by about 3 points due to mix. So the things affecting the go forward is probably less a mix effect and more volume. So every piece of incremental volume right now is going to have the biggest effect on our margin rate.


This concludes today’s question-and-answer session. At this time I’d like to turn the conference back over to our speakers for any additional comments.

Laura B. Hamilton

Thank you, Amber. Well I thank you again for all participating with us today. We are pleased to be closing out ‘9 and moving on to ’10. And like I said we are proud of what we’ve accomplished. We are pleased with our current positioning and we are prepared to make the most of fiscal year ’10. We look forward to keeping you up to date on that. Thank you.


This does conclude today’s conference. Thank you for your participation.

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