Industrial test system and sensor manufacturer MTS Systems (MTSC) is the sort of small company (if over a half-billion dollars in sales is truly small) that just does what it does, year in and year out. As the company's customers operate in cyclical markets, MTS Systems' business inherits some of that cyclicality, but the company reliably delivers very good returns on capital as a byproduct of its strong market share and long customer relationships. With the shares not quite recovered from a post-earnings swoon, there is some value here though it is not a severely undervalued stock at this point.
Fiscal Q2 Basically Consistent With The Trend
MTS Systems reported a 3% decline in fiscal second quarter earnings, as test revenue declined 6% and swamped 15% growth in the much smaller sensor business. That was not all that different than expected (accounting for the fact that this is an exceptionally under-followed company), but it does mark a roughly two-year period where quarterly revenue has stayed in a fairly narrow band while many other companies exposed to auto and aerospace OEMs have seen growth.
Margin improvement efforts have yet to really pay off. Gross margin improved by 150bp after adjusting for a restructuring charge, but adjusted operating income was still down 8% on higher SG&A and R&D spending.
Orders Have Yet To Ignite
As MTS Systems typically carries around two quarters' worth of revenue in backlog, there is a pretty close directional link between orders and revenue. The very slight increase in orders could be seen as a positive sign, then. Sensor orders were up 15% and while test orders were down 3% in absolute terms, management said that base orders (orders worth $5 million or less) were up 3%.
Admittedly, that is not the stuff of growth stock dreams. Remember, though, that MTS Systems has historically been a late-cycle story and one where Europe plays a significant role. Auto OEMs (a large customer group for MTS Systems) have pulled back on capital equipment orders, or at least that is what companies in the laser, robotics, and machine tool industries have been reporting. Likewise, companies in end markets like wind power, power gen, and med-tech have been more careful with spending of late.
It's also worth noting that MTS Systems isn't much of an outlier. Moog (MOG.A) reported a 3% decline in its industrial systems business this quarter, and Illinois Tool Works' (ITW) Instron doesn't seem to be doing all that great either (though teasing Instron out of ITW's Test & Measurement requires plenty of guesswork).
Can Sensors Get Even Bigger?
I continue to believe that MTS Systems can grow its sensor business without compromising its strong presence in test and simulation systems. Whereas the company believes it has more than 20% share in ground vehicle testing/simulation, more than 30% share in structural testing, and more than 15% share in materials testing/simulation, the company's share in the nearly $2 billion sensor markets it addresses is in the single digits.
As industrial and process automation continues to advance, I would expect machine sensors (which can measure the physical displacement of machines or machine parts) to be a significant part of the process. Likewise in mobile hydraulics - the construction equipment market is not exactly healthy yet and the agricultural market seems to be rolling over, but I would expect greater penetration from automation and precision control in these markets to offer growth opportunities for MTS Systems.
A Bigger Skew To The Second Half
I believe that at least some of the negative reaction to MTS Systems' last earnings report was tied to the company's guidance. While management didn't really change much about the full-year outlook, the guidance for the next quarter suggests a heavier skew to better results later in the year.
Still A Story With Credible Growth
I still do not fully share management's bullishness on the company's growth prospects, but I do believe there is above-average growth potential here. As Europe recovers, I expect results to improve later in 2014 and into 2015. Sales to Europe were down 10% this quarter in the test business and that was a significant headwind.
Likewise, I expect the ongoing incorporation of new materials and composites in industries like aerospace, autos, power gen, and medicine will lead to good demand growth for the company's materials testing/simulation products. Encouragingly, the company is seeing good order growth in China, and I believe that becoming a go-to partner for Chinese auto and aerospace companies is vital to the long-term success of the company.
All told, I'm still looking for just over 7% revenue growth for MTS Systems over the long term, with low double-digit growth in free cash flow. The cyclicality of MTS Systems' business would normally lead me to use a higher discount rate, but the company's strong history of ROIC leads me to go the other way. Discounting it all back, I calculate a fair value of $74 to $79 today.
The Bottom Line
MTS Systems shares have done pretty well since my last review (up about 18%), but I still lean bullish on these shares. The bargain isn't quite as significant as it was in September but I continue to believe this is a good long-term holding for patient investors.