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MTS Systems (NASDAQ:MTSC)

Q2 2011 Earnings Call

May 06, 2011 10:00 am ET

Executives

Laura Hamilton - Chairman and Chief Executive Officer

Susan Knight - Chief Financial Officer and Vice President

Analysts

Michael Hamilton - RBC Wealth Management, Inc.

John Franzreb - Sidoti & Company, LLC

Liam Burke - Janney Montgomery Scott LLC

Operator

Good day, everyone, and welcome to the MTS Second Quarter 2011 Earnings Release Conference Call. Just a reminder, today’s conference is being recorded. At this time, I would like to turn the conference over to Ms. Sue Knight.

Please go ahead, ma'am.

Susan Knight

Thank you, Vicky. Good morning, and welcome to MTS Systems’ Fiscal 2011 Second 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 over time. They should not be considered in isolation or as a substitute for GAAP measures.

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

Laura Hamilton

Thank you, Sue. Okay, let me just start with an outline for today's call. We're going to start with Q2 key messages. I will then take you through a review of orders, again, to kind of give us sense of what's happening in our market. Sue will take through the financial details. I will then touch on our U.S. government proceedings and then talk about the 2011 outlook.

Before I jump in though, I would like to start with a comment on the situation in Japan. MTS has been doing business in Japan for decades, and this is one of the most difficult situations their country has faced.

I was in Japan the week of the earthquake and tsunami. On Tuesday, I had visited KAJIMA Technical Research Institute, a customer and one of Japan's largest general contracting companies. KAJIMA is dedicated to realizing a better society through its R&D activities. In part, this includes a focus on safety as it relates to earthquakes. KAJIMA works with MTS on earthquake simulations to support these activities. And on that Tuesday, I watched the simulation of the Kobe and New Zealand earthquakes, and it was quite emotional. On Friday, I was at Narita airport when the earthquake actually hit. Fortunately, none of our MTS employees were harmed, although this is going to have our -- or has had significant impact on the country and the people of Japan.

We want to thank our employees for their dedication and working through the many challenges faced. We strongly believe in Japan's ability to recover over time. And today, we're doing all we can to meet our customers’ needs while providing for the safety of our employees.

Let's shift to our key messages for the quarter, of which there are 3. The first message is Q2 results were strong, especially as they demonstrate a continuation of our Q1 performance. Our second key message, which you are most likely aware, is that during the quarter, we were suspended from U.S. government contracting. And our third message is that we maintain our strong outlook for the year. Let me shift to orders and talk about what's happening this quarter and year-to-date in our markets.

For total company, Q2 orders came in at $118 million, up 27% year-over-year, with 2 points attributable to favorable currency. There were no large orders. No orders greater than $5 million in the quarter, though all 27 points is growth of the base business, which put us above our base order range for this one quarter.

There was one large order delayed about 3 weeks and into Q3 due to the earthquake in Japan. This is now our third very strong quarter in a row, and there was no material impact from the U.S. government suspension. Backlog for the total company ended at $254 million, which continues to set a new record.

So let's understand this side business. Sensors for the quarter came in at $26.8 million for orders, which is an all-time high for the Sensors business, so it’s very exciting. We were up 28% year-over-year, of which 4 points of that is attributable to currency. All regions of the Sensors business were up similarly.

From a business perspective, Industrial was up 26% year-over-year, and we've said this before, but the key drivers continue in our traditional markets in plastic and rubber, metal-forming machines, fluid power and wood. And what we're not seeing is an increase in steel. And in our newer markets, we're seeing increases due to energy, medical equipment and recreational vehicles. Mobile Hydraulics was up 38% year-over-year, again, continuing to be driven by agriculture and construction equipment in North America, as well as material handling and road-building equipment in Europe. Sensors’ first half orders came in at just over $50 million.

We've started the year at a record pace. All geographies are up year-over-year. And China now comprises about 16% of the total orders year-to-date. Industrial is up 28% year-over-year, with Mobile Hydraulic up 61%.

First half is really driven by 3 things. First is that volume is returning in traditional Industrial segments. Second, we continue to capture new industrial applications for magnetostrictive technology globally. And third, we see accelerating technology adoption in Mobile Hydraulics. Fundamentally, MTS has the products, the applications expertise and the customer support to win in our Sensors market.

I’m going to shift to Test now, and Q2 orders for Test came in at $92 million, which is a good order, up 27% year-over-year, 2 points of that attributable to currency. Again, there were no large orders in the quarter, so all of this came from base orders. I did mention already one large order was delayed due to the Japan earthquake.

I'm going to analyze the first half for Test rather than a single quarter because quarter-to-quarter variability is so dramatic, it can be quite misleading in terms of what's happening in the marketplace. So first half orders for Test are up 27% year-over-year. 80% of the growth is an increase from base orders, and 20% of it is attributable to an increase in large orders. Customers are making more capital investments as their profitability continues to improve. Looking at this by market, ground vehicles for the first half is up 152%, so clearly, the ground vehicles market is recovering. We see continued strength in durability, in tire and we've even had recent wins in rail.

Materials for the first half is approximately flat on a year-over-year basis. Anecdotally, there’s higher commercial mix and less government due to less stimulus and more budget cuts across government. The first half is really pre-suspension, so there's no suspension effect in this.

Structures, on a year-over-year basis for the first half, is essentially flat except for the 2 large orders that we booked in fiscal year '10 for $20 million. We did have a key win this quarter in structures in wind, and I want to talk to you a little bit about it.

We won an order at National Renewable Energy Lab in Colorado. Their mission is to help utilize maximized wind power generation. We developed for them a Non-Torque Loading System, and it's our third order for this NTL in one year. The importance of this is that MTS is first to market. We've developed a solution that's endorsed by the industry and industry-sought leaders. And we're delivering best total value. We meet the market needs for real-life simulation, while doing this through a pre-engineered, cost-competitive, lower-risk solution. This is a great example of an investment we made during the recession that's paying off today.

Let me shift just quickly to a geographic view from a year-to-date. Asia makes up about 40% of our first half orders, which is unusual, and really, it was driven broadly, China, Japan, Korea and Southeast Asia, and it really was predominantly ground-vehicle-driven. North America and Europe each make up approximately 30% of the balance -- or of the total.

From a mix perspective, custom makes up about 55% of first-half orders. So now, that's 4 consecutive quarters of increased custom mix. Our opportunity pipeline is up about 10% on a sequential quarter basis. It's up in all regions. It's up in both base and large orders so across -- very broadly, it's up everywhere. Backlog ended at $237 million, up 3% sequentially. So it continues to be a record, and the custom in backlog is also at a record level. The significance of this is that custom turns more slowly into revenue and is generally at lower margin.

At this point, I'm going to turn it over to Sue, and we'll go through the financial details, and then I'll come back to U.S. government.

Susan Knight

Thank you Laura. My remarks today will focus on the second quarter year-over-year comparison, beginning with revenue.

At $113 million, we were very pleased to achieve 20% year-over-year growth in the quarter. Strong short cycle demand in Sensors, as evidenced in our 28% orders growth and the $62 million higher beginning company backlog, contributed to the increase in revenue. Favorable currency translation contributed 2 points of growth.

On a segment basis, Test revenue was $87 million, up 15% and driven primarily from higher backlog. Currency translation positively impacted the growth rate, also by 2 points. Sensors revenue increased 39% to $26 million including a 3-point positive effect of currency translation. Sensors growth was a result of strong orders in the quarter and $5 million higher opening backlog compared to last year. Both Test and Sensors had revenue growth in all 3 geographic areas: North America, Europe and Asia.

At $49 million, gross profit was strong, increasing 27% from the prior year. Approximately 75% of the increase was from higher revenue and 25% from a higher gross margin rate. On a segment basis, Test and Sensors each contributed approximately half of the $10-million increase. Test gross profit increased by 18%, primarily the result of 15% of the revenue. Volume leverage had a favorable impact, which more than offset the negative mix impact of higher custom revenue. Sensors gross profit increased 52% from a combination of 39% higher revenue and the benefit of volume leverage.

Moving on to gross margin rate. At the company level, the gross margin rate was up 2.4 points, at 43.3%, which was very good, particularly given the increase in Test revenue from lower margin custom backlogs. Higher volume and the associated leverage are the key drivers. The Test gross margin rate was up approximately 1 point to 38.7%, which is in our expected performance range considering both volume and mix. Sensors gross profit rate was excellent, 58.4%, up approximately 5 points from operating efficiencies and volume leverage and above our expected mid-50% performance range.

Moving on to operating expenses. For the quarter, they were $31 million, an increase of 9%. Of that increase, 3 points was attributable to higher selling costs, driven by the 27% increase in orders, 2 points from higher legal and consulting expenses and 2 points from increased salaries and benefits. As a percent of revenue, operating expenses declined at 2.7 points to 27.5%. Overall, $31 million is within our expected range for the quarter of $28 million to $31 million.

Looking forward, operating expenses will likely be in the range of $32 million to $34 million in the second half from higher legal and consulting expenses, as well as business investments which enable our strategy. We were very pleased to achieve an EBIT rate in the quarter of 15.9%. It's up approximately 50% compared to last year from improvements in both gross margin and operating expense as a percent of revenue, as volume has increased.

The tax rate for the quarter was 32.9%, consistent with the mid-30s quarterly range and lower than the 36% in the prior year. This year's rate includes approximately 1 point of benefit from the R&D tax credit, the remaining difference is due to favorable mix of income by country.

At $0.75, earnings per share was 2x the prior year. Of the $0.38 increase, approximately $0.30 was from volumes, $0.10 from higher margin rates and $0.04 each from a lower share count and lower tax rate, which more than offset the $0.10 negative impact of higher operating expenses.

The last topic today is cash and cash utilization. Our balance sheet remains healthy with $106 million of cash, an increase of $25 million in the quarter. Operating cash flow was $22 million, driven primarily by earnings and some change in other assets and liabilities. Working capital utilization was unchanged. We are proactively buying additional inventory range of $2 million to $3 million to offset the Japan earthquake effects on Test and Sensors supply chains that will impact operating cash flow in the second half of the year.

That completes my comments on the second quarter. Now I'll turn the callback to Laura.

Laura Hamilton

Okay. So let me move to U.S. government proceedings of which I think you are mostly aware. We communicated in the second quarter regarding the U.S. government investigation and suspension of MTS.

First, I'd like to say that the U.S. government is a very important customer to MTS. We take this matter very seriously, and we are cooperating fully. The government is investigating why MTS had not disclosed on the government’s Online Representations and Certifications Application, otherwise known as an ORCA, that the company had pled guilty in 2008 to 2 misdemeanors regarding false statements related to certain export matters in 2003.

We are also conducting our own investigation of these matters. We continue to complete U.S. government contracts in backlog, and an extended suspension or debarment from contracting with the U.S. government and/or related fines or penalties, if any, could have a material adverse affect in our business. At this time, we are unable to determine the likely outcomes or the range of loss, if any.

Year-to-date, the U.S. government revenue, as a percentage of total company revenue, is approximately 5%, and full year fiscal 2010 was approximately 7%. Regardless of the outcome of the investigation, MTS wants to be a presently responsible contractor, as defined by the U.S. government.

Let me shift to the 2011 outlook. We’re pleased with our very strong first half performance and what it demonstrates about our capability. But like most industrial companies, 2011 earnings are rapidly outpacing investment. For the long term benefit of customers, employees and shareholders, we're working to increase investment in the business to capture the opportunities ahead. There are many indications of continued global economic improvement, while there are also still concerns about inflation and economic stability. Given this backdrop, let's talk about fiscal year '11's outlook.

Our strong first-half performance, our backlog entering the second half and the opportunity pipelines support our outlook. Order expectations remain unchanged for the year, which means we anticipate the second half Test orders to be down from first half, and this is really due to 4 things: first, typical quarterly variability; second, we see extra strong ground vehicle demand in the first half, and much of these orders were really carried over from previous years as there was more caution in investing and, finally, in the first half, much more confidence; third, we do see some cooling slightly in China; and fourth, government stimulus and budget cuts will continue.

We expect second half revenue to be up modestly from the first half due to higher beginning backlog, offset somewhat by slower turning custom mix. And first half EBIT rate of 17% will come down in the second half due to 4 things: one, higher custom mix; two, test development projects in wind and rail; three, higher legal and consulting fees associated with the government proceedings; and four, increased investment in China, in marketing and in R&D.

So our full year outlook continues to be that revenue growth rate will be in the mid to upper teens. Our EBIT rate will return to historical rates, and return on invested capital will be close to our goal of 20% or greater. The 2 most significant variables in our second half are volumes and U.S. government proceedings.

At this point, I'm going to turn it over to Vicky for Q&A.

Question-and-Answer Session

Operator

[Operator Instructions] We'll take our first question from Liam Burke with Janney Capital Markets.

Liam Burke - Janney Montgomery Scott LLC

Laura, on the Sensor margin, the gross margins were at high-40s. I know that Sue touched on it in her discussion, that higher volumes were helping. Is there anything else in there? I think those were record margins, the gross margins you had in that area.

Laura Hamilton

Yes. So you mean Sensors, and you mean high-50s?

Liam Burke - Janney Montgomery Scott LLC

Yes.

Laura Hamilton

Yes. Okay. 58%, it's -- so, we've always said our strategy is performance up, cost down. So one aspect is just our constant working on our cost. But a big effect right now is that the costs that we took out during the recession and how quickly the volume has come back and add high margins, there's so much leverage. So it's really the effect of the incremental margin -- incremental revenue and the effect on margin rates.

Liam Burke - Janney Montgomery Scott LLC

Now having said, with the volume coming back so quickly, are you going to have to go in and add cost in order to support this continued volume?

Laura Hamilton

Yes. We have been -- so that's the part about -- I think everybody's a little bit behind. I think the news out there is that everybody's seeing extra strong profitability because you're slower to respond. You see the volume pick up, you don't trust it in the beginning so you're slow to add, then once you decide to add, it's takes time to add. So yes, we do intend to ensure that we can do these volumes on a sustainable basis, so we are adding. It’s not one-for-one, but we are putting some more capacity in place.

Liam Burke - Janney Montgomery Scott LLC

Okay. And on the Test side, there were no large orders, but obviously, the orders growth has been pretty strong. I know that on a quarter-to-quarter basis, it's not easy to create a trend but in the long term, are you looking at more smaller, more profitable orders or is this just the short-term quirkiness of the order process in Test?

Laura Hamilton

That's a good question. I think we would say that -- so for orders greater than $5 million, that those opportunities will continue to happen. And on a larger-term trend like 10 and 20 years, they have been coming down because companies aren't as likely to invest in some of those really big things, but those will continue. But as a trend, it's really hard. Like you said, they’re more sporadic. They come more from -- sometimes, they come more from a like a greenfield opportunity, and you'd see those more often in your developing countries. Some can come from wind, and depending on just the size of kind of the facility -- for example, in things like aerodynamics and wind tunnel testing, and some of these systems are part of larger facilities, so it varies. Going forward, we expect those to still happen periodically and that the base is -- I think we said 80% of the growth came from base in the first half. I think we’d expect that to continue to be our focus.

Operator

[Operator Instructions] Next, we will hear from Mike Hamilton with RBC.

Michael Hamilton - RBC Wealth Management, Inc.

First, you'd mentioned in association with legal, higher consulting costs. Can you give us some flavor as to what that means?

Laura Hamilton

We just said legal and consulting and so what we mean is with respect to the proceedings, it’s a -- so some of the consulting is about your U.S. government compliance program, so we really mean together. Other consulting is really related to marketing and some of the investment work that we're doing.

Michael Hamilton - RBC Wealth Management, Inc.

Laura, a quarter ago, you mentioned that a large majority of what you were seeing in new order activity was related to customer productivity activity rather than projects-driving growth. Are you seeing that change at all or is that environment still pretty much the case?

Laura Hamilton

I'm actually trying to remember what I said. So productivity. I think...

Michael Hamilton - RBC Wealth Management, Inc.

That what you were seeing was projects driving labor reductions rather than projects designed to enhance growth. At least that was my take of your comments.

Laura Hamilton

Okay. And I think I meant -- I was referring at the time more to the economy and how companies are investing capital for productivity as opposed to hiring people. Then I would say -- so that was misleading in that most of our projects aren't really -- our projects aren't productivity, but it was really in support of they’re feeling good about spending capital as opposed to hiring people. And so we saw the capital investment part of that in R&D. I would say, though, that while productivity is one of their requirements, that most of the investment of our customers is driven by energy, the environment -- like tire investment right now is about characterization of tires as it relates to fuel efficiency. Wind is all about alternative energy. And then it's also about building capability which would be a big piece of ground vehicles. China.

Operator

[Operator Instructions] Next we'll hear from John Franzreb with Sidoti & Company.

John Franzreb - Sidoti & Company, LLC

Laura, it sounds to me that we should kind of reset our Sensor expectations. You had a record revenue quarter. You’re investing in the business. What kind of revenue opportunity you think is actually out there for the Sensor market?

Laura Hamilton

So when we think about opportunity, we characterize Sensor opportunity in 2 ways: Industrial and mobile. And with respect to Industrial, the opportunity will be 2 parts. One will be the general economic conditions, and that -- we're seeing the benefit of that clearly today. The other is the part about continuing to capture new applications. And you can see that in our numbers, and we don't expect that to go away. We expect that we need to continue to drive that in light of that the economic side might not be super stable. And then, on the Mobile Hydraulic side, that's the second arm, we see the adoption of this technology. We can see it in the change in trade show, how it’s being displayed at trade shows, and you can kind of see on a year-over-year or 2 years how much more intelligent machines is kind of the trend. So we see that opportunity continuing as well. So the biggest part for Sensors that's hard is the economic side of Industrials, but the rest, we're not moderating.

John Franzreb - Sidoti & Company, LLC

Great. Now it seems to me you've also dropped from your discussion or maybe deemphasized from your discussion from last quarter about the competitive landscape and how difficult that was. Am I misreading that? Does it seem that the pricing environment has gotten better or no?

Laura Hamilton

Well, that's interesting. I would say that you're not misreading it, and it's not the environment. It's that we've made working on Test cost the #1 priority for the last 9 months. And we can see the initial effects of -- by improving our cost position, we are more competitively priced, and then we can still capture that 5% to 15% premium, and so that's going better.

John Franzreb - Sidoti & Company, LLC

Great. And I guess my last question then maybe I'll queue back up, I think I checked back to 2005 it was, maybe 2004. It's been that long since I've seen that you weren’t a net reducer in shares outstanding, and I was kind of surprised that you didn’t buy any in the open market this quarter. Any particular reason for that?

Susan Knight

John, the accelerated share repurchase program that started last August is still in progress, and so we can't restart any repurchase activity independently in the 10b-5 program until that's done.

John Franzreb - Sidoti & Company, LLC

Okay.

Laura Hamilton

Yes. This is the effect that we got credit for those share reduction when we put the program in place, but the program, technically, is playing out over the course of up to a year.

John Franzreb - Sidoti & Company, LLC

Okay. Good. That helps. And I guess…

Susan Knight

So we haven't -- just, John, to your point, we haven't changed our philosophy at all towards [ph] share buyback.

John Franzreb - Sidoti & Company, LLC

Right. You just -- okay, you maxed out. One last question, I guess back to that legal expense. I assume that's going to go away at some point. Can you kind of quantify what that number was in the quarter and what your expectations are for that in the second half build [ph]?

Laura Hamilton

We can quantify what it was in the quarter. It was about $800,000 in legal costs. And at this point, we -- yes, it will go away at some point, and no, we don't know when.

Operator

At this time, there are no further questions. [Operator Instructions]

Laura Hamilton

Okay. I'm going to close, Vicky. So thank you. I think in part -- it was a good quarter. I think it's pretty straightforward, relatively understandable. We do have good momentum. We are working to resolve the government proceedings, and we will keep you up-to-date as appropriate. Thank you.

Operator

And that does conclude today's teleconference. Thank you all for joining.

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