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Executives

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

William V. Murray - Interim Chief Executive Officer, Interim President and Director

Analysts

John Franzreb - Sidoti & Company, LLC

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

MTS Systems (MTSC) Q1 2012 Earnings Call February 3, 2012 10:00 AM ET

Operator

Good day, and welcome to the MTS First Quarter 2012 Earnings Release Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Ms. Sue Knight. Please go ahead.

Susan E. Knight

Thank you, Jennifer. Good morning, and welcome to MTS Systems' fiscal 2012 first quarter investor teleconference. Joining me on the call today is Bill Murray, Interim Chief Executive Officer.

I'd like to begin by reminding you that statements made today, which are not historical facts, 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 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.

Bill will now begin his update on our first quarter results.

William V. Murray

Thanks, Sue. Good morning, everyone, and thank you for joining us on our call today. It is a pleasure to share with you our strong first quarter results and improved outlook for the year. Before Sue and I provide more detail, I would like to summarize the agenda for our briefing during today's call.

I will begin with the key messages, then I will review the order's results in Q1. Sue will review financial details. I will briefly comment on government matters. And finally, I will review our revised outlook for 2012.

To begin, I have 2 key messages. First, our momentum from 2011 is continuing into 2012. We achieved record revenue, earnings per share and backlog in Q1 driven by our Test business momentum, which is extremely strong, offsetting some softness in our Sensors business. Second, we are raising our full year revenue and earnings per share growth outlook based on the strength of our Test business backlog and order pipeline, along with the belief that the economy will remain volatile but improve modestly during the year.

Moving to orders and backlog. In Q1, total company orders were a robust $135 million, reflecting strong base orders in our Test business. Overall orders declined 3% versus last year, including a less than 1% favorable impact.

Looking at orders in more detail, Sensors orders grew a modest 1%. Adjusting for large orders, Test base orders grew 27%. We had no large orders greater than $5 million in the quarter, while last year, we had $29 million in large orders. Sequentially, orders are up 2% compared to Q4. Finally, our backlog is up 18% versus last year, setting a new record of $292 million.

Now I'd like to give you more detail by business beginning with Sensors. At $24.1 million in orders, we're up 1% over last year but less than a 0.5 point of favorable currency impact. While the growth rate slowed this quarter, it is noteworthy that Sensors achieved the highest order total in Q1 in the company's history. From a geographic perspective, the Americas was up 14%, while Europe declined 1%. Asia was down 4% driven by the decline in China.

From a market perspective, our mobile hydraulic growth story continues with a 34% growth over last year from $3.3 million to $4.4 million. Our Industrial segment was down 4% from $20.5 million to $19.7 million. Considering the broader context, Sensors has had 8 consecutive quarters of growth going back to Q4 of 2009 to Q3 of 2011. Q4 last year fell to 11% sequentially and Q1 was down 4% sequentially. While there's some order weakness related to cyclical worldwide manufacturing, we see no evidence of steep declines that we saw in early 2009.

There are 2 primary [indiscernible] quarter regarding sensors orders. First, mobile hydraulics continues to be a growth story. The U.S. results are particularly strong because of new design wins. Agriculture and heavy equipment for energy and raw material mining remain strong. We are seeing some weakness in road-building equipment due to government budget cuts.

Second, the industrial market growth slowed in Europe and the Americas, primarily due to large customer order pattern changes. For example, in Europe, when energy OEMs typically place blanket orders in Q1 and issue releases throughout the year. Their forecasts have actually increased from last year, but the historical blanket orders previously placed have been replaced by small orders with short delivery requirement. This suggests tighter inventory management is occurring.

We saw a similar behavior in Europe food and beverage markets, as well as the U.S. medical markets. China was down 6% consistent with 2 quarters of PMI below 50. Ongoing weakness in steel demand reduces the need for a high level of replacement sensors required in the harsh environment in steel production. Backlog was $16.3 million, down 4% year-over-year returning to historical levels.

In summary, we do have concerns about the strength of the global economy in Europe in particular. However, we believe our Sensors' broader underlying business is better than Q1. We remain cautiously optimistic that the rest of the year will be stronger as we are seeing better order volume in Q2, with weekly average orders up versus last year.

Moving on to Test. At $111 million in orders, we were down 4% year-over-year. However, base orders were strong. In Q1, we had no large orders greater than $5 million compared to $29 million in large orders last year. Adjusting for large orders, base orders were up impressively at 28%. $111 million in base orders compares favorably to FY '11, orderly base orders of approximately $90 million. There was no currency impact for Test in Q1.

At a high level, customers are continuing to invest in new capital equipment and upgrades. Demand is driven by fuel efficiency projects, including testing of new materials. In particular, ground vehicle simulation testing of component systems for fuel-efficient cars, ground vehicle tire testing for rolling resistance and advanced material testing for aircraft engines are experiencing strong demands.

We also had $8 million of seismic orders in the quarter to test communications infrastructure in earthquake zones. By geography, Asia growth was up 48% from $35 million to $52 million. Asia did not have any large orders in either period. All $8 million of our seismic orders were in Asia and ground vehicle tire systems were also strong.

The Americas was down 25% from $41 million to $31 million. The decline was exclusively the result of no large orders this quarter. Overall for the quarter, base orders were flat.

Europe was down 28% from $39 million to $28 million. Similar [ph] to the Americas, no large orders occurred this quarter versus $18 million in large orders last year. Base orders in Europe were up 33%.

From a market perspective, orders in 2 markets were up and one was down. Ground vehicles was down 27% from $73 million to $53 million. Our prior year included $29 million in large orders. We had none this year. Base order growth was solid at 20%. Material orders grew 22% year-over-year and all geographies were up. Structures was up 67% year-over-year. All the growth was accounted for in 2 seismic orders.

Backlog remains high at $275 million and is up 20% versus prior year and 1% sequentially. In summary for Test, we achieved very good base order growth, large order time increased lumpiness in this quarterly comparison as is historically the case. Our order opportunity pipeline is growing. It is up 13% from last quarter and up 16% year-over-year. We believe energy and geographic expansion trends will continue to provide Test with growth opportunities in our key markets.

Before I turn it over to Sue, I will briefly discuss our U.S. government proceedings. As we communicated previously, the U.S. Air Force lifted the suspension in Q4, enabling MTS to do business with the U.S. Federal Government under our administrative agreement. The other government matter is that the Department of Justice/Commerce proceedings which are still progressing. We continue to fully cooperate. We are unable, at this time, to determine the likely outcome or range of impact or resolution of timing.

Now I will turn it over to Sue for financial details.

Susan E. Knight

Thank you, Bill. My remarks today will focus on a first quarter year-over-year comparison. I will also briefly comment on our sequential Q4 2011 and first quarter comparison. Bill provided an order summary, so I will begin with revenue.

At $134 million, revenue was strong and up 26% compared to the prior year. We beat last quarter's record high by approximately $2 million. While we had growth in both segments, the results were clearly driven by Test. On a segment basis, Sensors revenue was up 7% to $25 million. The majority of the increase came from backlog as orders in the quarter were only up 1%. The backlog reduction was in response to the customer-required delivery date. Currency translation had a positive impact, but it was immaterial at less than 1%. And geographically, the Americas were up 14%, Europe was up 13% and Asia declined 8%.

Moving on to Test. Revenue was $109 million, up impressively at 32%. Higher beginning backlog of $73 million and strong base orders in the first quarter were contributing factors to the $26 million increase. Currency contributed 1% and all regions had strong growth. Asia was up 45%, followed by 28% in the Americas and 20% in Europe.

In total, we are very pleased with our revenue growth as we begin 2012. At $59 million, gross profit increased $12 million. This was a 26% increase and equal to the revenue growth rate in the quarter. Of the $12 million increase, approximately $11 million was from Test and $1 million was from Sensors, as expected, given their respective business mix and volume. The gross margin rate was also good at 43.9% and our highest rate in the last 4 quarters. The results were roughly flat with last year's 44.1% rate.

The Sensors gross margin rate was once again squarely in the middle of 50% range at 55.9%, which was down slightly compared to 56.2% last year due to mix. Test's gross margin rate increased 0.5% to 41.2%. Volume leverage and productivity improvements more than offset the impact of our continued high custom mix.

Operating expenses were $35 million, up 25% and in line with revenue growth and consistent with our commitment to invest for future growth. R&D was up 59% to $5 million, with proportional increases in both Test and Sensors. The Test R&D investments include both hardware and software projects that align with its strategic growth and best total value productivity initiatives. Sensors R&D investments continue to be focused on driving product performance up while reducing our costs in order to win a larger share of the market. Approximately 6% of the increase was in selling and marketing, due to timing of order-related commission payments. The majority, or 67% of the operating expense increase was in G&A.

G&A was up $4.7 million, impacted by 5 primary drivers. The first was $700,000 for Test investment and productivity profit improvement initiatives, approximately $0.5 million related to interim CEO and Board-related expenses including the search, $200,000 on government matters as there were no expenses in the prior year, $1.6 million associated with compliance-related external expenses and structural investments and $700,000 for headcount-related salary and benefit increases. Of this total increase, roughly 25% is nonrecurring.

Operating expenses as a percent of revenue were 26.3% compared to 26.6% last year. This result is within the expected range of 26% to 27%, which I communicated in the call last quarter.

Moving on to EBIT and EBIT rate. The EBIT in the quarter was approximately $24 million, up 27% on 26% revenue growth. The higher gross margins funded the increased operating expenses and increased the bottom line by $5 million. The EBIT rate of 17.6% was excellent. While roughly flat with last year's 17.5% rate, it reached a record performance level for the company. As a reminder, this rate can vary on a quarterly basis by as much as 2 points based on business mix.

The tax rate of 33.4% was up approximately 7 points. The primary reason for the increase is that last year's rate of 26.6% included a 6-point nonrecurring benefit from the legislative actions that retroactively reinstated the R&D tax credit for fiscal 2010. This gave us 4 quarters of benefit in one quarter last year.

Once again, the R&D tax credit has expired so we expect, based on legislative history, that the benefit in the remaining quarters of 2012 will likely not occur. That was about just over 1 point impact on our rate, which will keep us at the higher end of our low-30% expected range for a tax rate.

Earnings per share of $0.98 was up $0.12. Volumes, of which 90% was from Test, contributed $0.49. Other miscellaneous items, including lower Test warranty expense, accounted for $0.04 of the increase. These increases were partially offset by $0.29 per planned operating expense increases, including $0.01 for government matters and a negative $0.10 impact from the higher tax rate and down $0.02 from 2% higher share count. The net impact was a 14% increase in earnings per share.

That concludes my comments on the year-over-year comparison. I will now briefly share my perspective on the broader trend in the last few quarters. While there has been both top and bottom line growth momentum at the company level over the most recent past 5 quarters, this has largely been driven by Test. Test base and large orders have been, and are expected to continue to be, strong based on our current opportunity pipeline. Sequentially, Test orders were up 3% in the quarter. In comparison, Sensors' recent order pattern has modestly weakened in the last 2 quarters, down 4% from the fourth quarter. While we believe this reflects that our customers are adjusting their inventory positions and the size of their purchase orders in light of end-market uncertainty, we are actively engaged with our customers to understand their needs while maintaining flexibility in our cost structure so we can respond accordingly.

We also believe that the current level of global economic uncertainty will create volatility for both segments for the foreseeable future, with Sensors in particular, because it's a short cycle business. We are prepared and we have the flexibility and experience to handle this volatility from both a customer and a financial perspective.

My last topic today is cash. The cash balance is $104 million, flat compared to the fourth quarter. Operating cash flow was approximately $3 million. Strong net income was offset by a $10 million increase in working capital, primarily volume-related build receivables and $9 million for variable compensation payments associated with 2011.

Capital expenditures were $2.3 million and dividends were $4 million in the quarter. There were no share purchases as we have suspended this activity until the government matter is resolved. That concludes my remarks on the first quarter.

Overall, we're very excited about our start to fiscal '12. Now I'll turn the call back to Bill for his final comments.

William V. Murray

Looking at our outlook for 2012, during last quarter's call, I indicated that we expect a continuation of the sluggish global economy, but we also believe it is strong enough to stir investments in capital equipment. In general, we continue to hold that view.

On the cautionary side, we are concerned about current Sensor softness but we believe it's more about an inventory correction than a big change in end-user demand. We are also uncertain about implications of spending cuts from European austerity programs and euro currency fluctuations on our business.

We are closely monitoring the changing environment in China for exports and domestic demand. On the positive side, global PMI rose to 53 in December, the highest level since March 2011. Our value propositions are well aligned with the macro trends of increased energy/fuel-efficiency demands, productivity and product performance improvements, compressed product development cycle times and new regulations.

We also entered Q2 with record backlog and a robust order opportunity pipeline. And just to give you a little context on the pipeline of orders, we had no large orders in Q1, but we still have a very robust orders pipeline for large orders looking at a 56% pipeline opportunity above last year. Also, a seismic pipeline is a major opportunity for us this fiscal year. And we are seeing pipeline growth in all regions, and one of particular note is Europe, which is, from an economic perspective, there's been a lot of questions. But obviously, it's very encouraging to see that we have strong pipeline opportunities in that region. Based on our Q1 results and our assessment of our market opportunities, we are raising our revenue outlook for the year from low double-digit growth to growth in the mid- to high-teens.

Additionally, we are raising our outlook for earnings per share from operations from low double-digit growth to low to mid double-digit growth. Earnings will depend both on volume and level of investment. That's the end of my remarks.

I will turn the call over to Jennifer for the Q&A session.

Question-and-Answer Session

Operator

[Operator Instructions] We'll go first to John Franzreb with Sidoti & Company.

John Franzreb - Sidoti & Company, LLC

Bill, I guess I want to start with the guidance number. You're looking forward mid- to high-teens sales growth and a little bit under that on the EPS growth. Is the lack of leverage reflecting the increased costs related to the government issue and some of the overhead you had to assume from that, or is there something else in the mix that we should be cognizant of?

William V. Murray

I'll start, and then I'll turn it over to Sue. I think first of all on the growth side, obviously, we feel very good about the fact that we're increasing our growth for the year. And that speaks to how, as I said in our remarks, how we feel about the opportunities we have. And the other side of that in terms of our earnings is related to the fact that we're making investments in our business. So we're taking advantage of those opportunities by making some additional investments to support the growth that we have. And then I'll let Sue add to that.

Susan E. Knight

John, I agree with Bill. That's the story. There's some compliance-related infrastructure we're building. There's some ongoing costs associated with the government matters. But I think the driver is the investments we're making in both Test and Sensors, as represented by the R&D teams in the first quarter, as well as some of the G&A costs that I referenced as being related to Test productivity initiatives.

John Franzreb - Sidoti & Company, LLC

Okay. I was also kind of curious if we're going to have some maybe some large system work, both for the balance of the year that might be margin depressing. How does that kind of lay out?

Susan E. Knight

As we look at our backlog of projects, I would characterize it as normal.

John Franzreb - Sidoti & Company, LLC

Okay. Secondly, Bill, I think you said the opportunity pipeline, you actually gave a lot of good detail on the opportunity pipeline. I'm assuming that was all based on the large project opportunity pipeline. And you said it was robust in Europe. Did I hear you correctly? Can you just maybe elaborate a little bit on that? Because it seems not to reconcile with your earlier comments about concerns about spending in Europe.

William V. Murray

Yes. First for the Test business, our opportunity pipeline is we have more visibility than we do in Sensors obviously, given the profile of the business. The opportunity pipeline is up in both our base orders as well as our large orders. So it's a broad-based uptick in our opportunity pipeline. That's one of the reasons we feel good about the increased outlook for the year. The other comment was related more to the shorter cycle business and the Sensors aspect of that, which is where that comment came from.

Susan E. Knight

Yes, I would also add to Bill's comments that it's hard not to have generic concerns about Europe, given what's going on there. But it is inconsistent with the strength of our opportunity pipeline.

John Franzreb - Sidoti & Company, LLC

I agree, Sue. That's why I was pleasantly surprised.

Susan E. Knight

So are we.

John Franzreb - Sidoti & Company, LLC

Great. Now if I bring that back to North America, the order book was down, I think, you said 25% in the quarter. Is there any sense that, that business is firming up, maybe to offset some of the weakness or the potential weakness we see in Europe?

William V. Murray

If you go back to the Americas, in my comments, we had large orders in the U.S., in the Americas in the prior year. So our base business, if you will, I think what I said was flat year-over-year, if I remember it right.

Susan E. Knight

It was flat.

John Franzreb - Sidoti & Company, LLC

And looking at the order opportunity pipeline for the Test business again, we see growth opportunities in all geographic regions: Europe, Asia and the U.S.

John Franzreb - Sidoti & Company, LLC

Okay, great. One last question and I'll let somebody else ask. You said your share repurchase was suspended until the government issue is resolved. Why would that be the case?

William V. Murray

Sue, you want to comment on that?

Susan E. Knight

Sure. From a company perspective, we don't want to be in a position of having material information that isn't public. And so we have not been purchasing our shares since the suspension happened last year. And from a company philosophy point of view, we think this is the right decision to take.

Operator

We'll go next to Liam Burke with Janney Capital Markets.

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

Bill, could we talk a little bit about China? You did mention that the steel production volumes have declined and that's consistent with the numbers and it would translate into lower Sensor orders. And then you said a couple of things about orders in the second quarter firming on the Sensors side. Are you seeing any improvement in China either in that application or anything outside of steel?

William V. Murray

Yes. So on China related to Sensors, you are correct. We did see a softness in the last quarter and that was related to the steel production area. We do see momentum increase in China and the rest of the world in Q2. But more specifics than that, I'm not prepared to give.

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

Okay, that's fine. On the Test side, how has pricing been? One of your initiatives have been to maintain margins while being a little more price competitive. How's the market there?

William V. Murray

Well, obviously, it is a competitive market. But I think as it relates to our applications and our focus on providing solutions that our customers value and is reflected in our margins performance, we still see a very strong performance there. And we're benefiting from the increased leverage of higher volumes in our business right now. And so obviously, productivity improvements come from multiple avenues, but the increased volumes obviously have a significant benefit in that area.

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

And Sue, you talked in your prepared comments about why receivables were up to address the revenue volumes. If I stretch out your working capital for the full year, do you anticipate any changes that would not have the company generate positive cash for the full year?

Susan E. Knight

No. We expect a relatively normal year from a cash flow point of view relative to the net income. We just had almost $20 million of milestone billing associated with projects in late December, and those obviously don't turn into cash quickly. The milestones are generally contract based, based on work that's been completed, and that's just a really big number for us in any one month.

Operator

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

William V. Murray

Very good. Well, thank you, all, for participating on our call today. We had a lot of good news to communicate about our performance in Q1, and I look forward to our next meeting update in May. Have a great day.

Operator

This does conclude today's conference call. We thank you for your participation.

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