MTS Systems F1Q08 (Qtr End 12/31/07) Earnings Call Transcript

Jan.27.08 | About: MTS Systems (MTSC)

MTS Systems Corporation (NYSE:MTS)

F1Q08 Earnings Call

January 24, 2008 10:00 am ET

Executives

Susan E. Knight – Chief Financial Officer & President

Laura B. Hamilton – President, Chief Executive Officer & President

Analysts

John Franzreb – Sidoti & Company

Michael A. Hamilton – RBC Dain Rauscher

Operator

Good day and welcome to the MTS Systems’ first quarter conference call. Today’s conference is being recorded. At this time I’d like to turn the conference over to Sue Knight, Chief Financial Officer. Please go ahead.

Susan E. Knight

Good morning and welcome to MTS’ fiscal 2008 first quarter investor conference. Joining me on the call today is Laura Hamilton, Chief Executive Officer. I’d like to remind our audience 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 Form 10Q and 10K. 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 update you on the first quarter results.

Laura B. Hamilton

Good morning and thank you for joining us on our first quarter investor call. I am honored and excited to assume my new roll of CEO for MTS. I’m excited because MTS has a rich 40 year history to build upon. MTS has a strong leadership position in our market. MTS has some of the smartest technical people in our field who work with great customers who want to partner with us to develop future capabilities and MTS has great opportunities for the future. Chip Emery and the employees of MTS have so much to be proud of. As Chip said in our annual report, MTS is building momentum. I personally want to thank Chip for his commitment to MTS over the last 10 years as MTS has grown stronger and is better positioned for the future. Thank you Chip and good luck in your future endeavors. By building momentum we are creating more opportunities for our customers, for our employees and for our shareholders. I look forward to talking with you in the weeks and months ahead about the opportunity we see for the future.

Let’s move to the first quarter results beginning with the headlines. There were many outstanding highlights in our quarter including $126 million in orders, double digit revenue growth, record Q2 opening backlog and continued strength of the sensors business. Unfortunately, the 36% test growth margin rate was an unexpected disappointment. We believed and we communicated in fiscal 2007 that custom project cost overruns were behind us. Additional cost adjustments were made in the first quarter. However, despite this issue, earnings met our expectations for the quarter and we are confirming our guidance for the year. More details on all these headlines to follow.

I had the opportunity to spend Tuesday with many of you at the Sidoti Investor Conference. Fundamentally, everyone wants to know how MTS would weather an economic slowdown should one occur. While answering this question is not the purpose of this call today, I want to provide some insight on what we’re seeing in our market as I talk about orders. Orders grew a strong 13% to a $126 million which is a great quarter for us, the best in 12 quarters and puts backlog at a record 229. While approximately four points is attributable to currency, we are very pleased to deliver 9% real growth given the uncertainties in the economic situation. Interestingly by geography, Americas’ orders grew 57%, Europe 16% and Asia was down 18%. The large variations by geography in any one quarter are generally more reflective of the lumpiness of test customer orders than the result of a change in the ordering trend. Historically, we first experienced the impact of an economic slowdown in sensors as they supply to industrial manufacturing and have a typical two to six week customer ordering cycle. Test lagged by six to nine months as capital equipment is provided to product development rather than manufacturing. In addition, test customers include government and universities where budgets are not typically affected by a slowdown until the following budget cycle. We are closely monitoring our sensors order trends to ensure we respond quickly to changes in industrial customer demand.

While we are by no means immune to an economic slowdown, our global business profile and the breadth of our served market in test and sensors could help us weather an economic slowdown better than others. Test orders grew 11% and included only one order over $5 million. Test Americas’ results were excellent increasing 67% over the prior year. With no orders greater than $5 million Americas’ was strong on all fronts. We saw growth in South America, Canada and the United States. Of note, is investment by automotive OEMs in South American and Detroit, continued spending in aerospace and motor sports and strong standard in aftermarket business. Europe was also up 12% while Asia was down year-over-year 24% due to the impact of orders greater than $5 million. Although, we did win one order greater than $5 million from a leading Asian University for a seismic simulation system. Orders less than $5 million grew 24% and China was particularly strong in part due to the Chinese government stimulating automotive investment. From a global test market perspective we have not experienced major changes but we continue to face long sales cycles and a very competitive environment.

Sensors also had excellent orders growth at 25%. All three geographies were up. 5% in Americas, 25% in Europe and 55% in Asia. Americas’ growth at 5% is consistent with the prior year growth rate. Our primarily industrial market segment, Fluid Power remains strong globally driven by the demands of the heavy machine industry. We also saw a positive uptick in the domestic Japanese plastic machine market. Global hydraulics orders, while small, are tracking with our expectations. Each quarter we continue to build our pipeline of active customers who work with us at various stages in their product development to evaluate our sensors capabilities. Technology adoption in North America and Europe is accelerating, albeit from a relatively small base, thus increasing the number of OEM customers we’re working with.

Let’s shift to our one area of disappointment for the quarter; test growth margins. Our first quarter total company gross margin results reflects strong sensors performance offset by weaker than expected results in the test segment. Additional unplanned custom project costs and unfavorable product mix resulted in a 36% test growth margin rate. Let me talk about our custom business addressing the issues underlying the test margin rate and the key elements of our action plan to resolve them. As background, custom projects comprise 40 to 50% of annual test revenue. At one end of the spectrum custom projects include modifications of existing technology for specific applications and at the other end of the spectrum custom projects cover development of new technology and large complex systems that are built very infrequently. Approximately 200 projects are in progress at any one time and favorable and unfavorable project costs variances are a normal aspect of this business.

Over the last three quarters we have been developing technology for specific customers primarily in the ground vehicles market. We’ve been aggressive in these areas and we are executing our strategic growth initiatives. While we expect to leverage this technology in future offerings, costs of these projects have exceeded our previous estimates due to unexpected development issues and resource capacity constraints as we work through the [inaudible] process of developing technology. We believed we had resolved these issues but we were wrong. Quite frankly, these projects have turned out to be a lot harder than we thought and in the first quarter we recorded $1.5 million of additional costs associated with these projects. While the dollar impact is significant, these projects represent 5% of the total custom projects we manage every year. We know how to successfully manage this type of work and will work through this. Specifically, we have reprioritized our technical resources to ensure we complete these projects. In addition, we have enhanced our pre and post order management review process to ensure that performance specifications are clear, risks are well identified and appropriate engineering capacity is allocated. And, we have taken cost containment measures to offset additional project costs adjustments should they be necessary as we complete these projects.

Also impact test margins in the quarter was project mix. Our broad product portfolio has significant margin variability across business types: custom, standard, service, across market segments: aero, seismic, ground vehicle and across customer type: large OEM, tier suppliers, governments and university. This has been and will continue to be a key variable in test growth margin rates. Thus, the combination of custom project cost adjustments and an unfavorable mix resulted in a 36% margin rate for test. I hate to spend this entire call talking about test gross margin while sensors gross margin rate was 57% reflecting the continued benefit of improved factory utilization driven by higher volumes.

Let’s move to earnings per share. At $0.47 earnings per share was down 13% excluding the $0.09 non recurring tax benefit from favorable tax legislation last year, earnings per share was up 4%. Our full year outlook assumed a stronger second half than first and that remains true.

I’d like to make a few quick comments regarding cash. We ended the quarter with $113 million of cash and short term investments. Typical for the first quarter we used $2 million of operating cash. Also for the quarter we established a $75 million five year credit facility to provide long term financial capacity to implement our strategic plan.

Before moving to the Q&A I’d like to reiterate our thinking on confirming our guidance for the year. While there is concern about a possible US economic slowdown and the potential impact it could have in other regions, we have finished our first quarter with strong orders and have built backlog. Revenue and earnings were in line with our expectation. Our order pipeline remains strong and we implemented cost containment actions to offset unplanned custom project costs. Therefore, we’re confirming our guidance of $440 to $450 million in revenue and $2.43 to $2.53 for earnings per share.

I am proud to have been given the opportunity to lead MTS and I look forward to sharing our progress with you as we move forward.

Question-and-Answer Session

Operator

(Operator Instructions) We’ll go ahead and take our first question from John Franzreb with Sidoti & Company.

John Franzreb – Sidoti & Company

My first question is, and I’m sorry I’m going to harp a little bit on the test segment here. You mentioned that part of the problem is that it is new product development, something that you want to lever in the future, expand upon whatever product knowledge you’re gaining. Is it safe to assume then that you’re also pursuing similar type jobs and we’ll continue to see some lumpiness in test? Or, is this maybe a onetime hit with these types of projects and you’re no longer pursuing those types of jobs?

Laura B. Hamilton

That’s a good question. I think it’s more that we’re building capability off of this existing group of jobs that we are gaining a fair amount of learning as we’re doing that. As we move forward and sell these capabilities again, most likely there will still be some customization or development but, I think for these jobs we’re doing most of the learning on the set we have. We get smarter every time we work in these areas.

John Franzreb – Sidoti & Company

So, would it be fair to assume that the rate of pursuit of these kinds of jobs will slow?

Laura B. Hamilton

I would say yeah. The jobs that we’re talking about are more of the first big step of building capability and after that there are smaller incremental steps.

John Franzreb – Sidoti & Company

Second question, the backlog at 229 is the best since 2005. You allude that the order book, nothing was above $5 million so that makes the backlog even more impressive. I wonder if there’s any kind of end market strength within the backlog that is particularly note worthy?

Laura B. Hamilton

I would say that the biggest end market strength is ground vehicles. I would say it’s in part geographic reach as well as in part the work that we’ve been doing over the last four years in terms of trying to align our product offerings to enable us to move downstream somewhat. I think that we’re feeling that this is the benefit of those two moves.

John Franzreb – Sidoti & Company

In addition, one of the Laura with MTS has been that you’ve always carried a lot of cash. That certainly helps in times when the stock’s getting hit like this morning but also begs the question what kind of uses for cash do you foresee? I guess it’s a dovetail. How is your management style going to differ from the previous CEO?

Laura B. Hamilton

That’s a big question. I think from a cash, to start, I think our priorities remain the same. Our first priority is to use the cash to execute our strategy and grow the business in the long term. I know it’s frustrating, we continue to look for opportunities both organic and [inaudible] but the timing of those deals just don’t happen as quickly as we’d like to. We will continue to evaluate how to return cash to shareholders to the extent that we can’t use that cash in the deployment of our strategy. But, it would be long term strategic growth first.

Operator

(Operator Instructions) Next we’ll hear from Mike Hamilton with RBC.

Michael A. Hamilton – RBC Dain Rauscher

A couple of questions; first, your test comments, you had alluded to some resource capacity constraints being a factor in the test cost overruns. Could you walk through in the big picture what you’re alluding to and kind of what actions have been taken?

Laura B. Hamilton

Yes. Let me just start at kind of the highest picture. When we’re quoting custom projects, often we can be quoting years in advance and so the timing of these orders is never clear. So, once these orders come in they may or may not align with the high end technical resource capacity that we have. So then, what we have to do is kind of stretch those resources whether it’s having them work on multiple projects and/or using maybe less experienced people and that’s what we found as we brought this book of business in. The things we’re doing, we’ve been working to take the resources and resources are either specific application knowledge or specific technical capabilities and we’ve been working on building our bench strength, we’ve been working on processes to help deploy these resources more effectively. Those are the two areas. The third thing that we’re really doing is also working in the pre-sale side of this to use these resources to more clearly understand performance specifications that we’re committing too.

Michael A. Hamilton – RBC Dain Rauscher

Does what you’re seeing change anything in terms of what you’re trying to write into specs with respect to timing of implementation and any penalties or ability to charge for stretch outs, etcetera?

Laura B. Hamilton

Yes. I would say most definitely. Part of what we’re also doing is we’re doing more high end technical resource capacity planning, is we are going back and renegotiating before we close the deal. In terms, like you said, in terms of timing or specification, commitment, penalty, etcetera.

Michael A. Hamilton – RBC Dain Rauscher

As you look forward over the next couple of years are you capacity constrained anywhere on the physical side where capital is going to need to be deployed?

Laura B. Hamilton

I want to make sure I understand your question. When you say capital you mean MTS capital?

Michael A. Hamilton – RBC Dain Rauscher

Brick and mortar?

Laura B. Hamilton

No. No. Really this is more of a knowledge worker businesses. Brick and mortar, we’re in good shape.

Operator

(Operator Instructions) We’ll go back to John Franzreb.

John Franzreb – Sidoti & Company

It’s kind of been the theory out there that MTS maybe more recessive resistant by virtue of the fact that by being a R&D hardware supplier that companies are more adapt to spend on R&D when times are tough and they need to find a way to get out of it. Any thoughts to that?

Laura B. Hamilton

Yeah John, I think the good news is that we’ve been watching the automotive industry compete on product for the last five years. And, what we talk a lot about is our customers are competing by making their products more complex, more capable and that makes predicting their performance harder which plays to MTS’ strengths. And, they’re also playing by getting their products to market faster. Another example is let’s say somebody like Toyota, who has come back and said, “We grew fast and we’ve got more quality issues in the field than we think is appropriate for our brand and we’ve got to come back and improve our testing, the prediction of our product performance and our designs.” So, I think that is what’s been helping us and I think that will continue to benefit us.

John Franzreb – Sidoti & Company

One last question, the sensor business had great year-over-year growth but sequentially was flat. You pointed out that it is a leading indicator for you, does that give you reason to pause? Or, is there nothing to be gleaned from that?

Laura B. Hamilton

I think nothing to be cleaned from that. I mean, we’ve been kind of looking at this from all angles, by geography, by product mix, I think we’re in good shape.

Operator

At this time we appear to have no further questions. Mrs. Hamilton I’ll hand the conference back to you for any final or closing thoughts.

Laura B. Hamilton

Okay. I just want to thank everybody and as I said I really look forward to working with you in the future. Bye-bye.

Operator

That will conclude our conference. Again, thank you all for your participation. We do hope you enjoy the rest of your day.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!