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Moderator: Sue Knight
November 16, 2012
9:00 am CT
Operator: Please stand by, we are about to begin. Good day and welcome to the MTS Fourth Quarter 2012 Earnings Release Conference Call. Today's conference is being recorded. And at this time I'd like to turn the call over to Ms. Sue Knight, CFO of MTS Systems. Please go ahead ma'am.
Sue Knight: Thank you, (Chris). Good morning and welcome to MTS Systems fiscal 2012 fourth quarter investor teleconference. Joining me on the call today is Jeff Graves, President and Chief Executive Officer.
I'd like to remind you that statements made today that are not a historical fact should be considered forward-looking statement as defined by the Private Security 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 10-Q and 10-K. The company disclaims any obligations to revise forward-looking statements made today based on future events.
Presentation may also include reference to financial measures that 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 an isolation or as a substitute for GAAP measures. Jeff will now begin his update on our fourth quarter results.
Jeff Graves: Thank you, Sue. And good morning everyone. Thank you for joining us today for our fourth quarter investor call. It's a pleasure to share our financial results for the fourth quarter of fiscal '12 and guidance for fiscal '13 with you.
I'm also excited about the opportunity to discuss our $1 billion revenue goal. For today's call I'll first discuss the key takeaways for our business and provide some perspective on our end-markets and fourth quarter orders. Sue will discuss the quarterly financials in more detail and provide some summary comments on the full year results.
Following Sue's comments, I'll finish the call with our guidance for fiscal '13 and our strategy to achieve $1 billion in revenue in fiscal '18. We'll then open the call for your questions.
There are four key messages for today. First, we had another good quarter that was once again driven by our Test business. Despite continued softness in Sensors and headwinds from currency we delivered double-digit orders growth and 5% revenue growth.
Earnings per share were flat reflecting continued aggressive investments in R&D and processes in systems to scale the business. Operating cash flow of $13 million net of the $8 million government settlement payment was very strong.
Second, we had an excellent full year in fiscal '12 achieving record highs in all of our major financial metrics including orders, revenue, earnings per share from operations, operating cash flow and return on invested capital or ROIC. Additionally, we have significantly improved our compliance and control environment, better obligations under the administrative agreements and settled the government matters.
I feel very good about this performance and our leadership team at MTS. Third, our revenue and EPS growth for fiscal '12 was within our outlook range for the year achieving 16% revenue growth and 14% growth in EPS from operations.
Fourth, while we remain cautious about the global economy and the fiscal challenges that many governments face around the world, we're forecasting 5% to 10% revenue and EPS growth in fiscal '13. This represents a solid continuation of our momentum on the heels of an excellent fiscal '12 and the next key step in meeting our $1 billion revenue objective for fiscal '18.
Sue and I will discuss these topics in more detail beginning with Q4 orders. Total company orders were up impressively to $147 million, 11% over last year. Adjusting for currency, orders increased 14%. Consistent with the year-to-date quarterly trend the growth was driven by Test which was up 15%.
These results were partially offset by an 8% decline in Sensors. Backlog reached a record high of $299 million, up $10 million compared to the prior year. Now I'll provide you with some additional color by business and I'll begin with Sensors.
Sensors orders were $23 million, down 8% as previously mentioned. Currency was the primary cause of the decline. Of the $1.9 million decline, 70% was currency related. The remaining 30% difference was the net result of continued weak industrial demand in global energy, China's steel and U.S. mobile hydraulics markets partially offset by a strong European mobile hydraulic market in road building and agriculture machinery and stronger results in the U.S. medical market.
In total, industrial orders declined 10% while mobile hydraulics orders were down - or grew 11%. Regionally, Asia was down 1% while Europe and the Americas declined 9% and 10% respectively.
From a customer perspective, of the 2,500 customers that placed orders in Q4 with our Sensors business, which was 47% of our total customers, it was almost a 50-50 split between those who ordered more this quarter than last quarter and those who ordered less, a clear signal of the erratic and uncertain economy.
On a positive note, orders from new customers and or applications accounted for over $5 million this quarter. While new customers generally do not order large quantities of sensors immediately, they generally collectively create steady growth and demand over time as their new product platforms gain traction in the market.
Backlog at the end of the quarter was $13.8 million, down 5% from last quarter. In summary, Sensors continued to be negatively impacted by currency and volume related end customer demand. We continue to add new accounts which are a partial offset to the volume decline.
Additionally we believe these new winds will add to our long-term success as the global economy improves. Now I'd like to spend a few minutes on Tests. At $124 million Test orders were up $16 million or 15%. Excluding currency, orders increased 17%.
This quarter's results include one large $20 million seismic order in Asia. Base orders of $103 million were strong but down slightly from 107 million in the prior year. Geographically Asia was the bright spot once again this quarter accounting for 56% of total orders in our Test business.
In addition to the large structures order, materials and ground vehicles were also strong in Asia up 48% and 23% respectively. China comprising roughly 1/3 of our total Asian Test business continues to be a very positive story with orders up 18% year-over-year led by a strong materials testing market.
MTS is well positioned in China and other emerging Asian markets and we look forward to continued growth in this market. The America's orders were down 22% across all markets for our Test business as our customers really focused their energies on their Asian development challenges.
Meanwhile, Europe was up 2% including a 7% point negative impact from currency. Excluding currency effects, 9% base order growth in Europe driven largely by the materials market seemed like a reasonable performance given Europe's sever economic fiscal uncertainties.
From a market perspective, ground vehicles declined 5% to $50 million, materials was $43 million, a 15% increase and structures grew 78% to $31 million driven by the $20 million seismic order I previously mentioned. Within our ground vehicles market strong demand for tire testing systems in Asia continues.
Growth and materials was driven by global demand for our recently launched criterion product family which is being very well received and high temperature testing demand from contract test labs to support aerospace and automotive OEM product development efforts. In our structures market, we won as previously stated a key order for a seismic system that will be used for advanced earthquake research in Asia.
Large scale testing systems and methods are a real strength on MTS and we were selected because of our proven capability and industry leading offerings. With the tragic loss of life and property from earthquake and other mega storm related events of recent years we expect research in this area of civil construction to remain significant and the market for MTS products to remain strong for some time to come.
Backlog in Test was $285 million, up 5% year-over-year and sequentially. It's a new record and a strong starting point for our fiscal '13. The test pipeline which is defined as orders that could close in the next 12 months continues to be strong and is a leading indicator of our business. At $765 million it's up 11% year-over-year and 5% on a sequential quarterly basis. The increases in base orders are good indication of the overall health of our Test business markets.
In summary for our Test business it was another strong quarter for orders despite some currency headwinds. Our backlog positions and our robust pipeline indicate that Test is well positioned to have another good year in fiscal '13 barring a significant economic decline or disruption as our customers need testing capability and capacity to meet the product requirements of an ever changing world.
Now I'd like to turn the call back over to, Sue to add further detail to the Q4 and full year fiscal '12 performance. Sue?
Sue Knight: Thank you, Jeff. My remarks today will summarize our fourth quarter results based on a year-over-year comparison. I will also provide a brief overview of our full year results and I'll begin with the fourth quarter.
Revenue in the quarter was $137.8 million, another strong quarter, with approximately $4 million lower than last quarter and typifies the variability in quarterly results that's driven by the nature of the Test project based business. Year-over-year revenue grew 5% including a 3 percentage point unfavorable currency impact primarily from the euro.
Again this quarter, growth in Test was partially offset by a modest decline in Sensors that was driven by soft end customer demand. On a segment basis Sensors revenue of $24 million declined 10%, six percentage points of which was currency related.
Geographically Europe was down 17% impacted by both market demand and currency. The America's revenue was down 3% and Asia was flat which was an okay result given the overall sluggish global economy.
Test revenue of $114 million was very good on strong quarterly based orders and a high beginning of quarter backlog of $272 million. Year-over-year growth was over 8% including a 3 percentage point negative currency impact.
From a geographic perspective the Americas and Europe had significant increases, 37% and 17% respectively. Test revenue in Asia declined 10% driven by the completion timing of large custom projects which does cause variability in the results when comparing a single quarter's performance.
Overall, revenue results were within our expected range. The next topic is gross profit. At $57 million, gross profit increased 1% on 5% revenue growth impacted primarily by the volume decline in the higher margin rate Sensors business.
Sensors was down $2.3 million or 16% relatively, strong performance in light of a 10% revenue decline. The gross profit in Test increased 3.2 million or 8% which equaled the revenue growth. The benefit of volume leverage was offset by a mix impact and an increase in the number of technical and support service personnel as part of our service growth initiative.
The gross margin rate was 41.7%, down 1.3 percentage points compared to the prior year. The Sensors rate declined 3-1/2 points to 54% which is still a very good margin rate. Approximately 2/3 of the decline was volume related and 1/3 was due to higher indirect factory expenses including warranty and a year-end physical inventory adjustment.
Test growth margin rate was essentially flat at 39.1% and within our normal range considering mix and volume. Moving on to operating expenses, costs were $35.8 million, an increase of $500,000 over the prior year.
Legal expenses declined approximately $2 million due to the conclusion of the government investigation and settlement of the outstanding matters. This reduction was more than offset by our continued investments in possesses and systems to increase productivity, enable our growth with expanded sales coverage and achieve scale to meet today's and future business requirements.
The Test revenue volume is almost 50% greater than it was only two years ago and the backlog and opportunity pipeline remains strong so these investments are critical. Additionally R&D increased approximately $1.6 million or 36% driven by Test program.
As a rate to revenue operating expenses were 26%, down 9/10 of a percent on higher volume and at the bottom of our expected range of 26% to27%. The next topic is EBIT. EBIT increased 2% to $21.6 million, less than the 5% revenue increase due to the previously discussed lower growth margin rate in Sensors and slightly higher operating expenses.
As a rate to revenue, the EBIT rate was very strong at 15.7% relatively flat compared to last year's rate of 16.2%. Tax rate in the quarter of 28.6% was lower than our typical quarterly rate which is in the low to mid 30% range and lower year-over-year by about 1 percentage point.
Approximately 2 percentage points relates to the benefit of cash repatriation from higher tax rate jurisdictions and the remaining variance was from favorable geographic earnings mix. Earnings per share was 94 cents, flat compared with the prior year.
Revenue volume and mix contributed 6 cents which was offset by higher planned expenses of 10 cents. A slightly higher share count had a 2 cent negative impact on earnings per share compared to the prior year. And the lower tax rate added a penny of additional earnings.
My last topic before I transition to a high level summary of the full year is cash. The cash balance at the end of the quarter was $80 million, a decline of $66 million. Operating cash flow of $13 million was very good, net of the $8 million settle payment to the U.S. government.
Results include a $5 million decrease in working capital primarily from a $7 million or 35% advance payment associated with the large $20 million order that Jeff previously discussed. Capital expenditures and dividends were each $4 million.
There were two large financing expenditures this quarter. The first, the $35 million for the previously announced accelerated share repurchase program and $40 million to pay off our debt. At this time paying down the debt was a good use of a low yield cash asset.
Additionally, in the fourth quarter we established a new $100 million credit facility to replace the existing $75 million credit facility that was scheduled to expire in December. This gives us access to capital at attractive rates for the next five years to fund our growth as required.
Finally I'd like to briefly recap the fiscal year from a financial perspective with three noteworthy messages. The first message is about our growth. We delivered very strong growth and record highs in orders, revenue, earnings per share from operations which is non-GAAP and operating cash flow despite a volatile global economic environment and net of investments needed for long term growth.
We attribute this success to our differentiated market offerings in both Sensors and Tests and our investment several years ago having anticipated the energy testing knowledge demand and emerging market megatrends so we could rapidly respond to changing customer needs particularly in China.
The second message is about our effective cash generation and deployment to achieve an impressive 25% return on invested capital including the previously mentioned settlement charge. We generated a record $65 million of operating cash flow which is almost 50% more than our historical best year ever.
We increased capital expenditures by about 50% to $16 million making investments in productivity and scale. We returned cash to shareholders through a 20% dividend increase and a $35 million accelerated share repurchase program and we repaid $40 million of borrowings reducing our debt to zero.
My third and final message is we achieved our beginning of year outlook for the year despite weaker than expected end-market demand in Sensors. That included 16% revenue growth against the guidance outlook of low double-digit growth and 14% earnings per share growth from operations compared to a low double-digit growth outlook.
In summary we are proud of what we've accomplished in fiscal 2012 thanks to the dedication and excellent work of our employees around the world. That concludes my remarks. Now I'll turn the call back to Jeff for his final comments.
Jeff Graves: Thanks, Sue. Having executed to our commitments for fiscal '12 I'd like to fast forward to our longer term goal for MTS namely to become a $1 billion company.
Since my arrival at MTS six months ago I have travelled extensively to meet our key customers and our employees around the world. Most importantly I've evaluated our business model to understand if we have the opportunities and competitive advantages to create sustainable growth in shareholder value over the long term. The answer is a resounding yes.
I believe our two core businesses, Sensors and Tests are serving markets that offer significant growth opportunities and we have as our customers the key long-term winners in these markets, most of whom we've known and supported for decades.
Moreover, our key customers know MTS as a technology leader who understands them and is will to invest for their future success. Given our excellent market position and the growing need for our products and services around the world, we've established a goal of delivering $1 billion in revenue by 2018.
This goal has been fully endorsed by our Board of Directors and our management team is committed to delivering it. This $1 billion goal means that we'll move from being a cyclic company to one that is focused on growth, attaining a sustainable rate of over 10% compounded annual growth over the next few years.
Our three priorities to achieve this goal are number one, accelerating innovation. Two, capturing the opportunities in the rapidly changing emerging markets. And three, realizing the potential of the Test services business.
Achieving our $1 billion goal requires that some things remain the same while other things change. Unchanged will be our customer intimacy philosophy which gives us unmatched insight into our key markets and allows us to anticipate the future needs of our key customers and our commitment to ensuring ethical behavior and corporate compliance every day.
Also unchanged will be our determination to be the innovation leader in each of these markets, a reputation that we carry with great pride and one that is strongly associated with our MTS brand around the world.
This culture of innovation is the cornerstone for out new mission statement with which every employee is aligned. Very simply, our mission is to be the innovation leader in creating test and measurement solutions to enable our customer success.
Our vision for MTS through innovation, create value to drive growth is embedded deeply in the DNA of our employees around the world. The essence of our mission and vision is unchanged from the past, indeed has been with us since our founding almost 50 years ago but stating it clear and publically is an effective way to tell the world what MTS is really about.
While many things will remain unchanged, there are some things that are changing as we transform the company to accelerate growth. First and foremost, we will accelerate our pace, that's the pace of innovation, the pace customer responsiveness and the pace of organizational change to respond to the rapidly changing market place in which our customers now operate.
Second, we'll leverage our outstanding market position, geographic footprint and installed base to generate more growth from Test services and our expanded static testing product lines. In Sensors we'll capture the emerging market opportunities particularly in China and bring new technology solutions to solve our customers measurement needs.
Third, we will invest more money in the near-term putting our strong balance sheet to work to hire, develop and expand our global talent base and build the processes systems and infrastructure required to be a $1 billion global enterprise.
While these investments are significant, given that our growth opportunities are largely organic in nature, we believe they will yield meaningful shareholder value in the future. I'm very confident about our ability to achieve this $1 billion goal and excited to be leading this transformation to accelerate growth and MTS.
Looking at fiscal '13 I'd like to spend a few minutes on our guidance for the fiscal year and provide a little more insight into the quarterly progress we anticipate. From a global economic perspective like most companies we're anticipating neither a bust or a boom but rather a continuation of a slow growth environment that we experienced in fiscal '12.
We've proven that we can grow in these conditions as our customers continue to make capital equipment investments to enable their emerging market competitiveness and local infrastructure expansion, preserve and source energy and develop innovative products for their evermore complex global customer base.
Of particular note over the next few years is accelerating the pace of change - is the accelerating pace of change of - in the Chinese market, a particular strength for our company. While the growth of modern manufacturing infrastructure in China is commonly discussed and has helped MTS grow rapidly in China in recent years, China is now also experiencing rapid changes in their consumer market place with increased discretionary spending driving strong demand for new automobiles and the desire for expanded travel by air and high speed rail.
Product developments in all of these areas is robust in order to meet these demands. There is also a tremendous migration of the Chinese populous from farms to cities requiring the construction of new high-rise buildings and other civil infrastructure to accommodate this influx.
This urbanization in the face of recent tragedies from earthquakes and related seismic and mega storm events has created a much greater demand for research in building design and construction in China. MTS is well positioned to respond to this need as the long recognized leader in civil seismic testing systems and methods.
Additionally, China aspires to export products that meet global performance standards which is creating Sensor opportunities as more technically sophisticated machinery is now produced. We expect these trends to continue both within China and more broadly in the developing nations and a support of continuation of order growth in our core businesses in the new year and beyond.
Thus our outlook for revenue growth compared to fiscal '12 is 5% to 10% while the single largest variable underlying the range is the global economy and what it will actually do, the fundamental growth drivers for MTS remain intact and very positive. As this is the first year of our plan to achieve $1 billion in revenue in 2018, it'll take some time to build up to the compounded annual growth rate of 11% that's inherent in that longer term plan.
Regarding earnings per share, our outlook is 5% to 10% growth compared to fiscal '12 which is the same as the revenue growth range. We're using the incremental benefit of volume leverage to accelerate critical investments which I previously discussed.
Capital spending is expected to increase from $16 million or 3% of revenue to $25 million of 4% of revenue in fiscal '13. The primary increases are for Test services, delivery and sales support, IT systems and Sensors manufacturing automation which are the key enabling us to achieve our growth goals.
These initiatives began in fiscal '11 and '12 timeframe and are well underway. A lower share count from the accelerated share repurchase program, slightly lower tax rate and lower interest expenses as a result of paying of our debt all contribute to the earnings growth outlook.
I'd also like to share some context about our financial profile by quarter. We do not expect the growth to be linear throughout the year. In particular, and despite a record beginning backlog of $299 million, we expect first quarter revenue growth will be modest at 1% to 3% due to the timing of Test custom projects and the continuation of a soft economy for Sensors end-markets.
This modest growth combined with accelerated investment pace will result in earnings per share on 72 cents to 82 cents in the first quarter of the year. We do expect the second half of the year to be stronger than the first half and slightly more skew to the second half of the year than in previous years with 52% to 54% of the full year revenue compared to 51% in fiscal '12.
This is due to Test customer delivery schedules and order timing and an anticipated stronger second half global economy. Similarly we anticipate earnings per share in the second half of the year will be 55% to 57% of the full year based on volume and timing of investment spending. This compares to 55% in the second half of fiscal '12.
Overall our experience in fiscal '12 and our robust opening backlog position give us confidence in our outlook at this time. However, as always we'll be closely monitoring our markets for changing conditions so that we can make adjustments as required.
We look forward to updating you on our progress as the year progresses. It's an exciting time at MTS. That concludes my prepared remarks. (Chris), I'll turn the call back over to you to start our Q&A.
Operator: Thank you. If you would like to ask a question please signal by pressing the star key followed by the digit 1 on your telephone keypad. If you're using a speakerphone please make sure your mute function is turned off to allow your signal to reach our equipment.
If you have signaled for a question prior to hearing these instructions on today's call please repeat the process now by pressing star 1 again to ensure our equipment has captured your signal. And we'll pause just a moment to allow everyone an opportunity to signal for questions.
Again, that's star 1 for your questions and we'll take our first question from John Franzreb of Sidoti and Company.
John Franzreb: Good morning, Jeff and Sue.
Jeff Graves: Good morning, John.
Sue Knight: Hi, John.
John Franzreb: Hey. Jeff, I applaud you for reinstituting the guidance. And I really want to start right there because if I do some simple math it looks like on a sequential basis that revenues in Q1 will be pretty similar to what we just had in Q4. But the profit profile is substantially lower.
It sounds to me that he's signaling that it is all expense related and not mix related. Is that the case? And how much more of incremental expenses are we looking at?
Jeff Graves: Yes, John you got it right on the button. So our revenue is - we're projecting up modestly from Q4. So we said 1% to 3%. EPS drop is entirely due to our investments for growth.
John Franzreb: So if I kind of quickly annualize that we're looking like an $8 million headwind from investments and in fiscal 2013 is that a ballpark type number?
Sue Knight: John, I think that's at the high end. You know, we're looking at six to eight.
Jeff Graves: Yes. And annualizing the Q1 level, John is probably too aggressive. So to Sue's point it drops throughout the year. It's frontend loaded, you know, because of hiring and training needs.
John Franzreb: Got it. I didn't quite catch the order book number for Asia in total how much was up for the company year-over-year, Sue when you said that or Jeff. I forgot who said it. What was that number again?
Sue Knight: For the year, John or the quarter?
John Franzreb: For the quarter.
Sue Knight: Let me just look back at the number. At the company level we didn't talk about total Asia. Test was the big driver or Asia was up - so we didn't highlight that number.
John Franzreb: Okay. You said that China was up 18%. I guess what I was going to draw down to is was why was America so weak in the auto bookings?
Jeff Graves: Yes. We were - we've been talking a lot about that as well, John. And it's, you know, weaker than you'd probably expect just from, you know, kind of macroeconomic factors.
But our conclusion that it's just based on what - just from discussion with customers is, they're really focusing most of their investment around growth in Asia. And because that's, you know, that's where the consumer base is growing, that's where a lot of the spending is and the new product needs are.
So they could very well be American companies but they're growing over there and that's where most of their investments. So that's where a lot of our sales are. So I view it that way.
I think, you know, America's economy was much like the headline said. But if you look at their investment profile it was just more driven by their investments in Asia.
John Franzreb: Okay. And sticking to the geographic theme here, you talked about the opportunity pipeline. Is it equally strong in Test in Europe or is there any concerns about the Europe spend rate right now?
Jeff Graves: Well it gets a little complicated because we've got, you know, some very global customers that are spending a lot of money is Asia but they're headquartered in Europe. So, you know, we classify our orders based on the geography that the purchase orders received in.
And so we could call it Asian. It could still be driven out of Europe. I think our, you know, our customers are certainly facing big headwinds in Europe like everybody is from a production standpoint and capacity utilizations off.
But from an R&D standpoint the markets we play in, very, very strong. So Europe for us has still been a good story because they continue to invest in product development and R&D over there.
John Franzreb: Great. One last question. What was the shares at the end of the quarter? What's the current share count standing at right now?
Sue Knight: About 15.8.
John Franzreb: 15.8. Okay. Thank you very much, Sue.
Sue Knight: You're welcome.
Jeff Graves: Thanks, John.
Operator: And we'll take our next question from Liam Burke of Janney Capital Markets.
Liam Burke: Good morning, Jeff. Good Morning, Sue.
Jeff Graves: Good morning, Liam.
Sue Knight: Hi, Liam.
Liam Burke: Jeff, part of your growth or one of the pieces of your growth strategy are the Test services business for - to support a fairly extensive imbedded base. Could you give us a sense on what the - or how you feel it did on a startup basis in 2012 and what's the outlook for 2013?
Jeff Graves: Liam, I would tell you we're around - we run today $65 million in what we call services today which, you know, is a combination of parts and services we provide. And, you know, and frankly we're the, you know, we are definitely the person they call when they have an extreme issue.
And we go in and help them or we have - or there's a unique part type. What we - that's about 15% of our revenue if you do the math. What we believe that number really should be frankly if we were pursuing services in a way that we should like many companies do is about 30%.
So that number as a percentage of revenue should be 30%. And you look at our growth, that $65 million should be north of, you know, well north of 100 probably north of 150 million if we were actually doing it right and realizing, you know, the services from our installed base.
So we've got a tremendous opportunity. We have to approach it differently which we've organized ourselves to do now and we have to hire and train a lot of field engineers to go after it which we're in the process of doing. And we started actually back in '12 - in fiscal '12 and we'll continue aggressively in '13.
We've estimated, Liam and it just is a rough number to calibrate you, our customers are spending probably - for our $3-1/2 billion installed base of equipment they're spending probably $0.5 billion of expense revenue a year to service the equipment. We capture a very small percentage of that.
And so that's really our target. That's what we're going after and training our service folks to do and we're also designing our equipment for service ability now and really embracing this whole services model which I think is largely untapped from the past here.
Liam Burke: So do you anticipate being able to make any progress towards getting more of that $500 million market in 2013, excuse me.
Jeff Graves: Yes. It'll be - but it certainly won't be linear. I mean we've got - you know, I just met with two teams of people coming through for training the last couple weeks and it's, you know, it's - our equipment's very technical and it requires a lot of training and there's a pretty steep learning curve.
So it'll - we'll certainly see an improvement in '13. I can't give you a number. We'll see an improvement in '13 on a percentage basis of revenue. And obviously our revenues are up, so that's good.
But the real benefits, Liam, I would expect in year two and three and then I think by the third year the progress will be very clear and you'll see what kind of a growth rate we're on.
Liam Burke: Okay, great. Thanks, Jeff. And on the Sensor side, you discussed in 2013 you'd expect that to be weak as well as it had been in 2012. Is there any particular geography or application that you see weakness or is it just across the board?
Jeff Graves: Well the - I can tell you in my time here, the industrial equipment business certainly hit the skids first. And that's - those are, you know, things like plastic injection molding machines and steel processing equipment, things like that.
So that's been down with the overall economy. The mobile hydraulics piece is, again it's - you've probably read the headlines around the big heavy equipment manufacturers, they've all slowed down which means their pace of introducing new platforms has slowed down and that's really what drives our Sensor sales.
Clearly we're making a lot of progress on landing new customers and getting designed into products. But those products have to move into production and be sold and that's really what's slowed down.
And it was disappointing last year. I can tell you had hope for better growth in the second half of the year. In retrospect I feel pretty good about it being flat, aero was down slightly. But then we held gross margins nicely in that business.
But, you know, the guys really reacted fast on the cost side and we're able to hold gross margins reasonably well. But the real problem there is on volume and we just need the economy to cooperate a bit more.
So I would tell you it became by the end of the year broader based. We would anticipate this year, the same kind of environment in the first half of the year. In the second half I think we'll see some improvement based on our product adoption rates.
We are landing a lot of new customers and particularly in Asia where, you know, a lot of the manufacturing is happening now. We're seeing the Asians move from wanting to compete on price in their market place to compete more on technology.
And because of that they're adopting our Sensors. And that's a big, big, focus of our investment around sales force and sales support is in China specifically in the Asian marketplace.
Liam Burke: Great. Thank you, Jeff.
Jeff Graves: Sure, Liam. Thanks.
Operator: And again, it's star 1 to ask questions today. That's star 1. And we go next to Mike Hamilton of RBC.
Mike Hamilton: Good morning everyone.
Jeff Graves: Good morning, Mike.
Sue Knight: Morning, Mike.
Mike Hamilton: Jeff, wondering if you could spend a little time on your feelings of components of your growth targets, what your view is on what's going to be required in taking market share or what your view is on new market activity? Obviously you're talking a pretty healthy step up here in outlook relative to a very long history for this company.
Jeff Graves: Yes, absolutely, Mike. And I - let me just hit the major components. The Services thing, I talked to, you know, with John and Liam on the prior questions. But again, I look at that and truly I think 2 to 3 times growth in our Services revenue from what we saw in '12 is very doable when you fast forward over the next five years.
You know, we have an installed base and a relationship with our customers where they would really prefer us to be doing the servicing. But we have to be staffed for it, equipped for it, we've got to have the IT infrastructure which is often overlooked in terms of scheduling and part availability.
We have to have all that in place and that's why we're making the capital investments and the people investments we're making right now. So I think Services will certainly be a cornerstone, an absolute cornerstone of our business and it's been done in many industries by many companies and it's extremely doable.
Because I can tell you from talking to our customers firsthand, they would prefer us to do it a lot of times but we just aren't really equipped and priced competitively to do it today. So we will participate much more significantly in that business.
Our core markets, when you just walk across our end-markets you've got automotive, you've got aerospace, materials, advanced materials that go into those products. They're - in spite of a weak economy around the world there is a huge proliferation of new products required because where the buying is occurring is in new geographies.
So you've got more Chinese folks, Indian folks, Brazilians that suddenly have disposable income that want to buy cars and they want to travel to see their relatives or travel out of the country. So aerospace, high-speed rail, new automotive, all of that drives R&D spending and product development.
So our customers to out words in their mouth, they look at it and say, yes, the economy may not be good, I may not be selling a lot of volume but if I want to be positioned for future sales I better have the products that these folks want to buy. And then they need our Test equipment to test those products.
So fundamentally I love the businesses we're in, I love the R&D and product development focus we have and we have a reputation for. So all of our core businesses I think are positioned for growth because of the emerging markets.
The - if you put on top of that the energy scarcity and the drive for more fuel efficient vehicles and aircraft, you enhance that growth rates further and you add in areas like oil and gas where they're much more concerned now about testing, how they drill and how they refine these products for safety and environmental concerns. It all drives the need for Test.
And then - let's see, emerging markets, energy and infrastructure, those elements are really driving a great need for R&D and product development around the world. And then I'll add two more quick comments, Mike and then shut up and let you ask another question if you'd like.
But the - this civil seismic thing is really an interesting occurrence and it makes a lot of sense when you look backwards. You look at the tragedies that have occurred in the last several years around earthquakes and tsunamis and tidal waves, floods that's destroyed civil infrastructure. And you look at where the migration patterns are in the world, for example in China and it's mirrored in India and elsewhere where you've got vast migration of people into cities.
I heard numbers in the last couple of weeks of - well I can tell you from my own discussions in China. They're putting up a new high-rise every five days. And a high rise means over 50 stories every five days. You've got estimated populations of 20 plus million in China migrating to cities every year, you know, creating a city the size of New York every single year.
Therefore, they're very concerned as they should be about the stability of their buildings. You know, are they building things that are resistant to these earthquakes and flooding because you've seen in the press what's happened in the past and that problem just gets magnified. So they're making the smart investments in R&D and in the design of buildings and materials that go into those buildings and we're selling a lot of equipment to support it.
So I'm really excited about our position in that market globally, not just in China but these tragedies have struck everywhere in the world and we're in a position to really help out with that problem by selling them equipment that'll save lives. And then you switch to the Sensor side of the business, there's a - if the volume comes back because of the economy there's a good pinup demand for more automated machinery and our Sensors go into help automate it in a very rugged, robust way.
So when the world needs for plastic injection molding or steel processing equipment, things like that we are designed in - increasingly designed in everyday and positioned to meet the demand. And in the mobile hydraulics thing in Sensors is - we're really excited about because people that drive heavy, you know, safe - heavy equipment that are concerned about both safety and efficiency, it could be in agriculture or earth moving or heavy cranes, those people need smart systems.
And at the heart of a smart system is our Sensor that goes in a mobile hydraulic cylinder. And that's - so that - again we're getting designed in to a lot of those platforms. Unfortunately the lead time is long because the platforms have to go into production and the end-markets are still weak.
So I'm really excited about the products we have, we're in an increasingly good cost position in sensors. I'm just frustrated by the economy. If you look at, we had a record year last year and that was in spite of tremendous headwinds in our Sensors business.
So I look at all that and say, yes, a $1 billion is a big goal but it's - we've got, certainly got the horsepower, we've got the technology base, the customer base and market exposure to deliver it. So, you know, pending some calamity in the world I feel very, very comfortable with setting the goal and being very public about it.
Mike Hamilton: Thank you for the detail.
Jeff Graves: You're welcome, Mike. Thanks for the interest.
Operator: And we turn next to John Franzreb of Sidoti and Company.
John Franzreb: Yes, Sue you actually brought up the growth rate in the revenue stream over the past couple years. I'm curious, Jeff if the company's capacity constrained, if some of the spend that you're talking about is on bricks and mortar?
Jeff Graves: No. No, we're fine, John on that. We - our investment is to make our operations more efficient. And it's clearly, you know, updating our IT systems, updating our infrastructure in the Sensors business, it's certainly automation manufacturing to have more output from the factory because if you run the map on our sensors business we'll be by 2018 we'll be producing at least three times the number of Sensors in each one of these plants that we are today. And automation is a key component of that.
It's going very well and, you know, we continue to make a lot of progress there. One the Test side of the business it's really around productivity and efficiency of our IT systems and putting on front end systems that help our sales force both identify and quote opportunities more quickly and making our engineers more productive through configuration tools and things like that. So it's basically, it's what's required for scale and productivity in the business, John. It's not brick and mortar. We're fine.
John Franzreb: Okay. More feet in the street?
Jeff Graves: Yes, certainly. The other part of our investment is hiring. And I would tell you it's kind of three categories, sales and sales support and again we sell to a very technical customer base. And within our customers we sell to engineers largely.
So our sales people are engineers, we have significant sales support requirements for providing engineering data and technical discussion dialog with customer's around the world. So we're expanding that.
And we also obviously, as I said we're hiring a lot of service folks, we call them field service engineers. And again it's a very technical position that requires a year or two to get good at. But - so there's an incubation period. But those are the folks that really call on customers every day to keep their equipment running better and better.
John Franzreb: Do you have any sense of how many people you'll be adding this fiscal year, Jeff?
Jeff Graves: Oh, John I would tell you it'll be in the - at least in the range of a couple hundred folks.
John Franzreb: Okay. Thank you very much guys.
Jeff Graves: Thanks, John.
Operator: And up next is Chris McDonald.
Chris McDonald: Hi, good morning. Could you share the assumption relative to the tax rate and then also maybe comment on the potential impact if the R&D tax credit is extended.
Sue Knight: So typically our annualized tax rate is in the low 30% and that range is driven by geographic mix primarily. But the R&D tax credit that's currently expired could have a benefit next year if it's reintroduced in the legislature and approved we would get a full year benefit in '13 and we would get a retroactive benefit associated with three quarters of fiscal '12. So year-over-year that would give us about a one to two point improvement in the rate.
Chris McDonald: Okay and that's not assumed in the guidance I imagine.
Sue Knight: We - you know, it's pretty granular point. When we look at the overall tax rate range, we would say that we are assuming at the low end that it doesn't happen - excuse me, at the high end it's not happening, at the lower end it would be included in the outcome.
Chris McDonald: Okay. And then the $6 million to $8 million of incremental spending in the coming year on these growth initiatives, maybe first how much of that is - from a year-over-year comparison perspective how much of that is offset by the non-recurring spending associated with legal and compliance that was incurred during fiscal 2012?
Sue Knight: Well certainly the non-recurring settlement is different. But on an operating cost basis we - the compliance expenditures that we had are ongoing. And then from a legal cost perspective we should be down, you know, $1 million or so.
Chris McDonald: Okay. How does that $6 million to $8 million, how is that spread over the three areas that you discussed, just innovation and generically emerging markets and then the services expansion?
Sue Knight: So that's a level of detail that I'm not prepared to get into today. But I think you can be confident that we are spending in all three areas.
Chris McDonald: And how...
Jeff Graves: It gets a little tricky about what you - what do you call innovation. You know, certainly our sales folks and sales support people are out, you know, working with customers to develop specific solutions with them. Either you could classify that as innovation - what I usually think of though is more, you know, basic R&D spending and things like this which is up as well.
But again, a lot of our expenses here are around sales, sales support and field service engineers to grow our Services business. So it's - we have a tremendous innovation machine internally already. And frankly we'll tune and tweak it but we don't need significant increases in people doing R&D work frankly.
Chris McDonald: And just relative to measuring the - in the services business specifically where it would seem like you could have pretty good granular data there. What systems and processes do you have in place to measure the return on that investment and what's your plan as far as maybe sharing that externally with just the progress that's being made, you know, given that the investment is pretty significant, it's certainly weighing on profitability next year.
Sue Knight: That number of return on investment will be the topline growth in service.
Chris McDonald: Okay and that's something that we can maybe track quarterly, Sue?
Sue Knight: That information is available in our quarterly filings where we separate service as a line item.
Chris McDonald: Okay and then just, you know, since it's a new area of emphasis, what's the historical experience relative to how quickly you might start to see a return on that investment? And when do you reach breakeven if you will or, you know, what's a payback period type thought process to apply to that?
Jeff Graves: It's probably, you know, it's hard - it's really kind of hard to estimate because it's around, you know, how fast are folks trained, how quickly can they go out and start realizing revenue. That - the margin in that business is among our highest margin business today.
And, you know, we assume it will remain so as we grow it. I think there's a lot of good demand out there. But in terms of return I - it's really hard to put a real specific number on it.
Sue knight: Yes. On the people aspect, you know, it's a year for them to get to I would say up the learning curve far enough to start paying back that investment on the capital.
We expect to achieve hurdle rates, you know, well beyond our cost of capital in the service business in particular and, you know, that's going to take a few years to generate that kind of result.
Chris McDonald: Okay. Good, very good. Thank you.
Jeff Graves: Thanks.
Sue Knight: You're welcome.
Operator: And there are no further questions at this time. I'd like to turn the conference back over to Dr. Graves for additional or closing remarks.
Jeff Graves: Thanks, (Chris). Thank you all for participating on the call today. I'm very pleased about MTS's performance in fiscal '12 and believe we have a promising future. We've already begun working to accelerate our pace so that we can achieve our $1 billion revenue goal in 2018. I look forward to updating you on the progress in our future calls. Thanks and have a great day.
Operator: And this does conclude today's presentation. Thank you for joining and have a nice weekend.