- News & Events
- About MTS Sensors
- About MTS Test
- Global Presence
- Environment & Sustainability
- Customer Case Studies
- Product Safety & Design
- MTS Patents
- Quality Management Systems
- Supplier Information
- Terms & Conditions
Moderator: Sue Knight
May 7, 2013
9:00 am CT
Operator: Please stand by. Good day everyone and welcome to today's MTS Systems second quarter 2013 earnings conference. Just as a reminder, today's call is being recorded. At this time I would like to turn the conference over to your host for today, Miss Sue Knight. Please go ahead ma'am.
Sue Knight: Thank you (Sarah). Good morning and welcome to MTS Systems' fiscal 2013 second quarter investor teleconference. Joining me on the call today is Jeff Graves, President and Chief Executive Officer.
I want to remind you that statements made today which are not a historical fact should be considered forward looking statements as defined by the Private Securities Litigation Reform Act of 1995.
Future results may differ materially from these statements depending upon risks, some of which are beyond management's control. A list of such risks can be found in the company's latest SEC forms 10-Q and 10-K. The company disclaims any obligation to revise forward looking statements made today based on future events.
This presentation may also include reference to financial measures which are not calculated in accordance with generally accepted accounting principles, or GAAP. These measures may be used by management to compare the operating performance of the company over time. They should not be considered in isolation or as a substitute for GAAP measures. Jeff will now begin his update on our second quarter results.
Jeff Graves: Thank you Sue and good morning everyone. Thank you for joining us for our second quarter investor call. We appreciate having the opportunity to discuss our financial results for the quarter and our outlook for the rest of the fiscal year. In today's call I'll first discuss key takeaways for the quarter, followed by our orders and backlog results. Sue will then discuss the rest of the quarterly financials.
Following Sue's comments I'll provide an update on our outlook for fiscal '13 and our anticipated position as we enter our new fiscal year in October. We'll then open the call for your questions.
There are three key takeaways today. First we're pleased that we delivered orders growth in the quarter even though sensors markets remain tough and the test order mix and late timing in the quarter were less favorable than expected.
I'll explain the implications of this later in the remarks. Second, in a period in which many companies are struggling to deliver top line growth, continuing strength in the markets for our test segment, which is directly tied to global R&D spending, enabled us to deliver 6% topline revenue growth fueled by 11% growth in test. While we were pleased with our growth momentum, higher costs resulted in flat earnings per share.
There were several costs, puts and takes, and Sue will provide more details in a few moments. Third, based upon a delayed sensors market recovery and tests backlog and second half order timing, we've adjusted our revenue and earnings per share outlook for the full year. Having said that we're very pleased to still expect a record year for orders, revenue and backlog driven by the macro trends in the test market.
This outlook, combined with our ongoing productivity initiatives, position us well for a second half of the fiscal year and strong momentum as we enter our fiscal '14 in October. Now before I go further, let me remind you about the nature of our two businesses and the market dynamics we're now experiencing.
The larger of our two businesses is tests which provides highly engineered testing systems and services to product development groups within automotive, aerospace, energy and infrastructure OEMs worldwide.
This business is fueled by customers R&D and development spending on new products, and these markets are growing rapidly in response to strong macroeconomic drivers, which we believe will be sustained for several years to come.
This market exposure sets us apart from many other companies. Our second business is sensors, which provides products that are essential for automating heavy industrial equipment and increasing the precision and safety of heavy vehicle systems that utilize hydraulic controls.
These sensor markets are directly tied to industrial capacity utilization and heavy equipment demand which have been in a multi-quarter trough driven by ongoing sluggishness in the global economy. It's important to understand these distinct market forces as we discuss the growth opportunities and investment strategies that we're now following.
With this backdrop on our two businesses I'll now provide more detail on the quarter. Total company orders were $138 million, up 2% over last year. Adjusted for currency, orders were up 3%.
The recent quarterly trend by business continues as a 3% growth in test, was partially offset by a 6% decline in sensors, which is the smaller of our two businesses. In the quarter sensors and tests were 17% and 83% of total orders respectively.
Backlog of $287 million was down 2% compared to the prior year as our operations investments continue to bear fruit resulting in fast returns of our orders backlog. I'll now provide you with some color on order patterns by business segment, and I'll begin with sensors. Story for our second quarter and sensors is a mirror reflection of the last several quarters. Overall global market conditions are weak, particularly for mobile hydraulic applications.
The one bright spot is that for the first time in four quarters we delivered a sequential quarterly increase. While one quarter is not enough to confirm a change in the trend, we're happy about the 7% increase which was driven by North America and Europe. Asia declined sequentially which was primarily attributable to the Chinese New Year in the second quarter. Sensors orders were $24.1 million, down 6% year over year.
Adjusted for currency orders were down 4%. Industrial equipment orders declined 5% driven by lower demand in three areas, North American recreational vehicles, Japanese plastics and China steel. Europe's flat result - Europe's results were flat, delivering better year over year results than the other regions.
Mobile hydraulics orders remain weak, down 16%, and 11% growth in Europe driven by material handling and construction equipment orders was more than offset by a 45% decline in North America. This decline was primarily related to one large OEM that is ordering 50% less than they did last year based on lowering mining and construction equipment demand.
We're encouraged by the recent public statements by this OEM that markets are expected to improve going forward and we look forward to when these comments translate into firm orders for our sensors products.
In summary, sensors is a great business that remains under pressure based on soft market volume. We remain confident that our markets will recovery, that the timing which is tied to industrial demand for capacity expansion remains elusive. Meanwhile we're working aggressively to get specked into new machines worldwide.
For example within the quarter we won application opportunities with two European cylinder manufactures for pitch control on wind energy systems and a ship that's specifically designed for construction of offshore wind turbines.
Additionally we were selected as the sensor partner for a truck steering and suspension application at a European OEM, these are representative of the customer value we create with our precision measurement sensors.
Backlog and sensors segment at the end of the quarter was $15.7 million, essentially flat year over year. Sequentially backlog is up 6%, reflecting the uptick in orders this quarter. Our hope is that this strengthening in the market continues. Next I'll spend a few minutes on the test markets and orders. Overall we're very pleased that our test business continues to grow despite the sluggish global economy.
As always the nature of our business creates a lumpy profile from quarter to quarter, so I'll provide you with some context about what are the trends and where we are seeing variability due to timing. Test orders in the quarter were $114 million, up 3%. Excluding currency, orders grew 5%. The order growth was base order driven as large customer orders were flat at $5 million.
I'll also note the base orders of $108 million were up 13% sequentially following first quarter results of $96 million, reflecting in part the success of our new product introductions which we expect will continue to be strong throughout the remainder of the year and into FY 14. Similar to first quarter we had good growth in two of our three markets for test.
Ground vehicles was up 31%, driven by R&D lab expansions in Asia and materials grew 1% on the strength of static testing product demand in China. Structures was down $12 million or 47% on fewer large wind and seismic system orders, which are very lumpy quarter to quarter and year to year.
Of particular note we're pleased the service orders were up 8% this quarter and 10% year to date, reflecting our focus on and investment in the aftermarket opportunities from our large installed base. With that overview, I'd like to provide you with some additional color in each of the three test markets.
Beginning with ground vehicles, in addition to the previously mentioned R&D lab growth in Asia, we had strong aftermarket sales in the Americas as OEM spent money to maintain their existing equipment. In Europe we had a key motor sports win for $5 million for a new transmission test system.
Globally there were strong demand for tire testing systems, $10 million in total and a damper in elastomer system $5 million in total, driven by up and comers in Asia that are now rising to new levels of performance and global expansion of key tier one suppliers.
Also test line systems had a healthy quarter because our customers are making upgrade investments to more fully utilize their existing equipment, achieve productivity gains and solve specific problems related to regulations and new vehicle technology such as elastomer and advanced steering systems. Next for tests is the materials market.
At 1% growth we continue to see some softness in the Americas due to government funding decreases which directly affected military and university laboratory spending in the quarter. Demand for static testing - materials testing systems was up 12%, particularly in China but was offset by a less demand for dynamic systems which were down 19%.
Since our business is lumpy neither the static nor the dynamic growth rates suggest any trend, but simply a characterization of the second quarter orders. And lastly, our structures market was down $12 million or 47%.
In the Americas and Europe that decline was due to the timing of wind applications while Asia was impacted by the relatively large aerospace order we received in the prior year, which provided a tough comparison this year.
Also in aerospace we're very pleased with orders for our new FlexDAC system, our new high efficiency data acquisition system that we launched last year, as well as recent US and Korean automotive OEM and tier two supplier wins.
Geographically test orders were up 16% in Asia, 1% in the Americas and down 11% in Europe, China and the emerging markets continue to provide outstanding growth opportunities for us and will remain a key focus for MTS in the quarters and years ahead.
While we had originally projected the four year orders would be more frontend loaded, the profile now indicates that it will be skewed to the second half of the year. Reflecting this order pattern and a higher backlog conversion rates revenue within the second quarter, test backlog of $270 million was flat sequentially and down 3% year over year.
With our factory efficiency investments gaining traction, we anticipate these higher conversation rates will be sustainable, the subject of mixed considerations. I'll comment in more detail later on the net effect of these order and revenue conversion factors on the full year. My last comment in this section of my remarks is about the test order pipeline.
At $805 million, the pipeline remains strong and stable, providing us with excellent orders growth opportunities. We did experience delays with some larger projects in the second quarter but they were typical for our test businesses and there were fewer delays than in the first quarter, which we feel very good about.
We're closely monitoring larger projects by analyzing customer trends, reconfirming budgets and managing the technical scope of pipeline opportunities to maximize our win rate and provide operations with accurate order timing information. Now I'd like to turn the call back to Sue for additionally financial detail on the quarter. Sue.
Sue Knight: Thank you Jeff. My remarks today will summarize our second quarter results based on a year over year comparison, and I'll start with revenue. Second quarter revenue was $136.9 million, which was a 6% increase. Similar to the first quarter, currency continues to have a 2-point negative impact.
Excluding currency, revenue growth of 8% is reasonably good performance in light of the economic headwind. Again this quarter, double digit growth in test was partially offset by a decline in sensors. Comparing results by segment, sensors revenue of $23 million declined 12%, and excluding currency revenue was down 10%. Europe, our largest market at 50% of the total business, was down modestly at 3%.
North America and Asia were down 18% and 22% respectively. On a market basis, revenue results tracked with the order pattern as customers generally continue to buy small quantities for short-term needs rather than committing to larger blanket orders for longer-term delivery. (Test) revenue of 114 million was strong, up 11% compared to last year.
This growth occurred on flat backlog of 276 million, evidence that we are achieving process improvement efficiency from our productivity investments and test operations. Excluding currency, revenue is up 12%. Geographically the revenue results in tests are always much more aligned with backlog than current quarter orders.
Europe and Asia were up 25% and 16% respectively, while the Americas went down 8%. Overall, we feel very good about the topline growth in tasks. The next topic is gross margins, at 54 million, gross margin was down 4% on higher revenue. Approximately 4 million of volume related gross margin increase was more than offset by the impact of a four-point decline in the gross margin rate.
A lower mix of total company revenue from sensors had an approximate .3-point negative impact. Additionally, the margins were down in both sensors and tests, which resulted in a 39.4% rate to revenue, compared to 43.7% in the prior year. In sensors, gross margin declined 2.4 million to 12.6 million. Approximately 75% of the decline was volume related and 25% was mix related.
Despite these impacts the gross margin was strong at 54.8% but down from 57.4% in the second quarter of last year. In test, gross margin of 41 million was flat on 11% higher revenue impacted by a lower 36.3% margin rate. This is less than the one plus percentage rate improvement we expected compared to the almost 37% in the first quarter when we discussed it in our first quarter call.
Compared to a strong gross margin rate of 40.2% last year, the rate is down almost four points, and down four and a half points considering the benefit of volume leverage. In summary, the key drivers are - I'll summarize them in three points. The first item, three point decline due to higher mix of lower margin custom projects and cost increases on custom development projects.
We had a very high custom mix this quarter, which accounted for two and a half points of the decline from last year. Also, we had five first of a kind projects for wind and oil and gas energy applications and one ground vehicle system had cost adjustments in the quarter.
While it is common to have some amount of custom project cost adjustments each quarter, it is unusual for us to have five development projects reach the testing and installation phase concurrently, which is when we typically see system design or performance issues. These projects will be completed over the next six to nine months.
Impact of these projects in the quarter was a negative impact on margin of half a point. The second category of impact on the margin rate in the quarter was one point from planned investments and productivity and growth initiatives, primarily service expansion. This was similar to what we saw in Q1. The last point of variance was associated with over plan operational variances.
In this category, the primary cost drivers were warranty, infrastructure spending and indirect engineering labor cost. The annualize warranty rate remains relatively low, on an annualized basis it's less than 1%, but higher claims on a few systems and a greater - larger install base have impacted the last (two) quarters.
Regarding infrastructure related cost, facility and IT expenses were higher than planed based on the needs of our growing business. These costs are expected to moderate in the second half of the year. Looking forward we do expect higher gross margin rate results in the second half of the year for test and for the company.
Moving next to operating expenses, costs were 38.3 million, down 2%. And as a percent of revenue, operating expenses were 28%, down 2.4% year over year on higher volume. Lower legal and consulting expenses, sales commission and R&D were partially offset by people related direct and indirect costs. Thus, operating expenses were slightly above our expected range of 26 to 27%, although for the full year we still expect those expenses to be in the 26 to 27% range.
Moving onto EBIT at $14.7 million. EBIT declined approximately $2 million, driven by lower gross margins, net of lower operating expenses, as previously discussed.
Additionally, currency related expenses were up $1/2 million, primarily because the 9% devaluation in the Japanese yen in the quarter was in excess of our hedging position, as it was quite unusual. Even as a percent of revenue, with 10.7%, down 2.3 points, a disappointing result, given our higher revenue.
The next subject is tax. The rate in the quarter was 23.8%, almost a nine-percentage point year-over-year reduction. This difference was almost entirely due to the retroactive reinstatement of the U.S. R&D tax credit. The tax benefit was $1.3 million dollars. Earnings per share of $0.69 was flat, compared to the prior year, on a relatively flat share count.
Finally, I'd like to close with a few comments on cash. At the end of the quarter, the cash balance was $47 million, down slightly from $48 million last quarter. We used $1 million of operating cash flow, which was driven by $14 million of higher working capital requirements, to enable test revenue growth in the second quarter, as well as our forecasted growth in the second half of the year. Receivables were the primary driver of the increase.
We do expect strong collections in the third quarter, as a result of that higher balance. Additionally, capital expenditures were $6 million. As you may recall, we accelerated the second quarter dividend payment into December, in consideration of the change in the dividend tax rate, so there were essentially no second quarter impacts.
That concludes my prepared remarks for today. I'll turn the call back to Jeff for his final comments. Thank you.
Jeff Graves: Thanks, Sue. My final topic before we take questions is our revised outlook for the full year. Our growth outlook for the second half of the year for sensors has been tempered by our orders experience in the second quarter, and the delayed recovery of the in-markets that several of our OEM customers have publically communicated.
Again, our sensors business is directly tied to global capital equipment spending, which remains relatively weak. In additional, while test markets remain robust, the timing and mix of backlog and second-half orders is now expected to shift more revenue into the fourth quarter of this year and into fiscal 14 than originally planned.
In light of these conditions, we thoughtfully considered what actions are required to balance our investment needs with market dynamics. We've taken immediate action to curtail our discretionary spending globally.
However, in light of strong test market tailwinds, we've also determined that it's critical for us to continue on with our productivity and growth investment initiatives that will enable us to accelerate innovation, capture the rich opportunities in the emerging markets and realize the potential of our services business. These initiatives drive meaningful long-term value creation for our shareholders.
In our view, the short-term earnings impact in fiscal 13 is well worth the longer-term sustainable growth and margin performance of our business in fiscal 14 and beyond. Today, our view is that revenue will be $560 to $570 million or 4 to 6% growth, compared to the previous growth rate of 5 to 10%. Earnings per share are expected to be in the range of $3.30 to $3.70, down from the previous outlook of 5 to 10% growth.
From a quarterly perspective, the conversion timing of the test backlog is heavily skewed to the fourth quarter. Thus, third quarter revenue will be relatively flat compared to the second quarter, but lower costs will result in higher earnings. Including these revisions, we are still expecting a record year of orders, revenue and ending backlog for the company.
This backlog will then position us well for a very strong start in fiscal 14, and the macro tends are expected to drive momentum in future years. That concludes my prepared remarks. I'll turn the call to (Sarah) for the Q&A session.
Operator: Thank you doctor. Today's question and answer session will be conducted electronically. If you have a question or comment today, please press star then 1 on your Touch-tone phone.
For those of you joining us today using a Speakerphone, please make sure your mute button is turned off to allow your signal to reach our equipment. Once again, to the audience today, please press star then 1 if you have a question or a comment. Up first from Sidoti and Company, we'll go to John Franzreb.
John Franzreb: Good morning everyone.
Jeff Graves: Good morning John.
Sue Knight: Hi John.
John Franzreb: Hi. The services revenue is up 8% in the quarter, 10% year-to-date. Are you able to discern how much of this is the result of some of your new program initiatives?
Jeff Graves: Oh, I think - well it's a combination of factors John. I mean we have quarter by quarter a bigger install base, frankly, but also, the biggest driver is our hiring of resources - training of resources. They're finally starting to get some traction, so again, we've been at this for several quarters now of hiring and training people.
As we've said, it takes a while for them to learn the technology of the products, and we've now deployed them, and we're starting to get some traction in the field, so I was quite pleased with 8% growth. I think that's terrific, and we expect that momentum to do nothing but grow.
John Franzreb: Okay. The gross margin in tests was weak and Sue Knight, you called out a couple of buckets there. I guess I want to focus on the one that had to do with the custom projects. Again, is this a function of taking things in, say the all-in-gas segment?
Is this part of your new program initiatives? You seem to imply that you expect the gross margin in tests to revert back to historical norms, but I wonder if the incoming order book is such that the gross margins, maybe we should be thinking about them differently or not.
Jeff Graves: No John, there's no change in our fundamental model. I mean, I'm really pleased with our penetration in some new, exciting areas like oil and gas, and wind, and wind technology. We've got some really revolutionary equipment out there that's going into service right now.
You know, unfortunately, when you do first of a kind stuff, there's often, you have cost issues related to the last mile, if you will, of getting that equipment up and running. And many of those are driven by regulatory changes in health and safety kind of things in places.
In particular, these projects, this quarter, are largely in Europe, and many European regulations have changed over the 18 to 24 months that these products have been designed and being installed. So, we see those costs at the end of the project. On the good news side, it drives our learning very quickly in these new and exciting growth markets, like oil and gas, and wind.
Unfortunately, there's a cost associated with that, which I almost think of as R&D type costs, and we learn as we go. But, our chance of putting a benchmark project in a new growth market has been a model this company's followed for years and years, and it's a real winner for us, because then we set the standard for technology and expectations of the customer base. And, we have a technology edge then going forward, but no change in the base model.
As Sue Knight mentioned, this was an unusual quarter because we have five of these projects being installed right now, and so the cost just happened to hit us in a quarter. Did that answer your question, John?
John Franzreb: Oh yes, I mean essentially what you're saying to me, Jeff, is that the gross margin profile, it just happened that all these custom projects fell into the quarter, should revert back to norm, so you're not addressing new markets that's going to, you know, hurt the margin profile, okay, okay.
Jeff Graves: No, in fact I think this energy market as an example is really an exciting one from a margin standpoint. I mean, they're very high value kind of applications for our customers, so we're willing to spend money on testing. So, I'm really excited about that.
We're being very deliberate in which of these markets we choose for new projects, and the energy market, I think, is a very, very exciting one. The oil and gas stuff, John, I would tell you is just tremendous. You look at the changes that have occurred in our country, the United States, in the last couple of years, we're now talking about being energy independent.
And, what that really means from an infrastructure standpoint is a lot more, you know, exploration, transmission of these natural resources, and all of that drives a need for reliable infrastructure, which our technology is great at testing.
So, I'm really excited about it. It will occasionally cost us money in the quarter, you know, from a margin standpoint, but it positions us beautifully from a first of a kind offering out there that sets the standard for technology, which I think is very difficult for others to compete with.
John Franzreb: And Sue, can you remind me what the legal costs were that you incurred in fiscal 2012 that are not reoccurring this year?
Sue Knight: Mostly those costs were associated with the government investigation.
John Franzreb: No, I know what they were associated, what was the total tally last year?
Sue Knight: Oh, the dollar amount of legal costs?
John Franzreb: Yes.
Sue Knight: I don't know that off the top of my head. I'll have to get back to you with that because I just can't recall it.
John Franzreb: Okay. Okay, I'll get back into queue and let somebody go on. Thank you.
Jeff Graves: Thanks John.
Operator: Up next, we'll hear from Liam Burke of Janney Capital Markets.
Liam Burke: Thank you. Good morning Jeff. Good morning Sue. How are you?
Jeff Graves: Good, thank you.
Sue Knight: Hi Liam.
Liam Burke: Jeff, you talked about a couple of design wins on the sensor side. How quickly, I mean, I know mobile hydraulic, just as a reference, took a while for it to be designed in, and then ultimately converted to revenue. How quickly do you anticipate design wins to start showing up on the revenue front here?
Jeff Graves: You know, Liam, it's really frustrating because, you know, I can feel really good everyday coming in, looking at this litany of design wins that we have in sensors, you know, there really is an increasing demand out there for the technology, and our technology is pretty compelling, both from a performance and a cost standpoint.
The frustrating thing to me is getting on a platform is just a first step. That platform has to sell, and that sales process is strictly driven by capital investment for capacity in the world, and it's frustratingly slow, and difficult to get high visibility into.
And part of the reason we had to change our guidance is, we had expected the world to actually exhibit some kind of recovery in the second half of our fiscal year here, and, you know, as we sit here today, I don't have enough visibility to say it's actually going to happen. So, that's why we had to bring our guidance down. It's really, really frustrating to not have direct visibility into that in demand.
What I can tell you is we're getting designed into some really compelling platforms, and I'll be really happy when the world gets stronger in those platforms and sell for more customers.
Liam Burke: Great. And, you mentioned again 8% on the aftermarket growth in the quarter. Is one particular region of the world, geographic region doing better than others or are you seeing some uniform roll out of the initiative?
Jeff Graves: It's an interesting dynamic, Liam. Our installed base, historically, you know, we've got $3 1/2 billion of installed equipment out there, we're running a disproportionate amount is in the U.S. and Western Europe, because that's where the old, you know, the older infrastructure was installed. So, we've got a lot of equipment with a lot of life in it, running in those parts of the world, obviously some exciting growth in Asia.
From a services standpoint, I think we're getting traction, certainly in our install base, which would be in the U.S. and Western Europe, but I'm equally excited in the emerging markets that they really need the service because they don't have the infrastructure yet. They really need the service for buying new equipment. They have to have the services right along with it.
So, I would tell you, we're getting traction in all of our markets, and I should have included Japan in our install base. We've got a significant install base in Japan as well. So, as customers look to upgrade older equipment or shed costs within the laboratory by doing things more efficiently, we're there now to sell them that kind of service, and that will do nothing but grow in the future.
So, frankly, I was excited about 8%, and that 10% growth year to date and I think it's the tip of the iceberg. I think we're going to have a lot of momentum in the coming quarters and years in our services segment.
Liam Burke: Great. Thanks Jeff, and Sue, accounts receivable stepped up during the quarter, is there some reason for that?
Sue Knight: That's just time of shipments, Liam.
Liam Burke: Okay.
Sue Knight: You know, periodically based on how shipments go out, and revenue recognition on large projects occurs. It does kick back the profile from quarter to quarter, but we watch the path to percentage, and it's actually declined, so there's no risk in that regard. It's just a matter of turning it in the cash cycle.
Liam Burke: Great and your capital budget is the same? You haven't changed that?
Sue Knight: We have not changed the capital budget for the year.
Liam Burke: Okay, great. Thank you, Sue.
Sue Knight: You're welcome.
Operator: As a reminder to the audience today, it is star then 1 if you have a question. We'll go next to Brown Advisories, Nigel Frankson.
Nigel Frankson: Hi guys. Thanks for taking the question. I have two. The first really quick one, tax rates for the rest of the year, we should assume to be 24%?
Sue Knight: Ah, no, I don't think we've ever had a 24% from ongoing operations. This quarter was unique, as it relates to the one-time benefit of the R&D tax credit. So, you have to look at a more historical rate, which for us is in the low to mid 30% range.
Nigel Frankson: Got it. And, the second question is, I was hoping you could educate me on the value of your custom business. I knew there was margin risks there, because the contracts are fixed-price contracts where you inherently take on the risk of any cost overrun.
So, I knew the potential was there for this business to be a lower than corporate average margin business, but I'm surprised to learn, if I'm reading the press releases correctly that it's typically a lower than corporate average-margin business.
I would think that anything that's a custom-made product is something you could charge a premium for. I'm curious as to why that's not a better business, and why it's worth MTSC to chase it, that business.
Sue Knight: The custom business is still good business. It's just relatively lower margins than either standard products or the service aftermarket business, and there's a few reasons for that. One, custom does carry development risk, and this quarter, the five projects that I referenced are examples of that. They are fixed price contracts where designing things that haven't been made before and we carry that risk.
The second thing to think about custom, is when you don't make a specific piece of equipment often, you don't get the material volume benefit of large quantity repeatable products, as we do in the standard area. So, margins are impacted there.
And then, there are many projects that have content that is more than sophisticated engineering design, and sophisticated functional parts. When you think about a seismic system, for example, there's a lot of concrete that goes into the pit that is a basis for putting the system in, and we can't markup concrete like we can in engineering our, and those are just lower margin projects by the nature of the content.
Jeff Graves: See Nigel, at the heart of your question, is a really important point for our business model, though. We have to be in this business of doing first of a kind projects in key growth markets. That's the way I'd look at this.
When we see a market that's going to grow around the world, we want to be the guy setting the standard for the new equipment, because once we do that, we can replicate the key components of that technology quite rapidly. We've done it in the automotive sector for years.
I look at this energy market now with oil and gas, and even wind, and say, we're the guys out there setting the standard based on our technology and our innovation. So, it is very important. I look at that almost as a part of our R&D spend, to be first of a kind in key growth markets.
That doesn't mean we do everything for everybody, but when we identify a market that's going to grow around the world, we want to be the guy setting the standard, and so even though those margins might be slightly lower, it is essential in order to allow us to continue to grow the business.
So walking away from those, you might feel good for a couple of quarters, until everybody caught up with you, and you were just competing on price. We compete largely on the value of our technology to our customers, and so, that's a key part of our business model.
Sue Knight: The other comment I would make about cost variances in custom. When you look at our total direct cost, within the test business, those variances on an annual basis run about 2%.
You know, in a good year they're one, and in a year where you've got a lot of development contents, it's 2 1/2, but it's relatively modest when you look at our total spend, and the complexity and challenges with these highly customized systems.
You know, we work to make it be as small as possible, but we can't predict to know the timing on a quarterly basis.
Nigel Frankson: So, when you say set the standard, are you effectively saying it's almost a market share grab? That if you're the first there, and you're doing it in a fair way, that fosters repeat business, as with same customer and perhaps their competitors and so forth?
Jeff Graves: As an outcome, I believe it really doesn't, but it does result in market share growth, Nigel, but the way to look at this really is, okay, there's a new demand. Take a large gas pipeline or an oil pipeline, and you think back to the disaster that happened in the Gulf of Mexico, with oil leakage at a deep level, and so now, you know, there's a much larger interest in people having test machines and methods for measuring the quality of a pipe.
Okay, a large oil and gas, which is a very, very highly loaded system and the precision requires are very high. We want to be the first of a kind out there, the first guy out there with the machines and the methods to do that kind of thing because if we set the standards others will want to replicate that in our customer base because we've successfully done it for one party.
So, yes, it does result - I believe it does result in market share growth clearly but it allows us to continue to compete on a technology basis rather than have the product just commoditized and compete on price because I - it's, you know, our history says that net, net all of the projects combined our margin performance is outstanding and, you know, as is with our payment plans, our cash flow in the business.
So we want to replicate this model and continue growing it and our markets are strong provided we've picked them properly so automotive, oil and gas, aerospace, those are some of our key markets out there and the materials testing that supports those markets.
Nigel Frankson: So the idea is - just so I want to repeat it so I make sure I have it right. So the idea is that you do the custom projects. It's a lower margin business but you're fine with that because you develop new technologies that you can use in other applications in the future and you charge a premium for those because at that point in time it's proprietary, it's above and beyond what the competition has out there and it's effectively customer-funded R&D.
Jeff Graves: Yes. Fundamentally you've got it and as Sue mentioned, as the volumes grow and other customers buy this our cost position in terms of supplier cost and things all get better. So, yes, the first-of-a-kind project you might take a margin hit for that, it's still a very good quality business, okay.
It's not like many businesses where, you know, you give away the first few. We're still making very good margin on our first-of-a-kind but it sets the standard out there in our customer base and then as our volume grows we can drive our costs down and standardize components and gain share and margin as we grow.
Nigel Frankson: Thank you.
Jeff Graves: Thanks, Nigel, good question.
Operator: And now we'll go back to John Franzreb of Sidoti with a follow-up question.
John Franzreb: Sure, just to follow up on Nigel's thought, you said one of them was in oil and gas and I think you kind of called out to test the piping. Is that the kind of system you're actually making or is that an example? Are you doing, you know, valves? What are you testing in the oil and gas market or developing equipment to test in it?
Jeff Graves: We're now shipping the first-of-a-kind for a large oil piping, John, and, you know, this will be years in, you know, in a market developing and expanding but there's a lot of interest right now and I will tell you we're doing similar things from in the fracking arena. We're testing drilling and piping to support drilling in the fracking market as well as how the rocks respond when you frack them.
John Franzreb: Really.
Jeff Graves: This whole energy segment for us is fantastic and we're doing first-of-a-kind work in everything from exploration to transmission of fossil fuels and, you know, you look at the market out there and say, wow, it's growing.
It's growing in our homeland here in the United States very quickly and the concerns from an environmental and safety standpoint are very high so it's a natural for us to be the leader in that kind of a segment and look at some sustained growth there. And once the equipment's installed it pulls our services right along with it.
John Franzreb: Right.
Jeff Graves: So that's the simple model and we are shipping a fantastic system, you know, within the next quarter here it's getting ready to leave the factory and I believe it'll set the world standard for oil pipeline testing frankly.
John Franzreb: Right now, Jeff, I don't recall you having much exposure to the oil and gas market at all.
Jeff Graves: Oh, it's been around especially in the rock mechanics area, John, for a long time for oil and bores.
John Franzreb: Okay.
Jeff Graves: But there's a tremendous interest now but, you know, just because of the changes in that end market that everybody sees and it's everything you get from exploration to transmission of fossil fuels.
John Franzreb: Got it. Now as far as adding any incremental fixed costs, where are we on that process? Are you happy with the way the company's structured now or are there more incremental costs coming in in upcoming quarters?
Sue Knight: So, John, we - I commented about where we expect operating expenses to be relative to revenue and, you know, that's as specific as we're going to get. Revenue growth we should see in that rate of 26% to 27%.
John Franzreb: Twenty-six to 27%, right.
Sue Knight: Yes.
John Franzreb: Okay, so that would - I mean it kind of replies that you expect things to kind of flat line on the cost side from here on out. Is that a fair assessment or no?
Sue Knight: John, you can do the math.
John Franzreb: Okay. Okay, I guess, one last question is on the sensor side. We're starting to hear from some of the sensor companies that the order profile is moving on a sequential basis, slightly positive.
It seems like you're having mixed results in that regard, some businesses are down. Some are up. What are your expectations as far as - what are your customers telling you as far as their order patterns coming in the June quarter?
Jeff Graves: Well, you know, again John, we had our first quarter of growth in the sensor business in five quarters so I'd - that's great. One data point doesn't make a trend but, you know, certainly directionally it's a start, you know.
Two data points do, so if we can deliver another quarter of growth you might say the trend is upward. I was very happy to see some improvement quarter over quarter. What our customers are saying publicly is, you know, the same thing they're saying privately is, hey, things aren't getting worse and we can see some light at the end of the tunnel and we think things are going to get better.
The disappointment for us is we really thought that would happen here in the second half and until we see an orders flow we're just going to be very cautious about saying it's, you know, it's here.
I - so my personal opinion which, you know, could change daily depending on the economic conditions here is, yes, we've seen the worst of it and it's going to be upward from here but it looks like it'll be a slow trek and we just have to keep pounding away. So I'd love to see the economy more robust and have that thing grow faster.
Operator: Anything further Mr. Franzreb?
John Franzreb: No, that's it for me, thank you.
Jeff Graves: All right, thanks John.
Operator: As a final reminder to our audience today, press star then 1 for questions. We'll go next to (Dan Caposo) with Invicta.
Jeff Graves: Good morning, (Dan).
(Dan Caposo): Hey, good morning. Thanks for the question.
Can you just give us a sense of where you guys are at in terms of the hiring process of the engineers and service personnel?
Jeff Graves: I - it's an ongoing process so, you know, every month, every quarter we're hiring these guys, training them up and deploying them. It's nice to see, you know, that we're starting to get some benefit from the first folks that we hired, you know, driving that 8% growth.
That was really encouraging to me so, you know, the model works. We have to just continue doing that. I wish it were a quicker process but our equipment's very complex and, you know, there's a training period required so it'll be an ongoing effort. It's - I really can't give you an end time. We're just going to continue - we're going to continue investing in that direction.
(Dan Caposo): Okay, great, thank you.
Jeff Graves: What we can do - I would add what we can do (Dan) is just measure our - is just really be tight on our discretionary costs. I put what you just asked about on service. That's a required cost for growth and we're spending money in that direction because we are - the model works. We're seeing revenue growth and nice margins from that service growth particularly addressing our install base initially.
Anything discretionary we're tightening down on to make sure we're not getting out in front of ourselves there but the investments for growth we're continuing and services is in that category. Okay?
Operator: Anything further (Mr. Caposo)?
(Dan Caposo): No, that's it. Thank you.
Jeff Graves: Thanks, (Dan).
Operator: And it appears we have no further questions at this time. Dr. Graves I would like to turn the conference back over to you for additional remarks.
Jeff Graves: Thanks, (Cheryl). Well thank you all for joining us today on our call. While the second quarter was more challenging than we had expected, we're confident about our market opportunities and our growth prospects and strongly believe that our employees make a true difference for our customers every day. We look forward to updating you again next quarter on our progress. Thank you again and have a great day.
Operator: Again that does conclude today's conference, and we thank you all for joining us.