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Edited Transcript of MTSC earnings conference call or presentation 7-Aug-18 2:00pm GMT

Q3 2018 MTS Systems Corp Earnings Call

EDEN PRAIRIE Aug 19, 2018 (Thomson StreetEvents) -- Edited Transcript of MTS Systems Corp earnings conference call or presentation Tuesday, August 7, 2018 at 2:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Brian T. Ross

MTS Systems Corporation - Senior VP, CFO & Principal Accounting Officer

* Jeffrey A. Graves

MTS Systems Corporation - President, CEO & Director

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Conference Call Participants

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* John Edward Franzreb

Sidoti & Company, LLC - Research Analyst

* Liam Dalton Burke

B. Riley FBR, Inc., Research Division - Analyst

* Ronald J. Jewsikow

Wells Fargo Securities, LLC, Research Division - Associate Analyst

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Presentation

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Operator [1]

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Good day, and welcome to the MTS Third Quarter 2018 Earnings Conference Call. Today's conference is being recorded.

At this time, I would like to turn the conference over to Mr. Brian Ross, MTS' Senior Vice President and Chief Financial Officer. Sir, please go ahead.

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Brian T. Ross, MTS Systems Corporation - Senior VP, CFO & Principal Accounting Officer [2]

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Thank you, Chelsea. Good morning, and welcome to MTS Systems Fiscal 2018 Third 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 historical facts, 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 any forward-looking statements made today based on future events.

This presentation will also include reference to financial measures, which are not calculated in accordance with generally accepted accounting principles, or GAAP. These measures are used by management to evaluate the operating performance of the company over time. They should not be considered in isolation or as a substitute for GAAP measures. A reconciliation of our non-GAAP measures to the nearest GAAP measures can be found in the company's earnings release.

I will now turn the call over to Jeff so that he can provide an update on our third quarter business performance.

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Jeffrey A. Graves, MTS Systems Corporation - President, CEO & Director [3]

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Thank you, Brian, and good morning, everyone. We appreciate you joining us for our call today. Overall, our third quarter performance was similar to our second quarter as our Sensors business performed very well while our Test business had mixed results.

I'll start with the 3 main takeaways from our third quarter. First, our Sensors business now has reported 5 consecutive quarters of double-digit growth. Strong economies in most of our global markets continued to translate into robust demand and our Sensor team executed well to maintain our positive momentum. In addition, Sensors delivered a book-to-bill ratio of 1:1 and exited the quarter with a near-record backlog of $51 million. With the forecast for our core Sensor markets remaining positive and the anticipated addition of significant orders from the U.S. Department of Defense, we continue to believe that our Sensor business will finish fiscal year 2018 with double-digit revenue growth, continued operating margin expansion and a strong backlog that will sustain this momentum in fiscal 2019.

Second, orders in the ground vehicles sector of our Test business were up significantly in the quarter as all regions reported an increase, particularly Korea, China and Europe. We were very pleased to see the positive order trends in the quarter. However, we will remain cautious, and until confirmed more definitively, we'll continue to anticipate volatility in the ground vehicles market over the near term. In simple terms, this volatility is a reflection of the automotive OEMs' need to prioritize their R&D spend in the areas of safety for automated driver assist in fully autonomous vehicles and costs for electric vehicles. We believe these trends will reverse at some point in the near future as these new technology issues are being addressed aggressively and that there will be noticeable recovery in durability testing of these new car types. The strength of our 12-month opportunity pipeline is consistent with this view.

Third, the other major areas of our Test business, including materials Test, Test Services and structures Test all continue to perform well and to our expectations.

So in short, from a full company standpoint, our Sensors performance remains very strong and 3 of our 4 major end markets in Tests are performing consistently well. Our consolidated results are being impacted solely by our ground vehicles Test business.

Looking forward, our near-term expectations for the Test ground vehicles market continues to reflect strong overall demand but with the continuing risk of variability and timing on order placement. Importantly, each of these new vehicle types will rely on different and most often very new technologies, which we expect in turn to require new and unique testing solutions to ensure safe operation, durability and operating performance. As the testing requirements for these new vehicles become more evident, we're very well positioned with our leading technology and global sales and service presence in all key markets around the world to capitalize on this resurging demand.

In a moment, Brian will provide a detailed review of our financial performance for the quarter, but before I hand off to him, let me allow you -- let me give you some color on our orders performance by end market for each of our business units, and I'll begin with Test.

We look at Test in 3 -- in our 3 equipment sectors that we serve, ground vehicles, structures and materials as well as Test Services. As I mentioned earlier, Test -- vehicles Test orders increased sharply in the third quarter, being up 56% year-over-year and 89% on a sequential quarterly basis from Q2. We were encouraged that the demand for durability testing equipment, upgrades and laboratory testing and components were key drivers of this growth. These products are part of the core technology and product offerings in our vehicles Test business and comprise a significant portion of our total Test opportunity pipeline. The opportunity pipeline for this base business within Test increased at strong single-digit rates in the third quarter and provided another meaningful indicator that customer demand remains solid. This will inevitably lead to exciting growth opportunities for our vehicle Test business.

Our outlook for the structures Test business remains unchanged as we expect order levels to be relatively flat in fiscal '18 compared to fiscal '17 and that demand will then start to expand going forward. A key growth area for us centers on seismic testing systems that are used in the design of a variety of civil structures, including bridges, buildings and power plants. In addition, infrastructure investment is expected to increase due to both economic growth in key Asian countries and the enhanced government focus on addressing the aging structures in the U.S. In response to the expected growth in the structures market, we recently launched a new generation of high-performance actuator systems with longer service lives and have introduced new aerospace and seismic test software that enables greater testing efficiency for our systems and products.

The materials Test business reported double-digit orders growth in the third quarter due to the increased demand for testing applications across multiple markets. Of note, we have strong order activity from customers in Asia and the Americas for projects which included rock mechanics test systems, a core expertise for our company. Rock mechanic systems are essential in oil and gas exploration, enabling a detailed understanding of rock fracture characteristics, which are central to fracking.

Another driver of growth for materials Test is the proliferation of -- in a number of applications for advanced materials, such as carbon fiber composites and very-high-temperature lightweight structural materials. The rapidly expanding use of additive manufacturing is also a key driver of materials Test systems as these novel components often have unique material properties that must be characterized as they are introduced into the market.

Test Services continued its growth momentum, with orders in the quarter up 7% year-over-year. This continued performance puts us confidently on track to exceed $100 million in service orders for the full year, a nice milestone for our Test business. Customer reception to our service initiative remains very positive, and with our installed base of equipment now approaching $5 billion, we expect this recurring revenue stream to continue its growth.

I'll now move to our Sensors business, which, as I mentioned earlier, is performing very well in an exciting market. We discuss our Sensors business in 4 market sectors: test, which our sensor is used in the testing of new products and in our expanding range of U.S. Military applications; industrial, which our sensor is used for industrial automation; systems, which are turnkey systems for measuring noise or for calibration; and position, which our sensor is used for highly precise position measurement in industrial equipment and mobile hydraulic applications.

Beginning with our position sensors sector, Q3 saw excellent revenue growth of 16% versus the same quarter in the prior year, with Europe posting especially strong results. Demand in this sector remains strong across multiple industrial and OEM markets. Mobile hydraulic growth was solid, driven by the ongoing strength of demand from OEMs in the construction, agriculture and mining industries, reflecting design wins earned over the last few years. While subject to some seasonal effects that we often see in our fourth quarter, we expect the growth drivers in this sector to remain intact as the global industrial economies continue to expand.

Next is our test sector for sensors, where revenue in the third quarter increased at strong double-digit rates, primarily due to large orders received from China for test and measurement systems and our fulfillment of a large order for a new U.S. Department of Defense platform program. The strength in China reflects the increasing emphasis the Chinese automotive and aerospace OEMs have on the development of new products for the domestic Chinese marketplace. These products include electric vehicles that are critically needed for reduced air emissions, which have reached alarming levels in some of the largest Chinese cities, as well as new commercial aircraft systems being developed for air transportation for the Chinese public. The demand for new aircraft in China is expected to grow rapidly in the years ahead, and the Chinese government is focused on developing a domestic source for these aircraft.

Given these trends, which are being repeated across our end markets, we're excited about the test sector of our Sensor business. We believe this growth is still in its early stages and that it will further benefit from the long-term sales synergies with our ground vehicles and aerospace testing equipment business.

In addition to the growth we're experiencing due to the increased testing of new products, the test sector of our Sensor business also comprises our rapidly expanding opportunities with the U.S. military. Having completed a key initial production contract successfully in Q3, we're anticipating significant new awards from the U.S. military in the near future and that these opportunities will expand in the years ahead. We've estimated revenues from these new awards to approach $300 million over the next decade.

The industrial sector for Sensors reported a nice increase in revenue as well, despite continuing pressures in the industrial gas turbine market. We expect these headwinds to continue for the foreseeable future, however, they will be more than offset by the increasing demand we see in the renewable energy market for industrial machinery, factory automation, which will drive continued overall growth in this exciting market sector.

And lastly, the systems sector had another strong quarter of double-digit revenue growth as well. This business remains on track to deliver a double-digit increase in revenue for the full year. Contributing to this growth is an increase in global demand across several markets for systems designed to measure and monitor noise levels. This includes aerospace and defense, energy and electric vehicle applications. Incremental growth is coming from new products that were developed to monitor both airplane and environmental noise levels. The successful introduction of the new products and continued demand for calibration systems is continuing -- is contributing to the revenue growth of this business.

Now I'd like to turn the call over to Brian to further discuss our financial results and our outlook.

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Brian T. Ross, MTS Systems Corporation - Senior VP, CFO & Principal Accounting Officer [4]

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Thank you, Jeff. I'd like to expand on a few of the items Jeff addressed. First, as you heard from Jeff, our Sensors business is performing very well. We are growing the top line in double-digit fashion as planned, managing the cost structure and driving strong profitability. This performance has been a primary reason for our ability to continue to reduce our outstanding debt.

Second, the nonvehicles area of our Test business are performing well. This includes structures and materials Test and Test services. We are pleased with the 8% revenue growth in these areas of Test as we continue to execute on the strategy we laid out at the beginning of the fiscal year.

Lastly, our ground vehicles Test business remains under pressure as the world's largest auto manufacturers continue to navigate a very dynamic and volatile environment. We continue to see pressure on the top line as the timing of R&D investments by our customers have been moving targets, especially for those auto industry growth areas such as autonomous and electric vehicles. We believe we will see this pressure for at least the next few quarters, but it is quite possible it could be longer, and we are monitoring it very closely.

In the longer term, we continue to believe that durability testing for new products, which is our core expertise historically, will be essential to all of the new vehicle types that are in the development pipeline. Therefore, from our standpoint, it's a matter of when, not if, we will see a sustained rebound in orders for our vehicle Test area.

There are several metrics that help us feel good about our Test business. First, Test orders increased 33% in the sequential quarter comparison and 17% compared to the same period a year ago. This increase in orders was weighted favorably by our ground vehicles sector growth and also partially attributable to the timing of order placement.

Second, backlog was up 9% sequentially from the second quarter and 15% year-over-year. We had a good quarter growing our Test backlog, which currently stands at $326 million, the highest backlog level since the end of fiscal year 2016. As much as we would like to see these orders transition to revenue more quickly, the fact is, we are positioning the company for growth once we get through this volatile period in the auto industry.

Third, we experienced a 5% increase in revenue on a sequential basis and expect growth of 5% to 7% sequentially in the fourth quarter. While the timing has been delayed from our estimates early in the year, the trend is positive. And with backlog growing, we remain positive about the future.

One more point I'd like to add. Although we are positioned well for the long term, for the fast -- past few quarters, we have carried excess capacity in our Test business cost structure that was intended to be servicing a heightened level of activity in our ground vehicles Test business. This includes high-caliber engineers to be used for the development and execution of new Test equipment that our customers continue to tell us they need but for which a historical high percentage of which have been delayed into the future. This has clearly pressured our profitability the past few quarters as we have experienced delays in order placement by our customers, which at its peak was over 80% of total orders in our 12-month opportunity pipeline.

At this point, we want our shareholders and investors to be clear that we are willing to reduce these costs if the market environment continues to be volatile. However, as I hope you appreciate, these resources are valuable and scarce, particularly in the current low-unemployment environment, and are needed to fulfill our growing backlog, provided this growth continues. So it is a delicate balance that we are evaluating regularly.

I will now discuss our third quarter fiscal 2018 results and focus primarily on a year-over-year quarterly comparison. Total revenue of $195 million was 50 basis points higher than the same quarter results in fiscal 2017 as the 13.8% increase in Sensors was almost fully offset by the Test decline of 6.7%. Sensors performed outstanding again during the third quarter as broad global economic growth, coupled with good business execution, delivered a solid double-digit increase in revenue.

Despite our revenue pressures in Test, our gross margin had a slight increase in the consolidated gross margin percentage. Our Test segment remained in the low 30%, and our Sensors segment was right around 50% gross margin. Both segments were in line with our expectations and reflect the demand for our high-end products and services. We continue to closely manage gross margin well with our primary goal of driving increased gross profit dollars.

Consolidated operating expenses remained relatively flat at $60 million when compared to the prior year and is an important factor we managed within the business to ensure profitability levels are moving in the right direction. We expect to remain at or below this level for the fourth quarter.

Two items have positively impacted the net interest expense, which declined by $1.5 million compared to the prior year same quarter. One, we are realizing savings after we repriced our debt in July of 2017; and two, we have continued to reduce our debt balance over the last 12 months.

The effective tax rate for the third quarter was 10.6% compared to a benefit rate of 32.9% for the prior year same quarter. The prior year rate included additional U.S. tax benefits associated with domestic manufacturing, deductible acquisition-related expenses and U.S. R&D tax credits. Excluding these discrete tax benefits, the effective tax rate for the prior year would have been 2.2%. Comparing the 2.2% from last year's quarter to the 10.6% this quarter, the change is primarily due to higher earnings before taxes and our mix of geographic earnings, partially offset by the lower U.S. corporate tax rate under the Tax Act. We anticipate a tax rate of approximately 15% to 18% for full fiscal year 2018.

On a GAAP basis, earnings per share of $0.47 was lower than prior year GAAP results of $0.55 per share. This was due primarily to the increase in the effective tax that I just described.

Third quarter adjusted EPS was $0.49 per share, a decrease of $0.07 per share compared to prior year adjusted EPS of $0.56. The $0.02 per share difference between GAAP EPS and non-GAAP EPS was related to restructuring charges.

Adjusted EBITDA grew to $27.8 million in the third quarter, which is a 3.9% increase to the prior year same quarter and flat compared sequentially to the second quarter of fiscal year 2018.

Next, I would like to give you an update on the restructuring taking place in China. As we announced last quarter, we are in process of transferring our production from an MTS-owned facility to a contract-manufacturing partner. We believe this move will save us $5 million to $10 million annually, starting in the second half of fiscal 2019.

In the third quarter of fiscal 2018, we recognized approximately $739,000 of restructuring costs, mostly in the form of severance. In addition, of the 2 buildings we own, we have made good progress in the sale of 1 of them and expect the sale to be completed by the end of September 2018. The gain on the sale of this building is expected to be approximately $3 million and is included in our adjusted EBITDA guidance. Overall, the restructuring has gone smoothly to date.

Another topic I'd like to address is the proposed tariff increases on goods imported from China. Specifically with regard to our production in China, we have not historically imported these products into the U.S. and would expect minimal impact from U.S. import tariffs. We believe our exposure is small and is related mostly to steel and aluminum used in the U.S. manufacturer of Test equipment. We believe we have several viable options on how to manage increased tariffs if they ultimately are enacted, and we continue to manage this closely.

I have just a few specific items to note on working capital and our balance sheet. We have proven our financial viability as a debt holder since the inception of our term loan B 2 years ago by consistently operating comfortably below our covenant thresholds. In addition, we have reduced our debt for 7 consecutive quarters and notably have made total debt payments above the minimum requirements in the last 3 consecutive quarters. In total, we have paid down an incremental $83 million of debt in the past 7 quarters, including $59 million in excess payments. In the third quarter alone, we decreased our debt by roughly $20 million. We expect to continue to use excess cash to pay our dividend and to further reduce our debt balances for the foreseeable future. This, along with our consistent working capital rate to revenue of approximately 25%, provide us with the confidence in our ability to manage the balance sheet and our business.

The final topic I would like to discuss is the update to our fiscal year 2018 guidance. We now expect full year fiscal 2018 revenue to be in the range of $775 million to $785 million, our adjusted EBITDA in the range of $112 million to $118 million and diluted earnings per share in the range of $3.25 to $3.35 per share. The reduction in our expected ranges for the fiscal year are solely attributable to the challenges in ground vehicles sector of our Test business as we navigate the volatile time in this market.

Before I pass it back to Jeff, I would like to reiterate that our company continues to perform well, especially given the dynamic ground vehicles environment. We are positioned well for the long term, we will manage appropriately through these short-term headwinds and are committed to managing our business to provide long-term value to our shareholders.

I will now turn the call back over to Jeff.

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Jeffrey A. Graves, MTS Systems Corporation - President, CEO & Director [5]

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Thanks, Brian. Before moving to Q&A, I'd like to reinforce the key takeaways I mentioned at the beginning. Our Sensor business has excellent momentum and strong financial performance. Our Sensor business is executing well to our business plan and delivering leading technology with an intense focus on total customer satisfaction. Double-digit growth in the current fiscal year, coupled with increasing operating margins, is exactly how we foresee our performance in the future. We expect to finish the fiscal year 2018 strong from both a top line growth and profitability perspective, delivering record performance for our Sensors business. This momentum will lead us into fiscal 2019 with high expectations.

With regard to the Test business, we laid out a plan at the beginning of the year that showed the needed improvement in the business, with growth in the second half of the year exceeding that in the first half. The execution of this plan has been overshadowed by significant timing delays in the largest market we serve, that of ground vehicles. As I mentioned earlier, we expect this dynamic to continue in the short term, with timing for durability testing in the automotive market remaining volatile quarter by quarter. We continue to execute well with growth in our other Test sectors and expect this trend to continue.

As we remain focused on serving all of our Test markets, we're also taking actions to ensure our profitability is sustained. We're evaluating our cost structure in light of the potential for continuing volatility in the vehicle Test market to ensure we're positioned well to service our customers while delivering increased value for our shareholders. This balance requires particular care as our order rates now show the first signs of significant improvement and our backlog strengthens, but with continuing risk of order volatility quarter by quarter. We're mindful of this as we manage an engineering knowledge base that is a true competitive advantage for our company and heavily valued by our customers.

With that, Chelsea, Brian and I are happy to open it up for questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) And our first question will come from John Franzreb with Sidoti & Company.

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John Edward Franzreb, Sidoti & Company, LLC - Research Analyst [2]

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Actually, I just want to start with one of the last things you said, Brian, about the guidance. Does EPS guidance include facility sale? And if so, how much is in there?

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Brian T. Ross, MTS Systems Corporation - Senior VP, CFO & Principal Accounting Officer [3]

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The -- yes, it does. So approximately $3 million is what we expect to incur as a gain on the sale. And then there is a simple U.S. tax-effected piece to it.

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John Edward Franzreb, Sidoti & Company, LLC - Research Analyst [4]

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Okay, got that. And regarding the custom jobs, you kind of put -- cited that as impact of higher jobs in the backlog and maybe weighing down the gross margin. Can you just give us a sense of what the gross margin profile of custom jobs are today versus a year ago? Is there any meaningful difference there?

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Brian T. Ross, MTS Systems Corporation - Senior VP, CFO & Principal Accounting Officer [5]

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Yes, so as far as the custom backlog and what we're seeing flow through on revenue, we do see a slight decrease in the gross margin compared to maybe 2, 3 years ago. A lot of that due to the size of some of those custom projects. In addition to that, the large amount of materials that go into it, which don't always have as much of a markup. So there is a slight decrement to what we've seen maybe 2, 3 years ago.

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John Edward Franzreb, Sidoti & Company, LLC - Research Analyst [6]

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Now correct me if I'm wrong, but didn't you put in place a check and balance a couple of years ago to make sure that that wasn't a case so that the margin profile on the jobs written were at adequate profitability?

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Jeffrey A. Graves, MTS Systems Corporation - President, CEO & Director [7]

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Yes, John. I would tell you we did, in mid-'16. And this is when our automotive customers particularity started coming in and requesting tremendous amounts of custom content to the point of being first-of-a-kind equipment. We started really metering out very carefully how many of these jobs we took and how we priced them. So all in all, I would tell you, that our -- if you will, the risk profile in our backlog on the custom content is down substantially. And those projects, in terms of the timing of delivering those, the last of those are being installed right now. So -- and that -- it tells you how long our cycle time is. So jobs that we would've taken prior to mid-'16, a couple of those really difficult first-of-a-kind jobs are moving behind us now. So that's a good thing. And the number of first-of-a-kind projects are dropping. So if you will, kind of unexpected job cost adjustments in these fixed-price contracts are -- have fallen fairly dramatically and will continue to do so. So what Brian is referring to is kind of the typical custom job that we get in backlog. There has been some -- it's been relatively steady, but some downward pressure on that just due to material content and things of that nature. But by and large, if we look at the total makeup of the custom content in backlog, those first-of-a-kind projects have fallen off fairly dramatically by our own choice, so we just have to meter that as best (inaudible) very carefully.

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John Edward Franzreb, Sidoti & Company, LLC - Research Analyst [8]

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I guess, considering what the order booking is like, is there any sense that maybe just for an absorption rate, you may want to take on some of those jobs you've been turning away in the past?

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Jeffrey A. Graves, MTS Systems Corporation - President, CEO & Director [9]

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Yes, we look at two things, John. One is the absorption, just the financial impact of the volume coming through, and the second is the IP generation. And in some cases, we'll take a low-margin job because the IP content is extremely high, and we see it as a growth market. But I would tell you, we spend a lot more time upfront now than we did, and it really has been true over the last year, than we did in mid-'16 because we had so many of those coming in at that point. It was -- and it was all lovely work and novel machines. I mean, truly incredible engineering machines, but there was just too much of it. So we've metered that down now. We've picked very carefully, some for volume reasons and some for the IP generation itself. And as we sit here today, I believe our -- we should start seeing some tailwinds from our backlog mix in terms of overall gross margin now. Part of that is a first-of-a-kind effect on custom and part of it is just more componentry, some of our high-end single componentry and other items that are in backlog, standard products that are in backlog.

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Operator [10]

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(Operator Instructions) And our next question will come from Rich Kwas with Wells Fargo.

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Ronald J. Jewsikow, Wells Fargo Securities, LLC, Research Division - Associate Analyst [11]

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This is Ron Jewsikow on for Rich. And I just was curious with the push for real-world emission testing in Europe. Is that having any impact on the Test business?

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Jeffrey A. Graves, MTS Systems Corporation - President, CEO & Director [12]

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Yes, I would tell you, some of the -- now we're not traditionally in the actual emissions testing, there are other companies that specialize in that. But some of the -- creating the test environment for the car, if you will, or truck or any other environment, a lot of times there are rolling -- what we would call, rolling belt systems. These -- you could think of them as kind of stainless steel treadmills, if you will, that go under the tires of a car, to vibrate a car, things like that, that affect the emissions performance because it effects the powertrain. Some of those systems we participate in. So there has been some lift. We're not directly in that business, so it hasn't been as dramatic for us. But certainly, it does help. And the overall thrust, Ron, I would tell you for quality checks the -- of what the companies are signing up for, clearly, the penalties that have been metered out for not doing those tests properly have been very high. So there's an overall heightened sensitivity in our customer base about doing good -- very good quality checks when you're developing a new car. And our end of that world tends to be durability. So how long will the car last on the road and aerodynamic performance. And unfortunately, those attributes have kind have taken a backseat to some of the safety-related issues in autonomy today. But still, it's a critical factor for a car to hit the road, and that's why we feel good about future demand.

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Ronald J. Jewsikow, Wells Fargo Securities, LLC, Research Division - Associate Analyst [13]

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Yes, that makes sense. And then given the issues, Tests have primarily been attributable to push outs from auto OEMs, is it reasonable to assume that the backlog is now just proportionally weighted towards ground vehicles relative to historical mix?

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Jeffrey A. Graves, MTS Systems Corporation - President, CEO & Director [14]

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Yes, with -- you mean with the current orders performance in the quarter being up so much?

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Ronald J. Jewsikow, Wells Fargo Securities, LLC, Research Division - Associate Analyst [15]

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Yes. And just about...

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Jeffrey A. Graves, MTS Systems Corporation - President, CEO & Director [16]

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Yes, Brian, I don't know, maybe you know the numbers better, but yes. Directionally, Ron, that's certainly correct. Yes, we had a big burst of orders coming through on the ground vehicles sector. Brian, do you have any color you want to put on that?

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Brian T. Ross, MTS Systems Corporation - Senior VP, CFO & Principal Accounting Officer [17]

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No, it is. There's, I wouldn't say disproportionality in the ground vehicles side of it, but we have had a nice uplift in the ground vehicles backlog.

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Jeffrey A. Graves, MTS Systems Corporation - President, CEO & Director [18]

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The way to think of it, Ron, is we've just -- we've seen nice, consistent, smooth growth, a relatively exciting growth in materials testing. Big seismic testing machines tends to be choppier and lumpier, but we've seen nice growth in materials testing. We've seen nice growth in services all year long. We expect those trends to continue. The seismic machines will be lumpy quarter by quarter, but generally, the trend has been upward. It's the ground vehicle business that has fluctuated for us. And we were thrilled with the orders in the quarter, but it takes more than 1 quarter to draw a line. So we're -- that's why we continue to use the word volatile. We just have to see that performance continue.

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Ronald J. Jewsikow, Wells Fargo Securities, LLC, Research Division - Associate Analyst [19]

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And then just mix implications of that, you seemed pretty optimistic just a moment ago, but...

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Jeffrey A. Graves, MTS Systems Corporation - President, CEO & Director [20]

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Yes, I think, Ron, it gets kind of back to the prior question that John had. The -- I feel really good about our discipline on order acceptance today. We do a lot of presale work with customers. The presale activity can take a year or 2 with a lot of customers, which is why we have such good visibility into our 12-month opportunity pipeline. We do better work now than we've ever done in terms of presale activity, concept design, all of that, so that we have a very clear line of sight on what risk we're accepting for both performance and schedule when we take a job. So I feel really good about that. So what business we're booking now, I feel it's great-quality business. We should be able to execute it very well. And we've retained, as Brian said, excess capacity to deliver on those -- on that volume when it's in our backlog. We just want to see the order rates become more consistent and rise from our automotive OEMs.

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Operator [21]

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We have another question from John Franzreb.

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John Edward Franzreb, Sidoti & Company, LLC - Research Analyst [22]

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Jeff, could you just kind of walk me through the volatility you're seeing in ground vehicle? You've said that it revolved around your custom spending around safety and costs. What does it mean? Does that mean that it's not as an addressable market for you? Could you just kind of clarify what you -- what the discussion is there?

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Jeffrey A. Graves, MTS Systems Corporation - President, CEO & Director [23]

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So here's the situation, John. And we're very intimate with our customers worldwide, so we hear this feedback real time from them is, look, they have a -- they have what's probably a record number of new products they're developing. They're doing tremendous amounts of work. And all of those vehicles have to have durability testing, which is what we really do heavily for a living. That's our core capability, right? Durability testing. Those -- that all has to get done, and they know it. They talk to us about it. We have it all in our presales activity. And then eventually, within 12 months of issuing a PO, it goes into our opportunity pipeline and we track it. And what we've seen over the last year, 1.5 year, Brian, is at the last minute, they'll come back and say, guys, I'm sorry. We have to do that, but we've got an emergency need right now to redirect our R&D spending into what, John, and I would broadly refer to as safety. So when you think about autonomous cars or even driver assist systems on the road, the auto companies have announced introduction of those cars very clearly, like 2019, 2020. It's coming right up on us, and the safety testing of those sensor systems and things for cars and the computer systems that are associated with them, they've got to get that right or there's a high risk of accidents. And so safety, it becomes their paramount priority. Now as soon as that's done, John, or that -- or they feel good about that, they've got to come back to durability testing because durability relates to the warranty of the vehicle on the road. And as you know, many of these autonomous cars are going to be driving very heavy-duty cycles. Some in 18, 20 hours a day, delivering things from people to pizzas. And so the durability testing is critical for them, but -- so we see -- so what that means for us is we see a record -- a near-record opportunity pipeline now every quarter for the next 12 months. It's at well over $1 billion now of opportunity pipeline. But that testing has to work its way through their queue, and it is a lower priority than safety of drivers or passengers in a car. So I hope that clarifies. The electric vehicle situation is a little bit different because electric cars, while there's lower concerns around safety because people still drive the cars, it's a concern around cost. I mean, if you look at electric vehicles today, they are -- it's hard to make any money on electric car for an OEM, let's just put it that way. So they've got to get cost and they've got to still get performance range out of these electric vehicles, so that's become their paramount thing. They want to be selling more and they've committed to sell more, but at this point, they can't make any money at it. So they've got to fix that. Now John, this is turning into a long-winded answer, but I would tell you that's really helping our materials business -- materials Test because that is encouraging them to lightweight vehicles, to put in carbon fiber composites and lightweight aluminums into cars to extend the range. So that's helping our materials Test business, and that's a good thing. But in terms of the exposure we have to the automotive industry, it's hurting our durability testing because it's coming in a lower priority. So different reasons, but I hope you followed all that logic. So our customers continue to say, "Guys, keep your capacity, please. Keep your resources. We got to have these systems." But then they keep delaying purchase orders, and it's just maddening, John. I was thrilled with the quarter in terms of the uptick. It's great to see. I'd love to believe that's going to just continue running, and I think in the long term it certainly will. I -- we have no doubt that it will. It's the short-term quarter-by-quarter volatility that we remain concerned about, and we just watch. So I'm not raising an undue red flag, it's just something that we have to watch and string together a few quarters of this upward trend to feel really good about it.

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John Edward Franzreb, Sidoti & Company, LLC - Research Analyst [24]

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Okay. So then in the Sensors side of the business, do they benefit from increased ground vehicle testing on safety and cost?

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Jeffrey A. Graves, MTS Systems Corporation - President, CEO & Director [25]

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Yes, and we're seeing that, John. The Test portion of Sensors is doing really well. So yes, you're precisely right. That does benefit from no matter what kind of car they're testing for what kind of purpose, you still have to put Sensors on the car, even if you're doing safety tests. And in fact, we make great sensors for safety testing, and we're thrilled about that business. And it's part of why the Test portion of Sensors is growing so well and why I love having Sensors and Tests as a part of MTS because we still benefit, no matter what kind of tests they're running.

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John Edward Franzreb, Sidoti & Company, LLC - Research Analyst [26]

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Okay. That helps me a little bit. Actually, a lot of it. And one last question then. Why is the ground vehicle order book up 56% year-over-year? I mean, what's driving that increase in the ground vehicle Test order book up 56% year-over-year if there's a retrenchment in some of the other parts of that testing business?

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Jeffrey A. Graves, MTS Systems Corporation - President, CEO & Director [27]

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Yes, they just -- John, they just can't wait any longer. What you're starting to see, and we saw this in Q4 as well last year, is it builds -- the need builds and builds, and then finally, these cars get so close to being launched but they've just got to do some more durability testing on them. And that's what you see breaking through now, certainly in Q3, was they just couldn't wait any longer. They had to place the orders. And we -- so eventually, you'll see that happening consistently. And what Brian and I are trying to say is, I'm not sure that it'll be every quarter right now. But certainly, Q3 was great with that in trying to continue our backlogs up about $20 million, Brian, and it's all driven by vehicles testing. It's -- it was great. We just want to see that trend kind of continue now.

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Operator [28]

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Our next question comes from Liam Burke with B. Riley FBR.

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Liam Dalton Burke, B. Riley FBR, Inc., Research Division - Analyst [29]

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Jeff, the -- your orders were up nicely in service again. You seem to be getting traction with that business. But the revenues were flat. Is there a timing issue or recognition issue on the services side when looking at the revenue?

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Jeffrey A. Graves, MTS Systems Corporation - President, CEO & Director [30]

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Yes, there is occasionally, Liam. We -- some of the orders that we book are multiyear orders or yearlong contracts and they have different time phasing by customer. Sometimes, you'll run into a geographic shutdown like in China or Europe or somewhere where they -- it's a -- it may be a year-long contract that's sitting in backlog, but they don't want you in certain months because they're shutdown or they want you in certain months. There -- it tends to vary. So you see a little variability in revenue, but the important thing to watch, really, is that consistent orders growth because that's really what feeds it. And I'm thrilled this year that we're going pass the $100 million mark in services. Customers love it. They want more worldwide, and we continue to expand that and grow. And that -- we view that as a recurring revenue stream. So we'll just continue building on it every year. But yes, this year will be a nice milestone of $100 million and, like I said, they were up 7% again this quarter in orders.

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Liam Dalton Burke, B. Riley FBR, Inc., Research Division - Analyst [31]

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Great. And on Sensors and on Test, both sides of the business, are you getting any traction on cross-selling opportunities?

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Jeffrey A. Graves, MTS Systems Corporation - President, CEO & Director [32]

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Yes, we are, Liam, and we have modeled those. We're in year 2 now of having a much larger Sensors business; we're working our way through year 2. Year 1 was largely spent integrating our PCB acquisition and converting them to a public company. Year 2 now, we've -- obviously we've harvested some of the cost synergies, which have been really effective. So we have critical volume moving through our plants. We're getting some sourcing savings flowing through now. The real exciting part of it is now going to be the revenue synergies as those play out over the next few years. And I mentioned China specifically, Sensors had a terrific quarter in China. And they're being helped by -- we've been in China on the Test side for well over 20 years. So we know these customers intimately. And there's a lot of new Chinese customers. We have a big footprint. And we're able to get PCB Sensors into the labs over there and really help them get introduced much more quickly. And you're starting to see some of the revenue flow through from that. We were thrilled with the performance in China this quarter of our Sensor business driven out of the Test space particularly. It's going to be marvelous for us.

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Operator [33]

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All right. As there are no further questions in the queue at this time, I'd like to turn the call back over to Jeff Graves for closing remarks.

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Jeffrey A. Graves, MTS Systems Corporation - President, CEO & Director [34]

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Thanks, Chelsea. And thank you, everyone, for participating in our call today. We look forward to updating you on our progress again next quarter. So thank you all, and have a great day.

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Operator [35]

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Thank you. Ladies and gentlemen, this concludes today's teleconference, and you may now disconnect.