MTS SYSTEMS CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

(Edgar Glimpses Via Acquire Media NewsEdge) Forward-Looking Statements This Quarterly Report on Form 10-Q contains "forward-looking statements" regarding financial projections made pursuant to the safe harbor provision of the Private Securities Litigation Reform Act of 1995 that are subject to certain risks and uncertainties, as well as assumptions, that could cause actual results to differ materially from historical results and those presently anticipated or projected. Words such as "may," "will," "should," "expects," "intends," "projects," "plans," "believes," "estimates," "targets," "anticipates," and similar expressions are used to identify these forward-looking statements.

Factors that could cause actual results to differ from those discussed in the forward-looking statements include, but are not limited to, those factors described in Part I, Item 1A, "Risk Factors" of our 2012 Form 10-K. Such important factors include: • The Company's business operations may be affected by government contracting risks • The Company's business is significantly international in scope, which poses multiple risks including, but not limited to: currency value fluctuations; difficulty enforcing agreements and collecting receivables; import and export matters; higher danger of terrorist activity; difficulty in staffing; and compliance with laws • Volatility in the global economy could adversely affect results • The Company's business is subject to strong competition • The Company may not achieve its growth plans for the expansion of the business because the Company's long-term success depends on its ability to expand its business through new product development, mergers and acquisitions, geographic expansion, and service offerings, all of which are subject to inherent risks including, but not limited to: market demand; market acceptance of products; and the Company's ability to advance its technology • The Company may experience difficulties obtaining the services of skilled employees • The Company may fail to protect its intellectual property effectively, or may infringe upon the intellectual property of others • The business could be adversely affected by product liability and commercial litigation • The Company may experience difficulty obtaining materials or components for its products, or the cost of materials or components may increase • Government regulation imposes significant costs and other constraints • The backlog, sales, delivery and acceptance cycle for many of the Company's products is irregular and may not develop as anticipated • The Company's customers are in cyclical industries • Interest rate fluctuations could adversely affect results • The Company may be required to recognize impairment charges for long-lived assets • The Company will need to begin disclosing its use of "conflict minerals," which will impose costs on the Company and could raise reputational and other risks The performance of the Company's business and its securities may be adversely affected by these factors and by other factors common to other businesses and investments, or to the general economy. Forward-looking statements are qualified by some or all of these risk factors. Therefore, you should consider these risk factors with caution and form your own critical and independent conclusions about the likely effect of these risk factors on our future performance.

Forward-looking statements speak only as of the date on which such statements are made, and we undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date on which such statement is made to reflect the occurrence of unanticipated events or circumstances. Readers should carefully review the disclosures and the risk factors described in this and other documents we file from time to time with the SEC, including our reports on Forms 10-Q and 8-K to be filed by the Company in fiscal year 2013.

About MTS Systems Corporation MTS Systems Corporation is a leading global supplier of high-performance test systems and position sensors. The Company's testing hardware and software solutions help customers accelerate and improve their design, development, and manufacturing processes and are used for determining the mechanical behavior of materials, products, and structures. MTS' high-performance position sensors provide controls for a variety of industrial and vehicular applications. MTS had 2,147 employees and revenue of $542 million for the fiscal year ended September 29, 2012.

18 -------------------------------------------------------------------------------- Table of Contents Financial Results Total Company Orders and Backlog Three Fiscal Months Ended December 29, 2012 ("First Quarter of Fiscal 2013") Compared to Three Fiscal Months Ended December 31, 2011 ("First Quarter of Fiscal 2012") The following is a comparison of First Quarter of Fiscal 2013 and First Quarter of Fiscal 2012 orders, separately identifying the estimated impact of currency translation (in millions): Three Fiscal Three Fiscal Months Ended Estimated Months Ended December 29, Business Currency December 31, 2012 Change Translation 2011 Orders $ 139.2 $ 5.8 $ (1.4 ) $ 134.8 Orders totaled $139.2 million, an increase of $4.4 million, or 3.3%, including an estimated 1.0% unfavorable impact of currency translation, compared to orders of $134.8 million for the First Quarter of Fiscal 2012. This increase was driven by two large (in excess of $5.0 million) custom Test segment ("Test") orders totaling approximately $21 million. There were no large orders in the First Quarter of Fiscal 2012. Test orders grew 5.4% while Sensors segment ("Sensors") orders declined 6.6%.

Backlog of undelivered orders at the end of the quarter was $290.9 million, relatively flat compared to backlog of $291.8 million at the end of the First Quarter of Fiscal 2012. While the Company's backlog is subject to order cancellations, the Company has not historically experienced a significant number of order cancellations. During the First Quarter of Fiscal 2013, one custom order in Test totaling approximately $2.1 million was cancelled. This order was booked in the previous fiscal year. The cancellation reflects a decision made by the customer to postpone the order until such time as the design phase of a testing system project has been completed.

Results of Operations First Quarter of Fiscal 2013 Compared to First Quarter of Fiscal 2012 The following is a comparison of First Quarter of Fiscal 2013 and First Quarter of Fiscal 2012 statements of operations (in millions, except per share data): Three Fiscal Months Ended December 29, December 31, 2012 2011 Variance % Variance Revenue $ 142.7 $ 133.7 $ 9.0 6.7 % Cost of sales 86.1 75.0 11.1 14.8 % Gross profit 56.6 58.7 (2.1 ) -3.6 % Gross margin 39.7 % 43.9 % (4.2 ) pts Operating expenses: Selling and marketing 19.2 17.0 2.2 12.9 % General administrative 12.3 13.2 (0.9 ) -6.8 % Research and development 5.0 5.0 - 0.0 % Total operating expenses 36.5 35.2 1.3 3.7 % Income from operations 20.1 23.5 (3.4 ) -14.5 % Interest income (expense), net - (0.2 ) 0.2 NM Other income (expense), net 0.4 - 0.4 NM Income before income taxes 20.5 23.3 (2.8 ) -12.0 % Income tax provision 6.7 7.8 (1.1 ) -14.1 % Net income $ 13.8 $ 15.5 $ (1.7 ) -11.0 % Diluted earnings per share $ 0.87 $ 0.98 $ (0.11 ) -11.2 % 19 -------------------------------------------------------------------------------- Table of Contents "NM" represents comparisons that are not meaningful to this analysis.

The following is a comparison of First Quarter of Fiscal 2013 and First Quarter of Fiscal 2012 results of operations, separately identifying the estimated impact of currency translation (in millions): Three Fiscal Three Fiscal Months Ended Estimated Months Ended December 29, Business Currency December 31, 2012 Change Translation 2011 Revenue $ 142.7 $ 10.7 $ (1.7 ) $ 133.7 Cost of sales 86.1 12.2 (1.1 ) 75.0 Gross profit 56.6 (1.5 ) (0.6 ) 58.7 Gross margin 39.7 % 43.9 % Operating expenses: Selling and marketing 19.2 2.4 (0.2 ) 17.0 General administrative 12.3 (0.8 ) (0.1 ) 13.2 Research and development 5.0 - - 5.0 Total operating expenses 36.5 1.6 (0.3 ) 35.2 Income from operations $ 20.1 $ (3.1 ) $ (0.3 ) $ 23.5 Revenue was $142.7 million, an increase of $9.0 million, or 6.7%, compared to revenue of $133.7 million for the First Quarter of Fiscal 2012. The increase was primarily driven by strong backlog execution in Test, partially offset by a lower beginning backlog and reduced order volume in Sensors, as well as an estimated $1.7 million unfavorable impact of currency translation. Test revenue increased 11.5% to $121.1 million, while Sensors revenue decreased 13.9% to $21.6 million.

Gross profit was $56.6 million, a decrease of $2.1 million, or 3.6%, compared to gross profit of $58.7 million for the First Quarter of Fiscal 2012. Gross profit as a percentage of revenue was 39.7%, a decrease of 4.2 percentage points from 43.9% for the First Quarter of Fiscal 2012. This decrease reflects continued investment in productivity initiatives in both businesses, as well as investment in expanded Test service capacity, an unfavorable mix of lower-margin products, and higher warranty expense in Test, partially offset by volume leverage in Test.

Selling and marketing expense was $19.2 million, an increase of $2.2 million, or 12.9%, compared to $17.0 million for the First Quarter of Fiscal 2012. This increase was primarily due to higher compensation and benefits driven by increased headcount, higher sales commissions, and increased travel and other discretionary expenses to support selling efforts. Selling and marketing expense as a percentage of revenue was 13.5%, compared to 12.7% for the First Quarter of Fiscal 2012.

General and administrative expense was $12.3 million, a decrease of $0.9 million, or 6.8%, compared to $13.2 million for the First Quarter of Fiscal 2012. This decrease is primarily driven by a $1.2 million relatively lower level of investment in legal and compliance initiatives compared to the First Quarter of Fiscal 2012, partially offset by higher compensation and benefits driven by increased headcount. General and administrative expense as a percentage of revenue was 8.6%, compared to 9.9% for the First Quarter of Fiscal 2012.

20 -------------------------------------------------------------------------------- Table of Contents Research and development expense was $5.0 million, flat compared to the First Quarter of Fiscal 2012. Research and development expense as a percentage of revenue was 3.5% on higher volume, compared to 3.7% for the First Quarter of Fiscal 2012.

Income from operations was $20.1 million, a decrease of $3.4 million, or 14.5%, compared to income from operations of $23.5 million for the First Quarter of Fiscal 2012. This decrease was driven by lower gross profit and increased operating expenses. Operating income as a percentage of revenue was 14.1%, compared to 17.6% for the First Quarter of Fiscal 2012.

Interest income (expense), net was less than $0.1 million of net interest income, compared to $0.2 million of net interest expense in the First Quarter of Fiscal 2012, driven by a $0.2 million reduction in interest expense. Net interest expense in the First Quarter of Fiscal 2012 included $0.2 million of interest expense associated with outstanding borrowings under the Company's credit facility. During the First Quarter of Fiscal 2013, there were no outstanding borrowings under the Company's credit facility.

Other income (expense), net was $0.4 million of net other income, compared to less than $0.1 million of net other expense in the First Quarter of Fiscal 2012.

The net other income primarily consists of royalty income associated with the sale of a Test product line that was sold by the Company in fiscal year 2012.

Provision for income taxes totaled $6.7 million for the First Quarter of Fiscal 2013, a decrease of $1.1 million, compared to $7.8 million for the First Quarter of Fiscal 2012. This decrease was primarily due to decreased income before income taxes and a lower effective tax rate. The effective tax rate for the First Quarter of Fiscal 2013 was 32.8%, a decrease of 0.6 percentage points compared to a tax rate of 33.4% for the First Quarter of Fiscal 2012, primarily driven by changes in certain foreign tax rates.

Net income was $13.8 million, a decrease of $1.7 million, or 11.0%, compared to $15.5 million for the First Quarter of Fiscal 2012. Earnings per diluted share decreased $0.11 to $0.87, compared to $0.98 for the First Quarter of Fiscal 2012. The decrease was primarily driven by lower income from operations.

Segment Results Test Segment Orders and Backlog First Quarter of Fiscal 2013 Compared to First Quarter of Fiscal 2012 The following is a comparison of First Quarter of Fiscal 2013 and First Quarter of Fiscal 2012 orders for Test, separately identifying the estimated impact of currency translation (in millions): Three Fiscal Three Fiscal Months Ended Estimated Months Ended December 29, Business Currency December 31, 2012 Change Translation 2011 Orders $ 116.7 $ 6.7 $ (0.7 ) $ 110.7 Orders totaled $116.7 million, an increase of $6.0 million, or 5.4%, compared to orders of $110.7 million for the First Quarter of Fiscal 2012. The First Quarter of Fiscal 2013 orders included a $12 million European order in the ground vehicles market for a rolling road wind tunnel measurement system, and a $9 million Americas' structures market order for a vehicle motion simulator. There were no large orders in the First Quarter of Fiscal 2012. Geographically, Europe increased 47.5% and the Americas grew 7.3%, driven by the previously mentioned large orders. Asia declined 19.1%, primarily due to the cyclical nature of Chinese seismic orders in the structures market. Although base orders (those under $5.0 million) declined 13.6%, the Company believes this decline was caused by variability in order timing. Currency translation unfavorably impacted orders by approximately $0.7 million. Test accounted for 83.9% of total Company orders, compared to 82.1% for the First Quarter of Fiscal 2012.

21 -------------------------------------------------------------------------------- Table of Contents Backlog of undelivered orders at the end of the quarter was $276.1 million, relatively flat compared backlog of $275.5 million at the end of the First Quarter of Fiscal 2012. As previously mentioned, backlog at the end of the First Quarter of Fiscal 2013 was negatively impacted by the cancellation of a custom order totaling approximately $2.1 million.

Results of Operations First Quarter of Fiscal 2013 Compared to First Quarter of Fiscal 2012 The following is a comparison of First Quarter of Fiscal 2013 and First Quarter of Fiscal 2012 results of operations for Test, separately identifying the estimated impact of currency translation (in millions): Three Fiscal Three Fiscal Months Ended Estimated Months Ended December 29, Business Currency December 31, 2012 Change Translation 2011 Revenue $ 121.1 $ 13.5 $ (1.0 ) $ 108.6 Cost of sales 76.5 13.4 (0.8 ) 63.9 Gross profit 44.6 0.1 (0.2 ) 44.7 Gross margin 36.9 % 41.2 % Operating expenses: Selling and marketing 15.0 1.9 (0.1 ) 13.2 General administrative 9.5 (0.6 ) - 10.1 Research and development 3.7 - - 3.7 Total operating expenses 28.2 1.3 (0.1 ) 27.0 Income from operations $ 16.4 $ (1.2 ) $ (0.1 ) $ 17.7 Revenue was $121.1 million, an increase of $12.5 million, or 11.5%, compared to revenue of $108.6 million for the First Quarter of Fiscal 2012. The increase was primarily driven by a 5.2% higher beginning backlog and strong short cycle orders in Asia, partially offset by an estimated $1.0 million unfavorable impact of currency translation. The backlog execution was primarily driven by the implementation of operational process improvements that have resulted from the Company's investment in various growth and productivity initiatives.

Gross profit was $44.6 million, relatively flat compared to gross profit of $44.7 million for the First Quarter of Fiscal 2012. Gross profit as a percentage of revenue was 36.9%, a decrease of 4.3 percentage points from 41.2% for the First Quarter of Fiscal 2012. Of the reduced gross profit rate, approximately 2 percentage points resulted from continued investment in productivity initiatives and expanded service capacity, approximately 2 percentage points resulted from an unfavorable mix of lower-margin products, and approximately 1 percentage point resulted from higher warranty expense. These decreases were partially offset by an approximate 1 percentage point benefit from volume leverage.

Selling and marketing expense was $15.0 million, an increase of $1.8 million, or 13.6%, compared to $13.2 million for the First Quarter of Fiscal 2012. This increase reflects continued investment in sales expansion and is primarily comprised of higher compensation and benefits, driven by increased headcount, as well as increased travel and other discretionary expenses to support sales efforts. Selling and marketing expense as a percentage of revenue was 12.4%, compared to 12.2% for the First Quarter of Fiscal 2012.

General and administrative expense was $9.5 million, a decrease of $0.6 million, or 5.9%, compared to $10.1 million for the First Quarter of Fiscal 2012. This decrease is primarily driven by a relatively lower level of investment in legal and compliance program enhancement initiatives, partially offset by higher compensation and benefits driven by increased headcount. General and administrative expense as a percentage of revenue was 7.8% on higher volume, compared to 9.3% for the First Quarter of Fiscal 2012.

Research and development expense was $3.7 million, flat compared to the First Quarter of Fiscal 2012. Research and development expense as a percentage of revenue was 3.1% on higher volume, compared to 3.4% for the First Quarter of Fiscal 2012.

22 -------------------------------------------------------------------------------- Table of Contents Income from operations was $16.4 million, a decrease of $1.3 million, or 7.3%, compared to income from operations of $17.7 million for the First Quarter of Fiscal 2012. The decrease was driven by increased operating expenses. Operating income as a percentage of revenue was 13.5%, compared to 16.3% for the First Quarter of Fiscal 2012.

Sensors Segment Orders and Backlog First Quarter of Fiscal 2013 Compared to First Quarter of Fiscal 2012 The following is a comparison of First Quarter of Fiscal 2013 and First Quarter of Fiscal 2012 orders for Sensors, separately identifying the estimated impact of currency translation (in millions): Three Fiscal Three Fiscal Months Ended Estimated Months Ended December 29, Business Currency December 31, 2012 Change Translation 2011 Orders $ 22.5 $ (0.9 ) $ (0.7 ) $ 24.1 Orders totaled $22.5 million, a decrease of $1.6 million, or 6.6%, including an estimated 2.9% unfavorable impact of currency translation, compared to orders of $24.1 million for the First Quarter of Fiscal 2012, primarily due to soft market conditions in Europe and Japan in both the industrial and mobile hydraulics markets. Industrial market orders in the U.S. and China were strong. Sensors accounted for 16.1% of total Company orders, compared to 17.9% for the First Quarter of Fiscal 2012.

Backlog of undelivered orders at the end of the quarter was $14.8 million, a decrease of 9.2% from backlog of $16.3 million at the end of the First Quarter of Fiscal 2012.

Results of Operations First Quarter of Fiscal 2013 Compared to First Quarter of Fiscal 2012 The following is a comparison of First Quarter of Fiscal 2013 and First Quarter of Fiscal 2012 results of operations for Sensors, separately identifying the estimated impact of currency translation (in millions): Three Fiscal Three Fiscal Months Ended Estimated Months Ended December 29, Business Currency December 31, 2012 Change Translation 2011 Revenue $ 21.6 $ (2.8 ) $ (0.7 ) $ 25.1 Cost of sales 9.6 (1.2 ) (0.3 ) 11.1 Gross profit 12.0 (1.6 ) (0.4 ) 14.0 Gross margin 55.5 % 55.9 % Operating expenses: Selling and marketing 4.2 0.5 (0.1 ) 3.8 General administrative 2.8 (0.2 ) (0.1 ) 3.1 Research and development 1.3 - - 1.3 Total operating expenses 8.3 0.3 (0.2 ) 8.2 Income from operations $ 3.7 $ (1.9 ) $ (0.2 ) $ 5.8 23 -------------------------------------------------------------------------------- Table of Contents Revenue was $21.6 million, a decrease of $3.5 million, or 13.9%, compared to revenue of $25.1 million for the First Quarter of Fiscal 2012. This decrease was primarily driven by a 20.8% lower beginning backlog, reduced order volume, and an estimated $0.7 million unfavorable impact of currency translation.

Gross profit was $12.0 million, a decrease of $2.0 million, or 14.3%, compared to gross profit of $14.0 million for the First Quarter of Fiscal 2012, driven by lower revenue volume. Gross profit as a percentage of revenue was 55.5%, relatively flat compared to 55.9% for the First Quarter of Fiscal 2012.

Selling and marketing expense was $4.2 million, an increase of $0.4 million, or 10.5%, compared to $3.8 million for the First Quarter of Fiscal 2012. The increase was primarily due to higher compensation and benefits driven by increased headcount to support future sales growth. Selling and marketing expense as a percentage of revenue was 19.4% on lower volume, compared to 15.1% for the First Quarter of Fiscal 2012.

General and administrative expense was $2.8 million, a decrease of $0.3 million, or 9.7%, compared to $3.1 million for the First Quarter of Fiscal 2012. This decrease is primarily driven by a relatively lower level of investment in compliance program enhancement initiatives. General and administrative expense as a percentage of revenue was 13.0% on lower volume, compared to 12.4% for the First Quarter of Fiscal 2012.

Research and development expense was $1.3 million, flat compared to the First Quarter of Fiscal 2012. Research and development expense as a percentage of revenue was 6.0% on lower volume, compared to 5.2% for the First Quarter of Fiscal 2012.

Income from operations was $3.7 million, a decrease of $2.1 million, or 36.2%, compared to income from operations of $5.8 million for the First Quarter of Fiscal 2012. The decrease was primarily due to lower gross profit. Operating income as a percentage of revenue was 17.1%, compared to 23.1% for the First Quarter of Fiscal 2012.

Capital Resources and Liquidity The Company had cash and cash equivalents of $47.9 million at the end of the First Quarter of Fiscal 2013. Of this amount, $2.6 million was located in North America, $32.1 million in Europe, and $13.2 million in Asia. Of the $45.3 million of cash located outside of North America, approximately $34.9 million is not available for use in the U.S. without the incurrence of U.S. federal and state income tax consequences.

The North American balance was primarily invested in bank deposits. In Europe and Asia, the balances were primarily invested in money market funds and bank deposits. In accordance with its investment policy, the Company places cash equivalent investments with issuers who have high-quality investment credit ratings. In addition, the Company limits the amount of investment exposure it has with any particular issuer. The Company's investment objectives are to preserve principal, maintain liquidity, and achieve the best available return consistent with its primary objectives of safety and liquidity. At the end of the First Quarter of Fiscal 2013, the Company held no short-term investments.

Total cash and cash equivalents decreased $31.9 million in the First Quarter of Fiscal 2013, primarily due to increased working capital requirements, dividend payments, investments in property and equipment, and employee incentives and related benefit payments, partially offset by earnings. Total cash and cash equivalents decreased $0.4 million in the First Quarter of Fiscal 2012, primarily due to increased working capital requirements and employee incentives and related benefit payments, partially offset by earnings. The Company believes that its liquidity, represented by funds available from cash, cash equivalents, credit facility, and anticipated cash from operations, are adequate to fund ongoing operations, internal growth opportunities, capital expenditures, dividends and share purchases, as well as to fund strategic acquisitions.

Cash flows from operating activitiesused cash totaling $14.5 million for the First Quarter of Fiscal 2013, compared to cash provided of $2.5 million for the First Quarter of Fiscal 2012. Cash used for the First Quarter of Fiscal 2013 was primarily due to $14.7 million increased accounts and unbilled receivables resulting from general timing of billing and collections, $8.4 million decreased advance payments received from customers driven by the timing of orders in the quarter, $4.7 million increased inventories to support future revenue, and $5.2 million net employee incentives and related benefit payments, primarily consisting of variable compensation relating to Fiscal 2012. These decreases were partially offset by earnings.

24 -------------------------------------------------------------------------------- Table of Contents Cash provided for the First Quarter of Fiscal 2012 was primarily due to earnings and $11.3 million increased advance payments received from customers driven by payment terms on base orders, partially offset by $19.1 million decreased accounts and unbilled receivables resulting from general timing of billing and collections, and $8.5 million net employee incentives and related benefit payments, primarily consisting of variable compensation relating to Fiscal 2011.

Cash flows from investing activitiesrequired the use of cash totaling $8.0 million for the First Quarter of Fiscal 2013, compared to the use of cash totaling $2.3 million for the First Quarter of Fiscal 2012, each of which reflects investment in property and equipment. The significant increase was driven by investments in various growth and productivity initiatives.

Cash flows from financing activitiesused cash totaling $9.0 million for the First Quarter of Fiscal 2013, compared to the cash provided totaling $0.5 million for the First Quarter of Fiscal 2012. The cash used for the First Quarter of Fiscal 2013 was primarily due to two quarterly cash dividend payments totaling $9.6 million, one of which was an accelerated payment that was originally planned for in January 2013. The cash provided for the First Quarter of Fiscal 2012 was primarily due to the $4.4 million received in connection with stock option exercises, partially offset by payment of cash dividends of $4.0 million.

Under the terms of its borrowing agreements, the Company has agreed to certain financial covenants. At the end of the First Quarter of Fiscal 2013, the Company was in compliance with the financial terms and conditions of those agreements.

Off-Balance Sheet Arrangements As of December 29, 2012, the Company had no off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on the Company's financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to investors.

Critical Accounting Policies The Consolidated Financial Statements are prepared in accordance with U.S.

generally accepted accounting principles, which require the Company to make estimates and assumptions in certain circumstances that affect amounts reported.

In preparing these financial statements, management has made its best estimates and judgments of certain amounts, giving due consideration to materiality. The Company believes that of its significant accounting policies, the following are particularly important to the portrayal of the Company's results of operations and financial position, may require the application of a higher level of judgment by the Company's management and, as a result, are subject to an inherent degree of uncertainty. Further information is provided in Note 1 in the Condensed Notes to Consolidated Financial Statements in this Quarterly Report on Form 10-Q.

Revenue Recognition. The Company is required to comply with a variety of technical accounting requirements in order to achieve consistent and accurate revenue recognition. The most significant area of judgment and estimation is percentage of completion contract accounting. The Company develops cost estimates that include materials, component parts, labor and overhead costs.

Detailed costs plans are developed for all aspects of the contracts during the bidding phase of the contract. Cost estimates are largely based on actual historical performance of similar projects combined with current knowledge of the projects in progress. Significant factors that impact the cost estimates include technical risk, inflationary cost of materials and labor, changes in scope and schedule, and internal and subcontractor performance. Actual costs incurred during the project phase are monitored and compared to the estimates on a monthly basis. Cost estimates are revised based on changes in circumstances.

Anticipated losses on long-term contracts are recognized when such losses become evident.

Inventories. The Company maintains a material amount of inventory to support its engineering and manufacturing operations. This inventory is stated at the lower of cost or market. On a regular basis, the Company reviews its inventory and identifies that which is excess, slow moving, and obsolete by considering factors such as inventory levels, expected product life, and forecasted sales demand. Any identified excess, slow moving, and obsolete inventory is written down to its market value through a charge to income from operations. It is possible that additional inventory write-down charges may be required in the future if there is a significant decline in demand for the Company's products and the Company does not adjust its manufacturing production accordingly.

Impairment of Long-Lived Assets. The Company reviews the carrying value of long-lived assets or asset groups, such as property and equipment and intangibles subject to amortization, when events or changes in circumstances such as market value, asset utilization, physical change, legal factors, or other matters indicate that the carrying value may not be recoverable. When this review indicates the carrying value of an asset or asset group exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset or asset group, the Company recognizes an asset impairment charge against operations. The amount of the impairment charge recorded is the amount by which the carrying value of the impaired asset or asset group exceeds its fair value.

25 -------------------------------------------------------------------------------- Table of Contents Goodwill. The Company tests goodwill at least annually for impairment. Goodwill is also tested for impairment as changes in circumstances occur indicating that the carrying value may not be recoverable. Goodwill impairment testing first requires a comparison of the fair value of each reporting unit to the carrying value. If the carrying value of the reporting unit exceeds fair value, goodwill is considered impaired.

The Company has three reporting units, two of which are assigned goodwill. At December 29, 2012, one reporting unit was assigned $14.8 million of goodwill while another was assigned $1.6 million. The fair value of a reporting unit is estimated using a discounted cash flow model that requires input of certain estimates and assumptions requiring management judgment, including projections of economic conditions and customer demand, revenue and margins, changes in competition, operating costs, and new product introductions. At the end of the prior fiscal year, the estimated fair value of the reporting unit assigned $1.5 million of goodwill was substantially in excess of its carrying value, while the estimated fair value of the reporting unit assigned $14.7 million of goodwill exceeded its carrying value by approximately 28 percent. While the Company believes the estimates and assumptions used in determining the fair value of its reporting units are reasonable, significant changes in estimates of future cash flows, such as those caused by unforeseen events or changes in market conditions, could materially impact the fair value of a reporting unit which could result in the recognition of a goodwill impairment charge.

Software Development Costs.The Company incurs costs associated with the development of software to be sold, leased, or otherwise marketed. Software development costs are expensed as incurred until technological feasibility has been established, at which time future costs incurred are capitalized until the product is available for general release to the public. A certain amount of judgment and estimation is required to assess when technological feasibility is established, as well as the ongoing assessment of the recoverability of capitalized costs. In evaluating the recoverability of capitalized software costs, the Company compares expected product performance, utilizing forecasted revenue amounts, to the total costs incurred to date and estimates of additional costs to be incurred. If revised forecasted product revenue is less than, and/or revised forecasted costs are greater than, the previously forecasted amounts, the net realizable value may be lower than previously estimated, which could result in the recognition of an impairment charge in the period in which such a determination is made.

Warranty Obligations. The Company is subject to warranty obligations on sales of its products. The Company records general warranty provisions based on an estimated warranty expense percentage applied to current period revenue. The percentage applied reflects historical warranty claims experience over the preceding twelve-month period. Both the experience percentage and the warranty liability are evaluated on an ongoing basis for adequacy. A certain amount of judgment is required in determining appropriate reserve levels for anticipated warranty claims. While these reserve levels are based on historical warranty experience, they may not reflect the actual claims that will occur over the upcoming warranty period, and additional warranty reserves may be required.

Income Taxes. The Company records a tax provision for the anticipated tax consequences of the reported results of operations. Deferred tax assets and liabilities are measured using the currently enacted tax rates that apply to taxable income in effect for the years in which those deferred tax assets and liabilities are expected to be realized or settled. The Company records a valuation allowance to reduce deferred tax assets to the amount that is believed more likely than not to be realized. The Company believes it is more likely than not that forecasted income, including income that may be generated as a result of certain tax planning strategies, together with the tax effects of the deferred tax liabilities, will be sufficient to fully recover the remaining net realizable value of its deferred tax assets. In the event that all or part of the net deferred tax assets are determined not to be realizable in the future, an adjustment to the valuation allowance would be charged to earnings in the period such determination is made. In addition, the calculation of tax liabilities involves significant judgment in estimating the impact of uncertainties in the application of complex tax laws. Resolution of these uncertainties in a manner inconsistent with management's expectations could have a material impact on the Company's financial condition and operating results.

Other Matters The Company's dividend policy is to maintain a payout ratio that allows dividends to increase as earnings per share increases over time while sustaining dividends through economic cycles. The Company's dividend practice is to target, over time, a payout ratio of approximately 30% of net earnings per share.

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