News Column

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

May 5, 2014

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 2,299 employees at September 28, 2013 and revenue of $569 million for the fiscal year ended September 28, 2013.



Terms

When we use the terms "we," "us," the "Company," or "our" in this report, unless the context otherwise requires, we are referring to MTS Systems Corporation.

Second Quarter of Fiscal 2014 refers to the three fiscal months ended March 29, 2014; Second Quarter of Fiscal 2013 refers to the three fiscal months ended March 30, 2013; First Half of Fiscal 2014 refers to the six fiscal months ended March 29, 2014; First Half of Fiscal 2013 refers to the six fiscal months ended March 30, 2013. Fiscal 2014 refers to the fiscal year ended September 27, 2014. Fiscal 2013 refers to the fiscal year ended September 28, 2013.



Company Strategy

Our goal is to grow profitably, generate strong cash flow, and deliver a strong return on invested capital to our shareholders by leveraging our leadership position in the research and development, product development and industrial equipment global end markets. Our desire is to be the innovation leader in creating test and measurement solutions to enable our customers' success. Through innovation we believe we can create value for our customers that will drive our growth. There are four global macro trends that will help enable this growth: energy scarcity; environmental concerns; continued globalization and the development of the emerging markets; and global demographics. These macro trends have significant implications for our customers, such as increasing the demand for new and more innovative products and increasing our customers' organizational complexity. We believe we have an excellent geographic footprint and are well positioned in both Test and Sensors to take advantage of these macro trends and deliver significant profitable growth in the years ahead. We are working toward our previously communicated goal of achieving $1 billion in annual revenue. Economic conditions and the competitive environment will impact the timing of when the $1 billion goal is achieved. Our three priorities to achieve this goal are: Accelerating innovation; Capturing opportunities in the rapidly emerging markets; and Realizing the potential of the Test service business. Our business model supports achieving our $1 billion revenue milestone through both organic growth and strategic acquisitions, assuming we continue to move aggressively to build our infrastructure, expand our offerings and execute on our opportunities with our key customers around the world. In order to accelerate our revenue growth over the next few years, investments in infrastructure, sales support and field service capacity and capability are essential. We began investing in earnest in both fiscal years 2012 and 2013, and will continue investing in Fiscal 2014. Financial Results Total Company Orders and Backlog The following is a comparison of Second Quarter and First Half of Fiscal 2014 and Second Quarter and First Half of Fiscal 2013 orders, separately identifying the estimated impact of currency translation (in millions): Three Fiscal Three Fiscal Six Fiscal Six Fiscal Months Months Months Months Ended Estimated Ended Ended Estimated Ended March 29, Business Currency March 30,



March 29, Business Currency March 30,

2014 Change Translation 2013



2014 Change Translation 2013 Orders $ 163.2$ 25.6$ (0.1 )$ 137.7$ 302.0$ 25.7$ (0.7 )$ 277.0

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Orders

Orders in the Second Quarter of Fiscal 2014 were a quarterly record $163.2 million, an increase of $25.5 million, or 18.5%, compared to $137.7 million for the Second Quarter of Fiscal 2013. The increase is driven by variability in large (in excess of $5.0 million) orders as well as base order growth in both the Test segment ("Test") and Sensors segment ("Sensors"). Orders in the Second Quarter of Fiscal 2014 included two large custom Test orders totaling $19.0 million. Orders in the Second Quarter of Fiscal 2013 included one large $5.5 million custom Test order. Excluding the large orders, base orders increased 9.1%, reflecting growth of 6.7% in Test and 20.0% in Sensors. Orders in the First Half of Fiscal 2014 totaled $302.0 million, an increase of $25.0 million, or 9.0%, compared to $277.0 million for the First Half of Fiscal 2013. The increase is driven by base order growth in both Test and Sensors as well as variability in large orders. Orders in the First Half of Fiscal 2014 included four large custom Test orders totaling $32.9 million. Orders in the First Half of Fiscal 2013 included three large custom Test orders totaling $26.2 million. Excluding the large orders, base orders increased 7.3%, reflecting growth of 5.0% in Test and 17.2% in Sensors.



Backlog

Backlog of undelivered orders at the end of the Second Quarter of Fiscal 2014 was an all-time high of $304.2 million, an increase of 6.3% compared to $286.3 million at the end of the Second Quarter of Fiscal 2013. While we are subject to order cancellations, historically, we have not experienced a significant number of order cancellations. During the Second Quarter of Fiscal 2014, one custom order in Test totaling $11.1 million was cancelled. This order was booked in the previous fiscal year. Results of Operations The following is a comparison of Second Quarter and First Half of Fiscal 2014 and Second Quarter and First Half of Fiscal 2013 statements of operations (in millions, except per share data): Three Fiscal Months Ended Six Fiscal Months Ended March 29, March 30, March 29, March 30, 2014 2013 % Variance 2014 2013 % Variance Revenue $ 137.3$ 136.9 0.3 % $ 275.8$ 279.6 -1.4 % Cost of sales 81.8 83.0 -1.4 % 165.7 169.1 -2.0 % Gross profit 55.5 53.9 3.0 % 110.1 110.5 -0.4 % Gross margin 40.4 % 39.4 % 39.9 % 39.5 % Operating expenses: Selling and marketing 22.4 19.5 14.9 % 43.9 38.7 13.4 % General administrative 14.0 13.2 6.1 % 27.2 25.5 6.7 % Research and development 6.8 5.6 21.4 % 12.5 10.6 17.9 % Total operating expenses 43.2 38.3 12.8 % 83.6 74.8 11.8 % Income from operations 12.3 15.6 -21.2 % 26.5 35.7 -25.8 % Interest expense, net (0.2 ) (0.2 ) 0.0 % (0.4 ) (0.2 ) 100.0 % Other expense, net (0.2 ) (0.9 ) NM (0.5 ) (0.5 ) 0.0 % Income before income taxes 11.9 14.5 -17.9 % 25.6 35.0 -26.9 % Income tax provision 4.1 3.4 20.6 % 8.7 10.2 -14.7 % Net income $ 7.8 $ 11.1 -29.7



% $ 16.9$ 24.8 -31.9 % Diluted earnings per share $ 0.50$ 0.69 -27.5 % $ 1.09$ 1.56 -30.1 %

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"NM" represents comparisons that are not meaningful to this analysis.

The following is a comparison of Second Quarter and First Half of Fiscal 2014 and Second Quarter and First Half of Fiscal 2013 results of operations, separately identifying the impact of currency translation and severance and related costs (in millions): Three Three Six Six Fiscal Fiscal Fiscal Fiscal Months Severance Months Months Severance Months Ended Estimated and Ended Ended Estimated and Ended March 29, Business Currency Related March 30, March 29, Business Currency Related March 30, 2014 Change Translation Costs 2013 2014 Change Translation Costs 2013 Revenue $ 137.3$ 0.5$ (0.1 ) $ - $ 136.9$ 275.8$ (2.6 )$ (1.2 ) $ - $ 279.6 Cost of sales 81.8 (1.6 ) - 0.4 83.0 165.7 (5.9 ) (0.5 ) 3.0 169.1 Gross profit 55.5 2.1 (0.1 ) (0.4 ) 53.9 110.1 3.3 (0.7 ) (3.0 ) 110.5 40.4 % 39.4 % 39.9 % - 39.5 % Operating expenses: Selling and marketing 22.4 2.8 - 0.1 19.5 43.9 4.5 (0.2 ) 0.9 38.7 General administrative 14.0 0.6 0.1 0.1 13.2 27.2 0.6 0.2 0.9 25.5 Research and development 6.8 1.2 - - 5.6 12.5 1.8 0.1 - 10.6 Total operating expenses 43.2 4.6 0.1 0.2 38.3 83.6 6.9 0.1 1.8 74.8 Income from operations $ 12.3$ (2.5 )$ (0.2 )$ (0.6 )$ 15.6$ 26.5$ (3.6 )$ (0.8 )$ (4.8 )$ 35.7 Revenue Revenue in the Second Quarter of Fiscal 2014 was $137.3 million, an increase of $0.4 million, or 0.3%, compared to $136.9 million for the Second Quarter of Fiscal 2013. The increase was driven by higher beginning backlog and increased order volume in Sensors, partially offset by timing of custom order backlog conversion in Test. Test revenue decreased 2.6% to $110.9 million while Sensors revenue increased 14.8% to $26.4 million. Revenue in the First Half of Fiscal 2014 was $275.8 million, a decrease of $3.8 million, or 1.4%, compared to $279.6 million for the First Half of Fiscal 2013. The decrease was driven by lower beginning backlog in Test, as well as an estimated $1.2 million unfavorable impact of currency translation, partially offset by higher beginning backlog and increased order volume in Sensors. Test revenue decreased 4.6% to $224.4 million while Sensors revenue increased 15.5% to $51.4 million. Severance and Related Costs As previously disclosed, productivity benefits from investments in Test business processes are expected to result in $4 to $5 million of cost savings during Fiscal 2014. The cost savings that began during the Second Quarter of Fiscal 2014 and are expected to continue over the last six months of Fiscal 2014 will be reinvested primarily in the Test business to enable our long-term growth objectives. Associated with these savings, we initiated workforce reduction and other cost reduction actions throughout the First Half of Fiscal 2014. As a result of these cost reduction actions, we incurred severance and related costs. During the Second Quarter of Fiscal 2014, we incurred severance and related costs of $0.6 million, of which $0.4 million, $0.1 million, and $0.1 million were reported in Cost of Sales, Selling and Marketing, and General and Administrative expense, respectively. During the First Half of Fiscal 2014, we incurred severance and related costs of $4.8 million, of which $3.0 million, $0.9 million, and $0.9 million were reported in Cost of Sales, Selling and Marketing, and General and Administrative expense, respectively. Gross Profit Gross profit in the Second Quarter of Fiscal 2014 was $55.5 million, an increase of $1.6 million, or 3.0%, compared to $53.9 million for the Second Quarter of Fiscal 2013. Gross profit as a percentage of revenue was 40.4%, an increase of 1.0 percentage points from 39.4% for the Second Quarter of Fiscal 2013. The previously mentioned severance and related costs of $0.4 million unfavorably impacted gross profit as a percentage of revenue by 0.3 percentage points. Excluding these costs, the gross margin rate increased 1.3 percentage points, primarily driven by a favorable mix of product and service sales in Test, as well as a favorable impact of the relative increase in Sensors revenue compared to total Company revenue. 23



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Gross profit in the First Half of Fiscal 2014 was $110.1 million, a decrease of $0.4 million, or 0.4%, compared to $110.5 million for the First Half of Fiscal 2013. Gross profit as a percentage of revenue was 39.9%, an increase of 0.4 percentage points from 39.5% for the First Half of Fiscal 2013. The previously mentioned severance and related costs of $3.0 million unfavorably impacted gross profit as a percentage of revenue by 1.1 percentage points. Excluding these costs, the gross margin rate increased 1.5 percentage points, primarily driven by reduced spending on productivity and infrastructure initiatives, favorable product mix in Test, as well as a favorable impact of the relative increase in Sensors revenue compared to total Company revenue. Selling and Marketing Expense Selling and marketing expense in the Second Quarter of Fiscal 2014 was $22.4 million, an increase of $2.9 million, or 14.9%, compared to $19.5 million for the Second Quarter of Fiscal 2013. Selling and marketing expense in the First Half of Fiscal 2014 was $43.9 million, an increase of $5.2 million, or 13.4%, compared to $38.7 million for the First Half of Fiscal 2013. Both increases were driven by higher compensation and benefits resulting from increased headcount, higher sales commissions, as well as the previously mentioned severance and related costs of $0.1 million and $0.9 million in the Second Quarter of Fiscal 2014 and the First Half of Fiscal 2014, respectively. Selling and marketing expense as a percentage of revenue for the Second Quarter of Fiscal 2014 was 16.3%, compared to 14.2% for the Second Quarter of Fiscal 2013. Selling and marketing expense as a percentage of revenue for the First Half of Fiscal 2014 was 15.9%, compared to 13.8% for the First Half of Fiscal 2013. General and Administrative Expense General and administrative expense in the Second Quarter of Fiscal 2014 was $14.0 million, an increase of $0.8 million, or 6.1%, compared to $13.2 million for the Second Quarter of Fiscal 2013. General and administrative expense in the First Half of Fiscal 2014 was $27.2 million, an increase of $1.7 million, or 6.7%, compared to $25.5 million for the First Half of Fiscal 2013. Both increases were primarily driven by higher legal expenses, higher compensation and benefits driven by increased headcount, as well the previously mentioned severance and related costs of $0.1 million and $0.9 million in the Second Quarter of Fiscal 2014 and the First Half of Fiscal 2014, respectively. These increases were partially offset by a lower level of investment in productivity and infrastructure initiatives. General and administrative expense as a percentage of revenue for the Second Quarter of Fiscal 2014 was 10.2%, compared to 9.6% for the Second Quarter of Fiscal 2013. General and administrative expense as a percentage of revenue for the First Half of Fiscal 2014 was 9.9%, compared to 9.1% for the First Half of Fiscal 2013. Research and Development Expense Research and development expense in the Second Quarter of Fiscal 2014 was $6.8 million, an increase of $1.2 million, or 21.4%, compared to $5.6 million for the Second Quarter of Fiscal 2013. Research and development expense in the First Half of Fiscal 2014 was $12.5 million, an increase of $1.9 million, or 17.9%, compared to $10.6 million for the First Half of Fiscal 2013. Both increases were primarily driven by higher compensation and benefits resulting from increased headcount in both Test and Sensors. Research and development expense as a percentage of revenue for the Second Quarter of Fiscal 2014 was 5.0%, compared to 4.1% for the Second Quarter of Fiscal 2013. Research and development expense as a percentage of revenue for the First Half of Fiscal 2014 was 4.5%, compared to 3.8% for the First Half of Fiscal 2013. Income from Operations Income from operations in the Second Quarter of Fiscal 2014 was $12.3 million, a decrease of $3.3 million, or 21.2%, compared to income from operations of $15.6 million for the Second Quarter of Fiscal 2013. Excluding the previously mentioned severance and related costs of $0.6 million, income from operations decreased 17.3%, driven by a $4.7 million increase in operating expenses resulting from ongoing investments for growth in sales and research and development, partially offset by higher gross profit. Operating income as a percentage of revenue for the Second Quarter of Fiscal 2014 was 9.0%, compared to 11.4% for the Second Quarter of Fiscal 2013. Income from operations in the First Half of Fiscal 2014 was $26.5 million, a decrease of $9.2 million, or 25.8%, compared to income from operations of $35.7 million for the First Half of Fiscal 2013. Excluding the previously mentioned severance and related costs of $4.8 million, income from operations decreased 12.3% for the First Half of Fiscal 2014, driven by a $7.0 million increase in operating expenses resulting from ongoing investments for growth in sales and research and development. Operating income as a percentage of revenue for the First Half of Fiscal 2014 was 9.6%, compared to 12.8% for the First Half of Fiscal 2013. 24



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Interest Expense, net Net interest expense in the Second Quarter of Fiscal 2014 was $0.2 million, flat compared to the Second Quarter of Fiscal 2013. Net interest expense in the First Half of Fiscal 2014 was $0.4 million, an increase of $0.2 million compared to the First Half of Fiscal 2013. The increase was driven by a relatively higher level of outstanding borrowings under the Company's credit facility during the First Half of Fiscal 2014 compared to the First Half of Fiscal 2013. Other Expense, net Other expense, net in the Second Quarter of Fiscal 2014 was $0.2 million, compared to $0.9 million in the Second Quarter of Fiscal 2013. This decrease was driven by $0.9 million decreased net losses on foreign currency transactions primarily due to volatility in the value of the U.S. dollar against the Japanese Yen during the Second Quarter of Fiscal 2013. Other expense, net in the First Half of Fiscal 2014 was $0.5 million, flat compared to the First Half of Fiscal 2013, as decreased net losses on foreign currency transactions were substantially offset by royalty income in the First Half of Fiscal 2013 that did not repeat in the First Half of Fiscal 2014. Provision for Income Taxes Provision for income taxes in the Second Quarter of Fiscal 2014 totaled $4.1 million, an increase of $0.7 million, or 20.6%, compared to $3.4 million for the Second Quarter of Fiscal 2013. The increase is primarily due to an increase in the effective tax rate, partially offset by decreased income before taxes. The effective tax rate for the Second Quarter of Fiscal 2014 was 34.8%, an increase of 11.0 percentage points compared to a tax rate of 23.8% for the Second Quarter of Fiscal 2013. The increase was primarily driven by the enactment of tax legislation in the Second Quarter of Fiscal 2013 that retroactively extended the U.S. research and development tax credits and provided a tax benefit of $1.3 million, as well as changes in certain foreign tax rates. The U.S. research and development tax credit expired as of the end of the First Quarter of Fiscal 2014. Provision for income taxes in the First Half of Fiscal 2014 totaled $8.7 million, a decrease of $1.5 million, or 14.7%, compared to $10.2 million for the First Half of Fiscal 2014. The decrease is primarily due to lower income before income taxes, partially offset by a higher effective tax rate. The effective tax rate for the First Half of Fiscal 2014 was 34.0%, an increase of 4.9 percentage points compared to a tax rate of 29.1% for the First Half of Fiscal 2013. The increase was primarily driven by the previously mentioned U.S. research and development tax credit tax legislation in the prior fiscal year that retroactively extended the United States research and development tax credit and provided a tax benefit of $1.0 million, as well as changes in certain foreign tax rates. Net income Net income in the Second Quarter of Fiscal 2014 was $7.8 million, a decrease of $3.3 million, or 29.7%, compared to $11.1 million for the Second Quarter of Fiscal 2013. The decrease was primarily driven by lower income from operations and a higher effective tax rate, partially offset by decreased net losses on foreign currency transactions. Earnings per diluted share were $0.50, a decrease of $0.19 per share, or 27.5%, compared to $0.69 per share for the Second Quarter of Fiscal 2013. The previously mentioned $0.6 million charge for severance and related costs in the Second Quarter of Fiscal 2014 negatively impacted earnings per diluted share by $0.03. Net income in the First Half of Fiscal 2014 was $16.9 million, a decrease of $7.9 million, or 31.9%, compared to $24.8 million for the First Half of Fiscal 2013. The decrease was primarily driven by lower income from operations. Earnings per diluted share were $1.09, a decrease of $0.47 per share, or 30.1%, compared to $1.56 per share for the First Half of Fiscal 2013. The previously mentioned $4.8 million charge for severance and related costs in the First Half of Fiscal 2014 negatively impacted earnings per diluted share by $0.21. 25



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Table of Contents Segment Results Test Segment Orders and Backlog The following is a comparison of Second Quarter and First Half of Fiscal 2014 and Second Quarter and First Half of Fiscal 2013 orders for Test, separately identifying the estimated impact of currency translation (in millions): Three Fiscal Three Fiscal Six Fiscal Six Fiscal Months Months Months Months Ended Estimated Ended Ended Estimated Ended March 29, Business Currency March 30,



March 29, Business Currency March 30,

2014 Change Translation 2013



2014 Change Translation 2013 Orders $ 134.4$ 20.9$ (0.2 )$ 113.7$ 247.4$ 17.4$ (0.4 )$ 230.4

Orders

Orders in the Second Quarter of Fiscal 2014 totaled $134.4 million, an increase of $20.7 million, or 18.2%, compared to orders of $113.7 million for the Second Quarter of Fiscal 2013, primarily driven by variability in large orders as well as 6.7% growth in base orders. Second Quarter of Fiscal 2014 orders included two large orders in the Americas totaling $19.0 million, one of which was a $12.2 million order in the ground vehicle market for a rolling road system and the other was a $6.8 million order in the structures market for aircraft structural testing. Orders in the Second Quarter of Fiscal 2013 included a $5.5 million European order in the ground vehicles market. The 6.7% increase in base orders was fueled by 13.9% orders growth in the service business from strong worldwide demand, as well as growth in the European materials market. Currency translation unfavorably impacted orders by approximately $0.2 million. Test accounted for 82.4% of total Company orders, compared to 82.6% for the Second Quarter of Fiscal 2013. Orders in the First Half of Fiscal 2014 totaled $247.4 million, an increase of $17.0 million, or 7.4%, compared to orders of $230.4 million for the First Half of Fiscal 2013, primarily driven by variability in large orders as well as 5.0% growth in base orders. First Half of Fiscal 2014 orders included two large orders in China totaling $13.9 million, one of which was an $8.0 million order in the structures market for seismic testing and the other was a $5.9 million ground vehicle order for suspension testing, as well as the two previously mentioned large Americas orders totaling $19.0 million. Orders in the First Half of Fiscal 2013 included two large European orders in the ground vehicles market totaling $17.2 million, as well as a $9.2 millionAmericas' order in the structures market. The 5.0% increase in base orders was fueled by 15.9% orders growth in the service business from strong demand in Europe and the Americas. Currency translation unfavorably impacted orders by approximately $0.4 million. Test accounted for 81.9% of total Company orders, compared to 83.2% for the First Half of Fiscal 2013.



Backlog

Backlog of undelivered orders at the end of the second quarter was $285.6 million, an increase of 5.2% compared to backlog of $271.6 million at the end of the Second Quarter of Fiscal 2013. As previously mentioned, Second Quarter of Fiscal 2014 beginning backlog was negatively impacted by the cancellation of a custom order totaling $11.1 million.



Results of Operations

The following is a comparison of Second Quarter and First Half of Fiscal 2014 and Second Quarter and First Half of Fiscal 2013 results of operations for Test, separately identifying the impact of currency translation and severance and related costs (in millions): Three Three Six Six Fiscal Fiscal Fiscal Fiscal Months Severance Months Months Severance Months Ended Estimated and Ended Ended Estimated and Ended March 29, Business Currency Related March 30, March 29, Business Currency Related March 30, 2014 Change Translation Costs 2013 2014 Change Translation Costs 2013 Revenue $ 110.9$ (2.9 )$ (0.1 ) $ - $ 113.9$ 224.4$ (10.1 )$ (0.6 ) $ - $ 235.1 Cost of sales 69.6 (3.4 ) - 0.4 72.6 142.4 (9.4 ) (0.3 ) 3.0 149.1 Gross profit 41.3 0.5 (0.1 ) (0.4 ) 41.3 82.0 (0.7 ) (0.3 ) (3.0 ) 86.0 37.2 % 36.3 % 36.5 % 36.6 % Operating expenses: Selling and marketing 17.4 1.8 - 0.1 15.5 34.0 2.6 - 0.9 30.5 General administrative 11.1 1.3 0.1 0.1 9.6 21.1 0.9 0.2 0.9 19.1 Research and development 5.1 0.9 - - 4.2 9.3 1.3 - - 8.0 Total operating expenses 33.6 4.0 0.1 0.2 29.3 64.4 4.8 0.2 1.8 57.6 Income from operations $ 7.7$ (3.5 )$ (0.2 )$ (0.6 )$ 12.0$ 17.6$ (5.5 )$ (0.5 )$ (4.8 )$ 28.4 26



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Revenue

Revenue in the Second Quarter of Fiscal 2014 was $110.9 million, a decrease of $3.0 million, or 2.6%, compared to revenue of $113.9 million for the Second Quarter of Fiscal 2013. Revenue in the First Half of Fiscal 2014 was $224.4 million, a decrease of $10.7 million, or 4.6%, compared to revenue of $235.1 million for the First Half of Fiscal 2013, including an estimated $0.6 million unfavorable impact of currency translation. These decreases were primarily driven by lower beginning backlog as well as the timing of conversion of custom order backlog, partially offset by growth in service and short cycle products. Gross Profit Gross profit in the Second Quarter of Fiscal 2014 was $41.3 million on lower volume, flat compared to the Second Quarter of Fiscal 2013. Gross profit as a percentage of revenue was 37.2%, an increase of 0.9 percentage points from 36.3% for the Second Quarter of Fiscal 2013. The previously mentioned severance and related costs of $0.4 million unfavorably impacted gross profit as a percentage of revenue by 0.4 percentage points. Excluding these costs, the gross margin rate increased by 1.3 percentage points. Of the increased gross profit rate, approximately 1.6 percentage points resulted from a favorable mix of higher-margin products and services, and 0.5 percentage points resulted from favorable engineering variances driven by higher labor utilization. These increases were partially offset by a 0.6 percentage point unfavorable impact from decreased leverage on lower volume. Gross profit in the First Half of Fiscal 2014 was $82.0 million on higher volume, a decrease of $4.0 million, or 4.7%, compared to $86.0 million for the First Half of Fiscal 2013. Gross profit as a percentage of revenue was 36.5%, relatively flat compared to 36.6% for the First Half of Fiscal 2013. The previously mentioned severance and related costs of $3.0 million unfavorably impacted gross profit as a percentage of revenue by 1.3 percentage points. Excluding these costs, the gross margin rate increased by 1.2 percentage points. Of the increased gross profit rate, approximately 1.0 percentage point resulted from reduced spending on productivity and infrastructure initiatives, and 0.6 of a percentage point resulted from favorable manufacturing and engineering variances driven by higher labor utilization. These increases were partially offset by 0.4 of a percentage point unfavorable impact from decreased leverage on lower volume. Selling and Marketing Expense Selling and marketing expense in the Second Quarter of Fiscal 2014 was $17.4 million, an increase of $1.9 million, or 12.3%, compared to $15.5 million for the Second Quarter of Fiscal 2013. Selling and marketing expense in the First Half of Fiscal 2014 was $34.0 million, an increase of $3.5 million, or 11.5%, compared to $30.5 million for the First Half of Fiscal 2013. Both increases were driven by continued investment in sales expansion to drive future revenue growth, higher sales commissions, as well as the previously mentioned severance and related costs of $0.1 million and $0.9 million in the Second Quarter of Fiscal 2014 and the First Half of Fiscal 2014, respectively. The continued investment in sales expansion primarily consists of higher compensation and benefits resulting from increased headcount. Selling and marketing expense as a percentage of revenue for the Second Quarter of Fiscal 2014 was 15.7%, compared to 13.6% for the Second Quarter of Fiscal 2013. Selling and marketing expense as a percentage of revenue for the First Half of Fiscal 2014 was 15.2%, compared to 13.0% for the First Half of Fiscal 2013. General and Administrative Expense General and administrative expense in the Second Quarter of Fiscal 2014 was $11.1 million, an increase of $1.5 million, or 15.6%, compared to $9.6 million for the Second Quarter of Fiscal 2013. General and administrative expense in the First Half of Fiscal 2014 was $21.1 million, an increase of $2.0 million, or 10.5%, compared to $19.1 million for the First Half of Fiscal 2013. Both increases were primarily driven by higher legal expenses, higher compensation and benefits driven by increased headcount, as well as the previously mentioned severance and related costs of $0.1 million and $0.9 million in the Second Quarter of Fiscal 2014 and the First Half of Fiscal 2014, respectively. These increases were partially offset by a lower level of investment in productivity and infrastructure initiatives. General and administrative expense as a percentage of revenue for the Second Quarter of Fiscal 2014 was 10.0%, compared to 8.4% for the Second Quarter of Fiscal 2013. General and administrative expense as a percentage of revenue for the First Half of Fiscal 2014 was 9.4%, compared to 8.1% for the First Half of Fiscal 2013. 27



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Research and Development Expense Research and development expense in the Second Quarter of Fiscal 2014 was $5.1 million, an increase of $0.9 million, or 21.4%, compared to $4.2 million for the Second Quarter of Fiscal 2013. Research and development expense in the First Half of Fiscal 2014 was $9.3 million, an increase of $1.3 million, or 16.3%, compared to $8.0 million for the First Half of Fiscal 2013. Both increases were primarily driven by higher compensation and benefits resulting from increased headcount. Research and development expense as a percentage of revenue for the Second Quarter of Fiscal 2014 was 4.6%, compared to 3.7% for the Second Quarter of Fiscal 2013. Research and development expense as a percentage of revenue for the First Half of Fiscal 2014 was 4.1%, compared to 3.4% for the First Half of Fiscal 2013. Income from Operations Income from operations in the Second Quarter of Fiscal 2014 was $7.7 million, a decrease of $4.3 million, or 35.8%, compared to $12.0 million for the Second Quarter of Fiscal 2013. Excluding the previously mentioned severance and related costs of $0.6 million, income from operations decreased 30.8%, driven by a $4.1 million increase in operating expenses, partially offset by higher gross profit. Operating income as a percentage of revenue for the Second Quarter of Fiscal 2014 was 6.9%, compared to 10.5% for the Second Quarter of Fiscal 2013. Income from operations in the First Half of Fiscal 2014 was $17.6 million, a decrease of $10.8 million, or 38.0%, compared to $28.4 million for the First Half of Fiscal 2013. Excluding the previously mentioned severance and related costs of $4.8 million, income from operations decreased 21.1%, driven by decreased gross profit as well as a $5.0 million increase in operating expenses. Operating income as a percentage of revenue for the First Half of Fiscal 2014 was 7.8%, compared to 12.1% for the First Half of Fiscal 2013. Sensors Segment Orders and Backlog The following is a comparison of Second Quarter and First Half of Fiscal 2014 and Second Quarter and First Half of Fiscal 2013 orders for Sensors, separately identifying the estimated impact of currency translation (in millions): Three Fiscal Three Fiscal Six Fiscal Six Fiscal Months Months Months Months Ended Estimated Ended Ended Estimated Ended March 29, Business Currency March 30,



March 29, Business Currency March 30,

2014 Change Translation 2013 2014 Change Translation 2013 Orders $ 28.8 $ 4.7 $ 0.1 $ 24.0 $ 54.6$ 8.3$ (0.3 )$ 46.6 Orders Orders in the Second Quarter of Fiscal 2014 totaled $28.8 million, an increase of $4.8 million, or 20.0%, compared to orders of $24.0 million for the Second Quarter of Fiscal 2013. The industrial and mobile hydraulic markets were up 13.3% and 56.8%, respectively, driven by strong demand in all geographic regions. We continued to see broad-based increases in demand across multiple markets, and growth was achieved from both new and existing customers. Sensors accounted for 17.6% of total Company orders, compared to 17.4% for the Second Quarter of Fiscal 2013. Orders in the First Half of Fiscal 2014 totaled $54.6 million, an increase of $8.0 million, or 17.2%, including an estimated 0.6% unfavorable impact of currency translation, compared to orders of $46.6 million for the First Half of Fiscal 2013. The industrial and mobile hydraulic markets were up 14.5% and 31.1%, respectively, driven by strong demand in all geographic regions. Sensors accounted for 18.1% of total Company orders, compared to 16.8% for the First Half of Fiscal 2013.



Backlog

Backlog of undelivered orders at the end of the second quarter was $18.6 million, an increase of 26.5% compared to backlog of $14.7 million at the end of the Second Quarter of Fiscal 2013.

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Results of Operations

The following is a comparison of Second Quarter and First Half of Fiscal 2014 to Second Quarter and First Half of Fiscal 2013 results of operations for Sensors, separately identifying the estimated impact of currency translation (in millions): Three Three Six Six Fiscal Fiscal Fiscal Fiscal Months Months Months Months Ended Estimated Ended Ended Estimated Ended March 29, Business Currency March 30, March 29, Business Currency March 30, 2014 Change Translation 2013 2014 Change Translation 2013 Revenue $ 26.4$ 3.4 $ - $ 23.0$ 51.4$ 7.5$ (0.6 )$ 44.5 Cost of sales 12.2 1.8 - 10.4 23.3 3.5 (0.2 ) 20.0 Gross profit 14.2 1.6 - 12.6 28.1 4.0 (0.4 ) 24.5 53.8 % 54.8 % 54.8 % 55.1 % Operating expenses: Selling and marketing 5.0 1.0 - 4.0 9.9 1.9 (0.2 ) 8.2 General administrative 2.9 (0.7 ) - 3.6 6.1 (0.3 ) - 6.4 Research and development 1.7 0.3 - 1.4 3.2 0.5 0.1 2.6 Total operating expenses 9.6 0.6 - 9.0 19.2 2.1 (0.1 ) 17.2 Income from operations $ 4.6$ 1.0 $ - $ 3.6$ 8.9$ 1.9$ (0.3 )$ 7.3 Revenue Revenue in the Second Quarter of Fiscal 2014 was $26.4 million, an increase of $3.4 million, or 14.8%, compared to revenue of $23.0 million for the Second Quarter of Fiscal 2013. Revenue in the First Half of Fiscal 2014 was $51.4 million, an increase of $6.9 million, or 15.5%, compared to revenue of $44.5 million for the First Half of Fiscal 2013, including an estimated $0.6 million unfavorable impact of currency translation. Both increases were primarily driven by higher beginning backlog and increased order volume. Gross Profit Gross profit in the Second Quarter of Fiscal 2014 was $14.2 million on higher volume, an increase of $1.6 million, or 12.7%, compared to $12.6 million for the Second Quarter of Fiscal 2013. Gross profit as a percentage of revenue was 53.8%, a decrease of 1.0 percentage points from 54.8% for the Second Quarter of Fiscal 2013. Gross profit in the First Half of Fiscal 2014 was $28.1 million on higher volume, an increase of $3.6 million, or 14.7%, compared to $24.5 million for the First Half of Fiscal 2013. Gross profit as a percentage of revenue was 54.8%, a decrease of 0.3 percentage points from 55.1% for the First Half of Fiscal 2013. The lower gross margin rates were driven by significant sales improvement in certain industrial and mobile hydraulic markets that have a lower margin rate. Selling and Marketing Expense Selling and marketing expense in the Second Quarter of Fiscal 2014 was $5.0 million, an increase of $1.0 million, or 25.0%, compared to $4.0 million for the Second Quarter of Fiscal 2013. Selling and marketing expense in the First Half of Fiscal 2014 was $9.9 million, an increase of $1.7 million, or 20.7%, compared to $8.2 million for the First Half of Fiscal 2013. Both increases were 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 for the Second Quarter of Fiscal 2014 was 18.9%, compared to 17.4% for the Second Quarter of Fiscal 2013. Selling and marketing expense as a percentage of revenue for the First Half of Fiscal 2014 was 19.3%, compared to 18.4% for the First Half of Fiscal 2013. General and Administrative Expense General and administrative expense in the Second Quarter of Fiscal 2014 was $2.9 million, a decrease of $0.7 million, or 19.4%, compared to $3.6 million for the Second Quarter of Fiscal 2013. General and administrative expense in the First Half of Fiscal 2014 was $6.1 million, a decrease of $0.3 million, or 4.7%, compared to $6.4 million for the First Half of Fiscal 2013. Both decreases were primarily driven by expenses recognized in the Second Quarter of Fiscal 2013 related to a senior management transition. General and administrative expense as a percentage of revenue for the Second Quarter of Fiscal 2014 was 11.0%, compared to 15.7% for the Second Quarter of Fiscal 2013. General and administrative expense as a percentage of revenue for the First Half of Fiscal 2014 was 11.9%, compared to 14.4% for the First Half of Fiscal 2013. 29



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Research and Development Expense Research and development expense in the Second Quarter of Fiscal 2014 was $1.7 million, an increase of $0.3 million, or 21.4%, compared to $1.4 million for the Second Quarter of Fiscal 2013. Research and development expense in the First Half of Fiscal 2014 was $3.2 million, an increase of $0.6 million, or 23.1%, compared to $2.6 million for the First Half of Fiscal 2013. Both increases were primarily driven by higher compensation and benefits resulting from increased headcount. Research and development expense as a percentage of revenue for the Second Quarter of Fiscal 2014 was 6.4%, compared to 6.1% for the Second Quarter of Fiscal 2013. Research and development expense as a percentage of revenue for the First Half of Fiscal 2014 was 6.2%, compared to 5.8% for the First Half of Fiscal 2013. Income from Operations Income from operations in the Second Quarter of Fiscal 2014 was $4.6 million, an increase of $1.0 million, or 27.8%, compared to income from operations of $3.6 million for the Second Quarter of Fiscal 2013. Income from operations in the First Half of Fiscal 2014 was $8.9 million, an increase of $1.6 million, or 21.9%, compared to income from operations of $7.3 million for the First Half of Fiscal 2013. Both increases were driven by higher gross profit, partially offset by increased operating expenses. Operating income as a percentage of revenue for the Second Quarter of Fiscal 2014 was 17.4%, compared to 15.7% for the Second Quarter of Fiscal 2013. Operating income as a percentage of revenue for the First Half of Fiscal 2014 was 17.3%, compared to 16.4% for the First Half of Fiscal 2013.



Capital Resources and Liquidity

We had cash and cash equivalents of $43.7 million at the end of the Second Quarter of Fiscal 2014. Of this amount, $6.1 million was located in North America, $20.6 million in Europe, and $17.0 million in Asia. Of the $40.4 million of cash located outside of the U.S., approximately $27.1 million is not available for use in the U.S. without the incurrence of U.S. federal and state income tax. 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 our investment policy, we place cash equivalent investments with issuers who have high-quality investment credit ratings. In addition, we limit the amount of investment exposure we have with any particular issuer. Our investment objectives are to preserve principal, maintain liquidity, and achieve the best available return consistent with our primary objectives of safety and liquidity. At the end of the Second Quarter of Fiscal 2014, we held no short-term investments. Total cash and cash equivalents decreased $4.6 million in the First Half of Fiscal 2014, primarily due to purchases of our common stock, investment in property and equipment, dividend payments, and increased working capital requirements, partially offset by earnings and proceeds received from short-term borrowings. Total cash and cash equivalents decreased $33.2 million in the First Half of Fiscal 2013, primarily due to increased working capital requirements, investment in property and equipment, and dividend payments, partially offset by earnings. Cash flows from operating activities provided cash totaling $24.1 million for the First Half of Fiscal 2014, compared to the use of cash totaling $15.5 million for the First Half of Fiscal 2013. Cash provided for the First Half of Fiscal 2014 was primarily due to earnings and $5.0 million increased advanced payments received from customers driven by the mix of orders in the quarter, partially offset by $5.2 million increased accounts and unbilled receivables resulting from general timing of billing and collections, $1.3 million decreased accounts payable resulting from general timing of purchases and payments, and $1.1 million increased inventories to support future revenue. Cash used for the First Half of Fiscal 2013 was primarily due to $29.2 million increased accounts and unbilled receivables resulting from general timing of billing and collections, $7.1 million increased inventories to support future revenue, $4.8 million decreased accounts payable resulting from general timing of purchases and payments, $2.4 million decreased advance payments received from customers driven by the timing of orders, and $3.4 million net employee incentives and related benefit payments. 30



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Cash flows from investing activities required the use of cash totaling $10.5 million for the First Half of Fiscal 2014, compared to the use of cash totaling $14.4 million for the First Half of Fiscal 2013, each of which reflects investment in property and equipment. The decrease was driven by a lower level of investment in various growth and productivity initiatives. Cash flows from financing activities used cash totaling $18.2 million for the First Half of Fiscal 2014, compared to the cash used totaling $1.0 million for the First Half of Fiscal 2013. The cash used for the First Half of Fiscal 2014 was primarily due to the use of $23.3 million to purchase approximately 339,600 shares of our common stock, as well as dividend payments of $9.2 million, partially offset by $10.0 million proceeds from short-term borrowings, and $3.4 million received in connection with stock option exercises. The cash used for the First Half of Fiscal 2013 was primarily due to cash dividend payments totaling $9.6 million, partially offset by $5.0 million proceeds from short-term borrowings, and $3.4 million received in connection with stock option exercises.



Under the terms of our borrowing agreements, we have agreed to certain financial covenants. At the end of the Second Quarter of Fiscal 2014, we were in compliance with the financial terms and conditions of those agreements.

Off-Balance Sheet Arrangements

As of March 29, 2014, we did not have any off-balance sheet arrangements, as such term is defined in rules promulgated by the SEC, that have or are reasonably likely to have a current or future effect on our 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 GAAP, and GAAP requires us to make estimates and assumptions in certain circumstances that affect amounts reported. In preparing these financial statements, we have made our best estimates and judgments of certain amounts, giving due consideration to materiality. We believe that of our 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 us, and as a result, are subject to an inherent degree of uncertainty. For further information see "Summary of Significant Accounting Policies" under Note 1 to the Consolidated Financial Statements, included in Item 8 of our Annual Report on Form 10-K for Fiscal Year 2013. Revenue Recognition: We are 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. We develop cost estimates that include materials, component parts, labor and overhead costs. Detailed cost 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: We maintain a material amount of inventory to support our engineering and manufacturing operations. This inventory is stated at the lower of cost or market. On a regular basis, we review our inventory and identify 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 our products and we do not adjust our manufacturing production accordingly. Impairment of Long-Lived Assets: We review 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 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, we recognize an asset impairment charge against operations. The amount of the impairment loss recorded is the amount by which the carrying value of the impaired asset or asset group exceeds its fair value. 31



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Goodwill: We test 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. We have three reporting units, two of which are assigned goodwill. At March 29, 2014, one reporting unit was assigned $14.9 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 our judgment, including projections of economic conditions and customer demand, revenue and margins, changes in competition, operating costs, and new product introductions. At September 28, 2013, the estimated fair value of the reporting unit assigned $1.6 million of goodwill was substantially in excess of its carrying value, while the estimated fair value of the reporting unit assigned $14.9 million of goodwill exceeded its carrying value by approximately 25%. While we believe the estimates and assumptions used in determining the fair value of our 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 that could result in the recognition of a goodwill impairment charge. Software Development Costs: We incur 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, we compare 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: We are subject to warranty obligations on sales of our products. We record 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 months. Both the experience percentage and the warranty liability are evaluated on an ongoing basis for adequacy. In addition, warranty provisions are also recognized for certain nonrecurring product claims that are individually significant. 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: We record 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. We record a valuation allowance to reduce deferred tax assets to the amount that is believed more likely than not to be realized. We believe 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 our 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 our financial condition and operating results.



Other Matters

Our dividend policy is to maintain a payout ratio that allows dividends to increase with the long-term growth of earnings per share, while sustaining dividends through economic cycles. Our dividend practice is to target over time a payout ratio of approximately 30% of net earnings per share.

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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 2013 Form 10-K. Such important factors include:



We may not achieve our growth plans for the expansion of our business

because our long-term success depends on our ability to expand our 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 changes we are making in our Test segment processes and operating

systems may not deliver the results we require for growth of the business

Our business operations may be affected by government contracting risks

Our business is significantly international in scope, which poses multiple

risks including, but not limited to: currency value fluctuations; difficulty

enforcing agreements and collecting receivables; trade protection measures

and import and export matters; tax rates in certain foreign countries that

exceed those in the U.S. and the imposition of withholding requirements on

foreign earnings; higher danger of terrorist activity; imposition of

tariffs, exchange controls and other restrictions; difficulty in staffing

and managing global operations; and compliance with a variety of foreign

laws and regulations; changes in general economic and political conditions

where we operate, particularly in emerging markets

We may be required to recognize impairment charges for long-lived assets

Volatility in the global economy could adversely affect results

Our business is subject to strong competition

We are subject to risks because we design and manufacture first-of-kind

products

We may experience difficulties obtaining the services of skilled employees

We may fail to protect our intellectual property effectively, or may

infringe upon the intellectual property of others

Our business could be adversely affected by product liability claims and

commercial litigation

We may experience difficulty obtaining materials or components for our

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 our products

is irregular and may not develop as anticipated

Our customers are in cyclical industries and a downturn in those industries

could adversely affect results

We will need to begin disclosing our use of "conflict minerals," which will

impose costs on us and could raise reputational and other risks that could

adversely affect results

Interest rate fluctuations could adversely affect results

The performance of our business and our 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 risks with caution and form your own critical and independent conclusions about the likely effect of these risks 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 Forms 8-K to be filed by the Company in Fiscal 2014. 33



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