National Instruments Corp (NATI) 2008 Q3 法說會逐字稿

Good day, everyone. Welcome to the National Instruments Corporation third quarter earnings conference call. Today's call is being recorded. (OPERATOR INSTRUCTIONS). With us today are Dr. James Truchard, President and Chief Executive Officer, Alex (Name on Company website is listed as Alex. Most participants are pronouncing it as Alec) Davern, Chief Financial Officer, and John Graff, Vice President of Marketing. For opening remarks, I would now like to turn the call over to Mr. David Hugley, Corporate Counsel. Please go ahead sir.

Good afternoon. During the course of this conference call we shall make forward-looking statements regarding the future financial performance of the Company, including statements regarding the following -- our expected revenue, expected revenue growth, expected effective tax rate, expected earnings per share, expenses and expense growth outside of R&D and our sales force, exchange rate impact on our expenses, expected cash flow from operating activities, benefits from sales force expansion, gaining market share, and performance in spite of adverse changes in the global PMI.

We wish to caution you that such statements are just predictions, and actual events or results may differ materially. We refer you to the documents the Company files regularly with the Securities and Exchange Commission, including the Company's annual report on Form 10-K for the year ended December 31, 2007 and our quarterly report on Form 10-Q filed August 4, 2008. These documents contain and identify important factors that could cause our actual results to differ materially from those contained in our forward-looking statements. With that, I will now turn it over to the president and CEO of National Instruments Corporation, Dr. James Truchard.

Thank you, David. Good afternoon, and thank you for joining us. Our key points for Q3 are 17% year-over-year revenue growth, record sales of PXI, Modular Instruments, CompactRIO, Machine Vision and Motion Control, and continued strong growth in large system level orders. I was pleased with our performance in Q3, as we delivered record revenue and 17% revenue growth in spite of significant weakening in the global investor environment. Our results during this period are a testament to the strength of our business model, and we believe that the continued growth of large system sales validates our increased investments in research and development and our focus now to invest in our field sales force.

On our call today, Alex Davern, our CFO, will review our financials. John Graff, our Vice President of Marketing, will discuss our business, and I will close with a few comments before we open up for your questions. Alex?

Good afternoon. Today we reported record quarterly revenue of $215 million, above the midpoint of our guidance and a 17% increase over Q3, 2007. Both GAAP and non-GAAP operating income were up 14% year-over-year, but operating margins in line with Q3, 2007. Net income is $23.2 million, up 7.5% year-over-year, with GAAP fully diluted earnings per share of $0.29. Non-GAAP net income was $27.7 million, a 7.4% year-over-year increase with fully diluted earnings per share of $0.35, at the midpoint of our guidance. Reconciliations of the Company's GAAP and non-GAAP results are included as part of the news release. Included in both GAAP and non-GAAP earnings to Q3, is a net loss on foreign exchange of $3 million or $0.03 per share, as a result of the significant strengthening of the US dollar in Q3. This compares with a gain of $100,000 in Q3 last year. We did not anticipate this loss when giving guidance in July.

Now looking at our revenue performance in more detail, our continued strong double-digit growth was driven by the success of our system level orders, and by record revenue in the areas of Modular Instruments, PXI, CompactRIO, Machine Vision and Motion Control.. You can see from slide number 5 of the presentation which accompanies this webcast, that our performance relative to the global PMI has been steadily improving over the last eight quarters, and this continued in Q3. Given the very weak September PMI data and the 5% year-over-year decline we saw in our Instrument Control business during Q3, we believe that the overall test of measurement market may have contracted in Q3. Our ability to grow our business by 17% showed that we are finding new business and taking market share. The success of our sales force in driving large orders and new application areas has been the key to this growth, and validates our strategy of investment in R&D and field sales. We believe we are very well-positioned to capture market share, and we are committed to our goal of doubling the field sales force between the start of this year and the end of 2010.

During Q3 we saw growth in all regions. We are pleased to see improved growth in the Americas in Q3, with a 12% increase in revenue. Europe saw a continued growth this quarter of 28% year-over-year, and Asia's 11% year-over-year growth was heavily impacted by a decline in sales in Japan. The decline of sales in Japan was driven by a large decline in instrument control sales. Excluding instrument control, we saw continued growth in Japan in Q3.

As we look at the current economic uncertainty, I think it is useful to review how the evolution of the Company over the last five years has significantly improved our ability to perform well during a moderate industrial slowdown. The core of our strategy has been to expand the percentage of our revenue coming from large application areas that are new to NI, but which heavily leverage our technology and our competitive position. The intent of this strategy is for NI to be able to grow through moderate industrial slowdowns, preserving our investments and to then accelerate our revenue growth when the industrial economy recovers. Among the major changes over the last five years, are that our relative exposure to instrument control is now less than half of what it was in 2003.

The percentage of our revenue coming from the key growth areas of Modular Instruments, PXI and Distributed I/O has more than tripled. The percentage of our revenue coming from emerging economies has almost tripled. And the number of our employees in emerging countries has increased by a factor of four, helping to significantly lower our cost base. This strategy has worked very well through Q3, and the changes have shown through in our performance. While the last five years have not been easy for our target markets, NI has more than doubled its quarterly revenue, a five-year, compound annual growth rate of 15.5%. Additionally, we have increased our quarterly non-GAAP diluted earnings per share by 250% during that same time, five-year compound annual growth rate of 29%. We believe that our sales force expansion will reinforce this strategy.

Now, looking at some detail on elements of our income statement. Software development cost capitalized in Q3 2008 was $1.1 million, down from $1.7 million in Q3 last year. Capitalized software costs amortized was $2.9 million in Q3 2008, up from $2.2 million in Q3 last year. Going into some more detail on the net loss of foreign exchange mentioned earlier, this loss is related to the unhedged portion of our foreign currency denominated assets. This line item is unusually large this quarter as a result of the dramatic strengthening of the US dollar against some of NI's key currencies in Q3. The loss is primarily related to our foreign currency denominated receivables. We did not anticipate this loss when giving guidance in July. On another note, our interest income for the quarter was $1.4 million, down from $2.6 million in Q3 last year. This is due to the decline in interest rates over the last year, and to our movement toward shorter term investments such as US Treasuries in Q3.

Now turning to the balance sheet. As of September, 30, 2008, the Company had $276 million of cash and short-term investments, up $28 million from June 30. This cash position is net of $9 million that the Company paid in dividends during Q3. In addition, the Board of Directors approved a quarterly cash dividend of $0.11 per common share, payable December 1 to shareholders of record on November 10. 10th. Now I would like to make some forward-looking statements concerning our expectations. In July, our guidance was based on an assumption that the global PMI remained weak and had modest sequential declines in Q3 and Q4 before recovering in 2009. While we were directionally correct, the scale of the recent decline in the global PMI in September was significantly greater than we had anticipated.

In addition, the preliminary PMI for the Euro zone points to a further decline in October. As a result, the short-term economic outlook is very difficult to predict. Given this uncertainty, our strategy is to be very realistic about the economy, but to continue to drive market share gains. We will manage our expenses carefully by focusing our investments on R&D in the field sales expansion, while significantly limiting expense growth in other areas of the Company. This will be reflected in the significant slow down in hiring in areas outside of R&D in the field sales force. While we are very realistic about the economy on one hand, we are very optimistic about NI's long-term future on the other. With that in mind, the following items are driving our guidance.

On negative side -- Number one, we are assuming that the quarterly average of the global PMI will decline meaningfully in Q4 before recovering in the second half of 2009. Number two, we are reflecting the dramatic weakening of the global PMI in September by reducing our revenue guidance, led by a significant reduction in expectations for our Instrument Control business. Number three, given the continued surge of the US dollar in October, our guidance assumes a $1 million -- excuse me, a $2 million loss on foreign exchange in Q4. This compares to a $1 million gain in Q4 last year. On the positive side -- Number One, the 26% year-over-year growth in our field sales head count, combined with new products will help us continue to gain market share as we go forward. Number two, the dramatic strengthening of the dollar in recent months will have a significant impact on reducing our operating expenses in Q4. Number three, the reduction in our revenue guidance will also have the impact of reducing our variable compensation expense in Q4. This element of our compensation package is designed to respond rapidly to any change in revenue growth.

We estimate that the impact of today's exchange rates combined with the expected decline in variable compensation will help reduce our total year-over-year non-GAAP expense growth in Q4 to between 3% and 6%. This will be down from the 18% year-over-year growth rate we have seen in the first nine months of the year. This reflects our strategy of limiting the impact of weaker revenue growth on our overall profitability. Number four, we expect a $2 million tax benefit in Q4 as a result of the extension of the US R&D tax credit in October. This tax credit has now been extended for two years, and this also helps reduce our non-GAAP effective tax rate expectations for 2009, to approximately 16%. So in summary, we expect currently -- we currently expect revenue for Q4 to be in the range of $208 million to $222 million. This is equivalent to year-over-year revenue growth of between 2% and 8%. We currently expect the GAAP fully diluted earnings per share will be in the range of $0.33 to $0.41 for Q4, with non-GAAP fully diluted earning per share expected to be in the range of $0.39 to $0.47.

But these are forward-looking statements, and I must caution you that actual revenues and earnings could be negatively affected by numerous factors, such as any decline in the global economy, delays in new product releases, expense overruns, manufacturing inefficiencies, effective tax rates and foreign exchange fluctuations. Also, when comparing our guidance with our GAAP and non-GAAP fully diluted earnings per share in Q4 of last year, of $0.56 and $0.62 respectively, please remember that in Q4 last year, NI recognized a $18.3 million tax credit, which had the impact of increasing our GAAP and non-GAAP EPS by $0.23. Since the future direction of the financial markets is very uncertain, and its impact on a broad-based industrial economy is very difficult to currently predict, we have decided to hold a business update call on December 4 at 4:00 p.m. Central Standard Time.

In summary, Q3 was another record quarter for NI. Achieving the midpoint of our guidance for Q4 would result in 13% year-over-year growth in revenue for the full year, with non-GAAP EPS of $1.42, an outstanding performance given the current macro environment. With that I will turn it over to John Graff, Vice President of Marketing.

Thank you, Alex. We delivered record revenue Q3 in spite of significant weakness in the global industrial economy. Growth in the quarter was driven by very strong execution by our field sales force to close large system level opportunities, resulting in record revenues in the key product areas of PXI, Modular Instruments, CompactRIO, Machine Vision and Motion Control. Despite the global PMI falling in September to its lowest level since the fourth quarter of 2001, orders over $20,000 were up 36% from Q3 last year and accounted for 40% of total revenue. This drove average order size to a new record of approximately $3,800, up 15% from a year ago.

Even as large orders continue to lead our growth, we remain highly diversified across many industries and geographies. In Q3, Europe and Asia accounted for 31% and 24% of sales respectively, and we continued to see success in industries as diverse as advanced physical research, energy production, [Mill Arrow] and communications. The key to our growth in Q3 was success in large application areas that are new to NI, and where we provide disruptive technology that offers significant cost savings over traditional solutions.

Our ability to weather down cycles better than the traditional test measurement market, has been a function of this business diversification and our ability to penetrate and disrupt new and large market opportunities. This diversification, combined with strong growth in new application areas, and success with large system level orders, gives us confidence to continue our investment in our direct sales channel. Our field sales resources are instrumental in identifying, fostering and closing the large system level orders that drove much of our growth in Q3. We are on track with our plan to double the sales force by the end of 2010, and believe that this will provide growth acceleration when the economy recovers. This investment in our field sales organization is also made possible by continued efficiency in our high-volume transactional business.

A key highlight in Q3 was our annual NI Week Conference, where we announced several new products. We saw record attendance at NI Week this year, with over 2,500 attendees from 55 countries around the world. Much of the excitement at NI Week this year was centered on the release of LabVIEW 8.6, which added significant new functionality and IP for multicore and FPGA programming. We were pleased in Q3 with strong software revenue growth that outpaced the rest of the business. Volume license agreements for LabVIEW showed very strong growth in quarter, an indication that we continued to successfully penetrate large, multi-user accounts.

Software subscription revenues and renewal rates also showed strong growth from Q3 last year, signaling that we continue to build loyalty in our customer base. Our data acquisition business in Q3 was again driven by very strong growth of USB data acquisition device revenue. We were also very pleased with strong early sales of Wi-Fi and ethernet data acquisition devices that we released at NI Week. These devices leverage the same C-series technology as our CompactRIO and CompactDAQ systems, and the Wi-Fi capability enables us to sell into new applications where cabling would be difficult or impossible. As mentioned previously, Q3 was a record quarter for PXI and Modular Instruments. As we continue to fill out our product offering with new and higher-performance instruments, we have repeatedly won opportunities that moved our large base of GPIB and LabVIEW customers onto PXI and Modular Instruments. In fact, the growth rate of PXI system revenue has accelerated over the past three years through Q3.

We believe this is a result of the adoption of the platform in even the most mission-critical applications including Mill Arrow. Further evidence of the long- term prospects of PXI was provided by the announcement in September by BAE Systems and Phase Matrix of a 26-gigahertz RF and microwave down-converter on PXI Express for use in both military and commercial applications. At NI week, we announced our new PXI Express 6.6 gigahertz RF Modular Instruments, which extend the capabilities of PXI into new applications such as [WiMax and MIMode] testing that we were previously unable to address. Internal and customer testing of these devices has shown improvements in measurement speed of up to 10X compared to traditional RF instrumentation. This offers both significant reductions in testing time, as well as reduced number of test systems required for a given volume of production units, which makes our PXI RF solution especially attractive during periods of tightening capital spending.

In Q3 we continued to see success in industrial and embedded applications, driven by another quarter of strong growth of our FPGA base CompactRIO systems. At NI Week, we announced a new board-only version of CompactRIO, designed for very high-volume deployments. These systems integrate the Real-Time Processor, FPGA and I/O under a single printed circuit board, enabling machine designers to easily incorporate the CompactRIO systems into their own mechanical packaging.

We have already closed several large design wins, including a system designed by Ventura Aerospace that uses Single-Board CompactRIO to control an on-board fire suppression system for FedEx cargo planes.

In fact, in the Wall Street Journal's 2008 Technology Innovation Awards, two companies highlighted in the medical devices category, [OptiMedica] and [Cenaris] Medical, are using LabVIEW FPGA within their devices. Some of you may recall both companies have been highlighted in the past NI Week keynotes, in 2005 and 2006.

In closing, we were very pleased with another strong quarter of growth, especially in light of the difficult industrial environment. The R&D investments that we have made over the last five years to produce highly differentiated products, such as RF Modular Instruments and Compact RIO, have enabled us to grow rapidly in large application areas where our products are highly differentiated from the incumbent technology.

This has allowed us to grow our business despite adverse changes in the global PMI, and we remain confident that the investments we are now making to grow our field sales channel will allow us to further leverage our success in these new growth areas. With that I will turn it over to Dr. T.

Thank you, John. I was very pleased with the execution in performance of the Company in Q3 and this year in the face of a very weak economic climate. The significant uncertainty in the global economy in recent months -- I'd like to take a few minutes to touch on some of the key tenets on which we founded National Instruments that I believe position us to outperform the industry during this time.

From the very early days, when we self-financed to start up National Instruments, we have always taken a long-term perspective on creating a Company built to last. The discipline brought about by being self-financed created a culture we are prudent with our spending and investments. And we have demonstrated that consistently over the years. We have operated our business around a very consistent business model that has changed little over the years. This has led to a very strong financial position we are in today with no debt, strong cash flow, and a strong cash position.

I have often stated that when we founded the Company, I was looking to create a job that I would enjoy. It quickly became clear that for that to happen, we would have to create a business that delivered steady and consistent growth. Growth provides new opportunities as well as new challenges, both of which are key to building successful careers as well as a successful business. A fundamental driver of long-term sustained growth is new product R&D. Over the last 30 years we have invested aggressively and steadily in research and development, with the output being new products that open up new opportunities of new businesses. Many of you will recall that in the face of the industrial recession of 2001 through 2003, we actually accelerated our investment in research and development. That strategic decision has played a critical role in the strong results we have delivered this year, and I believe it positions us well to deal to deal with the current economic climate.

Today we offer a very large and growing portfolio product. We have long focused on making sure our offerings cover a range of price points and feature sets, that we referred to as Good, Better, Best. This approach insures that we give customers a scalable set of options to meet their financial and performance requirements, which ensuring the long-term customer loyalty that has also been one of the hallmarks of National Instruments. Another important strategy tied to our research and development efforts, is that we have always focused on creating a product platform that is serves a wide and diverse customer base. This approach has forced the level of innovation in our products that, while not always easy to do, has been absolutely critical to delivering a significant value proposition to our customers.

The diversity of our customers in the industries we serve has meant that there are times -- there are times where particular industries or cycles are in the down cycle -- we are -- there are still areas seeing investment and growth. A recent example comes from the increased focus on energy, and specifically the search for new forms of clean energy, National Instruments is well-positioned to capitalize on the opportunities provided by the increased investment that's already happening in those areas. Another example is medical devices, where greater understanding of the human genome, as well as an aging baby boomer generation has led to a surge in companies looking for ways to quickly design prototypes and deploy innovative new medical devices.

During this call you heard some specific examples where National Instruments has helped make this happen. Over the past year you have also heard us talk about a very strong growth in new areas like communication tests and industrial embedded systems. National Instruments is a new play in these areas, and we believe our continued success in -- in industrial embedded, is heavily tied to our own execution, especially in research and development and sales.

Whether we are talking clean energy, medical devices, RF tests or industrial embedded systems, the key point is that the diversity of our business has served as a significant asset for National Instruments, especially in tough economic times. We have long demonstrated the nimbleness to quickly respond to the diverse and industries and markets we serve, and we pride ourselves on the flexibility to quickly respond and capitalize on those opportunities. This is why we will continue to focus our investment on our technical field sales force. Our direct and long-term relationship with our customers has also been a significant benefit or National Instruments. Because of the direct communication between National Instruments and our customers, we are in a position to understand the needs, the challenges and the opportunities that our customers face. In fact, during tough economic climates, we have the opportunity to directly work with our customers and help them find ways to lower their costs, improve their productivity and help them bring their own innovative products to market quickly. The lower system costs and higher performance of the National Instruments platform can be an even greater asset for National Instruments during tough times. There is no doubt that the current global economic situation presents challenges for all businesses, including National Instruments. But I do believe that National Instruments is well-positioned to execute on the opportunities in front of us. I believe that our business model is strong, our investments are wise, and our long-term strategy is sound.

It is times like these that I feel National Instruments has the opportunity to more clearly demonstrate its value to our customers, employees, our partners, our suppliers, and to our shareholders. I want to thank you -- all the National Instruments employees for their excellent execution in the strong Q3. We will now take your questions.

(OPERATOR INSTRUCTIONS). Our first question comes from Terrence Whalen with Citigroup.

Hi. Great. Thank you for taking my question.

Hi, Terrence.

Hey. So the first one here is on the revenue outlook for revenue growth of 2% to 8%. Can you help us understand what the foreign exchange impact of that is?

Sure. Obviously we are coming off of a very strong Q3 here as you can see, with record revenue, 17% revenue growth. And as we look out into Q4, there has been a tremendous amount of disruption and dislocation in the financial markets over the last six weeks, which I'm sure everybody listening to the call is well aware of. As we look out, the main element that is driving the change in our outlook, really relates to the uncertainty around those issues. From an exchange rate point of view, obviously we'll have -- we've seen a significant strengthening of the US dollar during the third quarter as we discussed in the call. But as you're aware, our strategy has always been to adjust pricing periodically to reflect the change in exchange rates. And that would continue going forward.

Okay. So if I could follow up, could you give us a little bit more resolution in understanding how you have encountered softness over the past, say six to eight weeks as the PMI has declined? Have you seen order rates simply fall off in Europe, more than Asia? Have you seen a gradual winding down? And if you could give us any granularity on how things have progressed, specifically in the past six weeks to things -- and weaker than they were two weeks ago for example? So we can help understand what simply credit -induced shock versus a real slowing in the run rate of organic growth. And I apologize for tacking this on. What is your expectation? Because this demand slowing has occurred before. A lot of capital budgets have been analyzed by companies in the October-November time frame. How do you anticipate we see capital spending in the first half versus in 4Q? Thank you.

That's a long question, Terrence. Let me try to break that out and try to respond. First off, and I obviously think it is uniquely well-positioned in the industry to gain market share. We are seeing a situation here where we believe it is highly probable in Q3 that the overall [T&N] market contracted, and NI was successfully able to grow its revenue 17%. So I think we've shown very clearly in this time frame, an ability to -- while not dislocate ourselves completely from the PMI, to be able to grow at a much stronger rate, relative to the PMI we have been able to do historically. And we show that very, very clearly here in the third quarter.

When we get specifically to Q3 in terms of how revenue run rates came through, our quarter was very linear. We did not see any disruption in the normal linear pattern in the third quarter, and we actually -- our order rates finishing September were quite strong. However, as we look at the very recent data, it is a getting a little difficult for us to predict exactly. And that's one of the reasons why we're having a call in about five weeks time to give an update. Dislocation of -- the dislocation that has happened in the last four or five weeks is not something that we have a lot of historical track record with at NI, even though we have been around 30 years. It's a slightly unusual event. So we are being cautious as we look at the outlook. We've seen a dramatic fall-off in the PMI in September. We've seen early indications that the Euro PMI is going to fall again in October, and we are going to be cautious until we can get further clarity as we look out into future periods. But we did not see a fall-off in September. Nonetheless, I think given the scale of this climate in the global PMI, it would not be prudent of us not to anticipate that we will see tougher operating conditions in the fourth quarter.

Relative to next year, again we'll see -- we belief our business is very, very competitive that we are very well positioned so I think relative to our peers, NI will be one of if not the best performing Company in the industry. We are seeing our expense ratios obviously come down, our expense growth come down, heavily in line with our expectations for revenue growth in Q4. And I think we will be in a better position on December 4 to give you more clarity into expectations into next year. For now, we want to see how this thing settles out. But I think in terms of the Management Team and employees of the Company, I am very proud of our performance against a very tough headwind in Q3 to deliver phenomenal results, including both on top line 14% growth in operating margin. And then we are going be very realistic about the economy, and the realistic answer right now is this disruption makes it difficult for us to predict exactly. So, we're going to be cautious, and then as we know more we will communicate that in the call in December.

We will take our next question from Antonio Ampanzano with Macquarie Capital.

Good evening.

Hi, Antonio.

I just wanted to follow up with the same question, regarding the order trend. I think you mentioned that at the end of September, you didn't see a fall-off in order activity. But now we are at the end of October. I was wondering, what do you see in October?

Obviously what we are seeing in October, Antonio, helps us guide and build our expectations that we built in for Q4. And so, that is also coupled with a -- as I said on answer to the last question, a fairly healthy degree of caution relative to the uncertainty that has appeared in the financial markets for the last four or five weeks. So what we have seen in October, plus that healthy caution is what is building into our guidance for Q4.

But it's not that you saw a significant decline in October. You're just more cautious again, because of the low visibility in the near term.

I can answer your question, I guess, this way, that we did not see a significant year-over-year decline in orders in October. If that's the specific question you have in mind. But I would -- I would hesitate to use one quarter's run rates as an indication of the quarter. We've got to look not only to what actually happened in October, but also out to our best guess relative to the economic metrics we have in front of us as to how the rest of the quarter might play out. And the reality is, that's probably more uncertain now with the scale of the drop we've seen in the PMI than we have seen in quite a long time. The drop we saw in the October or September PMI is similar to what we saw in September of 2001. However, we -- that recovered relatively quickly from that PMI number in '01. It remains to be seen exactly how the PMI will behave in the next three months. We do believe that the PMI will recover in the second half of 2009, but the next couple of months are a little bit muddy. And I think it is prudent for us to be cautious in that environment.

Now, in the prior recession, operating margin declined because of the downturn and also because of you boosting your R&D. How should we think about margins next year if we see that such weakness, at least in the first half that you just mentioned?

I guess the best thing I can do is indicate to the guidance we gave on the call. First off, I guess, reflecting back to '01, the biggest impacts that really drove a sustained drop in margins in '01-'02 timeframe, was the strategic decision that Dr. Truchard referred to earlier on in his comments, really to raise R&D from 12% of revenue to 16% and keep it at that sustained level. That's 4% of operating margin commitment to long-term growth. Took a number of years to pay off. And so the situation right now is very,very different. We are not trying to take any of our expense categories and increase them by four percentage points of revenue in this time frame. That's absolutely not our intent. As you see from our guidance and discussion of Q4, we are expecting expense growth rate in Q4 of 3% to 6%, which is very similar to the revenue growth rate of 5% to 8%. So our guidance, obviously for the fourth quarter, is to have expenses growth and revenue growth much more closely in line than we saw in the timeframe of 2001.And that's also reflected -- I think, for those who look to Q4 of how Q4 compares, I would again point to, and I know a number of people may not have realized this in their previous analysis, but point to that $18 million tax credit we had in Q4 last year when evaluating what I would consider to be the relevant way to look at operating performance Q4 over Q4.

I'd also hazard to point out that last year we had a significant increase -- or significant both foreign exchange gain and interest income in q4 of last year. we don't anticipate those same strong levels this year. yet we're still looking for operating margin and operating income growth in the quarter. So i see the situation fundamentally different than in '01, because our strategic position is fundamentally different than it was seven years ago. I can tell you I'm very glad that we made those decisions and took the short-term hit to profits seven years ago. That is going to be a tremendous asset to us in this timeframe. But as I said, we're looking for expense growth and revenue growth in Q4, which are very much in the same ballpark.

We will take our next question from Mark Moskowitz with JPMorgan.

Yes, hi. Thanks very much. This is Anthony [Lesgray] for Mark.

Hey, Anthony, how are you.

Good, how are you? First question. Given that you plan to keep moving forward with your field sales build-out alongside your R&D investments, can you talk about what areas, what levers you have to tighten expenses beyond, I believe you mentioned hiring. How much, how much head room do you have there?

Anthony, this is John. So, yes, as we said in the call, that we continue to be very confident about the strategic effort to double our field sales force by 2010 and we are on track with that. We think that continues to be a strong driver of the system level business that we referred to quite a bit, not just in this quarter but really the last three or four quarters. So that investment, coupled with the R&D investment, we think are the key long-term drivers. In terms of leverage and efficiencies, really in the high volume transactional business, we continue to get leverages out of our marketing organization on G&A and a lot of our operational system investments over the last few years. We are seeing great efficiencies there to help us serve this large customer base, large number of orders. And so we believe we can drive innovation and efficiency in the business that lets us turn around and make that at that strategic investment in field sales. Let me turn it over to Alex.

Just a few other comments. As I said, we are going to be very realistic about the current economy and how it plays out over the next couple of quarters. As I said earlier on, our guidance is to have expense growth and revenue growth roughly in line in Q4. As we mentioned in the call in addition to what John said, we have variable compensation plan that's different now than it was going into the '01 recession. It now is turned to move much more rapidly up and down relative to revenue growth. And in addition, there has been significant strength in the US dollar relative to a number of currencies in which we have significant cost basis, both in the Euro and the Hungarian and other currencies. And that will have the benefit of offsetting and significantly easing the expense growth pressure we've seen in the last three quarters.

Okay. Thank you very much. And then next -- last quarter you mentioned a $14 million-plus order that was going to be recognized over three years, and this quarter you are talking about subscription renewals and volume license agreements for your revenue. What percentage of your revenue comes from what we could consider to be a recurring revenue stream? I'm looking at your deferred revenue, which increased about $1 million quarter-over-quarter, but I don't know if that gives me full viewpoint in terms of overall revenues that you derived from something that would be considered a -- an order or a predisposed order agreement.

I will try and translate that. into -- we have obviously -- Backlog, as you are aware our strategy execution We backlog as you are aware our strategy execution is to ship our products very quickly from the placement of an order by a customer. We typically operate with a couple of days worth of backlog. In addition to that, we do have some scheduled orders, like the $14 million order you mentioned. And that gives us some visibility into the next quarter. But when you look at that combined with renewals, or if you like the amortization or recognition of deferred revenue, you are probably talking somewhere in the region of about 15% of revenue that is going to come from a combination of those three things. Now, that can change from quarter to quarter obviously. But it is in that rough ballpark in terms of -- as those play out into the next quarter. We will now move to our next question from Richard Eastman with Robert Baird.

Alec, what was the percentage of sales that was traditional instruments, and how much was that down?

The instrument control business, Rick, was down 5% year-over-year in Q3, and I believe it was about 8% of revenue or somewhat similar. As we guided, as I talked in the call, I believe that it is arguable to me, certainly you you look at numbers from some of the ATE vendors, that there was a contraction in [T&M] in the third quarter. And I would contrast, I guess to 5% decline in our Instrument Control business with the 19% growth in the rest of the business. That puts us in a really different position, again than we were in '01. Looking at the global PMI etc., we are anticipating in our guidance a significant year-over-year decline in instrument control revenues in Q4.

Okay. All right. And then I was trying to maybe tabulate -- maybe some of the commentary about PXI Modular Instruments, CompactRIO, where you had record sales. But if you were to view that from a virtual instrumentation and an industrial embedded cut, which of those grew better in the quarter? Which of those product categories.

You are asking like PXI I Modular Instruments relative to the Compact RIO?

Yes, that's basically it. If you think of it in terms of applications, the industrial embedded grow at a faster rate than virtual instrumentation -- that product categories?

From -- Looking at a product line break down, the growth rates are pretty similar. Those, like we've highlighted, I think in the last few calms, those are two areas where we see growth rates that are obviously above the Company average. So these are things driving the long-term growth. So we are very pleased with the execution. Again, both of these are very tied to our field sales force because they tend to be larger average order sizes. They're more opportunity driven, longer selling and that process. So again, it is the success we are having that reinforces our confidence in that field sales investment.

We will take our next question from Ajit Pai from Thomas Weisel Partners.

Good afternoon.

How are you?

Good. A couple of quick questions. the first one is about the Asian [production]. I think it got talked about at your Analyst Day, about looking at shifting from production to Asia. So can you give us an update as to whether there has been any progress there, whether the shifting currencies etc. and the weakening economic environment has helped in the negotiations with governments over there?

I assume, Ajit, that you wouldn't expect me to comment on negotiations with the governments, live in public. But beyond that, obviously we are continuing our plans to grow the Company. As Dr. T. said, in the short-term, we are going to be very realistic about the economy. In the long term, we are very optimistic about NI's growth. So we are continuing in our plans to solidify a decision on location for an Asian production facility, and we'll be making that announcement in due course. In terms of its plan, obviously we don't intend really to transition production to Asia. We intend to grow as we grow the business, that that growth will be deployed. The likelihood timing of a production plant coming on line would be late sometime in late 2010. And that plan at this stage has not changed. We will continue to review that as we go forward.

Got it. And then just looking at the expense. The first three quarters of this year, the expenses were slightly above [17% and down abroad]. And you are a Company that thinks pretty much in a forward basis, for the long term. So could you give us an indication as to based on what your current plan in terms of ramping up expenses and if that [contradiction] that you see etc. etc. that you already have in your plan. I mean it is objective change, but where that is in terms of percentage growth for 2009?

Well --

I don't need a forecast. Just an expense right now.

I don't think I am prepared at this point to comment on '09. I can obviously repeat what we said for Q4. Year-over-year ,perhaps some data that might be useful for you. Right now, out head count is 5,030, which is up about 10% year-over-year. So our head count is up about 10% on a 17% increase in revenue as of Q3. As we look into Q4, I guess another data point that might be of interest, is that our field sales head count as of the end of September is up 26%.

So as we look out to Q4, we will continue with our original plan in Q4 for field sales head count additions and R&D positions in engineering. And we are going severely limit the growth in head count in other areas of the business in the fourth quarter. That, with the other kind of variable elements we have to our expense plan, will bring our expense increase in Q4 we believe, down to somewhere in the range between 3% and 6%, significantly below the 18% we've seen for the first nine months. We'll be in a position, I think, to give you a better idea about '09 when we talk again in December.

We will take our next question from David Yuschak from SMH Capital.

Good afternoon, guys. As far as the fourth quarter's concerned, you did 40% of your revenue in the third quarter on system sales, I think you said, which would be a new high for you -- all-time high for you. As look into this fourth quarter, you indicated that your traditional estimate, is you expect it to be down quite a bit. How does this -- what kind of expectations do you have in this fourth quarter guidance then that the system sales can continue to make new percentage of sales highs, even at the expense of a substantial decline on your traditional? I just want to get a sense of that mix, how that revision in estimates shifts more to the burden being on traditional versus the systems.

Sure, maybe I can try and answer that, Dave First off, I think that our -- in terms of the reduction in our expectations, the biggest percentage of reduction in our expectations is definitely coming, as you would, I'm sure, expect, in the instrument control side of the business. That is the area where traditionally we have been most economically sensitive. It's now a much smaller percentage of revenue than it used to be. While we expect that to behave in response to a dramatic drop in the PMI the way it has in the past, it shows a significant year-over-year decline in Q4. And I think that will also be reflected potentially from other players in the industry.

In relation to the rest of our business, we do not see the same kind of significant or dramatic reduction in expectation. But I think it would be probably naive at this point not to expect some moderation in a larger order business in Q4, given our expectation of a significant sequential decline in the global PMI quarterly from Q3 to Q4. And so we think the prudent thing is to expect to see some softening in the large order business in Q4. In response to this economic uncertainty, and I am sure we're going to have a period of pause here, as people re-collect and get their plans together. So we are anticipating that we will see a reduction in the rate of growth of large orders in Q4, and that's built into the guidance that we've issued today.

Now --

We'll be a position I think to give you a better update on that in December.

When you mentioned earlier about your order trends through October, does that kind of show that same kind of pattern then, of system sales in line with what you just commented? Or is there something -- just being a little more cautionary about the rest of the quarter?

Certainly our -- what we have experienced in October is built into that guidance and helps us to make that determination.

Okay. Then as far as the December -- because of these uncertain times I am just kind of curious December -- you're having your call on December 4. Is there enough in there that is kind of spooking you out about the fourth quarter as well, or is it more to just say, look, we'll just give you more information about how we think things will shape up for '09 relative to more concern about additional weakness in Q4?

I think it's the latter. I know that the investors in this timeframe are very hungry for information. We've seen -- certainly, as we came into this call, a decision to bring down our earnings guidance and to adjust our expense ratios to fit that earnings guidance. But it is based on really, a very recent decline in the global PMI in September. We're very interested so see what happens in the next couple of months, in November -- in October and November for the PMI. I think a lot of new information is going to come to light perhaps in the next six weeks, more than we would normally see during a normal quarter. And that's the real reason why we're coming back to the fore. And also to be able to give you much more clarity we will have completed our budget cycle internally, also by that time, and we will be able to give you some better insight into '09.

We'll now move on to our next question from Bruce [Harrop with Aim Trimark.

Hi, Alex. How are you?

Good and yourself?

Fine, thank you. Well, it's a little bit of a gloomy environment these days. But outside of that I am fine. Just a couple of quick questions. On the balance sheet, there's something -- long-term investments. Can you remind me what that is?

Sure. We have included in that long-term investment category, we've got about -- some auction rate securities we moved to long-term. It is about $8 million or so. Back in January we moved those out to long -term.

Okay. So are they sort of cash-like. Can I view them that way?

I guess there has been a lot of question about that particular designation recently. But certainly, we view them as a potential asset that we may choose to liquidate at some point in the future.

On the cash flow, I noticed a $16 million inventory build. What was the cause of that?

Well, the cash flow is a nine-month number, Bruce, but that inventory build reflects the increase in the state of the Company's business over the last nine months. Obviously we've had close to 17% revenue growth the last two quarters. So that build in inventory is roughly in parallel with the build in our revenue growth over the last six months.

Okay. You just don't see a similar number last yea, so I guess the growth rate wasn't as high last year, is what it comes down to?

Our growth rate this year has been significantly higher than last year.

Okay. Just a couple of smaller things. With your increase in the field sales force, just can you remind me -- so you are really covering a great number of your customers with a direct sales force. And my expectation would be many of your competitors are using more of an indirect sales force. Is that correct?

It depends on the competitor. We cover a pretty broad range and in large ATE and more system-oriented test business, most of the competitors have a relatively direct sales force. And the more transactional business, maybe it is -- would be more indirect. In the industrial space, it is a combination. Some of your competitors have direct approaches, and others have a mix of direct and distributors. Our approach, because -- the approach we use with our graphical systems design technology, works very well for us to be able to directly support customers as we go into these new areas as we talked about in the call with a high level of system level support in the sales process of defining how our products can be applied to new areas, which we are doing many times. We do what we call proof of concepts that demonstrate that the technology will work for the customer. This is very labor-intensive, at least the first time we do it. Once it is established and obviously it is easier -- as we go into new areas, we have to show that technology does what it is needed for that particular application.

But definitely our field sales force is a strategic advantage by giving us access to those customers and opening up new opportunities.

Exactly.

And that does conclude our Q&A session for today. I would like to turn the call back over to Mr. Davern.

Thank you for joining us today. We will be presenting at the Thomas Weisel Partners conference in Chicago on November 18, and also at the Needham Brothers -- or Needham conference in New York on January 7. Thank you very much.

That does conclude today's conference. We appreciate your participation, and have a great day.