Oct 28, 2008
Executives
David Hugley - VP and General Counsel, Secretary James Truchard - President, CEO and Co-Founder Alex Davern - CFO, Sr. VP, Manufacturing and IT Operations John Graff - VP, Marketing and Customer Operations
Analysts
Terence Whalen - Citi Investment Research Antonio Antezano - Macquarie Capital Anthony Luscri - JPMorgan Richard Eastman - Robert W. Baird & Co., Inc.
Ajit Pai - Thomas Weisel Partners David Yuschak - SMH Capital Bruce Harrop - AIM Trimark
Operator
Good day everyone and welcome to the National Instrument Corporation's Third Quarter 2008 Earnings Conference Call. Today's call is being recorded.
You may refer to your press packet for the replay dial-in number and passcode. The replay will be available from 7:00 PM Central Time today and will end at Midnight Central Time on November 4, 2008.
With us today are Dr. James Truchard, President and Chief Executive Officer; Alex 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.
David Hugley - Vice President and General Counsel, Secretary
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 in 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.
James Truchard - President, Chief Executive Officer and Co-Founder
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 industrial 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. In our call today, Alex Davern, our CFO will review our financials; John Graff, our Vice President in Marketing will discuss our business and I will close with a few comments before we open up for your questions.
Alex?
Alex Davern - Chief Financial Officer, Senior Vice President, Manufacturing and IT Operations
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 with operating margins in line with Q3 2007. Net income was $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 for 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 U.S. 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 related 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 and measurement market may have contracted in Q3.
Our ability to grow our business by 17% shows that we are finding new business and taking market share. The success of our sales force in driving large orders in 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 continued growth this quarter of 28% year-over-year and Asia's 11% year-over-year growth was heavily impacted by decline in sales in Japan.
The decline in sales in Japan was driven by a large decline in instrument control sets. Excluding instrument control, we saw continued in Japan in Q3.
As we look at the current economic uncertainty, I think it's useful to review how the evolution of the company over the last five years has significantly improved our ability to perform well during a modern 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.
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 4, something 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, a 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 costs 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 on 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 U.S.
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 towards shorter term investments such as U.S. treasures during 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 30th.
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 1st to shareholders of record on November 10th.
Now I'd 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 preliminarily 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 and to field sales expansion while significantly limiting expense growth in other areas of the company. This will be reflected in a significant slowdown in hiring in areas outside of R&D and 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 the 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 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 U.S. dollar in October, our guidance assumes a $1 million...
excuse me, a $2 million loss on foreign exchange in Q4. This compares with 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 U.S.
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 that GAAP fully diluted earnings per share will be in the range of $0.33 to $0.41 for Q4 with non-GAAP fully diluted earnings per share expected to be in the range of $0.39 to $0.47.
As these are forward-looking statements, 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 an $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 the broad-based industrial economy is very difficult to currently predict, we have decided to hold a business update call on December 4th at 4 PM 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.
John Graff - Vice President, Marketing and Customer Operations
Thank you, Alex. We delivered record revenue in 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 $3800, up 15% from a year ago. Even as large orders continued 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 [ph] 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 and 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 NIWeek conference where we announced several new products.
We saw record attendance at NIWeek this year with over 2500 attendees from 55 countries around the world. Much of the excitement at NIWeek this year was centered on the release of LabVIEW 8.6, which added significant new functionality and IP for multi-core 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 the 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 NIWeek. These devices leverage the same C Series technology as our CompactRIO and CompactDAQ systems and the Wi-Fi capability enables us to sell under into 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 [General Purpose Interface Bus] and LabVIEW customers on to 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 [ph].
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 NIWeek, 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 MIMO 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 offer has booked [ph] 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-based CompactRIO system. At NIWeek, 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 system into their own mechanical packaging. We have already closed several large design wins including a system design by Ventura Aerospace that uses single board CompactRIO to control an onboard fire suppression system for FedEx cargo planes.
Since releasing our first LabVIEW programmable FPGA-based devices five years ago, we have seen tremendous adoption across a broad range of application areas including new areas for NI such as medical device design. In fact, in The Wall Street Journal's 2008 Technology Innovation Awards, two companies highlighted in the medical devices category, OptiMedica and Sanarus Medical are using LabVIEW FPGA within their devices.
Some of you may recall both companies have been highlighted in past NIWeek 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 produced highly differentiated products such as RF modular instruments and CompactRIO 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.
James Truchard - President, Chief Executive Officer and Co-Founder
Thank you, John. I was very pleased with the execution and performance of the company in Q3 and this year in the face of the very weak economic climate.
The significant uncertainty in the global economy in recent months, I would like to take a few minutes to touch on some of the key tenants on which we have founded National Instruments that I believe position us to outperform the industry during this time. From the very early days, when we self-financed the start up of 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 where we are prudent with our spending and our investments. And we have demonstrated that consistently over the years.
We've 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 a company, I was looking to create a job that I will 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 and new business. Many of you will recall that in the face of an 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 delivered this year and believe it positions us well to deal with the current economic climate. Today, we offer a very large and growing portfolio of products.
We have long focused on making sure our offerings cover a range of price points and feature sets that we refer to as good, better, best. This approach ensures that we give customers a scalable set of options to meet their financial and performance requirements while ensuring 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 serves the 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 for delivering a significant value proposition to our customers.
The diversity of our customers and the industries we serve have meant that during times where particular industries or cycles are in a down cycle, we are... there are still areas seeing investment and growth.
A recent example comes from the increased focus on energy and specifically research 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 ageing baby boomer generation has led to surgeon companies looking for ways to quickly design, prototype 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've also heard us talk about very strong growth in new areas like communication test and industrial embedded system. National Instruments is a new player in these areas and we believe our continued success in RF and 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 test 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 a nimbleness to quickly respond to the opportunities presented by the diverse industries and markets we serve and we provide our self on the flexibility to quickly respond and capitalized on those opportunities.
This is why we will continue to focus our investment on our technical field sales source. Our direct and long-term relationships with our customers has also been a significant benefit for National Instruments.
Because of 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 to help them find ways to lower their costs, improve their productivity and help them bring their own innovative products to market quickly.
To lower system cost and higher performance at 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, our employees, our partners, our suppliers and to our shareholders. I want to thank you all the National Instruments employees for their excellent execution in a strong Q3.
We will now take your questions. Question And Answer
Operator
Today's question and answer session will be conducted electronically. [Operator Instructions].
Our first question comes from Terence Whalen with Citi.
Terence Whalen - Citi Investment Research
Hi great. Thank you for taking my question.
Alex Davern - Chief Financial Officer, Senior Vice President, Manufacturing and IT Operations
Hey Terence.
Terence Whalen - Citi Investment Research
Hey Alex. 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?
Alex Davern - Chief Financial Officer, Senior Vice President, Manufacturing and IT Operations
Sure. Well, obviously, we're coming off 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's 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 U.S.
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.
Terence Whalen - Citi Investment Research
Okay. So if I could follow up, could you give us a little bit more resolution in understanding how you've 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 end weaker than they were two weeks ago, for example, so we can help understand what's simply credit induced shock versus a real slowing in the run rate of organic growth? And I apologize for tacking this on.
What's your expectation because this demand slowing has occurred before a lot of capital budgets have been analyzed by companies in the October, November timeframe? How do you anticipate we see capital spending in the first half versus in 4Q?
Thank you.
Alex Davern - Chief Financial Officer, Senior Vice President, Manufacturing and IT Operations
Well, that's a long question, Terence, so let me try to break that out and try to respond. First off, NI obviously I think is uniquely well positioned in the industry to gain market share.
We've seen a situation where we believe it's highly probable in Q3 that the overall T&M market contracted and NI was successfully able to growth its revenue 17%. So I think we've shown very clearly in this timeframe an ability to while not dislocate ourselves completely from the PMI, to be able to grow at a much stronger rate relative to PMI than we have been able to do historically.
And we show that very, very clearly here in the third quarter. When we get specifically into 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 into very recent data, it is getting little difficult for us to predict exactly.
And that's one of the reasons why we're having a call in about 5 weeks time to give an update. Dislocation that's 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've been around 30 years.
It's a slightly unusual event. So we're being cautious as we look at the outlook, we've seen the dramatic fall off in the PMI in September.
We've seen early indications that the Europe PMI is going to fall again in October and we're 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 kind of the lower PMI would not be prudent of us, not to anticipate that will see tougher operating traditions in the fourth quarter. Relative to next year, again we'll see, again we'll believe our business is very, very competitive that we're very well positioned to gain market share.
So I think relative to it appears and I'll be one of if not the best performing company in the industry. We are seeing our expense ratio has obviously come down and expense growth come down heavily in line with our expectations for revenue growth in Q4.
And I think we'll be in a better position on December 4th to give you more clarity into expectations into next year. But now we want to see how this thing settles out but I think in terms of the management team and the operating employees of the company, I'm very proud of our performance against the very tough headwind in Q3 to deliver phenomenal results including both on the top line, 40% growth on operating margin.
And then we're going to be very realistic about the economy and the realistic answer right now is this little disruption makes it difficult for us to predict exactly, so we're going to be cautious. And then as we know more, we'll communicate that in the call in December.
Operator
We'll now take our next question from Antonio Antezano with Macquarie Capital.
Antonio Antezano - Macquarie Capital
Good evening.
Alex Davern - Chief Financial Officer, Senior Vice President, Manufacturing and IT Operations
Hey Antonio.
Antonio Antezano - Macquarie Capital
I just wanted to follow up on the same question regarding the order trend. I think you mentioned that at the end of September, you will 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?
Alex Davern - Chief Financial Officer, Senior Vice President, Manufacturing and IT Operations
Well, obviously, what we're seeing in October Antonio helps us guide and build our expectations that we've built in for Q4. And so that is also coupled with a, as I said...
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, I'd say, four or five weeks.
So what we've seen in October plus that healthy caution is what's building into our guidance for Q4.
Antonio Antezano - Macquarie Capital
That is not that you saw a significant decline in October, you are just more cautious again because of the low visibility in the near term?
Alex Davern - Chief Financial Officer, Senior Vice President, Manufacturing and IT Operations
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 then you have in mind but I would hesitate to use one quarter's run rates as an indication of the quarter.
We got to look not only to what actually happened in October but also how to our best guess relative to the economic metrics, we have in front of us as to how the rest of the quarter may play out and the reality is that's probably more uncertain now with the scale of drop that we have seen in the PMI than we've seen in quite a long time. The drop we saw in the October or September PMI is similar to what we saw in September 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 PMI will recover in the second half of 2009, but the next couple of months are a little bit muddy. And I think it's prudent for us to be cautious in that environment.
Antonio Antezano - Macquarie Capital
Okay. Now in the prior recession, operating margin declined because of of course the downturn, also because of you boosting your R&D.
How should we think about margins next year if we see that such weakness at least during the first half that you just mentioned?
Alex Davern - Chief Financial Officer, Senior Vice President, Manufacturing and IT Operations
Well, 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 impact that really drove the sustained drop in margins in the '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 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're not trying to take any of our expense categories and increase them by 4 percentage points of revenue in this timeframe.
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, over 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 the...
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 a 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 out of '01 because our strategic position is fundamentally different than it was seven years ago. I can tell you I'm very glad that we've made those decisions and took the short-term hit to profit 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.
Operator
We will now take our next question from Mark Moskowitz with JPMorgan.
Anthony Luscri - JPMorgan
Yes, hi, thanks very much. This is Anthony Luscri for Mark.
Alex Davern - Chief Financial Officer, Senior Vice President, Manufacturing and IT Operations
Hey Anthony, how are you?
Anthony Luscri - JPMorgan
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 for tightening expenses beyond I believe you mentioned hiring? How much headroom do you have here?
John Graff - Vice President, Marketing and Customer Operations
Anthony, this is John. So, yes, as we've stated in the call that we continue to be very confident about the strategic effort to double our field sales force by 2010, and we're on track with that.
We think that continues to be a strong driver of the system level business that we referred to you 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 in 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 and system investments. Over the last few years, we're seeing great efficiencies there to help us serve this large customer base, large number of orders.
And so we believe we can drive the innovation and efficiency in the business that lets us turn around and make that strategic investment in field sales. Let me turn it over to Alex.
Alex Davern - Chief Financial Officer, Senior Vice President, Manufacturing and IT Operations
Just a few add-on [ph] 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 early on, our guidance is to have expense growth and revenues growth roughly in line in Q4. As we mentioned in the call and in addition to what John said, we have variable compensation plan that's different now than it was going into the '01 recession.
And now its turned to move much more rapidly up and down relative to revenue growth. And in addition obviously there's been significant strength in the U.S.
dollar relative to a number of currencies in which we have significant cost basis, both in the Euro and the Hungarian, France and other currencies and that will have the benefit of offsetting insignificantly easing the expense flow pressure we've seen in the last three quarters.
Anthony Luscri - JPMorgan
Okay, thank you very much. And than next, last quarter you mentioned a $14 million plus order that was going be recognized over three years and this quarter you are talking about subscription renewals and volume license agreements due to revenue.
What percentage of your revenue comes from what we could consider it to be a reoccurring revenue stream? I'm looking at your differed revenue which increased about $1 million quarter-over-quarter, but I don't know if that gives me a full view point in terms of overall revenues that you derive from something that would be considered an order or a predisposed order agreement?
Alex Davern - Chief Financial Officer, Senior Vice President, Manufacturing and IT Operations
So I will try and translate that into... we have obviously...
backlog, as you are aware, our strategy and 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 that 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're probably talking somewhere in the region of about 15% of revenue that's going to come from the combination of those three things. That can change from quarter-to-quarter obviously.
But it's in that rough ballpark in terms of... or as those play out into the next quarter.
Operator
We will now move on to our next question from Richard Eastman with Robert Baird.
Richard Eastman - Robert W. Baird & Co., Inc.
Hi. Alex, could you...
what was the percentage of sales that was traditional instruments and how much was that down?
Alex Davern - Chief Financial Officer, Senior Vice President, Manufacturing and IT Operations
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's arguable to me certainly looking at the 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 the 5% decline in our instrument control business with the 19% growth in the rest of the business. And that puts us in a really different position again than we were in '01.
Looking at the global PMI et cetera, we are anticipating in our guidance a significant year-over-year decline in instrument control revenues in Q4.
Richard Eastman - Robert W. Baird & Co., Inc.
Good. 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 kind of product categories?
Alex Davern - Chief Financial Officer, Senior Vice President, Manufacturing and IT Operations
So you are asking like PXI, modular instruments relative to the CompactRIO in --
Richard Eastman - Robert W. Baird & Co., Inc.
Well, yes, that's basically it. But if you think of it in terms of applications, did the industrial embedded grow at a faster rate than virtual instrumentation, that product categories?
Alex Davern - Chief Financial Officer, Senior Vice President, Manufacturing and IT Operations
From looking at a product line breakdown, the growth rates are pretty similar. I mean those like we've highlighted I think in a last few calls, those are two areas where we see growth rates that were obviously above the company average.
So these are things that are driving the long-term growth. So we're very pleased with the execution.
Again both these areas 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's the success we're having that kind of reinforces our confidence in that field sales investment.
Operator
We'll now take our next question from Ajit Pai with Thomas Weisel Partners.
Ajit Pai - Thomas Weisel Partners
Yes, good afternoon.
Alex Davern - Chief Financial Officer, Senior Vice President, Manufacturing and IT Operations
How are you?
Ajit Pai - Thomas Weisel Partners
Good. A couple of quick questions.
The first one is about the Asian facility. I think you talked at your Analyst Day about looking at shifting some production to Asia.
So can you give us an update as to whether there has been any progress there, whether the shift in currencies et cetera and the weakening economic environment has helped in your negotiations with governments over there?
Alex Davern - Chief Financial Officer, Senior Vice President, Manufacturing and IT Operations
Well, 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're going to very realistic about the economy; in the long term, we're very optimistic about NI's growth.
So we are continuing under our plans to solidify a decision on a 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 of timing of a production plan coming on line would be sometime in late 2010, and that plan at this stage has not changed.
We will continue to review that as we go forward.
Ajit Pai - Thomas Weisel Partners
Got it. And then just looking at your expenses, the first three quarters of this year, the expenses were slightly above 17% in terms of year-over-year growth.
And you are a company that thinks pretty much on a forward basis like for the long term. So could you give us some indication as to based on what your current plan in terms of ramping up expenses is, the kind of head count addition that you see et cetera that you already have in your plan?
I mean it's subject to change, but where that is in terms of percentage growth for 2009. Not a revenue forecast, just an expense, right now.
Alex Davern - Chief Financial Officer, Senior Vice President, Manufacturing and IT Operations
I don't think I'm prepared at this point of comment on '09, Ajit. I can obviously repeat what we said for Q4.
Year-over-year, perhaps some data that might be useful for you, right now our head count is 5030, that's 5030, which is up about 10% year-over-year. So 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 to 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 line [ph] will bring our expense increase in Q4 we believe down to somewhat of a range between 3 and 6%, significantly below the 18% we have seen for the first nine months.
Now we'll be in a position I think to give you a better idea about '09 when we talk again in December.
Operator
We'll now take our next question from David Yuschak with SMH Capital.
David Yuschak - SMH Capital
Hey, good afternoon guys. As far as the fourth quarter in concerned, you did 40% of your revenue in the third quarter on system sales I think you said, which would be a new high...
all-time high for you. As you look into this fourth quarter, you had indicated that your traditional estimates you expected 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 in your traditional?
I just want to get a sense is that mix, how it... or that revision in estimates shifts more the burden being on traditional versus the systems.
Alex Davern - Chief Financial Officer, Senior Vice President, Manufacturing and IT Operations
Sure. Maybe I can try and answer that Dave.
First off, I think in terms of the reduction in our expectations, the biggest percentage reduction in expectations is definitely coming, as you would I am sure expect, in the any instrument control side of the business. That is the area where traditionally we have been most economically sensitive, its now much smaller percentage of revenue that it used to be.
But we expect that to behave in response to a dramatic drop in the PMI the way it has in the past and 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 expectations. But I think it would be probably naïve 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 are going to have a period of pause here as people recollect and get their plans together.
So we are anticipating that we will see a reduction in the rate of growth in large orders in Q4 and that's built into the guidance that we have issued today. We'll be in a position I think to give you a better update on that in December.
David Yuschak - SMH Capital
But when you mentioned earlier about you order trends through October, does that kind of show that same kind of patterning then of system sales in line with what you just commented or is there something just being a little more cautionary about --
Alex Davern - Chief Financial Officer, Senior Vice President, Manufacturing and IT Operations
Well, I mean certainly what we have experienced here in October is built into that guidance and helps us to make that determination.
David Yuschak - SMH Capital
Okay. Then as far as the December program [ph], because of these uncertain times, I'm just kind of curious, December, having your call on December 4th.
Is there enough in there that's this kind of spooky about the fourth quarter as well or is it more just a, look, we'll just give you more information about how we think things could shape upward'09 relative to more concern about additional weakness in Q4?
Alex Davern - Chief Financial Officer, Senior Vice President, Manufacturing and IT Operations
I mean I think it's the latter. I know that investors in this timeframe are very hungry for information.
We have seen, and 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 and we're very interested to see what happens in the next couple of months in November...
in October and November for PMI. I think a lot of new information is going to come to light perhaps in the next 6 weeks more that we would normally see during a normal quarter, and that's the real reason why we're coming back to the four and also be able to give you much more clarity, we will have completed our budget cycle.
Internally also by that time then we would to able to give some better insight into '09.
Operator
We'll now move on to our next question from Bruce Harrop with AIM Trimark.
Bruce Harrop - AIM Trimark
Hi Alex, how are you?
Alex Davern - Chief Financial Officer, Senior Vice President, Manufacturing and IT Operations
Good and yourself?
Bruce Harrop - AIM Trimark
Fine, thank you. Well I mean it's a little bit of a gloomy environment these days that [ph] aside of other I'm fine.
The... just a couple of quick questions, on the balance sheet there's something long term investments can you remind me what that is?
Alex Davern - Chief Financial Officer, Senior Vice President, Manufacturing and IT Operations
Sure. We have included in that long-term investment category.
We got about... some auction rate securities that we moved to long term it's about $8 million or so back in January we moved those out to long term.
Bruce Harrop - AIM Trimark
Okay are they sort of cash like, can I view them that way?
Alex Davern - Chief Financial Officer, Senior Vice President, Manufacturing and IT Operations
Yes, there has been a lot of questions about that particular designation recently.
Bruce Harrop - AIM Trimark
Okay
Alex Davern - Chief Financial Officer, Senior Vice President, Manufacturing and IT Operations
But certainly you know we view them as potential asset that we may choose to liquidate at some point in the future.
Bruce Harrop - AIM Trimark
Okay, on the cash flow I noticed $16 million inventory build, what was the cause of that?
Alex Davern - Chief Financial Officer, Senior Vice President, Manufacturing and IT Operations
Well obviously the cash flow was a nine month number Bruce.
Bruce Harrop - AIM Trimark
Yes.
Alex Davern - Chief Financial Officer, Senior Vice President, Manufacturing and IT Operations
But that inventory build reflects the increase in the state of the company's business over the last nine months. Obviously we have had close to 17% revenue growth here in 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.
Bruce Harrop - AIM Trimark
Okay. You just don't see a similar number last year, so I guess the growth rate wasn't as high last year is what it comes down to?
Alex Davern - Chief Financial Officer, Senior Vice President, Manufacturing and IT Operations
Right. Our growth rate this year has been significantly higher than last year.
Bruce Harrop - AIM Trimark
Okay. Just a couple of smaller things.
Like 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?
James Truchard - President, Chief Executive Officer and Co-Founder
It depends on the competitor. We cover a pretty broad range in large ATE and more system-oriented test business.
Most of our competitors have a relatively direct sales force in the more transactional business, maybe it's with the more indirect and the industrial space. It's a combination.
Some of our competitors have direct approaches and others have a mix of direct and distributors. Our approach, because the approach we're using with our graphical system 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 area, which we're doing in many times.
We do what we call proof of concept to demonstrate that the technology will work for the customer. This is very labor intensive, at least the first time we do it.
Once it's established, then obviously it's easier as we go into new areas then we'll to show that technology does what is needed for that particular application.
Alex Davern - Chief Financial Officer, Senior Vice President, Manufacturing and IT Operations
But definitely our field sales source is a strategic advantage by giving us access to those customers and opening up new opportunities.
James Truchard - President, Chief Executive Officer and Co-Founder
Exactly.
Operator
That does conclude our Q&A session for today. I would like to turn the call back over to Mr.
Davern.
Alex Davern - Chief Financial Officer, Senior Vice President, Manufacturing and IT Operations
Thank you very much for joining us today. We will be presenting at the Thomas Weisel Partners Conference in Chicago on November 18th and also at the Needham brothers...
Needham Conference in New York on January 7th. Thank you very much.
Operator
That does conclude today's conference. We appreciate your participation and have a great day.
.