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2002 Annual Report

To Our Shareholders and Friends

To Our Shareholders and Friends
Throughout our history, NI has delivered long-term value to shareholders. While 2002 was another challenging year for the industrial economy, I believe we executed very well. Our increased R&D investments paid off with many exciting and successful new products. We effectively managed our expenses, delivered solid profitability, generated strong cash flow from operations, and delivered the 25th year of growth in the company's 26-year history.

Our Mission
Our mission is to create innovative computer-based products that improve everyday life by improving technology. Our customers are scientists, engineers, and technology professionals in a range of industries, who use our measurement and automation tools to research, design, build, test, automate, and improve a wide array of products and services. With our innovative software and hardware tools, we give our customers a better solution for measuring and automating the world around them. Our strategy is to innovate, constantly improve, and deliver a steady stream of new products that provide higher value to our customers and increase our business opportunities.

Our vision is to revolutionize the measurement and automation industry through virtual instrumentation, an innovative approach NI pioneered and continues to lead. With virtual instrumentation, we leverage off-the-shelf, mainstream computer technologies and add our own innovative modular hardware and software products, such as our flagship LabVIEW product family, to create powerful computer-based instrumentation solutions. Our approach empowers customers to easily build solutions that are open, flexible, and user-defined, rather than rely on closed, fixed-function, vendor-defined traditional instrumentation. With virtual instrumentation, our customers can save time and money and achieve higher performance solutions.

Our Results
Our sales for 2002 were $391 million, up $6 million from the $385 million in revenue we saw in 2001. I am pleased with our performance, especially with our execution in new product R&D and expense management. We delivered solid profitability in each quarter and for the year, and our performance relative to our competitors shows that we gained market share.

The diversity of our business - across geographies, industries, customers, and applications - is a key factor in our long track record of success. In 2002, we sold products to more than 25,000 different companies in more than 80 countries around the world, and no single industry accounted for more than 10 percent of our total revenue.

Throughout 2002, broad-based metrics such as U.S. industrial production and the Institute of Supply Management's Purchasing Managers Index indicated that the U.S. industrial economy was no longer deteriorating as rapidly as it did in 2001. However, it also showed the economy was not yet improving significantly. While our revenue in the first half of 2002 was down year-over-year, the success of our many new products drove 13 percent year-over-year growth in the second half of the year. We believe this shows that even in a stagnant industrial economy, our increased investment in R&D has begun to pay off. In 2002, our business returned to the seasonal pattern we have historically seen, with the exception of 2001. Revenues for the first three quarters were relatively flat sequentially, with Q4 increasing a solid 11 percent sequentially over Q3.

Our Product Mix
When our company was founded 26 years ago, we started by building a leadership position in instrument control products (GPIB and VXI) that allow computers to control traditional instruments made by other vendors. Today, these instrument control products have established a mature market position and their sales generally correlate to the number of traditional instruments sold by other vendors. In 2001, sales from traditional instrument suppliers plummeted with the economic downturn, and sales of our instrument control products followed suit.

In 2002, sales of our instrument control products continued dropping on a year-over-year basis in the first half of the year and then were basically flat sequentially throughout the second half of 2002 - reflecting the somewhat stabilized but continued soft demand for traditional instruments from other vendors. In 2002, our instrument control products represented about 19 percent of our overall revenue, down from 27 percent of revenue in 2000 and 35 percent of revenue in 1997.

The majority of our business today is from our newer computer-based virtual instrumentation product platforms, including our LabVIEW, LabVIEW Real-Time, DIAdem, and TestStand software products, as well as our PXI modular instrumentation, FieldPoint distributed data collection, and machine vision products. Sales of these virtual instrumentation products, which represent a lower-cost alternative to traditional solutions, increased from 73 percent of our overall revenue in 2000 to more than 80 percent of our revenue in 2002, and they delivered solid growth in 2002.

Our New Products
Throughout our history, a key to our success has been the regular introduction of innovative new products which strengthen our core business, while at the same time expanding our market opportunities. In 2001 and 2002, as many companies reduced investments in response to the weak industrial economy, we continued to increase our investment in new product R&D.

This investment paid off with many exciting new products that helped drive our double-digit growth in the second half of 2002. Our new PXI-based 61/2-Digit FlexDMM instrument increased our measurement accuracy by a factor of 10, and our PXI-based RF Signal Analyzer increased the frequencies we can measure by a factor of almost 30 - from 100 MHz up to 2.7 GHz. These products both feature revolutionary architectures that deliver dramatic performance and cost advantages compared to traditional approaches. They expand our served available market, and both received strong positive reaction from trade press and industry experts around the world. Most importantly, our customer's success with these products helped drive continued strong growth and record sales for our PXI platform in 2002.

In Q4 we introduced a major enhancement to our fast-growing FieldPoint distributed data collection platform with our Compact FieldPoint family of more than 20 new products. Compact FieldPoint gives our customers an even smaller, more rugged platform that further extends the reach of LabVIEW into extremely harsh industrial environments on factory floors, within industrial machines, and in remote locations. This expands the number of industrial applications we can pursue, and positive customer reaction resulted in record sales and strong growth in FieldPoint sales in Q4.

In late 2002 we shipped the first version of our new LabVIEW FPGA Pioneer System. Building on the tremendous success of LabVIEW Real-Time, LabVIEW FPGA is an ambitious new initiative that empowers customers to compile and embed their LabVIEW applications directly inside FPGA chips by using our revolutionary new architecture for reconfigurable I/O hardware. Executing LabVIEW programs directly in silicon increases I/O performance and allows us to target a much broader range of embedded and distributed applications. Though we are just getting started, we are very pleased that early LabVIEW FPGA users have easily implemented systems that are very difficult to create with traditional tools.

Our New Opportunities
Many of our latest product introductions give us a strong technology advantage that has increased our success in penetrating key new application areas. For example, we saw strong growth throughout 2002 in sales of PXI and FieldPoint systems for real-time, embedded, and distributed industrial applications, especially in the military, aerospace, and automotive industries. We also had continued success with PXI penetrating high volume consumer electronics manufacturing applications. With our new LabVIEW FPGA Pioneer Program, lead customers in military, aerospace, automotive, and other industries are already building ultrahigh-performance solutions that go far beyond the capabilities of our previous products. We also made significant progress in extending the use of our flagship LabVIEW software platform throughout the design chain, through initiatives such as integrating LabVIEW with DSP system design tools from Texas Instruments and embedding LabVIEW directly inside new oscilloscopes from Tektronix.

In Q4 of 2002, we increased our sales and marketing investments almost 20 percent from Q2 to aggressively launch and promote our new products, and we are excited about our success. I am very pleased with the execution in our sales and marketing organizations, especially in driving strong initial sales of our new products. With the significant increase in our number of R&D engineers over the last two years, we have many more exciting new products in the pipeline for 2003 and beyond.

Our Finances
Our employees did an outstanding job managing expenses and executing on strategic investments in 2002. For the year, our selling, general, and administrative expenses were flat, while our R&D investment was up five percent. This left our total expenses up four percent compared to 2001. At the same time, we maintained our strategy of focusing investment in R&D and our sales channel, ending 2002 with 1,360 engineers, up 27 percent from December 2000. Total headcount on December 31, 2002 was 3,008, up six percent from 2001 and up 20 percent, or approximately 500 people, from the end of 2000. This demonstrates our continued commitment to funding sustained company growth.

In 2002 we saw a large variation in our patent litigation expenses compared to 2001. In 2001 we recorded a $1.2 million gain from the settlement of a case, and in 2002 we incurred a $4.7 million expense related to our patent suit against The MathWorks, Inc. This resulted in a $5.9 million increase in litigation expenses. Excluding this swing, our full year operating expense growth would have been only 1.6 percent.

Our suit against The MathWorks was successful. The jury upheld the validity of our LabVIEW patents, found that certain products from The MathWorks infringed on our patents, and awarded us $3.5 million in damages. This victory demonstrates our commitment to and success in protecting our intellectual property. At the end of 2002, we had a total of 186 issued patents and 230 applications pending.

For 2002 we had $49 million in cash flow from operations. Our capital expenditures for the year were $31 million, down significantly from the $65 million we spent in 2001. We completed our 379,000 square-foot R&D headquarters on our Austin campus and successfully ramped up production at our Hungarian manufacturing facility. We expect our capital expenditures to decline significantly in 2003 and are currently budgeting approximately $18 million. Our 32 percent effective tax rate in 2001 was reduced to 28 percent in 2002, and we expect further reduction to 26 percent in 2003.

Our Culture
I am very proud that for the fourth consecutive year, FORTUNE magazine named NI among its 100 Best Companies to Work For. Keeping NI an innovative, rewarding, and fun place to work is a commitment we take very seriously, and we met the challenge again in 2002 by keeping our focus on the success of our employees and our customers. I want to personally thank all of our employees for their dedication and contribution to National Instruments success, and I am honored to know that they continue to enjoy working here as much as I do. I would also like to thank our Board of Directors for their guidance in building our visionary company.

Our Future
I congratulate and thank our customers, shareholders, employees, and suppliers for their support during 2002. While the economy has made the past two years very challenging, the strong profitability of our business model enabled us to substantially increase our investments in R&D, as well as strategic sales and marketing initiatives, and I believe those investments have begun to pay off.

In 2002 we completed our world-class manufacturing facility in Hungary, built our new R&D center, bringing 2,000 Austin employees together on one corporate campus, delivered record-breaking success at NIWeek, and released ground-breaking new products that significantly expand the boundaries of virtual instrumentation and our future opportunities. Our execution on new products and new opportunities enabled us to return National Instruments to double-digit growth in the second half of 2002 despite the stagnant economy.

As we enter 2003, our primary challenge is to continue to increase our growth rate. We are excited about the success of our latest products, and we are determined to build on that success going forward. We will continue to invest aggressively, expand our market opportunities, and execute on our core vision for virtual instrumentation. We are determined to continue to innovate, execute effectively, and deliver long-term value to our shareholders.

Dr. James Truchard,

President, CEO, and Chairman