3D Systems Corp (DDD) 2006 Q2 法說會逐字稿

Good morning and welcome to the 3D Systems conference call and audio web cast to discuss the Company's operating for the first quarter and the first six months of 2006. My name is Luwanna and I will facilitate the audio portion of today's interactive broadcast. All lines have been placed on mute to prevent any background noise. (OPERATOR INSTRUCTIONS). At this time, I'd like to the call over to Chanda Hughes, Investor Relations for 3D Systems.

Good morning and welcome to 3D Systems' conference call to discuss the Company's operating results for the second quarter and first six months of 2006. I am Chanda Hughes and with me on the call are Abe Reichental, CEO; Fred Jones, our CFO and Bob Grace, our General Counsel. The audio web cast portion of this call contains a slide presentation that we will refer to during the call. Those following along on the phone who wish to access the slide portion of this presentation may do so via the web at www.3dsystems.com. Should you choose to do so, we recommended that you sign in for the interactive teleconference. This will give you the ability to ask questions at the end of the session. For those who have access to the streaming portions of the web cast, please be aware that there is a three-second delay and that you will not be able to ask questions via the web.

Before we begin, I would like to preface our presentation today with a statement regarding forward-looking information. Certain statements made in this presentation that are not statements of historical or current facts are forward-looking statements within meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements may involve known and unknown risks, uncertainties and other factors that may cause the actual results, performance or achievements of the Company to be materially different from historical results or from any future results expressed or implied by such forward-looking statements. In addition to statements which explicitly describe such risks and uncertainties, readers are urged to consider statements in the future tenses or that include the terms believe, belief, expects, estimates, intends, anticipates or plans to be uncertain and forward-looking. Forward-looking statements may include comments as to the Company's beliefs and expectations as to future events and trends affecting its business. Forward-looking statements are based upon management's current expectations concerning future events and trends and are necessarily subject to uncertainties, many of which are outside the control of the Company. The factors stated under the heading forward-looking statements, cautionary statements and risk factors and risk factors in the Company's periodic filings with the Securities and Exchange Commission, as well as other factors could cause actual results to differ materially from those reflected or predicted in forward-looking statements. This call is being recorded and will be available for review until one week from today. The call and presentation can also be accessed via the 3D Systems website under the investor relations section. At this time, I would like to introduce Abe Reichental, CEO.

Good morning everyone and thank you for taking the time to join our web cast this morning. Yesterday afternoon after the markets closed, we reported our operating results for the second quarter and first half of 2006. We were very please that we were able to file our quarterly report on form 10-Q with the SEC within the allotted five-day extension period permitted by its rules.

As we shared with you last Wednesday, the disruptions we experienced during the second quarter made it difficult for us to enter and process customer orders, to procure and manage inventory, schedule orders for production and shipping and invoice finished products to customers. Consequently, we reported $28 million of revenue for the second quarter of '06, a 15% decrease from the revenue we reported for the second of '05. Revenue for the first six months of '06 was $61.5 million, a 3% decrease from revenue reported for the first six months of '05, largely due to our record first quarter revenue in the first quarter of '06.

Also as a result of these business interruptions, we reported that we ended the second quarter with a $9.8 million order backlog. Of this amount, $8.3 million in orders primarily for systems and material were generated and planned for shipment during the second quarter. We are pleased that as of today, the focused corrective action plan that we have implemented enabled us to process and ship the majority of the new orders backlog we had at the end of the second quarter.

Gross profit for the second quarter of '06 declined 43% to $8.1 million in the second quarter of '05 19% to $21.1 million in the first six months of '06 -- I'm sorry -- as a result of our lower second quarter revenue, higher warranty costs and increased extraordinary expenses associated with accommodations as we extended to customers whose orders or repairs were delayed by the ERP system disruptions we encountered. We also encountered supply chain disruptions, resource constraints on our service organization and increased costs incurred to remedy or compensate customers for stability issues with certain equipment installations and a $400,000 charge that we made to cost of sales to reconcile inventory values in our new ERP system to those in our legacy system.

Total operating expenses increased by $3.4 million to $16 million in the second quarter of '06 and by $6.6 million to $30.6 million in the first six months of '06. The second quarter increase in operating expenses was due primarily to a $2.3 million of severance and restructuring costs related to the relocation of our headquarters to Rock Hill, South Carolina which were generally in-line with our previously announced expectations; $0.8 million of higher selling, general and administrative expenses and $0.3 million of higher research and development expenses.

For the first six months of '06, the increase in operating expenses was due to a $3.9 million of severance and restructuring costs which were also generally in-line with our previously announced expectations, and $1.9 million of higher selling, general and administrative expenses and $0.8 million of higher research and development expenses. This year's higher research and development expenses reflect our continued commitment to investing in new product development and specifically projects in connection with our recently announced Symyx agreement and the acceleration of our 3D printing developments. The higher selling, general and administrative expenses in each period resulted mostly from higher consulting expenses primarily related to our ERP and relocation projects, higher bad debt expense and equity compensation expense related to unvested options, partially offset by lower legal expenses.

Our net loss available to common stockholders in the second quarter of '06 was $8.9 million, or $0.56 per diluted share, reversing $0.9 million of net income available to common stockholders, or $0.05 per fully diluted share in the '05 quarter. Our net loss available to common stockholders in the first six months of '06 was $10.2 million, or $0.65 per fully diluted share, compared to $1.6 million of net income available to common stockholders, or $0.10 per fully diluted share in the first six months of '05.

Moving on to slide number 7, during the second quarter, we experienced a number of temporary challenges relating to the ERP implementation, the startup of our recently outsourced logistics and warehousing activities and the relocation of our operations, including the need to hire and train the new employees who are not yet fully experienced with our new ERP system, or quite frankly familiar with our business. Specifically, we started up our new ERP system in the U.S. on May 1st of '06 and in most of Europe in mid-June of '06. While we expect the ERP system to ultimately improve our business processes, efficiency and control environment, following the startup of the system, we encountered disruptions in processing transactions in the system that affected our ability to enter and process customer orders, procure and manage our inventory, schedule orders for production and shipping and invoice finished products to customers.

We also experienced significant disruptions in our supply chain activities that led to shortages of parts and materials, resulting in loss of parts and materials revenue, a consequent loss of service revenue, higher service and expediting costs and the need to compensate customers who were adversely affected by these shortages. These shortages also delayed shipments of finished products which reduced revenue recognized in the second quarter and resulted in an estimated $8.3 million of backlog for new orders placed during the second quarter that we were unable to ship during the quarter.

As a result of the disruptions and adverse effects that we encountered in the second quarter of '06, we identified control deficiencies in our procedures for compiling and reconciling our financial records for the second quarter of '06, and in our procedures for accounting for inventory. We believe that these control deficiencies constitute either individually or in the aggregate a material weakness with respect to those measures. And along those lines, our form 10-Q that we filed yesterday reports on these deficiencies and the actions we are taking to diligently and quickly remediate them.

In the wake of the disruptions that we encountered following the startup of our new ERP system and to remediate the control deficiencies we have identified, we have adopted an immediate corrective action program that includes, amongst other things, correcting all visible ERP system disruptions, completing our remaining global ERP implementation, fine-tuning and improving our outsourced logistics partners' performance inaccuracy, reducing and containing costs from the disruptions, resolving our remaining growth [pain] from increased new systems placements and completing staffing and training to alleviate resource and learning curve constraints. We are pleased to share with you this morning that in the past six weeks, the focused corrective action plan that we have already implemented enabled us to process and ship the majority of the new order backlog we had at the end of the second quarter.

Although there can be no assurance that all of these outstanding orders ultimately will result in sales and revenue from customers, we believe that the backlog and our progress in shipping it suggests first that the demand for our products and services remains strong and that but for the problems we experienced in fulfilling orders, such orders would have contributed to a significantly better second quarter than we experienced; and second, that we're making real progress in correcting the disruptions. We are continuing to aggressively resolve all of the remaining ERP, supply chain, relocation and systems stabilization related issues, and to remedy as promptly as we can the control deficiencies that we identified for the second quarter. We expect to successfully resolve all remaining issues within the next few months and to end 2006 with all of our key initiatives fully implemented and with our controls in effective compliance.

As you can clearly see on slide number nine, we have identified a number of the types of ERP system-related disruptions that we encountered in the second quarter and the control deficiencies that they give rise to, many of which deal with database integrity, date entry, processing speed and training issues. We are working diligently to prioritize and correct all of these issues and we believe that we're making good progress towards complete resolution on all currently identified open items. We have made this our top priority and are confident that we should be able to resolve all of these [non-open] items swiftly and efficiently. While we expect to identify additional items as we become more proficient and efficient in the use of this powerful new ERP system, we expect that we will be in a position to improve our operating effectiveness with the system on a daily basis and we are planning to achieve full functionality by fourth quarter of 2006.

[A] few significant events thus far this year are also worthy of mention this morning. First, regarding our Grand Junction facility. As we previously mentioned, we successfully closed the Grand Junction facility on April 28th and we agreed in July to sell the facility for $7.3 million subject to certain customary conditions. As a result of the closure of the Grand Junction facility, we curtailed depreciation on the facility, which going forward represents a $0.6 million per year reduction in depreciation expense.

Regarding our preferred stock conversion during June, we successfully completed the conversion of 15.3 million of preferred stock to common stock. As a result of this conversion, we incurred a $0.6 million additional dividend cost in the second quarter. And on a going forward basis, we expect to save $1.6 million annually from the elimination of the preferred dividends.

I would also like to spend a few moments on the progress that we're making towards our relocation to Rock Hill, South Carolina. Our interim Rock Hill, South Carolina facility is now in full operation with some 90 employees on the ground filling all the key functions. The remainder of our Valencia personnel are slated to relocate to Rock Hill by the end of this month. And construction on our new headquarters and R&D facility is in its final stages of completion as we are all looking forward to being housed under one roof in this new state of the art facility. During the second quarter consistent with our desire to extend the range of field service capabilities and to deliver to our customers' additional capabilities, we extended our team of field service providers to include Integra and TCST. Specifically, we signed agreements in principal with these two companies that would enable each of them to become a nonexclusive 3D Systems authorized service provider and to deliver, repair and upgrade services in the United States for our selective laser centering and stereo lithography equipment.

At this point, I would like to turn presentation over to Fred Jones, our Chief Financial Officer, for a more in-depth financial review.

Thanks, Abe. Our web cast participants can see on this bar chart the 15% decline year-over-year in revenue reflecting the effects of lower unit volumes arising from the ERP system implementations, outsourcing of our logistics and warehousing and our growth challenges. Because of the disruptions, backlog rose to a record $9.8 million with $8.3 million of that arising during the second quarter from orders we normally would have expected to be able to ship during the quarter. Our ERP system difficulties slowed our order processing following the May 1 implementation in the U.S. and we just could not catch up by quarter end. Unit volume of legacy products continued to decline in the second quarter, but the $1.3 million increase in new product revenues was not enough to overcome that decline. Foreign currency translation had about 0.5% adverse effect on revenue.

On a consolidated basis, the $4.8 million decrease in revenue in the second quarter of 2006 resulted from $4.5 million of lower volume, $0.1 million from the unfavorable combined effect of price and mix and $0.2 million from the unfavorable effect of foreign currency translation. Unit volume declines were most heavily concentrated in systems which witnessed a 35% year-over-year decline. Material sales, which are less complicated to book in our new ERP system and consequently less affected by it, increased by 10%. Services volumes and revenue were down 17% as a result of ERP implementation issues, growth challenges and supply chain interruptions which led to parts shortages that adversely affected parts revenue, time and material billings, installation and training revenue and recognition of warranty revenue from new system sales. For the first six months of 2006, revenue declined 3% compared to the first half of the year. Materials revenue was much less impacted by our issues and challenges and it showed a 13% gain during the first half. Foreign currency translation adversely impacted first-half revenue by $1.5 million, mostly in the first quarter. New product revenue constituted 31% of revenue for the second quarter and 33% for the first half.

By region, U.S. revenue declined by 15% in the second quarter compared to last year's quarter primarily due to lower unit volume as a result of the various disruptions. Revenue from European operations was down 19%, primarily from lower unit volume as ERP system disruptions emanating in the U.S. impacted the supply of units to Europe and secondarily from the combined effect of price and mix. Revenue from Asia-Pacific operations decreased 2% primarily from unfavorable effects of foreign currency translation and lower unit volumes, partially offset by a favorable combined effect of price and mix.

By product category, the second quarter impacts were mixed. Systems and materials revenue benefited from the volume of new products, but those increases were more than offset by declines in the volume of core products and services in all three categories. All categories were also impacted by unfavorable foreign currency effects. Systems revenue experienced an unfavorable price mix effect while materials revenue benefited from a favorable price mix effect. As a result, you can see the proportionately larger share of revenue garnered by the materials business rising to 43% of total revenue in the second quarter.

For the first six months of 2006, revenue from U.S. operations increased by 6%, expanding the U.S. share of global revenue to 51%. The U.S. increase was offset by decreases in both Europe and Asia-Pacific. By product category, geographical proportions of revenue in the first half had the same but less pronounced changes as occurred in the second quarter. Materials revenue approached 40% while both systems and services were in 30% range for the first half.

Although our order processing and order fulfillment were adversely affected in the second quarter, our booking of orders remains strong. Unfulfilled bookings backlog grew by $8.3 million during the second quarter to a record $9.8 million of backlog. We expect to ship all of this backlog during the remainder of this year and we have already shipped a majority of the new backlog thus far this quarter. We believe the size of this backlog underscores the fundamental strength of the underlying demand for our products and services and that our shipment of a large portion of it thus far this quarter shows that we're overcoming the ERP system disruptions that we encountered in the second quarter.

Gross profit margin for the second quarter decreased from $14.3 million in 2005 to $8.1 million in 2006, reducing the gross profit margin from 44% in last year's second quarter to 29% in this year's second quarter. Gross profit margins were unfavorably affected by lower revenue, by the multiple ERP system and logistics disruptions we experienced, by warranty costs associated with our growing pains, by special accommodations extended to certain customers whose orders were delayed by our disruptions or who encountered stability issues with equipment that our service organization was not able to quickly address as a result of resource constraints on our service organization and by a $0.4 million charge to reconcile inventory to physical counts loaded into our ERP system. Service margins were also impacted by strains on service resources related to installation, service and training that resulted in foregone revenue without a commensurate decrease in the service organization's cost space. Service margins were also impacted by lower sales of upgrades for other legacy systems.

As a result of the same factors that affected the second quarter, our consolidated gross profit decreased from $27.4 million in the first half of 2005 to $22.1 million in the first half of 2006. The gross profit margin for products decreased from 48% payment to 41% year-over-year while the gross margin for services declined from 34% to 22%.

On slide 19, the graph on the left illustrates an overall increase in operating expenses in the second quarter from $12.6 million in 2005 to $16.0 million in 2006. As you can see, most of the increase is driven by restructuring costs associated with the relocation of our corporate headquarters to Rock Hill, South Carolina, and higher R&D investments that were made in support of our product development efforts. Because of the combination of a lower revenue base as well as higher costs in this year's second quarter, operating costs as a percentage of revenue increased from 38% in the second quarter of last year to 57% in this year's quarter.

Slide 20 shows some specific items that drive the increases in operating costs. The $0.8 million increase in SG&A expense from the second quarter of last year is primarily the result among other things of four impacts. First, the $0.4 million of ERP implementation costs incurred subsequent to the conversion date that were not capitalized. Secondly, the $0.2 million related to deferred stock option amortization which commenced on January 1 of this year and which will trail off by the end of the next year in the absence of any additional stock option grants which we do not currently plan to issue. Thirdly, 0.4 million of additional bad debt expense compared to last year's second quarter; and lastly, a variety of other expenses, including expenses associated with the disruptions and growth challenges partially offset by $0.3 million of [lower] legal expenses. The $0.3 million in R&D expense year-over-year is equivalent to the expense associated with our new collaboration with Symyx for new materials development. The restructuring cost of $2.3 million consists entirely of costs associated with our corporate headquarters move.

Operating costs increased contracted from $23.9 million in the first half of '05 to $30.6 million in 2006's first half. The driving forces for the SG&A increase are essentially the same as those for the second quarter. The graph on the right-hand side of the screen shows the increase in operating costs as a percentage of revenue from 38% in last year's first half to 50% in the first six months of this year, reflecting higher expenses and a lower revenue base. The net loss available to common shareholders was $8.9 million in the second quarter compared to a $0.9 million profit in last year's quarter. The weighted average number of shares reflects the partial effects of approximately 2.6 million additional common shares issued upon conversion in early June of our Series B preferred stock. Because our stock options and convertible subordinated debentures would be antidilutive, basic and diluted loss per share are equal at $0.56. This compares to basic and diluted earnings per share of $0.06 and $0.05 during last year's second quarter, respectively. For future EPS calculations, you might want to note that as of August 11th, we had 18.3 million of common shares outstanding.

For the first half of 2006, the net loss available to common shareholders was $0.65 per share for both basic and diluted calculations. In last year's first half, we had $0.11 and $0.10 of basic and diluted EPS, respectively. Net cash used in operating activities for the first six months of 2006 was principally driven by our $8.8 million net loss, which was partially offset by $4.6 million of non-cash items. Working capital investments of $4.2 million resulted in net cash used in operating activities of $8.3 million. We invested $4.2 million during the first half primarily for capital expenditures related to information technology systems and our ERP system and for CapEx related to our corporate headquarters relocation project. Cash from financing activities consisted of $2.2 million of proceeds from stock option exercises, partially offset by preferred stock dividends and debt service. Net cash usage of $11.5 million reduced cash balances at June 30 to $12.7 million.

On slide 25, we can see the components of the $11.5 million cash usage during the first half which was strongly influenced by second quarter events. Our increase in inventory investment occurred primarily during the second quarter and is related to our inability to fulfill orders in hand with inventory on hand by June 30. As previously mentioned, over half the new backlog which arose during the second quarter has now been shipped which should lead to a reduction in inventory that should be monetized in due course. Severance and restructuring costs aggregated $3.9 million during the first half. These headquarters relocation costs are expected to be incurred almost entirely within this calendar year so we do not expect them to be recurring costs in future years. Similarly, our investment during the first half in our new ERP system used $3.9 million of cash. These costs should also diminish over the remainder of this year. A portion of the inventory build has been financed with increased accounts payable which should be satisfied with proceeds from the sales of inventory. The accounts receivable have increased in conjunction with the sum of the elongated systems installations. We're working through those system stability issues and achieving customer satisfaction with the minority of systems which experienced startup issues. Resolution of startup issues, together with greater experience by our new credit and collection personnel are expected to bring down our high mid-year DSO in accounts receivable. The remainder of all cash flows during the quarter, including additional costs related to disruption, customer accommodations and increased R&D spending totaled $4.3 million during the first half. Cash flow during the first half included dividends on our preferred stock which have now ended with its conversion to common, saving us $1.6 million per year in dividend payments and we have signed an agreement subject to customary conditions for the sale of our Grand Junction, Colorado facility for $7.3 million. Abe?

Thank you, Fred. We are continuing to [extend and] grow our 3D printing program and product line and I wanted to take a couple of minutes and bring you up to speed on what is happening with this key program. Specifically during the quarter, we extended our reseller network in Europe, we introduced the $14,900 desktop 3D printer, making it the most affordable 3D printer in its class and accessible to a broad audience of engineers, marketers and students worldwide. And we are particularly gratified that we were able to launch during the second quarter the InVision Dental Pro, which helps dental labs transition to the digital age. We also rolled out two new InVision LD material colors -- red and blue -- that give our customers a broader range of capabilities. And we are very encouraged with the overall market reception for the InVision LD, particularly in the untapped educational segment.

Consistent with our belief that the only sure way to achieve and maintain market leadership is through technology leadership, a significant portion of our increased R&D investment during the first half of this year reflects our previously announced plans to launch additional affordable and compact 3D desktop printers before the end of this year.

With regards to our second key growth initiative, rapid manufacturing, we were pleased that during the second quarter and first six months of this year a growing number of our systems were sold into direct and indirect manufacturing operations. We attribute this success to our ability to deliver a more sophisticated and automated manufacturing solution, as well as our success in introducing a steady stream of higher-performance end use engineered material and composites. And notwithstanding our short-term costly growing pain, it is abundantly clear that the combination of larger frame SLA and SLS automated manufacturing platforms and the new materials is delivering significant new benefits to a growing customer base. Specifically, our customers can now produce much larger parts in a single build cycle and these much larger parts are more accurate than has ever been seen before for many [additive] manufacturing systems, which in and of itself opens the doors to numerous direct and indirect manufacturing applications such as tooling, fixturing and more importantly precision casting. Additionally, because of the significant build size envelope increases, both are new from the ground up manufacturing capable systems, the Viper Pro and the Center Station Pro, our customers can now build more products faster, reducing their cost per part and their time to market. And finally, our growing family of high-end engineered materials and composites in combination with our proprietary smart material packaging and delivery system provide our customers with unique flexibility and much higher yields.

Reflecting on some of the key underlying trends of our business, we are pleased with the strength and progression we have experienced in new orders booking through the second quarter. This shows us that our business has a strong potential to generate higher levels of revenue and cash flow. We are equally pleased that temporary erosion we experienced in gross profit margins is not the result of a decline in average selling price. To the contrary, we are heartened by the strengthening and firming of our average selling prices on systems and materials and it is particularly gratifying to us that notwithstanding all of our European supply-chain-driven disruptions, our recurring revenue for material sales continued to growing in the face of significant business, logistics and transactional business interruptions.

The fundamentals and drivers surrounding our cost of goods sold structure also remain unchanged. So going forward, excluding special customer accommodations, freight intensity and increased warranty costs, we expect to be able to return to normalcy in our cost of goods sold. Similarly on a post-ERP and a relocation basis and excluding R&D in which we intend to continue to invest our resources, we expect our SG&A to return to its normal spending level and to realize cash flow benefits as we begin to experience annual savings from the elimination of our preferred stock dividend and the efficiencies of operating from our new Rock Hill, South Carolina facility.

Bottom line is that while implementing our strategic initiatives created temporary business setbacks and disruptions in the second quarter of this year, we are pleased with our revenue booking progressions through the second quarter, and by the same token, we're deeply disappointed that disruptions in delivery and service resulting from our initiatives let down our valuable customers and stockholders. And we continue undeterred to focus on our goals and our efforts to transform our company and the way we do business to establish a strong record of sustained growth and profitability.

While we're continuing to address the issues, growth pains and control deficiencies that caused our temporary disappointments, we believe that we're making consistent progress against our planned business transformation goals and plan to stay the course, recognizing full well that from time to time, we may sacrifice short-term results for longer-term stockholder value. In line with that, we're continuing to focus on several significant growth programs and key initiatives for the balance of this year. Specifically, we obviously plan to complete our planned headquarters consolidation and relocation on schedule and within budget. And as evidenced by our continued increase in R&D investments, we are planning to (indiscernible) additional desktop 3D printers, some prior to the end of this year. And to get ready for this, we are continuing to grow our 3D printer reseller channel globally with recently intensified focus on Europe. Bolstered by our recent successes in growing direct and indirect manufacturing applications, we are targeting an expansion of our activities aimed at creating additional Rapid Manufacturing opportunities. We continue to enhance service effectiveness and profitability and at the same time continuing to prune our portfolio and retire all their legacy systems. And as a result of the remaining transitional issues with UPS, we expect to identify opportunities to further improve our operations and customer experience.

We believe that we're continuing to turn the Company around and place it a solid, long-term sustained profitable growth path and we will continue to leverage our strong fundamentals, which include our leading marketplace position which we continue to strengthen and build further through technology, our experienced team and organization, our clear customer priorities and guiding principles, our stronger financial base and flexibility, our total transform and comprehensive solutions portfolio, our healthy pipeline of additional opportunities which results in a steady stream of new product introductions, our performance improvement initiatives and our continued progress on our two significant growth programs, 3D printing and Rapid Manufacturing; and finally, our fundamental understanding that we're in business to deliver immeasurable value to our customers and stockholders.

We will now open the call to questions. We request that you ask one question at a time and return to the queue, allowing others to participate in the question and answer session.

(OPERATOR INSTRUCTIONS). Eric Martinuzzi, Craig-Hallum.

Good morning. The stability issues that you outlined in your earnings announcement, I was wondering if you could be more specific -- what stability issues and what product lines are most impacted?

The stability issues, Eric, relate to a minority of systems that were in installed in the course of the last few quarters. These are primarily related to selective laser sensoring and stereolithography large frame systems. It is a part of training and learning curve primarily related to the ability of our own engineers to successfully complete installations and startups. And some of it's related to what we consider to be out-of-box related issues with quality and workmanship.

But the stability issues are considered temporary in nature, such that the warranty expense would be expected to go down over time and we don't need to re-jigger our expectations for cost of goods?

No, that is correct. We consider this temporary teething and growing pains, not something that will be baked into the business model on a long-term basis.

Thank you.

Dennis Wassung, Canaccord Adams.

Thank you. There are a few items in the quarter. You talked about the inventory reconciliation charge, I think it was $400,000; you've got the uncapitalized ERP expense and bad debt expense, and also the special customer accommodations. I was just curious what kind of feeling you have in terms of how much of those you're going to see again in Q3. Do you expect them to decline, or is there any way to look at those at this point?

It's hard, Dennis, to predict what we will see in Q3 and in Q4. We certainly identified all these items which we consider to some extent to be special in nature because we don't believe that they belong in our business model on an ongoing basis. We believe that particularly because most of these items emanated from the ERP/relocation initiative that we have, that as we remedy the remaining ERP issues, as we correct the control deficiency issues and as we fully settle in Rock Hill, South Carolina, those are going to go away. We hope and expect that we will have fewer of these items in the third quarter and we hope and expect that we will have even fewer by the fourth quarter. And we certainly indicated this morning that between now and the end of the year, we expect to successfully remedy and resolve all of them so that we can continue going forward without all these disruptions and extra freight that the P&L is carrying at the moment.

Just a quick follow-up on that. The inventory reconciliation charge, do you feel like you've gone through all the inventory and that's mostly out of the way here, or is that kind of something ongoing? And also, on the customer accommodations, did you quantify that? Is there any way to look at that from a quantitative perspective here? And what special accommodations did you have to make?

I will answer the part about the accommodations and I will let Fred explain in more detail what we did with regards to inventory. On the accommodations, Dennis, it could be as simple as us not having spare parts to ship to a customer who is down and then providing that customer with either free parts or some other [sweetener] -- one free visit of service call or some free material. Those would be the nature of the accommodations that we have to make in essence to acknowledge that we were unable to respond to a particular customer need in a timely fashion. And to a large extent, our inability to respond emanated from either ERP or supply chain disruptions. So that is the nature of that we had to do. We firmly believe that in times like this, you do what you need to do to acknowledge the pain that you inflicted on a customer and to keep the customer relationship. The customer comes first and when the system has glitches or when the system is stopped, you still go out and you take care of the customer. And that's the nature of the accommodation that we make. Obviously, as our system regains functionality, the needs to offer this accommodation goes away. With regards to the inventory, Fred, why don't you explain what we did and share with the audience your confidence level on a going forward basis.

Okay. We wanted to make sure we got the inventory at the correct level, so we started from a physical count basis, rather than historic book value. And in June, mid-June, late June, we recounted the major inventory amounts. They went through a rigorous reconciliation process, identified some adjustments that we needed to make to make sure that our records were complete. And when we had finished that process, we still had an unreconciled $0.4 million difference between what we were pretty confident we had and the legacy records. So that was a charge to cost of goods sold specifically to an inventory shrink account. We are going to recount that inventory in a few weeks just to make sure we have it right. But we're confident now through a number of different approaches to confirming the completeness of the transactions that we have that we have the right number in inventory.

Thank you.

Jay Harris, Goldsmith and Harris.

Abe, when are we likely to get into a free cash flow mode, forgetting for a moment the proceeds that we expect from the sale of Grand Junction?

Well, you know, Jay, that we're not in the business of giving this kind of guidance, and you also heard from Fred all the uses of applications of cash in the second quarter and the first half of this year. And the recognition, Jay, that this year we have undertaken certain significant initiatives that are large consumers of cash on let's say a onetime basis, I think that during several quarters, in the last 10 or 12 quarters when we had so-called normal operating conditions, we demonstrated the ability of this business to generate free cash. And we have a pretty strong conviction that once we get past our current investments and initiatives and we put all of this behind us, excluding the proceeds from the sale of Grand Junction, that this business has the capability to generate free cash. Once we complete the transformation of the business and once we cease to make some of these special investments, the plain fact of the matter, Jay, is that this business desperately needed an ERP system, even as evidenced by the inventory adjustments that we had to the make. This business desperately needed a rejuvenated IT infrastructure and this business needs the consolidation of facilities. Once we get past that, this is not a capital-intensive business. And once you get past the special investments, the business on its own from quarterly revenues should be able to generate free cash.

Do you have enough cash to complete the process?

At the moment, we believe that we're adequately provided for.

Okay. I just -- having dissipated half of your cash in the first six months of the year, I thought it was a reasonable question.

It is, Jay, but you also have to look at what was the impact of the extraordinarily high backlog in the second quarter, you have to look at where the cash is tied up, whether it's in inventories or, receivables. And in looking at everything in the aggregate, knowing what we know today, we believe that we are well provided for. It is a reasonable question, it's a question that everybody should be asking themselves as they manage a business every day.

Thank you.

Bill Gibson, Nollenberger Capital.

I want to zero in on the backlog that you've already mostly shipped. Does that serve as a onetime spike to third quarter revenue, or just with the ongoing solving of the ERP issues, does third quarter sort of normalize out where it would have been otherwise?

No. This is one of those questions, Bill, that we are asking ourselves every day as we get the flywheel of ERP to build more (indiscernible). If you imagine this ERP thing as a great big flywheel that the organization is tugging on every day and it builds momentum, the question is -- at what point in time do we not only catch up to be able to process what we have already booked, but in addition, begin to benefit from the automation of ERP to also go through the digestion of everything that we're booking in the third quarter. Under ideal conditions, our plan would be to ship everything that we booked in the second quarter and everything that we book in the third quarter during the third quarter so that we will take this spike and return to normalcy. And if we succeed in doing that, which we have no guarantee today that we will, but if we succeed in that, then that would also tell us and tell you that we will have successfully remedied all of our remaining ERP problems within the third quarter. If for some reason we continue to encounter some residual glitches and challenges, then some of it is likely and may spill into the fourth quarter. Our plan is to remedy these issues as soon as possible, to try and get back into booking and shipping within a given reporting period, and to the extent possible, take the spike in the third quarter and move on to normal conditions in the fourth quarter. And time will tell if we succeed or if we miss it by a few weeks.

Thanks.

Troy Jensen, Piper Jaffray.

Can you give us some insight into your decision to outsource services with Integra and TCST? And would you expect service revenues to decline going because of this relationship?

The reason that we decided to do it is because we would like to give customers choices. We like to expand our own capabilities and to use our own trained field engineers to take care of newer systems that we are launching into the marketplace, and to use some of these original service organizations in essence to augment and complement our own capabilities. What it also does for us is, we now get them to provide better service. We make them authorized providers. They're like a reseller, if you will, of service, which means they will now as part of this deal buy their parts from us. They will now pay us certain fees for this authorized status. And I don't think that it will reduce our revenues. To the contrary, we believe that it will provide a supplemental revenue stream from spare parts, which in the past they did not buy from us. And it will give us a stream of, if you will, training and use fees from these guys, and it gives us the opportunity to put more of the United States in front of the customer to provide a standard level of service across the board and to offload some of our own spikes in demand for field services to these companies.

Good luck.

Phil Goldsmith, Goldsmith and Harris.

Good morning. Just to follow up on Jay's question, when do you expect to close the sale of the Grand Junction facility?

I believe that the contract gives a lead time to the buyer that takes them into just about year-end.

Okay. Will that amount, the 7.3 million, largely finance the move to Rock Hill? Or, what percentage do you expect will be?

By the time that this transaction goes through, we hope to be fully in Rock Hill and will have financed the move to Rock Hill out of operating expenses throughout the year. I think Fred mentioned a number in the range of 3.9 million that we already spent on the project for the first half of 2006. Remember that the Rock Hill facility is a leased facility. We are not (indiscernible) and so we will have an annual lease on it, lease payments. And the profits from what we get from Grand Junction will probably go into our cash balances.

Okay, so you will not use up that full amount in terms of the move to Rock Hill, is that correct?

We don't have -- our plan to Rock Hill was not hinged on our ability to sell the Grand Junction facility.

Okay. In past quarters, the cash coming into the business, a large percentage of that was option exercise, which obviously is coming to an end, we hope. So on an operating basis going forward, I would assume that you factor in healthy excess cash flow?

I think Phil that I've already answered this for Jay and it sounds to me like you're asking the same question differently.

Okay, well we're concerned about that amount and hopefully it will start to go the other way.

Phil, I might just add that the proceeds from the sale will be used first to pay off the industrial revenue bonds that -- for which -- that are secured by that facility. That is in our current liabilities now, the 3.6 million, but the sale will also free up 1.2 million of restricted cash as well.

Okay, that's fine. Thank you very much.

Michael McCormick, Gilder Gagnon.

Good morning. I was wondering if you could just make some kind of commentary on booking trends as your customers may become frustrated with your service issues, your warranty issues and so forth in the third quarter and as you see visibility to the fourth quarter. In addition, your time line of corrective actions effectively puts you that you would be in normalcy by the end of the fourth quarter. So should we expect your balance sheet, you know, working capital type of issues that you've been having to be normalized by the end of the fourth quarter as well?

Let me first comment on your first question, which had to do with booking trends. We have said for quite some time that in the ordinary course of business, this is not backlog kind of a business. And so when we generate a great deal of backlog, we examine it and ask ourselves why. And in this case, I think we know the answer and we explained the answer. Do we expect to maybe lose orders as the result of customer frustration? There is always that risk in any kind of a business. I would have to say that thus far in the last three or four months, we did not have any material cancellations that would have amounted to a material amount for us to be concerned about. We have stayed very close our customers and we have done our level best to validate their feelings and concerns, and at the same time, to get them what they needed just as soon as we could. And with regards to the corrective action time line, clearly, to the extent that we are successful in the here and now execution in the next few months, we will also be able to return our balance sheet and our working capital to the normalcy that we enjoyed prior to these disruptions.

Thanks.

Dennis Wassung, Canaccord Adams.

Thanks. Just a quick one. You've been talking about Rapid Manufacturing over the last several quarters on the calls in terms of an increasing percentage of your systems booked and going into those types of applications. Can you quantify that for us? I think over the last couple of quarters, it has been in the half, maybe 50%, 60%range -- any quantification there?

It continues to be in that range. It's more than half of the system. It's going into very interesting applications, it's going more into automotive preproduction applications, it's going into unmanned air vehicle limited production, it's going into the making of very large tools and [patterns] for precision castings. There are incredibly interesting applications that are opening up because of the size of parts that we can make now, and also because of the incredible accuracy that the new systems are typical of. And we have seen a real groundswell, particularly in automotive-related applications, direct and indirect in all three major markets -- in the United States, in Europe and in Japan. And we have also seen a great deal more interest in aerospace applications, and all of that is kind of creating the pool for more Rapid Manufacturing systems.

Thank you.

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