FARO Technologies Inc (FARO) 2011 Q2 法說會逐字稿

Good morning, everyone and welcome to FARO Technologies' conference call in conjunction with its second-quarter 2011 earnings release. At this time, all participants are in a listen-only mode, but we will have an opportunity to ask questions during our question-and-answer session at the end of the teleconference. Please also note that this call will be recorded. For opening remarks and introductions, I will now turn our call over to Vic Allgeier. Please go ahead, sir.

Thank you and good morning, everyone. My name is Vic Allgeier, the TTC Group, FARO's investor relations firm. Yesterday, after the market close, FARO released its second-quarter results. By now, you should have received a copy of the press release. If you have not received the release, please call Nancy Setteducati at 407-333-9911. The press release is also available on FARO's website at www.FARO.com.

Representing the Company today are Jay Freeland, President and Chief Executive Officer and Keith Bair, Senior Vice President and Chief Financial Officer. Keith and Jay will deliver prepared remarks first and will then be available for questions.

I would like to remind you that in order to help you understand the Company and its results, management may make some forward-looking statements during the course of this call. These statements can be identified by words such as we expect, we believe, we predict, we target, our growth targets, our goals, our guidance and similar words. It is possible that the Company's actual results may differ materially from those projected in these forward-looking statements.

Important factors that may cause actual results to differ materially are the risk factors set forth in yesterday's press release and in the Company's filings with the SEC. I will now turn the call over to Keith.

Thank you, Vic. Good morning, everyone. Sales in the second quarter of 2011 were $59.7 million, a 30.6% increase from $45.7 million in the second quarter of 2010. On a regional basis, second-quarter sales in 2011 in the Americas increased $5.5 million, or 33.6%, to $21.9 million compared to $16.4 million in the second quarter of 2010.

Sales increased $5.8 million, or 32.2% in Europe, to $23.9 million from $18.1 million in the second quarter of 2010. Sales in the Asia-Pacific region increased $2.7 million, or 23.8%, to $13.9 million from $11.2 million in the second quarter of 2010. The effect of changes in foreign exchange rates on sales was an increase of approximately $3.7 million in the second quarter of 2011.

New orders increased 42.4% in the second quarter of 2011 to approximately $62.5 million compared to approximately $43.9 million in the second quarter of 2010. On a regional basis, second-quarter orders in 2011 in the Americas increased 57% to $23.4 million compared to $14.9 million in the second quarter of 2010. Orders increased 35% in Europe to $24.7 million from $18.3 million in the second quarter of 2010.

Orders in the Asia-Pacific region increased 34.6% to $14.4 million compared to $10.7 million in the year-ago quarter. The top five customers by sales volume in the second quarter of 2011 were Airbus, the US military, BMW, Siemens, and Komatsu Limited, which represented only 7.1% of sales. The top 10 customers in the second quarter of 2011 represented only 9.2% of our sales, once again indicating our lack of dependence on any one or a handful of customers.

Gross profit increased $6.4 million or 23.7% to $33.5 million in the second quarter of 2011 from $27.1 million in the prior-year quarter. Our gross margin declined to 56.1% in the second quarter of 2011 compared to 59.3% in the year-ago quarter, primarily due to a decrease in gross margin from product sales to 61.1% in the three months ended July 2, 2011 from 66.1% in the three months ended July 3, 2010 as a result of a change in the historical product sales mix caused by the increase in the sales of the new Laser Scanner product, which currently has a lower gross margin.

As a percentage of sales, selling expenses decreased to 25.6% of sales in the second quarter of 2011 compared to 26.3% in the year-ago quarter. Selling expenses increased $3.3 million to $15.3 million in the second quarter of 2011 from $12 million in the second quarter of 2010, primarily due to an increase in compensation and commission expenses of $2 million, marketing and advertising costs of $600,000 and travel-related costs of $500,000.

As a percentage of sales, administrative expenses declined to 11.6% of sales in the second quarter of 2011 compared to 13.2% in the second quarter of 2010. Administrative expenses in the second quarter of 2011 increased by $900,000 to $6.9 million from $6 million in the second quarter of 2010 primarily as a result of an increase in compensation costs of $600,000, professional fees of $300,000 and travel costs of $100,000.

Research and development expenses increased to $3.8 million for the second quarter of 2011, or 6.4% of sales, compared to $3 million, or 6.6% of sales in the second quarter of 2010. The increase is primarily related to an increase in compensation expenses of $700,000, $400,000 related to the closing and relocation of the R&D facility in Andover, Massachusetts to our existing facility in Kennett Square, Pennsylvania offset by a decrease in materials expense of $200,000.

Total operating expenses were $27.8 million for the second quarter of 2011 or 46.5% of sales compared to $22.6 million, or 49.4% of sales in the year-ago quarter. Operating profit increased $1.3 million, or 27.3%, to $5.8 million in the second quarter of 2011 from $4.5 million in the year-ago quarter.

Operating margin for the second quarter of 2011 was 9.6% compared to 9.9% in the year-ago quarter. Other income expense net decreased by $1.8 million to expense of $100,000 in the second quarter 2011 from expense of $1.9 million in the second quarter of 2010, primarily as a result of a decrease in foreign currency transaction losses due to the reduction in the intercompany account balances of the Company's subsidiaries denominated in different currencies subject to changes in foreign exchange rates.

Income tax expense increased to $1.4 million in the second quarter of 2011 compared to $900,000 in the second quarter of 2010 due to an increase in pretax income. The Company's effective tax rate for the second quarter of 2011 was 25.3% compared to 32.1% for the second quarter of 2010.

Net income increased by $2.4 million, or 130.3% to $4.2 million, or $0.25 per share in the second quarter of 2011 from $1.8 million or $0.11 per share in the second quarter of 2010. The number of fully diluted shares outstanding in the second quarter of 2011 was 16.8 million compared to 16.3 million in the second quarter of 2010.

I will now briefly discuss a few balance sheet and cash flow items. Cash and short-term investments were $122.2 million at July 2, 2011 compared to $115.7 million at December 31, 2010 and includes $65 million of US treasury bills.

Accounts receivable was $47 million at July 2, 2011 compared to $51.9 million at December 31, 2010. Days sales outstanding at July 2, 2011 decreased to 72 days from 81 days at December 31, 2010, primarily as a result of improvements in the collection cycle in Europe and Asia.

Inventories increased to $59 million at July 2, 2011 from $42 million at December 31, 2010, primarily due to an increase in raw material related to the production of the new FARO Laser Scanner and the new Edge FaroArm.

Finally I will conclude with some statistics regarding our headcount numbers. We had 847 employees at July 2, 2011 compared to 781 at December 31, 2010, an increase of 66, or 8.5%. Account manager headcount increased from 147 at December 31, 2010 to 152 at July 2, 2011 with 45 account managers in the Americas, 50 account managers in Europe and 57 account managers in Asia. Geographically, we now have 333 employees in the Americas, 294 employees in Europe and 220 employees in the Asia-Pacific region. I will now hand the call over to Jay.

Thanks, Keith. We had strong second-quarter results with high double-digit growth that continues to be supported by significant market demand around the world. As I highlighted in last night's earnings release, orders in Europe and Asia grew 35% while orders in the Americas grew 57%, giving us total orders growth of 42% for the quarter. We are seeing encouraging signs from all of our verticals. Some of this is definitely driven by our customers' desire to drive greater productivity in their plants and our ability to provide quick and definitive return on investment.

Some of it is driven by the fact that many of our customers are doing very well and are investing for today, as well as the future. And for certain, some of the growth we are seeing comes from the Focus Laser Scanner, which is opening new verticals we have never touched before.

The Focus has only been on the market nine months. During those short nine months, we have already received more orders than in the entire history of the previous generations combined. I will discuss that more in a minute.

Our metrology products, specifically the Arm, ScanArm, Tracker and Gage, continue to be seen as world-class by new and existing customers alike. The new FARO Edge Arm officially released during the second quarter has been well received. Our new Laser Line Probe, which mates exclusively with the Edge Arm, was officially released at the beginning of the third quarter. We believe that the new Laser Line Probe will be highly disruptive to the market. Compared with our previous generation, it has wider coverage and faster coverage.

We also created a simple plug-and-play interface to the Edge Arm through a standard serial port, the only interface like it in the market. We dropped the weight to 2.5 ounces, eliminating almost a pound from the user's hand and making it the lightest laser line probe in the market by a substantial margin.

Finally and similar to what we did with the Focus Laser Scanner, we took out enough cost that we were able to drop the price from approximately $30,000 per unit to only $12,500, making it less than half the price of the next closest laser line probe in the market.

Most of our account managers were demonstrating the Edge Arm by the beginning of June and started demonstrating the new laser line probe at the beginning of July. As a result, we expect sales of Arms and ScanArms to grow even more as we go forward than they already have over the last few years.

So let's now talk about the Focus Laser Scanner. The Focus continues to exceed our expectations. Demand is strong and the bulk of the demand we are seeing is being generated by pull from the market rather than push from FARO. The disruptive nature of the Focus technology can be seen in our early results from sales of the device.

So far this year, close to 75% of our Focus orders came from FARO's internal sales team. As the distributors we have established start showing the product, demand should further intensify. I am frequently asked how big we think the market is for the Focus. For the last couple months, we have spent time refining our market data. I thought I would share one piece of that research with you today.

Let's look at the market segment that has shown the most immediate interest -- surveying and construction. Today, there are 600,000 professional surveyors around the world, 1.4 million architects, 1.5 million civil engineers and 3.5 million construction professionals. Now if I were really dreaming, I would say that all of them need at least one scanner and at today's prices, that would create a $280 billion opportunity.

Now although I am a dreamer, I am also a realist. Perhaps only 10% of those individuals need a laser scanner. And I would argue that is a pretty conservative estimate. At 10%, it is still a $28 billion opportunity and that is if they only buy one scanner and never buy another one again. And I will remind you that is just for construction and surveying. I am not even discussing the possibilities for forensics, insurance, heritage, manufacturing, asset management, gaming, process power and pipe or any other segment we could serve.

My point is I believe that the market potential for the Laser Scanner is far bigger than we have previously estimated and I also believe that as we continue our disruptive development path for both technology and price, the opportunity will only get bigger.

One good example of how much interest there is for the Focus Laser Scanner is the first annual 3D Documentation Users Conference that FARO hosted in Germany during the second quarter. Our goal for the conference was to bring together current and potential users of laser scanner technology and educate them through a three-day program, which included world-class applications delivered by real users, product-specific training and general information on the technology.

The cost to FARO was about $250,000. However, the ROI was immediate. Over 300 people attended the conference with participants coming from every region of the world. We received a substantial increase in leads and orders started closing within days of the event. Most importantly, it established FARO as a clear global leader and innovator in the scanning space. Next year's conference will be held in the United States and we are already receiving customer interest in it.

As we have discussed on previous calls, orders for the Focus have been so strong that we have been building a sizable backlog for the last three quarters. In June, our supply chain finally caught up with our revised demand. This enabled FARO's internal manufacturing team to produce at the run rate that will be required to meet future demand while driving down the existing backlog.

If you look at our manufacturing output, we shipped almost twice as many Laser Scanners in the second quarter as we did in the first quarter. In the third quarter, we expect to ship more than twice as many as we did in the second quarter. As a result, I believe that we will reduce the bulk of our Focus backlog to normalized levels by the end of Q3 allowing us to quote standard four to six week delivery cycles for new orders by the beginning of Q4.

We believe that the actions we are taking internally, combined with the growing demand from the market, should cause our Focus Laser Scanner growth rates to continue to increase in the coming quarters.

In the second quarter, the Laser Scanner became our second-highest volume product with only the Arm ahead of it. I have been saying for a couple of quarters that the Focus Laser Scanner should become our highest volume product in the near term and that trend continues to look real. I also believe that at some point in the not-too-distant future the Laser Scanner will outsell all the other FARO products combined. That is not because the other products aren't growing, because they certainly are. It is only because the Focus Laser Scanner is growing at such a substantially higher rate and given the market potential I discussed earlier should continue to do so.

As Keith mentioned earlier, the rapid increase in these Laser Scanner sales has caused our gross margin percent to decline as it relates to historical levels due to the lower gross margin currently being carried by the Laser Scanner. This is being driven primarily by startup costs associated with the manufacture and ramp-up, which should dissipate in the third quarter.

However, Laser Scanner margin is also being impacted by sales to distributors due to the upfront discount we provide to the distributor. We are using these distributors to reach new markets such as construction and surveying that we don't have the expertise or ability to cover internally and our utilization of distributors will increase over time.

However, there are minimal sales and marketing costs to FARO associated with the sales generated by distributors, so the bulk of the discount we provide to them is recovered at the op margin line. In addition, virtually all Laser Scanner sales are incremental when compared with historical results so the operating profit we generate from them is also incremental. We don't anticipate further deterioration in gross margin. Although Laser Scanner sales from distributors should continue to increase, we also expect positive improvements in product costs, as well as continued growth from higher margin products like the Arm to help offset the ongoing pressure.

Ultimately though, the most important thing to remember about the Focus Laser Scanner is that its sales upside potential for the Company is significant.

We did some strategic repositioning of our technology operation for the AMP 3D imager during the second quarter by moving it from Andover to our existing facility in Kennett Square and then closing the Andover facility. As Keith mentioned, the cost impact for the quarter was $400,000.

Strategically, this was the perfect time for us. First, the AMP product has been launched and as I have mentioned in previous calls should generate a small amount of sales volume as the current version is a clear first-generation offering. The team we had in Andover was very good, but they were primarily a research operation. They took the technology rights we acquired, redesigned the associated product from scratch and took it from being a science experiment to an operational device.

However, as we look to move the product to its next generation, we decided we wanted two things. One was far more focus d on development and real productization rather than core research. The second was the levers that could be created by housing the AMP engineering team within an existing FARO facility.

The choice in this regard was easy. Production and product management for the AMP were already in our Kennett Square facility and we already had a tremendous amount of optical knowledge amongst the engineering team that is already there. This move should generate cost productivity, technical leverage and ultimately create a better product for our customers.

The rest of our R&D programs remain on track. We have two more disruptive releases on the way, at least one of those releases should occur this year. The other one should occur early next year. Not surprisingly, the engineering teams associated with our recent disruptive product releases are already developing the follow-on generations to those products as well. The disruptive course we have embarked on is one we intend to maintain.

Needless to say, I feel very good about our prospects both short term as well as long term. We have strong market demand, disruptive new products and an organizational structure to support the continued high growth rates we have been seeing. As always, I would like to thank the FARO team for their passionate dedication and execution, as well as our customers, suppliers and investors. Thank you for your attention and I will now open the call to questions.

(Operator Instructions). Jim Ricchiuti, Needham & Co.

Hi, thank you, good morning. I was hoping to drill down a little bit more on the decline in gross margins in the quarter. If we look at the sequential decline in product gross margins, which I guess was about 260 basis points, can you say how much of that decline was related to the startup issues on Focus?

I think primarily it is a result of the change in the product sales mix. Without getting specific to the actual Laser Scanner, as you know, we don't provide gross margin by specific product, but I can tell you and I think we have always said that the Laser Scanner carries the lowest gross margin so that when you have an increase like in sales like we have had an increase in the Laser Scanner sales, that is going to have an impact on the overall gross margin.

Okay. And that really leads to the next question. I mean given the strength you are seeing for the Laser Scanner, as we think about gross margins, as I recall in the last call, you thought there was an opportunity to get back to 65% gross margins in product sales at some point this year. I mean just given what you are seeing now, is that still a reasonable target or is it just going to be a different mix that we are going to see in the second half of the year?

I think it is going to be a combination. To the extent that sales to distributors increase, you are going to have a lower gross margin simply because of the discounted price upfront and that should be offset to some extent by improvements in the actual costs after we get through some of these startup cost issued associated with ramping up. But to the extent that the Laser Scanner sales continue to be a much larger product -- line item sales in the product mix, you are going to see those product margins in that same range.

And what we don't know is to what extent you are adding new distributors. And I mean is there any color you can give us on that? What can we expect in the second half of the year in terms of new distributors because clearly that is going to impact your margins?

You are right, we don't disclose how many we have, but I would say you are absolutely right. Generally speaking, right now, it is about 25% of the sales come from the distributors and 75% are coming from the internal force roughly. I certainly anticipate that to shift more towards the distributors as we go forward, if you think about the fact that we have had a pretty good sizable backlog for the last three quarters and so many of the distributors are just now getting their units into their hands to really start their sales of the product and we are still in fact signing up new distributors every week.

So for sure, you would see some more pressure from that. Keith is right. The product costs will improve now that we are at full production output. Resolving those issues that we had with the supply chain just to catch up to that demand will certainly improve the product cost side and then, of course, ultimately the part we tried to point out is that, yes, that may put some pressure on gross margin for sure, but there is almost no sales and marketing cost within FARO then associated with those distributor sales. You get a little bit tied to just the distribution management portion of it. Otherwise it all falls straight through. So the operating margin should continue to benefit and grow and improve based on those incremental sales coming through on the LS even though they may come through at lower gross margin.

And I will jump back in the queue, but it sounds like -- just one follow-on -- it sounds like, based on the strength you are seeing in the core business and with the incremental demand for the Laser Scanner, I think earlier in the year, you had talked about the potential to see the business get back to the kind of 25% growth you have seen in the past. I mean it sounds like, given what we are seeing, you could exceed that.

Obviously, I will never say definitively, Jim. You know me. But number one, obviously, we are certainly -- we have done that the first two quarters this year and given the amount of opportunity that we see out there, I think that is a very real possibility and the real question is just how much over that number do we go. But I think it is a real distinct possibility.

Okay, thanks a lot.

Ajit Pai, Stifel Nicolaus.

Yes, good morning. So just probing on the Laser Scanner and the distribution, did I hear you right, you said I think 25% of the -- is it Laser Scanner products are going through the indirect channel right now, is that the right number?

That's right.

And was that in orders or was that in revenue that is recognized?

That is in sales, yes.

That is in sales. So then also understanding, and if I remember right and correct me if I am wrong, it is also sell in not sell through, right, for the products? When it goes to the distributor, when it is received by them, that is when it is recognized as a sale to you?

Correct.

So just understanding that part of the channel starts growing very rapidly, at what point do you think, based on your visibility now, do you think the channel will have enough inventory and what percentage of the build over the next like year and a half is going to be sell-through and what percentage is going to be the channel building inventory? Would it be more like a 50/50 over a 12-month period or will it be 75% sell-through and 25% sort of channel build?

I think that depends. Once we get to a steady state, the number of distributors that we are currently selling to we may be able to get a better grip on that number, but as the number of distributors continue to increase, trying to differentiate that statistic is a little difficult.

I think that is right. I think, obviously, right now, we are building to both current demand, as well as the forecast demand, including all the way through 2012 at this point has been forecasted out through the supply chain. So we don't have the same issues again next year that we had this year getting the product ramped up.

The metric, obviously, of how long those units sit on the shelf with these distributors is something that we will be watching very, very closely and product that is not moving will be a relatively short life for that distributor if that were to occur.

But is it fair to say that the channel right now is completely clean and is actually starved for the product for the folks who have already signed up?

I would say they were -- most of them were starved as they got into the second quarter and there may be a few that are still very, very hungry right now, but at least a decent number have what they need to start promoting the product.

Okay. And then moving to the cost side of things, not so much for the Laser Scanner, but you also talked about a generational change I think in the Arm and that impacting margins in the previous quarter. Are most of those sort of transition issues behind us?

They are. The way I would describe it with the Arm, it is not so much a cost issue with the Arm on the transition; it was a timing and availability of the new Arm. As you may recall, first quarter even, we had sort of had the soft launch in Q1 of the product and that definitely held back some sales. By the time we released it and finally started shipping it around the world, it really -- in the Americas, it was kind of early to mid-May that they finally had units in their hands to start demonstrating and for Europe and Asia, it was call it the beginning of June that they were able to start demonstrating the new product.

So this concept of kind of holding off, holding off from Arm customers ramped right through that time period and we sort of see that that once the units, the new Edge Arm got in the hands of the account managers, even though they didn't have the new LLP yet, they could at least talk to it, you saw that shift begin. And now that the account managers all have the new LLPs in hand and they actually have the ability to demonstrate what that technology can do because it is so disruptive for a variety of different reasons, we see that improve again now.

So one of the reasons that we think that some of the gross margin pressure is alleviated, not necessarily completely offset, is because, as we go through Q3 and Q4 here moving forward now, you should have a more normalized level of Arm sales within the mix.

That being said, I do recognize that we are also saying the Laser Scanner as a percentage of sales may continue to grow even though Arm sales are growing substantially and other products are growing; it is just because the LS is growing so much faster.

Got it. And just looking at your core business outside of the Laser Scanner, I know you probably don't have a very good idea, but you might have a very good guess on what the mix is on the military and the government program side. I know that you are selling into aerospace; you might not have that. But is there any sense that you have with the government budgets slowing and the military contractors becoming slightly more cautious, are you seeing any of that slowdown yourself and what do you expect over the next 18 to 24 months from that area?

I guess my first comment would be is that we don't necessarily see a lot of it now. That is probably just because we are obviously a very, very, very small piece of any military or government budget dollars that would be allocated. And at the same time, when you look at our sales per customer, just take the military, yes, they were in our top five, but they were -- Keith, I don't remember the number, but maybe a 0.5% of sales or less for the quarter. So we still don't have a huge amount of sales going through any one entity.

Now if you put them all together collectively, yes, it would be bigger than 0.5%, but it is not going to be 10% of sales let's say that could be impacted. So the impact to us would be relatively minor. The other customers that we sell to, we are still seeing really good demand, still asking all the right types of questions in the dialogue with the account managers and the inside sales team.

Got it. And then the last question is just looking at the top five customers and top 10 customers that you have talked about and the potential revenue, whether those were only actual companies or when you include distributors, did those stats also include that?

That is end-user -- just end-user results.

Just end-user, but there are distributors that are within now within the top five of your customers or definitely top 10?

I don't think I would say there were any that -- just saying the (inaudible) as they populated their arsenal so to speak. I don't think we have any that would've made the list this quarter. Collectively maybe if they took shipments over a couple of quarters perhaps.

Now a really good distributor, I would argue that if they do their job right, the volume they generate across multiple end-users could be big enough that it might make our top five if you aggregated all those end customers, but obviously we don't really look at it that way because ultimately we know who the end customer is on every sale and we are looking to that as to who is using, how they are using and what kind of penetration we are getting from a true market perspective.

Got it, thank you. I will get back in queue.

Mark Jordan, Noble Financial.

Good morning, gentlemen. Jay, a question relative to salesforce. You really have been pretty bouncing around on a fairly flat basis for the last seemingly four, five, six quarters. When do you believe that you are going to have to start lowering that again meaningfully so that you don't constrain your sales capability?

Yes, I would say we are sort of at that point now. If you look at the types of openings we have out there and posted right now, you will see multiple account managers in each of the three regions. That being said, I think the ad -- number one, fortunately or unfortunately, I guess depends on which view you take, unfortunately, you cannot get all of them at once because despite the unemployment numbers, we are looking for fairly specific types of people. So we are very selective and we are not afraid to keep saying no until we get the right person and bring them into the fold. So those openings get spread out over the next couple of quarters probably if we have hired the right way.

It is not like we are adding 50 new account managers to the mix either. We actually see -- we will add for sure. I think the growth ultimately will end up being in the teens for the year sort of like we talked about before. Again whether it is low teens or high teens, really at that point, it is more a matter of the timing of the hire more than anything else.

Okay. Keith, comments on the tax rate? It looks like you were again a little below what I think you were looking for in the second quarter. Do you expect that 25% rate to continue through the year or any other comments?

Well, I think we are targeting -- we are still targeting roughly a 30% rate. We actually get what the accountants call a discrete item that reduces your tax rate as a result of stock option exercises. And to the extent that I really can't predict how many people are going to exercise options and that related benefit, from a go-forward basis, I am still using 30% in my models.

Okay. I guess final question, if I may, you said you have been really production constrained in the scanner and you have got excessive backlog. Could you give us any kind of crude guidance on a percentage basis of once you have actually worked off that backlog and could be shipping in line with order flows sometime later this fall, what percent of revenue could be coming from this class of product?

I don't think I will do it on a percent of revenue basis only because that gives a pretty good indicator as to a metric we haven't normally disclosed. Given that it is -- in the second quarter was the number two revenue-generating product behind the Arm and that we feel it could surpass the Arm. Near term, I am not saying it is necessarily the third quarter, but it probably will in the next few quarters for sure and could be soon, sooner than that.

I think that is probably the easiest way to state it and I guess if you look at just the generalized -- again, we shipped basically almost twice as much in Q2 as we did in Q1 and then we are going to do that again. So in Q3, we will double, more than double Q2's output and that all flows through the sales line obviously as it ships and that should reduce the bulk of the backlog at that point.

I don't know if that paints it a little bit better for you, Mark, but that is probably as close as I want to get to calling what the percentage of sales is.

Thank you.

Richard Eastman, RW Baird.

Good morning. Keith, you had mentioned in your earlier comments that your inventories were up due to raw material costs, partially due to raw material costs. Is that flow-through also impacting the gross margin on the product side?

Most of that build-up is simply an increase in the actual quantity of inventory to meet the production, not -- it's units instead of dollars per unit. We are seeing some small increases in raw material costs, but most of that dollar increase is related to actual quantities of inventory.

Sure, okay. No, I understand. And then so, Jay, I think you went through this any number of times. There is lots of puts and takes here on the gross profit margin line for products. When you summarized these, we have got some positives, we have got some negatives. Do you expect the gross profit margin on the product side to work higher sequentially off of this fairly low 56.1% number in this quarter? I mean is that -- how should we piece these together here?

Without definitively saying that we think it would increase sequentially, I do believe we are at a point where it is at least sort of stabilized for sure. Again, you have got, like you said, the puts and takes between better gross margin on the product itself maybe offset by some of the distributor discount. You have got more arms in the mix as we go forward potentially than we did this quarter and they clearly still carry some higher gross margin.

So I guess if I were to look at it and say I do believe we probably are at a stable point for sure and then could you see some improvement? It is possible. At that point, I think it really depends on the overall mix and what we do. Obviously, we are planning to ship a lot of Laser Scanners here as we go forward and if the Laser Scanner does overtake the Arm as the top seller, all those types of things relative to mix that just creates some pressure there and like I said, the upside to it is those are sales that we wouldn't have had prior or previously because the LS was not into the early majority of the marketplace. So ultimately as it falls through, op margin for sure should continue to improve as we go forward.

So we have kind of had this -- FARO has kind of had this long-standing kind of plan here for their ratios. And if you look at your long-term financial goals and just, again, you have had this kind of 18% to 23% operating margin goal just kind of hanging out there as a long-term goal. And so given the puts and takes, new product distribution, but less SG&A, is there any reason that your business model shouldn't still have an outlook that generates an 18% to 23% operating margin goal long term?

No reason at all. We still believe that to be the appropriate op margin target for the Company.

Okay, all right. And then just a thought, the number of demos that you have done say in the second quarter and maybe into and through July here, did the number of demos in kind of that front log if you will, does it support 25% type of growth for the core business for the Arms and leaving the Laser Scanner out of the picture because I guess you are not doing the demos there?

It does. The normal that ratio leads to demos to closures, we still like what we see there. Like I said, with the exception of, and I think it was a function of timing and waiting for the new Arm more than anything else, that is not quite where I would like it, but I do expect that to improve now that the product is fully available and actually in the hands of all the account managers.

Okay, okay. All right. And I was a little bit curious about the growth rate in Asia-Pac. It kind of trailed the Americas and trailed Europe from a sales perspective. Is that a function of the Laser Scanner maybe being introduced in the Americas and Europe first or is that lower growth rate in Asia-Pac a function of the core business or is that just kind of a timing issue with the Laser Scanner?

Yes, I really think it is just timing in general.

All three regions really, for the most part, got their hands on the initial Laser Scanners at fairly equal rates and certainly they have all had them for a good six months in their hands at this point or more. So I think it is really just a timing issue. The Americas had a really good quarter.

Sure. Okay. And then just a last question, I mean we have kind of tracked your backlog and you have continued to build a backlog and is the implication that the backlog build is really primarily the scanner?

Yes, the core business continues to be -- as we have always said, we quote the ability to ship within four weeks and we always do and sometimes it's, as you know, far less than that. Sometimes it is next day as you get to the end of the quarter. So the real issue has been in output of the Laser Scanner.

I see. Okay, all right. And so again sequentially when you think about the third quarter, often you can see sales dip there a little bit, primarily Europe, but if you are going to work your backlog down, then we are not going to see that dynamic this year. We should not.

Obviously, I'll -- I never say definitively, but you have a very good thesis there.

That would be the math, yes, okay. All right, thanks so much, guys.

Rick D'Auteuil, Columbia Management.

Yes, again, I want to drill down on the same issues that several other people, including Rick just did. So if we look at the puts and takes and maybe I am first misunderstood I think Jay's comment on the raw material issues. So that was not a factor in depressing gross margin? It wasn't raw material inflation judging from your answer to Rick Eastman.

That is correct.

Okay. So we have two mix issues. The Laser Scanner is a lower margin product and will be sold increasingly through distributors, which will create a lower gross margin also. Is that true?

Yes, lower than the rest of the products. That is correct.

Right. Okay. And then I guess on the puts and takes on the other side of the coin, the supply chain issues, and I assume there were -- I think we talked about learning curve or startup costs related to just coming up to this kind of volume on manufacturing. Those are offsetting things that should start to work their way to improve the gross margin, right?

That's right. Just general throughput from a facility standpoint, as well as I will say, in Q1 and 2, because we were trying to meet this high demand, there were definitely some what I'd call acceleration type charges relative to some of the components coming in to help meet the demand that part of getting the supply chain up to normalized output alleviates that as well.

Okay. And would you be willing to say what you hope to recover? Could that -- put down a loan on those inefficiencies and those kind of issues, did that impact overall gross margin by 100 basis points or something much less than that?

I am not sure that is one I am willing to drill to that level of detail on. It had an impact for sure.

I mean the issue is -- I know you don't like to provide that granularity, but everything related to this release was good information or positive information except for the gross margin and it seemed to -- you seem to be taking a step back from where you were even last quarter on where gross margin eventually would get to.

And maybe the thing is with the kind of meteoric growth that you're looking at for the scanner, you need to sort of reset people away from the gross margin and focus on operating margin. Overall, would you expect the operating margin after you are up the learning curve to -- and I know what you just answered Rick Eastman -- but should we expect the operating margin to improve over the next four to six quarters in a material way? Leverage should be there with the kind of growth you are talking about.

I think those are all fair statements, Rick. The leverage should be there for certain and you are right that the real difficulty that we have right now -- I mean if you were to poke a problem, to say it is a problem -- is we know this Laser Scanner is going to grow dramatically. I mean in very, very substantial fashion. It is a question of just how rapidly do we think it will grow, how much of that will really flow through and obviously that can make a bit of a difference as it relates to the gross margin, including how much of it is really flowing through the distributors versus our own account managers who obviously continue to be pretty successful since they are still generating 75% of the current Laser Scanner sales volume.

So that is more of the issue than anything else and I think you are right that on the op margin side, we certainly expect the bulk of this should be incremental, should be improving operating margins for the Company and that is why you want to take advantage of having a product like this that has such, as you used the word, a meteoric growth rate.

So should we -- when do you expect to get to a stable -- I mean I heard you. You said you shouldn't see any more deterioration in gross margin, but when should we get through the issues that are at hand here and begin to build gross margin again? Is that a couple of quarters out? I mean as you pointed out, you have got the new Arm in place where that is likely to have higher margins. Have you commented on the Laser Line Probe and its margins?

We haven't though the Laser Line Probe has margins that are even better than the Arm. Without saying how much better, it is a really high margin product, which is great because it is high value add to the customer too. And you are right, so part of our strategy on the Laser Line Probe -- you look at the older device, it was an accessory for sure. It was a little bit bulky, a little bit heavy, it did the right job, did the right thing. You had to pay an extra $30,000 to get it after paying $50,000 for an Arm. The math wasn't always there.

So at $12,500, when it is only 2.5 ounces, you can barely feel it on the user's hand. Our strategy was, look, every customer should buy a Laser Line Probe. They should just make it part of the standard package when they buy it and at $12,500, that is not too intimidating a price and obviously the weight isn't either.

So we are looking for uptick in the number of Arms that are sold with LLPs and I will admit that we have never disclosed what that number is, but it is certainly not the majority of Arms for sure. It is -- a minority of arms are currently sold with Laser Line Probes, so we are looking for that to improve fairly dramatically and obviously that adds additional gross margin as well because it is higher gross margin product than the Arm.

So to get to your original question, Rick, could it be a couple of quarters? Probably. Again, the difficulty in predicting it is the biggest put and take on this is there are two. How fast does the LS growth rate, which we have some ideas, but it could be faster, at the same time and how quickly does the 25% of sales that is currently being sold through distributors go to 30% and then 35% and then 40%. Until we see kind of what the flow looks like, it is a little bit harder to predict that part, so that is why I say, yes, I do believe it is stable for sure. Could we see improvement over the next couple of quarters? I think we probably could. Might it be meaningful over the next couple of quarters? That is where it gets really hard to predict.

Is there a commitment -- I mean you have proven that the Laser Scanner is disruptive given the demand curve here. Is there any thought on using price? Maybe it is so disruptive because of the price that you have introduced it at and perhaps if you want to maximize the opportunity, it may not be in selling unlimited volumes at a lower margin. Maybe it's selling a few less at a higher margin with a higher price.

Yes, obviously, we've certainly had that debate internally multiple times. I am comfortable that the price we have is right. Could we be leaving a teeny bit on the table? Maybe, but I do know that that price is a substantial competitive advantage right now. In addition to, as I said, all the technology changes we have made, without a good price move on that product, it still would have been okay a real fancy early adopter product and an easy-to-use early adopter product, but it wouldn't have gotten us into the early majority.

So I think there are other ways to maximize value on that through other accessories, maybe some of the software, some of the other things that we do with it that could provide value without jeopardizing that competitive advantage at the price point we are at today.

Lastly, on the two other products being the Edge Arm and the Laser Line Probe, are there any supply chain issues anticipated or already experienced in those?

There have not been nor are there any anticipated. The nice part -- obviously, the difference from the arm, I will say, is that it is a product that we already had in the marketplace. We have got fantastic experience with our supply chain over the years. We were already producing at substantial volumes and so what the Edge Arm does is it replaces two out of the three Arm models that were already there. So we have done the clean and complete cut over there and to date, we have seen zero issues.

Okay, thank you.

Jim Ricchiuti, Needham & Co.

Thanks, guys. The discussion moves perhaps more from gross to operating margins. I wonder if you could talk a little bit about, and I realize that there is still some moving parts with how much could go through distributors, but can you talk about the incremental operating margins for Scanner and then maybe just in general for the business as a whole, can you give us any color on that?

Probably not at a layer of detail that you would be looking for obviously. Like I said, do we believe that op margin could and should improve sequentially from where we are right now? For sure. Do you think it is going to be a 2-point pop every quarter for the next few quarters? I think that might be extreme, but you just never know. And you are right, the problem is, again, you're right. It is the moving parts at not just the top line, but how much flows through distributor versus through our own account managers.

But I do -- I will reiterate that the -- I think maybe it was your question originally, Jim -- that the structure is already there in place below the gross margin line. So anything that is sold on the LS side should fall straight through with the exception of the small little percentage that goes to either -- the variable percentage that goes to the distribution manager say in Europe who is helping drive and manage those distributors in general. Otherwise, the bulk of it falls straight through.

Okay. Jay, as you look at the reception to the LS and you are working we think on newer product and you have talked about moving down the price curve, I mean do you, given what you see now, given the demand for the product at the current price point, does that cause you to maybe rethink the pace at which you move down the price curve going forward?

So as not to tip my hand to anybody who is in the same space, I still believe ultimately the price needs to get there. I do believe the product we have on the market right now is extremely good and it will be the product we are selling in the market for a while. And then you are right. At the point in time when the next generation comes, and for sure it will, obviously part of our debate internally is, as I always ask, what problem are we trying to solve.

The problem is you get into more and more verticals, probably splits into multiple pieces and you may not need to solve it the same way for a channel that has already been well established or is establishing now and by then we will be well established like construction and surveying, but you might find some others where, yes, that is still an issue and how they use it and the type of LS they use is different so maybe the price pressure is really in that vertical more so -- hey, we still need more price to get it over the chasm and into the real early majority in that particular vertical.

But in the ones that we have been having the success in, maybe there's a little bit of price pressure, but not nearly the same way and it is not necessarily going to give you the same acceleration. So for sure, we will be factoring all those considerations in when the next gen comes out.

Okay and just final question. Just on the strength of the Americas, the revenue growth that you showed, 57%, you have made some investments in Latin America and Brazil, in particular. How much of a contributor was that to the growth that we saw from the Company in the quarter in the Americas?

Yes, we typically wouldn't break out countries or regions or smaller regions within our three regions -- the Americas, Europe and Asia. But I think Brazil is enjoying very good growth. I think there is a lot of potential in Mexico as well, but we typically do not break out those subregions of the Americas region and discuss those separately.

So without breaking it out, was it a driving factor in the growth that you saw in the Americas, which was so much in excess of Europe and Asia?

Yes, certainly it contributed, but what I will say is if there is a concern whether the US itself was much more stagnant, I would say the answer is no. The US was very, very, very high and then you have Brazil, you had to have good growth there too, but it is a very small piece of the pie.

Got it. Okay, thanks a lot.

Jeff Bernstein, AH Lisanti.

Hi, just a quick question on the non-Laser Scanner products. Did they grow sequentially?

Yes, they did.

Great. And then just in terms of how the accounting works, you guys had a significant increase in the demonstration units that you built. How does that flow through the cost of goods and impact gross margins?

We are just building inventory that goes out to the field for our account managers and at some point in time, when they actually sell them, they will sell them for a small discount and that will just run through our normal quarterly sales.

In the meantime, are those costs capitalized or --? I am just looking at it -- presumably you make more units, it is a positive to gross margin whether they are sold or not in the quarter, right? Did that impact that in a positive way, not at all?

Really not at all. There is not enough account managers in the field for the core products to have it make a dent to the gross margin that would be meaningful and on the LS side, obviously the units are -- the only demo units we have are for our own account managers. Everything else is going to distributors and we are passing title at the time of sale to the distributor.

Thank you.

Ajit Pai.

Yes, just looking at the two products that you talked about that are fairly disruptive, one being introduced later this year and one early next year, can you give us some color as to whether these products are all new addressable market or whether there's actually going to be perhaps an upgrade to existing products?

I will start with they are both existing products and they are both disruptive in terms of what we are doing to them for sure. What I would guess generally say is that one of them, the addressable market still remains essentially the same, but I think it gives us more opportunity to penetrate that market.

The other one, I would say it does potentially open up a little bit broader fields -- it may be many of the same customers, but it is -- the capability is more than what we had and we have never had it in -- we've never had that capability before. So that by itself may open up and should open up sales that we aren't currently getting.

Got it. And then the last question would be you have these upgrades, etc. happening, but you have also got a very solid balance sheet, lots of cash. Can you give us some color as to what the uses of cash, how you prioritize the uses and also the M&A environment, especially with the recent sort of recalibration evaluation that is happening in the market, whether the interest and the probability of potential acquisitions has gotten greater?

Yes, I can't say the probability has gotten any greater because, for us, we are always -- it is more about the technology and the fit and those factors first and then we start talking about the valuation. So a general change in valuation wouldn't suddenly make somebody more attractive to us unless we hadn't looked at it before and if we had, then it's going to start first with just the -- okay, how do they fit from a technology and the portfolio standpoint.

So we are still looking. I don't think the probability of doing a deal is any different than it ever has been. We are always very selective there. Uses of cash are primarily -- we primarily look at that. However, not surprisingly, as volume continues to grow and we have more and more high-volume products, we obviously would consider other options for the cash as well, which could include -- you start thinking about how many you have to build and you need to help automate more of the facility, do you increase some CapEx and things like that.

I don't think it is going to be anything substantial or anytime soon that you would see a major mark there. So it is still geared for M&A and like I said, the change in valuations though would not necessarily increase the possibility of us doing a deal because it wouldn't necessarily change our view of a company just by the valuation change.

Got it. Thank you.

Thank you and it appears there are no further questions.

Okay, very good. Thanks, everybody, for participating today. We look forward to updating you again next quarter. Thank you.

This does conclude our teleconference today. You may disconnect your lines at any time and have a wonderful afternoon.