FARO Technologies Inc (FARO) 2013 Q2 法說會逐字稿

Good morning everyone, and welcome to FARO Technology's conference call in conjunction with its second quarter 2013 earnings release. At this time all participants are in a listen-only mode. Later you will have the opportunity to ask questions during the question and answer session. You will receive instructions later in the conference. Please note this call may be recorded, and I will be standing by should you need any assistance. It is now my pleasure to turn the conference over to Vic Allgeier, please go ahead.

Thank you and good morning everyone. My name is Vic Allgeier with TTC Group, Faro's Investor Relation's firm. Yesterday after the market closed, FARO released its second quarter results. By now you should have received a copy of the press release. If you have not received a 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 the call. These statements can be identified by words such as expect, will, believe, potential, continue, predict, target, growth targets, goals, 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, and good morning everyone. Sales in the second quarter of 2013 were $68.3 million,a 2.3% increase, from $66.8 million in the second quarter of 2012. On a regional basis, second quarter sales in 2013 in the Americas increased $2.7 million, or 10.5% to $28.4 million, compared to $25.7 million in the second quarter of 2012. Sales were flat in Europe at $23.2 million in the second quarter of 2013. Sales in the Asia Pacific region decreased $1.2 million or 6.7% to $16.7 million, from $17.9 million in the second quarter of 2012.

The effect of changes on foreign exchange rates on total sales was a decrease of approximately $0.6 million in the second quarter of 2013 compared to the second quarter of 2012. New orders decreased 6.1% in the second quarter of 2013 to approximately $66.7 million compared to approximately $71 million in the second quarter of 2012. On a regional basis, second quarter orders in 2013 in the Americas increased to $27.5 million from $27.4 million in the second quarter of 2012. Orders decreased 15.9% in Europe to $21.7 million from $25.8 million in the second quarter of 2012. Orders in the Asia Pacific region decreased 1.7% to $17.5 million compared to $17.8 million in the year ago quarter.

The top five customers by sales volume in the second quarter of 2013 were Boeing, General Motors, Global Tooling Systems, Dimensional Certification, and the US Military,which collectively represented only 4.1% of sales. The top ten customers in the second quarter of 2013 collectively represented only 5.7% of our sales, once again indicating our lack of dependence on any one or a handful of customers. Gross profit decreased $0.2 million to $36.9 million in the second quarter of 2013 from $37.1 million in the prior year quarter.

Our gross margin was 54% in the second quarter of 2013 compared to 55.5%in the year ago quarter, primarily due to a decrease in gross margin from product sales to 58.5% in the three months ended June 29, 2013 from 59.7% in the three months ended June 30, 2012, as a result of lower average selling prices. As a percentage of sales, selling expenses increased to 24.5% of sales in the second quarter of 2013 compared to 23.7% in the year ago quarter. Selling expenses increased $900,000 to $16.7 million in the second quarter of 2013 from $15.8 million in the second quarter of 2012, primarily due to an increase in compensation of $600,000 and travel costs of $300,000.

As a percentage of sales, administrative expenses decreased to 11.5% of sales in the second quarter of 2013, compared to 12.2% in the second quarter of 2012. Administrative expenses in the second quarter of 2013 decreased by $0.3 million to $7.8 million from $8.1 million in the second quarter of 2012, primarily as a result of the decrease in professional fees of $1.2 million related to the FCPA matter, offset by an increase in compensation of $300,000, an increase in Other professional fees of $300,000, and an increase in bad debt expenses of $200,000. Research & Development expenses increased to $5.2 million for the second quarter of 2013, or 7.6% ofsales, compared to $4.5 million or 6.8% of sales in the second quarter of 2012. The increase is primarily related to an increase in compensation expenses of $400,000 and sub-contractors expense of $200,000.

Operating margin for the second quarter of 2013 was 8% compared to 10.3% in the year ago quarter. Other income expense net increased by $100,000 to an expense of $500,000 in the second quarter of 2013, from an expense of $400,000 in the second quarter of 2012, and primarily represents the effects of changes in foreign exchange rates on the value of the current intercompany account balances of the Company's subsidiaries denominated in different currencies. Income tax expense decreased to $1.4 million for the second quarter of 2013, compared to $1.7 million in the second quarter of 2012, due to a decrease in pretax income. The Company's effective tax rate for the second quarter of 2013 was 27.4% compared to 27% for the second quarter of 2012.

Net income decreased by $1.1 million to $3.6 million, or $0.21 per share in the second quarter of 2013, from $4.7 million, or $0.28 per share in the second quarter of 2012. The number of fully diluted shares outstanding in the second quarter of 2013 was $17.2 million, compared to $17.1 million in the second quarter of 2012.

I will now briefly discuss a few balance sheet and cash flow items. Cash and short-term investments were $176.3 million at June 29, 2013 compared to $158.2 million at December 31, 2012, and include $65 million of US Treasury bills. Accounts Receivable is $51.2 million at June 29, 2013 compared to $62.6 million at December 3, 2012. Days Sales Outstanding at June 29, 2013 decreased to 69 days from 71 days at December 31, 2012 primarily as a result of improvements and collections in Europe. Inventories decreased to $65.6 million at June 29, 2013 from $68 million at December 31, 2012, primarily due to a decrease in raw materials of $3.2 million, and a decrease in service inventories of $1.3 million, offset by an increase in finished goods of $2 million.

Finally, I will conclude with some statistics regarding our headcount numbers. Globally, worldwide sales and marketing head count increased by 56 or 15.7%, to 413 at June 29, 2013, from 357 at June 30, 2012. Globally account manager head count at June 29, 2013 increased by 34 or 19.2% to 211 from 177 at June 30, 2012. Regionally, account manager headcount increased by 15 or 25.9% to 73 at June 29, 2013 from 58 at June 30, 2012 in the Americas. Europe account manager headcount increased by 7 or 12.5% to 63 from 56. And Asia increased account managers by 12 or 19% to 75 from 63. We had 1,031 employees at June 29, 2013 compared to 938 at June 30, 2012,an increase of 96 employees or 10.2%. Geographically we now have 412 employees in the Americas, 347 employees in Europe, and 272 employees in the Asia Pacific region.

I will now hand the call over to Jay.

Thanks Keith. I am going be relatively brief, so that we can get right to the Q&A. Sales growth for the quarter at 2% was lower than our expectations. We are continuing to face economic headwinds, particularly in Europe and Asia, as we have been highlighting over the last few quarters. Auto sales in Europe were at their lowest levels in two decades. Industrial output in China and Japan continues to slow, and credit markets are tight in countries like India. While the Americas remains a bit of a bright spot, achieving double-digit sales growth in the second quarter, European and Asian economic conditions remain relatively weak, and are having a real impact on the business. Customer interest is strong in those regions, but purchase decisions are being delayed.

In the Americas the industrial markets that we are in are investing more meaningfully, as are the survey and construction markets we serve with the Laser Scanner. Sales to existing customers globally were 64% in the second quarter, demonstrating that the ROI generated by FARO's products is strong enough to justify additional asset purchases, despite the pressure that economic uncertainty has on customer CapEx budgets. However, convincing new customers to purchase in this environment is obviously a more difficult task. As I just stated there is good interest, but getting them to invest in something new in this environment remains challenging.

Sales of the Vantage Laser Tracker were very strong in the quarter, as were sales of FaroArms though Arm sales continue to be impacted by aggressive price competition in the marketplace. Scan Arm sales and Focus Laser Scanner sales were not as strong as we would have liked in the quarter. Scan Arm sales were impacted by some of the economic difficulty in the industrial environment I just discussed. To be clear the Laser Scanner is still doing well in the marketplace, but our high expectations for the product were not fully met in the second quarter. Specifically, distributor channels for the Laser Scanner in Europe and Asia did not perform as well as we would have liked. This is not an a issue of competition. The focus Laser Scanner continues to be the only device of its kind in the market. We have programs in place to help our distribution network enhance its performance, and we are also continuing to work more closely with additional distributors in the space. We expect both of these initiatives to drive incremental improvement in Laser Scanner growth in the second half of this year.

As we manage the current headwinds we have continued to invest in the future of FARO via new sales personnel in all three regions, and increased product development resources and spending. As a Company, we have been adding to both groups for the last four or five quarters. We expect to see benefits from these increases in the second half of this year. New account managers have been assigned to multiple territories, where leads and overall customer interest was larger than existing account manager capacity. Even if the productivity of the new account managers is lower than our expected run rates they should still generate incremental sales that we aren't getting today. New R&D personnel are helping us accelerate our robust product development pipeline. My aim as always is to maintain our technology leadership position. Several of these programs are the direct result of the Cambrian explosion initiative launched last year, and the remainder are tied to the strategy of obsoleting the previous generation of our existing product line every three to four years.

The pipeline today is stronger than ever. The next 12 months will be very exciting for us on the product side, and we are positioned to maintain an aggressive pace of introductions well into the future. We are continuing to look aggressively at acquisition opportunities to help us broaden our portfolio, while simultaneously strengthening the offerings that we provide to our customers. With close to $180 million in cash we have substantial capacity for growth through M&A. As always, my criteria focuses on technology first, people second, then on financial impact. There are several interesting companies we are reviewing right now, and several additional ideas which could expand our efforts here in the coming months, and add meaningfully to the Company.

On the personnel side, two weeks ago I finished the search for the new Managing Director for the Americas. This is a significant role at FARO because it contains full P&L responsibility for all business in the Americas, as well as global R&D and Manufacturing for three of our product lines. As previously announced, we have hired Kathleen Paul to fill this role. Kathleen was most recently a corporate officer at Avery Dennison, following a successful career at Dupont. She has managed businesses significantly larger than the Americas in her past roles, and has strong international experience. Kathleen has hit the ground running, and is off to a good start. I have high expectations for her and she has high expectations for herself a good combination in any Company.

Also as previously announced, our nearly five year patent dispute with Nikon was resolved soon after the quarter ended. You will recall that FARO received a favorable verdict in a bench trial on the first patent, and a favorable ruling from a jury trial on the second patent in question. Reaching a settlement with Nikon avoids any further cost impact from the appeals process or otherwise, and eliminates a minor but persistent distraction for the Company. Despite everything we are seeing in the marketplace, we continue to believe that performance should improve in the second half of the year, both on the top line and the bottom line. The ongoing economic uncertainty does create pressure particularly in Europe and Asia, where meaningful economic improvement is unlikely in the near term. However, there are enough things going well internally to help us work through those economic issues.

Thank you for your attention and l will now open the call for questions.

(Operator Instructions). Our first question from Patrick Newton with Stifel. Please go ahead.

Good morning Jay and Keith. Several questions here. Thanks for the details on the Arm volumes. Sounds like that was actually a pretty good data point, but clearly some material pricing pressure. Curious as to whether you are walking away from any business in the Arm due to pricing?

Relatively few transactions. I can't say we are not walking away from any. But what we have done and it is similar to what we have done in the first quarter, is we are being more aggressive out of the gate anyways, and we are discounting further as needed, depending on the strategic value of the customer, is it one that we are trying to get into and haven't been in before. Is it one where we have a very strong installed base and relationship, so we are moving there as appropriate.

At the same time there comes a threshold where you examine the transaction, and say gee, we could go another pick a number, 5 points, 8 points, and is the competition going to follow anyway, so you get to a point where some of them you just decide to hold up. Have we walked away from a few? Yes, I think a few. Do I believe it has impacted our share materially? No, not at all.

I believe that last quarter you guys were kind of scratching your head as to what drove the somewhat sudden and persistent pricing pressure out of Hexagon. I am curious if you have any sense of the reasoning behind it, duration, or should we think about this pricing pressure in perpetuity?

Perpetuity is a long time, of course. What I will say is that we are assuming this will continue for some period of time to come, and as a result have planned the business around that, and we are planning both just our market approach, as well as what we are doing on the R&D side to ensure that we can remain competitive if that environment isto continue. At the same time obviously if the pressure eases up, we are prepared for that as well. That is obviously an easier decision. I think in the current economic environment that may be driving some of the activity out of the competition. I think given the high market share that FARO has in the Arm marketplace, we believe we still have as much as 70% of the installed Arm share around the world, this may be a little bit of an attempt at a land grab. We are doing everything we can to ensure we remain competitive, but being as smart as possible about that.

Can you update us, dovetailing off of the competitive comment, on your new product introduction side, and what you are doing there? I think you have talked about likely one, not necessarily new product, but one important refresh by the end of the year. Is there any chance we could see some new product introductions pulled into this calendar year, or perhaps in 1Q?

I am not going to say pulled into this year. Though I still remain confident that we have one very meaningful product release in the second half of the year. Without saying the timing of next year, obviously there are some that we expect to occur during the first half, since in the commentary I said that the next 12 months look very promising on the product development side. I am not going to comment yet as to whether they will be in the first quarter or the second quarter. You can assume that there is probably a little bit of both. As focused as we are on speed, I am also very focused on the meaningfulness, the accuracy of the product not from a technical standpoint, but does it meet the customer spec, does it meet the customer demand. Does it meet a new demand that they haven't necessarily been asking a lot for, is it the most competitive that it can be in the market. Those are all obviously important factors that occasionally weigh in to the final release date, even as much as a few months in advance of when it comes out.

And as we think about these investments for new products, Keith how should we think about your OpEx trending sequentially in the September quarter, and then through the remainder of the year?

One of the things has always been the Nikon litigation and now that is behind us one of the wildcards is taken out of the equation. Continuing the head count and building for the future. You may see a little increase in OpEx going forward as we continue to add mostly account managers and sales and marketing people, as well as R&D.

Just to piggyback on that though, I would say that there has probably been more heavy lifting done in the first half in that regard than we will see in the second half.

Okay. And then as far as the $1 million in legal and professional fees is that 100% out in the September quarter, or was that year-over-year comp that you were alluding to in your press release?

That was a year-over-year comp.

What is the sequential impact from legal perspective by Nikon going away?

I think it was roughly a little bit over $1 million in the third quarter of last year.

Versus what in 2Q?

Sequentially?

Yes.

A couple hundred thousand dollars for the Nikon litigation in Q2.

Thank you gentlemen, good luck.

Thanks, Patrick.

Next to Mark Jordan with Noble Financial. Please go ahead.

Good morning gentlemen. Jay, a question relative to marketing. You spent a lot of time focused on that area I think in Europe and domestically as you have made changes in management there. I was wondering if the time you had spent focusing on that and bringing in the new people, has there been any change, or have you identified ways to modify your marketing programs that would improve, or the productivity or enhance the ability to identify and qualify customers?

Yes, that is a great question. So I would say in the Americas it is a little early to say that, given that Kathleen really just started, and obviously with any new leader particularly one who has a tremendous amount of commercial experience, as both Kathleen did previously and as Ralf did, and I will go back to Europe in a second. It is a little early in the Americas to say that there have been meaningful change there. That being said, I think it is very safe to assume there will be changes in our marketing approach, and how we go to market and trying to drive our efficiency there in the second half out of the Americas, and it is a good time for us to be doing it, because we obviously feel very good about the Americas market. Performance has been pretty good for the first two quarters, and we do feel like the second half looks good there.

In Europe there have been meaningful changes made already. The impact of those changes has not pushed through or translated through yet. There is some lead time and lag I think between making your changes, generating your new leads, getting the leads into the hands of the inside sales team, getting them to work the leads, and then getting those into the hands of account managers who can go out to the customer, and then handle the rest of the sales process. So I think we have plenty of good leads on the table. One of the reasons that we continue to add account managers was when you look at territory coverage, we had still in the second quarter even more leads coming in the door than account managers to handle them, given the capacity constraint of how many demos in a month an account manager can do.

So that is a good thing and some of those incremental leads for sure are new programs, and some of them there is good interest there but again the economic environment makes it harder to pull the trigger. I suspect that when you look at the second half of the year you will get a combination then of the changes to some of the marketing programs and how we are going out to market from a pure marketing standpoint in Europe, coupled with the additional account managers and those individuals coming up to speed, particularly the ones who were added in the first quarter adding more incremental revenue in the second half of the year. It is one of the reasons that we feel good about Europe in the second half, despite the fact that the economy may not move meaningfully during that time period.

Okay. Question. In the Americas you obviously saw growth year-over-year in revenue. If you were to exclude the scan product did the legacy Arm product families grow year-over-year?

What I will say is we try not to get into specific details on the product lines. What I will say is that the metrology side was good, and the Laser Scanner was also good. Obviously we are looking for great out of both. 10% for the Americas year-over-year versus our normal internal targets. I think 10% is good. We certainly can do better, but I would say it was well balanced.

Okay. Final question. You did talk about rating potential acquisitions in terms of technology, financial, et cetera. One thing you didn't talk about is during this period of difficulty, you have had opportunities with where the stock has hit recent trading lows. Where would you put the potential of using some of that cash as a buyback?

Certainly I won't flag a price, but what I would say is that we do have a buyback still in place. We have not transacted on it since the beginning of 2009 so it has been a while. We still believe fundamentally that the best use of our cash is the right acquisitions to drive the growth of FARO over the long term. So obviously that is still my priority, and where I would like to deploy it. I think as it continues to grow it as question of, we have some acquisitions that we are looking at right now that would meaningfully utilize the cash position that we have inside the Company. If I can deploy it in that regard that is still priority number one, and it would if deployed in that fashion then I think most of us would look at it and say, hey, using it for a buyback at that point is the less valuable move to the Company's long-term. I still think obviously there is near term impact from doing something like that, but we have really interesting acquisitions that clearly change the long term position of the Company.

Thank you very much.

Thanks Mark.

And we will go next to Jim Ricchiuti with Needham & Company. Please go ahead.

Thank you. Good morning.

Good morning, Jim.

Jay, still struggling a little bit with what I think you are indicating improvement in the second half, and I am trying to get a better with sense of what is going to drive that. My impression was Q4 last year was a good quarter for the scanner, with the Trimble channel fill initially anyway. What drives the improvement? Is it increased sales coverage? Account managers? Anticipating some better market conditions in Europe?

Yes, so I would be less focused on better market conditions in Europe. Obviously that would help , but I don't have confidence, and I can't control it certainly as to the improvement any type of economic improvement there in the next six months. The key drivers I think you are right on the Laser Scanner, I actually think Q4 was just an okay quarter by FARO standards. Better than what the Street was estimating but from an internal standpoint when you look at what we are normally used to, I thought Q4 was sort of average from a performance standpoint.

We did have obviously revenue going through into the distribution network in Q4 and obviously through the distribution network as well. We still don't have 50 or 60 distributors who are all taking 20 and 30 units at a time, and then figuring out how to weed them out of the system. They still tend to buy in clumps of three, four, five. So I think that some of this is just they continue to come up the learning curve, become more efficient in their ability to sell the product, they get continued assistance out of some of the FARO personnel on the right way to present it, those are all things that will help improve the Laser Scanner side.

On the metrology side, it is almost entirely driven by the increment in account managers. I am not saying that there may not be new products that will enhance that as well, but if you just look at the year-over-year growth in account managers in Q1, again in Q2, the growth will slow down a bit in Q3 and Q4, because I think we have added sufficiently for the most part we have added sufficiently in the first two quarters of this year. That learning curve which can run anywhere from six months to nine months, like I said, even if they are not at full productivity if they are generating any revenue at all out of the leads that we have that aren't getting handled by people currently, or weren't getting handled by people in the first and second quarter, that has the potential to add meaningfully to the revenue stream in the second half. Even without economic improvement in Europe and Asia, that is still possible when you look at that headcount growth around the world.

It is clear Europe is still relatively weak, but from looking at for instance the automotive vertical, it appears that some of the export driven auto companies are doing a bit better. What is your experience? What are you seeing from some of those players, are you seeing the same cautiousness on their part as well?

We are. It depends on the customer. So we have some that, I won't say which ones, but some that are always sort of ahead of the curve on making sure their investments keep pace with where they see the business headed in two or three years not in the next 12 months. That being said, when you look at overall and I highlighted it earlier, auto production in Europe in total, and demand in Europe is the lowest it has been in 20 years. In Germany I think it is the lowest it has been in 25 or 28 years, something like that.

So clearly the levels of production are significantly lower and it does drive some alternative focus within the companies as to what they are doing with retooling their plants, or what they are doing to maintain that lower demand volume, and keep the business moving. And while we are an important investment there, there are obviously lots of other places they can invest their CapEx dollars that are also beneficial to the company in that kind of weak environment. Some improvement there over the next few quarters obviously would have some benefit. We are seeing a little better out of Asian auto at the moment. I can't say it is meaningful yet either.

Okay. You mentioned just getting the final question on the scanner, I think you characterized Q4 last year as an okay quarter by FARO standards, not necessarily great. Q2 I get the sense was not also a great quarter for the product. Given the wider distribution. What do you think is happening there?

I will say first that my comments relative to Q4 are generic to FARO in total, not specifically say laser scanner versus metrology. Just in general Q4 was not as strong as we would have liked. Obviously it wasn't bad, but we still would have liked more. Q2 was the same thing. Though I will say that in Q2 I can highlight that there is some disappointment on our part for the Laser Scanner. Some is that we have very high expectations of what that product should be doing, so it is relative to how high that expectation level is.

What I think we are seeing if you look at our primary distribution channel through Trimble currently, they are very good in the Americas. So the scanner performance there has been pretty consistent the last couple of quarters, last three or four quarters. It is not the only driver of growth in the Americas. The metrology side did well. The Laser Tracker is doing extremely well in the marketplace. That new Vantage tracker that released almost a year ago now, has been really well received in the marketplace and has received favorable pricing in the marketplace.

Europe and Asia the distribution network is not nearly as strong through Trimble there. The support structure, the leadership structure is not as strong as the structure that they have in the Americas. That is certainly one of the reasons that we have started working more closely with Topcon, who is one of the other three sort of primary players in the construction surveying space, and as we get tighter with them, then that is another way that we see opportunity in the second half of the year to improve that performance in the Laser Scanner side.

When you look at the individual, on the distributor by distributor basis, you really get down to I think both talent and ability to embrace the product, which is kind of a one-off at every single distributor. You have to treat them differently. So you can't make a mass comment about all of them in that regard. Some are really good at it already, and they understand exactly where to sell it,what the best applications are, how to show it to the customer. Some are definitely still in that learning phase, and that is not necessarily to be unexpected, though we would certainly like to see that move faster. We are spending more time and attention on trying to get, particularly in Europe and Asia, to get those folks better trained, better prepared for how to show the product, because it is clear that the interest and demand is still there. Now it is the ability for them to execute.

Thanks. I will jump back in the queue.

Thanks, Jim.

We move next to Hendi Susanto with Gabelli & Company. Please go ahead.

Good morning Keith and Jay. Once the revenue increase positively in Europe and North America, may I know what the tax rate of warranty services look like in Q2, and let's say relative to Q1 and Q4, and where do you expect that going forward in the second half?

I am sorry I missed, was that the question what the tax rate was in each of the individual regions?

Yes, the tax rate of the warranty services for the EFC, and any meaningful increases in the last, let's say like three quarters?

I don't know if we have disclosed the tax rate specific to warranty before. I think in general we are seeing good growth out of warranty in all three regions. We have been more aggressive in trying to sell them, particularly the expanded warranties not just the normal warranty that comes on the first purchase. We now have individuals in place in all three regions, that their only role is to sell extended warranties and expanded warranties to the customer base, and that focus by itself has driven an increase there. Relative to tax rates specific to the service side or warranty side, I don't think we have ever disclosed down at that level of detail.

Would you be able to share qualitatively whether there is still more room to go?

More room to grow service revenue?

The warranty services attach rate?

Attach rate. Yes, there is room to grow that for sure. Obviously any new unit growth creates opportunity. I can't say that we have got, I won't give the exact percentage, but certainly we are not at a point where the majority of customers have an extended warranty or an expanded service agreement on their product, so if you don't have a majority that certainly leaves plenty of run rate there.

Earlier this year my management had set expectation of reducing the pricing, this practice going into the second half of 2013, what did the pricing discount look like in Q2 relative to Q1, and in light of the current market will selective aggressive pricing continue into the second half?

We haven't disclosed the exact percentage of what the discounting was. Though it is meaningful, I have said before that the competitors, it is not unusual in this environment right now that they are 25% below our normal pricing in some cases. And as I said earlier, we will definitely, our assumption and so I have planned the business accordingly is that these price levels while Q1 and Q2 discounting is similar, so I can't say that it accelerated in Q2. We assume that rough environment continues at least the rest of this year, and so we are planning accordingly.

Thank you.

Thank you.

We will go next to Richard Eastman with Robert W. Baird. Please go ahead.

Yes, good morning, Jay, Keith.

Good morning, Rick.

Hi, Rick.

Just a question, Jay you had commented about Asia sales being down, and you commented about credit conditions in India. Are you seeing the same situation in China, and can you give us a sense of what China sales did in the quarter?

I won't say specifically what they did. I will say that they are part of the general statement of not as we would have expected for sure, and that is generic to Asia, and certainly China is a piece of that. China is one of the big three for us in Asia are Japan, China, India, and obviously they are a contributor to that. Yes, you are right, Rick, I should have clarified that. The credit situation in China also continues to be very difficult.

In China now, this is I believe it is five quarters in a row, possibly six, certainly five, where we have seen this difficulty of customers obtaining credit, and for everybody the reminder there is that in China, a large number of our customers particularly the smaller ones, not our big multinationals, but our smaller ones we he make them pay 100% up front or close to it, and many of them require credit to be able to do that. So the ability to get credit continues to be very slow. Not that they are not getting credit, but it is definitely slower. We have seen some instances where once the customer receives credit, the bank has paused what I would say extraordinarily long in then providing the funds to that company. And so that is sort of an exacerbating impact. So yes, it is still there and we have not necessarily seen anything out of the government that would imply that the industrial credit market anyways, would necessarily improve in the next couple of quarters. So it is slower. It is not that they are not giving credit, it just takes a long time for customers to get approved.

Was there given Japan in that sales number for Asia Pac was there a currency impact there that essentially exceeded the consolidated number?

Yes there was an offset, in Japan it was roughly about $1 million.

$1 million, so that Asia Pac revenue number as reported includes $1 million negative FX impact?

That is right.

Correct.

Okay. And then I have a question on services. Two things on services? One is, how is it that the is service gross margin sequentially drops as much as it did? And then secondly, how does services revenue growth has been greater than product growth for like five straight quarters. I am trying to understand, how is, again if you are not selling one product, if your product sales are flat, how is it that your service revenue is growing for that consecutive period of time?

Let me address the sequential margin issue first. In the second quarter we added quite a bit to the capability of the other regions to service the laser scanner. Previously the laser scanner had to be sent back to Germany for servicing, so there was quite a bit of costs incurred in getting the Americas, as well as Asia set up to service the Laser Scanner. A lot of that on the service side in the margins can fluctuate depending upon how many units you have serviced that quarter, it depends upon the sales mix of whether it is a time and materials, sort of a pay by the drink service, or if it is covered under warranty.

There are a lot of factors that can go into that margin, but I think one of the biggest issues or contributors in the second quarter was the expenses incurred to build out the Laser Scanner. Going forward I think we are probably give or take in that 35% to 40% range, historically we have been over the past probably five years or so, probably in the 30% to 35% range. With regards to the services growth, I think that comes from primarily a focus on the sales of the warranty product itself, and the dedicated inside sales people we have focused on selling those additional warranty contracts.

So you will actually go back to units installed and sell a service contract?

Yes, in fact, that has definitely been a driver of the growth. Previously the account managers, and I don't want to say it this way because it sounds worse than it is, but the account manager would try to sell extended warranties while they are in the midst of handling other transactions, it was sort of a side project. And what we saw was that by adding a relatively small number globally, a couple in each region of inside sales people, to just go back to the installed base and focus on the value and the benefit that an expanded service contract can provide, has definitely proven valuable. And so the growth rate granted is coming off of a fairly low revenue number to start with, but that is driving the growth rate, and I think based on the question earlier of, is there still plenty of installed base to go after currently, yes because we are definitely not at a point are the majority are as successful as we have been with the program, we are not at the point where the majority are holding expanded service contracts or extended warranties.

I see, okay. Jay, when I look at the orders in the second quarter, and I look at how your business typically unfolds seasonally, typically you see a third quarter where orders drop below, the third quarter orders drop below the second quarter and a lot of that has to do with seasonality in Europe. Given the tone of business and how you have spoken to it here, as second quarter has rolled out late in the second quarter, is there any reason to believe that that order pattern, that seasonal order pattern doesn't play out again this year, where your orders in the third quarter maybe sag a bit further?

I guess I will start at a conceptual level. Despite economic uncertainty, it appears that we are going to see in the normal vacation schedules out of Europe and Asia, and then likewise some of the normal plant shutdowns that we see in the Americas where they tend to time it mostly in the month of August, so the month of August is clearly the target point there. So conceptually you would expect some of that again. Give than it dipped a little bit in Q2, are there some timing issues where the dip sequentially may not be as bad or may not be what we normally see. Possible it is certainly way too early to tell, because we are still early in the third quarter, that will be sort of a September-ish issue. But I think generally speaking, yes, I don't think despite how rough it is and how hard everybody should be working to work through the economic environment at the customer side, I still believe that most of them are taking their normal August vacation schedules.

Okay. And then just a last question. When you commented a little bit about M&A, you had talked about a couple opportunities that would change the complexion of FARO and when I think about your priorities on the M&A side, technology, people, and then financials. If there are a couple of things out there that could absorb a big chunk of your cash on the balance sheet, do those couple opportunities have that same priority? In other words, would you put a big chunk of your balance sheet to work if the financials if those companies require input capital, rather than generating accretion?

So in general I would say, look if it was the right the strategic deal for FARO for driving long term growth, assuming it wasn't an unreasonable purchase price, and we are still, look we are not blind on purchase price for sure. We have been holding this cash for a long time, so we are obviously fairly selective there. We are not going to buy at any cost if that is the question. The ones that we are looking at certainly appear that they would be accretive day one anyway, so it is less of a concern on the ones that we are looking at. And yes, what I will say is they all still fit under that umbrella of 3D measurement imaging realization, what we view as being our role in life, they all still fit under there, so we are not moving from, I always use the analogy of we are not moving from baseball to football. It is still a bigger baseball stadium, but not a different sport.

The order of magnitude when it comes to a project and transaction costs, the risk goes up exponentially, and just want to make sure that when you put technology and people ahead, again transaction size is smaller given the investment you would require?

Yes, for sure. What I will say is that when we look at, for almost all of the acquisitions we are looking at, all of the ones really, the integration risk is different from, in a much more mature market when you look at acquisitions where you may have significant product line rationalization, that these do occur after the acquisition, significant facility rationalization, things like that. The types deals we are looking at add meaningfully to the portfolio with in many cases zero overlap at all, so that risk of what you have to do to help extract significant incremental value from day one is a little bit different from what you see in some of those other types of transactions. There will be clearly opportunity for productivity inside the operation, but the risk factor changes a little bit in that regard too. I don't agree the bigger the deal obviously the higher the risk to the Company, just from a pure financial standpoint, but when we have looked at them, we feel pretty confident about that piece of it.

Okay. Alright. Thank you so much.

Thanks, Rick.

Thanks, Rick.

And we will go next to Patrick Newton with Stifel. Please go ahead.

Just to follow-up on the focused laser scanner side. Curious, relative to expectations and kind of the, I don't think softness is the right word, but not meeting expectations in 2Q, can you help us understand sell-through versus sell-in, is it possible that you guys have hit somewhat of a saturation point inside of Trimble, and not quite accelerating the ramp inside of Topcon, on a sell-in basis, and anything that you can give us on the sell-through, positive or negative relative to expectations?

Given that all of the unit volumes on the sell-in are relatively low, it is not like I can point to any one distributor, Trimble and say, oh my gosh they are sitting on way too much inventory, we have a sell-through problem. We are definitely not seeing that. We are seeingaverage return rates, return meaning coming back to order the next wave of product, that is the piece that we would like to see them, we would like to see better flow, but again it is not that they have units sitting on a shelf getting stagnant.

On the Topcon side, given that the relationship is still in more of a developmental phase, obviously we haven't signed and haven't announced any type of global agreement with them , so it is still a little bit different in terms of the ramp-up with the Topcon folks, so I am not going to point the finger in that direction necessarily, because the expectations are a little bit different out of Topcon at the moment, given that it is a little bit more localized in terms of how the relationship is still being built up.

Fair to say on the Trimble side, sp clearly not worried about inventory on the Trimble side, but have you reached a saturation point with penetrating their distribution, that you are maybe not seeing the sell-in tail wind as they build their inventory, and now you are operating purely on a sell-through basis?

I don't think we have ever been worried about having too much of a tailwind from the sell-in. That being said, do most of their distributors have the amount of product that they should have in a normal operating basis for sure. There is relative flow-through or sell-through from those distributors, so it is a matter of getting better volume out of them now.

Very helpful. I might have missed this Keith, but did you give distribution as a percentage of your FLS revenue?

I don't think we gave it in the stats.

Q2 was roughly the Laser Scanner sales through the distribution channel was about 54.6% versus Q2 of 2012 was 58.1%.

Alright. That is helpful. And then I guess just given the distribution dynamics, given Arm pricing pressure, as we look at gross margin I think that last quarter we had been targeting, I want to say you said 55% to 56% was kind of a reasonable area, and we came in a little bit soft, I am sure that was the persistence of the pricing pressure. How should we think about the gross margin through the remainder of the year, and then structurally how should we think about it longer term?

Well, I think the remainder of the year to the extent that we continue to face pricing pressures, it is not going to deviate significantly from where it was in Q2 of the first half of this year.

Longer term structure. Generally speaking, we still believe this Company can get gross margins into that 60% range. Obviously it takes still some heavy lifting. That being said, I can say we do see some success as we talked earlier about the Laser Tracker doing extremely well in the marketplace, and very well received by the customer base and having some improved pricing.

So the combination of improved pricing and a little bit lower product cost obviously helps the Company any time we can do that, and we still see the opportunity to do that across all products, particularly in say a newer less mature product like the Laser Scanner, there is still sizeable room for improvement there, and if you mix that with increased volume over time, then that even though it might all be going through distribution or a large chunk of it is going through distribution, still gives the opportunity for gross margin improvement. I will say that the scanner even in the current environment, there has been slight gross margin improvement just from continued cost takeout purely on the manufacturing side, without even having the impact of next generation engineering work that is going into it.

Great. Thank you.

And we will go next to Jim with Needham & Company. Please go ahead.

Just wanted to follow-up on the subject of acquisitions. My impression was you were a little bit more visible in terms of talking about the potential for acquisitions earlier in the year, Jay and I am just wondering, has the target list changed much from when you were first earlier this year talking about it?

It has not decreased necessarily. I would say that the overall target list has increased a little bit. The bigger ones given that these are not companies that are being shopped so to speak, some of this as you know, there is some baiting that needs to occur to get everybody comfortable with what might happen. So yes, I would say that A, I think we are still very visible and out in front with it. We are definitely being aggressive about it. And it is, they are definitely companies that fit well into the FARO portfolio.

And I am also wondering if the overall market conditions, the economic conditions are affecting either party here?

In some cases it may make them more interested. I can't say it is necessarily affecting price expectations, valuations. I am not saying that they are unreasonable by any stretch, but I can't say that valuation expectations are dramatically lower than you would have seen two years ago let's say.

And just to switch gears a little bit to the tracker. Is what you are seeing in the market sustainable? I mean the product is relatively new. Are you getting the benefit from the initial enthusiasm around it, or do you view this as sustainable in the second half as well?

I believe it is sustainable. What I would say is that in Q3 and Q4 last year, though I can't say it was a sizeable contributor, but there was definitely pent-up demand in Q3 and Q4 of last year. If you look at the first half of last year, some of our customers knew that we had a new tracker coming, and so while our tracker volume was good, because you had customers buying the previous version the one they really liked and knew, there was definitely some pent-up demand prepping for the release of that product.

Q1 and Q2 of this year, and I can't say that the growth in the Tracker is only because you had lower comps in Q1 and Q2 of last year because you really didn't, so it is that meaningful from a growth standpoint. I do think it is sustainable. If we didn't do anything to the product again in the next two years, is it eventually going to slow down, sure. There is still that normal business cycle of wanting additional features, functionality, ease of use, and things you normally focus on. But we certainly believe the coming multiple quarters still have significant potential for the tracker.

Okay. Thanks a lot.

And we have no further questions at this time.

Very good. Thank you very much, everybody.

This concludes today's conference. Please disconnect, and have a wonderful day.