FARO Technologies Inc (FARO) 2013 Q3 法說會逐字稿

Good morning everyone and welcome to the FARO Technologies conference call in conjunction with its third 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. (Operator Instructions)

For opening remarks and introductions I will now turn the call over to Vic Allgeier. Please go ahead.

Thank you and good morning everyone. My name is Vic Allgeier, the TTC Group, FARO's Investor Relations firm.

Yesterday, after the market closed FARO released its third 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 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 increased by $7.5 million or 12.3% to $68.2 million in the third quarter of 2013 from $60.7 million in the third quarter of 2012.

On a regional basis, third quarter sales in 2013 in the Americas increased by $5 million or 20% to $29.8 million compared to $24.8 million in the third quarter of 2012.

Sales increased by $500,000 or 2.3% in Europe to $21.5 million from $21 million in the third quarter of 2012. Sales in the Asia Pacific region increased by $2 million or 13.4% to $16.9 million from $14.9 million in the third quarter 2012.

The effect of changes in foreign exchange rates on total sales was a benefit in Europe of approximately $1.3 million offset by a reduction in sales in Asia of approximately $1.7 million and a decrease in the Americas of $100,000 resulting in a net decrease of approximately $500,000 in the third quarter of 2013 compared to the third quarter of 2012.

New orders increased 3.9% in the third quarter of 2013 to approximately $63.4 million compared to approximately $61 million in the third quarter 2012.

On a regional basis, third quarter orders in 2013 in the Americas decreased 3.4% to $25.8 million compared to $26.7 million in the third quarter of 2012. Orders in Europe increased 16.1% to $21.6 million compared to $18.6 million in the year ago quarter. Orders increased 1.9% in Asia to $16 million from $15.7 million in the third quarter of 2012.

The top five customers by sales in the third quarter 2013 were the U.S. Military, Beechcraft Corp, Porsche AG, Dimensional Engineering, and Major Tool and Machine which represented only 2.4% of our sales. The top ten customers in the third quarter 2013 represented only 3.7% of our sales, once again indicating a lack of dependence on any one or a handful of customers.

Gross profit increased by $6.5 million or 20.2% to $38.8 million in the third quarter 2013 from $32.3 million in the prior year quarter. Gross margin increased to 56.9% in the third quarter of 2013 from 53.2% in the third quarter 2012, primarily due to an increase in gross margin for product sales, to 61.2% in the three months ended September 28, 2013 from 57.2% for the three months ended September 29, 2012 primarily as a result of lower manufacturing costs and improved pricing for laser trackers but still offset by lower overall average selling prices.

Gross margin from service revenues increased to 39.3% in the third quarter of 2013 from 36.1% in the prior year period primarily due to an increase in warranty sales.

As a percentage of sales, selling expenses increased to 24% of sales in the third quarter 2013 compared to 23.3% in the year ago quarter. Selling expenses increased by $2.2 million to $16.4 million in the third quarter of 2013 from $14.2 million in the third quarter 2012 primarily due to an increase in compensation of $1.8 million and travel costs of $300,000.

As a percentage of sales, administrative expenses decreased to 10.7% of sales in the third quarter of 2013 compared to 12% in the third quarter of 2012. Administrative expenses in the third quarter of 2013 remained flat at $7.2 million for the three months ended September 28, 2013 and September 29, 2012.

A decrease in legal fees primarily related to patent litigation of $1 million was offset by an increase in compensation of $200,000, an increase in bad debt expense of $200,000 and an increase of $600,000 related to other professional fees.

Research and development expenses increased by $1.8 million or 44.8% to $5.9 million in the third quarter of 2013 or 8.6% of sales compared to $4.1 million or 6.7% of sales in the third quarter of 2012. The increase is primarily related to an increase in compensation expense of $800,000, subcontractors' expense of $500,000, and materials of $300,000.

Operating margin for the third quarter 2013 increased to 11.1% from 8.3% in the year ago quarter. Other income expense net increased by $900,000 to expense of $800,000 in the third quarter of 2013 from income of $100,000 in the third quarter of 2012 and primarily represents the effects of changes in foreign exchange rates on the intercompany account balances of the Company's subsidiaries denominated in different currencies.

Income tax expense increased by $300,000 for the third quarter of 2013 to $1.7 million from $1.4 million in the third quarter of 2012 due to an increase in pretax income. The Company's effective tax rate for the third quarter of 2013 was 25.9% compared to 27.8% for the third quarter of 2012.

Net income increased by $1.3 million to $5 million or $0.29 per share in the third quarter 2013 from $3.7 million or $0.21 per share in the third quarter of 2012. The number of fully diluted shares outstanding in the third quarter 2013 was 17.2 million compared to 17.1 million in the third quarter 2012.

I will now briefly discuss a few balance sheet and cash flow items. Cash and short term investments increased $23.7 million to $181.9 million at September 28, 2013 compared to $158.2 million at December 31, 2012 and includes $65 million of U.S. Treasury bills.

Accounts receivable was $52.9 million at September 28, 2013 compared to $62.6 million at December 31, 2012. Days Sales Outstanding at September 28, 2013 remain unchanged at 71 days compared to December 31, 2012.

Inventories increased to $67.1 million at September 28, 2013 from $68 million at December 31, 2012 primarily due to a decrease in raw material and surface inventories, offset by an increase in finished goods and demo inventories.

Finally, I'll conclude with some statistics regarding our headcount numbers. Worldwide sales and marketing headcount increased by 61 or 16.6% to 429 at September 28, 2013 from 368 at September 29, 2012. Globally, Account Manager headcount increased 20.1% to 221 at September 28, 2013 from 184 at September 29, 2012. Regionally, Account Manager headcount in the Americas increased to 74 or 25.4% from 59 Account Managers in the third quarter of 2012.

In Europe, Account Manager headcount increased to 65 or 10.2% from 59 Account Managers and Account Manager headcount in Asia increased to 82 or 24.2% from 66 Account Managers in the third quarter of 2012.

We had 1,055 employees at September 28, 2013 compared to 961 at September 29, 2012, an increase of 94 employees or 9.8%. Geographically, we now have 421 employees in the Americas, 355 employees in Europe, and 279 employees in the Asia Pacific region.

I will now hand the call over to Jay.

Thanks, Keith. The third quarter was strong for us with 12% growth in sales and 38% growth in earnings per share. Gross margin grew to almost 57% and Op margin increased to more than 11%.

Our sales team executed well as market conditions continued to improve in the Americas and Europe but remained difficult in Asia. Sales in the Americas were strongest, posting a 20% increase with demand for the Vantage Laser Tracker being particularly good.

Sales in Asia increased 13%, though without the impact of FX, sales would have increased almost 25%. Availability of financing in China and India continues to be a struggle and economic conditions in both countries generally speaking remain weak.

Sales in Europe grew 2% but orders grew more than 16%, the result of somewhat improved market conditions coupled with significantly improved execution by the sales team.

Globally, sales from existing customers was 64%, demonstrating that FARO's best customers continue to see the value added by FARO's products while we work aggressively to develop new customers who are less familiar with the benefits we provide.

We had strong double digit growth in our metrology business in all regions while our Asia scanner business was impacted by a moderate slowdown in demand as customers anticipated the unannounced but highly anticipated launch of our next generation laser scanner.

Gross margins benefited from favorable pricing in the tracker market, partially offset by continued pricing pressure in the arm market. While competitive pricing for arms has not improved, I can also report that it has not gotten any worse. FARO Account Managers are being competitive where appropriate while also continuing to sell the value of the overall FARO package.

We also continued to improve manufacturing efficiency of laser trackers as well as laser scanners, both of which contributed to the improved gross margin in the quarter.

We controlled our costs well in the quarter, benefiting from minimal legal expenses and minimal headcount increase administratively. The largest cost increase in the quarter came from R&D which grew 45%. As I have consistently communicated, R&D is fundamental to the continued growth of our Company. While our target is to spend between 5% and 7% of sales, I have also said that we might occasionally accelerate that if the programs under development showed particular promise.

That was certainly the case over the last three months. Our engineering teams are working on exciting, new and disruptive products for FARO and the benefits of our spending increases in the third quarter should be realized throughout 2014.

We also had an exciting seven weeks as it relates to product launches. In the second week of September, we introduced the next generation of our laser line probe. In addition to remaining the smallest and lightest laser line probe in the market, we also significantly improved the speed and data density of the device while also improving its ability to manage the shiniest and darkest of surfaces.

Right after the quarter ended we launched the Laser Scanner X330, the latest in a very disruptive generation of this exciting product. The range of the new X330 was expanded to more than 330 meters, almost triple the range of our previous generation. In fact, in some of the testing we have done, we are receiving high accuracy data at a distance of 600 meters or more than one-third of a mile in distance-at-millimeter accuracy.

We also improved the image clarity from the scans by twofold and added GPS for instant and continuous positioning recognition of the scanner. On top of all that we were able to maintain the size and weight that had been so disruptive to the marketplace.

Launched at the Energia Fair in Germany, customer response was immediate and highly favorable. While we don't discuss sales by product line within quarters or across the year, I can tell you that orders, since launching the product four weeks ago, have been beyond our expectations. Many of those orders came from customers who haven't even seen the device yet. I can also report that while there were several product releases by other companies at the Energia show, none of them as close to FARO in terms of form factor, range, price, or ease of use. The X330 has been in production for about two months so customer shipments are already underway.

Finally, we launched the next generation of our FARO WebShare service with complete point cloud measurement capability in the cloud. This paid for service via subscription fees or pay-by-use will allow customers to store complex point cloud models in cloud, enabling access to their data by users around the world on a real time basis.

Ease of use and simplicity remain cornerstones of our disruptive focus in the marketplace and FARO SCENE WebShare will become a fantastic enabler over time.

Our cash balance, up 15% since January 1 now sits at $182 million. This gives us plenty of flexibility. We continue to look at acquisitions that could enhance our business strategically. However, concerns over longevity of the technology we're examining combined with high valuation expectations keep us in the search phase at this point. I still believe that there are meaningful acquisitions for this Company. At the same time, I remain confident that acquisitions would enhance but are not required for the continued growth of FARO.

In aggregate, the third quarter was a good one for the Company. Sales grew double digit. Gross margin improved and EPS grew 38%. Market conditions appear to improve in Europe and remain strong in the Americas.

Asian markets may continue to feel pressure through the end of the year. However, results from Asia in the third quarter are encouraging. We have two extremely new products in the market with several more coming in 2014 and the FARO brand remains as strong as ever. Being recognized as one of Fortune Magazine's top 100 growth companies of 2013 is just icing on the cake.

As always, I thank our customers, our employees, and our investors for their continued support. Thanks for your attention and I'll now open up the call for questions.

(Operator Instructions)

And we'll take our first question from Patrick Newton from Stifel. Please go ahead. Your line is open.

I guess jumping right in, Jay, when we think about, I guess how should we think about the seasonality in your December quarter? I think our model indicates a 12 year average sequential increase of about 23% with a pretty wide standard deviation and so given September quarter trends, is normal seasonality on the top line a reasonable expectation?

Without saying whether we think it's normal seasonality, I would say yes, we would expect seasonality in Q4 even though the markets obviously, particularly in Asia, are still a little weaker than we would like and Europe is just starting to improve, general indications would imply that yes, that use it or lose it mentality of fourth quarter budgets is probably still there. The degree to which we receive that in the fourth quarter this year is still harder to tell. You're right, we have a pretty wide standard deviation over the years but I certainly think we're going to see some at least meaningful movement in that direction.

Thank you for that. And then I guess, you talked about orders being beyond your expectations for the X330. Can you help us understand how this demand compares to the FLS in a similar timeframe post its launch? Could you update us on thoughts surrounding an OEM relationship with the X330 and then can you also talk about your ability to ramp capacity to meet demand? I am just curious given that you were kind of overwhelmed with FLS demand when you launched in 2010.

I think I'll try to go in the same order you asked them. The order run rate out of the gate is better than the FLS in some respects because the product is already, the concept of the product is more well-known now than it was when we released the FLS three years ago. We knew it was released. There was a lot of excitement. There were orders coming in out of the gate but the real order stream was sort of tail end of the quarter as people got to know the product and realized that it was the real thing.

The launch of the X330, all of the technical or conceptual side of what the product can do was solved already. People already understood it so the fact that you're taking orders on the stand at the show which is not something we do -- there are plenty of industries that do that but that is not something we are used to and we're taking orders on the stand. We got orders coming out of the Americas where customers hadn't even seen it. They are just calling the Head of Sales saying, does it really do what it does? He says yes and they said great, I'll take x.

We're definitely seeing, I would say it's a faster take-up. Now, whether over the course of several quarters we would anticipate it would have better growth as the FLS as well just given that it is, at this range it is much more of a true surveyor's instrument than the FLS was at 120 meters. It was interesting to the surveyors and folks like that. At 330, it's really interesting and particularly if you are getting data at 600 meters. That is the real deal for that marketplace.

I guess I won't go in the order you asked. So relative to capacity, we do not have any concerns there. Because we already were running at such a high capacity from the FLS, that ramp up and that learning curve that we had to go through three years ago, we have solved multiple times over in supporting the FLS in having a very fluid manufacturing flow.

The fact that we were able to start production on the X330 during the third quarter while simultaneously continuing to produce FLS that was going out to customers on shipments at the same time I think is a pretty good indication there and a lot of the componentry is similar as are the manufacturing processes so there was not a tremendous amount of relearning that needed to occur on the floor.

Relative to OEM relationships, we do have a good relationship now with Topcon, obviously. We have been talking about that over the last couple of quarters that we were establishing that and we do have a good relationship with them around the world. Likewise, we still have a good relationship with Trimble. We have not finalized whether the X330 will be a Trimble branded product with FARO selling it to them that way or if it will just be sold by Trimble straight as a FARO product. Obviously, there is interest on their side given the increased range while still having the same size and form factor so we'll leave that one open for the moment. Either way though, we feel fairly confident in our ability to continue driving sales growth in that device and like I said, the customer reaction was really favorable for those who were at the show and for those who heard about it quickly after the show.

Okay, thank you for the details. I guess two more -- one is, Jay, when we look at the growth in Account Managers, are you now staffed to desired levels and can you remind us the duration to get to full productivity and then just one last gross margin question for Keith.

I think we are -- well, to be fair, we are probably never staffed to desired levels because we are always adding Account Managers at some sort of flow because you are always hiring for sales that will be generated six to nine months out.

To your question about ramp up, that is still about the right amount of time. We have seen some success. We have started adding some Sales Engineers as sort of a preliminary sales role where they are doing more application engineering work and supporting the sales team in the field and learning the market and then promoting them into the Account Manager ranks afterwards and that seems -- it's an early program but we seem to have had some success there that once they become a true Account Manager, the learning curve is significantly flatter and shorter so there are some promises as it relates to that, generally speaking though, six to nine months. Yes, you will continue to see us add Account Managers quarter to quarter. We're trying to keep it just sort of a steady flow knowing that we are always adding for six to nine months out.

Keith, on the gross margin side, to make sure that I got the major impacts on the sequential change, it was mainly manufacturing cost efficiencies? Service was a little bit better on a year over year basis and I think partially, volume. Were those the key drivers and then can you help us understand the sustainability or how we should think about the margin profile moving sequentially from here?

Actually, when we talked about increases in gross margin we were talking about quarter over quarter, comparing Q3 of '13 compared to Q3 of 2012 and in Q3 of 2012 we had some very large, unusual manufacturing variances related to some overhead and some manufacturing costs so those costs did not reoccur in this quarter.

Sequentially, I think as Jay had mentioned, the prices seem to have hit bottom or certainly not in the decline as they were in the first two quarters. I think going forward, and again service margins, that is primarily a function of warranty sales as well as the number of units that come back for servicing on a pay-by-drink method.

Going forward, I think you should expect to see probably this 56%, 57% margin range to the extent that we don't encounter those similar types of manufacturing variances that we did in the year ago quarter and we certainly don't anticipate that.

And we'll take our next question from Mark Jordan from Noble Financial. Please go ahead. Your line is open.

The product gross margin being the best since I think the first quarter of '12, what was the mix of demo product sales in there? Was that lighter than normal but also benefited margins? You did say your demo inventory was up. Is there going to be some higher movement of that product in the fourth quarter?

There was nothing unusual about the amount of demo sales this quarter sequentially or compared to Q3 of 2012. I think some of the demo inventory has gone up. I think we are still getting some of the Vantage Laser Trackers out there as well as some of the additional X330s so that is it primarily but the demo inventory really didn't have that much of an impact in Q3.

You mentioned that 64% of revenues were derived from existing customers. I think if we went back a few years you had looked for more balance, about 50/50 new customers/existing customers. What are you doing to raise the level of new customer sales relative to selling into your installed base?

You are right, Mark. We still, and today still believe that trying to maintain 50/50 is the right target for the Company. It shows the perpetuation of the technology across a broad set of users. If you look at it from a marketing standpoint, the marketing side, the lead side, is much better balanced in terms of going after the new customers. In fact, typically there are more new customers in the lead pool but you've got a different hit rate for those folks.

What I think we're seeing right now is that still just because of some of the economic uncertainty particularly in places like Europe and a little bit in Asia too is that the existing customers are much more willing to open the checkbook and buy the technology today because it has already been clearly proven to them what the value is.

Newer customers, the cycle is definitely longer. There is still a little bit of that mentality of while we are getting new customer sales, obviously, we still have some of that mentality of well, I can spend $50,000 and I might get that ROI that you guys are describing or I could not spend the $50,000 and I know I still have $50,000 in case I need it for something else urgently. Particularly, the smaller the company, the more magnified that impact becomes and we still obviously sell, 75% of our sales, give or take, are to the smaller tier 2 and tier 3 type companies so we're continuing to push hard with it. I think we are in the right spot as it relates to leads and demo counts coming in. I think unfortunately, it is just a matter of time. The good news is that the existing customers continue to help support along the way.

Final question, if I may, overflow in the Americas was book-to-bill less than one. Was there anything that you saw in terms of customer behavior in the quarter that would have had delayed orders?

Not really. I think there is a little bit of timing in there so I can't say that there is not a little bit of that but given the size of the typical transactions for us, it takes a lot of customers to delay to have that kind of impact. I think a little bit of it was coming off a decent order quarter in Q3. As we look forward, I'm not as worried about -- you know, we occasionally have these dips where you have a region that is definitely less than book-to-bill of one to one. We occasionally have a region where their book-to-bill is way over one to one and those usually settle themselves out the following quarter so something like that doesn't concern me too much. If I saw it two or three quarters in a row then obviously I would have a different opinion of that.

And we'll take our next question from Richard Eastman from Robert W. Baird. Please go ahead. Your line is open.

Keith, I just want to double back for a second on the gross margin in the product area. When I look at the raw numbers, the dollar amount, just explain how from the second quarter to the third quarter we generated not quite but close to $2 million more in profit on the same sales number. Is that a function of this new, the new laser tracker selling more? Is that a mix issue between the second and third quarter, the Tracker outsold the Arm?

As you know, we don't really talk about sales by product line. I can tell you that our costs have come down. Our average selling prices have somewhat stabilized sequentially. That is both on the arm and certainly on the laser tracker. I don't want to talk too much about mix but I can tell you that between the manufacturing costs coming down not just Q3 2012 over Q3 2013 but sequentially as well, I think the benefit this quarter was certainly we see the average selling prices kind of firming up and not decreasing like they have been in the past.

Yes, which helps explain the year over year but I just, I think the quarter to quarter, second to third quarter improvement in gross profit on flat sales would again suggest that the mix favors a higher margin product and since you are getting price in the tracker, presumably that had that kind of an impact.

Yes, we are getting better prices on the tracker. Some of that impact sequentially is also related to service margins as well, as well as our manufacturing costs coming down for all product lines.

Jay, just a couple things on the sales and order numbers. In the Americas, the order number looks maybe a little bit softer than your commentary and I think the book-to-bill in the U.S., in the Americas, was .87 which is pretty far below where it typically would be. To get the extra sales in the third quarter, we obviously pulled down backlog and I'm trying to understand why the order -- I mean, you commented about the strength looking, improved strength in the Americas and yet when I look at the order number, it looks softer than it should be.

I think you're right, Rick, that .87, that is a little bit lower than we would normally see. We have occasionally seen that but I guess, and I don't want to, I'm trying not to give away what we think Q4, Q1 will look like but it's not low enough when I look at what is in the pipeline for the Americas and Europe and Asia too. When I look at what is in the pipeline and I look at sort of the normalized deal flow that the sales team is working on, it's not a number that concerns me at this point.

I guess the Account Manager growth would, in the Americas, would again suggest that we should see that showing up in the orders. That is what is surprising. The sales number was fine but again, if that comes out of backlog, I'm just surprised the order number isn't more reflective of the growth in Account Managers in the Americas.

Some of that is you've got some ramp up time there with the new Account Managers as well and we do have -- some of the sales heads that live there are newer to the Company. It just takes longer to -- I mean, six to nine months. It's not like it takes them 18 months to get productive but it is certainly not an immediate transition either.

Okay and then just in Europe, when I look at the product service growth rate, what you notice is a significant service growth and the comment earlier that Keith talked to in terms of service gross profit margin and growth there, is the sale in Europe at this point, given the difficult margin conditions and pricing pressure, has the focus been there more on service and warranty sales versus product sales which were down a little bit? Is that a shift in strategy given the current market?

Not so much related to the current market. Clearly, there is incremental push globally on selling more service, particularly the extended warranties. The regions have added at least one, in some cases two dedicated people to just work on warranty and extended warranty sales coverage versus have the AMs do that so just like we saw the Americas had similar benefits starting to creep up, I think first or second quarter we're starting to see that more meaningfully, I think actually in both. You're seeing a little bit of that in Europe as well so it is not that they are shifting strategy in favor of that, it's just that that has become a bigger piece of the strategy for sure.

As it relates to CLs in the market, in this case if you look at the orders growth, you definitely have a better orders growth rate out of Europe so there is some improvement there. We do have some new Account Managers on board. There was some additional turnover of the ones who weren't performing and obviously, we have a whole, we've got a new leader over there that has really started to hit his stride now with that team and I think we are starting to see the benefits of that in the third quarter too.

Was service and warranty sales kind of underpenetrated in Europe relative to the other markets?

Yes, I think it was relative to the other markets. To be fair, in the Americas, when we put the dedicated people into the role there, there was a fairly quick uptick in service sales. Keith, you can confirm that as well but yes, I think in Europe, they were not as quick to pull the trigger on doing so and we're starting to see some of that benefit now.

Okay and then just a last question, Jay, could you just give a bit more color on this FARO WebShare product? Is that targeted at the laser scanner, the 3D laser scanner or is that a -- what product is that targeted at and what does a launch look like of that product? Is that sold as an add-on contract or --?

The FARO SCENE WebShare?

Yes.

Yes, obviously with any new scanner, we are certainly presenting it at the time that it is an opportunity for customers to use it. No question we are making that available to all of our existing customers as well and we have seen multiple. I can't say, it's not like we have thousands of customers using it yet, obviously. It's pretty new but the concept which is an interesting one of you see manufacturers using it to scan facilities and share that scan data with facilities elsewhere. If they redesign part of a manufacturing line, they can scan the new line anywhere where they have the identical line. That data can be grabbed by the other plants and used then to replicate the cell or cells at those other facilities so that is the really exciting part about it.

I think it will be a service that will take a little bit of time for us to see some meaningful traction but as we have often talked about, are there opportunities to generate a more meaningful recurring revenue stream for FARO and a stabilized revenue stream and obviously, this is one that we think has some potential and the early indications and feedback from customers is pretty positive as well and like many things that are virtually pure software with a little bit of hosting cost, it's a pretty high gross margin product so if we can get some stability there on subscription fees, license fees, and some that will be paid by use, I think that has a lot of potential for us in tail end of 2014 and beyond when it becomes more meaningful.

Do you have a dedicated sales force or a guy or something for that?

Great question. We don't yet but the concept is there. I have kind of looked at this saying it is the sale here and we are finalizing what we think the best way is to approach the customer base but conceptually, it is a little bit like an enterprise system sale and so it is possible that we would add a couple people to help enhance the flow, not that our Account Managers can't do it but it may help them or help assist them, kind of like what we do with the warranty sales too.

Keith, what was the percent of [BD] FLS product that went through distribution this quarter?

I think this quarter we were about 52%, basically flat with the third quarter of 2012.

Excellent, thank you very much.

And we'll take our next question from Hendi Susanto from Gabelli & Company. Please go ahead. Your line is open.

3D Systems announced earlier this week that it is planning to introduce commercial 3D scanners in December and this week we also heard that AMETEK announced acquisition of Creaform, a 3D measurement technologies company. What is your thought on new, emerging 3D scanner and how should we think about it and I would like to know also what your current relationship with 3D System and Stratasys is and whether you have a view on selling a 3D printing branded scanner similar to your partnership with Trimble?

Obviously, we know 3D and Stratasys very well, in good relationships with both teams, both at the leadership level as well as kind of the next tier below.

Relative to consumer grade scanners, not something we are interested in. It's not really our space, similar to the 3D printers on the consumer side. There is not a lot of value add that we provide there. We don't have tie to the customer. The technology that is required for the consumer side is not nearly as sophisticated. It's not nearly as patentable or IP protectable and so from that standpoint it's also less interesting to us and that's not to say it changes the partnership with, the relationships we have with 3D or Stratasys at all but it is just not really our space.

Where we do play is when you look at the printing side of their businesses, anywhere where you are making, where the customer is going to do short run production, quick tools, buy molds, first articles, things like that. Particularly if they don't have existing prints or CAD models, we definitely come into play there so a FARO scan arm on a part that you need to replicate for prototyping for doing actually a short run of production or a single, one-off production, that is where we play with them and will continue to play with them because you're not going to get the accuracy in a consumer device that is required for the vast majority of those industrial parts.

So that is where we are with them. Relative to AMETEK's acquisition of Creaform, we know Creaform well. Obviously, we looked at the company from both a technology standpoint and a fit standpoint and we didn't feel like that was the right place for FARO. We have known the technology for a long time. We just think there are different ways to solve the problem, so to speak, for customers.

Jay and Keith, could you remind us qualitatively, what attach rates for warranty sales across geographies look like and how different they are, let's say in third quarter versus a year ago?

The attach rates, we don't really disclose what the attach rates are for our existing sales for the quarter or our install base but I think historically, it has not received the focus that it has been receiving over the past maybe year to two. I think there is certainly a lot of opportunities in our existing customer base as well as for our new customers for us to continue to sell warranties but we typically wouldn't disclose that number and I think it has been receiving a lot of renewed or increased emphasis in the past year or two.

If I may ask differently, have you seen warranty rates improve meaningfully this year compared to last year?

I think you see warranty sales increasing and as a result, we don't talk about whether they are existing customers or new customers but clearly, the sales of warranty contracts have been increasing and I think it is primarily a result of additional of renewed focus and emphasis on that potential market.

And we'll take our next question from Brad Moss from Needham & Company. Please go ahead. Your line is open.

Just first off, wondering what you are seeing with the pricing environment in the metrology business and just kind of overall, the competitive environment in metrology.

On the arm side of the business which is where the fundamental pricing issues have been through the course of this year, while it hasn't gotten meaningfully better -- I can't say that -- it is not getting any worse so there seems to be stability. It was there throughout Q3. I think that from an execution standpoint, our team has gotten comfortable on how to manage that. It took a couple of quarters, Q1 and Q2. It took a couple quarters to get there and understand where it's at and like I said, it does not appear to be getting any worse which is good.

On the tracker side of the business, pricing is very good. The new tracker that we released a year ago has a higher list price and we are capturing a significant portion of that incremental list price in the sales to our customers and that is at the high end of the tracker business which is where we compete. Hexagon has a lower end tracker that is a lower price point but it has significantly different functionality and so we tend not to compete against them in that space so it helps keep the pricing side fairly robust.

To be fair, their high end tracker, we have not seen any type of aggressive movement there. I think both companies are getting, have good markets for those, the split in those products.

So the metrology side in general, I would say that still not better but not any worse than the arm side, definitely good pricing on the tracker side.

And then just quickly a follow up, just overall wondering what end markets you are seeing the most strength with.

Certainly, aerospace remains strong. It has been a great market for us for, I mean, all the way back through the downturn, Aerospace has been rock solid the whole way through. Not a shock given the state of their industry right now.

Automotive is definitely fairly strong as well which is a good thing. The heavier industrials are sort of hit or miss depending on industry. Energy, not bad, process, power, and piping, pretty good. Some of the lighter manufacturing depends on the size of the company and that is where we have seen some of, particularly when we go after new customers there, that's where we see some of the delays or pauses in purchase decisions because they are still relatively new to the technology but the markets which, good markets with good funding and good cash are also actually spending it too which we're seeing that in Q3 which is helping.

And we'll take our next question from Patrick Wu from Battle Road Research. Please go ahead. Your line is open.

Just piggybacking on a question earlier, in terms of the revenue distribution, it's at 52% versus the prior year and that was flat. I just wanted to get a better sense of how it was versus the previous quarter -- that would be great -- and what your expectations are moving forward for distribution for the FLS products.

I'm sorry, I didn't get the first part of that question.

Just wanted to get a better sense of the percentage of FLS parts distribution versus the previous quarter. It was at 52% for this quarter and 52% last year. It seems like it's almost flat but versus last quarter, wanted to get a better sense of that and sort of how your expectations are moving forward for that relationship.

In Q1 of 2013 it was about 63%. In Q2 it was about 52% and in Q3 it is 52%.

Relative to the market, I guess a couple thoughts there. One is as I indicated in the remarks, I think we saw a little bit in Q3. Though everybody knew there was a product coming, I never said what product was coming. I think because it had been three years since we had a new scanner release we did see the scanner market, there was some anticipation of something exciting coming just because it had been three, four years. We know how hard we work to try and disrupt ourselves every two to three years so we were right on schedule there.

They knew there was a major tradeshow coming up, the Energia show which is, the bulks of it is surveyors. I think there was some anticipation that, gee, that show is the first week of October. They must have something coming and we saw some slowdown there.

That being said, we also, we do have our own Account Managers for the scanner who continue to do very well in the markets they sell into so some of it is that you have a direct sales force in FARO that is working awfully hard and selling very well, offsetting some of that so as we go forward, particularly as it relates to the surveying space, we still see channels like Topcon, channels like Trimble being good access points for us. While our team could access those channels themselves, probably not at the same run rate. Having both of those companies going after that space for us is a good thing. If you only had one of them going after the space it would still be a good thing. There is plenty of market out there, plenty of activity and traction.

And again, the new X330, at least all the initial indications, because of that improved range in particular, seems like it is even more meaningful to the surveying space than before so going forward, for that particular vertical you'll expect to see us continue to sell direct to them. For the other vertical, as we develop them it is going to be a mix of direct Account Managers from FARO, we may supplement with different types of channels or different types of people come on board to help assist the Account Managers in getting them in the door to do the sell. That remains to be seen. That will still take some time.

Any commentary you guys may be able to add in terms of your products for the rest of this year, maybe beginning of next year and what areas are you looking to for reinforcements when it comes to that?

Clearly, when we talked at the end of Q2 I indicated there would be at least one major product release in the second half of this year. We had one major, the Laser Line Probe, while not quite as big a deal as the Laser Scanner, was actually still a pretty good product launch given the improvement in the data density and speed and the dark and shiny surfaces which is something that customers occasionally will struggle with.

For the rest of this year we are focused on execution on the products that we have yet into 2014 I would call it a fairly robust year. We have several things coming down the pipe and without saying which quarter they will be released in, you'll see and it's kind of an indication of that increased spending here in Q3. When we have things that are exciting that we think show potential and we see an end to the time horizon or we see a known time horizon and when we can complete it, we're going to move aggressively to do so, so 2014 should be a pretty robust year in that regard.

And we'll take our next question from Patrick Newton from Stifel. Please go ahead. Your line is open.

Just a follow up on the new product introduction cadence. I guess, Keith, if we think about that from an R&D expenditure perspective, can you help us understand how we should think about R&D either on an absolute basis or as a percentage of revenue or some way to quantify that as we move through 2014?

Historically, we have been in that 5% to 7% range and as Jay had mentioned earlier, I think we have talked about at some points in time, some quarters you are going to see that get to that 8%, 9% range. That is certainly not out of the question as we move forward with some of this new product development.

You're already at about 9% so it sounds like if anything, if I think about it from just a percentage of sales perspective, if we should see some incremental leverage assuming some revenue growth?

I think that is a fair comment, Patrick. When you see these accelerations it's because there is enough activity that we say look, let's hit the gas pedal. We know we are going to be upside down for a quarter and then your [IDs] tend to start seeing leverage again as you come through the next couple of quarters with incremental sales after that.

Okay, and then just kind of sticking to the leverage questions, as we look at the aggressive headcounts that you have made and I think that they are, at least the heavy lifting is kind of behind us. Would you expect that we are going to see some incremental leverage on your selling expense line as well?

I would think so. Obviously, we will add some Account Managers. We'll drip them in over the coming quarters, again because you are always adding for six to nine months out.

That being said, we have added aggressively, obviously. We are up 40-ish heads I think, 40-ish Account Managers since Q3 of last year and our Account Manager base is definitely not at full productivity when you look at sales spread across the number of Account Managers. We are not at our typical averages which have run 1.25 million on average, give or take, around the world, 1.5 million sometimes so we would expect to see leverage just purely based on that premise as well.

And we'll take our next question from Richard Eastman from Robert W. Baird. Please go ahead. Your line is open.

Jay, just one maybe higher level question, when you look at FARO's business model and you look at where the company has come over the last couple years, there has been so many metrics moving around here, from sales, sales channels, account managers -- there is more variable cost there but more of them -- if you look at how these metrics have moved around, is it fair to assume that when we come out of this sales pause that FARO is going to be in a position to perhaps leverage a lower sales growth rate into and scale that up into incrementals, EBITDA incrementals of 25 to 30 off of perhaps a 10% to 15% sales growth rate versus what we have traditionally targeted as kind of an elusive 20%. Maybe this is a law of large numbers question but so many metrics have moved around here from service, gross margin, product gross margin, just all the things we have talked about over the last couple of years so how do you see FARO's business model from an operating leverage standpoint if we come out of this in '14 and '15 with less than targeted sales growth?

So for me, the easier buckets are when we think about leverage, no question we do today and will continue to get more leverage on the manufacturing side as it relates to the number of incremental people required to support any level of growth, even if you are in the high double digits, the ratio is obviously quite favorable from a leverage standpoint.

And the same thing on the administrative side. We have been fairly tight on administrative personnel. They come in in tiny numbers, a handful here and there over the course of the year and so we get great leverage there.

Generally speaking, we should get decent leverage off of R&D but like I said, we occasionally have these spikes where we will increase the spending to get something moving.

Sales is the tricky one for sure because still today, unless we saw a massive shift to the way to go to market, particularly the metrology side, that is different from how we do it today, we are going to continue to have to add Account Managers over time and so that the 20%-ish, 25% when you include the marketing that we are spending on selling, probably continues to be a number that we are sitting with for the next several years so I would not want to make anyone think we anticipate significant leverage there.

That being said, we are obviously trying different channels which does create some, makes it a little bit fluid there. Clearly, we are using distribution for the LS on the construction surveying side. If we found another market that we like and we don't like distribution as the better route because they had better access, obviously that could change the model again.

Likewise, if we saw a market that was really exciting on the LS and we decided that direct was still the best way to go, you could see us adding more Account Managers on the LS side and then you are back to the normalized model again.

We have been spending more time selling the warranties which drives that service number up but you are getting significant leverage there. You're talking about a couple of people dedicated to selling it around the world with significant increases in revenue and good gross margin coming off of that as well.

I think, Rick, the tricky part is that as we continue to expand, we continue to grow, that sales bucket, the cost associated with the selling is the one that probably has the greatest amount of fluidness, or fluidity -- I'm not sure what the right adjective is there but it will have the greatest potential for variation while always probably still being in that 25%-ish bucket like we have today.

Good leverage off manufacturing, good leverage off of admin and in the R&D, we can get some leverage at times but also it's not, we're not purposely trying to drive down the ratio unnecessarily because we do have multiple things underway that are exciting for the long term prioritization of the Company.

So the real leverage is (inaudible), I know sales growth obviously matters significantly for those items but it is basically the mix of business going forward and how stable the gross margin is at this 56%, 57% level or better so a mix issue.

Right.

(Operator Instructions)

We'll go next to Joseph Garner from Emerald Advisers. Please go ahead. Your line is open.

Jay, I was wondering if you could comment a little bit on the linearity of sales during the quarter. It seems like your tone on the sales front is much more positive than it was last quarter at this time so I am wondering if we saw perhaps a stronger sales environment toward the end of the quarter than we might normally see.

Not stronger than normal but I will say stronger than the previous couple of quarters for sure. That lack, maybe a better way I guess for you to look at it is that lack of linearity here can definitely still hockey stick into the final weeks of the quarter. The tip of the stick was stronger in Q3 than in Q1 or Q2 and some of that makes me feel good about the go forward. Some of it is also just the market dynamic and what we are hearing from the Account Managers and the types of dialog they're having with their customers is definitely improving. Cautiousness from the customer side is definitely getting better particularly in Europe and the Americas.

And the second question I had, I'm wondering if you are seeing any noticeable differences in the end markets for the laser scanner outside of surveying? It seems like the new product certainly helps address that market but wondering if you are seeing anything in forensics or insurance or any of the other end markets that you have talked about in the past.

I can't say meaningfully though I will say at the 3D documentation conference we had a couple of weeks ago we had more, I believe, we had more people from the forensics side than we have ever had before. I had good meetings while I was there, short one on one dialogs as well as a pretty lengthy dialog with a couple of the forensics experts while I was there and the utilization of the scanner there is definitely moving in the right direction. We had a great example of an investigator who, the first time in the Toronto court system -- you had to look at this specifically to the different systems but the first time in the Toronto court system was able to get the 3D scan data admitted as evidence. She actually had to bring in a scanner and show the jury how it worked but once they got it, that was now admissible evidence for the law in Toronto.

One of the things we have always looked at, the more you can get into a court case where people can say I can prove because I have the data or I can disprove because I have it, obviously that has benefit.

One market I would say that is probably, we are going to see a little more traction in is that forensics side, really based on the participation at the documentation conferences in the back half of this year.

(Operator Instructions)

And it appears we have no further questions.

Very good, thanks everybody. We will look forward to updating you again at the end of Q4.

This does conclude today's program. You may now disconnect. Have a good day.