FARO Technologies Inc (FARO) 2017 Q4 法說會逐字稿

Good morning, everyone, and welcome to FARO Technologies' Fourth Quarter and Fiscal Year 2017 Earnings Release. For opening remarks and introductions, I will now turn the call over to Chief Financial Officer, Bob Seidel. Please go ahead.

Thank you, and good morning, everyone. Yesterday, after the market closed, we released our fourth quarter and fiscal year 2017 financial results. The related press release and fiscal year 2017 Form 10-K is available on FARO's website at www.faro.com.

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, anticipate, plan, potential, continue, goal, objective, intend, may 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 set forth in yesterday's press release and in the company's Form 10-K for the year ended December 31, 2017.

I will now turn the call over to Simon to provide his remarks on our progress toward our long-term goals, and afterwards, I will return with a brief discussion of our financial results. After our prepared remarks, we will open the call for your questions through the start of trading at 9:30 a.m. U.S. Eastern.

Thanks, Bob, and good morning, everyone. In 2016, we outlined our vision of strategic initiatives to restore FARO as a market-leading technology company by implementing a vertical market approach, an expanded sales force, modernized sales processes, a new product drumbeat and transformative acquisitions. I communicated clear long-term financial objectives for the end of 2019, which include double-digit sales growth, gross margin to 60%-plus and double-digit operating margin.

In 2016 and the first half of 2017, the entire company worked diligently around the world to execute these strategic initiatives and fully pivot the company into a high-growth, technology-leading 3D measurement and 3D machine vision enterprise.

We completed the vertical and horizontal reorganization, onboarded sales headcount across every vertical and geography, started the online demonstration studios, and completed several next-generation technology acquisitions, reinstilling the entrepreneurial spirit of innovation to sustain a multi-vertical new product drumbeat. As we noted, we were looking to the third and fourth quarters of 2017, as harbingers of the success of these strategies.

We're delighted to report that our financial results have started to demonstrate the benefits of investing in these strategic initiatives. We've experienced consecutive quarters of double-digit sales growth, consecutive quarters of gross margin improvement and consecutive quarters of increased operating margin. Of course, we are pleased by the market's response to these early successes, and despite the high market volatility, our stock price increased by an approximately 30% in 2017.

However, we must continue to perform, and as part of our 2018 initiatives, we have implemented a company-wide continuous improvement and lean initiative, which is being institutionalized for long-term sustainability. As the world evolves, we must adapt and continue to set a course as the world's leading provider of diverse 3D solutions. The development of our emerging verticals has demonstrated the huge advantages of clear customer focus with very high year-over-year growth in the emerging verticals.

Going forward, in 2018, we will manage our factory metrology and 3D machine vision verticals under the one name of 3D factory with 2 operating groups. The rationale for this move is based on the shared customer base of these 2 verticals and the natural synergy of the customized solutions that 3D Machine Vision group provides, working directly with the factory metrology sales team to bring innovative new solutions to the marketplace.

As we adapt to the demands of the machine vision revolution, we've understood that all of our 3D inspection technology, software, know how, places us in an extraordinary position to introduce a new class of 3D Machine Vision sensors. In this context, our tagline, FARO, the measure of success, will be updated to FARO, 3D visionary.

This triple entendre is designed to capture our strategic vision, 3D vision technology and our leadership in the field as we move rapidly into 3D machine vision, factory 4.0, and the revolution now happening in construction verification, product design and public safety forensics.

In 2018, we expect to introduce several new 3D machine vision sensors, which we believe will lead to a transformation in how machines see, inspect, adapt and collaborate in our various 3D verticals.

At the start of 2017, we began an aggressive expansion of our sales force, because of the direct correlation in our business between Feet on the Street, product demos and sales growth. The growth initiative involved a preinvestment in selling expense in the first half of 2017. New sales team members generally mature over a period of a year before becoming fully productive team members. At the end of the fourth quarter of 2017, our period ending sales headcount was 631, an increase of 95 or 18% compared with the end of the fourth quarter of '16.

Our full-time experienced sales headcount, or sales FTE, increased to 568 by the end of 2017. There's a difference between our period ending and FTE sales headcount, which represents start-up sales headcount of 63 and a start-up selling expense of approximately $1.9 million in the fourth quarter of 2017. For fiscal year 2017, the start-up selling expense totaled $9.5 million of investment to grow the size of our direct sales force.

The effectiveness of our sales force is closely tracked by our vertical leaders with our trailing 12-month orders per FTE metric. And we held ourselves accountable to our investors and analysts by reporting this all verticals corporate metric on quarterly earnings calls in 2017. Our trailing 12-month average sales FTE headcount was 530 at the end of the fourth quarter of 2017, an increase of 23% compared with 432 in the fourth quarter of 2016.

Our new order bookings for fiscal year 2017 was $377 million. The ratio of our trailing 12-month new order bookings per average sales FTE headcount was approximately 711,000, a decrease of 12,000 from the prior quarter.

Our double digit new order bookings and sales growth in the second half of 2017 provided a positive indication of the success of this strategic sales force initiative. With our 16% sales growth in the recent quarter, we now intend to increase our period ending sales headcount by 15% to 20% during 2018 in equal increments by quarter.

This higher sales force hiring rate will be accompanied by a higher investment in start-up selling expense and will decrease our trailing 12-month orders per FTE metric through 2018, particularly because significant hiring will occur in our emerging verticals and new geographies with lower vertical dollars per FTE.

We are focused on building the pillars of long term sales growth by investing now in expanding our future sales capabilities. It is a strategic initiative or imperative to have a strong R&D program. And we will continue to reinvest over 9% of sales back into research and development activities, and this has been the key for the past 2 years to executing our new product drumbeat and driving our financial gains in 2017.

In a short time, the hard work and innovative spirit of our research and development teams have returned FARO to the role of technology leader in 3D measurement and 3D machine vision. This team introduced an entirely new generation of product portfolio of software and hardware. Our technical leadership position is key to driving our top line and increasing our gross margin.

The technical advantages of our FARO Focus Laser Scanners in speed, size, point cloud, resolution and accuracy, combined with our leading application software made possible our 33% sales growth in our construction BIM/CIM vertical in 2017.

Our next generation Quantum Arm introduced in August is receiving positive feedback for being the first Arm with an ISO certification and it's helping to drive higher gross margin for the company. In addition, we will be introducing important new FaroArm-related technologies in 2018.

We have new innovations in our research development pipeline to introduce throughout 2018 in order to provide new solutions to our customers' applications and strengthen our position as the technology leader in 3D measurement. The expansion of our 3D capabilities beyond our traditional factory metrology market into new verticals, such as construction BIM/CIM with a much larger addressable market, is an essential component to our long-term growth strategy.

In the first half of 2018, we intend to introduce the first ever fully featured CAD-based surveying and construction 3D quality software called BuildIT Construction, for use with our Focus Laser Scanners and our tracer and projector systems. Our value proposition is to help the construction industry reduce process inefficiencies and costly rework, similar to the benefits that our FaroArm brought to our industrial manufacturing customers years ago.

While all BIM/CIM equipment suppliers are waking to the concept of the 3D process verification, we are a generation ahead with our deep knowledge of CAD-based verification in the factory. In addition, the use of our new laser projection technology is expected to radically change the way digital surveying methods are used in the construction process. We are leading in this revolution, and we will continue to do so.

Another strategic area of new product innovation for 2018 is to expand our product portfolio with our emerging 3D Machine Vision vertical. High accuracy and high resolution 3D sensors that see and measure on the move are the next evolution in factory automation. In the second half of 2018, we intend to introduce several new 3D sensor products into this space. The dynamic vision sensor, DMVS, will be introduced as an early adopter product that can see in high resolution and accuracy 3D while on the move.

Dynamic 3D vision sensors that allow robots to see and measure in high accuracy 3D, while moving, will change the way factories program and use robots. In addition, we will continue to roll out the Vector RI, 3D laser radar, which will be capable of performing multiple high-speed 3D measurements and imaging operations over large distances at multiple locations at the same time.

In addition, in Q3, we plan to introduce a new class of instrument for machine vision and quality control, the first ever high-speed directional, high-resolution illumination independent laser camera. We believe this camera will forever change the way we see in factory settings. We see unaddressed market opportunity in this vertical and are actively working to introduce the products and build the team to tap this opportunity.

After 2 years of reorganizing our company and rebuilding our entire product portfolio, we are focused on delivering double-digit sales growth, gross margin to 60%-plus and double-digit operating margin by 2019 as well as technical leadership in all product categories. As our stock price performance has shown in the second half of 2017, we firmly believe that the short-term risk and costs inherent in executing these initiatives will be rewarded with increased sustainable shareholder value.

We deeply appreciate the patience of our shareholders and the hard work of our employees around the world. I'm proud of our accomplishments over the past 2 years. We look forward to driving the business even further. Bob?

Thank you, Simon. Total sales increased by $14.7 million, or 16.1% to $106.4 million for the fourth quarter of 2017, from $91.7 million for the fourth quarter of 2016. Our sales increase was driven mainly by a strong increase in product unit sales in our construction BIM/CIM and our other segment, which includes the public safety forensics and product design verticals, higher average selling prices and continued service revenue growth.

New order bookings increased by $14.8 million or 15.5% to $110.6 million for the fourth quarter of 2017, from $95.8 million for the fourth quarter of 2016. With new order bookings of $110.6 million and sales of $106.4 million, our book-to-bill ratio was 1.04% for the fourth quarter of 2017.

Product sales were $84.4 million for the fourth quarter of 2017, an increase of 14.5% compared with $73.8 million for the prior year period. Our product sales increase was mostly related to higher unit sales in our construction BIM/CIM, public safety forensics and product design verticals as well as higher average selling prices with the introduction of our new products.

Service revenue was $22.0 million for the fourth quarter of 2017, a strong increase of 22.6% compared with $17.9 million for the prior year period. Our service revenue increase was mostly due to higher warranty revenue as we continue to drive sales initiatives to develop a recurring revenue stream from our installed base.

In our factory metrology segment, sales for the fourth quarter of 2017 were $71.6 million, an increase of 5.4% compared with $67.9 million for the prior year period. This increase was mostly driven by growth in service revenue and higher average selling prices in conjunction with the introduction of our new products.

In our construction BIM/CIM segment, sales for the fourth quarter of 2017 were $25.8 million, an increase of 47.2% compared with $17.5 million for the prior year period. This increase mainly related to a strong increase in unit sales with the growth of our sales force and strong market demand for a broad portfolio of Focus Laser Scanner hardware and software.

In our other segment, sales for the fourth quarter of 2017 were $9.0 million, an increase of 44.1% compared with $6.3 million for the prior year period. This increase was driven by higher unit sales in our public safety forensics and product design verticals, leveraging our sales headcount additions in these emerging verticals.

Gross margin for the fourth quarter of 2017 was 58.3%, an increase of 5.2 percentage points compared with 53.1% for the prior year period. This increase was mainly related to higher average selling prices in conjunction with technology-leading new products and improved manufacturing efficiencies.

Selling and marketing expenses were $28.7 million for the fourth quarter of 2017, an increase of 21.3% compared with $23.6 million for the prior year period. This increase was primarily driven by our strategic growth initiative to increase sales headcount as well as higher commission expense from our double-digit sales growth. Selling and marketing expenses were 26.9% of sales for the fourth quarter of 2017, compared with 25.8% of sales for the prior year period.

General and administrative expenses for the fourth quarter of 2017 were $10.9 million, an increase of 15.3% compared with $9.5 million for the prior year period. As a percent of sales, general and administrative expenses remained unchanged at 10.3% for the fourth quarter of 2017 and 2016. We will continue to drive G&A expense efficiency by our lean initiatives in 2018.

Research and development expenses were $8.8 million for the fourth quarter of 2017, an increase of 13.2% compared with $7.8 million for the prior year period. This increase was mostly related to engineering headcount additions to support our recent acquisitions. Research and development expenses were 8.3% of sales for the fourth quarter of 2017, compared with 8.5% of sales for the prior year period.

Research and development expenses as a percent of sales in 2018 will also benefit from the implementation of lean initiatives. In the fourth quarter of 2017, we report a provisional charge of $19.4 million in income tax expense related to the enactment of the U.S. Tax Cuts and Jobs Act, or U.S. Tax Reform on December 22, 2017.

This provisional charge consisted of $2.0 million related to the remeasurement of our deferred tax assets arising from a decrease in the U.S. corporate income tax rate and $17.4 million of transition tax related to the mandatory deemed repatriation of foreign earnings.

The provisional transition tax expense of $17.4 million represents a preliminary estimate and may change as additional guidance is issued in the future by the U.S. Department of Treasury or our own changes in estimate or interpretations.

Consistent with the guidelines of Staff Accounting Bulletin 118, we will adhere to a remeasurement period of up to 12 months from enactment and communicate any changes in this provisional amount, if material, as known.

Excluding the $19.4 million of additional income tax expense related to U.S. Tax Reform, our fiscal year 2017 income tax expense would have been $1.0 million, representing an effective tax rate of 17.0%.

Our net loss was $11.1 million or $0.66 per share for the fourth quarter of 2017. Excluding the $19.4 million impact of U.S. Tax Reform, net income would have been $8.3 million or $0.50 per share for the fourth quarter of 2017, compared with net income of $3.5 million or $0.21 per share in the fourth quarter of 2016.

Turning to working capital. Accounts receivable was $72.1 million at the end of the fourth quarter of 2017 compared with $61.4 million at the end of the prior year period. Days sales outstanding was 62 days at the end of the fourth quarter of 2017, up 1 day from the prior year period.

Total inventories were $93.4 million at the end of fiscal year 2017, compared with $81.0 million at the end of fiscal year 2016, mostly driven by an increase in sales demonstration inventory to equip our new sales hires and higher finished goods to support our sales growth.

As we drive the business towards our long-term financial objectives, we look at our fiscal year 2017 performance as an important helpful measure of our progress. I would like to highlight our performance on several key financial metrics for fiscal year 2017 compared with fiscal year 2016.

Sales of $360.9 million, increased 10.9%, highlighted by a 32.7% increase in construction BIM/CIM and a 21.6% increase in our emerging other segment.

New order bookings of $377.0 million, increased 14.0%, reflecting strong growth in construction BIM/CIM and public safety forensics. Gross margin of 56.7%, increased 2.0 percentage points, mostly driven by higher average selling prices and internal initiatives to improve our manufacturing efficiencies.

At the end of 2017, we maintained our strong balance sheet with cash and short-term investments at $152.0 million, of which $98.8 million was held by foreign subsidiaries, and no debt. Our cash and short-term investments increased by $2.8 million in fiscal year 2017.

We delivered double-digit sales growth and a strong increase in gross margin in fiscal year 2017, demonstrating substantial progress in the pursuit of our long-term financial objectives. A complete presentation and discussion of our fiscal year 2017 and 2016 financial results is available in our 2017 Form 10-K. I will now open the call for questions.

(Operator Instructions) We'll take our first question from Patrick Newton of Stifel.

I guess, this first one is on the segment front. You had a great BIM/CIM quarter, but the factory metrology business is growing mid-single digits. You had your Quantum Arm release. So I'm curious if you can comment on how that product is being received by customers?

And then if we think about this business longer term, is this a single-digit growth business that you're finding it harder to improve performance? And this is relatively mature? Or could we see growth reinvigorated here?

No, we will see growth back into the double digits in the factory metrology vertical. One of the reasons for the growth is that, that vertical used to handle a large piece of the 3D product design vertical, which, as you know, has now been split off. So it's going to through a readjustment as we -- as the new product design vertical grows, and of course, factory metrology is not having the benefit of that.

I would also point out that we did not add in proportion to the factory metrology vertical in terms of headcount because we needed to populate these new verticals proportionately higher. So had we put the necessary double-digit percentage headcount growth in factory metrology, because of the relative weighting the emerging verticals would have suffered. So we decided to put the headcount in the new areas. So I believe that over time we will get back to double digit.

The response to the Quantum FaroArm has been fantastic. It's the only ISO certified Arm on the market today. Its significant ergonomic features have been well received as well. And as I noted in my comments, we will be introducing additional technologies relating to it this year. So the average sales price has increased substantively. So we are very bullish on the many new products that we will be introducing into factory metrology and will see double-digit growth there.

And the -- comment on the headcount dovetails nicely into the next question. You'd said that sales headcount in 2018 should grow by 15% to 20%. So can you help us understand whether this will be more BIM/CIM focused or metrology focused?

And in the same vein, I think that the last 2 quarters you've missed your targeted headcount additions. And could you comment on any churn that you're seeing in your sales force or other dynamics that might be impacting the ability to add sales at the targeted pace?

So on our last -- Patrick, in our last conference call, we indicated that we expected our trailing 12-month sales that the headcount to come in at 535, we came in at 530. So that's a relatively close number this quarter that we came in at versus our target.

I would say, overall, just given the fact that we are a commission-based sales organization, we have a normal churn consistent with other companies. I would say, no higher, no lower. We look at that -- our HR group and our sales team collaborate very closely -- look at that and do a market comparison.

In terms of going forward, we'd said on our last call that we really evaluate the fourth quarter. We looked at the third quarter and the fourth quarter and we are very pleased by what we are seeing in terms of where we were seeing the orders growth, how we were seeing the employees perform, how we were seeing the growth of the verticals.

And so we made the decision to keep building for the future, and we would add 15% to 20% sales headcount on a period ending basis, but do that in a quarter-by-quarter fashion, so that it's more equally spaced across the year, because we're looking to build forward, but in the same time, we want to be conscious to build profitability along the way.

The only thing I would add to that, Bob and Patrick, is that, proportionally half of the sales headcount is planned to go into the emerging verticals, which represent only about 30% of the sales. So -- and they are respectively at a lower dollars per FTE because of the new geographies, the new product lines and the underdeveloped markets.

So I would expect you to see about half the headcount going into the new emerging, which is -- speaks to your first point about the metrology vertical growth. Proportionately that would be much less, of course, than metrology growth because of the relative size. So I hope that answers your question.

(Operator Instructions) We'll move next to Greg Palm of Craig-Hallum Capital Group.

Congrats on the results and I guess congrats on sort of all the improvements and success over the last couple years. I guess, I wanted to start with the BIM/CIM. Simon, you were recently quoted in an industry publication saying that you believe the opportunity there could be bigger than sort of what you're selling into the factory metrology manufacturing segment. So I was hoping you could expand upon that. I mean, what are you seeing in the market today that makes you so excited?

Well, clearly, the construction is from the addressable market size, the opportunities in construction exceed the factory in our opinion. All the calculations that we've done showed a substantively larger market. The thing that excites me is that the construction industry strangely is only now, but is now wakening up to the fact that they could have saved tremendous costs due to increased efficiencies, reduction in scrap and rework that are endemic to the construction industry.

The problem has been that there has been no cheap, easy-to-use -- or inexpensive easy-to-use 3 dimensional measurement equipment, including software, that allows them to gain those efficiencies available for the BIM/CIM market. Factory metrology software, while it is about comparing to CAD, is substantively different, the things you look for are substantively different in the factory than they are in BIM/CIM.

So I'm excited because of the uptake. I mean, there is so much interest in what I would call digital surveying and verification during the construction process that what was once tolerable -- and this happened in factory metrology as well. It used to be tolerable to have cars coming off the line with defects, which then they put out in the parking lot and wait to fix, and there was lot of scrap and rework.

That quickly became unacceptable as, for example, companies like Toyota introduced total quality into the factories, and now we have cars that don't need to be serviced for 90,000 miles. So that trend is going to happen in BIM/CIM, it's inevitable. I am surprised by how long it's taking, but perhaps part of the time delay was that there was no effective equipment for generalizing digital surveying and verification.

So products like the Focus Laser Scanner provide that capability easily, light weight, inexpensively. And then it combined with software designed to handle the specific tasks involved in construction have, in fact, fueled this excitement.

So we intend to -- and we're investing a lot more money this year in that process, intending to bring software out that takes you all the way from as-built in the case of renovation to new-built or greenfield or brownfield projects, all the way to completion, and our products will play an incredibly important role there.

Understood. And I presume in terms of headcount additions that a bulk of those intentions for this year will be for that segment, specifically. So I was hoping you could help us understand what the P&L impact of that could be in '17. Sales and marketing as a percent of sales was just under 29%.

Do you expect or think that you can improve upon that this year and drive some leverage in that line item? And curious how you're thinking about that specific line item as a percent of sales in order to attain your fiscal year '19 targets?

Well, there's numerous factors that affect that. I mean, clearly, in the emerging verticals, we have -- I'm not going to give the specific vertical dollars per FTE, but it's substantively less than, for example, the mature vertical like metrology.

BIM/CIM has, however, a very high dollars per FTE, which makes us very excited, that is somewhat clouded by the fact that some of those sales are through distribution. And perhaps distribution will be -- will play an important impact. Now because of that, that vertical's contribution margin is less because the gross margin is lower because of the distribution content.

I believe that by adding new products and driving the top line sales, increasing the potential for dollars per FTE, that it will make continued contribution. In response to the growth though too, I think that internally it's fair to say that if we continue to see substantive uptake in the first half of the year on the BIM/CIM products like the ones I was saying are going to be introduced, that we believe that we should probably increase the headcount in BIM/CIM. We should revisit that by mid-year in 2018.

So we may depart from the planned current headcount growth, if we get the response from the marketplace. That will again depress perhaps the -- or increase the sales expenses per dollar sales. But as I pointed out, it's an increase in the top line that we are looking toward to take market share.

I would make another point too that companies that are high in distribution content, for example, companies like Trimble and Topcon and other surveying companies, they work primarily through distribution. And there you will see typical discounted distribution of anywhere up to 30%, for example, on the average.

So if you think about our sales and marketing direct costs of 29%, that's not an unreasonable component. And you'll see in those companies, probably in that product -- those product lines, lower gross margin as well.

So you can give one place, but you'll take in another, and I would just ask you to consider that as part of your review of the cost of the direct sales force. It's not terribly out of line for what the cost is to go through distribution.

Yes, it makes sense. Bob, do you have the mix of Quantum Arms versus previous generation Arms sold in the quarter? And any significant sales of demo units?

So in terms of sales of demo units, it's been about flat versus prior year. We made great effort last year to do that process. And we continue to drive it. We continue to use that in the marketplace as we need to to keep our inventories fresh. In terms of the mix, we do not comment on a product level about mix of a certain model or a product.

(Operator Instructions) We'll move next to Hendi Susanto of Gabelli & Company.

Great Q4 results. First question is for Bob. Bob, post the U.S. Tax Reform, may I inquire what corporate tax rate we should expect going forward?

So in terms -- after the U.S. Tax Reform, we don't provide forward-looking guidance about our tax rate. When you think about FARO, we are a true multinational, with 39% of our sales only in the U.S. for 2017, that's disclosed in our Form 10-K. So we anticipate really minimal near-term benefit from the U.S. Tax Reform in our terms of our rate. Certainly, we will evaluate how we may adjust our operations or cash balances globally after tax reform.

Got it. And then, Simon, given the strong double-digit growth that you have seen for last 2 quarters, would you be able to share how much your business now is software? And in terms of new product introduction, should we expect new product introduction more towards the second half instead of the first half?

We sell solutions. So I can say that almost every sale that we have has some significant proportion of software and hardware. And so the actual split varies depending by the product line, in terms of the dollars. So I can't really comment in a constructive way around that. But I can say that, every one of our sales in general include significant hardware and software.

And then with regard to the timing of new product introduction, would you be able to share?

Well, as I mentioned in my comments, we have many releases that are going to happen this year. A lot of interesting ones in Q2 and in Q3. All the verticals will benefit from these new product introductions. We're most excited -- or I'm personally most excited by some of the ones that we're introducing into the machine vision.

Our decision to take a strong position as a leader in 3D machine vision versus the classic old 2D version of machine vision -- my excitement about that is very high. I believe that we can be transformative in that area, and that's what I'm looking forward to most. But every vertical will see new products this year.

Got it. And then one more question if I may. Bob, if I look at the service gross margin, service gross margin was sequentially lower despite of sales about flat sequentially. Any insight on that?

One of the things that we are doing on our service side, first and foremost, our service group is about serving our customer, making sure they're satisfied, their questions are answered from a technical basis, and they're really the source for getting us the second, third, fourth deal.

So we're focused, as we move through the quarter, to staff our call centers appropriately to handle the diversity of our new products. One of the focus that we certainly have in 2018 is our lean initiative, and we will be focusing to drive that service margin up throughout 2018, as we implement lean really across our company and understand kind of the better drivers of how we increase that service margin.

But if you really look at it in longer terms, step back from an investors' perspective, we delivered over 20% service revenue growth for the year. And over the last, nearly 2.5 years, we've taken that service margin from low 30s to mid-40s, with a goal of trying to get to the 50s.

Our next question is from Ben Klieve of NOBLE Capital Market.

So first, I want to make sure I'm comparing apples-to-apples here from a headcount perspective. Relative to the Q3 call, you indicated that you were targeting 5% to 8% FTE growth in 2018. And then today, you commented that your hiring rate would increase by -- to 15% to 20% next year. I just want to make sure that I'm comparing apples-to-apples here. Have you -- from Q3 to Q4, did you increase your expectations of hiring from 5% to 8% up to 15% to 20% for '18?

Yes, one of the things that we had said, Ben -- thanks for joining the call -- is that we would evaluate our sales strategies after our fourth quarter results and really take that inventory. And as we looked over the third quarter and the fourth quarter, what we've seen is, we've seen a direct correlation between the feet we have on the street and our orders growth, our sales growth and our demo growth recounts, the whole process.

So we went back to the team after our fourth quarter was in and we're going to move forward increasing our period ending headcount 15% to 18%. So I think if you go back to the transcript of Q3, you'll see that we kind of prefaced that, that we may change depending on the results of the fourth quarter. And we like the results of the fourth quarter where we're seeing a trend, and we want to grow the sales headcount accordingly.

Perfect. I did have those comments as well, I just wanted to make sure we were -- I was looking at the same numbers on a quarter-to-quarter basis. And then a quick follow-up regarding the modest build up you have in long-term inventory here. You commented earlier that demo sales are flat from '16 to '17. Would that build up in long-term inventory? Do you expect demo sales to be flat again in '18 relative to '17?

One of the things you certainly see is that a portion of our product sales consistently is the demo or certified kind of preowned units. So they come from the source of service loaners, which we have, they come from demo units.

One of the things we have done though is really tried to keep that inventory fresh, move it out to the field. We did that through a process in 2016, we included in 2017. The increase that you see of about $10.5 million in our demo and service units inventory on our balance sheet year-over-year, really, if you think about that we added 95 salespeople and generally, on a per sales person basis, just simple math is about $70,000 of demo equipment, you almost cover about 70% of that variance.

So that is a balance sheet impact that is related to our growth in sales headcount. But at the same time, we're looking for more effective ways to utilize our inventories of demo equipment as well as further leveraging our on-site demo web studios to kind of eliminate or reduce some of the need to have as much equipment in the field.

(Operator Instructions) We have a follow-up from Patrick Newton of Stifel.

Bob, I kind of wanted a walk through 2017 margin profile and how we bridge to get towards your target. So the gross margin pro forma that I'm showing is about 56.7% for the full year. You've talked about the goal of getting to 60%. So there is about 330 bps of improvement.

If we look at OpEx, you were talking about leveraging G&A. It sounds like sales is going to roughly track your revenue growth. So no leverage there. And then you're talking about keeping R&D at 9%-plus, for at least the near term.

So I guess, what I'm I missing that kind of -- that helps you get that op margin from about 1.5% in 2017 to double digits by 2019? And should we assume that a big part of this is not just gross margin, but the R&D level at 9%-plus is a 2018 comment and that we should start to see some leverage on R&D?

So first and foremost, Patrick, where we're focused over the course of 2017 has been in gross margin. So if you just put it in perspective, our first quarter was 53.6%. We ended the year at 58.3%. So if you think about really our comments on our long-term goals, check on double-digit sales growth for '17, we improved gross margin.

So where do we go from '17 to '18 and '19 is, we have a clear pathway through continuing to improve our product gross margin, but also continuing to improve our service gross margin, as kind of our service revenue is greater percentage of our overall business.

So in terms of the pathway from 58.3%, we see a pathway for us to get to a 60-plus -- 60%, 60-plus by '19. So in terms of that goal, I think it's clear based on our track record, based on being a technology leader, new product drumbeat coming out, and also acquisitions that we made to help with that process.

In terms of how do we continue to get the operating margin, one of the factors that we're certainly focused on and we've talked about in prior calls is really focused on headcount, managing our headcount in our operating expense departments, doing very tight non-payroll cost budgeting.

So one of the pieces that we've talked previously is about controlling our G&A. So what we would see is, over the period of '18 to '19, we can certainly walk our G&A as a percentage down of sales to make, I would say, an impact to improve our operating margin.

The other place is certainly, as Simon indicated, using lean for both G&A and R&D to help drive down that percentage of sales of R&D. It starts with driving top line. We have processes in place to drive the gross margin, control the G&A, bring down both G&A and R&D as a percentage of sales later in the cycle to get to a double-digit operating margin.

Just to add to that, Patrick. Our internal budgeting is -- around things like G&A are that they should not increase more than around 5% internally. So that's our internal goal for that if you have a -- you start to get to that operating margin impact when you -- growing the top line at 15% gross margin substantively and then slowing dramatically the growth beyond inflationary for the G&A.

Obviously that's impacted also by our M&A, which is not predictable, but with respect to what we can control right now, we intend M&A to grow at a far less rate going forward.

So is it reasonable to think that R&D as a percentage of revenue in 2019 is going to be more like your historical 8% or sub-8% of revenue?

Yes. If you think of it from the organic point of view, it's hard to predict what's going to happen on the acquisition front, and these are 2 difficult processes to keep in balance. So we do have an acquisition -- an M&A pipeline for 2018, that's fairly impressive. And -- so that may impact it. But our intention is to increase the efficiency and get more product for less dollars of R&D, to your point, around the 8% mark. Like I said, M&A throws a wrench into that.

We have a follow-up from Greg Palm of Craig-Hallum Capital Group.

Bookings outpaced revenue and saw that backlog was actually up quite a bit from year ago levels. Was there any amount of product that wasn't able to ship? I know you've had a couple of (technical difficulty) in terms of ramping up production capabilities in the last few quarters, given some of the surge or end of quarter orders. So just curious if you saw any impact in this quarter as well.

We have a significant amount of our sales in the last few days of the quarter. And rather than turn the organization upside down, trying to get those out the door, we have allowed a certain backlog to build, so that we can have a more regular production process. And with the sales growth rate that we have, we get surprises at the end of the quarter.

Countries like China and other regions of APAC, we have to be out there with the orders 3 weeks before in order to see them count in the year. So between the geographic challenges of getting product to the customer and actually responding to the significant increase in sales in the last few days of the month, you should expect to see a backlog increase, so that we can regularize our deliveries. We still are meeting our stated delivery times, but that's the logic behind what you're seeing.

Got it, okay. And then Simon, a lot of new product commentary on this call. Looking forward to seeing some of those introductions. But what are your expectations there in terms of contribution? And I guess, which ones could be most significant immediately versus maybe longer term?

On the immediate side, I see the BIM/CIM introductions of the construction verification software as well as the use of laser tracer products to do stake out and enhance the, what I call -- what we call digital surveying, those will happen quickly. I see the product introductions that I mentioned relating to the FaroArm product, which is one of our core products, will be -- may have an immediate and dramatic impact on sales.

The longer term ones are like machine vision sensors, which need integration understanding by the marketplace. We have a lot of educating to do in the marketplace for integrators and manufacturers to understand what are the benefits of actually seeing in 3D in the manufacturing environment. So those would be longer term. So we have a good mix of things that should have a quick impact and those that will have a longer impact as well.

And at this time, I'd be happy to return the call to Mr. Simon Raab and Bob Seidel.

Thank you, everybody, for you interest in FARO and your support throughout the year. We look forward to continuing to provide you good progress reports through this year. Thank you all.

Thank you.

This does conclude today's FARO Technologies' Fourth Quarter and Fiscal Year 2017 Earnings Release. You may now disconnect your lines. And everyone, have a great day.