Kornit Digital Ltd (KRNT) 2015 Q2 法說會逐字稿

Welcome to the Kornit Digital second quarter 2015 earnings conference call. As a reminder, today's conference call is being recorded. After prepared remarks, we will provide instructions to conduct a question and answer session.

At this time, I would now like to turn the conference over to Allison Townsend of ICR. You may begin.

Thank you, operator, and good afternoon to everyone. Before we begin, I would like to remind you that forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and other US securities laws will be made on this call.

These forward-looking statements include but are not limited to statements relating to the Company's objectives, plans and strategies, statements of preliminary or projected results of operations, or of financial condition, and all statements that address activities, events, or developments that the Company intends, expects, projects, believes, or anticipates will or may occur in the future.

Forward-looking statements are subject to known and unknown risks and uncertainties and are based potentially on inaccurate assumptions that could cause results to differ materially from those expected or implied by forward-looking statements. The Company's actual results could differ materially from those anticipated in the forward-looking statements for many reasons, and I encourage you to review the Company's filings with the Securities and Exchange Commission including without limitation the Company's final prospectus, which identifies specific risk factors that may cause actual results or events to differ materially from those described in the forward-looking statements.

Any forward-looking statements are made as of the date hereof, and the Company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise, except as required by law.

Additionally, the Company will make reference to certain non-GAAP financial measures on this call. The reconciliation of these non-GAAP measures to the most directly comparable GAAP measures can be found in the Company's earnings press release published today, which is posted on the Company's Investor Relations site.

With us on the call today are Gabi Seligsohn, Kornit's Chief Executive Officer, and Guy Avidan, Kornit's Chief Financial Officer. At this time I would like to turn the call over to Gabi. Please go ahead.

Thank you, Allison, and hello, everyone. And welcome to our second quarter of 2015 earnings conference call.

I will begin today's call by reviewing the main aspects of our financial and overall business performance during the second quarter of 2015. I will then add some color on the current state of the industry as it relates to us, and provide some insight into the activities of the third quarter. Guy will then walk you through the financial details and our guidance for the third quarter of 2015.

Let me begin by stating that we are very pleased with the results published earlier today and with our overall performance during the second quarter of 2015.

Sales of $21.3 million came in at about the midpoint of our revenue guidance, representing an increase of 35% over the same period in 2014 and a 21% increase versus the first quarter of 2015. The year-over-year increase stemmed from continued growth in our direct-to-garment business and some initial revenues from the Allegro.

Operating income on a non-GAAP basis for the second quarter came in above the high end of our guidance and was $2.7 million, or 13% of revenues, versus an operating income of $862,000, or 5% of revenues, for the second quarter of 2014.

During the second quarter, we also showed continued improvement of gross margins. Gross margin came in at 47.6%, and was up 380 basis points versus the second quarter of 2014 and also up 190 basis points sequentially. The increase was primarily a result of the higher revenue base as well as the mix shift as we continue to transition to industrial systems.

This impressive growth led to a sharp improvement in our adjusted earnings, which were $2.4 million, or $0.07 per diluted share, versus the prior year of $600,000, or $0.06 per diluted share.

Please note that although our adjusted net income increased four times, our earnings per share in the second quarter was close to flat versus the prior year as a result of conversion of preferred shares to ordinary shares and issuance of shares to the public as part of the IPO process. Guy will add more color on this issue in his prepared remarks.

Turning to main events during the quarter, as mentioned on our last earnings conference call, Q2 was a busy exhibition quarter, with FESPA Cologne and Shanghai Tex being the largest shows, added to which were several other exhibitions in Asia-Pacific.

At FESPA this year, we showcased a variety of DTG systems. We announced and demonstrated the NeoPigment Pure ink, and ran the Allegra roll-to-roll printer for the first time at a major tradeshow.

All events created a strong impression on existing and new customers. For our existing customers, the introduction of the NeoPigment Pure, which offers a significantly expanded color gamut, improved print quality, a better hand feel, and longer shelf life, was great news. Once again, we demonstrated our commitment to continuously improve our system and consumables' performance.

I am pleased to report that many of our customers are already in the process of transitioning to the Pure, as they clearly understand the benefits it offers. The very smooth transition to these new inks is enabled by the robust development process that we went through as well as by our application team, which is working hand in hand with customers to transition existing print setups to this new ink.

New product introductions such as the Pure are excellent proving grounds of the competitive advantage we possess as the only end-to-end solution provider in the digital printing textile market, whereby we are able to perfectly tune the ink and system performance and achieve backwards compatibility for our large installed base with minimal effort. We will continue to roll out new features and functionality over time to allow our customers to continuously expand their addressable markets.

For new customers, the Allegro created quite an impression as well. The Allegro system was the only system at FESPA to demonstrate an ability to print on a variety of different fabrics with a single step dry process.

During the second quarter, a few more orders were placed. And in the case of Spoonflower, an order was placed for a third system. The successful demonstration of Allegro at the show has translated into a much larger lead bank than the one we had just a few months ago.

It also laid solid foundation for a two week open house event at our US headquarters, which we started last week. This event is being attended by 15 potential customers from a wide range of different printing disciplines, including fabric converters, online customer decorators, baby and toddler clothes manufacturers, manufacturers of military applications, producers of outdoor hunting and fishing attire, and fashion designers assembling collections.

This further strengthens our sense of conviction that Allegro offers a truly unique solution to the market, and we are enthusiastic about how well the solution is being received.

During the quarter, we also saw continued strong demand from Asia for our Avalanche DC Pro platform. To remind everyone, the DC Pro is the only digital printer able to print using discharge inks. Discharge inks are primarily used for fashion applications where a very soft hand feel is needed, such that the printed images feel as though they were part of the fabrication process of the textile itself.

Within the Asia-Pacific region, our strongest demand in the last several quarters has been coming from China. Our customers there are serving both the export and local market for local and international brands. Generally speaking, we are seeing an increase in demand for DTG to serve local market needs, as local fashion and standards of living continue to evolve.

Now let me provide some more insight as to some of the trends we see evolving. I would like to start with fast fashion. As we have stated on several occasions, a lot of our growth historically has been with customer decorators and Web-to-print solution providers. These two segments continue to be very meaningful for us.

At the same time, recent discussions we have had with multiple leading brands lead us to believe that a large scale transition to fast fashion is underway, and digital printing is the manufacturing technique which is looked at as an enabler of that transition.

The change we are evidencing is not only focused on the obvious benefits of fast fashion such as shortening of lead times, reducing inventory risk, and margin protection. We are now hearing more and more about the need to identify design trends in real time, being able to react to them in real time, testing designs in small quantities, and quickly committing to large quantities for fast runners. It's all about creating an enticing shopping experience, whether at a physical store location or an online store.

Our belief is that brands and retailers are coming to terms with the fact that they are losing business to mass customization and personalization Web-to-print stores, and that they need to reinvent themselves. Crowdsourcing what is hip in real time and at an affordable price is gaining huge momentum.

Trends are evident on the streets of every major city, and smart brands have people photographing these trends and transferring them to designers in real time. This transition is about creativity, manufacturing efficiency, and state of the art logistics.

We believe that our solutions fit well within these trends. Discussions we have had with several brands in the last several weeks were met with enthusiasm, and we found a lot of common ground. While significant changes to supply chains of large retailers will take time, testing the ground is easily done through the guise of our existing customers who are enthusiastic about the possibility of playing the role of contract printers for these brands.

A recent visit with customers opened our eyes to several other trends. First, given the significant addition of capacity which is continuing, our customers are constantly taking on manufacturing demand from multiple sources, whether it's for licensed sportswear and apparel or from brand manufacturers producing small batches of six or 12 dozen of a particular design. They add this demand to their own Web traffic and make sure their available capacity is constantly fully utilized.

Secondly, many customers who currently perform both digital and screen printing are leaning towards strongly to move completely to digital. The strongest argument is around the fixed cost element, whereby the real estate, headcount, operational inefficiency, and energy costs associated with screen printing is difficult to deal with.

It was amazing to be at two different sites of 100,000 and 150,000 square feet, which have multiple carousels and multiple Kornit printers alongside one another, and discuss with the operations manager how cumbersome they find the screen printing versus digital.

The capacity and manufacturing flexibility afforded by digital at these large facilities, the small number of employees needed to operate the systems, the limited space needed, the simplicity of setting up a print job are all night and day versus the analog alternatives.

Another strengthening trend is environmental consciousness. State and local legislation in China, for instance, is now limiting use of water for industrial activity, and particularly cracking down on textile. Customers are looking for dry, nonpolluting solutions, and digital printing is a great answer. Here our dry solutions for both DTG and roll-to-roll are very relevant.

The need to continuously improve manufacturing efficiencies is also on the table. I am extremely pleased to see how many customers are eagerly awaiting the introduction of our mass customization platform, namely the Vulcan.

A recent tour by our marketing team with leading customers created a very strong demand by several customers wanting to be the first to adopt this innovative platform. The throughput and cost per print that Vulcan will offer are truly revolutionary.

Our plan remains that we will be shipping a first beta system to a key customer before the end of this year. And based on the strong demand, it seems that we will have to roll out multiple systems for early availability during the first half of next year, with general availability expected in the second half of 2016.

As we discussed previously, we are heavily investing in our business to provide the infrastructure and support to facilitate our growth plans. One area in focus is recruitment. And during the second quarter, we were able to reach our first half hiring objective, though most headcount was added towards the end of the quarter such that the relevant related cost will start to show in the third quarter primarily.

Given our continued growth and the positive trends we see going forward, we are committed to continue and grow our capabilities and resources so that we are well positioned to take full advantage.

During the second half of 2015, we will continue to add more employees throughout the organization. The additional headcount will include customer-facing support sales and marketing people, as well as product development and R&D at headquarters. Accordingly, you should expect OpEx to continue to increase during the second half of the year.

Before turning the call over to Guy, I wanted to share some thoughts on our progress as a company over the past 15 months.

I had an opportunity to visit with several customers in the last few weeks, and was proud to see how well positioned the Company is as a result of our efforts from the entire Kornit team to elevate the Company to the next level. Customers are taking notice of the many changes we have made and the impact it has had on product maturity and the support infrastructure we have developed.

Looking forward, we have an aggressive roadmap ahead as we continue to strengthen our position in the DTG market and as we expand into the roll-to-roll market, which has been applauded by many of our customers as the next step towards becoming a leading textile solution provider. Having seen the Allegro run high volume production at one of our customer sites gives me great confidence in our strategy as it continues to unfold.

And with that, let me now turn it over to Guy for a closer view on the numbers and our guidance for the second quarter -- for the third quarter, excuse me. Guy, go ahead.

Thanks, Gabi, and good evening, everyone. Before beginning the financial overview, I would like to remind you that the following discussion will include GAAP financial measures as well as non-GAAP pro forma results.

Our second quarter non-GAAP pro forma results reflect adjustment for the following three non-cash items -- stock-based compensation expenses, which totaled $535,000; depreciation and amortization expenses relating to the acquisition of the assets of Polymeric Imaging in the amount of $87,000 and continued amortization of IP acquired in 2010 in the amount of $31,000; and a one time expense related to the Company's IPO in April 2015 in the amount of $1 million.

A full reconciliation of our results on a GAAP and non-GAAP basis is available in the press release issued earlier today and on our investor section of our website.

Second quarter revenue increased 35.1% to $21.3 million versus $15.7 million in the prior year, and increased 20.8% versus the prior quarter. Higher revenue was driven by several items in the quarter, including higher sales of higher margin high throughput systems, a higher volume of ink, and initial revenues from the Allegro system.

By geography, 53% of our sales were from the Americas, 26% from Europe, the Middle East, and Africa, and 21% from the Asia-Pacific region. As in previous quarters, the Americas remain our largest territory.

Accordingly, our two US distributors contributed 30% of our overall revenue versus 41% in the prior year. It is important to note, however, that customer concentration is not indicative of our end users, as we supply our product mainly through distribution agreements.

Moving to profitability, non-GAAP gross margin in the quarter was 47.6% versus 43.8% in the prior year. On a GAAP basis, gross margin were 47.1%. Higher margins were the result of several factors in the quarter, including a higher mix of high throughput systems, an increased volume of ink, and leverage of higher sales.

Higher services revenue this quarter versus the second quarter last year also benefitted our gross margin, as the loss narrowed in this business as we continue to build towards profitability. Kornit services remain on track, and we continue to target break-even in 2016.

Moving to our OpEx items, I will discuss these items on a non-GAAP basis, which excludes non-operating charges previously mentioned and highlighted in our GAAP to non-GAAP reconciliation in our press release.

Adjusted research and development was 11.9% of sales, or $2.5 million, compared to 15.5% of sales, or $2.4 million, in the prior year. The relative slowdown in R&D expenses as a percentage of sales reflects the timing of projects conferred to the prior year.

However, as part of our growth strategy we expect to continue to invest heavily in R&D, and anticipate higher R&D run rate in the third quarter and fourth quarter of 2015, predominantly as a result of additional engineering personnel.

Sales and marketing in the quarter were $3.2 million, or 14.9% of sales, compared to $2.4 million, or 15.4%, in the prior year. Higher sales and marketing expenses were the result of higher marketing expenses this quarter related to previously mentioned marketing events that did not occur last year.

General and administrative expenses in the second quarter were $1.7 million, or 7.9% of sales, compared to $1.2 million, or 7.4%, in 2014. Higher G&A in the quarter related predominantly from management headcount additions and incremental expenses as a public company.

Headcount as of June 30th was 293 employees. The increase in personnel was primarily attributed to additions of R&D, sales and marketing, and support personnel.

Our strategic focus is to take advantage of growth opportunity in the transitioning analog to digital printing and textile markets. To that end, we have made investment in our engineering, sales, and services teams.

We expect to continue adding new engineers as well as additional sales, application, and services personnel to further develop and strengthen our leading position in the very fast growing DTG market and carry on our penetration of the roll-to-roll market.

Non-GAAP net income for the second quarter was $2.4 million, or $0.07 per diluted share, an increase of $1.8 million versus the year ago quarter. Non-GAAP net income for the first six months of 2015 was $3.3 million, or $0.15 per diluted share. The decrease in diluted EPS in the second quarter compared to the six months' EPS is based on additional shares and conversion of preferred shares at the IPO.

On a non-GAAP basis, the denominator for diluted net EPS share count for the first quarter was 11.2 million shares and, in the second quarter, 32.1 million shares.

GAAP net income was $718,000, or $0.02 per share, on a diluted basis compared with net income of $373,000, or $0.04 per share, for the year ago quarter.

Our financial expenses this quarter were $164,000 as a result of foreign currency fluctuations, primarily related to the depreciation of the US dollar versus the Israeli shekel.

Net cash provided by operating activities was $640,000 this quarter compared to $1.4 million cash provided in the prior quarter and net cash used in operating activities of $187,000 in the year ago quarter.

Cash balances at quarter end were $80.4 million compared to $5 million as of December 31st, 2014, with the increase of $75.9 million attributable to the net proceeds from our initial public offering in April.

Turning to our guidance for the third quarter of 2015, we expect revenues to be in the range of $22 million to $25 million, and non-GAAP operating income to be in the range of 10.5% of revenues to 14.5% of revenues.

As we mentioned in our remarks, many of our new employees started to work towards the end of the second quarter. And in addition, we are expecting to accelerate the pace of hiring to position the Company to meet our long term product roadmap.

In the third quarter, we are planning to start new R&D projects. And as a result, material expenses in R&D we expect to increase as well. Therefore, we expect an increase in our OpEx during the third quarter.

I will now transfer the call to Gabi.

Thank you, Guy. And with that, we'd be happy to take any questions.

(Operator instructions.) Patrick Newton, Stifel.

Thank you. Good afternoon, Gabi and Guy, and thank you for taking my question.

Sure.

So, I guess just jumping in, thank you very much for the update on the Vulcan and also the Allegro coming out of FESPA. I'm curious as to how we should think about sales recognition from the Allegro products layering into the second half of 2015 and as we look into 2016.

Yes. So, we expect to see more revenue coming in the second half of the year with Allegro as a result of activity that's already in the field, meaning installations that are already in place and further installations that will be happening. So, you should see some more revenue coming in.

Our plan is to use the interest and I would say the momentum that we're seeing in the last couple of months in order to take in multiple orders before the end of the year and allow us to start next year on even a stronger footing. So, that's really the plan right now.

Great. And then, I guess shifting to your new ink, Pure, can you help us understand if this is priced at a premium to our typical pigment, or does it have a premium margin profile? And then, any expectation as to how quickly your customer base will migrate to this new ink?

So, the pricing of the NeoPigment Pure is the same as the previous inks. Really, this is about adding capabilities and really supporting our customers' investment in our product, in our platform.

This is something that we feel makes a lot of sense. We see a lot of enthusiasm coming from the customers as to the quality of printing and the different attributes that I had mentioned. So, there's no price increase associated with this.

As far as the transfer to the NeoPigment Pure, as I had mentioned, multiple key customers are already actively testing it and starting to transition more meaningful amounts of their production in the direction of the pigment -- the NeoPigment Pure, excuse me. And really, the speed of migration or the move is a function of where they are with their current manufacturing, whether there's a season coming up or not.

So, what we're trying to do is to transition to that ink as soon as we can. Our plan is to try to be in a situation where in 2016 everyone has already transitioned to the new ink.

Great. And just last one for me is on the Vulcan. It seems like you're pulling forward the timeframe of the general availability by at least six months. So, is that a fair characterization? And were there some technological hurdles that you had overcome to pull it forward? Were there some cost thresholds you hit or some throughput thresholds you hit that would allow for the general availability in an earlier timeframe?

Yes. If you remember, in the past I had already mentioned that we expect Vulcan to start showing revenues in the second half of 2016. And so, when I say general availability coming in the second half of 2016, that's what I'm alluding to.

So, as far as we're concerned, it's still the same plan. What is moving I think faster is the number of first units that we're probably going to wanting to be shipping in the first half of 2016, because we see that this project is progressing well.

And also, as I had mentioned, we're in a situation where multiple customers are asking to be the early adopters of this platform, so we want to try to do both. On the one hand, offer a very mature product, do multiple beta sites, but try to expedite that process so that it can hit the market as soon as we possibly can, given the interest that this platform is showing.

Great. Thank you for taking my questions. Good luck.

Thank you.

Joseph Wolf, Barclays.

Thanks. Hi, guys.

Hi, Joseph.

A question about full scale production for Allegro. You mentioned that Spoonflower is on their third unit. Could you just talk about utilization and what that means in terms of capacity and how they're using the three machines in terms of how much product that means they're putting out, and what we could be thinking about in terms of ink refresh rates for next year?

I'll try to help you with that, although I'll carefully choose my words because obviously they have their own confidentiality to protect as a business.

But, I will say that they are running 21 hours a day, seven days a week, which I think is a great indication. And the systems are running very well. I actually would like to direct everyone to a recently added customer testimonial video where they actually describe how they're using the system.

So, it's pretty extensive use. The amounts of inks that they're using are pretty much in line with what we had expected. As these platforms are utilized more and more, more ink obviously is being utilized. The levels are pretty high.

We've mentioned in the past that ink utilization levels would be probably 80% of system cost on an annual basis, 70%, 80%. So, it's pretty extensive, and we see it going in that direction.

Thank you. So, all three are running like that, and that's why they're up to three?

So, two are running that way. And a third system was ordered, as I had mentioned, yet to be installed in the very near future.

Okay, perfect. Could you comment on the competitive landscape? There was an acquisition in the sector in the roll-to-roll market, and just what that means in terms of I guess customer broadening and availability and just the whole overall market picture right now.

Sure. So, I guess -- you're alluding to the Reggiani acquisition by EFI, I guess.

So, I think that the way we see Reggiani and the solutions that are out there is quite different. And if you remember, from day one when we've been discussing our roll-to-roll platform, what we have said continuously is that this is a solution which is very different from everything that's out there.

The acquisition of Reggiani does not change that. It's still the same system. It's a very reliable product that's been out there for a while that Reggiani provides. There's other players that we have mentioned in the past such as MS and Durst.

And really what we're saying and we continue to say, that while they run a good process, they run a very different process. And the differences are multiple.

First of all, as you know, the digital printer that they offer really is embedded into a printing factory that has multiple other manufacturing steps, five steps which include pretreatment as well as washing, steaming, drying, softening, etc. That remains the case, whereas the Allegro is a one stop shop where basically the entire process is done on a single system.

The other aspect is, as we have said before, what's unique about our pigment solution is that it's able to treat multiple types of fabric. And that's what's unique about pigments. And that's, by the way, one of the reasons, for instance, that pigment inks are utilized much more extensively for home decor, because you're able to deal with different blends of cotton, different blends of acrylic material, etc.

What happens when you're using other types of printers like the Reggiani ones, basically you're looking at two types of printing, either reactive, which is for cotton, or dispersive, which is for polyester. You can't mix the two onto the same printer, and therefore there's also a difference in the way that they process.

And so again, to summarize that, we see ourselves as unique in being able to offer a one stop shop solution. We think that our solution caters really well to the direction that the industry is heading, which is customized decorations.

We're seeing more and more inertia coming from that. If you heard, in my prepared commentary I mentioned a variety of different types of customers that are now actually attending our two week open house, customers ranging all the way from different types of disciplines like online custom decorators, people that do baby and toddler clothes manufacturing, even military applications and outdoor hunting and fishing attire.

So, I'm pretty enthusiastic about the variety of applications that we're seeing. And I think, again, our solution remains very unique, and that acquisition doesn't change anything in that aspect.

Thank you. That's helpful. And you mentioned it, so I'm just going to -- this will be my last one, just an update on where you guys are with the technology for printing on polyester.

Yes. So, we're progressing internally with a lot of testing. Actually, even with the NeoPigment Pure, we're seeing improved results already. But, at the same time, we're developing a unique solution for the polyester market.

To remind everyone, the challenge with dyed polyester is that once you print, you perform a drying process at high temperatures which can cause what is called dye migration. This is a well known phenomena throughout the industry.

So, we are progressing well, Joseph, with that process, and I expect to see meaningful stuff coming out over the next several months.

Perfect. Thank you.

Thank you.

Ken Wong, Citigroup.

Hey, guys. So, maybe touching on some systems outside of kind of the large scale ones, you guys had raised the price of Breeze a little while back. Now we're a couple of quarters in. Kind of how has the -- kind of how has customer traction been there? Have they decided to kind of pony up for the higher price or have they completely shifted to the high end, which sounds like what's going on?

We still have good traction with Breeze. It's a little bit slower than it used to be, which is what was anticipated. And so, it has directed people that were thinking -- whether it's either a Breeze or a Storm, some of them will lean toward the Storm.

But, we still do see nice business coming from the Breeze, even with the elevated price. And I think, again, for instance, what we did now with the NeoPigment Pure is something that solidifies decisions by customers to take that entry level system. They see that we're adding more functionality to the acquisition of a system that they made.

So, I'd say somewhat tapered down, but still seeing nice revenues coming from the Breeze with the different pricing.

Got you. And then, earlier you mentioned seeing pretty good demand from China. And I guess more recently, it seems like that's a region where the macro conditions aren't particularly great. Any changes on your end? I mean, does that still feel like a market where you could possibly see some capital investment in your product line or potentially some slowdown there?

Actually, we're seeing the opposite; in the last three months growing interest in our products. I think that probably part of it is related to what I had mentioned on environmental consciousness and what the Chinese government is doing as far as trying to reduce the level of pollution which is introduced by the textile industry.

I think it's that. I think it's the advent of more and more online e-commerce that people are leaning towards, and also the fact that the brands that they're serving, whether local or global, are leaning to smaller quantities, much in the direction of the fast fashion trend that I spoke about.

So, right now we're not seeing any slowdown. On the contrary, we're seeing an increase. And Asia-Pacific, as far as growth rate, percentage wise has been for the last year our fastest growing region. And within that region, China is the most meaningful.

Interesting. Thanks for the clarity there. And then, maybe a couple questions for Guy. You mentioned OpEx will be going up. How should we think about sales and marketing OpEx since you guys did have a pretty big quarter in terms of events around FESPA and I'm sure a lot of marketing around the new product? Going into Q3, should we expect a pretty meaningful bump there, or would it be more flat because you get some benefit from not having these big events?

So, on one end, as you mentioned, Q3 we have less tradeshows. But, on the other end, we already recruited some employees at the end of the second quarter. And we will continue to recruit more sales and marketing personnel in Q3, and that will offset the less tradeshows. And we expect to see sales and marketing in Q3 higher than in Q2.

Got you. And then, another I guess margin related question. You guys saw another good uptick on the gross margin, and you guys attributed that to higher end systems and also just some benefit from better utilization of services. Would you characterize that as -- I mean any way to quantify whether it was more from kind of the services, kind of the push towards break-even there, that helped the gross margins, or was it more the higher end systems?

Well, again, we cannot really quantify and segment this question. In a nutshell, it's all, meaning it's economy of scale. We're growing top line, and obviously that helped us to grow our gross margin.

Got you. All right, I think that's it for me. I'll pass it along.

Thank you, Ken.

(Operator instructions.) Bobby Burleson, Canaccord.

Hi. Congratulations on the strong earnings.

Thank you.

So, just curious, with all of these -- your product portfolio is broadening. I'm curious what your manufacturing capacity will be next year for industrial grade machines and then how you plan on addressing the challenge of anticipating what mix you'll need in a given quarter.

Yes. So, as you remember, we spoke about this in the past, that we now have added a third contract manufacturer, actually a leading global manufacturer. That gives us quite a bit of flexibility, and we have two very good suppliers here in Israel already.

So, as far as manufacturing capacity on the system side, no limitation to continue to grow at a very fast pace. And actually, the direction that we're going -- and we have been but even more so, going in the direction of full turnkey manufacturing of our systems.

As far as our ink factory capabilities, we have said in the past with the existing facility we can more than double our capacity and don't see a problem there either.

As far as predicting and forecasting, the way we work is, on the one hand, we do an annual process to the best of our ability, and then we continuously update that with the suppliers. One of the things that we're doing continuously also is working on reducing lead times on long lead time items, etc.

I think Guy mentioned inventory turns, which are seeing some improvement as well. So, I think in general we're doing pretty well on predicting. On the other hand, we do want flexibility because it's not -- we have to say it's not fully predictable.

And therefore, we leverage both the supply chain but also a finished goods inventory. That gives us the level of flexibility that we need in order to achieve the quarterly earnings that we set for ourselves. So, it's combination of the two, but we feel pretty comfortable with what we have.

Okay, great. And then, are there any margin, positive or otherwise, implications for the stronger anticipated first half in 2016 for Vulcan?

Well, the Vulcan, you need to consider the following, that when you're introducing a new product, revenue recognition will take some time, right? So, we're not anticipating meaningful revenues coming in the first half of 2016 from Vulcan.

And you should be aware of that because that's the normal cycle, right? You're introducing a new product. You want to do rigorous testing and acceptance processes. So, I don't expect a lot of revenues coming from Vulcan in the first half of 2016.

Okay, great. And then, a previous question touched on the macro environment, and I'm wondering whether or not -- just geographically, I know most of what you're doing is in North America right now, but you have nice China exposure. I'm wondering whether or not there's a shift away from labor intensive processes that you guys are benefitting from in China, if there are any other parts of Asia where you're starting to see increasing traction because of the kind of turnkey, clean, less labor intensive solution you're offering.

Yes, I think throughout the region there is a trend. Taiwan, by the way, is going strongly in the direction of digital printing, and we already have a pretty meaningful installed base there. And so, we see activity in Taiwan.

Sri Lanka is becoming more meaningful as well. Japan this year is better than last year, I have to say also, but that obviously is very different from the rest of the region.

So, I'd say in general there's a good situation in China, but it's also throughout the region. And again, the growth rate of that region has been significantly higher than everywhere else for us in the last year.

So, I think part of it is going away from labor intensive activity. Part of it is environmental. Part of it is the -- I would say the commercial aspect, meaning the accessibility to the Internet.

Part of it also is the changes that I spoke about which are related to fast fashion, that I spoke about extensively that really -- it's also that region which is facilitating some of the fast fashion turns. So, I think it's all those things together.

And do you see the brands -- you guys are getting better or continuing to deepen your ties with the brands. And I'm wondering, as those guys adopt the technology in a more meaningful fashion, whether or not you expect there to be -- most of that to be through contract manufacturers, third parties, or if you expect another segment in the supply chain to emerge that's dedicated to digital processes, and kind of where you see their capacity being placed over time.

Yes. So, all the major players qualify technologies for manufacturing, and they have pretty extensive knowledge of the textile world and the printing world.

So, what we're starting to see is that they're doing demonstrations with us, or sometimes collaboratively with us and with one of our customers to see it actually being printed at a manufacturing facility and not just in one of our facilities.

I have become aware now that some of the major brands actually have their own manufacturing capacity for very fast turns, for instance in Europe. So, limited capacity but for very fast turns.

And so, I think for the most part it's going to be as I had mentioned in the past where they will leverage contract printers. But, now what I'm learning is that there's going to be a variety of leverage -- of ways to leverage contract printers. It will be to do normal course of business in the move to fast fashion, but it will also be to use them and enjoy their benefits with Web to print.

If you read some of the materials brought out by the likes of Gap and others, they now speak about what they call retail 3.0 where they want to test things on the shelves and very quickly commit to capacity, which I believe implies that they will have regional printing capacity to be able to do stuff like that.

And what I had mentioned on my prepared commentary, that the likes of Inditex, with Zara and Bershka and Massimo Dutti and the rest of their brands, what they do actually is they continuously photograph people in different cities in the world, load that to a huge data warehouse, and on a monthly basis accommodate the changing environment.

All these people, when they look at digital, they definitely see and understand the benefit, so I see a really meaningful trend. And what I had mentioned was I believe it will take time to change the supply chain overall. But, testing the ground is starting to happen quickly, and we're getting enthusiasm from their direction. So, it's good news all over.

Great. Thanks.

Thank you.

Brian Drab, William Blair.

Hi, Gabi. Hi, Guy. Congrats on another good quarter here.

Hi there. Thank you.

Yes. So, I wanted to pin you down a little bit more precisely on the OpEx lines, if I could. Guy, you -- maybe these are questions for you, but you said selling and marketing would step up in the third quarter. Specifically, you're talking on an absolute dollar basis. Is that correct? And is it possible that, despite a step up on an absolute dollar basis, that as a percentage of revenue selling and marketing is actually down in the third quarter sequentially?

On a dollar basis, we expect it to grow, and, as a percentage of sales, not material change from Q2.

Okay. And then, same question with respect to R&D and G&A.

G&A, we're not expecting any material growth in dollar. That means that there's going to be some decline as a percentage of sales. In R&D, we expect growing in the dollar amount, and also growing as a percentage of sales.

Okay, that's helpful. Thank you. And then, I wonder if you can make some comment -- and this is nitpicking, I think, if someone would ask this question but I think it'd be good to address on the call.

The midpoint of the third quarter revenue guidance represents 27% year-over-year growth. In 2014, you grew 34% and then 33% in the first quarter, 35% in the second quarter of 2015. Can you make a comment maybe as to was there a difficult comparison in the third quarter of 2014? Obviously, the 10% sequential growth that the third quarter guidance represents is a strong growth rate, so wondering if you can just comment on the year-over-year.

Well, I'd say a couple of things. First of all, if you look at the first half now that we've reported Q2, first half versus first half, we're up 38%. So, the Company is growing extremely robustly. And I think a company size that we are, you need to look at things, when you look at overall growth rate, on an annualized basis, right?

Second of all, as we believe, this is -- we think that the guidance shows continued strong growth. I won't walk through quarter versus quarter. I don't have the data in front of me to try to walk you through a localized impact here or there.

Generally speaking, this is a very strong growth year. And as I said, first half 38% is I think a great momentum for the first half of the year. I don't see any deceleration or anything like that, on the contrary. And the growth rate is -- we think it's pretty good.

Okay, thanks. And then, on the service business, you're obviously making a whole host of changes in that operation. I was wondering if you could just give a little more detail on maybe how receptive customers have been to some of those specific changes and how that's going.

I think it's going very well. We've added a lot of service professionals, and we're going to continue to do that in the second half of the year. This comprises both of field service engineers as well as application capabilities. Also, we have upgraded our management in the service with people that have experience with service business.

I think what we're doing with customers which is starting to work quite well is going a good job articulating the benefits of signing service contracts with us. We see significant growth in the amount of contracts that are being signed up for by customers that realize and understand the benefit.

What helps you in the process of selling service is to be able to demonstrate to customers the alternative cost of not having service contracts. And because in the last year we spent a lot of effort and time on making sure that we log all the information associated with customers, we can now come to customers and show them here's you cost of ownership with the system even during warranty. When you come out of warranty, here's why it makes sense for you to consider a service contract.

The other thing that we're doing is we're adding more service products, whether it's upgrades, and you're going to see more and more upgrades coming as we go. So, we are developing more upgrade kits. Whether it's software or hardware, that becomes an important part of business over time, and also the time and material aspect.

So, generally speaking, I think it's moving in the right direction. It is still somewhat lumpy, I have to say. We don't break it out, but I will tell you it does have its lumpiness.

Because of the fact that this year is the first year in which we're starting to see meaningful service contracts, that is starting to percolate from one quarter to the next. As you know, service contracts you recognize over a four quarter period and not all at once.

So, generally speaking, I'm very happy with the progress. And as Guy said, we're still focused and committed to making it a break-even operation by the first half of 2016, and afterwards turning it into something profitable.

Okay. Thanks very much.

Thank you.

Jim Ricchiuti, Needham & Company.

Thanks. I was wondering if you can give us an update on Paradigm. I was just wondering and I didn't hear much on that in the call so far.

Yes, it's actually gaining momentum. We are learning a lot more about how screen printers want to utilize those systems. And so, a lot of focus and effort has been put on doing what we call open house events both in the US and in Europe where customers actually come with their own garments and actually perform work.

We're learning more and more about the application and actually optimizing the performance. And so, we're getting better and better results as a result of it. And one of the things that we're seeing -- and I didn't allude to Paradigm directly, but I spoke about screen printing versus digital printing. We're seeing what we had expected, which -- people realize the benefit of adding a digital capability to an existing carousel.

What we're working on now is larger customers that are testing a first unit, meaning they buy a first unit and then talking about expanding that into multiple units. We have a few of those customers historically. We're now looking to do that in the second half and going forward. Once you see that, I think we're going to see much more meaningful revenues from it.

So, it is progressing. I think the open house events have been very helpful. And we are learning more and more about the needs and wants of screen printing, and I think articulating the value proposition better. And as a result of it, there's more interest.

Will some of those customers that you just alluded to, Gabi, be the ones that would be potentially the early sites for Vulcan?

They could. They could be. Actually, at least one of them showed an interest in both and said I'm starting with Paradigm, but I'd like to go to Vulcan later on.

But, to be honest, the ones that we pick to be the first ones are ones that have been heavy direct-to-garment users that know exactly what they want to do with the Vulcan once it's available. And at a later point we'll go to a customer like the one I just mentioned, because I want them to realize the benefit of digital before they move to this very advanced system.

Okay. And just one last question for me just with respect to DTG. Just coming out of the major tradeshows, maybe if you would, characterize the competitive environment in that segment of the market. You I think gave some helpful color on how we should think of what's happening in the roll-to-roll market.

Yes. I think that on the industrial side we see no changes. There's still the one player that we spoke about, Aeoon, which we don't see them making a lot of progress. Actually, we've had a few situations in which customers that had a single unit came back to Kornit and actually migrated back to Kornit.

On the commercial side, we're seeing Epson more active than they used to be in the past. And that competition is primarily between them and Brother. And so, we see them more active there.

There haven't been very, very meaningful new product announcements, but they continue with the similar business model that they had before, not a very high cost system and more costly inks and consumables for types of businesses that are different from the ones that we're serving.

Okay, thank you.

Thank you very much.

It appears there are no further question at this time. Mr. Gabi Seligsohn, I'd like to turn the conference back to you for any additional or closing remarks.

Thank you, operator. I'd like to thank everyone for attending today's call. As you know, we issued a press release. We'll be attending a couple of conferences in the US, and we look forward to seeing you there or on our next quarterly earnings call. Thank you.

That does conclude today's conference. We thank you for your participation.