Novanta Inc (NOVT) 2014 Q2 法說會逐字稿

Good afternoon. My name is Sara and I'll be your conference operator today. At this time, I would like to welcome everyone to the GSI Group Second Quarter 2014 Earnings Conference Call. (Operator Instructions) Mr. Robert Buckley, Chief Financial Officer, you may begin your conference.

Thank you very much. Good afternoon, and welcome to GSI Group's Second Quarter 2014 Earnings Conference Call. I'm Robert Buckley, Chief Financial Officer of GSI Group. If you've not received a copy of our earnings press release, you may obtain one from the Investor Relations section of our website at www.gsig.com. Please note this call is being webcast live and will be archived on our website.

Before we begin, we need to remind everyone of the Safe Harbor for forward-looking statements that we've outlined in our earnings press release issued earlier this afternoon, and also those in our SEC filings. We may make some comments today both in our prepared remarks and our responses to questions that may include forward-looking statements. Those involve inherent assumptions with known and unknown risks and other factors that can cause our future results to differ materially from our current expectations.

Any forward-looking statements made today represent our views only as of today. We disclaim any obligation to update forward-looking statements in the future, even if our estimates change, so you should not rely on our--today's forward-looking statements as representing our views as of any date after today.

During this call, we will be referring to certain non-GAAP financial measures. A reconciliation of such non-GAAP financial measures to the most directly comparable GAAP measures is available as an attachment to our earnings press release. To the extent that we use non-GAAP financial measures during this call that are not reconciled to GAAP measures in the earnings press release, we'll provide reconciliations promptly on the Investor Relations section of our website.

I am now pleased to introduce Chief Executive Officer of GSI Group, John Roush.

Thank you, Robert. Good afternoon, everybody, and welcome to our call. So I'm pleased to update you on what I view as another very solid quarter for the Company. Customer demand remains very positive across the vast majority of our product lines and applications. Our growth initiatives across GSI are gaining momentum in most areas. In addition, we substantially completed the integration of the JADAK acquisition in Q2, and we're extremely pleased with the JADAK team and the performance of the business, which I would say is exceeding our expectations.

Since the acquisition we've made encouraging progress with our medical technology cross-selling initiative. And I'll also note that we completed the divestiture of our scientific laser business in mid-July.

In Q2, our revenue, profitability, and cash generation all came in ahead of our own expectations. I'd like to give you a brief summary and Robert will go into more detail in his section. So our Q2 revenue was $96.9 million, up 21% versus a year ago. Adjusted EBITDA was $14.5 million, up $2 million from Q2 2013. Q2 EPS was $0.10 on a GAAP basis, up $0.03 from a year ago. Non-GAAP EPS for the second quarter was $0.19, up $0.14 from a year ago--up from $0.14 a year ago. In the quarter, we generated over $17 million of operating cash flows and ended Q2 with net debt reduced to just under $90 million. So on the whole, I'm quite pleased with the financial results.

So at this point, I'd like to give you some commercial updates on our progress across the Company. In Q2, we saw a continuation of the previously discussed trend with demand improving modestly across the majority of our end markets. As I've said in recent calls, barring any unforeseen economic turbulence, we expect continued gradual improvement in market conditions throughout the year. On the industrial side of our business, we closely track the PMI indices around the world and all of the major ones at this point are trending to near term expansion.

On the medical side of the business, hospital capital spending has been reasonably healthy this year. Our overall book-to-bill ratio for GSI was 1.0 in Q2, with two of our three reporting segments above 1.0. On a cumulative basis through the half year, our overall book-to-bill ratio was 1.04. The majority of our major product lines had year-over-year sales increases in Q2. Our management teams around GSI have been focused for some time on executing on our growth strategies by launching more new products, increasing the revenue opportunity funnels, and capturing new design wins at our OEM customers.

These efforts are bearing fruit in most cases. Our funnels and our design wins are both increasing. So we're very pleased with the growth opportunities we've been able to create for the Company.

Obviously, our Q2 growth differed across the product lines, but we got positive contributions in the majority of areas. The only meaningful exceptions to that were NDS, which is still cycling up against the dual sourcing event that occurred last year, and our air bearing spindles and color measurement product lines, both of which saw slower demand in some of their application areas.

So let me start with the laser product segment, which remains the largest of our three segments. Laser based revenue increased by 8% year-over-year in the second quarter, with all of the business lines contributing to that growth. The book to bill ratio was 1.05 in Q2.

Our CO2 laser product line had strong demand during the quarter with sales up high single digits versus a year ago. We also closed on 13 new design wins with OEM customers, with over half of those coming from our new line of mid-power CO2 products. Applications included marking, engraving, film cutting, converting, and leather processing.

Orders for our new p250 pulsed laser also continue to trend ahead of our expectations. Our CO2 production site continued its focus on deploying lean principles in that operation and held seven lean events and workshops during the quarter.

Our laser scanning and beam delivery products had mid-single-digit overall growth, with particularly strong demand for our galvanometers, which had double-digit growth in the quarter. At the LASYS show in Germany, we launched our new 24-bit scan master controller, which eases the integration of our Lightning II all-digital scanner into OEM applications and offers best in class functionality, including reduced process cycle time and enhanced precision across a wide range of applications. Within the second quarter we saw a strong interest in the Lightning II platform, including six significant design wins, three of which were in laser additive manufacturing. Other applications included marking, converting, and patterning for touchscreens.

Our overall revenue funnel for scanning solutions has doubled during the course of 2014, which is a very encouraging indicator of our future growth prospects in this business.

Scanning solutions demand for via hole drilling applications was slower in the quarter versus a year ago, which somewhat reduced the overall growth rate of the scanning business.

As I previously discussed, the overall size and scale of the scanning business has increased significantly in recent times and a number of new products have gone into production. This has led to challenges in our scanner operations and that of our supply base. We continue to deploy significant resources on addressing these issues. We've set up a number of new lean manufacturing cells for scanning production. And we're working to improve yields, material availability, and to realize full labor utilization and achieve target run rates of these cells across what is now a multi-shift operation.

While we've seen improvements in some areas, we still expect it to take multiple quarters to be able to realize and sustain the operational improvements we're targeting.

Our sales of fiber laser products, which are really in the range of 3% of GSI's overall revenue, increased double-digit versus Q2 2013, due to increased order volume and several new customer wins. We do continue to see growing demand off of our small base in this business, along with significant price pressure that we see in the marketplace. So we have carefully managed our expenses in this area and we have seen year-over-year improvement in profitability in fiber lasers.

So turning to the medical technology segment, in the quarter we saw generally positive market conditions and we built momentum with our overall medical technology strategy. As I said, the integration of JADAK went extremely well. The business is performing above our own expectations.

On a pro forma basis, JADAK sales increased high teens in Q2 versus a year ago. Orders are strong in the business with Q2 book-to-bill ratio coming in at 1.17. They had 14 design wins in the quarter and have 29 halfway through the year. The JADAK management team is currently working with our Suzhou, China team in planning for an increased JADAK direct sales presence in China in 2015 that should significantly increase the sales reach of the business.

The JADAK management team has also played a lead role in driving our medical cross selling efforts.

Looking across all of GSI, we now have 35 medical OEM customers that buy more than $1 million per year from us, plus another half dozen or so that are just below the million dollar mark. But of those 35 customers, 10 of them presently buy more than one technology from us. But what we see is significant opportunities for cross selling in another 10 or even 15 of those accounts, and there are very realistic prospects for us to make that happen in the coming year or two where our teams are now engaged and working to achieve design wins in these accounts.

And I'll just note, if you carry the analysis down to the $500,000 account level, there are even more opportunities. So we're very enthusiastic about the future prospects of the medical business.

In the second quarter, our sales in medical displays were down substantially from prior year levels. As previously discussed, the decline was largely due to the dual sourcing by an OEM customer that was communicated to us in late March 2013. Thus, we had a very challenging revenue comparison in the second quarter. As we move into the back half of the year, we will return to more normal comparisons so this should be less of an issue.

NDS did launch the S6c radiology display in the market right after quarter end, which improves our product lineup and offers additional sales opportunities in the second half.

We also continue to see strong demand for our thermal printers for medical applications. During Q2, several new OEM design wins contributed to double-digit year-over-year sales growth.

Moving on to the precision motion segment, in the second quarter we had mid-single-digit sales growth driven by new program wins for our optical encoder product line, which had double-digit sales growth in the quarter. Our Q2 sales of air bearing spindles were up sequentially from Q1 levels, but down versus the prior year, primarily as a result of a surge of demand we had seen in Q2 2013 from printed circuit board via hole drilling customers.

We expect demand for spindles to be fairly stable for the balance of 2014.

So with that update on the segments, I wanted to comment on one more topic before turning things over to Robert, and that's gross margins. In the quarter, where our financial performance was strong in nearly every respect, gross margin was really the one chink in our armor. We were down a couple of points versus a year ago and over half a point versus Q1. Some product lines were up, but a number of them were down. And stepping back from this issue, I can say the challenge is virtually 100% execution.

Apart from fiber lasers, which make up less than 3% of GSI's revenue, we're not seeing meaningful price pressures in the market. Our margin challenges are operations related and there are a couple of primary drivers. The first is that we are aggressively pursuing our growth strategy across GSI and that's driving us to launch more new products in new applications, utilizing in many cases new suppliers and some new production processes. The new product strategies are working extremely well in the commercial sense. Revenue funnels and design wins - our orders are all trending in the right direction. But the new product launches are creating headwinds for us on the gross margin side.

Our product capabilities across the Company are still not fully mature and our factories are not able to launch all of the new products at the targeted yields, run rates, and cost structures. We are seeing in a number of cases high levels of scrap, rework, and other startup inefficiencies on new products.

The second driver on gross margin is our push towards lean principles, which to a degree has compounded the situation near term. As you know, lean manufacturing focuses on single piece flow through an optimized cell layout that minimizes waste of all types. This approach ultimately creates very substantial efficiencies, but in the near term, it tends to expose inherent flaws in your process that were previously being covered up by large batch sizes, excessive inventory levels.

As we have implemented lean in our major sites, we have deployed members of our continuous improvement team who have extensive experience with lean conversions at world class manufacturing firms. These individuals work alongside our local production teams to promptly address any inefficiencies that arise when we deploy lean. But we continue to see some very significant potential from lean medium term and strategic sourcing. We are very committed to this direction and that it's the right one. We're convinced we can persevere through these growing pains. But there's no question we're seeing some implementation inefficiencies.

So the combination of these two factors is currently depressing gross margins. I'm extremely confident we'll be able to navigate through these issues and ultimately become a world class manufacturer of all of our products. We have the right people on tap that are absolutely working on the right things. We will get where we need to be. But it may take another quarter or two to fully move past these gross margin headwinds we're seeing. So in the meantime, it's really something we just closely manage and execute in the factories to resolve.

So with that, I'd like to now turn the call over to Robert to provide more details on the financial performance.

Thank you, John. After the end of the second quarter, we closed the sale of the scientific laser business. We received $5.5 million in cash proceeds upon closing, which we'll record as cash flow from investing activities in our third quarter. After settling transaction fees, working capital, true-ups, and taxes, we expect to receive a net $4 million in cash from this transaction in 2014. However, we also expect to receive another $1.5 million of additional proceeds held in escrow following the expiration of the 12-month indemnification period. This transaction represents an important strategic divestiture of a non-core business and a great step forward in the execution of our strategic initiatives.

During the second quarter of 2014, GSI generated revenue of $96.9 million, an increase of 21% from $79.8 million in the second quarter of 2013. The JADAK acquisition contributed $15.5 million or 19% of the revenue increase year-over-year. Changes in foreign exchange rates favorably increase revenue by 1%. Excluding the impact of the JADAK acquisition and changes in foreign exchange rates, the Company's organic growth was approximately 1% compared to the second quarter of 2013.

Overall, all of our business segments reported growth in the second quarter. Sales of laser products for the second quarter increased 8% to $43.8 million, compared to $40.4 million one year ago. We experienced solid growth across all our technologies from our galvanometer based technologies to our sealed CO2 lasers and fiber lasers. Growth was driven by new product innovations, new customer wins for new applications, and an increase in capital spending in advanced industrial markets, and to a lesser degree, the medical markets.

Sales of medical technologies for the second quarter increased 57% to $34.8 million, compared to $22.1 million one year ago. The JADAK acquisition added approximately $15.5 million this quarter as a consequence of owning the business for a full quarter and due to strong high teens organic growth year-over-year on a pro forma basis.

Similarly, our medical printers business also experienced double-digit growth year-over-year. However, as John mentioned, sales of visualization solutions in imaging informatics product lines sold underneath the NDS and Dome brands were well below levels for the same period last year. This was driven by single customer dual sourcing of our products to them, which dramatically reduced our revenue in the business beginning in the second quarter of 2013.

Finally, sales in precision motion for the second quarter increased approximately 6% to $18.3 million from $17.2 million in 2013. This was driven largely by our optical encoder business line, which experienced strong double-digit organic growth year-over-year, driven by new product introductions and customer wins and to a lesser degree increases in capital spending in the advanced industrial markets.

Turning to profitability, second quarter gross profit was $38.7 million, or 39.9% gross margin compared to a gross profit of $33.2 million, or 41.7% gross margin during the same period last year.

Laser products first quarter gross profit was $17.2 million, compared to $16.7 million for the same period last year. Gross margins in our laser products decreased approximately 200 basis points to 39.1% from 41.2% a year ago. The 2.1 percentage point decrease in growth margin was driven largely by unfavorable mix associated with an increase in sales in our fiber laser product line and significant investments and other startup costs associated with new product introductions in our continuous improvement initiative.

Gross profit dollars increased $500,000, or roughly 3% for the same period last year, as a result of the sales growth.

Medical technology second quarter gross profit was $13.8 million, reflecting a 39.8% gross margin, compared to $8.3 million, or 37.4% gross margin, for the same period last year. The JADAK acquisition accounted for a $6.3 million increase in gross profit year-over-year. Excluding the impact of JADAK, gross profit dollars decreased slightly as a result of the decline in sales volume in our visualization solutions product line. This decline was directly associated with the aforementioned dual sourcing by a single customer.

Precision motion second quarter gross profit was $7.9 million, reflecting a 43.5% gross margin, compared to $8.3 million, or 48.2% gross margin for the same period last year. Gross profit dollars decreased roughly 4% compared to the prior year. Gross margins were 43.5% for the second quarter, compared to a gross margin of 48.2% for the prior comparable period. The decline in gross profit and gross margin was due to the decline in the sales of our air bearing spindle products, as well as higher manufacturing costs associated with the ramp up of an insourcing project.

Operating expenses increased to $32.2 million for the second quarter of 2014, from $27.8 million in the second quarter of 2013, an increase of approximately $4.3 million. The addition of JADAK was the primary driver of the increase. Excluding JADAK, operating expenses decreased slightly. Research and development expenses were $7.5 million, or 7.7% of sales during the second quarter, compared to $6.1 million, or 7.7% of sales during the second quarter of 2013.

SG&A expenses were $21.4 million, or 22.1% of sales during the second quarter, compared to $19.4 million, or 24.3% of sales during the second quarter of 2013.

Operating income from continuing operations amounted to $6.5 million, or 6.7% of sales in the second quarter, compared to $5.4 million, or 6.8% of sales in the second quarter of 2013. Interest expense increased to $1.4 million from $900,000 in the second quarter of 2013, as a result of the higher debt levels from the acquisition of JADAK.

We continue to borrow roughly 3% average interest rate on our senior credit facility.

Adjusted EBITDA, a non-GAAP financial measure, which includes the adjustments noted in the non-GAAP reconciliation attached to our earnings press release, was $14.5 million in the second quarter, compared to $12.5 million in the second quarter of 2013. The increase in adjusted EBITDA was predominantly attributed to the acquisition of JADAK and increases in sales volumes across our various business lines.

Diluted earnings per share from continuing operations was $0.10 in the second quarter, compared to $0.03 in the second quarter of 2013. Non-GAAP earnings per share was $0.19 in the second quarter, compared to $0.14 in the second quarter of 2013.

Turning to the balance sheet as of June 27, 2014, cash was $45 million, while total debt was $134.7 million. We completed the second quarter of 2014 with approximately $89.7 million of net debt as defined in the non-GAAP reconciliation table of our earnings release. And the weighted average interest rate on our senior credit facility was approximately 3% during the second quarter of 2014.

Our consolidated leverage ratio at the end of the quarter was approximately 2.2x, considering our gross debt and pro forma EBITDA. However, I would also highlight that we were well below this leverage level when considering our cash balances.

Operating cash flow from continuing operations for the second quarter of 2014 was $17.1 million. Our cash flow generation in the quarter was a significant improvement over the first quarter of 2014. The organization has made tremendous progress in improving our shipments linearity for our businesses, shortening customer payment terms, reducing past due receivables, and lengthening our vendor payment terms. We feel good about the progress we made in the first six months and put our sights on ways we could reduce our inventory needs to further drive improvement.

Overall, our businesses are seeing the benefit of new product introductions and our strategic focus on serving higher growth in more sustainable advanced industrial medical markets. We are seeing solid demand across our business lines and feel good about the progress we have made.

We continue to be optimistic about our opportunities and our future. These new opportunities require stronger and more developed operational capabilities, as John previously mentioned. Since the latter part of 2013, we have invested significantly in building our continuous improvement initiative and instituting it across the organization. We have seen significant reductions in quality problems that reach our customers, solid improvements in on-time delivery, and meaningful improvements in our cycle times and lead times. In many of our sites we have significant reduced floor space, streamlined production flows, and increased our production capacity.

While we feel good about our progress, we no longer make our quality problems our customer problems. We still have significant improvements to make. These are challenges, but they are not insurmountable and we feel very confident we can drive meaningful improvements.

So turning to the third quarter of 2014, we expect revenue from continuing operations of between $95 million and $97 million, representing year-over-year revenue growth of 19% to 21%. We expect adjusted EBITDA to be in the range of $14 million to $15.5 million. Our range in EBITDA largely represents operational investments we are making to structurally improve our medium term profitability and put us on a path to accelerated profit growth.

Overall, we expect the third quarter to look very similar to the second quarter of 2014, with the Company facing many of the same challenges and opportunities we faced in the second quarter. We are expecting depreciation and amortization expense, acquisition related costs, and stock compensation expense to be largely flat with the second quarter of 2014. We also expect our third quarter non-GAAP tax rate and interest expense to be largely flat with the second quarter of 2014.

And finally, we will look opportunistically at reducing our gross debt balances, bearing in mind our relatively low borrowing rate of 3%. Regardless, we expect to reduce our net debt to approximately $80 million.

This concludes our prepared remarks. I'll now open the call up to questions. Operator?

(Operator Instructions) Lee Jagoda, CJS Securities.

Hi, Lee.

John, can you discuss some of the types of challenges you face on the manufacturing side, and possibly quantify the impact it had on gross margins in Q2?

Well, I mean, I said that we don't think pricing and market factors really have much of an impact. Right? So I mean, is there a mix shift a little bit here and there? A small one. But most of what we see in impact really is the manufacturing efficiencies. And it's really when you put new products into production they just--they yield at 60% where they--the thing they're replacing is 90% to 95% or whatever. And so, we're running--scrap is high and rework is high, which is a labor cost. So we're just seeing it run through the variance lines in the factories.

It's not that our new products have a worse standard cost. I mean, I think--because we are obviously--when we design them we're looking at the bomb cost and the economics of the product. And I think we're fine with that. It's just we're not getting to that standard as quick as we'd like. And that's something we're seeing in the laser business. We're seeing it across a number of parts of the Company. It's not--it's really a result of us trying to do a lot more growth facing projects in the Company. And you can't just make what you've always made, if you want to grow. You have to kind of go where the market is heading and put out new products and new functionality for the growing applications.

And we just don't have as much maturity around that process, I would say, in our factories. We've got a lot of new folks and they bring those skills in. But the processes themselves are not mature.

Okay. And looking at the--on the lean initiative side, I think you would expect to spend about $5 million in the first half, and then see the benefit of that in the second half. How much of that $5 million was actually spent and is there any more expense expected in the back half for these initiatives?

I would say it's actually running higher than that because what that investment entailed is not only investments in individuals, but it took into account some of the yield losses and scrap rates and rework and all the--.

--Getting better, yes.

So some of that cost was--is running higher than we initially planned.

If you tried to separate the two and say, like have we brought in more continuous improvement people and are they spending more money on implementing stuff, it's not really that. It's really that the impact that they're having is just taking longer. Right?

Yes. So with that--you do have a front-end loading of that. We have been putting a significant effort around that. And then, that snaps back. So as you--as soon as you release this, you should be producing product at a much better level. And that's the savings element of it.

Got it. Switching gears a little bit to India, our expectation was that the dual sourcing issue was sort of anniversary post-Q1. I guess the question is, what if anything changed versus that previous assumption? And then, as a follow up, just any additional information regarding that customer and whether you expect to get any of that revenue coming back?

So there's a couple of things there. One is, I--the notification happened late Q1. And the implementation of the dual sourcing was not immediate. It's just not possible. It was a pretty good size customer and they had inventories and they had the pipelines of products and orders with us. So really, the notification is not the proper anniversary of the dual sourcing. I think by the end of Q2 it's safe to say it had been implemented. So Q3 and Q4 of last year were more at the fully reduced dual source run rate. So we should see less impact from that.

That customer is still a customer. We don't talk about who they are because it's confidential. An OEM no-disclosure agreement there. They're an important customer to us. We continue to serve them. There is an opportunity to gain business with existing products or with new products with that customer. So I don't know that they're going to like go back to single sourcing necessarily, so we kind of get back exactly what we used to have. I don't think that's likely. But I think we see growth opportunities in that account from where we are now.

Okay. Sounds good. I will hop back in queue. Thank you.

Thanks, Lee.

(Operator Instructions) Jim Richiutti, Needham.

Hi, Jim.

Thank you. Good afternoon. I joined a few minutes late. But I was wondering, John or Robert, did you give a breakdown of the revenue from new products? And I'm just wondering if there's a way for us to get a sense as to how that's--how much that's contributing say in the past quarter versus a year ago. That would maybe help explain some of the issue around gross margins.

Yes. We don't have a specific measure on that. I mean, it just--it's not something we explicitly track like that. I mean, we can see where we're getting variances flowing through the factory though, like what's causing those. And we can trace that to new products. But to say x% of our revenue and they're running at this different margin, I mean, we're not able to drill it down to that level. But what we can tell you is we just don't see deterioration in the pricing environment. And we don't really see a big let's say mix change where division A or business line A has 10 points higher margin than business line B and there was a mix shift.

It's really not that. It's really the variances in a number of our factories are running high. And when we look and say, well, why is that, why are we seeing rework and labor variances and why are we seeing scrap and material variances, they trace back to new product launches.

Okay. And John, implementing lean it sounds like sometimes can have a short-term negative impact. Is some of that as well contributing here?

Yes. I mean, it definitely is. It's--and so how much? I think more is coming from new products, but the lean is sort of the--it's a complicating factor. We are absolutely convinced that it's where we need to go. Because the lean is going to enable us not only to get the quality right, reduce lead times, but scale. I mean, it's just much more scalable, because our old processes were using way too much space and too much time. It's where we need to go to be able to scale. But what ends up happening is you surface problems that you've been living with all along. But they rise to the forefront in lean because you're not running batches of 100 where 20% of them can be bad and you just set those aside, right, and you keep running.

When you're running single piece flow, each piece if it's bad is more or less sort of shut the cell down and you've got to resolve that issue. You don't just keep working around problems in lean. It's an excellent sourcing devices, right, because it causes finally a root cause and corrective action and a resolution of the issue, as opposed to just burying it.

And as you go down this path in terms of slowing the implementation, that's really not necessarily a good option I guess either, is it?

Yes. I mean, you could sort of just punt on the problem a little bit and say, well, doing lean is just too painful short-term. Let's not do it or let's do it. I mean, we're not doing it every single part of the factory. We have made some judgments about where we want to put these cells in. But those are not geared to where do we have the most risk of disrupting production. We're making those decisions basically saying, where do we really see it as a strategic capability? Where do we want to grow? Where do we need the performance? And that's where we're doing lean. And in some cases that actually makes the pain level a little bit higher short-term, because you could go do it off an insignificant product line.

I mean, you would do that if you didn't have people who know how to do lean, if you were sort of learning how to do it. It's not that. I mean, we actually have experts who come in here from world class companies and have deployed lean dozens and dozens of times in the past. It's more the process maturity they are working with. Just the underlying consistency and the underlying yields and capabilities of those processes are not that mature.

Got it. Now, I know you guys don't give any guidance specifically on gross margins, but I'm just wondering under the circumstances, can you give us any sense as to--it doesn't sound like you're expecting a whole lot of change in Q3. And maybe just some sense as to when this might begin to turn for you. Is it going to be a couple of quarters? It sounds like that's what you're alluding to.

Well--yes, I mean, I think that is the question. And what we try to do is say it could improve faster, right? I mean, when you start to solve--improvements in yield aren't necessarily straight line. What ends up happening is you get at the root cause of yield loss and then you resolve it. And now you get a step change improvement, and now you're got to go work on the next thing on your Pareto and solve that. So you sometimes get step change improvements, but it's sort of hard to predict exactly when they come online. So we have taken the approach that it's possible it takes us a couple of quarters here to really get this thing moving upward.

It's entirely possible that happens sooner. And that sort of accounts for some of the spread in our profit outlook.

Understood. And I guess you must be encouraged I would assume from the reaction and the response in the market to the newer products. And what is your sense that you--assume you're taking some share here. And I'm wondering if you can give a little bit of color in terms of where you think you might be taking some share. Or possibly is it just that some of the market is getting better?

Well, to some degree the share we're taking is really laser processing or other types of processing that's overtaking some traditional method. That's true more in our laser side of the Company where you're seeing laser processing come into areas that were mechanical. And then, so a scanner is needed, a laser source is needed, and we can capture both of that. And it doesn't necessarily come at the expense of another laser company. It comes at the expense of some other process. And you look at our medical, in some cases, we're adding functionality into medical equipment that wasn't there at all. Right? So it's not--it's a new part of the market that's opening up.

That's very true with some of the JADAK technologies, which are error prevention techniques that are being added into equipment. And you're not displacing anything. It's--they're spending money to put that capability into instruments to reduce medical errors. And there's a payback on that for the end user. But in a few cases, I mean, certainly we feel like we're getting some share. There's no question about that. But it's not really just a share based story.

Okay. And just one final question. Just because you don't have a lot of experience with JADAK, is there much seasonality to their business in Q3 at all?

It will likely tick down a little bit in Q3. Not that much. I mean, what I mean by that is on a sequential basis. On a year-over-year basis we're still expecting some solid growth out of that. But sequentially, they'll tick down a little bit and then their Q4 will actually be a lot stronger than obviously Q3, but also Q2. That is more aligned with the overall medical markets. Hospital CapEx spending tends to be heaviest in the fourth quarter.

Just consuming the capital budget for the year that hospitals tend to do.

So you'll see (inaudible) a couple of our business lines.

Yes. Okay. Thanks very much. I'll jump back in the queue. Thank you.

Thank you.

(Operator Instructions) Stefan Mykytiuk, ACK Asset Management.

A few questions, I guess. First off, the growth in laser products was again quite good but it sounds like from what you're telling us in terms of the--how the throughput on the new product wins, that revenue growth actually could have been higher if you didn't have these kind of throughput challenges. Is that a fair statement?

In laser I would say that's at the margin a little bit true, but it was more a case of the flow-through on the volume we did get--those sort of start-up inefficiencies. We had some yield--people use the term yield (inaudible) in some of the laser business where--so in effect, if yield drops it really does cap your output a little bit. Because at a minimum it's going to take you time to re-work that stuff. And so it delays it getting out the door.

But it's more the cost impact that we felt than really--.

--Going to cost you more money to get it out the door.

It costs you more money to get it out the door and it's delayed. And if you really get into ultimately scrapping that product, then you actually kind of reduce the output. I would say that was probably a little bit less of our problem than just the margin flow-through.

Okay. And that--it sounds like that margin impact is pretty hard to quantify as it relates to just the new products and the throughput issues.

Well, I mean I would say--I mean, we can quantify it looking backwards fairly well. What's harder to do is say how quickly does it resolve itself. I mean, these are things that are solvable. There's more in your control. If customers aren't buying your products, you have a different problem. You've got to go back to the drawing board.

But we have demand for the products, and we know sort of the--let's say the bill of materials, the basic standard cost of our products is where they need to be. It's more just we've got to be able to build them the same way we could build the prior generation. And I mean, I think we've always experienced--GSI, if you look at its history, always had some of these challenges. They weren't doing as many new products, and it took that amount of time.

We want to kind of launch the products on a more regular basis--the new products--and then get them to the target costs in a more timely kind of manner. We need that skill to be a growing company, to sustain our growth.

Right. What I'm trying to get to is again back to--I think someone asked the question earlier, originally you had talked about spending $5 million on lean in the first half of the year, and then getting back that in terms of savings in the second half. It sounds like you're saying in terms of the lean initiatives, you're spending more than the $5 million and some of that spending or that impact is dragging into Q3 and the back half of the year. Right?

We're spending more on the first half of the year. That's absolutely true. And if you look at the gross margins, the entire drop is a consequence of either inefficiencies in those new launches or the lean efforts that we're doing.

I guess when I think of spending, though, I think of like deliberate acts that we are not hiring more people to run the lean programs. We are not paying them higher salaries than what we intended to. What's happening is that the impact on the operations is not as favorable as what we intended, that--.

--You're not getting the same incremental margin on that growth.

Yes. Right. And so there was a hit in Q2 on that. As we started to do more of this, we experienced more kind of start-up problems on some of this than we expected. Now--and when you say so we had planned to get whatever those costs were back in the second half. And are we still confident we can get every dollar of the savings that were modeled into the second half, I think we can get it. It's a timing question. I mean, we know we can solve these issues. But there's some headwinds on it as we head in here in Q3, and we're working pretty hard to improve it though.

That's why we have a range around our income is really most of the range is around this issue. The demand is lining up pretty nicely.

Okay. But however you slice it, it's more than $5 million of gross profit impact in the first half of the year, and then as we look forward, I mean, obviously you're saying you're not going to get it back in Q3. There's potential for Q4. As you get into 2015, do you think these problems are solved, or do you think you still could be dealing with those headwinds?

I think that they're largely resolved heading into 2015. I mean, that's the line of sight we have. Of course we want to be launching more new products in 2015. So it's not just resolving the known issues that's important to us. It's getting good at this in general. So being able to launch new products on a continual basis closer to the targeted cost structure, in a more tight time frame.

So we're trying to not only solve any issues we have now, but to kind of institutionally have that capability.

Right.

Okay.

All right. Thanks very much.

Thanks, Stefan.

(Operator Instructions) And at this time, presenters, there are no further questions. Do you have any closing remarks?

Yes, I'll wrap up. Thank you, Operator. So just to conclude today's call, I'd like to reiterate that I'm very pleased with the Company's overall progress this quarter. The growth strategies are clearly paying off, especially in our more significant business lines like CO2 lasers, scanning, the optical encoder products, the JADAK acquisition. Our medical cross selling program is surfacing a lot of attractive opportunities. These are already becoming part of our revenue funnel, and we're certainly going to help growth next year and beyond.

Overall we're making tremendous progress as an organization. The momentum is building with our OEM customers in key applications. And that's very encouraging to me. We have an outstanding management team in place, and they're all extremely committed to delivering on our strategy.

Like most companies, we still have challenges we need to address. The operations and gross margin issues that we discussed on this call are really the biggest area of focus for us now. The good news is this is really an execution issue, and it's ultimately in our control. I have excellent people focused on it in our production sites, and I'm confident we'll achieve the results we expect.

So with that, I really appreciate your interest in GSI, your participation in today's call, and I look forward to joining all of you in a couple of months on our next earnings call. So thank you very much. Today's call is now adjourned.

This concludes today's conference call. You may now disconnect.