Novanta Inc (NOVTU) 2014 Q3 法說會逐字稿

Good afternoon. My name is Salima, and I will be your conference operator today. At this time, I'd like to welcome everyone to the GSI Group 2014 Q3 earnings conference call. (Operator Instructions)

I will now turn today's conference call over to Robert Buckley. You may begin.

Thank you. Good afternoon, and welcome to GSI Group's third 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. These involve inherent assumptions with known and unknown risks and other factors that could 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 any of 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'm now pleased to introduce Chief Executive Officer of GSI Group, John Roush.

Thank you, Robert. Good afternoon, everybody, and welcome to our call.

I'm pleased to report we had good performance in the third quarter. The Company executed very well across our portfolio and delivered profitability and cash flow that exceeded our own expectations.

Robert will comment on the numbers in more detail, but Q3 revenue came in at $95 million, with GAAP EPS at $0.15 and non-GAAP EPS at $0.23. Q3 adjusted EBITDA was $15.4 million, up $1.8 million versus last year and at the top end of the guidance range that we have provided. Net debt was $68.3 million at quarter end.

So on our Q2 call in August, we had discussed the fact that our increased number of new product launches, combined with our rollout of lean manufacturing, had impacted our gross margins. I'm pleased to report that our operational team has put really tremendous effort and resources into addressing these issues, and we were able to increase Q3 gross margins by two full percentage points versus Q2. Though we're still not ultimately where we want to be, this was a big success for us and gives us increased confidence in our ability to drive attractive profitability in the future.

Our cash flow and working capital management were quite strong in the quarter, which enabled us to improve our balance sheet. In fact, we exited Q3 with our net debt lower than what we had projected for year end.

The JADAK acquisition has continued to perform well, with the integration process now essentially complete. The business has exceeded our financial expectations and again delivered strong growth, with sales increasing high single digits versus what JADAK did a year ago prior to our ownership.

The JADAK management team has proven to be highly capable, and they're increasingly taking a lead role in our medical cross-selling initiative, which is showing good promise in getting us increased exposure for our full lineup of medical technologies across our entire OEM customer base.

From a demand perspective, we came in at $95 million in revenue, which is an increase of 19% year over year. We had attractive growth in a number of areas of the company including a healthy stream of design wins that will support our future growth. Having said that, I will note Q3 revenue was slightly below our original expectations.

From a geographic perspective, we saw strength in the Americas but a deceleration in both China and the eurozone. But cutting it another way, the primary driver for sluggish overall demand was lower monthly order quantities from OEMs in a number of our medical applications.

We had one major OEM customer in patient monitoring that had a line shut down for the latter portion of the quarter that was completely unrelated to the components we supply them. This reduced our revenue by over $0.5 million within the quarter. We also saw medical customers reduce their monthly delivery quantities in several applications, including patient monitoring, ophthalmic OCT, robotic surgery and radiology displays.

In some cases, our customers have commented that their volumes are down due to US hospital diverting capital dollars to IT programs in order to comply with the January 1, 2015 deadline for electronic health records. To a lesser extent, we also saw reduced monthly delivery quantities from OEMs in printed circuit board via hole drilling applications. We view these headwinds as short term in nature, but they did impact Q3 in excess of $1 million on the revenue line relative to what our view had been as of the last earnings call.

From an orders perspective, we're at a cumulative book-to-bill ratio of 1 through the first three quarters of this year. So far, Q4 quarter to date, book-to-bill is slightly above 1, and our projection is that we'll end both Q4 and the full year with a book-to-bill at or slightly above 1. The takeaway there is that orders are tracking close to sales for us, with our OEMs preferring to remain cautious with respect to inventories and future visibility.

In terms of the business outlook, Robert will cover our guidance for the balance of 2014 in his section. And we're not in a position at this point to give guidance with respect to 2015. But what I can say is we've had numerous dialogs with our customers as part of the annual planning process that we're undertaking. And our customers are generally positive about 2015. We can't be specific at this point, but we do expect 2015 to be stronger than 2014 in most of our end markets.

At this point, I'd like to provide some commercial updates on our progress around the Company, beginning with the laser products segment, which remains the largest of our three segments.

So laser-based revenue increased by 2% in the third quarter versus a year ago. Our CO2 laser product line had strong demand during the quarter, with sales up high single digits versus a year ago. And the marking and coding applications were particularly strong for us in the quarter.

We also closed on eight new design wins with OEM customers, and these wins have annualized revenue potential of $10 million. This gives us 31 CO2 wins year to date, significantly ahead of our original goal of 25.

More importantly, our CO2 production site continued its focus on deploying lean principles in that operation. The team was able to reverse some challenging yield trends from earlier in the year and gain more experience in improved output from their lean manufacturing cells, which helped them to make important contributions to our improved gross margins for the Company.

Our laser scanning and beam delivery products saw revenue decline mid-single digits versus a year ago. There were two applications that drove this slower demand -- ophthalmic OCT and laser via hole drilling. Together, these two areas created a 10% headwind in our scanning revenue, with all other scanning applications delivering growth that partially offset the headwind. The reduction in OCT and via hole drilling came from lower monthly order quantities on ongoing customer programs where we remain the sole source.

We had 10 scanning design wins in the quarter, up from six in Q2. We saw strength in marking and coding, which is similar to what we saw in the CO2 products.

We also made important progress with our lean manufacturing efforts in the scanning operations. We're now running four volume production cells for galvanometers. We've gained experience and moved along the learning curve in these lean cells, as we've improved yields, labor utilization and material availability versus Q2 levels. These efficiencies helped us to significantly improve gross margins for scanning products at the same time that we've reduced out-of-box failures by 21% versus Q2.

The performance of the scanning operations is still not where we need it to be. But we made significant progress in Q3. And that gives us increased confidence with respect to our ultimate goals for [performance].

Sales of fiber laser products, which are in the range of 3% of the Company's overall revenue, increased double digit versus Q3 2013. And that was due to increased order volume on ongoing customers and several new customer wins.

We continue to see growing demand for fiber lasers off of our small base, along with significant price pressure in the marketplace. However, we have carefully managed costs in this area, and consequently this business was profitable for us in Q3.

Now, I'd like to comment on our medical technologies segment. From a strategic standpoint, we see tremendous medium-term opportunities to extend and broaden our position as a core supplier of highly engineered enabling technologies sold to medical equipment manufacturers. The strategy we have articulated includes investments in new products for these applications as well as medical-focused product management, applications and sales staff to support new design wins at medical customers.

Our strategy also includes our medial cross-selling program, which leverages our OEM relationships that may presently be served by a single product line, but which we believe can be extended across our entire lineup of 12 different medical product families.

The medical market is also a significant dimension of our acquisition strategy. As we continue to evaluate the potential of our overall medical strategy, we see a good pipeline of organic and acquisition-related growth opportunities.

I also need to be clear -- our overall medical strategy is broader than just our medical technologies reporting segment. A meaningful part of our laser products and precision motion segment revenue are also sold to medical customers.

But despite these medium-term strategic opportunities we see in the medical market, our Q3 medical sales were a bit of a disappointment to us. Q3 reported sales in the segment increased 66% versus a year ago as a result of the addition of the JADAK acquisition to the results. But absent JADAK, segment revenue declined in the quarter.

As I mentioned earlier, the JADAK business is performing very well and exceeding our own expectations from the time of the acquisition. So viewed as a standalone business, JADAK increased their sales organically by high single digits versus a year ago. They had 10 design wins in the quarter and had closed 39 such wins on a year-to-date basis.

Of particular note, JADAK has seen an increase in demand for its RFID technology in medical applications. After having seen only three RFID design wins in the last 10 years, they have closed on six RFID design wins so far in 2014.

RFID activity is continuing to accelerate, and we're seeing strong customer interest in applications such as clinical chemistry, blood analysis and patient monitoring.

As I mentioned, excluding JADAK, our medical technology segment revenue declined in the quarter. Our results were impacted by a line shutdown in a major patient monitoring OEM, as I mentioned. And that cost us over $0.5 million in the quarter across several different product lines. The customer shutdown was completely unrelated to our products. But it impacted our deliveries and our revenue in the quarter. This customer has since restarted production on a very limited basis, but run rates are not yet back to normal, and they may not get there until early next year.

Our sales of thermal printers for medical applications were up mid- to high single digits year over year, despite a significant impact from the aforementioned customer line shutdown. Sales of medical displays were down low teens from year-ago levels. Sales of radiology displays, which are sold directly to hospitals or other end users, rather than the OEMs, were particularly soft in the quarter.

In several cases, hospital procurement projects were delayed, and the hospitals commented to us that they are allocating their near-term capital budgets to implementation of electronic health records programs in order to comply with the January 1, 2015 deadline that's part of the Affordable Care Act.

The surgical display business continues to offer attractive growth opportunities. We have a number of new surgical products that will be featured at upcoming trade shows, including the [medical] show in Dusseldorf that I will be attending next week.

Moving on to our precision motion segment -- in the third quarter, we had 5% year-over-year sales growth, driven by new programs in our optical encoder product line, which had mid-teen sales growth in the quarter, driven by strong demand in wire bonding and other advanced industrial applications. Encoder demand from robotic surgery customers declined in the quarter versus year-ago levels.

It's pretty well documented that this application has been declining for the last year but has recently started to grow, and we're encouraged by recent orders we have received. Our Q3 sales of air bearing spindles were down high single digits versus the prior year due to lower monthly quantity demand from printed circuit board via hole drilling customers, partially offset by some increased demand in non-printed circuit board applications, such as turbines and paint spraying and coating.

Overall, we've seen relatively consistent demand for spindle throughout this year, and we really don't expect that to change near term.

So one other area I'd like to comment on is our acquisition pipeline. We've had a very active effort to cultivate attractive deals that bring us added capabilities in our core applications. Most of the deals we look at are private companies, where we have developed the opportunity on a proprietary basis. We've had some challenges getting alignment with sellers on valuation, given the uncertainty in macro conditions.

Having said that, I'm pleased with our overall progress. We have several opportunities that are pretty far along. I'm optimistic that we can get one or two things done fairly soon.

These are not large deals -- generally below $20 million in revenue, but good strategic fits for us. And we will update you on any developments as soon as we can.

So with that, I want to now turn the call over to Robert to provide more details on the financial performance. Robert?

Thank you, John.

On July 15th, we closed the sale of the scientific laser business for $6.5 million in cash net of networking capital advertisements. In accordance with the purchase and sale agreement, $1.5 million of the sale proceeds will be held in ESCROW until January of 2016.

The Company has recorded the $1.5 million in ESCROW and other long-term assets on the balance sheet. The net inflow was recorded as cash flow from investing activities of discontinued operations in the third quarter. This transaction represented important strategic divestiture of our noncore business and a great step forward in the execution of our strategic initiatives.

On September 24th, we received a payment of $5.4 million, the full remaining amount held in ESCROW account established upon the closing of the acquisition of the NDS surgical imaging business in January of 2013. The payment or ESCROW recovery resulted from our claims that the sellers of NDS breached certain terms of the January 15, 2013 purchase agreement for the acquisition of NDS.

The ESCROW recovery was reported as a reduction to goodwill, as the $5.4 million payment was clearly and directly related to the acquisition price, which is now at $75.4 million. In addition, the cash received was recorded as cash inflow from investing activities of continuing operations in the third quarter.

During the third quarter 2014, GSI generated revenue of $94.7 million, an increase of 18.5%, from $79.9 million in the third quarter of 2013. All three of the Company's operating segments demonstrated year-over-year revenue growth in the quarter.

Sales of laser products for the third quarter increased 2.4%, to $45.8 million; compared to $44.7 million one year ago. We experienced solid growth in both our CO2 and fiber laser technologies as a consequence of new customer wins and new product launches in advance industrial applications. This was partially offset by a decline in our scanning solutions business caused by difficult year-over-year comparisons in the laser via hole drilling of printed circuit boards.

Sales of our medical technologies for the third quarter increased 65.7%, to $32.7 million; compared to $19.7 million one year ago. The JADAK acquisition added approximately $14.9 million in sales this quarter, experiencing high-single digit organic growth on a year-over-year pro forma basis.

Sales from JADAK were partially offset by a decline in our visualization solution products sold underneath the NDS and Dome brands as a result of a softness in the medical equipment spending by hospitals impacting customers' demand of our products. To a lesser extent, delays in new product introductions also contributed to the decline.

Finally, sales of precision motions for the third quarter increased approximately 4.8%, to $16.2 million from $15.4 million in 2013. This increase was driven by increased sales of our optical encoder products as a result of market share gains with a major OEM customer. This was partially offset by decline in sales of our air bearing spindles products due to lower demand related to mechanical via hole drilling of printed circuit boards.

Turning to our profitability -- third quarter gross profit was $39.7 million, or 41.9% gross margin; compared to gross profit of $34.2 million, or 42.8% gross margin during the same period last year. On a non-GAAP basis, our gross margins were 43.7% in the third quarter of 2014, compared to a gross margin of 44.6% in the third quarter of 2013.

Laser products' third quarter gross profit was $20.3 million, compared to $19.3 million for the same period last year. Gross margins of our laser products increased 110 basis points to 44.2%, from 43.1% a year ago. The 1.1 percentage point increase in gross margin was driven by continued progress in our lean manufacturing and continuous improvement in productivity programs, which was most evident in our CO2 and fiber laser businesses.

Medical technology's third quarter gross profit was $12.9 million, reflecting a 39.6% gross margin; compared to $7.5 million, or 38.2% gross margin for the same period last year. The increase was primarily attributable to the JADAK acquisition, which accounted for $6.4 million increase in gross profit year over year, partially offset by a decline in gross profit for our visualization solution products due to lower sales.

Precision motion third quarter gross profit was $6.8 million, reflecting a 41.9% gross margin; compared to $7.4 million, or 48.2% gross margin, for the same period last year. The decline in gross profit was due to a decline in sales volume over air bearing spindle products, partially offset by an increase in sales volumes are our optical encoder products.

The decline in gross margins was due to an unfavorable product mix in our air bearing spindles product line and higher manufacturing costs in our optical encoder product line, associated with a sharp increase in volumes from a major OEM customer.

Operating expenses increased $32.9 million to the third quarter of 2014 from $28.4 million in the third quarter of 2013, an increase of approximately $4.5 million. The acquisition of JADAK was the primary driver of the increase.

Research and development expenses were $7.7 million or 8.2% of sales during the third quarter, compared to $6 million or 7.6% of sales during the third quarter of 2013. While the acquisition of JADAK drove the majority of the increase, we have also increased investments to accelerate new product introductions, particularly in medical and market applications.

SG&A expenses were $21.5 million or 22.7% of sales during the third quarter, compared to $19 million or 23.8% of sales during the third quarter of 2013. Operating income from continuing operations amounted to $6.8 million or 7.2% of sales in the third quarter, compared to $5.8 million or 7.3% of sales in the third quarter of 2013.

On a non-GAAP basis, our operating income was $12.5 million or 13.2%, compared to $10.5 million or 13.2% of sales in the third quarter of 2013.

Interest expense increased to $1.5 million from $900,000 in the third quarter of 2013 as a result of higher debt levels from the acquisition of JADAK. As a reminder, we're currently borrowing at roughly 3.2% weighted average interest rate.

Adjusted EBITDA was $15.4 million for the third quarter of 2014, compared to $13.6 million in the third quarter of 2013. Diluted earnings per share from continuing operations were $0.15 in the third quarter, compared to $0.07 in the third quarter of 2013; whereas non-GAAP earnings per share from continuing operations was $0.23 in the third quarter, compared to $0.15 in the third quarter of 2013.

Turning to the balance sheet as of September 26th of 2014, cash was $53.5 million, while total debt was $121.9 million. We completed the third quarter of 2014 with approximately $68.3 million of net debt. Our consolidated leverage ratio at the end of the quarter was approximately two times considering our gross debt and last-12-months pro forma EBITDA. However, I'd also highlight, when considering our cash balances, our net leverage ratio is significantly less than that.

Operating cash flow from continuing operations for the third quarter of 2014 was $14.5 million. Operating cash flows were driven by both an improvement in our after-tax profitability and better working capital management.

We completed the third quarter with days sales outstanding of approximately 54 days, a five-day improvement compared to the prior year; whereas days inventory outstanding were roughly 103 days, a 10-day improvement from the prior year. Days payable outstanding was roughly 51 days, representing a two-day improvement year over year. The net result was a 17-day reduction in our cash conversion cycle to approximately 106 days, which represents the strong progress we have made in our operations and working capital management.

Overall, we're pleased with our operating results for the third quarter. As we finish out the year, we expect revenue to come in on track with the guidance we provided back in March of 2014, with a range of $364 million to $367 million. Whereas we expect adjusted EBITDA to come in closer to $54 million to $56 million, largely as a consequence of gross margins coming in one to one and a half points weaker than previously expected on a full-year basis.

This weakness, as we discussed in the second quarter, is largely being driven by new product introduction yield losses and startup inefficiencies from our lean manufacturing and continuous improvement programs in the first half of the year.

However, with these programs making strong progress now, as evidenced by the sequential improvement from Q2 to Q3, we expect gross margins to continue to recover and trend in the right direction. R&D expenses will trend up slightly, completing the full year at roughly 8% of sales. We continue to invest in a number of new opportunities in both existing customer accounts as well as new applications, with the bulk of our incremental investment dollars being spent on medical and market applications.

Similarly, we expect SG&A to trend up slightly, driven by investments we are making on our medical businesses to better position these businesses competitively and to capture organic growth opportunities. Consequently, SG&A will likely finish off the year slightly above 23% of sales.

We expect depreciation and amortization expense, acquisition-related costs, stock compensation expenses and other non-reoccurring expenses of close to $32 million in the aggregate for the full year 2014, with depreciation and amortization expense representing roughly 75% of that overall expense. Net interest expense will trend down slightly in the fourth quarter, finishing off the full year at just under $5 million. We expect non-GAAP tax rate to finish off the full year at approximately 36%, and our GAAP tax rate to finish off the full year at approximately 32%.

Finally, as evident in the first nine months of the year, our operating cash flow and net debt progress has been very strong. Our goal for the year was to reduce our net debt position to $70 million, which we surpassed in the third quarter. Consequently, we expect to make further progress by year end, finishing off the year with operating cash flows of approximately $40 million and a net debt balance below $65 million.

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

(Operator Instructions) Lee Jagoda, CJS Securities.

John, could you provide a little more detail regarding NDS specifically in the quarter? And within NDS, radiology, with the rest of my questions sort of around whether the issues you're seeing are more company-specific or macro?

Yes, I would say the radiology business -- it's a combination of both. I mean, we do have gaps in the product line, right? And some of that relates to the fact that it's a relatively small business, and so you can only spend so much R&D. And if you're trying to do three or four new products, you got to do them more in a serial fashion instead of parallel. So some of that's company-specific.

But we definitely saw what I would characterize as more macro. Because some of the things where we are being told we're going to be the supplier of the displays but it's being pushed out in time, because the customer doesn't have the budget or they're diverting the budget. So I think it's a blend of the two.

The surgical business is definitely in, I would say, a stronger position than radiology. It's a marketplace where there's more technology differentiation, more integration of the display in an overall surgical system, in an OR environment, an integrated OR environment. So you have more ways to kind of create value for the customer in that area. So I just think it's not under the same amount of pressure.

Of course, we did have that dual sourcing event that happened. But we're sort of more or less past that. And I think surgical is holding up better.

So then, looking at NDS specifically for Q4, what are the assumptions for that business in your guidance?

It's similar to Q3.

Okay.

And then, one last -- go ahead. One last question --

I was just going to repeat what John said. I would say it's similar to Q3 in that. But given that Q4 generally has some seasonality uptick associated with it, it'll be a little bit down -- it'll be down further on a percentage basis.

And then, one last question, and I'll hop back in queue. The Q4 gross margin would imply a sequential decline of anywhere between 100 to 150 basis points. What's causing that, if we're through sort of the heavy lifting on the lean, other than just new products rolling out?

Let me make sure I understand the question. You're projecting our Q4 gross margin to decline sequentially?

Versus Q3. On an adjusted basis.

I would say you made a mistake somewhere.

Okay.

I think the guidance would somewhat suggest that gross margins would be roughly the same to a little bit higher.

Okay. I guess we could --

There's definitely no -- variable [lean] and all that is always mixed, right? When you're trying to project $94 million, $95 million, $96 million of revenue. And there's always a few million that can swing you on a mix basis.

But in terms of the actual progress in the factories, we're not projecting that we're launching a new product that's going to cause a hit in gross margin. We're not projecting that some lean cells are going to get implemented in Q4 that are going to take us backwards or something. Because we're extending off of what we've been doing in Q3.

And we weren't even sure that we would turn the corner in Q3 the way we did. But we got a nice sort of result there, that yields kind of came back up in areas where they were challenged in Q1, Q2, and they're stayed there so far. The lean cells are getting more volume running across them. So the operators and the teams are more experienced with it. So it's not as if we see any backsliding on any of that.

Okay, that's actually very helpful. Thank you.

Okay.

Jim Richiutti, Needham & Company.

I just wanted to follow up, too, on the medical technology business. It sounds like, excluding JADAK, the business was down around 10% year over year. Is that in the ballpark?

Yes, that's in -- we had said it was down. That's not far off.

Yes. And John, you had one customer that had to shut down, which was not connected to you guys. But nonetheless, you were affected by that. So ex that, is the business just kind of down mid-single digits?

I don't know that we did kind of the math on that. I mean, that was about a $0.5 million impact in the quarter.

Yes.

Of stuff that didn't go out the door, just because we were slowed down. And we were completely stopped for a portion of time. It's actually some confusing signals out of that customer, because they slowed us down. Then they stopped, and then they started back up, and then they backed off to start up. It's been -- we don't know exactly what's going on. Because it doesn't have to do with our product. But it was about $0.5 million. And it was across a couple different products.

Okay. And JADAK -- as you look out into Q4, sounds like you feel you're seeing pretty good momentum in that business. Is that fair to say?

We are. I think the JADAK business has been doing well since we've acquired the business. Some of our other medical technologies, as John mentioned, are doing fairly well. The printer business is up similarly. I think some of the challenges just seem to lie within the NDS business.

Okay.

And then, just to switch gears for a second -- you called out a little bit of macro-related impact, I guess, in Europe, and I wasn't sure if you said China. But I wonder if you could elaborate on that. Is that more so in the laser products area? Although it seems like you had a reasonably good quarter [then], precision motion was also up.

So I wonder if you could talk a little bit about what you're seeing --

Sure. I mean, the most obvious place we saw that is in the via hole drilling. And that shows up for us in a couple different places. Because on the mechanical side of via hole drilling -- and that's the spindles, that's the Westwind branded product -- and that was definitely a bit challenging for us.

The other place that shows up is we're doing scanning, the beam delivery for laser via hole drilling. So it's some of the same and some different OEMs, but ultimately comes back to the same kind of dynamic. And we saw both of those be down versus year-ago levels. And I would say that's the biggest, most obvious place you can see it.

A lot of where we were strong, say, in the lasers, was this coding and marking. That's pretty good. And that's not really what I'd call heavy industry. A lot of that is food and beverage, pharmaceutical packaging.

3D printing is another area that has been strong for us. It's not a huge part of the base, but it's trending up nicely. So there was some mix in there; it's not all negative. But when you look macro-wise, you definitely saw, particularly coming out of Asia, that was slowing down. And the biggest piece of that was that via hole drilling.

Okay. And that business still looks a little soft, looking out to Q4?

Yes, I don't see a bounce off that. Now, having said that, some customers are signaling 2015 could be pretty positive.

Got it.

And wasn't quite clear -- was the book-to-bill for the quarter below 1?

Yes, it was a little below. But what we see is every time we trend a little above, it corrects back to 1; when we trend below, it corrects back to 1.

And you know, we have now a few weeks into Q4, and we have the order forecast. And I think we're going to end the quarter and the year, and it's going to be 1. But it was slightly below in Q3.

Okay. And it sounds like your satisfied, that you're back on the right track with gross margins trending in the right direction. And I know you're not giving guidance for 2015. But should we see the benefits of lean continuing to work in favor of higher margins, assuming the top line is at a reasonable level?

Yes. I mean, that's obviously why we're driving it. I mean, we had some growing pains with that. I think we're working our way through those, and we're more confident now we can extend that to more areas, set up more cells. I would say it's not just lean, though; it's also the supply chain stuff, which is -- it's a little bit different, it's trying to leverage the procurement and the capabilities across the whole $150 million of direct material that we buy, which has in the past been handled very locally. And we're trying to get global leverage on that.

But the combination of those two things, I think, does help us gross margin-wise as we head into next year. And we're seeing that now in the back half. So we have a lot more confidence now than we did, say, 90 days ago that we've got that at least heading in the right direction.

What we don't do is kind of make it all up from what we had planned for this year. I mean, we've got it now trending back. But we're not sort of on-plan for the full year with gross margin. I think we will see benefit heading into next year.

Got it.

Okay. Thanks very much.

Thank you.

Keith Maher, Singular Research.

I had a question about just your acquisition strategy, just in terms of the kind of acquisitions you're looking for, and what you are willing to pay in terms of evaluation multiple.

Yes. I'll let maybe Robert comment on our criteria financially and other stuff. But we are typically looking for added capabilities either within our medical strategy or in some of the industrial applications that we think have a lot of growth runway. A lot of that ends up being product technology extensions off of what we do, types of components or subsystems that are adjacent to what we're supplying, or they're used with our products, or they're very similar in nature. So we can just have a broader offering.

It's particularly a big deal in medical, where we're really pursing this cross- selling and trying to show OEMs a broad capability, so we get in on the ground floor of their R&D efforts. So more content, more product types, helps us there.

In the industrial, it's really the same, but it's a little bit more application-specific. So you could say in robotics or in 3D printing, additive manufacturing, some of these areas, is there more content we can get? So we think about acquisitions that way as being adjacent to stuff we're supplying, or things that make us more relevant to the customers we're working with.

A lot of this is stuff that's manageable bolt-on size for us. There are some bigger transactions in there. But a typical app thing we're looking at is probably $30 million or less in revenue. It depends, there's some that are larger.

But most of the time, it's something that we've identified through our own research, our own business teams, our own relationships that we have, even dialogs we have with customers. And we'll identify a target, and then we're out cultivating that. And it can take a long time to cultivate some of this.

So we're working on quite a few things, trying to get a few of them close to where they can be actionable. But right now, we have some that are pretty far downfield, so we're encouraged about that.

But Robert, you want to just comment on how we think about --?

Yes. We don't necessarily think about it in the traditional sense. I think what you're trying to get a feel for is what's the multiples of probably EBITDA that we're willing to pay. I can answer that kind of broadly that we generally look at stuff that's in the 7% to 10%, seven times to 10 times range.

If you go back and look at the JADAK acquisition, which is very indicative of what we're looking at to date, where there are attractive assets that are growing well with nice profitability, we paid roughly nine times EBITDA for that transaction on a reported basis, and eight times when considering the tax attributes, which were fairly significant.

Generally speaking, we try to get an ROIC of at least 10% by year two. And we look for cash on cash returns that are at or above that for the overall company as we've spent a lot of more time looking at the cash returns of businesses than any sort of GAAP returns. And that's largely on the basis that we're trying to create some value for our shareholders.

Ok, great. Yes, that was really helpful.

And should we think about -- I mean, in terms of the primary uses of cash, it's going to be these acquisitions, and then paying down the debt? Is that kind of the two focus areas for you?

That's been the operating plan for the last two years. We do have an authorization of $10 million to purchase stock, if we think it's an attractive thing to do. And that's -- all comes down to what you're trading at.

But to date, we see a lot of opportunity on the acquisition side. And then, paying down of that debt allows us to go out there and action transactions relatively quickly. And that's an important attribute to have when you're a buyer.

Okay.

And in terms of your international exposure -- I was looking in the 10-Q, but I didn't see that -- I mean, what percent of sales is international?

That's a very difficult question to answer, and I'll tell you why.

Okay.

Generally speaking, when you look at our geographic breakout that we've put into the 10-K, that's telling you what factories we're shipping to. And that's not what I would deem as our exposure. What I mean by that is that we could be selling product to a Phillips factory in China, but 100% of that product could be coming back into the US.

And so economic factors or hospital capital spending factors in the US would be influencing our China sales in that particular case much more so than any sort of capital spending in China, or any sort of manufacturing sentiment in China.

And so it's a very difficult thing to kind of get at. I would say, generally speaking, the nature of most of our products -- given that they're precision engineered componentry, they general sell for a higher price -- are going into higher-end applications. And those higher-end applications in most cases are being installed someplace in the US, or in Europe as it pertains to our medical products, and, to a lesser extent, industrial being a lot more evenly mixed.

The thing that you can notice -- the upshot of what Robert just said is we don't track to GDP trends in a lot of the regions, right? But what we do find is that we will track to things like indices of industrial activity.

So if you look at the PMIs, which are not measuring GDP; they're measuring industrial activity in a region, we will track to that a little bit more. If the factories in China are procuring stuff, they might be building products that are going to ship back to the US. But those factories are ramping up in China; that's going to lead to some business for us.

So the PMIs are a good proxy for how our industrial business would behave. There are not good measures of hospital capital spending even in the US, never mind globally. It's not, especially in real time, hard to get. But we would track with hospital CapEx at some level.

Although we do see this whole issue that the hospital CapEx gets spent on IT significantly. And that's diverting it away from clinical and diagnostic technologies, which is what we need the capital dollars to go to.

Okay. Great, thanks a lot. I appreciate it. That's all I had.

Thank you.

(Operator Instructions) Stefan Mykytiuk, ACK Asset Management.

A couple questions. I guess first off, when you talk about the hospital CapEx being pushed out due to their deadline to satisfy the electronic medical records requirements -- do you have pretty good visibility that those sales are actually just kind of pushed into 2015, as opposed to you got to go fight for them in the future again?

I mean, you never can say for sure. But these are programs where we've been told that we basically are getting the business. So do I have it written in stone that I'm getting that? No. But these are -- in the cases that we referred to, these are processes, sort of procurement processes, on radiology displays, where we have been told that it's our business. So I do expect it to be there in 2015. Is it definitely Q1? I can't say for sure.

So, in other words, you (multiple speakers) sorry, go --

Well, the other thing I was going to say is that John mentioned the OCT applications. In the OCT applications, our products are already embedded into the OCT instrumentation. And so, to the degree that that market is -- spending in OCT equipment is going up and down, we flow exactly with that. We're in all the major OEMs that supply OCT equipment. And so as a consequence of that, we ebb and flow with that. To the degree that's down, that's more representative of hospitals not spending their CapEx dollars on OCT equipment.

And that same analogy could be applied to patient monitoring in other areas. We are already embedded into the device itself. And so any sort of fluctuations in our revenue is more indicative of fluctuations of demand of our customers' products.

You go back and look at some of the major OEM customers out there, medical companies that have reported earnings, they all are somewhat saying the same thing -- that while hospital CapEx we're seeing signs of recovery, there's been a diversion into IT spend and lower dollar-value items, or lower, smaller equipment type of purchases have been delayed. Not stopped; delayed.

And what you'll likely see -- and this has happened now for two years in a row -- is that there'll be a pickup at some point in time. Because you can't keep buying IT equipment.

And we talk to all the major customers that we serve, the OEMs, to get planning volumes, right? Because as we start to do the annual planning process and map out what are our labor and material requirements, most of the customers are actually telling us they expect good conditions next year.

We're not really hearing how we expect things to be worse in two quarters than they are right now. We haven't kind of picked up on any of that.

Okay, terrific.

And then, I know you touched on it earlier when Lee asked the question about gross margins on a sequential basis. But now that you're getting through the lean, and it's great that you've shown that you can get through these on a kind of product line-by-product line basis. What are you goals for gross margins in the future? And I know in the past, I think you've talked about greater than 50% flow-through on incremental revenues -- is that a good bogie for -- I'm not calling it for 2015, but just at some point in the future, that you get there?

At some point, when John was talking, he was talking about kind of a medium-term ambition for the Company of being in the $500 million to 20% EBITDA type of range. One of the ways you get to the 20% EBITDA is that you start getting a gross margin that's closer to anywhere between a 45% and 50% --

I think mid- to high 40s is really where we like to be. I'm not sure in the end our business model in all the areas we want to serve is going to sustain 50% plus. But we think mid- to high 40s is a level we could definitely attain and stay there.

We have some businesses [we] obviously track higher than that, and some businesses that track a little less. And so the aggregate, that average, comes out of that range.

Right. And you'll get there Q2 next year?

(Laughter)

Maybe just moving to some of the sequential increases, SG&A and R&D -- is that kind of staffing up ahead of some of the new product and cross-selling opportunities next year? Or what's driving that?

Yes, well, part of that is. From an R&D side, I think that our R&D spend needs to be higher than where it is. I think there's some opportunities. We wanted to focus before we started spending a little bit of money there, and wanted to make sure that we knew exactly what programs we wanted to spend those dollars on, and then we knew what the returns were associated with those.

So that's -- one of the reasons why that it's ticking up a little bit is that we've identified a number of really good opportunities for the businesses to start investing. And we can see some big application opportunities down the road.

On the selling and marketing -- I think that a portion of that is certainly us getting more into the cross-selling effort. A portion of that is just beefing up our selling effort around our medical technologies products. And I think that's necessary in order to make that business more competitive, more sustainable, and will help it get [lowered] on a quicker basis.

Okay. And I missed a little bit of what you said on the acquisitions. It's encouraging that it sounds like you have a couple things teed up. Are these things that you've just been sourcing over time, and like some of the past deals you're just trying -- it's a meeting of the minds in terms of when someone's willing to part with their baby, or the exact price that they want for it?

Yes, it's all of the above. Most things -- we don't start conversations and then three months later do a deal. That's really not our model. A lot of these things are going to be dialogs that go on for a year or more.

And it's not only about the deal itself, and what's valuation. A lot of it is, are these business teams compatible? Our most relevant teams and activities that line up as an adjacency to the acquisition -- do those teams work well together? Can it be -- can we jointly approach customers? Can we put this together? Do we think about the business the same way?

One of the reasons why JADAK got done, frankly, is when we took our team and went up to Syracuse and met their team, and we sat in a room and talked about our business and their business, what we're trying to do in medical and how we think about it -- we were on the same page with how we think about how to capture and support OEM programs in medical. It was very compatible philosophies.

And we saw what they were doing in their factory, even though it was a relatively small business, $50 million type of private company. We walked into that factory and said they run it as well or better as what we do. They share those values. Lot of ex-Honeywell people in that operation. So I think we felt like -- hey, this can be a GSI business and work well.

We're always looking at those factors, too. Sometimes we walk into a private company, and we can see there is a philosophical gap here; it's not going to work. They will keep margins at 10% operating margins or something and continually pass savings through to customers. And they don't understand margin expansion, or they just have a culture that's not compatible with lean or something.

So a lot of it is that. And when we get things further along, it's saying those factors line up pretty well. It's also saying that we're not far apart on value. That's always been a little bit of a struggle. If you have a macro environment that's been choppy, growth isn't there in a business. Is the growth not there because the market has been choppy? Or is it because it's fundamentally something that can't grow?

So you're trying to buy growing businesses like JADAK?

That's greatly preferred.

(Laughter)

Okay. And are most of the acquisitions, or the things that are near term, in the medical arena?

There's a mix. One of the things -- there's not that many targets that we run across that are pure plays in medical. It so happens we found a couple in action, but a lot of them are blends, where they look like us. They have 30%, 40%, 50% of their stuff is medical, and then some is -- so the nonmedical piece, if there is one -- we got to look and say, does that look attractive to us or not?

Right. But the key is that they're value-added technologies?

Yes.

Okay.

And just lastly, Robert, I think you said for the year you expect operating cash flow of $40 million or more, and we're at $33 million for the year. Is there anything with working capital in Q4 where some of that will reverse? Because it would seem like on $14 million of EBITDA and [less] million and change in CapEx and some interest and taxes that you could do almost another $10 million or so of free cash in Q4, unless some working capital goes the other way on you.

We roll up to around $34 million to get to $40 million of operating cash. And I said approximately $40 million of operating cash, you just got to add $6 million in there. Is it possible to get $10 million? It certainly is. There's some cash payments that have to be made in the fourth quarter. So I was just trying to factor in and be somewhat conservative and ensure that things were on the right track.

We are -- just as a reminder, we just blew through our $70 million net debt level, and so we continue to go down further from that. So I don't want to get overly optimistic.

Okay. All right. I'm not trying to diminish what you've achieved, because it's certainly impressive.

And as you roll lean through the rest of the organization, is there still more working capital to come out of the business, again over time?

Well, what you'll see -- really, at the end of the day at this point in time, our payables and our receivables we feel pretty good about. Our receivables are now going to ebb and flow with any sort of shipment linearity that we have in the quarter. And so, if orders come in a little -- if a order comes in late that's of significant size, or orders in general come in a little late, that would have an impact on our DSOs. To the degree that we can't get product out the door as quickly as we can, that would have an impact on our DSOs.

The one dynamic along those lines -- we do see it, I kind of alluded to this -- the behavior we see from a lot of customers -- and it's probably a little more prevalent on the industrial side than the medical side -- is everybody wanting to operate on a shorter lead time with less forward order coverage, and take less risk on parts inventory. Everybody just seems to be worried that there's going to be sudden downdrafts, and they don't want to be stuck with parts.

And so there's definitely a push to order as late as possible and still get their parts. And so we don't have -- this business is not operating with as much backlog coverage as it used to.

The good news is lean lets you be able to do that, right? You take the slack out of your own delivery lead times, you can fulfill against shorter order lead times and still get the revenue. But it makes the planning and the working capital management -- it can be challenging, right? Because you're sitting there saying -- do I build against demand that I don't yet have firmed up? And so orders can come later in the period, and then it's harder to turn them into a cash receipt within period.

I think coming down, where does the opportunity lie from a lot of lean manufacturing efforts, a lot of the productivity programs? And that's going to be around inventory. I know we turn inventory around three and a half times. That's a very good number when comparing us to, say, the traditional laser companies, traditional manufacturing, small manufacturing companies. But that's pretty pathetic, in our view. And so that's something that we're going to really be concentrating on.

What you don't want to do, and you got to always be careful about, is that you can drive big improvements in that and have material impacts on your profitability in the form of not having inventory on hand, which causes some overtime run rates to run higher; or causing some material shortages that could have an impact on sales. So you got to do it the right way. So we've always been reluctant to pull the trigger on that too aggressively and making sure that -- let's get the lean program underway, let's get some stability into that. And then we'll start getting the improvement naturally in our inventory terms.

Got you. Okay. Thanks very much.

Thanks.

(Operator Instructions)

There are no further questions at this time.

Okay. So let's go ahead and wrap up.

I'd like to say that Q3 was a success for GSI in that we made strong progress in that one area that was our biggest challenge this year, and that's gross margin. We're able to stabilize and improve the yields on new products, the growing new products. We made a lot of progress with lean.

The sales we set up in Q1 and Q2 started to really achieve what I call stability in full rate in Q3. And we did get really the first meaningful savings out of our supply chain initiative that we're undertaking.

As Robert said in his section, we'll finish 2014 in the range of $364 million to $367 million of sales, pretty consistent with the original range of $360 million to $370 million. Full-year profitability is coming in a bit lower than what we had originally targeted because of the gross margin issues, but pretty confident. The Q3 encouraged us, and we are confident now we're driving towards the profitability goal we have medium term. Again, that'd be that 20% adjusted EBITDA target.

The business lines are making good progress. They've all mapped out their future growth strategies and are securing design wins to support that. There are some resources we need to invest to capture that, as Robert commented.

Capital expenditure trends have not been particularly favorable for us for the last few months. But we view that as a short-term dynamic.

As I mentioned, most of the customers are sending pretty positive signals about 2015. Medical cross-selling is surfacing a lot of attractive opportunities that are already in our revenue funnel and certainly will help growth next year and beyond.

So overall, we're making pretty strong progress as an organization. The improved execution and profitability, cash generation we saw in Q3 -- they're encouraging. And we're confident in our upgraded management team. They're all extremely committed to delivering on our strategy. So having clear plans and capable people on task, I'm confident, will achieve the results we're looking for.

Appreciate your interest in GSI and your participation in today's call. And Robert and I look forward to joining all of you in a few months on the fourth quarter earnings call.

So with that, we'll go ahead and adjourn. Thank you very much.

[Thank] you.

This will conclude today's conference call. You may now disconnect your lines.