Proto Labs Inc (PRLB) 2015 Q3 法說會逐字稿

Greetings, and welcome to the Proto Labs third-quarter 2015 earnings conference call.

(Operator Instructions)

As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Bill Dietrick.

Please go ahead, sir.

Thank you, Operator.

Good morning everyone.

This morning, before the market opened, Proto Labs issued a press release announcing its third-quarter financial results for the quarter ended September 30, 2015. The release is available on the Company's website at protolabs.com.

Before we get started, during the course of this call, the Company will provide financial projections and make other statements about its business that are forward-looking and subject to many risks and uncertainties that could cause actual results to differ materially from expectations. A detailed discussion of the risks and uncertainties that affect the business is contained in the Company's annual report, filed on Form 10-K and other SEC filings, particularly under the heading Risk Factors. Copies of these filings are available online from the SEC or on the Proto Labs website.

The Company's projections and other forward-looking statements are based on factors that are subject to change. And therefore, these statements speak only as of the date they are given. The Company does not undertake to update any projection or forward-looking statement.

In addition, to supplement the GAAP numbers, we have provided revenue growth on a constant currency basis, non-GAAP operating margins, and non-GAAP adjusted net income, and basic and diluted net income per share information. The non-GAAP operating margin information excludes the costs of stock compensation, amortization of intangibles, and transaction costs related to the Alphaform acquisition. The non-GAAP adjusted net income excludes the after-tax costs of stock compensation, amortization of intangibles, the non-cash unrealized foreign currency activity, and transaction costs related to the Alphaform acquisition.

We believe that these non-GAAP metrics provide meaningful supplemental information, are indicative of our core operating results, and are helpful in assessing our historical and future performance. A table reconciling the GAAP information to the non-GAAP information is included in our financial release.

Now I'd like to turn the call over to Vicki Holt, President and Chief Executive Officer of Proto Labs.

Vicki?

Thank you, Bill.

Good morning everyone. Thank you for joining us on our third-quarter conference call.

With me today is John Way, our Chief Financial Officer.

I will begin with an overview of the third-quarter financial performance and some operational highlights. Then I will offer some insights into our recently completed acquisition of the operations of Alphaform. Finally, I will provide an update on some of our strategic initiatives during the quarter. John will conclude our formal remarks with a more detailed look at our third-quarter financial results and our outlook for the fourth quarter of 2015. Following that, we will be happy to take your questions.

Proto Labs generated $67.8 million in revenue in the third quarter, at the top end of our guidance. This represents an increase of 24% over the third quarter of 2014 and set another quarterly record for the Company. On a constant currency basis, adjusted for the $2.1 million negative revenue impact of foreign currency in the quarter, revenue grew 28%.

We also achieved record net income in the quarter of $12.4 million, or $0.47 per diluted share. Excluding the after-tax costs of stock compensation, amortization of intangibles, transaction costs related to the Alphaform acquisition, and the non-cash unrealized gain related to foreign currency translation, non-GAAP net income was $13.7 million, or $0.52 per diluted share.

Our success this quarter is once again attributable to the focused and strong execution of our strategy by our employees. Revenue from our Fineline additive manufacturing business grew 79%, compared with the third quarter last year, to $6 million. The strength in additive manufacturing continues to reflect growing customer awareness of our additive manufacturing capability, as well as the strength of our cross-selling efforts. Additive manufacturing revenue represented 9% of our total revenue in the third quarter.

We anticipate additive manufacturing to remain a significant growth engine for the Company. To ensure we can accommodate the current and future demand we expect, we are focused on completing the necessary infrastructure improvements, and installing machinery and other equipment at our newly purchased 77,000 square foot facility in Raleigh, North Carolina. You will recall that we will be consolidating two smaller facilities, with a total of 21,000 square feet, into this new building and further expanding our capacity there. It is scheduled for completion by early 2016, and we are on track to meet this timeframe.

Our additive manufacturing efforts in the UK continue to gain momentum. Our full launch began at the end of third-quarter, and orders for our stereolithography services in Europe are building. And importantly, the acquisition of Alphaform will accelerate the growth of our additive manufacturing business in Europe.

I will provide more details on the acquisition shortly, but first I'd like to turn our attention to our other two service lines. Firstcut CNC Machining Service revenue increased 28% compared with the prior year and set another quarterly record. In constant currency, Firstcut revenue grew 31%. Our CNC Machining business has benefited from the lathe offering introduced in North America in Q1 and Europe in the second quarter.

Protomold's third-quarter revenue set another record and grew 18% year-over-year. The growth was 22% on a constant currency basis. Third-quarter Protomold revenue grew $2 million sequentially, and we expect continued healthy growth in this business.

We recognize that Protomold growth is slightly lower than our 25% overall target. The market for prototype and low-volume custom injection-molded parts is large. And we are seeing no particular increase in competition.

We've completed a successful first year with additive manufacturing fully integrated as a third-service offering, and the results have been excellent. This was accomplished with focused sales and marketing efforts to drive this growth.

We're still completing our 2016 sales and marketing plan, and expect to shift the mix of our marketing activities and provide more tailored sales incentives to ensure each of our services are meeting their growth goals. We are confident that with focused marketing efforts and some changes in our sales incentives, we will see enhanced growth rates in Protomold.

Looking at revenue by region, sales in North America increased 26% year over year, led by strong additive manufacturing and CNC Machining growth. Revenue growth in Europe grew 40% on a constant currency basis, as compared to 21% when converted to US dollars, reflecting the continued strong execution in the region. We also continued our strong performance in Japan, with revenue up 14%, or 33% growth on a constant currency basis. During the quarter, we launched our lathe service in Japan and began taking new orders for this service.

I'd like to turn now to some discussion on our recent acquisition of Alphaform. Alphaform AG was a leading service bureau headquartered in Germany. It serves product developers and engineers through additive manufacturing and injection molding. The company specializes in the same additive manufacturing technologies we offer: stereolithography, selective laser centering, and direct metal laser centering.

We purchased the assets and operations associated with these capabilities in facilities located in Germany, Finland, and the UK. This acquisition is very complementary to our business and will significantly accelerate our additive manufacturing growth in Europe. We will leverage Alphaform's manufacturing assets, customer base, and experienced workforce to accelerate our growth by quickly and cost effectively integrating this business into our existing European operations. The addition of Alphaform's stereolithography capability will augment our recently launched operation in the UK.

In addition, Alphaform allows us to provide SLS and DMLS services immediately. We are very pleased to have a major presence and manufacturing operation in Germany, the largest single market for our services in Europe. Alphaform has a particular strength in the automotive industry and also serves customers across a wide variety of additional end-use verticals. Alphaform has strong brand recognition and is known for the quality of the parts it manufactures.

The business was forced into bankruptcy due to poor financial decisions and bad contracts. Alphaform had also entered into several fail lease-back transactions at unfavorable terms. We are in the process of winding down the unfavorable contracts and implementing our business discipline to turn this operation around. The transaction will be slightly dilutive to our earnings per share for the next few quarters as we integrate the operations into our Business.

The acquisition was structured as an asset purchase, and included the purchase of set select assets and operations of Alphaform, excluding MediMet, a medical casting business that does not currently fit our operating model. The total purchase price, including the buyout of some equipment leases, was approximately $10 million. We anticipate that run rate revenue will be approximately $4 million a quarter after we have exited the unfavorable contracts.

The integration process has begun, and we will be working through this over the next several quarters. We have been in contact with Alphaform customers, and so far the reception has been quite positive. We are thrilled to welcome the Alphaform team members to Proto Labs. And they are excited to begin implementing Proto Labs' strong, technology-based, e-commerce business model utilizing their manufacturing assets. We will continue to take orders and build parts using our stereolithography capabilities in Telford, England, as well as Germany.

The legacy Alphaform operations will be managed under the leadership of John Tumelty, our VP GM for the European Region. We are very excited about this opportunity, which we believe will help drive Proto Labs to the next level in Europe. John Way will provide a few more financial details in his comments.

Finally, I would like to provide an update on some of our strategic initiatives. We continue to invest in our Business to sustain our high growth rates while delivering on our brand promise to our customers. This included investments in human resources, training, IT infrastructure, manufacturing quality and continuous improvement, and manufacturing assets.

We added another 43 pieces of manufacturing equipment across all three of our services in the quarter, bringing our total to 630. We also continue to invest in our customer-facing organization, with the addition of 14 more professionals to bring our total to over 250 team members globally.

A key goal for 2015 is to expand our envelope of services globally. I've mentioned the full launch of stereolithography in the UK and its positive reception to date. The lathe process have been another important service offering. We launched lathe turned parts North America in the first quarter, Europe the second quarter. And, as planned, we launched lathe service in Japan last month. Customer interest in lathe turned parts continues to expand, and we anticipate growing demand in 2016.

We've been very pleased in the continued sales growth of liquid silicone rubber mold and LSR parts, part of our Protomold offering. Our magnesium injection molding, sometimes called thixomolding, and metal injection molding, are more of a specialty niche offering, but are providing our customers with alternatives to CNC machining for higher volumes of metal parts.

From inception, Protomold has been committed to encouraging and supporting innovation in industrial design. Since 2011, our Cool Idea! Award program has provided more than $1 million in prototyping and short-run production services to entrepreneurs working on new products in the US and Europe. We granted two Cool Idea! Awards in the third quarter.

In July, we gave an award to the creators and developers of Wristify, a wearable bracelet that cools or heats the skin. This brings comfort to the wearer in rooms that they may perceive to be too hot or too cold. The ultimate goal of Wristify is to help reduce energy consumption by focusing on adjusting the temperature based on the needs of the individual, not an entire building.

In August, we granted a Cool Idea! Award to the developers of Compliant Games. This company has developed of respiratory system that uses video games to help pediatric and nursing home patients comply with respiratory therapy requirements. We are very proud to support these worthy new efforts.

And finally, we were honored to be named by one of Fortune magazine's top 100 Fastest-Growing Companies in our first year of eligibility. This is the magazine's annual compilation of public companies with the best annualized revenue, profit and stock growth over a three-year period. Proto Labs ranked 75th on the list, with 28% growth in revenue; 36% growth in EPS; and an annualized stock return of 33% over the past three years. This is a record to be proud of, driven by the commitment to excellent execution day in and day out by our employees. And the third-quarter results were further demonstration of these efforts.

With that, I will turn the call over to John Way for further comments on our financial performance.

John?

Thank you, Vicki.

Revenue during the third quarter was $67.8 million, an increase of $13.3 million, or 24%, over the same quarter in 2014. Excluding the $2.1 million negative impact of currency in the quarter, revenue growth in constant currencies was 28% year over year. Protomold, Firstcut, and Fineline revenues were $42 million, $19.8 million, and $6 million, respectively.

Revenue in the third quarter came from 12,541 unique product developers and engineers, a 24% increase over the third quarter of 2014 and an increase of 719, or 6.1%, sequentially. Average revenue per product developer increased 3% on a constant currency basis compared to the third quarter last year.

Gross profit for the quarter was $40.3 million, an increase of $7.2 million over the comparable period for the prior year. Gross margin was 59.4%, an increase of 70 basis points from the second-quarter gross margin of 58.7%, and 120-basis-point decline from 60.6% in the third quarter last year.

Foreign currency exchange rates had a negative impact on gross margins of 50 basis points year over year. The remaining year-over-year fluctuation primarily reflects the costs of ramping recently launched services and capacity investments to ensure we meet our promise to customers to deliver quality custom parts with consistent reliability. Our additive manufacturing margin continues to improve as we gain efficiencies from the scaling of the Business. This gross margin improvement has reduced the dilutive impact on gross margins from 90 basis points in Q2 to 50 basis points in Q3.

Our operating expenses increased to $22.3 million, or 33.8% of revenue in the quarter, compared with 32.3% in the prior year. These expenses for the quarter included transaction costs of $648,000 associated with the Alphaform acquisition. These costs have been added back to adjusted net income in our non-GAAP reporting.

We continue to invest in our sales and marketing organization to drive the growth of our business. Sales and marketing expense of $10 million, or 14.8% of revenue, was consistent with our guidance. We also invested $4.8 million, or 7% of revenue, in research and development in the quarter, which was also in line with our previous guidance.

During the quarter, we invested in certain activities to ensure we have the foundation necessary to support our future growth. These projects include IT systems updates and an upgrade to our ERP system. Investments in employee recruiting, training and development, and initial costs such as real estate taxes associated with our new facility in Raleigh, North Carolina. These investments will be ongoing and are now embedded in our run rate.

The quarter also included a number of nonrecurring expenses. These items, while individually insignificant, aggregated to approximately $300,000. Examples includes costs associated with launching additive manufacturing services in Europe, consulting costs associated with tax and compensation planning, and repairs and maintenance on our facilities.

Reported net operating income was $17.4 million in the third quarter of 2015, compared to $15.4 million in the same quarter of 2014. On an adjusted non-GAAP basis, operating income increased to $19.8 million, or 29.3% revenue, compared to $16.9 million, of 31% of revenue, in the prior year. Diluted earnings per share in the third quarter of 2015 were $0.47.

Adding back the after-tax costs of stock compensation, amortization of intangibles, transaction costs, and the effect of the unrealized gain on foreign currency, our non-GAAP diluted earnings per share in the quarter were $0.52. Our capital spending during the third quarter of 2015 was $11.5 million, and included payments on the building in North Carolina; manufacturing equipment across all our services; and computer software and hardware.

As Vicki mentioned, we paid approximately $10 million for the Alphaform assets and operations. This includes $5.5 million for the transaction and approximately $5 million to buy out certain equipment leases. The lease buyouts were completed after the transaction; and as a result, are accounted for as capital expenses in the statement of cash flows. With the addition of the capital associated with the Alphaform transaction and the equipment necessary for our continued growth we expect capital expenditures of approximately $48 million in 2015.

During the quarter, we continued to generate consistent operating cash flow of $13.5 million. Cash and investments increased $8 million from the prior quarter to $150 million at the end of September.

I would now like to provide some guidance into our projected results for the fourth quarter.

We currently expect Q4 2015 revenue to be in the range of $70 million to $74 million. This revenue guidance includes an estimated $4 million related to the acquisition of Alphaform and an estimated $1.1 million negative impact related to the exchange rates compared to the fourth quarter of 2014. Adjusting for the estimated impact of Alphaform and the exchange rates, this guidance represents organic revenue growth in constant currencies of 20% to 27%.

For the full year, we are projecting revenue of $260 million to $264 million. This represents revenue growth of 28% to 30% on a constant currency basis. We estimate that Alphaform will have a dilutive effect on gross margins of approximately 250 basis points in the fourth quarter.

Additionally, we estimate the operations of Alphaform will be approximately $0.03 dilutive to fourth-quarter earnings per share, and the integration-related costs will have an additional $0.01 to $0.02 dilution. We are working diligently to integrate the Alphaform operations into our existing systems, processes and operating models as quickly as possible. We anticipate Alphaform will remain dilutive to the Company's financial results for the next few quarters, and project the Alphaform operation to become profitable in the second half of 2016.

Stock compensation costs for the quarter will be approximately $1.6 million. Amortization of intangibles related to the Fineline acquisition will be approximately $185,000. We estimate an additional $200,000 of transaction costs in the fourth quarter. Taking into consideration all of the above, including the $0.04 to $0.05 dilution related to Alphaform, we expect our quarterly non-GAAP EPS to be between $0.45 and $0.49 per share.

This concludes our prepared remarks.

Operator, we will now open up the line for questions.

Thank you.

(Operator Instructions)

Our first question today is coming from Troy Jensen from Piper Jaffray. Please proceed with your question.

Congrats on the nice quarter, Vicki and John.

Thanks, Troy.

How about, quickly for you, Vicki, first, if we just focus on Firstcut and Protomold, what do you think a sustainable near-term growth rate is for those two businesses?

Right, so each of our service offerings are going to grow at different growth rates, varying by quarter. We are an on-demand manufacturer. In general, we've said we feel pretty comfortable with a 25% type growth rate. And you can see, with Firstcut this year, we're actually exceeding that growth rate with the addition of some new services and just general fluctuation that happens from service to service. I firmly believe that the Protomold injection molding prototyping on-demand manufacturing can move back up toward that 25% growth rate. It's a very large total available market out there.

As I mentioned in my comments, we focused a lot of our sales and marketing efforts on making sure our customer base understands our new full suite of services this year, and that included the additive manufacturing business. And as we reflect and look at the growth rates across all of our services, we really feel that we can refocus a little bit of our marketing effort across -- more evenly across all of our service offerings, as well as making sure we've got the right kind of sales incentives for our salespeople, commission structure, to make sure that we are managing their time across all of our services. The two of those coupled together, I'm confident, can begin moving that Protomold growth rate up from the 20% where it is now, back up toward the 25%. But the TAM is out there; it's a very large market.

Yes, I agree with you on the size of the market. You mentioned marketing in that response. I'm just curious to know how you feel the marketing investments have gone? Clearly, the growth rate's still pretty high -- any changes in the marketing strategy, going forward?

Yes, I feel very good about the marketing investments. The leading indicators are great; our prospect growth has been excellent. We've mentioned that we have been beginning to look at our market in a segmented way, and what I can say is our top three verticals that we're focusing on, which include medical, aerospace and automotive, are in fact seeing growth rates greater than the Company's growth rate at large. And the other leading indicator we've got is, as we've started providing content-specific marketing campaigns to those industry verticals, our response rate has been higher than it has been with the historic, more generic marketing activities.

So our conversion to prospects, our opening and our click-throughs and all of that have been better with a segmented content approach. So I'm confident that, over time, that's going to improve the effectiveness of our marketing efforts, so that marketing spend will convert to prospects and uploaders at a greater rate per dollar. So that's what the intent is around segmentation. I feel really good about it.

All right, and maybe one quick one for John. John, I wondered if you contemplate any new business model targets? I think the old guidance was really based on Firstcut and Protomold, and Jack's thoughts, and Brad to that extent, but now that you have included FineLine and Alphaform, have you thought through what a longer-term business model could look like for you?

Yes, we're going through our annual business planning process, right now, as we speak, and also digesting the Alphaform acquisition. As we complete the process this quarter, we will be refreshing that information in probably next quarter's call.

All right, perfect. Keep up the good work.

Thank you.

Our next question today is coming from Ben Hearnsberger from Stephens. Please proceed with your question.

Hey, thanks for taking my question -- a couple on Alphaform. I guess first, it sounds like it's going to be dilutive for a couple of quarters. Can you just take us through the timeline on integrating Alphaform with your eCommerce model? Does that occur next quarter, or a couple quarters from now, or later next year?

Yes, great question, Ben. The neat thing about this Alphaform acquisition is that we know what we need to do to turn this business around. We need to take our business model, and our technology-based eCommerce model, and put it right on top of a great, talented workforce that knows how to make good quality additive parts and the assets there. So that's the great thing about it.

As with any integration, you've got to get all that work done, and so there is a timeline that we're working to get customers converted over, and begin to move to an eCommerce model and turn on the website for SLS and DMLS. And it will be first quarter before we can get to that point. And then we also have to put in place all of the operational software that allows us to be who we are, and that is to be able to very quickly and reliably turn quality parts. And that software work will really continue throughout the first quarter.

We don't expect to have all that fully implemented until the end of the first half, so we have a lot of work that needs to be done. We're beginning to deploy some of those assets, which means pulling those people off of other projects and beginning to get them to work on this one. But that's why we've said to really look at the second half of 2016 to get that turned around. The beauty is we know exactly what do, and I know it's going to work, so we just have to get all the hardware and software in place.

Okay. I know when you acquired FineLine, you provided a user count. Can you give us a sense for the number of Alphaform users that are new to the Proto Labs platform?

Ben, I think that one's difficult in this situation, especially given the magnitude of the changes we're going to have to make. We mentioned some of the contracts that we are going to have to wind down that were just unfavorable. And we're going to have to execute price increases on some of it. So, to give a number related to that at this stage, until we get some visibility as to what's really going to happen there, really I don't know is meaningful information.

Okay. Would it be fair to say, though, it's smaller than the FineLine user count?

I wouldn't say -- in terms of count, it may not be smaller. I will also say the IT infrastructure is not as sophisticated. So it's not as easy for us to get access to all of the individual product developer data, as it was with FineLine, who has a very sophisticated web-based eCommerce model that was easier to fit right into our model.

Okay. One last question on sales and marketing expense: It sounds like you were going to do some things to stimulate Protomold growth. The question is: What can you really do here? And then, is the expectation that we continue to run at that 15% of revenue range on the sales and marketing line?

Let me answer the second one, first. Yes, I would estimate we're going to be in that 14% to 15% sales and marketing as percent of sales. And what we can do -- what we did in second half of 2014, and 2015, after we fully integrated the additive manufacturing business, is we made sure that we had content out there to help our customers understand what our additive manufacturing service offering was.

So there was a shift in mix. And I think as now that we have got that business fully integrated into our suite of services, we can take our content and our activities, and spread it a little more evenly across all of our services. And I'm confident that's going to help with Protomold. We also had some specific sales incentives to make sure that we have a really good launch of our very first acquisition with additive. And as we move into 2016, we'll be making sure that our sales incentive plans are a little more balanced across all three of our services to incent Protomold growth.

Okay. Great. Thank you very much.

Thank you. Our next question today is coming from Brian Drab from William Blair. Please proceed with your question.

Good morning. Congratulations on a great quarter.

Thanks, Brian.

I don't know if you said this specifically yet, but Alphaform for 2016, do you view that as dilutive or accretive to EPS?

So, as we look at the full year, we're currently planning for it to be about breakeven for the full year. Probably lose a little bit in the first couple quarters, and become profitable in the second half. So relatively neutral as we look at full year, probably excluding the integration costs. So the integration cost may have a little bit of dilution.

Okay. Thanks. And then within Protomold, can you comment on the relative growth rates between the mold-making or first-order-of-parts type of business versus the parts business in the quarter?

Yes, so as we said before, our sales between Protomold parts and Protomold molds are about half and half. And frankly, the growth rates of both of those have been very similar. So not a lot of difference between the two segments.

Okay. Thanks. And then, can you give us an update on maybe the impact of the SolidWorks and Autodesk partnerships? Has that been meaningful?

I think it's still pretty early in both of those. Autodesk Fusion 360 is probably the more integrated partnership that we've got. We're actually out on their cloud-based system, and can click straight through, and we're seeing a little bit of activity. It's really early to tell. SolidWorks is a little bit less connected. It's out on their website. But those partnerships remain important, and they are important parts of our ecosystem. So we continue to work closely with them.

Okay. And then on Alphaform, I'm wondering if you can make any comment as to just -- can we elaborate a little bit on just how good this deal was, in terms of -- it seemed like it just came at exactly the right time and exactly the right geography, at a great price. Meaning, Germany -- you were looking for this particular type of additive equipment. So the specific question is: What would it have cost you to buy new equipment and start from scratch relative, maybe in terms of a multiple on what you actually ended up having to spend on Alphaform?

Sure, yes. As we've looked at it, we did the build-versus-buy analysis related to it, and the organic component would have been spread out over a longer period of time and had investments related to it to get there. This gives us not only the revenue base that come with the operations, but really the employee base and the skill set that knows how to make quality parts, which is very important. And gives us a presence in Germany. So building organically just takes a long time, and we've seen that in other geographies and other places like that. So just looking at it, the jumpstart that this gives us, we feel that we got the assets and the [expanded] workforce really and customer base at a distressed price.

Okay. Do you feel like you got the assets -- can you give us any feel? I know you have a feel for it, but did you get the assets at, like, 50% off or 80% off, or any sense?

They were at a distressed price, we can say that. And we're going to continue to invest in this business. So we know that we're going to have to acquire additional equipment as we bring in new customers and upgrades. So this isn't the end.

What this does is jumpstart us. It buys us time. And as we did the make-buy, it made tremendous sense for us to proceed with this because, like you said, we get a place in Germany, which really is a great location for us -- great people and assets to get started. It jumpstarts us.

Great. And just one more related to that: Now you've got injection molding, you've got CNC, you've got additive in both the US and Europe. What might you need to acquire going forward, and where, and maybe more broadly can you just talk about the capital allocation philosophy over the next two or three years?

Gosh, right now, what I'd like to say is that, let's digest what we just acquired. We just completed this acquisition October 9, which is only 13 days ago. We are not two weeks into it -- not ready to say when the next one might be. We will continue to invest in CapEx for organic growth, which, as you know, is the largest single contributor to our growth. And that investment has continued to be in that $40 million kind of range for both equipment and buildings, and that will continue into 2016 and 2017.

Okay. Thanks very much.

Thanks, Brian.

Our next question today is coming from Holden Lewis from Oppenheimer. Please proceed with your question.

Great, thank you, and good morning. Just want to make sure I understand on the G&A -- you had about $8.1 million in expenses in the G&A line this quarter, and it sounds like you're saying there's between $900,000 and $1 million that were non-recurring. So we should think about $7.1 million, $7.2 million as being the run rate for G&A at this point, absent Alphaform?

That's absent Alphaform, yes.

Okay. So obviously that reflects significant investments versus where you were in the first half. Are we going to see further significant investments in the organic business, so that $7.1 million, $7.2 million is not the right number? Maybe we're at $8 million at the end of Q4. How should I think about the ongoing investment and what it means to those lines organically?

Yes, so I think you've got the right run rate, as we look at kind of the legacy business. As we enter Q4, I think there will be a little bit more expense, and it really is more related to some of the seasonality of our expenses.

Let me explain that a little bit. Our commission structure starts with lower commission rates, and as people achieve quotas and things like that, they get kickers in the end of the year. So commissions will be up. We perform interim audit work in the fourth quarter, in advance of the year end, so our audit fees are up. Those are examples of costs that we incur in the fourth quarter that will be a little bit of an uptick there. As you look at it, I think there will be a little bit of an increase in the fourth quarter related to items like that.

But that's just seasonal? You're not looking at another big nut of fresh expense to add to the platform?

No, we will continue to invest in R&D, as well as sales and marketing. But consistent with the ranges that we've talked about as a percent of revenue.

And [IT] infrastructure is important.

Got it. And then, trying to understand again, I guess getting at the organic business, it sounds like, if I understand, $70 million, $74 million in revenue, that's a mid-point of about $68 million organically, which is not much of an uptick from Q3, even though seasonally I think you typically see that. And then your non-GAAP EPS is $0.45 to $0.49, and it sounds like that's impacted by $0.03 from Alphaform. So organically, that would be $0.48 to $0.52, which, again, wouldn't be any better than what you put up on Q3; and Q4 is seasonally typically a better quarter than Q3. That doesn't seem to be coming through.

Am I looking at those numbers correctly? And if so, why are we not seeing a seasonal uptick?

Yes, so let me answer the first question around the revenue guidance, and then I'll send it over to John and he can kind of comment on what's falling through.

So when we pulled together our revenue guidance for the quarter, we do that based on a model that takes into account a lot of factors around both quoting activity and prospect growth, as well as the seasonal nature of the Business. And as we go into the fourth quarter, and you look at the number of days that are available, it's fewer than the number of days in the third quarter. And the fourth quarter is always the more difficult one to forecast because of the vacation time that occurs, particularly here in North America, both in November and December. So you have Thanksgiving; and then around the world, we've got the year-end factor. So we tried to put all of that into the forecast. And at this point, this is the best forecast that we feel putting out there for revenue guidance.

And, John, maybe you could talk about how that's flowing through with the investments that we're making?

Yes, so with the revenue guidance, that's contributing a little bit to the earnings per share. I think that the other thing that jumps out from the seasonal perspective is, we have paid time off, paid holidays during the fourth quarter, more of them here in North America. That is unproductive time, effectively. So we're paying for some of that time. So that's impacting us a little bit on the gross margin end of things. And I think the other component that maybe you're missing, Holden, is we're estimating $0.01 or $0.02 related to integration costs that we're going to incur here in the fourth quarter, just as we're trying to accelerate that integration and make sure that we get those operations plugged in to what we're doing.

When you talked about non-GAAP, you don't strip that $0.01 or $0.02 out?

We haven't, historically, in disclosing that right now at this stage. I don't know that we will strip that out.

What we did in the third quarter -- we did have some transaction costs with third parties, and that was the $648,000 that we did put into non-GAAP, but a lot of our internal expenses and stuff associated with that, maybe that call out.

Okay. Thank you, that's helpful. And I guess last thing for me, European automotive is not in the best place right now. This acquisition gets you a lot of exposure to that. What do you think -- is your exposure to Volkswagen or that sector -- what is the level of concern, given what's going on there at about the same time you've acquired this asset -- or these assets?

Right, well, first, we're in, as you know, prototyping a low-volume production, and the automotive sector for us in Europe, with our current product offering, Protomold and Firstcut is actually pretty good, pretty strong, and has been growing at some nice rates. So let me put that as the caveat.

But also, we did mention that we do expect to see some change in the customer mix going forward. There were some contracts that are in place that, frankly, are not good contracts for the Company. So we've kind of built that into what we think is that $4 million per quarter run rate revenue, because we do expect to see some shift in the mix, particularly as we turn on our website and we start getting a broader set of customers and customer sizes and verticals involved ordering parts from us.

So there will be a shift there, over time. But the relationship they have with the automotive companies -- we're excited about that because automotive is an important sector for us in Europe. There is a lot of engineers, and a lot of innovation. That's really the hub of innovation in the automotive industry, tends to be in Germany.

So, any production exposure you had is embedded in those contracts, and that's what you are unwinding and walking away from?

Correct.

Okay. Great. Thank you, guys.

Thank you.

Thank you. Our next question today is coming from Bobby Burleson from Canaccord Genuity. Please proceed with your question.

Yes, good morning, and congratulations on the strong results.

Thanks, Bobby.

Just curious -- we've talked a lot about the FineLine growth, and 80% is a great number. Wondering whether or not you are seeing any benefit the other direction toward Protomold, towards Firstcut, as engineers go out there and look for additive solutions?

Yes, that's a good question. What I will say is I think there are as many examples of customers that come in and start asking for an additive manufactured part, and it really is we work them through what their needs are. What they really need is a machined part or injection molded part, and sometimes it's vice versa. They will come in for a machine, and really, as you talk them through, it should be an additive part. That's the beauty of our suite of services. So that's the positive that we get with cross-selling.

I also think that, by having additive manufacturing in our portfolio, it helps drive total product developer growth, because we've got a broader suite of services, and as we are out there trying to bring developers into the fold, and get those ones that Google 3-D printing and then they come in and they also understand we do CNC machining and injection molding. So overall, it helps our brand awareness, it helps our acquisition of product developers, and there's cross-selling that takes place. It's really hard to point to, by having 3-D printing, we get X amount of lift in each of those services, but I'm confident it helps our brand awareness and it helps cross-selling across each service and the value we bring the developers.

Okay. Great. And then in terms of the FineLine gross margin, it looks like you've done a nice job there moving that higher. Wondering how much more room there is to go? And then, I'm wondering, Alphaform versus FineLine, whether or not, long term, you see those two businesses operating at essentially the same margin?

Yes, so the first one -- we have done a nice job improving the margins on FineLine. I guess, as I look at it, we will be moving into a new facility next year, so a larger space. And with that move, we might see a little bit of compression on that margin, just because we will have more space and more costs associated with that space and as we grow into it. So that's kind of the capacity investment.

But where they are operating now, I'd hate to say there's no room. I think there might be a little bit more room for more quick turns and more things like that as we add capacity, but we are pleased with where it is performing.

As we look at Alphaform, we've got a long way to go to get there, and it is in a different geography. I think, generally speaking, we would expect them to migrate to near the same levels. But like I said, there's a ways to go to get there.

Okay. Great. And then, does Alphaform do anything for your legacy businesses in Germany? Is there any benefit, in terms of the customer Rolodex that you inherit in terms of what Protomold or Firstcut might see in terms of demand?

Yes, I think so, absolutely. So first, let me comment on the fact that Alphaform had a really good brand recognition in Germany. So the fact that we've made the acquisition, it gets us brand awareness within that geography, which is great. And you've got the cross-selling opportunities that come with that, so that's a positive. As I mentioned before, we haven't been able to really take the Rolodex of prospects, and move them into our sales and marketing engine yet, but we will be working on that.

The other thing I will say that Alphaform does have a injection molding business, that's in [Esheloa], just outside of Munich. That business manufactures injection molding tooling and injection molding parts, with a focus on larger parts, and parts that are generally more complex and outside the envelope of our current software. So we are evaluating how we might use that capability, and leverage that capability to bring greater value to our customers right now.

And I think one thing to add related to that is just that having the presence, the manufacturing presence in Germany, we think will be beneficial to our overall Business.

Okay. Great. Thanks.

Thank you. Our next question today is coming from Jim Ricchiuti from Needham & Company. Please proceed with your question.

Thanks. Just again going back to Alpha, trying to get a sense as to looking out to 2016, when you could see more of the cross-selling opportunities beginning to be realized? Is that in the second half? Do you expect to put more resources into their marketing efforts?

I think the cross-selling will start in the first quarter. So, as we get to the point, once we get the website turned on -- which will take time. We don't have SLS and DMLS turned on, on our website. We turned on SLA, and we're taking orders through the UK with SLA, but we still have to get SLS and DMLS turned on and get all that in place. But once that website gets turned on, we can turn on our sales and marketing people on that portfolio, and start the cross-selling between all of the services. And marketing will start when we get to that point as well.

Okay. I was just thinking in terms of the training that might be involved in putting all of this together. You still think in early 2016?

First quarter -- mid to end of first quarter, so let's give ourselves room, but we want to do this quickly. This is a turnaround. So, this business isn't profitable today. We don't like to have bleeders, so we want to get this fixed.

So we're working with a sense of urgency around getting our sales and marketing people trained, and moving that forward here in the fourth quarter and the early part of first, and getting the website turned on, so that we can begin getting a better mix of customers and parts coming in. And actually, getting more parts coming in will also help our earnings as well, because we will get a [broad] number of parts in each build prep and all those good things that come with that. So getting sales and marketing training, and getting the website up, are two important first steps for us.

Okay. And just looking at the core business -- North America, I think you said, John, 26% growth, and driven -- it sounds like the strength was coming primarily from additive and CNC, additive being a smaller part of the Business. I wonder if you could talk a little bit about what the growth rate was in the Protomold business in North America? And when you can start seeing the benefits of some of the new incentives that you are putting in place, kicking in? Thanks.

Yes, the growth rates of Protomold were relatively consistent across all the regions. A little bit higher in Europe and Japan on smaller basis, but overall, I'd say they were relatively consistent. So I wouldn't necessarily call that out there.

As we look at incentives, our incentive plans are for the full year, so we will launch a new plan in January of 2016. We will be looking at tweaks to that plan to incent and accelerate that growth. But we are looking at marketing efforts and things like that currently, and trying to move the needle there.

But I'd say in North America, all three of our services grew. And on a percentage basis, FineLine and our machine business grew faster than our injection molding business, but all three businesses grew at a healthy pace.

Okay. Thanks a lot.

Thank you. Our next question today is coming from Weston Twigg from Pacific Crest Securities. Please proceed with your question.

Yes, you touched on it briefly, related to gross margin, but I'm just wondering if you could help us understand better the pricing environment in the additive manufacturing side? You said that Alphaform struggled with some bad contracts. Maybe you can help us understand how you avoid getting pulled into some pricing battles, given a lot of the additive manufacturing service bureaus have developed and operate on a similar model to Proto Labs?

Yes, the way I'll answer that is that we are putting our business model -- it's a web-based eCommerce business model onto that Alphaform business. And our quoting is actually generated by virtually manufacturing the part. And our software does that.

We turn around an instant quote, and that's the price for the part that the customer buys. And our service offering around that, which is speed and reliability, really results in the customers seeing that as great value. So we need to put in place all the steps to deliver reliably and quickly the high volume -- the valuable parts on-demand, and the website that puts in place disciplined business process around pricing those, and then training our salespeople to sell that value.

One thing related to Alphaform specifically, they looked at their business kind of as two separate operations. One, a prototyping business that they priced one way, and one a volume production of additive parts, which they priced based on a material usage basis that doesn't take into effect the complexity and size of parts, and things like that, and build time related to it. So just the way they had looked at, especially that volume production of additive parts component of the business, they just were looking at it wrong.

Got it. That's helpful. And then, you didn't give a number on the long-term gross margin profile for the additive manufacturing business as a whole, but could you give us a feel for where you think that could settle out over the next year or two?

Yes, so you can back into the number. We are approaching 55% here in the quarter. Long term, we see it north of 50%, kind of in the same range where we are now.

Yes, over the long term, again, after Alphaform gets integrated and we turn the business around, and that's going to take a little while, but once we get there, I see no reason why we couldn't have similar margins for the European additive manufacturing business, just as we have here in North America.

Very helpful. Thank you.

Thank you. Our next question today is coming from Andrea James, from Dougherty and Company. Please proceed with your question.

Hi, thanks so much. Most already asked; I'll just ask a couple quickies. Once Alphaform normalizes, what's your expectation for target operating margin? I think historically you targeted 27% to 29%, but not sure with the changing offerings, if there's a new normal?

Yes, so Andrea, like I said earlier, we're going through our annual business planning and budgeting process right now, and working through some of that related to it, and I think we will be prepared to give that guidance next quarter.

Okay. And then one more thing: As you segment your sales force and you target different customers within the organizations, are you seeing that customers need more handholding?

And then, Vicki, you had said something about, as you go through with someone on the part they want, you are helping them decide whether to go with a mold or additive manufacturing. Is that a conversation happening over the phone increasingly, or is the software still primarily handling that?

I'll answer the second one first. It's primarily over the phone. Our software is not yet consultative, and that will take quite some time. So at this point, a lot of the conversations between service offerings happen with both our sales team as well as our customer service engineers and designers. So that's where that takes place.

And again, from a segmentation point of view, it's not more handholding in one segment versus the others. I mean, it really is customer-by-customer specific, to be honest with you. Some customers really require a little bit more attention than others. Some are -- we call these customers -- we call them Dexter, and they just buy over the website and never want to talk to a person. And we have other customers who do like to talk to people -- (multiple speakers).

Like Debbie?

Exactly. It really varies by customer persona and how they like to use us.

Okay. That's helpful. Thank you.

Well, actually let me follow-up on that. I'm just going to use the names you go with. There's more Debbie's -- I'm just thinking about the expenses going forward. There's more Debbie's than there has historically been, as you target higher-level managers within organizations, right?

I think the growth in our sales force is really focused on just making sure more and more product developers come into the fold, and they play a part in closing those developers and bring them in. So I wouldn't say there's more. There's a lot of engineers that don't like to talk to people, that just like to order. We have both. It's probably pretty consistent. I haven't seen data on it, but it's probably pretty consistent.

Okay. Thank you so much.

Thank you.

Thank you. We've reached the end of our question-and-answer session. I'd like to turn the floor back over to Ms. Holt for any further or closing comments.

Great. Thank you for joining us today. We are very proud of the progress we have made this quarter, and we remain excited about the outlook for Proto Labs and its continued growth around the world. I, again, want to thank our employees for all of their dedication and hard work in achieving this performance, and we look forward to updating you next quarter. Thank you.

Thank you. That does conclude today's teleconference. You may disconnect your lines at this time, and have a wonderful day. We thank you for your participation today.