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Edited Transcript of FARO earnings conference call or presentation 2-May-19 12:15pm GMT

Q1 2019 FARO Technologies Inc Earnings Call

LAKE MARY May 11, 2019 (Thomson StreetEvents) -- Edited Transcript of FARO Technologies Inc earnings conference call or presentation Thursday, May 2, 2019 at 12:15:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Robert E. Seidel

FARO Technologies, Inc. - CFO

* Simon Raab

FARO Technologies, Inc. - Co-Founder, CEO, President & Director

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Conference Call Participants

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* Andrew Lodovico DeGasperi

Joh. Berenberg, Gossler & Co. KG, Research Division - Analyst

* Gregory William Palm

Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst

* Hendi Susanto

G. Research, LLC - Research Analyst

* James Andrew Ricchiuti

Needham & Company, LLC, Research Division - Senior Analyst

* Richard Charles Eastman

Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst

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Presentation

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Operator [1]

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Good morning, everyone, and welcome to FARO Technologies Conference Call First Quarter 2019 Earnings Release. For opening remarks and introductions, I will now turn the call over to Chief Financial Officer, Bob Seidel. Please go ahead.

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Robert E. Seidel, FARO Technologies, Inc. - CFO [2]

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Thank you, and good morning, everyone. Yesterday after the market close, we released our financial results for the first quarter of 2019. The related press release and Form 10-Q for the first quarter of 2019 is available on FARO's website at www.faro.com.

In order to help you better understand the company and its results, management may make some forward-looking statements during the course of this call. These statements can be identified by words, such as expect, will, believe, anticipate, plan, potential, continue, goal, objective, intend, may and similar words. It is possible that the company's actual results may differ materially from those projected in these forward-looking statements. Important factors that may cause actual results to differ materially are set forth in yesterday's press release and in the company's Form 10-K for the year ended December 31, 2018, and Form 10-Q for the quarter ended March 31, 2019.

I will now turn the call over to Simon to provide an update on our business initiatives, and afterwards, we'll return with a review of our financial results. After our prepared remarks, we will open the call for your questions up to the start of trading.

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Simon Raab, FARO Technologies, Inc. - Co-Founder, CEO, President & Director [3]

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Thanks, Bob, and good morning, everyone. When I returned as CEO over 3 years ago, I had a vision on how to reshape the company to position it for future growth in new unaddressed 3D markets. In 2016, we reorganized from 3 regional businesses to global verticals with the people and products to better address our customers' applications. At the same time, we reinspired product development with an entrepreneurial spirit to create a new product drumbeat that has led FARO to achieve our #1 strategic goal, which is to be the technology leader and visionary in 3D measurement and imaging solutions in our chosen verticals.

At the start of 2017, we outlined an aggressive sales headcount investment strategy to increase our sales force at a mid-teens year-over-year growth rate. We aimed to expand our channel to market by investing in the growth of our sales footprint across new vertical markets and geographies. We increased our sales headcount by 201 people or 38% from the start of 2017 to the end of the first quarter of this year.

To better communicate our intentions, we created a new key performance indicator, namely the trailing 12-month orders per sales full-time experienced headcount. At the same time, we modernized the sales process by introducing web sales demonstrations, which are now becoming important as a medium for the first demonstrations to our customers and have been shown to significantly improve sales efficiency.

We accelerated our pace of capital deployment to acquire new technologies to expand into new vertical applications. We made a series of acquisitions to create a new Photonics vertical, which is now positioning FARO to be a player in the light steering market for 3D laser processing and in the LIDAR space for autonomous vehicles.

In July 2018, we acquired Open Technologies, which expands the reach of our 3D structured light technology and leverages our global sales force into the very large unaddressed 3D dental market, which itself is going through a 3D and quality revolution.

Our strategy has been to drive top line growth with new products, focused channel to market via our verticals and expansion of our global sales force. Each new product introduction was aimed to both drive top line and gross margin increases by being the technology leader. We increased our gross margin from 54.7% after our first year in 2016 to 58.8% in the first quarter of 2019.

We employ a long-term mindset by making investments to expand our sales force, develop new products and acquire new technologies, which may impact the quarter's results, but better positions FARO for realizing its long-term potential in the 3D revolution.

In the first quarter 2019, we expended $2.6 million to continue to develop the expanded sales force, which represents over 100 sales representatives that have not yet reached full effectiveness. Over the trailing 12 months, our new order bookings totaled $403 million, up 11.3% year-over-year. Our first quarter 2019 orders exceeded the $100 million Q1 milestone for the first time in the company's history at $100.7 million, an increase of 4.8% year-over-year, which included a 4% negative impact from foreign exchange rate.

Our Construction BIM and Emerging Verticals segments performed well in first quarter 2019 by leveraging the sales headcount investments and new products in unaddressed markets, with new order bookings up 17% and 46% year-over-year, respectively. Our Construction BIM vertical is disrupting the legacy construction quality control market with unique 3D information. Last year, we introduced the first fully featured CAD-based 3D construction quality control software called BuildIT Construction for use with our FARO Focus laser scanners and our Tracer SI projection systems.

Our value proposition is to help the construction industry, reduce process inefficiencies and costly rework similar to the benefits that our metrology products brought to our industrial manufacturing customers years ago. Our long-term growth objective for Construction BIM is 20-plus percent year-over-year. We achieved 17% in the first quarter of 2019, which included a 4 percentage negative impact from the foreign exchange rates.

Our Emerging Verticals are expanding the reach of our 3D technology into broad, untouched market, including virtual crime scene walk-throughs for jury, rapid prototyping for product design in dental, medical and gaming, and laser steering for 3D laser processing and autonomous vehicle applications.

Despite our Construction BIM and Emerging Verticals segments increasing by 15% in total or 19% in constant currency, our 3D manufacturing segment orders declined by 5% year-over-year, which included a 4% negative impact from foreign exchange rates. Our long-term orders growth objective for 3D manufacturing is high single digits year-over-year, which we achieved in 2018. Our first quarter orders growth was impacted by a short-term disruption with the reorganization of its sales force into multiple portfolios and higher-than-expected sales headcount turnover.

We reorganized 3D manufacturing sales force into 3 application portfolios: small volume, large volume measurement and assembly quality. With a number of new product introductions, the 3D manufacturing account manager carrying all product could no longer appropriately address the range of applications. This reorganization better leverages our expanded product line to customer applications and enables higher sales force coverage in the same geographical territory without channel conflict.

Throughout 2019, we will continue to add sales headcount to 3D manufacturing, especially focused on expanding the 3 portfolio teams. These portfolio changes may impact sales growth in 3D manufacturing until the end of third quarter. The portfolio reorganization will have a long-term benefit on our sales growth and will naturally accommodate new product introductions and sales force expansion. We intend to employ the same portfolio restructuring later in the year in Construction BIM due to the introduction of many new products and the need for multiple portfolios.

Over the past 2 years, we have repeatedly spoken about that 12-month maturation process for a new sales hire in order to become a full-time experienced or FTE. This reinforces the importance of hiring the right people, training them well and then retaining them. We continue to evolve every aspect of our sales recruiting on-boarding, training and talent management to increase and retain FTE. In the first quarter, we did experience higher-than-expected sales force turnover in our 3D manufacturing segment, which impacted our first quarter orders by an estimated $3 million or 5%. We are actively recruiting to replace these roles, but given the 12-month maturation time line for an FTE, the new portfolio strategy, there may be an impact on 3D manufacturing orders growth over the next 2 quarters.

On our first quarter earnings call, we communicated that we intended to increase our period-ending sales headcount by 15% during 2019 in equal increments by quarter or about an increase of 25 per quarter. In the first quarter, we only increased our ending sales headcount by 4 relating to higher-than-expected turnover. However, our first quarter 2019 headcount was 13% higher than the first quarter last year. Our sales recruiting team is working hard with our vertical sales leaders to accelerate recruiting efforts in the second quarter to position us to meet our 15% goal for the full year.

With our trailing 12 months new order bookings of $429.9 million and our trailing 12 months sales full-time experienced or FTE headcount of 612 , our trailing 12 months orders per sales FTE metric was approximately $703,000, up from the $698,000 in the first quarter of 2018.

We are implementing what we call Sales 2.0 to more effectively and differently manage leads in early adopter versus late market verticals. There are significant challenges in developing the sophistication of the FARO sales model to deal with the personality and industry differences of established markets versus new emerging markets relating to new product introductions. After all, we are a prime mover in the creation of the entire 3D industry, being the first to introduce portable and adaptable 3D into the construction and public safety sectors as an example.

Our 2019 business initiatives are focused on increasing profitability by increasing gross margin and maintaining our underlying G&A, R&D expenses at 2018 run rates. We demonstrated tangible signs of success in the first quarter for those initiatives. We continued our steady increase in gross margin to our 60% long-term objective by reaching 58.8% in the quarter due to service margin improvements. With numerous programs to streamline our service activities, we increased our service margin by 4.5 percentage points year-over-year. We decreased selling and marketing expense as a percentage of the sales year-over-year by 1.9 percentage points by adhering to our 2019 expense goal for marketing and maintaining tight spending controls on our sales force. We decreased R&D spending below prior quarter in line with our full year goal.

Finally, we were pleased to announce that Michael Burger will assume duties as President and CEO starting June 17. The executive team and I are focused on a successful leadership transition in the second quarter.

I appreciate the support of the global FARO team over the past 3 years and thank you for your hard work in executing our vision to position us for the future. I deeply appreciate the support of our shareholders that have enabled us to grow and change the 3D measurement world together. I plan to continue to drive the business towards our 2019 operational objectives until the new CEO assumes his role.

I'll now turn the call over to Bob.

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Robert E. Seidel, FARO Technologies, Inc. - CFO [4]

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Thank you, Simon. Total sales were $93.6 million for first quarter 2019, an increase of 0.8% as compared with $92.8 million for first quarter 2018. Foreign exchange rates had a negative impact on sales of $4.0 million, decreasing our overall sales growth rate by approximately 4.3 percentage points. Based on foreign exchange rates as of today, we anticipate a 3 to 4 percentage point negative impact on sales from foreign exchange rates for second quarter 2019.

Our sales increase for first quarter was driven mainly by double-digit service revenue growth and an increase in product unit sales in our Construction BIM and Emerging Verticals segments, offset partly by lower product unit sales in our 3D manufacturing segment.

In February, we disclosed that we reported the potential noncompliance to the General Services Administration, or GSA, and its Office of Inspector General relating to products and services sold to the U.S. government. We've been working with our outside legal counsel on the reporting, inquiries and remediation process in the week since reporting this GSA matter. We do not have material adjustments to our reported sales in first quarter 2019 related to the GSA matter. We are continuing our efforts to resolve the matter quickly and efficiently.

In our 3D manufacturing segment, sales for first quarter 2019 were $56.6 million, a decrease of 6.7% as compared with $60.7 million for the same prior year period. This decrease was mostly driven by lower product unit sales, partially offset by continued growth in service revenue. Our 3D manufacturing sales decreased year-over-year in the Americas and Asia Pacific regions and increased modestly in EMEA on a constant-currency basis. Even with the introduction of additional import tariffs in October 2018, we continue to realize solid sales growth in China for the past 2 quarters.

In our Construction BIM segment, sales for first quarter 2019 were $25.4 million, an increase of 12.2% as compared with $22.7 million for first quarter 2018. This increase was mainly related to higher product unit sales reflecting the strong market demand for a broad portfolio of laser scanner hardware and software as well as an increase in service revenue. Our Construction BIM sales were highlighted by strong year-over-year sales growth in our Asia-Pacific region, emphasizing the high customer demand potential for Construction BIM in this region.

In our Emerging Verticals segment, sales were $11.6 million for first quarter 2019, an increase of 22.3% as compared with $9.5 million for the same prior year period. By investing in and developing these emerging verticals since 2016, we can say that we have created approximately $50 million in new annual sales in markets outside our historical core sectors.

Gross margin for first quarter 2019 was 58.8%, an increase of 0.9 percentage points compared with 57.9% for first quarter 2018. This increase was mainly related to a higher service margin as a result of double-digit revenue growth and improved efficiencies in our customer service repair process. Our increase in service margin represents a step forward to our long-term strategic objective of 60% gross margin.

Selling and marketing expenses were $26.8 million for first quarter 2019, a decrease of 5.4% compared with $28.3 million for first quarter last year. This decrease was driven mostly by lower sales commission expense, controlling discretionary spending and lower marketing expenses, offset partly by higher sales headcount.

Selling and marketing expenses were 28.6% of sales for first quarter 2019 as compared with 30.5% of sales for the same prior year period. Previously, we communicated that our 2019 objective is to actively manage marketing expense to our 2018 run rate. We achieved this objective in first quarter and remained in line with our full year objective. General and administrative expenses for first quarter 2019 were $13.2 million, an increase of 19.4% as compared with $11.1 million for first quarter 2018. This increase was mostly due to an incremental cost of $1.8 million related to our CEO succession, as we recognized additional compensation expense during the quarter in connection with the acceleration of outstanding stock-based awards as well as advisory fees incurred for the GSA matter. As a percent of sales, general and administrative expenses were relatively unchanged as compared with first quarter 2018, excluding the incremental cost for CEO succession and the GSA matter. At this time, we anticipate that expenses related to our CEO succession and the GSA matter will increase our second quarter 2019 general and administrative expenses by approximately $2.0 million as compared to prior year. We anticipate that the incremental expense year-over-year related to these activities may decrease in the third and fourth quarter.

Research and development expenses were $9.9 million for first quarter 2019, an increase of 5.6% as compared to $9.4 million for the same prior year period. This increase was mostly related to additional engineering headcount from our 2018 acquisitions. Research and development expenses were 10.6% of sales for the first quarter of 2019 compared with 10.1% of sales for first quarter 2018. Our 2019 objective is to actively manage our research and development expense to 2018 run rates. We achieved this objective in first quarter and remain in line with our full year objective.

Our net income was $0.2 million or $0.01 per share for first quarter 2019 compared to $0.5 million or $0.03 per share for first quarter 2018.

We continue to maintain a strong capital structure with high liquidity and no debt. At the end of the first quarter of 2019, cash and short-term investments totaled $135.5 million. Our cash and short-term investments increased by $1.9 million from the end of 2018, driven by positive cash flow from operations.

A more complete presentation and discussion of our first quarter 2019 results is available in our Form 10-Q for the quarter ended March 31, 2019.

We deeply appreciate the support of our shareholders and the dedication of our employees around the world.

Thank you for your attendance on today's call. And we will now open the call for questions up to the start of market trading.

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Questions and Answers

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Operator [1]

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(Operator Instructions) And we'll take our first question from Greg Palm with Craig-Hallum.

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Gregory William Palm, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [2]

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Wanted to dig into the sales force disruption a bit more. That was a decent size surprise. Can you characterize that as something that was impacted across all geographies, all segments? Or was that more pronounced in a specific area?

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Simon Raab, FARO Technologies, Inc. - Co-Founder, CEO, President & Director [3]

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Well, it was only in 3D manufacturing, and it did impact all regions. I mean we did see a correlation with lower sales in regions that had lower PMI scores, but we don't feel that, that was the primary cause. We literally significantly disrupted the sales force by creating these portfolios, which meant transition of leads and contacts among the different sales forces, and then also we needed to renew expertise and training around each of the product lines as the product line expanded for each of the portfolio. So it was more disruptive than we imagined it would be, but it was necessary for the future growth as we described in the call.

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Robert E. Seidel, FARO Technologies, Inc. - CFO [4]

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And then Greg, just one follow-on is that we are evaluating the portfolio strategy to expand the Construction BIM later in the year.

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Gregory William Palm, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [5]

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Got it. I think, Simon, you made a comment that you expect the disruption at least to persist in the near term. Can you maybe talk a little bit more about that? And I guess -- I mean when all is said and done, what's your comfort level in terms of improvements later this year at least or early next?

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Simon Raab, FARO Technologies, Inc. - Co-Founder, CEO, President & Director [6]

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Well, I think we mentioned in the call that it would take a couple of quarters to work itself out. The problem that really arose, which motivated the reason for the portfolios, is that because of the extent of the product line, because of the new product drumbeat that we were generating what we call orphaned products that, for reasons of experience and expertise and other reasons, were becoming orphaned. They weren't getting the attention in the marketplace. So there's not a lot of point to developing new products and doing acquisitions for that purpose if in fact your channel can't adapt to it. And so it became obvious and necessary that we needed to take our sales force and start to make portfolios. It does create long-term advantages for the company. First of all, you get better concentration over a limited product set and particular customer group, which is the reason why we created small volume, large volume and then built quality portfolios. But it also allows you then to layer multiple sales people in the same territory without having to split territories and/or get channel conflict. It also does mean though that in some cases where there's an overlap between small and large volume, the 2 portfolios have to work together on a same customer. But it creates a dynamic in the marketplace, which will pay off hugely in the future because now you'll be structured to deal with constantly growing sales force in an expanding product line.

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Robert E. Seidel, FARO Technologies, Inc. - CFO [7]

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And Greg, one other point on the 3D manufacturing side, as Simon had pointed out in the course of his prepared remarks, is higher-than-expected sales headcount turnover. We quantify that to about $3 million impact or 5%. That is one of the other factors that may be a headwind to the 3D manufacturing in the next several quarters because of our FTE model and time it takes for those individuals that we then rehire to come up to full effectiveness.

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Operator [8]

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And we will take our next question from Jim Ricchiuti with Needham.

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James Andrew Ricchiuti, Needham & Company, LLC, Research Division - Senior Analyst [9]

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I actually dropped off, so I'm not sure if some of this was covered. But did you -- can you talk about the kind of churn rate you saw in the sales force? It was clearly unusual. And is it -- was it more concentrated in the U.S. market?

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Robert E. Seidel, FARO Technologies, Inc. - CFO [10]

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So we didn't disclose the churn rate. It was just higher than what we had anticipated, especially in our 3D manufacturing. Where you really see the correlation to financial results directly on a regional basis is if you look at our Americas results that we disclosed in our Q, you'll see it's down about 3% year-over-year. And that was really the region that we saw higher turnover on the sales force, and so you see that kind of direct correlation. If you then look at the 3D manufacturing business outside of Americas, it was less of a factor, more in Asia, where we saw the factor being, as Simon pointed out, about the PMI, the countries of Japan, South Korea, India. So sales headcount, America, you see that in overall sales results.

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Simon Raab, FARO Technologies, Inc. - Co-Founder, CEO, President & Director [11]

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I want to add some color to some of the potential causes for the additional turnover in the sales staff. There's always a -- there's an industry average, and it's in the mid-teens for sales groups around the world. But we undertook a commitment to reduce sales expenses and to, of course, reorganize the sales force in order to better use or better sell the new product lines. That meant commission structure changes. That meant territorial changes. That meant portfolio changes for the -- for each of the salespeople, which required new training. And then we had a lot more cost controls around the typical T&E, travel and entertainment, expenses around sales processes. So in all, many of the actions that we took resulted in an inevitable disruption in the sales force. It was a matter of ripping off the Band-Aid and getting some of this done. And of course, as we noted in the prepared remarks, our intention is to work for the long term. And net-net, we are flat 4. If you take the exchange rates, we're only down 1 percentage point over the prior quarter. So given all the changes that we undertook, we think it was fairly well executed, and we did have inevitable, however, disruptions. But that goes along with making all the huge changes that we made in the sales force.

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James Andrew Ricchiuti, Needham & Company, LLC, Research Division - Senior Analyst [12]

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Is there a way to think about the incremental hiring plans apart from replacing some of the folks who you've lost?

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Simon Raab, FARO Technologies, Inc. - Co-Founder, CEO, President & Director [13]

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I'm sorry, I'm not sure I understand the question.

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James Andrew Ricchiuti, Needham & Company, LLC, Research Division - Senior Analyst [14]

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Well, you're clearly going to be adding additional salespeople this year, right?

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Simon Raab, FARO Technologies, Inc. - Co-Founder, CEO, President & Director [15]

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Right. Yes.

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James Andrew Ricchiuti, Needham & Company, LLC, Research Division - Senior Analyst [16]

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And so -- but you've also had turnover. I'm just trying to get a sense is, incrementally, what additional salespeople over and above the people you've needed to replace you might be adding?

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Simon Raab, FARO Technologies, Inc. - Co-Founder, CEO, President & Director [17]

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Well, as we've pointed out -- no, I understand it. In the prepared remarks, we noted that we were still 13% up on Q1 of '18. We only committed to 15% overall increase year-over-year in the sales force. So in one respect, we're on target. We wish we had had kept more of the sales people that we had in Q1 so we'd be ahead of target. We only increased by 3 in the first quarter because of the turnover while we expected to have 25. I would point out, though, that there's going to be a natural reduction in -- or calming of the turnover effect because we're not going to be changing as much about the sales process, the portfolios, the customer organization, the territories, the commissions, the T&E and everything else that we did for Q1 of this year. So I expect that people will be hired into a much more stable environment than the disruption we caused in Q1.

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Robert E. Seidel, FARO Technologies, Inc. - CFO [18]

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And I think, Jim, just for your understanding of how this may flow through our income statement as we go forward is, our human resources team and our vertical leaders, as Simon stated, are really actively working on trying to get caught up where we wanted to be by the end of the second quarter -- by the end of the first quarter to get to the second quarter. So we will certainly try to catch that up in Q2 and early part of Q3. So you could certainly see kind of those people come on board in the course of the second quarter and our selling expense go up accordingly.

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Simon Raab, FARO Technologies, Inc. - Co-Founder, CEO, President & Director [19]

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I think it's an important point to make as well that the typical average industrial turnover is in that mid-teens -- the low-teens and mid-teens range annually. So to increase the sales force and deal with the natural both voluntary and involuntary turnovers, it reflects quite a challenge for the HR. But I think -- we think the system is in place to accommodate that, and I think our 13% year-over-year for Q1 suggests that we can handle it, and we are making all the necessary improvements to retain people.

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James Andrew Ricchiuti, Needham & Company, LLC, Research Division - Senior Analyst [20]

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If I may just ask one other question and I'll jump back in the queue. The service gross margins really have stepped up certainly year-over-year, but even sequentially. Wondering was there anything unusual about Q1? Or do you feel like we're -- you're at a level now that perhaps some of the service margins are more sustainable?

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Simon Raab, FARO Technologies, Inc. - Co-Founder, CEO, President & Director [21]

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I believe so. I believe this margin that we're demonstrating is sustainable. There may be minor fluctuations as we experiment with different efficiencies in the service department. But we think that, that is sustainable. It's a long-term goal for the service leadership team, and we think that we will continue to maintain and perhaps even improve upon it.

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Operator [22]

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And we'll take our next question from Andrew DeGasperi with Berenberg.

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Andrew Lodovico DeGasperi, Joh. Berenberg, Gossler & Co. KG, Research Division - Analyst [23]

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I just had a quick one on the macro environment generally and how that may be impacting you. I think you touched on PMIs in certain region. Do you think, as of today through April, things are slowing down a bit in the U.S. and Europe, given what is going on there?

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Simon Raab, FARO Technologies, Inc. - Co-Founder, CEO, President & Director [24]

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I would say that the preliminary indicators do not indicate the situation getting any worse in the beginning part of the quarter. We don't have any signals that it's deteriorating.

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Robert E. Seidel, FARO Technologies, Inc. - CFO [25]

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What I'd say, Andrew, at least in the past quarter we can comment, we saw really the PMI impact on our 3D manufacturing business. That's probably where the closest correlation would be, really, in those Asia countries of Japan, India and South Korea. If you look at our results in our EMEA region, we had a very good quarter in EMEA.

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Andrew Lodovico DeGasperi, Joh. Berenberg, Gossler & Co. KG, Research Division - Analyst [26]

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Right. And maybe just on the competitive environment today, has anything changed either in metrology or Construction BIM?

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Simon Raab, FARO Technologies, Inc. - Co-Founder, CEO, President & Director [27]

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I would say that in Construction BIM, the market is waking up. There are a number of new introductions of quality control software. People are realizing that in construction, they missed the total quality revolution that occurred in many of the industrial sectors. And so we see a definite interest in pickup. That means new competitors, small and large. So it will be an aggressive and competitive environment.

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Andrew Lodovico DeGasperi, Joh. Berenberg, Gossler & Co. KG, Research Division - Analyst [28]

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Got it. And then lastly for me. You mentioned that Construction BIM, you might see some restructuring coming in the second half of the year. Should we expect a 2- or 3-quarter sort of disruption like we saw in 3D Factory? Or should it be a little less in terms of -- a shorter timeline?

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Simon Raab, FARO Technologies, Inc. - Co-Founder, CEO, President & Director [29]

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Well, I think there are going to -- they were certainly more lessons learned in terms of the portfolio restructuring in 3D, which we intend to take advantage of with BIM. So I'm expecting less of a disruption. We also have less of an established sales force, of course, because that's a growing vertical that was not our core sector years -- for the years that others have. And there's enough dynamics in that market that we think that the growth rates will absorb any kind of disruption that we have. So yes, there will likely be some disruption, but I'm certainly hoping that it's much less than in 3D manufacturing.

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Operator [30]

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And we will take our next question from Hendi Susanto with G. Research.

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Hendi Susanto, G. Research, LLC - Research Analyst [31]

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First questions. With regard to the disruption in 3D manufacturing that you said would take like 2 more quarters and a plan to do similar reorg in Construction BIM, does FARO technology still maintain its growth of double-digit operating margin in Q4 2019? Or should we expect that goal to be achieved later beyond Q4?

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Simon Raab, FARO Technologies, Inc. - Co-Founder, CEO, President & Director [32]

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That is still our goal. And we believe that the Emerging Verticals margins and sales are increasing at a sufficient rate to make up for any disruption effects, and our cost controls are geared to provide those double digits. So yes, we still maintain that. That's our goal.

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Robert E. Seidel, FARO Technologies, Inc. - CFO [33]

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One of the things to really look at [our] results is that -- one of the pieces to get there is to get to a 60% gross margin. We made a step forward in the quarter with our service margin. We controlled those selling and marketing costs, as we talked about, seen control in the R&D. So there is the steps in place. You really start to see that in Q1.

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Hendi Susanto, G. Research, LLC - Research Analyst [34]

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And then second question, I would like to understand the timing of the sales headcount turnover and sales force reorg in 3D manufacturing. When FARO reported Q4 on February 20, we did not anticipate these 2 would come and disrupt sales in Q1. Was the sales force reorg quickly decided and executed in March? And I'm wondering whether the sales headcount was observed in early March.

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Simon Raab, FARO Technologies, Inc. - Co-Founder, CEO, President & Director [35]

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Well, we had decided -- we knew we were going to head in the direction of portfolio. We didn't realize the kind of disruption it would cause. We also had a number of new policies around commission structure and cost controls. So when we decided to go ahead in the first quarter and start making change, that's when we started to realize that there was going to be more disruption than we thought. It's one of those long-term strategic things that just have to get done. When you do them and how you do them, of course, is up to you. But the -- so we decided to get it done in the first quarter. A lot of that restructuring has impacted the other verticals, which, as you saw, though, still maintained good growth rates. The 3D manufacturing being a core one, of course, with long-established expertise in various product lines was the one where we both have most of our salespeople and most of our core sales. So inevitably, it created some disruption. And we're hoping to remedy that very quickly. And it was just one of those long-term things that you got to do if you're really going to build the business to take advantage of all the market changes and product changes.

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Operator [36]

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And we'll take our next question from Richard Eastman with Baird.

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Richard Charles Eastman, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [37]

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Just to pick up on the same topic here in the 3D kind of unwinding or reorganizing. How much of this is unwinding some of the investments that we made 3 years ago? I mean we added people. I think, at that time, we verticalized our markets. We -- so what I'm trying to understand is what are we doing here that's different from what we put in place -- the actions we've put in place 3 years ago? And what is the underlying reason for the turnover? I mean is it -- are you reshuffling territories? Are you cutting commissions? I'm not quite sure that I understand why the big churn here after 3 years of kind of investing in headcount.

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Simon Raab, FARO Technologies, Inc. - Co-Founder, CEO, President & Director [38]

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Well, first of all, let's put that in perspective. The headcount did increase by 13% of Q1 of previous year. So we had a higher-than-expected churn. The commissions were restructured -- commission tier structure were redone. The expectations on performance by sales people were increased. The controls around the costs were increased. Now that -- all that is kind of the operational side of sales. There was no change in the overall concept around the verticalization of the company. But just imagine this. You have an expanded product line. So now, let's say, you have 5 instead of 2 primary products and that you have sales people who have to carry a bag around of these products and have expertise in widely diverse areas, large scale, small scale and also in building the actual manufacturing quality control. So we have -- we had a problem that we were having products because of extensive new products that we've added that were basically being ignored because the salesman has an option when he goes into a customer to sell all 5 things or 1 of 5 things. And so it was even a demonstration limitation. You can only demonstrate -- let's say, if you do 10 or 11 demos in a month, that would mean that if you had 5 products, most you could do 2 demos of each of those products. And so inevitably it just was no longer a viable structure. So we took the exact same sales force. Let's say, you have a couple hundred people, and instead of just having each one of them show 5 products, you can now split it up into 3 groups so that they're each selling 2 products. And those 2 products then get the necessary attention and you don't get the orphaned products. So it's not a -- it's a natural evolution of the vertical's sales force. It is now being specialized within their own vertical around the new and added products. I mean if we continue adding products at the same rate, it's absolutely impossible for a salesperson to come in with a binder listing 10 products and even remotely give these different products the exposure that they need. So this is a natural evolution forward of the vertical process. Like I said, the sales were, basically with exchange rates, even over last year. That's a small disruption, given we were talking about high single digits for 3D manufacturing. And we think it will quickly recover. Part of the other challenge was that you have people who -- let's say, you are an arms salesperson that was so focused on arms that they ignored other 4, 5 products that we were selling. So they needed to be retrained as well on the other products and expertise had to be -- we had to ensure that the expertise were there. So I think it's just growing pain and a natural evolution of the sales force to deal with all the new products that we're adding.

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Richard Charles Eastman, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [39]

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Does FARO have a head of global sales? And is that person the same person?

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Simon Raab, FARO Technologies, Inc. - Co-Founder, CEO, President & Director [40]

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Well, we have a global head of the 3D -- we have a global head of each of the verticals, and that person is the same right now. Yes.

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Richard Charles Eastman, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [41]

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Okay. And then just a question, Bob, around the G&A. The $1.8 million that you flagged, how much of that is legal?

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Robert E. Seidel, FARO Technologies, Inc. - CFO [42]

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So for us, the total $1.8 million relates to CEO compensation and recruiting. That's about $1.2 million and then $600,000 is for the GSA expense. What we talked about, we would look for a similar number about $2 million in the prepared remarks in the second quarter and then going down potentially with the progression of the GSA matter in the third and fourth quarter.

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Richard Charles Eastman, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [43]

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So GSA expense would go from $600,000 in the first to $2 million in the second?

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Robert E. Seidel, FARO Technologies, Inc. - CFO [44]

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No, that's -- the $2 million that would be in the second quarter includes continued of the stock option acceleration, second quarter, and then in the later half of the year is primarily the GSA expenses and also our new incoming CEO.

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Richard Charles Eastman, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [45]

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Okay. And then just one last question. When I look at the -- the question came up before. But when I look at the service gross margin being up 450 basis points, I believe, my question is just how do you improve service efficiency to that degree? You just have fewer people? I mean it's -- by definition, a service is a service. So you either have less break/fix ratio, experience or you have fewer people, but how else can you -- how can you drive efficiency that meaningfully year-over-year?

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Simon Raab, FARO Technologies, Inc. - Co-Founder, CEO, President & Director [46]

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Well, part of it, of course, is pricing for warranties in actual service and training because that department is responsible for all training application engineers as well as the selling of the warranties and doing a nonwarranty service. So the rates -- we want to just make sure that we were priced right in the marketplace. At the same time, there are efficiencies to be had. We have had actually a significant effort by the R&D department to provide tooling and replacement parts configured in such a way as to reduce the actual cost of repair, and that has contributed significantly as well. And there are also efficiencies. I mean the diagnostic -- the amount of diagnostic time that's required -- certainly, product reliability increases are incredibly important too. So a strong blending of the service department with the R&D department to make sure, as products go out, that they're more reliable. So it's actually many, many little pieces that contribute.

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Robert E. Seidel, FARO Technologies, Inc. - CFO [47]

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I would say, the other piece we mentioned, and you can really see it in the face of the income statement, we had a 11.5% year-over-year sales growth recorded in service. And so one of the activities that we started some time ago is really an inside sales team that's dedicated to selling in that recurring revenue stream. And so those activities are really helping to drive that service revenue, which is the other piece to what is driving the gross margin. So it's really 2 pieces that's driving the gross margin, just so you understand the dynamics.

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Richard Charles Eastman, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [48]

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Okay. Very good. Now I understand. Just my last question, again. The gross margin around the product side continues to move higher. We're basically suggesting new products have more value and a higher price. And conversely, we're seeing our revenue growth literally slow, and we're seeing churn in sales, orphaned products. Is there any correlation here between new products, higher price, less competitive and more difficult to sell?

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Simon Raab, FARO Technologies, Inc. - Co-Founder, CEO, President & Director [49]

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No. I mean not in the way you put it. I mean the orphaned products is a pure arithmetic problem. You have certain number of demos your sales force can do and when you have too many products for them to demo so 2 things have to happen. You have to first start reducing the number of products that you expect the salesman to have to demo. So that's where you do the portfolios. And then to catch back up, you need to have to replenish the vertical so that you get the right number of demos per product. And that's the way you get the sales. Now with respect to competitive pricing and -- I mean we have a much higher value proposition and so we can charge premium pricing. We'll sell used equipment against other people's new equipment. And people are prepared to pay those prices for the advanced technology that we have. This was purely a throughput problem. And that's why we split the portfolios and we have to catch back up again is that we just had too much product for the sales force. And we have to do a better job also on the leads side because with the broader product line, we we have to advertise in different ways. So it was really a little bit of a wake-up call for us about the way that if we were going to sustain this kind of drumbeat on -- with product development and, at the same time, we were going to have to evolve the sales force and its process to adapt to that, and that's really what this was in Q1. In my view, it's all good news for the long term. It's something that had to be done and could have been done perhaps more efficiently, I'm not sure. But we certainly had lessons learned, and we will continue to start to evolve that in the other verticals as well.

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Operator [50]

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And we'll take another question from Greg Palm with Craig-Hallum.

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Gregory William Palm, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [51]

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Just a few follow-ups from me. Within 3D manufacturing segment, you talked about continued FX headwinds in Q2 and, obviously, the continuation of some of these sales force disruptions. So I mean, usually, there is some seasonal uptick in revenue in Q2 from Q1. But given everything going on, I'm just curious if you expect growth in that segment on a sequential basis to be more muted this year than maybe in years past.

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Robert E. Seidel, FARO Technologies, Inc. - CFO [52]

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I would say that the factors going into Q2 that would be affected is the FX we've talked to is 3 to 4 percentage points, our estimate overall for the company, which, if you look at our 3D manufacturing business, it is really represented similar to the company's footprint. The other piece certainly is the headcount turnover that we saw and to continue getting those FTEs up. So I think that when we look at Q2, there's going to be challenges there and better second half of the year. But between those 2 items, there will be some headwinds in that second quarter for us.

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Gregory William Palm, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [53]

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Okay. Fair enough. And just in terms of inventory, I noticed that jumped up again in Q1. Presumably, the -- maybe the sales projections, obviously, didn't come in as expected. But what's your comfort level there in terms of time line of working some of that off? What's your best guess?

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Robert E. Seidel, FARO Technologies, Inc. - CFO [54]

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So if you look at it just with the level the business has increased over the past year with their sales growth, our turns are improving. So that's a positive step forward. The other piece is, we're continuing to cycle the demo inventory from the field back into our inventory, refurbish it and sell it. So there'll be some cyclicalities as you go through a quarter-to-quarter in our inventories just as we go through that process. And then I would say also with it just that we are capital spending business, by the end of the quarter, if your sales are slightly below, you're going to get an increase in inventory. But going forward, we're actively managing this and looking to bring that inventory down and continue to increase the turns over time.

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Simon Raab, FARO Technologies, Inc. - Co-Founder, CEO, President & Director [55]

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There is another piece, of course, to that as well and that is that we have more product and you have to sustain a minimum number of the different variety of products that you have both for the sales force and to accommodate sales. So there's going to be a natural increase as well. Nevertheless, it should be well managed, but there will be a natural increase because of the different product lines.

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Operator [56]

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And we will take our next question again from Jim Ricchiuti with Needham.

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James Andrew Ricchiuti, Needham & Company, LLC, Research Division - Senior Analyst [57]

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The question really relates to the macro environment in a couple of the verticals. We're seeing softness in the automotive -- global automotive market. We've seen some very high-profile challenges in the commercial aircraft market with one supplier. Are you seeing any impact in either of those verticals from some of these issues, both macro and company specific?

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Robert E. Seidel, FARO Technologies, Inc. - CFO [58]

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At least in the first quarter, Jim, where we see the most direct correlation is really in our 3D manufacturing segment. That's where you're going to see -- that's where we saw the most relationship with some of those end markets and, as Simon talked about, with PMI. I would say most directly we saw that in Japan, with our automotive manufacturing being down to lower levels, their PMI being down. And in term of aerospace more broadly, is certainly this is an important market for us, an end market in that 3D manufacturing space. We can't say that we necessarily had an impact in the first quarter related to that supplier, but certainly as that industry would slow, it would create headwinds for us in future quarters. So those are 2 significant markets for us. I would say, directly in the first quarter, though, it was mostly Japan for the automotive market and then just really slowing in India and South Korea.

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James Andrew Ricchiuti, Needham & Company, LLC, Research Division - Senior Analyst [59]

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But, Bob, as we think about the next couple of quarters, I mean, it appears that some of these issues may persist. So is that -- how much of a concern is that?

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Robert E. Seidel, FARO Technologies, Inc. - CFO [60]

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I would say, from our point of view, it is a concern because, historically, we've seen a relationship between our 3D manufacturing business in those PMIs around the globe. We do have a broader portfolio of products to help offset that than what we had 3 or 5 years ago, with the portfolio redefinition of assembly and verification. So that's an offsetting factor. But certainly, the -- if the automotive market, the aerospace market, metal machine working was more brisk, we would certainly feel a little bit stronger about the 3D manufacturing in the next several quarters.

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Operator [61]

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At this time, it seems we have no further questions. I'll turn the call over to you, the speakers, for any closing remarks.

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Simon Raab, FARO Technologies, Inc. - Co-Founder, CEO, President & Director [62]

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Thank you all for your attention today, and we look forward to speaking to you soon.