U.S. Markets open in 5 hrs 6 mins

Edited Transcript of FARO earnings conference call or presentation 20-Feb-19 1:15pm GMT

Q4 2018 FARO Technologies Inc Earnings Call

LAKE MARY Feb 21, 2019 (Thomson StreetEvents) -- Edited Transcript of FARO Technologies Inc earnings conference call or presentation Wednesday, February 20, 2019 at 1:15:00pm GMT

TEXT version of Transcript

================================================================================

Corporate Participants

================================================================================

* Robert E. Seidel

FARO Technologies, Inc. - CFO

* Simon Raab

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

================================================================================

Conference Call Participants

================================================================================

* Andrew Lodovico DeGasperi

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

* Ben Zion Rose

Battle Road Research Ltd. - Founder, President & Analyst

* Gregory William Palm

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

* Hendi Susanto

G. Research, LLC - Research Analyst

* Richard Charles Eastman

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

================================================================================

Presentation

--------------------------------------------------------------------------------

Operator [1]

--------------------------------------------------------------------------------

Good morning, everyone, and welcome to the FARO Technologies Fourth Quarter and Fiscal Year 2018 Earnings Release Conference Call.

For opening remarks and introductions, I will now turn the call over to Chief Financial Officer, Bob Seidel. Please go ahead.

--------------------------------------------------------------------------------

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

--------------------------------------------------------------------------------

Thank you, and good morning, everyone. Yesterday after the market close, we released our preliminary fourth quarter and fiscal year 2018 financial results. The financial information included in this call is preliminary as the company has not yet issued its audited financial statements and may differ from those results. The press release is available on FARO's website at www.faro.com.

I would like to remind you that in order to help you 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, goals, 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, 2017, and Form 10-Q for the quarter ended March 31, 2018.

During the fourth quarter of 2018, we changed the name of our former 3D Factory reporting segment to 3D Manufacturing, in order to better align with it's focused applications and end markets. 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 questions.

--------------------------------------------------------------------------------

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

--------------------------------------------------------------------------------

Thanks, Bob, and good morning, everyone.

We've made great progress in achieving our sales growth and operating margin objectives this past year. In 2018, we delivered $425 million in new order bookings, up 12.8% year-over-year and surpassing the $400 million in annual sales for the first time in our history. We achieved double-digit year-over-year sales growth in both 2017 and '18.

In addition, we took actions to improve our sales force efficiency throughout the year. After hitting the low at $698,000 per FTE in sales in the first quarter of 2018 because of the aggressive sales force expansion, our trailing 12-month orders per sales FTE increased through 2018 to finish at $710,000 in the fourth quarter.

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 aim to expand our channel to market by investing in the growth of our sales footprint across our new vertical markets and geographies. We increased our sales headcount at this rate in both 2017 and '18. Our sales headcount increased by 197 people or 37% from the end of 2016 to the end of 2018, focused initially on staffing our Emerging Verticals. We made progress in improving our service margin in 2018, especially in the second half of the year. Our service margin is an important contributor to an increase in overall gross margin. Every aspect of our service business was examined to streamline processes, incorporate engineering support on service repair processes and incorporate technology to better manage our customer calls without sacrificing customer satisfaction. We are working on more initiatives to continue our increases to increase our service margin to our 50%-plus objective from our trailing 3-year average of 44.3% and achieve 48.6% gross margin in Q4 of 2018.

Recurring revenues are an important part of establishing a profitable growth platform. Service revenues are one of two paths FARO is pursuing to develop its recurring revenue stream. Service revenues were approximately $93 million or 23% of sales in 2018, and are derived from the support of our installed base. We've opened a new mobile service platform in 2018 called FARONow!, providing real-time relationships with all our users and already have over 14,500 registered users on this essential portal. The portal provides all the tools to manage users FARO Solutions, including warranties, services, software licenses, and provides a direct path for communicating important news to our customer base.

Recurring revenues from software subscriptions is our second major initiative to drive a recurring revenue base. FARO is moving aggressively to continuous deployment of all its software products, and consistent with worldwide trends in software delivery, all software products are being converted to subscription only. This ensures that all users will be on the latest product ensuring reliability and productivity for the client and a regular relationship management of all FARO customers.

FARO considers its installed base of users as one of its most important assets and intends to pursue every available tool to improve those relationships and drive customer loyalty. Sales to existing customers represents 79% of 2018 sales, underlying the importance of this operating principle.

Since returning as CEO over 3 years ago, my top priority was to reinforce FARO as the technology leader in 3D measurement and imaging solutions in our chosen verticals, while also upgrading every operational system and globally harmonizing operations. We first focused on getting our new next-generation primary platform products to market with urgency. We redesigned our entire product development process from drawing board to customer so that it is consistent and repeatable process facilitating our new product drumbeat. In 2018, we introduced 14 new products even after a highly active new product development effort in 2017. To be the technology leader, we must have a world-class new product development process instilled in the organization and fueled by an entrepreneurial spirit.

Each function made strides to better leverage information technology in order to streamline its processes and become more efficient as sales continue to grow at mid-teens rates. We started our FARO Best! lean initiative to focus every employee on operational pain points and their elimination.

Since 2002, we have sold products and related services to the U.S. Government under the General Services Administration, or GSA, contracts. Unfortunately, late in the fourth quarter of 2018, during an internal review, we preliminarily determined that we may have overcharged the government under these contracts. Sales to the government under the contracts represent only 3.5% of our total sales in 2019 -- or '18 rather. Nevertheless, we take our GSA contract compliance responsibilities very seriously. We reported the potential noncompliance to the GSA and its Office of Inspector General on February 14, 2019.

As a result of our preliminary review for the fourth quarter of 2018, we reduced our total sales by a $4.8 million estimated cumulative sales adjustment, representative of the last 6 years of estimated overcharges to the government under the contracts. We engaged outside counsel to assist us through the reporting inquiries and remediation process.

After market close yesterday, we filed an 8-K to more fully describe the matter and potential financial risk to the company as we work to resolution. Until this matter is fully resolved, we will bear legal and related cost in connection with the government's review of this matter. We believe that FARO's strong balance sheet and serious compliance mindset will allow us to effectively resolve this GSA matter.

We intend to resolve this matter while sustaining our double-digit sales growth, high gross margin and product development in our continued mission to achieve double-digit operating margin by the fourth quarter of this year.

Excluding the GSA matter, we achieved a strong operating margin in Q4 providing a strong directional indicator that our operating income goals are within reach. We plan to continue our sales growth by increasing our sales headcount by 15% linearly by quarter throughout 2019, similar to 2018. The sales headcount additions will be focused on our Construction BIM segment in order to pursue the growth in this market. We'll also expand our 3D manufacturing sales headcount to support our expanding product portfolio and continue to grow the public safety and 3D Design Verticals as our product line in these 2 Emerging Verticals matures.

We continue to drive our gross margin towards our goal of 60%-plus. Research and development has a strong emphasis on software development with over 12 applications supported by approximately 50% of our R&D headcount. High-margin software sales and recurring subscription revenue will increasingly contribute to our product gross margin. Our continued lean initiatives, institutionalized as FARO Best!, is further contributing to our reduction in the operational and product cost in order to meet our gross margin objectives.

As I communicated in last quarter's earnings calls, our 2019 spending plan in marketing, general and administrative and research and development are budgeted to remain consistent with 2018. However, we may see higher general and administrative expenses with the recent announcement of our CEO succession and the GSA matter, but we will be vigilant to maintain the base spending at near 2018 levels.

I appreciate the support of our FARO global team in executing our vision to reorganize the company by verticals and establish new R&D processes to ensure FARO's continued role as a technology leader in 3D measurement and imaging solutions. I plan to continue to drive the business towards our 2019 operational objectives until I hand the reins of CEO to my successor.

We deeply appreciate the patience of our shareholders and the hard work of our employees around the world. And I'm proud of our accomplishments over the past 3 years, and look forward to continued growth and a smooth leadership transition.

I'll now turn the call over to Bob.

--------------------------------------------------------------------------------

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

--------------------------------------------------------------------------------

Thank you, Simon.

As explained in yesterday's earnings press release and Simon's prepared remarks, to account for the GSA matter, we reduced our total sales by $4.8 million as an estimated cumulative 6 years sales adjustment in the fourth quarter of 2018. In addition, for the fourth quarter of 2018, we recorded $0.5 million of imputed interest related to the GSA cumulative sales adjustment, which increased other expense and resulted in an estimated total liability of $5.3 million for the GSA matter. This estimated liabilities based on our preliminary review as of the date of yesterday's earnings press release.

Total sales were $112.8 million for the fourth quarter of 2018, an increase of 6.0% as compared with $106.4 million for the fourth quarter of 2017. Our sales increase was primarily driven by higher unit sales across all segments, higher average selling prices in our 3D manufacturing reporting segment and total service revenue growth, partially offset by the GSA cumulative sales adjustment. New order bookings were $122.2 million for the fourth quarter of 2018, an increase of 10.5% as compared with $110.6 million for the fourth quarter of 2017. With our trailing 12 months new order bookings of $425.3 million and sales full-time experienced, or FTE, headcount at 599, our trailing 12 months orders per sales FTE metric was approximately $710,000, up $4,000 from the third quarter of 2018. Our trailing 12-month sales FTE increased by 13.0% from 530 at the end of 2017 to 599 at the end of 2018.

Our new order bookings year-over-year growth of 12.8% for 2018 provides support for our sales force growth strategy. Our historical trailing 12 months orders per sales FTE by quarter is disclosed as supplemental data in yesterday's earnings press release. In our 3D Manufacturing segment, sales for the fourth quarter of 2018 were $75.6 million, an increase of 6.6% compared with $70.9 million for the same prior year period.

We recorded a $3.0 million reduction to sales in this segment for the quarter related to the GSA cumulative sales adjustment. The sales increase was mostly driven by an increase in unit sales, higher average selling prices and service revenue growth.

In our Construction BIM segment, sales for the fourth quarter of 2018 were $26.2 million, an increase of 1.7% compared with $25.8 million for the fourth quarter of 2017. Our Construction BIM sales fell short of our growth expectations for the quarter, reflecting weaker demand from our Americas and European customers, as well as product sales mix changes and higher demo sales. We remain positive on the long-term growth expectations of this segment, as we continue to expand our product offerings and increase our sales headcount in 2019.

In our Emerging Verticals segment, sales for the fourth quarter of 2018 were $11.0 million, an increase of 13.7% compared with $9.7 million for the fourth quarter last year. We recorded a $1.6 million reduction to sales in this segment for the quarter related to the GSA cumulative sales adjustment. The sales increase was primarily due to higher unit sales, reflecting our expanded product portfolio and dedicated sales headcount investments.

Gross margin was 57.2% for the fourth quarter of 2018, down 1.1 percentage points, as compared with 58.3% for the fourth quarter of 2017, reflecting higher average selling prices in our 3D Manufacturing segment and improved service margin, which were more than offset by the effects of the GSA cumulative sales adjustment.

Selling and marketing expenses were $30.8 million for the fourth quarter of 2018, an increase to 7.3% compared with $28.7 million for the fourth quarter of 2017. Selling and marketing expenses grew at approximately half the rate of new order bookings demonstrating improved sales leverage. This increase was driven mostly by our strategic investment in sales headcount and higher sales commissions due to our sales growth. Selling and marketing expenses as a percentage of sales was 27.3% for the fourth quarter of 2018 as compared with 26.9% for the same prior year period.

At the end of the fourth quarter of 2018, our ending sales headcount was 733, an increase of 102 or 16.2% compared with 631 at the end of the fourth quarter of 2017.

General and administrative expenses for the fourth quarter of 2018 were $12.8 million, an increase of 16.8% compared with $10.9 million for the fourth quarter last year. This increase was driven mainly by an increase in headcount and administrative expenses related to our recent acquisitions as well as cost associated with implementing the European Union's General Data Protection Regulation.

As a percentage of sales, general and administrative expenses were 11.3% for the fourth quarter of 2018 as compared with 10.3% for the same prior year period. For the fiscal year 2018, general and administrative expenses as a percentage of sales decreased by 0.3 percentage points to 11.8% as compared with prior year.

Research and development expenses were $10.3 million for the fourth quarter of 2018, an increase of 16.9% compared with $8.8 million for the fourth quarter of 2017. This increase was mainly driven by higher engineering headcount related to our acquisitions and activities to accelerate our new product development.

Research and development expenses as a percentage of sales was 9.2% for the fourth quarter of 2018 as compared with 8.3% for the fourth quarter of 2017.

Both fiscal year 2017 and 2018, research and development expenses as a percentage of sales, remained unchanged at 9.8%. Our net income of $5.8 million or $0.33 per share for the fourth quarter of 2018 included a $1.0 million income tax benefit related to finalizing our transition tax under the U.S. Tax Cuts and Jobs Act of 2017 and a $3.9 million unfavorable after-tax impact of the GSA matter.

In conclusion, as we drive the business towards our long-term financial objectives, we look at our fiscal year 2018 performance as an important, helpful measure of our progress. I would like to highlight our performance on several key operational metrics for our fiscal year 2018.

New order bookings were $425.3 million for 2018, up 12.8% year-over-year, consistent with our trailing 12-month sales FTE year-over-year increase of 13%. Ending sales headcount increased by 102 or 16.2%, consistent with our objective at the start of the year. Our trailing 12 months orders per sales FTE ended 2018 at $710,000, driving upwards after reaching a low point of $698,000 in the first quarter.

Sales were $403.6 million for 2018, up 11.8% year-over-year for a second consecutive year of double-digit sales growth. Gross margin was 56.6% for 2018 consistent with prior year. At the end of 2018, we maintained our strong balance sheet with cash and short-term investments at $133.6 million, of which $77.5 million was held by FARO subsidiaries, and no debt.

We greatly appreciate the support of our shareholders and the hard work of our employees around the world. Thank you for your attendance on today's call, and we will now open the call for questions through the start of market trading.

================================================================================

Questions and Answers

--------------------------------------------------------------------------------

Operator [1]

--------------------------------------------------------------------------------

(Operator Instructions) And we will take our first question from Greg Palm with Craig-Hallum Capital Group.

--------------------------------------------------------------------------------

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

--------------------------------------------------------------------------------

Simon, obviously, congrats on your career here at FARO and, obviously, the most recent turnaround of the company. I know you will be missed.

--------------------------------------------------------------------------------

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

--------------------------------------------------------------------------------

Thank you. I appreciate the comment.

--------------------------------------------------------------------------------

Gregory William Palm, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [4]

--------------------------------------------------------------------------------

Maybe just curious, you mentioned those operational objectives in -- I know you have some pretty lofty fiscal year '19 targets out there. What's your comfort level on the company being able to hit those or at least exit the year with a pathway for fiscal year '20? I'm not sure if you can give us any color on that.

--------------------------------------------------------------------------------

Simon Raab, FARO Technologies, Inc. - Co-Founder, Chairman, CEO & President [5]

--------------------------------------------------------------------------------

Well, I can by doing some of the calculations, which I would expect you to do. I mean, it was really unfortunate to have this GSA matter to cloud what was otherwise an incredible year and an incredible accomplishment. If you back that out, there is about $0.22 of that just GSA adjustments. So we feel that the approximately $0.50 indicate that we are in the position to go after that double-digit operating margin by the end of 2019. And all the little incremental fixes that are being made at every level, it's the devil's in the details, are all finally coming together to produce that kind of profit margin. So I'm still very upbeat on 2019 goals.

--------------------------------------------------------------------------------

Gregory William Palm, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [6]

--------------------------------------------------------------------------------

Okay. And as it relates to the quarter specifically, from an end-market and geographic standpoint, any areas of strength or weakness that you want to call out? I know you gave a little bit of color on segment. But I'm more looking for sort of specific end markets and geographic areas.

--------------------------------------------------------------------------------

Simon Raab, FARO Technologies, Inc. - Co-Founder, Chairman, CEO & President [7]

--------------------------------------------------------------------------------

Well, as you've probably heard, there is a lot of noise in the automotive market. There are plants being closed and there are movements -- geographical movements, you hear things like Tesla going to China and other matters of that type. So there is some disruptive activity. There's also a lot of new smaller manufacturers coming in, for example, into the electric car market so that can be compensated for in some way. There is a tremendous demand in the aerospace worldwide, but there is also consolidation and changes. Airbus, as you heard, is getting rid of one of its jumbo and I think that we're going to see pluses and minuses in different parts of the world. There is a lot of economic disruption because of the trade conversations that are going on. So that's having temporary impacts on different markets and different places. But in general, we're very upbeat. The overall demand for the product continues and is reflected in our growth in the year.

--------------------------------------------------------------------------------

Robert E. Seidel, FARO Technologies, Inc. - CFO [8]

--------------------------------------------------------------------------------

Greg, this is Bob. One of the -- I think, one of the high points for us this year has been really our Asia Pacific region has done very well. It is about 16% year-over-year growth for the full year and a very strong Q4. Japan was strong for us, and certainty, as Simon indicated about the trade discussions that you see going on in the market, we had saw a very strong Q4 in APAC, or Asia Pacific region. So certainly, that was a strong point for us.

--------------------------------------------------------------------------------

Operator [9]

--------------------------------------------------------------------------------

Our next question will come from Ben Rose with Battle Road Research.

--------------------------------------------------------------------------------

Ben Zion Rose, Battle Road Research Ltd. - Founder, President & Analyst [10]

--------------------------------------------------------------------------------

Congratulation to you, Simon, on your new transition plan.

--------------------------------------------------------------------------------

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

--------------------------------------------------------------------------------

Thank you.

--------------------------------------------------------------------------------

Ben Zion Rose, Battle Road Research Ltd. - Founder, President & Analyst [12]

--------------------------------------------------------------------------------

I want to start off with a few questions. Could you talk about perhaps how large the U.S. Government vertical is overall in the context of the business?

--------------------------------------------------------------------------------

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

--------------------------------------------------------------------------------

So we sell to the GSA contract through a couple of schedules, one relating to the public safety and one relating primarily to the industrial 3D manufacturing segment. As we indicated, total sales between those 2 schedules are approximately 3% of 2018 sales. So they are important. We take our compliance extremely seriously. Our -- as you can tell, they don't represent a huge piece of our sales.

--------------------------------------------------------------------------------

Ben Zion Rose, Battle Road Research Ltd. - Founder, President & Analyst [14]

--------------------------------------------------------------------------------

Right. And with regard to the services gross margin improvement during the quarter, which was quite impressive. How sustainable/capable of being improved is that as we move into the rest of 2019?

--------------------------------------------------------------------------------

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

--------------------------------------------------------------------------------

Yes. We absolutely believe that it’s all starting to come together. We think that the 50%-plus is definitely achievable. As you know, they -- service represents around 23% of our sales. So any 4-point increase in service margin is a 1 point to the company gross margin. And it will definitely [be good]. We think it's sustainable and actually beyond our -- the short-term goal of the 50%-plus. So we are quite upbeat about that.

--------------------------------------------------------------------------------

Operator [16]

--------------------------------------------------------------------------------

Our next question will come from Hendi Susanto with G. Research.

--------------------------------------------------------------------------------

Hendi Susanto, G. Research, LLC - Research Analyst [17]

--------------------------------------------------------------------------------

First question is for Bob. With regard to the GSA matter reduction of $4.8 million in sales, may I inquire what the split between products and services? And I think you may have mentioned that in which segment the reduction and quantified that when you talked about segments, but I think I missed that.

--------------------------------------------------------------------------------

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

--------------------------------------------------------------------------------

Sure. So first of all, on the segment side, it was $3 million reduction to sales in our 3D manufacturing, $1.6 million reduction to sales in the Emerging Verticals, primarily related to the public safety vertical there. And then also $0.2 million in our Construction BIM segment. So $3.2 million, $1.6 million for the $4.8 million. Then in terms of -- so overall, that kind of frames it. In terms of product service split, very consistent with the rest of our business, about a 75-25 split. We do not disclose specific numbers there but it should be consistent with the rest of our normal business.

--------------------------------------------------------------------------------

Hendi Susanto, G. Research, LLC - Research Analyst [19]

--------------------------------------------------------------------------------

Got it. And then Simon, I have a question. I think you did a lot of M&A during your recent leadership. And I'm wondering whether you would focus on integrating and then developing like new products from acquisitions? Or whether you're still actively looking for M&A in 2019?

--------------------------------------------------------------------------------

Simon Raab, FARO Technologies, Inc. - Co-Founder, Chairman, CEO & President [20]

--------------------------------------------------------------------------------

Well, we have the challenge that we've committed to trying to keep the 2018 expenses fairly flat. But that should not change our -- or flat to -- 2019 expenses flat to 2018, but that shouldn't change the momentum and the drumbeat that we also wanted to sustain around M&A. So we do have an active plan to continue our M&A activities. There are still holes in our product line, particularly in Emerging Verticals, that we think need addressing. But I think it would be reasonable to expect a slight reduction in the activity in 2019 as we consolidate and take advantage of the acquisitions of 2018. But I want to make a point that the M&A drumbeat is to continue.

--------------------------------------------------------------------------------

Hendi Susanto, G. Research, LLC - Research Analyst [21]

--------------------------------------------------------------------------------

Okay. And then one last question for me. Simon, you talked in the past about your expansion into 3D Machine Vision. And how should we expect 3D Machine Vision's development and initiatives in 2019?

--------------------------------------------------------------------------------

Simon Raab, FARO Technologies, Inc. - Co-Founder, Chairman, CEO & President [22]

--------------------------------------------------------------------------------

Well, in 2019, I think, you're going to start to see a very clear marketing effort around the new sensors that we've introduced. We have the new Photonics vertical, plus we have new sensors that we've introduced from the other research departments that we believe will make a contribution through integrators. And so you'll see a much higher profile for these stand-alone sensors and the sensor market for us. And these are the primary contributors to the 3D solutions effort that we have in play. I hope I answered your question, Hendi.

--------------------------------------------------------------------------------

Operator [23]

--------------------------------------------------------------------------------

Our next question will come from Richard Eastman with Baird.

--------------------------------------------------------------------------------

Richard Charles Eastman, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [24]

--------------------------------------------------------------------------------

Simon, all the best, as we kind of move forward into '19 here.

--------------------------------------------------------------------------------

Simon Raab, FARO Technologies, Inc. - Co-Founder, Chairman, CEO & President [25]

--------------------------------------------------------------------------------

Thank you very much.

--------------------------------------------------------------------------------

Richard Charles Eastman, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [26]

--------------------------------------------------------------------------------

Could I just quickly ask just on that front? Where is the search process? Is -- and maybe is there a time line related to that? I mean, would you be, you and the board be most comfortable if there was a new CEO in place by mid-year? Or -- what's just the thought process around that search process?

--------------------------------------------------------------------------------

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

--------------------------------------------------------------------------------

We are in the process. There are candidates being interviewed and reviewed. There is no -- we can't give any assurance as to when that will happen in the year but I expect it to happen sometime in 2019.

--------------------------------------------------------------------------------

Richard Charles Eastman, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [28]

--------------------------------------------------------------------------------

I see. And then just a question around the headcount. I think you have mentioned the sales headcount target would be 15%. So -- off the 733. So I think that's headcount additions off the 733 at year-end would put you at about 843, I think, that's the straightaway math there. And if the FTE equivalent is like 85% of that, then maybe FTE would be up, again, similarly 15% or 16%. And I'm -- the question I might have for you is, would the $710,000 number -- so the orders per FTE, would you expect to drive some productivity on that number, the overall FTE number? Or would you be pleased if the $710,000 orders per FTE number held? How are you kind of viewing the productivity there in addition to the adds?

--------------------------------------------------------------------------------

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

--------------------------------------------------------------------------------

Well, I -- we would not be satisfied with $710,000. We have many initiatives underway to increase that number. So -- in fact, that's our primary leverage on sales growth. I mean, if we can increase that number, you get to leverage times of 500 or 600 people at the FTE level. So it is extremely important that we improve that number. We were happy to see it bounce off in autumn with all the hiring as we mentioned in Q1 of '18 and come back. It has been as high as 780s. And actually, it's much higher in some of the different verticals. We don't provide sales per FTE by segment. But I can tell you that there is substance of variation and room for improvement, particularly in the Emerging Verticals.

--------------------------------------------------------------------------------

Richard Charles Eastman, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [30]

--------------------------------------------------------------------------------

Okay. Because -- I guess, my thought is that if I just look at the FTE number and I assume that $710,000 orders per and then use a full year average, I'd probably get something in the neighborhood of 8% growth in orders just off of the FTE adds. And so does the balance -- the double-digit balance come then from that productivity gain?

--------------------------------------------------------------------------------

Simon Raab, FARO Technologies, Inc. - Co-Founder, Chairman, CEO & President [31]

--------------------------------------------------------------------------------

Well, if you take the $710,000 times the FTE and you increase the FTE by mid-teens, you're going to get a mid-teens growth rate.

--------------------------------------------------------------------------------

Robert E. Seidel, FARO Technologies, Inc. - CFO [32]

--------------------------------------------------------------------------------

Correct.

--------------------------------------------------------------------------------

Simon Raab, FARO Technologies, Inc. - Co-Founder, Chairman, CEO & President [33]

--------------------------------------------------------------------------------

Now, you could exceed mid-teens if you can get the $710,000 up. So any improvement in the $710,000 would be bonus on the mid-teen sales growth. It comes just from headcount, is the way I would look at it.

--------------------------------------------------------------------------------

Richard Charles Eastman, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [34]

--------------------------------------------------------------------------------

Okay. Do you feel that given some of the soft spots that you had flagged and maybe if all of -- that are visible and whether it's the PMI numbers, whether its auto, whether it's EMEA or China? Do you feel that the headcount growth will correlate -- FTE growth will correlate kind of one-for-one or is the macro challenge picked up some here? I mean, anything in the fourth quarter that you saw, the cadence of orders or anything that would suggest the macro might be a stronger headwind to your FTE kind of projections to revenue?

--------------------------------------------------------------------------------

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

--------------------------------------------------------------------------------

We know -- we've managed the risk of that eventuality by being in all the geographies and in multiple verticals. So you could have a little bit of up and down in one region or another. So we started to mitigate that substantively that geographical as well as industrial mix. A lot of the headcount additions will be in the fastest-growing verticals, like the BIM as well as the Emerging. So that mitigates that risk too because we have such low penetration in those verticals. So I would expect that still to be -- that growth still to be realized there.

--------------------------------------------------------------------------------

Robert E. Seidel, FARO Technologies, Inc. - CFO [36]

--------------------------------------------------------------------------------

I think, one thing, Rick, you probably heard this from other companies as well, certainly. We report on a GAAP basis on translating to U.S. dollar or foreign currencies. But we had a headwind of about 2% on our sales with FX in the fourth quarter. And depending what happens to different markets around the world, whether it's India, whether it's U.K., we could face some translational pressure on our top line similar to kind of what you've heard from other Fortune 500 companies over the past few weeks as well as we move into '19.

--------------------------------------------------------------------------------

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

--------------------------------------------------------------------------------

Okay. Yes, good point. And I would think most of that will be in the first half. And then just...

--------------------------------------------------------------------------------

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

--------------------------------------------------------------------------------

Rick, I'm sorry, we're trying to limit the questions (inaudible). You're welcome to drop back in on the queue, and then we'll be happy to take more of your questions. Forgive me for interrupting.

--------------------------------------------------------------------------------

Operator [39]

--------------------------------------------------------------------------------

Our next question will come from Andrew DeGasperi with Berenberg.

--------------------------------------------------------------------------------

Andrew Lodovico DeGasperi, Joh. Berenberg, Gossler & Co. KG, Research Division - Analyst [40]

--------------------------------------------------------------------------------

The first one -- I guess, my first one, you mentioned subscription revenue and you have a target of trying to grow that. I'm just curious to know. Do you have a particular target in terms of what -- exactly how much of your stock-base today is tied to subscription revenue? And what do you think is a achievable target in the medium term?

--------------------------------------------------------------------------------

Simon Raab, FARO Technologies, Inc. - Co-Founder, Chairman, CEO & President [41]

--------------------------------------------------------------------------------

That's a great question. I actually don't have the number for you on the actual component of subscription. What we did -- as you know, we were selling packages, and so we have -- you have to be careful as you transition from outright sales of software package to a subscription model because you can influence your revenues. So every new software that we introduce in, for example, in '17 and '18, has been introduced at a subscription level. And then what we are doing is, we're converting the existing sales of packages of software to a subscription level, and we're trying to do it in a systematic way so that we don't disrupt overall revenues. Remember also that, that's somewhat mitigated by the fact that we have a large installed base. So as we convert, we can go into the installed base and convert them to a subscription-based to get them up to the speed. I expect a very substantive element in the next 12 to 18 months be converted to subscription at all levels. I wish I could be more definitive about the number but it's really hard to estimate.

--------------------------------------------------------------------------------

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

--------------------------------------------------------------------------------

Just as background, Andrew, in 2018, we really had minimal subscription revenue just because the products that we started with were some of our newer, smaller volume products. So you really see kind of that shift more into '19.

--------------------------------------------------------------------------------

Andrew Lodovico DeGasperi, Joh. Berenberg, Gossler & Co. KG, Research Division - Analyst [43]

--------------------------------------------------------------------------------

Alright. Got it. And then as a follow-up, just on the GSA matter. I know it's still in the first stages and it's preliminary in terms of the amount. But it seems we're not too familiar with it. Just curious to know, does the government normally assess penalties on this? And if so, would they be proportional to the amount that was overcharged? Just if you can give us a little more color on that.

--------------------------------------------------------------------------------

Simon Raab, FARO Technologies, Inc. - Co-Founder, Chairman, CEO & President [44]

--------------------------------------------------------------------------------

Sure. The -- quite clearly, as you pointed out, it's way too early to comment. But I mean, there can be as much as treble damages depending on the issues that are related to that. We believe that we have done a good job explaining to the government and will explain further to the government how we should not be assessed with those. But I think that that's really very much a function of the way the government reviews the case. It's hard to estimate.

--------------------------------------------------------------------------------

Robert E. Seidel, FARO Technologies, Inc. - CFO [45]

--------------------------------------------------------------------------------

And yesterday after market close, we did, as Simon indicated, have an 8-K that does kind of give you some more background for investors on the potential risk. You may want to read that, Andrew.

--------------------------------------------------------------------------------

Operator [46]

--------------------------------------------------------------------------------

Our next question is a follow-up from Greg Palm with Craig-Hallum Capital.

--------------------------------------------------------------------------------

Gregory William Palm, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [47]

--------------------------------------------------------------------------------

I want to go back to the FTE comment because the growth in FTE, at least, by my math has tracked well below your actual sales headcount growth over the past year. So I guess, if you plan on growing headcount by 15% this year, what do you envision the corresponding growth rate in FTE?

--------------------------------------------------------------------------------

Simon Raab, FARO Technologies, Inc. - Co-Founder, Chairman, CEO & President [48]

--------------------------------------------------------------------------------

I'm not sure I understand the comment because the -- when you say tracked well below, I mean, we -- as we said in our prepared comments, we were approximately 13% growth in the FTE headcount, which tracked very well with the 12.8% in the new orders growth. Yes, it's true that we -- the actual headcount went up by the 16.5%. But -- so there's a correlation. And as was indicated by another caller, if you took about 0.85 of the FTE or the raw headcount, you would get an idea of the FTE headcount. We do have to deal with turnover, which is high around the world in the sales category. But we've been able to sustain, generally, a reasonable increase in the FTE headcount.

--------------------------------------------------------------------------------

Gregory William Palm, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [49]

--------------------------------------------------------------------------------

Yes, I know. I guess, my comment was -- you had said something around the lines of, if we grow FTE by mid-teens at a similar rate to the headcount that would equate to a mid-teens growth rate. But I guess, by my math, FTE didn't grow anywhere near 15% this past year, maybe I'm confused. That was my question.

--------------------------------------------------------------------------------

Robert E. Seidel, FARO Technologies, Inc. - CFO [50]

--------------------------------------------------------------------------------

So I think my comment, Greg, was if I take a look at the trailing 12 months sales FTE headcount, which kind of correlates to what goes into the calculation of our trailing 12 months orders per FTE, we were up 13% at 599 versus the 530. 599 of trailing 12 months FTE headcount in Q4 '18 versus 530 in '17. One of the things that we are certainly working on though is really on the retention side, so that we are -- as we increased that headcount, we are retaining more people and that correlation kind of, that Rick talked about, between any sales headcount and sales FTE stays at a pretty high rate. But that would be the kind of color on my comments.

--------------------------------------------------------------------------------

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

--------------------------------------------------------------------------------

Got it. Okay. Yes, I guess, I was more or less comparing it to Q1 levels. Anyways, one last one from me. Construction BIM, I know your large competitor, they've got some new products in that arena. So curious if the weaker segment sales were at all competitively driven, rather than just macro-driven, which is what I think your comment said?

--------------------------------------------------------------------------------

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

--------------------------------------------------------------------------------

One of the pieces in that business for last year, it was a very tough comp for us in Q4. We grew 47% last Q4. So certainly this -- that was a tough comp. Then also I would say is we very much focused on trying to move some of our aged, ex series equipment, which reduces our ASP, or average selling price. But certainly, like it has been they entered the market with a new product. And really what I would say how it affects us is more from the standpoint of having to go out to our customers and doing demos more. Maybe another demo to show how our product is different from theirs. But I would say, it was more macro-driven, sales mix-driven and a tough comp from prior year.

--------------------------------------------------------------------------------

Operator [53]

--------------------------------------------------------------------------------

Our next question is also a follow-up from Andrew DeGasperi with Berenberg.

--------------------------------------------------------------------------------

Andrew Lodovico DeGasperi, Joh. Berenberg, Gossler & Co. KG, Research Division - Analyst [54]

--------------------------------------------------------------------------------

Just wanted to ask a point of clarification. The operating margin, the double-digit target, that assumes the G&A expense going up for the CEO search and the GSA matter?

--------------------------------------------------------------------------------

Robert E. Seidel, FARO Technologies, Inc. - CFO [55]

--------------------------------------------------------------------------------

No. The only operating margin being double digits, we look to get there by the fourth quarter. So our fourth quarter of '19 being that double digits, mid-teens level. Really what we had based that on was holding our G&A and other expenses, such as marketing, R&D at 2018 levels. Outside of that as headwind to our G&A would be the CEO search and any GSA Council or other cost. So that was not factored in.

--------------------------------------------------------------------------------

Operator [56]

--------------------------------------------------------------------------------

And there are no further questions at this time. So I'll turn it back to the speakers for closing remarks.

--------------------------------------------------------------------------------

Simon Raab, FARO Technologies, Inc. - Co-Founder, Chairman, CEO & President [57]

--------------------------------------------------------------------------------

Thank you all for your attention today, and we look forward to an exciting 2019. Thank you, again.

--------------------------------------------------------------------------------

Operator [58]

--------------------------------------------------------------------------------

This does conclude today's program. Thank you for your participation. You may now disconnect.