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FARO Technologies (FARO) Q2 2019 Earnings Call Transcript

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FARO Technologies (NASDAQ: FARO)
Q2 2019 Earnings Call
Jul 25, 2019 , 8:15 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:


Operator

Good morning, everyone, and welcome to FARO Technologies conference call second-quarter 2018 earnings release. For opening remarks and introductions, I will now turn the call over to Chief Financial Officer Bob Seidel. Please go ahead.

Bob Seidel -- Chief Financial Officer

Thank you, and good morning, everyone. Yesterday after the market close, we released our financial results for the second-quarter 2019. The related press release and Form 10-Q for the second quarter is available in 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 quarters ended March 31, 2019 and June 30, 2019. During today's conference call, we will discuss certain financial measures that are not presented in accordance with U.S.

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generally accepted accounting principles or non-GAAP financial measures. In our press release, you will find additional disclosures regarding these non-GAAP measures, including reconciliations of these measures to comparable GAAP measures. Management believes that these non-GAAP financial measures provide investors with relevant, period-to-period comparisons of our core operations. These financial measures are not recognized terms under GAAP and should not be considered in isolation or as a substitute for a measure of financial performance prepared in accordance with GAAP.

I will now turn the call over to Michael, for his comments. And afterwards will return with a summary of our financial results. After our prepared remarks, we will open the call for your questions up to the start of market trading.

Michael Burger -- President and Chief Executive Officer

Thank you, Bob. Good morning, and welcome to our second-quarter conference call. I'd like to take this opportunity to share with you how thrilled I am to be joining the FARO team. FARO is a wonderful combination of technology, leading edge products and an entrepreneurial spirit, which is dedicated to innovation.

FARO's core competencies and robust product portfolio are the answer to many of the 3D measurement technologies challenges facing our customers today. After joining FARO on June 17, I've spent the last month conducting one-on-one discussions with our employees across three sites and two continents. I plan to complete over 125 discussions after visiting our Asia Pacific team within the next two weeks. I believe it is important to understand where the company and its employees have been and where they are now in order to better collaborate in charting a path forward for the company.

After listening with an internal focus, I believe, it's critical to hear directly from our current and prospective customers, suppliers and partners in order to gain an external perspective. My initial impressions from these discussions is that we have significant opportunities available to improve and to grow FARO going forward. I'll be collaborating with our leadership team and the board of directors to develop a comprehensive multiyear strategic plan with a clear objective of delivering long-term shareholder value. Over the last three years, the leadership team has increased our technology competitiveness, expanded our product portfolio and increased gross margin.

In the next chapter of FARO's evolution, we will build on the past successes, reevaluate selected aspects of the current business model and execute a new strategic plan to deliver sustained increase profitability and shareholder value. Now let's turn our focus to the most recent quarter. Our sales were $93.5 million for the second quarter of 2019, which included the unfavorable impact of $5.8 million from the GSA sales adjustment described in our earnings release. Our non-GAAP sales of $99.3 million was up 1% year over year, which included a nearly 3% headwind from changes in foreign exchange rates.

Our service business reported another quarter of mid-teen sales growth driven by growth of our installed base and our focused aftermarket sales initiatives. With our service revenue growth and repair delivery improvements, we've reported a service gross margin above 50% for the first time. Our 3D manufacturing segment experienced a second consecutive quarter of year-over-year decline driven primarily by a soft Asia Pacific region reflecting China and Japan customers delaying spend to future quarters. Industrial manufacturing economic indicators such as PMI, Purchased Mangers' Index, automotive production and GDP across Asia suggests challenging business conditions for our 3D manufacturing customers.

Slowing their purchases of discretionary capital goods such as FaroArm and laser tracker. Our construction BIM segment sales increased at a low single-digit percentage year over year in the second quarter. We realized robust sales growth in our EMEA region with volume gains in Central and Southern Europe. While in the first quarter, our Asia Pacific region delivered strong year-over-year sales growth, our second-quarter sales in Asia Pacific showed a marked slowdown.

Overall, our non-GAAP second-quarter sales performance was impacted primarily by changes in foreign exchange rates and more challenging economic factors as just discussed. Asia Pacific represented about 25% of total sales in the quarter with the sales regions -- with the regional sales down 2% year over year. Our industrial manufacturing customers globally are more tentative to commit discretionary capital given the general market uncertainty related to trade wars and slowing demand in selected sectors and countries. On July 15, we submitted a comprehensive report to the general services administration and its office of Inspector General as a follow-up to our preliminary internal review on February 14 regarding potential noncompliance with certain provisions of our government contracts.

Our current 8-K dated July 15, 2019, provides additional disclosure of this matter and associated future business risks. As you know, we have announced Bob departure, and before I turn the call over to Bob, I'd to thank him publicly for his contributions to FARO over the past five years.

Bob Seidel -- Chief Financial Officer

Thank you, Michael. Total sales were $93.5 million for second-quarter 2019, as compared with $98.2 million for second-quarter 2018, which included the unfavorable impacts of $5.8 million from the GSA sales adjustment and $2.5 million from changes in foreign exchange rates. Our non-GAAP total sales were $99.3 million for second-quarter 2019, up 1.1% as compared with $98.2 million for second-quarter 2018. We grew our service revenue year over year by 13.2% in second-quarter 2019 driven by the growth of our installed-base and our focused aftermarket sales initiatives.

Our product sales for second-quarter 2019 decreased year over year, primarily due to the GSA sales adjustment, the impact of changes in foreign exchange rates and a decrease in unit sales within our 3D manufacturing segment, especially in our Asia Pacific region. New order bookings were $106.1 million for second-quarter 2019, down 0.4% as compared with $106.5 million for second-quarter 2018. In our 3D manufacturing segment, sales for second-quarter 2019 were $59.0 million as compared with $64.0 million for the same prior-year period. Non-GAAP sales for our 3D manufacturing segment for second-quarter 2019 were $62.3 million, down 2.7% as compared with second quarter last year.

This decrease in non-GAAP sales was mostly driven by lower unit sales partially offset by continued growth in service revenue. In our construction BIM segment, sales for second-quarter 2019 were $24.2 million as compared with $23.6 million for second-quarter 2018. Non-GAAP sales for our construction BIM segment for second-quarter 2019 were $24.6 million, up 4.5% as compared with second quarter last year. This increase in non-GAAP sales was mostly due to an increase in service revenue and higher average selling prices of our products.

In our emerging verticals segment, sales were $10.3 million for second-quarter 2019 as compared with $10.7 million for the same prior-year period. Non-GAAP sales for our emerging verticals segment for second-quarter 2019 were $12.4 million, up 15.9% as compared with second quarter last year. This increase in non-GAAP sales mainly reflected higher unit sales across all the emerging businesses in this segment. Gross margin was 56% for second-quarter 2019, as compared with 58.7% for the same prior-year period reflecting a strong increase in service margin, which was more than offset by the impact of the GSA sales adjustment.

Non-GAAP gross margin was 58.5% for second-quarter 2019. Selling and marketing expenses were $29.1 million for second-quarter 2019, a decrease of 3.2% compared with $30.1 million for second-quarter 2018. This decrease was driven mostly by lower marketing expenses and a decrease in selling commission expense partially offset by an increase in compensation expense related to higher sales headcount. Selling and marketing expenses were 31.2% of sales for second-quarter 2019 as compared with 30.6% of sales for the same prior-year period.

General and administrative expenses for second-quarter 2019 were $14.4 million as compared with $11.3 million for second-quarter 2018. This increase was mostly due to an aggregate incremental cost of $2.2 million related to our Chief Executive Officer's succession and the advisory fees incurred for the GSA matter. General and administrative expenses were 15.4% of sales for second-quarter 2019 as compared with 11.5% of sales for the same prior-year period. Research and development expenses were $9.1 million for second-quarter 2019, a decrease of 8.9% as compared with $10.0 million for second-quarter 2018.

This decrease was mainly driven by lower materials and consulting cost, as well as favorable changes in foreign currencies. Research and development expenses were 9.7% of sales for second-quarter 2019 compared with 10.2% of sales for the same prior-year period. Our operating loss was $4.9 million for second-quarter 2019 as compared with operating income of $1.94 million second quarter of last year. Our non-GAAP operating income was $3.1 million for second-quarter 2019, representing a non-GAAP operating margin of 3.1%.

Our net loss was $6.4 million or $0.37 per share for second-quarter 2019, compared to net income of $1.2 million or $0.07 per share for second-quarter 2018. Our non-GAAP net income was $2.5 million or $0.14 per share for second-quarter 2019. We continue to maintain a strong capital structure with high liquidity and no debt. In second-quarter 2019, we generated $11.9 million in cash flow from operations with cash and short-term investments totaling $145.4 million.

A more complete presentation and discussion of our second-quarter 2019 results is available in our Form 10-Q for the quarter ended June 30, 2019. I greatly appreciate the hard work, dedication and collaboration among my finance team over the past three years as your CFO. I am proud of your accomplishments. Thank you for your attendance on today's second-quarter teleconference.

We will now open the call for questions up to the start of market trading.

Questions & Answers:


Operator

[Operator instructions] And we will go ahead and take our first question from Hendi from G. Research. Please go ahead. Your line is open.

Hendi Susanto -- G. Research -- Analyst

First of all, welcome on board, and congratulations, Michael, and all the best for your next chapter, Bob.

Bob Seidel -- Chief Financial Officer

Thank you very much, Hendi. We appreciate all of your support during my three years here as CFO. Thanks.

Michael Burger -- President and Chief Executive Officer

Thank you.

Hendi Susanto -- G. Research -- Analyst

First question is for Michael. So Michael, how should we think about the style of your leadership? And what kind of major changes that you would like to implement at FARO?

Michael Burger -- President and Chief Executive Officer

Well, actually, we're still working on what we want to do going forward. I think as I mentioned in the script, we're conducting a number of conversations internally and externally and when we get done -- when I get done with that, the objective then will be to sit down my management team and work on a strategic plan, a business model, etc. And I -- until that's complete, I'm reticent to really talk about any changes or any plans. We really haven't completed them yet.

Hendi Susanto -- G. Research -- Analyst

Got it. And then about three months ago, management share some anticipation that disruption in 3D manufacturing might continue through the third quarter of 2019. And in light of trade war that you mentioned, macroeconomic uncertainties and weaknesses in Asia. Should we anticipate the disruption to stay longer beyond Q3 2019?

Bob Seidel -- Chief Financial Officer

You know, Hendi, one of the things we saw in the course of the second quarter was slowing across Asia. If you look at it from a China perspective, which we disclosed in our 10-Q, we saw decline of 2% year over year versus 28% in the first quarter. We continue to see that trend going forward just based on GDP, based on PMI and other indicators in the market as a feedback from our customers and discretionary capital goods spend, we continue -- we would expect to continue to see headwinds in 3D manufacturing for the next two quarters at least.

Operator

[Operator instructions] And we'll go ahead and take our next question from Jim from Needham & Company. Please go ahead. Your line is open.

Jim Ricchiuti -- Needham and Company -- Analyst

Thank you. Good morning. Bob, a couple of questions for you. I'm wondering if you can -- by the way, thank you for all the disclosures in the earnings report, very helpful.

What were the product gross margins, looking like if we add back the GSA sales adjustment?

Bob Seidel -- Chief Financial Officer

So if you look at the -- we had $5.8 million in the sales adjustment for the GSA, and that was the only metric that would have affected gross profit. So if you look at how that's broken down, Jim, on a non-GAAP basis, first, I'll start with our GAAP. Product margin from a GAAP basis was 57.3%, non-GAAP was 60.2%. If you look at our service, our GAAP was 52.4, non-GAAP was 53.9.

Jim Ricchiuti -- Needham and Company -- Analyst

Perfect. Thank you. I was also surprised to see that this GSA issue hit the emerging vertical as much as it did. What were the products or potential applications that were impacted there?

Bob Seidel -- Chief Financial Officer

So one of the businesses that we have talked about over the past several years is really seeing emerging business for us is our public safety forensics business, and that truly is selling to law enforcement and much of the sales that you would see to the law enforcement in the U.S. portion of that business is through the GSA. So one of these segments that is more impacted than others is the emerging verticals because of the public safety forensics.

Operator

[Operator instructions] We'll take our next question from Greg from Craig-Hallum Capital. Please go ahead. Your line is open.

Greg Palm -- Craig-Hallum Capital Group LLC -- Analyst

Yes, thanks. Michael, welcome aboard, and Bob, enjoyed working with you over the years, so best of luck going forward.

Michael Burger -- President and Chief Executive Officer

Thank you very much. I appreciate all the support.

Greg Palm -- Craig-Hallum Capital Group LLC -- Analyst

So I guess just following up on the GSA, should we assume that those sort of potential reductions are done? Or is there a potential for more here in the second half of the year?

Bob Seidel -- Chief Financial Officer

So in terms of the GSA, we submitted our comprehensive report with assistance from our outside legal counsel and forensics experts and the 8-K we released on July 15. At this point in time, we've accrued the total liability of $11.6 million, as our best estimate based in alignment with that report. Now we will go through a process with the assistance of our advisors, the government will review that. And really at this point, it's up to the government going through that process with our advisors.

So at this time, $11.6 million is our best understanding of a liability. The 8-K does describe though more details and it does describe other risk to the company that may occur.

Greg Palm -- Craig-Hallum Capital Group LLC -- Analyst

Got it. Fair enough. And then just following up on an earlier question, this one's for Michael. I'm not looking for any specific details around sort of what the strategic plan might look like, but just in general, curious, what are you most excited about when you look at the potential opportunities for FARO over the coming years?

Michael Burger -- President and Chief Executive Officer

Well, I think it's actually increasing shareholder value. I think 60% gross margins, high 50% gross margins is enviable in any business, and I think FARO has demonstrated that. So for me, the baseline is that we've got a company with deep technology, we've got a really interesting and I think defendable market position. The real objective then is how do we actually get a higher return for our shareholders through that without actually throwing the baby out with the bath water.

So I'm very excited that the baseline that we've got as a business is doing very well, and now the objective is how do we shore up the bottom line. That answer your question?

Operator

And we'll take our next question from Andrew from Berenberg. Please go ahead. Your line is open.

Andrew DeGasperi -- Berenberg -- Analyst

Thanks. Welcome, Michael, and good luck to you, Bob.

Michael Burger -- President and Chief Executive Officer

Thank you, and thanks for the flash report last night. Appreciate it.

Bob Seidel -- Chief Financial Officer

Thanks, Andrew.

Andrew DeGasperi -- Berenberg -- Analyst

Thanks. So I guess I know we're trying to get in your head, Michael, on future strategy. But I guess what I was -- I think people want to know is first like timing, do you think you'd be able to share with us something in terms of where you see -- what are you thinking in the next earnings call or by that timeframe? And then maybe secondly, I know that FARO has a, relative to its peers, has a decent software platform, but some people feel hasn't been monetized well enough. How do you see software? And maybe can you discuss also, I mean new markets you might find interesting given your background?

Michael Burger -- President and Chief Executive Officer

OK. Well, let me kind of jump around on your questions. I think I'm very excited by software. I think FARO has a large portfolio of software that it's developed or acquired over the last decade and I'm very excited about that and anxious to understand how we as a company can better monetize that.

I don't have the answer yet, but I'm excited by the prospect. As it relates to timing of the plan, I'm reticent to commit, but I will obviously on each earnings call update you on where we're at. But FARO is a complex company and it is in a very complex technology market. So I think we need to be very thoughtful versus quick.

And my board is very supportive and very interested in kind of understanding what the next three years looks like. So the scope of the plan will be three years out and my leadership team and I have already begun, so I'm excited.

Andrew DeGasperi -- Berenberg -- Analyst

Great. And I guess when we look at, maybe, Bob, you can answer this, the second half, I know you mentioned 3D manufacturing the weakness around that. What are you seeing in the construction BIM side? I know that ex GSA, you were probably mid-single digits in the quarter. Is there something -- besides Asia in terms of your organic growth, do you think that's still double-digit growth story at this point? Or do you think the macro is weighing on that segment as well?

Bob Seidel -- Chief Financial Officer

So if I look to the quarter, first of all, let's set the table. We were on a non-GAAP basis, we were up about 4.5%. What Michael commented on is, we did see a slowing versus Q4 and Q1 in Asia in that business, which kind of mitigated the growth that we saw in the prior quarter. As I would look forward, though, Europe for us has been traditionally a strong region and it continued to be so in Q2.

So I would expect to see it going forward in the remaining half of the year. The piece that certainly I can't forecast is the continuing trade wars that may have interrupted our business in Asia. But fundamentally, we have a leading product in the market. We have leading software delivery.

We have been actively growing the sales team to address those markets and adopted technology. So I'm confident as we go forward. If the capital environment is favorable for us in the second half of the year on the BIM space we'll continue to see that. My concern is more on the 3D manufacturing side, as Michael indicated, the industrial manufacturing customer stuff.

Operator

And we'll go ahead and take a follow-up from Hendi from G. Research. Please go ahead. Your line is open.

Hendi Susanto -- G. Research -- Analyst

Good morning again. Is FARO still maintaining its target of mid-teen operating margin goal by Q4 2019?

Bob Seidel -- Chief Financial Officer

So as we look at, Hendi, the kind of current business conditions and some of the things that Michael highlighted and I highlighted now in the Q&A, as we look forward in more of the midterm, we will see continued headwinds in that 3D manufacturing business based on just how we see our customers embracing the discretionary capital spend. At this point, we would not see that as a high likelihood for a fourth-quarter double-digit operating margin at this time.

Hendi Susanto -- G. Research -- Analyst

Got it. And then, Bob, excluding GSA matters, would you be able to share product and service revenue?

Bob Seidel -- Chief Financial Officer

Yes. Product and service revenue in terms of the $5.8 million, $5 million was related to product, $800,000 was related to service. So if you look at it, first of all, from a GAAP basis, the GAAP service -- product number was 67,992; the non-GAAP or adjusting out the $5 million for the GSA was 73,039; and then the service, 25,499 GAAP, non-GAAP 26,257. So if you look at the earnings release, what I encourage all of you to do, go to the reconciliation tables, also we'll provide you a very good understanding of that GAAP to non-GAAP for you, by total sales, gross profit, gross margin, operating income, net income, EPS and also sales by vertical.

Operator

And we'll take our next question from Ben from Battle Road Research. Please go ahead. Your line is open.

Ben Rose -- Battle Road Equity Research -- Analyst

Yes, good morning, Michael and Bob. I want to say welcome aboard to Michael as well. And thanks to Bob over many years for insights into the business. We wish you the best going forward.

Michael Burger -- President and Chief Executive Officer

Thank you very much and also appreciate the continued Red Sox updates.

Ben Rose -- Battle Road Equity Research -- Analyst

Well, I hope they're favorable. I don't know how favorable they're going to be, but we'll find out this weekend anyway. Michael, I just wanted to get your thoughts just in terms of looking at the 3D manufacturing area, currently in something of a state of malaise. Is there a scenario that you see over say the next 12 or 18 months, where things could begin to turn around? Or put differently, are there any specific verticals within manufacturing that look more promising kind of near-term than some of the others?

Michael Burger -- President and Chief Executive Officer

Ben, I don't really have enough insight. I think one scenario is that the aerospace and automotive business could recover, which I think we have a relatively strong position in. And if that was the -- a curve, certainly, we would benefit from that. We are looking at a number of sub-verticals within the 3D manufacturing space.

Right now, we kind of treat these sub-verticals as kind of disparate parts, and I think we have an opportunity perhaps focus more on some of these sub-verticals. And we're -- part of the strategic land will focus on identifying in priority what those are and what we're going to be specifically do about it, but I think it's early days for me.

Ben Rose -- Battle Road Equity Research -- Analyst

OK. And then maybe just one follow-up question. Obviously, there's been a significant proliferation of new products over the last 12 or 18 months. And I'm just curious without sort of commenting specifically on the product areas, is an important part of the product -- excuse me, an important part of the strategic plan to take a look at these -- take a closer look at these products and sort of see which ones make since moving forward versus perhaps deemphasizing others?

Michael Burger -- President and Chief Executive Officer

Absolutely. I think at a 50,000-foot level, I look at FARO as really an engineering driven hardware company and has been very, very successful in that regard. And I think part of the opportunity is to really kind of reposition the company around more of a solution space. And I think some of those products may fit in that, some of them may not, but part of the process will be looking at the entire product portfolio and roadmap all in conjunction of -- all in the context of which markets we want to drive and then make some decisions about killing or not and that will definitely be part of the strategic plan.

Operator

[Operator instructions] And we'll go ahead and take a follow-up from Jim from Needham & Company. Please go ahead. Your line is open.

Jim Ricchiuti -- Needham and Company -- Analyst

Hey, before I get cut off, Bob, I want to thank you for all the help you've provided investors in the sell side in understanding the business, and I want to wish you the best. Michael, question for you, and again, you're in attack a little over a month, so none of these -- none of these questions are fair. But I'm just wondering if you can share any observations that you have regarding FARO's business. Maybe relative to your prior experience in the semi cap and in the component capital equipment markets.

Any kind of similarities or differences in the way you're looking at the business.

Michael Burger -- President and Chief Executive Officer

I think the -- Jim, thanks. It's a good -- great question. I think one of the things that has surprised me is FARO is definitely in the capital equipment business and so that's probably where the similarities end. I think this company with 15,000 customers or 14,000 customers whatever the published number is, is a lot different than other businesses that I have been involved in in the capital business.

So in some cases -- in some instances, it's more like a B-to-consumer type of company. And so we've got a really kind of understand what the go-to-market strategy is. And keeping with the capital side of this business, which is -- these are not cheap devices. They do require a capital [Inaudible] within the customer base.

So the cycles are still -- I think that the purchase cycles are similar to what I'm used to. But the way we actually reach customers and the way we find opportunities is much different than I'm used to. And that's part of what I think the team and I need to really rationalize is what is the go-to-market strategy? It looks more like a consumer electronics company then a capital equipment company. And we've got some deep digging to do in that regard.

But -- so I think that's the big difference from a product definition, product design, the complexity, the service requirements, the inventory requirements, the manufacturing requirements are very similar than to what I'm used to. It's really the go-to-market strategy that seems new for me, and I've got some work to do.

Jim Ricchiuti -- Needham and Company -- Analyst

How would you characterize the competitive environment versus your prior experience?

Michael Burger -- President and Chief Executive Officer

Yes. I think it's -- we've got some really big companies that we are competing with and I like that. I think the -- and it's similar to what I'm used to. I think the objective is really to continue to out innovate.

It's all about understanding what our customer's cost of ownership model is and continue to out innovate and out position, which FARO I think has done an admirable job in its history. So I don't want to lose that and in fact, if anything I want to accelerate that. I think, but we need to do it, I think in a very focused manner and we need to do it in the context of markets that we believe are going to give us long-term sustainable revenue growth. And from that, via business model we need to be able to drive the bottom line in a more consistent and an arguably more competitive way.

But from a revenue perspective and a gross margin prospective, the company's done I think an admirable job. Well, it looks like we're out of questions. I really appreciate everyone's interest in FARO. I'm anxious to give you updates as we go forward.

Again, I want to thank Bob for all he has done for the company over the last five years. He's been the steady rock through the process and really appreciate that. I look forward to talking to you in Q3. I appreciate your interest.

Thank you.

Bob Seidel -- Chief Financial Officer

Thank you.

Operator

[Operator signoff]

Duration: 40 minutes

Call participants:

Bob Seidel -- Chief Financial Officer

Michael Burger -- President and Chief Executive Officer

Hendi Susanto -- G. Research -- Analyst

Jim Ricchiuti -- Needham and Company -- Analyst

Greg Palm -- Craig-Hallum Capital Group LLC -- Analyst

Andrew DeGasperi -- Berenberg -- Analyst

Ben Rose -- Battle Road Equity Research -- Analyst

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