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FARO Technologies, Inc. (NASDAQ:FARO)

Q3 2008 Earnings Call Transcript

October 30, 2008, 11:00 am ET

Executives

Vic Allgeier – IR, TTC Group

Keith Bair – SVP & CFO

Jay Freeland – President & CEO

Analysts

Mark Jordan – Noble Financial Group

Jim Ricchiuti – Needham & Company

Jeff Bash [ph]

Rick D'Auteuil – Columbia Management

Michael McCormick – Gilder Gagnon Howe & Co.

Rob Mason – Robert W. Baird

Operator

Good morning everyone, and welcome to the FARO Technologies Conference Call in conjunction with its third quarter 2008 earnings release. For opening remarks and introductions, I would like to now turn the call over to Mr. Vic Allgeier. Go ahead, sir.

Vic Allgeier

Thank you, and good morning, everyone. My name is Vic Allgeier of the TTC Group, FARO's Investor Relations firm. Yesterday after the market closed, FARO released its third quarter results. By now you should have received a copy of the press release. If you have not received the release, please call Darin Sahler at 407-333-9911.

Press release is also available on FARO's Web site at www.faro.com. Representing the company today are Jay Freeland, President and Chief Executive Officer, and Keith Bair, Senior Vice President and Chief Financial Officer. Keith and Jay will deliver prepared remarks first and will then be available for questions.

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 “we expect,” “we believe,” “we predict,” “we target,” “our growth targets,” “our goals,” “our guidance” 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 the risk factors set forth in yesterday's press release and in the Company's filings with the SEC. I'll now turn the call over to Keith.

Keith Bair

Thank you, Vic, and good morning, everyone. Sales in the third quarter of 2008 were $49.1 million, a 10.3% increase from $44.5 million in the third quarter of 2007. On a regional basis, third quarter sales in 2008 in the Americas decreased $700,000 or 3.7% to $18.4 million compared to $19.1 million in the third quarter of 2007.

Sales grew 27.2% in Europe to $21.5 million from $16.9 million in the third quarter of 2007. Sales in the Asia-Pacific region increased 8.2% to $9.2 million from $8.5 million in 2007. The effect of changes in foreign exchange rates on sales was an increase of approximately $2.2 million in the third quarter of 2008. New orders grew 12.3% in the third quarter of 2008 to approximately $49.2 million compared to approximately $43.8 million in the third quarter 2007.

On a regional basis, third quarter orders in 2008 in the Americas declined 12.9% to $17.6 million compared to $20.2 million in the third quarter of 2007. Orders increased 35.4% in Europe to $21.8 million from $16.1 million in the third quarter of 2007. Orders in the Asia-Pacific region increased 30.7% to $9.8 million compared to $7.5 million in the year-ago quarter.

The top five customers by sales volume in the third quarter of 2008 was the U.S. Military, BMW, MetroTech LLC, JFE Shoji Trade Corporation and Global Aeronautica and represented only 5.9% of sales. The top ten customers in the third quarter of 2008 represented only 8.8% of our sales, once again, indicating our lack of dependence on any one or a handful of customers.

Our gross margin was 59.1% in the third quarter of 2008, compared to 59.4% in the year-ago quarter. The decrease was primarily due to an increase in service costs as a percentage of sales compared to the prior year quarter. Selling expenses were 31.3% of sales in the third quarter of 2008 compared to 30.6% in the year-ago quarter, primarily due to an increase in sales and marketing personnel.

Administrative expenses in the third quarter of 2008 decreased to 13.5% of sales compared to 17.9% in the third quarter of 2007, primarily due to a reduction of $2.65 million in expenses for estimated fines and penalties related to the settlement of the FCPA matter, offset by an increase in compensation costs and expenses related to additional lease space.

Research and development expenses were $3.2 million for the third quarter of 2008 or 6.6% of sales compared to $2.9 million or 6.5% of sales in the third quarter of 2007. The increase is primarily related to compensation expense and reflects the Company's continued investment in new growth platforms.

Operating margin for the third quarter 2008 increased to 5.3% from 2.2% in the third quarter of 2007 as a result of the factors just discussed.

Income tax expense was $500,000 for the third quarter 2008 compared to $1.6 million in the third quarter of 2007. As a result of a decrease of $2.65 million in expenses that are non-deductible for U.S income tax purposes, the Company's effective tax rate for the third quarter 2008 decreased to 19.9% compared to 69.5% for the third quarter 2007. The Company's effective income tax rate, excluding this effect would have been 19.9% for the three months ended September 29, 2007. The Company estimates effective tax rate will approximate 18% to 22% for the remainder of 2008; however, the Company's tax rate could be impacted positively or negatively by geographic changes in the manufacturing or sales of its products and the resulting effect on taxable income in each jurisdiction.

Net income was $2 million or $0.12 per share in the third quarter of 2008 compared to $700,000 or $0.04 per share in the third quarter 2007 marking our 25th consecutive profitable quarter. The number of fully diluted shares outstanding in the third quarter 2008 was 16.7 million, compared to 16 million in the third quarter of 2007. The increase of approximately 700,000 shares is primarily related to the sale of 1.65 million shares of common stock in the Company's registered direct offering in August 2007, and the exercise of stock options by employees throughout 2007.

I will now briefly discuss a few balance sheet and cash flow items. Cash and short-term investments were $102.5 million at September 27, 2008 compared to $103.2 million at December 31, 2007. Accounts receivable was $45.4 million at September 27, 2008, compared to $54.8 million at December 31, 2007. Days sales outstanding was 84 days at September 27, 2008 and December 31, 2007. Inventories increased to $49.9 million at September 27, 2008 from $40 million at December 31, 2007.

The increase in inventories was primarily related to an increase in raw materials and finished goods as well as an increase in demo inventories related both to the increase in the account managers and the additional new products carried by many of them.

Finally, I will conclude with some statistics regarding our headcount numbers. We had 909 employees at September 27, 2008 compared to 780 at December 31, 2007, an increase of 129 employees or 16.5%. Account Manager headcount increased from 149 at December 31, 2007 to 173 at September 27, 2008 with 61 Account Managers in the Americas, 55 Account Managers in Europe and 57 Account Managers in Asia. Geographically, we now have 422 employees in the Americas, 289 employees in Europe and 198 employees in the Asia-Pacific region.

I will now hand the call over to Jay.

Jay Freeland

Thanks, Keith. To say that we are in the midst of the most difficult economic environment this Company has ever faced would be an understatement. I have been asked by our investors and analysts many times in the past, what would it take for FARO to experience a serious slowdown from your normal 20 plus percent growth rate? My answer has always been a serious economic decline in all three regions simultaneously. No doubt the world is there. Relative to those specific economic conditions, I'm pleased that we are able to maintain double-digit growth in both orders and sales during the third quarter. That being said, let's talk about some of the highlights, because I do think there are several.

Despite a slight increase in sales to existing customers during the quarter, we continue to maintain our annual goal of generating approximately 50% of our sales from new customers and 50% from existing. Even with the economic uncertainty most companies are facing, we've been able to drive adoption of our technology at new accounts by demonstrating the clear return on investment of our solutions.

As I frequently said, the new customer adoption rate is extremely important for us as an indication of our technology becoming the global standard for three dimensional imaging and measurement. Our ability to maintain the 50-50 ratio also remains a reliable indicator of how under penetrated our space really is. During the third quarter, we updated our penetration rates against all SAC codes and viable customers within each code. The data continues to indicate that we are less than 5% penetrated across the board.

Our top ten customers continue to contribute less than 10% of our total sales during the third quarter. Year-to-date we are at about 5%. Again, this is important particularly in this environment as it shows that we don't have to rely on one big customer to generate our sales and keep the business moving.

It's not uncommon during slower growth periods for companies to rely significantly on their best customers to help them weather the storm. Again, the compelling value proposition FARO provide allows us to keep this in check.

As you've seen by now we've lowered our sales guidance for the full year. This is 100% attributable to the economic environment, specifically; it's attributable to the economic uncertainty. The front end of our sales pipeline continues to grow at the rates we've acquired historically to maintain our traditional 20% to 25% sales growth. The number of demos we are performing has also grown at the same rate. The backend however is where the uncertainty lies.

Our close rate has slowed significantly. We tested this at the end of the quarter by conducting an independent survey by a third party. They went to potential customers who had received the FARO demo, but did not choose FARO. Of all the customers surveyed, less than 5% had chosen to buy a competitive product. The other 95% had not committed yet. Some wanted to conserve cash, some had pushed budgets by a quarter or two and some just hadn't decided yet.

However, all of them indicated that they still had a need for the product and almost all confirmed that FARO was their preferred vendor. We will continue to do everything we can to close those deals, but we do expect a continuation of this stretched decision-making process for the foreseeable future.

However, because of the strength in demand and our firm belief that our close rates will eventually return to those normalized levels, we also see this as an opportunity to continue spreading our reach. As we've talked about during these calls before, FARO is heavily dependent on a direct sales model due to the highly missionary sales environment required to drive penetration.

It also takes 12 months to 15 months for our Account Managers to be fully productive. So downturn in the economy is not going to keep us from continuing to expand our presence, particularly when there are literally tens of thousands of accounts around the world, which we still have not yet touched. Positioning is always critical to any company success and FARO will continue to position itself to drive our return to the 20% to 25% historical growth levels as economic conditions around the world improve.

We continue to introduce new products to the marketplace. During the third quarter, we released the full suite of online for new Quantum FaroArm product line and also released the new generation of our proprietary software, CAM2 Q. The release of CAM2 Q was extremely important as it marks the first time in about 8 years that we've released a brand new software package that was completely redesigned and every line of code rewritten. CAM2 Q provides significant enhancements to our user interface and CAD capabilities. It is also highly modular in its structure, which enables simple integration of future application releases.

We have been increasing our spending on R&D throughout the year, and expect to continue doing so going forward as we have a significant number of new products in the pipeline that will further enhance our customers experiences as well as enhancing our ability to democratize three dimensional imaging and measurement around the world.

Despite being down slightly from the second quarter, gross margin continues to be strong. Pricing is stable and product cost is as well. Our gross margin percentage dipped slightly, mostly due to service expenses being applied against slower than the expected sales volume. That drove a 59% gross margin for the quarter, but kept us at almost 61% year-to-date. As such, we continue to maintain our annual gross margin guidance of 58% to 60%.

Finally, the balance sheet is extremely strong. With no debt and over $100 million in cash, we are well-positioned. The cash on hand will be used to fuel the growth of this Company and may fund any combination of things, additional Account Managers, new R&D or acquisitions, name a few. We expect to continue generating cash and our strategy has not changed. The cash is for growth and that remains the best application for its deployment.

This is a world-class team with world-class products. We have a huge under penetrated market to serve. We have the best brand in the space and remain financially healthy. As always, I would like to thank the FARO team for their continued excellence, spirit and determination no matter what, and, of course, I thank our investors for their ongoing support of the Company. I appreciate your attention. I'll now open the call to questions.

Question-and-Answer Session

Operator

(Operator instructions). We will take our first question from Mark Jordan with Noble Financial. Go ahead, Sir.

Mark Jordan - Noble Financial Group

Good morning, Jay

Jay Freeland

Morning.

Mark Jordan - Noble Financial Group

Could you talk about, obviously, as we go through this period here, you're continuing to make rational investments on the sales side. Do you have an opportunity to control cost in the G&A or R&D arena that might be able to improve things a little bit in the next couple of quarters?

Jay Freeland

Yes, certainly, I think in the G&A line, obviously, we could in the R&D line as well, certainly adding new heads there in many respects is discretionary in a lot of different ways. We also though as I talked about, we've got several things in the pipeline on the R&D side, so will we control it, yes, but it's not that we're going to stop hiring on the R&D side as well because it obviously provides a decent chunk of the growth for us and we have some exciting things that we're working on. But certainly those two are areas that we can control, like I said G&A for sure, is an area that we will continue to focus on controlling here over the next couple of quarters.

Mark Jordan - Noble Financial Group

Okay. Keith, could you address what, in the last two quarters especially here in this one, you had a very significant other expense, could you give us clarity on what that was this quarter, last quarter and any light on where that line might go moving forward?

Keith Bair

Sure. What's happening on that line, you're seeing foreign exchange losses for our Q2 and Q3 of '08 and then in the prior year periods you've seen foreign exchange gains. Those basically arise from foreign exchange transactions with our subsidiaries where transactions are denominated in currencies other than their functional currency. So to the extent that there is foreign exchange exposure and the dollar is getting stronger, we will continue to record losses whereas last year as the dollar was getting weaker we recorded gains. So to the extent that the dollar continues to strengthen you will probably see that line remain at a loss.

Mark Jordan - Noble Financial Group

Okay. Is that primarily against therefore a market basket be strengthening of the dollar versus the euro the primary --

Keith Bair

Right.

Mark Jordan - Noble Financial Group

-- thing to focus on?

Keith Bair

That's correct.

Mark Jordan - Noble Financial Group

Okay. Could we -- Jay, could you talk a little bit about this delay you've seen in the decision-making cycle and is this really a function of sort of a freeze in that sort of a period of kind of panic towards the end of the quarter or is this something it was more uniform throughout, I guess, number one. And then, number two, there is a clear difference in terms of order both of order flow in Europe and Asia versus the U.S. Do you -- could you give color as to what you see in terms of the international segment you see that weakening or being maintained roughly where it is?

Jay Freeland

Yes. I can't say it's necessarily an acceleration of sitting on hands so to speak as you get to the end of the quarter. It's pretty consistent through the quarter itself. The Americas, no question, and we've talked about this on the previous calls, the Americas has been seeing it since Q1, for sure. Europe started seeing it during the third quarter as the economy started moving in the wrong direction over there as did Asia, though certainly they're not feeling it at a quite same rate that we're seeing in the United States. So it's -- but it's fairly equal across the course of the quarter.

And what we're seeing is it's still it's a variety of things, no question we've seen, particularly some of the bigger companies you just see some budgets being either cancelled or moved and moved is often the case. And in the smaller ones they're still -- panic is not a bad word, but I can't say there is panic, like I said at the end of the quarter, it's more just this panic over, my gosh look at all the things that are happening around the world we just -- we're going to conserve cash for a while and just kind of sit and watch and wait this thing out. So it's more of that than anything else.

Mark Jordan - Noble Financial Group

Okay. Final question, relative to the U.S. as you had pointed out, you've seen this length in the decision cycle domestically now here for a couple of quarters. Could you -- what has been the salesmen's feedback and how are they monitoring these folks that in theory are on hold? Are they -- are you going back and touching base with these folks again and has there been any sense of how long these people are going to hold off on their decision-making process?

Jay Freeland

Yes, certainly, they go back on a pretty regular basis. The Account Managers – it's one of the things that we get a lot of credit for from our customers once they are a part of the FARO family too is that we do over serve both from the sales side and on the back-end once they have the product on a pretty regular basis. So, on the front-end right now, no question the Account Managers are in touch regularly, and I can't say is it every single day, well, certainly not. But, are they touching base with them once a week, once every other week, no question.

What we're seeing is that in some cases, sometimes the larger companies, they may not know when the budget is coming back. That's in many respects just a function of large company and bureaucracy where the person may not just behind of up the food chain to have a good feel for when that budget will return. The smaller companies which obviously is still a large piece of who we sell to. Some cases you maybe selling directly to the owner or to the Number two person in this small, little company. They've got a great feel for one who is coming back and what they'll say is, maybe next quarter, maybe the one after that, they clearly are tying it to -- looking for some rebound or return in the overall economy and a lot of that for them is just based on what they can read and see in the press and a little bit of what they feel with their own customers.

Mark Jordan - Noble Financial Group

And you said that the salesmen are still maintaining that same demo rate, which is what -- 15 plus a month is that correct?

Jay Freeland

Yes, it depends on the products. 12 to 15 is kind of the typical average. A gauge person does more, a tracker person will do less and that's more a function of the demo itself being a little more complex on the tracker side than it is on the gauge side typically.

Mark Jordan - Noble Financial Group

I guess a final question, relative to your sales force. Are they earning sufficient funds to have a decent income at this point in time or are you having to kind of subsidize the income to keep these folks on board?

Jay Freeland

Yes, I would say most are earning a decent income. Obviously, there are many who are earning less income given the variable nature of the plan. Those environments where we provided subsidy before such as new Account Managers coming on or say the laser scanner product line or newer product line as they are still developing the market. We haven't really had to make any change there over the course of this period either. That's been pretty consistent.

Mark Jordan - Noble Financial Group

Okay. Thank you.

Jay Freeland

Thanks Mark.

Keith Bair

Thanks Mark.

Operator

(Operator instructions). We'll take our next question from Jim Ricchiuti with Needham & Company. Go ahead, sir.

Jim Ricchiuti - Needham & Company

Thank you. Good morning.

Jay Freeland

Hi, Jim.

Keith Bair

Good morning, Jim.

Jim Ricchiuti - Needham & Company

Just a question on the order patterns, it looks like you saw the biggest sequential decline in orders in Europe, is that correct?

Keith Bair

Yes, that's correct. Europe, when you look at the actual order flow this quarter, you have to keep in mind that one of the big items from Q3 '07 was Asia and when you look at Asia's increase this year at over 30%, you have to remember in the third quarter '07, Asia actually had a decline. So this is somewhat of a make up for that as well.

Jay Freeland

Jim, are you asking sequentially from Q2 to Q3 with the bigger decline coming out of Europe versus the other regions?

Jim Ricchiuti - Needham & Company

Right. And I know there is some seasonality at work there, and I guess what I'm wondering is, has the pattern normally would be business starts to come back in Q3 in Europe from an order standpoint I guess in the September month and I guess what I'm trying to get some sense is to how weak was that in the month of September?

Keith Bair

33 to 35.

Jay Freeland

Yes. So, Jim, I am sorry. Is it -- you are talking about on raw dollar basis Q2 to Q3 for Europe?

Jim Ricchiuti - Needham & Company

Yes.

Jay Freeland

I don't think that the decline was huge. I think certainly no question Europe has a little bit of -- again the August effect although admittedly that tends to be worldwide now. You certainly see more of it in Europe still. Obviously, a little bit of the dollar going in an opposite direction at this point also in the third quarter versus what we would have had in the second quarter. So their comp if you are looking at sequentially and year-over-year both of that (inaudible) as well.

Jim Ricchiuti - Needham & Company

What customer segments, market segments are you seeing the more pronounced weakness and conversely where has business seem to be holding up better?

Jay Freeland

Well, I can't say there is any one necessarily that is significantly down or one that's significantly up either. They are all kind of middle of the road. What I will say and it wouldn't be a surprise is that in the third quarter, aerospace would be a little bit lighter, we always have couple of orders from Boeing that you would have in any given quarter and no question will strike, put things on ice for a little bit during the third quarter. But again we don't really rely on any one customer substantially either, so I can't say that would have swung us any more than 0.5% may be in either direction if they were buying. So when you look at it though, when you look at the customers we had in the quarter, it's pretty steady across the board. I can't say that any one of them is really dipped or spiked in either direction.

Jim Ricchiuti - Needham & Company

And, Jay, with respect to the product portfolio, is it safe to assume that the more customers are taking a wait and see on the higher end products? Is it easier to move on at this point?

Jay Freeland

Yes, that's a fair point. Certainly, the decision process is longer on the higher end projects. You're right. It's -- and this is typically been the case anyways, but gauge decision process is pretty quick, it's a very low price product, tracker decision-making process has always been longer because it's a higher priced. And I think that gets compounded in this environment right now.

Jim Ricchiuti - Needham & Company

Okay. And just a final question. Don't know if you could help us with this at all, but if we think of your revenues given the macro issues you're seeing, but if you think of your revenues kind of in a $50 million to $52 million quarterly run rate, is there any -- is it -- is your selling expense -- could you see that in somewhere the $15.5 million to $16 million range? I'm just trying to get a sense as to -- I know you are adding headcount, but I'm just trying to get a feel for where you might see selling expense if we were to see revenues kind of in this range on a quarterly basis for the next couple of quarters?

Jay Freeland

Yes, given that we don't guide below the gross margin line, I'm probably not going to shed a whole lot of light on that other than -- obviously, there is a pretty significant variable nature to the selling expense and so when sales go up you get a little bit more leverage out of it. You're not going to get four points or five points of leverage out of it in either direction unless you need really have the sales fall off the map I guess to have it go in the negative direction, but in a positive direction, you're not going to get 4 points, 5 points out of it in a single quarter, let's say. I know that doesn't help you.

Jim Ricchiuti - Needham & Company

Yes. Your headcount looks like from June grew about 5%, overall headcount, and is that the kind of -- are we going to see that kind of a low-to-mid single digit headcount growth do you think?

Jay Freeland

I won't comment relative to the whole -- relative to the whole company. What I will say is that, yes, we still anticipate on the sales side hiring at kind of a normalized rate that Account Managers for the year up about 16%, I think give or take. And that 16%, 17%, 18% range is fairly typical for us. So you wouldn't be surprised to see that again probably in the fourth quarter. For the rest of the company, I won't comment on. Should it be -- is it going be sizably lower? Obviously, 16% to 17% across the whole company. No questions, because the bulk of the adds go into the sales and marketing line obviously.

Jim Ricchiuti - Needham & Company

Okay. Thanks a lot.

Jay Freeland

Thanks, Jim.

Operator

And we will now take our next question from Jeff Bash [ph], a private investor. Go ahead, sir.

Jeff Bash

Good morning.

Jay Freeland

Good morning, Jeff.

Jeff Bash

You said earlier that this was the worst downturn in memory. In my memory, I go back to the 2001, 2002 time frame when a lot of machine tool and related companies went out of business or had to find partners to stay in business. Do you think this is approaching that condition or not?

Jay Freeland

Yes, I think we're not seeing the same rates, say machine tool vendors or companies going out of business. But when you look at it in 2001, 2002 and some of this also was because the company was sizably more aligned on the U.S. market at that time also. So, bear both of this in mind but when you look at it, the impact across the entire world, it certainly is the most difficult that we are facing. So really it's all three regions now are seeing the same, sitting on the hands, concern over the environment, their customers scaling back their projections on whether it's the auto industry and their production rates or the supply chain that feeds them or any of the other manufacturers that are out there. So from that regard, it's the most difficult we have seen, because it truly is global in nature.

Jeff Bash

Okay. In terms of expense control are you -- and combined with the tough environment are you less tolerant or more tolerant of weak performance out of your new sales hires?

Jay Freeland

I think the tolerance level is still the same, because again if the history hadn't been so consistent that it really does take that 12 months to 15 months to ramp up. You got to give the new folks obviously some time to get there and we do -- we watch obviously their run rates every month and every quarter because the pattern is fairly similar. But we want to make sure that we are giving everybody the same fair shake that we normally do, because it does -- sometimes it takes 9 months to 12 months to prove somebody out and then you find out that they just started a little slower than somebody else and they end up being a far better performer.

Jeff Bash

Will you however be more careful in hiring new sales folks to be sure that they really are prime candidates than you might have been in great times?

Jay Freeland

I would say that we are always very, very selective coming in the front door. Obviously, you never get a perfect -- but I believe it's not just on the sales line, I think that the model we have -- the FARO fit model that looks for core, say, fundamental competencies that are pretty equivalent across the board for any employee, and then you've got individual functional traits that are very well defined that we are looking for in each different role. I think we've got a pretty good curtain on that and we use the same thing regardless of good times versus bad, and in fact, one of the things I frequently talk about with the team is that as we've been in the higher growth mode, the previous quarters, it's even more important to be strict during that time period because you would have the possibility of just hiring to get folks in and the team is I think pretty strict about making sure that the last person in the door is as good as the first one, let me say that way.

Jeff Bash

On forex effects, are they reflected in your sales estimate for the balance of the year to the best you can? In other words, I guess the current level of a dollar?

Jay Freeland

Yes, as best we can, without obviously being forex experts, but we are trying to factor in as much variations we can.

Jeff Bash

On the backlog, you built the backlog at least orders were larger than sales by $6 million in the December quarter, $1 million in the March quarter and $1 million in the June quarter and even in the September quarter. Ordinarily, you'd think that would give you an $8 million backlog bill that you could help support sales going forward. On the other hand may be you're experiencing order cancellations and this is a mirage. So could you comment on that please?

Jay Freeland

Yes. Certainly, we're not seeing any order cancellations. What you see there is you've got funding for say the first three weeks to four weeks worth of sales going into any given quarter. And then at the tail end of the quarter, you always have even still in this environment. You've got the orders that are placed on the very last day of the quarter and just can't be fulfilled where the last couple of days of the quarter that just can't possibly be filled or the customer is not ready for the product yet either. And so, I think what you just see is a rolling number there. But we've not seen any order cancellations through this period.

Jeff Bash

So to paraphrase your current backlog is perhaps $8 million bigger than it was at the end of the September quarter last year?

Keith Bair

Yes, we typically wouldn't provide backlog data on a quarterly basis until year-end.

Jay Freeland

But I will tell you that the backlog is healthy and the backlog is all shippable and will be shipped during the Q4 period, the backlog we do have.

Jeff Bash

Alright. On the SCPA monitoring, has that started the work -- I think you said would start in the Q3 and then be a little more full scale in Q4. How's that going?

Jay Freeland

Yes. It has not started yet. We're waiting for the formal approval from DOJ still. We have gotten verbal approval of the monitor that we selected. Formal approval is we believe coming eminently and so they will -- they certainly will probably start work in the fourth quarter. But the loading will be a little bit lighter in the fourth quarter than what we had originally expected in the third quarter just because it takes a long to get the formal approval.

Jeff Bash

And finally, I think people understood that you raised a $50 million last fall with the 1.65 million shares sale partly for acquisitions. And at this point, I'm thinking with the stock down near $10, net working capital per share approaching that neighborhood. The best acquisition that company could possibly make would be in its own stocks. Have you given this any consideration?

Jay Freeland

As a company and as a board, we certainly look at it. I'll say you never say never of course. But, it is still our belief that is not the best use of cash and that's again not to be -- it's not meant to be an indication of our view of the value of the stock by any stretch of imagination. We believe, number one, that there are still great places to put that cash that we're going to want to put it for growth acceleration. And number two, that even in this kind of economic environment, not that you would need to burn through the $100 million by any stretch of the imagination, but having that there and the flexibility that provides is extremely valuable and more valuable than just propping up EPS in the near-term.

Jeff Bash

I'm not concerning in terms of propping up EPS, but if you get the business for nearly free, if it gets down to net working capital per share, how can you do better than that?

Jay Freeland

Yes. Certainly understand the variations of the possibilities there. We just don't believe it's the right use at this point.

Jeff Bash

Well, I guess I have to say that I'm happy to hear that you think there is such -- much better uses for the cash. That's all.

Jay Freeland

Thanks, Jeff.

Operator

Alright. We'll take our next question from Rick D'Auteuil with Columbia Management. Go ahead, sir.

Rick D’Auteuil - Columbia Management

Yes, it's Rick D'Auteuil.

Jay Freeland

Hi.

Rick D’Auteuil - Columbia Management

I have similar line of questions, but maybe I'm going to be little more aggressive on our views on expense reductions. We have a number of companies in our portfolio and like you many are experiencing weakness in their pipeline, and while in the clarity of their business. Unlike you, they react to that with prudent expense cuts in light of reduced revenue. And I'm a little concerned and I understand the penetration issue, but when you have your sales guys that are essentially unproductive, because all they can generate is leads and demos and they can't close business, why do we want to continue to hire unproductive people in light of the revenue picture as you say across all your geographic territories?

Jay Freeland

Well, number one, obviously, like I said, the plan is to continue hiring and we can't ever guarantee what rate we're going to hire at, because sometimes it also depends on the quality of the people that we find. I think there is also though the -- still the predictability on the close rates and when deals will close or how they will close, there is still a lot of uncertainty there. So, in many respects, heads coming in the door. Number one, since it takes 12 months to 15 months to get them productive, we're affecting potentially sales that are 9 months to 12 months out with minimal cost to carry when they first come in. And the historical model works. If you bring the folks in they'll start being productive. We have newer people right now that will start being productive in the fourth quarter. Is the close rate a little bit slower? No question. But based on the way the model works, I would be very cautious also to slow down the heads that we have in here or even certainly be conscious to think about cutting any head that we have in the near-term given that we truly believe this is a near-term issue.

Rick D’Auteuil - Columbia Management

Okay, but you say it's a near-term issue, and then you say we don't know what's going to happen and we want to have that $100 million out there just in the piggy back when as I think the prior questionnaire pointed out, your stock if you believe your own line is a hell of a deal here and I know you guys have traditionally not bought back stock but these companies they kind of believe in themselves that have the war chest like you guys do have mostly stepped up and little disappointing they hear that you guys don't -- your board doesn't find this a compelling investment at this point.

Jay Freeland

Well, I shouldn't say like we find it compelling, we just find that there is -- or we believe there will be better ways to use the cash and not saying that -- like I said it's not a reflection on our view of the company stock at all, certainly it's a very low price right now relative to what we feel the value is, but we feel there are other areas that are more compelling to have the cash available for.

Rick D’Auteuil - Columbia Management

Another interesting point that you, I think pointed out earlier, your customers are sitting and watching and waiting and you guys aren't, you're just plowing ahead. And I think I have heard you say that your target, I don't think you've laid out a time frame because then you get pinned down, but your selling expense as a percentage of sales target I believe you said is 25% and in fact we're at 31.3 now and it sounds like, if you're looking at weak growth and continued 16% hiring rate that if anything just continues to escalate, so where do you kind of draw the line and say, let's step back here and not -- we've already done some pretty good damage to investors with our reduced guidance the last several quarters, let's step back just like our customers are doing and waited out a little bit?

Jay Freeland

Well, a couple of (inaudible) I wouldn't say plowing ahead, because again I'm not making any prediction on what the hiring growth rate would be on the sales side other than we still believe there is responsibility to add heads because we feel it was a near-term issue and that the historical model has always proven that as the heads come in and they come online, they become productive at the rates that we -- that the rates that we need. So in that regard and relative to reduced guidance for the last quarter and this quarter which are the two that we reduced, it is purely a matter of the economic environment. It could return any time soon, it could return at the end of next year, nobody knows obviously and that's the uncertainty that's out there, but I don't feel that this is a time for us to completely sit on our hands, I think we're going to do this, we're going to be cautious, and we're going to be smart about how we proceed, but it is certainly not a time to pull back and sit idle either.

Rick D’Auteuil - Columbia Management

Okay. Can you just a measure the lack of productivity in the -- on the sales side, maybe if you can talk about the close rate of trends that you're seeing?

Jay Freeland

We don't normally disclose the overall -- the close rates of the team other than what we've said is, typically we're in anywhere from a 30% to 40% range of what we demo we will close, and right now, even though that may have slowed a little bit, we still believe that those will close.

Rick D’Auteuil - Columbia Management

Okay, That's all I have.

Jay Freeland

Thanks, Rick.

Operator

We will take our next question again from Jim Ricchiuti with Needham & Company.

Jim Ricchiuti - Needham & Company

Hi, I was just wondering if you talk a little bit about the new product pipeline, and how you would characterize the next 6 months to 12 months in terms of new products. Is it going to be a more active year than the past 12 months and if you can give us say obviously you're not going to announce anything, is there any flavor you can give us for the types of markets or product range that you're going into?

Jay Freeland

Yes. I certainly won't talk specifically to the products mostly for competitive reasons. But, what I will say is we will be more active than last 12 months. It depends on how we -- how we gauge active. The last 12 months have been pretty active. We've had two new Arm releases, a new Laser Scanner, a New Laser Line Probe, new software and then additional Arm links relative to the new Arm and the acquisition of the DPI Technology in March. So, do I believe that we will have some comparable level of releases during the course of next 12 months regardless of product line I think the answer is yes, I think we'll be pretty close to that.

Jim Ricchiuti - Needham & Company

Okay. And Jay, is this more -- do you see these rolling out over the close of the year, or is it going to be heavier in the second half of the year?

Jay Freeland

It's a little bit harder to predict. Typically, we roll them through the course of the year. They are not intrinsically tied to each other, so there's not -- it doesn't necessarily mean that they couldn't be done in parallel, it really depends on the timing of when the work is done and we are ready to release.

Jim Ricchiuti - Needham & Company

Okay. And just given your current philosophy with respect to the cash on the balance sheet and the potential for seeing opportunities maybe other opportunities out there are you guys how actively are you looking at acquisitions at this point and to what extent are the things that you're seeing have valuations come in at all?

Jay Freeland

Yes, we're always looking, we've got a pretty regular process of looking at technology. The cash and I will say the (inaudible) certain people I don't know the cash is not burning a hole in our pocket either for sure. We want to be very cautious to make sure if we are going to do something we are going to do at the right way. We are always looking at it from a technology standpoint first and a potential for development or the future enhancements and so forth going forward off of that. Have the values come down come down a little bit? Hard to say, because most of what we look at are private companies, I will say that there is a little bit more interest in working with FARO whether it's partnership or otherwise than there has been in the past, but that's relative too, because FARO as a market leader has always been a little bit of beacon, we get a lot of activity where people come to us looking to work as partners or otherwise. So I can't say it's anything that's substantial either.

Jim Ricchiuti - Needham & Company

If we look back in the last downturn and I guess that was the only period where you had a decline in revenues. I am just wondering, how would you characterize the competitive landscape at this point. Is pricing still fairly stable or to what extent is -- has the macro issue begun to, to maybe bleed into the competitive environment and how people are reacting?

Jay Freeland

Yes, what I will say is that the -- the pricing methodologies, let's say are fairly consistent which is we know that our primary competitors always lower price when they go in and they have been pretty aggressive on price. Our pricing has been able to stay very, very stable which has certainly supported the bulk of our gross margin at -- at the 61% level year-to-date. And so and I think a lot that really is, is the, you've got just such an under penetrated market space that were serving and the ROI still at the price levels we have is very compelling, you are still in that three months to four months range, five months to six months depending on the product give or take, but it is still a pretty compelling ROI and it makes the price discussion less applicable than the discussion surrounding how to use it, how to save money, how to build efficiency inside the company that you are selling to and keeps the focus there.

Jim Ricchiuti - Needham & Company

Okay. Thank you.

Operator

We will take our next question from Mike McCormick with Gilder Gagnon Howe. Go ahead, sir.

Michael McCormick - Gilder Gagnon Howe & Co.

Hi, guys.

Jay Freeland

Hi, Mike.

Keith Bair

Hi, Mike.

Michael McCormick - Gilder Gagnon Howe & Co.

I apologize I got on a little late. Could you just give me the breakdowns by the three geographies just for my own data set and then I have some other questions?

Jay Freeland

From a sales perspective?

Michael McCormick - Gilder Gagnon Howe & Co.

Yes.

Keith Bair

I will just read right from the script. On a regional basis, third quarter sales in 2008 the Americas decreased $700,000 or 3.7% to $18.4 million from $19.1 million. Sales grew 27.2% in Europe to $21.5 million from $16.9 million and sales in the Asia-Pacific region increased 8.2% to $9.2 million from $8.5 million.

Michael McCormick - Gilder Gagnon Howe & Co.

Terrific. And what was the --do you have the FX calculations for, let's say the yen and the euro?

Keith Bair

I have the overall effect on sales was $2.2 million, was an increase in sales of $2.2 million.

Michael McCormick - Gilder Gagnon Howe & Co.

Okay. Okay. Thanks. I'm sorry to make you do that again. I know you may be active, you raised some money and you made small acquisitions, but our conversations around acquisitions were always that they were going to be small dollar amount acquisitions $5, $15 maybe $20 million. Has anything changed in that characteristic and the opportunities you're looking at?

Jay Freeland

Yes. Certainly not. The companies that we look at are all very, very small, mostly early stage technologies and if we were to do a deal it still would be in, I'm sure that range.

Michael McCormick - Gilder Gagnon Howe & Co.

Okay. So would you anticipate that you would do more than two in the next 12 months?

Jay Freeland

Really hard to predict, Mike. It will be hard for me to say anything on an in the anticipation level of that.

Michael McCormick - Gilder Gagnon Howe & Co.

It wasn't so much on an anticipation level, speaking to some prior questions about share buybacks and so forth is that, if you assumed two, which would be a large amount at $40 million, the company being cash flow positive and you having an additional $60 million war chest, it is puzzling and I echo that comment that you may not dedicate it even $20 million towards the share buyback which -- it isn't about propping up EPS, it's that you're buying a business close to your working capital as the gentlemen pointed out. And I'm just interested in why -- there is a time value of money relationship to you too. So if you're -- if it's just sitting on the bank earning 1% yield, you have the ability to potentially buy an asset base, your own company at a significantly discounted value and I'd really like a further explanation about that thought process. Taking into the fact a lot of conservativeness and opportunity, if you'd to buy other companies from an R&D side?

Jay Freeland

Right. No, I completely understand and conservativeness is obviously is one great word for it. I just -- we really believe that and look again I'm not arguing that there is compelling value there and like I said before, you never say never. I will not put that door shut. We just believe that during -- at this time, it's the right thing to have that cash available to us for any number of different things that we could do with it. Like I said, never say never on a buyback, but we just feel like there are other things we could use it for.

Michael McCormick - Gilder Gagnon Howe & Co.

But once again, address the time value component for me.

Jay Freeland

In what regard, Mike?

Michael McCormick - Gilder Gagnon Howe & Co.

Well, you raised the money. You put some of it to work. There was a large amount of money.

Jay Freeland

Yes.

Michael McCormick - Gilder Gagnon Howe & Co.

But now assuming you buy one or two other companies, you still have a substantial cash balance, and when you think of the time value of money, its poor utilization of your asset base.

Jay Freeland

Yes. I completely understand the view of that on the time value, and I'm not going to put any type of time clock on it going forward, it's just -- I'm just not ready to do that.

Michael McCormick - Gilder Gagnon Howe & Co.

But you think of your physical assets in a return on investment calculation, don't you?

Jay Freeland

I do.

Michael McCormick - Gilder Gagnon Howe & Co.

So why would you think of it differently in your cash value?

Jay Freeland

We just -- my view -- look, we want to have the cash available for any number of different things that we could use it for to fund the business and as soon as we take some cash off the table, obviously, then you don't have the cash available at that point in time. I absolutely understand the concern and the time value and the low interest rate, for sure, because we got it in safe harbor investments that are there for protection not for interest there, and I understand all that.

Michael McCormick - Gilder Gagnon Howe & Co.

We will talk offline.

Jay Freeland

Okay.

Operator

We will now take our last question from Rob Mason with R.W. Baird. Go ahead, sir.

Rob Mason - Robert W. Baird

Yes, Jay. I just want to get a clarification. When you define an order that is shippable over what time frame?

Jay Freeland

Yes, typically it's shippable in the next four weeks. What -- our standard quote, from that regard, the standard quote to customers is four weeks. Obviously, we will ship quicker than that if they request it. If the customer is looking at it and wants to place the order and it's more than four weeks, we have to have a pretty compelling reason as to why we need to do it that way. And sometimes that would then force larger down payment or whatever the case is. But typically the four weeks is a good gauge.

Rob Mason - Robert W. Baird

Okay. And so we should assume backlog reflects that four weeks shipping cycle?

Jay Freeland

It does. Again, not absolutely to the line, but it's on average pretty close to that.

Rob Mason - Robert W. Baird

Okay. And then, Keith, do you happen to have the net income impact or the EBIT impact from currency. I know you gave the sales impact, but how does it impact the bottom line?

Keith Bair

No, it didn't have a material effect on the bottom line, but we typically don't disclose that number, we just typically disclose the effect on sales. But historically, it hasn't had any material impact either.

Rob Mason - Robert W. Baird

So, you -- is it fair to say you're naturally hedged on from currency of movements?

Keith Bair

That's right. Because you have all the operating expenses in that currency as well.

Rob Mason - Robert W. Baird

Sure. Okay. And then, I guess last question just Jay, if revenues were to slip and it looks like will be down year-over-year just based on your guidance here in the fourth quarter, but how comfortable are you with this 58% to 60% gross margin guidance? Or how sensitive is that to your volumes absent any change in discounting policy?

Jay Freeland

Yes, I mean, obviously absent some significant change in the discounting policy, we feel pretty good about that. And again that, now that we've been through three quarters of pretty tough economy in the United States, and at least one full quarter of rough economy in Europe and Asia, given that price levels in particular would certainly has the biggest impact on gross margin, we've not seen any material change in the price levels at all, nor have we seen any material change in cost levels coming in from the supply base either. So I think the 58% to 60% is still a good range for sure.

Rob Mason - Robert W. Baird

Do you have the opportunity to reduce cost, manufacturing cost?

Jay Freeland

Yes, we always have the opportunity; it's always a piece of what the R&D team is working on from a design standpoint that's a piece of what the sourcing team will work on in their negotiations with their suppliers. So there is always opportunity for productivity and there is always targets for the team on trying to get cost down.

Rob Mason - Robert W. Baird

Okay. Thank you.

Operator

That is all the questions we have time for today. I will now turn the program back over to Jay Freeland.

Jay Freeland

Very good. Well, thanks everybody for the call today, and we look forward to updating you again at the end of the fourth quarter.

Operator

This does conclude today's conference. You may disconnect at any time.

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Source: FARO Technologies, Inc. Q3 2008 Earnings Call Transcript
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