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FARO Technologies (NASDAQ:FARO)

Q4 2008 Earnings Call

February 13, 2008 11:00 am ET

Executives

Vic Allgeier - IR, TTC Group

Keith Bair - SVP and CFO

Jay Freeland - President and CEO

Analysts

Mark Jordan - Noble Financial Group

Jim Ricchiuti - Needham & Company

Rick D'Auteuil - Columbia Management

Richard Eastman - Robert W. Baird & Co., Inc.

Jeff Bash - Private Investor

Operator

Good morning, everyone, and welcome to FARO Technologies conference call in conjunction with its fourth quarter 2008 earnings release. (Operator Instructions).

I will now turn the program over to Mr. Vic Allgeier. Please begin, 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 fourth quarter results. By now, you should have received a copy of the press release. If you have not received the release, please call [Nancy Setteducati] at 407-333-9911. The press release is also available on FARO's website 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 fourth quarter of 2008 were $56.3 million, a 4.9% decrease from $59.2 million in the fourth quarter of 2007. That brought our 2008 annual sales to $209.2 million, a 9.2% increase from $191.6 million in 2007.

On a regional basis, fourth quarter sales in 2008 in the Americas declined 5.9% to $20.6 million compared to $21.9 million in the fourth quarter of 2007. Sales decreased 3.7% in Europe to $26.2 million from $27.2 million in the fourth quarter of 2007. Sales in the Asia-Pacific region decreased 5.9% to $9.5 million from $10.1 million in the fourth quarter of 2007. The effect of changes in foreign exchange rates on sales was a decrease of $2.4 million for the fourth quarter of 2008.

Comparing year-over-year growth, [2008] sales in the Americas decreased 2.1% to $78.3 million from $80 million in 2007. Europe sales for 2008 increased 19.5% to $93.6 million from $78.3 million in 2007.In Asia, sales increased 12% in 2008 to $37.3 million from $33.3 million in 2007. The effective changes in foreign exchange rates on sales was an increase of $7.5 million in fiscal 2008.

New orders declined 13.8% in the fourth quarter of 2008 to approximately $56.4 million, compared to approximately $65.4 million in the fourth quarter of 2007. On an annual basis, new orders grew 6.8% to $211.3 million in 2008 from $197.8 million in 2007.

On a regional basis, fourth quarter orders in 2008 in the Americas decreased 7.5% to $20.9 million compared to $22.6 million in the fourth quarter of 2007. Orders decreased $19.6 million in Europe to $26.3 million from $32.7 million in the fourth quarter of 2007. Orders in the Asia-Pacific region decreased 8.9% to $9.2 million compared to $10.1 million in the year ago quarter.

Again, comparing year-over-year orders growth, new orders in the Americas decreased 4.2% to $77.1 million in 2008 from $80.5 million in 2007. Orders increased 12.2% in Europe to $95 million in 2008, compared to $84.7 million in 2007, and orders grew by 20.2% in Asia in 2008 to $39.2 million from $32.6 million in 2007.

The top five customers by sales volume in 2008 were the US military, Northrop Grumman, BMW, [Metalurgia] and Boeing and represented only 3.9% of sales. The top 10 customers in 2008 represented only 6.3% of our sales, once again indicating our lack of dependence on any one or a handful of customers.

Our gross margin was 57.3% in the fourth quarter of 2008 compared to 60% in the year ago quarter. This decrease was due to lower product sales, which carry higher gross margins and an increase in service costs as a percentage of sales. Gross margin in fiscal 2008 was 59.8% compared to 60% in fiscal 2007.

Selling expenses were 28.6% of sales in the fourth quarter of 2008 compared to 27.3% in the year ago quarter, but remained relatively unchanged at approximately $16.1 million compared to $16.2 million in the year ago quarter. In fiscal 2008, selling expenses increased to 30.1% of sales compared to 29.3% in fiscal 2007.

Administrative expenses in the fourth quarter of 2008 were 12.2% of sales compared to 11.8% in the fourth quarter of 2007, declining by $100,000 to $6.9 million from $7 million in 2007. In fiscal 2008, general and administrative expenses were $26.1 million or 12.5% of sales compared to fiscal 2007 of $25.5 million, or 13.3% of sales.

Fiscal 2007 expenses include a $2.65 million charge for estimated fines and penalties with respect to the FCPA matter and $1.1 million of professional fees related to the company's FCPA matter and the resolution of the patent litigation.

Research and development expenses were $3.5 million for the fourth quarter of 2008, or 6.2% of sales, compared to $3.1 million or 5.3% of sales in the fourth quarter of 2007. R&D expenses for fiscal 2008 were $12.6 million or 6% of sales, an increase of $2.3 million from $10.3 million or 5.4% of sales in fiscal 2007. The increase was driven primarily by an increase in compensation costs related to the addition of new employees, primarily related to the development of the DPI technology.

Operating margin for the fourth quarter of 2008 was 8.1%, compared to 13.8% in the year ago quarter as a result of the previously mentioned decline in gross margin and increased selling and administrative expenses as a percentage of sales. Operating margin for fiscal 2008 decreased to 9.1% from 10% in fiscal 2007.

Other income and expenses, which includes foreign exchange transactions with our subsidiaries changed to a loss of $1.5 million in the fourth quarter of 2008 from a gain of $300,000 in the fourth quarter of 2007. On a year-to-date basis, foreign exchange transactions included in other income and expense swung to a loss of $2.3 million in fiscal 2008 from a gain of $1.5 million in fiscal 2007.

Income tax expense was $1.4 million for the fourth quarter of 2008 compared to $1.1 million in the fourth quarter of 2007. The company's effective tax rate for 2008 increased to 24% compared to 21.5% for fiscal 2007 due to an increase in income in higher tax jurisdictions.

Net income was $2.2 million or $0.13 per share in the fourth quarter of 2008, compared to $8.4 million or $0.50 per share in the fourth quarter of 2007, marking our 26th consecutive profitable quarter. Net income for fiscal 2008 decreased to $14 million or $0.83 per diluted share from $18.1 million or $1.15 per diluted share in fiscal 2007.

I will now briefly discuss a few balance sheet and cash flow items. Cash and short-term investments were $105.5 million at December 31, 2008, compared to $103.2 million at December 31, 2007. Accounts receivable was $49.7 million at December 31, 2008, compared to $54.8 million at December 31, 2007.

Days sales outstanding at December 31, 2008, decreased to 81 days from 84 days at December 31, 2007. Inventories increased to $46.3 million at December 31, 2008 from $40 million at December 31, 2007. The increase in inventories was primarily related to an increase in finished goods and demo inventories.

Finally, I will conclude with some statistics regarding our headcount numbers. We had 959 employees at December 31, 2008, compared to 780 at December 31, 2007, an increase of 179, or 22.9%. Account manager headcount at December 31, 2008 was 187 with 62 account managers in the Americas, 61 account managers in Europe, and 64 account managers in Asia. Geographically, we now have 439 employees in the Americas, 305 employees in Europe, and 215 employees in the Asia-Pacific region.

I will now hand the call over to Jay.

Jay Freeland

Thanks, Keith. I would be stating the obvious if I claim that 2008 was a year unlike any other. The speed with which a large number of our end markets deteriorated in the second half of the year, particularly in the fourth quarter, was substantial. Despite generating strong double-digit growth in the first half of 2008, we finished the year in the single digits and actually recorded across the board sales declines in Q4.

When all was said and done, no region was spared the shift in the market. Even though Europe and Asia posted double-digit gains for the year, the fourth quarter was a real fight for them and in the Americas we have been feeling the pain for five straight quarters now.

Visibility and predictability is the toughest I have seen in my career. Historically, we would have 90 days of hard visibility and an additional 90 days beyond that based purely on lead and demo counts. Today, we have about 30 days visibility at best.

Customer interest is still strong, but our customers' decision making processes slowed considerably in each of the last six months of 2008. The math associated with our lead and demo conversion ratios has changed reducing the visibility and predictability we have experienced in the past.

We have had very few competitive losses; however, customers clearly have a fear of spending cash and an inability to get budgets approved or purchase orders released. That being said, we do have customers who are still buying. Efforts to expand our vertical markets over the last three years have helped in the current environment. As a result, we had another quarter where sales to new customers and sales to existing customers were split about 50-50.

Selling new technology to existing customers is one thing during a downturn. Getting new customers to adopt new technology during a downturn is very unusual. Our ability to sell value and real ROI and not just technical features makes a difference. The biggest market issues we face today appear to be economic and psychological.

We certainly don't have a crystal ball, but we expect 2009 to be extremely difficult. The erratic purchasing patterns that evolved in the second half of 2008 will probably continue throughout 2009. It is very possible that we will experience sales declines despite the continued customer interest in our solutions and despite the diligent efforts by our sales team. This will not be elegant, but we will do everything we can to keep it simple and to remain focused on the basics.

We have already taken actions within the company to keep FARO positioned well through all of this. Bonuses were cut deeply at the end of 2008. Salaries were frozen across the board for all of 2009. Our global sales meetings and departmental planning meetings were changed from face-to-face to webcast-only. Non-customer related travel budgets were pared back substantially, and as the market evolves, the company will continue to act quickly.

Despite the environment, we do plan to continue adding account managers as required. New personnel on the sales side have continued to pay for themselves and contribute to the business regardless of the economic conditions. This is a missionary sale, so coverage in the field is important for driving the volume.

We are also continuing with our core R&D programs. The launch of the photon laser scanner in 2008 was a significant event in that market and drove nice growth for the product line in the second half of the year. As you know, we also added an exciting new technology in 2008, the 3D Imager.

Though we don't expect substantial, if any, revenue to come from this product in 2009, its potential value to FARO as we move forward remains the same. Our new 3D imaging technology Center of Excellence in Cambridge is operational and we expect great things from that team.

As stated in last night's earnings release, we expect 2009 to be a challenging year for everyone and as a result, we will not be providing guidance this year. We will provide updates during these calls as we always have, but trying to predict any result in this business climate would be extremely difficult and quite frankly not very productive. We continue to believe that the long-term fundamentals of the company and the markets we serve are strong.

As always, I will wrap up by thanking the FARO team around the world who give it everything they have got every day of the week, to our customers who continue to place their faith in us as they look for ways to improve their enterprises and to all of you, our investors, who put your money behind us so we can continue to transform this marketplace. 2009 may be a challenge, but FARO will execute with as much energy and passion as we always do.

I appreciate your attention and we will now open the call to questions.

Question-and-Answer Session

Operator

(Operator Instructions). We'll take our first question from the side of Mark Jordan at Noble Financial.

Mark Jordan - Noble Financial Group

Good morning, gentlemen; a couple of questions. First of all, on gross margin, definitely was down sequentially for the average for the first half of the year. Was there any disproportionate mix, let's say, demo hardware that was worked off during the quarter? And a related question, could you comment in terms of the quality of your inventory and your (inaudible) demo inventory [finished goods]?

Jay Freeland

Yeah, good morning, Mark. On the gross margin question, the answer is no. Really the biggest impact there was slightly lower sales from a product standpoint than what we had expected and planned, which do carry higher gross margins with them than service revenue. So, the service that came in has a lower gross margin and was a greater piece of the mix, so that threw the gross margin down during the quarter.

In terms of the inventory itself, we think the inventory that we have is good. It is new. The demo gear is inside, certainly well inside the window of what we would normally sell in the marketplace as used equipment to help get customers into the technology. And not surprisingly, we have a good push on with that right now given the current economic conditions.

Mark Jordan - Noble Financial Group

Given the fact that we are obviously in a recession and sales productivity per rep et cetera is down, would you expect that sales mix issue that was evident here in the fourth quarter to continue as long as we are in sort of this troughing of a recession, and therefore, if you are looking at normal margins of 58% to 60% that we should expect to be bouncing around the lower end of that range in '09?

Jay Freeland

Yeah, without talking specifically about the margin number itself, I think there is a possibility, as you look at the potential for sales declines if those occur, you might see the same phenomenon. If the service side remains the same, if customers are pulling a little more life out of their equipment than before that is a possibility.

It has always been hard to predict the service volume, even as the installed base has grown, given that you just don't know how often customers are going to return the equipment for general service work or something more specific, but it certainly is a possibility.

Mark Jordan - Noble Financial Group

Okay. Looking at next year, clearly, you had a little bit of higher tax rate than anybody was expecting here in the fourth quarter. Should we plan on a similar 24% corporate tax rate next year? And you said that you had higher profitability in high tax areas, does that mean that the United States was more profitable than you were assuming?

Keith Bair

Well, let me address it by saying this. The way the tax projections are put together for the year is based upon annual forecasts, and Q4 certainly turned out to be a little bit different than what we had anticipated. And primarily what has happened in Q4 is that there were additional losses at our foreign sales subsidiaries, which included the large foreign exchange transaction losses.

To the extent that some of those subsidiaries are relatively new and are still in a cumulative loss position, there was no tax benefit that you are allowed to accrue from that. Going forward, a big piece of that is primarily related to the FX transaction gains with those subsidiaries. With regards to providing some guidance regarding the tax rate, as Jay said, we are really not in a position to provide any guidance going forward.

Mark Jordan - Noble Financial Group

Okay. Let me ask one more and then I will give somebody else a chance and come back later. You have spent $9.5 million on CapEx this year. Clearly, way above anything you have ever done. Could you give us an outline of where you have invested that money?

Keith Bair

Yeah. Primarily, the acquisition of the technology rights related to DPI. We have also expanded our offices down here. We renovated an existing facility and built out some office space, and we have also added some new IT equipment and production equipment at our regions globally actually.

Jay Freeland

I think, generally speaking, and a lot of it is obviously are unusuals. To your point, it was a higher rate than what we normally see. And so I think as we go into 2009, you certainly would not see the same type of CapEx spending going forward.

Mark Jordan - Noble Financial Group

Thank you. I'll give somebody else a chance and come back later.

Jay Freeland

Okay. Thanks Mark.

Operator

We will take our next question from the side of [Jeff Bash] that is a Private Investor. Please go ahead, sir.

Jeff Bash - Private Investor

Good morning, Jay.

Jay Freeland

Good morning, Jeff.

Jeff Bash - Private Investor

First, I want to observe I thought you did really exceptionally well in the fourth quarter and that, if the fourth quarter tax rate had been the 24% average for the year, you would have made $0.17 instead of $0.13.

Jay Freeland

Thank you.

Jeff Bash - Private Investor

You commented in your release about the delays in customer decision making processes as they review their CapEx needs. Do you think FARO products, with their very fast return on investment, and not being an exceptionally expensive helps insulate you from these problems relative to other equipment makers or you are fully subject to these situations?

Jay Freeland

Yeah, I certainly can't say that it insulates us. We definitely see it. It is interesting. There are some who are moving as fast as they had in the past, but that is certainly far and few between. The thing that is interesting, the predictability part is very, very frustrating right now and I will give you a good example.

We had a fairly sizable order in the fourth quarter that we actually did press release, which was a nice order. The customer involved, though it was a different division at the time, four months was talking about the fact that we could give the equipment to them but they just couldn't get purchase orders processed at that point in time anywhere inside the company. And so we had at that point assumed that this probably was not going to happen in this other division and then lo and behold, three weeks later, we got the purchase order.

And it is that kind of unpredictability that we know the interest is there, we know they want to get the product and pull it in. It is getting those purchase orders pushed through, the req is pushed through, the budget approved. That is the part that we don't have a good feel for and I think a lot of the customers don't have a good feel for either, particularly the bigger ones as their companies try to see what they need to do in this environment.

Jeff Bash - Private Investor

Okay. Europe is sort of the euro zone is pretty much a basket case. Can you comment on your relative situation in your three geographic areas? They are probably not all equally as bad.

Jay Freeland

Yeah, I think the Americas is probably worst only because they have been feeling it longer. Europe, the market change is probably still a little bit behind the other regions, but obviously you look at this morning's data for Germany, Italy and France, and particularly Germany and Italy, certainly was not encouraging.

Asia, though we expect some fight during the course of the year, not nearly in the same boat right now that the other two are in, in my opinion at least from what we had seen coming out of the year. The Europe situation, you are absolutely right, is a basket case and certainly does not appear to be getting any better in the near-term.

Jeff Bash - Private Investor

On the buyback, I just want to observe that I am pleased that so far you are using it as an insurance policy against some catastrophic market decline particularly related to the company, and I will move on. With respect to administrative expenses, does the fourth quarter level now include the full FCPA monitoring load?

Jay Freeland

Great question. Unfortunately, it does not. The monitor still has not started. We have been waiting as patiently as we can. It is still my understanding that the clock is running. So, as we have talked about in previous calls, it started running basically in July of last year and so assuming that is in fact the case, the two years of monitoring is down to 15 months give or take.

I think the only downside of that is that I look at it now and say, "Well, that means that all the work they have to do will be crammed into 15 months or 14 months, whenever it starts, versus the two years that were originally set up." When they will show up is still anybody's guess. I have been watching this, as you know, for months now trying to figure out when they will actually start their work.

The work they have to do, that part won't necessarily change. We still expect, we had said maybe $1 million to $2 million in total over the two-year time period or whatever the time period is they end up being here. There will be a decent amount that is front-end loaded because the first four months after they arrive they have to deliver their first and probably most substantial report back to the DoJ relative to our progress. So, I would expect the cost to be more front-end loaded once they do arrive and once they arrive, we will certainly talk about it in that quarter once they are on site.

Jeff Bash - Private Investor

Next, my personal view is that many large banks are insolvent. Are you watching SunTrust carefully with respect to the large amount of money you have with them?

Keith Bair

Yes, we continue to monitor that situation just about on a daily basis, and I am not really sure which bank is in a better position than any other bank these days, but we do actually monitor SunTrust.

Jeff Bash - Private Investor

And finally, are you still comfortable with your long-term goals for the company, 20-25% sales growth and your repeated comments about the very, very low penetration?

Jay Freeland

Yes. I believe that everything we have stated in the past about the potential is absolutely still intact. The low penetration, no question about it; the growth potential for the company, no question about it. Putting a timeline on it at this point, obviously, is kind of a moot point and certainly is not on the table.

But none of that has changed. That is clear when you talk to the customers. Every time you get in the door and they see it for the first time, you see the eyes light up and you know that you still have something that is extraordinarily useful and beneficial to them.

Jeff Bash - Private Investor

Okay. Thanks a lot.

Jay Freeland

Thanks Jeff.

Operator

We will take our next question from the side of Jim Ricchiuti from Needham & Company.

Jim Ricchiuti - Needham & Company

Thank you. Good morning, Jay. Good morning, Keith.

Jay Freeland

Hey, Jim.

Jim Ricchiuti - Needham & Company

Keith, I wonder if you could help us a little bit with expenses. I realize revenues at this point is very difficult to forecast, but just in terms of G&A, if we put the monitor issue aside, how should we think about your G&A expense this year?

Keith Bair

As Jay has mentioned, we are not in a position where we are going to be providing guidance for 2009. I hate to keep saying that, but.

Jim Ricchiuti - Needham & Company

Yeah.

Jay Freeland

I think the one thing I would say to characterize it, generally speaking for everybody is you wouldn't be surprised to hear us say that it is going to be run extraordinarily tight in 2009. I know that doesn't give you a whole lot to work with, Jim, but that is the right way to look at it.

Jim Ricchiuti - Needham & Company

Okay. Jay, it sounds like you are still going to be adding folks probably. There are some good people out there. Can you maybe help in terms of how we might think about the expansion to the sales force and under what conditions you might decide to maybe ratchet things back a little bit just in terms of your hiring plans?

Jay Freeland

Yeah. We are, as you point out, we are still planning to add account managers because, even last year as we added new account managers, even the ones we added in the back half of the year as conditions were worsening, were still delivering and will pay for themselves within that first year. I think when you look at it, certainly, we are going to continue to be surgical about it. We have put them in spots where we believe there is the greatest amount of potential based on the clustering of the customer base. We will do it based on what products we think have the best opportunity to move.

You are absolutely right. The types of people that are out there right now, we have always gotten great people at the company, but the number of great people that are available is sizably larger versus before you really had to kind of work through it to find the great ones in the mix and that is how we always did it to match the fit and the culture that we have here.

Conditions that would change that, without stating specifically what they are, obviously, dramatic swings from a sales standpoint in the wrong direction would be a huge indicator. If we saw that we had some new folks that we had put on recently that were clearly struggling more so than usual or if we saw that our more experienced people were struggling more so than usual, those are signals that we would look at and say, "hey, it is time to hit the brakes a little bit."

Because what we want to make sure we have is this balance of account managers who can help continue to enable the growth going forward whenever the world pulls out of the spin we are in right now and at the same time can generate revenue for the company in the current period. And so we are obviously, one of the things you always worry about too is it you don't want your A players that you have had for a while on the sales side to suddenly start struggling and start running the risk of those folks disappearing as well. So, we are going to be very cautious about how we balance that.

Jim Ricchiuti - Needham & Company

Okay, that's helpful. Jay, can you talk a little bit about the verticals, the markets where business seems to be holding up better? And I wonder if you also might be able to provide some color in terms of areas of strength within the product portfolio.

Jay Freeland

I will go in reverse order. Certainly, the Gage continues to be very, very strong for us and there is lots of different reasons for that. I think not surprisingly the price point. Obviously, that is helpful. It is substantially lower than your basic arms. The fact that it targets, you can not only put it in manufacturing facilities, but all of the machine shops around the world.

Just the total potential of available customers out there is sizable and far greater than any of the other products. And that is not to say that there aren't a great number of potential customers for any of the other products because they are still in that 5% penetration range that we believe, but the Gage is an exciting product and no doubt, we see a lot of growth there.

Arm, still lots of opportunity in the arm; the ScanArm has gotten some good traction. More and more people are utilizing the three-dimensional data. Because of what the ScanArm can provide, obviously, it is a little bit less detailed from an accuracy standpoint, but the modeling capability and the ability to reverse engineer and the things you can do with it are of particular interest and right now, as market conditions get worse, there is a lot of opportunity for players who are doing that.

And then Laser Scanner, as I talked about the photon in particular, mostly due to both speed and the amount of clarity. The accuracy improved as well, but the clarity that came through, similar to a camera with pixels and the number of pixels and the clarity inside the pixel continues to improve. You have got the same thing in the scanner. That drove nice growth in that product line in the back-half once it was released.

And then Tracker, Tracker is still a great product. It is a much narrower market for us. It has traditionally been more focused inside of aerospace and auto and obviously, those verticals are struggling a little bit more than some of the others right now. So, Tracker is a good product, but the markets we can target it into are still a little bit more selective and we are spending time finding other ways to use it for machine tool alignments and otherwise at other types of manufacturers.

For the verticals, without getting specific, as you know, we don't get real specific on those. Look, obviously, auto and aero are struggling out there. Every day goes by, you see another auto company doing another round of cuts and pulling back their production forecasts. Even with BMW being in our top five last year and Boeing being in our top five last year, they are still struggling in those verticals.

The light manufacturing, still pretty good. It depends on the product, the output, but many of those are using the tools more than ever before, which is good, as some of the heavier manufacturers slow up a bit. Even in the slowdown, the need is still there obviously. Because we have been so under penetrated and these guys are desperately looking for ways to improve their processes, we are still a great play. It is just a matter of their decision making process because of everything that they are going through definitely is definitely slower.

Jim Ricchiuti - Needham & Company

Okay, thank you.

Jay Freeland

Thanks Jim.

Operator

We will take our next question from the side of Rick D'Auteuil of Columbia Management. Please go ahead.

Rick D'Auteuil - Columbia Management

Good morning.

Jay Freeland

Good morning, Rick.

Keith Bair

Good morning.

Rick D'Auteuil - Columbia Management

The first question I have is regarding the 3D imaging technology you guys bought last year and you set up the Cambridge facility. Maybe you can just give us a status of where that is relative to where you hoped it would be at this point? Because I thought you had originally assumed that we would start to see some revenues from there in 2009, but is it behind plan, and what are the obstacles you are encountering?

Jay Freeland

Yeah. Well, I think it is pretty close to plan. I still think there is a possibility of seeing some revenues this year. No doubt we are hedging a little bit there given the market environment versus when we first picked up the technology. Obviously that has changed substantially. So that is the part again that is a little bit unpredictable.

We have the team fully staffed minus one at this point for that organization and so they are in the process of taking. There is kind of two steps there. One is refining the product as it was in fairly rapid fashion and getting it. It was a good product, but it was not unlike a lot of start ups. In some respects, a little bit of a science experiment. So, truly kind of productizing it for the first generation of I would call it, and the previous generation was really zero. It wasn't even alpha at that point.

And then all of the emphasis will focus on the miniaturization and turning it into a product that can be used in multiple markets and in multiple applications beyond even what we do today. And that is the part that will take a little bit of time, but the team that we have, I have great confidence in the types of resources we got. I think the decision to stay up in the Boston, Cambridge area was absolutely the right one in terms of the types of talent that the leader up there was able to attract and to bring in.

And so as they start hitting their stride, because a lot of them really didn't get added until the second half, so as they start hitting their stride, we will see certainly in the back-half of the year, we will start getting a feel for is there some revenue being generated. And it will be, again, certainly still test market mode in many respects as you put it out there and see how customers are using it, because that will help shape and refine what we do with it in the real, kind of the next gen.

Rick D'Auteuil - Columbia Management

So, you are not getting real market feedback in the design or customization of the product? So you are kind of, I mean, I would think that that would be helpful to get end market, potential end market users feedback now rather than wait for their feedback after.

Jay Freeland

Absolutely. All of that was done leading into the work that they are doing right now. So what the first gen looks like will reflect as much information as we could get from customers for what is still a relatively new technology even compared to our others. So that has been factored in for the first gen. Some of what they are looking for cannot make it in the first gen would go in the next release after that. But we certainly don't release products and throw them over the wall to see if anything will stick.

Rick D'Auteuil - Columbia Management

Okay. And a question; my recollection was sometime during the fourth quarter, and this has been a popular topic on many of the past conference calls, but you guys instituted a buyback, right?

Jay Freeland

We did, right around late November.

Rick D'Auteuil - Columbia Management

Okay. And you didn't mention anything regarding that today and cash is still there. Maybe what are your thoughts there then?

Jay Freeland

Yeah. I am sorry, and I should -- Keith corrected me. It was actually early December that it actually started. We do have the buyback in place. We did put a 10(b) in place when our quiet period started on December 15, and obviously, that has been in place all the way through the release here until Tuesday when we are allowed to start trading again. In the first couple of weeks, I actively managed it with our broker. We will start doing so again once we get out of the quiet period.

We have been buying through the quiet period. We had a small amount that was purchased in December relative to the targets, the price ceiling that we gave the broker. That was about $100,000 worth in the month of December. And then what I will say is that we were buying throughout the quiet period and obviously you get a better feel for what that looked like when we do the first quarter release.

Rick D'Auteuil - Columbia Management

Okay. I appreciate it. Thanks.

Jay Freeland

Yep. Thanks Rick.

Operator

We will take our next question from the side of Richard Eastman of Robert Baird. Please go ahead.

Richard Eastman - Robert W. Baird & Co., Inc.

Hi, Jay. Hi, Keith.

Jay Freeland

Good morning, Rick.

Richard Eastman - Robert W. Baird & Co., Inc.

Hey, could you just talk in the fourth quarter, what was the revenue split between equipment and service?

Jay Freeland

Yeah. Though service was a little bit greater proportion of the normal, we still aren't splitting it out. It wasn't significant enough to split it out.

Richard Eastman - Robert W. Baird & Co., Inc.

Okay. So, are we to think that the service revenue recognized in the quarter would be less than 10%? Is that kind of the idea?

Keith Bair

We don't usually speak to that split.

Jay Freeland

Right. Yeah, we normally don't and it is mostly, and it is because we have never been above the required reporting threshold.

Richard Eastman - Robert W. Baird & Co., Inc.

Okay. And then let me ask you, the gross margin impact that you talked about where service cost was a greater portion of sales. The way I think about that number is the service cost that you recognized as part of your cost of goods sold, is that a number that you true up at the end of the year? Do you account for that against like a standard service cost through the first three quarters and then true that up?

Keith Bair

No, it is really based upon actual expenses incurred. So, really, when you look at service costs as a percentage of sales and the sales numbers come down, that is primarily the reason for the increase in the percentage of sales for the service costs.

Richard Eastman - Robert W. Baird & Co., Inc.

Okay. So when I look at your COGS, and let's just assume just a simple number, like say your COGS is 40%, what portion of that is a typical service cost number?

Keith Bair

Yeah. I don't think we have ever disclosed the break down of the cost of sales number with regards to customer service.

Richard Eastman - Robert W. Baird & Co., Inc.

Okay. Well, if I look at, in the quarter, if I assume that your margins are closer to say 59%, it would suggest that the service cost was maybe $1 million above what you would have forecast?

Keith Bair

Again, I don't want to provide any specific guidance with respect to customer service costs within a particular…

Richard Eastman - Robert W. Baird & Co., Inc.

Let me state it in other way. I am not sure that I understand why that number moves in one quarter by what would be a material amount. Just in the fourth quarter, why does the service cost, if it is just a pay as you go type of cost, how does that jump up like that?

Keith Bair

Well, particularly what happened in this quarter was we have opened up service centers in Asia, primarily in Japan, and in China, and in India that was not there in the prior quarter. So, this is a relatively new increase in our customer service costs in Q4.

Jay Freeland

And some of that was just opening costs. These are obviously this is service work that was being done in the past that you would have to go through the cost of the shipping and bringing it back to either Singapore or Lake Mary or to Germany depending on the product that we had to do there. And then the service costs themselves, you've got normalized increases just as the installed base continues to grow, you have your normal increases there and we can't say we have seen anything unusual about service cost growth relative to the installed base growth. It has been fairly consistent that side of it.

So obviously then when you have slightly lower sales than what you are planning for, expecting in the quarter, the sales growth doesn't go with the normalized rate compared to the service cost, which is still going at your normalized rate. That threw it out of proportion as well.

Richard Eastman - Robert W. Baird & Co., Inc.

But are you guys incurring and absorbing any additional service costs that previously might have been captured in a service contract?

Keith Bair

No.

Jay Freeland

I don't think so.

Richard Eastman - Robert W. Baird & Co., Inc.

No? Okay. And then just one last question. Jay, given the current environment and the business and the tone of business maybe going forward, are you in a position at all to pull anything kind of out of the sales toolbox to close orders, whether you stretch out payment terms or again, maybe extend the service contract for the same fee or anything like that?

Jay Freeland

Yeah, you're absolutely right. We're trying a lot of things from the toolbox right now. We have tried additional focus on the financing programs we have available through US Bank and they still have been very supportive in this environment. If the customer has got good enough credit, they have been supportive in getting those deals done.

We have tried basic things. We have had additional focus on getting application out, engineers out to customer sites to help more of the solution sale side of it with them to help them understand better some of the potential problems that they have. We have thrown in the ability to extending the warranties and things like that. So, we have done a lot of the things that are relatively easy for us to do to try and help drive the benefit for the customer.

A lot of it, of course, is just shifts in the marketing too. I think we talked about this during the last call in general. But previously when you would have -- kind of half your marketing would be really tied to the ability to match the technical spec and what it does for the customer from a pure technical feature standpoint, I don't think we are doing any marketing that is unrelated to ROI at this point and the ability to save money for the customers. So, we have shifted that focus substantially as well.

Richard Eastman - Robert W. Baird & Co., Inc.

Okay. And so as you go forward, I mean you guys have never been generous with the guidance. On the gross margin front again, I think there was a question earlier too, the 58% to 60%; given the state of the marketplace, given again, we have got to get some business and some volume, is the backlog, the bit of backlog that you do have, if it is Gage related, that will slant a little bit more on the gross margin line, but are you nervous about the gross margin here given the sales environment? Is that part of the reason that you don't want to give gross margin guidance?

Jay Freeland

Yeah, I think, generally speaking -- I hope this doesn't come across as flippant, Rick, so I am sorry. It is more that we are just nervous about the entire market. It is just it is all of that unpredictability and you are absolutely right. Certainly, sales volume is a huge driver of gross margin for us. So as that becomes less predictable, then our ability to maintain the gross margin feels less comfortable. And so as a result, that makes me feel like it is less predictable, and that is why we are not putting anything out there.

Richard Eastman - Robert W. Baird & Co., Inc.

Okay. All right. Well, hey, thanks.

Jay Freeland

Thanks Rick.

Operator

(Operator Instructions). We will take our next question from the side of Mark Jordan, Noble Financial. Please go ahead.

Mark Jordan - Noble Financial Group

Couple of follow-ups; Jay, can you go back and just talk again about the sort of sales metrics in terms of currently now, what are the numbers of leads that you are fielding, the qualified leads that you develop and then the demos per month that the average sales guy is doing, has that changed or is this the issues are all just in the close rates rather than the other metrics?

Jay Freeland

Yeah, without getting into the specifics of the numbers since we never talk about those, generally speaking, the ratios are about the same except for the close side clearly is longer. The others, obviously there is a little bit of dependency on the account manager and the specific geographic territory that they cover. But generally speaking, that side of the equation has been solid and fairly consistent. It is the back end on the closing side.

Mark Jordan - Noble Financial Group

Okay. So the salesmen still have the requisite number of truly qualified leads to go out and try to develop?

Jay Freeland

Well, again, some of that is the unpredictability. Based on our normal definitions of how we understand qualified leads and the right ones to go after, it certainly appears that most of the guys are in the right bucket. The question is has that changed any, what was qualified in the past, is that still qualified now?

From what we have seen, the answer is still yes, except that it is taking forever for that qualified lead to close. I hate to say. I don't read that the wrong way. It is taking a long time for the qualified lead to close. We haven't necessarily seen a shift yet where how we have defined what is qualified versus not qualified has changed dramatically. We have not seen a change there yet.

Mark Jordan - Noble Financial Group

Okay. You said that you've ended the year with 187 reps. That looks like it is up 25.5% from 149 at the end of last year. Should we assume that in the new environment, that your net adds of reps right now we should kind of build into models in the 5% to 10% range for '09?

Jay Freeland

Yeah. I'm not going to predict a percentage. Historically, we used to say that if we are going to grow 20% to 25%, you would expect us to add account managers at roughly that same clip. Without having sales guidance out there this year, I can't say what the add rate would be.

Given the economic environment, could it be as high as 25% again, probably not. You would have to see obviously a lot of good traction being generated to really run at that clip. At the same time, unless again, unless it got really dire, I don't think we're going to get to a point where we would completely shut off that door because once things do return, obviously you're going to want to have some additional legs out there to keep driving the growth back to normalized rates.

Mark Jordan - Noble Financial Group

A question for Keith. It looks like your interest income is still up around the 2% rate. What is the current reinvestment interest rate you are yielding and is that 2% rate sustainable do you think going forward?

Keith Bair

Currently, we are receiving anywhere from 0.4% to 0.6% interest on our investment.

Mark Jordan - Noble Financial Group

Okay. So, do you have maturities that roll off or is that whole portfolio now down to that rate?

Keith Bair

Yes, the whole portfolio is now down to that rate.

Mark Jordan - Noble Financial Group

Okay. And I guess a final question is on the foreign exchange losses there. The $1.4 million or $1.5 million that you had in the quarter is that a full period loss or is there some offset for that in the operating profit side?

Keith Bair

No, that is the full period loss. There is no corresponding offset. That is basically a mark-to-market adjustment.

Mark Jordan - Noble Financial Group

Okay. And can you kind of weight the currency from an enclosure standpoint?

Keith Bair

Well, we have exposures in Europe where we deal with some of our subsidiaries outside the euro zone. For example, UK, and we have known what has happened to the pound. We also deal with -- we have inter-company transactions with Switzerland, their currency is the Swiss franc, which is outside the euro zone, so there is exposure there. And over in Asia where our Singapore subsidiary sells to India and Thailand and China and Japan as well, there is exposure there. You have some of them going up, but most of them going the other direction.

Mark Jordan - Noble Financial Group

Okay. I guess the final question; could you just give us a little bit of guidance on depreciation expense? Would that [big slug of] CapEx [you put in] kind of the latter part of the year?

Keith Bair

I am sorry. I didn't quite follow the question.

Mark Jordan - Noble Financial Group

The question is could you just give us some kind of guidance on depreciation expense that we could expect given the fact that you have had a big slug of CapEx being spent, invested here in the latter part of the year?

Keith Bair

Yeah. It will probably increase by about, I would say, roughly $1 million or so.

Mark Jordan - Noble Financial Group

Okay. Thank you very much.

Jay Freeland

Thanks Mark.

Keith Bair

Thanks Mark.

Operator

And we will take our next question from the site of [Jeff Bash], Private Investor. Please go ahead.

Jeff Bash - Private Investor

I have got two follow ups, Jay. With respect to the Gage, which we talked about earlier, I remember on the last Investor Presentation that you talked about Hexagon coming out with a new product in that area. Do you have anymore information on that product?

Jay Freeland

I don't. We still really haven't seen them in action and we don't know of any customer losses relative to Gage either. Now, it is very possible they have sold some Gages because that marketplace is so widespread. Obviously, we win lots of deals where there is no competitor in sight in that space. It is possible they are doing the same, but we have not physically seen one operate yet, haven't seen one operate at any of the tradeshows as far as I know.

Jeff Bash - Private Investor

Okay. And with respect to this closing rate issue, I seem to remember that when the economy turned in 2003, the company had experienced one year of a 12% sales decline, but then sort of came out with a slingshot effect that sales suddenly started accelerating at an exceptionally dramatic rate.

Do you see any reason why that might not recur at this time when and if the economy starts to recover, that the close rates make up for lost time and people who are now running these low inventories as they can possibly get away with, suddenly you have to start producing a lot of stuff?

Jay Freeland

Yeah. First comment is I certainly hope they would. Hope is not a strategy, so then we say what is the potential. What is inside the pipeline, obviously, we still believe is good. Everything that is in there, the customers are saying -- particularly if we're waiting on a purchase decision, these customers are saying we want it, we want it, we want it and it is more of the transactional side they just can't get done.

So, if the economy swung -- I think the thing that concerns me is if the economy is on a slow roll upwards, is that enough to spark kind of everybody at the same time out of the slump? Because I think you need to have more than just a slow roll to get that type of a slingshot effect.

So, if there is more than a slow roll, then is there the possibility that we would see a nice jump again into the normalized, quote normalized from what we are used to growth rates? I think that is a possibility given how much is sitting in that pipeline and not being lost. It's just sitting there waiting for the right time. But it is so hard to predict and I do believe that that one is a little bit more economically driven than anything else right now.

Jeff Bash - Private Investor

Thanks.

Operator

And we will take our next question from the side of Jim Ricchiuti from Needham & Company.

Jim Ricchiuti - Needham & Company

This question actually ties into the last question. If we go back to that 2001 timeframe, and Jay, this may not be a fair question because it was prior to you coming to FARO I believe, but how different do you see the company now with its product portfolio and the markets you are going after versus that '01 timeframe when we did see that 12%, 13% decline in revenues?

Jay Freeland

Yeah. Obviously, I wasn't here at that time, so I can only go based on what I know from the history there and what I can see in the data and where we are today. The things that I would look to are, number one, the company is far more global today, so in the 2001 time period, we had a little bit in Asia, a little bit more in Europe and then the bulk really was in the Americas from a sales standpoint.

In 2001, we really only had one product, which was the Arm. We had not made the acquisition of the Laser Tracker business yet. We did not have the ScanArm technology, did not have the Gage, did not have the Laser Scanner. So, as we look at it coming out of this year, we have multiple products in the portfolio.

And then the final piece is, generally speaking, the vertical spread was not nearly as wide as it is today. If you remember 2001, the company had really -- number one, they had only been public for four years. They had only been in the industrial space for eight years and it was absolutely still early adopter technology. It was way back on the adoption curve, whereas pretty much everything we have today, with the exception of the Laser Scanner and the new 3D Imager, everything else is into the early majority.

So there is a different type of acceptance in the market, even though we still have this huge amount of untapped customer base and potential for us. Those are the things I think that make it better positioned coming out of this downswing than it was in 2001. But again, a lot of it is still dependent upon how quickly all the different regions recover and in what order they recover.

Jim Ricchiuti - Needham & Company

Okay, that's helpful. And lastly, just wondering if you are hearing any rumblings from the sales force just in terms of the competitive environment? I would assume things are more competitive as folks pursue business maybe a little bit more aggressively. Have you seen or are you hearing any signs of pricing becoming an issue either from a competitive standpoint or from a customer?

Jay Freeland

No doubt when our team sees our competitor, the competitor is aggressive. Then again, they always have been. That has just been the way they have operated. We have asked multiple times, and it is not quite weekly, but it happens frequently, whether or not significant discounts would make a huge difference and most of the teams still feeds back saying, "this is not a price issue right now, this is a transactional issue, this is tied to the economy and it wouldn't matter how low the price got, there would be very little incremental kick at this point in time." That's not to say we are not trying certain types of promotions in certain areas.

So from that standpoint, I think the competitive environment is not a whole lot different from what we saw in the past. Where I think the competitive environment has changed a bit for our team is it is competing against, this will sound bad, but competing against the customer and it is only because the customer of what they are going through.

We have gotten feedback from the guys where they have said, in some respects, some of this is a lot like when I was a young salesperson and didn't have the full skill set yet, so I was knocking on lots and lots of doors before I would get one to finally pull the trigger and give me my order. Yeah, I got. They were interested, they liked it, but they just wouldn't do it. So in that respect, I think the competitive environment has changed a little bit because you are competing against something that is more out of your hands. Competing against your competitor, you have lots of ways to be able to show what you do and how you do it and why it is better.

But when you're doing it against -- as Keith calls it, it's a bit of the CFO mentality, "Hey, look, I can spend the money and I believe there's ROI and I can spend the money, but then I have to go generate the ROI or I can not spend the money, which is a guaranteed known answer and I don't have to do anything else about it." And so that piece we are definitely competing more against than ever before.

Jim Ricchiuti - Needham & Company

Okay and Keith, I may have missed it. I think you gave some help with how we should think about the tax rate in '09. Did you and can you just repeat that if you did?

Keith Bair

Actually, Jim, I didn't. What I did talk about was some of the losses at our foreign subsidiaries and the fact that some of the losses related to the foreign exchange, we were not able to receive a corresponding tax benefit because some of those foreign subs are relatively new and are still in a cumulative loss position.

Jim Ricchiuti - Needham & Company

Okay. Thanks very much, guys.

Jay Freeland

Thanks Jim.

Operator

It appears that we have no further questions at this time. I would now like to turn the program over to Mr. Jay Freeland for concluding remarks.

Jay Freeland

Well, very good. Thanks, again, everybody for a good call today. We look forward to updating you again at the end of the first quarter. So thanks very much.

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Source: FARO Technologies Q4 2008 Earnings Call Transcript

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