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FARO Technologies Inc. (NASDAQ:FARO)

Q2 2009 Earnings Call

July 30, 2009; 11:00 am ET

Executives

Jay Freeland - President & Chief Executive Officer

Keith Bair - Senior Vice President & Chief Financial Officer

Vic Allgeier - Investor Relations, The TTC Group

Analysts

Mark Jordan - Noble Financial

Jim Ricchiuti - Needham & Company

Richard Eastman - Robert W. Baird

Operator

Good morning everyone and welcome to FARO Technologies conference call in conjunction with its fiscal 2009, second quarter earnings release. For opening remarks and introductions, I will now turn the call over to Vic Allgeier. Please, go ahead.

Vic Allgeier

Thank you and good morning, everyone. My name is Vic Allgeier, The TTC Group, FARO’s Investor Relations Firm. Yesterday, after the market closed, FARO released its second 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.

Including statements regarding the future state of the economy, the company’s future financial condition and results of operations, the company’s operational plans and strategies and their impact on the company’s product development and sales model, the company’s ability to reduce costs, streamline operations, improve efficiencies and reduce inventories, and their short and long term impact on the company, the balance between new and existing customers and the success and continuation of the FARO Test Drive program.

These statements can be identified by words such as expect, believe, predict, intend, will, should, and similar words. These forward-looking statements are subject to a number of risks and uncertainties that might cause actual results to differ materially from those projected in these forward-looking statements.

Important factors that may cause actual results to differ materially are those set forth under the heading Risk Factors in the company’s Annual Report on form 10-K for the year ended December 31, 2008 filed with the SEC.

I will now turn the call over to Keith.

Keith Bair

Thank you, Vic, and good morning, everyone. Sales in the second quarter of 2009 were $34.6 million a 40.2% decreased from $57.7 million in the second quarter of 2008. On a regional basis, second quarter sales in 2009 in the Americas decreased $7.9 million or 39.3% to $12.3 million compared to $20.2 million in the second quarter of 2008.

Sales declined 44.2% in Europe to $15.1 million from $27 million in the second quarter of 2008. Sales in the Asia/Pacific region were down 31.8% to $7.2 million from $10.5 million in the second quarter of 2008. The effect of changes in foreign exchange rates on sales was a decrease of approximately $2.1 million in the second quarter of 2009.

New orders decreased 39.7% in the second quarter of 2009 to approximately $35.4 million compared to approximately $58.7 million in the second quarter of 2008. On a regional basis, second quarter orders in 2009 in the Americas declines 39.6% to $12.2 million compared to $20.2 million in the second quarter of 2008.

Orders decreased 45.1% in Europe to $15.1 million from $27.5 million in the second quarter of 2008. Orders in the Asia/Pacific region decreased 26.4%, $8.1 million compared to $11 million in the year ago quarter. The top five customers by sales volume in the second quarter of 2009 were Northrop Grumman, BMW, the U.S. Military, Daimler, and Siemens, and represented only 4.3% of sales.

The top ten customers in the second quarter of 2009 represented only 7.4% of our sales, once again indicating our lack of dependence on anyone or a handful of customers. Our gross margin was 56.1% in the second quarter of 2009 compared to 62.8% in the year ago quarter.

This decrease was primarily due to a change in the sales mix between higher margin product sales and lower margin service revenue, resulting from a decrease in product sales. As a percentage of sales, selling expenses were 35.1% of sales in the second quarter of 2009 compared to 29.6% in the year ago quarter.

Selling expenses declined $5 million to $12.1 million in the second quarter of 2009 from $17.1 million in the second quarter of 2008. As a percentage of sales, administrative expenses were 17.8% of sales in the second quarter of 2009, compared to 12.1% in the second quarter of 2008.

Administrative expenses in the second quarter of 2009 decreased by $900,000 to $6.1 million from $7 million in the second quarter of 2008, primarily as a result of decreased compensation and travel related costs.

Research and development expenses were $3.3 million in the second quarter of 2009 or 9.5% of sales compared to $3.2 million or 5.5% of sales in the second quarter of 2008. This increase is primarily related to an increase in material costs related to new product development.

Operating margin for the second quarter of 2009 was a negative 10.3%, compared to a positive margin of 13.6% in the year ago quarter, as a result of the previously mentioned decrease in sales and gross margin.

Other income includes foreign currency transaction gains of $800,000 in the second quarter of 2009, compared to a loss of $400,000 in the year ago quarter; interest income decreased by approximately $400,000 in the second quarter of 2009, to approximately $36,000 from $500,000 in the second quarter of 2008, due to a decline in interest rates.

Income tax expense decreased to a benefit of $600,000 in the second quarter of 2009, compared to an expense of $1.5 million in the second quarter of 2008. The company’s effective tax benefit rate for the second quarter of 2009 was 22.1%, compared to an effective tax rate of 19.3% for the second quarter of 2008.

Net income decreased to a net loss of $2.1 million or $0.13 per share in the second quarter of 2009, compared to a net income $6.4 million or $0.38 per share in the second quarter of 2008. The number of fully diluted shares outstanding in the second quarter of 2009 was $16.1 million, compared to $16.8 million in the second quarter of 2008.

The decrease of approximately 700,000 shares is primarily related to the repurchase of approximately 600,000 shares during the first quarter of 2009 of the company’s common stock as part of its share repurchase program.

I will now briefly discuss a few balance sheet and cash flow items. Cash and short term investments were $91.8 million at July 4, 2009 compared to $105.5 million at December 31, 2008. In the first quarter of 2009, the company sold its investment of $82 million in variable rate demand bonds and now holds $65 million of U.S. Treasury Bills.

As I mentioned earlier during the first quarter of 2009, the company repurchased approximately 624,000 shares of common stock, totaling approximately $8.8 million as part of its previously announced share repurchase program.

Accounts receivable was $32.9 million at July 4, 2009 compared to $49.7 million at December 31, 2008. Day sales outstanding at July 4, 2009, increased to 87 days from 81 days at December 31, 2008 primarily as a result of an extension of the collection cycle in Europe. Inventories decreased by $4.2 million to $42.1 million at July 4, 2009 from $46.3 million at December 31, 2008.

Finally, I’ll conclude with some statistics regarding our headcount numbers. We had 810 employees at July 4, 2009, compared to 959 at December 31, 2008, a decrease of 149 or 15.6% primarily related to two reductions in force that occurred in the first quarter of 2009.

Account manager headcount decreased from 187 at December 31, 2008 to 178 at July 4, 2009. We now have 57 account managers in the Americas, 57 account managers in Europe, and 64 account managers in Asia. Geographically, we now have 338 employees in the Americas, 271 employees in Europe, and 201 employees in the Asia/Pacific region.

I will now hand the call over to Jay.

Jay Freeland

Thanks, Keith. Needless to say, business conditions around the world continue to be weak. The weakness certainly doesn’t appear to be in terms of customer interest. Leads and demos are up double-digit year-to-date. Unfortunately, customers simply can’t close. If they have cash, customers can’t get approvals for purchase orders, because budgets for capital expenditures have been cut dramatically.

If they don’t have cash, customers are struggling to arrange financing. Even with their own financing programs through banks in the U.S., Europe, and Asia, the hurdles are still significantly higher than they were this time last year. I keep hearing the phrase "green shoots" discussed by the various talking heads on TV. Though it’s a clever phrase from a marketing perspective, the reality is that it takes an awful lot of green shoots to make a lawn.

Lawns take a long time to grow and grow by sprouting a few shoots at a time. I believe the recovery in the industrial markets will behave in a similar fashion and as a result may require a decent germination period. Nonetheless, the sight of sprouts provides some hope even though hope is not a strategy. So, let me highlight where I do see some positive signs for FARO.

Leads, demos, and as a result the pipeline, continue to grow. We don’t believe we’re losing deals. They’re simply being delayed. We consistently hear the phrase, "As soon as I can get the PO approved, the deal is yours." In an attempt to help our customers work through this issue, we introduced the Test Drive in the U.S. in the middle of Q2 and have seen some nice results there.

Many customers have told us that they would not have been able to do the deal were it not for the Test Drive. As a result, we have selectively introduced modified version of the Test Drive in Europe and Asia, tailored to match market requirements and cultural differences.

As I’ve stated before, if leads and demos weren’t growing well, I’d be far more concerned about the long term health of the company. Sequentially, sales grew almost 10% from Q1 to Q2. I’m not trying to pass the buck on analyzing the year-over-year sales decline.

However, the current market is so fundamentally different that the sequential comparison is really the better way to understand the current climate and performance. That being said, it’s still too early to know if that trend is either predictable or stable. We also return to our historical mix of 50% of our sales coming from new customers and 50% from existing.

Last quarter we saw our mix shift more heavily towards existing customers. No question we were leaning a bit more on our established customers in Q1 to drive sales; however, this quarter, return to our historical norm, which is a positive indicator as new customers are less likely to buy than existing.

Gross margin improved sequentially from the first quarter to the second quarter as well. In Q1, service sales increased as an overall percentage of sales as a result of the decline in product sales around the world. That percentage was relatively consistent this quarter, but the gross margin associated with those service sales increased from 16% to 33%, driven primarily by productivity in the customer service organization.

Product pricing has remained relatively consistent which has also helped. Despite global economic conditions, we continue to receive feedback that price is not a necessary lever for increasing sales. Although the second quarter benefited from the cost actions we took during Q1, we took additional actions at the end of Q2 in order to further drive down costs.

These actions included implementing mandatory unpaid two week furloughs for all departments except Account Managers and a select group of R&D teams. This should result in approximately $1 million of additional savings in 2009. However, there are additional levers we expect to pull in Q3 to continue to reducing our costs to match current sales volume.

For the last 12 months, we’ve been implementing 5S in standard work at our production facilities around the world. 5S and standard work are driving increases in productivity, increased capacity and a decrease in our manufacturing footprint. An additional benefit of standard work is that it makes us significantly more flexible in our ability to respond to changes in customer demand.

These programs also helped us reduce our inventory by over $4 million in the second quarter and we expect to see continued inventory reductions in the second half as we focus on working capital management.

At this point, I’d also like to insert a special thank you for our team in Germany as well as our teams in Lake Mary and Kennett Square. With one day left in the quarter, our production facility in Germany was hit by a severe thunderstorm which lasted 25 minutes. At the end of the storm, the facility was left with 20 centimeters of water on the production floor and nearly a meter of water in the underground parking garage.

After ensuring that there were no injuries, the team went to work assessing the damage and the status of the production and shipping areas. As many of you know, a significant amount of our revenue comes during the final two weeks of the quarter, particularly during the last two or three days. The team’s assessment of the damage was clear. They would not be able to operate for at least a week. That’s when the strength and flexibility of FARO’s manufacturing network kicked in.

Rather than miss a significant number of shipments, the teams in Kennett Square and Lake Mary were able to fulfill orders directly for our customers in Europe while maintaining their shipment schedule for U.S. customers as well. Those actions ensured there was no shippable backlog left in the pipe. At the same time, the team in Germany went to work cleaning and reestablishing our capabilities in Germany.

As is often the case at this time of year, we had customer inventory in the German facility

getting their annual checks during the summer shutdowns, a sizable amount of that inventory was lost and as a result is being replaced with new equipment. We also lost demo inventory, loaner inventory, and a few pieces of equipment.

In total $900,000 had to be written off. The total cost to the company, however was approximately $150,000 net of insurance claims. Through the event, we had members of our German team working round the clock on cleanup, including account managers, who happened to be in town. We also had our production and logistic teams in Lake Mary and Kennett Square working on the Fourth of July holiday to ensure all customer commitments were met.

I highlight this episode not to bore you with the details, but rather to highlight that the FARO team continues to persevere through everything we face. As I stated in last night’s earnings release, we still anticipate the remainder of 2009 to be a difficult operating environment.

As long as the economy remains weak, our customers will continue to have difficulty predicting their own business demands. As long as our customers have uncertainty regarding their operations, it will be impossible for us to provide any level of forward-looking guidance. We will remain flexible as an operation.

We will continue to innovate from a technology perspective. We will continue to be creative in finding ways to serve our customers and ultimately we will continue to ensure that FARO is well-positioned to leverage the economic recovery when it starts. We have a strong balance sheet with $92 million in cash, no debt and a strong team with a huge amount of passion for this business.

As always, my thanks go to the FARO team, our customers and our investors. We remain committed to returning the profitable growth and appreciate all your support in the most challenging of times.

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

Questions-and-Answer Session

Operator

(Operator Instructions) our first question will come from the side of Mark Jordan from Noble Financial. Your line is open.

Mark Jordan - Noble Financial

Good morning, gentlemen and it’s nice to see things at least potentially turning in the right direction, albeit a small turn. Question relative to expenses, sequentially SG&A went down $861,000.

In your first quarter earnings release, you said the two restructurings that were implemented in the first quarter were to have an annualized savings of $11.9 million or roughly $3 million per quarter. When should that full decline in expenses to be seen? I guess I’m surprised, SG&A did not go down more than the $891,000 in Q2.

Keith Bair

Hi, Mark, it’s Keith. Well, a couple of things, there’s additional commissions as a result of higher sales in Q2. There were some legal costs that we talked about with regards to patent litigation. There were some additional R&D materials as a result of product development. So, we didn’t quite get the full impact of the $3 million, primarily related to those additional expenses in Q2.

Jay Freeland

A portion of those savings were also coming from the production side as well. So, they’re actually residing up in the gross margin line.

Mark Jordan - Noble Financial

Again, I just following up on that concept then, looking sequentially, assuming sales are flat to modestly up, would one assume those SG&A expenses would be sort of on the flattish side sequentially or should they decline?

Keith Bair

So, without us getting involved in providing guidance, I think that the concepts are still valid as they were when we announced the RIF programs back in Q1. The number that you talked about roughly $12 million in savings is still a valid number.

Jay Freeland

I think the two, obviously the unpredictable pieces, well there’s a couple different moving parts there, but two unpredictable pieces that go with it are obviously the patent litigation that we expect to continue having some, certainly in Q3 and Q4 at this point.

The other one is and we’ve discussed this before on the phone call. We’ve consistently had questions about, when will the monitor start relative to the FCPA follow-up from three years ago.

We’ve actually had dialogue now over the last three or four weeks with the Department of Justice. This seems to be moving again and it is possible that the monitor would start during the third quarter here, based on just kind of reading the tea leaves and the dialogue that we’re having at this point in time.

As we’ve talked about before, once that starts, it could be anywhere from $1 million to $2 million of costs spread over the time horizon of the monitor stay. Now, what I will say is that, the clock has been ticking for one year on a two year assignment, so to speak.

So what we will be doing is having the monitor come and they will be onsite for only one year. It is my understanding that that is, that the DOJ is consistent in their view of that as well. So that’s the other unpredictable going into Q3 and Q4. It does appear the monitor will probably start during the third quarter, at least late into the third quarter.

Mark Jordan - Noble Financial

Okay. Relative to question, when you’re talking about leads, demos, and therefore business opportunity that’s in limbo, could you tell us how you are revisiting those opportunities? So that as hopefully at some point in time, you get more than green shoots that you’re able to benefit from that business?

Jay Freeland

Yes. There’s a couple different ways. There’s contact from the inside sales team and then there’s contact as well from the account managers, particularly after we’ve already done the demo. As you know, the funnel starts with the leads and when I look at the leads, I’m really looking at our good customer interest leads. It’s not just we have the name of somebody and we haven’t made contact yet, but it might be worth something.

They have actually taken steps to at least have a single or more than one response to indicate they have interest at some level in the technology and have a potential need. So, on the demo side, obviously the concern is when things start opening up again, are we going to have to go back and re-demo the product and reestablish the relationship. So, we use Salesforce.com as a tool globally across all three regions.

So that we can monitor and watch and see where we’re at, you can set up flags, that you follow-up between either the ISS or the account manager to call the customer to see, how things are progressing? Get a status check on the business. So we try to set those at a frequency that keeps us in touch without the customer feeling like we’re nagging them.

Mark Jordan - Noble Financial

Okay, final question relative to the buyback. It sounds like you did not do any in the second quarter. Does the board have a position on what they might do through the balance of the year on that front?

Jay Freeland

Two parts to the question; the first part is correct. We did not make any purchases during the second quarter. We do have a price out there with the firm that’s handling the transactions for us and we’ve not hit that price in a long time. As we go forward, the board is still of the belief that the program is there, it’s in place. If we get to that price that we have established that we will continue to buy on a selective basis and an appropriate basis.

Outside of the blackout periods, I will be managing that still week-to-week depending on how the price is moving with the firm that’s handling the transaction. During the blackout periods we go into with the 10(b) in place indicating what the strike price is and run with it from there.

Mark Jordan - Noble Financial

Any final view as to or any relative to sort of the first month of this quarter relative to the first month of the second quarter in terms of sales activity?

Jay Freeland

It definitely not relative to obviously just from a guidance standpoint, there’s not anything I would comment to you there.

Mark Jordan - Noble Financial

No observations? Okay.

Jay Freeland

As you know, we are very cautious about how we describe the coming quarter as we finish up this previous quarter. I know that’s difficult for everybody, but I feel more comfortable doing it that way. In this environment quite frankly, the way the markets are, I think it makes a lot of sense.

Mark Jordan - Noble Financial

Thank you.

Keith Bair

Thanks Mark.

Operator

Our next question will come from the site of Jim Ricchiuti from Needham & Company. Your line is open.

Jim Ricchiuti - Needham & Company

Thanks. Good morning.

Jay Freeland

Hi, Jim.

Keith Bair

Hi, Jim.

Jim Ricchiuti - Needham & Company

Hi. In the past, you’ve seen some seasonality in Q3. I’m just wondering, in this kind of environment Jay, I mean does that even play into the situation at all, off of these kinds of revenue levels? Is it really not all that relevant?

Jay Freeland

Yes. It’s really hard to predict. You’re absolutely right. We had a fairly consistent seasonality track record over the previous four to five years. “Is it possible?” “Absolutely, no” The flip side is and I was discussing this with the team just the other day saying.

In the past we weren’t come in off a quarter, where sales were down 40% over the previous quarter. So, I don’t know if that’s the appropriate level relative to what the historical trend is or if it’s way off the market. I think it’s just way too hard to tell in the current environment.

Jim Ricchiuti - Needham & Company

Yes. Okay. Keith, with the additional cost initiatives that you have, is there can you provide some kind of quarterly revenue breakeven level that you expect to be at when all this is said and done?

Keith Bair

Based on the cost reductions that we’ve already put in place and making some assumptions with regards to the margins anywhere from 54% to 56%, breakeven levels, if you do the arithmetic, come out to be somewhere between $36 million and $38 million a quarter.

Jay Freeland

Obviously our goal given we’ve described that there are other levers that we intend to pull in the third quarter here is to lower that breakeven point. I’m not at a point where I’m ready to say what the number is because I don’t want to put that kind of guidance out there yet.

Jim Ricchiuti - Needham & Company

Okay. And that’s kind of what I was getting to, Jay. Okay. That’s helpful and last question from me, as you look at your vertical markets, can you tell us which of these verticals appear to you based on what you’re hearing from your sales guys to be closer to recovery, which ones further out? Where are you seeing stability?

Jay Freeland

Again, it’s really hard to predict, you look at it and I keep watching this closely saying, at some point aero and auto are going to really start to impact us in someway, shape, perform and yet here I sit at the end of the second quarter with an aero company and a couple of auto companies sitting in my top five and still seeing decent revenue out of them.

As you look across the board, if you looked at our top ten customers, GM was even in the list during the top ten this past quarter, which seems extraordinary, but in fact they were in there and once they went into bankruptcy protection, it was actually a pretty good environment. So, from that standpoint, we haven’t necessarily seen anyone vertical be hurt, so to speak, or hammered more than the others.

General manufacturing, we’re seeing a little bit of increase there and I think that’s probably only because at some point you have to assume the longer cycle businesses, we are going to start feeling it a little bit more for a short time period before they recover, but again, we haven’t necessarily seen it yet.

I’ve talked in the past, as long as our customers start thinking about the business as a going concern versus how to keep it out of the freefall, then there’s business to be had and there’s opportunity to drive productivity and in many cases it doesn’t necessarily matter if their volume is down 20%, 30%, or up 15% or 20%.

There’s still a need for the productivity inside the facility. We’re still under penetrated in those accounts and we’re going to continue to take advantage of that and work with the customers to help them through it.

Jim Ricchiuti - Needham & Company

Okay. Thank you.

Operator

(Operator Instructions) Our next question will come from the site of Richard Eastman from Robert W. Baird. Your line is now open.

Richard Eastman - Robert W. Baird

Yes, good morning. Just, Jay and Keith, can I just circle back for a second on this restructuring cost realization? In this quarter, basically operating expenses were down again kind of $800,000 plus, but if I go back to the first quarter, this run rate was $3 million quarterly and then in addition in the first quarter you absorbed about $1.7 million of the cost.

Again, that should have more or less disappeared moving into the second quarter. So, I’m still a little bit stuck on are you realizing the benefits that you laid out at the end of the first quarter? Or do we need to take an additional series of actions to actually realize what we had thought we would have already accrued?

Keith Bair

Let me address the Q1 RIF savings. That $1.7 million in severances that you mentioned is split between cost of sales and operating expenses. The $3 million savings is also split between cost of sales and operating expenses. So, if you’re just simply looking at the operating expenses line, we’re off a little bit, but as I mentioned earlier, it’s primarily related to additional legal fees related to patent litigation.

We had some additional commissions related to higher sales levels and we had some additional materials on the R&D side. Up in the cost of sales section, that’s where you’re going to see some of those savings as well, but it’s not as easy to follow, as it is on the operating expense line because of the changes in the mix.

Jay Freeland

Yes. To Keith’s point, the legal fees on the patent case and the increased materials in the R&D through some of the development work we’re doing right now, no question. They were a decent chunk that offsets what we had planned and anticipated out of and are seen out of the RIFs. We are realizing those cost savings.

Now, to your other question though. Is there more to come from a cost savings standpoint, no question, we have other levers that we are going to pull from a company standpoint here in Q3.

Obviously, we already pulled one at the end of Q2 by implementing the furloughs here for the back half of the year, but it’s all intended to drive down what that breakeven mark is from a revenue standpoint, because I’m not comfortable with where we’re operating at this point still.

Richard Eastman - Robert W. Baird

Okay, alright and then, can I also ask you Jay, what was the linearity of the orders in the quarter? I know it’s usually, weighted towards the back months say June, but was it quite extreme here?

Jay Freeland

It wasn’t really that extreme. It was pretty darn consistent. I will say it was a little bit heavier in the final, that final two week rush, but not inconsistent pattern wise with what we’ve seen in any of the previous quarters, just obviously off of a lower dollar amount in total.

Richard Eastman - Robert W. Baird

Okay, alright. What’s your sense on the Europe portion of your business? Does that stabilize around this current level or is Europe still trending south?

Jay Freeland

Yes, it’s tough to say. I think the team in Europe, generally speaking, let me start there, feels like things have are at least somewhat stable. They’ve got a couple of countries that are down doing a little bit better than what we had anticipated and they have a couple of countries that are as bad as we expected it to be.

The one difficulty for Europe of course is that, they are still even in Q3 coming off. Generally speaking, a tough comp compared to Q3 of last year. The Americas, as you know was flat every quarter last year. So, their comps are completely different and in some respects, when you see the declines in the Americas orders still, it shows you just how tough the environment is in the Americas when they’re coming off of a pretty low comp from the previous quarter.

Europe still had a decent comp in Q3 and it was only Q4 that they started really feeling the pain. So, could it truly from a quarter-over-quarter standpoint, could it look ugly again in Q3 for Europe?

I think that’s very possible, but do we feel like, when you look at it sequentially then, do we feel like we could see it kind of bottomed-out and maybe starting to tick the other direction?

I think that is a possibility. The team feels, like I said, they feel like they’re resting at the bottom at this point, as they go into Q3 and then as you know, that only goes as far as you can kind of throw it, so to speak. There’s still so many different moving parts out there. We just don’t know if there’s anything else that would impact them.

Richard Eastman - Robert W. Baird

Okay and then just the last question. Keith, can you just give me a sense of how does the gross profit margin as reported varies so dramatically on the services side. We went from 16% in the first quarter to 33% in this quarter. Last year in the second quarter it was 23%. I mean isn’t that a function of recognizing, a deferred revenue?

Keith Bair

A lot of it has to do with customer service costs. In the first quarter of ’09, we had some severance costs in that customer service number, which affected the margin negatively. There’s a timing issue too with regards to when customers return their products for servicing and the mix of those that are under warranties versus those that are not. So, it can fluctuate from quarter-to-quarter, but the first quarter was unusually low as a result of those severance costs.

Richard Eastman - Robert W. Baird

So, would you put the gross margin on that business without the cost absorption, I mean would you put it around, what 30%? Or, when you weighed it based on your mix of revenue, I mean it’s a huge impact on your gross profit line.

Keith Bair

I think 25% to 30% is probably historically the ballpark where it’s been, but I’m just a little leery of providing guidance going forward.

Jay Freeland

Yes. Again, the tough part is…

Richard Eastman - Robert W. Baird

You can do it, Keith.

Jay Freeland

I think 25% to 30% is fair when you look at the historical trends even outside of 2008 as well. The difficult, it’s that predictability. You go into particularly this quarter, you go into the third quarter, if you get August plant shutdowns in Europe, you get some in the U.S. Might we see more in the U.S. this year just because of the economic climate, possible.

If you get more returns at that point, just further checks but they’re under warranty that will change it versus those who are bringing stuff in for pay by the drink. It is a little bit unpredictable but clearly, yes, I think if you said 25% to 30% is about the right level in a normalized environment.

Richard Eastman - Robert W. Baird

Okay and you’re pricing strategy on new units, does it affect what gross margin on the service side you can record?

Jay Freeland

It does not. No.

Richard Eastman - Robert W. Baird

Okay and then, one last question. On the Test Drive program, how do you book revenue on that?

Keith Bair

During the rental period, whatever we receive as rental payments gets reported as income. The actual unit that goes to the customer ends up being depreciated so there are some costs that offsetting that rental income. When they buy the unit, we record the sale at the discounted price and a reduced margin at that time.

Richard Eastman - Robert W. Baird

Okay. So, the rental payment becomes your revenue?

Keith Bair

That’s right.

Jay Freeland

Yes, during the trial period. That’s right.

Richard Eastman - Robert W. Baird

The cost on that unit, does that go into inventory? Does that unit cost?

Keith Bair

The depreciation, the cost on that rental unit actually goes into cost of sales.

Jay Freeland

Yes. The unit itself is certainly residing in inventory. We’re using existing assets to manage the program, but, yes, the cost hits gross margins.

Richard Eastman - Robert W. Baird

I see. Okay. Thank you.

Keith Bair

Thanks, Rick.

Operator

(Operator Instructions) It appears that we have no further questions at this time.

Jay Freeland

Very good. Well, thanks, everybody for participating in the call today and we’ll look forward to updating you again at the end of the third quarter.

Operator

This does conclude today’s teleconference. You may disconnect at any time. Thank you and have a great day.

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Source: FARO Technologies Inc. Q2 2009 Earnings Call Transcript
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