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FARO Technologies Inc. (NASDAQ:FARO)

Q2 2013 Results Earnings Call

July 31, 2013 08:30 AM ET

Executives

Vic Allgeier - TTC Group, IR

Jay Freeland - President and CEO

Keith Bair - Senior Vice President and CFO

Analysts

Patrick Newton - Stifel

Mark Jordan - Noble Financial

Jim Ricchiuti - Needham & Company

Hendi Susanto - Gabelli & Company

Richard Eastman - Robert W. Baird

Operator

Good morning, everyone. And welcome to the FARO Technologies Conference Call in conjunction with its Second Quarter 2013 Earnings Release. At this time all participants are in a listen-only mode. Later, you’ll have the opportunity to ask questions during the question-and-answer session. You’ll receive instructions later in the conference. Please note this call maybe recorded and I will be standing by should you need any assistance.

It is now my pleasure to turn the conference over to Vic Allgeier. Please go ahead.

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 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. 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 expect, will, believe, potential, continue, predict, target, growth targets, goals, 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 second quarter of 2013 were $68.3 million, a 2.3% increase from $66.8 million in the second quarter of 2012. On a regional basis, second quarter sales in 2013 in the Americas increased $2.7 million or 10.5% to $28.4 million, compared to $25.7 million in the second quarter of 2012.

Sales were flat in Europe at $23.2 million in the second quarter of 2013. Sales in the Asia Pacific region decreased $1.2 million or 6.7% to $16.7 million from $17.9 million in the second quarter of 2012.

The effect of changes of foreign exchange rates on total sales was a decrease of approximately $0.6 million in the second quarter of 2013 compared to the second quarter of 2012. New orders decreased 6.1% in the second quarter of 2013 to approximately $66.7 million, compared to approximately $71 million in the second quarter of 2012.

On a regional basis, second quarter orders in 2013 in the Americas increased to $27.5 million from $27.4 million in the second quarter of 2012. Orders decreased 15.9% in Europe to $21.7 million from $25.8 million in the second quarter of 2012. Orders in the Asia-Pacific region decreased 1.7% to $17.5 million, compared to $17.8 million in the year ago quarter.

The top five customers by sales volume in the second quarter of 2013 were Boeing, General Motors, Global Tooling Systems, Dimensional Certification and the U.S. Military, which collectively represented only 4.1% of sales. The top 10 customers in the second quarter of 2013 collectively represented only 5.7% of our sales, once again indicating our lack of dependence on any one or a handful of customers.

Gross profit decreased $0.2 million to $36.9 million in the second quarter of 2013 from $37.1 million in the prior year quarter. Our gross margin was 54% in the second quarter of 2013, compared to 55.5% in the year ago quarter, primarily due to a decrease in gross margin from product sales to 58.5% in the three months ended June 29, 2013 from 59.7% in the three months ended June 30, 2012, as a result of lower average selling prices.

As a percentage of sales, selling expenses increased to 24.5% of sales in the second quarter of 2013, compared to 23.7% in the year ago quarter.

Selling expenses increased $900,000 to $16.7 million in the second quarter of 2013 from $15.8 million in the second quarter of 2012, primarily due to an increase from compensation of $600,000 and travel costs of $300,000.

As a percentage of sales, administrative expenses decreased to 11.5% of sales in the second quarter of 2013, compared to 12.2% in the second quarter of 2012. Administrative expenses in the second quarter of 2013 decreased by $0.3 million to $7.8 million from $8.1 million in the second quarter of 2012, primarily as a result of a decrease in professional fees of $1.2 million related to the FCPA matter, offset by an increase in compensation of $300,000, an increase in other professional fees of $300,000 and an increase in bad debt expenses of $200,000.

Research and development expenses increased to $5.2 million for the second quarter of 2013 or 7.6% of sales, compared to $4.5 million or 6.8% of sales in the second quarter of 2012. The increase is primarily related to an increase in compensation expenses of $400,000 and subcontractors’ expense of $200,000.

Operating margin for the second quarter of 2013 was 8%, compared to 10.3% in the year ago quarter.

Other income expense net increased by $100,000 to an expense of $500,000 in the second quarter of 2013, from an expense of $400,000 in the second quarter of 2012, and primarily represents the effect of changes in foreign exchange rates on the value of the current inter-company account balances of the company’s subsidiaries denominated in different currencies.

Income tax expense decreased to $1.4 million for the second quarter of 2013, compared to $1.7 million in the second quarter of 2012, due to a decrease in pre-tax income. The company’s effective tax rate for the second quarter of 2013 was 27.4%, compared to 27% for the second quarter of 2012.

Net income decreased by $1.1 million to $3.6 million or $0.21 per share in the second quarter of 2013, from $4.7 million or $0.28 per share in the second quarter of 2012. The number of fully diluted shares outstanding in the second quarter of 2013 was 17.2 million compared to 17.1 million in the second quarter of 2012.

I will now briefly discuss the few balance sheet cash flow items. Cash and short-term investments were $176.3 million at June 29, 2013, compared to $158.2 million at December 31, 2012, and include $65 million of U.S. treasury bills.

Accounts receivable is $51.2 million at June 29, 2013 compared to $62.6 million at December 31, 2012. Days sales outstanding at June 29, 2013 decreased to 69 days from 71 days at December 31, 2012, primarily as a result of improvements in collections in Europe.

Inventories decreased to $65.6 million at June 29, 2013 from $68 million at December 31, 2012 primarily due to a decrease in raw materials of $3.2 million and a decrease in service inventories of $1.3 million offset by an increase in finished goods of $2 million.

Finally, I’ll conclude with some statistics regarding our headcount numbers. Globally, worldwide sales and marketing headcount increased by 56 or 15.7% to 413 at June 29, 2013 from 357 at June 30, 2012. Globally, account manager headcount at June 29, 2013 increased by 34 or 19.2% to 211 from 177 at June 30, 2012.

Regionally, account manager headcount increased by 15 or 25.9% to 73 at June 29, 2013 from 58 at June 30, 2012 in the Americas. Europe account manager headcount increased by 7 or 12.5% to 63 from 56 and Asia increased account managers by 12 or 19% to 75 from 63.

We had 1,031 employees at June 29, 2013, compared to 938 at June 30, 2012, an increase of 96 employees or 10.2%. Geographically, we now have 412 employees in the Americas, 347 employees in Europe and 272 employees in the Asia-Pacific region.

I will now hand the call over to Jay.

Jay Freeland

Thanks, Keith. I’m going be relatively brief so that we can get right to the Q&A. Sales growth for the quarter at 2% was lower than our expectations. We’re continuing to face economic headwinds, particularly in Europe and Asia, as we have been highlighting over the last few quarters.

Auto sales in Europe were at their lowest levels in two decades. Industrial output in China and Japan continues to slow and credit markets are tight in countries like India. While the Americas remains a bit of a bright spot, achieving double-digit sales growth in the second quarter, European and Asian economic conditions remain relatively weak and are having a real impact on the business.

Customer interest is strong in those regions but purchase decisions are being delayed. In the Americas, the industrial markets we’re in are investing more meaningfully as are the surveying and construction markets we serve with the laser scanner.

Sales of existing customers globally were 64% in the second quarter, demonstrating that the ROI generated by FARO’s product is strong enough to justify additional asset purchases despite the pressure that economic uncertainty has on customer CapEx budgets.

However, convincing new customers to purchase in this environment is obviously a more difficult task. As I just stated, there is good interest, but getting them to invest in something new in this environment remains challenging.

Sales of the Vantage Laser Tracker were very strong in the quarter as were sales of FaroArms though arm sales continue to be impacted by aggressive price competition in the marketplace.

ScanArm sales and Focus laser scanner sales were not as strong as we would have liked in the second quarter. ScanArm sales were impacted by some of the economic difficulty in the industrial environment I just discussed.

To be clear, the laser scanner is still doing well in the marketplace, but our high expectations for the product were not fully met in the second quarter. Specifically, distributor channels for the laser scanner in Europe and Asia did not perform as well as we would have liked. This is not an issue of competition. The Focus laser scanner continues to be the only device of its kind in the market.

We have programs in place to help our distribution network enhance its performance. We’re also continuing to work more closely with additional distributors in the space. We expect both of these initiatives to drive incremental improvement in laser scanner growth in the second half of this year.

As we manage the current headwinds, we have continued to invest in the future of FARO via new sales personal in all three regions and increase product development resources and spending.

As a company, we have been adding to both groups for the last four or five quarters. We expect to see benefits from these increases in the second half of this year. New account managers have been assigned to multiple territories where leads and overall customer interest was larger than existing account manager capacity, even as the productivity of the new account managers is lower than our expected run rates, they should still generate incremental sales that we aren’t getting today.

New R&D personnel are helping us accelerate our robust product development pipeline. My aim as always is to maintain our technology leadership position, several of these programs are the direct result of the Cambrian explosion initiative launched last year and the remainder are tied to our strategy have also leading previous generation of our existing product line every three to four years.

The pipeline today is stronger than ever. The next 12 months will be very exciting for us on the product side and we are positioned to maintain an aggressive pace of introductions well into the future.

We’re continuing to look aggressively at acquisition opportunities to help us broaden our portfolio, while simultaneously strengthening the offerings we provide to our customers. With close to $180 million in cash, we have substantial capacity for growth through M&A.

As always, my criteria focus is on technology first, people second, then on financial impact. There are several interesting companies we’re reviewing right now and several additional ideas, which could expand our efforts here in the coming months and add meaningfully to the company.

On the personnel side, two weeks ago I finished a search for the new Managing Director for the Americas. This is a significant role at FARO because it contains full P&L responsibility for all business in the Americas, as well as global R&D and manufacturing for three of our product lines.

As previously announced, we have is hired Kathleen Hall to fill this role. Kathleen was most recently a Corporate Officer at Avery Dennison, following the successful career at duPont.

She has managed businesses significantly larger than the Americas in her past roles and has strong international experience. Kathleen has hit the ground running and is off to a good start. I have high expectations for her and she has high expectations for herself, a good combination in any company.

Also as previously announced, our nearly five-year patent dispute with Nikon was resolved soon after the quarter ended. You’ll recall that FARO received a favorable verdict in a bench trial on the first patent and a favorable ruling from a jury trial on the second patent in question. Reaching a settlement with Nikon avoids any further cost impact from the appeals process or otherwise, and eliminates a minor but persistent distraction for the company.

Despite everything we’re seeing in the marketplace, we continue to believe that performance should improve in the second half of the year both on the topline and the bottom line.

The ongoing economic uncertainty does create pressure, particularly in Europe and Asia, where meaningful economic improvement is unlikely in the near-term. However, there are enough things going well internally to help us work through those economic issues.

Thank you for your attention and I’ll now open the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) We’ll take our first question from Patrick Newton with Stifel. Please go ahead.

Patrick Newton - Stifel

Yeah. Good morning, Jay and Keith. Several questions here, I guess, thanks for the details on the arm volumes, it sounded like that was actually a pretty good data point but clearly some mature pricing pressure. I’m curious is to whether you’re walking away from any business in the arm due to pricing?

Jay Freeland

Relatively few transactions, I can’t say, we’re not walking away from any. But what we have done and it’s similar to what we did in the first quarter is that, we’re being more aggressive out of the gate anyways and we are discounting further as needed depending on the strategic value of the customer, is one that we’re trying to get into and haven’t been in before, is one where we have a very strong installed base and relationship.

So we’re moving there as appropriate. At the same time, there comes a threshold where you examine the transaction and say, gees, we could go another, pick a number 5 points, 8 points and is the competition going to follow anyway. So you get to a point where it’s, some of them you just decide to hold off. So have we walked away from a few, yeah, I think a few. Do I believe it has impacted our share materially? No, not at all.

Patrick Newton - Stifel

And I believe that last quarter you guys were kind of scratching your head as to what drove the somewhat sudden and persistent pricing pressure out of Hexagon? I’m curious if you have any sense of the reasoning behind it, duration or is this -- should we think about this pricing pressure in perpetuity?

Jay Freeland

Perpetuity is a long time, of course, what I will say is that, we are assuming this will continue for some period of time to come and as a result, have planned the business around that and we’re planning both, just our market approach, as well as what we are doing on the R&D side to ensure that we can remain competitive, if that environment is to continue. At the same time, obviously, if the pressure eases up, we’re prepared for that as well, that’s obviously an easier decision.

I think, in the current economic environment that maybe driving some of the activity out of the competition. I think given the high market share that FARO has in the arm marketplace. We believe we still have as much as 70% of the installed arm share around the world. This may be a little bit of an attempt to land grab and so, like I said, we’re doing everything we can to ensure we remain competitive but being as smart as possible about that.

Patrick Newton - Stifel

And could you update us, dovetailing off the competitive comment on your new product introduction side and what you’re doing there? Is -- I think you’ve talked about likely one, not necessarily new product, but one important refresh by the end of the year? Is there any chance we could see some new product introductions pulled into this calendar year or should -- or perhaps in 1Q?

Jay Freeland

I’m not going to say pulled into this year, though I still remain confident that we have one very meaningful product release in the second half of the year. Without saying the timing of next year, obviously there are some that we expect to occur during the first half, since in the commentary, I said, look the next 12 months look very promising on the product development side. I’m not going to comment yet as to whether they will be in the first quarter or second quarter, you can assume that there is probably a little bit of both.

But as focus as we are on speed, I’m also very focused on the meaningfulness, the accuracy of the product not from a technical standpoint but does it meet the customer spec, does it meet the customer demand, does it meet a new demand that they haven’t necessarily been asking a lot for, is it the most competitive that it can be in the market. Those are all obviously important factors that occasionally weigh in to the final release date even as much as a few months in advance of when it comes out, so.

Patrick Newton - Stifel

And as we think about these investments for new products, Keith how should we think about your OpEx trending sequentially in the September quarter and then through the remainder of the year?

Keith Bair

Well, I think, one of the largest variables in our OpEx has always been the Nikon litigation and I think now that that’s behind us, I think, one of the wildcard is taken out of the equation. I think that the other variable that we’ve experiencing is continuing the headcount and building for the future.

So to the extent that we continue to do that, I think you may see a little bit of an increase in OpEx going forward as we continue to add account managers, mostly account managers in sales and marketing people, as well as R&D.

Jay Freeland

Yeah. Just to piggyback on that though, I guess, I would say that there has probably been more heavy lifting done in the first half in that regard than we will see in the second half.

Patrick Newton - Stifel

Okay. And then, as far as the $1 million in legal and professional fees, is that 100% out in the September quarter or was that year-over-year comp that you were alluding to in your press release?

Keith Bair

That was a year-over-year comp.

Patrick Newton - Stifel

What’s the sequential impact from legal perspective by Nikon going away?

Keith Bair

I think it was roughly a little bit over $1 million in the third quarter of last year.

Jay Freeland

Yeah.

Patrick Newton - Stifel

Versus what in 2Q?

Keith Bair

Sequentially.

Patrick Newton - Stifel

Yeah.

Keith Bair

A couple $100,000 for the Nikon litigation in Q2.

Patrick Newton - Stifel

Okay. Perfect. Thank you, gentlemen. Good luck.

Jay Freeland

Thanks, Patrick.

Operator

And we’ll go next to Mark Jordan with Noble Financial. Please go ahead.

Mark Jordan - Noble Financial

Good morning, gentlemen. Jay, a question relative to marketing, you spent a lot of time focused on that area, I think, in Europe and domestically as you have made changes in management there? I was wondering if the time you had spent focusing on that and bringing in the new people, has there been any change or have you identified ways to modify your marketing programs that would improve or the productivity or enhance the ability to identify and qualify customers?

Jay Freeland

Yeah. That’s a great question. So I would say in the Americas it’s a little early to say that, given that Kathleen really just started and obviously with any new leader particularly when it has a tremendous amount of commercial experience, as both Kathleen did, previously and as Ralf did, and I will go back to Europe in a second.

So I think it’s a little early in the Americas to say that there have meaningful changes there. That being said, I think it’s very safe to assume there will be changes in our marketing approach and how we go to market and trying to drive our efficiency there in the second half out of the Americas.

And it’s a good time for us to be doing it because we obviously feel very good about the Americas market, performance has been pretty good the first two quarters and we do feel like the second half looks good there.

In Europe, there have been meaningful changes made already. The impact of those changes has not pushed through or translated through yet. There is some lead-time and lag I think between making your changes, generating your new leads, getting the leads into the hands of the inside sales team, getting them to work the leads and then getting those into the hands of account managers who can go out to the customer, and then handle the rest of the sales process.

So, I think we have plenty of good leads on the table. One of the reasons that we continue to add account managers was, when you look at territory coverage, we had still in the second quarter even more leads coming in the door than account managers to handle them, given the capacity constraint of how many demos in a month an account manager can do.

So that’s a good thing and some of those incremental leads for sure are new programs and some of them are just, there is good interest there. But again, the economic environment makes it harder to pull the trigger.

I suspect that when you look at the second half of the year, you will get a combination then of the changes to some of the marketing programs and how we are going out to market, from a marketing standpoint in Europe, coupled with the additional account managers and those individuals coming up to speed, particularly the ones who were added in the first quarter, adding more incremental revenue in the second half of the year, it’s one of the reasons that we feel good about Europe in the second half, despite the fact that the economy may not move meaningfully during that time period.

Mark Jordan - Noble Financial

Okay. Question, in the Americas you obviously saw growth year-over-year in revenue. If you were to exclude the scan product, did the legacy arm product families grow year-over-year?

Jay Freeland

What I’ll say is, we try not to get into specific details on the product lines. What I will say is that, the metrology side was good and the laser scanner was also good, obviously we are looking for great out of both. So 10% for the Americas year-over-year versus our normal internal targets, I think 10% is good, we certainly can do better. But I would say it was well-balanced.

Mark Jordan - Noble Financial

Okay. Final question. You did talk about the rating potential acquisitions in terms of technology, financial, et cetera. One thing you didn’t talk about is, during this period of difficulty, you have had opportunities where the stock has hit recent trading lows. Where would you put the potential of using some of that cash as a buyback?

Jay Freeland

Certainly, I won’t flag a price, but what I’d say is that, we do have a buyback still in place, we have not transacted on it since the beginning of 2009, so it has been a while. We still believe fundamentally that the best use of our cash is the right acquisitions to drive the growth of FARO over the long-term.

So, obviously, that’s still my priority, where I would like to deploy it. I think as it continues to grow it’s a question of, if we -- we have some acquisitions that we’re looking at right now that would meaningfully utilize the cash position that we have inside the company.

If I can deploy it in that regard that’s still priority number one and it would, if deployed in that fashion then I think most of us would look at it and say, hey, using it for a buyback at that point will give less valuable move to the company long-term. I still think it’s, obviously there is near-term impact from doing something like that. But we have really interesting acquisitions that clearly change the long-term position of the company.

Mark Jordan - Noble Financial

Thank you very much.

Jay Freeland

Thanks, Mark.

Operator

And we’ll go next to Jim Ricchiuti with Needham & Company. Please go ahead.

Jim Ricchiuti - Needham & Company

Hi. Thank you. Good morning.

Jay Freeland

Good morning, Jim.

Jim Ricchiuti - Needham & Company

Jay, I’m still struggling a little bit with the, what I think you are indicating improvement in the second half and I’m trying to get a better sense as to what’s going to drive that. My impression was Q4 last year was a good quarter for the scanner with the Trimble channel fill initially anyway. What drives the improvement? Is it increased sales coverage, account managers, are you anticipating some better market conditions in Europe?

Jay Freeland

Yeah. So I would be less focused on better market conditions in Europe, like obviously that would help. But I don’t have confidence and I can’t control it certainly as to the improvement, any type of economic improvement there in the next six months.

The key drivers, I think you’re right on the laser scanner. Though, Q4, actually I think Q4 was just an, okay, quarter by FARO standards. It was better than what the street was estimating but from an internal standpoint, when you look at what we’re normally used to, I thought Q4 was sort of average from a performance standpoint.

We did have obviously revenue going through into the distribution network in Q4 and obviously through the distribution network as well. We still don’t have -- we don’t have 50 or 60 distributors who are all taking 20 and 30 units at a time, and then figuring out how to weed them out of the system. They still tend to buy in clumps of three, four, five.

So I think that some of this is just as they continue to come up the learning curve, become more efficient in their ability to sell the product. They get continued assistance out of some of the FARO personnel on the right way to present it. Those are all things that will help improve the laser scanner side.

On the metrology side, it’s almost entirely driven by the increment in account managers. And I’m not saying that there may not be new products that would enhance that as well. But if you just look at the year-over-year growth in account managers in Q1, again in Q2, the growth will slow down a bit in Q3 and Q4 because I think we’ve added sufficiently -- for the most part, we’ve added sufficiently in the first two quarters of this year.

That learning curve, which can run anywhere from six months to nine months, like I said, even if they’re not at full productivity, if they are generating any revenue at all out of the leads that we have, that aren’t getting handled by people currently or weren’t getting handled by people in the first and second quarter, that has the potential to add meaningfully to the revenue stream in the second half. And so I think even without economic improvement in Europe or in Asia that is still possible when you look at that headcount growth around the world.

Jim Ricchiuti - Needham & Company

It’s clear Europe is still relatively weak but from looking at, for instance, the automotive vertical, it appears that some of the export driven auto companies are doing a bit better. What is your experience? What are you seeing from some of those players? Are you seeing the same cautiousness on their part as well?

Jay Freeland

We are, it depends on the customer. So, we have some that, I won’t say which ones, but some that are always sort of ahead of the curve on making sure their investments keep pace with where they see the business headed in two or three years, not in the next 12 months.

That being said, when you look at overall and I highlighted it earlier, auto production in Europe in total and demand in Europe is the lowest it has been in 20 years. In Germany it’s the lowest it has been I think in 25 or 28 years, something like that.

So clearly, the levels of production are significantly lower and it does drive some alternative focus within the companies as to what they are doing with retooling their plants or what they are doing to maintain that lower demand volume and keep the business moving. And while we’re an important investment there, there are obviously lots of other places they can invest their CapEx dollars that are also beneficial to the company in that kind of weak environment.

Some improvement there over the next few quarters, obviously would have some benefit. We’re seeing a little better out of Asian Auto at the moment, but not -- I can’t say it is meaningful yet either.

Jim Ricchiuti - Needham & Company

Okay. You mentioned just getting the final question on the scanner. I think you characterized Q4 last year as an okay quarter by FARO standards, not necessarily great. Q2, I get the sense, was not also a great quarter for the product, given the wider distribution. What do you think is happening there?

Jay Freeland

Yeah. So, I’ll say first that my comments relative to Q4 are generic to FARO in total, not specific to say laser scanner versus metrology. Just in general, Q4 was not as strong as we would have liked. It obviously wasn’t bad but we still would have liked more.

Q2 was the same thing. Though I’ll say that in Q2, I can definitely highlight that. There is some disappointment on our part for the laser scanner. Some of it is that we have very high expectations of what that product should be doing. So it’s relative to how high that expectation level is.

What I think we’re seeing is, if you look at our primary distribution channel which is through Trimble currently. They are very good in the Americas. So, the scanner performance there has been pretty consistent the last couple of quarters, last three or four quarters.

It is not the only driver of growth in the Americas. The metrology side did well. The Laser Tracker is doing extremely well in the marketplace. That new Vantage tracker that released almost a year -- basically year ago now is -- has been really well received in the marketplace and has received favorable pricing in the marketplace.

But Europe and Asia, the distribution network is not nearly as strong through Trimble there. The support structure, the leadership structure is not as strong as the structure they have in the Americas. And so that is certainly one of the reasons that we have started working more closely with Topcon, who is one of the other three sort of primary players in the construction surveying space. And as we get tighter with them, then that’s another way that we see opportunity in the second half of the year to improve that performance in the laser scanner side.

When you look at the individual by -- on the distributor by distributor basis, you really get down to, I think, both talent and ability to embrace the product, which is kind of a one-off at every single distributor. You have to treat them differently. So you can’t make a mass comment about all of them in that regard. Some are really good at it already.

They understand exactly where to sell it, what the best applications are, how to show it to the customer. Some are definitely still in that learning phase. And that’s not necessarily to be unexpected though we would certainly like to see that move faster.

We are spending more time and attention on trying to get, particularly in Europe and Asia, to try and get those folks better trained, better prepared for how to show the product, because it’s clear that the interest and demand is still there. Now it is the ability for them to execute.

Jim Ricchiuti - Needham & Company

Okay. Thanks. I will jump back in the queue.

Jay Freeland

Thanks, Jim.

Operator

And we’ll move next to Hendi Susanto with Gabelli & Company. Please go ahead.

Hendi Susanto - Gabelli & Company

Good morning, Keith and Jay.

Jay Freeland

Good morning.

Keith Bair

Good morning.

Hendi Susanto - Gabelli & Company

Warranty revenue increased positively in Europe and North America, may I know what the attach rate of warranty services look like in Q2 and let’s say relative to Q1 and Q4, and where do you expect that going forward in the second half?

Keith Bair

I am sorry, I think I missed the -- was that the question what the attach rate was in each of the individual regions?

Hendi Susanto - Gabelli & Company

Yeah. The attach rate of the warranty services for the EFC and any meaningful increase in the last, let’s say like three quarters?

Keith Bair

I don’t know if we’ve disclosed the attach rate specific to warranty before. I think, in general, we’re seeing good growth out of warranty in all three regions. We have been more aggressive in trying to sell them, particularly the expanded warranties not just the normal warranty that comes on the first purchase.

We now have individuals in place in all three regions, that their only role is to sell extended warranties and expanded warranties to the customer base and that focus by itself has driven an increase there. But relative to attach rates specific to the service side or warranty side, I don’t think we have ever disclosed down at that level of detail.

Hendi Susanto - Gabelli & Company

Would you be able to share like, let say, qualitatively whether there is still like more room to grow?

Keith Bair

More room to grow service revenue?

Hendi Susanto - Gabelli & Company

Yeah. The warranty services, attach rate?

Keith Bair

Attach rate. Okay. Yeah. So there is room to grow that for sure. Obviously any new unit growth creates opportunity. I can’t say that we’ve got, I won’t give the exact percentage, but certainly we are not at a point where the majority of customers have an extended warranty or an expanded service agreement on their product. So obviously if you don’t have a majority that certainly leaves plenty of run rate there.

Hendi Susanto - Gabelli & Company

Yeah. And then earlier this year management had set expectation of reducing the pricing discount practice going into the second half of 2013. What did the pricing discount look like in Q2 relative to Q1 and in light of the current market will selective aggressive pricing continue into the second half?

Keith Bair

We haven’t disclosed the exact percentage of what the discounting was though it is meaningful. I have said before the competitors, it is not unusual in this environment right now that they are 25% below our normal pricing in some cases.

And as I said earlier, we will definitely -- our assumption and so I have planned the business accordingly is that these price levels while Q1 and Q2 discounting is similar, so I can’t say that it accelerated in Q2. We assume that rough environment continues at least the rest of this year and so we’re planning accordingly.

Hendi Susanto - Gabelli & Company

Thank you.

Keith Bair

Thank you.

Jay Freeland

Thank you.

Operator

And we’ll go next to Richard Eastman with Robert W. Baird. Please go ahead.

Richard Eastman - Robert W. Baird

Yeah. Good morning, Jay and Keith.

Jay Freeland

Hi, Rick.

Keith Bair

Hi, Rick.

Richard Eastman - Robert W. Baird

Just a question, Jay you had commented about Asia sales being down and you commented about credit conditions in India. Are you seeing the same situation in China? And can you give us a sense of what China sales did in the quarter?

Jay Freeland

I won’t say specifically what they did. I will say that they are part of the general statement of not as we would have expected for sure and that’s generic to Asia and certainly China is a piece of that. China is one of the big three for us in Asia, Japan, China, India, and obviously they are a contributor to that.

Yeah, I should -- you’re right, Rick. I should have clarified that. The credit situation in China also continues to be very difficult. In China now, this is, I believe, its five quarters in a row, possibly six, certainly five, where we have seen this difficulty of customers obtaining credit and for everybody the reminder there is that in China, a large number of our customers particularly the smaller ones, not our big multinationals. But our smaller ones, we make them pay 100% upfront or close to it and many of them require credit to be able to do that.

So the ability to get credit continues to be very slow. Its not that they’re not getting credit, but it definitely is slower. We have seen some instances where once the customer receives credit, the bank has paused what I would say extraordinarily long in then providing the funds to that company.

And so that is sort of an exacerbating impact. So, yeah, it is still there and we’ve not necessarily seen anything out of the government that would imply that the industrial credit market anyways would necessarily improve in the next couple of quarters. So it’s slower. It’s not that they’re not giving credit. It just takes a long time for customers to get approved.

Richard Eastman - Robert W. Baird

Was there -- given Japan in that sales number for Asia Pac, was there a currency impact there that essentially exceeded the consolidated number?

Keith Bair

Yeah. There was an offset in Japan, it was roughly about $1 million.

Richard Eastman - Robert W. Baird

Okay. $1 million, so that Asia Pac revenue number as reported includes $1 million negative FX impact?

Keith Bair

That’s right.

Jay Freeland

Correct.

Richard Eastman - Robert W. Baird

Okay. And then I have a question on services. Two things on services? One is, how is it that the service gross margin sequentially drops as much as it did? And then secondly, how does services revenue growth has been greater than product growth for like five straight quarters. And I’m trying to understand, how is -- again if you’re not selling one product, if your product sales are flat, how is it that your services revenue is growing for that consecutive period of time?

Keith Bair

Let me address the sequential margin issue first. In the second quarter, we added quite a bit to the capability of the other regions to service the laser scanner. Previously the laser scanner had to be sent back to Germany for servicing. So there was quite a bit of costs incurred in getting the Americas, as well as Asia set up to service the laser scanner.

A lot of that on the service side in the margins can fluctuate depending upon how many units you’ve serviced that quarter. It depends upon the sales mix, whether it is a time and materials, sort of a paid by the service or if it is covered under warranty. So there is a lot of factors that can go into that margin. But I think one of the biggest issues or contributors in the second quarter was the expenses incurred to build out the laser scanner.

So going forward, I think we’re probably give or take in that 35% to 40% range. Historically, we’ve been over the past probably five years or so, probably in the 30% to 35% range.

Jay Freeland

Yeah.

Keith Bair

With regards to the services growth, I think that comes from primarily a focus on the sales of the warranty product itself and the dedicated inside sales people we have focused on selling those additional warranty contracts.

Richard Eastman - Robert W. Baird

So you will actually go back to units installed and attempt -- and sell a service contract?

Jay Freeland

Yeah, in fact, that has definitely been a driver of the growth. Previously, the account managers and I hate -- I don’t want to say it this way because it sounds worse than it is. But the account manager would try to sell extended warranties while they are in the midst of handling other transactions, it was sort of a side project. And what we saw was that by adding a relatively small number globally, a couple of each region of inside sales people, to just go back to the installed base and focus on the value and the benefit that an expanded service contract can provide, has definitely proven valuable.

And so the growth rate granted is coming off of a fairly low revenue number to start with, but that is driving the growth rate. And I think based on the question earlier, is there still plenty of installed base to go after currently. Yeah, because we are definitely not at a point where the majority are as successful as we’ve been with the program. We are not at the point where the majority are holding expanded service contracts or extended warranties.

Richard Eastman - Robert W. Baird

I see. Okay. And then Jay, when I look at the orders in the quarter, in the second quarter, and I look at how your business typically unfolds seasonally, typically you see a third quarter where orders drop below -- the third quarter orders drop below the second quarter and a lot of that has to do with seasonality in Europe.

But given the tone of business and how you’ve spoken to it here, as second quarters rolled out late in the second quarter, is there any reason to believe that that order pattern, that seasonal order pattern doesn’t play out again this year, where your orders in the third quarter maybe sag a bit further?

Jay Freeland

I guess, I’ll start at a conceptual level. Despite economic uncertainty, it appears that we’re going to see in the normal vacation schedules out of Europe and Asia, and then likewise some of the normal plant shutdowns that we see in the Americas where they tend to time it mostly in the month of August. So the month of August is clearly the target point there.

So conceptually, you would expect some of that again. Given that it dipped a little bit in Q2, there are some timing issues where the dip sequentially may not be as bad or may not be what we normally see. Possible it’s certainly way too early to tell, because we are still early in the third quarter that will be, sort of, a September-ish issue. But I think generally speaking, yeah, I don’t think despite how rough it is and how hard everybody should be working to work through the economic environment at the customer side, I still believe that most of them are taking their normal August vacation schedules.

Richard Eastman - Robert W. Baird

Okay. And then just a last question, when you comment a little bit about M&A, you had talked about a couple opportunities that would change the complexion of FARO. And when I think about your priorities on the M&A side, technology, people, and then financials, if there is a couple things out there that could absorb a big chunk of your cash on the balance sheet, do you -- those couple opportunities have that same priority? In other words, would you put a big chunk of your balance sheet to work if the financials, if those companies require input capital, rather than generating accretion?

Jay Freeland

So in general, I would say, look if it was the right strategic deal for FARO for driving long-term growth, assuming it wasn’t an unreasonable purchase price. And we are still -- look we are not blind on purchase price for sure. We’ve been holding this cash for long time. So we are obviously fairly selective there.

We are not going to buy at any cost if that’s the question. The ones that we are looking at certainly appear that they would be accretive day one anyway. So it’s less of a concern on the ones that we are looking at. And yeah, what I will say is they all still fit under that umbrella of 3D measurement imaging realization, what we view as being our role in life, they all still fit under there. So we are not moving from -- I always use the analogy of we are not moving from baseball to football. It’s still maybe a bigger baseball stadium, but it’s not a different sport.

Richard Eastman - Robert W. Baird

Just, again the order of magnitude when it comes to a project and transaction costs, the risk goes up exponentially. When you put -- just want to make sure that when you put technology and people ahead, again transaction size is smaller given the investment you require?

Jay Freeland

Yeah, for sure. And what I will say is that when we look at, for almost all of the acquisitions we are looking at, all of the ones really. The integration risk is different from, in a much more mature market when you look at acquisitions where you may have significant product line rationalization that these do occur after the acquisition, significant facility rationalization, things like that.

The types of deals we’re looking at, add meaningfully to the portfolio with in many cases zero overlap at all. So that risk of what you have to do to help extract significant incremental value from day one is a little bit different from what you see in some of those other types of transactions.

There will be clearly opportunity for productivity inside the operation but the risk factor changes a little bit in that regard too. I don’t disagree that if it’s the bigger the deal obviously the higher the risk to the company, just from a pure financial standpoint. But when we have looked at then we feel pretty confident about that piece of it.

Richard Eastman - Robert W. Baird

Okay. All right. Thank you so much.

Jay Freeland

Thanks, Rick.

Keith Bair

Thanks, Rick.

Operator

And we will go next to Patrick Newton with Stifel. Please go ahead.

Patrick Newton - Stifel

Yeah, Jay. Just to follow-up on the focused laser scanner side. I’m curious, as relative to expectations and kind of the, I don’t think softness is the right word but not many expectations in 2Q. Can you help us understand sell-through versus sell-in, is it possible that you guys have kind of hit somewhat of a saturation point inside Trimble and not quite accelerating the ramp inside of Topcon on a sell-in basis and anything you can give us on the sell-through, positive or negative relative to expectations?

Jay Freeland

Given that all of the unit volumes on the sell-in are relatively low, it is not like I can point to any one distributor, Trimble and say, oh, my gosh they’re sitting on way too much inventory. We have a sell-through problem. We’re definitely not seeing that. We’re seeing good -- I shouldn’t say good. We’re seeing average return rates. Return meaning coming back to order the next wave of product, that the piece that we would like to see them. We would like to see better flow, but again it is not that they have units sitting on a shelf getting stagnant.

On the Topcon side given that the relationship is still in more of a developmental phase, obviously we haven’t signed and haven’t announced any type of global agreement with them. So it’s still little different in terms of the ramp up with the Topcon folks. So I can’t point -- I am not going to point the finger in that direction necessarily because the expectations are a little different out of Topcon at the moment, given that it is a little more low localized in terms of how the relationship is still being built up.

Patrick Newton - Stifel

So is it fair to say that on the Trimble -- clearly not worry about inventory on the Trimble side, but have you reach a saturation point with penetrating their distribution that you are not seeing, may be the sell-in tailwind as they build their inventory and now you are purely operating on a sell-through basis?

Jay Freeland

I don’t think we have been worried about having too much of a tailwind from the sell-in. That being said most of their distributors have, sort of, amount of product they should have in a normal operating basis for sure. But again there is relative flow-through or sell-through from those distributors so it’s a matter of getting better volume out of them now.

Patrick Newton - Stifel

Okay. Very helpful. And then I might have missed this, Keith, but did you give distribution as a percentage of your FLS revenue?

Keith Bair

I don’t think we gave it in stats actually.

Jay Freeland

No.

Keith Bair

Q2 was roughly the laser scanner sales through the distribution channel was about 54.6% versus Q2 of 2012 was 58.1%.

Patrick Newton - Stifel

All right. That’s helpful. And then I guess just given the distribution dynamics, given arm pricing pressure, as we look at gross margin I think that last quarter we had been targeting -- I want to say you said 55, 56 was kind of a reasonable area. We came in a little bit soft, I’m sure that was the persistence of the pricing pressure. How should we think about the gross margin through the remainder of the year and then structurally how should we think about it longer term?

Keith Bair

Well, I think the remainder of the year to the extent that we continue to face pricing pressures, it’s not going to deviate significantly from where it was in Q2 of the first half of this year.

Jay Freeland

Longer term structure, we still -- generally speaking we still believe this company can get gross margins into that 60% range. Obviously, it takes still some heavy lifting. That being said I can say we do see some success as we talked earlier about the Laser Tracker doing extremely well in the marketplace, very well received by the customer base and having some improved pricing.

So the combination of improved pricing and a little bit lower product cost, obviously helps the company any time we can do that. And we still see the opportunity to do that across all products, particularly in, say a newer less mature product like the laser scanner. There is still sizeable room for improvement there.

And if you mix that with increased volume over time, then that -- even though it might all be going through distribution or a large chunk of it is going through distribution, still gives the opportunity for gross margin improvement. I’ll say that the scanner even in the current environment, there has been slight gross margin improvement just from continued cost takeout purely on the manufacturing side, without even having the impact of next generation engineering work that’s going into it.

Patrick Newton - Stifel

Great. Thank you.

Operator

And we will go next to Jim Ricchiuti with Needham & Company. Please go ahead.

Jim Ricchiuti - Needham & Company

Yeah. Just wanted to follow-up on the subject of acquisitions, my impression was you were a little bit more visible in terms of talking about the potential for acquisitions earlier in the year, Jay. And I’m just wondering, has the target list changed much from when you were first earlier this year talking about it?

Jay Freeland

It has not decreased necessarily. I would say that the overall target list has increased a little bit. The bigger ones given that these are not companies that are being shopped so to speak. Some of this as you know, there is some baiting that needs to occur to get everybody comfortable with what might happen.

So yeah, I would say that, a, I think we’re still very visible and in front of that, we are definitely being aggressive about it. And it is -- they are definitely companies that fit well into the FARO portfolio.

Jim Ricchiuti - Needham & Company

And I am also wondering, if the overall market conditions, the economic conditions are affecting either party here?

Jay Freeland

In some cases, it may make them more interested. I can’t say it’s necessarily affecting price expectations, valuations. I am not saying that they are unreasonable by any stretch. But I can’t say that valuation expectations are dramatically lower than you would have seen two years ago, let’s say.

Jim Ricchiuti - Needham & Company

And just to switch gears a little bit to the Tracker. Is that -- is what you are seeing in the market sustainable? I mean do you -- is there -- the product is relatively new. Are you getting the benefit from the initial enthusiasm around it or do you view this as sustainable in the second half as well?

Jay Freeland

I believe it’s sustainable. What I would say is that in Q3 and Q4 last year, though I can’t say it was a sizeable contributor, but there was definitely pent-up demand in Q3 and Q4 of last year. If you look at the first half of last year, some of our customers knew that we had a new Tracker coming. And so while our Tracker volume was good because you had customers buying the previous version, the one they really liked and knew, there was definitely some pent-up demand prepping for the release of that product.

Q1 and Q2 of this year and I can’t say that the growth in the Tracker is only because you had lower comps in Q1 and Q2 of last year because you really didn’t. So it’s that meaningful from a growth standpoint. I do think it is sustainable. Look if we didn’t do anything to the product again in the next two years, is it eventually going to slow down? Sure. I mean, there is still that normal business cycle of wanting additional features, functionality, ease of use and things you normally focus on. But we certainly believe the coming multiple quarters still have significant potential for the Tracker.

Jim Ricchiuti - Needham & Company

Okay. Thanks a lot.

Operator

And we have no further questions at this time.

Jay Freeland

Very good. Thank you very much, everybody.

Operator

This concludes today’s conference. Please disconnect and have a wonderful day.

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