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Cognex Corporation (NASDAQ:CGNX)

Q3 2009 Earnings Call

November 2, 2009 5:00 pm ET

Executives

Richard A. Morin – Chief Financial Officer, Senior Vice President Finance and Administration & Treasurer

Robert J. Shillman – Chairman of the Board, President & Chief Executive Officer

Analysts

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

James Ricchiuti – Needham & Company

Chuck Murphy – Sidoti & Company

Operator

Welcome to Cognex third quarter 2009 earnings conference call. At this time all participants are in a listen only mode. Later, we’ll conduct a question and answer session and instructions will be given at that time. (Operator Instructions) As a reminder, this conference call may be recorded. I would now like to hand the conference over to your host Mr. Richard Morin, Chief Financial Officer.

Richard A. Morin

Earlier tonight we issued a press release announcing Cognex’s earnings for the third quarter of 2009. For those of you who have not yet seen this report a copy is available on our website at www.Cognex.com. The press release contains detailed information about our financial results and because of that we are not going to repeat most of that material. During tonight’s call we may use a non-GAAP financial measure if we believe it is useful to investors or if we believe it will help investors better understand our results or business trends.

For your reference you can see the company’s income statement as reported under GAAP in exhibit one of the earnings press release and a reconciliation of certain items in the income statement from GAAP to non-GAAP in exhibit two. I’d like to emphasize that any forward-looking statements we made in the press release or any that we may make during this call are based upon information that we believe to be true as of today.

Things often change and actual results may differ materially from those projected and/or anticipated. You should refer to the company’s SEC filings including our most recent Form 10K for a detailed list of these risk factors. Now, I’ll turn the call to Bob Shillman

Robert J. Shillman

I want to welcome you to our third quarter conference call. If I sound a little bit under the weather that’s because I am. First of all it’s cold and grey in the northeast which is where I am today, we’re at the headquarters and the second reason is that I have a head cold. But, I am happy to tell you that is the only reason I’m under the weather as business appears to be improving.

As you can see from the press release that we’ve just issued, we’ve reported revenues of $41 million for this quarter and earnings of $0.03 a share and that excludes both a modest restructuring charge and also a significant tax benefit which we’ll talk about in a moment. Customer demand in the third quarter was a bit better than in the prior quarter which is encouraging considering it was the second quarter in a row where orders increased on a sequential basis.

This was unexpected in this Q3 as we had anticipated that the quarter would be softer than the second quarter due to the normal seasonality in the factory automation market which is the largest market that we serve. The higher demand for our products in Q3 led to higher revenue on a sequential basis. This higher revenue combined with an 800 basis point increase in the gross margin percentage and the additional savings from our cost cutting measures resulted in our return to profitability sooner than we had anticipated.

Excluding restructuring charges, operating income was $1.1 million for the third quarter which is an increase of $5.2 million over the loss of $4.1 million in Q2 and non-GAAP earnings of $0.03 a share for Q3 are an increase of $0.11 per share over the non-GAAP loss of $0.08 in Q2. I’m going to talk about revenue in more detail and then we’ll walk down the P&L.

Revenue from the semiconductor and electronic capital equipment market or semi as we call it was approximately $4 million for the quarter which represented a large increase, 61% of $1.5 million on a sequential basis. We saw improvements in Japan, Europe and Asia primarily because customer replenished their inventory and to a lesser extent to meet higher demands of their product.

In the surface inspection market revenue in the third quarter was $8.4 million. Although this represents a 15% decrease from the prior quarter it was slightly better than we had expected. The decrease was due to the fact that we recognized more previously deferred revenue in Q2 than we did in Q3. Actual throughput increased over Q2 which resulted in better overhead absorption.

In the third quarter we saw a pickup in orders from the paper industry which increased both year-on-year and sequentially. In particularly we received orders totaling more than $1.3 million from two paper customers in the United States. These were competitive wins in an industry that recently began to invest in plant upgrades and retrofits after holding spending low for a few years. The timing is very appropriate, perfect for our recent acquisition of the smart advisor web monitoring system which strengthens our product line in specifically the paper industry.

The smart advisor web monitoring systems are complementary to our smart view web in service inspection systems. When used together smart view automatically identifies and classifies the defects on the material and the smart advisor provides the customer with the ability to track the cause of those defects back to their source so that they can be quickly eliminated. The acquisition of smart advisor provides additional functionality that our customers want and we expect to gain incremental revenue from an established product line which had been sold primarily in North America but now we intend to expand globally through our existing worldwide sales and service network. In addition, smart advisor opens some opportunities for us to expand our customer base in to accounts that traditionally have not been Cognex customers.

In the third market that we serve, factory automation, revenue was up $28.8 million in Q3. This is a slight increase over the prior quarter and was unexpected again, because the factory automation market typically declines on a sequential basis from Q2 to Q3 due to the summer seasonally slowdown. Customer demand indeed was soft during July and August but came back stronger than anticipated in September due to a couple of big projects that we closed in North America.

The largest order we received was valued at approximately $1 million for our new DataMan 200 ID reader. The DataMan will read 2D codes that are printed on financial documents that are moving at very high speeds through printing and mailing lines to confirm that each personally addressed envelope includes the correct person’s document. Every one of the pages is verified. This is an important win for Cognex as it was a highly competitive situation. The performance of the DataMan 200, its Ethernet capabilities and its very small size one the business for Cognex over a tough competitor.

Turning now to expenses, there are a couple of items in the third quarter results that I want to highlight. The first was the gross margin percentage which was 71% in Q3 as compared to only 63% in the prior quarter. This improvement is primarily due to a lower provision for obsolete inventory in the third quarter and to revenue from [MBSD] systems which have a higher product margin than surface inspection systems so therefore it represented a higher percentage of total revenue in Q3 than they did in Q2.

The second item is operating expenses. The combined total of RD&E and SG&A, of course excluding stock option expenses, for the third quarter declined by 24% year-on-year and 6% from the prior quarter. This significant decrease was due to the cost cutting measures that we implemented in late 2008 and the first half of 2009. Many of the cost cutting measures are permanent however, we receive a full benefit of them starting in the third quarter.

Also, we received the benefit of approximately $1.5 million in the third quarter from mandatory shutdown days during the summer months. These savings will not repeat and therefore will contribute significantly to the expected sequential increase in Q4 operating expenses. We also intend to increase some of our spending in our strategic initiatives that I’ll be talking about.

As I have discussed on prior conference calls, Cognex is focused on a number of strategic projects that we believe are crucial for our long term success and I’ll go through them now. First is our collaboration with Mitsubishi which is doing very well. To date we have signed up 14 of Mitsubishi’s largest distributors which was our goal for all of 2009 and we believe it’s possible we may have as many as 20 signed by year end which will provide us tremendous access to the factory floor in Japan in 2010.

These are starting to come in through the channel which indicates that we’re getting traction in the channel and these projects are both machine builders and end users in factories in Japan. Some of these projects have large volume potential and Cognex would not have had access to these opportunities without this very important partnership. We’ve also closed some significant orders.

Our second key initiative is with our ID products where we are continuing to invest R&D resources to tap the significant growth potential we see in this business area. ID has been a fast growing business for us and manufacturers continue to invest in what is termed track and trace projects. In 2009 we won a number of projects in the direct part marketing of medical devices. In particular one well known manufacturer gave us orders totaling nearly $200,000 in Q3 for DataMan ID readers.

We’ve a pipeline of ID products under development that will be introduced starting in 2010 and our goal for these products is to set the bar higher for performance of reading and the ease of use while also broadening our reach in to the industrial market.

Our third initiative is to focus on key vertical markets such as solar and pharmaceuticals where we believe there will be strong demand for Vision. In particular, there is a strong need for inspection traceability throughout the pharmaceutical supply chain to combat counterfeiting and diversions as well as to comply with the new GS1 standards. Adoption of machine vision to these applications is in the early stages and we’re laying the groundwork for growth in this industry as well as for others that we believe have significant growth prospects even in a slow economy.

On the engineering side, we’re pleased with the fourth initiative which is our vision system on a chip. In the third quarter we completed an important milestone in the development efforts of VSOC, the tape out, that’s the term, that we did in July was successful and we currently have working samples on hand for internal use. A Cognex product based upon our VSOC is scheduled to be introduced in the second half of 2010 and we’re also in active discussions with a few potentially large volume OEM customers who are exploring the use of VSOC on equipment that they will bring to market.

In summary, the current tone of business is encouraging but certainly not bullish. Customers continue to spend money but only when they have to do so and the timing of when or if an order will close continues to remain uncertain. However, the project pipeline has increased so that our sales team has more potential orders to chase and that is the good news and we’re working hard and fast on these four strategic initiatives. We see many opportunities for Cognex machine vision both for markets we serve today and in the new markets that we plan to enter in the near future.

It looks like we’re positioned for a pretty good 2010 and we expect to grow the business and also be profitable in every quarter of next year. Now, we’ll take any questions that you may have.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Richard Eastman – Robert W. Baird & Co., Inc.

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

Just a couple of things, one is in the factory automation business could you just provide maybe a little bit of color on how the distributor channel did relative to the direct channel against that 32% decline or better yet slight increase quarter-to-quarter?

Robert J. Shillman

Dick can give you the more accurate answer but I can tell you that for the factory automation projects for our In-Sight products about 60% to 70% go through direct and the remaining go through distribution but when it comes to Checker which is the vision sensor it’s pretty much the other way around, the majority of the projects go through distribution.

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

Could you just talk for a second about the vision system on a chip, maybe some of the potential early adopters, give me us an idea of maybe like an end market application where it has big advantages?

Robert J. Shillman

For competitive reasons Rick we’ve decided that we’re not going to talk about the first applications which are pretty much in the work. We’re going to have a product, as I mentioned, the second half of next year. It’s going to be in one of our products for a very particular application where it’s going to increase the depth of field and make the product much faster than the existing one. It’s going to be able to do things that the existing products can’t do and also the OEM applications that we’re talking about, the high volume ones, we’d prefer not to say what the tool is that they’re going to be using. But again, it’s something that cannot be done with vision today and is being done in high volume with other technologies.

Richard A. Morin

On your other question Rick relative to the factory automation business, we saw a slight increase of about a couple of percentage points. If you look it was a little bit higher towards direct than it was to distributor. I think a couple of reasons for that were as mentioned in the script we had a couple of large project orders that were booked in the quarter and those came direct not through distribution.

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

How big is the product ID business for you at this point? Can you just roughly size it on an annualized basis?

Richard A. Morin

Year-to-date it was approximately through three quarters $26 million.

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

Dick, was there any inventory charges at all in this quarter?

Richard A. Morin

Minimal.

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

Not enough to mention?

Richard A. Morin

There’s some pretty much every quarter but this quarter was very minimal.

Robert J. Shillman

The ID business is one of our fastest growing, I think it is the fastest growing business for us. We expect somewhere around mid $30 million, $35 million this year.

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

Is that a function of those end markets? I mean obviously you have some refresh product there and some fresh product but is that also a function of the type of markets and the growth in the end market, for instance pharma or not necessarily?

Robert J. Shillman

No. I think the growth is from two things, one is the initiative the company is taking to use direct part marking and they’re required in certain industries to do that now, to market directly on parts and we are, I think, the global leader on that. I don’t know what percent of the $36 million is direct part marking but I’d be surprised if it wasn’t at least a third. That is just starting to take place.

One of the orders that we closed was direct part marking on medical instruments and the objective there is for every instrument that is used in an operating room is to have a 2D code on it and a unique 2D code so it doesn’t just say it’s a forceps it says which forceps it is so they can keep track of all these items, make sure they don’t leave them in patients and make sure that they’ve gone through the sterilization process.

Some of the growth is due to the initiative on direct part marking, more the growth I think or the equivalent amount of the growth is due to the fact that ID codes, 2D codes are being put on paper documents like life insurance documents to make sure that people get all the pages that they are suppose to be getting. Also, we have some good business with the post office on reading codes. The market is growing and we are displacing in many cases other alternative methods of doing these jobs. I can see this growing in to a $150 million business for us. ID itself should be $150 million business.

Operator

Your next question comes from James Ricchiuti – Needham & Company.

James Ricchiuti – Needham & Company

The revenue improvement that you’re anticipating for this quarter, would you expect it to be revenues up in the three main areas: factory automation; semi and SISD?

Richard A. Morin

I guess we would expect it to be up in factory automation because we’re not expecting the decline that we saw in Q3 from Q2 in Europe. The other regions essentially increased quarter-on-quarter, Europe had it’s typical decline so we would expect not to have that kind of decline. Semi, increase a little bit but it may not be a significant one and on the SISD side we’re hoping that the acquisition that we just completed at the end of the third quarter that that should help us in the fourth quarter as well as we’ve already landed a few orders in the first couple of weeks of the quarter.

Robert J. Shillman

We are very pleased with this acquisition that Tom Nash helped bring in, he’s the president of SISD. We’ve already booked in October nearly $1million of business of that new product, in one month. Now, these were orders that were already in process but nevertheless, this looks like a very good acquisition for us.

James Ricchiuti – Needham & Company

Any color that you can give us on bookings elsewhere in the business in October?

Robert J. Shillman

Yes, I just looked at some charts and I’d say the only disappointment that I see is Checker. Checker is not growing and we have a constant problem with this product. The distribution of this product is a real problem for us. Other than that they all look good. Now, having said that they look good from down numbers, 2010 is going to be a year of great comparables because 2009 just sucked, it was terrible. That’s a technical term, you can learn from politicians and the like.

We’re happy that we’re making money again after only two quarters of losses which is better, I think, than most companies but nevertheless, the economy is still in my view very, very soft and I see heavy sledding ahead for most companies. It’s not a good time and when 10% of Americans are unemployed and maybe even more than 10% it’s not a good time. We’re putting together a business plan and it looks okay. It’s not going to be back to 2008 levels yet I think, is that fair to say Dick?

Richard A. Morin

Yes.

Robert J. Shillman

It’s not going to be 2008 but we’re going to show growth and we’re going to make money.

James Ricchiuti – Needham & Company

You mentioned that you saw a little bit of an uptick in your semi electronics business in Japan in the quarter. If you exclude that, Japan looks particularly weak in factory automation, do you get any sense that the business there has bottomed? What are you seeing and what are you hearing there?

Robert J. Shillman

I know that our business is going to be I would say up significantly in 2010 because of the Mitsubishi relationship. We’re going to be getting business that we never would have heard about even in a very down economy. I mean, they’re still buying things and now they’re going to be buying Cognex’s vision instead of [inaudible] vision, OMRON vision and they’re going to be buying Mitsubishi PLCs instead of OMRON and [inaudible] PLCs because of the combined product line that we bring to these customers.

We’ve already had some significant wins not only for Cognex but we’ve helped Mitsubishi where Mitsubishi was going to lose the PLC business which is a very large piece of business for them in this particular customer. But, because Cognex vision was there, they went with Mitsubishi PLC. That’s the reason why, from Mitsubishi’s side that they formed this relationship with us. They’re not making any money on this deal as a matter of fact. The money they’re making is protecting their own PLC business.

They’re a fantastic company to work with. I have to say our experience in Japan has always been very positive and these are some of the smartest people that we’ve met and savvy and they understand how to make products and how to get products to customers. They’re already talking with us about expanding the relationship to other parts of the world.

James Ricchiuti – Needham & Company

Last question for me is just the growth in Asia that you saw in the quarter, is that mostly coming from China and what can you say about the business there?

Robert J. Shillman

Well, the SISD growth is certainly in China.

Richard A. Morin

Not in the quarter. In this particular quarter SISD grew mainly in North America and Europe. Japan and Asia –

Robert J. Shillman

I was thinking bookings and you’re talking about revenue?

Richard A. Morin

I was talking about the bookings and revenue.

Robert J. Shillman

Okay.

Richard A. Morin

Principally came from North America and Europe this quarter for SISD. Those paper orders were mainly American orders or whatever and the metals industry was pretty low this past quarter. I think on the factory automation side I think what we saw in Asia was a lot of the increase, some of it came from China but a lot of it came from other areas of Southeast Asia mainly related to electronics.

Operator

Your next question comes from Richard Eastman – Robert W. Baird & Co., Inc.

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

I just wanted to review for a second, not to start a riot on your end of the phone or anything, but from a restructuring perspective and I think you flagged this in the Q, the savings from the April event were expected to be about $8.5 million for next year and then I think there was a plant closure in Finland for SISD which was maybe flagged for another $1 million of savings for next year. How should we think of that total, that $9.5 million of savings? Obviously, that includes some variable costs, how should we think of that savings number as we head in to calendar ’10? Do you retain half of that or two thirds?

Richard A. Morin

I think if you take a look at the Finland costs, we’ll retain most of that I would say. We’re closing that operation down within the next month or so and we’ll have a couple of people working on finishing up a couple of items. Relative to the $8.5 million that you’re talking about, I think most of that will in fact is related to certain personnel reductions or whatever or the closing of a couple of offices. The office savings will be permanent, the people won’t be replaced unless we see that business does in fact increase.

I think a lot of those personnel issues were sales people that were cut in various areas including in Japan where now we expect that an awful lot of the business will be going through the Mitsubishi distribution network. So, it’s hard to quantify exactly how much of that will stick because to a certain degree, for example, as the Mitsubishi network expands, we’re going to have to provide additional support, training and marketing or whatever to help support that network.

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

One other thought, on the semi OEM side of the business I noticed there was a reference to pricing pressure there and given that the business now is primarily a software sale, does the price pressure surprise you since there’s not a hardware content to much of that?

Robert J. Shillman

Well, an interesting point Rick. It turns out that software is easy to discount because it’s hard to keep track of what it costs so we have competitors out there, one of whom we are suing, quite successfully I might add, for infringing on our patents, it’s a lot easier to sell things cheaply when you steal them I suppose so that is some of the pricing pressure.

Operator

Your next question comes from James Ricchiuti – Needham & Company.

James Ricchiuti – Needham & Company

What do you think about 2010, are there any cost savings that you’ve been able to ring out in the last couple of quarters that might be temporary in nature and that might be phased in over the course of 2010?

Robert J. Shillman

My answer is no except for VSOC I guess, certain initiatives that [inaudible].

Richard A. Morin

As you’re talking about cost savings, cost that we’ve taken out that you don’t see the full benefit of – I believe if I understood your question correctly Jim you were trying to figure out how much of a cost savings that we might not get the full benefit in 2009 but we would in 2010?

James Ricchiuti – Needham & Company

The question is more along the lines of companies that have had cost reductions but they’ve been more temporary in nature and some of these will be restored –

Robert J. Shillman

No.

Richard A. Morin

There will be some of these costs that will be restored.

Robert J. Shillman

Well, I know what Jim means. For example, we do not have the Friday shutdowns now, that’s what you mean Dick.

Richard A. Morin

Yes.

Robert J. Shillman

That’s not what he means. I believe what you’re getting at is are we going to hire a lot more people next year. Is that what you meant?

James Ricchiuti – Needham & Company

That’s part of the question, yes.

Robert J. Shillman

The answer is if we do they’ll be hired in low labor rate locations. We do not intend to go back to where we were. Maybe we will on headcount but with less expensive heads.

James Ricchiuti – Needham & Company

Just looking at gross margins is there anything that you can say about how we might think about gross margins in this quarter just given the improvement we saw this past quarter?

Richard A. Morin

I can feel pretty comfortable in saying I don’t believe that you’re going to see another 800 basis point increase quarter-on-quarter. I’m fairly comfortable in making that but absent any unusual items I would expect that we would be able to remain above 70%.

James Ricchiuti – Needham & Company

You seem very pleased with the acquisition that you made, anything else that you’re looking at? What’s the level of acquisition activity out there?

Robert J. Shillman

Disappointing I’d have to say. We have three people looking at acquisitions [inaudible] is the lead dog and then Rob Willett and myself follow up with things that are interesting and right now there’s nothing that’s terribly interesting to us. There’s some new technologies, some new applications of machine vision but they’re losing a lot of money, a ton of money and that’s no fun. Let them lose it on the venture capital’s nickel not on ours. So, I’d have to say that there’s nothing on the front burner and we’re disappointed about that.

We’d love to buy some entities out there that fit in well with us. We found this one that’s a web monitoring system that fits in perfectly, perfectly. It fills a hole in our product line, it’s similar kinds of customers, some of them are the same customers, it just fits in really well. We do one a year, we’d like to do five a year.

James Ricchiuti – Needham & Company

Final question for me, I think it was in your press release or it might have been in your introductory remarks but I believe you alluded to a fair number of projects you’re going after. Can you be more specific as to where this is coming from, verticals, geographies?

Richard A. Morin

Geographies, that’s very easy, we’ve seen an increase in potential projects in all of the major regions that we serve.

Robert J. Shillman

We’ve had some nice quote activity going on out there, very nice quote activity. But, we hesitate to give you the particular market places and applications.

Richard A. Morin

Tons of problems that we’re seeing too is some of these while the projects are surfacing and we’re going out and quoting but some of them are staying on the open list and not closed for a little bit longer than they may have a couple of years ago. People are still a little bit cautious about when in fact they’re committing the dollars.

Robert J. Shillman

I just want to make a comment, now that we’re on the phone, regarding acquisitions to all of my competitors who are out there now, why don’t you join the Cognex family, it’s a lot simpler. We’ll put some money and stock options in your pocket and reduce expenses through the synergies and go beat up the real competitors around the world, the other guys. The phone lines are open today, they’re open always. I know you’re listening out there, I know what companies are listening, we have a list, let’s get together and do some business.

Richard A. Morin

I’d just like to make one clarifying comment relative to some of the expense increases that we might see in 2010, we reduced our headcount by about 145 to 150 people or whatever. We have no intention whatsoever of getting back up to that original level in 2010. We may be hiring some additional sales people or some engineering talent or whatever but a lot of those reductions will remain in permanent savings if you will.

Operator

Your next question comes from Chuck Murphy – Sidoti & Company.

Chuck Murphy – Sidoti & Company

Most of my questions have been answered but just a couple for you. My line got cut off earlier, did you say that kind of your expectations for semi in the fourth quarter, is it still going to have the momentum that it had in the September quarter?

Robert J. Shillman

We said that we expect it to be at least as good in the fourth quarter as in Q3.

Chuck Murphy – Sidoti & Company

I don’t have to imagine that that played a pretty key role in the gross margins for the September quarter?

Richard A. Morin

Not that much. I mean, what we had happening – there were a lot of things happening in the gross margins. First you had a significantly less E&O charge quarter-on-quarter, we had better absorption at both divisions because of throughput going through and reduced expenses with the shutdowns that we had during the quarter. SISD fared better because they went from in Q2 they had some more of the revenue was coming from metals type customers especially from Asia which was lower margin and in Q3 it we had some good orders coming from paper in the US and those had better margins.

SISD also benefited from additional throughput because a chunk of their revenue in Q2 came from deferred revenue from shipments of prior quarters. We also had favorable purchase price variance. There were all kinds of little things, each of which might have contributed 50 to 100 basis points and the E&O charge was probably a couple of hundred basis points.

Chuck Murphy – Sidoti & Company

My other question was regarding the factory automation order you got, the DataMan one, the competitor that you beat out for that business, was it a domestic or foreign competitor?

Robert J. Shillman

It’s a domestic company owned by a foreign holding company, a foreign conglomerate. Okay, the team here wants to thank you for your continued interest in the company. We’re rather pleased with the results, surprised by the results actually so that’s a good thing. We hope to be positively surprised when we talk to you next time reporting Q4 and the results of the year. Signing off its Dick Morin and Sue Conway and Laura McDonald and Dr. Bob Shillman. Take care.

Operator

Ladies and gentlemen, thank you for participating in today’s conference. This concludes our program for today. You may all disconnect. Have a wonderful day.

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