FARO Technologies' CEO Discusses Q3 2013 Results - Earnings Call Transcript

Oct.31.13 | About: FARO Technologies, (FARO)

FARO Technologies, Inc. (NASDAQ:FARO)

Q3 2013 Earnings Conference Call

October 31, 2013 8:30 a.m. ET

Executives

Jay Freeland – President & Chief Executive Officer

Keith Bair – Chief Financial Officer & Senior Vice President

Vic Allgeier - Investor Relations, TTC Group

Analysts

Patrick Newton – Stifel, Nicolaus & Company, Inc.

Mark Jordan – Noble Financial Group Inc.

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

Hendi Susanto – Gabelli & Company, Inc.

Brad Moss - Needham & Company, LLC

Patrick Wu – Battle Road Research, LTD

Joseph Garner - Emerald Advisers, Inc.

Operator

Good morning, everyone and welcome to the FARO Technologies Conference Call in conjunction with its Third 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. (Operator instructions). Please note this call maybe recorded. I’ll be standing by should you need any assistance.

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 of the TTC Group, FARO’s Investor Relations firm.

Yesterday after the market close FARO released its third quarter results. By now you should have received a copy of the press release. If you have not received the release, please call Nancy Setteducati at 407-333-9911. The press release is also available on FARO’s website at www.faro.com.

Representing the company today are Jay Freeland, President and Chief Executive Officer; and Keith Bair, Senior Vice President and Chief Financial Officer. Keith and Jay will deliver prepared remarks first and will then be available for questions.

I would like to remind you that in order to help you understand the company and its results management may make some forward-looking statements during the course of this call. These statements can be identified by words such as 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 increased by $7.5 million or 12.3% to $58.2 million in the third quarter of 2013 from $60.7 million in the third quarter of 2012. On a regional basis, third quarter sales in 2013 in the Americas increased by $5 million or 205% to $29.8 million, compared to $24.8 million in the third quarter of 2012.

Sales increased by $500,000 or 2.3% in Europe to $21.5 million from $21 million in the third quarter of 2012. Sales in the Asia Pacific region increased $2 million or 13.4% to $16.9 million from $14.9 million in the third quarter of 2012.

The effect of changes in foreign exchange rates on total sales was a benefit in Europe of approximately $1.3 million, offset by a reduction in sales in Asia of approximately $1.7 million and a decrease in the Americas of $100,000, resulting in a net decrease of approximately $500,000 in the third quarter of 2013 compared to the third quarter of 2012. New orders decreased 3.9% in the third quarter of 2013 to approximately $63.4 million, compared to approximately $61 million in the third quarter of 2012.

On a regional basis, third quarter orders in 2013 in the Americas decreased 3.4% to $25.8 million compared to $26.7 million in the third quarter of 2012. Orders in Europe increased 16.1% to $21.6 million compared to $18.6 million in the year ago quarter. Orders increased 1.9% in Asia to $16 million from $15.7 million in the third quarter of 2012.

The top five customers by sales in the third quarter of 2013 were the U.S. Military, Beechcraft Corp, Porsche AG, Dimensional Engineering and Major Tool & Machine which represented only 2.4% of sales. The top 10 customers in the third quarter of 2013 represented only 3.7% of our sales, once again indicating a lack of dependence on any one or a handful of customers.

Gross profit increased $6.5 million or 20.2% to $38.8 million in the third quarter of 2013 from $32.3 million in the prior year quarter. Gross margin increased to 56.9% in the third quarter of 2013, from 53.2% in the third quarter 2012, primarily due to an increase in gross margin from product sales to 61.2% in the three months ended September 28, 2013 from 57.2% for the three months ended September 29, 2012, primarily as a result of lower manufacturing cost and improved pricing for laser trackers, but still offset by lower overall average selling prices. Gross margin from service revenues increased to 39.3% in the third quarter of 2013 from 36.1% in the prior year period, primarily due to an increase in warranty sales.

As a percentage of sales, selling expenses increased to 24% of sales in the third quarter of 2013, compared to 23.2% in the year ago quarter. Selling expenses increased by $2.2 million to $16.4 million in the third quarter of 2013 from $14.2 million in the third quarter of 2012, primarily due to an increase in compensation of $1.8 million and travel costs of $300,000.

As a percentage of sales, administrative expenses decreased to 10.7% of sales in the third quarter of 2013, compared to 12% in the third quarter of 2012. Administrative expenses in the third quarter of 2013 remained flat at $7.2 million for the three months ended September 28, 2013 and September 29, 2012. A decrease in legal fees primarily related to patent litigation of $1 million was offset by an increase in compensation of $200,000, an increase in bad debt expenses of $200,000 and an increase of $600,000 related to other professional fees.

Research and development expenses increased by $1.8 million or 44.8% to $5.9 million for the third quarter of 2013 or 8.6% of sales, compared to $4.1 million or 6.7% of sales in the third quarter of 2012. The increase is primarily related to an increase in compensation expense of $800,000, subcontractors’ expense of $500,000 and materials of $300,000.

Operating margin for the third quarter of 2013 increased to 11.1% from 8.3% in the year ago quarter.

Other income expense net increased by $900,000 to expense of $800,000 in the third quarter of 2013, from income of $100,000 in the third quarter of 2012, and primarily represents the effect of changes in foreign exchange rates on the current inter-company account balances of the company’s subsidiaries denominated in different currencies.

Income tax expense increased to $300,000 for the third quarter of 2013 to $1.7 million, from $1.4 million in the third quarter of 2012, due to an increase in pre-tax income. The company’s effective tax rate for the third quarter of 2013 was 25.9%, compared to 27.8% for the third quarter of 2012.

Net income increased by $1.3 million to $5 million or $0.29 per share in the third quarter of 2013, from $3.7 million or $0.21 per share in the third quarter of 2012. The number of fully diluted shares outstanding in the third quarter of 2013 was 17.2 million compared to 17.1 million in the third quarter of 2012.

I’ll now briefly discuss a few balance sheet and cash flow items. Cash and short-term investments increased $23.7 million to $181.9 million at September 28, 2013, compared to $158.2 million at December 31, 2012, and include $65 million of U.S. treasury bills.

Accounts receivable was $52.9 million at September 28, 2013 compared to $62.6 million at December 31, 2012. Day sales outstanding at September 28, 2013 remained unchanged at 71 days compared to December 31, 2012.

Inventories increased to $67.1 million at September 28, 2013 from $68 million at December 31, 2012, primarily due to a decrease in raw material and service inventories, offset by an increase in finished goods and general inventories.

Finally, I’ll conclude with some statistics regarding our headcount numbers. Worldwide sales and marketing headcount increased by 61 or 16.6% to 429 at September 28, 2013 from 368 at September 29, 2012. Globally, account manager headcount increased 20.1% to 221 at September 28, 2013 from 184 at September 29, 2012.

Regionally, account manager headcount in the Americas increased to 74 or 25.4% from 59 account managers in the third quarter of 2012. In Europe, account manager headcount increased to 65 or 10.2% from 59 account managers. Account manager headcount in Asia increased to 82 or 24.2% from 66 account managers in the third quarter of 2012.

We had 1,055 employees at September 28, 2013, compared to 961 at September 29, 2012, an increase of 94 employees or 9.8%. Geographically, we now have 421 employees in the Americas, 355 employees in Europe and 279 employees in the Asia-Pacific region.

I’ll now hand the call over to Jay.

Jay Freeland

Thanks, Keith. The third quarter was strong for us, with 12% growth in sales and 38% growth in earnings per share. Gross margin grew to almost 57% and our margin increased to more than 11%. Our sales team is executing well as market conditions continue to improve in the Americas and Europe, but remain difficult in Asia.

Sales in the Americas were strongest, posting a 20% increase, with demand for the Vantage laser tracker being particularly good. Sales in Asia increased 13%, though without the impact of FX, sales would have increased to almost 25%. Availability of financing in China and India continues to be a struggle and economic conditions in both countries generally speaking remain weak.

Sales in Europe grew 2%, but orders grew more than 16%, the result of somewhat improved market conditions, coupled with significantly improved execution by the sales team. Globally, sales from existing customers were 64%, demonstrating that FARO’s best customers continue to see the value added by FARO’s products, while we work aggressively to develop new customers who are less familiar with the benefits we provide.

We had strong double digit growth in our metrology business in all regions, while our laser scanner business was impacted by a moderate slowdown in demand as customers anticipated the unannounced, but highly anticipated launch of our next-generation laser scanner.

Gross margins benefited from favorable pricing in the tracker market, partially offset by continued pricing pressure in the arm market. While competitive pricing for arms has not improved, I can also report that it has not gotten any worse. FARO account managers are being competitive where appropriate, while also continuing to sell the value of the overall FARO package. We also continued to improve manufacturing efficiency of laser trackers, as well as laser scanners, both of which contributed to the improved gross margin in the quarter.

We controlled our costs well in the quarter, benefiting from minimal legal expenses and minimal headcount increased administratively. The largest cost increase in the quarter came from R&D which grew 45%. As I have consistently communicated, R&D is fundamental to the continued growth of our company. While our target is to spend between 5% to 7% of sales, I’ve also said that we might occasionally accelerate that if the programs under development showed particular promise. That was certainly the case over the last three months. Our engineering teams are working on exciting, new and disruptive products for FARO and the benefits of our speeding increases in the third quarter should be realized throughout 2014.

We’ve also had an exciting seven weeks as it relates to product launches. In the second week of September, we introduced the next generation of our laser line probe. In addition to remaining the smallest and lightest laser line probe in the market, we also significantly improved the speed and data density of the device, while also improving its ability to manage the shiniest and darkest of surfaces.

Right after the quarter ended, we launched the laser scanner X 330, the latest and a very disruptive generation of this exciting product. The range of the new X 330 was expanded to more than 330 meters, almost triple the range of our previous generation. In fact, in some of the testing we have done, we’re receiving high accuracy data at a distance of 600 meters or more than one third of a mile in distance at millimeter accuracy. We also improved the image clarity from the scans by twofold and added GPS for instance and continuous positioning recognition of the scanner. On top of all that, we were able to maintain the same size and weight that has been so disruptive to the marketplace.

Launched at the Intergeo Fair in Germany, customer response was immediate and highly favorable. While we don’t discuss sales by product line within quarters or across the year, I can tell you that orders since launching the product four weeks ago have been beyond our expectations. Many of those orders came from customers who haven’t even seen the device yet. I can also report that while there were several product releases by other companies at the Intergeo show, none of them is close to FARO in terms of form factor, range, price or ease of use. The X 330 has been in production for about two months. So customer shipments are already underway.

Finally, we launched the next generation of our FARO WebShare service, with complete point cloud measurement capability in the cloud. This paid for service via subscription fees or pay by use will allow customers to store complex point cloud models in cloud, enabling access to their data by users around the world on a real time basis. Ease of use and simplicity remain cornerstones of our disruptive focus in the marketplace and FARO SCENE WebShare will become a fantastic enabler over time.

Our cash balance, up 15% since January 1, now sits at $182 million. This gives us plenty of flexibility. We continue to look at acquisitions that could enhance our business strategically. However, concerns over longevity of the technology we’re examining, combined with high valuation expectations keep us in the search phase at this point. I still believe that there are meaningful acquisitions for this company. At the same time, I remain confident that acquisitions would enhance, but are not required for the continued growth of FARO.

In aggregate, the third quarter was a good one for the company. Sales grew double digit, gross margin improved and EPS grew 38%. Market conditions appear to be improving in Europe and remain strong in the Americas. Asian markets may continue to feel pressure through the end of the year. However, results from Asia in the third quarter are encouraging. We have two extremely powerful new products in the market, with several more coming in 2014 and the FARO brand remains as strong as ever. Being recognized as one of Fortune Magazine’s top 100 growth companies of 2013 is just icing on the cake. As always, I thank our customers, our employees and our investors for their continued support.

Thanks for your attention and I’ll now open up the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions). We’ll take our first question from Patrick Newton from Stifel. Please go ahead. Your line is open.

Patrick Newton – Stifel, Nicolaus & Company, Inc.

Congratulations on the quarter. I guess jumping right in, Jay, when we think about – I guess how should we think about the seasonality in your December quarter? I think our model indicates a 12 year average sequential increase of about 23% with a pretty wide standard deviation. So given September quarter trends, is normal seasonality on the topline of reasonable expectation?

Jay Freeland

Without saying whether we think it’s normal seasonality, I would say yes, we would expect seasonality in Q4, even though the market’s obviously, particularly in Asia still a little weaker than we’d like and Europe is just starting to improve, general indications would imply that use it or lose it mentality of fourth quarter budgets is probably still there. The degree to which we receive that in the fourth quarter this year is still harder to tell. You’re right. We had a pretty wide standard deviation over the years. But I certainly think we’re going to see some at least meaningful movement in that direction.

Patrick Newton – Stifel, Nicolaus & Company, Inc.

Then I guess you talked about orders being beyond your expectations for the X 330. Can you help us understand how this demand compares to the FLS in a similar timeframe post its launch? Could you update us on thoughts surrounding an OEM relationship with the X 330? And then can you also talk about your ability to ramp capacity to meet demand. I’m just curious, given that you were overwhelmed with FLS demand when you launched it in 2010.

Jay Freeland

I think I’ll try to go in the same order you asked them. The order run rate out of the gate is better than the FLS. In some respects because the product is already – the concept of the product is more well-known now than it was when we released the FLS three years ago. So when it was released, there was a lot of excitement. There were orders coming out of the gate, but the real order stream was tail end of the quarter as people got to know the product and realized that it was the real thing. The launch of the X 330 all of the technical or conceptual side of what the product can do was solved already. People already understood it. So the fact that you’re taking orders on the stand at the show which is not something we do.

There are plenty of industries that do that, but that’s not something we’re used to. We were taking orders on the stand. We got orders coming out of the Americas where customers hadn’t even seen it. They’re just calling the head of sales saying does it really do what it does? He says yes and they say great, I’ll take X. so we’re definitely seeing – I’d say it’s a faster take up. Now whether over the course of several quarters we would anticipate it would have better growth than the FLS as well just given that it is – at this range, it is much more of a true surveyor’s instrument than the FLS was at 120 meters.

It was interesting for the surveyors and folks like that. At 330 it’s really interesting because that’s – particularly if you’re getting data at 600 meters. That’s the real deal for that marketplace. In terms and relative – I guess I won’t go in the order you asked. So relative to capacity, we do not have any concerns there because we already were running at such a high capacity from the FLS that ramp up and that learning curve that we had to go through three years ago we have solved multiple times over in supporting the FLS and having a very fluid manufacturing flow. The fact that we were able to start production on the X 330 during the third quarter while simultaneously continuing to produce FLS that was going out to customers on shipments at the same time I think is a pretty good indication there.

A lot of the componentry is similar as of the manufacturing processes. So there was not a tremendous amount of relearning that needed to occur on the floor. Relative to OEM relationships, we do have a good relationship now with TopCon obviously. We’ve been talking about that over the last couple of quarters that we were establishing that and we do have a good relationship with them around the world. Likewise we still have a good relationship with Trimble. We have not finalized whether the X 330 will be a Trimble branded product with FARO signed to them that way or if it will just be sold by Trimble straight as a FARO product.

Obviously there’s interest on their side given the increased range while still having the same seismic form factor. So we’ll leave that one open for the moment. Either way though we feel fairly confident in our ability to continue driving sales growth of that device and like I said, the customer reaction was really favorable for those who were at the show and for those who heard about it quickly after the show.

Patrick Newton – Stifel, Nicolaus & Company, Inc.

Thank you for the details. I guess two more. One is, Jay, when we look at the growth and account managers, are you now staffed to desired levels? And can you remind us the duration to get to full productivity? And then just one last gross margin question for Keith.

Jay Freeland

I think we are – to be fair we’ll probably never staff to desired levels because we’re always adding account managers. But some flow because you’re always hiring for sales that will be generated six to nine months out. To your question about ramp up, that’s still about the right amount of time. We have seen some success. We’ve started adding some sales engineers as a preliminary sales role where they’re doing more application engineering work and supporting the sales team in the field and learning the market and then promoting them into the account manager ranks afterwards.

It’s an early program but we seem to have had some success there that once they become a true account manager, the learning curve is significantly flatter and shorter. There are some promises as it relates to that. Generally speaking though, six to nine months, yeah you’ll continue to see us add account managers quarter to quarter. We’re trying to keep it just a steady flow knowing that we’re always adding for six to nine months out.

Patrick Newton – Stifel, Nicolaus & Company, Inc.

I guess, Keith, on the gross margin side to make sure I got the major impacts on the sequential changes. It was mainly manufacturing cost efficiencies service was a little bit better on a year over year basis and I think partially volume. Were those the key drivers? And then can you help us understand the sustainability or how we should think about the margin profile moving sequentially from here.

Keith Bair

Actually, when we talked about increases in gross margin, we were talking about quarter over quarter, comparing Q3 of ’13 compared to Q3 of 2012. In Q3 of 2012 we had some very large, unusual manufacturing variances related to some overhead and some manufacturing costs. So those costs did not reoccur in this quarter. Sequentially I think as Jay had mentioned, the prices seem to have hit bottom, but certainly not in the decline as they were in the first two quarters. I think going forward, and again service margin, that’s primarily a function of warranty sales as well as the number of units that come back for servicing on a pay by drink method. Going forward I think you should expect to see prices 56%, 57% margin range to the extent that we don’t encounter those similar types of manufacturing variances that we did in the year ago quarter. We certainly don’t anticipate that.

Operator

We’ll take our next question from Mark Jordan from Noble Financial. Please go ahead. Your line is open.

Mark Jordan – Noble Financial Group Inc.

Congratulations on excellent margins this quarter. Looking at the product gross margin, being the best it’s been since I think the first quarter of ’12, what was the mix of demo product sales in there? Was that lighter than normal that also benefited margins? You did say your demo inventory was up. Is there going to be some higher movement of that product in the fourth quarter?

Keith Bair

There was nothing unusual about the amount of demo sales this quarter sequentially or compared to Q3 of 2012. I think some of the demo inventory has gone up. I think we’re still getting some of the Vantage laser trackers out there as well as some of the additional X 330 so that’s primarily – but the demo inventory really didn’t have that much of an impact in Q3.

Mark Jordan – Noble Financial Group Inc.

You mentioned that 64% of revenues were derived from existing customers. I think if we went back a few years you had looked for more balance, about 50-50 new customers, existing customers. What are you doing to raise the level of new customer sales relative to selling into your install base?

Jay Freeland

Yeah, you’re right, Mark that we still and today still believe that trying to maintain 50-50 is the right target for the company. It shows the perpetuation of the technology across a broad set of users. If you look at it from the marketing standpoint, marketing side, the lead side is much better balanced in terms of going after the new customers. In fact, typically there’s more new customers in the lead pool, but you’ve got different ship rates for those folks. What I think we’re seeing right now is that still just because of some of the economic uncertainty, particularly in places like Europe and a little bit in Asia too is that the existing customers are much more willing to open the check book and buy the technology today because it’s already been clearly proven to them what the value is. Newer customers the cycle is definitely longer.

There’s still a little bit of that mentality of while we’re getting new customer sales obviously, you still have some of that mentality of I can spend $50,000 and I might get that ROI that you guys are describing, or I could not spend the $50,000 and I know I still have $50,000 in case I need it for something else urgently. Particularly the smaller the company, the more magnified that impact becomes. We still obviously sell 75% of our sales give or take to the smaller tier two and tier three type companies. So we’re continuing to push hard with it. I think we’re in the right spot as it relates to leads and demo accounts coming in. unfortunately it’s just a matter of time. The good news is that the existing customers continue to help support along the way.

Mark Jordan – Noble Financial Group Inc.

Final question for me. Order flow in the Americas was a book to bill less than one. Was there anything that you saw in terms of customer behavior in the quarter that would have had delayed orders?

Jay Freeland

Not really. I think a little bit – there was a little bit of timing in there. So I can’t say that there’s not a little bit of that. But given the size of the typical transactions for us, it takes a lot of customers to delay to have that impact. I think a little bit of it was coming off a decent order quarter in Q3. As we look forward I’m not as worried about, we occasionally have these dips where you have a region that’s definitely less than book to bill of one to one. We occasionally have a region where their book to bill is way over one to one. Those usually sell themselves out the following quarter. But something like that doesn’t concern me too much. If I saw it two or three quarters in a row then obviously I’d have a different opinion of that.

Operator

We’ll take our next question from Richard Eastman from Robert W. Baird. Please go ahead. Your line is open.

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

Keith, I just want to double back for a second on the gross margin in the product area. When I look at the raw numbers, the dollar amount, just explain how from the second quarter to the third quarter we generated not quite, but close to $2 million more in profit on the same sales number. Is that a function of the new laser tracker selling more? Is that a mix issue between the second and third quarter that the tracker outsold the arm?

Keith Bair

As you know, we don’t really talk about sales by product line. I can tell you that our costs have come down. Our average selling prices have somewhat stabilized sequentially. That’s both on the arm and certainly on the laser tracker. I also don’t want to talk too much about mix, but I can tell you that between the manufacturing cost coming down, not just Q3 2012 over Q3 2013, but sequentially as well, I think the benefit this quarter was certainly as we see the average selling prices firming up and not decreasing like they have been in the past.

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

Yeah, which helps explain the year over year, but I think the quarter to quarter second to third quarter improvement in gross profit on flat sales would again suggest that the mix favors a higher margin product and since you’re getting pricing on the tracker, presumably that had that kind of an impact.

Keith Bair

Yes, we’re getting better prices on the tracker. Some of that impact sequentially is also related to service margins as well as well as our manufacturing costs coming down for all product lines.

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

And then Jay, just a couple of things on the sales and order numbers. In the Americas, the order number looks maybe a little bit softer than your commentary. I think the book to bill in the U.S, in the Americas was 0.87, which is pretty far below where it typically would be. To get the extra sales in the third quarter, we obviously pulled down backlog. I’m trying to understand why the order – you commented about the strength looking – improved strength in the Americas and yet when I look at the order number, it looks softer than it should be.

Jay Freeland

You’re right, Rick. The 0.87, that’s a little bit lower than we would normally see. We’ve occasionally seen that. But I guess and I’m trying not to give away what we think Q4, Q1 look like, but it’s not low enough when I look at what’s in the pipeline for the Americas and Europe and Asia too. When I look at what’s in the pipeline and I look at the normalized deal flow that the sales team is working on, it’s not a number that concerns me at this point.

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

I guess the account manager growth in the Americas would again suggest that we should see that showing up in the orders. That’s what’s surprising. The sales number was fine, but again if that comes out of backlog, I’m just surprised the order number isn’t more reflective of the growth in account managers in the Americas.

Jay Freeland

I think some of that you’ve got some ramp up time there with the new account managers as well. We do have -- some of the sales heads as they’re newer to the company it just takes longer to – so again it’s six to nine months. It’s not like it takes them 18 months to get productive, but it’s certainly not an immediate transition either.

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

And then just in Europe, when I look at the product service growth rate, what you notice is a significant service growth. The comments earlier that Keith talked to in terms of service gross profit margin and growth there, is the sale in Europe at this point, given the difficult market conditions and pricing pressure, has the focus been there more on service and warranty sales versus product sales which were down a little bit? Is that a shift in strategy given the current market?

Jay Freeland

Not so much related to the current market. Clearly there’s incremental push globally on selling more service, particularly the extended warranties. The regions have added at least one, in some cases two dedicated people to just work on warranty and extended warranty sales coverage versus having the AMs do that. So just like we saw, the Americas had similar benefits starting to creep up I think in the first quarter -- first and second quarter we started seeing that more meaningfully. I think actually in both. Just seeing a little bit of that in Europe as well. So it’s not that they’re shifting the strategy in favor of that. It’s just that that has become a bigger piece of the strategy for sure.

As it relates to sales in the market, I think in this case if you look at the orders growth, you definitely have a better orders growth rate out of Europe. There’s some improvement there. You do have some new account managers on board. There was some additional turnover of the one to one performing. Obviously we have a whole – you’ve got a new leader over there that is really starting to hit his stride now with that team. I think we’re starting to see the benefits of that in the third quarter too.

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

Was service and warranty sales under penetrated in Europe relative to the other markets?

Jay Freeland

Yes. I think it was relative to the other markets, though to be fair in the Americas when we put that dedicated – dedicate people into the role there, there was a fairly quick uptake I think in service sales. Keith, you can confirm that as well. But yeah, I think in Europe just they were not as quick to pull the trigger on doing so. We’re starting to see some of that benefit now.

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

And just the last question, Jay, could you just give a bit more color on this FARO WebShare product. Is that targeted at the laser scanner, the 3D laser scanner or is that – what product is that targeted at and what’s the launch look like on that product? Is that sold as an add-on contract or?

Jay Freeland

For the FARO SCENE WebShare?

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

Yes.

Jay Freeland

Yeah. So obviously with any new scanner we certainly presented it at the time that it’s an opportunity for customers to use it. No question we are making that available to all of our existing customers as well and we’ve seen multiple. I can’t say – it’s not like we have thousands of customers using it yet obviously because it’s pretty new. But the concept which is an interesting one of you see manufacturers using it to scan facilities and share that scan data with their facilities elsewhere. If they redesign part of a manufacturing line they can scan the new line anywhere where they have the identical line. That data can be grabbed by the other plant and used then to replicate the cell or cells at those other facilities. So that’s the exciting part about it.

So I think it will be a service. It will take a little bit of time for us to see some meaningful traction. But as we’ve often talked about are there opportunities to generate some meaningful recurring revenue stream for FARO and a stabilized revenue stream. Obviously this is one that we think has some potential and the early indications and feedback from customers is pretty positive as well. Like many things, they’re virtually pure software with a little bit of hosting cost. It’s a pretty high gross margin product. So if we can get some stability there on subscription fees, license fees and some that will be paid by use, I think that has a lot of potential for us in tail end of 2014 and beyond where it becomes more meaningful.

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

You have a dedicated sales force or a guy or something for that?

Jay Freeland

Big question. We don’t yet, but the concept is there. I’ve looked at the saying is the sale here? We’re finalizing what we think the best way is to approach the customer base. But conceptually it’s a little bit like an enterprise system sale. And so it’s possible we would add a couple of people to help enhance the flow. Not that our account managers cant’ do it, but it may help them or may help the system like what we do with the warranty sales too.

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

I’m sorry, one more thing. Keith, what was the percent of ADFLS product that went through distribution this quarter?

Keith Bair

I think this quarter we were about 52%, basically flat with the third quarter of 2012.

Operator

We’ll take our next question from Hendi Susanto from Gabelli & Company. Please go ahead. Your line is open.

Hendi Susanto – Gabelli & Company, Inc.

Congratulations on a great quarter. 3D Systems announced earlier this week that it is planning to introduce commercial 3D scanners in December. This week we also heard that AMETEK announced the acquisition of Creaform, a 3D measurement technologies company. What is your thought on new emerging 3D scanner and how should we think about it? I would like to know also what your current relationship with 3D System and Stratasys and whether you have a feel on selling a 3D printing branded scanner similar to your partnership with Trimble?

Jay Freeland

Obviously we know 3D and Stratasys very well and good relationships with both teams, both at the leadership level as well as the next tier below. Relative to consumer grade scanners, not something we’re interested in. it’s not really our space, similar to the 3D printers on the consumer side. There’s not a value add that we provide there. We don’t have tie to the customer. The technology that’s required for the consumer side is not nearly as sophisticated, is not nearly as patentable or IP protectable. From that standpoint it’s also less interesting to us. It’s not to say that it changes the partnerships we have with 3D or Stratasys at all. It’s just not really our space.

Where we do play is if you look at the printing side of their businesses, anywhere where you’re making – where the customer is going to do short run production, quick tool die molds, first articles, things like that, particularly if they don’t have the existing print or CAD models, we definitely come into play there. So if they’re scan arm on a part that you need to replicate for prototyping for doing actually a short run of production or a single one off production, that’s where we play with them and we’ll continue to play with them because you’re not going to get the accuracy in a consumer device that is required for the vast majority of those industrial parts.

So that’s where we are with them. Relative to AMETEK’s acquisition of Creaform, we know Creaform well. Obviously we looked at the company from both a technology standpoint and a fixed standpoint. We didn’t feel like that was the right place for FARO. We’ve known the technology for a long time. We just think there are different ways to solve the problems so to speak for our customers.

Hendi Susanto – Gabelli & Company, Inc.

Jay and Keith, could you remind us what the – like qualitatively, what the attach rate of warranty sales across geographies look like and how different they are let’s say in third quarter versus a year ago?

Keith Bair

I think the attach rates, we don’t really disclose what the attach rates are for our existing sales for the quarter or our install base. But I think historically it has not received the focus that it has been receiving over the past maybe year to two. I think there’s certainly a lot of opportunities in our existing customer base as well for our new customers for us to continue to sell warranties. But we typically wouldn’t disclose that number. I think it has been receiving a lot of renewed or increased emphasis in the past year or two.

Hendi Susanto – Gabelli & Company, Inc.

If I may ask differently, have you seen warranty rates improve meaningfully this year compared to last year?

Keith Bair

I think you see warranty sales increasing and as a result, we don’t talk about whether they’re existing customers or new customers. But clearly the sales of warranty contracts have been increasing and I think it’s primarily the result of additional or renewed focus and emphasis on that potential market.

Operator

We’ll take our next question from Brad Moss from Needham & Company. Please go ahead. Your line is open.

Brad Moss - Needham & Company, LLC

Hey guys. This is Brad filling in for Jim this morning. Just first off, wondering what you’re seeing with the pricing environment in the metrology business and just overall the competitive environment in metrology.

Jay Freeland

On the arm side of the business, which is where the fundamental pricing issues have been through the course of this year, while it hasn’t gotten meaningfully better, I can’t say that, it is not getting any worse. So there seems to be stability. It was there throughout Q3. I think that from an execution standpoint our team has gotten comfortable on how to manage that. It took a couple of quarters, Q1 and Q2 -- it took a couple of quarters to get there and understand where it’s at. Like I said, it does not appear to be getting any worse, which is good. On the tracker side of the business, pricing is very good. The new tracker that we released a year ago has a higher list price and we’re capturing a significant portion of that incremental list price in the sales to our customers and that at the high end tracker business which is where we compete.

Hexagon has a lower end tracker that is a lower price point, but it has significantly different functionality. So we tend not to compete against them in that space. So it helps keep the pricing side fairly robust. To be fair, their high end tracker we’ve not seen any type of aggressive movement there. I think both companies are getting – have good markets for the split in those products. So on the metrology side in general, I’d say still not better, but not any worse than the arm side. Definitely good pricing on the tracker side.

Brad Moss - Needham & Company, LLC

And then just quickly a follow up, just overall wondering what end markets you are seeing the most strength with.

Jay Freeland

Certainly aerospace remained strong. It has been a great market for us – all the way back through the downturn aerospace has been rock solid the whole say through. Not a shock given the state of their industry right now. Automotive is definitely fairly strong as well, which is a good thing. The heavier industrials are hit or miss deepening on industry. Energy, not bad. Process, power, and piping, pretty good. Some of the lighter manufacturing depends on the size of the company. That’s where we’ve seen some – particularly when we go after new customers there, that’s where we see some of the delays or pauses in purchase decisions because they’re still relatively new to the technology, but the markets which – good markets with good funding and good cash are also actually spending too, which we’re seeing that in Q3 which is helping.

Operator

We’ll take our next question from Patrick Wu from Battle Road Research. Please go ahead. Your line is open.

Patrick Wu – Battle Road Research, LTD

Congratulations on a good quarter. Just piggybacking on a question earlier, in terms of the revenue distribution, you said it's at 52% versus the prior year and that was flat. I just want to get a better sense of how it was versus the previous quarter. That would be great. And what your expectations are moving forward for distribution for the FLS products.

Keith Bair

I’m sorry. I didn’t the first part of that question.

Patrick Wu – Battle Road Research, LTD

Just wanted to get a better sense of the percentage of FLS parts distribution versus the previous quarter. It was at 52% for this quarter and 52% last year. It seems like it sounds flat, but versus last quarter, wanted to get a better sense of that and how your expectations are moving forward for that relationship.

Keith Bair

In Q1 in 2013 it was about 63% and Q2 it was about 52% and in Q3 it’s 52%.

Jay Freeland

Yeah, and relative to the market – I guess a couple of thoughts there. One is as I indicated in the remarks, I think we saw a little bit in Q3. Though everybody knew there was a product coming, I never said what product was coming. I think because it had been three years since we had a new scanner release, we did see in the scanner market there was some anticipation of something exciting coming just because it had been three, four years and they know how hard we work to try and disrupt ourselves every two to three years. So we were right on schedule there. They knew there was a major trade show coming up, the Intergeo show which is -- the bulk of it is surveyors.

So I think there was some anticipation that shows the first week of October they must have something coming. We saw some slowdown there. That being said, we do have our own account managers for the scanner who continue to do very well in the markets they sell into. So, some of it is that you have a direct sales force in FARO that is working awfully hard and selling very well offsetting some of that. So as we go forward, particularly as it relates to the surveying space, we still see channels like TopCon, channels like Trimble being good access points for us. While our team could access those channels themselves, probably not at the same run rate. Having both of those companies going after that space for us is a good thing. If you only had one if we were going after the space it would still be a good thing.

There’s plenty of market out there, plenty of activity and traction. Again the new X 300, at least all the initial indications because of that improved range in particular seems like it’s even more meaningful to the serving space than before. So going forward, for that particular vertical you expect to see us continue to sell direct to them. For the other vertical, as we develop them, it’s going to be a mix of direct account managers from FARO. We may supplement with different types of channels or different types of people coming on board to help assist the account managers and get them in the door to do the sale. That remains to be seen and it will still take some time.

Patrick Wu – Battle Road Research, LTD

Any commentary you guys may be able to add in terms of your products for the rest of this year or maybe beginning of next year and what areas are you looking to for reinforcements when it comes to that?

Jay Freeland

So clearly when we talked at the end of Q2, I indicated there’d be at least one major product release in the second half of this year. We had one major. The laser line probe, while not as quite as big a deal as the laser scanner was actually still a pretty good product launch given the improvement in the data density and speed and the dark and shiny surfaces which is something that customers occasionally will struggle with. So for the rest of this year we’re focused on execution on the products that we have. You get into 2014, I would call it a fairly robust year. We have several things coming down the pipe and without saying which quarters they’ll be released in, you’ll see indication of that increased spending here in Q3. We have things that are exciting that we think show potential and we see an end to the time horizon or we see a known time horizon on when we can complete it. We’re going to move aggressively to do so. So 2014 should be a pretty robust year in that regard.

Operator

We’ll take our next question from Patrick Newton from Stifel. Please go ahead. Your line is open.

Patrick Newton – Stifel, Nicolaus & Company, Inc.

Just a follow up on the new product introduction cadence. I guess, Keith, if we think about that from an R&D expenditure perspective, can you help us understand how we should think about R&D either on an absolute basis or as a percentage of revenue or some way to quantify that as we move through 2014?

Keith Bair

I think historically we’ve been at that 5% to 7% range. And as Jay had mentioned earlier I think we had talked about at some point in time some quarters you’re going to see that, get to that 8%, 9% range. That’s certainly not out of the question as we move forward with some of these new product developments.

Patrick Newton – Stifel, Nicolaus & Company, Inc.

You're already at about 9%. So it sounds like if anything, if I think about it from just a percentage of sales perspective, we should see some incremental leverage assuming some revenue growth.

Jay Freeland

Yeah. I think that’s a fair comment, Patrick. When you see this acceleration it’s because there’s enough activity that we say let’s go check the gas pedal. We know we’re going to turn it upside down for a quarter and then you’re right, you tend to start seeing levels again as you come through the next couple of quarter incremental sales after that.

Patrick Newton – Stifel, Nicolaus & Company, Inc.

And then just sticking to the leverage questions, as we look at the aggressive headcounts that you’ve made and I think that they are -- at least the heavy lifting is behind us. Would you expect that we’re going to see some incremental leverage on your selling expense line as well?

Jay Freeland

I would think so. Obviously we will add some account managers. We’ll drip them in over the coming quarters again because you’re always adding for six to nine months out. That being said, we’ve added aggressively obviously. We’re up 40ish heads I think, 40ish account managers since Q3 of last year and our account manager base is definitely not at full productivity when you look at the sales spread across the number of account managers. We’re not at our typical averages which have run a million in a quarter-ish on average given or take around the world, million and a half sometimes. So we would expect to see leverage just purely based on that premise as well.

Operator

We’ll take our next question from Richard Eastman from Robert W. Baird. Please go ahead. Your line is open.

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

Jay, just one maybe higher level question. When you look at FARO's business model and you look at where the company has come over the last couple years, there has been so many metrics moving around here, from sales, sales channels, account managers. There’s more variable cost there but more of them. If you look at how these metrics have moved around, is it fair to assume that when we come out of this sales pause that FARO is going to be in a position to perhaps leverage a lower sales growth rate into and scale that up into incrementals, EBIT incrementals of 25 to 30 off of perhaps a 10% to 15% sales growth rate, versus what we’ve traditionally targeted as elusive 20%? Maybe this is a law of large numbers question, but so many metrics have moved around here from service, gross margin, product gross margin, just all the things we have talked about over the last couple of years. So how do you see FARO's business model from an operating leverage standpoint if we come out of this in '14 and '15 with less than targeted sales growth?

Jay Freeland

For me the easier buckets are when we think about leverage, no question, we do it today and we’ll continue to get more leverage on the manufacturing side as it relates to the number of incremental people required to support any level of growth, even if you were in the high double digits. The ratio is obviously quite favorable from a leverage standpoint and the same thing on the administrative side. We’ve been fairly tight on administrative personnel. They come in in tiny numbers, a handful here and there over the course of the year. So we get great leverage there. Generally speaking, we should get decent leverage off of R&D but like I said we occasionally have these spikes where we’ll increase the spending to get something moving.

Sales is the tricky one for sure because unless -- still today unless we saw a massive shift to the way to go to market, particularly on the metrology side that it’s different from how we do it today, we’re going to continue to have to add account managers over time. So that 20%ish, 25% when you include the marketing that we’re spending on selling probably continues to be a number that we’re sitting with for the next several years. I would not want to make anyone think we’d anticipate significant leverage there. That being said, we’re obviously trying different channels which does create – makes it a little bit fluid there.

Clearly we’re using distribution for the LS on the construction and surveying side. If we find another market that we like and we felt like distribution was the better route because they had better access, obviously that could change the model again. Likewise if we saw a market that was really exciting on the LS and we decided that direct is still the best way to go, you could see us adding more account managers on the LS side and then you’re back to the normalized model again. We’ve been spending more time selling the warranties, which drives that service number up. But you’re getting significant leverage there. You’re talking about a couple of people dedicated to selling it around the world with significant increases in revenue and good gross margin coming off of that as well.

I think Rick the tricky part is as we continue to expand and we continue to grow, that sales bucket, the cost associated with the selling is the one that probably has the greatest amount of fluidness or fluidity. I’m not sure what the correct adjective is there. But it will have the greatest potential for variation while always probably still being in that 25% ish bucket like we have today. Good leverage off manufacturing, good leverage off of admin. And then the R&D, we can get some leverage at times, but also it’s not – I’m not purposely trying to drive down the ratio unnecessarily as we do have multiple things underway that are exciting for the long term prioritization of the company.

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

So the real leverage is -- again I know sales growth obviously matters significantly for those items, but it’s basically the mix of business going forward and how stable the gross margin is at this 56%, 57% level or better still a mix issue.

Jay Freeland

Right.

Operator

(Operator Instructions). We’ll go next to Joseph Garner from Emerald Advisers. Please go ahead. Your line is open.

Joseph Garner - Emerald Advisers, Inc.

Most of my questions have already been asked and answered, but I did have a couple. One, Jay, I was wondering if you could comment a little bit on the linearity of sales during the quarter. It seems like your tone on the sales front is much more positive than it was last quarter at this time. So I’m wondering if we saw perhaps a stronger sales environment toward the end of the quarter than we might normally see.

Jay Freeland

Not stronger than normal, but I will say stronger than the previous couple of quarters for sure. That lack of – the better way I guess for me to look at it is a lack of linearity definitely still hockey stick into the final weeks of the quarter. The tip of the stick is stronger in Q3 than we’ve seen in Q1 or Q2. And some of that gives me obviously makes me feel good about the go forward. Some of it is also just the market dynamic and what we experience the managers and the types of dialogs they’re having with their customers is definitely improving. Cautiousness from the customer side is definitely getting better, particularly in Europe and the Americas.

Joseph Garner - Emerald Advisers, Inc.

And the second question I had, I'm wondering if you are seeing any noticeable differences in the end markets for the Laser Scanner outside of surveying? It seems like the new product certainly helps address that market but wondering if you are seeing anything in forensics or insurance or any of the other end markets that we have talked about in the past.

Jay Freeland

I can’t say meaningfully, though I will say 3D documentation conference we had a couple of weeks ago we had more I believe – I think I have this right, we had more people from the forensic side than we’ve ever had before. I had good meetings while I was there and short one on one dialogs as well as a pretty lengthy dialog with a couple of the forensic experts while I was there. The utilization of the scanner there is definitely moving in the right direction. We had a great example of an investigator who, the first time in the Toronto court system – if you look particularly to the different systems.

But the first time in the Toronto court system was able to get 3D scanner admitted as evidence. They actually had to bring in a scanner and show the jury how it works. But once they got it, that is now admissible evidence for the law in Toronto. One of the things we’ve always looked at is the more you can get into a court case where people can say I can prove it because I have the data or I can disprove because I have it. Obviously that has benefit. So one market I would say that’s probably we’re starting to see a little more traction in was that forensics side, really based on the participation at the 3D documentation conference the back half of the year.

Operator

(Operator Instructions). It appears we have no further questions.

Jay Freeland

Very good. Thanks everybody. We look forward to updating you again at the end of Q4.

Operator

This does conclude today’s conference. You may now disconnect. Have a good day.

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