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FARO Technologies, Inc. (NASDAQ:FARO)

Q1 2010 Earnings Conference Call

May 6, 2010 11:00 AM ET

Executives

Vic Allgeier – IR, TTC Group

Keith Bair – SVP and CFO

Jay Freeland – President and CEO

Analysts

Larry Solow – CJS Securities

Mark Jordan – Noble Financial Group

Jim Ricchiuti – Needham & Co.

Richard Eastman – Robert W. Baird

Ajit Pai – Thomas Weisel Partners

Operator

Good morning everyone, and welcome to FARO Technologies conference call in conjunction with its first quarter 2010 earnings release. At this time all participants are in a listen only mode. Later you will have the opportunity to ask questions during the question-and-answer session.

(Operator Instructions)

Please note this call may be recorded. I will be standing by if 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 closed, FARO released its first quarter results. By now you should have received a copy of the press release. If you have not received the release, please call Nancy Setteducati at 407-333-9911. The press release is also available on FARO's website at www.faro.com.

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

I would like to remind you that in order to help you understand the company and its results, management may make some forward-looking statements during the course of this call. These statements can be identified by words such as we expect, we believe, we predict, we target, our growth targets, our goals, our guidance and similar words. It is possible that the company's actual results may differ materially from those projected in these forward-looking statements.

Important factors that may cause actual results to differ materially are the risk factors set forth in yesterday's press release and in the company's filings with the Securities and Exchange Commission.

I'll now turn the call over to Keith.

Keith Bair

Thank you, Vic and good morning everyone. Sales in the first quarter of 2010 were $42.3 million, a 34.4% increase from $31.4 million in the first quarter of 2009. On a regional basis, first quarter sales in 2010 in the Americas increased $3.7 million or 29.9% to $16.3 million, compared to $12.5 million in the first quarter of 2009. Sales increased 30.4% in Europe to $16.1 million from $12.4 million in the first quarter of 2009. Sales in the Asia Pacific region increased 50.5% to $9.9 million from $6.6 million in the first quarter of 2009.

The effective changes in foreign exchange rates on sales was an increase of approximately $1 million in the first quarter of 2010. New orders increased 45.3% in the first quarter of 2010 to approximately $39.8 million compared to approximately $27.4 million in the first quarter of 2009.

On a regional basis, first quarter orders in 2010 in the Americas increased 59.6% to $16.6 million compared to $10.4 million in the first quarter of 2009. Orders increased 17.1% in Europe to $13.7 million from $11.7 million in the first quarter of 2009. Orders in the Asia Pacific region increased 79.2% to $9.5 million compared to $5.3 million in the year ago quarter.

The top five customers by sales volume in the first quarter of 2010 were the US military, Honda, the US Naval Ship repair facility in Japan, Boeing and (inaudible) and represented only 4.8% of sales. The top 10 customers in the first quarter of 2010 represented only 7.3% of our sales, once again indicating our lack of dependence on any one or a handful of customers.

Our gross margin was 60.1% in the first quarter of 2010 compared to 51.7% in the year ago quarter. This increase was primarily due to a change in the sales mix between higher margin product sales and lower margin service revenue resulting from an increase in the higher margin product sales. As a percentage of sales, selling expenses decreased to 26.6% of sales in the first quarter of 2010 compared to 40.8% in the year ago quarter.

Selling expenses declined $1.6 million to $11.2 million in the first quarter of 2010 from $12.8 million in the first quarter of 2009. As a percentage of sales, administrative expenses were 14.8% of sales in the first quarter of 2010 compared to 20% in the first quarter of 2009.

Administrative expenses in the first quarter of 2010 decreased by $100,000 to $6.2 million from $6.3 million in the first quarter of 2009 primarily as a result of a decrease in compensation cost of $400,000, travel cost of $100,000 and training and recruiting cost of $100,000 offset by an increase in professional and legal fees of approximately $600,000 primarily related to patent litigation.

Research and development expenses were $3 million in the first quarter of 2010 or 7.1% of sales compared to $3.5 million or 11.1% of sales in the first quarter of 2009. The decrease is primarily related to a reduction in compensation and subcontractors expense.

Operating margin for the first quarter of 2010 was 8% compared to a negative operating margin of 24.3% in the year ago quarter, as a result of the previously mentioned increase in sales and gross margin.

Foreign currency transaction losses were $500,000 in the first quarter of 2010 compared to a loss of $700,000 in the first quarter of 2009. Income tax expense increased $800,000 for the first quarter of 2010 compared to a benefit of $1.6 million in the first quarter of 2009 due to an increase in pretax income.

The company’s effective tax rate for the first quarter of 2010 was 28% compared to a benefit of 19.1% for the first quarter of 2009.

Net income increased by $8.7 million to $2.1 million or $0.13 per share in the first quarter of 2010 compared to a net loss of $6.6 million or $0.41 per share in the first quarter of 2009.

The number of fully diluted shares outstanding in the first quarter of 2010 was $16.3 million compared to $16.2 million in the first quarter of 2009.

I'll now briefly discuss a few balance sheet and cash flow items. Cash and short-term investments were $103.3 million at April 3, 2010 compared to $100.1 million at December 31, 2009 and includes $65 million of US Treasury Bills.

Accounts receivable was $40.6 million at April 3, 2010 compared to $42.9 million at December 31, 2009. Days sales outstanding at April 3, 2010 increased to 88 days from 85 days at December 31, 2009, primarily as a result of an extension of the collection cycle in Europe. Inventories remained flat at $38.6 million at April 3, 2010 and December 31, 2009.

Finally, I'll conclude with some statistics regarding our headcount numbers. We had 737 employees at April 3, 2010 compared to 734 at December 31, 2009, an increase of three.

Account manager headcount increased from 146 at December 31, 2009 to 147 at April 3, 2010 with 42 account managers in the Americas, 51 account managers in Europe and 54 account managers in Asia. Geographically, we now have 292 employees in the Americas, 253 employees in Europe and 192 employees in the Asia Pacific region.

I’ll now hand the call over to Jay.

Jay Freeland

Thanks Keith. Business conditions in the first quarter this year were robust similar to the fourth quarter of 2009 and significantly improved from the first quarter of 2009. We posted substantial orders growth of 45% with all three regions performing well.

Asia led the way with nearly 80% growth over the first quarter of 2009. The Americas was also impressive with 60% growth. Europe's growth was a bit lower than Asia and the Americas but was still up double digits at 17%.

As mentioned in the earnings release, our topline growth in Q1 was attributable to market momentum and productivity gains from our sales team.

Our order strength was also distributed pretty well across all our verticals. Just like the declines last year when we couldn't point to anyone vertical as the recause, the growth we saw in the first quarter followed a similar pattern. We saw strength in all three regions and we saw strength in all verticals.

I've mentioned before that FARO’s growth does not rely on our customers necessarily returning the growth themselves. Rather, it relies on our customers looking at their businesses as a growing concern and identifying the need to generate productivity.

We're definitely starting to see that behavior from the bulk of the industries we serve.

There was an interesting shift in our sales balance between new and existing customers in the first quarter. We strategically target this ratio to be 50-50 as a way of ensuring we keep our existing customers engaged while still spreading the FARO message in gaining new installations from those who didn't know us before.

In the first quarter, however, that ratio shifted. We generated 65% of our sales from existing customers and 35% from new customers. The positive message here is that our existing users still see the value in adding to their fleets as they seek ways to generate more productivity.

Based on what we saw in the first quarter, our existing users were the quickest to recognize the productivity value of our technology and thus were quicker to utilize some of their CapEx dollars there.

Going forward we'll still be targeting a 50-50 balance but we may see a short period of time where sales from existing customers outweigh sales from new.

Gross margin improved substantially in the first quarter. The improvement occurred more quickly than we anticipated and was driven by lower service costs, lower manufacturing costs and a slightly larger mix of products in our sales profile. It's possible we'll still see some fluctuations in gross margins through the rest of the year but at least in Q1 all the primary drivers were favorable.

We also did a nice job in the first quarter controlling costs. Head count remained essentially flat and the team continues to generate productivity within their departments, finding ways to do things even better than we did before but with far fewer people.

As I mentioned in my annual report letter, our renewed focus on running asset life is something we'll continue to talk about. Asset light does not mean scaling back or jeopardizing the long-term growth potential of the company. It simply means running lean and getting the most out of every dollar we spend.

Generally speaking research and development remains on track. Our newest product the FARO 3D Imager was scheduled to be released by the end of the second quarter, we'll now be releasing this unit in the third quarter. This is a minor delay and it’s tied to work the engineering team is doing to finalize the product. We had not planned on generating material revenues from this product in 2010, so the delay should have minimal impact on our financial performance.

The work we're doing in preparation for our other product releases remains on schedule and I continue to be impressed by the creativity and execution displayed by the associated engineering teams.

Clearly the first quarter of this year was a significant improvement from the first quarter of last year. Momentum is good, the customers are buying again and the structural changes we made last year are yielding benefits. However, as I previously stated we will not be providing specific financial guidance this year due to the potential for continued uncertainty in our markets.

I'm optimistic about the year but I should add the word cautiously precedes that statement. So I suspect I'll remain cautiously optimistic at least until we have a few more solid quarters under our belt.

As always, my thanks go out to the FARO team, our customers and our investors. Together, we've managed through a difficult 18 months without losing the spirit, passion and creativity that makes this company great. There is still a lot of work to be done but all the right pieces are in place. I appreciate your attention and we will now open the call to questions.

Question-and-Answer Session

Operator

(Operator Instructions) We'll take our first question from Larry Solow from CJS Securities. Your line is open.

Larry Solow – CJS Securities

Good morning, Keith and Jay.

Jay Freeland

Good morning Larry.

Keith Bair

Good morning Larry.

Larry Solow – CJS Securities

In terms of the gross margin, I know you – it's hard to predict exactly where it'll stand and I could certainly appreciate some volatility through the quarters. But would you say as a whole most of the increase is sustainable? I know last quarter you had a decent sales number but you had a lower gross margin, that was sort of lower arm sales. Did those at least come back this quarter? I imagine so, but can you give more color on that.

Keith Bair

Yes, you're absolutely right. Certainly there was an increase in products just within the profile itself, arms being one of those. All of our products still have much higher gross margin than service even though our service gross margin has improved substantially when you look at it year-over-year. Obviously, we feel like a good chunk of it is certainly sustainable because we've been planning – historically our gross margin has run right about the 60% mark just shy or right at, and our target longer term not this year but certainly longer term we still believe 60% to 65% is the right gross margin range for the company.

So, do we think we'll see a little bit of fluctuation during the course of the year? Look, it's always possible because it is reliant upon sales mix, product mix appear a little bit more service one quarter versus the other, it shifted a little bit here and there. But we feel like the bulk of it is sustainable.

Larry Solow – CJS Securities

Then any shifts in leads or demos? I imagine those are still increasing at a pretty good rate. And selling cycle, it was expanding a lot. Are you seeing any – customers, it looks like they're coming back a little bit faster, certainly your existing customers.

Jay Freeland

Yes, I mean I think we're seeing certainly on the leads and demo side typical ratios. Even last year we saw all through the year that just nobody was pulling the trigger. So we're seeing the same ratios there right now. The fact that we had such a high profile of existing customers this quarter, many of those we had already demoed, so we got a little bit of benefit there. But at the same time when you think about it from a cost standpoint, we're still doing the same numbers of demos too. So it's not like we got substantial cost leverage because we had existing customers pulling the trigger and they didn't require a demo because the reality is we were demoing to other customers all through the quarters too. So, yes, I think we're still seeing the same type of momentum and activity there too.

Larry Solow – CJS Securities

Just last question, sort of more of a global type question. We're relatively new to the name and one of the negatives or sort of bears-type things, statements is you guys have a high exposure to the automotive and aerospace industries. And clearly, I know you don't necessarily need growth in those industries to get growth in your products, just with penetration. But any thoughts on how you can gross significantly with the larger part of your end markets not doing so well?

Jay Freeland

They are still a big piece of our overall profile; however, we are certainly not as reliant upon them as – if you look at our installed base, we have a pretty hefty portion that's in auto and aero, 35% auto, roughly 25% aerospace. When you look at sales in any given quarter it's not nearly the same ratio and if you just look at our sales profile this quarter, we got one auto company in there out of the top five and it's still a very small percentage of the sale. So, yes, if you include the supply chain; we're certainly feeding all those folks.

The reality is that a lot of the auto companies are doing significant work right now on the productivity side as they've come out of the doldrums so to speak that they went through in 2008 and 2009. So there is some benefit there. At the same time we still go out of our way to target all of the other industries as many of the verticals and customers in those verticals as we possibly can. And when you look at our marketing campaigns and what we send out and who we try to get in touch with, there is a substantial amount of time spent going after those folks outside of auto and aero because we're trying to expand that profile.

Larry Solow – CJS Securities

One more quick question. Any update on the patent litigation, timelines or next milestone we might look for?

Jay Freeland

Yes, it's still very open and influx I would say. We have filed a motion for summary judgment on some of the issues at hand and we're still waiting. It'll be probably a couple of months before we even hear on that. Most of the depositions are done at this point in terms of all the fact finding and gathering but to put a time table on it would be really hard. I mean we could suddenly settle and be done with it or it could continue going. And I hate to say it but I mean we could be going for another year maybe more, you know how these things can surprise. We are doing everything we possibly can though to minimize the cost associated with it. We saw a bump in Q1 and that's because there was a significant amount activity relative to you doing the depositions and things of that nature, which I expect to really slow down a little bit here in the coming quarters.

Operator

And we'll take our next question from Mark Jordon with Noble Financial. Your line is open.

Mark Jordan – Noble Financial Group

Jay, you talked about first quarter you were recapturing some of the previously demoed customers. Could you quantify that in terms of what percent and related to that, do you have any sense of what potential recapture is still out there?

Jay Freeland

I won't put a number on it, not surprising probably to you. What I'd say is that there is still a lot of opportunity. If you look at it and it would say for the last, I include the back half of 2008 and plus all of 2009 because the back half of 2008 is when we really started to see the declines on the sales side. Even though the leads and demos were not declining, they were still growing through that whole time period. So you've got more or less six quarters of leads and demos growth under your belt going into finally orders profile starting to pick up again and customers starting to order again. So I'd say there's still a substantial amount in that pipeline that we can generate orders from.

At the same time I can't say that every single customer who got demoed before will pull the trigger without seeing a demo again. I mean we know there's a possibility of having to do some leg work to get back to those same customers again and refresh them. Particularly if it is a new customer, if we demoed him 12 months ago they probably are going to want to see the product again versus just pulling the trigger.

So when I say that we look at it and say, well, there's still leverage to come there but at the same time, like I said, it's not like we got a huge amount of cost benefit because we are closing deals but didn't require demos on them because we were still out there demoing today and it's still possible that some of the folks who we demoed a year ago would need to see another one before they pull the trigger.

Mark Jordan – Noble Financial Group

Second question relative to cost structure. If you look at two segments of your company, one would be sort of the generic overhead, G&A, your marketing infrastructure, and then the second group being sales reps. How much larger can you be before you add to your broad-based corporate infrastructure, one? And the second question is what would be your catalyst to start growing your rep base again?

Jay Freeland

We still believe that we have substantial leverage out of the headcount that we have today, both the sales side as well as the rest of the company, manufacturing, R&D, admin, etc. We believe, if you just look at productivity of the sales team, what they've done historically versus what they should be able to do, even though they have definitely improved that we got productivity out of them in Q1, they're still not at the run rate that I would expect that team to run at.

So we believe that we should at least be able to get to kind of our high watermark prior to the downturn, which was we did $209 million of sales in 2008. We should at least be able to get back to that level without adding substantially to any of the infrastructure including the sales headcount. As we see momentum and it's possible that you get to the tail end of this year and we say, hey, look we are seeing enough momentum, maybe we'll start adding a few more account managers. But it's also entirely possible that we could go the entire year or longer without adding back to the account manager base.

On the admin side even including research and development, we should see I think even further than the $209 million mark before we have to do any type of substantial ads there. Some onesies-twosies in manufacturing are possible but last year if you recall, we did a lot of retooling of our entire manufacturing process so that we could generate the same type of output with far fewer people and the team has done a wonderful job there.

So we have a lot of leverage room still there, and again maybe some onesies-twosies on the R&D side depending on what we're doing with products and where we're headed and quite frankly sometimes it just comes down to a skill set that's required to help get something over the hump so to speak. But generally speaking, we're still expecting a significant period of time here with leveraging that existing team.

Mark Jordan – Noble Financial Group

Is there a specific economic rationale for the weaker book-to-bill ratio in Europe versus the Americas and Asia?

Jay Freeland

I don't think so. There is a lot of good activity there. As you know the back half of the final month of the quarter is when substantial amount of the activity occurs. There is a lot activity during that final two week period. We just didn't get as much over the goal line in Europe as we did in Asia and the Americas. Obviously, we're a little more cautious in Europe only because I think there's a little more pressure there and let's face it. Europe went into this probably, at least for us, went into the down cycle last. So it's possible that we're still seeing the final kind of fluctuations of them pulling back out of it. So from an economic standpoint that could be why they were a little bit behind.

But when I talked to the team over there, I can't say there's any one item that they're all jumping up and down saying, holy cow, this is a real pressure point. I think for us the pressure point as we go through the rest of the year, Keith you can correct me if I'm wrong or I think differently, but I think we're probably going to see some headwind just relative to the Euro, so just purely an exchange rate factor that we're going to get some headwind there for the rest of this year.

So, assuming Greece doesn't drag the rest of the EU down into the mud, the economy remains stable even from where they are right now, we should see Europe continue to pick up over the course of the year.

Operator

We'll take our next question from Jim Ricchiuti from Needham & Co. Your line is now open.

Jim Ricchiuti – Needham & Co.

A question just about the mix that you talked a little bit about, the new and the existing. Is there any way you could maybe provide a little bit more color on that, Jay, as it relates possibly to the verticals that you serve?

Jay Freeland

Yes, certainly not by the verticals. We looked at this a lot obviously. Keith and I spent a substantial amount of time with the team. The first reaction of course was, holy cow, the ratio swung wildly and it’s way out of what our target is, the 50-50. And I still think that's the right target to be shooting for because there's so much untapped potential out there. But as we looked at it, like I said the good news is that it was existing customers who were adding to their fleets. It's really anecdotal, so there's not a ton of science to this when I say this. But when we talked to the teams, most of the feedback was, hey, look existing customers really understand the technology. They already understand the benefits, they've seen the benefits that they've been getting. So they in many cases they ran 8 months, 12 months, 16 months where they couldn't get a single CapEx dollar allocated to their name. And as soon as the leadership team started releasing CapEx dollars again because they understand the technology they put it as a higher priority in their pocket so to speak or in their planning, then some of the newer customers who – they're still going through the first question mark of I think I can get that productivity because they say it can and I've heard that it can but I also have all these other things that I need to do and they're more definitive of what the benefit is that I get; either it’s replacing some machine tools or whatever they're doing.

So that's why I say that we may still see for a short period of time here a little bit of lag in the pickup of new customers back to the 50-50. And again that's all anecdotal, I can't say that there's any momentum in that direction either. We could turn around at the end of Q2 and be right back to the 50-50 and I'd say well, they recovered quicker than we expected. It's a harder one to really put your finger on.

Jim Ricchiuti – Needham & Co.

Yes. In terms of the sales and orders with the existing customers, is it concentrated among the higher-end product lines?

Jay Freeland

No, I can't say higher end meaning say arms and trackers. Yes, I think we certainly saw more arms in the mix in the first quarter than we did say in the fourth quarter. And so if you look at it and say well, arm has always been our highest sales driver for the company, it's always been arm first, tracker second, then gauge, then laser scanner. So, you definitely see those are the known productivity tools, the most successful ones out there. So I guess it wouldn't be a surprise that the increase is being driven a little more by arm and tracker than say laser scanner or even gauge.

Jim Ricchiuti – Needham & Co.

Maybe you also are showing some very nice momentum in Asia-Pacific and I was just curious, again, just to go back to this new existing kind of ratio, is it similar to what you are seeing out there as well?

Jay Freeland

Yes, it is. It was a little heavier on the new in Asia but not by a whole lot, it was pretty close – the ratio is pretty similar in all three regions I think.

Keith Bair

Yes, that's one of the interesting aspects of this in the first quarter is that typically all three regions are fairly close to 50-50 and this quarter they were all fairly close to that 65-35 split and Asia as well.

Jim Ricchiuti – Needham & Co.

Keith, it's always tough to look at your service margins, they tend to bounce around quarter to quarter and was clearly up year-over-year, and sequentially we had a little bit of a swing the other way. Can you talk a little bit about how we should think about your service margins?

Keith Bair

Typically the margins are related to warranty expense and customer service. So typically it depends on the number of units that are coming back, the number of units that are under warranty versus the number of units that are coming back where they're not under warranty or under a warranty contract and they're kind of paying by the drink. So that can fluctuate at any point in time, it just simply depends on the mix of those service items.

Jim Ricchiuti – Needham & Co.

Last question for me is just with respect to some commentary you've made in the past about looking at maybe expanding your channel for your products. I wondered if you could just provide a bit of an update in that area. And perhaps if you're willing to maybe comment on the level of acquisition activity that you're seeing out there.

Keith Bair

Yes, I think on the acquisition front, I'd say probably it's the same as what we've seen historically. There are multiple companies that we're interested in and we follow and we watch. Obviously, there's not been anything compelling enough for us to move on. The strategy is still the same. I'm very interested in technology that's either noncontact in nature, which would allow us to expand our portfolio there or software particularly in the application side whether potentially niche application, packages that we decide we would like to have in-house versus using the third party for or the opportunity to spread a broader umbrella, let's say across the customer base from a software standpoint of the functionality we provide to them through our devices and other devices.

So from an M&A standpoint, that still what the focus is. Most of the companies that we look at are all small and private companies. So being able to make a determination on, people ask frequently, has evaluation changed coming out of last year and so forth, and I say, it's hard to say because they're not publically traded where I can say, yes, the stocks up 50%, the value has increased dramatically. They're all private and so it's more a discussion and dialog point then in terms of getting a feel for whether that evaluation has changed any. And in many cases the smaller ones all have significant funding and have been doing relatively well through all of this at least have been holding their own through all of this. So from their standpoint, the long-term value and potential they see tend to remain the same. So I can't say there's a lot of giant fluctuations there.

Service of other sales channels, we do have distributors signed up now in all three regions. We'll continue to add more there. It's hit or miss and it's going to be that way I suspect for a while until we really find the right types of distributors or the right way to do this and expand our sales channel. And it doesn't all have to be distributors, we've got some partnerships in the works as well that would assist there. We have some where there was a lot of activity and they closed some deals for us and generated some revenue, and then it would slow up. The thing we're going to always face with the distributor which is why it can never replace our direct sales model, we're always going to have a good direct sales model for some portion of our sales for sure. The issue is focus, is keeping their attention, making sure that they're driving it and they're pushing it with their own customers and so you really have to stay on top of them. And so I think we're going to continue to see that for some period of time.

We're going to continue with the experiments, we're going to keep trying it, we'll keep tweaking it, modifying it but it'll be a while before we see I think any type of substantial revenue coming out of those groups. In the meantime, it doesn't mean we shouldn't continue trying.

Jim Ricchiuti – Needham & Co.

So, it wasn't necessarily meaningful in Q1. But was it up from Q4?

Keith Bair

I won't necessarily say again Q4, it's up in general. But again, you're coming off of a very – we had so little that gets generated by distributors. Historically, the only way you could go is probably up at this point.

Jim Ricchiuti – Needham & Co.

Fair enough. Okay, thanks a lot.

Keith Bair

Yes, but not material relative to our revenue growth all at all.

Operator

(Operator Instructions) We'll take our next question from Richard Eastman at Robert W. Baird. Your line is now open.

Richard Eastman – Robert W. Baird

I just want to circle back for one second on the gross profit margin on the product side, I guess your suggestion is, when I look at that number sequentially at 66.8% in the first quarter and about $5 million less of volume than the fourth quarter. I'm still surprised that that number jumped that substantially and you're suggesting that is due to significant increase in arms sales relative to the other products. Is that solely what's happening there?

Jay Freeland

Keith, you want to talk to that one?

Keith Bair

Yes, primarily like Jay mentioned earlier, the arms carry the highest margin and without providing a lot of specific details, some of our manufacturing costs have come down quite substantially, the overhead costs. And on a sequential basis the margins for or the cost for all the products have come down quite a bit. So when you look at it on a sequential basis and you see the increase in the arms sales, you're going to get that increase in the gross margin as well.

Richard Eastman – Robert W. Baird

Is there any link in that product gross margin to your higher sales to existing customers? In other words, are they more likely to purchase an arm versus a new customer that you maybe have to evangelize on the gauge or something?

Jay Freeland

No, it's really more tied to their application right out of the gate. The gauge is not a good substitute for an arm in a large majority of application. So occasionally a customer will start with a gauge let's say and then they end up moving and buying more arms and trackers as time goes by but typically even the first sale, it's more focused on the application need and there are things that the gauge cannot do, that only the arm can and obviously there are certain things that a tracker can do that an arm cannot do. So the first sale really is more dependent on the application than anything else.

Richard Eastman – Robert W. Baird

So as we track and again, you saw the order flow and maybe the momentum in the orders as the quarter progressed. Is there anything in the order flow that suggests that this arm favorable mix doesn't continue? I mean the one thing from our model, it is substantial like $0.08 per share upside just buried in that product gross margin and we certainly wouldn't have modeled it that high. So given the way the sales are unfolding and the orders are unfolding, is there any reason that we shouldn't model the gross profit margin by product up at 67%?

Jay Freeland

I will let Keith answer that specifically.

Keith Bair

Yes.

Jay Freeland

I guess I would say in a general sense, obviously, there is some visibility of some fluctuation back and forth, and we saw that in Q4 just relative mix as well. I do think we probably should emphasize though that the manufacturing cost, that structure is definitely lower. And so the benefits we are getting there as they impact gross margin certainly should continue to the rest of the year regardless of, if we see some fluctuations on arm relative to the overall sales mix.

Richard Eastman – Robert W. Baird

Is that like a point difference sequentially of margin?

Keith Bair

Well, I guess the other aspect of that – those cost reductions has been the selling price. And I think sequentially, anyway, we have seen some strength in that selling price. And then when you look at Q1 of ‘09 versus Q1 of ‘10, there has been some fluctuations there. But as long as – in addition to the cost holding based on unit volume and that sort of thing, if we look at the selling price and that selling price maintains that relative strength. I don't want to provide guidance at the product specific level. But I think those are the two factors, the strength in the selling price and the cost reductions.

Richard Eastman – Robert W. Baird

Okay. And that comes – when you say strength in the selling price, does that come in the form of less discounting to close a piece of business?

Keith Bair

Yes, I think it's both less discounting as well as – we have tried to move some demo equipment last year as well, there was a conscious effort on to move some demo arms and demo product.

Richard Eastman – Robert W. Baird

Okay. And then, the other thing I just wanted to flush out a little bit further again, I am just going back to this existing customer versus new customer. And is there any message in there that perhaps the tightness we still see in some of the credit markets for small manufacturers, is that possibly constraining the growth on the new customer side?

Jay Freeland

I don't think so and this is a little bit more anecdotally. But generally speaking, we still have very few customers who actually utilize financing. The financing we offer is rarely used. Sometimes they have their own financing already in place obviously when we get in there. But even last year at the peak of how ugly things were and how tight the credit markets were, we still had very few customers who were financing their purchase.

And so we have not had a whole lot of impact where we can say, “Yeah, they are definitely slowing us down” or “Hey, now that gives us the opportunity to pick up,” it's really more just the understanding of the technology and where they prioritize it. And like I said, I think the existing customers, it was just a little bit easier for them to put that higher in the priority list as they started spending CapEx dollars again and we know it's on the priority list for new customers too. It's just a matter of when the other priorities get knocked out of the way and they move into our equipment.

Richard Eastman – Robert W. Baird

Okay. And then also, Jay I guess one last thought, given – I think you expressed some comfort with the momentum into April. I think cautiously optimistic or something. But it sounds like the order momentum from March maybe continued into April or at least the demo momentum. But typically, you have a seasonal pattern in your business with orders and sales. I mean, is there anything in that very recent order demo momentum that would suggest that we don't – again, this year doesn't play out very seasonally? In other words, Q2 up and – is that the type of revenue and order pattern we should expect, is there any reason not to?

Jay Freeland

Yes. Boy I hate to even say it, but that's the $62,000 question. Normally, obviously, the – until 2009, that pattern was fairly predictable, and I would have sat here and said, “Yes, I mean there is no reason to not expect that pattern.” I will say that I am – the cautiously optimistic is actually for the entire year not just current quarter. But obviously, cautiously optimistic to says, hey, look, if some other major economic shoe drops off again, like I said Greece drags Europe into the mud or the housing market in China crushes, it causes everybody to pause out there, whatever the case is, and those are factors that are outside of our control.

So I do feel cautiously optimistic about the rest of the year. But given how unusual last year was, it's probably too early to say that the normal FARO profile would occur this year. Do I think it will? I think it's probable. Certainly, I think the Q4 pattern where you have still got that use it or lose it mentality. So Q4 being substantially higher than any of the other three quarters, that certainly seems like it should be a realistic expectation. How Q2 and Q3 play out relative to Q1 and Q4 with that? I think it's way too – it would be hard to say, yes I think it's going to follow the same pattern, just because it was so unusual last year. I think we are in a recovery off of an unusual pattern. It doesn't mean you are going to go immediately back to the same pattern, so it's just too hard to say.

Richard Eastman – Robert W. Baird

And that – and then if you look at using that same characterization, if you look at the regions, then presumably, you are least comfortable with Europe for obvious reasons. And then, in both Asia and the US, at least the recovery to you feels like it's on solid footing?

Jay Freeland

Yes, Keith, I think that's a fair statement, yes.

Richard Eastman – Robert W. Baird

Yes. Because your – I mean your business correlates just so closely to the PMI and that's been surprisingly strong certainly for the last four or five months – quarters, excuse me – months. So I guess we can at least look for the US and Asia to continue to lead this thing?

Jay Freeland

If I were, yes, I did it purely based on how my gut felt today, then I would say yes. Certainly I am most cautious about Europe. And then, yes, the Americas and Asia certain feel (inaudible).

Richard Eastman – Robert W. Baird

Yes, okay. Well, thank you.

Jay Freeland

Thanks Rick.

Keith Bair

Thanks Rick.

Operator

And we will take our next question from Ajit Pai from Thomas Weisel Partners. Your line is open.

Ajit Pai – Thomas Weisel Partners

Yes, good morning.

Jay Freeland

Good morning Ajit.

Keith Bair

Good morning Ajit.

Ajit Pai – Thomas Weisel Partners

Just looking at the European orders, I think the book to bill that you experienced in Europe was probably the weakest in over 20 quarters. So while your commentary is that things over there are fine and improving, things seem to be getting worse over there from a macro perspective. It was already a very weak quarter from a book to bill. What level of comfort do you have that things in Europe, you have mentioned that your sales folks over there are continuing to see things not get worse. What gives you comfort that they won't get worse?

Jay Freeland

Well to say that I have comfort that they won't get worse is probably not – that's probably not the right message to take away. Definitely, I am most nervous about Europe relative to the company right now, because definitely we see more pressure there than we do in the other two regions. Now, that being said, the sales team is basing their data and experience at the moment on demo counts, lead counts, activity from customers in that regard, though you are right they are not closing at the same rate. I mean 17% orders growth is good, but not as good as we would like particularly coming off of a weak 2009.

So we are watching that one closely. The team is on it, they are pushing very hard to get that orders rate back up. When it fully recovers is a question mark like you are absolutely right. I think the greatest economic pressure in the three regions certainly resides in Europe at the moment, even though the team I think looks at and says, yes, but it doesn't – the economic pressure is not at least generally speaking does not feel as bad as the economic pressure they were seeing with their customers last year at this time.

Ajit Pai – Thomas Weisel Partners

So what's your reaction from a distribution sales force perspective in Europe? I mean, it's a fairly challenged market. The economic environment is fairly challenging as well. But your product also needs to be sourced rather than its push not pull right from your customers?

Jay Freeland

Right.

Ajit Pai – Thomas Weisel Partners

And this quarter yes, was pulled from existing customers, but on an ongoing basis you are still underpenetrated. So are you planning to cut back on investment in a market where things appear that they are going to be sluggish for a while? Are you planning to sort of hold the costs over there, are you planning to continue to invest? How are you thinking about Europe?

Jay Freeland

Yes. I at the moment still thinking about it the same that I think about all three regions which is we are actually holding costs and headcount flat across the board until we see substantial growth. And like I said earlier, we are still highly under leveraged in terms of the productivity of the sales force in all three regions. So I don't feel the need to invest additional people at this point in time.

When we get closer back to that 200 million mark give or take, then we will probably start adding some people again. And then at that point, it really depends on where the momentum is. If you looked at it right at the second if we said, yes we are going to go ahead and start investing you right now, certainly it would be Asia first, America second, Europe probably wouldn't even if we were starting to put some bucks in. But we are not putting anything in at the moment, because we have so much productivity to come still from the existing team.

Ajit Pai – Thomas Weisel Partners

Got it. And then just looking at that ratio – revisiting a subject, I think you visited in prior questions, but new customer sales to existing customer sales and correlating that with your head count addition. So for many, many years you were adding headcount and adding sales folks and then you cut back. Cutting back on new sales force, do you think that over the past holding the line on that, has that impacted your new customer sales with each additional person that you hired – would they usually have a much higher proportion of new customers relative to existing customers because existing customers are already allocated and one of the reasons why you were driving such a high new customer percentage of sales was it because you were continuing to hire new sales guys?

Jay Freeland

Yes, actually I don't think it's tied to that. And the reason I say that is when we – historically when we would add new account managers, you actually – what we are doing is splitting an existing territory. So the new account manager will end up picking up customers that already were existing with FARO and then they would also pick up new potential customers that we hadn't hit yet. So each person that comes in the door actually already has a slate of existing customers when they join FARO for the most part.

Occasionally, we would have a real big strategic customer that we wouldn't take away the account manager for obvious reasons. But generally speaking, that's what would happen. So I can't say that by not adding new account managers that that would affect our new customer sales, because it's not like they were focused solely on new customers when we are adding them. Why we had been successful at keeping that 50-50 ratio in some respects is that we are giving a slight incremental incentive to the inside sales team to try and maintain that 50-50 split, so ensuring that they don't just do the milk run and go after the easy accounts – easy is a loose term that please. There's nothing easy about selling. Go after just the ones that we already know, so we always had a little bit of extra incentive there.

And if you look at leads and demo counts, we are still getting plenty of leads and demos from the new customers. I just think they are a little slower on the market to pull the trigger I think there was so much pent up demand on the existing side that went for so long without having CapEx dollar approval that when they finally got approval like I said it was easier for them to have it higher in their priority list, because they already knew what the benefits would be.

Ajit Pai – Thomas Weisel Partners

Got it, okay, thank you.

Jay Freeland

Thanks Ajit.

Keith Bair

Thanks Ajit.

Operator

And we will take our next question from Larry Solow with CJS. Your line is now open.

Larry Solow – CJS

Guys, just a quick follow-up on the – just trying to get a little better hold of the gross profit in the mix. Would it be fair to say that there was an unusually low mix of arms in Q4 that sort of normalized in Q1 or was it may be normal in Q4 and higher in Q1, any way you can put color to that?

Jay Freeland

Keith do you want to?

Keith Bair

Yes, again without getting into the actual mix percentages, I think the arms in both quarters were number one in sales followed by trackers and gauges. But again with regards to the mix and the profits, I think some of that had to do with maintaining our selling prices as well as realizing some of the cost reductions that were made last year and reducing quite a bit of our manufacturing overhead.

Jay Freeland

Yes, I guess what I would add though I think this is probably safe to say Keith and fair to say though. Q4 would be less normal from a mix standpoint, I will say it that way. I can't say it was completely abnormal, but it was definitely less normal.

Larry Solow – CJS

Got you, okay, that's fair enough. Great, thank you very much.

Operator

And we will take our next question from Jim Ricchiuti with Needham & Co. Your line is now open.

Jim Ricchiuti – Needham & Co.

Just wondering about your R&D line; if we will see that – if you think that's going to move up steadily over the course of the year. It sounds like you have got a pretty active new product effort underway.

Jay Freeland

We do have a very active new product effort underway. The primary drivers obviously in R&D are heads and then materials as you get – as you execute your programs. So, on the head side, our plant is still essentially running flat through the course of the year. We had a lot of people in 2008 to help ramp up some of the programs and then you held the line pretty well in 2009. In fact, our spending was almost dollar-to-dollar between '09 and '08.

So in 2010, on the head side, I think we have got good leverage that we can still get to most teams. Like I said maybe add one or two here and there depending on specific skill set needs that may pop up. There is the possibility, of course, as particularly in the launch year when you have got some near-term pickups just from material purchases, help build alphas, help build beta units things like that. I can't say that I think it would necessarily be material either. Keith, I don't know if you want to add some additional color on that but –

Keith Bair

No, no I agree I wouldn't say anything materially different.

Jay Freeland

Okay.

Keith Bair

Especially in terms of adding additional heads.

Jim Ricchiuti – Needham & Co.

Keith, is there anything you can say with respect to the tax rate for the year, any update there?

Keith Bair

Well, this was the first year where we actually have a tax agreement in Singapore, a multiyear tax agreement. This is the first year where it went to 10% and that added about four points to our effective rate. And if you go back and kind of run that through prior years, say '06, when it was first operational in Singapore, you run that from '06 to '08, and it kind of fits in in the pattern of adding about four points to our effective rate. In 2008, our effective rate was around 24%, so adding four points to that is just about where we are now.

Jim Ricchiuti – Needham & Co.

Okay great. Thank you.

Operator

And we will take our next question from Richard Eastman at RW Baird. Your line is now open.

Richard Eastman – Robert W. Baird

Yes, I guess we are all teeing up a second time here. But Jay whatever happened to that potential liability in cost with the FCPA monitor, is that – do we need to think about building that in at any point here or where does that stand?

Jay Freeland

Yes, it is always still – obviously there is still always the possibility that the monitor is going to start. We know that there has been some discussion with – we had a monitor that both the DOJ and FARO had to said yes to a long time ago and just no activity as you know has happened, we have been sitting here waiting, waiting. It's always been our understanding that the clock for the DOJ side expires – the two-year period expires at the end of July and they have said the same – they have said that to us in dialog.

I think I still believe that we are going to get the monitor at some point for some period of time. And obviously discussion with the DOJ would – in my view is look, it supposed to be two years from the date of the signature and that's what we have always been talking about and that ends in July. Yes, I understand that we may want the monitor to come in and do at least the first review and make sure that all the things we said we were doing and have been doing are in fact correct, and I have no concerns about that when the monitor comes and visits and assuming they do come and visit. I am also assuming that the DOJ will continue to say yes it's two years from the day they show up, it's two years in total from when the clock expired or when the signature happened.

So, what we have always said is we thought it would be $1 million to $2 million and that was way back when the clock first started running. I think the last update we provided Keith was well, even if they showed up, could it be as much as a million dollars if they came in and really did three or four months of hard aggressive work with lots of people on it to get one good report out? I think that's possible, it's hard to imagine running up a million dollars of cost if they were really only onsite three or four months.

And you are going with that I guess it's always a possibility that the DOJ or the SEC looks at it and say, you know what yes we know you've been doing well, we would really like to still have two years. And obviously I would argue against that pretty heavily, because it's like getting additional penalty on top of the two years we have been sitting here already waiting for them to come in. But I never put that out of the question completely, but there's no kind of signal in there.

Richard Eastman – Robert W. Baird

Well, if nothing else, Keith could probably do this for less than $1 million or $2 million, couldn't you?

Keith Bair

Well, you know –

Jay Freeland

We are certain that we would get a much better cost profile.

Keith Bair

It's pretty hard to imagine if their work is going to end by July that there is a tee of a million dollars –

Richard Eastman – Robert W. Baird

To spend that much. Okay, alright, well thank you. That was all. Thanks.

Operator

And at this time, we have no further questions.

Jay Freeland

Very good, well thanks everybody for your participation. And we look forward to updating you either out on the road or when we get onto the next call at the end of Q2.

Operator

This concludes today's program. You may disconnect at any time. We thank you for your participation and have a wonderful day.

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THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

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Source: FARO Technologies, Inc. Q1 2010 Earnings Call Transcript
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