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Executives

Vic Allgeier - IR

Jay Freeland - CEO

Keith Bair - CFO

Analysts

Mark Jordan - Noble Financial

Larry Solow - CJS

Richard Eastman - Robert W. Baird

Barry Randall - Crabtree Asset

FARO Technologies, Inc. (FARO) Q2 2010 Earnings Call August 5, 2010 11:00 AM ET

Operator

Good morning everyone, and welcome to FARO Technologies conference call in conjunction with its second quarter 2010 earnings release. For opening remarks and introductions, I will now turn the call over to Vic Allgeier. Please go ahead, sir.

Vic Allgeier

Thank you and good morning everyone. My name is Vic Allgeier, the TTC Group, FARO’s Investor Relations firm. Yesterday after the market closed, FARO released its second quarter results. By now, you should have received a copy of the press release. If you have not received a 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 SEC.

I will now turn the call over to Keith.

Keith Bair

Thank you, Vic. And good morning, everyone. Sales in the second quarter of 2010 were $45.7 million, a 32.4% increase from $34.6 million in the second quarter of 2009. On a regional basis, second quarter sales in 2010 in the Americas increased $4.1 million or 33.7% to $16.4 million compared to $12.3 million in the second quarter of 2009. Sales increased 19.9% in Europe to $18.1 million from $15.1 million in the second quarter of 2009. Sales in the Asia-Pacific region increased 56.7% to $11.2 million from $7.2 million in the second quarter of 2009.

The effective changes in foreign exchange rates on sales was a decrease of approximately $1.1 million in the second quarter of 2010 compared to the second quarter of 2009. New orders increased 24% in the second quarter of 2010 to approximately $43.9 million compared to approximately $35.4 million in the second quarter of 2009.

On a regional basis, second quarter orders in 2010 in the Americas increased 22.1% to $14.9 million compared to $12.2 million in the second quarter of 2009. Orders increased 21.2% in Europe to $18.3 million from $15.1 million in the second quarter of 2009. Orders in the Asia-Pacific region increased 32.1% to $10.7 million compared to $8.1 million in the year ago quarter.

The top five customers by sales volume in the second quarter of 2010 were, Advanced Integration Technologies, IHI, Global Tooling Systems, Westinghouse Electric and Daimler AG and represented only 3.3% of sales. The top 10 customers in the first quarter of 2010 represented only 5.5% of our sales, once again, indicating our lack of dependence on any one or a handful of customers.

Our gross margin was 59.3% in the second quarter of 2010, compared to 56.1% 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 higher-margin product sales.

As a percentage of sales, selling expenses decreased to 26.3% of sales in the second quarter of 2010 compared to 35.1% in the year-ago quarter. Selling expenses declined by $100,000 to $12 million in the second quarter of 2010 from $12.1 million in the second quarter of 2009.

As a percentage of sales, administrative expenses were 13.2% of sales in the second quarter of 2010 compared to 17.8% in the second quarter of 2009. Administrative expenses in the second quarter of 2010 decreased by $100,000 to $6 million from $6.1 million in the second quarter of 2009, primarily as a result of a decrease in compensation costs of $200,000 and training and recruiting costs of $100,000, offset by an increase in professional and legal fees of $200,000 primarily related to patent litigation.

Research and development expenses were $3 million for the second quarter of 2010 or 6.6% of sales compared to $3.3 million or 9.5% of sales in the second quarter of 2009. The decrease is primarily related to a decrease in compensation costs and subcontractors’ expenses.

Operating margin for the second quarter of 2010 was 9.9% compared to a negative margin of 10.3% in the year-ago quarter, as a result of the previously mentioned increase in sales and gross margin. Foreign currency transaction losses were $1.8 million in the second quarter of 2010 compared to a gain of $800,000 in the second quarter of 2009, primarily as a result of the effects of the decline in the euro on the value of the intercompany account balances with the company’s European subsidiary.

Income tax expense increased to $900,000 for the second quarter of 2010 compared to a benefit of $600,000 in the second quarter of 2009 due to an increase in pre-tax income. The company’s effective tax rate for the second quarter of 2010 was 32.1% compared to a benefit of 22.2% for the second quarter of 2009, primarily as a result of an increase in taxable income in jurisdictions with higher tax rates.

Net income increased by $3.9 million to $1.8 million or $0.11 per share in the second quarter of 2010 compared to a net loss of $2.1 million or $0.13 per share in the second quarter of 2009. The number of fully diluted shares outstanding in the second quarter of 2010 was $16.3 million compared to $16.1 million in the second quarter of 2009.

I will now briefly discuss a few balance sheet and cash flow items. Cash and short-term investments were $106.9 million at July 3, 2010 compared to $100.1 million at December 31, 2009 and include $65 million of US Treasury bills.

Accounts receivable was $40.3 million at July 3, 2010 compared to $42.9 million at December 31, 2009. Days sales outstanding at July 3, 2010 decreased to 81 days from 85 days at December 31, 2009, primarily as a result of improved collections in the Americas region. Inventories increased to $39.4 million at July 3, 2010 from $38.6 million at December 31, 2009, primarily as a result of an increase in raw materials.

Finally, I’ll conclude with some statistics regarding our head count numbers. We had 753 employees at July 3, 2010 compared to 734 at December 31, 2009, an increase of 19. Account manager head count increased from 146 at December 31, 2009 to 148 at July 3, 2010; with 41 account managers in the Americas, 52 account managers in Europe and 55 account managers in Asia. Geographically, we now have 300 employees in the Americas, 253 employees in Europe and 200 employees in the Asia-Pacific region.

I will now hand the call over to Jay.

Jay Freeland

Thanks, Keith. Global market conditions continue to improve in the second quarter, and we saw the effect of this on our top-line. Sales in Asia remained particularly robust growing more than 50% again for the second straight quarter. We’re seeing strength not just in China, but also in Japan where markets last year were pretty weak.

Europe improved even more this quarter, growing more than 30% on a local currency basis which helped offset the rapid decline in the euro over the course of Q2. We also grew sales by more than 30% in the Americas, thus capping a very good quarter across all three regions.

We also had solid orders growth of 24%. There weren’t any significant drivers for the difference between sales growth and orders growth other than certain transactions pushing into Q3. What I think we saw this quarter was a balancing effect from the 45% growth we generated in the first quarter. Year-to-date, our orders growth and sales growth are exactly the same at 33%, which matches the typical book-to-bill ratio of the company.

Overall, manufacturers are spending their CapEx budgets in investing in the facilities again. Pricing has remained stable just as it has been for the last several years. We still get plenty of competitive price pressure, but that pressure has caused only a handful of losses that we know of. Customers choose FARO because we provide them with the total solution, cutting edge technology, ease of use, reliability and outstanding customer service. Historically and still today, price is much lower on the decision tree because we’re able to deliver compelling ROI which is typically in the five to six months range.

Sales to new customers rose to 46% in the second quarter, much closer to our historical and targeted ratio of 50%. During the first quarter only 35% of our sales came from new customers. However, I felt confident that this was an anomaly created as the world stabilized from the financial crisis and as the global economic recovery started.

More specifically, in Q1 our existing customers were the first to start buying again, because they already knew the value of FARO’s equipment from their first-hand experiences. At the time, I predicted that our sales to new customers would rebound to normalized levels within a couple of quarters. Q2 almost got us there.

Based on the current environment, I still believe we’ll be back to 50/50 by the end of the year if not sooner, demonstrating continued belief in the ROI our technology generates.

Our cost control remains tight in the second quarter creating good leverage in every department. Selling cost as a percentage of sales represent our largest line item, and they’re running at their lowest levels at ever. Nearly all of our account managers have improved their productivity, and we anticipate continued improvement going forward. As I have stated before, we believe that we can get to at least $200 million per year annual run rate before we start hiring incremental account managers again. All other departments are also running below last year’s levels, demonstrating that the actions we took last year are having a real and sustained impact.

We have a very active 12 months ahead of us in terms of new product releases, and the engineering teams have kept that trip schedule on track. Our decision to maintain engineering spending throughout the downturn is beginning to provide benefits. A few weeks ago we announced the launch of a very important accessory product, our new best-in-class break-resistant SMRs.

SMRs are the reflectors used with a laser tracker to receive and return the measurement signal from the tracker. They are critical to the performance and output of tracker. With this release, we have combined high accuracy and high durability with low cost for the first time in the market. We talk a lot about the pending releases of our core products. But accessory releases such as this one are just as critical to delivering ease of use and total solutions to the customers.

Finally, for the last two years, I’ve discussed the possibility that the monitor we were assigned when we settled our SCPA matter with SEC and DOJ would start their work. Well, the monitors work begin this past quarter. The monitors focused on ensuring that we are in compliance with the terms of our settlement with the DOJ and the SEC. The total cost of their work is difficult to estimate. However, as we have stated in previous calls, we believe it could be at least $1 million over the coming 12 months.

Assuming the world does not experience another global economic decline, we remain cautiously optimistic with respect to the second half of this year. Customer activity is good, and the team is executing well. We continue to improve our efficiencies and gain leverage across the company. We are still not providing financial guidance as has been our practice for the last 18 months, but we will continue to keep you up to date with respect to market conditions, customer sentiment and, of course, overall performance.

As we enter the second half of the year and look to continue our performance, I’d like to offer my thanks to the FARO team, our customers and our investors.

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

Question-and-Answer-Session

Operator

(Operator Instructions) We’ll take our first question from the site of Mark Jordan with Noble Financial. Please go ahead.

Mark Jordan

Could you talk a little bit about the euro exposure which generated this uniquely large loss this quarter? Specifically, could you outline what is the actual dollar value of your typical exposure, and is there a way for you to dampen the potential of volatility in that number moving forward?

Keith Bair

Yes, let me give a little bit of background on the FX issue. The United States, as you know, basically sells to Switzerland and to Singapore. And when we sell to Switzerland, we have a receivable that’s denominated in US dollars. Switzerland then takes the product for their manufactures so that then sells it to Germany, and now Switzerland has a receivable in euros. That same sort of thing happens when we sell to Singapore and Singapore sells to Japan and to China and to Thailand and other countries.

So we have an exposure there to the extent that we have receivables and payables among the subsidiaries and currencies other than their functional currencies. So Switzerland could have a euro receivable and during the course of the quarter that euro receivable has become less in value. So they have to record a transaction to reflect that.

So typically, we have transactions throughout the quarters for payments on those accounts as well as additional sales on those accounts. And what has happened throughout that second quarter was that the dollar got much stronger compared to the euro and the Swiss franc. So we had to some FX exposure and some transaction losses on those intercompany transactions.

What we typically do, we try to have national hedges in place by having some of our expenses denominated in local currencies. So typically, rather than using financial instruments to hedge, we try to have some national hedges. What we typically would do, is to pay down these intercompany balances throughout the quarter; and typically, that’s what we intend to do going forward. We’ve paid down some of those balances to reduce our exposure, and that’s typically our hedging program is to provide more of a functional hedge rather than a financial hedge.

Jay Freeland

We have already paid down a chunk of those balances to reduce that exposure going forward in Q3 and Q4. The other thing I would say is that I think you used the word unusual, Mark. That’s probably appropriate. A part of this is as sales started ramping up again in Q1 and Q2, receivables are growing prior to the collection as well. So those intercompanies, it was harder for them to make the payment until they collected some cash from the growth in Q1. And so you had a couple of quarter effect there, I think, we magnified. As they now that they have the cash in hand and we’re at this higher growth rate and the cash has started coming in from that growth, now they’ve got the ability to pay down those receivables also on a normalized basis, too.

Mark Jordan

Could you give us an update on where you are on your patent litigation?

Jay Freeland

We’ve had the first of what will probably be several evidentiary hearings, first almost a couple of weeks ago. And this is tied to concerns we had over in equitable conduct and what had happened at the time with what is now a third removed party. The party that originally patented the technology was then sold to Metris, who has since been sold to Nikon. So the case is now with Nikon.

Next court dates are next week, and they will continue as evidentiary hearings at that point in time. And others will be scheduled beyond that if needed. As I said in the past and continue to say, we have been open to settlement and very open to settlement all along the way and just having gotten a lot of support for that from the other side at this point.

So, right now this is slowly playing out. Again, these are evidentiary hearings only and slowing playing out there at the moment. And the evidentiary hearings are current because the judge did say that there was valid reason, that FARO had valid points to be able to get those hearings which was I think a positive item in that regard. But ultimately, we still would like to get this settled and move on.

Mark Jordan

Final question for me is, if you look at the performance in the Americas both from a revenue standpoint and an order standpoint, revenues were flat sequentially while you saw growth in the other two geographies. Quarters were down, again, with growth sequentially in other two geographies. What was particular in the US market that would have created a weaker relative performance?

Jay Freeland

There’s nothing specific to point, Mark. I think we do know there’s a little bit of timing there. I referenced before that we had some orders that kind of moved in the Q3. Some transactions that pushed out. Yes, I said we think we probably pulled a little bit into Q4 and that give the Q1 effect also. So I think it’ s a timing thing more than anything else. When you talk to the team, overall, they feel very good about the market, about the customer behavior. We’ve seen pockets here and there of customers still being nervous about releasing cash, particularly some of the bigger ones but, certainly, not like last year. And again, it’s more pockets than anything else. So what I look at is, when we look at the rest of the year, again, assuming there’s not some major economic calamity, things look pretty good in that regard. And so I think you’ve got more of a timing issue than anything else.

Operator

Our next question comes from the site of Larry Solow with CJS. Please go ahead.

Larry Solow

Could you guys maybe talk a little bit about, I know, historically, through the downturn, leads and demos have remained very strong and just sort of an extended selling cycle. Have you seen any change in that or are leads and demos still running pretty strongly through the first half of the year?

Jay Freeland

They are. Yes, they’re running exactly where we would want them to and would match appropriately to the growth that we are seeing.

Larry Solow

Did you talk about, have you seen anything more recently maybe even just anecdotally during the quarter sequentially were there any positive/negative changes or maybe even in July are customers more hesitant, less hesitant or anything, any color on that?

Jay Freeland

I think certainly what we saw in the first half was a vast improvement in the overall environment. And as you know, it really actually started in Q4, but we’ve finally seeing the actual growth correlation to it in Q1 and Q2 here. So that overall environment has been very favorable.

Again, customers, they’re investing in their plants again. Delays that they just kept putting off, putting off, they’re finally going ahead and pulling the trigger. They do feel better in many cases about their businesses, and you’re seeing admittedly some of it is mixed but you’re seeing good performance at a lot of the customers that we sell to, day in and day out.

Nice growth in Asia, good rebound, not just in China but in Japan as well, and a lot of favorable sentiment as they look forward out there. So really, for me the biggest thing at this point is, unless there’s some major economic meltdown which would be kind of out of our control, similar to what happened going into 2009, the overall market environment looks very good. Leads are growing. Customer sentiment still remains pretty strong and, certainly, significantly stronger than last year. And so that’s what we are focused on right now.

Larry Solow

And then you guys had a release during the quarter, you signed a deal with Airbus. And it seemed like a nice little deal. And I guess they are an existing customer yours and this just would provide about a million a year additional. Is there potential for more than just what the release said? How do you look at it?

Jay Freeland

Yes. You’re right. They were an existing customer. They’ve been a good customer for a long time. So this was them reaffirming their commitment to FARO, and their belief in the technology. And I can’t say it’s a straight line million bucks per year. Obviously, the orders come and go quarter-to-quarter based on their needs and the rollout schedule. We will certainly see benefits here in 2010 from the deal.

There is absolutely the opportunity for that to grow. And the reason I say that is the thing that was interesting about the order and the commitment from Airbus is that, I shouldn’t say, commitment because the orders are placed quarter-to-quarter. To make sure everybody’s clear on that we didn’t book one giant order in the first quarter when that was signed. We book it as they place the demand on us.

But the units that they’re purchasing are not just for themselves. Many of these units will end up being put into the supply chain as well. And as that process begins and it rolls out, either within the supply chain that’s received in them or other members of the supply chain, that’s where I would see the potential for incremental activity. As those other suppliers see what Airbus is doing or as they start, the ones who are being handled the technology or being, the technology being promoted within them, they start seeing the benefits and they start ramping up from there.

Larry Solow

And then look at your P&L, do you think your operating expenses are, I know you’re going to at least bring back management comp, has that returned to sort of to a sustainable level? And then the only additional increase would be, obviously, if on variable compensation and higher sales or...?

Jay Freeland

We are looking to continue getting leverage out of the structure. So we’ve added minimal heads. We’ve added a few in sales side, not just the account managers, but they support that goes with them. A couple of head count adds you see in the first half of the year are actually backfill for those where it’s just a timing where the person had resigned or had left at the tail end of the year and we hadn’t got them back into the position or anything like that. But we’re not looking to add incremental positions at all at this point.

And as we go forward, we still expect to get that leverage. So, Yes, we had a little bit increase comp, not from base salaries but accruals tied to bonuses, assuming we actually meet our financial target for this year. And that’s slightly different from last year where you didn’t pay any bonuses.

Other than that, its flat across the board, and I expect to continue getting leverage throughout the year. And so you’re right, Yes, you get some incremental commissions on the sales line. But even there, you look at our selling cost of percentage of sales, we’re obviously getting nice leverage compared to, you, really, not just last year but even years when we were still running in the 30%, 31% range, maybe 29% for a while. So we’re getting good leverage there, too. That is the theme here of the streamlined and kind of newer, leaner organization as we go forward as looking for every possible way to wait adding the head. Almost, you kind of wait till you’re at almost the breaking point. And then you try one more time to systemize and before you finally breakdown and add the additional person.

Larry Solow

Then just excuse me, you may have already touched on this but did you mention anything about the ongoing, the minor, the legal, the couple things you had the ongoing patent case and then the potential for a monitor put in by the DOJ?

Jay Freeland

Yes, the monitor has started their work. They did start at the tail end of last quarter. And it’s hard to predict what the cost will be because these are couple of lawyers with billable hours based on site work and so forth. It could be $1 million over the next 12 months. And that’s kind of timeframe we’re looking at is a first report, and then a follow-up report 12 months from that. And so that’s where we are at the monitor.

The patent case, we have had some evidentiary hearings now. We’ve got follow-up hearings next week. We continue to try to settle the case and have made offers to settle and just not getting any reception from the other side. We feel very good about our case. So we’re not settling because we’re nervous about our case, we’re settling to be smart about this from a business standpoint and move forward. But right now, we feel very good about our position, and so we’re going to keep hammering forward on that side if we have unwillingness on the other party.

Operator

(Operator Instructions) We’ll take our next question from the site of Richard Eastman with Robert W. Baird. Please go ahead.

Richard Eastman

Say, could you just talk for a minute about kind of that front log numbers that we think of as the demos. Did the demos in the quarter run ahead of, on a percentage basis, ahead of the order number?

Jay Freeland

I don’t know if we’ve ever disclosed kind of the ratio or the timing of those before, so I won’t say if it is ahead or behind. Like I said, I can’t remember if it was Mark or Larry. I said what I will is that they are definitely running at the rates that we need or want it corresponds well to the growth that we’re seeing and what we want in the second half of the year here. So that side of it has been very good. Similar to last year, we were running at those rates, but they weren’t transacting. Obviously, this year customers are transacting and closing the deal with us in conjunction with those demos.

Richard Eastman

So you, let me ask you what, I mean, since you know what your sales target is for the second half or orders target, can I presume that the demos that you’re comfortable with, the growth rate is north of 20%? In other words, you’re doing 20% more demos year-over-year in the second quarter to deliver that type of growth? Is that a just a fair assumption?

Jay Freeland

It is if you think about it in the respect that many of the demos that we do in a quarter, close in that quarter also. So again, if you look at the growth we’ve had the first two quarters, it sustains that well. And based on activity, we feel good about where our Q3 and Q4 are headed. Again, barring a major economic collapse, the rest of the activity does kind of sustain itself and give us that direction that we want.

I know that’s not exactly the answer you’re looking for, but you know I’m not going to

Richard Eastman

And then the other thought I had, you mentioned again year-to-date, I think that order number and book-to-bill and sales number is appropriate way to look at it, but you did mention that some orders got pushed into the third quarter. And I’m curious. Is that a commentary about the closure rates fading towards the end of the quarter?

Jay Freeland

I don’t think so. I really look at it just as, again, more of a timing thing than anything else. We, historically, that always happens to us. Typically, what happens is that you get to the end of the quarter, that’s why we still have this profile with last two weeks are 50% of our sales are during the final two weeks of the quarter.

And what’s happening, and I guess the good news is with some respects, I won’t say is perfectly normal yet, but it has definitely returned to that normalcy, is if you have a customer that suddenly they got a machine tool issue or something else happens those last couple of weeks and they need it to actually produce product, they will delay our purchase for a few weeks in order to put the money to something else or the company says during the final to two weeks, you know what, no more cash out the door or no more orders placed. I want to control our commitments until we get out of this fiscal quarter. We still see that quarter-in and quarter-out.

So I can’t say it’s not unusual for us to see that happen. So we saw some of those in Q2 here. And the fact that Q1 was so large, did we have a few that might have been Q2 orders that ended up in Q1 instead because the customer said they were ready? That’s possible too.

Richard Eastman

And then do you look at the gross profit margin trend, maybe from this point forward, is that going to be fairly stable given the mix of customers and products that you would expect over the second half or is there some, is there some room for improvement there due to mix or...?

Jay Freeland

There’s always room for improvement, certainly, not just from mix but just from product cost and all the other obvious areas. Is it more sustainable or predictable going forward? Hard to say. Now, what I will say is that, and I think we talked about this last year, that the sales decline was so tightly wounded with the products themselves and service revenue remained stable. That caused a big drop, that drop drove most of the drop in gross margin last year from a percentage standpoint.

And what we kept saying was, well, we assume when the sales return it will almost all be in product and that will drive gross margin right back up. And indeed, you look at the first two quarters, that’s exactly what’s happened is that the growth is coming from the product side as it should. That’s the right place for it to come from. So assuming that trend continues in Q3 and Q4, which again it should then that should keep the gross margins up in that 59%, 60% range which is where we want to be in the near term with the longer term being still to get well over 60%. Could it move a percentage point? Obviously there’s a point of fluctuation in there no matter what you do going forward. But we feel pretty good about that higher end where it is now.

Richard Eastman

Keith, was there any FX impact at the gross margin line?

Keith Bair

No. There was really no material effect at the gross margin line.

Richard Eastman

And then just a last question, Jay, we talked, you had mentioned earlier that this will be a pretty active year on the new product front, when you look through that pipeline and the newer products that are staged in that pipeline, are they slanted directionally towards any of the product lines; the arm, the tracker, the gage, just, I’m just curious if there’s a particular R&D emphasis on any one product line that you think could have a more material impact on the growth of that line?

Jay Freeland

In some respects, I hate the say this; and in some respects, I love to say this. I think it’s across the board. What, without disclosing any of the individual products, what I have said I think before is that every product is getting a dramatic work over, every product but one. And I haven’t said which one isn’t. However, the ones that we have chosen I think will all have dramatic impact on the business, on the marketplace, on our ability to continue disrupting from a technology standpoint and so forth.

So, I feel very good about that. And so the reason that I hate to say that it’s all of them because that sounds kind of wishy-washy, but it actually, it was that aggressive. So last year when we were still hitting the gas pedal with all of the engineering spending, it was across the board because we saw that much opportunity across all of our products. And sometimes you get pigeonholed. You look at it you say, man, you know what, we really can only make a dramatic change on one. And you focus all your efforts there. We have focused the efforts across the whole spectrum.

Richard Eastman

Have you made progress on the scanning product line in terms of that, the concept, the strategy there was price elasticity and cost elasticity. I mean, have we made some progress there? Is that still the plan there in that product line?

Jay Freeland

That is still the plan. I think we’ve made progress, and there’s always the opportunity to make substantially more progress.

Operator

And our next question comes from the site of Ajit Pai with Stifel Nicolaus. Please go ahead.

Unidentified Analyst

This is Robert [Walker] on for Ajit. You mentioned that you won’t need to hire account managers until at least you hit the $200 million in run rate, but with the book-to-bill below one and an accelerating manufacturing environment, what you mentioned as normal linearity, growing leads and improving sentiment. Did you guys cut it deep, and why aren’t you looking to add at this point?

Jay Freeland

I don’t think we cut the deeper. What we cut to was our, you really end up what was left was our proven, A players for sure. We had, when we look at the cuts that we made, do I think that there were potentially some budding A players, but they needed time? Always a possibility.

The reason that I don’t think we cut too deep is that even with the improved productivity that the account managers, the run rates that they’re on right now and what they have generated, it’s still below what we expect from a run rates basis out of our account managers. Without getting into each individual product line or account manager, it’s lower still, even on the current run rate, than we would come to expect. So we believe, just based on that, we will get more productivity out of them.

And again, the book-to-bill is balanced. It’s perfectly one to one for the year-to-date. So the order side of it is just some timing differences that occurred in Q1 and Q2 I think. Not that there’s a slowdown that we would say, well, we’re foreseeing that. We are certainly not saying that or seeing that at this point.

Again, the timing of when we start adding them it’s really a function of how rapidly the world is ramping up. Do we wait until we’re exactly at $200 million? Possibly. If it was, if we thought the ramp was occurring even faster, might we start adding sooner than that? Possibly, though I don’t see that happening certainly during 2010 because we’re already at a pretty good ramp. And again, we’re not at full productivity out of the team from a run rate standpoint that we want to be yet.

So we watch it very ,very closely. There is still a timing factor that it’ll still take roughly 12 months for new account managers to really get good, so we have to watch that carefully and see when we think we’re going to be clearing sort of that $200 mark where we might say, okay, now it’s time to start adding account managers, so they’re at full tilt when we clear that line.

But right now, we feel very good about the head count we have and that there’s still productivity to come without jeopardizing our growth potential.

Unidentified Analyst

And just, I guess you mentioned in the past, obviously, the mix shift and what the impact that can have on gross margin, kind of, like, in case I missed it, can you quantify kind of the gross margin impact of any sequential mix shifts you guys saw kind of quarter-to-quarter?

Keith Bair

I don’t have the mix shift between products and services in front of me sequentially, but they are out there. They’re in our filings, so you can usually pull those filings from our quarters and see. What had happened primarily in ‘09 when our sales declined 30%, just about all of that 30% decline came from products. And products have a margin on the 65%, 66% range. So as sales started to come back, all of that increase in the sales is 25% to 30% in sales, all that’s coming from the products. So all that’s in that 65%, 66% gross margin range. But I don’t have sequential share.

Unidentified Analyst

Just in terms of, I mean, in the product mix, in terms of tracker, arm scanner?

Keith Bair

We typically wouldn’t disclose changes in the mix within the product line itself.

Jay Freeland

I think, the most, the only time we really talked about it recently, I think at Q4 we mentioned that the tracker mix was slightly higher on a relative basis from what we historically saw, and it returned kind of a normalized mix returned in Q1. And I think we’re seeing that again now.

Again, we don’t disclose the actual mix, but that was the one point where there is a little bit of anomaly that we actually said it was higher without saying exactly how much higher. But it is, what I would consider, normal mix across the products right now the last couple of quarters.

Unidentified Analyst

So fair to say that no major sequential mix shift among the products that kind of negatively hurt the Q-over-Q kind of margins there?

Jay Freeland

Right.

Unidentified Analyst

And then just finally, any update on the expected launch of your high end imaging product and when we should expect that revenue to become material? Thank you very much.

Jay Freeland

Very soon on the launch. That sounds awful. I hate to say that because we just don’t like to telegraph exactly when it’s cap happening, but very soon. And it’s on the schedule that we were planning.

When will the revenue become material? Given the size of the company, I mean, I think you would expect it would probably be a couple of years. And even the laser scanner is, you would say, really not 100%, it’s not fully material yet. And that’s been in the company for five years. And it’s not a reflection on the laser scanner in the marketplace because it has grown well every year over these five years. But it’s starting at such a low baseline compared to arm and tracker and gauge and scan arm that it just takes a little while to ramp-up.

Could the imager grow faster than that, maybe. That one’s a little bit harder to see. The thing that’s different with imager is that that product is being fed into an existing market that has already crossed the chasm, so high accuracy metrology with needs for portable devices that are very flexible and adaptable, which is exactly what that imager is in an established market.

The laser scanner, when it come out was going into a poorly adaptor market. And many respects it still is because you’re really finding where’s the best place to utilize it. How do customers utilize it? The technology was probably s little ahead of its time at the time that it was s purchase so that keeps things s little bit slower.

So the imager could be different only because it is being sold into an existing marketplace where there are known customer needs. When we started to beta testing, we had multiple existing customers with their hands up saying I’ve got application exactly for that. I want to be in the beta test, so that we could bring it there. And that’s very different from the LS, which was, okay, let me show you what this can do, and let’s talk about how you might use it. That’s a very different equation obviously.

Operator

(Operator Instructions) Looks like our next question comes from the site of Barry Randall with Crabtree Asset. Please go ahead.

Barry Randall

I heard your explanations to the first caller with respect to the foreign exchange issue, and so I don’t need any, well, maybe I still need an education, but I understand what you said there. But I am curious about the issue that since the end of the quarter, the euro actually has defied expectations and appreciated. So in terms of the accounting if, for example, the euro remains roughly where it is which is, it’s up about 10% this quarter-to-date. Suppose the euro remains roughly the same versus the dollar from now until the end of September, would we see when you reported your earnings, comparable positive effect? I’m not asking you to predict the euro movement, but just so I understand the effect that it has on your P&L. Would it be a comparable positive effect in the same way that it was a negative effect when the euro depreciated in the second quarter. Could you elaborate a little on that?

Jay Freeland

You have the accounting correct to the extent that the euro get stronger. Some of those FX losses reverse. However, to the extent that the intercompany balances have either increased or decreased as a result of further sales transactions or further payments on those accounts, you wouldn’t get the equal and offsetting gain to recoup that loss, but the accounting is correct.

Barry Randall

So just on a cash flow basis, you would have some offset but not a full offset. Is that fair? Is that correct?

Jay Freeland

Yes. All right.

Operator

(Operator Instructions) We’ll pause momentary to allow any additional questions into the queue. And it looks like there are no further questions on the phone.

Jay Freeland

Very good. Thanks everybody for joining us today, and we will chat with you again at the end of Q3.

Operator

This concludes today’s conference. You may now disconnect and have a wonderful day.

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Source: FARO Technologies, Inc. Q2 2010 Earnings Call Transcript
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