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Stratasys (NASDAQ:SSYS)

Q3 2010 Earnings Call

October 26, 2010 08:30 am ET

Executives

Shane Glenn - Director of IR

Scott Crump - Chairman & CEO

Bob Gallagher - CFO

Analysts

Troy Jensen - Piper Jaffray

Brian Drab - William Blair

Jim Ricchiuti - Needham & Company

Ryan Thibodeaux - Maple Leaf Partners

Chad Bennett - Northland Capital Market

Andy Schopick - Nutmeg Securities

Chuck Murphy - Sidoti & Company

Jeff Evanson - Dougherty & Company

Graeme Rein - Bares Capital

Neil Chatterji - Craig-Hallum

Operator

Good day ladies and gentlemen and welcome to the third quarter welcome to the third quarter 2010 Stratasys earnings conference call. My name is Chris and I will be your operator for today. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. (Operator Instructions). As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the conference over to your host for today, Mr. Shane Glenn, Director of Investor Relations. Please proceed.

Shane Glenn

Thanks Chris. Good morning and welcome to the Stratasys conference call to discuss our third quarter financial results. Representing Stratasys’ executive management on the conference call today is the Chairman and CEO Stratasys, Scott Crump and, CFO Bob Gallagher.

A quick reminder, that today's conference call is being transmitted over the web and can be accessed through the Investor section of our website at www.stratasys.com or directly by accessing the link provided in our press release.

We will begin with the Safe Harbor statement. All statements herein that are not historical facts or that includes such words as expects, anticipates, projects, estimates, vision, planning, could, plan, believes, desires, intends or similar words, constitute forward-looking statements covered by the Safe Harbor protection of the Private Securities Litigation Reform Act of 1995.

Except for the historical information herein, the matters discussed in this news release are forward-looking statements that involve risks and uncertainties. These include statements regarding projected revenue and income in future quarters, the size of the 3D printing market; our objectives for the marketing and sale of our Dimension and uPrint 3D printers, and our Fortus 3D Production Systems, particularly for the use in direct digital manufacturing; our agreement with HP to expand the distribution and sales of our 3D printers, our WaveWash support removal system, the demand for our proprietary consumables; the expansion of our paid parts service and our beliefs with respect to the growth and demand for our products.

Other risks and uncertainties that may affect our business include our ability to penetrate the 3D printing market; our ability to maintain the growth rates experienced in this and preceding quarters; our ability to introduce, produce and market new materials such as ULTEM and the market acceptance of these and other materials; the impact of competitive products and pricing; our timely development of new products and materials, and market acceptance of those products and materials; the success of our recent R&D initiative to expand the DDM capabilities of our core FDM technology and the success of our RedEye on demand and other paid parts services.

Our actual results may differ from those expressed or implied in our forward-looking statements. These statements represent beliefs and expectations only as of the date they were made. We may elect to update forward-looking statements, but we expressly disclaim any obligations to do so even if our beliefs and expectations change.

In addition to the statements described above, such forward-looking statements include the risks and uncertainties described more fully in our reports filed or to be filed with the Securities and Exchange Commission, including our annual reports on form 10-K and quarterly reports on Form 10-Q.

The information discussed within this conference call includes financial results that are in accordance with US Generally Accepted Accounting Principles or GAAP. In addition, non-GAAP financial measures are included that exclude certain expenses. The non-GAAP financial measures are provided in an effort to give information that the investors may deem relevant to the company’s operations and comparative performance, primarily the identification and exclusion of expenses associated with impairment charges, restructuring expenses and expenses associated with stock based compensation. The company uses these non-GAAP financial measures for evaluating comparable financial performance against prior periods. The appropriate reconciliations between non-GAAP and GAAP financial measures are provided in a table at the end of our press release.

Now I’d like to turn the call over to our CEO, Scott Crump.

Scott Crump

Good morning and thank you for joining us to discuss our third quarter financial results. The third quarter results of $30 million and $0.15 per share in GAAP EPS reflects the improvement in business conditions, we continue to observe within our core markets.

Considering the seasonal weakness that is typical during the summer months, the strong third quarter also indicates a continued building of positive momentum. Sales growth of our system area was very, very impressive with 3D printer systems revenue increasing by 26% and Fortus system revenue growing by 39% during the third quarter over last year.

Our game changing collaboration with HP continued to generate positive results during the period. Orders for their new Designjet 3D printer were strong and end-customer demand continued to build. Unit sales of our Designjet in markets served by HP were more than double than comparative uPrint sales generated within those markets last year, an impressive achievement. We remain pleased with the progress of our distribution agreement with HP and are optimistic about expanding the collaboration in the future.

Our consumable revenue grew by 34% during the third quarter, the fastest quarterly growth rate within the past three years. We believe this positive momentum can be sustained given the usage trends that we are observing within the channel. In addition, strong unit system growth which grew by 39% during the third quarter bodes well for future growth and consumable sales.

We generated nearly $12 million in cash from operations during the third quarter alone and now maintain approximately $84 million in cash and investments. Our financial help is the strongest in our company's history. We are optimistic about the fourth quarter and enter the period with positive sales momentum at a strong pipeline of our opportunities.

Okay, I will return later to update you on some of our initiatives, but first I’d like to turn call over to our CFO, Bob Gallagher, who will further highlight our third quarter results. Here’s Bob.

Bob Gallagher

Thank you, Scott. Total revenue was $30.3 million for the third quarter, a 24% increases over the $24.3 million reported for the same period last year. The company shipped 631 units during the third quarter, a 39% increase over the last year. This represented a record third quarter for unit shipments. The strong unit expansion was driven by growth in both our 3D printer and 3D production system sales.

Domestic sales grew by 31% during the third quarter and represented $16.8 million or 56% of total revenue. International sales grew by 17% to $13.4 million. Slower international growth was due to a more modest 6% growth in the Far East. Third quarter product revenue was $24 million, a 33% increase over the $18 million reported for the same period last year.

Several factors impacted our product revenue growth during the quarter. First, Fortus system sales increase by 39% when compared to the third quarter of last year. As you may recall from our comments last quarter, we entered the third quarter with a strong backlog of Fortus system sales. In addition, we observed strong orders for Fortus systems during the quarter which when combined with our strong Fortus backlog contributed to an impressive growth over the last year. The second item impacting our product revenue during the third quarter was a 34% increase in our consumable revenue compared to last year. This represents an acceleration from the growth rate we experienced during the second quarter and as a continuation of the positive trend that we began late last year. We continue to believe that our strong consumable growth represents a positive leading indicator for our business going forward. Lastly, our 3D printer system revenue increased by 26% when compared to the third quarter last year, driven by strong sales of all our 3D printers. This growth was a result of strong sales for our own Stratasys brand of 3D printers as well as strong orders for the new Designjet systems we ship to HP.

During the third quarter unit sales of Designjet in the five countries served by HP were more than double the comparable uPrint sales generated within those markets last year. Our total 3D printer unit volume within the HP markets, which includes both design jet and Stratasys brand of 3D printers increased by 88% in the five countries served by HP. Although HP has only recently initiated their marketing programs, we believe this is strong evidence of a positive impact on the market.

Despite these positive trends, we want to remind everyone than HP's rollout is still limited to only two products in the five European countries and they are more focused over the near to mid term on refining their go-to-market strategy to better prepare for future expansion and accelerated sales volume.

Third quarter service revenue was $6.3 million which was flat compared to the same period last year. Our maintenance revenue declined by 8% during the third quarter compared to last year. The recent declines in maintenance revenue are expected and reflect an extension in the warranty period we implemented in 2009 for most of our systems.

Revenue in our RedEye paid parts business increased by 21% in the third quarter compared to last year. This represents a positive trend that began earlier this year as RedEye continues to recover from a period of overly competitive pricing that occurred during the recent recession. RedEye is also benefiting from a resurgence in order of activity from automotive customers as well as new DDM applications within the medical device industry. The addition of several Fortus 900mc systems within the RedEye has also provided improved capacity for customers that need large parts.

Gross profit was $14.7 million for the third quarter of 2010, a 24% increase over $11.9 million reported for the same period last year. Gross profit as a percentage sales was 48.6% which was relatively flat when compared to the same period last year, and flat when compared to the second quarter of this year. The sales of our lower margin 3D printers were strong during the third quarter which negatively impacted our gross margin percentage. However, this negative impact was greatly offset by the positive impact generated by the sales mix within our Fortus systems sales, as well as the strong sales of our high margin consumables.

We want to highlight in the third quarter the positive dynamic between our lower margin system sales and our higher consumable revenue given the long term financial implications. Any near term acceleration in lower margin system sales should ultimately provide significant financial leverage as our higher install base of systems consumes an increasing quantity of higher margins consumables.

Operating profit was $4.1 million for the third quarter of 2010, a 69% increase over the $2.4 million reported for the same period last year. Operating profit as a percentage of sales increased to $13.4 million when compared to 9.9% for the same period last year. Operating expenses increased by 13% over last year to $10.6 million during the third quarter. The biggest impact on operating expenses was a 12% increase in selling and general and administrative expenses. This was driven by the acceleration in commission and incentive compensation expenses which is resulting from strong sales and earnings growth.

In addition, the R&D expenses increased by 13% driven by our new product initiatives within both, 3D printing and 3D production systems. Funds provided by our unnamed Fortune 500 partner to develop DDM applications for our Fortus line was lower during the quarter at $352,000 versus $405,000 for the same period last year. SG&A expense in the third quarter included $262,000 of stock based compensation expense net of cash compared to $210,000 for the same period last year. In other income, the third quarter included a foreign currency gain of $228,000. This gain was a result of the significant appreciation of the Euro relative to the Dollar during the period.

Pretax profit was $4.6 million for the third quarter compared to $2.6 million for the same period last year. Income tax expense amounted to $1.4 million in the third quarter or an effective rate of 30.3%, compared to $1 million or 39.7% for the same period last year. The tax rate for the third quarter benefited from a reduction in contingency reserves pertaining to positions taken on our 2006 return, as well as our higher protected 2010 manufacturers reduction as we are now projecting higher 2010 cash flow income.

Net income was $3.2 million for the third quarter compared to $1.6 million for the same period last year. Non-GAAP net income was $3.4 million or $0.16 per share compared to $1.8 million or $0.09 per share for the same period last year. Non-GAAP net income excludes stock based compensation expense in both periods. A table provided within our press release provides itemized details surrounding all non-GAAP items incurred during both periods.

We generated nearly $12 million in cash from operations during the third quarter alone and now maintain approximately $84 million in cash and investments on our balance sheet. Inventory balances were $8.7 million at the end of the third quarter, which is up compared to the $14.6 million at the end of fiscal 2009. Inventories have risen to match the strong quarter and forecast for both systems and consumables. We expect inventories will decline as we move through the last three months of the year.

Accounts receivable were $9.7 million at the end of the third quarter. Day sales outstanding or DSO improved 60 days compared sequentially to 66 days at the end of the second quarter and compared to 68 days at the end of the fiscal 2009. Overall we are very pleased with our financial performance during the third quarter and the continued improvement in our financial position.

And now I would like to turn the call over to our Director of Investor Relations, Shane Glenn for comments regarding our outlook.

Shane Glenn

Thank you, Bob. We appreciate the need to provide financial guidance to our shareholders and investment community. And we continue to observe an improvement in market conditions during the third quarter and we are optimistic about the balance of 2010.

We are currently evaluating various scenarios for our collaboration with HP in 2011 and beyond, all of which could have varied effects on our financial performance. It is our ultimate goal to provide long term target operating model which is supported by our expectations of a broader HP relationship.

We hope you can appreciate if there are many moving parts in our relationship with HP that currently include uncertainties on the location and new market expansion, the timing of that expansion as well as the inclusion of new products.

Now, I’d like to turn the call back over to Scott Crump.

Scott Crump

Thank you, Shane. We are very pleased with the rebound in our financial performance over the past nine months. We are optimistic that our positive momentum will be sustained. We remain excited about the potential of our game changing agreement with HP as the collaboration continues to generate positive results.

As we outlined earlier, HP's entrance into the market six months ago is having a positive impact on 3D printer sales within HP's market. These trends suggest that HP's distribution capabilities, brand power and marketing mussel can expand 3D printing awareness and can greatly accelerate the sales of our 3D printers.

HP's near to midterm goals remain the refinement of their go-to-market strategy and to better understand the 3D printing market. To achieve that goal, HP has assembled a dedicated 3D printing team managed out at Barcelona, Spain and have begun to engage their reseller network. They have produced marketing materials to promote their design jet series of 3D printers and have attended multiple trade shows within the five countries that they currently serve.

They are monitoring customer feedback on product performance and customer uses and are observing the expansion of the 3D printing opportunities. Despite their need to better understand the 3D printer market over the near term, we believe HP's dominance within the 2D [platter] market give in an extensive appreciation of the end customer as well as the 3D printer market in terms of the market potential.

Following their recent successes HP has communicated their desire to expand into additional markets and we are currently involved in discussions surrounding this expansion. As we have communicated previously, the near term financial impact of the current phase of our agreement with HP is expected to be relatively immaterial and that our expansion with HP will likely remain a gradual and a measured process.

However, we look forward to expanding the collaboration over the mid to long term as the potential effect becomes more significant. We continue to believe this game changing relationship represents the beginning of a revolutionary new phase of our company’s history. Stratasys and HP believe that millions of product designers are now ready to bring their design to light and 3D and we are collectively preparing to satisfy that demand.

Within our Fortus line, strong system sales were driven by incremental demand created by the emerging direct digital manufacturing or DDM applications as well as the ongoing economic recovery. We now have a dedicated effort to Stratasys called the Stratasys Manufacturing Solutions Group that is proactively working with customers to develop innovative manufacturing applications using our technology.

The aerospace industry is a leading innovator in the use of these applications. As you can appreciate, aerospace applications require low volume manufacturer part sets plus maintain stringent part, material cut [growth] sticks and part performance.

In addition, many of these complex parts and assemblies are often difficult to manufacture to traditional techniques, making them ideal for our DDM solutions. A great example of this is a project with Delta Airlines to provide a DDM solution to address a priority maintenance issue on approximately 200 of their aircrafts. This unique application will ultimately include several hundred in-use parts produced in our Fortus systems using our high temperature resistant ULTEM material.

Another example of a successful DDM application is with our customer DST Controls in Sweden, which makes advanced embedded electromechanical products mainly for unmanned aerial and ground vehicles. DST uses Fortus to manufacture 20 of the components for an electro-optical gimbal or eye that rotates on two axis’ providing stabilized images. Aside from the camera and the wiring, the mechanical components and the enclosure were produced with direct digital manufacturing on our systems. This customer reduced part cost by 66% and improved production time by 63%. We believe these proven applications will provide a springboard for other opportunities not only with Delta and DST Controls but other major airlines and aerospace companies.

Well, as Bob mentioned, our strong backlog of Fortus system orders to begin the third quarter was augmented by strong order activity throughout the period. We are optimistic that we can now repeat this performance during the fourth quarter given the positive impact from our strengthening markets and our DDM growth initiatives.

We continue to observe strong positive trends within our consumable sales and our RedEye business. As Bob mentioned, RedEye is benefiting from improved market conditions as well as new DDM applications.

More impressively, our consumable revenue grew at the fastest rate within the past three years during the third quarter. We believe this positive momentum can be sustained as channel surveys suggest consumable usage is accelerating, while reseller inventories remain relatively tight. In addition, the 39% growth in unit system sales for the third quarter bodes well for future growth in that consumable revenue.

Okay, in summary, we entered the fourth quarter with a positive sales momentum in nearly all aspects of our business and a strong pipeline of opportunities. We have successfully leveraged our growth with a distribution strategy that minimizes the expansion of our operating expenses while continuing to invest aggressively for the future. We believe these investments will yield evolutionary new platforms that can further the adoption of our products. We are well positioned competitively and our financial health is the strongest in our company's history. Most importantly, we look forward to expanding our distribution agreement with HP and realizing the full potential of that collaboration. So, I'm very excited about our future.

Okay, we'll return with some closing comments, but first we'd like to address any questions that you might have. Operator, let's open up the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from the line of Troy Jensen. Please proceed.

Troy Jensen - Piper Jaffray

So quick one on the HP expansion, is it logical to think that they would roll out the remaining countries in Europe before they move into other continents first?

Bob Gallagher

It's difficult to say where they would expand next. I think they have a strong presence within those five European countries and that doesn't necessarily mean that the next expansion would be within Europe. It has to do with their strongest partners and demand.

Troy Jensen - Piper Jaffray

And then shifting gears on the delta example that you guys gave for the direct digital manufacturing, was that a system order or is that a paid parts customer?

Scott Crump

Actually Troy that order was serviced by a service bureau that is qualified to do that for aerospace customers. So, it was done by a third-party, but obviously using our equipment.

Operator

Our next question comes from the line of Brian Drab, please proceed.

Brian Drab - William Blair

I know the year-over-year growth rates are just looking outstanding, but I was hoping that maybe you could give us a little color on how things went sequentially from second quarter to third quarter, particularly within Fortus and the consumables market. Clearly, the growth rate looks better from second quarter to third quarter, but could you talk about the direction in absolute sales of those products that went and maybe what we could expect going forward?

Bob Gallagher

I think what you really saw in terms of our overall revenue, you saw that it was very similar to what we had in the third quarter, remembering that the third quarter is usually our seasonally weakest quarter. We had strong sales within our Fortus systems as we ended the quarter with a strong backlog and sequentially consumables were predominantly flat on a quarter-to-quarter basis, as well as RedEye maintenance. So, it was a very comparable quarter in terms of overall product mix and color to the second quarter, remembering then again that we have that seasonal weakest quarter.

Brian Drab - William Blair

And then going forward into the fourth quarter, it sounds from your commentary like you would expect sequential improvement in most of those businesses?

Bob Gallagher

Again, if you take Q3 as a seasonal weakest quarter, traditionally what you’ve seen for us, is Q4 as being one of our stronger quarters.

Brian Drab - William Blair

And then just one more quick one, regarding gross margin, I mean sales aren’t clearly much improved from last year and you made some comments in gross margin so I may have missed this, but could you say that the main reason that gross margin is up only about 60 basis points even on such strong sales improvement, is the HP agreement in having to give up some value at HP now that they are in the picture?

Bob Gallagher

Well, certainly HP is a part of that but if you look at our products that we have introduced and one of the comments that we made during the call is that since last year our products are more focused on uPrint Plus which are lower average selling price within the products, though we have moved down some of our price points in there. Offsetting part of that was improvements then in the Fortus product mix as well as consumable products themselves.

Scott Crump

Yeah, Brian if you look at [the] during the quarter, what you call a higher margin 3D printers, and the higher margin 3D printers includes the Stratasys Dimension line as well as the uPrint Plus. So, what's excluded from that is the basic uPrint as well as the Deskjet systems that we sell to HP. But if you just look at the Dimension line plus the uPrint, you add the uPrint Plus, that was about 58% of our total 3D printer volume during the quarter, that’s versus around 55%, you could do a similar analysis for last year. So, we still sold a lot of higher margin printers, but certainly the HP systems as well as the basic uPrint are definitely lower margin systems.

Operator

Our next question comes from the line of Jim Ricchiuti of Needham & Company. Please proceed.

Jim Ricchiuti - Needham & Company

Just a question regarding the strength you are seeing in consumables, I know it’s still very early but is there anything you can point to in the European business with HP now in the market that perhaps is having some impact on consumables?

Scott Crump

I think you said it right when you said its very early in relationship, it’s only been six months now that HP has really been selling products into marketplace and we don’t really have anything on the dynamics to point any difference in that market relative to the rest of the world.

Jim Ricchiuti - Needham & Company

Can you talk a little bit about whether you were seeing more strength in growth in consumables with Fortus versus the 3D printers?

Scott Crump

We've actually seen a rebound in use of both systems. What we are trying to do is focus our Fortus product line on direct digital manufacturing applications, and a good example was the one that we talk about with Delta Airlines, that’s a customer of ours that’s going to generate a tremendous number of consumable sales in order to make all those parts. So we are continuing to try to drive higher volume with the DDM applications, but we have also seen a rebound compared to the 2009 levels on our 3D printers.

Operator

Our next question comes from the line of Ryan Thibodeaux of Maple Leaf Partners. Please proceed.

Ryan Thibodeaux - Maple Leaf Partners

Could you expand a little bit on a comment that HP is now refining their go-to-market strategy? I guess they are refining it from what is the question.

Bob Gallagher

They started off selling on a very similar basis and looking at some of the techniques that we use. Now they are in the process of going back for the systems that they sold as well as systems where they haven’t been as successful. They are doing customer surveys and follow-up within the marketplace and talking to additional resellers to find out the reaction within the marketplace. They are very good at going back and double checking things within the marketplace and surveying the market much better than Stratasys has ever been at that.

Ryan Thibodeaux - Maple Leaf Partners

Would that indicate that the roll out to date is going better or worse than expected?

Bob Gallagher

For HP it’s definitely gone better than their initial plans.

Ryan Thibodeaux - Maple Leaf Partners

But they are still have to refine their strategy…

Bob Gallagher

Right. And remember, this is only two products in five European countries, so it’s what they are doing in the short term.

Scott Crump

And maybe I can add to that. HP, as a company, are experts in 2-dimensional printing. This group is expanding the company into a 3-dimensional goal. It’s more than just the go-to-market. It’s also an interesting education and expansion process for the company with obviously some huge upside for both Stratasys and HP.

Ryan Thibodeaux - Maple Leaf Partners

Okay. And then, Bob you usually breakout the uPrint as a percentage of the total dimension shipments. I think Shane may have said it offhandedly. Can you just clarify that again?

Bob Gallagher

Yes, the Dimension line and the uPrint Plus was 58% of the total volume. The Deskjet and the basic uPrint is the balance.

Operator

Our next question comes from the line of Chad Bennett of Northland Capital Market. Please proceed.

Chad Bennett - Northland Capital Market

Yes, just a couple of questions. Fortus for the quarter, was there anything unusual in terms of ASP larger systems going out or can you give us some type of comparison either sequentially year-over-year kind of what the ASP was overall for that business?

Scott Crump

Yes, the ASP on that business is really because of the products ranged from our 360mc that has the ASP out at the retail level of the $80,000 to $100,000 and then you move all the way up to a 900mc that will retail out at about $400,000. You will see a huge mix of the ASP isn’t necessarily meaningful within that market. But to give you a little bit of color of that we saw an increasing demand for our 900mc products which is the large build-on globe and the one that has an average end-customer selling price for around $400,000.

Chad Bennett - Northland Capital Market

And you talked about kind of the backlog coming into the quarter and strong orders throughout the quarter. Do we have any way of, what's backlog going into the fourth quarter here or is it similar up down versus what you had coming into third quarter?

Shane Glenn

Unfortunately we don’t give you the exact backlog. We try to give a little bit of qualitative flavor around the numbers. It’s a strong backlog relative to typically what we see but we're not going to give out the specific number.

Chad Bennett - Northland Capital Market

Okay. And then I think a couple of callers have tried asking this. So the HP kind of units in the quarter, I guess you gave one metric that the business basically doubled year-over-year in those five countries versus uPrint last year. Was uPrint last year in those five countries even a meaningful number to base that off of?

Bob Gallagher

Yes, because if you look at the color around last year's numbers, last year was down substantially from the 2008 level but business was down much more dramatically in the US markets last year and Europe actually held up relatively strong. So we think it's important. It’s a small measure because it’s only the two products in the five, but we think it’s a significant measure.

Shane Glenn

Chad if you look at uPrint last year, it was by far the best-seller; I'm talking system-wise here, I don’t actually have the Europe numbers in front of me, but if you look at, system-wise, but it was by far the best-seller last year in the third quarter.

Chad Bennett - Northland Capital Market

Right, now I understand. I didn’t know kind of the relative geographical breakouts specifically when you kind of get down to five countries in Europe, if that’s a meaningful metric, debates it off of. Okay. I guess just lastly…

Bob Gallagher

I need to see how I already did it to one other person; I'll need to do it you so I ask you to get back in the queue.

Operator

Our next question comes from the line of Andy Schopick of Nutmeg Securities. Please proceed.

Andy Schopick - Nutmeg Securities

Thank you and good morning. I will try to keep this quick. Bob, I wonder if you can give us any color at all such as you did last quarter on the sell-through in the HP channel, whether there was really anything here that would provide a little additional color on to what’s happening.

Bob Gallagher

Yes. Most all of the systems that we shifted to HP, just like last quarter most of all the systems sold through to end customers.

Andy Schopick - Nutmeg Securities

Okay and secondly Bob, R&D tax credit. Do you have any greater visibility or can you give us any color on what might happen if Congress does renew that R&D tax credit, how that will affect your tax rate given the adjustments you've already made here in the third quarter to lower the overall effective rate?

Bob Gallagher

I’ve taken no R&D tax credit into consideration in my effective rate. If it does happen legislation in the fourth quarter, typically its had about a 2% impact in the overall effective tax rate which we then apply for the effective rate and reduced that in the Q4.

Scott Crump

That’s the upside of the year.

Operator

Our next question comes from the line of Chuck Murphy of Sidoti & Company. Please proceed.

Chuck Murphy - Sidoti & Company

Just kind of coming back to the comment about the HP markets having 3D printer volume up 88% year-over-year, could you say what the year-over-year improvement was in like the first and second quarter?

Scott Crump

You know what, I think we did, Chuck, just go back and look at the comments in the script. I think the year-over-year improvement in the third quarter is better than the one we reported in the second quarter. I don’t believe we provided you in the first quarter.

Shane Glenn

And of course the launch was mid to second quarter. So, Q3 and definitely Q4 are better measurements.

Chuck Murphy - Sidoti & Company

And the other question was, just any change in the Designjet’s price?

Bob Gallagher

No.

Scott Crump

No.

Operator

Our next question comes from the line of Jeff Evanson of Dougherty. Please proceed.

Jeff Evanson - Dougherty & Company

Bob, could you tell us if there was any FX impact to the gross margins in the quarter?

Bob Gallagher

Well, relative to the rates in effect at the end of the Q2, it would probably be a negative impact of $115,000. If you looked at it on a year-over-year basis, from the third quarter last year it was probably a negative impact of about $578,000.

Jeff Evanson - Dougherty & Company

And then Scott, I guess what I’d like to know is what would you put on as the probability that you guys expand this HP distribution relationship into North America in 2011?

Scott Crump

Well, I’m definitely optimistic about not only the relationship on the expansion, but the potential for 500,000 systems to go serve the existing 6 million [cavities] what the probability is, is pretty difficult that it determines, so I think I’m not going to give an exact probability.

Jeff Evanson - Dougherty & Company

Why would they not expand in Europe at this point and said potentially go into a new geography, I don’t quite understand that.

Bob Gallagher

It really has to do where demand comes from within their existing reseller base, but I don’t think Stratasys should get in the business in trying to predict HP’s marketing strategy. I think they are much better at marketing than we are.

Jeff Evanson - Dougherty & Company

I respect the latter part of that, I guess I’m confused why they wouldn’t be seeing continued demand in Europe. That seems not to comport with what you are telling us about strong growth through HP.

Bob Gallagher

Yes, there is a difference between, like I said, they’re refining their go-to-market strategy and it’s really a question probably a better voice to HP than it would be to Stratasys.

Jeff Evanson - Dougherty & Company

And Bob, last question, sorry. So, in simple terms, what should I model for a Q4 tax rate at this point?

Bob Gallagher

Right now if you look at the effective rate that we have on a nine month basis is the best estimate that we have for the year. If you see pass of the R&D tax credit in Q4 then the rate would reduce to a rate of 1 to 2 points below that effective rate. The one thing that comes into play, there is stock options and exercise the likes of stock options which are a discrete item in the quarter, and can have a significant impact on the quarterly effective rate, and there is no way to predict that.

Operator

Our next question comes from the line of Graeme Rein of Bares Capital. Please proceed.

Graeme Rein - Bares Capital

I’m interested in the RedEye business. You mentioned that the pricing is firmed up a little bit. Could you discuss, is that just due to strengthening in the economy in general or have you seen competitors exit the RedEye paid parts market?

Scott Crump

Well, I think the market’s dynamic, we certainly have seen a year-over-year improvement. RedEye has also done a very good job of analyzing our value proposition. And as we’ve done that along with the improvement in the economy and in the sector, short up prices, and I think that there will be next year some consolidation and effective pricing from that consolidation, but I don’t believe that we are seeing that this year. I think it’s more our actions and then an improvement of overall design prototyping, as well as some pre-orders in DDM and great opportunities in the DDM area for RedEye.

Graeme Rein - Bares Capital

And a follow-up on that, the new applications you are seeing in DDM and other paid parts customers, are these translating into system sales or are they more one-off projects?

Scott Crump

There has always been a very good correlation between doing thousands of parts and then selling tens of units, we call that prospecting and then that could be both up and down. We do a good job of supporting systems, our system users where they go through a normal design cycle, prototyping peak in valley. When they hit their peak, we are there, sometimes one day turnaround, they are back up. So, it’s not only selling systems up which also leads to the consumables, but then when customers get either machine or multiple machines, they typically can’t, I guess in no case can they get all of the offerings that RedEye has, and so RedEye is a natural resource for them.

Operator

(Operator Instructions). Our next question comes from the line of Neil Chatterji of Craig-Hallum. Please proceed.

Neil Chatterji - Craig-Hallum

Just a quick question on, in light of your cash generation, if you could just comment on any plans for using that going forward?

Bob Gallagher

We’ve been asked about our cash for a long period of time and we continue to say that we have a cash opportunity as opposed to our cash problem. We’ve looked at it, over the years we’ve looked at various opportunities and acquisitions on that and investments within technologies, but those are the type of things you would announce when they come. Until then we’re focused on generating cash which we think is positive for our business and our shareholders.

Operator

Our next question comes from the line of Troy Jensen of Piper Jaffray. Please proceed.

Troy Jensen - Piper Jaffray

So, a couple for Bob here. R&D spending was down sequentially, is it sustainable at these levels and then should we expect any commission accelerators in the SG&A line in Q4?

Bob Gallagher

In terms of R&D, what I said at the end of the second quarter is that we expected R&D spending to be at a similar level in the second half than we would in the first half. Q3 was about 2.2. Q2 was about 2.7 and R&D spending probably will come in somewhere between those two numbers in Q3. The second half will come close to the first half in terms of R&D spending. In terms of commissions, the accelerators were definitely going to see some accelerators on commissions in some of our variable compensation in Q4. We’ve taken some of that into effect in Q3 but you are also going to see it as an impact in Q4 definitely.

Troy Jensen - Piper Jaffray

And DSO’s, great job this quarter. It’s always been an issue for you guys, it was kind of higher than what investors like to see for the DSO line. Was it collections there or linearity? What improved dramatically here on the DSO line?

Bob Gallagher

One of the things that gives a positive impact is the timing on some of our sales within HP itself. I need to say that my staff is doing a great job of collections. They’ve got a good system down there, definitely. But at HP we've got our systems down also as it relates to HP, they've don a great job of collections as it relates to our largest customer too.

Operator

Our next question comes from the line of Ryan Thibodeaux of Maple Leaf Partners. Please proceed.

Ryan Thibodeaux - Maple Leaf Partners

Hey, Scott. A question, just curious on your thoughts and the growth on the emerging open source market, I know that it's for buying, this company was recently acquired by one of your competitors and I think they shipped a thousand units in '09 and they're up 100% year-to-date at a 2,500 yard price point. So I'm just curious what are your thoughts on that business model line?

Scott Crump

Well, I think you actually have maybe three business models there in the open source area. I think by definition it's not really a business, it’s more of a sharing. And in terms of Bits from Bytes, they're primarily targeting home [caveats], as well as the area of educators, not necessarily education but educators, as well as the do-it-yourself [areas]. And within the do-it-yourself [areas] that's not in the commercial area. So Stratasys is focused on, in professional rather prototype being worldwide as a tool is really focused on the commercial use of 3D printers, and there's certainly long-term both applications and markets in that area, but none of the products out there are what are called full product solutions for those that want to use them as tools to solve problems at least at this time.

Ryan Thibodeaux - Maple Leaf Partners

Okay, and then last question for Rob, just a follow-up from an early question, someone asked about gross margin. I believe in the second question you had commented that one of the reasons that you said the sequential decline in gross margins was because of the weaker Euro. I am just curious if you had a reversal of that effect in Q3.

Bob Gallagher

Yes, surprisingly we didn’t. It was actually, we continued to have an adverse effect relative to where we were at the beginning of the year, and last year on the Euro, what we may remember is that the Euro was going down in Q2 but it really started off in April and May that the rates with the Euro were relative high to where we're at in the August-September timeframe. So, relative to the beginning of the year we still had an adverse effect and actually Q3 had an adverse effect relative to Q2.

Ryan Thibodeaux - Maple Leaf Partners

So, it was till negative from Q2 to Q3?

Bob Gallagher

Yes, it was about $115,000 negative quarter-over-quarter impact.

Operator

There are no further questions at this time. I would now like to hand the call back over to Mr. Scott Crump, CEO.

Scott Crump

Okay. In closing, I’d like to thank you for your interest in Stratasys, Inc. and we look forward to speaking with you again next quarter. Goodbye.

Operator

Thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect.

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