GSI Group's (GSIG) CEO John Roush on Q2 2014 Results - Earnings Call Transcript

Aug. 7.14 | About: GSI Group, (GSIG)

GSI Group Inc. (NYSE:USA) (NASDAQ:GSIG)

Q2 2014 Earnings Conference Call

August 6, 2014 05:00 PM ET

Executives

Robert Buckley - CFO

John Roush - CEO

Analysts

Lee Jagoda - CJS Securities

Jim Richiutti – Needham

Stefan Mykytiuk - ACK Asset Management

Operator

Good afternoon, my name is Sarah, and I will be your conference operator today. At this time I would like to welcome everyone to the GSI Group's Second Quarter 2014 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (Operator Instructions)

Thank you. Mr. Robert Buckley, Chief Financial Officer. You may begin your conference.

Robert Buckley

Thank you very much. Good afternoon and welcome to GSI Group's second quarter 2014 earnings conference call. I am Robert Buckley, Chief Financial Officer of GSI Group. If you've not received a copy of our earnings press release, you may obtain one from the Investor Relations section of our website at www.gsig.com. Please note this call is being webcast live and will be archived on our Web site.

Before we begin, we need to remind everyone of the Safe Harbor for forward-looking statements that we've outlined in our earnings press release issued earlier this afternoon and also those in our SEC filings. We may make some comments today both in our prepared remarks and our responses to questions that may include forward-looking statements. Those involve inherent assumptions with known and unknown risks and other factors that could cause our future results to differ materially from our current expectations.

Any forward-looking statements made today represent our views only as of today. We disclaim any obligation to update forward-looking statements in the future even if our estimates change. So you should not rely on today's forward-looking statements as representing our views as of any date after today.

During this call, we'll be referring to certain non-GAAP financial measures. A reconciliation of such non-GAAP financial measures to the most directly comparable GAAP measures is available as an attachment to our earnings press release. To the extent that we use non-GAAP financial measures during this call that are not reconciled to GAAP measures in the earnings press release, we'll provide reconciliations promptly on the Investor Relations section of our Web site.

I'm now pleased to introduce Chief Executive Officer of GSI Group, John Roush.

John Roush

Thank you, Robert. Good afternoon, everybody, and welcome to our call. I’m pleased to update you on what I view as another very solid quarter for the company. Customer demand remains very positive across the vast majority of our product lines and applications. Our growth initiatives across GSI are gaining momentum in most areas.

In addition we substantially completed the integration of the JADAK acquisition in Q2 and we’re extremely pleased with the JADAK team and the performance of the business which I would say is exceeding our expectations. Since the acquisition we made encouraging progress with our medical technology cross selling initiatives and I’ll also note that we completed the divestiture of our scientific laser business in mid July.

In Q2, our revenue, profitability and cash generation, all came in ahead of our own expectations. I'd like to give you a brief summary and Robert will go into more detail in his section. So our Q2 revenue was $96.9 million up 21% versus a year ago. Adjusted EBITDA was $14.5 million up $2 million from Q2 2013. Q2 EPS was $0.10 on a GAAP basis up $0.03 from a year ago.

Non-GAAP EPS for the second quarter was $0.19 up from $0.14 a year ago. In the quarter we generated over 17 million of operating cash flows and ended Q2 with net debt reduced to just under $90 million. So on the whole I’m quite pleased with the financial results.

So, at this point I would like to give you some commercial updates on our progress across the company. In Q2 we saw continuation of the previously discussed trend with demand improving modestly across the majority of our end markets. As I’ve said in recent calls barring any unforeseen economic turbulence, we expect continued gradual improvement in market conditions throughout the year. On the industrial side of our business we closely track the PMI indices around the world and all of the major ones at this point are trending to near term expansion.

On the medical side of the business, hospital capital spending has been reasonably healthy this year. Our overall book-to-bill ratio for GSI was 1.0 in Q2 with two of our three reporting segments above 1. On accumulative basis throughout a half year, our overall book-to-bill ratio was 1.04. A majority of our major product lines had year-over-year sales increases in Q2.

Our management teams around GSI have been focused for sometime on executing on our growth strategies by launching more new products, increasing the revenue opportunity funnels and capturing new design wins that our OEM customers. These efforts are bearing fruit in most cases. Our funnels and our design wins are both increasing. So we're very pleased with the growth opportunities we’ve been able to create for the company.

Obviously our Q2 growth differed across the product lines but we got positive contributions in the majority of areas. The only meaningful exception to that were NDS which is still cycling up against the dual sourcing event that occurred last year, in our air bearing spindles and color measurement product lines both of which saw slower demand in some of their application areas. So, let me start with the laser product segment which remains the largest of our three segments.

Laser based revenue increased by 8% year-over-year in the second quarter with all of the business lines contributing to that growth. The book-to-bill ratio was 1.05 in Q2. Our CO2 laser product line had strong demand during the quarter with sales up high single digit versus a year ago. We also closed on 13 new design wins about OEM customers with over half of those coming from our new line of mid-power CO2 products. Applications included marking, engraving, film cutting, converting and leather processing.

Orders for our new P250 pulse laser also continue to trend ahead of our expectations. Our CO2 production site continued to focus on deploying lien principals in that operation and held seven lien events and workshops during the quarter. Our laser scanning and beam delivery products had mid-single digit overall growth with particularly strong demand for our galvanometers, which had double digit growth in the quarter.

At the latest show in Germany, we launched our new 24 bit scan master controller, which eases the integration of our lighting to all digital scanner into OEM applications and offers best in class functionality, including reduced process cycle time and enhanced precision across a wide range of applications.

Within the second quarter we saw a strong interest in the lighting tube platform including six significant design wins, three of which were in laser added manufacturing. Other applications included marking, converting and patterning for touch screens. Our overall revenue funnel for scanning solutions have doubled during the course of 2014, which is a very encouraging indicator of our future growth prospects in this business.

Scanning solutions demand for via hole drilling application was slower in the quarter versus a year ago which somewhat reduced the overall growth rate of this scanning business. As I previously discussed, the overall sight and scale of the scanning business has increased significantly in recent times and a number of new products have gone into production. This is let the challenges in our scanner operations and that out of our supply base. We continue to deploy significant resources on addressing these issues. We've set up a number of new lien manufacturing cell for scanning production. We’re working to improve yields, material availability and to realize full labor utilization and achieve targeted run rate of these cells across what is now our multi-shift operation.

While we’ve seen improvements in some areas, we still expected to take multiple quarters to be able to realize and sustain the operational improvements we are targeting. Our sales of fiber laser products which are really in the range of 3% of GSI’s overall revenue increased double digit versus Q2 2013, due to increased order volume and several new customer wins.

We do continue to see growing demand off of our small base in this business along with significant price pressure that we see in the marketplace. So we have carefully managed our expenses in this area and we’ve seen year-over-year improvement in profitability in fiber lasers. So, turning to the medical technology segment in the quarter we saw generally positive market conditions and we built momentum with our overall medical technology strategy.

As I said, the integration of JADAK went extremely well. The business is performing above our own expectations. On a pro forma basis, JADAK sales increased high teens in Q2 versus a year ago. Orders are strong in the business with Q2 book-to-bill ratio coming in at 1.17. They have 14 design wins in the quarter and have 29 halfway through the year.

The JADAK management team is currently working with our Suzhou, China team in planning for an increased JADAK direct sales presence in China in 2015 that should significantly increase the sales region of the business. The JADAK management team has also played a lead role in driving our medical cross selling efforts. Looking across all of GSI, we now have 35 medical OEM customers that baring more than $1 million per year from us. Plus another half a dozen or so that are just below $1 million mark. But of those 35 customers, 10 of them presently buy more than one technology from us. What we see is significant opportunities for cross selling in another 10 or even 15 of those accounts and they are very realistic prospects for us to make that happen in the coming year or two, where our teams are now engaged working to achieve design wins in these accounts. Just note if you carry the analysis down to the $0.5 million account level there are even more offers to me. So, we’re very enthusiastic about the future prospects in the medical business.

In the second quarter our sales in medical displays were down substantially from prior year level. As previously discussed the decline was largely due to the dual sourcing buying OEM customer that was communicated to us in late March 2013. Thus we had a very challenging revenue comparison in the second quarter.

As we move into the back half of the year, we will return to more normal comparison so this should be lesser than issued. NDS did launch the S6c radiology display in the market right after quarter end which improves our product line up and offers additional sales opportunities in the second half. We also continue to see strong demand for our thermal printers for medical applications.

During Q2, several new OEM design wins contributed to double digit year-over-year sales growth. Moving on to the precision motion segment, in the second quarter we had mid-single digit sales growth driven by new program wins to our optical encoder product line which had double digit sales growth in quarter. Our Q2 sales of air bearing spindles were up sequentially from Q1 levels but down versus the prior year primarily as a result of a surge of demand we had seen in Q2 2013 from printed circuit board via hole drilling customers. We expect demand for spindle to be fairly stable for the balance of 2014.

So, with that update on the segments I wanted to comment on one more topic before turning things over to Robert and that’s gross margins. In the quarter where our financial performance was strong in nearly every respect gross margin was really the chink in our armor. We were down a couple of points versus a year ago and over half a point versus Q1.

Some products lines were up but a number of them were down. And stepping back from this issue I can say the challenge is virtually a 100% execution. Apart from fiber lasers which make up less than 3% of GSI’s revenue, we're not seeing meaningful price pressures in the market. Our margin challenges are operations related and there are a couple of primary drivers. The first is that we are aggressively pursuing our growth strategy across GSI and that driving us to launch more new products and new applications utilizing in many cases new suppliers and some new productions processes.

The new product strategies are working extremely well in the commercial sense. Revenue funnels are design wins, our orders are all trending in the right direction but the new product launches are creating headwinds for us in the gross margin side. Our production capabilities across the Company are still not really mature and our factories are not able to launch all of new products at the targeted yields, run rates and cost structures. We are seeing in a number of cases high levels of scrap we work and other start up inefficiencies on new products.

The second driver on gross margin is our push towards lean principals which to a degree has compounded the situation near term. As you know, lean manufacturing focuses on single piece flow to an optimize cell layout that minimizes waste of all types. This approach ultimately creates very substantial efficiencies. But in the near term, it tends to expose inherent flows in a process that were previously been covered up by large back sizes accepted inventory levels.

As we have implemented lean at our major sites, we have deployed numbers of our continuous improvement team who have extensive experience with lean conversions at world-class manufacturing fronts. These individuals work alongside our local production teams to promptly address any inefficiency that arise when we deploy lean, but we continue to see some very significant potential from lean medium term and strategic sourcing. We are very committed to this direction and that it's the right one we’re convinced we can persevere through theses growing pains, but there is no question we’re seeing some implementation and efficiencies.

So the combination of these two factors is currently depressing gross margins. I am extremely confident we’ll be to navigate through these issues and ultimately become a world-class manufacturer of our all of our products. We have the right people on path. They’re absolutely working on the right things. We will get where we need to be. But it may take another quarter or two to fully move pass these gross margin headwinds we’re seeing. So in the meantime it’s really something we just closely manage and execute in the factories to resolve.

So with that, I would like to now turn the call over to Robert to provide more detail on the financial performance.

Robert Buckley

Thank you, John. After the end of the second quarter, we closed the sales of a scientific laser business. We’ve received 5.5 million in cash proceeds upon closing which will be recorded as cash flow from investing activities in our third quarter. After settling transaction fees, working capital true ups and taxes we expect to receive a net 4 million in cash from this transaction in 2014. However we also expect to receive another 1.5 million of additional proceeds held in escrow following the exploration of the 12 months indemnification period. This transaction represents an important strategic divesture of our noncore business and a step forward in the execution of our strategic initiatives.

During the second quarter of 2014, GSI generated revenue of $96.9 million, an increase of 21.5% from $79.8 million in the second quarter of 2013. The JADAK acquisition contributed $15.5 million or 19% of the revenue increase year-over-year. Changes in foreign rates favorably increase revenue by 1%. Excluding the impact of the JADAK acquisition and changes in foreign exchange rates, the Company’s organic growth was approximately 1% compared to the second quarter of 2013.

Overall all of our business segments reported growth in the second quarter. Sales of laser products for the second quarter increase 8% to $43.8 million compared to $40.4 million one year ago. We experience solid growth across our all our technologies from our galvanometer-based technologies to our sealed CO2 lasers and fiber lasers. Growth was driven by new product innovations, new customer wins for new applications and an increase capital spending advanced industrial markets and to a lesser degree the medical markets.

Sales of medical technologies for the second quarter increased 57% to $34.8 million compared $22.1 million one year ago. The JADAK acquisition added about only 15.5 million this quarter as a consequence of owing the business for a full quarter and due to strong high teen organic growth year-over-year on a pro forma basis. Similarly our medical printers business also experienced double digit growth year-over-year. However, as John mentioned sales of visualization solutions and imaging informatics product line sold underneath the NDS and Dome brands were well below levels for the same period last year. This was driven by a single customer dual sourcing of products to them, which dramatically reduced our revenues to the business beginning in second quarter of 2013.

Finally, sales of Precision Motion for the second quarter increased approximately 6% to $18.3 million from $17.2 million in 2013. This was driven largely by our optical encoder business line which experienced strong double digit organic growth year-over-year driven by new products introduction, customer wins and to a lesser degree increases in capital spending in the advanced industrial markets. Turning to profitability second quarter gross profit was $38.7 million or 39.9% gross margin compared to a gross profit $33.2 million or 41.7% gross margin during the same period last year.

Laser products first quarter gross profit was $17.2 million compared to $16.7 million for the same period last year. Gross margins on our laser products decreased approximately 200 basis points to 39.1% from 41.2% a year ago. The 2.1 percentage point decrease in gross margin was driven largely by unfavorable mix associated with an increase on sales in our fiber laser product line and significant investments and other startup cost associated with new product introductions and our continuous improvement initiatives. Gross profit dollars increased $500,000 or roughly 3% for the same period last year as a result of the sales growth.

Medical technology second quarter gross profit was $13.8 million reflecting a 39.8% gross margin compared to $8.3 million or 37.4% gross margin for the same period last year. The JADAK acquisition accounted for a $6.3 million increase in gross profit year-over-year. Excluding the impact of JADAK gross profit dollars decreased slightly as a result of decline in sales volume in our visualization solutions product line. This decline was directly associated with the aforementioned dual sourcing by a single customer.

Precision motion second quarter gross profit was $7.9 million reflecting a 43.5% gross margin compared to $8.3 million or 48.2% gross margin in the same period last year. Gross profit dollars decreased roughly 4% compared to the prior year. Gross margins were 43.5% for the second quarter compared to a gross margin of 48.2% for the prior comparable period.

The decline in gross profit and gross margin was due to decline in sales of air bearing spindles products as well as higher manufacturing cost associated with the ramp up of an in sourcing project. Operating expenses increased to $32.2 million for the second quarter of 2014 from $27.8 million in the second quarter of 2013, an increase of approximately $4.3 million. The addition of JADAK was the primary driver of the increase. Excluding JADAK operating expenses decreased slightly.

Research and development expenses were $7.5 million, 7.7% of sales during the second quarter compared to $6.1 million or 7.7% of sales during the second quarter of 2013. SG&A expenses were $21.4 million or 22.1% of sales during the second quarter compared to $19.4 million or 24.3% of sales during the second quarter of 2013.

Operating income from continuing operations amounted to $6.5 million or 6.7% of sales in the second quarter, compared to $5.4 million or 6.8% of sales in the second quarter of 2013. Interest expense increased $1.4 million from $900,000 in the second quarter of 2013 as a result of higher debt levels from the acquisition of JADAK. We continue to borrow roughly 3% average interest rate on our senior credit facility.

Adjusted EBITDA, a non-GAAP financial measure which includes the adjustments noted the non-GAAP reconciliation attached to our earnings press release was $14.5 million in the second quarter compared to $12.5 million in the second quarter of 2013. The increase in adjusted EBITDA was predominantly attributed to the acquisition of JADAK and increases the sales volumes across our various business lines.

Diluted earnings per share from continuing operations was $0.10 in the second quarter, compared to $0.03 in the second quarter of 2013. Non-GAAP earnings per share was $0.19 in the second quarter, compared to the $0.14 in the second quarter of 2013.

Turning to the balance sheet, as of June 27, 2014, cash was $45 million, while total debt was $134.7 million. We completed the second quarter of 2014 with approximately $89.7 million of net debt as defined in the non-GAAP reconciliation table of our earnings release.

And the weighted average interest rate of our senior credit facility was approximately 3% during the second quarter of 2014. Our consolidated leverage ratio at the end of the quarter was approximately 2.2 times, considering our gross debt and pro forma EBITDA. However, I would also highlight that we’re well below this leverage level when considering our cash balances. Operating cash from continuing operations for the second quarter of 2014 was $17.1 million. Our cash flow generation in the quarter was a significant improvement over the first quarter of 2014.

The organization has made tremendous progress in improving our shipments linearity for our businesses, shortening customer payment terms, reducing past due receivables and lengthening our vendor payment term. We feel good about the progress we made in the first six months and put our sights on ways we can reduce our inventory needs to further drive improvements. Overall, our businesses are seeing the benefit of new product introductions and our strategic focus on serving higher growth in more sustainable advanced industrial medical markets.

We are seeing solid demand across our business lines and feel good about the progress we have made. We continue to be optimistic about our opportunities and our future. These new opportunities require stronger and more developed operational capabilities as John previously mentioned. Since the later part of 2013, we have invested significantly in building our continuous improvement initiative and instituting it across new organization. We are seeing significant reductions in quality problems that reach our customers, solid improvements in on time deliveries and meaningful improvements to our cycle times and lean times.

In many of our sites we have significantly reduced floor space, streamlined production flows and increase of production capacity. While we feel good about our progress, we no longer make our quality problem our customer problems. We still have significant improvements to make. These are challenges but they are not insurmountable and we feel very confident we can drive meaningful improvements.

So turning to the third quarter of 2014, we expect revenue from continuing operations between $95 million and $97 million representing year-over-year revenue growth of 19% to 21%. We expect adjusted EBITDA to be in the range of $14 million to $15.5 million. Our range in EBITDA largely represents operational investments we are making to structurally improve our medium term profitability and put us on a path to accelerated profit growth.

Overall we expect the third quarter looks very similar to the second quarter in 2014 with the Company facing many of the same challenges and opportunities we’ve faced in the second quarter. We are expecting depreciation and amortization expense acquisition related cost and stock compensation expenses to be largely flat with the second quarter of 2014. We also expect our third quarter non-GAAP tax rate and interest expense to be largely flat with the second quarter of 2014. And finally, we look opportunistically at reducing our gross debt balances bearing mind our relatively low borrowing rate of 3%. Regardless, we expect to reduce our net debt to approximately $80 million.

This concludes our prepared remarks. I'll now open the call up to questions. Operator?

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line Lee Jagoda with CJS Securities.

Lee Jagoda - CJS Securities

John, can you discuss some of the types of challenges you face for the manufacturing side and possibly quantify the impact it had on the gross margin in Q2?

John Roush

Well, I said that we don’t think pricing and market factors really have much of an impact, right. So is there a mix shift a little bit here and there? A small one. But most of what we see in impact really is the manufacturing efficiencies and it’s really when you put new products into the production that they yielded 60% where the thing they're replacing is 90% to 95% or whatever. And so we’re running scrap is high and rework is high which is a labor cost. So we’re just seeing it runs through the variance lines in the factory.

It’s not that our new products have a worse standard cost. I think as we are obviously -- when we design them we’re looking at the BOM cost and the economics of the products and I think we’re fine with that. It's just we’re not getting to that standard as quick as we'd like. And that’s something we’re seeing in the laser business. We’re seeing across the number of parts of the Company .it’s really a result of us trying to do a lot more growth facing projects in the Company and you can’t just make what you've always made if you want grow. You have to kind of go where the market is heading and put out new products new functionality for the growing applications. And we just don’t have as much as maturity around that process I would say in our factory. A lot new folks and they bring those skills in but the processes themselves are not matured.

Lee Jagoda - CJS Securities

Okay and looking on the lean initiative side, I think you would expect to spend about $5 million in the first half and then see the benefit of that in the second half. How much of that $5 million was actually spent and is there any more expense expected back in the back half for these initiatives?

Robert Buckley

I would say it’s actually running higher than that because what that investment detail is not only investments of individuals, but it took into accounts some of the yield losses and scrap rates and rework and all those things. So some of that cost is running higher than we initially planned.

Lee Jagoda - CJS Securities

And you try to separate the two and say like having brought in more continuous improvement people, I know they’re spending more money on implementing stuff, it’s not really that, it’s really that the impact that they’re having just taking longer, right.

Robert Buckley

Yes. So to that, you do have a frontend loading of that. We have been putting a significant effort around that and then that snaps back. So as soon as you as you release this you should be producing products at a much better level and that’s the savings element of it.

Lee Jagoda - CJS Securities

Got it, switching gears a little bit to NDS, our expectation was that the dual sourcing issue would sort of anniversary post Q1. I guess the question is, what if anything change versus that previous assumption? And then as a follow-up just any additional information regarding that customer and whether you expect to get any of that revenue coming back?

John Roush

So there is a couple of things there. One is, the notification happened last Q1 and the implementation of the dual sourcing was not immediate, it just not possible. It was a pretty good sized customer and they had inventories and they had a pipelines of products and orders with us. So really the notification was not the proper anniversary of the dual sourcing. I think by the end of Q2, it’s safe to say, it had been implemented. So Q3 and Q4 of last year were more at the fully reduced dual source run rate. So we should see less impact from that. That customer is still a customer. We don’t talk about who they are because it’s confidential in an OEM non-disclosure agreement there. They are important customers to us. We continue to serve them. There is an opportunity gain business with existing products or with new products with that customer.

So, I don’t know that they are going to like go back to single sourcing necessary so we kind of get that exactly what we used to have. I don’t think that’s likely but I think we see growth opportunities in that account from where we are now.

Operator

(Operator Instructions) Your next question comes from the line of Jim Richiutti with Needham.

Jim Richiutti – Needham

I joined a few minutes late but I was wondering John, a lot of did you give that breakdown of the revenues from new products and I’m just wondering if there is a way for us to get a sense as to how much that’s contributing as say in the past quarter versus a year ago that would maybe help to explain some of the issue around gross margins.

John Roush

Yes, we don’t have a specific measure on that. It’s not something we exclusively track like that. What we can see what we are getting variances slowing for the factory like what’s causing them and then we can trace that for new products but to say X percent of our revenue and are running at it is different margin -- we're not able to drill it down to that level but what we can tell you is we just don’t see deterioration in the pricing environment and we don’t really see a big let’s mix change where division A or business line A has 10 points higher margin than business line B and there was a mix shift. It’s really not that. It’s really the variances in a number of factories our running high and when we look and say well why is that, why we’re seeing rework in labor variances to and are we seeing scrap in material variances, they trace back to new product launches.

Jim Richiutti – Needham

Okay, John, in implementing lien it sounds like it sometimes can have a short term negative impact. Some of that is well contributing here?

John Roush

Yes, I mean it’s definitely is. And so how much -- I think more is coming from new products but the lien is sort of that -- it’s a complicating factor. We’re absolutely convinced that it’s where we need to go because the lien is going to enable us not only to get the quality right, reduce lead times but scale. It’s just much more scalable because in our old processes as we’re using way too much space, too much time. It’s where we need to go to be able to scale but what ends up happening as you surface problems that you have been living that all along but they rise to the forefront in lien because you are not running batches of 100 where 20% of them can be bad and you just set those aside right and you keep running. When you're running single piece flow, each piece if it’s bad is more or less sort of shut the sell down and you got to resolve that issue. You don’t just get working around problems in lien. It’s an excellent sourcing device right because it causes finally a root cause and corrective action and a resolution of the issue as opposed to just varying it.

Jim Richiutti – Needham

And as you go down this cap in terms of slowing the implementation that’s really not necessarily a good option I guess either is it?

John Roush

Yes, I mean when you could sort of just punt on the problem little bit and say while doing lien it's just too painful short term, let’s not do it or let’s do it. We are not doing it every single part of the factory. We have made some judgments about where we want to put these cells in. But those are not geared to where do we have the most risk of disrupting production. We're making those decisions basically where do we really see it as a strategic capability, where do we want to grow, where do we need the performance and that’s what we do in lien and in some cases that actually makes the pain level a little bit higher short term because you could go do it often and in significant product line. You would do that if you didn’t have people who know how to do lien. If you are sort of learning how to do it, it’s not bad. We actually have experts who come in here from world class companies and have deployed lien dozens and dozens of times in the past. It’s more the process maturity they are working with, just the underlying consistency and the underlying yields and capabilities for those processes are not that mature.

Jim Richiutti – Needham

Got it, and I know you guys don’t give any guidance specifically on gross margins but I’m just wondering under the circumstances can you give us any sense as to -- it doesn’t sound like you are expecting a whole lot of change in Q3 and maybe just some sense as to when this might begin to turn for you? Is it going to be a couple of quarters? It sounds like that’s what you're alluding to.

John Roush

Yes, I think that is the question and what we try to do is say it could improve faster. When you start to solve improvements aren’t necessarily straight line. What ends up happening is you get out the root cause of the yield loss and then you resolve it and now you get a step change improvement and now you got to work on the next thing on your Pareto and solve that. So you sometimes get step change improvements but it’s sort of hard to predict exactly when they come online. So, we’ve taken the approach that it’s possible. It takes us a couple of quarters here to really get the thing moving upward. It’s entirely possible that happens sooner and that sort of accounts for some of the spread in our profit outlook.

Jim Richiutti – Needham

Understood and then I guess you must be encouraged I would say from the reaction or response in the market to the newer products and what is your sense that you -- I assume you’re taking some share here and I am wondering if you can give us a little bit of color in terms of where you think you might be taking some share or possibly if it just the tone of the market is getting better?

John Roush

Well to some degree, the share we’re taking is really laser processing or other types of processing that's overtaking some traditional method. That’s true more in our laser side of the Company where you’re seeing laser processing come in areas that were mechanical. And then so scanner is needed, a laser source is needed and we can capture both of that. And it doesn’t necessarily come at the expense of another laser company. It with the expense of some other process. And when you look at our medical and some cases we’re adding functionality into medical equipment that wasn’t there at all. So it’s a new part of the markets that’s opening up. That’s very true with some of the JADAK technologies which are error prevention techniques that are being added into equipment and you’re not displacing anything. They’re spending money to put that capability into instruments to reduce medical errors and there is a payback on that for the end user. In a few cases certainly we feel like we’re getting some share. There is no question about that but it’s not really just a share based story.

Jim Richiutti – Needham

Okay and just one final question, just because you don’t have a lot of experience with JADAK, is there much seasonality to their business in Q3 at all?

Robert Buckley

It will likely tick down a little bit in Q3, not that much. What I mean that is on a sequential basis. On the year-over-year basis we’re still expecting some solid growth out of that. Sequentially, they’ll tick down a little bit and then Q4 will actually likely much stronger than obviously Q3 but also Q2. That is more aligned with the overall medical markets. Hospital CapEx spending tends to be heaviest in the fourth quarter.

Jim Richiutti – Needham

Just consuming the capital budget for the real and the hospital kind of deal?

Robert Buckley

You will see that in couple of our business lines.

Operator

(Operator Instructions) Your next question comes from the line of Stefan Mykytiuk with ACK Asset Management.

Stefan Mykytiuk - ACK Asset Management

Few questions I guess first off, the growth in laser products was again quite good, but it sounds like from what you’re telling us in terms of the how that’s throughput on the new product wins, that revenue growth actually could have been higher if you didn’t have these kind of throughput challenges? Is that a fair statement?

John Roush

In laser I would say that’s the margin a little bit true but it was more of case of flow through on the volume we did get, just those sort of startup inefficiency. We had some yield. People used the term yield experience in some of the laser business where -- so in effect if yield drops it really does cap your output a little bit because at a minimum it’s going to take you time to rework that stuff and so it delays in getting it out the door, but it’s more as cost impact that we felt than really.

Robert Buckley

It’s costing more money to get out the door.

John Roush

It’s costing more money to get out the door and delayed and if you really get into ultimately scraping that product then you actually kind of reduce the output. I would say that was probably a little bit less of our problem and then just a margin flow through.

Stefan Mykytiuk - ACK Asset Management

Okay and it sounds like that margin impact is pretty hard to quantify as it relates to just the new products and throughput issues?

John Roush

Well, I would say I mean we can quantify looking backwards fairly well. What’s harder to do is say how quickly does it resolve itself. These are things that are solvable. There is more in more you control. If customers aren’t buying your products you have a different problem, you got to go back to the drawing board. But we have demand for the products and we know sort of -- let’s say the build materials, the basic standard cost of our products is where they need to be it’s more just we got be able to build them the same way we could build the prior generation. And I mean we’ve always experienced -- GSI if you look at its history always had some of these challenges that weren’t doing as many new products and it took that amount of time. We want kind of launch the products on a more regular basis the new products and then get them to the target cost in a more timely kind of manner. We need that skill to be a growing company in order to sustain our growth.

Stefan Mykytiuk - ACK Asset Management

Right, what I am trying to get to is again back I think someone asked the question earlier, originally you talked about spending 5 million on lean in the first half of the year and then getting back that in terms of savings in the second half. It sounds you’re saying in terms of the lean initiatives you’re spending more than the 5 and some of what spending or that impact is dragging into Q3 in the back half of the year, right?

Robert Buckley

We’re spending more on the first half of the year, that’s absolutely true. Even if you look at the gross margins, the entire drop is a consequence of either inefficiencies in those new launches or the lean efforts that we’re doing.

John Roush

I guess when I think of spending though I think of like deliberate acts. We are not hiring more people to run the lien programs. We are paying them higher salaries than what we intended to. What’s happening is that the impact on the operations is not as favorable as what we intended.

Stefan Mykytiuk - ACK Asset Management

You are not getting same incremental margin on that growth?

John Roush

Yes, right and so there was a hit in Q2 on that. As we started to do more of this, we experienced more kind of startup problems on some of this than we expected. Now, when you say -- so we had planned to get whatever those costs were back in the second half, are we still confident we can get every dollar of the savings that we are modeled into second half? I think we can get it, it’s a timing question. I mean we know we can solve these issues but there is some headwinds on it as we head here in Q3 and we’re working pretty hard to improve that way, that’s why we have range around our income. Really most of the range is around this issue. The demand is lining up pretty nicely.

Stefan Mykytiuk - ACK Asset Management

Okay, but however you says that it’s more than 5 million of gross profit impact in the first half of the year and then as we look forward, obviously as you’re saying you’re not going to get it back in Q3 there is potential for Q4. As you get into ’15 do you think these problems are solved or do you think you still could be dealing with those headwinds?

John Roush

No, I think that they are largely resolved heading into ’15. That’s the line of sight we have. Of course we want to be launching more new products in ’15 so it’s not just resolving the known issues that's important to us. It's getting good at this in general. So, being able to launch new products on a continued basis closer to the targeted cost structure in a more tight timeframe. So we are trying to not only solve any issues we have now but to kind of institutionally have that capability.

Operator

(Operator Instructions) And this time presenters, there are no further questions. Do you have any closing remarks?

John Roush

Yes, I'll wrap up, thank you operator. So just to conclude today’s call I'd like to reiterate that I’m very pleased with the Company’s overall progress this quarter. The growth strategies are clearly paying off, especially in our more significant business line like CO2 lasers, scanning, the optical encoder products, the JADAK acquisition.

Our medical cross selling program is sourcing a lot of attractive opportunities. These are already becoming part of our revenue funnel and we're certainly going to help growth next year and beyond. Overall, we're making tremendous progress as an organization, the momentum is building with our OEM customers in key applications and that's very encouraging to me. We have an outstanding management team in place and they are all extremely committed to delivering on our strategy.

Like most companies we still have challenges we need to address. The operations and gross margin issues that we discussed on this call are really the biggest area of focus for us now. Good news is, this is really an execution issue and it's ultimately in our control. We have excellent people focused on it in our production side and I’m confident we'll achieve the result we expect. So with that I really appreciate your interest in GSI, your participation in today’s call and I look forward to joining all of you in a couple of months on our next earnings call. So thank you very much. Today’s call is now adjourned.

Operator

This concludes today’s conference call. You may now disconnect.

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GSI Group (NASDAQ:GSIG): Q2 EPS of $0.19 beats by $0.02. Revenue of $96.9M (+21.4% Y/Y) beats by $3.22M.