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Executives

Richard Morin - SVP and CFO

Bob Shillman - CEO

Analysts

Antonio Antezano - Bear Stearns

Alexander Paris - Barrington Research

Chuck Murphy - Sidoti & Company

Richard Eastman - Robert Baird

Alexander Paris - Barrington Research

James McAree - David J. Greene

Ben Alexander - Alexander Capital Management

Jim Ricchiuti - Needham and Company

William Pike - Pine Street Securities

Eric Ende - First Pacific Advisors

Cognex Corp. (CGNX) Q4 2007 Earnings Call February 14, 2008 5:00 PM ET

Operator

Good day, ladies and gentlemen, and welcome to the Cognex fourth quarter 2007 earnings call. At this time, all participants are in a listen-only mode. (Operator Instructions). As a reminder, this conference is being recorded.

I would now like to introduce your host for today's conference, Mr. Richard Morin, Chief Financial Officer. Sir, you may begin.

Richard Morin

Thank you and good evening, everyone. Earlier tonight we issued a press release announcing Cognex's earnings for the fourth quarter of 2007. For those of you who have not yet seen this report, a copy is available on our website at www.cognex.com. The press release contains detailed information about our financial results and because of that we are not going to repeat most of that material.

During tonight's call, we intend to discuss our financial results as reported under GAAP. However, it is possible that we may use a non-GAAP financial measure if we believe that it is useful to investors or if we believe it will help investors better understand our results or business trends. For your reference, you can see the company's income statement as reported under GAAP in exhibit 1 of the earnings press release, and a reconciliation of certain items in the income statement from GAAP to non-GAAP in Exhibit 2.

I would like to emphasize that any forward-looking statements we made in the press release or any that we may make during this call are based upon information that we believe to be true as of today. Things often change and actual results may differ materially from those projected or anticipated. You should refer to the company's SEC filings including our most recent Form 10-K for a detailed list of these risk factors.

Now I'll turn the call over to Bob Shillman.

Bob Shillman

Hey thanks Dick. I'd like to welcome each of you to Cognex's fourth quarter conference call for 2007. It is Valentine's Day and we have a sweet gift for everyone, in a nice fourth quarter. We reported revenue of $65 million and earnings of $0.25 per share for Q4. Revenue increased by 19% on a sequential basis and 12% over the fourth quarter of 2006.

By the way this is the first quarter in over a year that we reported an increase in both revenue and earnings on both a sequential and year-on-year basis. The increase was primarily due to higher revenue from the Factory Automation and Surface Inspection markets, both of which set new records for quarterly revenue in Q4. Somewhat offsetting the higher revenue in Factory Automation and Surface Inspection was the Semiconductor and Electronics Capital Equipment Market, which we call SEMI.

Demand in semi continued to be soft in Q4 due to the industry downturn that started in early 2006. Semi revenue decreased by 8% on a sequential basis and 24% year-on-year and so far in 2008 spending by those customers continues to be slow and the timing for a pickup remains uncertain, which is typical for this market. Weakness in our semi business is symptomatic of the industries and not at all of our products or competition or the sales channel.

In the Surface Inspection market revenue was $12 million in the fourth quarter which was over a 125% higher than in the prior quarter and 50% over the amount reported for Q4 of 2006. This dramatic increase was due to two things, the wins that we had during 2007 in the metals industry in China and elsewhere in Asia, as well as deferrals from prior periods that were recognized as revenue in Q4.

Factory Automation revenue increased by 13% on sequential basis and 23% year-on-year driven primarily by strong business in Europe. However what I am more excited about is the positive trend in Factory Automation that we saw in Q4 is continuing into 2008. Year-to-date orders in the Factory Automation market are up 43% over the comparable period in 2007.

We are seeing growth in all the primary geographic regions we serve as well as in all our Factory Automation product categories. This is a strong indication that our sales channel is now working as they should.

As we reported in the past our ID business, this is the business of producing Vision systems who's sole purpose is to read numbers and letters or symbols of surfaces ranging from paper or metal types even. That's been growing very quickly. Our factory floor ID bookings grew by 55% in 2007 and although it is early in 2008 it appears that that rate of increase is actually growing.

Comparing quarter to date Q1 of '08, the Q1 of this quarter to date of 2007 orders of our inside industrial ID products are up 52% and day demand bookings are up by an amazing 184%. Taken together bookings for ID on the factory floor had increased by a 119% in the first month and half or so of 2008 as compared to the same period of '07.

Our initial success in the ID area was in the high end markets, which is reading codes that are very difficult to see either because of the material that they are etched on or due to the speed of the parts moving by. But a good example of a win is we announced a few weeks ago a large industrial printing and mail fulfillment company selected Cognex ID Readers to integrate into their document assembly equipment to ensure that all the pages of the document that they are mailing are accounted for and that they match with the right inserts and that they are inserted into the correct customer envelopes.

It’s a very high speed application and it is critical that the multiple pages of personalized information be mailed to the right recipient. The order from this customer in 2007 totaled $500,000 and there is a potential for more business from them over the next few years as they rollout Cognex ID to their other plants worldwide.

More recently we've been winning opportunities in the lower end of the market which has traditionally been served by companies that make barcode readers. For example, Cognex recently displaced one of the world's largest manufacturers of barcode readers as a leading Tier 1 supplier to automotive companies.

This was an existing Cognex customer who is using our vision system in their manufacturing and for tough ID problems; however, they were using less expensive barcode readers from a traditional supplier for their easier ID problems. But once our sales engineer gave them the preview of our new entry level lower cost ID reader, which will be formally introduced later this quarter, they decided to buy all their future code reading needs from Cognex. We have received a PO for a small number of units 15 or so and we expect another 50 to come by later on this year.

This is a strange example, because we did not win this business due to price nor due to performance, but we won it because of our relationship that we have with the customer and the fact that we've broadened our product ID line to meet all of the requirements on the factory floor, so the customer could consolidate and rely on one supplier for all of their vision and ID needs.

In 2007, we spend a great deal of time, effort and money on new product development. Our goal is to broaden our product offerings and to make our products easier to use and integrate and we now believe those initiatives will help us expand our business in our core markets and gain share.

We recently held sales kick off meetings for our worldwide sales team and distributors and they received in-depth analysis and experimentation with our new products that we will be rolling out in the next several months. And the reports are that everyone including our own end-user sales people and the distribution partners left the meetings energized and ready to sell.

Looking forward, I believe that 2008 is going to be a great year of Cognex. For the first quarter, we expect that revenue will be between $58 million and $61 million and earnings will be between $0.13 and $0.18 per share. Although these numbers are down somewhat from the results we just reported for Q4, they do represent a significant increase over our results for the first quarter of 2007.

Now I’m going to open the line for any detailed questions you might have and my team and Dick Morin's team are here to take those questions and help us answer them. First caller?

Question and Answer Session

Operator

(Operator Instruction) Our first question comes from Antonio Antezano from Bear Stearns.

Antonio Antezano - Bear Stearns

Good afternoon.

Bob Shillman

Hi, Antonio.

Richard Morin

Hi, Antonio.

Antonio Antezano - Bear Stearns

Regarding product development, because something that you highlight in the press release and also in your presentation today, outside the ID business what type of other initiatives you have for this year?

Bob Shillman

Well I am not going give too many things away to competitors, but I will tell you that we are coming out with a very, very small version of In-Sight called the In-Sight Micro. We have challenges in our company between the different groups. We have this product called In-Sight, and then a separate team came up with Checker, which is much smaller.

Now the In-Sight team and Checker, of course, you may know is a much less sophisticated, much less capable product. It’s a Vision sensor, not a Vision system -- so it makes sense that it could be much smaller. But that size challenged the In-Sight team, and then In-Sight came out with the In-Sight Micro, which is smaller than the checker. It is a full-size, a full Vision system, which is the size of a small remote camera head, smaller than your cell phone.

Its designed for robotic applications, and tight spaces in OEM machinery; it’s going to make a major difference in our thrust into Japan, where we've been competing with Omron and Keyence who have small cameras that they have using not small Vision systems but small cameras hooked up to a remote controller. So this In-Sight Micro, along with a new software interface called EasyBuilder, we believe is going to make a major impact and really give traction to our business in Japan, which as you know for past two or three years, has not been doing well and mainly from lack of product.

Antonio Antezano - Bear Stearns

Right, I think I missed something that you were saying about China, but when I was looking at the breakdown by geography noticed that rest of the world grew like more than 70% year-over-year. I wonder if that's reflecting China or something else?

Richard Morin

China is, in fact, included in those numbers, yes.

Antonio Antezano - Bear Stearns

So, what will be your outlook for China, I guess, for 2008 -- or maybe what percentage of revenues, China what could be this year or next?

Bob Shillman

If we start giving that for China, then Japan, and then everything, then you'll know what we are expecting to do for the whole year, and we just don't want to do that. But I can tell you that China is our fastest-growing region right now.

Antonio Antezano - Bear Stearns

Okay.

Bob Shillman

And that's not only because the denominator is low, just tremendous opportunity for us in China. We have a great team kicked off there, ready to sell, already trained and high energy and doing well.

Antonio Antezano - Bear Stearns

Just one final question regarding the gross margin. I am wondering if you expect this same level of gross margin going forward since you are not getting a lot of help from the OEM, which is supposed to have high margin, and you are delivering excluding stock option expenses is close to 74%. I was wondering what would be your outlook for gross margin for this year?

Bob Shillman

Low to mid-70s is our projection. By the way you are absolutely right. The OEM business has high gross margin, but for the past few years our gross margin, our product gross margin in the factory floor excluding the surface inspection is also very high.

Antonio Antezano - Bear Stearns

So there has been -- because surface inspection used to have like a lower gross margin.

Bob Shillman

That's correct, 45 to 48.

Antonio Antezano - Bear Stearns

That's right, and that surface inspection been there was very strong in Q4, and even without, you've got a very good gross margin. So I was wondering if there was something else there.

Richard Morin

If you take a look at it Antonio, what happened is the gross margin for SISD, the surface inspection business in Q4 were $12 million of revenues turned out to be much higher than it would typically be because of the fact that they had so much more volume. I mean, they did $12 million of reported revenues in Q4 versus $5 million in change in Q3, some of that due to the deferrals or whatever. But what you've got is your $12 million worth of revenues, and your fixed costs are essentially the same. So during the quarter instead of being around 50% gross margins, they were in the mid-60s, and the MVSD gross margin continues to be in the high 70% range.

Antonio Antezano - Bear Stearns

Right, thank you. I'll go back to the queue.

Bob Shillman

You're welcome.

Operator

Thank you. (Operator Instruction) Our next question comes from Alexander Paris from Barrington Research.

Alexander Paris - Barrington Research

Great quarter.

Bob Shillman

Hey, thank you, Alex, it's finally…

Alexander Paris - Barrington Research

When I hear you bullish -- that's really something, you usually call out like you see it.

Bob Shillman

That's right, and as you know, I've been here for this entire week, and I have been spending a lot of time with Eric and the sales team, and I’m confident we fixed the problems. We had four significant problems in the company that we faced in 2007, and I'll go over those later if you'd like, it’s going to be part of the annual report video. We identified each of those four problems, some of them we can't do anything about the slowdown in North America and Auto, but we can realign the sales and having them chase other things. The biggest problem that we could solve is the realignment of the sales force and the sales channel. We have very good channel partners, very good distributors and do our own mistakes, so we had, we made some significant mistakes, which caused it to be far more sufficient than it should be, and too many conflicts, and Eric has straightened it out.

Alexander Paris - Barrington Research

Okay, I just, maybe you can straighten me a little bit in terms of the ID business, talk little bit about the In-Sight ID product, a DataMan product, and now you are talking maybe about either if its smaller one, can you just, in just a couple of words put those into perspective?

Bob Shillman

Yes, it is a little confusing. Actually there are three products, three different products for ID. There is a wafer reader, which we are not even talking about in this discussion, we didn't even include that in ID, because we lump that with semiconductor or electronics OEM. But there is device that we sell that specifically meets, holds up with wafers, we are the world leader in that. I don't that builds business can go between $10 million and $20 million a year something like that. So I am not even referring to that.

Then there were two Factory Automation ID readers, one is called a version of In-Sight, you know what In-Sight is. In-Sight is a family of general purpose Vision systems, but there is one version of that family that only reads, and it’s a fixed position reader. It's bolted to the factory floor and looks at engine parts moving by or whatever and reads those numbers. It's a hardened product; it’s not handheld, and it’s factory rugged. That's the In-Sight ID reader, and it is Factory Automation.

Then we have DataMan readers, which are not rugged, physically rugged -- they are able to read everything, but they are not industrialized, they are lower cost, those come in two versions, mountable or handheld. And the handheld ones are now going to come in three versions; one, a top-end version that can read everything that you show it. Then there are two lower-price versions for reading easier-to-read things so we can compete with those lower-price solutions where the customer doesn't need it to read rusted parts or something.

It’s a complicated market out there, and what we've done is partitioned the space so that we can get high premium price for when the customer needs the premium of reading at very high speed, at a very high accuracy on the graded parts, but then there is a very large business out there for reading ink on paper, which many people can do, we can do a little bit better but that is price sensitive, and we have come out with some DataMan or we will be coming out with DataMan for that and with a different version number.

Alexander Paris - Barrington Research

Great, thanks. Just one other question, solar market -- is that going to develop as a significant inspection market for your or automation market for your types of products?

Bob Shillman

I know our software vision group is pursuing customers in the solar panel area, and we believe that we have the right software technology already in the bag. The same things we've been selling to the semiconductor people for working on solar. I just can't tell you how big it's going to be. I don't know.

Alexander Paris - Barrington Research

Okay. Thanks very much.

Bob Shillman

It's sort of like fiber optics, alright?

Alexander Paris - Barrington Research

Alright. Thank you.

Bob Shillman

You are welcome.

Operator

Thank you. Our next question comes from Chuck Murphy from Sidoti & Company.

Chuck Murphy - Sidoti & Company

Good afternoon, guys.

Bob Shillman

Hello, Chuck.

Richard Morin

Hi, Chuck.

Chuck Murphy - Sidoti & Company

Congratulations on the quarter.

Bob Shillman

Thank you.

Chuck Murphy - Sidoti & Company

Can you just give us a sense, as far as the guidance goes. Can you kind of give us a breakdown of what you are expecting for each of the different product groups, what would potentially be down and up in the first quarter?

Richard Morin

Typically, what we see in the first quarter is the factory automation part of the business declines. In Q4, we tend to see a lot of orders from customers who are looking to spend the last remnants of their capital budget before going into the next fiscal year. So typically we see a decline in.SISD, we clearly believe that we will see a decline in SISD revenues. They set an all-time record of $12 million in the fourth quarter, and we don't expect to duplicate that in Q1 and on the SEMI side, we continue to see the SEMI business, which declined every quarter in 2007, and we see no hope for a rebound in the first quarter.

Chuck Murphy - Sidoti & Company

Okay, it helps. And as far as the new products go, is this new technology for solving the same problem, or are you solving new problems for new markets with these new products?

Bob Shillman

Well, the product I've already talked about are solving the same problems, but opening up new markets because they are smaller or lighter or cheaper. However, I haven't talked about some new checker products. Are we talking about the checker? No. We definitely are not. I am talking about the two new branding products, brand new technology for entering totally new markets for Cognex. These came out of the brain of Bill Silver and his small team, just dramatic products that will do things in the photo sensor space, that photo sensors can't do for this. For about the same price, they're going to do things like measuring speed and measuring position that nothing else in the world can do, and those are going to be data tested at the end of this quarter and probably released I'd say at the end of Q2, something like that.

Chuck Murphy - Sidoti & Company

Okay.

Bob Shillman

So, we are expanding, our products in two different ways. One is making our products easy to use, and that's something called EasyBuilder, which the sales force now knows about that we haven't announced it to the world yet, and it's a front end to our product. To all of our Vision systems that make a Vision system as easy to use as possible. It's an incredible front end, and let me just give you an example.

If you took a calculator, and you want to examine the calculator, you are building these calculators, and you want to find if the key are there, traditionally any Vision system you would have to teach the Vision system, where the keys are and then write some code or lots of GUI to measure the difference between them.

Under EasyBuilder, you put the calculator -- or whatever it you want to measure -- under the camera under the Vision system, and immediately the Vision system finds all of the features as we can know enough about from history. We know enough about what people want to find out, so the Vision system is pre-thought what to look for. It doesn't have to know it’s a calculator, it could be a keypad on the telephone, it could be pills in the bottle, it will find all of the items, and then you just click and drag some icons and tell it what to do with that information.

Incredibly this is going to be unifying graphical user interface for all of our products from the PC vision to Vision systems to Vision sensors. So by making our products easy to use we are going to get tremendous amount of elasticity, there is elasticity in the market, that's one thing.

Chuck Murphy - Sidoti & Company

Okay, alright. And final question, as far as the ID products go calculated to be roughly 23 million for 2007. How big of a market do you think that could become for you over next two years let say?

Bob Shillman

Very good question, it depends on how aggressively we go out with channel partners and find OEMs. It’s an enormous market, if you think about it. Wherever you go today, there are about barcode readers. Wherever you go, if you buy anything on any retail store, in a loading dock there are barcode readers. Those are all one-dimensional readers. They are called one-dimensional readers, and the way those work is by a laser beam.

Within the next four or five years, all of those are going to be replaced with two-dimensional readers using camera or machine vision technology for a variety of reasons, I won't go through it now and we are the leader in that technology. We are not the leader in the distribution, we don't have the contacts, but we are actively pursuing that. So right now, I think it is looked as the barcode industry and added up of the revenues of all the barcode readers in the world, it's probably $1 billion a year right away or may be more.

This new technology is rapidly gaining hold because it could do many more things, and a barcode reader cannot read it to decode. So all these new codes that are coming out that everyone wants require a camera system to read it, and we are the leader in that. Our goal is to grow no less than 50% per year and the market and therefore.

Chuck Murphy - Sidoti & Company

Okay, and you kind of mentioned it would take probably four to five years to really have 2D takeover?

Bob Shillman

That's my estimate.

Chuck Murphy - Sidoti & Company

Okay.

Bob Shillman

Five years from now, you are not going to see laser-based readers anywhere.

Chuck Murphy - Sidoti & Company

Okay.

Bob Shillman

Frankly, I think they are more expensive. They are hard at the service, and also it's drawbacks in addition to the fact that company is -- everybody is moving towards these two decodes.

Chuck Murphy - Sidoti & Company

Alright, that's all I had. Thanks.

Bob Shillman

Sure.

Operator

Thank you. Our next question comes from Richard Eastman from Robert Baird.

Richard Eastman - Robert Baird

Hi, could you just spend a minute or two on the geographic growth difference between the Americas and Europe. Is the difference there in Europe -- is it product-driven, was the distribution more screwed up there than it was here, write down or are we seeing with the America's growth that we are seeing some economic impacts in the business year-over-year?

Bob Shillman

First of all, I can tell you that in Factory Automation. All regions grew -- North America was the least, but it did grow -- Japan was the greatest, next was Europe and Asia. North America grew the least. One of the reasons --

Richard Morin

I’m sorry, you're just taking a look with -- I think what you're looking at right there is '08 versus '07 year-to-date.

Bob Shillman

That's right, year-to-date.

Richard Morin

Yeah, but year-to-date '08 was only like --

Bob Shillman

Yeah, very right --

Richard Morin

Yeah, I think what Rick is doing, he is looking at the total revenue by the, are you talking specifically on Factory Automation, Rick?

Richard Eastman from Robert Baird

No, you know what in your revenue breakdown by geography, where you have the America's Europe and Japan, you put the percentages in there. But if you look at the growth year-over-year in the fourth quarter, America's was up, even Europe was 36%, the base is not that different, I’m just curious: is it what's driving the growth in Europe, and secondly there was modest growth in the US, and I was just trying to dig into that a little bit.

Richard Morin

Okay, there are two pieces to what's happening in Europe. One, Europe has had an outstanding year this year, and they did not have the same channel issues that we had here in the United States, so they and they've had an outstanding year. The other thing that also helped Europe is that they saw a benefit year-on-year. If you take a look at the total years, you are looking at an improvement in the exchange rate that gave them 8.5% to 9% of that total 36 or whatever percentage growth came from foreign exchange.

Richard Eastman from Robert Baird

Okay, very good. And in the US is that more of the same in terms of the end market softness or…

Richard Morin

What I think we had a couple of things, we didn't get our channel conflicts straightened out in the US until as we started going into the fourth quarter of this year or whatever. And I think that's part of or a good part of why there wasn't such a big increase in the US side.

Richard Eastman from Robert Baird

Okay, when we talk about the new products, and what we'll be introducing this year and we've kind of talked about this for a little bit. In the past, when we've seen new products the market acceptance of those newer products has been generally taken sometime?

Bob Shillman

Basically, yes, that's right.

Richard Eastman from Robert Baird

I am curious with this portfolio of new products that are coming out. Do you feel that your marketing Intel is better, and that these products can have a bigger impact sooner on sales than maybe what we've seen in the past?

Bob Shillman

You are asking a very good question. Certainly the new products in the ID category are designed specifically for existing customers that we are talking to or markets that we know about. So I expect those products to take off rather quickly. Where I was overly optimistic was in Checker that was coming out with a brand new kind of vision expert sensor or vision sensor that the world had not known about. That was neither a vision system nor a photo sensor, and it took a lot of education, and we're finally getting to the $10 million-a-year rake with that product.

And similarly it could be that these new inventions that Bill Silver and his team have come up with these two new inventions. They may indeed take time also. They are revolutionary in what they can do. But because of that it does take time to educate the marketplace. So, I don’t think we have any hard projections on either of those products, one is called Checker TG for trigger, and the other is called Checker SD for speed and distance, and we are not, I am not out there telling the world that we’re going to sell $10 million in the first year.

Richard Eastman from Robert Baird

Okay.

Bob Shillman

So, we have not built a lot of those into the plan.

Richard Eastman from Robert Baird

Understood, okay. And then how are the bookings in SISD in the fourth quarter? I mean, obviously, the book-to-bill will be below one, but I am just curious were the bookings sufficient to support your outlook for '08 for that business?

Richard Morin

Bookings in the fourth quarter were good and clearly keep us at the $30 million or whatever run rate.

Richard Eastman from Robert Baird

Okay.

Bob Shillman

I would like to say that, our partner and Vice President, Senior Vice President and General Manager of Surface Inspection Markku Jaaskelainen and his team have done a great job of that product line and enhancing the product line. We’re very successful now in China, and it's not easy to do business in China. And I want to thank that whole Chinese team. We are doing fine in that business. The problem with that business is slow growth. That’s the only problem in that business.

Richard Eastman from Robert Baird

Okay. And then just a last question, I noticed in the press release, I think it was in the SG&A section. There was some reference to patent related costs, what is that?

Richard Morin

There were a couple of things that we spent money on in Q4, one of which was actual patent filings in the preparation of patents or whatever which was higher than its had been in their previous quarter, and we're also involved in litigation on a patent suit that's disclosed in our 10-K and the 10-Q's with Veritec and Acacia.

Bob Shillman

Okay, alright this is patent role.

Richard Eastman from Robert Baird

Okay, very good, thank you.

Bob Shillman

You're welcome.

Operator

Thank you. Our next question comes from Alexander Paris from Barrington Research.

Alexander Paris - Barrington Research

Hi, for Richard just on the tax-rate that 23% for the first quarter and its. Looking forward, what's your expect in terms of revenues from lower-tax countries, maybe like perhaps China, is that 23% or so, is that good for the whole year?

Richard Morin

That's our current estimate for the whole year, okay?

Alexander Paris - Barrington Research

Okay.

Richard Morin

China doesn't have a low tax rate. The tax-rate in China is equivalent to the tax-rate here in the United States unfortunately.

Alexander Paris - Barrington Research

Okay.

Bob Shillman

But probably nobody pays it.

Richard Morin

We do pay it.

Alexander Paris - Barrington Research

Pay or the firing squad.

Richard Morin

We just don't ship anything with lead in it.

Alexander Paris - Barrington Research

Speaking of China, there is a lot of opportunities you're seem enthusiastic about it. I know you have been doing some business in the metals area and so forth in the Surface Inspection. Aside from that, where would you see in your regular business the outlook for growth in China, the semi electronics area?

Bob Shillman

No, most of our business in China outside of the Surface Inspection is in the factory floor. Yeah, we have to my knowledge we don't have any OEMs in China or in the semiconductor we are doing.

Richard Morin

I think we sold into a couple of those -- we sold some of the wafer readers to a couple of the fab in China.

Bob Shillman

It’s all factory-floor related.

Richard Morin

And to the extent that some of our OEM customers shipping their--.

Bob Shillman

That's in that. Factory floor --

Alexander Paris - Barrington Research

Okay, can you say what the In-Sight Micro the rough price, would that be your lowest price? Product would be below Checker or?

Bob Shillman

How many do you want to buy? No, it is not below Checker. No.

Alexander Paris - Barrington Research

Can I get a volume discount.

Bob Shillman

Yes, you can. You can you be certain that our products we still have the philosophy of value pricing. We try to get a price that's equal to the price value, and in most cases the product gross margins are designed to be 80%.

Alexander Paris - Barrington Research

And on ID going in five year from 1D to 2D you've got people like Symbol Technologies and others who have a big investment obviously in the low end, 1D. Will they be potential competitors, are they are going to come from other machine vision companies or not going to sit there and watch your business disappear?

Bob Shillman

The big competitors are the companies in the barcode business. As you know, Symbol Technology was recently purchased by Motorola. This is another company that we partnered with for a while but we compete occasionally in handheld products that were brought by Honeywell, and there are a variety of other there are probably eight or ten players in barcode reading around the world, and they are all potential competitors and Symbol will be a tough one.

Alexander Paris - Barrington Research

Do you see them in that market? They are not doing 2Ds Symbol as of yet?

Bob Shillman

Yes. They are.

Alexander Paris - Barrington Research

So you are seeing them.

Bob Shillman

Yes.

Alexander Paris - Barrington Research

Well, okay.

Bob Shillman

Yes. They are smart. They see the future. Now at some point there may be a customer.

Alexander Paris - Barrington Research

Just one other question it's too broad. I guess, I just I was looking at these technology area, their earnings in the fourth quarter, were up 26% and the S&P the best ones 13 out of the 14 industries the one that was down was semiconductor, which is an important market for you. Is there anything just really different going on? Is that just the same old cycle that just slowed to turn?

Bob Shillman

Well, the good news, Alex, is that it's getting less important to us.

Alexander Paris - Barrington Research

Alright.

Bob Shillman

Because we are growing our other businesses, and the bad news is it's a cyclical industry.

Alexander Paris - Barrington Research

Alright, but it's no worst than it was before.

Bob Shillman

Well --

Alexander Paris - Barrington Research

Nothing really new or disastrous?

Bob Shillman

I don't know.

Alexander Paris - Barrington Research

As far as your business, as far as your customers are concerned about?

Bob Shillman

No, our customers are still holding market share, but their customers which are the fabs. I don't know how many new fabs are being built but the capital equipment, semi-capital equipment businesses is way off, and the stocks that I happen to look at I don't own them, but just capital equipments there, they are doing very poorly right now and the chip companies are just what I see.

We're being tarred with that brush. I mean, we still get affected to some degree because 30% of our businesses is that about right, is semiconductor list of that, but we are broadening and at some point it will be less and less.

Alexander Paris - Barrington Research

Okay. Thanks again very much.

Bob Shillman

Welcome.

Operator

Thank you. Our next question comes to us from James McAree from David J. Greene.

James McAree - David J. Greene

Dr. Bob, looking at the investment intensity, we're seeing the new products that you promised from investments, and could you talk a little bit more about where you might be adding people, and if your focus on this new products is going to continue?

Bob Shillman

The key to success in high-tech is new product development. If there is only so much you can get out of the old products, I mean, we sell them for a long time. But nevertheless, the growth is in new products, new opportunities and so this is still, an engineering intensive business. Though we have learned that distribution is crucial. You can have all the products without a good distribution strategy, you got to fail, but we are still investing heavily in engineering. I think 15% of revenue goes into engineering last time I looked, and we don't anticipate cutting that back.

Where we are investing? You haven’t seen the payoff yet. Is the vision systems on a chip? I've talked about this a little bit. We have our first prototypes back from the fab, and they are working. This is under the direction of my partner and Senior Vice President of Research and Development, John McGarry and his team in England, [Pierce Plumber and Paul Marget] who have done a superb job.

We have the world's, what we believe, is the world's first vision system on a single chip of silicon, and it's not going to be productize, it's not going to be available in the market for quite some time, but may do at the end of this year. If the first product sale will be in Cognex products, but we envision that this chip will be embedded in many things in the future. Whether it's going to be automobile navigation systems or whether it's going to be banking terminals, this is the ultimately low-price, high-performance vision system. And we’ve been spending heavily on that, and the return of that will be in years to come.

A lot of current R&D closer to reaching the market are the things we're doing in the ID space and also in this new sensor space, which is competitive or superseding photo detector.

James McAree - David J. Greene

Okay. And could you talk about your hiring plans? I think, if I recall, you wanted to add to your sales force, and in my notes, I had a number of about 30 people, and it sounded like it was going to be waited in the Far East? Could you maybe update me a bit on that?

Bob Shillman

Dick will give the details on where we are going to do it and how many in each office, but it is mainly outside of North America. Manufacturing is being done now in Eastern Europe. We are looking at those countries there to open offices. We have opened an office already in India. We have a small office and expanding with three offices in China now or two --

Richard Morin

Two main offices, and we got the sales guys in different regions that are essentially operating out of there, but we are looking -- the principle new hires will be in Asia and also in Eastern Europe.

James McAree - David J. Greene

Can you define the quality-trained people that you need or what's kind of the pace?

Richard Morin

The good news is there are quality people out there, ready to sell. The bad news is it appears we haven't experienced this yet, but loyalty is a new concept in those countries. That for an extra $0.50 or a $1, they quit.

James McAree - David J. Greene

You are pretty creative guy, Bob. You could start some long-term agreements.

Bob Shillman

You got that right. You got that right I'll promise to marry their sisters.

James McAree - David J. Greene

Thanks so much.

Bob Shillman

You are welcome. I did marry. I have four brother-in-laws over there, so I did marry somebody's sister.

Operator

Thank you. Our next question is a follow-up from Antonio Antezano from Bear Stearns.

Antonio Antezano - Bear Stearns

Hi, again. I don't know if this has been asked, but regarding usage of cash and especially in terms of acquisition activity, whether there is any comment there?

Richard Morin

That’s the comment. I'd love to tell you that we were working on some big deals. They didn’t work up. Alright, I'd love to tell you that we have a pipeline of companies that we're looking at. Right now, the pipe is basically dry. So, I expect that we're going to be buying stock back instead of buying companies until we find some more companies to buy. I cannot say it's disappointing, but our criteria were very tough. We have a rather good record on acquisitions. I don’t think we've lost on any one of them. And doesn’t make sense to relax on that.

So, we're looking for companies with either unique technology or unique distribution or strong competitors. We'd love to buy competitors, and they have a certain kind of culture and we just can’t find them right now. Maybe we're not looking right, but I am going to spend more time on this by the way, the remainder of this year, but right now the well is dry.

But the good news is we're not going to waste the money. We're going to buy stock back, and I hope that stock doesn’t go up today.

Antonio Antezano - Bear Stearns

And then, one more question regarding the search for the COO position?

Bob Shillman

Yes.

Antonio Antezano - Bear Stearns

Any update on that?

Bob Shillman

Same update. We have professional search firm helping us, and we're pretty picky. We're pretty picky, we have high standards. So, there are some people that we're looking at now that might be right. We're still looking. We're still looking, but we have some active candidates.

Antonio Antezano - Bear Stearns

And then just one clarification on the Surface Inspection, what should be the run-rate going forward? I think you mentioned that annualized bookings will be around 30 million, will that imply between 7 million and 8 million run rate for Surface Inspection?

Richard Morin

That's the run-rate that we’ve had over the last couple of years in that range or whatever, yeah, we don't expect to be doing $12 million a quarter for the rest of the year.

Bob Shillman

God willing.

Antonio Antezano - Bear Stearns

Right, although the last two years of inspection has been down, and so I was wondering if there is no fundamental issue with that business, at some point we should see bigger positive comparisons for Surface Inspection, right?

Bob Shillman

There are an awful lot of new steel mills that are being built or whatever, and we're winning business in mills, where they are putting in their first inspection systems and there is some retrofit going on the paper side. We do expect that '08 will have favorable comparisons to '07.

Antonio Antezano - Bear Stearns

Thank you.

Operator

Thank you. Our next question comes to us from [Ben Alexander] from Alexander Capital Management.

Ben Alexander - Alexander Capital Management

Yes, good afternoon. Congratulations on a great quarter.

Bob Shillman

Thank you, Ben.

Ben Alexander - Alexander Capital Management

Well, some of my question have been answered, but I did want to ask you, since I was so impressed with what you did with Factory Automation and since we're reading in the papers everyday that the economy is either in a recession or almost in a recession, obviously it has not impeded you, so could you please talk about how you think the economic environment might affect you moving forward?

Bob Shillman

Yeah, I haven't read that. If the economy was stronger, we would have done better. I’m also suffering from malice, or the same feeling of slowdown in U.S. economy. I don't know, if everybody gets a check [for $800] and if it's going to do that much difference. And thank god, it’s not my job to have to cure it. But my job is to make sure that we put our resources where we can get return on those, and that's why we are spending a lot of our time in foreign destinations now. It's a shame, but it's true.

Ben Alexander - Alexander Capital Management

Right. Very good. Thank you.

Operator

Thank you. [Operator Instructions]. Our next question is from Jim Ricchiuti from Needham and Company.

Jim Ricchiuti - Needham and Company

Hi, thanks. Good afternoon.

Bob Shillman

Hey, Jim.

Jim Ricchiuti - Needham and Company

Nice quarter.

Bob Shillman

Thanks.

Jim Ricchiuti - Needham and Company

Question on the ID business, Bob. Normally you would thing that margins associated with some of the equipment in this business would be towards the lower end of what you guys would normally see?

Bob Shillman

Right.

Jim Ricchiuti - Needham and Company

How would you characterize the margins in this business, especially as it becomes a bigger part of the business?

Bob Shillman

Well, I've said that every product we design has a targeted gross margin of 80%, and so far we are reaching the target.

Jim Ricchiuti - Needham and Company

Great, okay.

Bob Shillman

Right, barcode readers are inexpensive, but it turns out. It's cheaper -- barcode readers are inexpensive at the low end. They are commodity items, but building a vision system doesn’t take a lot of parts anymore. So we are able to do it.

Jim Ricchiuti - Needham and Company

Now on the -- looking at your R&D spending in Q4, significantly higher than what we've seen, I think it’s record level for you guys, and you really got a bunch of products in the pipeline. Do we see the R&D spend taper a little bit as we get into the back half of '08 as you push more of the new products through, or do you see it remaining pretty steady?

Bob Shillman

Well, I would think that what we are going to do, and this is the first time I am thinking about it, [hold out large] is that we will hold the dollars constant, but the percentage will go down as the revenue goes up. I don't anticipate spending more dollars.

Jim Ricchiuti - Needham and Company

Okay. Fair enough. So, if we look at the business overseas, where you are clearly getting a lot of growth. It doesn't sound like you've seen any signs of customers getting somewhat more concerned about the overall global economy. It sounds like --

Bob Shillman

No, no.

Jim Ricchiuti - Needham and Company

Okay.

Bob Shillman

No. And I don't hear that at all.

Jim Ricchiuti - Needham and Company

Okay.

Bob Shillman

I go to China now three times a year and -- capital has been going wild. Everybody is happy. Everybody is making a lot of money, and everybody is busy. So this is not a world problem.

Jim Ricchiuti - Needham and Company

Okay.

Bob Shillman

At least, I don't see this as world problem.

Jim Ricchiuti - Needham and Company

Last question is, Bob, on EasyBuilder. I just wanted to get a sense as to how important -- it sounds like this is a significant advance for you guys….

Bob Shillman

Yes.

Jim Ricchiuti - Needham and Company

In the market. How does this roll through the product portfolio? How should we see this impact you over the next year?

Bob Shillman

Okay. Well, starting next quarter every In-Sight comes with EasyBuilder, every In-Sight. So that's the front end. Now, what's also unique about this, many people on the call will not probably understand this. There always have been some very easy GUI’s that program vision systems. The problem was they were very limited, and once you exceeded the limits, you had to throw away everything you did and then go to some other programming in modality.

With EasyBuilder that's not the case, so once if you did resell them on EasyBuilder you just click here and click there, and then you can modify all the code that was written. It's all in the spreadsheet, which was the original interface to In-Sight, and anything you do on the spreadsheet goes up to EasyBuilder. So it really is rather unique, and we have one of the extensive patents on this filed now. This is going to make it possible for any factory technician to now use Machine Vision. Go ahead.

Jim Ricchiuti - Needham and Company

Just can I ask if this has been [embedded] or have the customers been able to play with this sheet, or being assumed for the first --

Bob Shillman

No, Its not beta siding -- yes, it's going to be given to the sales force I think next month. I can tell you exactly that's next month, right, embedded tested already and with very with customers that we’ve been dealing with and just, this is, but I thought I was going to sell in 1981, okay. This is what I thought machine businesses going to be like, but it took a long time.

Jim Ricchiuti - Needham and Company

Alright, Dick, question for you Dick, what should we assume kind of rate on with the interest rates coming down which we assume you get on the cash?

Richard Morin

Probably around 3% or so.

Jim Ricchiuti - Needham and Company

3%, okay;. Well, I guess that will also argues for buying back stock, doesn’t it Bob?

Richard Morin

It sure does.

Jim Ricchiuti - Needham and Company

Okay.

Bob Shillman

If these prices, no question.

Jim Ricchiuti - Needham and Company

Terrific, thanks a lot guys.

Bob Shillman

You're welcome, Jim.

Operator

Thank you. Our next question comes to us William Pike of Pine Street Securities.

William Pike - Pine Street Securities

I think you actually answered the last one. I’m going to ask you about China in, particular -- if you see any economic impact. You act kind of enthusiastic, and I sense the opportunity is very big there, but that's what my question is, there is some talk that China could slowdown after the Olympics for a variety of reasons, but I sense you don't see that?

Bob Shillman

We don't see it, and maybe we're just too smaller player to see it -- we're not looking for $600 million of revenue out of Shanghai, so, no, we don't see it.

William Pike - Pine Street Securities

Great, do you have any other competitors in China that you may not have in the rest of the world?

Bob Shillman

No, they tend to be the same competitors.

William Pike - Pine Street Securities

And is currency in China, how are you dealing with that? You are going to sell for dollars there or how do you would --

Richard Morin

In China, we sell in dollars. Where there is a requirement to sell in the local currency, we have gone through distribution. We are in the process with the offices that we've setup. We've setup rep offices or whatever, and we are in the process of incorporating in China, and once we get incorporated we will be able to sell in and accept the local currency, which we will then use to fund our local expenses, and we'll be able to convert that currency for the inventory purchases.

William Pike - Pine Street Securities

Got it. Alright it’s all I have. Thank you.

Bob Shillman

You are welcome.

Operator

Thank you. We'll now here from Eric Ende from First Pacific Advisors.

Eric Ende - First Pacific Advisors

Hi, good afternoon.

Bob Shillman

Hi, Eric.

Eric Ende - First Pacific Advisors

The line for investments and other income was up very nicely despite what I would have thought would be flat cash-balances and lower rates. Could you kind of comment on how that happened, and then I have a follow-up.

Bob Shillman

I think let say there were a couple of things, the biggest increase in fact was in investment income, where we had converted some older bond that had lower rates, so we were getting a higher return there was also a little of extra invested cash during the quarter, and to a lesser degree, we had an increase in other income, which is rental income that we have a space building right behind the company headquarters.

Eric Ende - First Pacific Advisors

Okay, and the follow-up is given recent events in credit markets, would you be able to reassure us as to how your cash is invested, or on the other hand, perhaps you would have something to confess about how your cash is invested?

Bob Shillman

Mortgages.

Eric Ende - First Pacific Advisors

Mortgage, that’s alright.

Richard Morin

We're principally in staking municipal obligation. We're not into any of the stock trades the --.

Bob Shillman

Well, say that again.

Eric Ende - First Pacific Advisors

What kind of duration would that be, or how short is it?

Richard Morin

They are mainly less than, I think they are less three years. I think on average we're probably somewhere around two, two and half right now.

Eric Ende - First Pacific Advisors

Okay. Well, thank you.

Bob Shillman

You are welcome.

Bob Shillman

Okay. It sounds like – Oh, there are two more questions.

Operator

Yes sir, our next question is from [Ben Alexander] from Alexander Capital Management.

Ben Alexander - Alexander Capital Management

Yes, thanks for taking my follow-up. Wanted to as you, Dr. Bob, do you have any thought on the SEMI market as to why isn't recovering, why it’s taken so long to recover? You may have some insights or some theory on what's going on in that market?

Bob Shillman

No, I really don’t. If you ask me, if this was five years ago, when SEMI was a very big part of our business. I spent a lot of time talking to those customers, their customers, but now I don’t. And I don’t even, I can't even speculate. I just don’t know. I don’t know.

Ben Alexander - Alexander Capital Management

Thank you.

Operator

Thank you. Our final question comes from Antonio Antezano from Bear Stearns.

Antonio Antezano - Bear Stearns

Thank you for taking last question. Now that you are using the same GUI for all your product lines. How are you going to have position DVT versus the In-Sight, is there some changes that we expect now going forward?

Bob Shillman

We are committed to continuing to manufacture and supply DVT to any of those customers that still want it. The DVT product is made in the United States, and we are going to continue to provide it. I think that over time customers will see the advantages of this new GUI, and over time we'll migrate to a standard platform which is going to be called In-Sight.

Antonio Antezano - Bear Stearns

Thank you.

Bob Shillman

Yes.

Operator

Thank you. I am showing no other questions from the phone lines.

Bob Shillman

Okay. Well, thank you all for attending this call, and this is one of the first visits. It has been a pleasure, and I am going to work hard to make sure that every future one is as nice. So, go home and go to your spouse or girlfriend and have a happy Valentine's Day. Bye-bye everyone.

Operator

Ladies and gentlemen thank you for your participation in today's conference. This does conclude the program, and you may now disconnect. Everyone, have a great day.

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Source: Cognex Corp. Q4 2007 Earnings Call Transcript
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