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Stratasys, Inc. (NASDAQ:SSYS)

Q4 2007 Earnings Call

February 26, 2008 8:30 am ET

Executives

Shane Glenn - Director of Investor Relations

S. Scott Crump - Chief Executive Officer, President and Chairman

Robert F. Gallagher - Chief Financial Officer

Analysts

Troy Jensen - Piper Jaffray

Jeff Rosenberg - William Blair

Eric Martinuzzi - Craig-Hallum

[Ryan Thibodeaux] - Maple Leaf Partners

[Graham Raine] - Bear [Stearns] Capital

Jeff Evanson - Dougherty & Company

[Amit Kamat] -Capital Investment Service

Clinton Morrison - Feltl & Company

Presentation

Operator

Good day, ladies and gentlemen, and welcome to the fourth quarter 2007 Stratasys earnings conference call. (Operator Instructions) I would now like to turn the presentation over to your host for today’s call Mr. Shane Glenn, Director of Investor Relations with Stratasys.

Shane Glenn

Good morning and welcome to the Stratasys conference call to discuss fourth quarter and full year fiscal 2007 financial results. Representing Stratasys executive management on the conference call today is Chairman and CEO of Stratasys, Scott Crump; Chief Financial Officer, Bob Gallagher. A quick reminder that today’s conference call is being transmitted over the web and can be accessed through our “Investors” section of our website at www.stratasys.com.

We will begin with the Safe Harbor statement. All statements herein that are not historical facts or that include such words as expects, anticipates, projects, estimates, vision, planning, believes or similar words are forward-looking statements that we deem to be covered by and to qualify for the Safe Harbor protection covered by the Private Securities Litigation Reforms Act of 1995.

Except for the historical information herein, the matters discussed in this news release are forward-looking statements that involve risks and uncertainties.

These include:

the continued market acceptance and growth of our Dimension 3D printer line, FDM 200mc, 360mc, 400mc, 900mc, Maxum, Titan, and Vantage product lines;

the size of the 3D printing market;

our ability to penetrate the 3D printing market;

our ability to maintain the growth rates experienced in this and preceding quarters;

our ability to introduce and market new materials such as ABSplus and ABS-M30, and the market acceptance of these and other materials;

the impact of competitive products and pricing;

the timely development and acceptance of new products and materials;

the success of our recent R&D initiative to expand the direct digital manufacturing capabilities of our core FDM technology;

the success of our RedEye RPM and other paid parts services.

I believe that we have largest part-building service based on the number of dedicated machines, and the other risks detailed from time to time in our SEC reports, including the annual report on Form 10-K for the year ended December 31, 2006, our quarterly reports filed on Form 10-Q throughout 2007, and our annual report on Form 10-K to be filed for the year ended December 31, 2007.

The information discussed within this conference call includes financial results and forward-looking financial guidance that are in accordance with U.S. Generally Accepted Accounting Principles or GAAP.

In addition, non-GAAP financial guidance is included and excludes certain expenses. The non-GAAP financial measures are provided in an effort to give information that investors may deem relevant to the company’s operations and comparative performance, primarily the identification and exclusion of expenses associated with stock-based compensation expense required under SFAS 123R.

We’d like to confirm the date of our first quarter earnings release and conference call. Stratasys’ first quarter results will be released on or before morning of May 1, 2008 call by a conference call on the date of the release. We will release the conference call’s time and details about two weeks further that date.

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

S. Scott Crump

Good morning, thank you for joining us. We just released our record fourth quarter and record full year financial results. Revenues grew a strong 20% for our proprietary products and services in the fourth quarter and 25% for the full year. Our proprietary high-end FDM sales increased by 25% during the fourth quarter. This follows our successful transition to focusing on proprietary high-end products, as well as our successful launch of multiple new systems over the past year.

We are proud of our FDM group’s nimble transition out of $16 million of distributed Eden related sales into double-digit FDM proprietary system growth. Our Dimension 3D printer system revenue grew by 21% for the fourth quarter as our higher price systems continue to be our most popular products with our commercial Dimension customers.

Our proprietary consumables grew by an impressive 27% in Q4 approximately proportional to the expansion of our active installed base of systems. Operating profit growth was impacted by product mix and higher short-term spending levels as we accelerated marketing and new product development programs, which benefit 2008 and beyond.

Total unit systems sales grew by 21% during the fiscal 2007. We now have seven new products that have been introduced over the past 13 months, a first in our history, and we remained confident that we can generate strong growth throughout the year and beyond.

Okay, I will return later to discuss some of our strategic initiatives, but first, I would like to turn the call over to our CFO, Bob Gallagher, who will further highlight our fourth quarter and full year results.

Robert F. Gallagher

Prior to discussing the details of our financial results, we would like to outline the items that negatively impacted our performance during the fourth quarter relative to our previous expectations as well as outline the relative financial impact of discontinuing our distribution agreements of non-proprietary products.

First, from our product mix standpoint, the fourth quarter was negatively impacted by the sale of two Arcam systems, which represented approximately $1.4 million in revenue, but generated only 13% gross profit. We had previously announced our disappointment with the Arcam distribution initiative and our plan to discontinue distribution at the end of fiscal 2007. Our forecasts for 2008 have no additional Arcam system sales.

Secondly, we continued to underestimate the demand of our higher price Dimension Elite 3D printer, as bookings for the system exceeded our forecast and production schedule for the quarter. Consequently, we finished the period with a substantial number of Elites in our backlog.

We continue to try and improve upon our forecasting processes so as to more accurately match our sales mix with our production schedule. Given the timing of orders, and lead time and part delivery, we don’t always have the visibility we would like on orders. Our order flow is toward the later part of the quarter and this makes it difficult to accurately predict the flow in mix.

This quarter we are implementing system changes to have daily visibility to what’s shipped and what is in backlog along with promised delivery dates. We work with the salesmen and channel managers in advance to estimate the mix, but customers change their mind. This is a fact we can’t change. This quarter, a large number of orders we typically get toward the end of the quarter came in differently than expected and without enough lead time to react to it.

We have been unwilling to build additional finished units, because we believe this is not a good long-term practice. We should add that our system backlog for the year ended December 31, 2007 increased by 39% to $5.7 million and is comprised mostly of systems introduced over the previous year.

Thirdly, our RedEye paid parts business, although growing 14% during the fourth quarter, underperformed our expectations. We continued to invest in new sales and marketing programs that we believe will generate higher growth going forward, which we will discuss later in the call.

We should note that the paid parts business did grow by 30% for 2007 and the business remains highly profitable. We estimate that these issues related to sales and product mix negatively impacted gross profit for the fourth quarter by approximately $600,000 relative to our estimates.

The other area we would like to outline that negatively impacted our profits in the fourth quarter was related to higher operating and accelerated product development expenditures. First, we made a conscious decision to accelerate new product and market development programs related to our 3D Printer and high-end FDM System initiatives. As the fourth quarter attests, new product introductions are performing beyond our expectations.

Consequently, we feel accelerating these programs is in our shareholders’ best interest and will provide positive returns in the near future. Specifically, these costs are associated with spending on new product development and advertising and distributor programs. We should add that we continue to observe a robust pipeline of sales activity and have yet to observe any significant negative impact from a slowing economy.

Secondly, we failed to fully estimate and consider the impact from higher commission levels within our domestic systems businesses during the fourth quarter. Our operating expense model has been fairly predictive with the exception of commission, because of the higher commission rates paid once a salesman has exceeded quota.

We have been unsuccessful at predicting which regions will exceed quota versus those that may be under. Predicting 2007 was particularly difficult with the loss of Objet. We have a great sales team. And at the beginning of 2007 we wanted to make sure that they were retained in a time when we were losing a product line that had generated $16.4 million in domestic sales and we hadn’t introduced any significant new high-end products in the previous 18 months.

Going into 2008, we have a completely revamped high-end product line, and we have the confidence with the sales team, meaning we have higher quotas where the salesmen are more confident in their achievability. We expect the year-over-year commission expense to decline despite the forecast increase in revenue. We estimate that these issues, higher operating expenses and accelerated product development expenditures, negatively impacted the fourth quarter by approximately $900,000.

Now I would like to take a moment to discuss the relative impact of discontinuing our product distribution agreements. As we have previously outlined, we discontinued the distribution of Eden product at the beginning of 2007, and continued to recognize a nominal level of Eden related revenue throughout the year.

This decision has created certain issues when conducting year-over-year comparative analysis of our revenue growth and margins. In the fourth quarter of 2007, we recognized approximately $75,000 of sales related to Eden systems, consumables and maintenance compared to approximately $4.6 million in the same period of last year.

Given the discontinuation of our RPM distribution agreement at the end of fiscal 2007 we will continue to provide you with the type of a comparative analysis throughout 2008. Therefore for the purposes of conducting quarterly comparisons in 2008, I will now provide you with a distributed product-related revenue for each quarter of 2007. This will include some residual revenue we generated from our Eden product and services, as well as product revenue from our RPM distribution agreement.

For 2007 distributed product revenues were as follows; Q1, $1 million; Q2, $540,000; Q3, $1 million, and Q4, $1.4 million for a total of approximately $4 million. The overall gross margin on this revenue was essentially zero.

Total revenue increased by 2% to $30.2 million for the fourth quarter of 2007, compared to $29.7 million for the same period last year. The company shipped 536 systems during the fourth quarter versus 483 last year, an increase of 11% over last year.

Recall that the fourth quarter 2007 included a significant number of distributed Eden units. 3D printer units increased by 15% during the fourth quarter when compared to the same period last year, however, we ran out of Dimension Elite in December and we are unable to ship a significant number of systems.

The Elite, 1200 SST, and 768 SST, our three highest priced 3D printers, represented over 75% of our 3D printer unit volume during the fourth quarter. Our proprietary high-end system units grew by 25% during the fourth quarter, when compared to last year, which reflects a returned focus of proprietary products as well as positive impact on new product introduction.

Fourth quarter product revenue as reported increased by 1% to $24.7 million, when compared to $24.4 million for the same period last year. Eden-related product revenue amounted to $75,000 in the fourth quarter, versus $4.3 million in the same period last year. RPM related product revenue amounted to $1.4 million in the fourth quarter versus $1 million for the same period last year. Excluding distributed products related revenue, total product revenue increased by 22%.

Several factors drove the proprietary product revenue growth in the fourth quarter. First proprietary consumables grew by 27% during the fourth quarter, when compared to last year, driven by our ongoing expansion of our installed base of proprietary systems, especially 3D printers.

Second, proprietary high-end system revenue increased by 25% when compared to last year, driven by several new product introductions as well as, our successful transition out of the distributed Eden product line. And finally our 3D printer system revenue increased by 21%, despite our inability to shift several Dimension in lead orders at the end of the quarter.

Fourth quarter service revenue as reported increased by 4% to $5.5 million when compared to $5.3 million for the same period last year. We recognized no Eden related service revenue during the fourth quarter, compared to $277,000 in revenue from maintenance contracts, we recognized during the same period last year.

Maintenance revenue from contracts and proprietary systems increased by 9% during the fourth quarter when compared to last year. Maintenance revenue tends to be a slower growth portion of our business, as we are selling 3D printers to more and more repeat customers who are happy with its print reliability. In addition we offer a one-year warranty on all products internationally and on our 3D printers to the educational market domestically. Maintenance revenue was in line of with our expectations.

Our paid parts revenue grew by 14% during the fourth quarter while it was up 30% year-to-date. We continue to be optimistic about the future prospects of this highly profitable business. Gross profit increased by 6% to $15.9 million for the fourth quarter of 2007 when compared to $15 million for the same period last year.

Gross profit as a percentage of sales increased to 52.7% from 50.5% for the same period last year. The gross profit margin year-over-year benefited from better average prices for 3D printers as well as strong growth in our proprietary consumable products.

More importantly the gross margin percentage benefited year-over-year from improved mix from our high-end system business as the decline in sales of distributed Eden products was partially replaced by an increase in sales of our proprietary high-end systems. As we indicated previously, we maintained a low 27% gross margin in 2006, under distributed Eden product line. This is very low when compared to our higher margin proprietary products.

The positive impacts of higher average prices on 3D printers, strong growth on high-end proprietary systems were partially offset by the sale of two Arcam systems for $1.4 million during the fourth quarter, which generated 13% gross margin.

Operating profit declined by 4% to $4.9 million for the fourth quarter of 2007 compared to $5.1 million for the same period last year. Excluding stock-based compensation expenses, operating profit declined by 5% to $5.1 million for the fourth quarter of 2007 compared to $5.4 million for the same period last year.

Stock-based compensation expense required under Statement of Financial Accounting Standard or SFAS 123R amounted to approximately $232,000 in the fourth quarter compared to $284,000 for the same period last year.

Operating expenses increased by 11% during the fourth quarter compared to last year, which were driven by the factors I outlined in my opening comments. Total interest and other income for the fourth quarter increased to $470,000 versus $410,000 last year. Pre-tax profits declined by 3% to $5.4 million for the fourth quarter of 2007 compared to $5.5 million for the same period last year.

Excluding stock-based compensation expenses, free cash profits declined by 4%, $5.6 million for the fourth quarter of 2007, compared to $5.8 million for the same period last year.

Income taxes reported amounted to $1.1 million for a rate of 20% compared to $1.9 million or 34% for the same period last year. Income tax expense for the fourth quarter includes approximately 710,000 or $0.03 per share and previously unrecognized state tax credits for prior year’s research and development expenditures.

We filed for state tax refunds in Q4 2007 and recognized benefits in the fourth quarter in accordance with Generally Accepted Accounting Principles. Excluding the impact for stock-based compensation expenses, income tax expense amounted to $1.1 million or 19.9% for the fourth quarter versus $2 million or 33.6% for the same period last year.

Net income increased by 18% to $4.3 million for the fourth quarter of 2007, or $0.20 per share compared to $3.7 million, or $0.18 per share for the same period last year. Excluding stock-based compensation expenses, net income increased by 16% to $4.5 million or $0.21 per share for the fourth quarter of 2007, compared to $3.9 million or $0.19 per share for the same period last year.

Our diluted shares outstanding increased by approximately 1.3 million shares from the fourth quarter last year, a result of our higher stock price as well as the exercising of employee stock options.

Our cash and investment position amounted to approximately $61 million at the end of fiscal 2007, an increase of approximately $17 million from the end of 2006. The fourth quarter increase in cash and investments from the end of 2006, as a result of the positive cash flow from operations, combined with the positive impact of stock option exercises.

Inventory balances were $12.8 million at the end of fiscal 2006, which is down from the third quarter level and up from $9.9 million at the end of fiscal 2006. The increase is largely due to three things: the buildup in the dimension units due to differences in our forecast mix versus actual demand; an increase in inventory to support our new product introductions; and an increase in consumable inventory to support our increased installed base.

Net profit in equipment was $26.6 million at the end of fiscal 2007 compared to $20.4 million at the end of fiscal 2006. The growing components of our business have required much of the capital expenditure as well as the renovation in the 86,000 square foot building purchased in 2005 that is now our corporate headquarters.

Accounts receivable at the end of fiscal 2007 was $26.3 million compared to $25 million at the end of fiscal 2006.

Days sales outstanding or DSO were approximately 80 days down from 87 at the end of the third quarter. As we observed in prior quarters, our DSOs will likely continue to be impacted by our successful program for our resellers that allow participants to purchase a limited number of 3D printers with extended 180 days payment terms.

This follows the similar pattern we have now observed for the past four years. The current level of participation for reseller is consistent with historical levels and we have made no significant changes in the program. We believe our past history has proven our program’s value and manageability.

I would like to reiterate what I believe are four of the key points to highlight in the quarter:

strong growth in our proprietary products including systems and consumables

gross profit margins benefiting from discontinuation of Eden product distribution, and growth of proprietary products offset by the sale of two Arcam systems.

operating profit impacted by higher operating expenses including commission expense as well as product and market development

and lastly a favorable income tax rate due to amendments filed for prior years’ state research and development credits.

I would like to highlight some 2007 results. Despite some of the short-term conditions that impacted the fourth quarter, we believe our fiscal 2007 results suggest a solid performance and better reflect our long-term trends. Revenue from proprietary products and services increased by 25% in fiscal 2007 versus the same period last year.

Total system shipments increased 21% to 2169 units for the 12-month period of 2007 compared with 1796 units for the same period last year. However, excluding the distributed Eden product line, total units increased 26% during fiscal 2007.

This was driven by a 25% increase in 3D printer unit and an impressive 31% increase in our proprietary high-end system units. 3D printer system revenue increased by 35% significantly higher than the growth in 3D printer unit, this was the result of higher average 3D printer prices realized throughout the year.

Our paid parts business grew by 30% in fiscal 2007. Our proprietary consumables increased by 23% in 2007 as our installed base of systems, especially 3D printers continue to expand. Despite the near-term impact of higher expense levels and investments in product development, operating profits increased 18% during fiscal 2007 to $18.5 million.

And finally we remain a financially healthy company generating strong cash flow from operations during 2007, while maintaining over $16 million in cash or nearly $3 per share on our balance sheet, with no long-term debt.

Now I would like to turn it over to our Director of Investor Relations, Shane Glenn to outline our financial guidance.

Shane Glenn

Stratasys provide the following financial guidance for the fiscal year ending December 31, 2008 as follows. Revenue guidance of $130 million to $136 million or 16% to 21% growth over the fiscal 2007, however if you exclude the approximate $4 million in distributed product revenue we recognized during 2007 this represents growth of 20% to 26%. Our revenue growth estimate for 2008 is fully organic. The operating guidance of $0.77 to $0.85 per diluted share which if you exclude the $0.04 per share of state tax credits recognized in 2007 represents growth of 24% to 37% over 2007.

Non-GAAP earnings guidance of $0.81 to $0.89 per share, which excludes the impact of stock-based compensation expense required under SFAS 123R. Reconciliation between non-GAAP and GAAP financial projections is provided in a table in our press release. We’re providing non-GAAP financial estimates for those analysts and shareholders who want to use that information to evaluate our performance.

I would like to provide some additional information regarding our spending trends in 2008. Our vision remains to move down to the price elasticity curve, and target opportunities are developing within the direct digital manufacturing markets. Both of these initiatives will require continuous investment in product quality and development.

Consequently, in 2008 we planned to invest approximately $2 million of our current run rate to addressing these future opportunities. A portion of these expenditures will be recouping costs savings. Approximately $1 million or half of these investments will be incurred through increased R&D expenditures. All of these costs are incorporated into our 2008 guidance.

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

S. Scott Crump

Our core businesses continued to grow impressively during the fourth quarter. Our new product initiatives continued to produce positive results within our Dimension 3D printer business as well as our high-end FDM system business and our RedEye paid parts service.

The growth in our high-end proprietary system business is especially pleasing given the historical trends within that group. The growth in our high-end system business partially resulted from our improved focus on the sales of proprietary products as well as our introduction of two new systems last year the 200mc and the 400mc, which have been major contributors to this growth.

The 400mc has allowed Stratasys to expand into new applications for the manufacturer of end use parts or in other words DDM, direct digital manufacturing. This system produces parts with better accuracy and improved parts strength. This product also allows us to continue to grow at our successful based business of rapid prototyping.

Building on this success, we made our most significant new high-end product introduction ever with the new FDM 900mc at the big EuroMold Show in December. The 900mc represents the most advanced FDM system in our company’s history, exhibiting additional improvements and speed, build accuracy, and part quality.

Most notable is the new system size, which has a build chamber about nine times larger than our 400mc. This commercial of that system can build the biggest part in the world having the capability to build a part over a four and a half feet long on the diagonal.

We began commercial manufacturing of the 900mc in the first quarter and we will begin limited shipments, gradually ramping to full production by the end of the third quarter this year. Our new high-end mc products have all been very well received and we have established a strong sales pipeline especially for the 900mc.

Our strategy for this high end business is to continue the growth in our successful prototyping applications, while expanding into the new applications for the manufacture of end-use parts for direct digital manufacturing. The 200mc, 400mc, and 900mc are our first products built for, marketed to, and sold for direct digital manufacturing applications.

So, this is a very exciting time for Stratasys. The 3D printing business generated another solid performance during the fourth quarter. The Dimension Elite, which was introduced in January of 2007 continues to perform above our expectations and remained one of our best selling 3D printers in the fourth quarter.

It’s worth noting again that the sales of the Elite exceeded our plan. The Elite has proven the importance of offering a 3D printer, not only with an attractive price, but with high functionality. This system provides users with our hands-free automated support removal option, Waterworks, as well a premium material ABSplus, which produces stronger, functional models exhibiting finer feature detail and improved surface finish.

Driven by our success with the Elite in 2007 today we announced the availability of two new 3D printers that incorporate the same premium ABSplus material found only previously on the Elite. The new systems, the Dimension 1200es line, will replace the existing Dimension 1200 line and be offered only with the new ABSplus material.

Given the added functionality provided by ABSplus, which is up to 40% stronger than our standard ABS, we’re introducing the new systems at a significant price premium to our legacy Dimension 1200 systems at $26,000 for the BST version and $34,900 for the SST version. Now, customers that have legacy 1200 systems will be offered a $5,000 option to upgrade their existing 1200 to 1200es. The Dimension 1200 line with standard ABS material will no longer be offered.

Our RedEye paid parts business grew by 15% in the quarter versus last year, an impressive 30% for the full-year. We recently announced two new international initiatives with the rollout of our Internet instant quoting and ordering service of RedEyeRPM.com in Europe, as well as in Australia.

We’re also very excited about our announcement last week that targets architectural applications with a dedicated site that allows architects to upload, quote, and order, architectural models over the Internet. This new offering can be accessed at RedEyeARC.com.

Let’s put the unit potential into perspective. Over 2000 total system units shipped in 2007. We’ve now shipped more than 5000 units over the past three years exceeding the combined shipments over the company’s previous ten-year history. We’re planning for 4,000 units per year in the near future, with a longer-term vision of 13,000 units per year.

We believe a market exists today are over 500,000 3D printing systems at the right price by targeting the 5 million 3D CAD seats that currently exist worldwide. It’s noteworthy that we believe that the adoption of the 3D CAD usage still remains significantly less than half of the universe of our design engineer target market.

The rapid expansion in our installed base is contributing to a strong growth in our high-margin proprietary consumable revenue, which grew by 27% during the fourth quarter compared to last year. Consumables revenue will remain a central part of our growth strategy considering our estimate of the market’s potential and our expectation of continued strong growth in the unit sales.

Our system backlog grew 37% to $5.7 million at the year-end over the same time last year, as comprised almost entirely of products that were introduced in 2007, such as the Elite, 400mc and 900mc. Well, the 2008 will benefit from these new products and were introduced throughout 2007, as well as our last month’s launch of our new 360mc and today’s announcement of two new higher-priced 3D printers.

It’s worth noting that in addition to effectively raising the price of our two new 3D printers with today’s product release, we are maintaining stable pricing on our remaining portfolio of printers globally price as low as $18,900.

We will continue to invest heavily in new product and market development this year as well as in quality and process initiatives that will make us more efficient, our products more competitive and attractive for new applications. Our recent success with our new products provides us confidence that these investments will generate favorable returns in the near future.

We are also becoming increasingly confident that DDM applications can provide a significant incremental growth driver for Stratasys. Although, our product mix and higher spending levels impacted our fourth quarter profits, our mid-term and long-term strategy remains intact and we look forward to a very successful 2008.

I will return with some closing comments, but first I would like to address any questions that you might have.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Troy Jensen - Piper Jaffray.

Troy Jensen - Piper Jaffray

On the backlog, two quarters in a row now you have had some struggles with properly forecasting demand mix, and it has kind of impacted your revenue recognition in the quarter. So, I am curious to know what you are doing try to fix that. Bob, I think we spoke last quarter; you want to put a couple of million bucks of your cash balance in inventory, so you guys don’t have these issues here with predicting the mix.

Robert F. Gallagher

Yes, Troy, as I mentioned in my comments, we’ve created visibility; we have a daily indication of what shipped. We have everything in our backlog with promise-to-ship date, but the reality is of course a lot of orders come in late in the quarter and our visibility to that is low.

We work with our salesmen and our channel managers and try to predict what that mix is and they are also directly with customers but the customers change their mind. And from the way we do our business when we look at the lead-time for our parts etc., we haven’t been able to react quickly enough to that.

Given our size today, we could build additional units and build them up, but we don’t think that that’s a good long-term strategy. So, we made a conscious decision not to build units outside of our forecast. It’s a fair question, but long-term, I don’t think that’s a good strategy and we are suffering from it in the short-term right now.

Troy Jensen - Piper Jaffray

Scott, I think I’ve been following you for four years and I think that in all four years you are using 5 million 3-CAD seats as the addressable market. Why is that number not changing, because you listen to the Autodesk and the CAD resellers you are talking about pretty substantial growth in 3D?

So I mean, is it higher than that? And then we just don’t know exactly what the numbers are? Or you just kind of help explain why that number has been so consistent?

S. Scott Crump

Yes, it needs to be applied to rapid prototyping. So the best source that we have is through the Wohlers Report. And last time he reported it was for the year 2006 where we’re showing two million commercial seats that applied to rapid prototyping and three million in education. Obviously, adding up to the 5 million in that total.

And about two thirds of our business goes to the commercial for the 3D printer and about a third goes to the education. So yes we are about maybe one, and depending how we will look at, one to two years behind on the number, but I don’t know that is the point.

The point is that there is only about 30,000 output devices from five million the total CAD seats showing very under penetrated market, but there could be very well be a larger number than the 5 million. But we believe that there are at least 5 million seats that exist around the world that are operating.

Shane Glenn

Troy, it would be with the lack of some really solid researching number. It’s our tendency to be conservative with that estimate.

Operator

Your next question comes from the line of Jeff Rosenberg - William Blair & Company.

Jeff Rosenberg - William Blair

Bob, could you talk a little bit to differentiate between the shortfalls you talked about in gross profit versus gross margin. Is the Arcam mix, which my quick calculation was it’s about 200 basis points of gross margin, really the primary gross margin issue?

And so how should we think about gross margin going forward? Is that sort of 54% to 55% range a pretty good number to think about as we look forward?

Robert F. Gallagher

Yes, there was the two components to it I would say, Jeff, in the quarter. Certainly, Arcam was a component to it but also our paid parts business, while it grew 14% during the quarter and 30% for the year, the fourth quarter was lower expectations and that’s a strong margin business for us.

Given the mix between consumables, paid parts and our systems, I would probably broaden that range from 53% to 56% in terms of what I think about.

Jeff Rosenberg - William Blair

How should we think about the sort of normal seasonality you typically see in Q1 relative to the delinquencies and the strength in the backlog? And then maybe also you could comment on the timing of your reseller meeting this year and how that might impact things relative to history?

Shane Glenn

Jeff, one thing that we tried to point out in the conference call as it relates to the 900mc, we’ve obviously taken orders for that product. As Scott’s comments suggest, it’s a gradual ramp up in the production here. We’re not going to be able to ship all of the orders that we currently have for the 900mc in the first quarter and we don’t expect to get caught up there until the third quarter.

As it relates to the reseller meetings, if you look at the introduction of the 1200es that became public today, that was already kind of released privately to our owners of our reseller network so they were aware of the product line. They have already placed orders for that product and we will begin shipping the 1200es in the first quarter.

So, if you look at what we have done historically, obviously there’s been a lot of focus on the timing of the introduction of new products in the reseller meeting. This kind of matches up, somewhat similar to what we did last year, when we introduced the Elite, I believe it was in January and started shipping. We are introducing the 1200es in February and we are beginning shipment in the first quarter.

Jeff Rosenberg - William Blair

And do you think that the Elite backlog is something that would be different than, relative to the patterns we have seen in the past?

Robert F. Gallagher

Not sure that it would be significantly different from the historical pattern.

Operator

Your next question comes from the line of Eric Martinuzzi - Craig-Hallum.

Eric Martinuzzi - Craig-Hallum

I just wanted to go back over the four points you talked about, the shortfall in the quarter. The Arcam machines, were they in the forecast coming out of Q3?

Robert F. Gallagher

We had one of the two machines in the forecast coming out of Q3.

Eric Martinuzzi - Craig-Hallum

So, given that these things, we are talking about a roughly $700k price point. If you hadn’t sold the second, we would have come in even lighter.

I am looking at the Dimension Elite and this is kind of the back of the envelope, but if I am 40 short on Dimension Elites because I didn’t have them there to ship, that is roughly $1 million bucks, $0.5 million or so of gross profit. Then I’ve got RedEye weakness.

I am trying to figure out, it just seems like there is something else missing on the top line that doesn’t explain the shortfall, unless my estimate on the Elites is off.

Shane Glenn

Without getting into specific numbers, Eric, the Elite is, at least prior to this morning was our highest price 3D printer and our highest margin 3D printer. And the margins on that system are significantly higher than our corporate average.

So, without giving you a specific number on the impact as it relates to the, I believe, $600,000 that we identified on the gross margin, a portion of that was driven by several Elites that could have been shipped during the quarter.

Robert F. Gallagher

Also Eric, as it is relates to the paid parts business, once you cover the overhead portion of that business, because all of your depreciation on your machines is fixed, really what we are talking about to produce the parts there is the actual consumable usage itself. So incrementally shortfalls in paid parts have a significant impact on the overall gross profit.

Eric Martinuzzi - Craig-Hallum

And then further on the leverage, what was your comment regarding the sales expense, was it that the absolute dollar or that the percent for 2008 was going to be less than ‘07, what was that comment?

Robert F. Gallagher

Yes. I mentioned on the commission expenses and I was talking about, our forecast concludes the absolute dollars for commission expense to be lower irrespective of the significant increase in the overall revenue.

That’s just on the commission fees itself. As I said, going into 2007 without any new products and the loss of Objet, we have worked hard to maintain our sales staff and going into 2008 we have got all new products and we’ve got confidence of the team and we will do well with that group in 2008.

Operator

Your next question comes from the line of [Ryan Thibodeaux] - Maple Leaf Partners.

[Ryan Thibodeaux] - Maple Leaf Partners

On the inventory, you ended the quarter it looks like inventory growth was about six times the rate of sales growth. Yet you said you were sold out of the Elite. So, I am just trying to understand where the inventory is coming from?

Robert F. Gallagher

Yes, I think it was three components. I made a comment as it related to inventory. One, while we didn’t install the Elites, based on our forecast, we built other units in the Dimension product line, so we had a fair number of finished goods related to other units. That doesn’t give us concerns because that will flush out in Q1.

Secondly, with the number of new product introductions, we are just introducing the 900. We just introduced the 1200es, so we have inventory to support our new product introductions. Also we have a fair number of consumable inventory on hand at the end of the year to support our increasing installed base.

[Ryan Thibodeaux] - Maple Leaf Partners

So there is some legacy Dimension 1200s that are in the ending inventory that you are going to have to basically flush out?

Robert F. Gallagher

No, we were anticipating the introduction of the 1200es. We are talking about more the 768 models.

Shane Glenn

Yes Ryan, we’ve been building the 1200es now for at least a couple weeks and we haven’t been able to ship any of those systems until today.

S. Scott Crump

But, we hadn’t planned to.

[Ryan Thibodeaux] - Maple Leaf Partners

Are there any of the 1200es’s in the ending inventory in the fourth quarter?

S. Scott Crump

Yes, I think Ryan there was a few in there but as you’ll notice with our announcement of the es, the conversion to a legacy system is actually quite simple. We are selling the upgrade enhancement packages to existing holders. If we need to, it’s quite easy to do that with the systems that we currently have on hand.

[Ryan Thibodeaux] - Maple Leaf Partners

How will the upgrade, would that be counted as a unit sold or where will we see that on the income statement or I guess in the segment breakdown?

Robert F. Gallagher

It won’t be in our system unit count, when we discuss the number of units but we will include it as part of our product revenue.

[Ryan Thibodeaux] - Maple Leaf Partners

So we might end up seeing a little bit of skew on the ASP then if you’re including it in revenue but not in units, right?

Robert F. Gallagher

Yes, we will probably get some visibility to that as we go throughout 2008.

[Ryan Thibodeaux] - Maple Leaf Partners

And then could you just walk through once again on the SG&A for ‘08, you talked about, I think you said $2 million more run rate for the year, and then you said I think about a $1 million increased run rate in R&D. Was that $2 million total or was that $2 million for SG&A and then $1 million for R&D?

Robert F. Gallagher

No that was $2 million total.

[Ryan Thibodeaux] - Maple Leaf Partners

So of the $2 million, $1 million would be in R&D?

Robert F. Gallagher

That’s correct.

Operator

Your next question comes from the line of Graham [Raine] - Bear [Stearns] Capital.

Graham [Raine] - Bear [Stearns] Capital

In the past, you have mentioned that paid parts kind of serves as a leading indicator for DDM. Can you just provide a little bit more detail on where that weakness is coming from in the fourth quarter and just what you’re seeing in that area of the business?

S. Scott Crump

It sounds like you have two questions there. Let me start with the DDM. There are two fundamental applications that we’re targeting. One is jigs and fixtures for IDM that are used in manufacturing of our products, and we’re seeing good strong growth trends there both in our RedEye, as well as the use of the systems for those applications.

And we are also seeing a good trend within RedEye for continued growth within the parts for end-use parts, which is the DDM. It’s a 30% growth year-over-year but was a shortfall to our internal budgeted plan within RedEye.

We just overall had some execution problems. During the year, we have added both sales people as well as management within the group, but not at a fast enough rate to get leads to hit the numbers.

Graham [Raine] - Bear [Stearns] Capital

And as far as international exposure goes, do you break out your international sales versus domestic? I’m trying to an idea of what that rough spilt might be?

Robert F. Gallagher

I think it’s best to look at that, if we look at the proprietary products without the distributed products in there, it’s kind of a 50%-50% mix for the quarter and 51%-49% for the year.

If you look at the relative strength, I think our domestic market on proprietary products grew at about a 24% rate and international we had about a 27% rate. So we saw good strength growth in both domestically as well as internationally.

And I think that helps reinforce the fact that we think awareness as opposed to pricing is a factor. Because with the weak dollar you would have expected international to be a higher growth component between the years but they were very close in the overall growth between the years for our proprietary products.

Operator

Your next question comes from the line of Jeff Evanson - Dougherty & Company.

Jeff Evanson - Dougherty & Company

Bob, I don’t understand how domestic can grow 24%, international can grow 27%. But both those rates combined are lower than your proprietary growth rate. I’m confused. What did those rates mean that you just gave us for domestic and international?

Robert F. Gallagher

I gave that is overall. So, I included consumables, maintenance that is the full sales component, it’s not just products.

Jeff Evanson - Dougherty & Company

You talked a little about incremental spending for advertising and new distributor programs. Could you tell us what types of distributor programs you are planning on? This was in your opening comments regarding why you expected higher operating expenses in 2008?

Robert F. Gallagher

Yes, my opening comments were pertaining to the fourth quarter of 2007. We held some programs related around to the launch of the 900. We did some other programs within the 3D printers within the fourth quarter in anticipation of the 1200es launch and we had advertising surrounding the 900 product line.

What we talked about in 2008 is we talked about an increased incremental spending level as it relates to R&D and to some quality initiatives, in order to take advantage of both the DDM market and as we move down the price elasticity curve on the 3D printers.

We believe both the DDM market on the high end will require higher reliability and repeatability, as we get closer to a larger and larger market there, as well as higher reliability as we move down the price elasticity curve on the 3D printer market. And so to take advantage of those initiatives, we’ve will increase our spending in 2008 related to initiatives surrounding those things.

Jeff Evanson - Dougherty & Company

I guess you are not anticipating any significant distributor programs in 2008?

Robert F. Gallagher

Not outside of our current normal run rates.

Jeff Evanson - Dougherty & Company

Does it make sense or are you telling us you are going to be changing your commission structure so you can add more visibility into that?

Robert F. Gallagher

Well, what I said is I think we haven’t changed what we did in our commission structure in 2007, in terms of what we set for our commission structure, without having any new products on board on the high-end for the past 18 months and the loss of Objet with $16.4 million in sales. We had a very nervous sales team in 2007 and it was unclear what was the appropriate level of quotas to set for them given the loss of Objet and the commission percentage.

And we wanted to make sure we maintain those people because we have a really good sales team. So, in essence, I think we gave fairly low targets for those people relative to what their performance was and again geographic dispersion of that, you have people that exceed their quotas and some people tended to be under their quotas. And we have accelerators, once you go over the quarters, which will skew the commission expense relative to the overall sales dollars.

S. Scott Crump

But that was very appropriate for 2007.

Jeff Evanson - Dougherty & Company

I guess what I’m wondering is does it make sense to change the commission structures so you have more visibility I understand the challenge of knowing who all achieve quota. And this is the second time this has happened and in the past year.

Robert F. Gallagher

I won’t say that the second time it has happened in the past year. It certainly happened in the company’s history before. Jeff, all that I can say is that given the number of new product introductions that we’ve had we’ve got a full rebound high-end product line and we feel confident in the product line and where we’ve set our structure for 2008.

Operator

Your next question comes from the line of [Amit Kamat] -Capital Investment Service.

[Amit Kamat] -Capital Investment Service

My first question relates to Arcam, looking back at your past comments over the last several quarters and the optimizing that you expressed both for the technology as well as the distribution opportunity. What was it that ultimately drove the decision to discontinue the agreement?

S. Scott Crump

First of all Stratasys in Arcam, we are interested in merging. And part of the distribution process was to understand a complicated technology, a good technology but a complicated one, for some very targeted but complicated applications, one in medical and one in aerospace.

And over a two-year period, I will say an assessment period; we are only able to sell eight systems to early adopters. And not get into the early majority with multiple systems per site and of course the corresponding low amount of revenue and the assessment for 2008 and 2009 were that it was going to continue to be, actually not just in the US but worldwide a sale to early adopters which is different from what we had anticipated when we went into the agreement.

So we logically pulled out of that, believing that we would not sell a significant amount of systems or better way of saying is customers would not buy a significant amount of systems. Very typical of early adopter or you know a technology S-curves that take a while for adoption.

I do believe that long-term, there is a significant direct digital manufacturing application for the Arcam technology. But I guess we’re not willing to wait for that as a distributor.

Robert F. Gallagher

One other component to that in May of 2007, Arcam introduced a new system, the A2, and the average price point for the A2 was approximately $200,000 higher than their 400 with [inaudible] system before. And people liked the functionality that came with the A2 but and so it really quelled some of the interest in the 400 because they like the technology for the A2 but most people were finding not willing to pay that price point to date for that product.

S. Scott Crump

Which accelerated our decision.

[Amit Kamat] -Capital Investment Service

My second question relates to your reseller distribution network there. A few companies involved in what I would consider adjacent spaces for you and they’ve commented that they are seeing some consolidation among resellers. Are you seeing any consolidation out there within your network of resellers?

S. Scott Crump

And both the reseller dealer networks have always been dynamic. I was a reseller for SGI and Stratasys was a reseller for SGI and it’s a constant, not maybe for quarter but for year. But within our reseller locations around the world, we continue to grow that and we are not seeing that, well let’s say a negative dynamic, I guess we are seeing a positive dynamic by dealing with only pickup new resellers globally but then also train them.

But the nature of a reseller is more dynamic than typically a direct sales force. But we think it applies for the type of growth that that we won it on a global basis, because we are selling in and servicing in, I believe, 71 countries now.

Robert F. Gallagher

But the shorter answer is we haven’t seen much consolidation in our reseller network.

Operator

Your final question comes from the line of Clinton Morrison - Feltl & Company.

Clinton Morrison - Feltl & Company

Back to the reseller meeting didn’t find out when it was going to be relative to last year. We are obviously kind of trying to figure out when that sort of bulge comes through for the deal you offer?

Shane Glenn

Yes, Clint, I think we’ve indicated that we had a quiet principals only meeting earlier in the month where in each region the 1200es was introduced to them and we took orders for that system.

Clinton Morrison - Feltl & Company

So essentially that positive effect of the reseller meeting has already occurred.

Robert F. Gallagher

We would actually expect to have a full-blown or typical reseller meeting in the later part of the year.

S. Scott Crump

That meeting is for all, it’s a much wider meeting. We wanted to get the product out there and introduce that to a smaller group and that’s what we did in February.

Clinton Morrison - Feltl & Company

So, what I’m trying to get at is the impact of the offering on the extended terms has already been put forth for you reseller group. That’s what I want to know.

And then secondly, absolute commissions are going down, I assume your sales force isn’t decreasing, so essentially they have all taken a pay cut on average this year?

S. Scott Crump

Well, no not at all. Their overall volume having to the whole corporation seven products, their potential has gone up significantly and we’re well positioned for 2008. So they all should do very, very well.

To the comment on 2007, we are in a position of transition and so we increased things like our accelerators for those that got above the quota point, in terms of commission, but that was adjusted back down to a more normal level for 2008.

Robert F. Gallagher

They had a boom year in 2007-08.

Clinton Morrison - Feltl & Company

So the bonus in 2007, but their overall compensation will be lower in 2008.

Robert F. Gallagher

Right, yes, it will still be extremely lucrative for them.

Clinton Morrison - Feltl & Company

Final question, tax rate for the year?

Robert F. Gallagher

There is a question coming out of the shoot of whether the R&D credit will be around in 2008 or not at least initially in the year. I would estimate 33% to 35%.

Operator

Ladies and gentlemen this concludes all the time we have for questions. I will now turn the call back to Mr. Scott Crump for closing remarks.

S. Scott Crump

In closing we believe, we are in the early stages of a tremendous growth opportunity. When you include the two new 3D printers introduced today, we now have seven new systems, more new systems than any other time of our company’s history.

We look to maintain the positive momentum in our core businesses including 3D printing, high-end systems, and RedEye paid parts and expect the strong growth in our high margin proprietary consumable business to continue with our growing installed base of active systems.

In addition, we are excited about our new product offerings and strategic initiatives that should provide incremental growth opportunities. I would like to thank you for your interest in Stratasys, and we look forward to speaking with you again in May. Thank you.

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Source: Stratasys, Inc. Q4 2007 Earnings Call Transcript
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