Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message| ()  

Executives

Vic Allgeier - IR

Keith Bair - SVP and CFO

Jay Freeland - President and CEO

Analysts

Mark Jordan - Noble Financial Group

Ian Fleischer - FBR Capital Markets

Jeff Bash - - Private Investor

Richard Eastman - Robert Baird

James Gentile - Newland

Gregory Macosko - Lord Abbett

FARO Technologies (FARO) Q2 2008 Earnings Call Transcript July 30, 2008 11:00 AM ET

Operator

Good morning everyone and welcome to the FARO Technologies conference call in conjunction with its second quarter 2008 earnings release. For opening remarks and introductions, I will now turn the call over to Vic Allgeier. Please go ahead.

Vic Allgeier

Thank you and good morning everyone. My name is Vic Allgeier of the TTC Group, FARO's Investor Relations firm. Yesterday after the market closed FARO released its second quarter results. By now you should have received a copy of the press release. If you have not received a release, please call Darin Sahler at 407-333-9911. The press release is also available on FARO's website at www.faro.com.

Representing the Company today are Jay Freeland, President and Chief Executive Officer and Keith Bair, Senior Vice President and Chief Financial Officer. Keith and Jay will deliver prepared remarks first and will then be available for questions.

I would like to remind you that in order to help you understand the Company and its results management may make some forward-looking statements during the course of this call. These statements can be identified by words such as we expect, we believe, we predict, we target, our growth targets, our goals, our guidance, and similar words. It is possible that the Company's actual results may differ materially from those projected in these forward-looking statements. Important factors that may cause actual results to differ materially are the risk factors set forth in yesterday's press release and in the Company's filings with the SEC.

I will now turn the call over to Keith.

Keith Bair

Thank you, Vic and good morning everyone. Sales in the second quarter of 2008 were $57.7 million, a 21.4% increase from $47.6 million in the second quarter of 2007. On a regional basis, second quarter sales in 2008 in the Americas increased $300,000, or 1.5%, to $20.2 million compared to $19.9 million in the second quarter of 2007.

Sales grew 41.4% in Europe to $27 million from $19.1 million in the second quarter of 2007. Sales in the Asia-Pacific region increased 22.1% to $10.5 million from $8.6 million in 2007. The effect of changes in foreign exchange rates on sales was an increase of approximately $4.5 million in the second quarter of 2008.

New orders grew 16.5% in the second quarter of 2008 to approximately $58.7 million compared to approximately $50.4 million in the second quarter of 2007. On a regional basis, second quarter orders in 2008 in the Americas declined 1.5% to $20.2 million compared to $20.5 million in the second quarter of 2007.

Orders increased 32.9% in Europe to $27.5 million from $20.7 million in the second quarter of 2007. Orders in the Asia-Pacific region increased 19.6% to $11 million compared to $9.2 million in the year ago quarter.

The top five customers by sales volume in the second quarter of 2008 Komatsu, BMW, Daimler, the Boeing Company and Toyota and represented only 3.8% of sales. The top 10 customers in the second quarter of 2008 represented only 6.9% of our sales once again indicating our lack of dependence on any one or a handful of customers.

Our gross margin was 62.8% in the second quarter of 2008 compared to 61.3% in the year ago quarter. This increase was due to a change in the sales mix resulting in an increase in unit sales of product lines with a lower than average unit cost than in the prior year period and as a result of continuing productivity improvements.

Selling expenses were 29.6% of sales in the second quarter of 2008 compared to 29.4% in the year ago quarter, primarily due to an increase in sales and marketing personnel.

Administrative expenses in the second quarter of 2008 were 12.1% of sales compared to 11.6% in the second quarter of 2007. General and administrative expenses in the second quarter of 2008 increased by $1.5 million primarily related to increased compensation costs, expenses related to additional lease space an increase in the allowance for doubtful accounts and travel-related costs, offset by a reduction of professional fees related to the FCPA matter and patent litigation.

Research and development expenses were $3.2 million in the second quarter of 2008, or 5.5% of sales, compared to $2.3 million, or 4.8% of sales, in the second quarter of 2007. This increase is primarily related to compensation expense and reflects the Company's continued investment in new growth platforms.

Operating margin for the second quarters of 2008 and 2007 was 13.6% as a result of the previously mentioned increase in gross margin offset by slightly higher selling, administrative and R&D expenses.

Income tax expense was $1.5 million in the second quarter of 2008 compared to $1.4 million in the second quarter of 2007. The Company's effective tax rate for the second quarter of 2008 decreased to 19.3% compared to 19.6% for the second quarter of 2007.

The Company estimates its effective tax rate will be approximately 18% to 22% for the remainder of 2008. However, the Company's tax rate could be impacted positively or negatively by geographic changes in the manufacturing or sales of its products and the resulting effect on taxable income in each jurisdiction.

Net income was $6.4 million or $0.38 per share in the second quarter of 2008 compared to $5.8 million or $0.39 per share in the second quarter of 2007 marking our 24th consecutive profitable quarter.

The number of fully diluted shares outstanding in the second quarter of 2008 was $16.8 million compared to $15 million in the second quarter of 2007. The increase of approximately 1.8 million shares is primarily related to the sale of 1.65 million shares of common stock in the Company's registered direct offering in August 2007 and the exercise of stock options by employees throughout 2007.

I will now discuss a few balance sheet and cash flow items. Cash and short-term investments were $94.6 million at June 28, 2008, compared to $103.2 million at December 31, 2007.

Accounts receivable was $52.8 million at June 28, 2008 compared to $54.8 million at December 31, 2007. Days sales outstanding at June 28, 2008, decreased 83 days from 84 days at December 31, 2007.

Inventories increased to $50.6 million at June 28, 2008 from $40 million at December 31, 2007. The increase in inventories was primarily related to an increase in raw materials and finished goods as well as an increase in demo inventories related to both the increase in account managers and the additional new products carried by many of them.

Finally, I'll conclude with some statistics regarding our headcount numbers. We had 869 employees at June 28, 2008 compared to 780 at December 31, 2007, an increase of 89 or 11.4%. Account manager headcount increased from 149 at December 31, 2007 to 162 at June 28, 2008 with 58 account managers in the Americas, 54 account managers in Europe and 50 account managers in Asia. Geographically, we now have 410 employees in the Americas, 277 employees in Europe and 182 employees in the Asia-Pacific region.

I will now hand the call over to Jay.

Jay Freeland

Thanks, Keith. This was another successful quarter for our Company. We achieved double-digit growth in orders, sales, gross margin and net income despite the difficult economic conditions being faced by many of our customers and in several of our markets. Global demand for FARO's products is as strong as it's ever been.

What we've seen, however, is that despite the continued demand the time it takes for our customers to make their purchasing decisions has extended. Our opportunity pipeline continues to grow particularly in qualified leads which indicate a pull from the customer rather than a push by us.

During the first quarter we talked about customers who are sitting on their hands. We continued to see that in the second quarter, as well. In our estimate, it may take a couple of quarters for that to return to normal. As a result, we have lowered our revenue guidance for 2008 from growth of 20% to 25% to growth of 15% to 20%.

From what we've seen in the market, this is an issue relating primarily to weakened economic conditions and has nothing to do with the long-term growth potential of FARO. We believe and are confident that the available market remains significantly under-penetrated and overall this is still a growth Company.

Despite the current economic conditions, we were also able to maintain our strategic balance of generating 50% of our sales from new customers and 50% from existing customers during the second quarter. That keeps us at the same ratio year-to-date which has also been the same ratio for several years now.

The new customer adoption rate continues to be important in driving the adoption of our technology as a global standard. Our ability to maintain the 50/50 ratio is a reliable indicator of the clear market need for our solutions and reinforces our belief as to how under-penetrated our space really is.

We had another nice increase in gross margin this quarter. At 62.8% for 2Q and 61.6% year-to-date, we continue to benefit from solid price levels, real product cost productivity and well-balanced mix.

You'll note in our earnings release that we have not yet adjusted our gross margin guidance for 2008 despite being well above our guided range of 58% to 60%. Though I believe we will continue to see strength in gross margin, I also want room to be flexible in the second half of the year. A little bit of that is simply tied to some of the economic uncertainty. However, that flexibility also gives us the ability to continue testing our products in the marketplace with new channels and additional personnel as well as understanding new niches, competitive strengths and optimal price value equations.

As a Company with significant growth potential, these are actions we should and will continue taking to drive further acceleration of the top line. As a percentage of sales, selling expenses remained flat between the second quarter of 2007 and the second quarter of this year at approximately 29%. I continue to get questions asking when this number will decline meaningfully and I continue to have the same answer. I don't know. That's not the answer everyone loves to hear but it's also as open as I can be about it.

I believe that 25% selling costs is a good target to shoot for. However, at present, our direct model is still the most reliable way to drive sales growth and control our own destiny. I have been consistent in my view that I won't sacrifice this line as a percentage of sales in the near-term if I believe it will, in any way, shape or form, inhibit our sales growth.

If we weren't still so under-penetrated, I would have a very different view. However, the facts remain that strategically and tactically we need to continue adding sales personnel and, in fact, will continue to do so. We have two engines to drive growth in this space, the technology itself, which provides so much customer value and the sales and marketing organization which thrives on making sure every last customer knows what that value will mean to them.

In that regard you will see that we've also continued to feed the R&D machine with new cash and new technology. Near the end of last year I started signaling that our R&D expenditures would climb over the coming quarters as we accelerated several new product developments.

We still believe that 5% to 7% of sales is the right level of R&D for this Company and we anticipate that our current spending will continue within that range. In addition to the work we're engaged in on our existing products, we're making progress in getting the team established for our new 3-D imaging technology acquired in our transaction with DPI. We have a new engineering leader in place for that technology as well as key product managers and have received very good responses on the open engineering positions which will round out that team.

As a reminder, establishing the team is the most critical step at this point given that the acquisition was for patents and technology only and no people. As I indicated during our last call, this new non-contact technology adds significant growth potential for FARO. It is highly accurate and unique in its class. We have identified five different platforms from which to launch the application development of this technology, all of which could be game changers in the marketplace.

I'll continue to remind everyone that we don't expect any meaningful revenue from the new 3-D imaging technology for at least 12 to 18 months. Then again, our current growth plans don't require meaningful revenue from this technology anytime soon. What we have with 3-D imaging is an opportunity to add to the overall growth of FARO.

In summary, I'd like to reiterate the overall strength of this Company and the opportunity that sits in front of us. We have a world class team with world class products. Our market opportunity remains significant and continues to grow as we identify new applications and new ways to utilize our technology.

Despite some of the near-term economic uncertainty around the world, we're continuing to invest in the Company, we're investing in our growth platforms including additional engineering, sales and marketing talent and this is really the time to invest.

We have not seen any indications that we shouldn't be as aggressive as we've always been and will continue to update or we'll continue to do so confidentially and we'll continue to update all of you as we progress.

I'd like to thank the FARO team for another successful quarter and, as always, I'd like to thank our investors for your continued confidence in FARO. I appreciate your attention and I'll now open the call to questions.

Questions-and-Answer Session

Operator

(Operator Instructions) We'll take our first question from Mark Jordan from Noble Finance. Please go ahead.

Mark Jordan - Noble Financial Group

Good morning gentlemen, first a question relative to G&A expense. You mentioned a couple of reasons why it was higher. Could you quantify what was the lease expense and specifically where was that incurred. And secondly, the doubtful account reserve, how large was that? And how many potential clients were in that reserve?

Keith Bair

Hi, Mark. It's Keith. Let me just run down some of the numbers that you'll see in the upcoming 10-Q. For the quarter, the increase is primarily related to compensation, about $700,000, $300,000 related to additional lease space, which is here in Lake Mary, the allowance for doubtful accounts increased by about $300,000. That was actually global. That was in all three regions. I don't have the specific number of customers but we're taking a little bit more of a conservative stance on that account. As well as additional travel-related costs, approximately $200,000.

Mark Jordan - Noble Financial Group

Yeah, as I remember on your longer-term plan that G&A is kind of targeted at 10% of revenue, clearly this is a step up and given the fact its lease and comp those parts will be sticky, obviously. When do you see improvement in that metric relative to sales?

Keith Bair

I think we still have a target model out there that shows where the end of -- exiting 2009 for that target to be approximately 10%. So that's the target that we're shooting for right now.

Mark Jordan - Noble Financial Group

In terms of the lease space, what have you done there and how long will that take care of your incremental square footage needs in Lake Mary?

Jay Freeland

This is Jay, Mark. The expansion here we have, we'll end up with three buildings in the Lake Mary complex and what we have now is you'll have an operations center which will have some expanding manufacturing capacity. It's just our current building. Many of us will move out of this building to make room for that space. We have an engineering center next door and then we will have a new headquarters, sales and marketing and customer training center, as well. And that will make up the three different buildings.

Mark Jordan - Noble Financial Group

Could you also talk a little bit about what you characterize the lengthening of the marketing cycle? Could you quantify that and compare what you're seeing in the U.S. to what your European and Asian sales forces are seeing?

Jay Freeland

Yes. In reverse order we'll say that we've not necessarily seen the lengthening in Europe or Asia at this point. Obviously, there are several questions about general economic conditions in Europe and we talked before in the last call, I think, that we were seeing a little bit of it in Italy, Spain and the UK and France, in some respects, as many companies were.

There is, obviously, some concern relative to Germany on -- again, on a pure economic standpoint although I can't say that we've seen that. And, like I said, we have not seen the lengthening there. The lengthening has definitely been in the United States.

Quantifying it is difficult. Typically, an Arm transaction will run anywhere from, say, 60 to 90 days and a Tracker transaction will run anywhere upwards to sometimes as long as six months when things really get moving. It is definitely extended longer beyond that.

In some cases, the customer is still physically sitting on their hands so it's hard to say what the actual end date is where they finally pull the trigger which establishes what that new timeline is. And again, we believe that's a near-term issue only and primarily related to -- it's that economic uncertainty of what is their own company doing, what are some of their customers doing.

Like I said, the door into the pipe is still flush and in fact, the qualified leads where customers are pulling from us instead of us pushing to them have definitely increased. It's just a little bit slower coming out the other side, the actual orders that are booking.

Mark Jordan - Noble Financial Group

If my numbers are correct, you've got backlog of about $21 million going into the third quarter versus $11 million a year ago. Your backlog has been up since you exited last year. Why has that lengthened? Or why is the delivery cycle lengthened this year versus last year?

Jay Freeland

I can't necessarily say that the delivery cycle has lengthened at all. Clearly backlog is increased. We're going into each quarter with, say, three weeks worth of revenue give or take. That is up a teeny bit but then, again, and as we've talked about before we always try to target two and I still think that's a good target to shoot for. There's a question mark as we've gotten bigger of would three become a more appropriate number and I just don't-- we don't have a good answer for that yet.

Some of it, certainly, you have backlog relative to customer training, you've got backlog relative to extended warranties and things like that that obviously go into the number. But the delivery cycle, itself, is still -- our standard quota is still four weeks and we still have the ability to deliver. If a customer places the order today, we have the ability to ship tomorrow if they absolutely, positively needed the product tomorrow. So that flexibility in our model continues to be there.

Mark Jordan - Noble Financial Group

Final question, if I may. I've seen a quote of a patent suit by Metrics filed against you. Can you give us some details on that, please?

Jay Freeland

Sure. We did receive notice. The company is Metris. It's a Belgian-based company, publicly traded, have been for a couple of years there, smaller company than FARO. We did receive notice that they filed a patent suit against us. The claims are related to our ScanArm. The suit's only been filed. It has not been served at this point which is, obviously, of some importance. We also consider it to be immaterial.

As a result, number one, obviously we did not disclose it publicly. The claims are extremely vague and the other thing is, the best we can tell, this is filed in response to a patent we actually asserted against them back in January for claims that were very specific and related to the new Arm product line they have when they acquired a company called Garda.

So, at this point we're simply reviewing the claims and there's really nothing to it. Like I said, immaterial to the Company and, obviously, we'll keep everybody posted as it goes but like I said, I truly believe this is in response to the patent we asserted against them in January.

Mark Jordan - Noble Financial Group

Thank you.

Jay Freeland

Thanks Mark.

Operator

We'll take our next question from the side of Ian Fleischer from FBR Capital Markets. Please go ahead.

Ian Fleischer - FBR Capital Markets

Hi good morning.

Jay Freeland

Hi Ian.

Ian Fleischer - FBR Capital Markets

Noting the reduction in the sales guidance, do you still feel that the long-term growth of your business overall is still in that 20% to 25% range?

Jay Freeland

Yes. At this point, and that's the, obviously, the long-term model we've had out there calls 20%, 25%. And that's still the model that's sitting out there. What we're going through right now, for me, I try my best not to be disappointed of growth that's in the 15% to 20% range. We certainly believe long-term this is 20-plus percent growth as a Company in terms of what we can achieve. And in some respects look, even in the current year, there are still scenarios that would put us over the 20% mark, as well. But what we're trying to do is, based on everything that we see, we're just trying to be as realistic as possible, also.

So, even in the current environment, though, this should be a 20-plus percent Company and could be, and certainly longer-term we believe that's the case.

Ian Fleischer - FBR Capital Markets

And maybe touch on the tone of your customers in -- late in the quarter, maybe in June, as far as the US goes?

Jay Freeland

Yeah, it's interesting. The tone is the same as it's been for most of the year and really still the same as it's been for as far back as I can remember which is very, very positive on the technology, understanding the need for the technology, the desire to bring it in and it's this one piece that's different is the, "Yeah, but gosh, there's so many things going on in the marketplace. We don't know what's happening in the economy. We see some of our customers struggling. We see some of our suppliers struggling." That decision making process clearly has slowed.

No doubt we've always been a bit of a CapEx-driven Company despite the low price point on the products where customers would wait until that final couple of weeks and wait to see if they still had the CapEx to use. And many of them are now saying, "Well hey look, we know we don't have it this quarter and management has pushed it to next quarter." We're definitely seeing that and that's some of that elongating of the cycle but that is primarily, I mean that's the biggest difference that we see.

And obviously, some of the big companies that have been affected in the auto space, the aerospace areas that have been affected in some respects with the economy, they are still buying. You still see a couple of them showing up in our top five list. So, it's really more just that extension.

Ian Fleischer - FBR Capital Markets

And then maybe just switch to Europe. You were a bit cautious there. Can you just provide a little bit more granularity on that? Is it something you're seeing specifically in specific countries or is it just more of a broad cautionary type stance you are taking?

Jay Freeland

Yes. It's definitely broad and I'll say that it's mildly cautious at best. I do understand and certainly we've all seen in the last month or so some new economic data that there's some concerns over in Europe. The only difference, though, from what we had seen previously, like I said, Spain, Italy, UK, France we know have had some economic struggle already this year. The impact to us has been minimal and in some cases there's been zero impact.

Germany is a larger country for us, a larger country for many. It is obviously, the primary industrial hub over there. There have been some economic concerns raised there so that's why I say that it's economic first. I've not seen anything there that would indicate otherwise from that team and from our customers and it's more just a little bit of like I said, very, very mild cautionary stance.

Ian Fleischer - FBR Capital Markets

Okay, great. Thank you very much.

Jay Freeland

Thanks Ian.

Operator

We'll take our next question from Jeff Bash who is the Private Investor. Please go ahead.

Jeff Bash - Private Investor

Good morning Jay. With respect to this Metris suit, I know they are seeking an injunction in triple damages but could you characterize the ScanArm business that they are going after? Is that really a material product or not?

Jay Freeland

Obviously we don't disclose any of our revenue by product line. So, without trying to go there what I'd say is, we understand, obviously, what they are claiming and what they are searching for. It is our view, based on -- and it's certainly not in our review it definitively, based on the definition of what constitutes material or not material, that this is not material even based on what they are asking for.

Jeff Bash - Private Investor

Okay, good. Are short-term investments still in the muni-bonds with the put feature that you had at the end of the first quarter? And if so, are you comfortable with the credit quality of the bank you the put with?

Jay Freeland

They are and I'll let Keith talk to that first.

Keith Bair

Yes. We still have a variable rate demand bonds that are tax exempt municipal securities. It still has the put feature of five days. They are back by a letter of credit by SunTrust and we're still very comfortable with SunTrust.

Jeff Bash - Private Investor

Okay. Given the sales are coming in a little bit below the original plan, will sales compensations as a percentage of sales tend to be higher or lower or no different than plan?

Jay Freeland

In general I'd say it's, number one, it's a little bit hard to predict because we're obviously still adding account managers as we go because it is, look, despite some of the economic conditions, it really is the right time to continue investing in the Company particularly on that side of the business because there's so much opportunity out there.

So, it's as much a timing factor as anything else. Obviously if sales end up a little bit lighter than the original 20% to 25%, so we're in that 15% to 20% range, then on a dollar basis they come down in some respects proportionately because we have a highly commissioned sales force. If we've got a few more of the new people on board in the latter half of the year here, they are all on a draw at that point and not contributing to that 15% to 20%. So, it could go up a little bit, it could go down a little bit. That one is hard to predict. But generally speaking where we are right now I don't think it will swing necessarily in a dramatic fashion either direction in the next two quarters.

And there's a piece in there, obviously, which is purely tied to marketing expense which is variable, other than the people, it's variable from the standpoint of what we choose to spend it on and where we put it. And obviously, even in this environment we're going to continue to market the products because there's so much opportunity.

Jeff Bash - Private Investor

Now you commented on the increased level of inventory versus six months or so ago. But I also notice that the inventory to sales ratios are also running higher than previously. Could you comment on that?

Keith Bair

Yes, you're right. Inventories are a little bit higher, our finished goods are up, our raw materials are up, the sales numbers are down. We level loaded our manufacturing build in anticipation of hitting our quarterly targets. We're pulling back on some of our raw material vendor commitments but, as I mentioned during the call, a piece of that is also tied to the increase in the demo inventories as well as a result of adding new account managers and some of the new products that many of these account managers are now carrying with them.

Jay Freeland

Yes. I think it's interesting, this is Jay, Jeff. The balance there is definitely -- there's kind of a fine line that we walk. The finance side of my head, of course, says that I want to make sure that we're not mismanaging the capital, so to speak, by carrying too much inventory. The front-end sales side of my head which recognizes that, though we've lowered the revenue guidance for the year, looks at some of the scenarios that say we could still end up back in that original range with a variety of different things happening.

So the sales side of my head says I don't want to cut that line too close if the volume continues to come there. So we're monitoring that very closely, like Keith said, particularly on the front-end with raw coming in at this point.

Keith Bair

Yes. The cost of losing a sale is more than carrying a little extra inventory unless you have a real inventory obsolescence issue.

Jay Freeland

Exactly. Which we don't, so.

Jeff Bash - Private Investor

And finally, you've previously stated that the FCPA oversight expense would be roughly $2 million over a couple of years. Has that kicked in yet and if not when do you think it will and how do you think that will be spread out over the next couple of years. Is it all front-loaded or what?

Jay Freeland

Yes. It has not kicked in yet. Where it stands is that we have made our, we've interviewed several potential monitors that we believe would be acceptable to the DOJ. We have made our recommendation and will wait to get, we will formally present that to the Department of Justice and then we'll wait to hear their word. We anticipate that that should be relatively quick once we put that in front of them.

The way it is structured, the requirements are that the monitor will have to provide a first report within 120 days of the engagement and then there will be subsequent follow-up reports. There will be two follow-up reports after that or three really if you include the end report, over the remaining 18 months or 20 months of the life of the agreement.

So, we would certainly anticipate once the monitor is on board I think you can anticipate there would be a spike in cost in the near-term to get that first 120 days done. How much of the $1 million to the $2 million constitutes the spike obviously is hard, hard to determine, but you've got to assume that there will be a decent portion of, say, at least that first million is in that time period.

And then, we'll get a little bit better feel for that when we all talk again at the third quarter call. I certainly anticipate that the monitor will be on board and doing their work at that point. So, we'll have a feel for what it's been for sure and what we think, perhaps, the run rate is. But that's, I think, what we can expect here at least through the end of the year of how that looks best that we know.

Jeff Bash - Private Investor

So, are you saying that, if I get you right, that the spike is likely to cover some point in the third quarter to some point in the fourth quarter?

Jay Freeland

Yes. I think, a little bit certainly in the third quarter and I certainly believe that we'll see a lot of activity in the fourth quarter given that, again, based on when the engagement actually starts, roughly the first 120 days is going to -- that report will end up being due right around year-end give or take a couple weeks.

Jeff Bash - Private Investor

Okay, thanks a lot. You really had a pretty decent quarter.

Jay Freeland

Thank you, Jeff.

Operator

We'll take our next question from Richard Eastman from Robert Baird. Please go ahead.

Richard Eastman - Robert Baird

Keith, could you perhaps give us a local currency growth rate in sales for Europe and Asia? Do you happen to have that?

Keith Bair

Yes. What we talked about and what I mentioned during the call was a combined, we don't break it out by region. But for the second quarter of '08 the effect of the foreign exchange rate changes in both Euros as well as the Asian currencies was about $4.5 million.

Richard Eastman - Robert Baird

Alright, okay. Alright. And then also, Jay, on the sales mix and the richer gross margin that it delivered, can you just give us a feel for which areas outgrew the corporate average?

Jay Freeland

Let me think about that for a second given my unwillingness to disclose revenue by product line. Look, we've said before that from a gross -- the rank order from a sales standpoint is still Arm first, Tractor second, Gage third and Laser Scanner fourth. Within Arm include the ScanArm. So, there are elements within Arm that have higher gross margin than others and obviously you would say that some of those were at a faster clip than other pieces of the Arm business. And obviously, I think that's the way to look at it. A decent amount of it certainly came from the Arm side of the house.

Richard Eastman - Robert Baird

And then, I guess, given the top five customers, Tomatsu, BMW, Toyota, even Daimler, again, maybe more Arm customers, I guess Boeing is in there on the Tractor side, perhaps?

Jay Freeland

Yes. It's not to say they are purely Arm customers. All of those folks do use Tractors as well but obviously based on the type of manufacturing they do, Arm is a more likely product or more common product for them.

Richard Eastman - Robert Baird

Okay. And then when you talk to the 15% to 20% growth rate going forward, we obviously are calling for the weak US. It's not clear to me. So, how are you viewing Europe, then? Are you assuming Europe is a little tougher sale or a little longer sales cycle or are we watching it with some risk to that low-end 15% number if Europe slows?

Jay Freeland

Obviously, no doubt we've tried to factor in what we're seeing in the US. When you look at the scenarios, we have scenarios that assume Europe does slow down a little bit and we have scenarios that assume Europe is kind of maintaining the pace that they are at today. And we've tried to factor those in and that's what helped us develop the 15% to 20% and feel like that was the right number to go to.

Like I said, we've got a couple of scenarios that include clipping over the 20% mark again but that scenario would include a little bit of pick-up again in the US.

Richard Eastman - Robert Baird

Okay. So, the 15% number assumes some slowdown in Europe. The 20, maybe, is maintained growth?

Jay Freeland

Right.

Richard Eastman - Robert Baird

Okay. I understand. And then, let me ask you, again, speaking to this 15% to 20% sales target going forward. How committed are you to showing leverage at the operating profit line on even a 15% number? And again, I understand the growth investments but paying attention to the growth investments, are you extremely committed to showing some operating leverage off of a 15% growth rate given that it's below the initial 20% to 25%?

Jay Freeland

Here's how I will word it. I am committed to trying to get operating leverage and certainly get it in areas that we believe are appropriate. So, I am committed to that. I am extremely committed to the ongoing top-line growth of the Company and technology development related to the Company. The top-line growth, again, if it wasn't so under-penetrated I wouldn't have nearly the same vigor in my view of what we want to do there.

So, and as I said, would I sacrifice the sales and marketing line knowing we could drive it down? With relative ease we could drive that number down as a percentage of sales but I think, I believe it would sacrifice growth. In fact, I'm certain it would sacrifice growth given the way our model works. So, it's one of those where no doubt I am not going to be afraid to invest there. And like I said, if you were to pick the adjectives, I am extremely committed to driving that top-line and committed to delivering margin in the areas that are not necessarily what I would see as a one-for-one correlation or close to a one-for-one correlation to the growth.

Richard Eastman - Robert Baird

But do you feel, I mean, I guess maybe another way to phrase it is do you feel that the investment to drive 15% growth is going to exceed that level? In other words, is it going to take us 25% increase in selling, marketing, to drive a 15% growth in a tough market?

Jay Freeland

I believe that the sales expenses as a percentage of sales running this kind of 29% to 30% we're at right now, I certainly believe that level is necessary for the 15% to 20% and much of that is because of the current environment because I would say that the 15% -- that the 29% to 30% we're at in the normalized environment should be sufficient to drive the 20% to 25%. I probably would look at it that way.

Richard Eastman - Robert Baird

Alright. And so, when you sit in front of the Board, let me just get to the net income line. Do you, in an environment like this when things are tightening up, do you still anticipate or expect or plan for growth in net income year-over-year in a slightly reduced growth market, not down, but slightly reduced growth outlook?

Jay Freeland

Given that we don't give guidance to net income, I won't talk specifically to it. But no question we still expect to grow some net income as a Company. Obviously, some can be a very broad range so please don't read that the wrong way, but obviously we expect to get net income growth just like we expect to get the top-line growth. And again, the biggest key is we are not afraid to continue investing in what it takes to drive the growth side of the equation because we really know that it's there.

Richard Eastman - Robert Baird

Okay, alright. Thank you.

Jay Freeland

Thanks Ric.

Operator

We'll take our next question from the side of James Gentile from Newland. Please go ahead.

James Gentile - Newland

Good morning guys.

Jay Freeland

Good morning.

James Gentile - Newland

I was just wondering if you could break out the expected interest income rate for the balance of this year?

Keith Bair

Well, I can tell you where it is right now. It's roughly 1.7% tax exempt.

James Gentile - Newland

Got you. Where I was off in my model was the million bucks, maybe a little bit less than that, on the R&D and I was a little bit high on the interest income. I mean, you guys would have put up a solid number over $0.40 for the quarter given the sales line. If I look at, you know, you kind of hinted toward the arm mix driving gross margins to this low-60 range which is above your target. How could we look at the second half gross margin trends? Jay, are you interested in driving top-line growth at the expense of a couple of points of gross margin?

Jay Freeland

Interested is probably not quite the right adjective. However, if I felt it was necessary, yes, we would do that. And that's one of the reasons that the range, we've kept the range at 58% to 60% even though we're sitting at 61.6% year-to-date. I will say that price in the marketplace continues to be low on the decision factor tree. There are three or four other things that customers, the feedback that we get, it's always these other three or four. Accuracy, reliability, usability, those are the things that continue to drive the decision making process primarily.

But what it does do, the flexibility side of it that I'm looking for is if there was an opportunity, say, with one of the newer products or any specific niche application or a niche industry that we were trying to get in, this is some of the -- call it experimenting, call it testing, whatever you want to call it, would we move price and test that as one of the variables? Absolutely, even if we didn't completely have the support of a normalized 60% or 65% gross margin that we see on many of our products.

And that's why I have, still, that flexibility built in there. We believe and we've still said over the long-term plan that's out there and again, calling for as we exit 2009, we certainly believe gross margin sits somewhere between 60% and 65% and obviously, we're certainly well in that range right now.

So that's a round-about way of saying we believe gross margin will still be strong. I just want to have a little bit of flexibility to experiment and test what we can do with it, knowing that price is not necessarily the primary decision factor.

James Gentile - Newland

Could you classify the 15% to 20% range with regard to conservatism? I mean, would you say that we're at 20 basically for the first half. Your orders were up strongly, 17%. You need to see another leg down in the US, for example, or a significant slowdown in Europe for this to happen. It seems like the trends are there, your new products are taking hold, your end market diversification seems relatively robust?

Jay Freeland

I don't think I'd ever use the word conservative because that's just not -- we use.

James Gentile - Newland

Understood.

Jay Freeland

I think what I would say is that the range we'd put out there we feel and believe is an appropriate range given what we see and what we know right now.

James Gentile - Newland

Got you.

Jay Freeland

And like I said, then I'll say the aggressive side of Jay knows that there are some scenarios that could be better than that and then what I believe is the appropriate, without saying conservative because I'll never say that, is the range that we put out, the new range.

James Gentile - Newland

Understood. And then with regard to your -- you did issue stock appropriately, the August period of last year. Are you finding some candidates to add to your product lines out there? We're looking at some significant tax changes that could occur out there with the new administration. Are you getting anymore calls? I even noticed on your website you have a button.

Jay Freeland

I'll say that in some respects the activity -- are we getting anymore calls? I can't necessarily say that we're getting anymore calls. We always get a decent number. As one of the industry leaders you do, actually, as you would expect, you serve as a little bit of a magnet in that regard that you get other companies looking to team up with or become a part of the Company. I would say that the ones that we are looking at, there's still lots of interesting technology out there. Obviously, none of it's been interesting enough to pull the trigger again since doing the DPI deal. But we're always looking.

Every week we sit down and review it. There's that balance between bringing the right stuff and making sure that we don't dilute the focus of the team either. We've got a lot of activity engaged on the new 3-D imaging technology at this point but, yes, that's always the caution.

James Gentile - Newland

That's my final question. What does FARO assess the 3-D imaging opportunity to be in terms of market opportunity?

Jay Freeland

Large. I don't mean to be crass about it. I think there's significant amount of opportunity there. I can't give you a good number now. It certainly helps us serve, we've talked before. There's this broader, you know, the potential market, the addressable market in the overall 3-Dimensional space is maybe as big as $6 billion to $8 billion of potential. No question I believe the 3-D imaging technology helps us serve and address some of that space.

And then as we start, we've got these five different launch pads, so to speak, that we're going to start working on and once we get 9, 12 months out and we've started getting specific on them and we actually have some working prototypes and we're starting to test it a little bit in the marketplace, I can talk a little bit more definitively about it.

No doubt it certainly helps us serve that overall $6 billion to $8 billion, though.

James Gentile - Newland

And that, in no way, cannibalizes your existing technology or customer base?

Jay Freeland

Certainly not the customer base because we do have customers who buy multiple products from us today so it's, in many respects, is a great fit there. I don't believe in the near-term it cannibalizes any of our technology. I believe that the applications we're looking at will be different and things that we would not have been able to serve with the current produce line we have.

James Gentile - Newland

Great. I think you guys did a great job this quarter. Take care.

Jay Freeland

Thanks, appreciated.

Operator

We'll take our next question from Gregory Macosko from Lord Abbett. Please go ahead.

Gregory Macosko - Lord Abbett

Yes, thank you. Just one question to follow-up kind of on Jim's questioning regarding the gross margin. In your comments you talked about new channels or different areas. Are there other opportunities with regard to the products that you have, perhaps different configurations of products that you might look to distributing and selling through a different channel mechanism?

Jay Freeland

That's part of the -- I'd put it in the category of the testing side where, are there some that we're playing with right now? A couple. Are there some that we've got on the board that we're thinking about moving further with? Yes. There's some there, as well. In the near-term, would they generate any type of meaningful shift in the revenue? I don't think so in the near-term. You've got to start the experiment and make sure that, in fact, that the model is right, that the transaction, itself, is right and that the customer value is there, et cetera.

But we do still see some opportunity there. No question I still believe that our direct model of the missionary sales, sending in the account manager, working with the customer, becoming a part of that customer, really becoming a partner with that customer is still the best channel for us hands-down. And obviously, that's why we continue to invest and will continue to invest on that side.

But the others are there. There's enough market opportunity out there for us to start testing and experimenting with them and in some respects a little bit of trial and error. We've got some that we think will be really good and we may find that several of them are not good and we may find that a couple of them really are.

Gregory Macosko - Lord Abbett

But if they make sense on a longer-term basis, are there structure so they would they be any different gross margin? In other words, if it's a new channel does it require a long-term, lower gross margin?

Jay Freeland

Probably way too early to tell. On the gross margin side, perhaps not. Would it change potentially the sales and marketing cost side of the equation? I'm sure you'd expect something there to be a little bit different. But it's probably too early to tell just because not more than 95% of our sales come from the direct sales force today. That will be part of the experiment as we test drive some of these.

Gregory Macosko - Lord Abbett

Thank you.

Operator

(Operator Instructions) we'll take a follow-up question from Jeff Bash who is a Private Investor. Please go ahead.

Jeff Bash - Private Investor

Jay, an observation and a question. With respect to the direct sales model it does offer a competitive advantage if all your customers are expecting the hand-holding that you can provide and would be extremely difficult for any new or other company to provide on the scale you can?

Jay Freeland

Agreed. No doubt there is a competitive advantage there and the relationship side of that, as we've talked, and Jeff you've followed the Company a long time, the 50/50 split between new and existing customers, certainly the new piece, that hand-holding, the missionary sale, introducing what the product is, et cetera., et cetera, is very important. On the existing side because the relationship is developed, that's what you call the true account management where you're in there, you're a part of their life and you're helping them find solutions other places inside the facility where they can use the product. And that one, also, really can't be done unless you've got the person hands-on and being there with them.

Jeff Bash - Private Investor

As to my question, foreign exchange was I think $4.5 million for the quarter which is, I think, a record high. However, I note the dollar, while it dropped a lot in the first quarter was really pretty stable in the second quarter. And if it were to continue stable or even rally in some respect, this contribution from foreign exchange gains to sales would eventually decline. And I'm curious as to how much you've reflected your view of possible dollar effects in your 15% to 20% sales guidance?

Jay Freeland

We have put that in there. Obviously, Jeff, we're certainly not ForEx experts by any stretch of the imagination, but in the scenario that we've put together as I was talking about before, one of the variables that's a part of that is foreign currency, particularly the Euro.

Jeff Bash - Private Investor

So, are you modeling it more likely than not it may come down a little?

Jay Freeland

We have tried that. We have looked at, we have very little that looks at it continuing to grow, although I know that's always a possibility. I've been saying that for a year that it can't possibly go higher, and it does. We certainly have models that show it inside that 15% to 20% but show it going the other direction.

Jeff Bash - Private Investor

Alright. Thanks.

Thanks Jeff.

Operator

(Operator Instructions) It appears that we have no further questions at this time. I will now turn the program back over to Jay Freeland for any closing remarks.

Jay Freeland

Again, well, just in summary, I want to thank everybody again for your participation today and the ongoing support. We look forward to updating you again at the end of the third quarter. And for the FARO team, thanks again for a great second quarter and let's go get them in the third. Thanks everybody.

Operator

This concludes FARO's teleconference. You may disconnect at any time. Thank you and have a great day.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: FARO Technologies, Q2 2008 Earnings Call Transcript
This Transcript
All Transcripts