Proto Labs (PRLB) Q4 2016 Results - Earnings Call Transcript

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Proto Labs, Inc. (NYSE:PRLB) Q4 2016 Earnings Call February 9, 2017 8:30 AM ET

Executives

Jason Frankman - Proto Labs, Inc.

Victoria M. Holt - Proto Labs, Inc.

John A. Way - Proto Labs, Inc.

Analysts

Troy D. Jensen - Piper Jaffray & Co.

Brian P. Drab - William Blair & Co. LLC

Weston Twigg - Pacific Crest Securities

Jon Fisher - Dougherty & Co. LLC

Ethan Potasnick - Needham & Co. LLC

Ben Hearnsberger - Stephens, Inc.

Operator

Greetings and welcome to the Proto Labs Fourth Quarter 2016 and Full Year Earnings Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host, Mr. Jason Frankman, Controller at Proto Labs. Thank you, Mr. Frankman. You may begin.

Jason Frankman - Proto Labs, Inc.

Thank you, Michelle, and good morning, everyone. This morning before the market opened, Proto Labs issued a press release announcing its financial results for the fourth quarter and full year ended December 31, 2016. The release is available on the company's website at protolabs.com.

Before we get started, during the course of this conference call, the company will provide financial projections and make other statements about its business that are forward-looking and subject to many risks and uncertainties that could cause actual results to differ materially from expectations. A detailed discussion of the risks and uncertainties that affect the business is contained in the company's Annual Report filed on Form 10-K and other SEC filings, particularly under the heading Risk Factors.

Copies of these filings are available online from the SEC or on the Proto Labs' website. The company's projections and other forward-looking statements are based on factors that are subject to change, and therefore these statements speak only as of the date they are given. The company does not undertake to update any projection or forward-looking statement.

In addition, to supplement the GAAP numbers, we have provided adjusted revenue growth, adjusted operating income and adjusted net income and basic and diluted net income per share information on a non-GAAP basis. Adjusted revenue growth includes product line revenue that excludes the fourth quarter 2015 impact of unprofitable Alphaform 3D Printing contracts and discontinued non-core resin resale business. Adjusted revenue growth also includes revenue calculated on a constant currency basis for both total revenue and excluding Alphaform revenue for the nine months ended September 30, 2016 to provide comparable year-over-year measures.

The non-GAAP adjusted operating margin and non-GAAP adjusted net income, each exclude the costs of stock compensation, amortization of intangibles, impairment on assets associated with discontinued manufacturing processes, charges related to the exit of facilities and unrealized foreign currency activity. We believe that these non-GAAP metrics provide meaningful supplemental information are indicative of our core operating results and are helpful in assessing our historical and future performance. Tables reconciling GAAP information to non-GAAP information are included in our financial release.

Now, I'd like to turn the call over to Vicki Holt, President and Chief Executive Officer of Proto Labs. Vicki?

Victoria M. Holt - Proto Labs, Inc.

Thanks, Jason, and good morning, everyone. Thank you for joining us on our fourth quarter conference call. With me today is John Way, our Chief Financial Officer.

I will begin with an overview of the fourth quarter results. Then, I'll offer a review of our significant accomplishments in 2016, which have positioned the company well to reinvigorate our top-line growth and to offer our customers expanded services this year and beyond. Then, I will spend a few minutes on key initiatives for 2017. John Way will then provide a more in-depth view of our financials and our outlook for the first quarter of 2017 revenue and earnings. Following his comments, we'll be happy to take your questions.

The fourth quarter financial results continue to reflect the challenges that we faced throughout 2016. Revenue in the fourth quarter was $72.4 million. This was midrange of the guidance we provided, and represented a 2 percentage point decline from revenue in the fourth quarter of 2015. You'll recall that we completed our acquisition of Alphaform in early October 2015. It is now integrated into Proto Labs, and we will no longer be providing its results on a standalone basis. On a year-over-year comparison, however, there were factors related to Alphaform that were significant contributors.

The fourth quarter of 2015 included revenue from unprofitable contracts at Alphaform that we have since terminated. We also discontinued the resin distribution business we acquired. Combined, these items resulted in a $1.5 million headwind year-over-year. In addition, foreign currency had a negative impact on Q4 of approximately $700,000. Adjusting for the 2015 non-recurring revenue and foreign currency, revenue growth was 1% over fourth quarter of 2015.

Looking at a breakdown by geography, revenue in the U.S. increased 1% over the prior year. Revenue in Europe decreased 8.2% in constant currency. Adjusting for the $1.5 million of Alphaform related non-recurring revenue mentioned previously, revenue was flat with the prior year. Japan grew 2.4% in constant currency.

In terms of revenue by services, 3D printing increased 8% from the prior year and it was up 16.6% excluding the unprofitable Alphaform contracts. CNC machining grew 7%. Injection molding was down 5% compared to Q4 2015.

As an on-demand manufacturer, our revenue can vary from quarter to quarter. As we discussed in our guidance last quarter, October was lighter than our historical seasonal pattern, and that continued through the quarter. We believe the lower growth rate experienced in Q4 2016 is consistent with the trends we experienced throughout 2016, with the general economic environment suppressing R&D spending in certain industries. And that was felt with greater impact as we closed out the year.

We remain focused on our growth strategy, which includes expanding our sales to new product developers and expanding the envelope of our services. We've been building our sales team by investing in sales leadership, additional sales representatives, and training. We're focused on improving the efficiencies and the effectiveness of our sales team through disciplined sales execution and use of tools.

GAAP net income was $9.4 million in the fourth quarter or $0.35 per share. On a non-GAAP basis, net income was $10.8 million or $0.41 per share, which was in the range of the guidance we provided.

We continue to experience strong cash generation, with cash provided by operations contributing $8.8 million, resulting in an increase in our cash and investment balances of $17 million in the fourth quarter and $47 million in total for 2016. This strong cash flow resulted in our cash and marketable securities balance increasing to $193 million at December 31, 2016.

As a result of our profitability and strong, consistent cash generation, our board of directors has approved the initiation of a stock repurchase program announced today. Under the program, Proto Labs is authorized to repurchase up to $50 million of our stock over the next five years. We expect to move forward on all our growth initiatives, while also buying back stock at appropriate times in the market. We are very pleased to be able to announce this buyback as a sign of our confidence in our outlook and a testament to our focus on maximizing shareholder value.

Turning now to operational achievements. While challenging from a revenue perspective, we accomplished a number of objectives in 2016 that have further strengthened our competitive position and enhanced our ability to generate improved top line results going forward. We augmented our management team with the addition of Rich Baker as Chief Technology Officer and David Fein as our Chief Revenue Officer. Both executives have excellent experience and a track record of success. David started in mid-December and has been very active with our sales staff and key customers and getting up to speed on our sales processes. He is currently in Europe working with the sales team and meeting with customers.

We now offer our full suite of 3D printing services in Europe, enhanced by the acquisition and integration of Alphaform. On the product side, we had a successful launch of overmolding, which has experienced very positive customer feedback and growing demand. We continue to expand Liquid Silicone Rubber in our injection molding service, and lathe-turned parts and 5-axis milling offerings in our CNC machining service. And, finally, we expanded our manufacturing floor space when we completed our facility moves in North Carolina and Japan, each without any disruption to our customers.

Now I'd like to update you on our priorities. We have three key priorities for 2017. First, driving productivity of our sales and marketing activities to bring in more product developers. Second, continued envelope expansion of our existing services to be able to fulfill more of our customers' needs of prototypes and low volume production custom parts. And three, improve our gross margins to meet our target of 58% to 60%.

Let me take a minute to describe each priority. Our primary focus in 2017 is to reinvigorating our sales and marketing programs to restore our growth rate. The hiring of David Fein, an experienced sales executive was an important component of this effort. We've made investments in our sales organization with a focus on sales management, sales and marketing automation tools and sales training. Our enhanced sales management team will be key to sales excellence, as they are on point to coach and mentor our frontline sales team. Sales management will emphasize disciplined execution of our sales playbook and use of automation tools to improve productivity.

Our sales teams are investing more time in planning their book of business and developing key account plans. They will be going wide and deep among our existing customer companies through colleague referrals, use of webinars and onsite visits and developing relationships with key decision-makers. We will continue to leverage marketing automation tools and data analytics to drive improved productivity of our marketing spend with the focus on driving increased quoting.

Envelope expansion among our current services is the second major leg of our growth strategy. Therefore, in addition to our sales initiatives, we have prioritized our expansions for 2017. We launched overmolding in Q4 2016. In 2017, we will continue to expand the envelope of both the parts we produce and the services we offer with the objective to provide a more total solution to our customers. We are off to a great start with Insert Molding as our most recent envelope expansion, which we launched this week.

Insert Molding is the process of molding thermoplastic material around a component or an insert to create a single injection molded part. The inserts are typically metal parts that are used to reinforce the mechanical properties of the plastic part. We also received delivery of the new HP Jet Fusion machine, which expands our 3D printing service envelope. We're testing this technology and look forward to launching it later this year.

Our last priority is gross margin improvement. We will focus on 3D printing in Europe, where our gross margin is lower than our 3D printing business in the United States. We focused on improving these margins through use of manufacturing technology and increasing sales volumes to leverage the fixed cost.

We have a relentless focus on quality. As a result, we passed ISO inspection audits at our new facility in Japan. We also continue to realize benefits from our Proto-Excellence program. Proto-Excellence is a Lean Continuous Improvement initiative. This work has uncovered opportunities for further efficiencies and waste elimination. I'm very proud of what our employees accomplished in the past year and look forward to a successful execution of our initiatives in 2017.

With that, I'd like to turn the call over to John.

John A. Way - Proto Labs, Inc.

Thank you, Vicki. Revenue in the fourth quarter was $72.4 million, a decrease of $1.4 million or 2% over the same quarter in 2015. As Vicki discussed, our revenue growth this quarter was impacted by $1.5 million of non-recurring revenue in the prior year.

Foreign currency represented a $700,000 headwind in the quarter, as the unfavorable of the weakened British pound was partially offset by benefits related to the Yen and the Euro. Adjusting for these items to arrive at a comparable basis, revenue grew 1% over the fourth quarter of 2015.

The revenue was generated from serving 14,046 unique product developers in the fourth quarter. This represented a 13% increase over the fourth quarter of 2015. Gross profit for the quarter was $40.3 million, a decrease of $1 million over the comparable quarter of the prior year.

Gross margin was 55.7%, this compares with 56% in the fourth quarter last year and 57.2% in the third quarter of 2016. As we discussed in our guidance prior to this quarter, our gross profit and gross margins were impacted by the sequential decline in revenue, which created challenges in adjusting the cost structure in the short-term. The lower revenue and a year-end adjustment related to our physical inventory account, resulted in a sequential decline of our gross margin percentage.

Operating expenses totaled $25.5 million or 35.2% of total revenue for the fourth quarter 2016. This compares to $24.7 million in Q4 of 2015, and $27.8 million last quarter. The sequential reduction is primarily the result of lower cost associated with the facility moves, a reduction in the incentive compensation, and other cost management activities.

Operating income was $14.8 million in the fourth quarter of 2016 compared to $16.6 million in the same quarter of 2015, with the decline driven by lower gross margin, increased investment in marketing and sales, and research and development partially offset by lower administrative costs.

Adjusting for stock-based compensation and amortization, and our final adjustment associated with our facility moves, our adjusted non-GAAP operating income was $16.7 million or 23.1% of revenue, compared to $18.7 million or 25.3% of revenue in the prior year.

Our effective tax rate was 37.3% in the fourth quarter. This tax rate is higher than the 30.1% effective tax rate in the prior year, due to the inability to recognize a current tax benefit of net operating losses incurred in certain legal entities, increases in valuation allowances on net operating losses in certain tax jurisdictions and R&D tax credit benefits recognized in 2015.

Net income totaled $9.4 million, resulting in diluted earnings per share of $0.35. Adding back the after-tax costs of stock compensation, amortization of intangibles and adjusting for the non-recurring items and the effect of the unrealized losses on foreign currency, our non-GAAP diluted earnings per share in the quarter were $0.41.

Revenue for the full year 2016 was $298 million, a 12.9% increase over 2015. This revenue growth included growth in injection molding of 7.7%, CNC machining of 9.5% and 3D printing of 50.6%.

Our operating income for the year was $61.8 million or 20.7% of revenue, compared to $67.1 million or 24.5% of revenue in 2015. The drivers of the 470 basis point reduction in margin included the following. Alphaform had a 250 basis point impact on our full year gross margin. Investments in sales and marketing and research and development each had a 60 basis point impact on operating margins. The move into new facilities and exiting our former locations had a 50 basis point impact. And the charge taken related to discontinuing our metal injection molding and magnesium injection molding services had a 20 basis point impact on operating margin.

Now turning to cash flow. We generated $75 million in cash from operations, a 28% increase from the prior year. Capital spending was $33.6 million during 2016 and included $18 million in land and buildings, primarily associated with our manufacturing expansions. This capital spend is below our historical levels and $10.7 million lower than 2015. The increase in cash from operations and the lower capital spend demonstrates the cash generation power of the business, even in periods of lower growth. The result was an increase in cash and investments of $47.1 million during the year to $193 million at December 31, 2016.

As Vicki mentioned, this strong cash generation capability allows us to embark on a stock repurchase program to provide a return of capital to shareholders. Our business generates sufficient cash flow on an annual basis to invest in the business to support future growth and support a stock repurchase program, while also maintaining a healthy cash and investment portfolio.

Now I'd like to turn to our expectations for the first quarter of 2017. We currently expect Q1 revenue to be in the range of $73 million to $78 million. This revenue guidance reflects the following factors. Foreign currency will have an approximately $1.2 million negative impact on our Q1 revenues. Q1 last year included approximately $1 million of revenue related to resin resale and terminated unprofitable contracts. Adjusting for these items, this represents revenue growth of 3.5% to 10%.

Moving to earnings guidance. Our non-GAAP add backs for the quarter will include stock compensation costs of approximately $1.8 million and amortization of $163,000. We currently estimate our tax rate to be approximately 32% to 32.5% in Q1. Taking into consideration all of the above, we expect our quarterly non-GAAP EPS to be between $0.42 and $0.48 per share in the first quarter.

That concludes our formal remarks. Now Vicki and I would be happy to take your questions. Michelle, can you please open up the lines for Q&A?

Question-and-Answer Session

Operator

Thank you. We will now be conducting a question-and-answer session. Our first question comes from the line of Troy Jensen with Piper Jaffray. Please proceed with your question.

Troy D. Jensen - Piper Jaffray & Co.

Hey, Vicki. Hey, John. Good morning.

Victoria M. Holt - Proto Labs, Inc.

Hi, Troy.

John A. Way - Proto Labs, Inc.

Good morning.

Troy D. Jensen - Piper Jaffray & Co.

Hey, so quick question, Vicki, I mean, a lot of the lack of growth seems to be credited to just a poor macro. But just be curious to know if the sales leadership changes and some of the changed strategy on the sales side are also kind of weighing on the growth here.

Victoria M. Holt - Proto Labs, Inc.

Yes, that's a good question. And I do think, Troy, when you take a look at the kind of changes we've put in place, new processes, pulling sales people out, the training that we've done throughout the second half of 2016 certainly has some impact as they become more comfortable with the approaches that we're taking and the level of planning and execution that we're expecting. So I'm sure that has some impact on it.

Troy D. Jensen - Piper Jaffray & Co.

Okay. Couple of more questions here on the – I guess I'm curious to know why injection molding or why you think injection molding is down more than CNC? I guess my thought would be injection molding has some reuse molds so less of the prototyping and R&D exposure.

Victoria M. Holt - Proto Labs, Inc.

Yeah. So when you look at our injection molding business at fourth quarter of 2016 versus fourth quarter of 2015, the parts piece of it was down a little bit more than the molds piece, but both did decline. And yet you can only – if you look at the details, I really attribute it to the fact that we are an on-demand manufacturer that has fluctuation in that, and we've got some situations where you have customers with very large bridge tooling orders last year, it didn't reoccur this year. So I really attribute it to that quarter-to-quarter variation that we're always going to have as an on-demand manufacturer.

Troy D. Jensen - Piper Jaffray & Co.

All right. Fair. And (24:20) to the last one here for John. The gross margin guidance that you gave of 58% to 60% as a target, is that for the full-year, is that going to be exiting the year?

John A. Way - Proto Labs, Inc.

Exiting the year.

Troy D. Jensen - Piper Jaffray & Co.

All right. Perfect. Thanks. Good luck this year.

Victoria M. Holt - Proto Labs, Inc.

Thanks, Troy.

Operator

Thank you. Our next question comes from the line of Brian Drab with William Blair. Please proceed with your question.

Brian P. Drab - William Blair & Co. LLC

Hi, good morning. Thanks for taking my questions.

Victoria M. Holt - Proto Labs, Inc.

Good morning, Brian.

John A. Way - Proto Labs, Inc.

Good morning.

Brian P. Drab - William Blair & Co. LLC

First, just following up on the injection molding question. So, if I look sequentially, injection molding was down about 10% from the third quarter, about $5 million. I'm wondering if you could talk about, were there any one-time factors that drove that? I think that you said, we should expect the discontinuation of MIM and Thixo to be about a $1 million sequential headwind, so, is that true? And then were there any other sequential headwinds like FX or number of days in the period, any particular customers, large customer stand out? And then also, could you tell us whether that sequential slowdown – again sequential was weighted more toward new molds or the parts business?

Victoria M. Holt - Proto Labs, Inc.

Okay. So again, we always have fluctuation as you know, Brian, because our customers at any point in time we have a 7 to 8 backlog, and we are always going to have customers at different points in their development lifecycle where at one point they may have a large number of bridge tooling taking place, and then cycle into a period where you don't. And with a large number of customers we've got, it's very hard to draw definitive conclusions about them, because we've got hundreds of thousands of customers that are showing that kind of fluctuation.

John A. Way - Proto Labs, Inc.

Yeah. And on the sequential decline, the decline actually was split pretty evenly between the two. On the parts, we are now in a stage where we usually have a couple large orders come through, and in the fourth quarter we didn't experience as much about as we have it historically. So the parts has always been a little bit more difficult to predict. On the mold side, I do think it is just tied to the overall things that we were experiencing throughout the year, and we didn't get the big push at the end of the year that we sometimes get, but – as people coasted it into the holidays potentially.

Victoria M. Holt - Proto Labs, Inc.

And it may have to do with budget cycles too. If engineers are working with budget cycles that are tight in 2016, they get towards the end of the year and they don't have a lot of money left in their budget. You start seeing them cycle into the first quarter. We felt – again, with what we're seeing in January, we felt comfortable with the guidance range, that shows that year-over-year growth again in that range of 3% to 10%.

John A. Way - Proto Labs, Inc.

And on the question on the MIM and Thixo, our metal injection molding service is completely done. Although, we've had some customers that have asked us to continue with the thixomolding and running final parts orders for them, and that continued through even the first quarter of this year, but we will have that completely shut down here in the first quarter, but it did not have a big impact quarter-over-quarter.

Brian P. Drab - William Blair & Co. LLC

So, the $1 million sequential number that I think we talked about last quarter that really wasn't a $1 million sequential headwind?

John A. Way - Proto Labs, Inc.

It really wasn't. No.

Brian P. Drab - William Blair & Co. LLC

Okay, got it. And then you're touching a little – Vicki, just touched a little bit about what you're seeing in January, but it seems like the guidance is reflecting a pretty strong sequential increase. So, have you – you're 40 days roughly into the first quarter, have you seen a substantial pickup in activity relative to what you're seeing as you exited 2016?

Victoria M. Holt - Proto Labs, Inc.

Yeah. You know what, substantial is always a funny word to quantify. But what I will say is we do feel comfortable with the guidance we've just provided based upon what we're seeing in the first 40 days.

Brian P. Drab - William Blair & Co. LLC

Okay, great. And then maybe just one more on the selling and marketing, I think recently you said that maybe it'd be on a – I think it was a GAAP number, but 16% to 17% of sales, is the expectation for the near-term that would be by my calculation like 15.5% to 16.5% on a non-GAAP basis. I mean, is that a reasonable kind of range to model for the full year of 2017?

Victoria M. Holt - Proto Labs, Inc.

Yes.

John A. Way - Proto Labs, Inc.

Yeah. I think it is. So, the fourth quarter was 16.5% on a GAAP basis, so, yeah, I think that is the right range.

Brian P. Drab - William Blair & Co. LLC

Okay. Thanks very much.

Victoria M. Holt - Proto Labs, Inc.

Thanks, Brian.

John A. Way - Proto Labs, Inc.

Thank you.

Operator

Our next question comes from the line of Weston Twigg with Pacific Crest Securities. Please proceed with your question.

Weston Twigg - Pacific Crest Securities

Hi. Thanks for taking my question. I guess, first, just on the sales efforts to revisit that idea. I know you had a lot of changes in 2016. Can you give us a better idea about what you think worked and what specifically you're changing moving forward to try to ramp sales in 2017?

Victoria M. Holt - Proto Labs, Inc.

Yeah. So, 2016 I really see is a really critical foundation building year. We brought in some great sales management talent that is critical to driving the kind of behavior change and excellence of sales on the sales front. We also developed a more disciplined sales process, and incorporated that sales process into our sales automation tools to help our sales people really drive the behaviors that have proven to deliver both quotes and then close those quotes and bring them to becoming a customer.

So, that discipline and that foundation for that discipline have all been put in place. And now, we're really in that mode of executing on those plans. David Fein has come in over the last month and I've been really pleased with what he's seen in terms of the foundation we've been putting in place in 2016, and we'll be continuing to enhance that, but basically agrees that we are now in an execution mode with the sales team that we've put together. So, it's basically continuing with that sales excellence and that foundation that we began putting in place in 2016.

Weston Twigg - Pacific Crest Securities

Okay. And then just related to the customer side, are you finding that you're getting some pushback from the customer side related to customers doing more in-house maybe related to bringing in 3D printers or other technologies?

Victoria M. Holt - Proto Labs, Inc.

Yeah. Many of our customers have in-house 3D printing technologies. And again, as they look at – they will look at utilizing that and using us for overflow. So, we do see that. We tend to focus on the 3D printing technologies that have more fine features and create a higher quality printed part. And so, when the customers need that level of precision and quality, they'll outsource to us, but many of our customers have in-house printing. And that's no different than I think what we've had in the past.

Weston Twigg - Pacific Crest Securities

Okay. And then just finally, you mentioned that you got the first HP printer in. Just wonder if you could give us your first impressions on that. You mentioned you expect to ramp later in the year, if you could give us some idea of what the triggers would be in terms of buying more of these printers?

Victoria M. Holt - Proto Labs, Inc.

Yeah. Yeah. So we received our first printer just recently, so we're very, very early in our testing of the technology. But so far, what I can say is what we've seen is it seems to be living up to some of the promises that the Multi Jet Fusion technology has set out for itself. So, we're encouraged by what we've seen so far.

The triggers will be, as we've got to understand the technology, we've got to build all of our pricing models, we've got to understand its capabilities and get another service out on our website for our customers to select. So Multi Jet Fusion will be another 3D printing service alongside of stereolithography, selective laser sintering and direct metal laser sintering.

Weston Twigg - Pacific Crest Securities

Very helpful. Thank you.

Operator

Thank you. Our next question comes from the line of Jon Fisher with Dougherty & Company. Please proceed with your question.

Jon Fisher - Dougherty & Co. LLC

Good morning. On the operating expense side, you guys did a very good job in the fourth quarter managing that pretty tightly. When we look through 2017, can you manage it pretty close to flat low single-digit, kind of year-over-year growth for OpEx spend?

John A. Way - Proto Labs, Inc.

Yes. I think we'll continue to manage it. I would say in the fourth quarter, we did have lower incentive compensation that that's something that we would expect to increase back into 2017. But the remainder of the cost we'll continue to manage tightly and in line or below revenue growth, with the potential exception of the sales and marketing, which we will be investing to ahead of the growth.

Jon Fisher - Dougherty & Co. LLC

And then in David's role, how much of his focus or how much of his initiative is on taking the business model up market into larger enterprises versus honing the message and leveraging the expertise and the market position that the company already has in the small and medium size business market? Is he going to be focused on both strategies or is his time and his efforts going to be biased more towards one or the other?

Victoria M. Holt - Proto Labs, Inc.

Right. That's a good question, because I think that sets up the fact that we have a current go-to-market model which has been very, very successful. It's an e-commerce based model focused on the product developer, and we feel that there's continued opportunity for growth in that go-to-market model, with improved execution by our sales team and improved productivity of our marketing spend. It's actually those improvements that are going to drive most of the 2017 improvements in our growth rate.

Now, that being said, we also believe we've got huge opportunity to enhance the way we engage companies in how Proto Labs can improve their business outcomes. And David's going to be spending his time continuing to enhance how we go about doing that with customers. And I think you'll be hearing more about that as we go through 2017. But he will be focused on both because they're both very important go-to-market models for us; one, focused on really helping that product developer with his project and moving it through from ideas through to commercialization a lot more effectively. But then also, we've got to continue to develop the approaches that we take to engage companies in how Proto Labs' technology enabled digital manufacturing model can really bring them some very valuable business outcomes. And he'll be doing both.

Jon Fisher - Dougherty & Co. LLC

Okay. And then just on top of that with David's role, and you can correct me if I'm wrong, but I think one of the other initiatives that you had once David or whoever was in that position was to hire a regional leader, so a head of Asia, a head of Europe, a head of North America. Are those positions in place or are those – the filling of those positions, are those critical to kind of a successful growth year from a revenue standpoint in 2017?

Victoria M. Holt - Proto Labs, Inc.

Yeah. So, they are critical. We have hired our European VP of Sales Dirk Rathsack, who comes to us after having six years of experience leading the European sales organization at Cognex. So we are thrilled to have him. We currently have in place in the United States – in North America here a temporary sales leader who's been very effective going through the second half of this year. He remains in place as we finalize our search and make our final selections for VP of Sales for the Americas. So, it's not a gap, as I would say right now on our sales force. This person has been involved with us since May and very effective in putting in place the foundation and executing, but we do need to complete that. And we actually have a strong sales leader already in Japan.

But those roles are critical, as are the sales management roles below them, and we brought in some really great talent there. David's been very impressed with the new talent that we brought in in the second half of 2016 and doesn't see – I mean, that's not something that he would need to change, he feels good about that.

Jon Fisher - Dougherty & Co. LLC

Okay, great. Thank you.

Operator

Thank you. Our next question comes from the line of Ethan Potasnick with Needham & Company. Please proceed with your question.

Ethan Potasnick - Needham & Co. LLC

Hi, guys. Thanks for taking the call. This is Ethan Potasnick filling in for Jim Ricchiuti. So, I guess, are you guys seeing any signs of improvement in your production parts business in either of your two major geographic regions or in any specific verticals with signs of a strengthening manufacturing environment?

Victoria M. Holt - Proto Labs, Inc.

Yeah. So, our production part business, it does tend to fluctuate based upon major programs that our customers may be moving through. So that's where we get bridge to link, bumps that take place. We've got a couple of those that are moving through in the first quarter, so that's good to see. We continue to see more and more customers pushing us for extended services to allow us to expand our production business. So you'll be hearing more about that as we move through 2017. But I think it's consistent with the guidance we've given with the increase in revenue growth year-over-year in the first quarter in that 3% to 10% range versus again down slightly here in the – or flat in the fourth quarter.

John A. Way - Proto Labs, Inc.

Yeah. And then volume is low volume production parts across thousands of customers, so it's hard to pinpoint, especially in the short window we're talking about.

Victoria M. Holt - Proto Labs, Inc.

And our average lead time for those production parts, the average lead time that our customers work with us less than 10 days. So again, we have about a seven-day backlog of orders.

Ethan Potasnick - Needham & Co. LLC

Okay. Got it. So also it looks like there's a bit of a decline in Europe. Can you maybe talk about what caused the reversal relative to Q3? And also it looks like you're seeing some deceleration in 3D printing business. Now, is mid-teens growth what you would be targeting going forward?

Victoria M. Holt - Proto Labs, Inc.

Yes. So let me answer the second one first. And yes, 3D printing I think will grow more than our other two businesses, so I would be expecting that to be in that mid-teen to 20% kind of range. In Europe, our 3D printing business, the growth in that is a real focus for us in 2017, because we've got significant fixed costs still in 3D printing in Europe, and we need to drive the revenue growth there to absorb those fixed costs. So that will be a big focus for us.

When you look at the Europe, in the fourth quarter, yes, a little bit of a deceleration, Europe had a really strong year in general, second quarter and third quarter showed some really strong year-over-year growth. The impact of some of the non-recurring businesses was felt most here in the fourth quarter, because right after the acquisition there were still quite a few sales – very unprofitable sales taking place in 3D printing in Europe with Alphaform and then the resin business. So, pulling those out had an impact there, as did currency.

Ethan Potasnick - Needham & Co. LLC

Okay, great. That's it for me. Thank you.

Victoria M. Holt - Proto Labs, Inc.

Thanks.

Operator

Thank you. Our next question comes from the line of Ben Hearnsberger with Stephens. Please proceed with your question.

Ben Hearnsberger - Stephens, Inc.

Hey thanks for taking my question. I wanted to start maybe with a higher level question around customer behavior. I know you had some, what I would call cyclical kind of volume softness. But are you seeing any fundamental changes in customer behavior, maybe less physical prototyping, more software simulation, or more of a trade down to 3D printing? Just maybe general thoughts around that subject, please.

Victoria M. Holt - Proto Labs, Inc.

Yes, that's a good question, Ben. And, in general, I do feel that customers are beginning to deploy more software to help them with simulations in product development, as well as really testing the capabilities that 3D printing might bring them in prototyping, and that allowing them to potentially decrease the number of iterations they may do in injection molding. So I think in general that's occurring.

I don't think that it's something that should be an excuse for us not to drive the revenue growth, because there's still a tremendous number of product developers and opportunities for us to penetrate our existing markets wider and deeper with our existing customers, and really also be able to bring more services to allow us to capture a bigger portion of what's available with our existing customers as well.

So, that's why the focus we've got on the two key growth vectors, bringing in more product developers to the discipline of our sales execution and our marketing execution. And secondly, continuing to expand the envelope of what we do both in terms of types of parts we make and the services we offer are going to allow us to capture more of what's available. But I do think on a macro basis, I think there is some increased use to 3D printing as a lower cost prototyping alternative.

Ben Hearnsberger - Stephens, Inc.

So, maybe as a follow-up, do you see the opportunity to pivot your molding business into more kind of short run, low volume in part production, is that a big market opportunity for you down the line?

Victoria M. Holt - Proto Labs, Inc.

It is. But we've got to be able to provide more of a total solution to customers, so that's why I mentioned a big focus for us in 2017 are going to be envelope expansion in terms of the part envelope, but also the services that we offer to allow us to capture more of that total solution that's necessary for that low volume production business.

Ben Hearnsberger - Stephens, Inc.

Okay. And kind of tying it into the model, should we expect revenue per user to remain a headwind for the foreseeable future? I know we're going to grow volumes and grow users on the platform, but on a revenue per user basis, should it be negative for the remainder of the year or foreseeable future beyond that?

John A. Way - Proto Labs, Inc.

Yeah. So I think mix plays a big part in that, and it will depend a little bit on the injection molding. And because that order size of the injection molding – orders is larger than 3D printing and CNC machining, it largely is going to depend on the growth in injection molding. 3D printing, we expect to grow strongly and probably a little bit faster than the other two services, but clearly that injection molding will be the driver there.

Ben Hearnsberger - Stephens, Inc.

Okay. And maybe one last one John for you on capital investment expected this year. It seems like we're kind of ratcheting it down delivering more free cash flow. Can you give us a ballpark based on planning through January?

John A. Way - Proto Labs, Inc.

Yeah. I think as we've talked about, our capital expenditures are really tied to our revenue growth and we'll manage our capital expense based on where that revenue growth is coming in. Right now as we look at it, looking at $30 million to $35 million in 2017, plus the potential for a facility in Europe. But that would be the current view.

Ben Hearnsberger - Stephens, Inc.

Okay. So it'd be $30 million to $35 million baseline, plus maybe $10 million to $15 million if we need to add it for European facility?

John A. Way - Proto Labs, Inc.

Correct.

Victoria M. Holt - Proto Labs, Inc.

Correct.

Ben Hearnsberger - Stephens, Inc.

Okay. Great. Well, thank you very much.

Victoria M. Holt - Proto Labs, Inc.

Thanks, Ben.

John A. Way - Proto Labs, Inc.

Thank you.

Operator

Thank you. There are no further questions. At this time, I would like to turn the call back over to Ms. Vicki Holt for closing remarks.

Victoria M. Holt - Proto Labs, Inc.

Thanks, Michelle. Thank you again for joining us today. We remain excited about the outlook for Proto Labs. As we look ahead, we are confident that current market trends are favorable to our strength and our business model. Our differentiated technology enabled digital manufacturing platform has demonstrated the ability to help companies and entrepreneurs get their products to market faster than their competition. We continue to innovate with our service offerings and technology interface and features to enhance our customers' experience.

I want to thank the Proto Labs' employees for their efforts over the past year. And I want to thank our customers for their support. We are committed to enhancing our revenue growth and driving greater shareholder value over the longer term, and we look forward to reporting to you on our progress during our next call. Thank you.

Operator

Thank you. This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation and have a wonderful day.

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