FARO Technologies, Inc.

Good morning, everyone, and welcome to today's Ferro Technology second quarter 2021 earnings call. For opening remarks and introductions, I will now turn the call over to Michael Finari at Sapphire Investor Relations. Please go ahead.

Thank you and good morning. With me today from Ferro are Michael Berger, Chief Executive Officer, and Alan Muhich, Chief Financial Officer. Yesterday after the market closed, the company released its financial results for the second quarter of 2021. The related press release and Form 10-Q for the second quarter are available on FARO's website at www.faro.com. Please note certain statements in this conference call, which are not historical facts, may be considered forward-looking statements that involve risks and uncertainties and include statements regarding future business results, product and technology development, customer demand, inventory levels, economic and industry projections, or subsequent events. Various factors could cause actual results to differ materially. Some of these factors have been set forth in yesterday's press release and are described at length in our annual and quarterly SEC filings. Forward-looking statements reflect our views only as of today, and except it's required by law, we undertake no obligation to update or revise them. During today's conference call, management will discuss certain financial measures that are not presented in accordance with U.S. generally accepted accounting principles or non-GAAP financial measures. In the press release, you'll find additional disclosures regarding these non-GAAP measures, including reconciliations to comparable GAAP measures. While not recognized under GAAP, management believes these non-GAAP financial measures provide investors with relevant period-to-period comparisons of core operations. However, they should not be considered in isolation or to substitute for a measure of financial performance prepared in accordance with GAAP. Now, I'd like to turn the call over to Michael. Thank you, Mike.

Good morning. Welcome to our call. Demand for our products in the second quarter reflected a return to a seasonal growth and typically following the typically soft first quarter. On a geographic basis, the Asia-Pacific market, and in particular China, performed well, while U.S. and Europe markets continued to recover, albeit at a slower pace. With the second quarter improvement across our served markets, we continue to believe the demand environment will improve throughout 2021 as our customers' activities normalize. Taken together with our ongoing flow of new product introductions, we believe year-end demand levels will be similar to those experienced in the fourth quarter of 2019. That said, we remain cautious as market uncertainties such as the continuing softness in commercial construction starts, the prioritization of capacity expansion over quality control initiatives, and the ongoing steps local governments take to combat the pandemic may adversely impact the ultimate slope and the timing of our recovery. We remain focused on laying the foundation for expanding the breadth and depth of our product offerings while streamlining our operations to continue to capture the long-term opportunities ahead. As discussed in our prior calls, Ferro is in the process of transitioning to a marketing-led organization focused on understanding our customers' problems and delivering hardware and software solutions to meet their needs. As an example of these efforts, An example of this effort could be found in our recently announced Quantum Max scan arm solution. Quantum Max was conceived by identifying our customer's need for both speed and accuracy. As a result, we have developed an advanced portable measurement solution which features three purpose-built, hot-swappable laser line probes, each of which offer distinct advantages for specific use cases. The XR probe, provides 30% better accuracy and resolution for high-precision measurement tasks. The XS increases scanning speeds by over 65%, and the versatile XP offers a balance of the XR's resolution and the XS's speed. Unlike prior physical arm solutions, the Quantum Max allows customers to swap laser heads on the fly, creating a versatile tool which meets a wide spectrum of speed, accuracy, and resolution needs in a single solution. This unique solution results in a productivity and value increase of over 30% compared to prior generation devices. Another critical component of the scan arm solution was the launch of our latest version of CAM2, our metrology software, which greatly improved scanning with our new laser probes. Through the combination of our new arm, probes, and the latest software, we believe we've set a new standard in the industry for metrology grade measurement solutions. While we continue to introduce new solutions throughout the year, it's worth highlighting that between launching a workflow solution and generating meaningful revenue takes time. That said, we are very encouraged by our recent customer feedback. In addition to our internal product development roadmaps, we continue to expand the breadth of our offering through acquisitions. Building off last year's ATS acquisition, which focused on high precision digital twin applications, In the second quarter, we expanded our capabilities with the acquisition of HoloBuilder, a leading photogrammetry-based 3D platform which delivers hardware-agnostic image capture, registration, and viewing. With an initial focus on construction management, HoloBuilder's platform provides general contractors a solution to efficiently capture and virtually manage construction progress using off-the-shelf panoramic cameras. Hello Builder's SaaS platform adds a fast and easy reality capture photo documentation and remote access capabilities to Ferro's highly accurate 3D point cloud-based laser scanning to create an industry's first end-to-end digital twin solution. The combined solution will provide a comprehensive scanning and image management capabilities for digital twin market aimed at robotic assembly simulation, construction management, facilities operation and management, and incident pre-planning in the public safety market. Ultimately, these digital twin capabilities will be brought into our soon-to-be-announced cloud-based solution, which we call Ferro Sphere, with its underlying subscription model representing Ferro's future long-term software go-to-market. Shifting to operations, two weeks ago, we announced the signing of an agreement to outsource our manufacturing to Sandvina Corporation. As the next step in our business transformation, we plan to transition ferro production from three manufacturing sites in Lake Mary, Florida, Exxon, Pennsylvania, and Stuttgart, Germany, to a Sanmina facility based in Thailand. Following a rigorous selection process, we chose Sanmina as our partner based upon their proven ability to deliver quality products on the required timelines. Together, we are very confident in our ability to meet our customers' demand throughout this transition process. Once complete, our new operational model greatly simplifies operations, reduces cost, and allows our management team to focus on the development and sale of differentiated solutions to customers in our target markets. Alan will discuss the financial impact of these changes in a few minutes. Taken together, these actions form the basis of our strategic transition, namely developing a deep understanding of our customer workflows, which allow us to further differentiate our capabilities in the marketplace while at the same time placing a solid operating structure in place to ensure incremental top line growth translates to greater operating leverage and higher shareholder value over time. Finally, we announced the election of two new members to our board of directors. As previously disclosed, a key element of enabling our successful transformation is ensuring that we maintain the right experience set on our board to help guide us. I am particularly pleased with the addition of Moonhee Chen, and Alec Davrin to the FERA Board. They each have demonstrated success in leading hardware and cloud-based software businesses in markets that are closely aligned with our strategic direction. I very much look forward to their contributions as they officially join us on October 1st. With that, I'll turn the call over to Alan for an overview of our second quarter financial results.

Thank you, Michael, and good morning, everyone. Second quarter revenue of $82.1 million grew 36% when compared to the second quarter of 2020 as a result of continuing market demand improvement compared to last year's market softness caused by the pandemic. Product revenue of $60.3 million was up 43%, and service revenue of $21.8 million was up 19%. Bookings of $88.2 million grew 44% year over year and were slightly ahead of revenue in the quarter, signaling a modest building of backlog. Gap gross margin was 55.4% and non-gap gross margin was 55.7% for the second quarter of 2021. Gross margin increased year over year and sequentially largely due to volume increases versus prior periods. Our second quarter material costs did not reflect inflationary pressures prevalent in today's market. That said, we do anticipate material cost headwinds to modestly affect gross margins in the near term. Gap operating expenses were $46.1 million and included approximately $3.6 million in acquisition-related intangible amortization and stock compensation expenses and $800,000 in restructuring costs. Non-gap operating expense of $41.8 million was $4.1 million higher than Q2 of 2020 as we continue to increase our software investments and as a portion of the travel-related expense savings realized during the pandemic began to return. GAAP operating loss was $700,000 for the second quarter of 2021 compared with an operating loss of $12 million for the second quarter of 2020, primarily due to lower volumes in the prior year period. Non-GAAP operating income was $3.9 million in the second quarter of 2021 compared to an $8.1 million loss in the second quarter of 2020. Adjusted EBITDA was $6.5 million or approximately 8% of revenue. Our gap net loss was $1.2 million or $0.06 per share. Our non-gap net income was $2.2 million or $0.12 per share for the second quarter of 2021, compared to a non-gap net loss of $0.36 per share in Q2 2020. We continue to maintain a strong capital structure with a cash balance of $133 million and no debt. The second quarter decrease in cash was primarily a result of the acquisition of HoloBuilder for which we paid $34 million in cash. With the addition of HoloBuilder and ongoing investments in our core software platform, our quarterly non-GAAP operating expenses is expected to increase to a mid $40 million run rate. As a result, to achieve our target model of 20% EBITDA margins, our quarterly revenue level has increased to $110 million versus the $100 million objective previously set. Given the long-term opportunities within the digital twin market, we believe these are the right investments to ensure future growth. Offsetting the spend over the midterm, we recently announced our plans to consolidate and outsource our manufacturing. The phased transition to Sanmina is expected to be completed over the next 12 months and results in approximately $12 million in annualized labor and material savings when complete. We believe the expected savings will have a negligible impact on 2021 followed by steady improvement through 2022, with the full benefit to be realized in the first quarter of 2023. The company expects to incur a cash charge of approximately $6 million in the second half of 2021, primarily consisting of cash severance. Total pre-tax charges of $15 to $20 million are expected through the first half of 2022, when including the impact of facility and other asset write-downs. With these charges, the company expects it will fully realize the 75 to 85 million in restructuring charges announced in February 2020. We're pleased in the continued end-market demand improvements and the organic and inorganic progress we're making towards realizing our strategic vision of hardware software solutions that solve our customers' real-world problems in a cloud-based environment. With the addition of HoloBuilder, our end-to-end solution for digital twin management positions us well to capitalize on this large and growing market. We have line of sight to completing the transformation of our cost structure with our new manufacturing partner, Sanmina. Lastly, we remain committed to the achievement of our financial success model, which as a reminder is to achieve 55% to 60% gross margin with 40% to 43% operating expense, resulting in 20% adjusted EBITDA. that we expect will be realized with approximately $110 million in quarterly revenue. We look forward to reporting our continued progress in the coming quarters. This concludes our prepared remarks at this time and we'd be pleased to take any of your questions.

At this time, if you would like to ask a question, please press the star and 1 on your touchtone phone. You may remove yourself from the queue at any time by pressing the pound key. Once again, that is star and 1 to ask a question. We'll pause for a moment to allow questions to queue. We'll take our first question from Greg Palm from Craig Hallam Capital. Your line is open. Please go ahead.

Yeah, thanks. Good morning, everyone. I guess just starting off with the orders, it looks like orders outpaced revenue by a decent amount in the quarter. Was there anything supply chain related, or was that just simply orders received late in the quarter that weren't able to ship? Just kind of curious if you're seeing any kind of supply chain related logistics issues out there.

Yeah, we've experienced some. Yeah, the order rate was back in loaded for the quarter, and so we ended up basically pushing some of the booking over into Q3. It's hard to say if that was really supply chain related from a customer perspective, but we've seen some logistics issues throughout the quarter, but it really didn't impact the end of quarter revenue. It was more around when we actually received the order.

Okay, makes sense. And Alan, I think you said something about elevated material costs. I don't know if that was an impact at all in the June quarter, but how should we be thinking about that impact going forward?

Yeah, Greg, good question. Not much of an impact in the second quarter. We do expect to see some material increases in the third quarter. That said, we do have some opportunity to be able to pass those along to our customers. And so, as I indicated in our prepared remarks, we would expect some modest impact to our gross margins here over the near term, depending upon ultimately how the length and duration and depth and changes of these material costs. But again, at this point in time, we think it's relatively modest, but maybe a little bit more towards the lower end of the range versus the middle of the range, which is where we've been operating.

Okay, got it. And then in terms of the kind of increasing OPEX, some of the investments, you know, I think most of us understand what the opportunity is. But maybe for those that don't, can you just go in a little bit more detail on sort of the excitement and opportunity around digital twin? Because it certainly seems like a kind of a theme that lots and lots of, you know, companies are starting to talk about.

Yeah, I think Digital Twin is a manifestation of, I think, many of our customers' desire to plan both facility changes or facility layouts or, in some cases, in public safety, pre-incident planning to be able to actually have a very accurate model in a virtual environment that allows you to plan. And I think the better you plan, the less waste. And I think we all know in the construction space and frankly running factories, one of the biggest issues you have is how do you minimize waste? And digital twin is becoming a catch-all, if you will. And digital twin means different things to different people. But our digital twin is a physical representation of the space and the ability to take that space in as close to accurate, as close to the truth as you can, and then change it virtually and plan, all in the context of reducing waste. It seems that it is, to your point, kind of a catch-all, but it definitely is a conversation we're having with a lot of customers, a lot of customers that we didn't really anticipate having that conversation with.

Got it. That's interesting. And then just last one, so the EBITDA 20% run rate with the revenue increasing to $110 million to achieve that, what would that number look like if you were to be able to capture all of the savings from the manufacturing outsourcing? Would that number be closer to the number you've been alluding to in the past? Just sort of curious how that will affect that number once those are Those costs are fully realized, those savings, I guess.

Yeah, it's a very good question. And I think that the timing, and you picked up on the nuance, right? The timing difference between the expenses coming on with the hollow builder acquisition versus our ability to be able to realize the savings with our outsourced manufacturing does cause over the next, you know, call it, you know, 12 to 18 months, an adverse impact on our model. I do think that there is a path towards getting to that 20% EBITDA on a lower revenue number or at the higher revenue number overachieving the 20%, but we're not ready to commit to that just yet.

Okay, fair enough. All right, thanks for the help. Best of luck going forward.

Thanks, Greg.

Thanks, Peg.

Our next question comes from Jim Mercucci from Needham & Company. Your line is open. Please go ahead.

Hi. Um, questions about, um, the, um, seasonality that you're, you're seeing you normally experience in this quarter. And I'm wondering if there's anything that you've seen in the first month, then that may not be a fair question, just given how back end loaded typically the quarters are, but is there anything that you're seeing that you might be able to share with us that give us a little better, uh, senses that have the momentum might be, um, entering Q3?

Actually, we've started Q3 pretty in typical fashion as we have probably most quarters. You know, we're typically back in loaded within the quarter. And I think the concern that we all have around Q3 is typically the vacation, the broad-based vacations that our customers are experiencing in Europe, which typically starts in August. So the first part of the quarter is kind of as expected, but again, we're not really, we traditionally see August kind of take a sideways step, and that's borne out in our history, Q2 to Q3 over the last several years. So I think it started off pretty normal, and we're anxious to see how August stacks up.

Okay. On the transition to Sandmina, Alan, maybe this is a question for you. Is there any reason why, as this process really gets going, you wouldn't see some or be able to realize some supply chain benefits just from some of their buying tower? I know you're talking about seeing opportunities in 22 gradually over the course of the year, but I'm wondering how to think about just some of the supply chain benefits. At what point do they begin? perhaps take a more active role on that side of the business?

Yeah, it's a good question. And again, I think as we've articulated the savings opportunity, we have indicated that there's both a labor and a material component. As everybody knows, our manufacturing has been centered in a couple of locations in the US and one in Germany. And the supply chains for those manufacturing are localized to those facilities. So as we move more towards a Sandmina Thailand-based facility, there is an opportunity absolutely to enhance the supply chain from a cost standpoint, at the same time leverage Sandmina's purchasing power. So we do think that there is an opportunity for decreased material cost savings as time goes by, and that's built into the numbers that we've been talking about, Jim. Okay, but not necessarily ahead of the move to Thailand.

You really need to be there with them before you're really able to realize some of that buying, the purchasing power that they have.

I think that's correct. I would say from a cost perspective, correct, but Sanmina has already begun to help us in some of the hard-to-source materials. They've helped us in advance of actually the announcement in anticipation thereof. They've been a big help. So we're excited about what we think they can do. Maybe not short term in terms of better pricing on materials, but really access to materials. Got it.

And then just a question on the the initiatives you have underway to build out the recurring revenue on the software side. Are there similar deals out there to HoloBuilder that you see? Which areas actually hold the most interest for you?

I think having the ability to actually capture whatever the truth is, and the There are technologies out there that we're looking at, nothing that's burning a hole in our pocket at this juncture. But there's quite a few companies that are kind of getting into this space, if you will, from a software perspective or an algorithm perspective that speeds up either our processing or, as in Hall & Builder's case, adds a completely different technology that we didn't really have commercially. So we're looking at all of those, Jim, but again, there's nothing burning a hole in our pocket right now.

Okay. And Sphere, on track, when should we think about this launching and how should we think about it looking out to next year?

Q4 is our current schedule. And I think, uh, as I've said, I think it, it, it'll be a slow ramp from a revenue perspective as we, as we sign up subscribers. So I would expect, um, very much to, you know, probably toward the end of 2022, where we can actually start pointing to I think meaningful revenue impact that said coincident with the launch of a sphere. we'll begin to break out our recurring revenue for you guys so that we're talking about it and you can track us on it.

Okay, good. All right, thanks a lot.

Thanks, Jim.

We'll take our next question from Andrew Discusberry from Barenberg Capital. Your line is open. Please go ahead.

Thanks. Good morning, Michael and Alan.

Good morning, Andrew. Good morning.

I had a quick one on hollow builder. Um, I know you said in the past and that when you're, you announced acquisition that was generating a, so 4 million or so revenue per year, and it's growing on a compounded annual basis at 75% since 2019. Just curious to know, like, um, with the integration, should we expect that high level of growth to continue with, if not even accelerate as you, as you potentially look at other use cases for that asset?

We expect the growth rate to continue on its current trajectory. I don't think we're planning on talking about accelerating that at this point. It's early days for us. We've had it under our belt here for just about six weeks, so we're still learning from them. We're very excited by what they offer, and we're extremely excited by the feedback that we're getting from their customer base. which we have some overlap, but frankly, they brought a different customer base to us. So the feedback that we're getting is fantastic. So we believe that we should be able to continue the growth rate that they've already experienced.

That's helpful. And I guess, excuse me, I guess when it comes to the Q4 revenue number, I think that that's a quarter that you expect to actually reach back to what we consider a normalized rate. Um, is that still kind of the plan based on what you're seeing in the market? Um, or should you, you know, has that changed at all? But do you think that, um, that, that the issues that you, you mentioned earlier, potentially, um, localized lockdown, that might, might impact that?

Well, I, I think we're optimistic. I think we've said publicly, we're not really giving guidance, but what we said is we would be disappointed if we weren't back at those levels. I don't think things have fundamentally changed with perhaps the supply chain shortages. And supply chain shortages may not necessarily affect our ability to ship product, but more our customers' ability for them to ship their products and therefore maybe dampen their appetite to buy capital. That's our concern. The supply chain situation is real. And while I don't see it I don't see it coming to an end in the next quarter or two. Our sales force is very optimistic about customer demand in general. And as we said in our script, our new products are really beginning to gain traction. So everything is headed the right direction. It's just, you know, it's been a crazy year. So we're just, we're cautiously optimistic. How's that?

That's helpful. And I guess the last one I have, and just a follow-up to Jim's question in terms of the Sanmina, I guess trying to ask you, do they have a better supply chain from a materials perspective than what you would have had with your own free sites?

Absolutely. And I think Alan alluded to it. Barrow had not really integrated many of the supply chains that were attached to each of the factories that you each of our factories. And as a result, we weren't really even internally gaining any buying power, if you will, by consolidating our internal demand. By transitioning to Sandmina, not only do we get their manufacturing expertise, but we actually get to leverage their supply chain. And as I mentioned to Jim, we've already seen some benefit of that even prior to the announcement in helping us source some hard-to-get material. so we're very uh very confident that they'll be able to help us on the supply chain side in this environment however where supply is really tight you're really not talking about getting price reduction you're more talking about getting access to materials and that's where send me has helped us short term i think long term they should be able to help us with cost and the way our contracts are written they're very motivated to help us with costs it's a big part of the of their business model and that industry's business model. So I think we're very fortunate to have Sanmina, and we're looking forward to a streamlined and probably healthier supply chain than we currently have. Great. Thank you. You're welcome. Thank you.

And once again, that is star and one to ask a question. We'll take our next question from Rob Mason from Beard. Your line is open. Please go ahead.

Yes, good morning. Good morning, Rob. Michael, if you think about where your targets may reside for getting back to these 2019 levels by the fourth quarter, I'm just curious, in terms of your sales force and its productivity level, How much capacity does the existing sales force have beyond that level, or do we need to consider adding more resources once you get back to, call it $100 million a quarter or type revenue level?

We don't believe that we need to add sales to get to the $100, and we're feeling really good about our productivity metrics of our selling organization as we kind of come out of the COVID situation. I don't anticipate that we would need to add any – dramatic resource, you know, much beyond, I would say, probably the $130 to $140 million a quarter. So I think we've got a lot of gas in the tank, if you will, with our current sales force. It's the demand environment that's precluded us from getting to those levels. I don't believe it's the number of salespeople.

Okay. Okay. Just on that point, could you offer some perspective on how you're seeing the 3D metrology versus your AEC markets perform as you came through the second quarter and into the third? Any distinctions, either by geography or, again, between those two key markets that you'd call out?

Yeah, we've seen the automotive space recover a bit, which is very encouraging. 3D metrology in Asia, I think we've been underserved in that market. And so we've seen a really nice gain, if you will, particularly in China, led by 3D metrology. I think North America, other than automotive, has been slower than we'd hoped, particularly in some of the smaller machine shops, which provide a long tail in terms of the number of customers that we have. So it looks like the big guys are buying again, maybe not at the rates they were, but they are buying again, which is super encouraging. In Europe, we've seen 3D metrology bounce along. We haven't seen a huge recovery yet, and we're hopeful that'll be a driver for Q4. Summarizing 3D metrology in general has been slower than, for example, in 2019, but we're seeing nice signs of recovery.

Just within AEC, you had made a reference to commercial construction starts. Is that still maybe the trigger point for uptake on the AEC product? Is the new start, you know, comes at the front end?

We believe so. You know, many of our customers actually buy capital based on the project that they are actually working on. So they actually bill out or charge against the project some of the equipment costs that they buy from us. And so as new projects start, there's opportunity for us to actually add equipment. but it's been relatively slow, particularly in commercial. We don't really participate as a company much on the residential side. That's changing, albeit it's relatively small. So really, commercial starts is really kind of, I think, should be the bellwether for us.

Okay, very good. Thank you.

Hey, congratulations on your new position.

Thank you.

And it appears that we have no further questions at this time. I will now turn the program back over to Michael Berger.

Well, we're excited. We're very pleased with where we are in terms of momentum, and we're making a lot of progress to our stated plans. So we appreciate everyone's interest and look forward to giving you an update next quarter. Thank you.

This does conclude today's program. Thank you for your participation. You may disconnect at any time.