Ferro Corporation

Good morning. Thank you for joining the Farrow Corporation third quarter and full year 2020 earnings conference call. An archived replay of this teleconference will be available through the investor information section at farrow.com later today and will be available for approximately seven days. Today's call is being recorded Thursday, November 5th, 2020. And now I'd like to turn the call over to Mr. Kevin Cornelius Grant, Director, Investor Relations and Corporate Communications. Please go ahead.

Thank you and good morning, everyone. Welcome to Pharaoh's third quarter 2020 earnings conference call. This morning, we'll be reviewing Pharaoh's financial results for the third quarter ended September 30, 2020. I'm pleased to be joined today by Peter Thomas, our Chairman, President, CEO, and Ben Schlatter, Group Vice President, Chief Financial Officer. The earnings release and conference call presentation deck are available in the investor section of our website. I'd like to remind everyone that some of the comments we are making today are forward-looking statements and are based on our view of conditions and circumstances as we see them today. However, those views may change as conditions and circumstances change. Please refer to the forward-looking statement disclosure in the earnings release in the earnings presentation. Also, today's call will contain various operating results on both a reported and adjusted basis. Descriptions of these non-GAAP financial measures and reconciliations are included in the earnings release and presentation deck. We encourage you to view that information in conjunction with today's discussion. It is now my pleasure to pass the call over to Peter.

Thanks, Kevin. Good morning, everyone. Thank you for joining us to discuss Ferro Corporation's third quarter 2020 results. We were pleased with FARO's third quarter results. We experienced a significant recovery in demand driven by our leadership positions in markets that have been recovering nicely from the low point of macroeconomic conditions brought on by the COVID-19 pandemic. Last quarter, we said that we were seeing what we thought could be the beginning of a V-shaped recovery in demand for FARO products. That V-shaped recovery became more pronounced in the third quarter, as demand for our high-margin products critical to growing industries continued its upward trend. Although down as compared to the pre-pandemic third quarter of 2019, sales in the third quarter increased by 18.1% over the second quarter of 2020, sales increased in almost all market categories. Margins in the third quarter were affected by product mix. However, we expect margins in the fourth quarter to rebound as we work through inventory and realize additional benefits from our North American Optimization Program. We continue to carefully manage expenses in the quarter, reducing SG&A even as sales volumes increase. Looking ahead, we are seeing signs that the positive momentum in demand for our products experienced in the third quarter will extend into the fourth quarter and early 2021. Our customers do not appear to be destocking in the fourth quarter to the degree they sometimes do. Order patterns for the fourth quarter and early in the new year suggest that our customers are preparing for continued expansion of the recovery in their markets. Accordingly, we are optimistic for the fourth quarter and early 2021, even as we recognize that the strength of global macroeconomic conditions remains uneven and uncertain. Of course, the COVID pandemic continues to challenge economies around the world, and while we currently do not anticipate a significant impact from the second wave of COVID cases, we are mindful of the situation and positioning the company to address circumstances as they evolve. I should add here that our employees have been exemplary, dealing with the many challenges brought on by the COVID pandemic. It bears repeating, especially during these times, that there is nothing more important than the health and safety of our employees, and we continue to utilize practices such as remote working and in-facility protocols to keep our people healthy and safe. So let's now step back for a minute from the immediacy of the last quarter and the next few months to consider a long-term strategy. As you will recall, the core of our focus is innovation and optimization. The strategic decisions we made to focus on high-margin, innovative functional codings and color solutions aligned with megatrends are proving beneficial in providing the foundation for additional growth. and our optimization initiatives are enabling us to more comfortably manage through macroeconomic downturns and further expand profitability during economic upswings. The megatrends that we discussed three years ago at our Investor Day are creating new product development opportunities and industries that we have targeted for our innovation programs. The innovation and quality of Ferro products, together with our technical expertise and functional codings and color solutions, enable us to play a critical role for our customers as their markets recover and demand for technically advanced products accelerates. Furthermore, many of the megatrend-related product development opportunities we are working on are in early stages, and we are right there alongside our customers positioned to be the supplier of choice. There are many examples that illustrate the value we provide to our customers in connection with the products they develop to address the megatrends we identified, such as 5G, the Internet of Things, AVs, EVs, and virtual communications, among others. Ferro is well-positioned with existing products, techno expertise, and continuing investment in R&D to support our customers. We mentioned some of these last quarter, namely, digital printing with organic and inorganic inks on various substrates, pigments for customized functions such as infrared reflection, food contact packaging, anti-corrosives, and pastes and sensors used in electronics. As we look forward to 2021, we are encouraged by a number of market dynamics reflecting megatrends, especially in healthcare, automotive, electronics, and decoration, all areas in which we have invested in technology platforms to support our customers. The breadth of our product portfolio and markets also provides us resilience to withstand weaknesses that might arise from time to time in one sector or another. The benefits of such diversity are starkly apparent in the current context when we compare Ferro's V-shaped recovery to the ongoing challenges facing many businesses that have a more narrow focus and continue to be hit hard by the COVID pandemic. Along with the value of a diverse product portfolio and customer base, the COVID pandemic also has brought another interesting dynamic to light. COVID related behavior changes are accelerating demand for certain products, especially those used by industry supporting mobility, such as people want individual smart and energy saving transportation, and entertainment and personal technology as people continue to work from home and limit attendance at large events. In addition, demand for our products to go into appliances also is growing as consumers seek new smart appliances. And construction also is picking up as people renovate their homes and move away from urban environments as a consequence of the pandemic. It is worth noting here that residential construction is picking up around the world. Construction is often a bellwether for changes more broadly in the macro economy. As global residential construction has strengthened, we are seeing demand increase in our tile coatings business, another indicator of recovery. Now, these drivers of our business are complemented by the cost management and optimization programs that have increased the efficiency of our company. We are seeing the benefits from our North American optimization program, and we will have more opportunities for efficiency as we remove stranded costs following the sale of our tile coatings business. To a modest degree, there has been some impact on our optimization initiatives from factors related to COVID, such as the additional time needed to complete transfers of certain assets, and these factors also have affected inventory levels for Farrow and our customers, but we are working through these. Improving productivity and efficiency is a core element of our strategy and fundamental to the quality of our business, and we are addressing these issues. All this is to say that we are doing what we told you we would do and generating positive results. With that, I'm now going to turn the call over to Ben for his comments on the quarter and our outlook for the remainder of 2020. Then I will talk about progress in our functional codings and color solution segments and provide some final thoughts on our expectations for 2021. Ben?

Thank you, Peter, and good morning, everyone. I would like to echo Peter's comments on how pleased we are with the company's performance in the third quarter. Despite the continuing challenges of the COVID pandemic, the business has delivered substantial revenue growth from the second to the third quarter, and improved adjusted gross profit margins year-to-date, all while managing to lower our SG&A. Moving on to discuss our consolidated financial results for the third quarter of 2020 from continuing operations, please note that the non-GAAP numbers I refer to are on an adjusted basis, and growth rates mentioned are on a constant currency basis compared to the third quarter of 2019. As a reminder, I'll also review free cash flow used in operations. The financial highlights and results for the third quarter can be viewed on slides 3, 4, and 5 in the presentation accompanying today's call, which you can find on farrow.com in the Investor section. Moving to slide 4, in the third quarter, net sales declined 2.1% to $241.9 million. Adjusted gross profit declined 7.4% to $72.2 million. Adjusted gross profit margin declined 172 basis points to 29.8%. Adjusted SG&A expense was down approximately 1% at $45.1 million. Adjusted EBITDA declined 14% to $36.9 million, or 15.2% of net sales. And adjusted EPS declined 29.6% to 19 cents. Now moving on to slide five. Year-to-date through September 30th, net sales declined 8.2% to $699 million, Adjusted gross profit declined 17.2% to $219.8 million. Adjusted gross profit margins improved 29 basis points to 31.4%. Adjusted SG&A expense declined by 4.1% to $142 million. Adjusted EBITDA declined 9.1% to $108.5 million. Adjusted EBITDA margins were flat at 15.5% and adjusted EPS declined 13.8% to 56 cents. These results reflect certain non-GAAP adjustments for the third quarter, primarily related to legal costs associated with previously divested businesses, corporate development, and optimization activities. First, in cost of sales, we have adjustments of approximately $2 million, primarily due to costs related to optimization initiatives of $1.5 million and $500,000 related to other costs. In SG&A, we have one-time adjustments of $2.7 million in the quarter, $1.9 million of that consisting of costs for legal fees, professional fees, and other expenses related to certain corporate development and optimization initiatives, including the North American manufacturing optimization and $800,000 related to divested businesses. Turning to restructuring and impairment, there was an adjustment of approximately $2.4 million, reflecting actions to achieve our ongoing optimization initiatives and acquisition synergies. And finally, in other expense, there was $1.2 million related to divestitures. I'll now move to SG&A. In the third quarter, adjusted SG&A expense declined approximately 1% to $45.1 million or 18.7% of net sales, compared with $45.5 million or 18.4% of net sales in the prior year quarter on a constant currency basis. We've managed to reduce SG&A expenses even while growing our revenue substantially from the second to the third quarter and saw the resulting benefits from that reduced spending in our SG&A leverage for the quarter. This brings me to GAAP cash flow from operating activities. I will also discuss adjusted free cash flow from operations, or what we define as cash flow available for items including but not limited to strategic investments, debt service, and shareholder returns. We calculate this adjusted free cash flow metric by combining the following lines from our statement of cash flows. Gap cash flow from operations, capital expenditures, and cash collected under securitization programs. This information can be found on Table 12 in our press release. In the third quarter, GAAP cash flow from operations was an outflow of $1.9 million. Then we subtract $6.7 million of capital expenditures and add cash received on other receivables of $34.7 million to arrive at $26.1 million of adjusted free cash flow in the third quarter, which reflects the earnings benefits we mentioned and changes in working capital for seasonality, but also for certain optimization initiatives. I would like to wrap up my comments by reintroducing guidance for 2020. As you may recall, during the first quarter 2020 earnings call, we withdrew our 2020 full year guidance as the COVID pandemic began to affect economies around the world and challenge visibility. Although we recognize there remains a level of uncertainty in the macroeconomic landscape related to the COVID pandemic, we believe we've gained sufficient visibility and confidence with respect to certain metrics through the end of 2020 to reestablish guidance. For 2020, we now expect full year adjusted EPS to be 71 to 76 cents and EBITDA to be 141 to $146 million for continuing operations. With that, I'll now turn the call back over to Peter to walk through each of the business units and add his final comments before we take questions. Peter.

Thanks, Ben. Now I take you through highlights of third quarter performance in our continuing operations reporting segment. As a reminder, earlier this year, we changed the name of our formal performance colors and glass segment to functional coatings, which includes the porcelain enamel business. We'll begin our discussion with the functional coating segment. In the third quarter, functional coding net sales on a constant currency basis were down 1% compared to the third quarter of 2019. However, on a sequential basis, net sales increased 17.1% from the second quarter of 2020. Adjusted gross margins declined to 27.8% in the third quarter from 31% over the prior year period on a constant currency basis. Adjusted gross profit declined 11.4%. from $48.2 million to $42.9 million. Now, the vast majority of the decline in sales volume and gross profit resulted from weaker demand in end markets that have been impacted significantly by the COVID pandemic. This includes end markets such as automotive and decoration, which serves the hospitality and travel industries, and industrial commercial construction. As I mentioned during the second quarter call, we were beginning to see what we would call virus-proof growth brought by the transition to virtual workplaces and schools. Examples are high-end electronics that support telecommunications and memory devices. In the quarter, we saw a continuation of these trends. Our electronic materials business was up approximately 11% in the quarter compared to the prior year quarter. Ferro's electronic materials technology is found not only in automotive sensors and high-end consumer electronics, but also in the electronics that serve communication systems such as 5G, NAND memory applications, and satellites. With people spending more time at home, demand also has increased for our products used in cooking appliance applications. In addition, our products are critical elements and devices that are used to monitor and assist people using healthcare apps and telemedicine. In the third quarter, automotive business sales were down high single digits relative to the prior year quarter, but snapped back swiftly relative to the second quarter this year, growing sequentially approximately 85%. This mainly was a result of factories in the Americas and Europe coming back online. In addition, we saw some share capture in this space in Latin America. Our decoration business was down approximately 10% due to lower demand in hospitality and travel. This business segment, too, is off its lows, improving from the second quarter by approximately 17%. We have every expectation that the business will return as the hospitality industry eventually recovers from the pandemic. In the industrial materials business and porcelain enamel business, sales increased low single digits. The commercial construction landscape continues to look weak due to the pandemic. On the other hand, we are seeing strong volume demand in Asia from two of the largest solar manufacturers for our glass enamels, which provides higher efficiency in power generation and solar panels. As I mentioned last quarter, home appliance manufacturers largely depleted their inventories in the wake of the COVID outbreak. Our PE business grew in the third quarter by approximately 30% from the lows in the second quarter as customer demand surged. Because of the strong demand for replacement and remodeling occurring in the appliance market, as people spend more time at home, many of our customers now carry a very, very long backlog. We expect this to translate into continuing strong demand for ferro products used in appliances. Now, turning to our color solution segment. In the third quarter, Color Solutions net sales on a constant currency basis were down 4.2% compared to the third quarter of 2019. However, on a sequential basis, net sales increased 19.9% from the second quarter of 2020. Adjusted gross margins increased 111 basis points to 33% in the third quarter from 31.9% over the prior year period on a constant currency basis. Adjusted gross profit declined approximately 1% from $29.2 million to $28.9 million. In the quarter, the majority of the decline compared to the prior year quarter was attributable to payments used in automotive and industrial coatings. However, coming out of the second quarter of 2020, we saw strong demand for inks utilized in single-use and disposable packaging applications, another consequence of the COVID pandemic. Also, we are seeing strong demand for our surface technology products utilized in N applications. In addition, demand has been strong for surface technology products used in eyeglass polishes, as these businesses are now getting back to normal after long shutdowns of eyewear stores due to the pandemic. And finally, we are seeing strong demand for our pigments and coatings, as automotive manufacturers now are back in operation. So, we had a strong third quarter, and we are confident that Farrow is positioned to continue the momentum in the fourth quarter and into the new year. At this point, we also wanted to update you on the sale of our tile business to Lone Star and its affiliate, Esmoglass. The transaction is subject to customary closing conditions, including regulatory approvals. Farrell and Lone Star have made substantial progress on the transaction and are working with the regulatory agencies to obtain the remaining approvals. While a definitive closing date cannot yet be determined, the parties are advancing with plans to be able to close the transaction by December 15, 2020, according to the purchase agreement terms. 15 days after satisfaction of the relative conditions or as the parties otherwise agree. Anticipating that additional time may be required, the parties have already expressed the intention to discuss an extension, if necessary. Again, from a longer-term perspective, our leadership positions in markets aligned with megatrends and our innovation initiatives focused on these markets will, we believe, continue to contribute to attractive growth going forward. When this growth is combined with our commitment to optimizing our business, we believe we have a winning formula for attractive, sustainable, and profitable growth. Now, I'll turn the call over to Kevin to open the call to our first question. Kevin?

Thanks, Peter. With that, operator, let's open up for the call for our first question.

Thank you. If you'd like to register a question, please press the 1 followed by the 4 on your telephone. You will hear a three-tone prompt to acknowledge your request. If your question has been answered and you would like to withdraw your registration, please press the 1 followed by the 3. If you're using a speakerphone, please lift your handset before entering your request. Once again, that's 1-4 to register for a question. One brief moment for the first question. And we have a question from the line of Rosemary Morbelli with GE Research. Please go ahead. Your line is open.

Thank you. Good morning, everyone. Rosemary, good morning. I was wondering if, Peter, you could give us a little more on the child's coding transaction. Why is it taking that long? And I do realize that it is regulators, but are they taking this long because this is usually how it happens, let's say, in Spain and Portugal, which is my best guess is where it is, since this is where Esmaglass is based? Or do you think that they are going to be asking you or Esmaglass to divest some pieces of the business in order to approve it? Can you give us a to the extent that you can, a little more on what is actually going on, you know, the way you see it.

Yeah, sure. I think you answered it yourself quite nicely when you first opened. Certainly, the regulatory process in Europe is the regulatory process in Europe. It's, you know, their timing, their schedule. Questions are asked, and Lone Star and Farrow are responding as necessary to answer questions. But I think it's more of those on the call and everyone who have done deals in New York understand that the regulatory agencies are what they are. We have no control over them. Esmiglass has no control over them, but we continue to speak all the time. And so that's basically the answer. You're right. It's just a timing situation.

Okay. And looking at... the results for the quarter, you mentioned in the press release that results were better than you anticipated. Could you talk about the areas which actually performed better than your expectation?

Yeah, sure. I think you might remember in the first and second quarter calls we did mention in our modeling that we were starting to see as we look forward that we would have some kind of a a V-shaped recovery, and certainly I think you're seeing more of that not only with us but a lot of other companies. But, you know, our modeling suggested back then that we would be kind of where we thought we would be on the last call, which I also made the comment that we would be materially better than the second quarter moving into the third quarter, which happened. So from that perspective, from our visibility with customer orders through our eight MBUs, We could even see in the second quarter that sales were coming into the third and even fourth quarters at that time. The automotive business itself has picked up a bit faster than we anticipated, even though we're in daily contact with our top customers. The appliance market picked up a bit better than we thought. And our electronics business continues to do well for the reasons that we mentioned in our prepared remarks. We see different types of pigments for different types of applications doing a little bit better than we had thought, particularly in the third quarter. Maybe the new Biola-type range of products were a bit better based on the application, but I think we did discuss it. In the prepared remarks how the inks for packaging and one-way usage versus reusable type of applications, that segment did a bit better. Our surface technologies, business did better, as I mentioned. around plastic polishing has picked up both in the consumer end and also in the industrial types of applications. So, you know, five out of the eight MBUs that we have kind of outperformed what we thought. And the good news is not only those five MBUs are also showing good performance now in the fourth quarter and maybe moving into the first quarter of next year. And the only MBU that's lagging a bit, actually getting a bit better, would be the decoration piece. Out of all eight of them, that's the one that's tied mostly behind fatality and travel. And although it is picking up, it picked up nicely from the second to the third quarter, it's still the lagger. But the other seven MBUs, as I mentioned about the V-shaped recovery, and I think we mentioned last quarter, that by the end of the year we would see a run rate that would solidify the B position. And I think we are definitely in that camp that that's going to occur. So hopefully that answers your questions.

It does. Just one last question, if I may. With your electronics business at DoubleDigit, do you see any inventory buildup? at your customers that is going to impede future growth, at least over the short term, or they are inventories who are so depleted that it is actually refilling it as opposed to real consumer demand?

Good question. Actually, it's all of the above. It depends on the customer. It depends on the application because in all of our market segments, as you know, we have hundreds and hundreds of applications. Let me answer it this way, because I think we're seeing something that's very interesting, and I think it's important, and maybe something that maybe a lot of our peers are seeing, but I haven't heard too much of what I'm going to say in a lot of the scripts, so let me lay it out there. What you're seeing is, one, the pandemic has caused an etch-a-sketch moment in everybody's supply chain, so It's sort of like we joke around here because of the pandemic. Everyone is remodeling, cleaning out their closets and doing this and that. I suspect that all that's going on in companies as well. So the pandemic is, from our perspective, through our lens and discussions with our customers, everyone is kind of cleaning house in their companies. They're doing what they can to be more efficient. draining out inventories and the like. And so now what you're seeing is there's a pretty strong demand on, I think, everybody in different degrees. But let's just talk for us for a moment. So the four or five MBUs that I mentioned that did better than we thought. Interestingly enough, when we speak with the customers, I think our customers enjoy the tightness of the supply and demand scenario. Not that we're going to get into an economics review here, but you know as well as I do, when demand and supply is tight, you know what happens. Maybe the consumer doesn't benefit from it. But I think a lot of people like the idea that manage the supply chains tightly. They've been doing it for five or six months. They're carrying maybe the minimal amount of inventory that's needed. I don't think anyone's becoming very ambitious about building inventory on fielded greens where they anticipate stronger growth. I think no one's really interested in having phantom sales skewing what's real in demand. And again, I believe that a lot of our customers, which are market leaders, by the way, because over 95% of our sales are with market leaders, and we're very close to them. We have nice fences around those customers, and their concept is This is like working okay. We like the way our plants are running. We like the tighter supply chain. It's helped with business rules. You know, customers are giving us orders with longer lead times, which is helping and allows us to have more visibility going forward. Last quarter, I mentioned that we had orders in the third and fourth quarter and maybe a titch in the first, and I can sit here today and say, you know, we are seeing an order pattern and we have visibility in our order books going into the first quarter. In some cases, we're touching the second quarter. And also, a lot of our customers are saying not only do we like kind of to help manage this tightness in supply and demand, but it's also a period where we can reduce our SKUs. You know, it's sort of like, you know, rather than having 15 different variants with this pandemic, why don't we try to focus on a narrower kind of an offering in a way that, you know, it would help us be more efficient, help with inventory and the like. So I think conceptually, this concept of keeping supply and demand as tight as possible is everyone's conservative way in view of managing through the pandemic, probably going through next year from our perspective.

Thank you. Our next question is from Mike Sison with Wells Fargo. Please go ahead. Your line is open.

Hey, guys. Nice quarter. Peter, when you think about 21 and maybe look at a bridge for next year, do you have some cost savings? What type of leverage on growth do you think you'll get? And I know it might be early to give specific guidance, but are there sort of variables you can help us think about as we head into 21 for Farrell?

Yeah, so at this point, let's just tee up what we've said in the past and what we're saying already. We are feeling this V recovery, and hopefully that puts us back on a normal cadence that we've had. I think we've been pretty Specific around the Optimization Act, we have, again, you know, the ACT cost savings. We continue to see those. We'll be working on our stranded cost, which we're already – the plans are already developed, and we're already starting to march down that path. And, again, we mentioned somewhere between $10 million to $12 million for those. Next year, we gave, you know, ranges for ACT. We see no real deviation from any of that. And the only big question is what happens with the revenue. We're not in a position now to discuss that, but I think the starting point would be your basic, hey, let's have a V recovery and then try to look at some normalcy, what Remanco would normally do for a year as a starting point. And I think that's how we're starting to see it. And again, we do see some indications with our order book that we're seeing some orders in the first quarter. We see some touches. In the second, now remember why that is. Remember what I mentioned about Remanco. In the past, unlike a lot of commodity companies where maybe 70% of the business is already booked out within the first seven or eight days of a month, you know, a lot of our products are so specialized and they move in kilograms that order patterns for our products could be anywhere between eight and 16 weeks, depending on the MBU and the slice of the product mix within each MBU. So because of that and because of what I mentioned about the supply and demand, which we really, really like that concept that our customers are discussing around managing the demand and supply in a very efficient way, I would assume would help everybody in terms of their planning moving forward. That you'll always be working on tight supply versus having and a slight backlog instead of over building inventories and hoping that the sales will come to fruition. And again, like I said, we believe that our customers are using that as their conservative approach of handling the pandemic by managing that tight supply chain. So what we would say is we feel really good where we sit today about what the prospects are barring anything that's catastrophic or something that's really, really way out of anybody's control. We like the way our Revainco business is shaping up. We like the business positioning with our eight MVUs. We've worked very hard, and you've heard us talk about this before, and I think it's worth noting since you've teed it up for us, is the concept of Why do we feel that comfortable? And again, a lot of that has to deal, Mike, with what you know from the very beginning when you sat with us. And I can remember the June meeting of 2013 sitting in Cleveland when you brought all those investors in. And we specifically, they adopted our strategy over multiple phases would deliver a company containing six very important characteristics of a leading performer, whether that's portfolio coherence or leadership positions and chosen products or sectors, very attractive market structure. I've gotten into that with each of our MBUs. We have no more than two or three major competitors in anything that we do. We certainly have strong technology and innovation capabilities as evidence of the what we would define our common technology competencies are, leading to a plethora of technology platforms with a broad range of programs that are emanating from them, leading to this, you know, our almost 20% vitality index. All of that is real, and we've delivered against it. And we now have a good growth dynamic. I think you're going to see, like we've discussed, we've moved from GDP to market growth. plus one to two because market growth for us is higher than GDP. And I think if you take a look out in what the pundits suggest for growth around the world next year, and you take a look at what you might believe are weighted averages from a market growth perspective, and you look at one to two percent, you know, certainly that's what we aspire to do. And it's very doable with our business. And I think the most important thing, strangely enough, even with our scale, is the concept of cycle resiliency. I think you're seeing that with this business. And I think it keeps getting better as the quarters go by. So that's the data I would give you to think about how we might look for 2021.

Great. And a quick follow-up, your balance sheet is going to be in really good shape as you head into 21 with the tile sale. Any thoughts on what you plan to use or focus your balance sheet on next year?

Hey Mike, it's Ben. Yeah, look, as we get into next year, the focus will still be to maintain leverage at a reasonable level. However, as you've heard us talk about in the past, the pipeline on the M&A side continues to be full and we're actively looking at opportunities there. And as we get into next year, I think you'll continue to see us look for bolt-ons from a technology perspective and to broaden the portfolio. There's a number of those out there across a number of different sides as well. So I think what is exciting from our perspective is the broad range of potential opportunities we could look at, and as we get into next year, we'll definitely be looking at those.

Our next question is from David Begleiter with Deutsche Bank. Please go ahead. Your line is open.

Thank you. Good morning. Peter and Ben, what are the assumptions underlying the low end of your implied Q4 EBITDA guidance?

Sorry, David, you broke up on the last part of that. Can you repeat the question, please?

What are the assumptions underlying the low end of your implied Q4 EBITDA guidance?

Yeah, sure. So let's start with Q3, right? Q3 was much better than expected, right? So we had a very strong Q3. And the view for Q4 is that Q4 will be much the same as Q3. So we expected originally some lift from Q3 to Q4. We've now, the recovery that we anticipated is actually accelerated, meaning we saw more of a benefit in Q3 than anticipated. So we now sort of see a very similar quarter between Q3 and Q4. I would say the only difference will be some administrative things that we typically see at the end of the year around healthcare and that sort of thing that will come into SG&A. But beyond that, the quarters will look will look pretty similar. With that as the baseline, what could move us to the top of the range versus what could move us to the bottom of the range? Look, if we see revenue increase a bit, we could get closer to the top of the range or even above the top of the range. There's opportunities for that. As we look at what could move us to the lower end of the range, to the extent that we're able to sell through more of some of this inventory that we have on hand, that will put a little bit more pressure on gross margins, and that will happen then all the way through earnings. So that depends on what the mix is in the fourth quarter, so that could push it a little bit lower as well. Look, I think as we sit here today, I think that there's a greater probability that we'll be above the midpoint of the range than below the midpoint of the range, but those are some of the things that can move it around.

So very helpful. And just they mentioned volumes and sales. Do you expect your Q4 volumes to be even flat year-over-year, or could they even be up year-over-year versus the prior year?

Yeah, so look, again, Q3, Q4, I think will look similar. Is there an opportunity for our sales levels to be greater than last year? I think there is. Is there an opportunity for it to be lower? Yeah. But, again, the way we're seeing things now, the markets are strong. So we had a very, very good September. October also looks good. So we're optimistic going into the fourth quarter.

Our next question is from John McNulty with BMO Capital Markets. Please go ahead. Your line is open.

Yeah, thanks for taking my question. Maybe just a follow-up around the opportunities for capital deployment. Can you speak to the M&A pipeline in terms of, you know, where the bid asks are? You know, I know earlier this year they were pretty wide. Do you see them narrowing, and do you see opportunities that – You know, realistically, you may push across the finish line as we look to 2021, obviously after the tile coating sale.

Yeah, so I think we saw, let's say, I think we saw multiples stabilize a bit, John, at the end of the summer. And I think as we get into the end of the year and into next year, I think a lot of it depends on what happens with COVID to the extent that there's an impact on earnings from COVID. I think you're going to see people sort of try to retrace what more of a run rate EBITDA will be. And so I think it's too early to tell how that looks in Q4 and even in Q1. But we did see some stability. I think the challenge with all that, and the challenge will be going into next year looking at some of these deals, is you know, how quickly will the recovery happen post any sort of second wave?

Got it. Fair enough. And then I guess speaking to the second wave, I mean, we've seen, you know, a decent flare-up in Europe, I guess. Have you seen much of a demand response yet? Is that still on the come, or is it just now maybe, you know, regions are a little bit more comfortable with how they managed through this, and so, you know, the demand response may not be as extreme, I guess. How would you characterize it?

Yeah, where we see it now, John, is that we're not seeing it. We speak with the European teams almost daily and anticipating this type of question. And where we sit today and where our team sit, everyone still feels comfortable regardless of what's happening in Europe with the second wave that things will be as they're forecasting. And as Ben mentioned, we feel really good about it. I think what's happened... Again, much in line, the second part of my comment around our customers enjoying managing a very tight supply and demand position for obvious reasons. The second part of that is everyone in our manufacturing facilities around the world, I'm not going to take this lightly, but are kind of accepting that it is what it is and the protocol that we've put in place and a lot of our customers have are very strong and would allow for the type of demand that we see against their products and our products to continue through the fourth quarter and into the first, even with the second wave as you're seeing it. So I think it's sort of like everyone is adjust from a manufacturing perspective. I know we have, and our discussions with customers suggest that they have, and it's sort of like get used to it. We're not going to stop the world here. We're going to do everything we can to keep running because we're not going to fall behind. back to where we were before, and nobody wants that. And the Europeans are pretty vocal about that. And it's like we'll manage through it and get it done and meet the demand.

Got it. Fair enough. Thanks very much for the call. Operator, we have time for one last question.

Thank you. We have a question from the line of Mike Harrison with Seaport Global Securities. Please go ahead. Your line is open.

Hi. Good morning. Morning.

Morning.

I was wondering, Peter, if you can talk a little bit about the margin performance. It looks like gross margin still showed some headwinds related to inventory drawdown. Are we at a point where we should see more normal fixed cost absorption moving forward? I know Q4 is typically seasonally a time where we could see you guys work down some inventories and see lower fixed cost absorption. And then maybe also touch on SG&A costs trends and whether there were still some temporary savings in that Q3 number.

Yeah. Hey, Mike, it's Ben. So, look, in the third quarter, we saw margins, growth margins come down as anticipated. Frankly, we worked down more inventory in the third quarter than we had even planned, which is a good thing. So we saw a little bit more margin pressure. That's going to continue into the fourth quarter. We said earlier we think the fourth quarter looks a lot like the third quarter. That's one of the reasons why. I think that as we continue this product move from North America into Latin America, that will continue into 2021. A lot of that is customer-based and lead time-based. So our sense was that's going to continue into 2021. When we get through that, a lot of this will be based on customer mix. as well as demand in 2021. And we can get into that more when we talk after the first of the year. But no, the short answer to your question is it'll certainly continue in the fourth quarter and likely continue into 2021.

And the SG&A cost, how much of that was temporary?

Yeah. So, look, most of what we're seeing from an SG&A perspective in the third quarter is real, meaning we would expect to, for the most part, see that continue into the fourth quarter. As I mentioned earlier, we will have some headwinds from an SG&A perspective. They'll be relatively minor, going from the third quarter to the fourth quarter, as we typically would around things like health care, et cetera.

All right, and then I wanted to also ask, there's a footnote in your press release mentioning a fire at a facility in Columbia. Is that the ultramarines plant that you recently expanded? Can you talk about what's going on there?

Yep, it is that ultramarines plant. That situation happened earlier in the quarter. We've dealt with it, moved on, and the plant is back up and running.

All right, thanks very much.

You bet.

We would like to thank everyone for joining us on the call today. We appreciate your interest in FARO, and we look forward to discussing the results with you again next quarter. Enjoy the rest of your day.

That concludes the call for today. We thank you for your participation, and I say please disconnect your lines.