Proto Labs, Inc.

Second quarter 2022 earnings conference call. At this time, all participants are on a listen-only mode. A question and answer session will follow the formal presentation. If you would like to ask a question, please press star 1 on your telephone keypad. If anyone should require operator assistance during the conference, please press star 0 on your telephone keypad. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Mr. Jason Frankman, Vice President and Corporate Controller. Thank you. Please go ahead.

Thank you, Donna, and welcome, everyone, to ProtoLabs' second quarter 2022 earnings conference call. I'm joined today by Rob Bedore, ProtoLabs' president and chief executive officer, and Dan Schumacher, chief financial officer. This morning, ProtoLabs issued a press release announcing its financial results for the second quarter ended June 30, 2022. The release is available on the company's website. In addition, a prepared slide presentation is available online at the web address provided in our press release. Our discussion today will include statements relating to future performance and expectations that are or may be considered forward-looking statements and subject to many risks and uncertainties that could cause actual results to differ materially from expectations. Please refer to our earnings press release and recent SEC filings, including our annual report on Form 10-K, for information on certain risks that could cause actual outcomes to differ materially and adversely from any forward-looking statements made today. The results and guidance we will discuss include non-GAAP financial measures consistent with our past practice. Please refer to our press release and the accompanying slide presentation of the investor relations section of our company website for a complete reconciliation of GAAP to non-GAAP results. Now, I'll turn the call over to Rob Bedore.

Rob? Thanks, Jason. Good morning, everyone, and thank you for joining our second quarter earnings call. I'm happy to report another strong quarter with revenue and EPS within or above our guidance ranges. Despite ongoing supply chain challenges in the broader manufacturing industry and macroeconomic growth concerns, PortalApp's comprehensive digital manufacturing offer continues to delight our customers. Highlights of our second quarter performance include strong growth in our CNC machining, 3D printing, and sheet metal services, as well as another quarter of strong growth at Hubs. Both the Portal Labs and Hubs offers continue to resonate in the marketplace, and we're now more excited than ever to bring the two offers together by the end of this year. In addition, pricing optimization and cost controls drove sequential improvements in both gross and operating margins. While we're very pleased with the performance in our CNC machining, 3D printing, and sheet metal services, revenue in our injection molding service did not meet our expectations in the second quarter. As was the case in the first quarter, our injection molding growth rate was negatively impacted by the absence of several large COVID-related medical orders that occurred in the first half of 2021. In addition, we experienced many customers placing unusually large orders in 2021 in order to stockpile inventory during that time of high uncertainty. In 2022, that behavior has significantly reduced among our customers in line with macro inventory trends in the industries we serve. Furthermore, the unprecedented surge of orders in 2021 led to record high backlogs for us. These extended lead times, coupled with system inefficiencies we described in prior quarters, impacted our customers. We have addressed this operationally, and our fastest lead times are fully available today. We're focusing on go-to-market teams, on targeted campaigns to inform and re-engage impacted customers with our world-class offerings. We're still very confident in the competitive advantages of our injection molding service and are focused on providing great customer experience going forward as we return to growth. Before I provide an update on our 2022 strategic priorities, I would like to take a few moments to address important actions that occurred during the second quarter of 2022. First, I'm excited to announce that in early June, after an extensive search process, Dan Schumacher was named ProtoLabs Chief Financial Officer. Dan has been with ProtoLabs for five years and most recently served as interim CFO for six months. Dan brings a strong pedigree of leadership experience and operational excellence to the ProtoLabs leadership team. He's a great asset to the business and a great partner to me. I'm very excited to work alongside him and all of our great employees as we continue to revolutionize manufacturing and delight our customers. Secondly, I want to discuss our strategy for managing our portfolio of businesses and initiatives. We're actively working to focus our investments in areas that promise the greatest return and ultimately the greatest shareholder value. Protolabs has the greatest opportunity for profitable growth through the integration of our manufacturing partner network and our internal digital manufacturing. Our resources and investments are focused on opportunities with the highest potential return, which means making decisions to reallocate resources away from those areas that are no longer aligned with our long-term objectives. Consistent with that philosophy, in May, our board of directors approved a plan to cease operations in Japan and close our manufacturing facility in the region. Protolabs entered Japan in 2009 but our Japanese business only grew to 3% of our total revenue over that period and did not meet our profitability expectations. Our low-touch e-commerce digital manufacturing business model did not resonate especially well in a region where customers place enormous value in long-term personal relationships. This was a difficult decision that I did not take lightly and I truly want to thank all our employees in Japan for their hard work and loyalty to ProtoLabs over the years. Affected employees in Japan will receive severance and other transition assistance. We will ship final parts to customers through September. Dan will provide details on the financial impact later in the call. Next, during the second quarter, ProtoLabs received another impressive piece of external recognition. In June, Protolabs was awarded Manufacturer of the Year from the Manufacturing Leadership Council, or MLC, a division of the National Association of Manufacturers. Protolabs has won numerous leadership awards from the MLC over the years, and this is the first time we've taken home the top prize. The award recognizes our all-around excellence as a small to medium-sized manufacturer. Protolabs joins an esteemed alumni group of recent Manufacturer of the Year award winners that includes Universal Robotics, InBev, IBM, and Merck. ProtoLabs continues to be recognized externally on a regular basis for our best-in-class digital manufacturing capabilities. This is a testament to the great work that our employees do and the value we provide to our customers. Now, let me remind you of our 2022 strategic priorities that continue to guide us as we deliver on our mission to empower companies to bring new ideas to market by offering the fastest and most comprehensive digital manufacturing service in the world. Our first priority is accelerating our revenue growth through expanded offerings, pricing optimization, and integrating the Hubs network into our e-commerce experience. As I mentioned earlier, we saw very strong growth in our CNC machining and 3D printing services. Sheet metal growth was also solid in the quarter. Going forward, we're focused on accelerating growth in our injection molding service. Regarding the integration of the ProtoLabs and Hubs offers into one e-commerce platform, We continue to make good progress with a dedicated focus on the customer experience. We're on track and we'll have the initial integrated CNC machining released by the end of the year. We are very excited to provide a unified digital experience combining our digital manufacturing with our digital network. Bringing together the strengths of Protolabs and Hubs will provide a customer offering that no one else in the market can replicate with unrivaled breadth of manufacturing capabilities, lead times, and prices furthering our industry leadership and profitable growth. Our next priority in 2022 is to delight our customers, and we continue to deliver on our strong on-time delivery and quality rates while offering the fastest lead times in the industry. Our best-in-class speed and reliability allows Portal Labs to partner with customers as they innovate and create new and improved products, products like electric vehicles to reduce carbon emissions, medical devices to help people live fuller, more active lives, habitats to help astronauts live and explore the lunar surface, and advanced prosthetic limbs that help athletes compete. Many of our customers are working to change the world for the better, and we're proud to collaborate alongside them toward that objective. Our third priority is to be the digital leader at scale by increasing our levels of automation in the factory and back office. We are pleased with sequential improvements in both gross and operating margins in the second quarter and will continue to optimize price and drive diligent operating efficiencies to continue this trend. We will continue to drive the organization to deliver on our target gross margins of 50% in internal digital manufacturing and 25 to 30% through the Hubs Manufacturing Partner Network. Our next priority for 2022 is to be a great place to work. Protolabs employees drive the success of our company, and we will continue to invest to recruit and retain the best talent. I am very encouraged by the energy and passion our employees have demonstrated by collaborating to make a positive impact on all of us at Protolabs and the communities that we live in. During the quarter, several employee-led groups organized cross-functional team-building activities and initiatives to raise donations for various charities. Thank you to the Green Team, the Diversity, Equity, and Inclusion Leadership Council, ProtoGivers, and many others for your continued efforts. They're truly inspirational. With these clear priorities in place, I am confident in our ability to execute on both our short-term and long-term objectives. The combination of ProtoLab's best-in-class rapid digital manufacturing services and HUB's outsourced manufacturing partner network is a unique and winning model in a rapidly growing market. While we may face near-term disruption on macroeconomic uncertainty, we remain confident in our long-term strategy and are focused on execution. With that, Dan will now take you through our second quarter financial results and our outlook for the third quarter.

Thanks, Rob, and good morning, everyone. We are pleased with our financial results in the quarter, including record quarterly revenue and non-GAAP earnings per share above our guidance range. Before I walk through our financial results in detail, I'd like to highlight the financial rationale behind our decision to exit Japan. After 13 years of operation, Japan represented 3% of our total revenue in 2021, or $13 million. In the same amount of time, our Americas and Europe business had grown to over five times that size. In addition, between 2009 and 2021, Protolabs Japan's achieved profitability in only four of those years. Based on this, we determined that we could achieve higher potential returns by investing additional capital, time, and resources in other areas of the business. Now on to the numbers. Our second quarter financial results begin on page seven of the presentation. Second quarter revenue of $126.9 million was within our guidance range and represents a 3.1% increase year over year or 5.4% in constant currencies. Hubs generated $11.3 million of revenue in the second quarter, representing growth of 26.3% year over year. With strengthening of the U.S. dollar throughout the second quarter, we experienced a $2.7 million unfavorable impact to revenue in the quarter, slightly above our guidance of $2.5 million. Second quarter revenue by region is summarized on slide 11. In the Americas, our largest region, second quarter revenue grew 5.6% year over year. In Europe, second quarter revenue grew 3.9% year over year in constant currencies. Transitioning to revenue by service, our CNC and 3D printing services continue their strong performance year to date, with second quarter revenue growth of 17.7% and 12.6% year over year in constant currencies, respectively. Sheet metal revenue growth was also strong at 9.4% year-over-year. As Rob noted, our injection molding business has underperformed expectations in the first half of 2022, and we are actively working to drive demand. Injection molding revenue declined 5.6% year-over-year in constant currencies. We served 24,058 unique product developers in the second quarter, up 3.5% year over year, consistent with revenue growth. Turning to slide 15 and our detailed income statement. Overall, second quarter non-GAAP gross margin increased 20 basis points sequentially to 45.9%. Gross margin improvement was driven by higher volume, price optimization, and prudent cost management in our manufacturing facilities. Hub's gross margin in the second quarter was 26.4% compared to 24.2% in the first quarter of 2022. The sequential improvement was largely driven by increased volume and improvements to pricing algorithms. In the second quarter, Hub's lower margin outsourced manufacturing model represented 180 basis point drag on our overall gross margins as it continues to grow faster than our internal digital manufacturing services. Total non-GAAP operating expenses were $42.3 million in the quarter, down $600,000 from the first quarter of 2022. Wages and contractor expenses declined slightly sequentially as headcount was below expectations throughout the second quarter. This was partially offset by an increase in Hubs operating expenses as Hubs continues to invest in go-to-market initiatives as well as an increase in professional services. Regarding the eventual exit of our Japanese operations, the decision to close Protolab's Japan business resulted in a $5.2 million in gap operating expenses during the second quarter, including $2.2 million of employee severance, $1.2 million related to the write-down of fixed assets, $900,000 of facility-related charges, $600,000 in goodwill impairment charges, and $300,000 in other closure-related charges. These expenses have been excluded from our non-GAAP financial results to enable clean comparisons to prior and future periods. See slide 15 in the appendix of our accompanying slide presentation for GAAP to non-GAAP reconciliations. Moving to taxes, our non-GAAP effective tax rate in the second quarter was 21.1% compared to 23.3% in the prior quarter and 26.7% in the second quarter of 2021. Our non-GAAP effective tax rate was lower compared to prior periods due to release of reserves for uncertain tax positions. Second quarter non-GAAP diluted net income per share was $0.46, representing a sequential increase of $0.08 per share. This sequential increase was driven by higher volume, gross margin improvement in the Americas and hubs, and lower selling general and administrative headcount. Non-GAAP earnings per share were above the high end of our guidance range, primarily due to lower headcount and a lower tax rate due to the reserve release. Transitioning to cash flow and balance sheet highlights on slide 16. We generated $13.3 million in cash from operations in the second quarter. We also deployed capital in the form of share repurchases in the second quarter in order to offset dilution from stock-based compensation. We repurchased $5.2 million in shares during the quarter. At June 30th, we had $110.1 million in cash and investments on our balance sheets. and we remain debt-free. Now I'll provide our outlook for the third quarter of 2022 as outlined on slide 18. We expect to generate revenue between 121 and 129 million in the third quarter, representing year-over-year growth of up to 7% in constant currencies, excluding the impact of the closure of Japan. This guidance incorporates July performance, current demand trends, and typical seasonality patterns. We expect foreign currency to have approximately a $2.9 million unfavorable impact on revenue compared to the third quarter of 2021. The closure of our Japan operations is expected to have a $1.8 million negative year-over-year impact on our revenue growth. Moving to earnings guidance. We anticipate non-GAAP add-backs in the third quarter to include stock-based compensation expense of approximately $3.8 million, an amortization of expense of 1.5 million. We anticipate the closure of Japan to negatively impact our non-GAAP gross margins in the third quarter. We currently estimate our non-GAAP effective tax rate will be between 23% and 24% in the third quarter. In summary, we expect third quarter non-GAAP earnings per share between $0.36 and $0.44. That concludes our prepared remarks. Rob and I will now gladly take your questions.

Thank you. The floor is now open for questions. If you would like to ask a question, please press star 1 on your telephone keypad at this time. A confirmation tone will indicate your line is in the question queue. You may press star 2 if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. Once again, that is star 1 to register a question at this time. The first question is coming from Brian Drabs of William Blair. Please go ahead.

Hi. Good morning. Thanks for taking my questions.

Morning, Brian.

First, morning. On injection molding, so it's declined in some quarters. The sequential declines basically flat, but it's declined sequentially for the last four quarters. So is there any specific reason or that you can point to or can you give us some confidence that that business specifically is going to turn around in the second half? Just trying to figure out how to model this business now at this point.

Yeah. So when you look at it year over year, a year ago we had a number of COVID-related orders that didn't recur. But as you look more broadly, during that period we saw you know, an unprecedented surge of orders across many customers and across many industries, right, as companies were stocking reserve inventory to weather the supply chain disruptions at the time. And so in addition to that, the impact of that for our business specifically was, you know, that surge in orders was coming at a time when there was difficulty in in direct labor headcount, there was a shortage of direct labor headcount, and the timing was such that we had recently launched our new systems and we had some inefficiencies due to those systems that we've talked about. And so all of those together impacted our on-time and led to record backlogs for us that took several quarters to resolve. Since then, we have made significant improvements operationally across all of that. We introduced automation in the factory which improved our operational efficiency and also reduced our need for the same kind of level of direct labor as we scale revenue and we made improvements to our systems and made those more efficient. So today we stand totally ready to take all orders. We can offer all our world-class lead times. We can make molds in a day. And so we're much better positioned actually to deal with that level of demand today than we were a year ago. So we're working right now to re-engage those customers that were impacted and our go-to-market teams are in the process of doing that to help us continue to drive demand.

So

Thanks for reviewing your dynamics. So you do feel like, you know, this is a business that, given those actions that you just mentioned, that this is going to increase sequentially going forward? Or is there less, you know, there's more uncertainty now just because the macro environment as well, I guess. I mean, can you make any statement on whether you see this injection molding business generating more revenue in the second half of 22 than it did in the first half, because it's just hard for me to model it now since the last, I understand the year over year dynamics, but the last three quarters have been, you know, 53 to 54 million in that range. So any, any without any increased confidence, I don't, I don't know why I, and the macro where it is, I don't know why I would forecast anything above 53 or 54 million for injection molding.

Yeah, so Brian, we're still feeling pressures from a macro perspective. When we talk to economists, they're talking about increased inventories at our customers resulting in less demand from our perspective. So we are working to improve from a go-to-market perspective to continue to bring customers into our injection molding service offer, but it's uncertain right now with the macro headwinds.

Yeah, that's fair. Okay. I got it. And in that business, can we just drill down a little bit? It sounds like the challenge is more in the new molds business rather than the parts business, or is it also parts just because production is some of these bigger orders that you were talking about were production and parts business?

Yeah, well, a lot of what we were seeing was in parts, right, because we saw a really strong surge in production parts business, and that's what we're seeing not recur, as Dan talks about. There's evidence that companies are sitting on high inventories, so that's really where we expect some of the headwind.

Okay, and then just the last question for me is just that can you remind me what impact this dynamic, you know, the more challenge injection molding business has on overall company gross margin?

Yeah. So if we take a look at it, our injection molding gross margins, right, have traditionally been around mid-50s. With the lower volume, our injection molding gross margins were around 50% in the quarter.

Okay. I'll get back in line. I might have a couple more. Thank you. Okay.

Thank you. The next question is coming from Jim Rusciutti of Needham & Company. Please go ahead.

Hi, thanks. Just some follow-ups on the topic of injection molding. Yeah, I'm curious, are you seeing any changes in the competitive dynamics in the market that might be contributing to some of the demand issues that you're seeing in this part of the business?

Yeah, you know, obviously we're known for speed, and we offer the fastest lead times in the world in injection molding. In those lead times, we don't really run into competition. During the period that I described when we had the significant backlogs and our lead times were longer, during that period, our customers could look at other alternatives, their local molders, So I think that's the dynamic that we're now really focused on overcoming as we, you know, drive our go-to-market teams, right, to reengage those customers.

Okay. And maybe just to talk about the overall level of demand that you're seeing in the market, just, you know, obviously in light of all of the concerns people have about macro, how did the business track or trend as you went through to June quarter, and what are you seeing thus far in Q3, and whether you want to deal with that by geographic region, U.S. versus Europe, or even talk about it in terms of changes you might be seeing in any of your major vertical markets.

Yeah, let me first say, in a constant currency basis, Our services outside of injection molding grew 15% year over year. So, you know, we're very happy with what happened there. In terms of what we're seeing in markets, like what we talked about from an injection molding perspective, where we had some larger COVID orders in the last year. So medical was... you know, on the lower decline slightly year over year. And then automotive was a headwind. But we saw things really strong from the end markets of aerospace and both industrial and commercial machinery. Both were strong. If you take a look at, you know, in, you know, our non-GAAP disclosures, you can see that we had growth, you know, constant currency growth across all regions. So, you know, we were very pleased with that in the quarter.

So just going into Q3, the final question, just any change in customer behavior one way or the other in some of the markets, your larger markets?

Yeah, I mean, so it's, you know, we've gone through July. We really haven't seen much change right now in terms of end customer behavior.

Okay. Thanks. I'll jump back in the queue.

Once again, ladies and gentlemen, that is star one to register any questions at this time. The next question is coming from Greg Palm of Craig Hallam. Please go ahead.

Yeah, good morning. Thanks for taking the questions. I wanted to follow up on the last question from Jim. If, you know, I look sequentially from Q2 at the midpoint, you're guiding down, you know, call it a couple million, basically offsets the impact from the exit from Japan. Usually Q3 is up, you know, at least a couple million, two, three million. So You said you're not really seeing much of a change, but guidance suggests maybe a little bit softer activity. Can you just maybe tie that out? Am I missing something?

I think the question was if I'm seeing anything from any specific end market. I read that by industry, right? I'm not hearing something different by industry. We set our guidance the same way we've done always. We're taking a look at what has happened through July. and then taking into account what we're seeing from an upload trend, what we're seeing seasonality. And so that's how we built our guide. And obviously with that, as you can see from our guidance, we're not seeing right now as strong as a sequential uplift Q2 to Q3, at least as we look through the initial results. So that's where that stands. We're continuing from a macro headwind perspective to look at injection molding and understand what's happening there in terms of customers with the amount of inventory that they have on hand today and what that demand is. Some might signal there that with that trend, we would see a bigger upward trend in injection molding if the macro market was different.

Okay. No, that's helpful. Thanks for clearing that up. Is it relates to the Japan exit? I think you said, you know, over the time span, only profitable four years. Can you say whether it was profitable in 21 or was it profitable in recent quarters, at least on a full run rate basis?

It was not profitable in 21 and it was not profitable this quarter.

And did you say the exit is going to have a negative impact on gross margins? Can you disclose what gross margins were in that region?

What I said is it's going to have a negative impact on gross margins in the next quarter. The reason it's having a negative impact on gross margins in the next quarter is we have the equipment, right? We have the depreciation. We have a staff that's on production, and we're slowly – shipping out the final orders. We expect to have that completed at the end of August or early September, and that's what's creating an unusually negative gross margin for Japan. It's not large enough to be a discontinued ops, so we can't completely remove it from our reporting from that perspective, and that's why in that quarter it has a negative impact. From a P&L perspective, The biggest challenge, and I talked about this, is that Japan was only getting to a $13 million revenue amount. And with the amount of sales and marketing and kind of infrastructure that you need, you know, overall, that was Japan's challenge to get to profitability.

Yep, understood. All right, I'll leave it there. Thanks and good luck going forward. Thank you, Greg.

Thank you. At this time, I'd like to turn the floor back over to Mr. Bodar for closing comments.

Thank you for joining us on our second quarter earnings call. We're pleased with our performance in the first half of 2022, particularly in expanding our earnings. We have clear priorities in place and are focused on the execution of our strategy, which will lead to the long-term profitable growth. Thank you to our customers and shareholders for their continued support and to our employees for their continued efforts. We look forward to updating you on our performance next quarter. Have a great day.

Ladies and gentlemen, thank you for your participation and interest in Protolabs. You may disconnect your lines or log off the webcast at this time and enjoy the rest of your day.