Richard A. Morin - Cognex Corp. Robert J. Shillman - Cognex Corp. Robert J. Willett - Cognex Corp. John J. Curran - Cognex Corp..

Ben Z. Rose - Battle Road Research Ltd. Jonathan DeCourcey - Canaccord Genuity Paul Coster - JPMorgan Securities LLC Jeremie Capron - CLSA Americas LLC Ethan Potasnick - Needham & Company Karen K. Lau - Deutsche Bank Securities, Inc. Richard Eastman - Robert W. Baird & Co., Inc. Joseph Giordano - Cowen & Co. LLC.

Good day, ladies and gentlemen and welcome to the Cognex Fourth Quarter 2016 Earnings Call. At this time, all participants will be in a listen-only mode. Later, there will be a chance to ask questions and instructions will be given at that time. And as a reminder, today's conference is being recorded.

And now, I'd like to turn over to your host, Chief Financial Officer, Dick Morin..

Thank you and good evening, everyone. Today's call will begin with a welcome message by Cognex Chairman, Dr. Bob Shillman and prepared remarks by our President and CEO, Rob Willett. Both, John Curran and I will be available for the Q&A session.

I'd like to point out that our earnings release and Annual Report on Form 10-K are available on the Cognex website at www.cognex.com. Both contain highly detailed information about our financial results.

During the call, we may use a non-GAAP financial measure if we believe it is useful to investors or if we believe it will help investors better understand our results or business trends. You can see a reconciliation of certain items from GAAP to non-GAAP in Exhibit 2 of the earnings release.

Any forward-looking statements we made in the earnings release or any that we may make during this call are based upon information that we believe to be true as of today. Things often change and actual results may differ materially from those projected or anticipated.

You should refer to the company's SEC filings, including our most recent Form 10-K for a detailed list of these risk factors. Now, I'd like to turn the call over to Dr. Bob..

Thanks, Dick, and hello, everyone. I'd like to welcome each of you to our year-end conference call for 2016. As you can see in the news release issued earlier today, Cognex had an outstanding year in 2016. We set new records for annual revenue, net income, and earnings per share, and we achieved a remarkable after-tax margin of 29% for the year.

Right now, I'm in San Diego, and everyone else is at our Natick headquarters. So for further details, I'm going to hand the microphone over to my partner, Rob Willett, our CEO, and I will be available at the end of the call to answer any questions that you may have for me. So, Rob, take it away..

Thank you, Dr. Bob. Good evening, everyone. I'm pleased with Cognex's performance in 2016. We've reported our seventh consecutive year of record revenue and the highest annual net income and earnings per share from continuing operations in Cognex's 36-year history.

In addition to reporting record financial results, other highlights of the year include our completion of four strategic acquisitions in the two fastest growing areas of our business, 3D vision and ID products.

These companies not only bring us exciting capabilities but equally, or perhaps, more importantly, they add highly skilled and experienced engineers to our team. Many of whom have advanced degrees in machine vision. And we introduced new products in 2016 that, we believe, will be important drivers of future growth.

The Cognex MX-1000 marked our entry into a $500 million segment of the mobile terminal market that's adjacent to our core business. The Cognex ABH-ID solution provides superior barcode reading of airport baggage tags in another new $50 million market.

And our first multi-camera vision system, the In-Sight VC200, leapfrogs similar offerings by competitors in our core 2D vision market. Let's now turn to details of the fourth quarter. I'm pleased to report that revenue, net income, and earnings per share all set new fourth quarter records.

Revenue of $129 million was $11 million higher than the top end of the range we gave in investors in October. This strong performance came from better than expected demand across a range of industries including automotives, consumer electronics, and logistics.

Gross margin was strong at 79%, representing an increase over both the prior quarter and last year's Q4, due to cost reductions, quality improvements, and manufacturing efficiencies. Operating margin expanded to 31% from 20% a year ago. This significant increase reflects the substantial leverage that incremental revenue has on our business model.

Net margin was impressive at 30% helped by significant tax savings related to stock option exercises in Q4. Earnings were $0.43 per share, which is $0.14 higher than the Thomson Reuters First Call consensus estimate, driven by our top-line performance, excellent fall through, and a net benefit from discrete tax items.

Looking at factory automation, which is our largest market, revenue grew 34% year-on-year in Q4 led by automotive, consumer electronics, and logistics. Sequentially, factory automation declined as expected due to seasonality in consumer electronics.

From a geographic perspective, as compared to Q4 a year ago, factory automation revenue from Europe delivered the largest contribution to growth in absolute dollars helped by large electronics orders that were placed in Europe for Cognex products used on assembly lines in China.

Even excluding those orders, factory automation revenue from Europe grew by more than 30% year-on-year due to increases in automotive and other industries. Our Greater China region continued to deliver strong growth, increasing in excess of 30% over Q4 of 2015, with consumer electronics and automotive leading the way.

In the Americas, factory automation grew mid-teens year-on-year and set a new quarterly revenue record. Growth was the result of higher sales to customers in a number of industries including automotive, consumer products, logistics, and food.

And factory automation revenue from our Other Asia region grew by more than 60% year-on-year, primarily due to growth in Korea. Moving onto operating expenses, RD&E and SG&A totaled $62 million for Q4. This level was above our guidance due to higher sales commissions related to the higher revenue level and product development activities.

Turning next to M&A. As I said a moment ago, we completed four acquisitions in 2016. I'll take a minute to put this activity into perspective for you. Three of our acquisitions were in the fast-growing area of 3D vision, EnShape and Chiaro, both add a new type of data capture technology, sometimes called snapshot sensors, to Cognex's product portfolio.

EnShape sensor is very fast and highly accurate, ideal for high-end applications such as picking and placing pharmaceutical bottles within a distribution center or electronic parts in the final assembly of smartphones.

Chiaro brings us complementary 3D sensor technology suitable for applications that require speed and a wide field of view but don't require micron level accuracy. These include applications such as measuring the dimensions and integrity of a box travelling on a high-speed conveyor in a warehouse.

These snapshot sensors along with Cognex's software interface and powerful 3D vision tools boosted by our third acquisition, AQSense, are complementary to our current 3D series of displacement sensors.

We expect these new capabilities will significantly accelerate our efforts to bring new 3D vision solutions to market and will broaden the applications and price points we can serve. Our fourth acquisition is in industrial ID.

Webscan significantly enhances Cognex's barcode verification capability by combining Webscan software with our DataMan products, Cognex can provide the industry's broadest range of high performance and easy to use barcode verification solutions, which were increasingly sort by many of our customers in retail logistics, pharmaceuticals, and electronics contract manufacturing, among other markets.

In summary, Cognex made substantial progress in 2016 and ended the year with a record fourth quarter. In regard to specific guidance for Q1, we believe that revenue will be between $122 million and $125 million. This is the decrease when the revenue reported today for Q4, which is typical, given the normal decline that we see from Q4 to Q1.

Looking year-on-year, this range represents an increase of 27% to 30% over last year's Q1 as a result of the strong backlog we have entering 2017 and the improved demand that we experienced in Q4 that has continued into January. We're also comparing to a weaker period a year ago.

Gross margin is expected to be in the mid- to high-70% range, somewhat lower than reported for Q4. We expect service will increase as a percentage of total revenue. Operating expenses are expected to increase by approximately 10% from Q4 as a result of higher stock option expense and our continued investments in engineering and sales.

The effective tax rate is expected to be 18% excluding discrete tax items. I'm now going to pass the microphone back to Dr. Bob..

Thanks, Rob. Before we start the Q&A, I want to take a minute to talk about my friend and colleague, Dick Morin, who I hired 18 years ago. As we announced earlier today, Dick has stepped down as CFO of Cognex, and will retire after nearly two decades with the company. Dick's list of accomplishments is impressive.

Cognex's annual revenue grew approximately $150 million to over $520 million during his tenure. His business acumen, his financial leadership, and strategic input have been instrumental in our company's success. Most recently, he helped select a successor and assisted in that transition.

I want to thank Dick personally and all of Cognex wants to thank him, and the shareholders should thank him for his many contributions to the company, and we wish him all the best in his approaching retirement. Now I'm going to hand the microphone over to Dick for a few words..

Thank you, Dr. Bob. It's really hard to believe that 18 years have passed since I first joined Cognex. It's been a distinct pleasure being involved in such a dynamic company and working with the best group of people that I have ever worked with. My leaving is somewhat of a bittersweet moment here.

I'm sure I'll be able to adjust when during the summertime I won't have to rush back from my home on Nantucket to come to the office on Monday mornings. I'm also very pleased to have someone of John Curran's caliber stepping in to succeed me.

He and I have been working closely together since he joined Cognex some six months ago from EMC, where he was the Corporate Controller. He spent over 20 years there, building and leading teams in both finance and IT, as EMC grew from less than $1 billion in revenues to $25 billion. His experiences at EMC fit in very nicely with Cognex's needs.

And with his experience and great attitude, I know he'll do a great job for us. Now let's open the call for your questions. Operator, we are ready to take those questions..

Okay. So we do show numerous questions coming in. Our first is from Ben Rose from Battle Road Research. Ben, your line is open..

Yes. Good afternoon. And congratulations to Dick on his retirement and thanks for your guidance over many years..

Thank you, Ben..

Thanks, Ben..

Okay. Just kind of launching in, just wanted to clarity the results in Europe. Rob, I did listen to what you said, but I just was hoping to clarify. It sounds like the strength in Europe in this quarter was in fact independent of Apple, the largest customer in the last year.

Could you please confirm that?.

Well, we don't talked specifically, as you know, about any – that large customer. But I will say that Europe had a terrific quarter in Q4, independent of consumer electronics business to China. It grew more than 30% year-on-year due to strong performance particularly in automotive, but also in other industries including logistics.

So yeah, it was broad-based, but automotive was particularly strong..

Okay. And just a question on the Americas region. Looked like it was up about 11% year-over-year in the quarter. I know you called out some specific industries.

What is your sense of the strength of manufacturing in the United States as it pertains to Cognex? Do you think we would see kind of a like rate of increase in the coming year?.

Well, in the fourth quarter, Ben, factory automation revenue from the Americas grew in the mid-teens year-on-year. And we saw improved demand from U.S.-based manufacturers across a range of industries, including automotive, consumer products, and food. Following what's been pretty lackluster growth in the last couple years in America.

So we definitely saw improvement. And I would say that improvement has continued into January. In Q4 we observed the Tier 1 automotive suppliers in the U.S. adding additional capacity and a vision technology, but we did see some caution in Mexico as you might expect.

But overall, I'd say we think the environment for our business in America is improving and we see that continuing for the foreseeable future..

Okay. Thanks very much..

Okay. Thank you. Our next question comes from Bobby Burleson from Canaccord. Your line is now open..

Hi, guys. This is Jon DeCourcey on for Bobby. A couple questions for you.

First, approximately how big were the new products in the fourth quarter? Any color on that even if you can't give a direct number?.

Well, it all depends on what we mean by new products really, Jon. I would say we launch a lot of new products and certainly some of the ones....

Well, and so specifically, the new products that you discussed, the MX-1000, the ABH-ID, and the VC200?.

Right. They would be very small contributors to growth. These are products we've launched relatively recently into new markets, so we're seeing a good amount of traction. And I can talk more specifically about the nine airport wins we've had in airport baggage handling and the tremendous interest we're seeing in the MX-1000 mobile terminal.

But these are not translating into significant revenue in Q4. I would say that..

Okay. So it's more of a 2017 and beyond driver..

That's right. And I would add generally, I'd say that's the case in industrial markets and particularly when we're entering new markets. We're getting out there, we're showing the advantages of vision, and we tend to see sort of an S-curve, where things start to pick up over time. But we don't see huge uptake initially, really in any products.

It's been the same, our entry into ID, our entry into 3D, et cetera. So we think we're right on track. But they're not making meaningful contributions to revenue at the moment..

Okay.

And then in the 3D displacement space, are you expecting any large orders as you have seen in the past? Or any commentary on potential large order?.

So our 3D products are gaining a lot of traction. We grew well in excess of 100% that business last year. We're still a small player in that market. It's a $200 million market that's growing mid- to high-teens and we have about a 10% share today. So, certainly, I don't think we really commented in the past about large orders in that market per se.

We have a lot of different customers using that technology. And I wouldn't be giving any guidance about future large orders for that or really any other technology or products at this point..

Okay.

And then my final question and then I'll get offline is, are you expecting an emerging customer in logistics that could present further barcode opportunities for you?.

Well, we're really starting to be the recognized technology leader in logistics. So we have a lot of exposure to really many big players in e-commerce fulfillment, in parcel and post applications.

And we've grown our business well in America, we're seeing it grow now strongly in Europe, and we have sort of a nascent and exciting business in other parts of the world too. So we would expect to see broad business. And I wouldn't comment on any particular customer bringing large orders our way, even though that may happen..

Okay. Great. Thank you, guys..

Okay. Thank you. So our next question comes from Paul Coster from JPMorgan. Paul, your line is open..

Yes. Thanks very much for taking my questions. Three quick ones really.

The first one is, what is the sort of characteristic deal size, is there any change that you're experiencing in deal size at the moment?.

Yeah. Hi, Paul. So, our business is pretty broad-based. We have, I would estimate, more than 20,000 customers and an average sale might be two units or three units priced of anywhere between $5,000 and $20,000. And then of course, as you know, we have some very large customers also, but I don't see a change in that per se..

Are you seeing any change in the nature of the application over the last year or is it just more of the sign – in factory automation that is?.

Well, we had moved into some new areas, notably 3D vision, so we think that's a really exciting area of technology where we can provide a lot more data and capability to our customers. So, certainly, there's a lot more interest in that area.

And then the endless kind of growth of ID, barcode reading, as barcodes become more complex, hold more data, become smaller, we see more and more demand, but we've been seeing that over many, many years and it just continues.

So, I'd say, those are the two big growth areas I'd point to and it's notable that we've made acquisitions and we're making investments and adding salespeople to address those areas..

Okay. Last question is on product cadence, which has been depicted in presentation materials I think something of a lead indicator.

Is the product cadence going to change moving forward? And in answering that question, can you also talk about the software that you're acquiring and whether it gets layered into existing products or whether it's in part the author of new products?.

Yeah.

So I assume, Paul, you mean by cadence, you mean the rate of introduction of new products?.

Yes..

Yeah.

So, I think as Cognex has got bigger and we've built our engineering teams where we work hard to introduce more products more frequently and as you map that over the years, you've certainly seen that happen, I would see as we grow bigger, invest more, and acquire new high performance engineering teams, as we just announced in places around the world, we're going to see that continue.

So, yes, I fully expect increased number of products every year, I would say, probably the amount of time it takes us to develop a product probably is relatively static, it's just we're putting more and more engineers onto doing it.

The second question I think you had was to do with software, but can you repeat that, please?.

Yeah.

So, does the software get layered into existing products, including those that are already deployed in the field or is it essentially the author of new hardware SKUs?.

Yeah. So, no – so, overall, in our base products, we have software which we continue to update once or twice a year with major revisions and new capabilities and then there was acquisitions which you might be referring to that that software can be very complementary.

We have widely considered the best vision software tools and library and technology, and we can work pretty quickly to incorporate that with new hardware and likewise with Webscan, the barcode verification software that we acquired earlier this year, that over sometime a few quarters we can integrate into our hardware platforms.

So I think there we shouldn't see a significant increase in the number of products, SKUs, as you say that we have, as a result of these acquisitions. They can be very complementary with the software and hardware platforms we have..

Got it. Thank you..

Okay. Thank you. So we'll take our next question from Jeremie from CLSA. Jeremie, your line is open..

Thank you and good evening, everyone. Congratulations on this very strong finish to 2016, and congratulations, Dick, on your retirement..

Thank you..

Rob, could you maybe provide any qualitative commentary on the business outlook for the year 2017, perhaps for each of your three largest end markets. So obviously some very good momentum going into the first quarter, but the second quarter and third quarter seasonally are probably key to the full year performance.

So appreciate your color here?.

Right. Thanks. Hi, Jeremie. So, it's very early in the year and we don't give full year guidance, as you know. I think what I can say is I think the year started off more strongly than we expected, when we have some visibility which gives us confidence as you seem to give pretty strong guidance for Q1, we do expect revenue growth this year.

And I think as you point out there, the second half comparison may get a little more difficult, because we certainly saw acceleration in the business in the second half of last year. Typically, Q1 is our lowest quarter of the year and our big quarters tend to be Q2 and Q3 because of the timing of large orders from consumer electronics.

We also are going to have the potential to be bringing in larger pieces of business, as the year progresses in logistics. So I think we're optimistic, but it's hard for us to see out much beyond what we're telling you now..

Thanks. And what about consumer electronics, in particular you've had a very strong 2016 despite what was perhaps a softer year for a lot of factory automation suppliers into this particular market.

Do you expect continued momentum here?.

Yeah. We saw a strong end to last year and a strong start to this year in consumer electronics. You can see it's a large market with a lot of growth potential for us.

And there's a lot of new technology coming to market from a number of providers in that space and lot of new technologies particularly around displays and other areas where vision has just a huge amount and to the successful rollout of those technologies.

So, yeah, we're optimistic about the outlook for consumer electronics and sales of vision into those, but it's still very early in the year..

Great. That's good to hear. And last one for me on, the gross margin was particularly strong in this quarter, not a record high, but clearly you've been trending towards the top end of your usual mid- to high-70%s guidance.

What would get you to the lower end? Are you seeing a risk to fall back to closer to that 75%? And maybe what's the reason for this very large margin expansion year-over-year? Thanks..

Yeah. So, Cognex is focused on high gross margin revenue enabled by great technology, that's the business we're in. So we take great pride in our gross margins. We're primarily a software company and that certainly reflected in the margins we report.

And much of our revenue comes from demanding applications where success is driven by performance rather than price. So we're focused on high growth, high gross margins, that's kind of what we're all about. You asked kind of what might dilute that.

In specific quarters, we can see a larger proportion of service revenue where we may be working with large customers, particularly in consumer electronics or logistics, to enable very sophisticated vision where we may deploy our engineers and that can lead to service revenue being a larger part of the mix.

So that can certainly dilute revenue in a particular quarter. But what I would say is, in the long run, I don't think we see a dilutive trend, it's more like a quarter-to-quarter thing where services mixing in more or less. And I think it was a little less in Q4 and we expect it to be a little more in Q1..

Thanks very much. Good luck..

Thank you..

Okay. Thank you. Our next question is from Ethan Potasnick from Needham & Company. Ethan, your line is open..

Hi, guys. Thanks for taking the call. This is Ethan Potasnick filling in for Jim Ricchiuti.

So I was wondering, are you guys seeing any encouraging signs in the mobile terminal market? Or is it still too early to judge the market reaction to the MX-1000? And should we assume that there could be other new products addressing this area of the ID market in 2017?.

Yeah. Hi, Ethan. So there's a lot of interest and many trials going on with the MX-1000. And we're sort of gearing up our sales force also to sell it more broadly. So feedback and activity is very encouraging.

We have customers who have purchased a few hundred units initially and seem very satisfied with its capabilities and are looking to deploy it more broadly. But as I said, it's not going to move the needle. It didn't in terms of revenue significantly in Q4, nor I would expect in Q1.

But we're used to that kind of rolling out innovative technologies into industrial markets. And we have our eye on the long-term, we're very confident about that. So we don't generally comment on new product introductions or new spaces just for competitive reasons.

But if you look historically, we've been pretty aggressive in terms of entering new markets, always with high performing vision technology. So I would expect in the long-term, you're going to see us do plenty of that. But in the near-term I won't comment..

Okay.

And could you maybe – so is the 3D vision business that you're expecting this year concentrated maybe more heavily in one or two markets? Or would you expect it to be more diverse as in your 2D machine vision factory automation business?.

I think the use of 3D vision is likely to be very diverse. I think we have seen significant sales into consumer electronics, where obviously there's so many people and so many challenging applications and very sophisticated engineers working to deploy vision.

So it's perhaps not surprising that this sophisticated technology is getting deployed a lot there. But we've seen very diverse applications in markets like medical devices and food, automotive have been significant.

And so I think in the long run, you will probably see our 3D vision business distribution be similar to the kind of distribution we see in the 2D business..

Okay. Great.

Finally, and how should we think about operating expense associated with implementing large projects, in either the consumer electronics or logistics market in 2017?.

I think you can expect us to go on investing in logistics and consumer electronics to support our large customers in those spaces where we see growth. Right? So I think we don't comment on specific kind of expense guidance and certainly not by customer or market.

I think in the long run, we expect to see expense grow at a slower rate than revenue, but not necessarily in each quarter. And where we see opportunity for vision to grow at high gross margins, we're certainly not going to be shy about investing to support customers or bring new technology to market..

Okay. Great. Thank you..

Thank you. And we'll take our next question from Karen Lau from Deutsche Bank. Your line is now open..

Thank you. Good afternoon, everyone. And congrats to Dick on his retirement..

Thank you..

First question, I don't recall you guys ever called out Korea as a source of strength.

Just curious, is that concentrated – what you realized in the fourth quarter, is that concentrated in certain end markets, is it consumer electronics, is it auto? And are you winning new customers there that might lead to further new orders down the road? In other words, this is just the start and then maybe there are a series of things that is on the come this year?.

Yeah. Hi, Karen. So Korea is a great market for machine vision. We've invested quite a lot in that market over the last couple years and built a really great team in that space. And I think some of what we're seeing is just the success of that team really getting traction.

The growth we're seeing significantly is interestingly in both consumer electronics and automotive. And we see a lot of runway for both of those markets in Korea as we go forward..

Okay. And then staying on the subject of Other Asia, there has been a lot of stories about your largest customer establishing some manufacturing capabilities in India. And I think a lot of the Chinese OEMs in the smartphone industry have also been establishing capacity over there.

Do you currently serve that market? And in your view, is that still sort of a more manual low automation content market? Maybe a little bit of color on that front?.

Yeah. So as you know, we don't comment on specific customers. But I will comment on India. It's a market that's being – it's still small for Cognex, but it's been growing consistently and quite rapidly over the last few years. And we've been developing our team with a number of offices in different markets there.

Generally, what we see in that market, you're right, there's a lot of labor. So generally, where Cognex is replacing eyes and brains in manufacturing and bringing a lot more productivity and performance into those markets.

I'd say, India has a very high labor content in its manufacturing base, and generally what we see in manufacturing is not particularly sophisticated, so the markets in machine vision there is still relatively small.

Now, as we do see large electronics or automotive companies do more domestic production there, obviously we would expect to capitalize on that as well and we have I think the right relationships to make that happen. But right now, I don't see it happening significantly, not this year..

Okay. That makes sense.

And then maybe touching on the acquisition and the new products, you mentioned they tend to follow an S-curve, but would you be able to integrate some of these newly acquired technologies into the large project deployment this year or is it more of a 2018 event?.

Yeah. I would not expect the new technologies that we've acquired which have relatively small revenues, in some cases, no revenue when we've acquired them. I wouldn't expect them to be going into very large deployment to large customers this year.

I think we've had a lot of interest in these technologies and we're certainly sharing them with some of our most sophisticated customers, but I would expect they're going to be more of a 2018 revenue contributor..

Okay. That makes sense. One more and I'll get back in queue. Could you comment on – I think in your 10-K you mentioned you're upgrading your ERP system in 2017, and we've seen a lot of cases from many companies these upgrade sometimes tends to turn into fiasco. So maybe you could – maybe first talk about the cost....

Right..

...in terms of OpEx and CapEx associated with that?.

Yeah..

And then – yeah..

Yeah. So, thanks, Karen. I'm going to ask John Curran, I think he was pretty instrumental in EMC's ERP implementation, a very successful one, to talk about that. He's got that among his other duties on deck.

John?.

Yeah. Thank you. Yeah, we're certainly hoping to avoid a fiasco. I have pulled this off successfully once before and I expect to do so again here in Cognex. With regards to kind of the expected cost, we don't kind of talk about the details in terms of impact to 2017, so. But like I said, we don't expect it to be an issue..

Okay. Thank you..

Thank you. And our next question comes from Richard Eastman from Robert W. Baird. Richard, your line is open..

Yes. Thank you. And wow, Dick, say it ain't so, congratulations on your retirement. That's fantastic. Man, you'll be missed, but....

Thanks. Thank you. I'll still be involved. I'm not totally walking away..

Okay. Well, John, I'll tell you what, I would not want to step into those shoes, I'll tell you that, but good luck..

Yeah, big shoes. Thanks..

Hey, just a quick question, Rob, would it be possible to just give us kind of, for 2016, what percentage of revenue came from the CE market, automotive, and then maybe what the third largest market is at this point in time for your revenue and your products, is that possible?.

Sure. I mean, I'll – yeah. Sure, Rick, I'm going to talk in generalities. So, a very approximately 30% of our revenue is from consumer electronics, really about the same amount 30% or so roughly is from automotives and then our next largest markets would be logistics and consumer products and they would be a little less than 10%..

Okay..

So, speaking in generality. So when we talk about consumer products, that's quite a big bag, it includes stuff like razor blades and diapers and watches and stuff like that..

Okay, okay. And then just within the consumer electronics market, is there any way to maybe just give us a little bit of a description around the applications that Cognex's vision is assisting with. I mean, have the applications broadened as well as apparently the customer base has as well.

I mean, from maybe manufacturing to assembly to – I'm just trying to understand if the applications have broadened along with the customer base?.

Sure. So, I think, probably if you go back many years, Cognex was working of course in semi and then in electronic components, right, so passive and other components, we would be inspecting connectors, so that's been a good solid part of our business for many, many years.

I think as we move forward in time, we've seen various trends happened such as LEDs and displays, and we've been sometimes very successful at catching those trends and we hope to be successful with the current trends going on around organic LED, OLED manufacturer, which is very sophisticated and quite complex, certainly a lot of automation investment going into that space.

And then, as we've kind of move down the production line, of course, there's inspection of components, whether it's housing for devices and smartphones or screens coming into production, and then more in the final assembly and test area and then that's become an area of significant growth for us in the last five years or so where a lot of our business now is in the final assembly test packaging part of business in electronics.

And there, there's a lot of integration with robotics where we could be helping to place Cognex's outstanding in the area of alignment. So aligning pieces that are inserted into end user devices, that's a very big part of our business.

And then also, inspecting the process there and assisting in that production, integrating with machines that work through the process to do that.

So I think, probably, that as we've kind of gone down that chain, that I described from components to final assembly, it's the final assembly part of the business which has become the largest and the fastest growing over the past few years..

I see. Okay. All right. Very good. And then just one last question, just around the ID products business, including logistics.

Is there any dynamic in that segment of the business that would not – or affect your confidence around the 30% type of growth outlook for the next few years, is there any reason in that, anything in that affects your confidence that that can't be sustained at this point?.

Well, we certainly have a long track record, I was reflecting, when I joined the company about eight and a half years ago, we had a business of less than $30 million in ID and our business is now approaching $200 million in that space. So certainly – and that's all organic.

And we've been successful by leading difficult to read barcodes and as barcodes are proliferated with more data, becomes smaller that's been something we really understand and have a great reputation.

I think, obviously as you get bigger, it's harder to grow that kind of growth rate, but how we are managing to offset that really is by entering new adjacent markets.

So certainly the mobile terminal market, which is primarily ID logistics, now verification, I think those have the potential to grow at faster than that 30% growth rate that we talked about as it's harder perhaps to grow the core ID business quite at that rate..

I understand. Yeah, yeah. Okay, okay, very good. Well, thank you. And best of luck, Dick.

Thank you very much..

Okay. Thank you. So our next question from Joe Giordano from Cowen & Co. Your line is open, sir..

Hey, guys, thanks for taking my question. Just one quick housekeeping one, you mentioned in the release that your largest consumer electronics, logistics, and automotive, all up double-digits, I'm sure there is a pretty wide variance between some of those, like in, especially logistics.

Can you scale those a little bit in terms of, like, rough percentage of growth this year for those three markets?.

Well, generally, automotive and electronics would have grown right around the overall growth rate of Cognex and logistics grew a lot faster than that, more than twice that rate, that would be kind of a general sense of it..

Okay. Perfect.

I wanted to ask you a question on tax, potential implications with whether it's a border adjustment and I know you guys have contract manufacturing and you have engineers all over the world and I don't know how do you like size, where the value is being added as kind of I guess a tough thing to do, but how are you thinking about that internally and what are you doing around that now?.

I think, the key thing, it's a little early to figure out exactly what the potential impact would be. But you're right, we do import the hardware into the United States from our contract manufacturer, and we do the value-add of loading the software here in the United States.

So the value of the hardware that we are importing is relatively insignificant so it should not have a major impact if in fact we're not allowed to deduct the import costs or whatever compared that to some of the exporting that we are doing into South America and into Canada that, theoretically, under that proposal that's been discussed would be exempt from tax, I think it would essentially be a push might even be slightly to our favor..

Okay. That's good color there and just relative, I know you're not going to give guidance past the 1Q, but typically the middle six months of your year by far the strongest.

One, do you get a sense just from your customer discussions that strong 1Q year is a little bit of a pull out of 2Q and do you have any sense as to how the 2Q, 3Q, it was pretty balanced last year and the year before was pretty weighted one way, like, do you have any sense of how that might play out?.

Right, so there is no sense that I have that the Q1 strong guidance we gave is any kind of a pull, that's not what we are seeing. You are right that Q2 and Q3 tend to have large – can have large orders in them. It's really not clear to us whether one – which quarter the majority of orders would or business would fall into.

It's too early to see that at the moment..

Yeah. I kind of figured that was going to be the case, so I'll leave it there. Thanks a lot guys, good job. And, Dick, congratulations..

Thank you..

Thanks..

Okay. Thank you. And I'm showing one more question from Jeremie from CLSA. Jeremie, your line is open..

Hi. Thanks for taking a follow-up question. Rob, you talked about the OpEx going up in Q1 a sizable amount, and I think you called out stock compensation as a key factor.

How do we think about this increase in stock comp, does it relate to the performance of the business in 2016 or is that based on forward-looking assumptions?.

Yeah. I think, I'll answer that question, Jeremie. I think one of the key factors in the stock option compensation is our stock options vest over a four-year period.

So what you have is those options that are going out of the expense pool this year were granted at an exercise price of some four years ago, which was probably somewhere around $25, $22, somewhere in that neighborhood. I think it was $22 to be exact. And we're replacing those with options that we're granting this year.

And when the annual grants come out in February here, I think the exercise price is going to be somewhere around $70. And as a result, when you go through the calculation of the expense, it is going to be significantly higher. So it's the increase in expense is mainly due to that. The amount of options that are being granted are relatively consistent.

And we, in fact, buy back all that dilution in our stock buyback program anyway..

Thank you very much..

Yes. Thank you. And our next question is from Joe Giordano from Cowen & Co. Joe, your line is open..

Hey, guys. Sorry, I had one that I wanted to ask and I forgot. Maybe this one is a bit for Dr. Bob as well, just a high level question. You're obviously in kind of a niche-y area with very good growth prospects and a great theme with very few players in it.

So something like that with the margins you guys see kind of incentivizes others to want to get in. Obviously anyone can get in via acquisition.

But what are you doing to kind of preempt other competitors from trying to get into such an attractive market?.

This is Dr. Bob here. The barriers to entry in this business are substantial, substantial. The first barrier to entry is the incredible amount of technology that one needs to have. And it first starts with the knowledge of machine vision.

I think at this point we probably have over 30 or 40 PhDs, guys who got their PhDs not just in computer science, but their thesis was specifically in machine vision. But – so we have I don't know how many engineers, Rob can tell us, probably 300 engineers in the company today. And they're not all machine vision experts, but that's another barrier.

You have to know how to interface things on the factory floor, communication protocols. So there is an enormous technical barrier to getting into the business. And there aren't that many people around to hire. Right? And if they are, we hire them when we buy those companies. Next is the distribution.

When you approach a large company, they want to know if you can service their plants around the world. So it's highly unlikely into the startup and Silicon Valley is going to come up, even if they had a better vision system, unlikely that most companies would do business with them. You have to have a field support team.

You have to have salespeople call on them and a call-in center. So we've built a very substantial business that has a very substantial barrier to entry. We do have a couple competitors. In each market we have strong competitors, but they're very few. And most of them also don't sell based on cutting price.

So we're quite happy that the business that we happened to choose.

Rob, do you have anything to add to that?.

No. We have about 400 engineers. We have very long tenure. We pride ourselves on a great culture where people come and do their life's work and do great work. So that's also a key part of it. I would say, historically, too, Joe, kind of as you hint, other companies have looked at our industry and thought, oh, like those margins. Let's get in.

What they discovered is they've seen a burn through $20 million, $30 million of investment trying to do machine vision and realized how difficult it is. So – and we continue to spend, last year 15% of our revenue on R&D. So there are pretty substantial barriers, I think, to new entrants in this market..

In addition, I would point out, our extensive patent portfolio. So to be able to do what we do, without infringing on our intellectual property would be very difficult too. So we haven't seen any new competitors.

And if we do find small companies with unique technology and unique people, then we go out and make love to them and tell them that we can take away from them all the aggravation of running your company of building products. They can focus on creating new technology. And then we put it into products and we sell it for them.

So we have just a great culture in the company that attracts startup companies to us and entrepreneurial kind of thinking. And we're going to continue to do that..

Great. Thanks, guys. I think those are all really important points. So thanks for that..

Yeah, sure..

Okay. Thank you. And our next question is from Karen Lau from Deutsche Bank. Karen, your line is open..

Thank you. Two quick follow-ups. If I did my math right, it looks like consumer electronics and your largest customers, they both grew at over a 20% rate in 2016. So that suggests outside of their largest customer, the rest of the business is growing at a pretty healthy pace as well.

Is that coming from the OLED, the inspection of components that you talked about earlier? Or is that growth coming from other smartphone OEMs, if you can comment on that?.

It's coming from all of those things. So certainly, yeah, it's coming from all different parts. And it's not like, per se, one area is delivering all of that growth..

Okay. Got it. And then I realized in consumer electronics, you don't – the lead-time is very short, but what about in logistics.

How far in advance do you get the orders or visibility as to somebody is building a warehouse and they're expected to place an order on scanning equipment and things like that?.

Yeah. It's – so we – among larger customers, actually both in consumer electronics and logistics.

We can get visibility on business building, we have a funnel and we can see projects coming on six months to nine months out as we have close relationships with those organizations, but then some of them can fall out as we get closer to the time of implementation.

In logistics, yes, we can see potential business building as we look out into the year, and then the timing of deployment and then the timing of revenue recognition also can vary based on those plans. So, I would say, in general, you might think it's about 20 weeks out. We can see funnel with significant probability starting to build..

Okay.

So with that visibility in logistics, would you – do you think you'll be able to sustain that 50%-plus growth that you realized in the first half of 2016?.

It's too soon to comment on the short-term. I'd say, in the long-term, yeah, we're very – we're confident that we're going to see some good growth. I think about 40% is what we saw our recent run rate at, so 40%-plus. So, yeah, there is plenty of potential in that market.

And I think as long as they go on investing, we're going to see continued growth for Cognex and logistics..

Got it. Thank you..

Okay. Thank you. Well, I'm showing no further questions in the queue..

Okay. It's time to wrap it up. Just in summary, we had an outstanding year in 2016. Our outlook for Q1 of 2017 is also strong and we are excited not only about the long-term potential of our business, but the short- and mid-term of our business. It's just a great business to be in.

I want to thank you all for joining us tonight and we look forward to speaking with you again on our next quarter's call, hopefully also very good news. Thank you for joining us..

Okay. Ladies and gentlemen, this does conclude your conference. You may now disconnect and have a great day..