John J. Curran - Cognex Corp. Dr. Robert J. Shillman - Cognex Corp. Robert J. Willett - Cognex Corp..

Paul Coster - JPMorgan Securities LLC Joe Ritchie - Goldman Sachs & Co. LLC Richard Eastman - Robert W. Baird & Co., Inc. Joseph Giordano - Cowen & Co. LLC James Ricchiuti - Needham & Co. LLC Josh Pokrzywinski - Wolfe Research LLC Jeremie Capron - ROBO Global Bobby Eubank - Chevy Chase Trust Co. Jairam Nathan - Daiwa Capital Markets America, Inc.

Jagadish K. Iyer - Summit Redstone Partners LLC.

Greetings and welcome to the Cognex Second Quarter 2017 Earnings Conference Call. At this time, all participants are in a listen-only mode. An interactive question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded. I'd like to turn the conference over to your host, Cognex's CFO, John Curran.

Thank you. You may begin..

Thank you, and good evening, everyone. I'm John Curran, Cognex's CFO, and I'd like to welcome you to our second quarter earnings conference call. With me on today's call are Dr. Bob Shillman, Cognex's Chairman, and Rob Willett, Cognex's President and CEO.

I'd like to point out that our earnings release and quarterly report on Form 10-Q 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, John, and hello, everyone. Thank you for joining us today. As shown in today's news release, we reported terrific results for Q2 of 2017. We set new records for quarterly revenue, net income and earnings per share, and we were highly profitable, reporting an operating margin of 34%.

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

Thank you, Dr. Bob. Good evening, everyone. I'm pleased with our second quarter results, which set new records for our company. Revenue was also above the top end of the range we gave to investors in May. Sales were better than expected across several industries, including logistics. Cognex is moving faster than ever before.

The use of our products is growing worldwide as manufacturers implement vision and ID to improve their throughput and the quality of their products. Our past investments in new product development and in sales are delivering significant returns in the form of high-margin revenue growth.

Importantly, we are making strong progress in several areas to ensure our success in the years ahead.

In particular, we continue to build upon the substantial momentum we have in logistics; integrate our recent acquisitions, including the deep learning tools of ViDi Systems and their team of artificial intelligence experts; expand our position in the high potential market for 3D vision, accelerated by our acquisitions of EnShape, Chiaro and AQSense; and add and develop sales noids (04:03), increase sales force productivity through process improvements and training, and provide the growing team with the equipment and technology they need to succeed.

With that as a backdrop, let's turn now to John for details of the second quarter..

Thank you, Rob. Cognex continues to make it easy for a new CFO by delivering great results. Here are the highlights from the second quarter, all from continuing operations. Revenue was $173 million, which represents a 17% increase over a strong quarter a year ago and a new all-time revenue record.

Growth year-on-year was led by strong performance in logistics. We also saw growth in the broad factory automation market outside of consumer electronics. Gross margin was strong at 78%, representing an increase over last year's Q2 due to manufacturing efficiencies from higher volume.

Total operating expenses for Q2 were $76 million, a 22% increase year-on-year resulting from continued investment for our future. These investments included new engineering and sales resources, costs from the six acquisitions we closed in September and higher commissions recorded because of our revenue growth. Operating margin was strong at 34%.

The substantial leverage that we have in our business model enabled us to improve our operating margin while investing for the future. Net income includes a $6 million discrete tax benefit from the exercise of stock options during the quarter.

Excluding all discrete tax items, earnings were $0.56 per share, which is $0.03 higher than the Thomson Reuters first call consensus estimate. In factory automation, which is our largest market, revenue grew by 17% year-on-year. From an end market perspective, growth was led by logistics and automotive.

Higher sales across several industries were partially offset by lower revenue from consumer electronics, as we discussed on last quarter's call. Looking at factory automation year-on-year from a geographic perspective, Asia was our fastest growing region, with factory automation revenue growing well over 50% year-on-year.

Our business in Greater China and the rest of Asia continues to demonstrate strong performance, particularly in consumer electronics, automotive and consumer products. The Americas set a new quarterly revenue record in Q2.

Factory automation revenue from the Americas grew in excess of 30% from higher sales to customers in the logistics industry and in the broader factory automation market. And as expected, our European factory automation revenue declined year-on-year due to lower revenue from consumer electronics.

Excluding the impact of consumer electronics, our European region increased more than 20% year-on-year even with the negative impact of currency exchange rates. Now, I'll hand the microphone back to Rob..

In summary, Cognex reported a record quarter in Q2. And if you like those results, just wait until you see Q3. Revenue in Q3 is expected to be between $250 million and $260 million, making it a record revenue quarter and the first to exceed $200 million in our company's history.

This range reflects substantial growth, both year-on-year and sequentially, due in large part to higher revenue from the consumer electronics industry. We do not expect anywhere near such high levels of revenue in the near future. Gross margin is expected to be in the mid to high-70% range, lower than reported tonight for the second quarter.

Operating expenses are expected to increase by approximately 10% from Q2 as we continue to invest in areas where we see opportunities for the long-term growth. The effective tax rate is expected to be 18%, excluding discrete tax items. Now, let's open the call up for your questions. Operator, we're ready to take questions..

Thank you. At this time, we'll be conducting a question-and-answer session. And our first question comes from Paul Coster from JPMorgan. Please go ahead..

Well, these are great results and the guidance, near-term guidance is astonishing indeed. So, congratulations, but of course, Rob, you know that we'll want a little bit of color around your comments about not expecting this in the near future.

What does that mean? Is this a one-time associated with, say, a new iteration of technology or a new specific customer or perhaps you can tell us why it's shaped in the manner that you're indicating here, presumably with 4Q being sequentially down, question mark?.

Yeah. Hi, Paul. Yeah, thanks for your question. So traditionally at Cognex, we don't give guidance past the next quarter but obviously, this is quite a monster quarter we're forecasting here in Q3, and it's really the result of some very large consumer electronics revenue hitting the P&L in that quarter.

So, we certainly expect Q4 to be a much more normal quarter for Cognex, and you're probably somewhere between Q1 and Q2 in terms of revenue.

Still some nice growth year-on-year but we certainly didn't want to leave anyone with the impression that the new normal for Cognex is the kind of quarter we're about to – we are going to report or expect to report for Q3..

Well, we appreciate the transparency there.

Regarding the CE surge, can you relate it to, for instance, the ramp in OLED production or to a new customer or to a new product cycle?.

Well, I think historically, Paul, if you look back, we've seen some pretty large quarters in Q2 or Q3 coming from the consumer electronics industry, and we're seeing that again this year and we are seeing it concentrated in Q3. I think we are seeing a lot of activity in that market. Certainly, OLED displays is helping us drive some growth.

The rollout of new products also is, I think, pretty substantial in terms of what we see across the industry and investment, and I would imagine it's something that other companies are seeing as well. But of course, Cognex technology is so important in the adoption of sort of new features and new technologies in this market.

So, we're really seeing the market respond very well to what we have to offer and demand really peaking here..

Okay. My last question is that there's talk of repatriating some consumer electronics manufacturing capabilities to North America. We assume it would be a very automated factory that gets ramped up here in North America in 2018.

Can you talk us through the sequencing? At what point in the process does Cognex get pulled into a new factory? What kind of lead time after they built the facility would you expect to see orders coming in, just generically?.

Yeah. I mean, if your question relates to consumer electronics, which I think it does because I think we're reading the same newspapers or whatever. Generally in consumer electronics, we tend to get bought into activities about a year to nine months before products go into production where we're working with large customers in that space.

It's pretty fast, pretty quick in terms of the industries we serve. In automotive, we tend to have more like a three-year look at what's going on but electronics move fast. We're a company that likes to moves fast so that certainly helps us meet their needs.

But I think sort of nine months before any of those plants when into production is when we would see investment and shipments from us..

Great. Thank you very much..

Thank you..

Our next question is from Joe Ritchie from Goldman Sachs. Please go ahead..

Thanks and, yeah, great quarter, everyone. I guess, my first question, you mentioned that logistics and auto really kind of led this quarter. So, really kind of thinking about the sustainability of that growth moving forward.

How do you think about that from a kind of cyclical perspective versus being product cycle driven and how sustainable do you see that growth moving forward?.

Yeah. Hi, Joe. So, your question relates to automotive and logistics. I'll talk about automotive first. So, automotive is pretty stable kind of – and a slower growing business, more mature business in terms of its adoption of vision and automation.

Over the long run, we've kind of said and I think it's proving true that automotive for Cognex will grow sort of high-single, low-double digits. And we've seen some growth recently that's a little faster than that, although, it did seem to slow down. In most places in Q2, the activity, the outlier being America where it actually accelerated.

But we think of automotive as a nice, solid market.

It's one of our two biggest markets but we realize it's going to lag or we expect it's going to lag our overall growth rate in the long run because we just see more adoption of vision technology and investment in markets like consumer electronics, and importantly, in the second market that you raised, logistics. So, let me address that for a moment.

Logistics it's a very exciting market for Cognex. We sized it as about a $350 million market when we met with the analysts last fall, and we have about a 15 to 20 share in that market today.

And we expect to be able to grow that business at about a 50% annual growth rate for the foreseeable future as we just see vision technology being adopted in all kinds of areas, initially barcode reading, but now, more and more vision type of activities in that space as well. Now, you kind of talked about the consistency of that revenue.

I think was what your question got to, and that's something we're still trying to understand more clearly ourselves.

We expect Q4 to be a slower quarter in logistics based on what we've heard and observed about the industry because big e-commerce and other parcel and postal kind of businesses slowing down implementation and getting into execution mode in front of Thanksgiving, Christmas and Chinese New Year. That didn't prove to be the case last year, though.

We saw logistics in Q4 last year was very good. So, we're still figuring that out but I would expect other quarters, Q1, Q2, Q3, to be pretty consistent and strong. So overall, very good prospects in that market and the only question about seasonality would be Q4..

That's helpful color, Rob. And maybe as my follow-up there, you guys mentioned just increased sales investments this quarter and I know that this is something that has been ongoing.

How do you think about like the variable nature of the increased investments moving forward if, in fact, growth were to slow down for you guys?.

Yeah. We've been – we're adding a lot of sales noids (17:30), as we call them, to our team and they're helping us reach customers and markets which as the adoption of vision kind of is more broad. So, we're in a market where we like any really great technology. Our products are getting less expensive and easier to use.

And so, as a result, it's being adopted more and more broadly in a whole bunch of markets like food and pharmaceuticals, medical devices and other markets. So, we're getting out and reaching those customers by adding sales people.

Now, your question kind of came to, I think, the issue of what happens if bookings slow down and how do we think about cost. Overall, we would think about 50% of sales noids (18:20) cost being fixed and 50% variable, in general. And so, we give them pretty substantial quotas as well.

So, certainly, there's a plenty of skin in the game for sales noids (18:36) as we grow. And in years like this where we're seeing substantial growth in our market, obviously, their compensation hits higher levels of accelerators, et cetera. So, I don't know if that really gets to what you're asking.

Please come back with more detail if you are after that..

Yeah. That hits it great. Thank you..

Our next question is from Richard Eastman from Robert W. Baird. Please go ahead..

Hi, yes, and good afternoon. I would second the fantastic quarter but astounding guidance for the third quarter, so good for you guys. Hey, just a couple of questions, Rob. On the second quarter here, you pegged FA growth was 17% and automotive was your second largest or fastest growing market.

Did automotive grow double digits in the quarter? I'm just trying to gauge.

Logistics, obviously, was much greater than the 17% number but how did automotive grow in total?.

Yeah..

Just roughly?.

Yeah..

Rough order of magnitude, be in the high-single digits..

Yeah, high-single digits....

I see..

...Rick, it's where it came in..

Okay, okay. And then, just in Europe, you were pulled out – well, obviously, Europe declined because of consumer electronics, but pulling that out, you'd suggested growth was greater than 20%.

Is there an end market or two in Europe that you could flag that drove the growth, excluding CE?.

It's really a broad base of industries, including automotive, consumer products and pharmaceuticals. Demand from the broad European factory automation market, I would say, is good. There's always this moment during the summer where you're kind of wondering is it slowing down because they're going on vacation or is it something more.

It's a little early to say in that. Other color, I would say, logistics continues to do very well for us. In Europe, spending in tier 1 automotive grew at a rate that we'd expect for the industry..

I got you. Okay. And can I just ask one last question here? Around the consumer electronics business is really the outsized driver here now for the third quarter.

And can I just ask when you look at your large customer revenue for the third quarter, and also, because the visibility must be in backlog here, but does the large customer really grow or drive growth in the third quarter, or is that coming from other consumer electronics?.

Well, Rick, we're pretty guarded about what we say about any customers in particular, but I think you can – certainly, when you look at consumer electronics being up so much and concentrated in the third quarter, you can figure out pretty much everything is driving it up..

Yeah, that's fair. Yeah. That's probably a fair comment. But I guess, the point being that, obviously, there is outsized growth outside of that large customer. So, much broader base of consumer electronics growth than what we had last year, is that – or consumer electronics revenue.

Is that fair?.

Yeah. I think it's a fair description. And certainly, I'd point to the kind of growth that you're seeing in other – Asia (22:09) in our business and the comments we've made about OLED manufacturing. So certainly, that technology, we think is very exciting, has multiple years to run and we're going to see it adopted, I think, broadly..

Does Cognex pay the commission out? When I look at the operating expense number and you talk about it being up sequentially another 10% potentially, is the commission on the consumer electronics side, irrespective of the customer, is that paid in the quarter that you get paid?.

It will follow revenue. So, our commission....

So, the rev rec, it would be third quarter is going to be that large and then the commission is paid out there.

Correct?.

Yes..

Yes, I understand. Okay, great. Thank you and congrats..

Our next question is from Joe Giordano from Cowen & Company. Please go ahead..

Hi, guys. Thanks for taking my questions. You've been nudging your consumer electronic growth outlook for the full year up progressively as we've gone here.

Now that you have the line of sight into 3Q guide, where do you see consumer electronics as an end market shaking out, like on a growth rate for the full year?.

Well, generally, we don't give kind of full-year guidance, but we're obviously seeing very strong growth in that market. So, we would see it being above our overall performance for the business for the year..

Okay, fair enough. And you mentioned the logistics, you've been consistently with a 50% growth estimate for foreseeable future.

How fast do you think the TAM is expanding relative to that growth rate?.

Yeah. I would put it into teens currently and that's maybe a bit more aggressive than you're going to see in other studies you might read. I think the adoption of automation, robotics, and particularly vision in that market is exceptional, but we are certainly gaining share and credibility in the space.

So, I would say we're probably 3x times the TAM expansion..

Is there a margin profile difference between what you're selling into that market and the rest of your business?.

Generally not. There is some business that we're doing there in that space which requires more application engineering, and that sometimes, that's – when we get into a new market, we're helping customers adopt our technology.

So that maybe a drag to gross margin, a few points, as we get into some of the large deployments in some of the newer applications. But overall, we would expect logistics' margins to be pretty similar to our business overall..

Okay. And then, maybe I just want to touch on the balance sheet here. Good problem to have, but $700-plus million in cash, no debt. Yeah. You've done M&A, but I think if there was a huge deal to be done, you probably would have been there already.

So, should we start thinking about the possibility for more outsized shareholder return whether it'd be a special or something like that, or you're happy to keep it on the balance sheet for now?.

I'll kick off and I'll hand it over to John. I mean, I think consistently – this is Rob. Consistently, we've always said the first use of cash is acquisitions. And you can see in the quarter, we've put some cash to work, particularly through the acquisition of ViDi.

So, we won't hesitate to do that, and significantly larger acquisitions as and when they become available. Second use of cash is stock buybacks and third is dividends. And I think we consumed cash in the quarter, eroded our cash balance a little bit. John? Yeah..

Yes. Yeah, Rob. Yeah, that's true. In this quarter, we basically consumed our domestic cash generation, so we're kind of holding at par from a cash perspective. And if we have a large transaction in the works or in the quarter, that would likely dip into our cash balance from a domestic cash perspective..

Okay. Maybe if I could sneak one more.

If you normalize 2Q and 3Q to take out the timing difference year-on-year for consumer electronics orders, I guess the big question is how much of this is just the market using this technology more or how do you frame out how much – is that just the market consuming more of this product versus some large high profile scaled launches that are more – not one time in nature, but you can kind of point this to very specific things? How much of this is just market growth versus those more idiosyncratic drivers?.

I mean, I think it's difficult to parse that out with any real precision, but what I would say is, I think it's a great market currently for industrial businesses and I think particularly in consumer electronics. So, I think we've certainly seen pretty strong conditions.

I think every year, we kind of being asked that question about consumer electronics. And I think every year, we seem to see solid growth and more and more vision being used in that market.

And then, obviously, we have some growth initiatives that I certainly have been commenting on, whether it's logistics, whether it's 3D vision, whether it mobile terminals where we're expanding our served market and we see opportunities for exceptional growth.

And then, the other kind of color I'd put on it is, we've been saying pretty consistently, our growth target is 20% in factory automation over the long run. And I think kind of as you look back over various periods, that's kind of what we're doing or better.

And we've always said, it won't necessarily be consistent but that's kind of what we're shooting for. So, I would encourage everyone to take a longer term view on what we're doing and seeing that this is really the consequence of many of the things we've been working on for a long time..

Thank you..

Our next question is from Jim Ricchiuti from Needham & Company. Please go ahead..

Hi, good afternoon. Rob, I'm wondering if we could talk a little bit more about the OLED opportunity in terms of how meaningful has it been up until now. And as we look out over the next couple of years, I think we're all aware of the capacity that's going to be coming on.

And I'm just wondering are you designed in? Can you talk a little bit about your line of sight into some of these factories?.

Yeah. Sure, Jim.

The opportunity for Cognex's with machine builders who build the OLED display modules because of the volume of equipment and high precision alignment that's needed to produce them, we're seeing manufacturers of the material itself using a lot of vision, because OLED displays are harder to make and certainly, more expensive than LCD displays before them because of the fragile layers in the display module.

Cognex has a clear technical advantage in the OLED manufacturing from our experience in consumer electronics manufacturing with very precise alignment, and vision is important in every step of the OLED display manufacturing and in the final assembly of the modules. And I think this adoption of this technology will come in phases.

It's difficult to see beyond the next couple of years but we believe the final assembly and testing of electronic devices has the potential for more substantial business over a longer period.

So, we really like what we're seeing and what we're able to do to help this market with machine builders but also then as it's going to flow into end-user consumer products.

We know everyone's thinking about smartphones' OLED but I think there are other markets also, particularly, I think, in the longer run, in automotive, going to see a lot of OLED inside cars.

And that material is difficult, requires precise alignment, it's easily damaged, it's difficult to move, and that's where automation is really coming into play and Cognex has a lot to offer..

Got it. That's helpful. Just on the logistics side, two quick questions.

You're showing very strong growth, and I'm wondering is, can you give us a sense, is the average deal size increasing, Rob, or are you just securing business with more customers in this market, or both?.

Yeah. It's really both. We have a broad range of customers now in this market. We have some large customers in that space who will do certainly more than $10 million with us this year.

And then, we have some much smaller customers who are really just doing presentation, scanning of barcodes, people working in warehouses, particularly in markets like China where logistics is still pretty manual and not highly automated. So, it's broad and we see growth across all those segments..

And then, last question, just on the logistics, can you give us an update on how the mobile terminals business is going for you guys? It's early days, I know, but just wondering how it's going..

Yeah. I would say our progress in mobile terminals is similar to our journey in other markets like logistics or 3D. It represents a significant opportunity with our installed base that's kind of under transition from old technology to new technology.

We've got a very good funnel developing but it's a little early to say when that funnel is going to turn into revenue, although, we're confident that it will. We like what we see but we're certainly not – it's not moving the needle significantly in terms of revenue just yet..

Got it. Congrats on the quarter..

Thank you..

Our next question is from Josh Pokrzywinski from Wolfe Research. Please go ahead..

Hi, good afternoon, guys..

Hi, Josh..

Just a question on the product ID side of just logistics.

Can you maybe help us out with the way the customers are purchasing? Is it a new facility opening or retrofitting existing facilities? Is there a density or content per forwarding facility that is going up over time? Can you give us a flavor for how the spending evolves with any given customer?.

Yeah. So, the biggest segment for us inside logistics is e-commerce fulfillment. That's certainly kind of the rapidly adopting vision there. You read about in the press a lot of new facilities opening up, smaller facilities in the more urban areas close to the customers, the drive to be able to deliver in a matter of hours.

So certainly, that's kind of new sites from our perspective, anyway, and it's – that's being driving some growth. The other area, though, is we've – as in a lot of new markets we enter, we enter with something specific that we can do, which is really barcode scanning, initially just in – on boxes going by on conveyors.

And over time, we've migrated into sort of tunnels which is scanning six sides of boxes, sometimes, moving as fast as 500 feet and 600 feet a minute much.

And then, now, we're seeing broader adoption of Cognex vision around the warehouse with things like mobile terminals and adjacent trucks being filled and 3D technology starting to be looked at for dimensioning. So, this is a market where we're seeing broader and broader applications of Cognex vision over time..

Got you. So when we think about a major e-commerce player opening a new facility a week for fulfillment centers, this isn't just each new fulfillment center is content of X, it's also going back and retrofitting what's already in the base, if I'm understanding that right..

Yeah. Yes. If I understand you correctly, that's right. Yeah, lots of opportunity to retrofit and sell, more broadly, vision to do more and more. And if you think in general about Cognex vision, what is it doing.

It's replacing eyes and brains on the manufacturing floor or in the distribution system, and there are a lot of those and lots of opportunities for Cognex to help with more productivity and more precision as people are trying to get packages to consumers quickly and without error..

Got you. That's helpful. And if you could maybe help indulge me on a little bit of a read across from some of the other folks out there in industrial and who have seen good momentum on the semiconductor side.

Where would you see content in that application or the strengthen in semicon suggests that one or two quarters down the road kind of further down in the tech supply chain for final components that you guys would see strength? I guess what I'm getting at is, is the strength in semicon that a lot of industrial companies have seen in the second quarter a precursor to the strength you're seeing in the third quarter or could that be something that is indicating strength even farther down the road, fourth quarter and beyond?.

I'm not sure I can even speculate on that. I don't really know. Semi is a pretty small part of our business these days. It tends to be more driven by new technology coming in that's flown through the supply chain. I think, obviously, we're seeing a lot of activity in consumer electronics and I guess, semiconductor materials goes into those.

So, I think that might be a leading indicator in some ways of what you're getting at. But I don't think I can really give you an insightful answer..

Got you. But I would – and I appreciate the color on that. That's helpful.

I guess, in that regard, though, would it be too soon for a ramp in that supply chain to help the consumer electronics side? It just seems like a one-quarter lag might not be the correlated factor that maybe that ramp in the semiconductor side sets something good later down the road.

But your customers, I wouldn't imagine ramp back quickly, you said like a nine-month kind of lead time, presumably that's what you'd be talking about in this situation as well..

It's tricky to say. I mean, what I would say, and I'm a very – we're very small in comparison to other customers, is we source electronic components to go into our own products and the market, overall, for processors and imagers and other things looks very hot.

So fortunately, we're a company that keeps a lot of inventory to make sure we can supply our customers quickly. So, it's not a significant problem for us but clearly, there's a huge demand pull on electronic components in the world today. So, that's an insight I would offer..

Fair enough. Thanks for the color, Rob..

Thank you..

Our next question is from Jeremie Capron from ROBO Global. Please go ahead..

Good evening. Thanks for taking my questions. Certainly, it was interesting to see the ViDi acquisition early in the quarter and I wanted to ask you about the deep learning approach to machine vision that seems to be gaining traction, including in a number of the more industrial and logistics type of applications.

We're seeing some relatively young companies becoming quite successful in this area.

So perhaps, could you discuss Cognex relative position here and how you view the deep learning approach in general? You perceive this trend as a threat or an opportunity for Cognex?.

Yeah. Hi, Jeremie. So – Bob..

Yeah. This is Dr. Bob here. And I know that Rob is going to pass the microphone to me for this. Deep learning offers some growth opportunity for us. AI applies to many different businesses and from stock trading to determining if when somebody makes a charge on their card that's a legitimate charge.

So, AI plays – it's going to play even a more important role in many different industries. And certainly, in machine vision, there is a segment that can best be served by this kind of deep learning and that's why we went out and searched and found a small company with just the technology we wanted.

And in addition to having the right technology, they had the right focus and their focus was on industrial uses of deep learning and artificial intelligence. So, we've come across many problems in the past that would've taken our own engineers many, many weeks or months to solve for the customers and just wasn't cost effective for us to do that.

Whereas today, some of these deep learning methodologies can solve these problems much more quickly in a matter of perhaps, hours or even minutes. So, we are looking at those and let me just give you examples of where deep learning and that learning machines do play a role in our business.

We're being asked by a number of different customers, large customers to look for flaws and defects on discrete items. Now, this is different. Of course, then the flaw and defect detection that is done in the paper industry or the steel industry on webs moving at very high speed.

This is looking at flaws and defects in the machining of items ranging from TV screens to cell phone cases and things like that, where everyone is very concerned that the milling machines operated quite correctly, there are no scratches, no bumps, no extra metal. And a lot of this can be solved with our 3D initiatives, with our DS products.

But other ones, like scratches and surface flaws cannot be detected by 3D because there is no third dimension of those kinds of flaws or nothing that can be really measured by anything today. So, what we've decided to do is look at those opportunities that our customers have already asked us to solve.

And we went out, found the technology, and we're incorporating not only the technology, but those technologists into our company so that we can add more tools into our existing very large toolset, but the large toolset doesn't yet include, doesn't currently include these kinds of learning tools, but they soon will.

So, does that answer your question, Jeremie?.

Yes, it does.

And perhaps thinking about the company's strategy going forward and the current state of the competitive landscape, are you already seeing some of those younger companies competing for some of the more traditional industrial business that Cognex has been going after for years?.

I'll let Rob answer that. My own impression is we have not seen any small entrepreneurial or companies, whether they're using AI or not using AI or deep learning or not using deep learning. I'm not aware of that, but I'll let Rob speak to it..

Yeah. You're right, Dr. Bob. I mean, I think there's a lot of noise about the application of deep learning techniques to industrial vision. And we've been trying to do this for decades, but no one's been able to do it to the degree required until ViDi.

And that's what we were very drawn to because this was a practical solution which really works rather than a theoretical lab approach.

And that's similar to how vision has been in a long time, through its history, is things can work in the lab under highly defined conditions, but that's not that useful when you get on to – into manufacturing where there's so much changing, the light is changing, the speed of the conveyor is changing, all these things.

So, that's been true for Cognex and it's particularly true right now at this kind of cutting edge of technology deep learning where we see ViDi really leading..

I would agree with everything Rob said. In addition, I'd like to add that this deep learning will not apply – does not apply to most of the customers and the applications that we now solve with our own artificial intelligence, which is pre-trained artificial intelligence systems.

Our current systems, you don't – if a customer, let's say, the application is to look at medicine bottles moving by to make sure that the label is on straight, it would be foolish to use self learning to show what good labels and bad labels and have the system figure out what a good label is and a bad label is.

The most appropriate technology, AI technology, is the one that we use, which is trained by our own customers who tell it what a good label is, explicitly tell it a good label is one that is 3.5 inches wide, by this high, that it is this straight and this amount of error, and so that the self-learning systems, although they may be able to work on this kind of a problem, wouldn't be practical and our customers wouldn't want to sit there and train it on the good label versus bad label, rather than just tell it explicitly what a good label is.

So, I don't think that our business – and I can say this with a lot of confidence, our business is not at risk by deep learning systems. Deep learning gives us an opportunity to grow in those markets and in those applications where deep learning is very appropriate, and that specifically is flaws and defects where you cannot define very easily.

You can't define what a scratch is. You have to show the system examples and let the system determine by itself after training. So, that's where we are. We are worried about competitive threats, but they aren't in the deep learning space..

Great. Thanks very much and congratulations on the upcoming monster quarter and good luck..

Thank you..

Our next question is from Bobby Eubank from Chevy Chase Trust. Please go ahead..

Congratulations on a strong quarter, guys. Thanks for taking my call. Couple of questions here. Following up on the prior question, the Amazon Picking Challenge just wrapped up and that might be an opportunity to use some of the deep learning technologies from ViDi.

So, is this an area that you could build out that you see doing a couple more acquisitions, smart engineers and trying to build out deep learning for robotic picking?.

I'll start off, but then, Dr. Bob might like to comment, too. So, we don't talk about specific customers, but certainly, we've acquired some technology that I think is going to make picking of parts, particularly large variety of parts, much more possible.

It's a 3D technology we've acquired, particularly EnShape I would point to, which is industry-leading in terms of acquiring and acting on information about parts and their position in a bin.

And then, also, potentially, I think further out, deep learning has the potential to look at what'll be a high degree of variety of different products coming through a production line. But I think it'd be interesting to hear from Dr. Bob because this problem of bin picking on robot guidance is certainly not a new one..

Yes. Thank you, Rob, and Bobby, thanks for the question. The problem of bin picking has been around since I was a graduate student back in – at MIT in the mid-1970s and it is a very, very difficult problem. The technology had not, until recently, been advanced enough to solve the problem.

And the key element or the key piece of technology that's necessary is 3D. And we have made extremely good progress in our 3D product offering, our 3D technology and in some of the acquisitions, EnShape, in particular to this.

And I can say that we are very involved with large customers in certain types of bin picking and lots of different bin picking applications gets very complicated. I'm not sure whether learning systems or expert systems are going to be the right solution but I certainly know that 3D is going to be a major component.

Without 3D, the problem is intractable. And now that you can buy 3D products from us and from maybe one or two competitors, there is a chance of solving these problems to a great degree. And I think it's very, very forward thinking of Amazon to hold these challenges and inspire people to try to solve these problems because it's well worth their money.

They even offer prizes for this. They should be substantial prizes to advance bin picking because from what I understand, from what I've read and nothing confidential, there's major labor components still in logistics and that is in picking the items off a conveyor or picking the items out of a bin or some sort of holder for shipment.

So, this is a problem that I believe will be solved and can be solved and will be solved within the next few years, and I fully anticipate that Cognex will be the primary beneficiary on the machine vision end. There are other problems with this. There are problems on the effector of the robot, on the gripper of the robot.

There are many different kinds of grippers that might be necessary. So, it's a very difficult problem, but the technology pieces are around to solve it. That's my view and there will be products offered or components that the customers or system integrators would put together to satisfy customer demand in the next couple of years..

Thank you for the color. That's really great and exciting time to be a consumer. Final question, back in Q1 2015, I guess we were in a little bit similar situation.

We were expanding the sales force, business looked good, and then, we had a little bit of a slip up that extended beyond just the large customer but that certainly contributed to it as well.

Are there any lessons learned from that period, looking at the business today that preparations being made in case a downturn occurs unexpectedly? Thanks and congratulations on a strong quarter..

Yeah. I would say really, Cognex, we take a long-term view. I would encourage you to not look at any specific quarters. I mean, obviously, there's going to be market conditions like we're seeing currently which are excellent, and then, market conditions like the ones you referred to that are more difficult.

But generally, our view is we're looking to grow this business at 20% compound annual growth rate, the factory automation business over the long term, and that's kind of what we're focused on and we're not overly focused on particular quarters, so – and I think, oh, we have to take the rough with the smooth.

Certainly, Q3 is going to – is looking very smooth and I'm sure there'll be rough quarters in future, too, but we have our eye on a bigger prize which is being the strong leader in what is turning out to be just a fabulous end market with a lot of barriers to entry and a lot of challenges where Cognoids are very enthusiastic about working and bringing great technology to market.

So, we kind of have our view, our eye on that..

Keep up the long-term vision. Thanks..

Our next question is from Jairam Nathan from Daiwa. Please go ahead..

Hi, thanks for taking my questions. I was wondering if you could update us on the sort of the other growth markets like life sciences and airports. And I have just one more follow-up..

Yeah, yeah. Thank you. Yeah. So, life sciences is a market we've been working out for some time, has a very, very long sales cycle.

So, the name of the game there is to get Cognex vision specified into new generations of life science OEM equipment that measures human blood and other bodily fluids as they go through analyses in hospitals or processing – medical processing centers, and we're making very good progress in that market. We measure success by design wins.

So often, it's about a three-year cycle to design a product before it comes to market and we're seeing Cognex winning a lot of design wins. So, we're getting specified into those products.

That means that it's not a lot of revenue today but as we get into the next decade, we're going to see, I think, millions and millions of dollars of regular revenue from those markets as our equipment is adopted.

To give you a little bit of a sense, we've been specified so far this year into nine new models of equipment, some of which we would expect to be delivering $1 million a year or more of revenue starting early next decade and going on for a period of 7 to 11 years.

So, it's a little bit about that market, one for the future and one that we're working at now. I'm kind of slightly back to the previous question about short-term versus long-term and how we think about things. The other market you asked about was airport baggage handling.

It's an interesting market for us where we deliver substantial benefits to customers seeking innovation in a market that's traditionally been dominated by lasers to read barcodes.

So now, as vision comes in, not only can it read barcodes much more effectively, which means luggage is moving more quickly baggage through airports, it doesn't have to be taken off line and processed, but potentially, there are other benefits also that it can bring, inspecting baggage for other things such as problems that can get stuck in conveyor can slow down the conveyors or jam up conveyors, and actually, even some security aspects we're certainly seeing interest in.

So, we are winning new business in that market where we're really a new entrant and one of our competitors has a very strong market share but we think outdated technology. So, we've had a major win at a recent airport in Europe and we're bidding on potential multimillion-dollar deals also, but those are things that have quite a long sales cycle.

So again, I don't see huge contribution from that market this year but it's one we're enthusiastic about in the future. And just to give you a little color, I learned of a term recently in the airport baggage handling market which is bag hygiene, baggage hygiene.

So, I was thinking dirty laundry, but turns out that that really has to do with problems with the bag that might get stuck in a conveyor. So, glad to share that with you..

Oh, that's funny. And just as a follow-up on the mobile terminal, how are you seeing the competition response from the two large players, kind of existing players in the market? It looks like they might be launching some, at least, mobile-based solutions as well as smartphone-based solutions.

So, what do you think of it?.

Well, I think I'd – I'm not – I don't think that they view us as a very significant player in the market which is fine by us. We are working more with innovators in this space.

I think what I would observe is that Android operating systems are really becoming more and more adopted and I think we've seen – one of the players in that industry tended to say, well, that Android is not really right for this market, and while another one has sort of said no, Android is more where it's going. We believe that's really true.

The Android operating system certainly was designed for use in mobile, in a mobile environment as opposed to Windows, which is really the vast majority of what the two big players make. And then, iOS also, obviously, is designed for mobile-type applications.

So, it seems to resonate with more forward thinking customers and that's kind of where we like to play. So yeah, as I mentioned, it's a journey for us. We are pleased with what we see. We're in this for the long term and I think it'll be a significant business for us in future.

But right now, I think the two big players you're talking about are much more focused on each other and that's fine by us..

Thank you. That's all I have..

And our last question comes from Jagadish Iyer from Summit Redstone. Please go ahead..

Yeah. Thanks for taking my question. I'll make it quick. Two questions, Rob.

First on, given your strong guide for Q3, and particularly, the magnitude of the consumer order, I was wondering whether you can provide insight whether Cognex got qualified for multiple products at this customer or is it purely a single product that you experienced significant surge in units. And then, I have a follow-up..

Yeah. Hi, Jagadish. So, I can keep this very quick and that we really don't – we're not going to comment at all about any business at any particular customer in that industry. It's much too sensitive..

Okay. Okay. Fair enough. Go ahead..

And you had a second question?.

Yeah. So, the second question is probably for Dr. Bob, also can jump in on this one. But if you look at your – on the semi market, there has been an increase spend on capital equipment which is historically one of the highest for the year, for the recent years.

So if you look at your semi revenues, it is hovered around $5 million to $7 million a quarter. So, my question is have you increased your offering there compared to your historical one? And specifically, Dr. Bob, are there any inflections that you might be able to intercept in the semi markets such as packaging or so? Thanks..

Yeah. Thanks for your question. We did extremely well in the semi industry from, like, 1985 to 1995, for a 10-year period, when the customers really needed what we had. It was very unique and to be able to run on a low cost product, nobody had technology that could do that.

But over time, we found that our OEMs, many of the OEMs, the high volume OEMs, and because technology moved forward, that even with less powerful software, they made up for just on more hardware at it. So, that's why we made a concerted effort to expand our business into the end user market. Now, we still think OEMs are valuable.

We have very good customers there but at this point in time, we prefer to put most of our engineering resources on the end user market, and other technologies, like 3D, which probably don't apply to most of the semi OEM applications. And even if they did, probably, too expensive for them. So, you can follow on with another question.

Rob or I will try to answer it, but that's where we are right now..

That's good. Congrats on a strong guidance..

Thank you..

Thank you. This does conclude the question-and-answer session. I'd like to turn the floor back over to Dr. Bob Shillman. Please go ahead..

Okay. Well, it's easy to wrap this one up. We've reported just great results for Q2 and we expect, as Rob told you, to deliver even better results to Q3 which we expect to be a record, not only for revenue but net income and earnings again. We look forward to speaking with you on next quarter's call.

And I want to thank you for joining us tonight and for your continued interest in Cognex. Goodnight..

Thank you. This concludes today's teleconference. Thank you for your participation. You may disconnect your lines at this time..