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

Joe Ritchie - Goldman Sachs & Co. LLC Joseph Giordano - Cowen & Co. LLC Richard Eastman - Robert W. Baird & Co., Inc. James Ricchiuti - Needham & Company, LLC Jonathan DeCourcey - Canaccord Genuity Josh Pokrzywinski - Wolfe Research LLC Paul Coster - JPMorgan Securities LLC Jairam Nathan - Daiwa Capital Markets America, Inc. Jagadish K.

Iyer - Summit Redstone Partners LLC Bobby Eubank - Chevy Chase Trust.

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

Thank you and good evening, everyone. I'm John Curran, Cognex's CFO, and I'd like to welcome you to our third 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 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, and thank you for joining us today. As shown in today's news release, we reported spectacular results for Q3 of 2017. We set new records for quarterly revenue, net income and earnings per share that far exceeded any previous quarter for Cognex's 36-year history.

And we were ridiculously profitable, reporting an operating margin of 42%, also a new record. 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, Cognex's CEO, Rob Willet.

I will be available at the end of the call to answer any questions that you may have for me at that time. Rob, the microphone is yours..

consumer electronics, automotive and logistics. Cognex products are increasingly being applied to a broadening range of difficult tasks in the industrial markets where we focus. As a result of the strong revenue growth, operating margin expanded to 42% in Q3, even with increased investments.

This is the highest level ever reported by Cognex in our 36-year history. While exceptional, it's indicative of the substantial leverage that we have in our business model as we grow. Underpinning the success that we enjoy today are many years of leading-edge engineering and the cumulative hard work of our special team of Cognoids.

Our investments in engineering, our sales force, operational improvements and culture have served us well. They represent a large barrier to entry for any prospective competitors. We plan to continue to invest in Cognoids and the processes and systems necessary to support growth for years to come.

We recruited, trained, and provided equipment for over 250 new Cognoids since January, more than at any time in our history. We expect that our year-end workforce will surpass 1,700 employees worldwide.

That's one reason we're so pleased to announce the promotion of Sheila DiPalma to Senior Vice President to head Cognex's Corporate Employee Services group. In addition, the Board has appointed Sheila as a Corporate Officer.

Sheila will lead what most companies call Human Resources, but at Cognex, we variously refer to as Cog Health and Wealth, Cog Career, and Cog Communications. With more than 20 years of experience at Cognex, Sheila understands the important role that culture has played and will continue to play in the success of our company.

Let's turn now to John for details of the third quarter..

Thank you, Rob. Here are the highlights from the third quarter all from continuing operations. Revenue was $260 million, which represents a new all-time record. It was also the first quarter in our company's history to exceed $200 million.

Growth came primarily from the consumer electronics industry, which increased substantially both year-on-year and sequentially. We also saw strong growth in the broad factory automation market, excluding consumer electronics where revenue grew well above our long-term target of 20%.

Gross margin was 76%, down 2 percentage points both year-on-year and sequentially. This was due primarily to the revenue mix from a material customer in the consumer electronics industry. Operating expenses for Q3 were $87 million, representing an increase of 15% on a sequential basis.

Most of this increase is related to growth initiatives around new product development, sales resources and the implementation of our new ERP system. Commissions and bonuses were also higher as a result of our revenue growth. As previously noted, operating margin expanded to 42% from 37% in Q3 of last year.

The fall through on our revenue growth was excellent. Net margin was outstanding at 39% helped by a significant tax savings related to stock option exercises in Q3. Excluding all discrete tax items, earnings for Q3 were $1.03 per share which is in line with the Thomson Reuters first call consensus estimate.

Revenue from our largest market, factory automation, represented 97% of our total business in Q3. Let's take a look at factory automation revenue year-on-year from a geographic perspective. Asia was our fastest growing region.

Revenue from Greater China and the rest of Asia more than doubled as a result of strong performance in consumer electronics and automotive. Europe delivered the largest contribution to growth in absolute dollars. The region was helped by large consumer electronics orders that were placed in Europe for Cognex products used on assembly lines in China.

Outside of those orders, our European revenue grew by more than 25% year-on-year in Q3, led by automotive, logistics and food and beverage. And in the Americas, revenue grew an excess of 35% from higher sales to customers in the logistics industry and in the broader factory automation market. Now, I'll hand the microphone back to Rob..

Thanks, John. In summary, Cognex reported a spectacular quarter in Q3 that was helped by volume orders from consumer electronics. Our outlook for Q4 is shaping up nicely. Revenue for Q4 is expected to be between $170 million and $180 million. While that represents a decline from Q3, it still represents growth exceeding 30% year-on-year.

Gross margin is expected to be in the mid-to-high 70% range, broadly in line with our year-to-date average. Operating expenses are expected to decline by low single-digits from Q3, but they will be substantially higher than in Q4 2016 as we continue to add Cognoids and provide our growing team with the resources they need to excel.

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 are ready to take questions..

At this time, we will be conducting a question-and-answer session. Our first question is from Joe Ritchie, Goldman Sachs. Please proceed with your question..

Good afternoon, everybody..

Hi, Joe..

Rob, maybe just touching on the quarter a little bit. Clearly, electronics was really strong in this quarter on a year-over-year basis.

Can you give us any more details on either electronics, auto, logistics, how much all of those different end markets were up on a year-over-year basis?.

Sure. I can give you some color on that. Factory automation in general demonstrated a phenomenal growth in Q3, increasing 78% year-on-year. Our investments in prior years are delivering growth in a range of areas like consumer electronics, logistics, and 3D all delivered substantial growth.

Outside of consumer electronics, Q3 revenue grew more than 30% year-on-year and growth came from many industries but was led by automotive and logistics. We're seeing continued strength in logistics, which is growing more than 50% this year. And consumer electronics demonstrated, as you noted, remarkable strengths.

So, looking at automotive specifically at China, automotive increased to the fastest rate of our major geographic regions. In the Americas and Europe, automotive grew quicker than we'd expect it to do over the long-term..

Thank you. That's helpful color. I guess, I know that your business is pretty short cycle, hence, the one quarter out in revenue growth expectations.

But I guess, if I'm thinking about your longer term framework where the expectation is kind of like 15% to 20% top line and bottom line growth, how should we be thinking about that framework for next year particularly in light of how strong things were in or have been in 2017?.

Yeah, Joe. It's Rob again. I mean, I think we like to think about the long-term growth plan for Cognex which is to grow the factory automation business at 20% a year. Obviously, we've been successful at doing that over the last three and five-year periods variously and obviously, we're doing much better than that this year.

But we're investing against a plan that has long-term growth in mind, hence, the investments we're making in engineering, the technology plans that you've seen us execute on this year with acquisitions and some new products and also the investments that we continue to make in processes like – that we're making.

But in terms of growth over the long-term, we're confident about the plans we're implementing. In terms of growth next year, it's really too early to say we're getting into the budgeting process right now. I mean, we continue to be confident about our growth prospects.

It would be fair to say, I think, that we would expect Q1 to be as normal our lowest quarter and then our big quarters tend to be Q2 and Q3. And we're optimistic about the potential to grow next year, but it's really too early to nail this down or to really understand any specific growth numbers at this point..

Okay. Great. Thanks, Rob and nice quarter..

Thank you..

Our next question is from Joseph Giordano of Cowen & Company. Please proceed with your question..

Hey, guys..

Hi, Joe..

Just quick cleanup.

The unbilled revenue that you've mentioned in the release, is that the only revenue from like unusually large orders that are – that's happening in the fourth quarter?.

Hi, Joe. This is John. Yes, that's a mix of revenue from large orders in consumer electronics as well as in logistics. So, there's a bit of a mix in there. We expect that to kind of – for the most part, clear up in Q4..

Okay. I think one of the bigger questions in people have with the growth profile you have, you've proven the ability to grow with existing customers.

But I guess, right now, with the explosive growth you're seeing in some of the consumer electronics, relative to maybe like OLED build-out and some structural things you want on in the space, without getting into detail on anyone – on any customer in particular, is there a way to frame out how much is this of what you're seeing is more of like a recurring kind of nature with customers that are going to be there or – and how much is more on just a capacity build in the industry to support a new technology?.

Hi, Joe. It's Rob.

Let me clarify your question that you're asking about electronics' ongoing customer revenue, is that what you're asking about?.

Yeah.

I'm just trying to separate how much of this is kind of a base that grows with existing customers and how much is infrastructure to support a new technology development, a new type of like an OLED kind of thing?.

Yeah, I would say, over the last four years, we've demonstrated very substantial and relatively consistent growth in consumer electronics and that's been around a number of customers, and it's been around particularly final assembly and test but also around really new technologies that are coming into the electronics market.

So, on that first part, I think that it's just a continuing drive towards the need to replace literally hundreds of thousands of bodies who are involved and people who are involved in manufacturing products and whose eyes and brains are involved in that process.

And as a technology evolution, that means that they're less able to be effective as products get more sophisticated, harder to assemble and as wages go up at a fast rate of productivity. So, I think that's just a great underlying trend that isn't going away and has a long way to go. So, I think you're seeing that.

I think another factor you're seeing is, every year, there is new, very exciting and pretty difficult to implement technology coming into the electronics market whether it's OLEDs, displays, and technology as you referred to or other new technologies around areas like facial recognitions and 3D sensors, new cameras, new sensors; a range of new things.

Generally we've seen that continue. So, I am – I think those kind of underlying factors have a long way to run for the industry and the difficulty of getting them into production where Cognex is the best machine vision partner in the world to make that happen.

And you point to OLED, I would say that's relatively early on in terms of technology, it's maturation.

I think we're just seeing its capacity kind of maxed out at the moment just in the smartphone market but I think the technology itself has huge potential to scale up over multiple years and find its way into all kinds of other markets; automotive, real estate and offices might be other examples where the technology is going to come.

So, we think we have really sustainable and value book competitive advantage to offer companies in that space.

So, I would say that's kind of our overall picture what I – this sort of perhaps some of the challenges that you were looking and try to forecast our business in that spaces to what degree the investment cycles kind of kick in and win some of the major capital in lines are deployed.

So, I think that may impact short-term quarterly kind of or even annual revenue cycles, but I think over the long-term, it's very, very positive for Cognex..

That's really helpful. And maybe if I could just sneak one quick one here for John.

When I look at your operating margin, I feel your 42% on a huge quarter obviously, getting to the benefit there but what kind of run rate of like your base business do you think we have to get to start seeing a real move from like a 30-ish percent rate to like a more sustainable rate closer to 40% as you kind of you scale the business and you can leverage SG&A and R&D, notwithstanding the investments you're making right now but more on a longer term basis?.

I think we're – we've got a number of years to run of growth, so we – I wouldn't expect to see something fundamentally different until the business matures and I don't see that in the near term. So, we're calling for something in the 30% range for the foreseeable future..

Fair enough. Thanks, John..

(19:49) – sure..

Our next question is from Richard Eastman, Robert W. Baird & Company. Please proceed with your question..

Yes. Good afternoon..

Hey, Rick..

Rob, John. A quick question, Robert, the 3D business you kind of called that out a little bit here in terms of driving growth in the third quarter.

Could you possibly just size that or give us some sense of significant scale and then also maybe just kind of call out? I'm sure the growth rate was high but is there a end market or two where the uptake is particularly quick?.

Yeah. Hi, Rick. So, our 3D business is about 5% of our business overall and gone from pretty nothing a few years ago. And the growth rate is well in excess of 50%, and we think 50% growth rate for the foreseeable future is what we're shooting at and is very achievable.

We really serve a variety of end user markets that actually might approximate our overall market breakdown with consumer electronics being perhaps the biggest market, automotive second largest, but increasing applications in all kinds of areas pretty well mirror our market overall and our sales force coverage overall..

And can I just – when you talk about automotive, obviously, China being the biggest growth driver for you there.

But are there any applications, are these indigenous Chinese auto manufacturers where you're gaining share or how do you account for some pretty significant growth that seems to be a pleasant surprise kind of quarter after quarter? Any – is it applications-driven or is it new customer-driven? Maybe you could throw a little color on that..

Sure. Yeah, yeah. So, Cognex is very well-known and very well-penetrated at all the large automotive companies in the world. But most of our business, more than half is with tier 1 automotive suppliers, right? So, not so much end users.

And there, there's a lot of – particularly in China which you're asking about, there's been a lot of investment going in into areas like vehicle model changes, less and less kind of sedans, more SUVs, electric and hybrid engines.

It's a lot of pressure in China to reduce pollution, as we all know, and also increasingly electric – electronic components and systems that are changing very rapidly as cars become more and more like consumer electronic devices.

So, certainly, we see all of that and we see very big levels of investment in China to support particularly their domestic growth..

I see. Okay. And then, just the last question.

How did the ID products business perform excluding the logistics component? Did we still see 20% growth there or...?.

Yes, in excess. In the quarter, in excess of – well in excess of our or actually in excess of our 30% long-term target..

Okay. Okay, great. Thank you..

Our next question is from Jim Ricchiuti, Needham & Company. Please proceed with your question..

Thanks. Good afternoon..

Hi, Jim..

Wondering – Rob, I'm wondering or John I'm wondering if based on your year-to-date numbers, if you can say whether you might be tracking to have more than one 10% customer in 2017..

So, in general, Jim, we don't talk about our material customer but clearly it would mean – so, certainly not enough.

But your question is would we have another one?.

Right..

And I think I can go on a limb there and say no..

Okay. Fair enough. Now, I'm wondering, and I know it's too early for you to give any kind of specific guidance for 2018.

I understand that, but I'm wondering if you – how much visibility do you have into larger projects in consumer electronics and logistics into 2018? Is that something you have a pipeline to now?.

Right. So, we work with pretty much all the kind of large consumer electronics companies in the world. So, we have pretty good view about kind of what's coming down the pike two years out, one year. But it does change, and there are different technologies that are ready for prime time and those that are not.

And that can be changing, right, the way as we get into implementation. And kind of referring slightly back to your last question, we do have some other pretty, very substantial customers both in electronics and logistics, so I wouldn't want you to take my answer to mean that we're a one-trick pony. We're nothing like that at all.

But then, what I would say also is that we tend to be discussing kind of deployments in electronics about 9 to 12 months out. So we start to get visibility of what's on deck for next year and to be zeroing in on that which is kind of nicely fitting with our budgeting process as we go into that.

So, that's kind of the visibility we get which is a lot shorter than we see in other industries that are perhaps slower moving like automotive..

Got it. And last question, jump back in the queue. The OLED market appears to be a good driver and that certainly has appears to have good likes to it based on the capacity plans in Korea and China.

Wondering is 3D sensing, how big an opportunity is that potentially for you as you look out over the next year or year and a half?.

Is your question about 3D sensing in OLED or 3D sensing in general?.

Well, how about both and specifically on the OLED market and then 3D sensing in general?.

Yes. So, in general, I don't see a lot of 3D Vision being applied to OLED manufacturing currently. There are many other techniques about inspecting and assembling and aligning that material and moving that material which is very fragile and helping OEMs scale up to produce that material. But generally, it's a 2D Vision problem not a 3D Vision problem.

In terms of the 3D market overall, it's like, I previously said, with that represents about 5% of our business. It's growing very well, well in excess of our 50% growth rate that we think we can achieve going forward on an annual basis overall for the next few years..

Okay. Thank you..

Our next question is from Bobby Burleson, Canaccord Genuity. Please proceed with your question..

Hi, guys. This is Jon DeCourcey on for Bobby. Congratulations on the quarter. Most of my questions haven't been asked. I was just hoping you could touch on upon the Mobile Terminal product.

I'm just seeing kind of what traction you have there and how that product has been received?.

Yeah. Thanks. Thanks for the question. So, yeah, mobile terminals is kind of an exciting new market where we're looking on at the moment. And I think of it like the 3D and logistics markets in terms of major potential and where we have a technology change and an advantage to offer the market.

And like those other markets, it's not generating large or significant revenue contributions in this early stage, but what it is showing is a lot of customer interest and a big funnel of opportunities that we hope will turn into revenue and start to be more material as we move through next year. We're really learning a lot about that market.

We have some innovative early adoptors who are using our technology and some very substantial companies that would like to implement our technology. So, we're pleased with the progress and the overall opportunities we see in the market, the products that we have and are going to be releasing here as we move through time.

But in terms of material contributions to the results, it's not making those at the moment..

Okay. Thank you..

Our next question is from Josh Pokrzywinski, Wolfe Research. Please proceed with your question..

Hi. Good evening, guys. Happy Halloween..

Hi, Josh..

Just a couple of questions here. I guess first on the smaller sequential step down in operating expenses into the fourth quarter.

Should we take that as a sign of maybe a more robust pipeline than usual just as we gear up from 2018? I guess, I'm not asking for specific guidance so much as just with the big sequential step down in revenue that you would normally see OpEx hasn't really faded as much.

Is there something specific that you guys have an eye to, that you're really ramping up for or is this carry over expense to support some of that unbilled revenue? Just trying to calibrate how we should read out those OpExes going forward and what you're trying to invest for..

Yeah. It's Rob. I'll comment and I'll invite John also to comment here. I think, we look at the long-term at Cognex. So, we see lots of opportunities where we're going to need our technology road map s implemented better and faster.

And where we're going to need sales coverage and where we're going to need process improvements, particularly around IT and would we – implementing SAP next year. So, some of these expenses that you're seeing are based around our plans for that.

And they're broadly – our expense growth is broadly going to be in line with our revenue growth year-on-year in the fourth quarter.

Sure, there are some things that happen in a great year like this where sales guys tend to get up into their highest tier of commission, earnings and bonuses maxing out and there are certainly some of that driving some of those issues, stock option expense and other things.

But overall, I would say, the message I want is that you need to understand is that we don't shy away from investing and that's produced an impressive pipeline of new products and business and that's what we have our eye on rather than any short-term expense challenges.

John?.

I couldn't say it better than that, Rob..

Okay..

That was perfect. Yeah. We were really just leaning into our long-term opportunities..

Got you. That's kind of what I thought you guys would say.

Anything on the technology road map that is imperative for the fourth quarter that you can share with us or does that need to stay kind of under wraps until we get closer to 2018?.

Yeah, we don't discuss our technology road map. No. Thanks..

Okay. And then just shifting gears over to the logistics side.

Have you seen any broadening out in terms of customer adoption there? I know ecommerce has been a big push, but anybody else in the logistics space, without naming names, that is starting to gravitate more towards the product set?.

I mean our logistics business is very exciting and growing very well. It represents about 10% of our own business currently and it's growing well in excess of 50% this year, and 50% is the growth rate at which we think we can grow with over the long-term.

Certainly, retail and ecommerce fulfillment is the biggest part of that and – but within that, certainly, we've had mostly ID but we're now broadening into more Vision-related applications which I think is exciting for our longer term prospects.

Again, as those companies face somewhat similar challenges for labor, productivity that we see in other parts of our customer base.

So there's certainly that, and there's also the potential for longer term growth as we broaden our business beyond America and Europe which is being the major growth drivers to date into markets which are newer in evolution like China and have just huge potential... (33:19).

I don't hear anything. Is any....

Okay.

Operator, can you hear us?.

I can still hear you, guys (33:29).

Okay. Sorry, I'll continue. Where are we? See, so geographic expansion certainly is, particularly into Asia, is exciting. So, I think that's what I'd say about logistics. I think it's a great market. I'm very glad we focused on it over the last few years. I think we have a lot of exciting technology and sales value to add going forward.

The one thing I didn't mention also, of course, is there are other segments where I think long-term growth can be driven in logistics, and that would be airport baggage handling, a small but interesting market where it's predominantly served with lasers today. And Vision has so much to offer in that space.

And also in mobile terminals where customers increasingly want to, particularly smaller customers, actually want to implement smartphone-based architectures. So, anyway logistics is, as you can tell, it's an area we see a lot of runway..

Excellent. Just one little follow-up and then I'll let it go. On the logistics front, I would imagine that maybe the upgrade cycles there aren't quite as regular as what you would see in factory automation where product lines get refreshed.

Is there anything we should keep in mind there about refreshes, upgrades, richness of product mix, just anything that can, I guess, have always surprises along the way as this continues to grow as a piece of the business?.

Yeah. I don't think so and I would say it's a very dynamic and fast moving market where big new distribution centers are being built and new models are being implemented around shorter and shorter delivery times, within 24 hours.

And where there's a lot of IT and architecture challenges around moving away from Windows towards other operating systems and other things. So, I am – no, I would say the pace of evolution of that market is very fast..

Excellent. Thanks, Rob..

Our next question is from Paul Coster, JPMorgan Securities. Please proceed with your question..

Yeah. Thanks for taking my question.

If we look at the factory automation segment and consumer electronics specifically, with whom do you generally end up in dialogue around large deployments? Is it the OEM, is it discrete component suppliers, is it the EMS provider or contract manufacturer who's doing final assembly, or is it all of the above? And if you can give us a bit of color around that would be helpful..

Yeah. Sure, Paul. It's Rob again. So, I would say that some of the big brand owners certainly have huge influence over how the industry operates and the technology that's being implemented and that kind of flows back through the – or upstream through the supply chain.

And then I would say, OEMs, some of the big OEMs tasked with meeting some of that demand and coming up with solutions to do it. So, we see – we work closely with both those groups.

And then I would say we work less closely and maybe on a more transactional basis with component suppliers who are practically supplying things like passive components or connectors or imagers or other technology that goes into electronics where it's a shorter cycle, we can do the job, they buy our product, it's a few weeks of process to get that sold.

But the real influence, the real reputation of Cognex to solve big problems and they're really – I think differentiation is occurring with the brand owners and the OEMs..

And it would have been true....

And then....

...to say that – sorry..

I was going to say and I'm sorry to interrupt you. And then really, it's a very much an engineer to engineer discussion with the challenges that they face. That's where the decisions are getting made and Cognex's reputation is doing well..

So, I mean, would it be true to say that there are certain products or product components that would not be possible without an upfront discussion with you about the process technology required to make them? I would add, for instance, was it kind of obvious to the industry that they needed to deploy this technology in order to be able to bring OLED down in scale?.

What we say – we've said for as long as I've been here and I think much longer that in many cases, products could naturally be made without Cognex Vision, that we really do help relatively early on in the design cycle to make a product either be made or be made in a way that's economically viable. So, that's certainly the case.

But it's really different in different industries, I would say. There's some amazing engineering going on in OLED manufacturing and I think there's some pretty great engineers who are working on problems. But in the end, they realized that our knowledge of Machine Vision is well beyond what even their substantial teams can do.

So, they bring us in to solve those problems. When they do it earlier, it works better. When they do it later, it still works to bring Cognex in. So that's kind of the state of play..

Got it. Okay, one other thing. The gross margins were down a little bit, and you attribute – although you're suggesting since there won't be a 10% customer this year, nonetheless, you had at least one big customer this quarter that weighed on the margins.

And is it a function of the actual product they are buying or is there a volume discount they get off this price break that would have caused the margin decline this quarter?.

Yes. So, Paul, I got to correct you on one thing, which is – I didn't mean to be misunderstood.

The question was would there be other 10% customer (39:35)?.

Oh, I see. Oh, I'm sorry. My bad..

This year or this quarter. So, no, I apologize if I misled people in that comment. No.

So that's – so – but your question had to do with gross margin and the gross margin outside other big customers in consumer electronics? Can you restate it?.

Yeah. So, you saw lower gross margins this quarter as a function of the product mix with a customer.

Was it actually the product mix with that customer? Was it the – where the volume and price breaks on volume that, that particular customer would have enjoyed?.

We don't want to talk – we're not able to talk specifically about pricing to individual customers.

In some cases in consumer electronics, there can be quite a lot of service revenue which is lower margin for us and it's involved in rolling out technology to – where we do it in a very sophisticated way for the very large customers but it's margin dilutive.

And in other cases, you would expect for large customers, in many cases, they got better pricing and that can and very large deployments like we saw in consumer electronics in Q3 that can impact our gross margin..

Right. Thank you, Rob..

Our next question is from Jairam Nathan, Daiwa Securities. Please proceed with your question..

Hi. Thanks for taking my question. I just wanted to kind of get some more details from the unbilled revenue. It hasn't been this strict (41:12) before. Is that a – what's driving it? Is it just – is it timing-related or is it characteristic of a new customer? If you could explain that..

It's John. Yes. It's predominantly driven by the timing of the underlying deployment. So we did have in consumer electronics and logistics the deployments have a longer cycle. And in many cases we're able to complete the earnings process prior to our invoicing cycle.

So it's purely just timing and as I said, that will for the most part clear itself in Q4..

And it's Rob, here. I'll do add to that that we have had substantial unbilled revenue in previous years, so this is not unprecedented..

Thank you. And just on the logistic side, there was a related company a couple of weeks back which kind of indicated that they could be seeing some slowdown in the order rate. There seems to be some hesistancy by large customers.

Are you seeing any of that on the logistic side?.

It's Rob. I'm not aware of what you're talking about. I know we're certainly not seeing that in any way..

Okay. And last question with regard to talent retaining that. We know we see a lot of recruitment ads asking specifically for vision technology experts.

And I just wanted to get an idea of how do you – are you seeing a lot of turnover? And if how confident – how you're retaining talent at Cognex?.

Yeah. Well, I kind of, in the initial, my prepared remarks I talked about our culture. We have a remarkably strong and committed group of Cognoids who really love working at Cognex and are really enjoying the success that we're seeing. So, we're very fortunate to have low turnover.

Our current turnover would be in the mid single-digits and that's very low for a technology company. And it's fair to say we lose very few good engineers that we want to retain.

Obviously, part of that it's not – our culture kind of permeates everything we do at Cognex and we have a very entrepreneurial view about our business and that goes to the empowerment we give people but it also goes to the fact that we want Cognoids to feel like owners.

And we do that particularly through stock options, give out a good range of stock options particularly to engineers. And as a result, they feel a great sense of ownership and pride and they are well-rewarded for the success, the kind of support, the success we're reporting now and go on doing.

So, that certainly is one of the reasons why I think we're certainly able to hold on to some of the best talent and attract really great talent, too. And in recent quarters, we've expanded our engineering footprint, something I'd point to as we just opened an office in Cambridge, just a little bit away from here.

And the interest we're seeing from highly qualified technical people in areas like Deep Learning for Vision to go work in that location and to go work with Cognex is great. So, we're feeling good about that and optimistic about retaining it.

Of course, there are places in the world where it's ridiculously difficult to hire people like San Francisco would be one area. Munich seems to be another area, right? But generally, those are places where we don't have a big or any substantial engineering footprint..

Okay. That's all I had. Thanks..

Our next question is from Jeremy Cameron, ROBO Global (45:22). Please proceed with your question..

Thanks and good evening..

Hello, Jeremy..

Great to hear that the 3D Vision offering has reached 5% of sales.

I'm wondering if you could give us an idea of what applications you're seeing most traction with?.

Yeah. Hi, Jeremy. So, it's Rob again. I think as I said to a previous caller, we really see a broad range of applications that mirror, in general, our end user profile. So, mostly consumer electronics where applications can be very varied but they might be looking at components that are not correctly attached to products.

They might be looking for problems like loose screws or screws getting into cavities, where lithium-ion batteries might be being inserted by robots. Those kinds of applications. They can be doing connector inspections.

So, these kind of applications are quite widespread and increasingly a valuable I think, in terms of what we can provide for our customers. In automotive, again, it's very broad.

It may be sometimes in the electronics applications of automotives like inspecting circuit boards, but it can also be looking at raised rubber (46:44), lettering on black tires, something you really can't do with the 2D Vision.

And then, there can be all kinds of other applications even in areas like food and beverage where you can be looking at – is the can correctly closed or is there enough solid matter in a food product, for instance.

So, very, very varied, and I think what's great is we have a sales force that's really very good at applying technically challenging Machine Vision to all those markets. And we have products that are increasingly advantaged and easy to sell. So, I think that's kind of a formula that's working very well for us..

Thanks. And I wanted to ask about Machine Vision on a chip. I know Cognex experimented with it in the past. Now, there's several companies that are coming up with machine vision chips for applications around video surveillance, the drones, and autonomous vehicles.

I'm wondering if that is something that Cognex continues to pursue and if you're seeing this as a competitor to your core business?.

Jeremy, we generally only do sort of custom in-house engineering challenges like that when we really see huge advantages of where we can't find what we need on the available market. So, our first choice generally is to use off-the-shelf electronic components and work with players in the industry to apply that technology to our industry.

In the past, on occasion, you're right. We've kind of reinvented certain applications or been ahead of what's available in the market through our own custom chip design. We don't really talk about our technology road maps, so I'm not going to talk about whether we're doing that or not at the moment..

Understood. And in terms of the competitive landscape in general and in the Americas in particular, your main competitor, the Japanese competitor, is showing some pretty significant growth in that market as well.

I know they have a broader portfolio of automation products but are you seeing any change in terms of the level of competition or any market share shift?.

Well, you're right to say that really Cognex and KEYENCE, the other company you referred to, are increasingly strong in the machine vision market I would say, are, I think, we think of ourselves as leading in technology. And, we think of them as having very strong sales presence. But obviously, both of us are investing in both those areas.

I would say that they look to be seeing the similar type of opportunities that we're seeing and are investing very heavily, particularly adding a lot of sales people.

We certainly see that and I think we're matching them and I would say we are both gaining share from other competitors who I think haven't invested and aren't just competitive in terms of their sales channel or their technology.

So I would say the overall dynamics are, I think, Cognex and KEYENCE are gaining share and other smaller players are losing share overall. And there aren't really the emergence of any other competitors of any strength or substance at the moment although we are always watching that space..

Thanks very much and good luck..

Thank you..

Our next question is from Joseph Giordano, Cowen and Company. Please proceed with your question..

Hi, guys. Thanks for taking the follow-up here.

I guess one of the questions and discussions I get in a lot with clients is, what is the ability for our customers to like essentially recycle old Cognex products into new production lines? So, if you're at a facility, whether it's automotive or consumer electronics that has a production line and then they build the next iteration of their product and have a new production line and as they roll – as they kind of shut down old ones, can they take the Cognex product off of their essentially, and put it on the new one rather than buy new things from you? How much do you see that in practice, and is that something that's realistic? Or is it generally new product every time there's an incremental production line?.

Yeah. Generally, the answer to that question is it's too difficult, and too time-consuming and not really worthwhile to reapply Machine Vision from one line to another. I mean, unless you want to spend a lot of money refurbishing it.

And generally, our technology is getting so much better so quickly that it's really very cost effective to implement new products, right? So, that's generally what we see. Not a lot of kind of refurb-ing of old equipment..

Yeah. And this is Dr. Bob. I'd like to add to that, that generally, when a company is preparing to introduce a new product line whatever it is, a new watch, let's say, or a new calculator, bad examples, that they are still manufacturing the old – the last generation.

So, it wouldn't be possible, generally speaking, to use the Vision from the N minus one generation of product and then to move it to the nth generation. So, there are two reasons.

Rob's – Rob gave you one reason which is that generally, we have a faster, better, more efficient product that they'll use on the next generation and the prior generation is already – is still being used to make the older product line.

So, in general, we have not seen – I don't know of any case where companies retrofitted, took an older product that was working fine on the older line and put it on the new line. I'm sure it must happen to some degree, but it was happening into a great degree, we wouldn't be seeing the phenomenal growth that we're experiencing..

Thank you..

Sure..

Our next question is from Richard Eastman, Robert W. Baird and Company. Please proceed with your question..

Sorry. Sorry. Yeah, just have one question for John and I kind of hate to ask this but I'm going to do it anyway. On page 26 of the Q, when you talk about the revenue for the quarter, there's a disclosure that speaks to Europe's growth rate exclusive of the timing of the large order – customer, because between the quarters.

But is my interpretation of that, that – is that the correct interpretation? If I take out the large customer and I look at Europe, Europe was up 36% all else, year-to-date.

Is that the right interpretation of that?.

Yes..

Oh. Sorry..

Rest of our business – yeah. The rest of our business outside of large orders was growing north of 30%. Yeah..

30% in Europe? Okay. All right. I'll save the rest of my footnote questions for Sue. Thank you. Thanks..

Our next question is from Jagadish Iyer, Summit Redstone Partners. Please proceed with your question..

Thanks for taking my question, Rob. Two questions.

First, as we look at 2017, between your consumer electronics and logistics segments, how much has been an expansion of existing customer base versus adding new customers? Which growth vector was – had a greater velocity? And is there something that you might be able to kind of claim at 2018 between adding customers versus growing content with existing customers? Then I have a follow-up..

Yeah. Hi. Hi, Jagadish. So, I think it's important to understand that Cognex is the world's leader and the brand the most well-known brand in machine vision.

So, generally, there aren't too many new customers buying from Cognex for the first time, right? Generally, we're well-known and almost any major company and consumer electronics or elsewhere that I can think of is already a Cognex customer.

But so, what we see instead is, they're focusing on Cognex Vision, they're finding new applications, they are taking their technology maybe from one plant and selling it in multiple plants, on multiple locations. So, it's more expansion within customers and verticals and it is sort of new customers and verticals.

But where that would be different is newer markets where we've entered. So, obviously, logistics, we've only been in that market five years, so we're still certainly meeting and the winning share at new customers in that space. And we're seeing a lot of great growth outside of our existing or large customers in logistics..

Then just as a follow-up. If we look at based on the guidance you have provided for fourth quarter, can you kind of give us some final view on in terms of how the end market segments are likely to grow this year between your consumer electronics, automotive? I think you did mentioned logistics is going to be up 50%.

But how about the other three segments, please?.

Yes, Jagadish. I think we've sort of talked about Q4. I would say we're seeing more revenue in Q4 from both consumer electronics and logistics than we had expected at the start of the year.

Normally, Q4 is slower for those segments in terms of seasonality and Q4 tends to be broad-based, right, but – and I think your question also sort of asked about the year in general and we're seeing outstanding growth in consumer electronics. On a percentage basis, even more outstanding growth in logistics.

And then our automotive business is growing well north of the 20% growth rate that we target for the company overall and multiples higher than the sort of 10-ish percent that we expect automotive to grow out over the long-term..

Congrats on a great quarter. Thank you..

Thank you..

Our next question is from Bobby Eubank, Chevy Chase Trust. Please proceed with your question..

Hi, guys. Happy early Halloween. I know that's important holiday for you guys. Congratulations on the strong quarter..

Thank you..

Wanted to see if there's any updates from the recent acquisitions over the last year or two and how you would label the acquisition pipeline? Thanks so much..

Yeah. Hi, Bobby. Yeah, thank you. Halloween is our favorite holiday here at Cognex and we celebrated it in a very spirited way on Friday. Some of us may still be feeling worse for wear from that. But anyway, so, yes. Our acquisitions, we made six acquisitions in the last year or so. And from our perspective, they're performing well.

ViDi deep learning software techniques are helping us broaden the scope of machine vision applications, 3D acquisitions, EnShape and Chiaro and AQsense really helping us open up new opportunities in 3D for Cognex and for the industry. And then GVi helping us get into automotive and Webscan is helping with barcode verification.

So, we're very pleased with all of those acquisitions and we're very hard at work at making them deliver for Cognex. So, there's that. Then we continue to very active in looking at new markets and looking at opportunities within – for acquisition in new markets and our own surge (59:39) market. So, that's an ongoing process that we have.

We've looked at many opportunities each quarter and we're very selective in what we choose to move forward on. We really like acquisitions like the six that we'd done in the last year which are small revenue, great technology, great engineers and engineering teams that are going to help give us advantage in our – around our existing markets.

So, that's kind of – that's what I would say you would expect to see more of us doing. While we wouldn't hesitate to acquire competitors or larger businesses, those don't often come up for sale, and when they do, when we scrutinize them, sometimes we're not impressed with what see there. So, we're not really looking to bolt-on revenue.

We're looking to bolt-on quality..

Great. Thanks so much..

Ladies and gentlemen, we have reached the end of the question-and-answer session and I would like to turn the call back to Doctor Shillman for closing remarks..

Yeah, thanks. Okay, just a quick wrap up. We reported record-breaking results tonight for the third quarter. The team did a – around the world, did a terrific job growing revenue and expanding margins. And we hope to continue on this growth path. And we look forward to speaking with you again, and reporting on our results once again.

Thank you for joining us tonight and good evening..

This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation and have a great day..