Vic Allgeier - Investor Relations, President and Chief Executive Officer of TTC Bob Seidel - Vice President of Corporate Financial Planning & Analysis Jay Freeland - President, Chief Executive Officer, Director Laura Murphy - Senior Vice President, Chief Financial Officer.

Patrick Newton - Stifel Ben Hearnsberger - Stephens Mark Jordan - Noble Finance Brad Moss - Needham & Company Richard Eastman - Robert W Baird Ben Rose - Battle Road Research.

Good morning everyone and welcome to FARO Technologies conference call in conjunction with its second quarter 2015 earnings release. At this time, all participants are in a listen-only mode. Later you will have the opportunity to ask questions during the question-and-answer session. [Operator Instructions]. Please note, this call is being recorded.

For opening remarks and introductions, I will now turn the call over to Vic Allgeier, TTC. Please go ahead..

Thank you and good morning, everyone. My name is Vic Allgeier of the TTC Group, FARO's Investor Relations firm. Yesterday, after the market closed, FARO released its second quarter 2015 results. By now you should have received a copy of the press release. If you have not received a copy, please call Nancy Setteducati at 407-333-9911.

The press release is also available on FARO's website at www.faro.com. Representing the company today are Jay Freeland, President and Chief Executive Officer and Bob Seidel, Vice President, Corporate FP&A. Jay and Bob will deliver prepared remarks first and then will be available for questions.

I would like to remind you that in order to help you understand the company and its results, management may make some forward-looking statements during the course of this call. These statements can be identified by words such as expect, will, believe, anticipate, plan, potential, continue, growth model, goals, objective and similar words.

It is possible that the company's actual results may differ materially from those projected in these forward-looking statements. Important factors that may cause actual results to differ materially are set forth in yesterday's press release and in the company's Form 10-K for the year ended December 31, 2014.

For comparability, where indicated, results exclude the impact of foreign currency transactions which is a non-GAAP measure. I will now turn the call over to Bob..

Thank you, Vic and good morning, everyone. Our reported sales for the second quarter of 2015 were $83.8 million, an increase of $1.7 million or 2% compared to $82.1 million for the second quarter of 2014. Excluding approximately $8.4 million of unfavorable foreign exchange impacts, primarily from the Euro and Yen, relative to the U.S.

dollar, our second quarter 2015 year-over-year sales growth would have been 12%. The Americas delivered a strong second quarter 2015 with year-over-year sales growth of 18% despite continued economic weakness in Brazil. The Focus laser scanner product reported 18% unit sales growth globally over the same quarter of last year.

And Laser Line Probe and Arm accessory continue in sales momentum with year-over-year unit sales growth of 31%. Macroeconomic industrial sluggishness continued to cast a headwind against metrology sales in Asia, especially China and Japan.

Our sales in China decreased $2.7 million in the quarter compared to the same period of last year mostly driven by lower metrology sales in automotive. Turning to product and service sales. In the second quarter of 2015, product sales were $69.4 million, an increase of $2.0 million or 3% compared to $67.4 million in the second quarter of 2014.

Excluding approximately $6.8 million of unfavorable foreign exchange impacts, second quarter 2015 year-over-year product sales growth would have been 13%. The Americas delivered strong year-over-year product sales growth of 21%.

In the quarter, sales through distribution represented 12.7% of total sales with Focus laser scanner sales mix to distributors increasing to 56.2%. In the second quarter of 2015, service revenue was $14.4 million, a decrease of $0.3 million or 2% compared to $14.7 million in the prior year period.

Excluding approximately $1.6 million of FX headwinds, second quarter 2015 year-over-year service revenue growth would have been 8%. Turning to sales by region. In the Americas, sales in the second quarter were $39.0 million, an increase of $6.1 million or 18% compared to $32.9 million in the second quarter of 2014.

Excluding approximately $0.9 million of unfavorable foreign exchange impacts, the Americas year-over-year sales growth would have been 21%.

This increase was driven by unit sales growth across all major product lines highlighted by a strong 37% increase in Focus laser scanner units sold and a 34% increase in Laser Line Probe units sold compared to second quarter last year.

In Europe, sales in the second quarter were $26.5 million, a decrease of $2.4 million or 8% compared to $28.9 million in the second quarter of 2014. Excluding the negative impact of approximately $6.1 million due to the Euro exchange rate, Europe's year-over-year sales growth would have been almost 13%.

The Europe team delivered a 56% increase in Laser Line Probe units sold over the prior year quarter and drove strong demand for the recently introduced FARO Freestyle. In Asia, sales in the second quarter were $18.3 million, a decrease of $1.9 million or 9% compared to $20.2 million in the second quarter of 2014.

Excluding the negative impact of approximately $1.4 million in foreign exchange rate driven mostly from the Yen, Asia's year-over-year sales decline would have been 3%. The sales decrease was primarily driven by a decline in China sales of $2.7 million following a slowdown in automotive related metrology sales.

As a positive sign in the second quarter, Asia reported a 20% year-over-year increase in Focus laser scanner units sold. Turning to orders. New order bookings in the quarter were $83.8 million relatively unchanged from second quarter of 2014.

Excluding approximately $8.4 million of unfavorable foreign exchange impacts, year-over-year growth in new order bookings would have been 10%. Second quarter 2015 reported results represent a book-to-bill ratio of 1.0 which is consistent with our long-term growth model. Turning to gross margin.

Gross margin of 53.2% increased 2.3 percentage points compared to 55.5% in the prior year period. Product margin of 57.5%, down 3.3 percentage points from the same quarter last year, decreased overall gross margin by 2.5 percentage points.

The decrease in product margin was mostly driven by higher manufacturing cost and a lower Focus laser scanner average selling price from product and channel mix, offset partly by higher Arm average selling price.

Gross margin from service revenue in the second quarter of 2015 was 32.4%, up 1.6 percentage points from the prior year period and increased overall gross margin by 0.2 percentage points, mainly due to lower customer service costs. Turning to operating expenses.

Selling and marketing expenses in the second quarter of 2015 were $20.1 million or 23.9% of sales, compared to $19.7 million or 24.0% sales in the second quarter of 2014. This increase of $0.4 million or 2% is mostly related to higher marketing headcount to support our vertical market strategy.

General and administrative expenses increased by $0.2 million or 2% to $9.1 million in the second quarter of 2015, compared to $8.9 million in the same period last year and remain unchanged at 10.8% of sales.

The increase of $0.2 million is mainly due to severance expense from cost reduction actions offset partly by deliberate spending reductions to mitigate severance impact.

Depreciation and amortization expenses were $2.7 million or 3.3% of sales in the quarter, up $0.8 million from second quarter 2014, primarily due to the opening of the Exton facility and startup of our ERP system.

Research and development expenses in the second quarter were $7.3 million or 8.7% of sales compared to $6.7 million or 8.1% of sales in the same period last year. The increase of $0.6 million or 9% is mainly related to higher headcount and an impairment charge relating to discontinuing certain licensing agreements. Turning to profitability.

Operating income in the second quarter of 2015 was $5.4 million, a decrease of $3.0 million compared to the second quarter of 2014. This increase was driven by a $1.0 million decline in gross profit mainly due to a lower gross margin and an increase of $2.0 million in operating expenses.

Income tax expense in the second quarter of 2015 is $1.2 million compared to an expense of $2.3 million in the same period last year. This decrease of $1.1 million relates primarily to lower pretax income and a decrease in our effective tax rate to 22.7% compared to 26.2% in the same period last year.

Net income decreased to $4.1 million or $0.24 per share in the second quarter of 2015 compared to $6.3 million or $0.36 per share in the second quarter of 2014.

Excluding the impact of a total of $1.5 million in severance expense and a write-off of a license related to the company's Imager product, net income in the second quarter of 2015 would have been $5.6 million or $0.32 per share. I will now briefly discuss a few balance sheet items.

Cash and short-term investments were $155.6 million at the end of second quarter of 2015 compared to $174.3 million as of December 31, 2014. The decreased to $18.7 million was primarily due to closing two acquisitions with a total cash payment $12.0 million and a $6.1 million in capital expenditures.

Accounts receivable was $70.0 million at the end of second quarter of 2015 compared to $84 million as of December 31, 2014. Day sales outstanding increased to 76 days at the end of second quarter 2015 from 74 days as of December 31, 2014 mostly due to lower prepayments for the decrease in China sales.

Inventories totaled $98.9 million at the end of second quarter 2015 compared to $80.0 million as of December 31, 2014. The increase was primarily related to lower than expected ended quarter sales, increase in raw materials and finished goods by a total of $7.0 million.

Demonstration inventory was up $2.5 million mostly on higher account manager headcount in new products. Our service inventory was up $1.4 million on new products and growth in our installed base. Finally, I will conclude with headcount numbers.

We had 1,350 employees at the end of second quarter 2015 representing a year-over-year increase of 212 employees or 19%. Geographically, we have 515 employees in the Americas, 527 in Europe, 308 in Asia. Account manager headcount increased by 26 or 12% to 248 at the end of second quarter 2015.

In the Americas, account managers increased by nine or 11% to 89. In Europe, account managers increased by 14 or 21% to 82. In Asia, account managers increased by 3 to 4% to 77. I will now hand the call over to Jay for his comments..

Thanks, Bob and good morning, everybody. Before we get started, I would like to highlight to the rest of the group that our new CFO, Laura Murphy is on the phone today. I am not throwing her into the fire to have her discuss any of the results or take Q&A, but I did want to give her a chance to introduce herself to the group.

So Laura?.

Yes. Thank you. Good morning, everybody, I am very excited to be joining the FARO team and look forward to having a chance to talk with many of you..

All right. Thanks, Laura. As we get started, I apologize to everybody, I have managed to kick up laryngitis, so please bear with me as I go through the script today. Our second quarter sales growth of 12% though excluding foreign currency represents a nice recovery from the first quarter and it's close to our long-term mid-teens growth model.

The Americas highlighted the recovery. It was strong 18% sales growth after 3% last quarter. Asia continued to be impacted by weaker capital spending, mostly within China and Japan. In the quarter, we executed on cost reduction actions to proactively take out cost to the business given the current market headwinds.

Our second quarter sales recovery and the delivered cost management increased EPS from $0.04 per share in the first quarter to a reported EPS of $0.24 per share in the second quarter and if you exclude $1.5 million in severance expense and a license write-off related to the Imager product, second quarter EPS would have been $0.32 per share, or slightly below prior year.

The Americas achieved 18% sales growth by delivering unit sales growth across all major products. As a direct result of proactive marketing initiatives, the Americas team delivered outstanding year-over-year unit sold growth of 37% for the Focus laser scanner and 34% for the Laser Line Probe.

In Europe, our second quarter sales grew almost 13% excluding foreign currency, slightly below last quarter's 16% growth rate excluding FX. On the laser tracker, unit sales were down on weaker automotive demand and Swiss manufacturers facing a less favorable export environment.

The Europe team marketed the superior technology of the Laser Line Probe to deliver 56% year-over-year growth in units sold. Asia continued to encounter challenging macroeconomic conditions causing capital spending delays and cancellations, especially in China and Japan.

Our second quarter 2015 sales in China decreased $2.7 million from the second quarter last year, mostly driven by lower sales into automotive. With China, new vehicle inventory increasing, light vehicle production growth rates have slowed to near zero which directly impacts the capital spending behavior of our automotive customers.

Despite the weak macro economy, Asia Focus laser scanner units sold posted 20% year-over-year growth in the second quarter of 2015. Sales growth for metrology remains relatively soft.

Our industrial manufacturing customers in the automotive, aerospace and machining verticals, especially in Asia, are hesitating on capital spending for productivity improvement, given uncertain global business conditions. Leasing demos remain high but manufacturers are taking longer to complete their purchasing decisions.

As a result, Arm units sold growth were down 6% in the quarter versus last year and laser tracker unit sold were down 10%. In times of soft capital spending, it becomes even more critical to provide the customer with a clear intangible return on investment via technology and price.

Our strong R&D reinvestment enables FARO to be the market leader in technology and price. For instance, our latest generation Laser Line Probe sets the standard in the ScanArm market. In the second quarter, Laser Line Probe units sold increased 31% year-over-year globally, demonstrating how our commitment to R&D drives sales growth.

Our technical advantages and disruptive price also drove 3D documentation in the second quarter. The Focus laser scanner reported 18% year-over-year unit sales growth. The Americas highlighted this growth with 37% year-over-year increase in units sold by expanding the distribution network and implementing effective marketing initiatives.

The average selling price of the Focus laser scanner was slightly lower on a year-over-year basis due to a higher distribution sales and a product mix shift to more Focus X 130s in Asia. The recently launched FARO Freestyle handheld laser scanner continued to gain sales momentum and contributed modestly to our year-over-year sales growth.

We anticipate currency headwinds and weaker macroeconomic conditions to challenge our sales growth in the near-term. With published indicators suggesting a slowdown in Chinese automotive and industrial manufacturing in general, we anticipate continued deferred capital spending to continue to negatively impact Asia in the near-term.

Our internal strategic decision-making remains focused on delivering long-term mid-teens sales. Consistent with prior communications, we remind you this is a long-term growth model and does not represent specific financial guidance for this quarter or this year.

Despite the near-term challenges, we believe in our long-term fundamentals and our innate capability to deliver value for the markets we serve. Our product pipeline today is stronger than ever, demonstrated by our recent product releases.

The next 18 months will be exciting for the FARO brand as we are preparing an aggressive product introduction plan to further disrupt our markets. While we are focused internally on product development, we closed and integrated three acquisitions in the last 12 months.

Our senior leadership team and I see meaningful acquisitions right now in the market that would broaden and strengthen FARO over the next 12 months. With that said, our strategy remains to reinvest our cash into R&D, long-term growth initiatives and maintain the financial capability to transact material acquisitions given the right price and fit.

While our second quarter results did not fully meet our internal expectations, I am pleased by how we delivered a topline recovery in this challenging market. Excluding currency, we achieved 12% year-over-year sales growth, just below our mid-teens long-term objective.

The Americas bounced back from a challenging first quarter to post 18% year-over-year sales growth and the Europe team delivered nearly 13% year-over-year sales growth excluding impacts and executed [indiscernible] third quarter. We reported another quarter of strong 3D documentation sales growth.

Our most recent product releases, the Laser Line Probe and FARO Freestyle delivered strong sales growth. At the end of June, our software team released a major revision of our CAM2 Measure 10 software.

The latest version CAM2 Measure 10.5 leads the market with the inability to connect multiple 3D measurement devices within the same coordinate system and simultaneously scan into a single seat of software on one computer.

The capability allows users to seamlessly scan large objects with rapid speed and precise accuracy and complete 3D scanning jobs faster than ever before. This major release reflects our continued commitment to investing in disruptive product development, this time on the software side of the business.

In closing, I would like to thank the FARO team who stepped up after the tough first quarter to search for extra leads, develop extra opportunities, execute extra demos and close the deals to deliver a solid second quarter recovery.

I would also like to extend my appreciation to our customers and shareholders for placing their confidence and investment in us. I will now open the call to questions..

[Operator Instructions]. We will take our first question from Patrick Newton with Stifel. Your line is open..

Yes. Good morning, Jay and Bob. And Laura, welcome to the team. Jumping in, just a housekeeping question.

Could I get your new customer as a percentage of sales? And also your top five and top 10 customers as a percentage of revenue?.

Yes. Good morning, Patrick. Hope all is well. On a new customer sales percentage in Q2 2015 we were at 30%. That's slightly down versus 35% last quarter. Top five customer sales percentage Q2 2015 at 4.8%, top 10 customers sales percent Q2 2015 at 6.6%..

I guess it's slowing up on that, the new customer percentage is the lowest number in my modeling history going back to pre-2008.

Jay, is there anything there that stood out for why the new customer acquisition was relatively low?.

Well, actually I will direct it to Jay as follow-up comments. Really what we saw was two things that drove that number lower, is that with the lower Asia sales, a lot of the new customer base comes from the Asia region. With the lower sales that we had in Asia, we saw a slightly lower new customer number as well as in the U.S.

that number was slightly lower because of, as we said in the call, something I know you monitor, is the sales through distribution of our laser scanner. So there were more sales through distribution. So therefore they were consistent customers. So that really drove that number down on a quarter-to-quarter basis..

And I think the other thing, just from an overall purchasing mindset standpoint, not surprisingly when you have got a little bit of economic uncertainty, newer customers you get into a mentality of well, I think that will deliver the productivity but if I don't spend $50,000 I know I still have that next quarter.

The more experienced customers are a little bit easier to sell because they are going to look at it and say, yes we know we got that productivity before and yes, we will out $50,000 but we know we are going to generate the ROI because we have already experienced it. So there is some of that.

We saw some of that mindset and we have seen before, 2009 is a good example where the shift on new customer sales definitely declined and it was sort of the same thing..

Okay. Great.

And then I guess Jay, just trying to understand the topline recovery and then again comments on the soft CapEx environment in metrology, can you talk a little bit about linearity of revenue in the quarter? And then did you see any of the push outs from the March quarter actually land and contribute to the June quarter upside? Or was this more of a FLS strength type of quarter that drove the upside?.

I would definitely put a lot of it on FLS strength. The metrology market is obviously heavily tied to the industrial macro issues that we are seeing. So that's definitely a part of it. I would say there was minimal contribution to the quarter of push-ups that we saw from Q1. Obviously there is a little bit of impact there.

The linearity within the quarter was as standard as it gets for us. It was north of 50% during the third month. It was not quite the same scramble at the end of Q2, I think, as it was at the end of Q1. I take that cautiously. Normally that would be a good sign.

But I take it cautiously only because there are so many working variables in the overall market conditions right now and that's why if there's any reason that I am just a little bit hesitant to jump up and down, it's probably that. I will say that it felt like there was better momentum through the quarter than it was in Q1..

Okay. Great. And then, I guess, Bob could you help us basket the $1.5 million in severance costs and the license write-off between COGS, R&D, selling and G&A, just so we can get some pro forma numbers? And then Jay, if you can talk a little bit about this license write-off? What drove it? What it is? That would be helpful..

Absolutely. So first of all, the license write-off costs is all as it says in the 10-Q. That is contained within our R&D expenses. So really one of the drivers that R&D expense being up $600,000 year-over-year was related to the license write-off. And number two on severance expenses, we do not specifically disclose the severance expense.

I would say, a portion on it is in G&A as we disclosed in the 10-Q. And then the remainder is really there was pieces throughout the rest of the P&L of nonmaterial basis on any single line..

Yes.

And on the license write-off, this was related to, we did the acquisition of the patent license rights of DPI back in 2008 and as we have developed the next generation scanner, we had one license that we really were not going to use in the next generation and so as we get closer and look I am not going to tell you when this new imager is coming, but as we get closer to launch, the realization that we are not going to leverage that technology at all into new product is what drove the write-off.

So it's clearly a one-time event. It does not affect the development cycle of the imager. In fact I think it certainly improved the next generation imager that we are bringing to market by going a different route and it actually probably accelerated the development cycle by not pursuing that particular technology that we wrote-off..

Thanks, Jay. That's helpful. And Bob, just kind of following up, so if I take the comment that the $1.5 million write-off was negligible in certain buckets. You didn't mention COGS. So I assume that gross margin of 53.2% that you reported is a fair pro forma gross margin.

So one, can you [indiscernible], two, that's the lowest level we have seen on your gross margins since 2009, understanding that your distribution was higher, how should we think about that metric going forward? Typically the low 53s has been kind of a floor for the company.

Anything you can help us with there?.

Sure. First of all on the severance, is one thing to note on the severance is, a primary piece of it was in G&A because that's when we had outlined certainly in our Q1 call that we would certainly continue to invest in R&D and sales and we will try to take cost out of business proactively where it makes sense and most notably in G&A.

As we went through the quarter, one of the things we were trying to do was certainly is also doing very deliberate discretionary spending cuts to mitigate the severance expense. So even though you had the severance impact in G&A, we did very deliberate spending cuts to try to offset that.

On the gross margin side, Patrick, really what the story there is, in terms of our gross margin was 53.2%, down 2.3% versus prior year. Most of that was driven by product margin, as I said. So really when you look at it, the product margin was 57.5%, down 3.3 percentage points which drove 2.5% of that decline.

That decline was really driven by two real pieces, one being the higher manufacturing cost. The higher manufacturing cost really related to the original primary manufacturing, first of our laser tracker in our new Exton, Pennsylvania facility.

One of the things we experienced there is, we talked about on Q1, you read it in the Q2 10-Q, is March being lower year-over-year unit sales volume in the laser tracker and so we did reduce our production slightly at that facility and therefore with reduced production rates we had higher costs.

The second piece of our manufacturing cost relates to the laser scanner production, primary laser scanner production in Europe and there we just had lower throughput rates to work through in the quarter.

The secondary piece that we mentioned on the product margin related to a lower FARO laser scanner average selling price which really was one we saw in the Americas a distinct increase in our distribution sales helping to drive that 37%.

With distribution, we get a lower ASP but really net neutral to the overall P&L because we don't have the selling expense. The second piece is in Asia we had some of the pressures that they have seen on the competitive side and on the capital spending side, we saw a shift between X 330 to X 130 from the higher price to the lower price.

So that was offset by the ASP. Going forward, we certainly do not provide guidance but what I would say is this we look forward internally. We continue to see metrology pressure. As Jay noted, it's a soft market. So we most likely will continue to see pressure on our tracker and potentially reduced lower rates of production out of our facility.

So we may certainly see a headwind or a pressure on our product gross margin related to lower tracker production. And number two, one of the things we are actively doing is we are trying actively grow our distribution business for laser scanner. So on a gross margin level, we may see pressure there as well going forward over the next several quarters.

Those would be the two items that I would see kind of pressure in our gross margin, offset partly by, we continue to see very strong sales of the LLP..

Yes. And Patrick, I will just add few more color to that. When you look at the production side of this, obviously unit volumes as it relates to tracker. There is not a ton of additional cost you could dig out there in the near-term without hurting the ability to serve.

So as volume improves, that will definitely help the gross margin on the tracker production side. And I do expect as we go forward, we see a little bit of that.

On the scanner, to be really specific, we also in the quarter, just to give you a feel for some of the ones by nature of it, we introduced a small technical change to the scanner purposely during the quarter. It did cause and requires some rework of a meaningful number of units during the quarter. So you add a little bit of that mix into it as well.

Again that will help you with it close away as you head into Q3..

Great. Thank you for taking my questions..

Thanks Patrick..

Thank you. And we will move next to Ben Hearnsberger with Stephens. Your line is open..

Hi. Thanks for taking my question. First for Jay. I know you have spoken before around your expectation that Japanese stimulus funds begin to flow again in 4Q.

Based on what you are hearing in the field now, is that still good guidance or good outlook?.

It is actually the team, I think, would say they feel like they will start seeing it in Q3, perhaps not at full run rate but they expect to see it in Q3 and then certainly by Q4 would expect to see back to normalized patterns, short of some major economic shift in Japan, but everything we are hearing from the team still supports that..

Okay. Great. And then on the OpEx line, you basically held operating expenses stable despite the step up in revenue from 1Q.

As sales continue to ramp back up, do you need to go and hire and spend in front of this? Or do you feel like you have the capacity in place at this operating expense level to support some higher growth?.

Yes. I think it at the OpEx line, we should get very good leverage there. No doubt, when we see the numbers, we have added in the Americas and Europe meaningfully to the account manager base, not nearly as meaningfully in Asia, that's probably a direct reflection of what you see in the current market conditions.

And for us, that's always a bit of a leading indicator of what we see coming from an activity standpoint because it does take six to nine months to get those folks fully ramped up. But on the operating expense line, we have got a couple of key adds that we are continuing to drive.

I have got account leader that I have talked about before that's being hired and coming on board. We will at some point backfill the Asia managing director role when the time is right, because Joe is covering both Europe and Asia right now. That's a ton of territory to cover on a day-to-day basis.

So there will be a couple of one-offs like that but the general OpEx line should be very leverageable..

Okay. That's helpful. And Bob, I know you said that FX impact flying by roughly $8.5 million.

Can you give us a sense for how it impacted your different expense lines and put a dollar figure on that if you can?.

Okay. So in terms of our expense lines, really where we see the favorability that comes through for expenses is in our European operations where we have a corporate headquarters there for our European region. There we also have our R&D facility as well.

And so really when you look at it, how I look at it versus the prior year basis, the Euro really lowered our operating expenses by about $2 million. So that's really the favorability that we saw overall come through on the FX line. That's primarily the operating expense favorability we see..

What about on the gross margin line?.

On the gross margin line, we are relatively hedged on the Euro and as it worked out for quarter, we were fairly neutral on FX on the gross margin line. The reason being is that our original primary manufacturing for Arm and laser tracker is in U.S.

dollars while our laser scanner with 3D documentation products, laser scanner and Freestyle are original manufacturing are in Euro. So really what happens is, it's a pretty nice balance right now the way our mix is. As our mix changes, our sensitivity with Euro will change.

Where we have exposure is in our Asia region with the change in Yen year-over-year, Brazil and slightly Mexico, but overall as those positive impacts worked out through the quarter, on the gross margin line we were relatively unaffected by FX, so it's puts and takes..

Okay. That's really helpful. Thank you very much..

Thank you. We will take our next question from Mark Jordan with Noble Finance. Your line is open..

Good morning, gentlemen. Question relative to moves in headcount and sales reps in the second quarter versus the first. You has declines in headcount in both the Americas and Asia-PAC, almost a 10% sequentially growth in headcount in Europe.

Is there a strategy in place that's emerging that you are moving activity to Europe to take advantage of the lower cost or the swings in currencies? Or what explains that significant divergence of trends?.

Yes. Mark, I would say that it's less a strategy [indiscernible] the focus of the assets. We tend to be very specific region-to-region, regardless. I think it's more a reflection of those two things. One is, you have got -- there is definitely a building market momentum that w are seeing in Europe right now and so the ability to take advantage of that.

We have seen some new, I think, pockets of activity that are not fully coverable by the account manager team that's already in place. So that's a positive.

The other positive I think is that you see Europe had a little bit of a pause and at points of time a slight decline in account managers over the trailing, call it, nine months, Europe went through the same thing.

Asia did a year ago where we transitioned all the account managers from either carrying an Arm or carrying a tracker to carrying both product lines. So now you have got your, on the metrology side of the business, your account manager base is covering all metrology products which is a shift for us.

We have done it very successful in Asia the previous year. And so it allowed us to run flat for a while as we made that transition and now you see the add of the headcount there reflecting the new opportunity in the new pockets of coverage or lack of coverage, there's so many ways to look at it.

The Americas, I think, you will see the same type of buildup.

You had a nice growth, quarter-over-quarter in the Americas account manager headcount this Q, again I think recognizing that there is definitely improved market conditions, improved market activity that knowing, again it's not immediate, it will take six to nine months for those folks to come fully up to speed but you are seeing that in the Americas too.

Asia, obviously it's definitely softer. So we are adding very, very sporadically right now, trying to be cautious without slowing things down. We don't want to cause the slowdown ourselves. We are doing it to match what we are seeing in the environment..

Okay.

You did give, I believe, the total orders for the quarter but could we get the orders by region please?.

The orders by region, they are in the Q. I do not have them exactly right here in front of me at the moment..

Okay. I will get them. Thank you very much..

Hold on. I have them right here. Sorry, the orders by region for the Q2, $38.9 million for Americas, $25 million for Europe, $19.8 million for Asia-Pacific..

Okay. Thank you very much..

Thank you. We will go next to Jim Ricchiuti with Needham & Company. Your line is open..

Hi guys. This is actually Brad, on for Jim.

Just wondered if you can talk about the demand that you are seeing in some of your larger end-markets?.

Hi Brad. What I would say is that the demand around the world remains very good. That's one of the frustrating parts when you go through a period of economic uncertainty like this because the lead count coming, the demo count going out the door from the account manager base is strong. It's growing at the rates that we would want or need it to grow at.

The real issue is customers transacted. So they will look at it. They will understand the value. They know that they should make the asset purchase, but a lot of them will then say, you know what, let me just wait one more quarter and see what happens. I can get through another quarter without it.

For as long as I been at FARO for 11 years now, we have always had a bit of that mindset with the customer when there's. periods of economic uncertainty. But I will say that the demand itself is very, very strong.

I think if were to point to one area and we highlighted that before, in China the automotive demand is a bit sluggish mostly because vehicle production rates have dropped and so I think they are all just watching what happens, are we overcapacitized or not.

This obviously is not the only driver of growth in our company but China is a big region and I would say, that the one spot where I would say, it's a little bit sluggish. Everywhere else, demand is really good. It's more a question of, are they transacting or not..

Okay. Thanks for that, Jay.

And then wondered if could talk about traction you are seeing the scanner outside of the AEC market?.

Yes. So the second core market there is law enforcement. It is not nearly as big a contributor to scanner sales as AEC, as that's still the prominent driver. We are seeing continued growth and momentum there.

The thing that we have said for a long time now that the one thing is nice about law enforcement is that that industry talks to each other much more so than any other industry I have ever seen. And so the word-of-mouth factor has a better acceleration to it than anywhere else. So that is helping laser scanner.

What I will say is that when you look at Freestyle, while Freestyle is a small contributor to growth right now, Freestyle is essentially a 50-50 split between law enforcement and AEC in terms of the types of customers buying it. And I think that's a reflection of number one is the price point.

It's no $13,000 is a lot different than $50,000 for the low-end scanner. And at the same time though, it's a clear recognition that law enforcement is understanding the need for three dimensional technology and scanning technology. So I think we view it as that's their first foray in for a lot of the smaller municipalities and departments.

They start using the Freestyle. They get used to the data. They get their opportunity to prove the data in a courtroom. And then at some point, they will look at it and say, yes but three meters is not enough. Now we understand the value of being able to scan 30 meters or 130 meters.

I think as law enforcement takes off, you certainly will see much more on the laser scanner side being in that 30 meter bucket versus the 130 and that's okay, because AEC is almost the poor opposite. Virtually everything in AEC is 330 meters and beyond. And so that's a perfect fit for our higher end scanner..

Okay. Great. And then the service margins keep bouncing around quarter-to-quarter.

Just wondering if you can talk about some of the components to the sequential decline there?.

So one thing on the service margin that we pointed out in Q1 was we had a very strong Q1, really driven by the large revenue increase, mostly in Americas on warranty, customer service, training, really across the board there.

There in general volatility in our service margin only because our cost base is relatively fixed and our revenue, so therefore it goes up and down with revenue.

First of all, I would like to say is, on a reported basis, is there is a year-over-year decline in revenue for services which lowered our reported service margin but when you back out or it look at the FX impact, we were up year-over-year. The reason why our service margin was lower, it was impacted mostly because the revenue was mostly by the Euro.

So if you really look at it, our cost base is relatively flat. We have the other customer service, our training, our warranty and it was really the Euro impact driving that piece in quarter of Q2..

Okay. And then just a last quick one from me. Just wondering if you can talk about the competitive landscape and the pricing environment? Thanks guys..

Yes. So the pricing environment obviously continues to be on the Arm side, same as it's been. So if it's an Arm, straight up head-to-head Arm transaction, prices are at the same levels you have been seeing for about two-and-a-half years now. So significantly lower than list price. They have gotten any worse in, particularly the Americas and Europe.

They have not necessarily gotten any better. When you add the Laser Line Probe, then we have a clear advantage there and so when we talk about Arm price is actually up slightly it's because of Laser Line Probe as an accessory attached to the drives.

I will say that in Asia and I think this is just a function of that market environment we talked about the macro weakness, we are definitely seeing more competitive price pressure across the metrology business in particular, a little bit on the scanner side, but much more so on the metrology side.

We are definitely seeing pressure on both tracker and on in Asia out of the primary competitor and that would be the one slight shift from what we have seen in the last couple of quarters. And again, it's only a function of the macro conditions.

When we look at our win loss ratios, the competitive environment from the win loss ratio standpoint has not changed at all nor has the root cause. The primary root cause and most meaningful root cause across all three regions is budget delays or budget cancellations and it is not a competitive loss..

Thank you. We will go now to Richard Eastman with Robert W Baird. Your line is open..

Yes. Good morning. Jay, could you perhaps expand a little bit on the scanner sales? I think in the Q it was disclosed the scanner sales were plus 15%. I guess that's a reported number.

Perhaps you could give us a local currency growth rate? And then maybe just walk through the three dynamics that impact scanner sales? I mean we have expanded distribution, we have the intro of the Freestyle product and then we have sellthrough at the older or experienced to mature distributors.

Could you just walk us through those variables?.

Yes.

Bob, do you want to walk through the first part?.

Absolutely. So what we indicated in the Q was, is that our unit sales volume is up 18% and so what that is, is that is the year-over-year comparison for the Focus laser scanner only. The sales side, the Q1 what we indicate there is laser scanner, it does conclude the Freestyle sales.

So the sales there is up year-over-year driven mostly by the addition of that second product. If you look at the ASP for the laser scanner and you take out currency, what we really seeing is, is that there is a decline in ASP year-over-year and that is driven by two things.

Number one being is that we have a higher percentage as we indicated of percentage through sales through distribution which is a strategic initiative for us.

And second of the piece is that we did see a mix impact as we indicated, really in Asia, just with the cost pressures and some of the capital spending hesitancies in Asia but they moved from the 330 purchases in the prior year to 130. But on a local currency basis, you did see a slight decline year-over-year in the ASP on the Focus laser scanner..

Yes. I think when you look at the drivers of [indiscernible], you are right, certainly the buildup of the distribution network.

Now that being said, we still have 45% of our laser scanner sales going through our direct sales force and we have continued to add to the direct sales force as well, where we have territories that we don't think is good distribution coverage. That's predominantly in AEC market issue.

And on the law enforcement side, we have seen at least for now, much more of these sales traction does come from the direct sales force. So that sort of balances that out. So number one and that's not unlike the rest of our model, it is just feet on the street, whether it's distribution or on people is primary driver number one.

Number two is still having the most competitive unit out there in terms of performance and price. That is the second one. And the third really is just the development of the market. So helping people understand wide scanning versus a total station. That's just very missionary.

And we do it at all levels, even for me, I will be presenting in a week-and-a-half at the World Geospatial Media Forum in U.S. and all of my presentation is standing there stabbing light through the heart of it saying why is anybody still using total station when you can do this.

And I have several clear examples of the value of the scanning, the ROI generated, why it was used for that particular project. So that's a much huge piece of it. I think the Freestyle, I like to talk about the Freestyle as being a potential leader. So you get in with Freestyle and then eventually they move up to the scanner.

I think that's going to be real. I can't say that we have a ton of data to point to you where I could say, yes its' actually driven 5% flow-through or 10%. It's too early to say that or you can't say there is a trend there yet.

Btu from what we, at least the early indications of what we are seeing is, hearing from the customer base, I think there's going to be that as a core driver of traction on the relative near-term. Maybe if we get in to the early part of next year we start seeing some of that..

So a couple of things.

One is, so if we just focus in on the 18% unit growth that you disclosed, then that's the FLS only but I am curious, how much would you venture a guess as to how much of that is sellthrough through existing distributors and how much is expanded distribution? Is it half and half? Or any feel for that?.

Yes. Since we haven't disclosed it, I wouldn't want to give real guess to it. I guess the one think I would say is that the number of new distributors that are added every quarter is obviously a very small number percentage wise when you compare to the total distribution base. So let's look at it that way, we have got a pretty large distribution base.

So it's not like we are doubling the distribution base every single quarter. We are nowhere near that kind of a ratio at this point..

And is the Freestyle, you introduced the Freestyle essentially in the first quarter, this is kind of the first full quarter maybe.

Can you just give us a sense, is the revenue run rate on the Freestyle, I would presume it's still sub-$5 million a year?.

Without giving a dollar amount, if you just look at the price point, it takes a lot of units sold obviously to get to $5 million in revenue.

But what I will say is that the demand is strong, we are still and this a positive, we are still struggling to keep up with lot of demand in the marketplace between our supply chain and mostly supply chain, a little bit of our own internal capacity.

So there is a ton of traction there, but again it is about our price point, you have got to sell a ton of them to get to $5 million and then $10 million and $15 million before you really start getting full meaningful contributor to the overall sales profile..

Sure. Okay.

And then just unrelated question and maybe this one for Bob, what's the annualized revenue run rate for FARO in total out of China? What kind of revenue do you do in China?.

So in terms of China, we had not specifically disclosed China. What we have done in our 10-K is that we have disclosed the Japan region which is, for us Japan just to say that it was $32.5 million in 2014 or approximately 39% of Asia-Pacific. Okay. So as of the end of 2014, China was not separately disclosed.

But what I will say is, is that with the growth in the China automotive market, the aerospace industries over the past several years, China is clearly a number two position for us and so that's a $2.7 million decline year-over-year is a material decline for us in our second largest market..

Okay. All right. There is $2.7 million decline. Is it 50%? What does material mean? Material means more than 5%.

So?.

It's a fairly large mix for us without us disclosing the total size of that market for us..

Okay. And then let me ask another question Jay. The commentary around the second quarter and the operating expense number, it seems like there was a strong intent to reduce outside expenses to offset the licensed charge and the severance.

So how sustainable is that kind of discretionary reduction? Or again, on a go forward basis, Q3, Q4 doers the second quarter operating expense number represent a good all-in number going forward?.

Certainly there is a good portion that's sustainable. So a couple of things to look at for us. So number one is, we have a new CFO onboard now, obviously. So that will start adding cost back to the profile that we did not have in Q2. So there is a portion of cost offset there.

The account leader which is not in place but will be in place certainly before the year is over, when that person comes onboard, we will have a little bit of a cost offset there. And then when we get to the point where we do backfill the Asia managing director role, obviously that will have some cost offset too.

That being said, we did take out a meaningful portion of cost from the organization, both internal as well as external resources and we do expect that we are going to get a portion of that, a meaningful portion of that would run through the income statement through the rest of the year and going forward..

And then some of these second quarter expenses that are more variable in the sense that the third-party service expenses and outsourced cost, some of that probably leaks back in into the third and fourth as well, correct?.

Yes, potentially. The real goal is to question everything as to how long can you live without it, could it be done differently from somebody already on the inside, but there is always that possibility that little bits and pieces will creep back in.

You hate to do it that way though, because you set yourself a new benchmark, so I would like to run off of that for a while before we let the creep start..

Okay. Well, I am thinking you created about $1.5 million cushion there to bring Laura in. So? Never mind. And then just one other thought on Europe.

When I look at the order momentum in Europe, I am trying to get my arms around it a little bit, I think the sequential improvement in orders is below seasonal, quite a bit below seasonal, also year-over-year increase in orders is soft.

What is the tone in Europe? Is that still expected to continue at the pace it's at or accelerate? Or is there of a bit of a lost momentum there in orders?.

No. I think its just a timing thing. For us, our book-to-bill always runs anywhere from 0.9 to 1.1 in any given quarter. So the ratio doesn't concern me a whole lot at this point. The general feel we have is that momentum continues to build there. Again I think it's not necessarily a function of substantially improved macroeconomic conditions.

I think it's just a function of people over 2013 and in the parts of 2014 sat on their hands long enough that they have decided stability is good enough and we have got businesses to run and we need to generate productivity and we need to continue to improve our output. So I would say, the momentum continues to be there, from everything we see.

And it's more a function of companies deciding that they just need to start moving forward and they are not going to worry as much about the macro. A major swing in the macro of course would bring them to a fairly quick halt. But that's been case for six, seven quarters now, that they have always been right on that fence..

Okay. And just one last real quick question.

From a product standpoint, when do I recall that we annualized on the laser line pointer in the third quarter, the introduction?.

Yes. I would say, we really don't officially lap ourselves at Q4. Yes, it got introduced in September of 2014. There were some incremental sales right out of the gate. I think the easiest way look at it is that we really haven't [indiscernible] tough Q4..

Okay. Excellent. Well, thank you much..

Thanks, Rick..

We will take our final question today from Ben Rose with Battle Road Research. Your line is open..

Good morning, Ben..

Good morning. Sorry, just two quick questions for Jay.

Can you remind us as to whether the product mix in Europe is substantially different from that in the U.S.? And then also for Bob, could you just give us the CapEx number for the quarter?.

Yes. For us the mix is relatively similar in all three regions. So it's not dramatically different enough that I would call out and say, hey there is something meaningful here..

Okay..

In terms of the CapEx for the quarter, we were $2.4 million in Q1, we had $3.7 million in Q2 and that's a total of $6.1 million for the year-to-date..

Okay. Thanks so much..

All right. Thanks, Ben. And so thank you everybody for your participation in the call today and continued support. We look forward to updating you again at the end of Q3. Thanks very much..

And this does conclude today's program. Thank you for your participation. You may disconnect at anytime..