Vic Allgeier - IR Bob Seidel - VP, Finance & IR Simon Raab - Co-Founder, CEO & Chairman.

Hugh Gooding - Stephens, Inc. Jim Ricchiuti - Needham & Company Richard Eastman - Robert W. Baird Patrick Newton - Stifel Nicolaus.

Welcome to today's FARO Technologies Conference Call in conjunction with its Second Quarter 2016 Earnings Release. [Operator Instructions]. I'll be standing by should you need any assistance. It is now my pleasure to turn the program over to Vic Allgeier for opening remarks and introductions. Please go ahead..

Thank you and good morning, everyone. My name is Vic Allgeier of the TTC Group, FARO's Investor Relations from. Yesterday after the market close, FARO released its second-quarter results. By now you should have received a copy of the press release. If you have not received a release, 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 Dr. Simon Raab, President and Chief Executive Officer; and Bob Seidel, Vice President of Finance and Investor Relations. Simon 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 my words such as expect, will, believe, anticipate, plan, potential, continue, 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, 2015. I will now turn the call over to Bob..

Thank you, Vic and good morning, everyone. Before going directly to our quarterly results, I would like to say a few words about our approach to intra-year reporting going forward.

As you may have seen from our press release, we have now indicated -- included reporting on our year-to-date results, new order bookings and focus on cash flow, in addition to our historical quarterly reporting.

We believe that this year-to-date information is more in line with how we actually view our progress and manage our operations throughout the year. We recognize that our analysts still expect to understand our quarterly results, but we want to place those results in the broader context of the year to date.

Based on analysts' feedback, we will be providing book-to-bill information. We will also be highlighting cash flow from operations which we believe is an important measure of Company health. With that in mind, I wanted to highlight our financial performance on key metrics for the first six months of 2016 compared to the first six months of 2015.

Sales of $154.3 million were up $1.5 million or 1.0%, excluding $0.9 million of unfavorable FX. New order bookings of $155.1 million were up 1.4%. Service revenue was up 14%. Gross margin of 56.1% was up 1.4 percentage points. Net income of $6.5 million was up 35%.

We generated $27.7 million of cash from operations or 18% of sales, to end the quarter with $176.5 million in cash and short-term investments and no debt. Now let me turn to second-quarter results. Sales were $78.5 million, a decrease of 6% versus $83.8 million in the prior-year period.

New order bookings were $81.6 million in the second quarter of 2016, a decrease of 3% compared to $83.8 million in the second quarter of 2015. With new order bookings of $81.6 million and sales of $78.5 million, our book-to-bill ratio was 1.04 for the second quarter of 2016.

Product sales decreased by $7.8 million or 11%, to $61.6 million for the second quarter of 2016, reflecting primarily a challenging prior-year comparison, with strong prior-year performance in the Americas region and the last quarter of a master distribution agreement in laser scanners.

Service revenue increased by $2.6 million or 18%, to $16.9 million for the second quarter of 2016. We have an installed base of over 15,000 customers for which we have refocused our warranty and training sales efforts to better care for our customers and leverage customer loyalty.

The service revenue generated by this broad customer base represents a significant, recurring and growing revenue stream. In Asia, sales in the second quarter of 2016 were $19.2 million, an increase of 5% compared to $18.3 million in the prior-year period, driven primarily by strong metrology sales in Japan.

In Europe, sales in the second quarter of 2016 were $27.0 million, an increase of 2% compared to $26.5 million for the second quarter last year, mostly due to a 14% year-over-year increase in service revenue.

In the Americas, sales in the second quarter of 2016 were $32.3 million, a decrease of 17% compared to $39.0 million for the second quarter last year, primarily reflecting a challenging prior-year comparison with 21% product sales growth in the second quarter of 2015 from aggressive discounting.

Gross margin was 55.9% in the quarter, up 2.7 percentage points compared to 53.2% for the same prior-year period. The increase in gross margin resulted mostly from higher pricing, a favorable sales mix and higher manufacturing costs incurred in the prior-year period.

Selling and marketing expenses decreased by $1.4 million or 7% to $18.7 million for the second quarter of 2016, compared to $20.1 million for the second quarter of 2015. This decrease was related mostly to lower commission expense from lower sales, sales mix and the implementation of our harmonized commission structure.

As a percentage of sales, selling and marketing expense remained unchanged at 23.9%. General and administrative expenses for the second quarter of 2016 were $10.2 million compared to $9.1 million for the second quarter last year.

This increase of $1.1 million was mostly due to higher acquisition-related costs, advisory fees and compensation expense associated with our reorganization. As a percentage of sales, general and administrative expenses increased to 12.9% compared to 10.8% for the second quarter of 2015.

We continue to invest in research and development, in line with our initiative of establishing a new product drumbeat. Research and development expense remained unchanged at $7.3 million, with higher headcount and product development costs offset by the non-recurrence of a prior-year impairment charge.

Research and development expenses increased to 9.2% of sales for the second quarter of 2016 compared to 8.7% of sales in the prior-year period. Operating income for the second quarter of 2016 was $4.5 million, an increase of $0.9 million compared to $5.4 million in the prior-year period, primarily due to lower sales.

Operating margin was 5.7% in the second quarter of 2016, a decrease of 0.8 percentage points compared to the prior-year period. For the second quarter of 2016, our effective income tax rate was 21.3% compared to 22.7% in the second quarter of 2015.

Net income for the second quarter of 2016 was $3.4 million or $0.20 per share, representing a decrease of $0.7 million or $0.04 per share compared to the prior-year period. I will now briefly discuss a few balance sheet items.

As of June 30, 2016, cash and short-term investments totaled $176.5 million, an increase of $26.1 million or 17%, compared to $150.4 million as of December 31, 2015, primarily driven by strong cash flow from operations of $27.7 million during the first six months of 2016.

Accounts receivable increased by $13.1 million to $56.8 million as of June 30, 2016, compared to $69.9 million as of December 31, 2015. DSO was 66 days at the end of the second quarter of 2016, down 4 days from the end of fourth-quarter 2015.

Total inventories increased to $84.9 million as of June 30, 2016, from $79.3 million as of December 31, 2015, mostly driven by our new product drumbeat and lower-than-planned sales. Finally, I will conclude with our headcount numbers. We ended 2015 with 1,288 employees. As of June 30, 2016, we added 65 employees, for a total of 1,353.

Geographically, we had 541 employees in the Americas, 513 employees in Europe and 299 employees in Asia. I will now hand the call over to Simon..

Thanks, Bob and good morning, everyone. Our renewal initiatives directly focus on rebuilding FARO to ensure its technical and market leadership in 3D measurement. This initiative starts with better understanding our key market applications with a realignment to specific verticals.

This redefined focus on applications better directs our R&D teams to develop a regular drumbeat of new market-leading product solutions for those areas of interest.

We have undertaken a significant sales process modernization initiative which is designed to improve the sales demo, close and information delivery process and thereby increase sales and marketing efficiencies.

The sales and marketing costs still represent our largest percentage of operating costs and therefore a fertile area to seek improvements to leverage growth to the operating income. In a similar vein, our global harmonization initiatives are targeted to increase the operating efficiency of our support functions.

Our strategic renewal initiatives aligned with our fundamental goal of delivering long-term shareholder value. For this first six months of the year, we achieved progress on several key financial goals versus last year.

Gross margin was up 1.4 points, EPS up $0.12 and cash flow from six months of operations up almost $28 million, representing a cash flow of 18% of sales.

Simply said, these six months' results demonstrate that our team has sustained industry average growth rates and new product introductions while being challenged with a top-to-bottom reorganization and yet is delivering a higher level of profitability and cash flow to our shareholders.

It is, of course, our intent to make every effort to exceed industry average growth rates by redefining our markets through innovation at the product and operating levels. Sustaining our growth through the disruptive process of implementing our initiatives is our current challenge.

In that regard, I want to provide you with a status update on our renewal initiatives, first mentioned in our fourth-quarter earnings call. Our broad-reaching-renewal at FARO begins with going vertical which means driving sales growth by aligning sales, marketing, product management and R&D to focus on specific vertical markets.

Our Chief Commercial Officer, Joe Arezone and his leadership are realigning our global salesforce to verticals.

Our key priority now is recruiting selling, marketing and product management professionals with the right expertise to develop and grow our emerging verticals which are factory automation, product design, public safety and 3D solutions and services. Going vertical also requires differentiating our products to better meet the needs of those verticals.

We demonstrated this approach by the release of the FARO-designed ScanArm in May, with the features, functionality, software and price for the product design vertical.

The redesign, solution repackaging, pricing and delivering of existing technologies such as the FAROarm for markets other than the metrology is essential to tap the full potential of our different verticals of interest. Going vertical includes building an M&A drumbeat to strengthen our offering.

Recently we acquired BuildIT Software & Solutions to enhance our metrology software solutions for the metrology and factory automation verticals. Going forward, we will leverage M&A to more quickly expand the offerings of our verticals or enter new verticals.

The FARO renewal process will not hold back our willingness to execute acquisitions that provide the right technologies to quickly build our solutions.

In addition, we're modernizing the sales process by transitioning our sales approach of the on-site demonstrations to a hybrid one of multimedia, Web-based demonstrations or other cloud-based customer interactions.

Our early successes in this modernization effort have inspired expansions throughout all our markets and regions and are being fully incorporated in our sales process to improve close rates, quantities of demos and customer access.

New products and solutions and a persistent new product drumbeat are essential components of growth for a technology company like FARO. FARO offers affordable 3D measurement solutions that are adaptable, very high in return on investment and play an essential role in the many areas where 3D data is the new standard.

The new product drumbeat means regular cadence of new product releases to the market. To date in 2016, FARO has released nine new or upgraded hardware and software products. We started an early adopters program to accelerate new product development with three products released thus far.

We're realigning our R&D efforts to be more agile and accelerate new product introductions. It is instructive to note that in the early 1990s, FARO developed patented technology for 3D guidance in neurosurgery which was licensed to important medical device companies and which today constitute a standard of care in neurosurgery around the world.

FARO will continue to lead the democratization of 3D measurement and impact the verticals of interest with similarly transformative 3D solutions. Simultaneously, while going vertical and creating a new product drumbeat, we must leverage our global scale to become more efficient and reduce our costs as a percentage of sales.

Our Chief Operating Officer, Kathleen Hall, has taken substantial steps to transition our operations from a regional to global focus. We're managing our customer service efforts from a global perspective and leveraging the regional best-in-class processes to reduce turnaround time.

We're reshaping our practices on procurement from regional to global sourcing to enhance margins and security of supply. I'm extremely proud of all the accomplishments of the team in these areas in such a short time. In total, the renewal initiatives are progressing. I believe in speed and activation to drive growth, so of course I want it faster.

However, I remind our leaders that we must run the underlying business first to drive the annual results. At the outset, I said that this process may take 12 to 18 months and we're going to take the appropriate time to get it right. Today, I am reiterating this timing.

Clearly, as we progress through this reorganization and change the manner in which we manage the business, there will arrive a time when our segment reporting will include the verticals. Until then, we will continue to manage our business and financial reporting by regions.

I want to thank all FARO employees for their continued focus on driving the Company forward, even as we're changing and continuously improving the way we do business. I will now turn the call over to questions..

[Operator Instructions]. And we will go ahead and take our first question from Ben Hearnsberger with Stephens Inc. Your line is open..

This is Hugh, sitting in for Ben.

I just want to start out by asking when do you all expect the contribution from new products launched this year to be material?.

The relationship between sales and our headcount in the sales and marketing is the primary factor which really limits or enhances sales growth. So, you're going to see that growth in new product delivery through the different verticals as we slowly add sales and marketing -- or rapidly add sales and marketing staff to the different verticals.

I can say that today, because of two risks last year, that we're still 6% below the sales and marketing headcount that we had in the first quarter of or the second quarter of last year. So we have catch-up to do. And I think that you're going to see enhancement of our sales and top line in the different verticals very soon from the new products.

But the reality is that until the salesforce is expanded, that sales are tied directly to the headcount..

And just to follow up, do you expect the increased pace of product introduction to continue?.

Absolutely. We call it a drumbeat because it's going to be continuous. It will be continuous from an internal and organic product development point of view, as well as M&A..

And Dr. Simon spoke a little bit about the virtual sales model in the call in the prepared remarks.

But I just wanted to ask, are close rates improving with the new virtual sales model?.

This is Simon. It's too early to say yet. We've had a lot of good feedback from customers. And the accessibility is high which is very good. The number of demos have substantively increased. They prequalification of on-site demos -- it has substantially improved. It's just a little bit early.

We barely got the various studios and infrastructure in place to accomplish that. And there's a lot of technology involved, from demo recording to demo environment, the sample parts, software, people, the teams that demo delivery on the Web and so on and so forth. So, it's too early to tell..

And I just want to ask one last question, too. I'm looking at the service gross margins. And, Bob, this might be more in your line. But I'm looking at the service gross margins; they are around low- to mid-40s.

How should we think about the normalized service gross margins?.

So, we do not provide specific guidance on any line of our P&L. But what we can say about service is that, as we said in our prepared remarks, our service revenue is up 14% year to date. We have gone through an extensive sales initiative to really try to capture our over 15,000 customers that are out there.

And when you look at it is -- it's a revenue-driven business. Our fixed costs are mostly headcount and they will move as the revenue moves. But in the same token, I would not give any guidance on our gross margin..

I do want to -- well, not giving guidance; I do want to make the general comment that we're trying to improve efficiencies at all levels through the Company through globalization. The impact will be reductions in costs in all departments through the removal of redundancies and more efficiencies in all places.

So, we would expect that to contribute appropriately to the margins..

Because one of the things here that we talked about earlier is -- and you see it in our focus -- is we have a focus on gross margin as a whole to improve that gross margin over time..

We will go ahead and take our next question from Jim Ricchiuti with Needham & Company. Your line is open. .

Just had a question about the performance in the Americas in the quarter. I understand, I think, the difficult comps. But I'm curious, if we look at previous years -- you can probably go back to three years or more -- normally you would see sequential increases in revenues from Q1 to Q2. And I'm just wondering what you are seeing in the Americas.

And maybe you can just give us a little bit more color on the metrology business versus the 3D scanning business. If you could elaborate on maybe the sequential trends you saw..

This is Simon. Generally, it's hard to fully understand what's going on in a marketplace. You can look at the manufacturers' index and things of that sort to try to get some inkling, but we definitely heard from our salesforce that things were soft. People were deferring decisions. So there was a certain lethargy in the marketplace in the Americas.

Strangely, despite Brexit, we were up in Europe, so that didn't have any effect. Primarily the comps, the lower margins in the second quarter of last year due to significant discounting -- that can always move product in an unusual, bumpy fashion.

But I can say from a general point of view that the salesforce did feel that the market was soft in the second quarter in Americas..

The changes that you're making in the organization, Simon -- are more of those changes taking place in the Americas initially? Or is it being administered through -- geographically, in all three regions at the same time? What I'm wondering is, is there any potential that as you go through some of this realignment and changes, that there is some near-term disruption before the benefits start coming in..

There's absolutely no question that there's near-term disruption. There's not a single part of the Company that isn't being transformed or re-examined from every point of view. It's happening globally. One of the biggest parts of our effort is harmonization globally.

So different processes and different tools and different ways of working regionally that can be harmonized, will be harmonized. Obviously there are regional specificities that you can't get around, but it's been very disruptive.

And that's why I mentioned twice in our script that the reality is that we're trying to stay focused on the annual results while literally turning the place upside down and reconfiguring everything.

So, everything from product to which verticals the salespeople are in, to how they interact globally, to how marketing is done on a global basis versus regionally, to how product is delivered and services are being affected. So that's why I'm actually quite pleased with the overall results of the Company from a performance level.

And I tried to accent that despite what is a very disruptive and hopefully very positive process in the end, but very disruptive now..

Jim, one thing to note that what we did internally -- so you understand what Simon means by disruption or how it could have disrupted our operations is -- our primary sales is in the last quarter of the month which you know [indiscernible] the last month of the quarter.

And so, our sales team and our whole business was totally focused on driving that quarter. So, in terms of what we're doing here, doesn't necessarily reflect any impact to the top line..

Okay.

And last question, can you provide any color on the metrology business versus the scanner business, as you -- from the trends you saw in the quarter, was metrology a little weaker than -- or was more of the softness that you saw -- and I'll maybe specifically in the Americas -- tied to the scanner business?.

In the Americas business, really what we saw there was mostly softness on our laser scanner side. This is coming off of a Q2 last year where we still had our master distribution agreement. There was some additional softness, I would say, year-over-year are lower, just because the promotions that we did do.

But overall, if you look globally, we saw a stronger Japan metrology market. That was certainly a benefit to our business..

We will go ahead and take our next question from Richard Eastman with Robert W. Baird. Your line is open..

Simon, can you speak for a minute or two to the Americas? Again, when we look at the year-over-year growth rate down 17%, can you just position scanner sales and metrology sales against that 17%? I know on the scanner side, we had the master distribution agreement that ended, so presumably scanner sales were down much more than 17%.

But was the metrology business down double-digit, high-single-digit?.

Well, overall, one of the things that has certainly helped us globally in the metrology business is the competitiveness of our ScanArm. When you look in the marketplace, our ScanArm is highly competitive compared to our competition.

So globally, that has been a force which year-over-year has helped us, because it has taken more traction into the market. Where we really see the softness or the lower year-over-year sales, as I said, especially in the Americas, is related to the laser scanner business, really from a perspective of the master distribution agreement going away.

And also the oil and gas business which is Texas-based, Western Alberta -- those two areas, we've seen that year-over-year. One thing I did want to make a point on laser scanner, we do not see a fundamental shift in the addressable market.

This is coming off of a master distribution agreement where it's very hard to, over time, quickly replace that number of outputs very quickly. We're doing that globally. Joe Arezone and his team is leading that effort. And it's certainly not helped by the headwinds in the oil and gas side..

Okay. And then maybe just a second question, if I have a follow-up here.

The commentary around the average sell price being higher, can you comment on average sell price within the metrology product line versus that which was caused by go-to-market strategy on the scanner last year?.

It's Simon here. Generally, obviously products need to keep up with inflation; product pricing needs to keep up with inflation. Excessive discounting or mismanaged discounting can reduce prices unnecessarily. So if you put more controls around your pricing, you are generally going to start moving your ASPs upwards.

And it's our intention, of course, to provide products which are technological leaders which drive a premium. So, we're going to continue to move in that direction. We want to be the high-value but still the higher-price, higher-performance product.

So you will be seeing our ASPs generally move in that direction as the quality of the technology improves and we start to take more market share and that we discipline ourselves with respect to seeking market with big discounts.

Which, frankly, speaks to your prior question which was very significant discounting in the second quarter of last year which represented a very unusual 21% increase which now we're battling against with a 17% drop.

So that kind of anomalous behavior which then contributes to margin drop, price conflicts in the marketplace and a perception in the marketplace is not healthy. So, you're going to see the ASPs generally move up..

I see. Because I know we went through a period of time on the metrology side where just the soft demand was leading to some pretty competitive pricing just to gain our share of volume in a down market.

But has that competitive pricing on the metrology side -- has that flattened out in the current quarter?.

I don't think so. Competitively, everybody is always there fighting over every sale. I think that the only way to win that battle -- because it's a loss for everybody when people start fighting over price; the margins drop, everybody loses profits.

So, we prefer not to entertain the kind of battle, although we're ready for it, if it happens, because of our strong margins and such. But I think that we would much rather compete on performance and that's why the products need to stay at the technological leading-edge. And that explains the R&D efforts and the new product drumbeat.

If you do not do that, you do not sustain leadership, you do not sustain leadership in pricing and you end up getting into price battles over modest technical features. And that's just not the way we prefer to work..

Understood. And then just my last question would be as we've entered July -- and I know you guys don't give guidance -- but through July into early August here, how has the business trended? And my question might be, again, the Brexit impact may be concealed a little bit by typical seasonal softness in Europe.

Have you seen any inflection in demand in any of the markets here as we track through July and into early August?.

I think that we've seen a general, consistent softness in the market. I agree with you; Brexit has not been evident. And you can see that in the European sales increases, although there has been an effect on FX.

But with respect to the general trends, obviously we can't give guidance on how we've seen our July work out, but I would say that nothing substantively has changed. You can point to a lot of excuses, like elections and other things, but I think right now what we're seeing is consistent with last quarter..

[Operator Instructions]. We will go ahead and take our next question from Patrick Newton with Stifel. Your line is open..

I'm curious if we could get that data point for Q1..

Sure. You can get that math really through the year-to-date from our -- versus the quarter, from our Q, but I will give it to you. Our order number for Q1 was $75.7 million. That was a book-to-bill for us on the sales that we had of 0.97. And -- you can get it by region, as well, from our Q..

And then if we think about just the products' families and relative revenue contribution, is there any change to the Arm, number one; FLS, number two; and Tracker, number three?.

Historically we have not set a specific revenue numbers for us by any single product, but it remains the Arm is strictly our number-one revenue product. Tracker and laser scanner are somewhat neck-and-neck. We're highly a metrology business right now..

Okay. And then, Simon, I think in answer to an earlier question, you talked to some soft sales environment and deferrals in the Americas.

But if we drill down into that, I'm curious, if we look at automotive or if we look at aerospace, are you seeing any a slowing there or any concerns around peak auto production or in general -- I guess peak aerospace trends?.

Honestly, with the -- my observation which was that the market was soft -- it was a qualitative indication by the salesforce, with no specificity about the actual markets. So I really can't speak to that..

And just maybe more broadly, do you have any market commentary on a worldwide basis of where you are seeing some strengths or a little bit of challenges?.

Obviously the construction area, APAC has been impacted, but aerospace is very strong worldwide. Automotive is growing worldwide. So no, nothing that stands out..

Okay. And then just last one for me is on the revenue trends.

I think last quarter you talked about how we should see seasonal -- barring some disruptions, I think that's when we saw a little bit of macro softness -- but taking the space from the June quarter, is it reasonable to think of seasonal sequential revenue trends through the remainder of calendar 2016?.

Yes. Historically these have been pretty consistent. I think the only factor which may disrupt that a little bit is that we're under a very aggressive hiring initiative to increase the -- to populate the different verticals with the sales and marketing force. So, that may affect positively -- hopefully, positively -- the seasonal trends.

But on a rolling 12 months, I think you are pretty safe looking at our seasonal variations..

And there are no more further questions at this time. I'd like to turn the program back to you for any closing remarks..

Thank you all for your attention today and we look forward to reporting next quarter..

And this concludes today's program. Thank you for your participation. You may now disconnect..