Good morning. My name is Andrea, and I will be your conference operator today. At this time, I would like to welcome everyone to the Novanta Inc. 2020 Third Quarter Earnings Call. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Ray Nash, Corporate Finance Leader for Novanta.

Please go ahead..

Thank you very much. Good morning and welcome to Novanta’s Third Quarter 2020 Earnings Conference Call. I am Ray Nash, Corporate Finance Leader of Novanta. With me on today’s call is our Chief Executive Officer, Matthijs Glastra; and our Chief Financial Officer, Robert Buckley.

If you have not received a copy of our earnings press release issued today, you may obtain it from the Investor Relations section of our website at www.novanta.com. Please note, this call is being webcast live and will be archived on our website shortly after the call.

Before we begin, we need to remind everyone of the safe harbor for forward-looking statements that we’ve outlined in our earnings press release issued earlier today and also those in our SEC filings. We may make some comments today, both in our prepared remarks and in our responses to questions, that may include forward-looking statements.

These involve inherent assumptions with known and unknown risks and other factors that could cause our future results to differ materially from our current expectations. Any forward-looking statements made today represent our views only as of this time.

We disclaim any obligation to update forward-looking statements in the future even if our estimates change. So you should not rely on any of these forward-looking statements as representing our views as of any time after this call. During this call, we will be referring to certain non-GAAP financial measures.

A reconciliation of such non-GAAP financial measures to the most directly comparable GAAP measures is available as an attachment to our earnings press release.

To the extent that we use non-GAAP financial measures during this call that are not reconciled to GAAP measures in the earnings press release, we will provide reconciliations promptly on the Investor Relations section of our website after this call. I’m now pleased to introduce the Chief Executive Officer of Novanta, Matthijs Glastra..

via-hole drilling for 5G mobile devices; laser additive manufacturing; battery processing for electric vehicles; fine-hole drilling for industrial medical applications; and high-speed automation and processing of, for example, sustainable packaging.

To wrap up, I’m very proud of the performance, resilience and agility of our teams in an uncertain environment. The team managed profit decrementals and cash flow extremely well while staying focused on innovation and supporting our customers.

Strategically, Novanta’s overall positioning is favorable and our portfolio resilient to weather the COVID-19 pandemic. Close to 90 – or 60% of our revenue year-to-date comes from medical markets, which are robust and structurally growing long term. Our balance sheet is strong as is our innovation pipeline.

And finally, our focus on portfolio diversification allows us to increase our exposure to long-term secular trends in robotics and automation, health care productivity and precision medicine, which are becoming more relevant post pandemic, while also giving us the resilience to whether the economic environment caused by the pandemic.

You can also expect us to lean in on acquisition opportunities, which is the primary focus of our capital deployment, provided they fit our stringent financial returns and strategic criteria. We are very actively engaged in pursuing M&A opportunities even within the constraints imposed by the pandemic.

So with that, I will turn the call over to Robert to provide more details on our financial performance.

Robert?.

Thank you, Matthijs, and good morning, everyone. We delivered $142.9 million in revenue in the third quarter of 2020, a decrease of 7% year-over-year on a reported basis and 9% decline on an organic basis.

As Matthijs already covered, despite the year-over-year decline, we were pleased with our sales performance in the third quarter, beating our own expectations and our previously issued guidance. To give some additional detail on our sales, 54% of Novanta’s total sales went into medical end markets in the third quarter.

This was despite experiencing low double-digit declines year-over-year as a consequence of the deferral of elective surgical procedures and the deferral of high-throughput instrumentation for clinical and research-based laboratories. On a year-to-date basis, sales to medical end markets was approximately 56% of total sales.

Considering the significant impact of these macro events, we are actually very pleased with the resilience of our business. We continue to see pockets of strength during the downturn such as our medical consumable business with integrated smoke evacuation and our integrated data collection products for clinical test equipment.

Novanta’s sales to advanced industrial markets was 46% of total sales in the third quarter. In the third quarter, we experienced higher demand specific to investments in 5G, high-speed networking and cloud-based infrastructure as well as higher demand from EUV-based applications. This application area was up more than 50% year-over-year.

We did see in the third quarter broad-based declines across the rest of our industrial end markets, which were down low double digits year-over-year. This was consistent with our expectations and what our industrial OEM customers are seeing in those same end markets.

The industrial capital spending environment and the overall economic climate continues to face high levels of uncertainty due to the recent resurgence of the virus in many countries. But while the outlook remains uncertain, there are pockets of growth and recovery.

Overall, we are proud of the application and end market diversification we’ve created over the years with our portfolio of technologies, which has clearly proven its resilience in one of the worst economic downturns in history.

In addition, on a geographical basis, our third quarter sales to China were up plus 46% year-over-year despite the continued disruption caused by the pandemic, whereas sales to the U.S. and Europe were down 7% year-over-year, reflecting the impact of the pandemic in those countries.

As a reminder, the location of our sales are based on where the product is shipped to, which could be different than the real end-user demand. Nevertheless, we feel these figures represent general directional trends. Turning to operating results.

Our third quarter GAAP gross profit was $54 million or 41% of sales compared to $64 million or 42% in the third quarter of 2019. On a non-GAAP basis, third quarter adjusted gross profit was $62 million or 43.3% of sales compared to $67 million or 43.7% in the third quarter of 2019.

Despite better sequential performance, our adjusted gross margins were under pressure from higher operational costs in our factories that were caused directly by the pandemic. To maintain a safe working environment, we continue to incur significant temporary costs that pressure our gross margins in the range of 200 basis points.

In addition, with the resurgence of the virus heading into the winter months, we are implementing new screening and tracing tools as well as new testing protocols.

Without a doubt, the winter is going to be a challenge in terms of managing a resurgence of the virus, but our teams have really developed a strong acumen for managing through these risks and disruptions.

And while we are implementing tools and processes that presume the virus is here to stay and at an elevated cost level, we also feel we can manage through these costs going forward while driving gross margin expansion.

With all these challenges, we want to reiterate that we’re extremely proud of the performance of our committed teams who are safely and successfully operating our facilities.

The fact that our gross margin was as good as it was is a testament of how much our teams have stepped up to the challenges brought on by this pandemic and is also a testament to the potential of the Novanta Growth System to bring structural changes to the way we operate. There’s a long way to go, but we are optimistic after seeing these results.

Moving on to operating expenses. Third quarter R&D expenses were $15 million or 11% of sales compared to $14 million or 9% in the third quarter 2019. This sequential increase in R&D spend was largely due to the timing around cost cutting measures.

With that said, we continue to have confidence in our innovation pipeline and therefore, continue to invest into the economic climate. As we stated in prior calls, we view the current pandemic as an opportunity to take market share and capture significant customer opportunities.

The third quarter marked a significant increase in the launch of new products for Novanta. These new products give us the confidence we are going to finish 2020 with a very strong dollar growth in design wins. Third quarter SG&A expenses was $27 million or 19% of sales compared to $28 million or 18% of sales in the third quarter of 2018.

We continue to see excellent execution in keeping tight controls on our spending, and we are very pleased with the flexibility our business teams have demonstrated in responding to the current market conditions. Moving on to other financial results. GAAP operating income was $12 million in the third quarter of 2020 compared to $13 million in 2019.

Non-GAAP operating income in the third quarter was $20 million or 14% of sales compared to $26 million to 17% in the prior year. Adjusted EBITDA was $30 million in the third quarter or 21% EBITDA margin compared to $31 million in the third quarter of 2019 or a 20% EBITDA margin. On the tax front, our GAAP tax rate was 18% in the third quarter of 2019.

It differed from the Canadian statutory rate of 29% driven largely by jurisdictional mix of income. On a non-GAAP basis, our tax rate for the third quarter of 2020 was 17%. This differed from the statutory rate driven by a jurisdictional mix of income.

Our GAAP diluted earnings per share was $0.03 in the third quarter of 2020 compared to diluted earnings per share of $0.25 in the third quarter of 2019. On a non-GAAP basis, adjusted earnings per share was $0.42 in the quarter compared to $0.52 in the prior year.

Our adjusted earnings per share was down year-over-year primarily from the higher stock compensation expense for the all employee equity grant. Stock-based compensation expense was $7 million in the third quarter. Third quarter operating cash flow was $42 million compared to $7 million in the third quarter of 2019.

This result was driven by strong profit, continued invest – improvements in net working capital and a variety of actions we took to preserve cash in response to the pandemic. We ended the third quarter with gross debt of $198 million, and our gross leverage ratio is 1.7 times.

Our net debt was $91 million as of the end of the third quarter, roughly 0.8 times. We are very pleased with our cash flow and financial position in the third quarter.

Based on these results, we believe that our $107 million of cash on hand and nearly $400 million of available borrowing capacity under our revolving credit facility as well as the anticipated cash flows from operating activities will be more than sufficient to meet our cash needs for the duration of the economic downturn and, most importantly, position us well for acquisitions.

Turning now to guidance. As we look at the fourth quarter, we are seeing some signs of stabilizing environment. However, given the resurgence of the COVID-19 virus in Europe and the U.S., we need to be mindful of the risk this places on our business.

While our teams have built up incredible acumen for dealing with this challenging climate, we need to remain cautious. For the fourth quarter of 2020, as we stand here today, we expect GAAP revenue in the range of $144 million to $149 million.

As we discussed in prior earnings releases, we do believe that the third quarter represents a low point for us in sales based on what we know today. So in the fourth quarter, overall, we’re expecting to see a sequential improvement in revenue.

And this will be driven largely by sequential improvement in revenue in our Photonics business, while sequential improvements in Vision and Precision Motion would be more muted. Our global elective surgical procedures have largely returned. The resurgence of the virus is the reason to remain cautious.

In addition, the medical capital equipment segment will generally lag any rebound in elective surgical procedures as hospitals build the needed cash flows and breathing room from the worst of the pandemic.

As we look at the industrial markets, we remain cautiously optimistic around the capital spending environment given the recent uptick in global purchasing managers indices across China, the United States and Europe. Similar to medical capital spending, the question is not one of if, but rather when spending increases.

Despite the uncertainty, we do expect a very strong fourth quarter and design win dollar growth as a handful of customers continue to invest in innovation and as we continue to invest in innovation.

While delays in spending during a pandemic are inevitable, we continue to see our customers investing in and giving significant mindshare to application areas, such as medical robotics, industrial robotics, minimally invasive surgery technologies, integrated operating room technologies and laser-based material processing, to name a few.

Thus, we continue to be excited about the market and applications in which we serve and the diversity of our portfolio, and we continue to expect to emerge from this pandemic stronger than we were going into the crisis. Moving on to other guidance.

Adjusted gross margins are expected to improve sequentially, roughly 100 basis points into the fourth quarter, driven by continued progress in the Novanta Growth System’s productivity program, strong cost controls and better volume.

R&D and SG&A expenses for the fourth quarter of 2020 will increase sequentially on a dollar basis, predominantly driven by less pandemic-related cost containment actions and from the uptick in selling expenses due to higher revenue. Moving on to the remainder of our guidance.

Depreciation expense, which was about $3 million in the third quarter, will be similar in the fourth quarter. Amortization expense, which was $6 million in the third quarter, will be similar into the fourth quarter. Stock compensation expense, which was about $7 million in the third quarter, will be similar in the fourth quarter.

Interest expense, which was about $1.7 million in the third quarter 2020, is expected to be slightly less than the fourth quarter due to the lower debt balances and favorable movements in interest rates. For adjusted EBITDA, we expect a range of $30 million to $42 million.

We expect our full year tax rate to be around 15%, absent changes in jurisdictional mix of income. However, due to the resurgence of the coronavirus and any resulting economic lockdowns, jurisdictional income could change more significantly than anticipated. And consequently, we are not currently providing earnings per share guidance.

Finally, we expect our cash flow for the full year of 2020 will end up a ratio close to adjusted EBITDA. This is driven by strong year-over-year performance as well as continued strength in the fourth quarter.

Ultimately, our view has not changed since the last call that the economic consequences of the pandemic are temporary and rebound of demand in both our medical and industrial end markets will occur, although the trajectory of the recovery remains uncertain.

We are thankful that during these difficult economic times, our customers have shown tremendous partnership with us. Both with current sales and delivery of products as well as with our innovation pipeline, we are partnering with our customers to bring future innovations to market.

We remain very proud of the performance of our employees and their commitment to helping us weather through the difficult environment. And most importantly, we remain excited about our future and look forward to continuing to deliver on our commitments to our employees, our customers and our shareholders. This concludes our prepared remarks.

We’ll now open the call up for questions..

[Operator Instructions] Our first question will come from Lee Jagoda of CJS Securities. Please go ahead..

So just on the cost side, Robert, can you talk about your customer relationships and how those relationships have evolved, given everyone’s incurring more cost because of COVID? And are you able to get or have you seen relief either through just straight price increases or surcharges?.

Yes. I think we’ve had some of that. We’ve been able to partner with them, and there’s been a recognition that the cost that we’ve been incurring is higher than what we would have normally planned for. And so there has been some sharing of costs that have helped mitigate and helped us to contain the overall impact of the pandemic..

And I assume those customers aren’t tired of that yet, and we should just kind of expect that to continue until it doesn’t? But hopefully, we get through it before it doesn’t..

Well, I think it’s fair to say that as long as those costs that are being incurred, that a partnership around those costs should continue to exist..

Okay. So then in terms of the costs that are still in the system or, I guess, the – let’s put it in a different way. How about the costs that are not – that you were taking out ahead of time? And you sort of that ad said there’s these costs that are out. And as volumes come back on, we’re going to put them back in.

Can you talk about how much of that is still out of the system that’s yet to return versus the permanent stuff that got taken out? And maybe some of the timing on when we should expect to see that come back in..

Yes. So if you look at the fourth quarter, we’re going to increase our gross margins 100 basis points or more. Our operating expenses are also going to increase. And that increase in operating expenses is really a termination of some of the pandemic-related cost containment actions. So we’re not investing in more things. We’re not hiring more people.

It’s really just we’re stopping certain actions such as furloughing. So it’s fair to say the majority of our cost actions were temporary. And that was largely on the basis that we thought the pandemic is temporary. We believe this is to be temporary and the implication of that to be temporary.

And – but we are starting to look at some structural improvements to make into the business as we go into 2021 to ensure that if there’s some, let’s say, a longer cycle around the recovery that we can contain the actual temporary actions we took and take some structural actions to reduce our costs further..

Sure. And then just one more for me. Just Matthijs, in your prepared remarks, you mentioned a couple of new products and gave us a little bit of color around what they do.

Is there any way for you to kind of size the market potential or opportunity around those products and when we should expect to see that potential start to kick in, in terms of your numbers?.

Yes. I think we – for Photonics, we commented in the past that we see a market opportunity of about $100 million, upwards of that number. And of course, we don’t get 100% of that. But that over time, we feel we can, yes, eat into that adjacency for us. So that’s just to give you a perspective.

And we’ve quoted also rough market size expansion opportunities for the minimally invasive surgery business, which is about $100 million, $150 million as well, I recall. So we’ve given – in the past, we’ve given those high level numbers. And yes, so those are things still – yes, still representative..

Okay, great thanks very much..

[Operator Instruction] And the next question will come from Brian Drab of William Blair. Please go ahead..

So continuing on the new product discussion. So do you believe that you’ll start to see the impact of that new product revenue in the fourth quarter and material contribution to revenue beginning in fourth quarter and in the first half of 2021 and to the point that, that really has an impact on accelerating organic revenue growth..

Yes. So I think in the – not yet in the fourth quarter. I think it’s fair to say it will be more pronounced in 2021 and 2022. I mean we’ve seen some delays with customers, right? Think about very complex systems that require hundreds, maybe thousands of engineers to introduce new platforms.

Yes, there’s going to be some delays in introducing those types of products. But I think in the big scheme of things, we materially don’t feel that, that changes the thesis a bit, quite frankly. So there might be a little bit of a shift to the latter part of next year, but it will definitely be more pronounced around that time.

And like I said, we continue to invest in those products. The products that we have launched have a good uptick, and the customers are now preparing their launches. And the timing of those launches, in some cases, are a bit delayed, but structurally, they’re not changing the growth potential of the company in the midterm.

And it’s a little turn to comment on 2021, specifically..

Okay. And you said that you’re expecting sequential revenue improvement for the company overall.

Does that apply to each of the three segments for the fourth quarter?.

No. I mentioned in my prepared remarks that the Photonics segment will see the larger uptick on a sequential basis and that Vision and Precision Motion will be largely muted..

Muted, I would translate to about flat sequentially, but how are you thinking?.

About flat, yes. It might be a – the bigger element is the Photonics element will see – the segment will see the bigger increase..

Okay. Can you talk just – and this is my last question for the call here, but the Precision Motion segment, there’s some good data out of the semiconductor market. And I’m wondering if you can talk us about your opportunity more broadly in the robotic surgery market. And then there’s clearly some recovery in industrial activity.

Can you talk about why maybe we’re not seeing more of a rebound in the near term sequentially into the fourth quarter in Precision Motion?.

Yes. Well, first and foremost, the Precision Motion as a group is growing 9% in the quarter, right? So there’s nothing to sneeze at, I would say so, in this environment.

So – but separately, I think on the robotic surgery, I think we stated in the prepared remarks as well that you see the procedures returning to about 90% to 95% of normal on procedure, sometimes even growing that doesn’t mean that the capital investments from the hospitals are yet happening.

So what we’re seeing is that’s actually being delayed, and it looks like growth will not return in the capital piece of surgical robotics until the latter part of 2021. Yes, again, the application has multiple benefits.

So hospitals do want that equipment, but they first need to get back their procedure volumes so they can generate the cash so they can actually avoid – afford spending capital. So that’s kind of what we’re seeing on the robotic surgery side. In the meantime, though, we are gaining share in design wins in multiple platforms.

So when that market rebounds, we’re in an extremely good position, right? So it’s just a timing thing there. And then on the – what was the other question? You had another question..

I just mentioned the semiconductor..

Okay. One caveat on the – on medical robots. If it’s a surgical-based robot, that tends to be true. There are lower-priced robots being implemented in the hospital environment that we are seeing some growth.

But those are relatively new entrants into the marketplace and will take a little bit of time to build the proper traction to offset the overall growth that you see on the surgical side. On the semiconductor, we are seeing growth in elements of our portfolio there.

So we are seeing it in the investments being made into G infrastructure and cloud storage. We are seeing it in EUV-based applications. We have not – as you know, we have not overly emphasized our applications within the semiconductor marketplace. And so it’s not an area that we would expect to see driving the overall growth of this company.

It is an element of growth, and it’s been benefiting us in the third quarter. It will benefit us in the fourth quarter, but it won’t be oversized to the point that will drive the overall growth of the company..

This concludes our question-and-answer session. I would like to turn the conference back over to Matthijs Glastra for any closing remarks. .

Thank you, operator. So to wrap it up and to summarize, in the third quarter of 2020, Novanta delivered a solid performance in an uncertain macro environment. We’re very pleased with our positioning and performance of our portfolio and proud of the performance and agility of our teams.

Novanta is not immune to the impact of the pandemic, but we’re well positioned to weather the COVID-19 crisis. Our balance sheet is strong, as is our innovation lineup, and our portfolio is diversified, with exposure to long-term secular trends in robotics and automation, health care productivity and precision medicine.

Despite an uncertain short-term outlook with the pandemic, we are investing into the headwinds and remain focused on the long-term growth drivers in our business on the back of the macro trends in Industry 1.4, precision medicine and minimally invasive surgery.

In closing, I would like to thank our customers, our employees and our shareholders for their ongoing support. I’m particularly grateful for the dedication and strong contribution of our teams of committed Novanta employees. They are showing tremendous agility and resilience during these times.

We appreciate your interest in the company and your participation in today’s call. I look forward to joining all of you in several months on our fourth quarter and full year 2020 earnings call. Thank you very much. This call is now adjourned. .

The conference has now concluded. Thank you for attending today’s presentation. And you may now disconnect your line..