Shane Glenn - Vice President-Investor Relations David Reis - Chief Executive Officer & Director Erez Simha - Chief Operating & Financial Officer.

Wamsi Mohan - Bank of America Merrill Lynch Troy D. Jensen - Piper Jaffray & Co. (Broker) Brandon S. Wright - Stephens, Inc. Patrick Newton - Stifel, Nicolaus & Co., Inc. Paul Coster - JPMorgan Securities LLC Shannon S. Cross - Cross Research LLC Sherri A. Scribner - Deutsche Bank Securities, Inc. Jason D. North - Jefferies LLC Ananda P.

Baruah - Brean Capital LLC Brian P. Drab - William Blair & Co. LLC Jim Ricchiuti - Needham & Co. LLC Kenneth Wong - Citigroup Global Markets, Inc. (Broker) Robert Stone - Cowen & Co. LLC.

Good day, ladies and gentlemen and welcome to the Stratasys First Quarter 2016 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session and instructions will follow at that time. As a reminder, this conference call is being recorded.

I would now like to turn the conference over to Shane Glenn, Vice President of Investor Relations..

Thanks, Latoya. Good morning, everyone and thank you for joining us to discuss our first quarter financial results. On the call with us today are David Reis, CEO, and Erez Simha, CFO and COO of Stratasys.

I'll remind you that access to today's call, including the prepared slide presentation, is available online at the web address provided in our press release. In addition, a replay of today's call including access to the slide presentation will also be available and can be accessed through the Investors section of our website.

We will begin by reminding everyone that certain statements in this press release regarding Stratasys' beliefs and its comprehensive new strategy will help grow its markets and the statements regarding its projected future financial performance including under the heading Financial Guidance are forward-looking statements reflecting management's current expectations and beliefs.

These forward-looking statements are based on current information that is by its nature subject to rapid and even abrupt change. Due to risks and uncertainties associated with Stratasys business, actual results could differ materially from those projected or implied by these forward-looking statements.

These risks and uncertainties include but are not limited to any failure to continue to efficiently and successfully integrate the operations of Stratasys, Inc. and Objet Ltd.

after their merger as well as MakerBot, Solidscape, Harvest and GrabCAD after their acquisition or to successfully establish and execute effective post-acquisition integration plans; changes in the overall global economic environment; the impact of competition and new technologies; changes in the general market, political and economic conditions in the countries in which we operate; any underestimates in projected capital expenditures and liquidity; changes in our strategy; changes in applicable government regulations and approvals; changes in customers' budgeting priorities; lower than expected demand for our products and services; reduction in our profitability due to shifts in our product mix into lower margin products or shifts in our revenues mix significantly towards our AM manufacturing services businesses; costs and potential liability relating to litigation and regulatory proceedings; and those factors referred to in Item 3D Key Information – Risk Factors, Item 4, Information on the Company, and Item 5, Operating and Financial Review and Prospects in our 2015 Annual Report, as well as in the 2015 Annual Report generally.

Readers are urged to carefully review and consider the various disclosures made through the Form 6-K, our 2015 Annual Report, and in our other reports filed with or furnished to the SEC, which are designated to advise interested parties of the risks and factors that may affect our business, financial condition, results of operations and prospects.

Any guidance and other forward-looking statements in this press release are made as of the date hereof, and Stratasys undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law.

As in previous quarters, today's call will include non-GAAP financial measures. These non-GAAP financial measures should be read in combination with our GAAP metrics to evaluate our performance. We also note that we are not providing any pro forma financial results for acquisitions.

Certain non-GAAP to GAAP reconciliations are provided in the table contained in our slide presentation and our press release. Now, I'd like to turn the call over to our CEO, David Reis.

David?.

Thank you everyone and thank you for joining today's call. We made significant progress in improving our operating efficiency during the first quarter. The progress helped drive favorable trends in operating profit and cash generating during the period, despite a market environment that remained challenging.

We were also encouraged to see sequential improvement in MakerBot's performance during the quarter, as we begin to recognize some positive results from the recent restructuring of that business.

MakerBot and the desktop category present both a long-term opportunity and challenge for us, as customer increasingly chose desktop systems over higher-end systems to address their concept modeling needs and in some cases also their rapid prototyping needs.

We believe we are well positioned to capitalize on this opportunity and trend, as we are the leader in both the professional and desktop segment of the prototyping market. In addition, our position is supported by our growing installed base of system, and online 3D printing community sites, both the largest in our industry.

We are pleased with the initial reception of the Stratasys J750 that we launched during the first quarter, which we believe provides the market with unmatched color and multi-material printing capabilities. Initial orders of this innovative system has exceeded our expectations.

Market condition, driven partly by the weaker global manufacturing environment, remain challenging, and we are committed to further improving our financial performance by aggressively managing our expenses and drive additional operational efficiencies.

At the same time, we'll invest aggressively around initiatives which help us maintain our leadership position in prototyping, and that support our effort to develop a solution-based business model that target application for tooling and end-use parts within key vertical markets.

I will return later in the call to provide you more detail on these important initiatives and other key developments, but first, I would like to turn the call over to our CFO and COO, Erez Simha, who will review in details our financial results.

Erez?.

Thank you, David, and good morning, everyone. David mentioned, we continue to observe a challenging business environment during the first quarter, but we are pleased with our ongoing efforts to control costs and improve our working capital management.

This resulted in improved gross margins as well as growth in operating income and significant improvement in cash flow from operations during the period. Total revenue in the first quarter decreased by 3% to $167.9 million when compared to $172.7 million for the same period last year.

MakerBot product and service revenue declined by 23% in the first quarter over last year, but increased sequentially by 27%, driven by the positive impact of ongoing reorganization of that business.

Non-GAAP operating income improved both year-over-year and sequentially to $4 million compared to an operating loss of $0.8 million for the same period last year, and a loss of $8.9 million in the fourth quarter of last year.

Non-GAAP net income for the first quarter was $0.6 million, or $0.01 per diluted share, compared to non-GAAP net income of $2.0 million, or $0.04 per diluted share, reported for the same period last year.

Net income included a tax expense of $3.6 million, which resulted from the non-cash valuation allowance against deferred tax assets derived from the losses in the U.S. Product revenue in the first quarter decreased by 6% to $118.6 million, as compared to the same period last year.

Within product revenue, system revenue for the quarter declined by 14% over the same period last year, driven primarily by the overall market weakness we discussed previously. Consumables revenue for the quarter increased 6% compared to the same period last year.

Service revenue in the first quarter increased by 7% to $49.3 million, as compared to the same period last year.

Within service revenue, customer support revenue during the quarter, which includes the revenue generated mainly by maintenance contracts on our systems, increased by 11% compared to the same period last year, driven primarily by growth in our installed base of systems.

We are pleased to see an improvement in year-over-year consumables and service revenue growth, compared to the flat growth in consumables we observed in the second half of 2015, and the flat growth in service revenue in the fourth quarter of last year.

The company sold 5,125 3D printing and additive manufacturing systems during the first quarter and has sold a total of 151,149 systems worldwide as of March 31, 2016, on a pro forma combined basis. Unit sales in the first quarter increased sequentially by 11%, driven by higher MakerBot unit sales.

Gross margin improved slightly to 55.1% for the first quarter, compared to 54.1% for the same period last year.

Sequentially, gross margin percentage increased by 7 points, helped by the one-time items that negatively impacted gross margin in the fourth quarter of last year, as well as the operational cost control measures that have helped mitigate production-related inefficiencies.

Product gross margin improved to 61.1% in the first quarter, compared to 58.6% for the same period last year, driven by sales mix that favored higher margin systems, an increase in consumables sales as a percentage of total product revenue, and improved production efficiency.

Service gross margin decreased slightly to 40.4% in the quarter, as compared to 41.7% for the same period last year. Sequentially, service gross margin increased by 4 points in the first quarter, helped by our cost control efforts and a product sales mix at Stratasys Direct Manufacturing that favored higher margin offerings.

We are pleased to recognize significant reduction in our operating expenses, and increase in operating profit during the first quarter.

These favorable trends reflect the positive impact of our operational initiatives, including reduction in head count, subcontractors, facility consolidation, and an overall focus on reducing our direct and indirect spend. Operating expenses declined by 6% to $88.5 million for the first quarter, as compared to the same period last year.

In addition, operating expenses in the quarter declined by 4% sequentially when compared to the fourth quarter of 2015. Net R&D expenses decreased by 7% in the quarter to $22.8 million over the same period last year, driven by our overall cost reduction efforts.

SG&A expenses decreased by 6% in the quarter to $65.6 million over the same period last year reflecting the cost reduction, as well as the impact of lower reseller commissions.

We should note that these planned cost reductions do not impact our long-term strategic initiatives and in some instances we have actually increased investments in area we view as strategically important for the long-term growth.

Net income included tax expense of $3.6 million, which resulted from the non-cash valuation allowance against deferred tax assets derived from losses in the U.S.; compared to a tax benefit of $7.8 million for same period last year.

It should be noted that these deferred tax assets have expiry dates many years into the future and we do anticipate being able to recognize their value to offset prospective tax liabilities. The following slide provides you with a breakdown of our geographic sales for the quarter, which reflect the broad-based weakness we have outlined previously.

Our regional results were consistent with the trends we have observed in recent quarters. Non-GAAP EBITDA for the first quarter amounted to $12.6 million. The company generated $31.6 million in cash from operations during the first quarter, driven by our cost-cutting initiative and improvement in working capital management.

The company currently hold approximately $280.2 million in cash, cash equivalents, and short-term bank deposits. Inventory at the end of the first quarter increased slightly to $124.5 million as compared to $123.7 million at the end of the fourth quarter, as we continue to focus aggressively on managing inventory levels.

Accounts receivable decreased by 11% to $109.1 million, compared to $123.2 million at the end of the fourth quarter. As a result of significant efforts to improve our cash position, DSO on 12-months trailing revenue decreased to 58, compared to 65 in previous quarter.

In summary, our first quarter results are in line with our expectations for the year, and reflect a continuation of the challenging market environment we have observed over the past several quarters. We were pleased with the positive trend in gross margins that was driven by manufacturing efficiencies and a favorable product mix.

We are pleased with the operational improvements we have achieved, which contributed to the improved profitability and cash flow from operations. Going forward, we will continue to aggressively manage our expenses and work towards additional operational improvement.

And finally, we believe we maintain a strong balance sheet and sufficient capital to invest for the future and capitalize on emerging opportunities. I would like now to turn the call over to our VP of Investor Relations, Shane Glenn, who will provide you greater details on our 2016 financial guidance. Shane..

Thank you, Erez. As Erez mentioned, our visibility into the timing and magnitude of a market recovery remains limited. This uncertainty is reflected in our revenue projections and operating budget, which assume no significant market improvements throughout 2016. Our guidance for 2016 remains as follows.

Total revenue in the range of $700 million to $730 million, with non-GAAP net income in the range of $9 million to $23 million, or $0.17 per diluted share to $0.43 per diluted share. GAAP net loss of $84 million to $67 million or $1.60 per basic share to $1.28 per basic share.

Non-GAAP earnings guidance excludes $59 million of projected amortization of intangible assets; $25 million to $27 million of share-based compensation expense; $7 million in merger and acquisition related expenses; $4 million to $5 million in reorganization and other related costs; and includes $5 million in tax expenses related to non-GAAP adjustments.

Additionally, we are providing the following information regarding our company's potential performance and strategic plans for 2016. Gross margins to improve modestly to a range of 54% to 55% Operating margins of 3% to 5%.

Tax expense of $10 million to $11 million, which includes the negative impact of the planned accounting treatment for deferred tax asset valuation allowance. Capital expenditures are projected at $60 million to $70 million, with approximately $45 million designated for completing the company's new facility in Israel.

Our tax expense guidance, and relatively high estimated non-GAAP tax rate for 2016 is a function of the ongoing non-cash valuation allowance against deferred tax assets we expect to record throughout the year.

As Erez mentioned, these deferred tax assets have expiration dates many years into the future, and we do anticipate being able to ultimately recognize their value to offset prospective tax liabilities.

The company believes that it can achieve a significant improvement in its operating structure in 2016 which can translate into improved operating profit compared to the prior year.

Given the expected impact on net income of the planned accounting treatment for tax valuation, the company believes operating profit growth would be the best measure of performance in 2016.

Appropriate reconciliations between GAAP and non-GAAP financial measures are provided in a table at the end of our press release and slide presentation, with itemized detail of the non-GAAP financial measures. Now, I'd like to turn the call back over to David Reis.

David?.

Thank you, Shane As previously noted, we observed no significant change in the market environment from last quarter. However, we are pleased with the progress of our various restructuring and cost-cutting initiatives, and believe that we are on track to meet our goals for improved financial performance in 2016.

In addition, the business transformation that we discussed on our last call is proceeding as planned. As outlined previously, our goal is to maintain our leadership position in prototyping, while developing a solutions-based business model that target key vertical markets and emerging applications for tools and end-use parts.

This include investment in R&D and go-to-market initiatives to support the many growth opportunities we have already identified; as well as incremental investment in our Strategic Accounts, Vertical Business Unit, MakerBot, GrabCAD software and IT infrastructure that will position us for long-term growth.

I would like to highlight some of the opportunities and unique challenges we face within the prototyping segment of our industry. As we have observed, the price-to-performance proposition of Desktop 3D printer has improved dramatically in recent years, helping drive increased penetration and rapid adoption of 3D printing technology.

This trend is supported by a recent industry survey we conducted, which found that between 60% to 70% of designers and engineers that have adopted 3D printing technology are using desktop units for a portion of their prototyping applications.

In a separate survey, we found that over half of our customers that own both Stratasys professional and desktop systems plan on purchasing additional desktop units over the next year; with over 30% planning on adding multiple units.

We believe this trend will continue, and represents an attractive opportunity for Stratasys and our industry-leading line of MakerBot desktop printers. In the first quarter, revenue at MakerBot increased sequentially by approximately 27%, despite weak season sales trends that are typical during this period.

We believe a renewed focus on quality, customer service, and improved go-to-market is beginning to have positive impact.

We're also focused on efficiency at MakerBot, and believe our recent announcement to transition all production of MakerBot products to Jabil, one of the largest contract manufacturing in the world will allow for greater manufacturing flexibility and help drive incremental operational savings going forward.

In addition, we see significant opportunities for cross and up-selling within our large installed base of desktop users, as those customers expand their use of 3D printing to application that require functionality not offered within the desktop markets.

However, the rapid development of the category has led to dynamic competitive environment, as the market absorbs a large number of competitive products that are low cost, but offer limited functionality to the end-users. We're also observing a growing utilization of desktop systems for basic concept model application.

This is impacting the sales of higher-end systems that have historically been purchased partly for the same purpose, a trend that will likely persist as functionality of desktop systems continue to improve.

Regardless of the opportunity or challenge, we believe Stratasys is well positioned to continue to lead the prototyping, given, our leadership position in both the professional and desktop segments, with an industry's largest installed base of systems worldwide; our market leading brands and ecosystems, including the largest online 3D printing community sites in the industry for both professional and semi-professional markets; a market opportunity that remains relatively unpenetrated; and our demonstrated ability to drive innovation.

A great example of our commitment to innovation is the recently launched Stratasys J750 printer. The new system breaks technology barriers enabling full color 3D printing, combined with an unprecedented range of materials ranging from rigid to flexible, from opaque to transparent.

The system helps users streamline their workflow process and speed product delivery cycle by eliminating time-consuming painting and assembly processes that are normally required to create true-to-life prototypes.

The system maintain a capacity of six material cartridges allowing customers to keep frequent used materials loaded at all times, which reduce the downtime associated with material changeovers. The multi-purpose system can produce production tools, manufacturing molds, teaching aids, as well as surgical guides and visual models.

We believe the J750 is well positioned to address the emerging market for medical models given the system ability to print high detailed models in full color, with material properties that can vary within each part.

We believe that J750 represents the ultimate 3D printing solution for advanced prototyping application, and we are pleased with the strong initial orders for this product. We also made good progress implementing our vertical market strategy during the first quarter.

Although early in its development, our Vertical Business Unit, or the VBU, outperformed the non-vertical areas of our business, highlighted by strong contribution from aerospace and medical.

We view aerospace as a key future market for manufacturing application with near-term opportunities to address aircraft interiors, and long-term opportunities for secondary structures that have higher technical requirements. In the first quarter, our aerospace vertical grew by estimated 14% year over year.

Aerospace is a vertical with high certification requirement within manufacturing, but OEMs are moving quickly to evaluate and adopt our technology given its potential cost savings. We believe that the manufacturing validation brought on by the broader adoption within aerospace would be invaluable across multiple other industries.

We are also observing positive trends in our medical vertical, with estimated 22% year-over-year growth. Medical is another market characterized by early adoption and strict manufacturing requirements.

We recently announced an agreement with the New York-based Jacobs Institute to create a Center of Excellence, with a goal of advancing the use of 3D printing for a variety of medical applications. Researchers at the Jacobs Institute will leverage Stratasys' 3D printing technology to develop and test new medical devices.

The center will also serve as a referral center for hospitals and medical research organizations that are considering implementing 3D printing labs. We believe that applications developed through this collaboration could apply to a broader medial audience and could support future growth opportunities within our medical vertical business units.

In summary, our first quarter results reflect a continuation of challenging market environment we observed in 2015; however, we are pleased with our improved financial performance and operational efficiency.

We are observing shifts in prototyping market, which include accelerated adoption of desktop units for use in concept modeling application, creating both an opportunity and challenge for the company that we are preparing to address.

We remain focused on maintaining our leadership position in prototyping, and are pleased with our positive trend in MakerBot, and strong early demand for our new advanced J750. We continue to develop key vertical markets and emerging application for tools and end-use parts.

We'll continue to focus on additional operational efficiency while investing aggressively in initiatives to support long-term growth. And finally, although we expect the market and macro-economic environment will remain challenging in 2016, we remain excited about the company future. Operator, please open the call for questions..

Thank you. Our first question is from Wamsi Mohan of Bank of America. Your line is open..

Yes, thank you. Good morning.

David, can you elaborate on your comment on desktops being used for prototyping? I mean, do you view this as an opportunity or threat in the long run, especially given that the desktop space is more competitive than higher end machines? And is this happening in some specific verticals and regions? Or is it pretty broad based? And I have a follow up for Erez..

I think it's a – first of all, it's a natural trend. Desktop printing is advancing. Printers in this segments are becoming better all the time and they're giving a good solution today for concept modeling. Historically, people have wanted to get into 3D printing, both higher – typical higher end printers also for concept.

So basically we believe the market in both areas will grow. On one hand, the adoption of desktop printing will accelerate and we see it and you are familiar, I'm sure, with the numbers.

At the same time, people which are adopting desktop printing soon after will have also need for more advanced rapid prototyping, which I think will push – we hope are going to push our historical core business even farther. And like I said in the script, I think that the Stratasys is very well positioned.

I mean we are, I think, the undisputed leader in rapid prototyping at the high end and MakerBot is number one brand and the leader in desktop. So we need to manage those two trend, but I think that in general it's a positive move of the market..

Thanks, David. And Erez, the cash flow was pretty strong in the quarter. There was a significant benefit from receivables. Can you talk about the linearity in the quarter and how you're viewing the sustainability of cash flow through the course of the year? Thanks..

Yeah. So Wamsi, good morning. You are right in your comment that part of the positive cash flow that we faced in Q1 was due to a significant effort to reduce accounts receivable in the quarter.

I think that as long as we progress throughout the year, we will continue, a) to try and manage our cost structure and CapEx investment in order to support and improve positive cash flow. But I don't think that further significant reduction in accounts receivable is something that we will face again in future quarters.

We are focusing ourself on managing our inventory at (27:15) items in order to try and reduce – and even reduce significantly the level of inventory that we have today on our balance sheet..

Thanks, Erez..

Thanks, Wamsi..

Thank you. The next question is from Troy Jensen of Piper. Your line is open..

Yeah. Thanks for taking my question. Maybe just start off with David. I wonder if you could dive a little bit into aerospace and medical? What are you doing in those verticals that's working well? Or is there just the space kind of high? It seems like a lot of firms are calling out those two verticals..

Yeah. Good morning, Troy. First of all, I think both medical and aerospace are a good example for industries which are very well suited for additive manufacturing in the way – in the state of their technology today and in the future, typically short run, high level of customization.

So naturally those two industries are a very good fit, specifically in Stratasys, that we talked about it in previous calls. We established already, I think, 2 years, 2.5 years ago, a very strong team within Stratasys which is dealing specifically with vertical markets such as aerospace and medical.

And I think a very good job that was done there, pushed sales and like I said in the script, in both markets we experienced growth year-over-year as a result of those efforts. More specifically, if you just want more point about aerospace, I think the opportunity for Stratasys in aerospace is very, very big.

I think our current technology is very suited for a lot of applications, specifically within cabin application and manufacturing. And putting all this together is the reason for the success and continued success in those segments..

All right. Understood. And then a follow-up of Erez here, just on the gross margin side, you guys did a great job this quarter getting the gross margins up. You're already kind of above your range for the year. If I look back historically, you guys have been in the high 50%s, even low 60% gross margins.

So just curious to know if the mix, if the cost structure or cost reductions drive upside to the gross margins above this 54% to 55% range this year?.

Troy, good morning. The gross margins that we finished this quarter is the result of a few issues. The first one, absolutely different product mix and a little bit higher consumables revenue compared to the mix that we faced in the past.

A job or work that we are doing in production flow in order to try and improve efficiencies in production and optimize productions activity. Looking forward into 2016, I wouldn't change the range.

I think that the move for outsourcing, which we started MakerBot, but we are doing in the other part of the company, will result in better gross margin probably toward the end of the year or beginning of 2017. It will take time and meanwhile it will cost us a little bit of money to do it.

So I would keep the overall range of gross margin for 2016 as it is. Keeping in mind that we are doing better job in production's efficiencies and capacity, which is somehow offset by the work that we are doing trying to move outside some of the production at Stratasys..

All right. Understood, guys. Good luck..

Thanks, Troy..

Thank you. The next question is from Ben Hearnsberger of Stephens, Inc. Your line is open..

Hey, thanks for taking my question. This is Brandon in for Ben. Just real quick on the core revenue growth, what kind of assumptions are baked into the guidance? What's your outlook here for core growth? Thanks..

Ben, this is Shane. We don't break it out between the core growth being – all the revenue excluding the MakerBot and SDM, so I think it's generally speaking the comments that we've made around the business really apply to all components of our business.

Obviously, as we mentioned on the call, we saw some improvements in MakerBot in the quarter, but we don't really break out the two segments..

Got it. And then just a quick follow-up on MakerBot. Given your outsourcing to Jabil, and the changes to cost structure, what internal run rate I guess, ballpark, are you guys trying to hit to kind of get your margin targets in that line? Thanks..

Again, we didn't provide a standalone revenue guidance to MakerBot. But the move is more strategic one and longer-term rather than a short-term impact on next quarter. It provide us flexibility. It shifts the cost structure from a fixed cost to variable cost.

It will probably provide lower cost of operation and higher quality of product once we finalize the move..

Got it. Thank you much..

Thanks, Ben (sic) [Brandon]..

Thank you. The next question is from Patrick Newton of Stifel. Your line is open..

Yeah. Good morning, David and Erez.

Maybe just to ask Troy's gross margin question from earlier differently is, one is in the near term, if we look at 2016, can you help us what would cause gross margin to actually decline from Q1 levels back into the range of 54% to 55% for the full year? Because it just seems like you have mixed tailwinds, benefits from operational improvements in that product gross margin, so there's room for upside.

And then the longer term, you posted close to 60% full-year gross margin in the past.

Is that – is there anything structurally within Stratasys that would preclude you from working towards that level over the next couple of years?.

Hi. Good morning. It's Erez. Again, in Q1 we saw a product mix that was highly favorable toward high-end product and higher margin product. And if I'm looking at 2016 and looking at the gross margin result, I'm sure that a) we will continue to do improvement on efficiency and production flow.

However, in order to maintain those current existing gross margins, we would have to face the same mix of product and consumables versus hardware that I cannot say today that this would be the mix. This is one. The second one is the move up in some of the production outside cost money. Before we see the benefit it would cost us money.

It's not yet reflected in the Q1 gross margin. It will have an impact in Q2 probably and Q3 until we finally finish the move. As for the future, traditionally, historically 60% gross margins, we're relying on a very high weight on high-end product, which clearly have significant gross margin.

The product mix that we see today is different than in the past, but I would say that looking into the future with existing product mix and after we conclude the move from production outside, we should expect a better gross margin above 55%. I'm not sure it's going to 60%, but about 55%..

Great. And then as my follow-up I guess for David, you talked about the VBUs or I'm sorry, vertical business units outperforming non-vertical areas in the quarter.

Can you help us understand the percentage of the revenue that's running through your vertical business units currently?.

Again, we do not disclose the breakdown, but going forward we already see today, we expect that those segment of activity should grow faster than the overall business. I think as technology will improve, our go-to-market will become more specialized. The acceleration in those areas should be more visible.

But as I said, we're not giving the breakdown between those..

Great. Thank you for taking my questions. Good luck..

Thanks, Patrick..

Thank you. The next question is from Paul Coster of JPMorgan. Your line is open..

Thanks for taking my question. David, I just want to drill down into this apparent focus on desktop and prototyping.

I'm just wondering, is this an observation about Stratasys' business or about the industry? If it's a shift, what is it a shift from? Is it a shift from the Objets and Dimensions back to MakerBot? And if that is the case, it might not be, then is this good or bad? I mean, it sounds like we're going into lower ASPs, more competitive environment, less consumables.

Your thoughts on all of the above, please..

Okay. So, first of all, I tend to believe and if you read the last, for example, Wohler's report, the growth in desktop is impressive, and it's covering all the world globally, number one.

We don't – I think we mentioned on the previous call that when we analyze the overall penetration into rapid prototyping, our conclusion was that the penetration, although is impressive, is still very, very low, if you look on a global basis. Going forward, the market will continue shifting.

There will be a lot of desktop printers which will be used by engineers and designers and students as a desktop device.

Nevertheless, we believe that if we – they try it and we expose the synergies between desktop users and high-end product users, there's still a lot of room to grow also for the high-end product that traditionally was sold by Stratasys, like the Objet printers, the Connex printers and the Dimension and uPrint-like printers.

So I think if you look at the analogy of the printing industry, you see a lot of desktop printers in the industry and you see a lot of professional printers which are doing the most sophisticated more demanding work.

I think that this differentiation in our market is going to be more significant because I think the difference between the basic jobs and the high-end jobs is more dramatic in compared, for example, to the printing world.

So I think that if managed correctly, and I said it on the script, I think that we are by far the company with the highest potential to benefit from this trend as long as we do it right because we are leading on both sides. Okay? So this is basically my answer..

And then so I still don't know if I understand what it means in terms of product mix, but it sounds like there's a shift back to MakerBot. And then if that's true, what does that do to your channel strategy and how you incentivize the channel's to take inventory and so on? It sounds like it's going to require a shift..

All right. First of all, I'm not sure I agree with you, with your statement that there's a shift to – both markets should grow. Obviously, and you see today in the numbers, the desktop market, from point-of-view of units, is growing dramatically faster than the high end 3D printers, which I think is natural.

Like I said earlier, I believe both should grow. To your question regarding the channel, today MakerBot has its own channel, or channels. Stratasys with the high-end products has its own channels.

But nevertheless, we are exploring today synergies between those activities because as I said I think that we believe that desktop printers are very good candidates for buying high end machines as they explore the technology and they understand that they have more need what desktop can provide today or in the future..

Okay. Thank you..

Thanks Paul..

Thank you. Yes, the next caller is Shannon Cross of Cross Research. Your line is open..

Thank you very much. Good morning. My question is basically on to start with for David is on the competitive environment. There have been a number of changes and obviously some coming. New CEO at 3D Systems, launch of carbon printers, and the coming of HP at some point here.

Curious as to what you're hearing from customers? How you are thinking about sort of positioning yourselves to save some of the new competition and some of the unknown out of 3D Systems?.

If it's okay with you, I prefer not to talk about the competition. I think Stratasys is well positioned to deal with the increased competition. I think we're doing the investments in the right areas to have the best products from desktop to high-end rapid prototyping to end-use parts manufacturing products. The market will become more competitive.

On the other hand, the market is very, very large. So I think there's a space for everyone. As I said, we are leading today in almost every segment and we're doing the right investment to continue leading..

Okay. Great.

And then I guess for Erez, can you talk a bit about channel inventory? I'm just curious as to within the various distribution channels that you have in consumables versus printers, just how are you feeling about the channel inventory? And perhaps if you could give us some color on how some of your new systems are helping you manage it, especially from a MakerBot perspective?.

So good morning. We manage channel inventory relatively close and tight. I don't think that there's any issue with the channel inventory in Stratasys business. We do not allow, do not permit to keep our inventory above any level that we think is the right one to the business. And if this is by any chance being done, it's not part of our revenue report.

And in general what we saw in the last few quarters is reduction in channel inventory which is in line with the business result that we see in the market. Meaning we see lower activity, and lower demand, and lower inventory in the channels, which is in line and makes sense to us..

Thank you..

Thank you. The next question is from Sherri Scribner of Deutsche Bank. Your line is open..

Hi. Thank you. I just wanted ask a big picture question. It sounds like you commented that the macro challenges remain and demand is still uncertain, there's not a lot of visibility, but you reiterated your guidance.

Can you – it really sounds like things are about the same as they were three months ago and we haven't seen a substantial improvement in demand.

Is that fair?.

Yes, Sherri. Good morning. It's Erez. It is fair, and we said it also in the guidance of 2016. We do not plan for a better 2016 compared to 2015 in terms of top line, and there is no change in our planning.

But we do communicated that you should expect a better performance in term of profitability and cash flow compared to 2015 even though the business environment is without change (43:42)..

Okay. Great. And then thinking about the addition of adding Jabil to manufacture the printers for MakerBot, when should we start to see some cost improvement as a result of the Jabil partnership? And are we going to mostly see that in cost of goods sold? Or are there any opportunities in operating expenses? Thanks..

So it will take time to see the Jabil impact on our financial report. I guess as of the beginning of 2017, so the first quarter of 2017 we'll have the opportunity to enjoy a better profitability margins on the MakerBot product. It's mainly, Sherri, it's mainly not only but mainly around the cost of goods sold.

There is some G&A leverage here around facility and other items, but not significant ones. The entire or the majority of the improvement is going to be on the cost of goods sold..

Thank you..

Thanks, Sherri..

Thank you. The next question is from Jason North of Jefferies. Your line is open..

Hi. Congratulations on a good quarter.

When I'm looking at the full year guidance, especially where GM is now and looking at the midpoint of revenues, would it imply that OpEx would be flat to up from here throughout the rest of the year? Is that the right way to look at it?.

Yeah. Jason, I would look at relatively flattish OpEx numbers for the remainder of the year..

Okay. And then diving into it, for Q1 for Asia-Pac was pretty strong for you.

Can you give any additional details?.

I wouldn't say pretty strong. All the regions were according to our plan. We didn't see any significant change neither positive nor negative in the business activity in none of the regions. Again, I wouldn't say it was relatively strong.

It was in line with our plan and we do not see any different market behaviors in APJ compared to, for example, North America and EMEA..

Okay. Thank you..

Thank you, Jason..

Thank you. The next question is from Ananda Baruah of Brean Capital. Your line is open..

Hey. Thanks, guys, for taking the questions. I guess, just two quick ones, if I could, with regards to the prototyping dynamic sort of shifting downstream that you were referring to.

So David and Erez, are you guys actually saying that you're beginning to see in a bigger way MakerBot capture sales or be purchased and used for prototyping activities that the higher end machines were previously used to? So are you saying that you're actually losing some higher end sales while picking up some incremental MakerBot sales? And then I have a follow-up.

Thanks..

Yeah. Let me clarify. The desktop printers, including MakerBot, are becoming over time more and more suitable for what we describe as maybe lower end rapid prototyping application, mainly concept modeling.

Okay? And some customers that would like to experiment with the technology might start their journey with the desktop printers and doing concept modeling in a reasonable good quality.

Okay? Like I said, I answered earlier, we see it as a challenge and an opportunity because we know for fact that customers which are buying desktop printers are electing many times, sometime after the beginning of using this technology to buy higher end printers because they realize that they need more functionality, they need color, they need speed, they need different materials.

There are many, many advantages for the higher end printers. So it's a kind of a new maybe market environment. But because of the overall low penetration of rapid prototyping in general, we believe it's an opportunity. And as I've said already a few times during the call, I think we're the best suited to enjoy it..

That's helpful. And just as a quick follow-up, can you remind us if MakerBot is recognized, if you recognize the revenue on sell-in or sell-through. And then what specifically are the challenges in that dynamic, David, that you've referred to a couple of times? Thanks. Those last two and that's it for me. Thanks..

I will start with the second part of your question. The challenge is to be able in a smart way work together on the go-to-market between MakerBot and Stratasys to identify those customers that are a good candidate to buy high-end machines.

On the other hand, make sure that MakerBot is continuing to be the number one brand in the industry and make sure that they capture the opportunity in the desktop segment. And if we do those well, we will definitely continue leading this segment, the rapid prototyping segment of the industry..

And then the sell-in versus sell-through on MakerBot, rev recognition..

It's revenue recognition according to sell-in, so once we ship it, we ship the product to the resellers with a very tight control on the level of inventory held at the channel..

Thanks so much, Erez. Thanks, guys..

Thanks, Ananda..

Thank you. The next question is from Brian Drab of William Blair. Your line is open..

Hi. Thanks for taking my questions.

First within services, could you give us any color on what you're seeing in the paid parts business and whether that grew year-over-year or sequentially?.

Yeah. So we didn't break out the number of the service business, but I think that a) you have to understand the environment we are coming from, when we compare it to the previous year which was extremely busy in term of integration and post-merger integration for the entire service business.

I think that our focus on long-term growth and the integration of this business with our broader strategy of combining our wide ranging capabilities into a solution based business model is what we are looking at in SDMs. It's difficult to compare SDM to different or other businesses given the size of SDM, a very large business today.

What we saw in Q1, better margins as a result of more profitable job that flied in (51:01) to SDM..

Okay. Okay. Thanks. I'll leave that one for now. And could you just talk a little bit about what your goal is in the outsourcing of Maker manufacturing? I doubt that you'd want to tell us where Maker gross margin is today and where you're planning to get it to, but that's what I'm looking for.

So maybe you could tell us just roughly how many basis points of gross margin expansion you think you can get from this initiative?.

Again, we didn't break down the gross margin of MakerBot. I can tell you in very high-level two reasons for the move. The first one, cost reduction. In a significant cost reduction around the cost of goods sold, too.

And a higher flexibility to the business model of MakerBot and Stratasys, providing that this is a business which probably will help to deliver high amount of boxes in the future, we want to make sure that the entire business model is focused on the right things and allow us to deliver high quality product in the right time.

And those quantities and expertise, I think, we found with Jabil as a partner to this outsourcing activity..

Okay. Thank you..

Thanks, Brian..

Thank you. The next question is from Jim Ricchiuti of Needham & Company. Your line is open..

Hi. Thanks. Just a question on the growth that you're seeing in the medical and aerospace and in general the focus on the vertical markets.

Are you seeing the same trends in these markets? That is, are you seeing an acceleration in desktop units within this market as well for concept modeling applications? Or are you seeing more traction on the higher volume additive side?.

The increased or the growth in both medical and aerospace, and the other – by the way, other verticals that we're focusing on such as auto and others, is more and more driven by our move, which is part of our strategy to be able to manufacture end-use parts and to move into manufacturing, okay? So this statement is not related to our previous statement talking about the great expansion in desktop.

It's more a very industry-oriented, focused on a very large variety of applications which are targeting end use parts..

Okay.

So as we see this continued acceleration and as you expand this vertical market strategy, presumably you're going to see a shift again toward higher volume machines?.

Yes. This is my expectations. Again, the growth is going to be driven by our increased penetration into manufacturing and end-use part applications..

Okay. And Erez....

Sorry. While growing also rapid prototype. It's not contradicting? I mean, the same companies will adopt also desktop printers to do concept, and will adopt high-end Connex and J750s for their high-end prototyping. It's not one on the account of others. It's an area which is growing faster. It does not mean that other areas are not going to grow..

Understood. Erez, just on the R&D side, it sounds like you've given some guidance for OpEx.

How should we think about the R&D component this year given where you're starting from?.

So I think it will be relatively flat compared to the level in Q1. And again, we made some changes in R&D, moving money and focus on some product to other direction, focusing on really strategic project that we see in front of us and are important for the strategic long-term direction of the company.

I wouldn't expect a significant increase or decrease in R&D in the rest of the year..

Thank you..

Thank you. The next question is from Kenneth Wong of Citi. Your line is open..

Hey, guys. Thanks for taking my question.

I guess, a follow up on the impact of desktop printers on the business, have you seen that particular trend play out on your services business at all?.

I don't have the numbers to answer this question. But I think it's a fair assumption to say that basic concept modeling, again, will move to the desktops. So I think over time it will have also impact on the service bureau, not only on our service bureaus.

Nevertheless, the service bureaus, like the rest of the industry is growing more and more into manufacturing applications, which I think will be able to compensate even more for the small decrease in the work which is done today for concept modeling..

I would add maybe that at least the service bureau that we run today is more focused on more complex applications..

Right..

Weighted toward end use parts, and as David say, it's really difficult to calculate, to measure and to quantify the impact of desktop on concept modeling, and as a result on the service bureau. But the service bureau in Stratasys is more weighted toward complex applications..

Got it. That fair.

And then on the Jabil relationship, I guess beyond MakerBot, do you guys see an opportunity to outsource production of any of your other product lines?.

So outsourcing is part of our strategy in Stratasys. We started in MakerBots. We are, I would say, in the process of evaluating the ROI and the benefit from outsourcing other activity in Stratasys.

We have some outsourcing activity going on in Stratasys today, but in order to develop it further to significant activity, we want to make sure what's the ROI, what does it mean? And if it makes sense with – and where it makes sense for Stratasys today..

Yeah. Got it. And the last question from me, guys. You guys saw a nice little inflection on the consumables growth. That popped up from flat in the back half as you mentioned.

Should we look at the growth in consumables as a good way to measure whether or not you guys have started to work off some of that excess capacity that you guys have spoke of in the past?.

David?.

I'll take it. It's a very difficult question. I think the growth in consumables is a good indication to the utilization of machines. The breakdown in allocating the gross utilization between the – sorry, the ability to break down the increasing consumption between the natural growth of the installed base and the increased utilization stuff.

From our analysis we see both. We see both increase in – which is resulting from the increase in installed base and increased utilization. It might be, because the numbers are small, it might be an indication that customers are using the machines more, yes..

Okay. Great. Thanks a lot..

Thank you. We have time for one more question. The last question is from Rob Stone of Cowen and Company. Your line is open..

Hi. Thanks for fitting me in. A follow-up for Erez. You mentioned that transition of MakerBot to Jabil is going to cost you some money (58:34). Is that something that's reflected in gross margins? Or is that part of the restructuring that's noted in the guidance? And then I have one follow up..

It's part of – it's going to be part of the cost of goods sold and the gross margin guidance that we provided. Some of it – small amount is part of the restructuring cost guidance that we have provided for 2016..

Okay. And you've highlighted the impact on taxes (59:06) from the valuation allowance.

Can you provide any color on what you think your effective tax rate will be beyond 2016?.

Currently I would assume that the tax valuation allowance will continue to take place beyond 2016. Again, I want to mention that this is purely accounting provisions. We have a tax asset that we will be able – a tax process that we are able to use in the next I would say 20 years. And we think that we'll be able to utilize them.

But again, the assumption for beyond 2016 as we see it now should be that we will continue to record a tax valuation allowance..

Okay. Thank you..

Thank you. And at this time, I'd like to turn the call back over to David Reis for closing remarks..

Thank you for joining today's call. We look forward to speaking with you again next quarter. Thank you, and goodbye..

Thank you. Ladies and gentlemen, this concludes today's conference. You may now disconnect. Good day..