Dan Schumacher - Proto Labs, Inc. Victoria M. Holt - Proto Labs, Inc. John A. Way - Proto Labs, Inc..

Brian P. Drab - William Blair & Co. LLC Troy D. Jensen - Piper Jaffray & Co. Gregory William Palm - Craig-Hallum Capital Group LLC Ethan Potasnick - Needham & Co. LLC.

Greetings and welcome to Proto Labs' Fourth Quarter and Year-End Earnings. At this time, all participants are in a listen only mode. A question-and-answer session will follow the formal presentation. I would now like to turn the conference over to your host, Dan Schumacher. Thank you. You may begin..

Thank you, operator, and good morning, everyone. With me today is Vicki Holt, our President and Chief Executive Officer; and John Way, our Chief Financial Officer. This morning before the market opened, Proto Labs issued a press release announcing its financial results for the fourth quarter and full year ended December 31, 2017.

The release is available on the company's website at protolabs.com.

Before we begin, I would like to remind everyone that our discussion will include statements relating to future performance and expectations that are or may be considered forward-looking statements and subject to many risks and uncertainties that could cause actual results to differ materially from expectations.

Please refer to our earnings press release and recent SEC filings, including our Annual Report on Form 10-K, for information on certain risks that could cause actual outcomes to differ materially and adversely from any forward-looking statements made today.

Additionally, the results and guidance we will discuss include non-GAAP financial measures consistent with our past practice. Please refer to our press release within the Investor Relations section of our company website for a complete reconciliation of non-GAAP to GAAP results.

Now, I'd like to turn the call over to Vicki Holt, President and Chief Executive Officer of Proto Labs.

Vicki?.

grow revenue by expanding our customer base and penetrating our existing customers; enhance our capabilities by expanding our services; and increase the scale of our operation, including the integration of RAPID Manufacturing. Let me take a minute to describe each priority.

Our first priority is to continue to evolve our sales approach and engagement with our customers to drive revenue growth. This is a journey we've embarked on over the past few years and it's one that we will continue far into the future.

Serving our customers effectively requires us to continue to both enhance our world-class e-commerce experience and deepen our relationships with customers where our value proposition resonates most.

Our sales management team, including new leadership, will guide a disciplined execution of our sales book and use of automation tools to improve productivity. Enhanced tools will be utilized to align sellers with highest opportunity customers using data and analytics. This will increase revenue and improve sales efficiency.

Sales and marketing processes will be integrated and aligned to effectively sell all our new services. Enhancing our capabilities by expanding our services continues to be a significant initiative in 2018.

We will continue to expand the envelope of both the parts we produce and the services we offer with the objective to provide a more total solution to our customers. And our last priority is to increase the scale of our operations.

This initiative starts with the integration of the RAPID Manufacturing business in North America and expanding the capacity of these services. Our teams in New Hampshire and Minnesota have made measured progress on gaining alignment and establishing integration plans.

Our Proto Excellence process improvement teams have already held joint Kaizen events and project planning is being executed to expand manufacturing capacity of Sheet Metal service, integrate our complementary CNC offerings and develop the go-to-market approach to capitalize on our expanded service portfolio.

We will continue to refine and execute on these plans as we go through the year. I am very proud of what our employees accomplished in the past year and look forward to the successful execution of our initiatives in 2018. With that, I'd like to turn the call over to John..

Thank you, Vicki. Revenue in the fourth quarter was $94.2 million, an increase of $21.8 million or 30% over the same quarter in 2016. As Vicki discussed, our revenue growth this quarter benefited from $3.6 million of revenue from our RAPID Manufacturing acquisition. In addition, foreign currency represented a $1.3 million benefit in the quarter.

Adjusting for these items to arrive at a comparable basis, revenue grew 24% over the fourth quarter of 2016. Fourth quarter revenue was generated from serving 16,985 unique product developers. This represented a 21% increase over the fourth quarter of 2016.

Gross profit for the quarter was $52.9 million, an increase of $12.6 million over the comparable quarter of the prior year. Gross margin was 56.2%, or 56.8% excluding RAPID. This compares with 55.7% in the fourth quarter last year and 56% in the third quarter of 2017. Our gross margins were positively impacted by our strong revenue growth.

Operating expenses totaled $34.1 million or 36.2% of total revenue in the fourth quarter of 2017. Our operating expenses included a couple of one-time non-recurring charges in the quarter. First, we incurred $1.9 million in transaction costs associated with our acquisition of RAPID.

We also recorded a $500,000 asset impairment charge related to our European operations. As we have discussed in the past, our European 3D Printing gross margins are below our expectations. This charge is the result of analyzing our operations and identifying opportunities to reduce our ongoing cost structure.

These expenses resulted in an increase in operating expense as a percent of revenue compared to prior periods. On an adjusted non-GAAP basis, operating expenses were 31.3% of revenue in Q4 compared to 31.7% in Q3 and 33% in Q4 of the prior year.

Sales and marketing expense remained relatively consistent at 16.3% of revenue compared to 16.5% in the fourth quarter last year.

Operating income was $18.8 million in the fourth quarter of 2017 compared to $14.8 million in the same quarter of 2016, with the increase driven by higher volume, slightly offset by investments in sales and marketing, acquisition costs and other operating expenses.

Adjusting for the transaction costs, impairment of assets, stock-based compensation and amortization, our adjusted non-GAAP operating income was $23.7 million or 25.1% of revenue compared to $16.7 million or 23.1% of revenue in the prior year, representing 41% growth in adjusted operating earnings during the quarter.

Our effective tax rate was 25.7% in the fourth quarter. This rate includes an estimated $1.8 million net tax benefit as a result of the Tax Act in the current period.

This benefit consists primarily of a $4.3 million benefit from the revaluation of our net deferred tax liabilities, offset by the estimated effect of deemed repatriation of foreign earnings totaling $2.4 million. Excluding the current period impact of the Tax Act, the effective tax rate was 35.4%.

As Vicki stated, our non-GAAP EPS was within our guidance range for the quarter at $0.58 per share. As we look at the full year results, revenue was $344.5 million, a 15.6% increase over 2016. Looking at revenue by region in constant currency, the U.S. grew 17.5%, or 16% excluding RAPID. Europe's growth was 10.3% and Japan grew 8%.

Our operating income for the year was $72.2 million or 21% of revenue compared to $61.8 million or 20.7% in 2016. On an adjusted basis, our operating income was $83.7 million or 24.3% of revenue. This is a 17.8% increase from 2016. Now turning to our cash flow. We generated $81.7 million in cash from operations during the year.

Capital spending was $32.6 million during 2017. This capital spend is below our historical levels as is generally the case in years in which we do not have facility expansions. Acquisitions resulted in the use of $119 million in cash.

We established a line of credit in conjunction with the RAPID acquisition to provide financial flexibility and utilized $5 million under this line during the quarter. We ended the year with a cash and marketable securities balance of $131 million. Now turning to guidance. During our Analyst Day Meeting in December, we gave full year guidance for 2018.

We are revising that guidance solely due to the U.S. tax law changes. As a result of the Tax Act, we estimate our effective tax rate will decrease substantially to 23% to 24% and will add approximately $0.30 per share to our annual earnings.

With this updated information, we are reiterating our annual revenue guidance of $425 million to $450 million and increasing our 2018 annual non-GAAP EPS guidance to $2.70 to $2.90 per share. Now I'd like to turn to our expectations for the first quarter of 2018.

We currently expect Q1 revenue to be in the range of $101 million to $106 million, or growth in the range of 26% to 32%. This revenue guidance reflects the following factors. We estimate foreign currency will have an approximately $2 million positive impact on our Q1 revenues. Q1 will also benefit from a full quarter of revenue from RAPID.

Moving to earnings guidance. Our non-GAAP add-backs for the quarter will include stock compensation cost of approximately $2.2 million. We are in the process of finalizing the valuation of our intangible assets associated with our acquisitions and currently estimate first quarter amortization expense of approximately $1 million.

We currently estimate our tax rate to be approximately 23% to 24% in Q1. Taking into consideration all the above, we expect our quarterly non-GAAP EPS to be between $0.64 and $0.70 per share in the first quarter. That concludes our formal remarks. Now we would be happy to take your questions..

Thank you. Our first question is from Brian Drab with William Blair. Please state your question..

Good morning. Congratulations on a great quarter and a great year..

Thanks, Brian..

Thanks, Brian..

Kind of exciting to be forecasting quarterly revenue that starts with 100-and-something, so congratulations..

It definitely does..

Feels good..

Yeah. So, John, just a quick clarification.

You said on the tax rate for the consolidated company tax rate for 2018 you're expecting what?.

23% to 24%..

Okay. I wasn't sure if you had said U.S. or consolidated on that 23% to 24%..

Yeah, that's consolidated..

And then on Alpha, I don't know if you gave us the figure this quarter in terms of what type of headwind Alpha was on gross margin for fourth quarter 2017?.

It was a little under 200 basis points. I think that it's been relatively consistent over the last couple quarters. I think, as we talked about, we're taking a close look at those operations and looking at the underperforming assets.

And in doing so, we identified some assets that were basically took an impairment charge on to write down the value of those assets to fair market value. So, yeah, that continues to be an area of focus for us..

Okay.

So, I guess, maybe 180 basis point, 190 basis point headwind this year?.

Yeah, right in that range..

Okay. And then, I guess, maybe for Vicki.

Can you talk in a little more detail on what type of interest, what level of interest you're getting in the quality analysis first on the digital side in-house and then outside with the full quality analysis at the third party?.

Yeah. We continue to get orders. I mean, it comes as part of our on-demand manufacturing service orders for inspection reports and it's fairly mixed. We've got a lot of traditional first article inspections and PPAPs that come through.

But more and more customers are becoming comfortable with the digital manufacturing or the digital inspection report as a really valuable and lower cost ways for them to get the kind of quality data they need. So we're seeing some pickup in that. We're pleased with that.

The overall response for us having a full suite of inspection services has been good..

Okay.

There's no way you can say, like, what percentage of orders at this point or is it just – it's still in the very early stages, is that how we should think about?.

Yeah. It's early, but very possibly. And this is an area that had been a what I would call source of objection by our customers because we didn't have that. Well, that objection is no longer in place and so it really is helping our sales team be able to drive closes.

It was a key part of our envelope expansions to become more of a total solution provider and be able to try and provide what we really call the full specification of what the customers need..

Okay. And then maybe just two modeling questions probably for John.

But CapEx for the year and the timing of the CapEx and the plan in terms of facility expansion, just all the timing of that?.

Yeah. So, in 2018, we will have a facility expansion in the U.S. that will occur likely in the first quarter and then we'll have build-out of that facility through Qs two and three.

We are still going through the integration planning with regards to RAPID and depending on our anticipated growth there, we likely will be looking to expand our space there. That timing is uncertain. And we'll also be looking at expansion in Europe and adding to our facility space there.

All in all, our current estimate as we look at 2018 is approximately $80 million in capital just because of the level of expansion we're looking at..

Okay.

And, I guess, is it reasonable to estimate that margins might take a tick down in maybe the, I don't know, first quarter, second quarter as a result of some of the shifting around that you're doing in capacity or disruption?.

So, yes, we'll keep updating you as we give our quarterly guidance, as we look at it. I think we'll have a little bit of costs here in Q1 as we're looking at the facility, but that is reflected in the guidance we gave..

And we'll keep you posted on the timing of the actual transition to the new facility, which we'll probably incur some costs as we move equipment between facilities and start up the new facility, but that'll be later in 2018 and we'll keep you informed as part of our quarterly guidance..

Okay.

And then my last quick question here is, selling and marketing in this new structure where we have RAPID in the numbers, it was like 16% on non-GAAP, 15.9% is what I'm trying to model here for non-GAAP for fourth quarter, is that a level that we should expect for 2018?.

No, I think it's in a reasonable range. I think fourth quarter was a little bit higher for us just with the year-end commissions and as we are hitting quotas and some accelerators. But as we look forward, it will probably be just a touch lower than that, but within that range..

Okay. Thank you. I'll get out of the way. Congrats, again..

Thank you..

Thanks, Brian..

Our next question is from Troy Jensen with Piper Jaffray. Please state your question..

Hey, also congrats on another great quarter..

Thanks, Troy..

Thanks, Troy..

Hey, so John, let me press you a little bit on guidance here.

So, for the March quarter, are you assuming about a $10 million contribution from RAPID?.

That's in the right range. Probably $1 million more than that, but in that range..

So then if you – can you just kind of help us out with what the margins will look like with a full quarter of RAPID here? I mean, you didn't see any dilution really in the fourth quarter on a sequential basis with the third quarter coming in, but any thoughts on where gross margins will be in Q1?.

Yeah. So RAPID did have about a 60 basis point impact in the fourth quarter. That was just one month of RAPID included. So, as we look at the full quarter, we're probably looking at about 200 basis points margin compression overall..

Maybe 120 basis points sequential, right, because you had one quarter and – one month in December and three months in?.

Yeah. And Q4 margins were strong on higher revenue. I think I'll remind you that we kind of staffed to our projected revenue levels. When revenue comes in a little bit higher, we get helped out a little bit on the margins.

Q1 is an interesting quarter for us, just as things flow through the month of the quarter, and it's always easier to manage your expenses and do your planning if the months are at level and consistent here we've got a little bit more of a, March tends to be a stronger month for us. So we will be watching that..

And to that point, that was the second part of my question. If I back out RAPID from March and December, the midpoint is about 2% sequential growth organically herein. Historically, I mean, Q1 has been a very big quarter for you guys. You're coming off of the quarter that's got the holiday seasons in it.

So, is conservatism baked in there or can you just kind of explain why we're not seeing a bigger kind of sequential growth, which we've seen historically?.

Troy, I guess, looking at it sequentially is hard to predict and is very much influenced by what happens in Q4. So, with a very strong Q4, it's harder to say that the sequential lift will be there. I think there is – as we look at it, we do our projections based on a number of data points and the historical trends and everything we're looking at it.

We give the guidance for the quarter based on the best information that we have. March is usually our biggest month in the quarter and as we sit here today, we don't have any visibility to it..

Great. Okay, completely understand.

And then as for Vicki, can you talk a little bit about the software acquisition you did in the quarter? What type of functionality is this going to add?.

Yeah. So this is a relatively small software company that we actually have been incorporating some of that software technology into our manufacturing engineering systems and manufacturing execution software for some time now for several years.

And the time was right for us to actually bring that into the portfolio and be able to continue to leverage that technology across both of those aspects of our manufacturing.

So the software plays a role in some of our software in both the engineering services, which is more the frontend part of our software, the quoting, the feature recognition of CAD and then how it flows through and then also on the manufacturing execution side.

We're really excited about being able to do that, picked up a couple of strong software engineers as well, then be incorporating that more and more into our technology and leveraging that further..

Okay. And last question for me. Can you just talk about CNC versus Injection Molding. I mean, CNC seems like you've seen a big inflection in the business, even if you strip out the RAPID business. Just kind of wonder why Injection Molding is not growing as well.

Could it start to see some acceleration or have you been focused more on pushing – I can't imagine you've been pushing CNC more than Injection Molding?.

Yeah. As you know, as we said before, we have a suite of services that we put in place to really meet the needs of our customers, so we don't really push one versus the other.

We did make some investments about a year ago, a little over a year ago in some software enhancements that I think has really allowed us increase some of the competitiveness and the range of what we can provide with CNC Machining. So you're seeing that impact in really strong year-over-year growth in CNC Machining.

In Injection Molding, we're really pleased to see the growth rates begin to pick up from where they were in 2016 in that service. And one of the big contributors we think on Injection Molding is the launch of our on-demand manufacturing service here in North America. We'll be launching those services outside of North America in 2018.

And what that does is it really allows our service to be well-positioned beyond just prototyping in Injection Molding. By far, the larger portion of the total available market in Injection Molding is in on-demand manufacturing.

In our case, low volume production is where we're focused, not large volume, but we'll be allowing our customers to really use our service for a product that they have that are relatively low volume and do that very cost-effectively.

So that move is going to allow us to maintain those double-digit growth rates with Injection Molding going forward and we're really pleased to be much more than just a prototyping company and Injection Molding and that's been an important strategic step for us..

Yeah. Understood. Congrats, again, and keep up the good work..

Thank you..

Thanks, Troy..

Our next question is from Greg Palm with Craig-Hallum. Please state your question..

Good morning. I'll echo my congrats as well..

Thanks..

Thanks, Greg..

So it's been a couple months to digest RAPID, so just wanted to get your initial thoughts there and maybe more importantly, what's the feedback then from their customer base, your customer base?.

Yeah. So we are almost exactly there about two months. We closed on December 1. And so, as you can imagine, it's a lot of the first activity, we bought a privately held company, so we had to be putting in place a lot of the controls and the approaches to make sure that we're operating in a way that's consistent with a publicly traded company.

So we've gotten a lot of those things accomplished in the integration plan. And then the other piece that we've been focused on is, is really jointly with the RAPID Manufacturing team, we picked up a great group of employees there in New Hampshire.

We've been developing joint plans on how we can expand our manufacturing capacity for Sheet Metal and our new CNC Machining capabilities in order to meet the demands of our customers.

We have not turned on in any significant way a lot of joint marketing and sales yet because we want to make sure we've got the capacity in place to meet those demand at the level of services that Proto Labs brand guarantees. So we've been working a lot on those plans and beginning to execute on those.

Early reaction from our customers, they're pleased to see us add Sheet Metal. So that's something that we were doing some trialing in 2017 and that's a service that many of our customers use. So it's been positive.

There's been positive on both sides of the customer base, but we really haven't opened the spigot in a big way yet on cross-selling until we've got the capacity in place..

Got it. Maybe shifting gears to the 3D Printing segment. I feel like that's maybe been a segment that's sort of, I guess, lost focus over the last few months, I mean, especially with the growth in the core and the RAPID acquisition.

But has the outlook changed at all in terms of growth and maybe you can update us on the competitive landscape compared to maybe 6, 12 months ago?.

Sure. Greg, so I think what gets lost in the reported numbers in 3D Printing is really we have a tale of two businesses. In the U.S., we're growing strong and we're performing quite well. In Europe, I think growth is harder to come by.

And I think that partially is related to the competitive landscape and the market pressures that are taking place and just the dynamics in Europe. But I think as you look at it and just peeling back the onion a couple layers, the U.S. is doing quite well and we continue to expand the services we provide there.

We're looking at the European operations, we'll be launching our Multi Jet Fusion here in the first quarter in Europe to help capture some of that share and continue to look at differentiated offerings..

Yeah. The word deemphasize is, is really should not be characterized by our 3D Printing. It's a major service for us, one we continue to focus in, and a big source of lot of our R&D investment with new services is being focused on 3D Printing and that is witnessed by the envelope expansions that John mentioned..

And I know you've talked, I guess, lately about sort of aggressively opening up somewhat with these newer technologies.

Do you think this helps you gain share? Does it open up new use cases applications, how are you kind of thinking about that opportunity?.

Yes. I do believe that some of the new technologies that are now being developed, we're working with some of them that are not yet commercialized, but will allow customers to expand what they can do with 3D Printing. It's still very new for engineers. Engineers are only just learning how to design for 3D Printing.

So very, very early in the adoption of this technology broadly by product development engineers. But Proto Labs in a great position to help those engineers understand the technologies that are out there and understand which ones make sense for which applications.

And that partnership that we're developing with customers on 3D Printing is continuing to grow because of the technical breadth that we're able to provide the kind of services that we offer..

Yeah. Makes sense. That's it for me. Thanks and good luck..

Thanks, Greg..

Thanks, Greg..

Our next question is from Ethan Potasnick with Needham & Company. Please state your question..

Hi. Good morning. This is Ethan Potasnick filling in for Jim Ricchiuti.

I was wondering, could you go back – and I think you mentioned this earlier, are you guys able to quantify in any way the early benefits of the initiative to drive increased sales efficiency?.

We look at a number of new product developers that we bring into Proto Labs is really the best metric for us to communicate publicly around our continued ability to drive sales and marketing initiatives.

So that's witnessed both by bringing in new developers from new companies, but also as we go wide and deep and high within existing customers, we're servicing more and more product developers there.

So I think the best way to look at it is the real solid growth that we had with new product developers in the quarter and we think that's a good indicator that the investments are having an impact..

Okay, great. And then if we could go back to activity in the United States and maybe just repeat what the organic growth in the U.S.

was?.

U.S. organic growth..

For the full year or for the quarter?.

Both..

For the full year, organic was 16%, 17.5 including RAPID, okay, and then for the quarter, it was 25.5%, excluding RAPID..

Okay, great. Okay. Thank you..

Thank you..

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

Great. Thank you, again, for joining us today. We remain excited about the outlook for Proto Labs. As we look ahead, we are confident that current market trends are favorable to our strengths and our business model.

Our differentiated technology-enabled digital manufacturing platform has demonstrated the ability to help companies and entrepreneurs get the products to market faster than their competition. We continue to innovate with our service offerings and technology interface and features to enhance our customers' experience.

I want to thank the Proto Labs' employees for their effort over the past year and I want to thank our customers for their support. We are committed to enhancing our revenue growth and driving greater shareholder value over the longer term and we look forward to reporting to you on our progress during our next call. Thank you..

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