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. Jim Ricchiuti - Needham & Company, LLC.

Greetings and welcome to the Proto Labs Second Quarter Earnings Conference Call. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Daniel Schumacher, Director of Investor Relations. 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, Protolabs issued a press release announcing its financial results for the second quarter ended June 30, 2018.

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.

And finally, this quarter is the second full quarter that includes the results of the RAPID Manufacturing acquisition that we completed at the end of 2017 and therefore is a component of our year-over-year comparisons. Now, I'd like to turn the call over to Vicki Holt, President and Chief Executive Officer of Protolabs.

Vicki?.

Thank you, Dan. Good morning, everyone. Thank you for joining us on our second quarter conference call. Protolabs had another strong growth quarter, reporting record quarterly revenue and earnings in the second quarter.

Our execution showed strong business performance in each of our geographic regions and in each of our services as demonstrated in our financial results. We reported revenue of $109.7 million in the second quarter. This represented growth of 34% over the prior year.

In addition to our revenue growth, we continue to service a record number of product developers. Our unique product developers increased 18.7%, to 19,198 compared to the prior year. This does not include unique product developers served through our RAPID acquisition. We continue to work to integrate this data.

Looking at the breakdown by geography, the U.S., our largest market, produced record revenue and strong growth of 36% over the prior year including the benefit from the RAPID acquisition. Europe also produced record quarterly revenue growth of 25% which benefited from foreign currency. On a constant currency basis, revenue growth was 16%.

Our Japan region grew 21% on a reported basis and 19% in constant currency. On the topic of Japan, we are pleased to welcome Ayumu Imai to Protolabs as Japan's new country manager. Ayumu joined us at the beginning of July and has experience growing innovative businesses at multinational companies such as Sony, Philips and Merck.

I'm confident Ayumu has the background to successfully lead our Japan operations. Moving to revenue by service, Injection Molding revenue increased 10% compared to the second quarter of 2017. We're pleased that this service returned to double-digit growth in the quarter.

Our CNC Machining service had another standout quarter resulting in record quarterly revenue and a 56% year-over-year growth. This year-over-year growth benefited from the acquisition of RAPID.

The ability to achieve and deliver growth of this magnitude is a testament to our scalable model and dedicated team, who deliver high quality machined parts in as fast as a day to our customers. 3D Printing revenue was also a record and increased 22% from the prior year. We continue to demonstrate our leadership in the 3D space in the market.

Recently it was announced that Protolabs joined the Manufacturing Partner Network of GE Additive. This is an exciting opportunity for Protolabs to partner with GE Additive to further advance and provide access to industrial-grade additive manufacturing technologies and materials.

In addition to this announcement, Protolabs was recognized in winning the Creative Use of 3D Printing Award at the 2018 3D Printing Industry Awards for its Black Panther Brisk Promotion with PepsiCo. As a leader in 3D, we continue to expand our capabilities and leverage our world-class knowledge to serve our customers.

And finally Sheet Metal, our newest service, contributed $6.3 million in revenue. Now I would like to update you on our 2018 priorities. As previously noted, we have three key priorities this year. First, to grow revenue by expanding our customer base and penetrating our existing customers. Second, enhance our capabilities by expanding our services.

And third, increase the scale of our operations, including the integration of RAPID Manufacturing. Our first priority is to continue to evolve our sales approach and engagement with our customers to drive revenue growth.

Our strong revenue growth this quarter and strong growth in the number of unique product developers served demonstrates we are making progress. We're also looking for additional avenues to reach more customers and provide our expertise to help grow their businesses.

We feel partnering with GE Additive will continue to provide visibility for Protolabs and contribute to the growth of our business over the long term. Our remaining priorities are to continue to expand the services we offer and increase the scale of our operations. Our focus with both these priorities is on the integration of the RAPID acquisition.

As a reminder this acquisition added Sheet Metal as a new service to our portfolio and also expanded our CNC capabilities. It is my executive team's priority to integrate the business and make sure our operations in New Hampshire have the capacity and processes to serve our customers as we increase the volumes.

Increasing the capacity starts with reviewing the operations process. We have deployed our lean continuous improvement professionals to take a fresh look at the workflow of the operations. Optimizing this workflow and developing plans for increased automation will help improve the productivity of the operations.

With revised workflow we are now adding the equipment and resources required to increase the capacity of both the Sheet Metal and CNC operations in New Hampshire. We have also brought our CNC R&D teams together to leverage each other's inventions and improve the CNC capabilities and automation at both locations.

Simultaneously, we are preparing and aligning our customer-facing organizations with process alignment and training to continue to delight our customers with new offering.

In addition to scaling the Sheet Metal and CNC operations in New Hampshire, we recognized during due diligence that the Wire and Cable business we acquired was a very manual process and was not core to our business or scalable. Wire and Cable was not a significant portion of the business with first quarter revenues of $500,000.

As a result we divested this business effective April 30. We are pleased with another quarter of greater than 30% growth and we'll continue to focus on execution of our priorities to drive business performance as the year progresses. With that, I'd like to turn the call over to John..

Thank you, Vicki. Revenue in the second quarter was $109.7 million, an increase of $28 million or 34% over the same quarter in 2017. As Vicki stated, our revenue growth this quarter benefited from our acquisition of RAPID Manufacturing. To help with sizing, the RAPID business had approximately $11.3 million of revenue in the second quarter of 2017.

In addition, foreign currency represented a $1.5 million benefit in the quarter with the remaining increase representing organic growth. Gross profit for the quarter was $59.2 million, an increase of $12.8 million over the comparable quarter of the prior year. Gross margin was 54%, a sequential improvement from 53.7% we reported in the first quarter.

This compares with 56.5% in the second quarter last year. As stated in our prior earnings call, RAPID has about a 200 basis point headwind to our consolidated gross margins that accounts for the majority of the year-over-year change. Operating expenses totaled $37.2 million or 34% of total revenue for the second quarter of 2018.

As a percent of revenue, this was slightly higher than last year's 36.6%, with the increase relating to seasonality of the marketing spend and increased investment in our research and development activities. As we look at year-over-year, operating expense as a percent of revenue improved from 36.5%.

On a non-GAAP basis, operating expenses were 31.1% of revenue, compared to 31% last quarter and 33.9% in the second quarter of 2017. Sales and marketing expense was 16% of revenue, an improvement from 17.8% in the second quarter of 2017, as we are seeing initial returns from the investments we have made in the sales organization.

GAAP operating income increased 34% to $22 million or 20% of revenue in the second quarter.

Adjusting for stock-based compensation and amortization, our non-GAAP operating income was $25.5 million or 23.3% of revenue, compared to $18.8 million or 22.9% of revenue in the prior year, representing 35.9% growth in adjusted operating earnings, outpacing our revenue growth of 33.7%. Our GAAP effective tax rate was 19.6% in the second quarter.

The current quarter tax rate includes tax benefits associated with stock option and other equity activity. On an adjusted non-GAAP basis, tax rate was 22.5% compared to 31.3% in the prior year. The reduction in the rate is due to the change in the U.S. corporate tax rate and creates a tremendous benefit for the earnings and cash flow of our business.

On a GAAP reporting basis, net income totaled $18.3 million, resulting in diluted earnings per share of $0.67.

Adding back the after-tax costs of stock compensation, amortization of intangibles, unrealized foreign currency gains, and eliminating the gain on the sale of the RAPID Wire and Cable and Finland businesses, our non-GAAP diluted earnings per share in the quarter was $0.73, representing a 49% increase over the prior year.

Now turning to our cash flow, we generated $33.2 million in cash from operations during the quarter. Capital spending was $17.7 million and includes continued investment in our new Brooklyn Park facility and the addition of equipment to support the growth of the business, particularly in our CNC Machining service.

We ended the quarter with a cash and marketable securities balance of $145 million on June 30, up from $130 million at the end of last quarter. Now I'd like to provide our expectations for the third quarter of 2018.

Given the quick-turn nature of our business with very limited backlog, we still feel that it is most appropriate to provide quarterly guidance for our business. We currently expect Q3 revenue to be in the range of $110 million to $115 million, or growth in the range of 25% to 31%. This revenue guidance reflects the following factors.

Q3 comparisons with 2017 will benefit from the inclusion of RAPID Manufacturing. We estimate foreign currency will have a negligible impact on our Q3 revenues compared to the prior year.

Moving to earnings guidance, our non-GAAP add-backs for the quarter will include stock compensation costs of approximately $3 million and amortization costs of $800,000. We currently estimate our tax rate to be approximately 22% to 23% in Q3.

Taking into consideration all the above, we expect our quarterly non-GAAP EPS to be between $0.71 and $0.77 per share in the third quarter. That concludes our formal remarks. Now Vicki and I would be happy to take your questions.

Operator?.

Thank you. The floor is now open for questions. Our first question is coming from Brian Drab of William Blair. Please go ahead..

Hi. Good morning. I have to say I'm a little disappointed you couldn't figure out how to rapidly fabricate a wiring harness..

It is a very manual process and as you know, our business model is really focused on things that we can automate and scale and that business is very difficult to automate and scale..

And that was $500,000 per quarter, you said?.

Yeah..

Yeah..

Yeah..

Okay.

Can you estimate at all the RAPID contribution? I know that it gets convoluted now with the CNC business being combined, but is it fair to assume that that was around $12 million that you would have gotten from RAPID?.

So, Brian, I think in the comments looking at last year, last year was about $11.3 million of revenue for RAPID. It's similar growth rates to the overall business. So your number's probably not far off..

$11.3 million was in 2Q 2017?.

Correct..

Okay.

And that included a wiring harness business then as well, right?.

Correct. Yeah..

Okay. Okay. Great.

And then selling and marketing as a percentage of sales has – it's moved – on an adjusted basis has moved into this kind of 15% to 16% range, what do you expect going forward?.

I think kind of consistent with what we've been saying, the 16% – that range kind of consistent with where we're at is where we'll continue to expect that to trend..

Okay. And then I'll get back in line after one more, the headwind from RAPID and from Alpha, if you can give any numbers around that in terms of gross margin in the second quarter, that'd be great. Thanks..

Yeah. So, as we stated, RAPID has about a 200 basis point headwind gross margin, and it's still in that above 40% range. As we look at Europe, we saw a little bit of improvement in the gross margin in the 3D Printing business in Europe this quarter, approaching the 20% range. So, the headwind there is about 170 basis points..

Okay. Thanks very much..

Thank you. Our next question is coming from Troy Jensen of Piper Jaffray. Please go ahead..

Hey, congrats on the great results..

Thanks, Troy..

Thanks, Troy..

Hey, Vicki, can you guys give us more color on GE Additive and how this partnership's working? Are you just primarily providing overfill volumes for them or just more color would be great..

Yeah. So, it's actually a partnership where we will have access to a lot of the capabilities that GE Additive has built over the years in metal 3D printing to help us help our customers as they look to develop programs primarily for production parts. So, as you know, a lot of our fleet of 3D printing equipment is concept laser equipment.

We feel we've got a very strong expertise in operating and maintaining concept laser equipment and producing high-quality metal 3D printed parts. And that's a value to GE, our concept laser, and wants to promote that technology to further customers.

So, it may involve Protolabs providing some 3D printed parts to GE Aerospace or GE Medical as they build out production-type applications for metal 3D printing within their other GE products, but the partnership really is focused more with GE Additive and promoting metal 3D printing, design for metal 3D printing, production capability and quality control for metal 3D printing, so that we can expand the use of metal 3D printing as a really cost-effective solution for companies that take advantage of the design flexibility that metal 3D printing can provide for their products..

Perfect. Sounds like a great partnership. Hey, next question, injection molding, you sound happy it's back to double digits. I guess – I'm curious if you think – just to know if you think you can accelerate.

If you think about that business, you've added low volume injection molding, you've added overmolding, insert molding and it's kind of coming off an easy comp. So, just thoughts on kind of your guys' penetration in injection molding..

I always wanted to go faster, but what I have to say is as we move from being just a prototyping supplier to be also a supplier of on-demand manufacturing services, we are developing relationships with supply chain managers and getting involved in production programs that have longer close cycles. Our pipeline is filling up nicely.

We're seeing some nice wins in on-demand manufacturing, but we're also recognizing as we do so, we're having to add other capabilities in order to be able to provide those solutions that customers expect in production parts. And we have to bring those on then work to automate and scale them as we advance them. So I think we're making great progress.

We're really pleased to see the 10%, back to double-digit growth. Acceleration, we're going to have to kind of take it one step at a time because it's a longer selling cycle, and it's a pretty dramatic shift for us with our customers. But I'm pleased with the performance and how we're repositioning the company..

Okay. Last question for me just on RAPID integration.

Have you benefited yet from cross-selling? I'm sure you can sell your Proto Labs services to RAPID's customers, but when will you be able to flip that and sell your customers to the RAPID service?.

Yeah. That is a great question, and we really haven't seen huge benefit from that yet. Our focus as I mentioned in the first half of the year was on first to really redesign a lot of the processes that we had in RAPID for sheet metal and even some of the complimentary CNC services.

And then, we're focusing on making sure we're automating some of that with new software tools and capabilities so that it can scale. And then as we moved into second quarter and then further into third, we're adding some capacity to make sure that they've got the equipment as well before we flip the switch on.

In parallel, we have been training our sales forces, aligning the sales teams so that it will be smooth and seamless with customers as we begin to do the cross-selling more in earnest as we go toward the end of the year.

So it's been a very disciplined process, so that we make sure that our customers don't have a negative experience with those new services. We want them to be delighted with the on-time delivery and the quality and the service that they get.

So we've done a little bit of work there to make sure we're ready and we made a lot of progress there and gearing up capacity here in the third quarter and turning on our sales force here as we move toward the end of the year..

Awesome. All right. Keep up the good work..

Thanks..

Thanks, Troy..

Our next question is coming from Jim Ricchiuti of Needham & Company. Please go ahead..

Hi. Good morning. I apologize. I joined the call a few minutes late, but I wanted to, I think I heard that you indicated you saw about 10% growth in the Injection Molding business.

Is that right, Vicki?.

Yeah. We saw year-over-year growth of 10% in IM. Yes..

Were you able to provide any additional color as to what's driving that? Is that just the improved tone to the manufacturing sector? Any additional color? Is improved productivity on the sales force?.

I think there is a lot of factors that are driving this. We launched on-demand manufacturing last year. Our sales team has been working hard to build relationships across the supply chain and procurement and operations sides of our customers in order to be able to do more than just prototyping, but to be able to bridge over to on-demand manufacturing.

And there's been a lot of training that's taken place among our sales force around selling injection molded tooling, not just for prototyping, but for the benefits that our on-demand manufacturing service can bring to companies to reduce risk and optimize supply chain on the supply chain side. So we're starting to see some benefits of that.

That's a longer selling cycle process, but I think that's certainly part of what we're seeing getting us back to double-digit growth there..

And I noticed also on the revenue per developer, the average revenue per developer that you're showing, I think this is the second quarter where you've shown some nice double-digit growth in that area.

How should we think about what's happening there?.

That's usually mix..

Okay. Okay..

So, yeah, if we're seeing Injection Molding, Injection Molding parts, it's mix. If we see a high mix of 3D Printing growth, you might see that drop a little bit. And so that is going to be somewhat variable depending on the shift in mix that we might see on a quarter-to-quarter basis..

And then final question for me, just it's been a bit of a slog in 3D Printing in Europe, but do you feel like you're kind of turning the corner? I mean just the fact that you showed some decent margin improvement in that part of the business.

What's your sense in that area?.

I do think we're making progress. We've got a ways to go to reach what our goals are for that gross margin, so we've got that steps that we want to see taking place really for the next four quarters with projects to continue to optimize our cost structure there. The market's a challenging market. It's different than the North American market.

The pricing is a little bit different than here in North America. So, it's a challenge for us to reach the kinds of margins that we see here in North America for 3DP.

But we've got things that we can do again on the cost side and in the mix side and really focusing on more differentiated applications with our customers and trying to move away from the more commodity and continue to be a leader with the latest technologies.

So our metal 3D printing business is doing very well in Europe and has a much better margin portfolio than the plastic portfolio. We've launched the HP Multi Jet Fusion which is seeing some good traction in Europe and positioning ourselves as the technology leader there on the plastics space.

So we've got to continue to pursue that angle of the technology and try to steer away from some of the segments that have become a little more commoditized in that market..

Thanks a lot..

Thank you. Our next question is coming from Brian Drab of William Blair. Please proceed with your follow-up..

Hi. I know that you mentioned that you're understandably only providing the quarterly guidance.

But is there any particular reason why you didn't give even a qualitative comment on your original for your guidance, given you did last quarter?.

Yeah, Brian, I think as we progress through the year, giving comments on the full year really would be providing guidance for the fourth quarter at this stage too. And just given the quick-turn nature of our business, we feel that the quarterly guidance is the most appropriate for us..

I just want to make sure that there is nothing that we should be thinking about for the fourth quarter that's changed from your perspective or is it just purely not wanting to give precise guidance for the fourth quarter at the moment?.

That's the reason..

Yes. Okay, nothing to be concerned about is what we're..

Nothing, nothing's changed..

Yeah, nothing's changed. We feel good about the business. We're really pleased with how the team executed in the third quarter. We're just executing on second quarter. We're just executing on the strategy, executing on the strategy..

Got it. Thank you..

Thank you. At this time, I'd like to turn the floor back over to Ms. Holt for closing comments..

Thank you again for joining us today. We remain excited about the outlook for Protolabs. As we look ahead, we are confident that our 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 their products to market faster than their competition. We continue to innovate our service offerings and technology interface and features to enhance our customers' experience.

I want to thank the Protolabs employees for their efforts, 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..

Ladies and gentlemen, thank you for your participation. This concludes today's conference. You may disconnect your lines at this time and have a wonderful day..