Novanta Inc.
Q3 2013 Earnings Call Transcript

Published: 6 Nov 2013

[Operator:]

Good afternoon. My name is Mike, and I will be your conference operator today. At this time, I would like to welcome everyone to the GSI Group 2013 Q3 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. (Operator Instructions) I will now turn the call over to Robert Buckley, Chief Financial Officer of GSI Group. You may begin your conference.

[Robert Buckley:]

Thanks Mike. Good afternoon and welcome to GSI Group's third quarter 2013 earnings conference call. I am Robert Buckley, Chief Financial Officer of GSI Group. With me on the call is John Roush, Chief Executive Officer of GSI Group. If you have not received a copy of our earnings press release, you may get one from the Investor Relations section of our website at www.gsig.com. Please note this call is being webcast live and will be archived on our website. Before we begin, we need to remind everyone of the Safe Harbor for forward-looking statements that we’ve outlined in our earnings press release issued earlier this afternoon and also those in our SEC filings. We may make some comments today both in our prepared remarks and our responses to questions that may include forward-looking statements. These involve inherent assumptions with known and unknown risks and other factors that could cause our future results to differ materially from our current expectations. Any forward-looking statements made today represent our views only as of today. We disclaim any obligation to update forward-looking statements in the future even if our estimates change. So you should not rely on any of today’s forward-looking statements as representing our views as of any date after today. During this call, we'd be referring to certain non-GAAP financial measures. A reconciliation of such non-GAAP financial measures to the most directly comparable GAAP measures is available as an attachment to our earnings press release. To the extent that we use non-GAAP financial measures during this call that are not reconciled to GAAP measures in the earnings press release, we will provide reconciliations promptly on the Investor Relations section of our website. I’m now pleased to introduce CEO of GSI Group, John Roush.

[John A. Roush:]

Thank you, Robert. Greetings everybody and thank you for joining our call. So today, we announced the third quarter results, and I would say on the whole, we're quite pleased with them. We increased growth in a number of important areas and we had stronger execution across the Company. We made progress on our strategic objectives, we improved our profitability and we strengthened our balance sheet, and most importantly, we strengthened our organisation in a number of critical areas which we believe enables us to sustain and further improve our performance over time. Robert of course will cover the financial results in more detail but I would like to provide some highlights. Third quarter revenue was $85.5 million with reported growth of 23% and organic growth of 3% versus the third quarter of last year. Our book-to-bill ratio in Q3 was 1.04. Adjusted EBITDA was $13.7 million or 16% of sales and represented increase of 14% on a sequential basis and 27% versus the third quarter of last year. Non-GAAP earnings per share were $0.15 in the quarter, which is an increase of 25% versus a year ago. And during the quarter, we received IRS refunds totaling $12.5 million and we ended the quarter with net debt below $25 million. Overall, I'm pleased with these financial results as they reflect the progress we have made as a company in a number of important areas as well as improvement in some of our end markets. In terms of the commercial landscape, we got important growth contributions on the laser side of the business. Overall, Laser Products sales grew 4% year-over-year with a 1.1 book-to-bill ratio. And within Laser Products, our scanning sales were up 16% year-over-year with a book-to-bill ratio of 1.11. Our scanning solutions growth platform, which is really a subset of the overall scanning business line, had year-over-year growth of more than 75% as a number of awarded programs began to ramp up into recurring volumes in the laser via hole drilling and converting applications. We also had strong performance in CO2 lasers. Our CO2 revenue grew by 5% year-over-year with book-to-bill at an encouraging level of 1.11, driven by strong demand from customers in marking and coding application for the food and beverage and pharmaceutical industry. We won a number of new customer platforms in the CO2 market during the quarter in applications such as marking, laser drilling and converting. We also saw a significant customer interest in our new P100 pulsed laser which offers an impressive 400 watts of peak power in a small and more compact footprint than competitive offerings. This product is well suited for a wide variety of applications including high-speed drilling and perforating where a minimal heat effect zone on a delicate material is crucial. With respect to fiber lasers, we made the decision in the quarter to narrow our focus and be more selective with our overall strategy. While the market continues to grow at attractive rates, we found that our resources were being spread too thinly in developing applications in the marketplace and launching a new product architecture that would significantly lower our cost and ultimately result in profitability. At the same time, price levels in the market have decreased significantly and our new architecture launch have taken a bit longer than we hoped. The combination of these factors resulted in economics that were less attractive near-term. Our response has been to be more selective in how we compete. In a number of cases we have chosen not to quote on more commodity-oriented projects, which has led our revenue to be essentially flat versus last year. In addition, we have taken steps to better align our expenses and investment levels with the revenue we currently have. We expect these actions to significantly improve our profitability going forward, albeit with lower expected revenue growth than what we had in the past. Having said all that, I do want to point out that we still see opportunities in the fiber laser market and we continue to pursue the more attractive projects where we bring not only technology but also customer relationships and applications expertise. We expect some portions of our new low-cost architecture to be in production in early 2014 and we continue to pursue lower cost versions of our mid-power fiber lasers. We also shipped our first production 3 kilowatt laser in the third quarter. The remaining area of our Laser Products group is the scientific market, and here we saw weak condition throughout the quarter. Scientific sales were down 25% versus a year ago. We expect double-digit revenue declines year-over-year in the fourth quarter as well. With government budget challenges around the world, we do not see near-term recovery in the scientific market anytime soon. On the Precision Technology side of the Company, revenue was up 66% due to the inclusion of NDS in the results, but on an organic basis, revenue was slightly down year-over-year. In the medical market, we continue to see good medium-term growth potential but current market conditions remained somewhat mixed. Our optical encoder business received a $2.8 million order from a surgical equipment OEM. This is the first production order associated with a significant program we were awarded several quarters ago. The encoder business had several additional large medical opportunities with OEMs that offer a significant future growth potential. The NDS medical business saw mid single-digit growth on the surgical side of the business, excluding the impact from the dual sourcing at one large customer that occurred in Q1 of this year, but the radiology side of the NDS business struggled during the quarter. A $2 million plus customer order was delayed from Q3 to Q4 and a number of other tenders were delayed or put on hold by customers. Our thermal printers medical business, which primarily serves the patient monitoring market, also saw lower order rate from OEM customers versus a year ago. The Affordable Care Act appears to be altering the mix of capital expenditures that U.S. hospitals are making to in some cases favor IP and workflow investments over clinical technology. The NDS radiology product line however had a number of new products in development that will be launched in the course of next year and we expect the new products to result in mid to high single-digit growth for the radiology business in the early part of 2014. Our thermal printers product line also expects several recent customer design wins to begin volume shipments early next year resulting in high single-digit growth year-over-year at that time. The Precision Technology segment also has a presence in the microelectronics market, and here the picture was mixed. Westwind spindles revenue was up over 20% on a year-over-year basis but declined nearly $2 million on a sequential basis. During the third quarter, customers reduced spindle order rate and forecasts several times. As a result, we expect Q4 to be sequentially down from Q3 for Westwind. Our optical encoder products are also sold into several microelectronics market including disk drive production and backend semiconductor applications such as wire bonding. These areas all saw slower orders and shipments during the quarter and we expect this trend to continue into Q4. While industry forecast call for mid-single-digit growth in semiconductor capital equipment next year, we expect the early part of 2014 to be relatively soft with growth picking up through the course of next year. During the third quarter, we made significant progress in building our organization and our talent base. The caliber of talent that we have attracted into GSI has been very encouraging to all of us. The leadership and talent upgrades that we made across the Company are beginning to deliver significant benefits. The quality and pace of our progress against strategic objectives are both improving and our execution as a company is becoming more predictable. In August, we brought in a new leader for our Synrad CO2 business and just after quarter end we reached agreement with a new business leader for NDS. We'll start work next week and bring significant leadership experience from major medical manufacturers in the radiology and surgical markets. During the quarter, we also had a number of strong hires within the functional leadership of our businesses. We added or upgraded our manufacturing leader for CO2 lasers, product manager for laser scanning, the product manager for optical encoders, and a production and manufacturing engineering leader for our Bedford operation site. Clearly consistent sustainable profitable growth is one of our primary goals of the Company, and one of the key elements of that focus is our significant commitment to operational excellence and continuous improvement. Since the summer of last year, we have upgraded or added 10 operational leadership roles at our plants across the Company. These leaders have joined us from world-class manufacturing firms such as Danaher, Crane, Ingersoll-Rand and Boeing. These leaders are working with all of our manufacturing teams to develop metrics for key performance indicators, hold [indiscernible] events, map our value streams, implement lean principles, and ultimately to improve our quality and customer satisfaction, reduce our cost and improve our working capital turns. My candid assessment is that we have work to do before we can count ourselves as a world-class operating company. We now have leaders in place, know what world-class looks like and know how to get there. Continuous improvement has become the key part of our culture. We're already seeing benefits. In the last three months, we've increased on-time delivery in our largest product line by 20 percentage points while delivering record shipments. In one of our fastest growing product lines, we have increased yields on a bottleneck circuit board component by 15 percentage points. We are early in this journey but it is clear there is significant untapped potential. As a further example, we recently reached agreement with a candidate to join as a global strategic sourcing leader for the Company. He will work with all of our manufacturing sites to leverage and drive productivity from our direct material spend. Across GSI, we procure approximately $150 million of direct material per year. This spend is currently managed at the local level without the tools, processes or capabilities to make use of our global leverage as a company. Our new leader has been through the same transformational process several times in the past. We believe the continuous improvement focus will pay significant dividends for us over time and is a key enabler of our growth strategy. So the new talent we brought into GSI is making a significant difference in our performance across the Company. Each of these individuals brings new talents, capabilities, perspective and a passion into the organization that makes it stronger. A stronger company is better aligned to achieve our strategic goals. Finally, I'd like to [indiscernible] that many for you saw the 8-K filing last week announcing the departure of Jamie Bader who has been serving as Group Executive of Precision Technology for us. We thank him for his contribution to GSI and wish him well in future endeavors. Going forward, the medical focused product lines within Precision Technology will report to Matthijs Glastra, who in addition to this new responsibly will continue to lead our Laser Products business. The precision motion control focused product lines within Precision Technology will now report directly to me, and I can tell you that I see some attractive growth opportunities within the precision motion space and you will hear more about our strategy in this area in the near future. So now with those comments, I'd like to turn things over to Robert to comment on the financials in more detail. So Robert?

[Robert Buckley:]

Thank you, John. During the third quarter of 2013, GSI generated revenue of $85.5 million, an increase of 23% from $69.5 million in the third quarter of 2012. The NDS acquisition accounted for roughly 21% of the 23% revenue increase year-over-year. Changes in foreign exchange rates adversely impacted revenue causing a roughly 1% decrease in revenue. Excluding the impact of the NDS acquisition and changes in foreign exchange rates, the Company increased revenue 3% organically compared to the third quarter of 2012. Sales of our Laser Products segment for the third quarter of 2013 increased 4.1% to $50.3 million compared to $48.4 million one year ago. Negative effects from foreign exchange rates impacted Laser Products sales by $400,000 for the third quarter. Sales of our Precision Technology segment for the third quarter of 2013 increased 66.2% to $35.1 million from $21.2 million in 2012. The NDS acquisition added approximately $14.6 million in sales this quarter. Changes in foreign currency rates adversely impacted our sales by 1.4% compared to the prior year. Excluding NDS and the impact of foreign exchange rate fluctuations, revenue declined 1.5% organically. Turning to our profitability, third quarter gross profit was $35.8 million or 41.9% gross margin compared to a gross profit of $28.9 million or a 41.5% gross margin during the same period last year. Laser Products third quarter gross profit was $20.9 million reflecting a 41.5% gross margin compared to $19.2 million or roughly 39.8% gross margin in the same period last year. The 1.7 percentage point increase in gross margin was primarily attributed to a change in product mix, specifically increased sales of our higher-margin scanning business lines. This mix shift was unexpected to be favorably due to the program timing with a key customer. Gross profit dollars increased $1.6 million or more than 8.5% compared to the prior year to nearly $21 million. The increase in gross profit dollars was driven largely by higher revenue in our scanning business line. Precision Technology's third quarter gross profit was $15 million reflecting a 42.6% gross margin, compared to $9.9 million or 46.8% gross margin in the same period last year. The 4.2 percentage point decrease in gross margin was primarily driven by the acquisition of NDS. NDS' gross margins are lower than the segment average, partially driven by purchase accounting adjustments. Excluding the impact of NDS, gross margins actually increased compared to the prior year driven by higher volumes and lower costs in our spindles business. Gross profit dollars in Precision Technology in the third quarter of 2013 increased $5.1 million or more than 51% compared to the prior year to roughly $15 million. The NDS acquisition accounted for the majority of the increase in the gross profit dollars. Excluding the impact of NDS, gross profit was essentially flat. Operating expenses amounted to $30.1 million in the third quarter of 2013, an increase of approximately $5 million driven by the acquisition of NDS. Excluding the impact of NDS, operating expenses were down $1.6 million driven by $1.2 million lower restructuring and the remainder driven by lower R&D spending. Research and development expenses were $6.6 million or 7.7% of sales in the third quarter. R&D expenses increased in terms of total dollars due to the acquisition of NDS. Excluding the impact of NDS, R&D expenses were lower due to lower employee compensation as a result of our restructuring plans. SG&A expenses were $20.1 million or 23.5% of sales during the third quarter of 2013 compared to $16.1 million or 23.2% of sales during the third quarter of 2012. SG&A expenses increased in terms of total dollars due to the acquisition of NDS. Operating income amounted to $5.7 million or 6.7% of sales in the third quarter of 2013 compared to $3.8 million or 5.5% of sales in the prior year. Laser Products operating income for the third quarter 2013 increased $2.3 million or 42.3% compared to the third quarter of last year whereas Precision Technology's operating income for the third quarter of 2013 decreased by $900,000 or roughly 25% compared to the prior year. This decrease was primarily due to amortization of intangibles related to the acquisition of NDS and the fair value adjustments. Excluding NDS, operating income actually increased $600,000 or roughly 17%. Adjusted EBITDA, a non-GAAP financial measure which includes the adjustments noted in the non-GAAP reconciliation attached to our earnings press release, was $13.7 million in the third quarter of 2013 compared to $10.8 million in the third quarter of 2012. The increase in adjusted EBITDA was predominantly attributed to a significant increase in profitability in our scanning business and our spindles business. To a lesser extent, the acquisition of NDS drove slightly higher profitability. Our scanning business is seeing benefit from improvements in its operational effectiveness and a mix shift to higher-margin scanning solutions. To a lesser extent, the business saw a favorable mix shift due to program timing with a key customer. Our spindles business line has experienced a short-term rebound in demand in the printed circuit board market. However, we are also seeing the benefits of our restructuring actions which had led to a more profitable business. Diluted earnings per share from continuing operations was $0.06 in the third quarter of 2013, which is flat compared to the third quarter of 2012, while the non-GAAP earnings per share which includes the adjustments noted in the non-GAAP reconciliation attached to our earnings press release was $0.15 in the third quarter of 2013 compared to $0.12 in the third quarter of 2012, representing a 25% increase year-over-year. Included in the non-GAAP earnings per share in the third quarter of 2013 was $1.6 million of foreign exchange transaction losses or approximately $0.03 per share. Turning to the balance sheet, as of September 27, 2013, cash was $53.7 million while total debt was $78.4 million. Since acquiring NDS in January 2013, we have made $31.6 million of debt repayments reducing our gross debt from $103 million in the first quarter of 2013 to $78.4 million. The Company completed the third quarter of 2013 with approximately $24.7 million of net debt as defined in the non-GAAP reconciliation table on our earnings release. This represents a $42 million decrease in our net debt position compared to the first quarter. The weighted average interest rate on our senior secured facilities was 2.9% during the third quarter of 2013. Operating cash flows during the third quarter was $16.8 million. The improvement in operating cash flow was driven predominantly by the $12.5 million in tax refunds received as a result of the settlement with the IRS, and to a lesser extent higher earnings in the quarter. Working capital was not a significant contributor to the cash flow this quarter as a consequence of temporary product quality related issues, which have now been largely resolved. In September of this year, we amended our senior credit facility to increase the uncommitted accordion feature provided in the agreement from $50 million to $100 million. This should allow the Company to access additional funds for acquisition strategy if necessary. Finally, the Company's Board of Directors has authorized a share repurchase program under which we may repurchase up to $10 million worth of shares of our common stock. These shares may be repurchased from time to time at our discretion based on our assessment of capital needs and market price of our stock and general market conditions. We believe this program is an integral part of our capital allocation strategy and represents the state of maturity we have reached with our business improvement efforts over the last few years. We continue to see strong opportunities to maximise returns through internal organic growth investments, some of which John covered earlier, and we see meaningful and attractive acquisition opportunities which will require us to maintain some level of financial flexibility. Consequently, we will more likely be more opportunistic in the near term with our share repurchase program to better balance these competing needs. Turning to the fourth quarter of 2013, we expect revenue to be in the range of $87 million to $89 million. On a reported basis, this translates to a revenue increase of 31% to 34% compared to the fourth quarter of 2012. Excluding the impact of the NDS acquisition and changes in foreign exchange rates, we expect organic revenue to increase 4% to 6% compared to the fourth quarter of 2012. We are experiencing some strength in a few of our end markets, and more importantly, as a consequence of targeted investments, we are seeing market share gains and new product introductions penetrating new applications. However, because the overall macroeconomic environment continues to remain volatile, we remain cautiously optimistic about our growth prospects. Turning to profit, we expect adjusted EBITDA in the fourth quarter to be in the range of $13 million to $14 million. We expect SG&A and R&D expenses to be largely in line with our third quarter of 2013 spend, with the range of adjusted EBITDA being driven by the range in revenue and slight mix shift impacting our gross margins. We expect our non-GAAP tax rate to be in the 37% to 39% range, and depreciation and amortization expenses to be slightly less than $5 million. And finally, we expect our net debt at the end of the year to be approximately $15 million, excluding any debt that may be incurred or assumed in connection with any future acquisitions. This concludes our prepared remarks and I'd like to open the call up to questions.

[Operator:]

(Operator Instructions) Your first question comes from Lee Jagoda with CJS Securities. Your line is open.

[Lee Jagoda:]

So can you quantify the losses if any related to fiber in the quarter and then your expectation for profitability in fiber in Q4 and in 2014?

[Robert Buckley:]

We don't really get too much into the specifics around that. We did mention before that the business loses over $1 million in a particular quarter. It wasn't a significant impact or a significant change to that in the third quarter, but we do expect that to shift as we enter into the fourth quarter. We have taken restructuring actions in our Rugby site and our Chinese site in order to deal with some of the costs, and then a lot of that will start to play through as we get into the fourth quarter.

[John A. Roush:]

And then into next year.

[Lee Jagoda:]

Okay. And then maybe could you talk in a little more detail about the potential positive factors in your business independent of the macro trend, like some of the new products, that we should look for next year that should drive growth independent of the macro economy?

[John A. Roush:]

One clearly is the scanning area, right. I mean so we do play in two parts of the scanning market, the galvo which is really a component galvanometer level, and then the scanning solutions or scan head market, and pushing into scan head sort of had doubled our addressable market to the north of $200 million, and that's really a penetration story for us, alright. So we don't really need the macro environment to grow for us to grow in solutions as we are kind of penetrating. And we have targeted areas that are sort of new applications, via hole drilling and converting and some of these other areas. So, our solutions growth can occur say into the double digits without any macro growth because it's pushing to a new area. I would say in the CO2 laser business, you have some of that as well where the pulsed laser technology and some of the mid-power applications for CO2 are areas we really haven't participated in a significant way in recent times. So, we've made our living on CW, 100 watt and below type of CO2. We will continue to do that, but as we pres into pulsed and mid-power, we've increased our addressable market. So I mean you can look for growth in some of those areas, and obviously we are tied to the macro environment in a number of cases like every company, so that's a factor, but we're not sitting there kind of just assuming all our improvement at the Company comes from a big economic acceleration because we frankly don't see huge signs of that.

[Lee Jagoda:]

Got you, and one more question and I'll hop back in the queue. Just as it relates to the share repurchase, you clearly indicate that share repurchase is sort of third in your list of priorities behind organic growth and acquisitions. Given the mode size of the share repurchase, why wouldn't you be able to do acquisitions as well as repurchase shares?

[John A. Roush:]

I mean we view those two things as very related. So the reason why the repurchase program isn't large is because of where it sits in the priorities. We view it as a tool. It's in the mix, it's a way to increase shareholder returns, returning cash, et cetera, and it's something we consider important but it isn't larger because we do see good opportunities for acquisitions and for investing in organic growth. So I guess if we didn't see those opportunities, maybe the authorization would be much larger.

[Lee Jagoda:]

Okay, thanks very much.

[Operator:]

Your next question is from Joe Bess with Roth Capital Partners. Your line is open.

[Joe Bess:]

Just a follow-up on the scan head market as well as some of the new applications you are pursuing with CO2 lasers, when we look into Q4 and look at an organic growth of about 4% to 6%, how much comes from new markets versus just organic growth with applications that you guys have done historically?

[John A. Roush:]

I don't know that we can sort of look at that [cut and put to you kind of] (ph) point on it without analyzing platform by platform, but clearly we do see that a good part of our growth is really being driven by new areas that we're pushing into, because we're just not seeing that GDP growth is all that robust anywhere.

[Robert Buckley:]

Coming to the capital spending in the manufacturing and medical markets, so there's not a big uptick in kind of macro factors beyond our businesses. So the organic growth you are seeing is really being generated by additional penetration of our products in the new applications that we haven't served before as well as the introduction of new products.

[John A. Roush:]

I mean I think if you look at our Q3 results and these comments here, we've said that scanning solutions is up 70 odd percent in third quarter. It's not quite at that level in Q4 but it's very high growth, I mean so way beyond approximately sort of market based type of growth. That's an example there, and you would see similar things looking at some of the CO2 where we are pushing into new areas. But actually, mathematically say the growth we're getting is $5 million or whatever it is in dollar terms, so how much of the $5 million specifically came from new programs, I mean that's math that we don't have as we sit here but certainly we can kind of work through that.

[Joe Bess:]

Got you, thanks. And then cross-selling of your medical components is a key growth driver moving forward. Is there any way you can help demonstrate the traction you are gaining with this initiative?

[John A. Roush:]

I would say it's in its early stages. I mean at this point, we kind of are probably more focused on on-boarding a new leader into NDS. We've put a new operations leader into NDS, we've put a new radiology sales leader for the U.S. into NDS and bolstering that team. There's a significant product roadmap there. There's some things on the surgical side of the business that are important for next year but the radiology product line is being revamped kind of almost in its entirety with upgraded models in every part of the product line. So we've been probably more focused on that because we think that can deliver more [from us] (ph) than the cross-selling initiatives near-term. I think it's a little bit longer term strategy where we looked at who has the stronger relationship in some cross-introductions. By the way, the encoder business is getting a lot of traction and some of the OEMs even in the surgical space, that's creating some opportunities with the NDS business.

[Joe Bess:]

Okay, great.

[John A. Roush:]

And I think – I was going to say we've had some cases where the sourcing relationship we have with encoders has opened the door for some of the display business.

[Joe Bess:]

Okay, thank you. And then thinking about 2014 and kind of your view of your end markets, how do you see your revenue mix by end markets changing in 2014 from where it is today?

[John A. Roush:]

You mean apart from acquisitions and divestitures or any – you're just saying as it is now, what it's about?

[Joe Bess:]

Yes.

[John A. Roush:]

I mean I think there is – actually in aggregate the industrial market is the one that's been sort of steadily getting some slight improvements, and then there's been question marks around China in the industrial space and the manufacturing sector there, but overall industrial has been [indiscernible] a modestly positive vector for us for about a year. Scientific is definitely struggling and we don't expect that market to be strong next year. Microelectronics is expected to be up modestly, not double-digit or anything but sort of 5% or 6% growth and I think that's what we factored into our plans, but I don't see it at uniform across the year. I think it's sort of 5% for the year but much stronger back half than first half. So the question is medical, right, because we've actually seen some tough conditions in certain parts of medical this year. We are not waiting around for the market necessarily to be way, way better next year. We have product strategies and specific programs in medical that are going to get us growth and we have a pretty good line of sight to that.

[Joe Bess:]

Okay, great. Thanks for that. And then just last question, with your comments on the semiconductor market and kind of having a view that growth is going to be a little bit slower than kind of what the industry is seeing, can you give us a little bit more insight into why you think this at this point of time?

[John A. Roush:]

I don't know a lot. I mean Robert can jump in here too, but my view is, the industry forecast is 5% or 6% growth in overall semiconductor capital equipment. I mean you can take different sources of data. I think that's true. I just don't think it's 5% or 6% in every quarter. I mean we're seeing parts of the market actually decelerating right now. So I mean it's November. So is something really going to be decelerating in November and then suddenly be ramping up in January, February, March? I mean that's where I think that takes some time to work itself out. And there's a difference between front-end parts of the market and back-end and we're seeing the back-end part is more slower, and we probably have more penetration in back-end applications. And so that somewhat plays into it where the front-end tends to pick up before back-end based on the way the capital dollars are being invested.

[Robert Buckley:]

The one thing I'd put into context here is that our exposure into that microelectronics market is relatively light at this stage. Roughly 16% of our sales is still into that end market. So it is not – regardless of its direction, it's not a significant driver of our revenue.

[John A. Roush:]

Where you see that is the Westwind spindles is very significantly penetrated into mechanical via hole drilling and a few other applications, and then you see some of the encoder businesses in there in the wire bonding and the disk drive production, and some of the scanning is in via hole drilling. So we are exposed to it in a few different places.

[Joe Bess:]

Okay, great. Thank you for the color.

[Operator:]

(Operator Instructions) The next question is from Jim Richiutti with Needham & Company. Your line is open.

[Jim Richiutti:]

Just wanted to follow-up on that comment you just made about the medical market, and I know you're not going to wait for the market that you can put a – it sounds like an active new product strategy. Is this more – should we think about this more towards the second half of next year or will there would be product rolling out in the first half that potentially gets that part of the business on a stronger growth trajectory?

[John A. Roush:]

I think it is something that impacts the first half. So there are several different things there. We have the surgical program and encoders that shipments are already occurring now and they do benefit even the early part of next year, so that's helpful. The radiology product strategy for NDS, there's a number of products in the product line and we are not able to sort of redesign all products all at once. So they are going to be phasing into the market through the course of next year, but there will be some benefit early in the year and then sort of a build as you go through. And then in the thermal printers which goes into patient monitoring, vital signs monitoring, EKG, pacemaker programming applications, there we've been awarded some new programs and it's just a question of the ramp-up timing by the OEM, and all indications from customers are that there will be some attractive growth even in the early part of the year. So that isn't sort of you've got to wait two or three quarters to see the benefit. We do see pretty good impact from that. NDS had some tough comparables on the surgical side of the business, and particularly Q1 because that dual sourcing event that occurred last year or earlier this year still had significant volume occurring in Q1 and then the dual sourcing happened in March, but the radiology side will start to see some nice growth.

[Jim Richiutti:]

Got it. And then in the laser scanning area, putting aside what's happening in the scanning solutions, clearly there's some real nice growth, market share gains. The growth in just the galvo business seems to be pretty healthy, double-digit growth, what's driving that? Is that – do you see that as being sustainable?

[John A. Roush:]

Keep in mind the overall revenue was the galvo and the scan head added together. So part of the reason the overall business is up 16% is because of the solutions, but we saw growth across all of it in third quarter, I mean not as high in galvos as you would imagine but there was growth there. I mean I would call it mid to high single-digit type growth on galvos.

[Jim Richiutti:]

Okay. And looking at next year and the mix of business, it appears that you're setting yourself up with a product portfolio across the different segments where you're going to be generating some higher gross margins. Can you give us any sense as to where we might see, and maybe Robert this is a question for you, where we might see gross margins going?

[Robert Buckley:]

Into 2014, I try to avoid those conversations until we get into January.

[Jim Richiutti:]

Can you say that it looks like a better [indiscernible] though?

[Robert Buckley:]

On a macro basis, they are absolutely going to go up. We are getting the mix shift changes but John spoke at great length about the continuous improvement efforts and productivity programs that we've implemented across the Company and the individuals that we hired to drive that. And so gross margin is where you're going to see that materialise in this organisation. We have $150 million of direct material spend that hasn't been touched in probably a decade in terms of any serious negotiations around pricing with our vendors or consolidation of purchasing power.

[John A. Roush:]

As I said, we haven't even touched indirect where there's also opportunities.

[Robert Buckley:]

Right. So it is an area of significant earnings growth driver as we go into 2014. How much is that, I'd like to kind of save until we get into the new year because of course revenue will be a little bit of factor on that. The four core parts of this portfolio that we talk about on a regular basis are our Cambridge Technology scanning business, our MicroE encoder business, the NDS surgical business and even the Synrad CO2 business, are significant drivers of profitability for the organization, and as we have made great changes in those four business lines, they've begun to really have a significant impact on us.

[Jim Richiutti:]

Okay, that's helpful. And John, one last question and I'll jump back. In terms of acquisitions, is there any – in broad terms, can you talk a little bit about – you've made some commentary in the past about focusing more on the medical market, has that strategy changed at all or is there any color you can give on the types of acquisitions you're looking at?

[John A. Roush:]

Sure. So I mean I think there's a few sort of major thrust areas within our acquisition strategy and one is medical, and I think there we really like the customer engagement of the major medical OEMs, we like their sourcing behavior, they are looking for technology and quality and a commitment long-term and we are very prepared to step up to those things. So we want to have more capabilities to offer them so we can broaden those relationships. So there I mean we're looking for acquisitions that are not necessarily the exact technologies we have today. They may be adjacent technologies but they strengthen these customer relationships. And I think there was a question asked about the pace of this key account strategy. The more you have to offer these OEMs, the faster you can kind of go with that and then be more efficient in covering those accounts. So you may see acquisitions that relate to adjacent technologies in medical. Another area is the sort of scanning and beam delivery and selected laser type of place because we still have a significant part of the Company that's tied into the laser space. A third area that maybe we haven't talked about as much but I think that will change is in the precision motion space. We're getting some good opportunities with the optical encoder business which is really a 1/1000 of a micron motion control technology in designing the very high-end robotics and other types of application areas, and we think there is more we can do in that space. That's a good play that we have but it's sort of – can be a building block to do more. So motion might be the third area. And you know what we'll look to build in those broad areas, fiber laser has been something we've talked about as a significant maybe a platform in the past. I would say we view it as something less. It's an opportunistic play, it's a great market, we have a targeted position in there and we're being pretty selective about it so we can kind of manage growth versus our economics and our profitability, and we pull back and [extract] (ph) a little bit more towards the profitability dimension. So I'm not sure we necessarily see acquisitions in that space, but you never know. So I would say it's medical, kind of scanning and then precision motion.

[Jim Richiutti:]

Okay, that's helpful. Thanks very much.

[Operator:]

There are no further questions. I will turn the call back over to the presenters.

[John A. Roush:]

Thank you, operator. So in conclusion, I would say that we were pleased with the Q3 results from a financial, operational and organizational perspective. The Company is making strong progress towards our goal. The makeup and culture of the Company are stronger and the team has greater bandwidth and capabilities. We are out showing the beginnings of a talent bench too. The financial results were positive, the balance sheet strong, and the economy is showing signs of modest but continued improvement and we've seen no return to organic growth. I'm cautiously optimistic about Q4 and 2014. We intend to control our destiny. Long-term, I'm convinced GSI can deliver on its very substantial promise. So on behalf of my whole team, I'd like to thank all of you for your continued interest in GSI. The call I snow adjourned.

[Operator:]

This concludes today's conference call. You may now disconnect.