Proto Labs, Inc.
Q2 2020 Earnings Call Transcript

Published: 28 Jul 2020

[Operator:]

Greetings, and welcome to the Proto Labs Second Quarter 2020 Earnings Call. At this time all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. 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.

[Dan Schumacher:]

Thank you, Michelle, 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 second quarter ended June 30, 2020. The release is available on the company's website at protolabs.com. In addition, a prepared slide presentation is available online at the web address provided in our press release.

[Vicki Holt:]

Thanks, Dan. Good morning, everyone, and welcome to our second quarter 2020 earnings conference call. Thank you for joining us today. I would like to start by expressing how proud I am of this Proto Labs team, and how we've handled the first-half of 2020. Like all businesses, we've had to evolve considerably in the first six months of the year. Proto Labs has rapidly adapted to change guided by our core values of teamwork, trust and achievement. As I mentioned on our first quarter call, our top priority is to keep our employees, communities and customers safe. Our manufacturing and office teams worldwide have done an incredible job of ensuring employee safety, while continuing to delight customers with our industry leading digital manufacturing services. Every one of our manufacturing facilities have remained operational throughout the global pandemic. The safety of our employees is extremely important to me, and our essential manufacturing employees are my heroes. I would like to thank them all for what they do to make Proto Labs a great organization. We have had some confirmed cases of COVID-19, but we believe they occurred outside of our facilities, and we have been able to greatly limit the impact to other employees. Our new cleaning and sanitizing standard operating procedures in all our manufacturing facilities have continued since the beginning of the COVID-19 pandemic. In addition to new procedures that minimize employee interaction, our digital manufacturing model offers an advantage in practicing social distancing, compared to more manual traditional manufacturing operations. Upon entry into our manufacturing or office facilities, we are conducting rapid temperature screenings via infrared camera technology, and have put in place a mandatory mask policy in all of our facilities.

[John Way:]

Thank you, Vicki. Second quarter financial results begin on Page 8 of our presentation. Revenue in the second quarter was $106.6 million, a decrease of $9.4 million over the same quarter in 2019. Foreign currency representing the $350,000 headwind in the quarter, resulting in revenue decline of 7.8% in constant currency. We served 17,000 unique product developers in the second quarter. As a reminder, our unique product developers served metric enumerates individual product developers that purchased parts from us during the corresponding quarter. Consistent with our results of our customer survey, many of our customers have been impacted by COVID-19, stay-at-home orders and business shutdowns. The 18.2% decline in product developers served was greater than our year-over-year revenue decline, due to the relatively large order size of the COVID-related orders, with $12 million in revenue coming from relatively few individuals. Turning to Slide 10, to review the income statement, our non-GAAP costs of revenue decreased $3 million compared to the first quarter, resulting in gross margin of 50.1%. This reduction was a result of very focused efforts of our plant managers to align staffing to the significant variability from week-to-week across our manufacturing services. The reduction in cost of revenue did not correspond to the revenue decline, due to the challenges in adjusting our fixed cost structure, resulting in 110 basis points sequential decline in gross margin. Continuing with the operating expenses, non-GAAP operating expenses totaled $34.6 million in the second quarter, down $3.7 million sequentially, reflecting our focus on controlling variable and discretionary costs. We have eliminated essentially all of our discretionary spend, and are prudently managing costs given the uncertainty with respect to the demand for our services. Aside from these spending reductions, lower incentive compensation expense, lower tradeshow activity, and travel were the largest drivers of lower operating expenses.

[Vicki Holt:]

Thank you, John. Before I turn the call over to Michelle for questions, I wanted to comment on Proto Labs commitment to supporting a diverse workforce and an inclusive culture. At Proto Labs, we do not tolerate racism and have a culture, which is focused on respect for all our employees. However, our employees clearly want to continue to improve and make a difference in our communities, so we'll be taking the following actions

[Operator:]

Our first question comes from the line of Brian Drab with William Blair. Please proceed with your question.

[Brian Drab:]

Hi, good morning. Thanks for taking my questions.

[Vicki Holt:]

Good morning, Brian.

[John Way:]

Good morning, Brian.

[Brian Drab:]

So, you mentioned very clearly that May was the softest month. Can you just talk through what the customer activity has looked like as we've moved through the months here and into July as -- have June and July, have you seen continued improvement in those months?

[John Way:]

So, May was the trough tropic. It picked up some in June and July has stayed pretty consistent with June activity. I think, I mentioned in my comments that we're looking still as an estimate for July, as we finish out the week, but somewhere in that 11% range down 10% to 12%, something like that.

[Brian Drab:]

Okay, thanks. And then how have -- looking at the different service lines and how have the different service lines been trending? And maybe you could comment on why it looks like injection molding is holding up quite a bit better than CNC in this environment, even if you exclude or actually specifically if you exclude the COVID-related order?

[Vicki Holt:]

Yes, injection molding as you know is our most differentiated service. And in this time of the supply chain disruptions and need for speed in areas like COVID-19, we really provide significant customer value. So, I think that's probably a good reason why it's holding up a little bit better. Again, it's up when you include COVID, if you exclude COVID, injection molding is down 17%. So, it's still significantly impacted by the economic situation that we're dealing with.

[Brian Drab:]

Okay, understood. And I'll just ask one more for now. I guess, can you talk about what you're expecting for gross margin? I think you mentioned, I've got a couple of conference calls going simultaneously here. But what's the expectation for gross margin for the balance of the year? And where do you see that in an environment where things have become a little bit more normal? What do you think you can do with gross margin '21? And then also how does Protolabs 2.0 play into that and potentially help gross margin?

[John Way:]

Yes. So, a lot in that question. I think as we've talked about volume significantly impacts our gross margin, and our ability to flex. With higher volumes, we can drive improvement in the gross margin. I think for the third quarter, we provided guidance in the range of 49% to 51%, which is essentially bookends where we finished here in the second quarter. Again, volume is going to be a big driver of where that goes in the fourth quarter and into 2021. And I think, we'll just have to continue to watch where that plays out. But, as we return to growth, that's when we'll see improvements in the gross margin over the long-term.

[Brian Drab:]

John, have you said on the call yet where or how big an impact Alphaform and Rapid each had on gross margin? Can you give us those numbers again if you haven't?

[John Way:]

Yes. So, New Hampshire is about 230 basis points of an impact on the quarter. And then 3D printing in Europe was about 130 basis points.

[Brian Drab:]

And where are those gross margins, the absolute gross margins now on those businesses roughly?

[John Way:]

They are currently sitting -- the Europe 3D is just below 10% and Rapid business is in the mid-20s.

[Brian Drab:]

Okay. Thanks very much.

[Operator:]

Thank you. Our next question comes from the line of Greg Palm with Craig-Hallum Capital Group. Please proceed with your question.

[Greg Palm:]

Yes, thanks. I guess just starting off since you didn’t provide guidance last quarter. I am curious how did the quarter compared to your own internal expectations? And I guess outside of healthcare in the COVID-related revenue any end markets that surprised significantly either to the upside or downside?

[Vicki Holt:]

Yes. It played out as we expected it to when we gave the guidance. We gave a lot of color as you recall around April. I think the May was a little softer than what we thought, but it’s rebounded little bit in June. In terms of end markets, not a lot different, aerospace has been very strong for us. As you know, we play not in the commercial aircraft part of aerospace, but more in satellite, communications space side of aerospace, and that’s been really strong for us all year. Other maybe little bit of surprise, auto was up slightly here in North America, that might be a surprise, but not significant. So, yes, I don't think anything else really surprised us. I think Europe has been very slow to recover. You think with some of the opening up happening in Europe, we see some faster recovery there. Some of our speculation is a lot of the economies in Europe are very export oriented in the manufacturing space. And again, we play in the industrial manufacturing space. So, with the weaker export economies that could be impacting Europe, even though, they're opening up a little bit.

[John Way:]

Yes. Greg, I think, maybe as I look back, remember our call was at the end of April. We had a lot of uncertainty at that point in time. I think as we continue to progress through the quarter, it ended up maybe a little bit better than where we were or where we were expecting, but we had a pretty wide range, just because we didn’t really know. I think one area that we did outperform was and I mentioned in the call, the ability for our plant managers to really dial-in and match that cost structure to what the revenue was coming in for the next week, really helped our gross margin in these uncertain times. And as you think about it across the individual plants, our injection molding plants were really busy because of the COVID orders. So, they were trying to flex up, while a lot of our other plants were trying to flex down and our plant managers just did a great job of managing those costs.

[Greg Palm:]

Yes. Okay. It makes sense. I guess, as it relates more to the cost structure, I mean, it seems like there are a number of trends coming out of this pandemic that could really accelerate growth and adoption of your services. I mean, I'm thinking, reshoring on demand digital, I mean, sort of the list goes on. And I guess I would have thought you may have started to ramp up spending here, whether that's Q3 or second-half, whether that's sales or marketing, just try to take advantage of everything going on, but it seems like you are keeping it really, really tight lid in the near-term. So, how do I reconcile that to your comments, Vicki about not sacrificing long-term growth, potential? I don't know maybe it's just more discretionary spending, but it seems like we're in an environment where you'd want to take advantage of it sort of a land grab opportunity here?

[Vicki Holt:]

Yes. We are doing quite a bit of shifting to make sure that we are taking advantage of the situation. So, particularly in marketing, we've been shifting to a much more digital appearance in marketing and also taking advantage of our leadership to thought leadership in the area of supply chain disruption as well as e-commerce. So we've had some great opportunities to showcase the company across a number of different venues, but in a very digital way. And that's one of the advantages that we have. We can pivot digitally very easily since we are such a digital company. And those are some lower cost approaches to marketing, as compared to trade shows, which can be quite expensive. So, I think we'd pivot and are investing appropriately in growth. We want to make sure that, we are managing our costs in this uncertain environment. And not being -- I don’t want to say, frivolous in the spend at a point in time, when many of our customers, as I mentioned in the survey results that we got are really working remotely and their projects have been delayed or often reduced funding. So, let's spend where it makes sense in order to get the revenue growth.

[Greg Palm:]

Okay. And John, just to be clear, as it relates to Protolabs 2.0, can you just repeat what you said about -- just the additional amortization and expense, does that occur when Europe goes live? Or is that half of that when Europe goes live, and half as the Americas? Maybe you can just go with that one more time please?

[John Way:]

Yes. Actually, when we place the asset into service, we will start amortizing it, because it's one system built for the entire company. So, once we place it into service and the monthly expense will be roughly $500,000 a month. And then, because of that, when we place in service, we still will have some of that contractors, that costs flips from capitalized expense or capitalized costs to expense, as we continue to go live and work through that process.

[Greg Palm:]

And you said Q4 was go live, correct?

[John Way:]

Yes. I'm sorry. That's our current plan.

[Vicki Holt:]

That's our current plan.

[Operator:]

Thank you. Our next question comes from the line of Jim Ricchiuti with Needham and Company. Please proceed with your question.

[Mike Cikos:]

Hi team. Mike Cikos here on the line for Jim Ricchiuti. Just a couple of quick questions here. The first, I wanted to make sure that I understood correctly, but the COVID-19-related revenue, the $12 million that you guys had called out, that is entirely flowing into that injection molding service line. And then the second item -- sorry, go ahead.

[John Way:]

No, it's not entirely in injection molding, but the vast majority of it is. I think like 90% plus is on the injection molding.

[Vicki Holt:]

Yes, it's about. Yes.

[Mike Cikos:]

Okay. And I guess coming back to the OpEx discipline that you guys were able to show. Curious, could you help parse out how much of that is tied to the incentive comp versus discretionary spending? And then if I'm thinking about the guidance and commentary, if we're looking to Q3, where is the additional benefit or costs control coming from if we're thinking about OpEx being either stable to down sequentially?

[John Way:]

Yes. So, the incentive comp was about $1.5 million or so of that cost reduction. I think as we look to Q3, we’ve flat to down in the operating expenses. I think it's just continuing to look at the areas of where we're spending in, and looking at opportunities related to that. So again, the COVID kind of hit us in March, and we were developing plans. So, the cost reductions, as we've been managing costs, we've been kind of picking up momentum, as we've gone through the year. So that momentum, I think, will carry on through the end of the second quarter into the third quarter. So I think a good chunk of it'll be run rate. And I think we had some expenses in Q2, even related to safety of our employees, making sure that we've got masks and protective equipment and things like that, that flows through that. And we've got most of that stuff on hand now, and we'll be incurring some of that expense.

[Mike Cikos:]

Okay. And if I'm thinking about the recovery that you guys are seeing now, in June similar activity in July versus where we were in May being the trough. Just curious, what are the some of the end markets, the service lines where you're seeing some of the, I guess better improvement versus some of the markets that are tending to lag right now?

[Vicki Holt:]

So, when we say improvement, so June was a little bit better than the trough in May, and July is pretty consistent with June, maybe a tad better. So, we continue to see strength in our aerospace segment. But the rest of the segments are pretty evenly split in terms of where recovery comes, maybe a little bit better with computer electronics than we're seeing in general from automotive. So it's still pretty broad brushed, manufacturing industrial segments remain weak. So, industrial machinery and equipment remained pretty weak. So, it's very gradual, it's not a Z by any stretch of the imagination.

[Mike Cikos:]

Okay. Understood. And then just final housekeeping guiding here. I know you guys were talking about that. Call it $1.5 million a quarter in amortization, once Protolabs 2.0 goes live. And then there was also the contractor cost and other go live costs of about $1.5 million to $2 million a quarter. Just wanted to make sure I understood that correctly. So, the contractor and go live costs for $1.5 million to $2 million, how should we be thinking about it? Is that going to be multiple quarters that's going out?

[John Way:]

I think, think about two quarters is how we're currently planning that. And that is a little bit of uncertainty around that, but I would think of that as a onetime cost for a couple of quarters after we go live, whereas the amortization obviously will be recurring.

[Mike Cikos:]

And those will obviously turn on alongside the amortization, and so we should expect I guess with those in aggregate for those first two quarters then?

[John Way:]

Yes. Unfortunately, that's the way it'll work right. Some of those contractors that are here helping us develop that system. When we go live, we cease capitalization, so that cost turns from a capitalized item to an expense at the same time when we start amortizing the system.

[Mike Cikos:]

Sure. Alright. I appreciate the color guys. Thank you very much.

[Operator:]

Thank you. Our next question comes from the line of Andrew DeGasperi with Berenberg. Please proceed with your question.

[Andrew DeGasperi:]

Good morning. Just a few questions from me as well. First, just a quick one, a follow-up to Mike. You mentioned the commercial aerospace was strong. I mean, can you give us maybe an idea of how did it skew like the defense versus commercial aerospace?

[Vicki Holt:]

I'm sorry.

[John Way:]

Defense versus commercial.

[Vicki Holt:]

Yes. So, it is definitely more on the defense side as well as what I would call space and telecommunications side of aerospace. We are not really big on the commercial aircraft side.

[Andrew DeGasperi:]

Got it. And just maybe some high-level question in terms of -- I think you mentioned in the prepared remarks that a 58% of your customers have delayed project timing in terms of the development cycle. Can you maybe let us know if this has to do with some of the physical testing labs being shut during the last few months, or a shift to, call it, more virtualized prototyping? Anything on that would be helpful.

[Vicki Holt:]

Yes, I think that’s a combination of both. So, we do a lot with the large industrial testing labs and many of those were shut down for a good part of -- early part of second quarter, starting to get some reopening of some laps on limited basis. But that's why we did that survey, really wanted to understand what was happening with our customers, in particular our product developers, and how are they being able to do their job during this period of time. And it's difficult, again, we said 73% of them are working remotely. And they've seen a decrease in demand for the products that they support. And their development cycles have been pushed out or seeing reduced funding, 33% have seen reduced funding. So, it helps us understand a little bit about what's happening with our product developers served, they're just out there with fewer projects today. And that's what we're seeing reflected in the underlying weakness in our revenue. As they begin to come back to work, which they will, and as they begin to drive innovation, which manufacturers will do in order to recover on the other end of this economic shock that we're seeing, we will see them get back to work and we will see them again placing orders again. But we're dealing with a structural change and how they're working right now.

[Andrew DeGasperi:]

That's helpful. One more for me is, in terms of on competition, cam you maybe update us how are your legacy competitors, like the machining place is doing today? And then maybe also, can you let us know if there are any emerging competitors from a service bureau perspective?

[Vicki Holt:]

Yes. So, I really don't know, how they're doing to be honest with you. I would think that they're seeing especially on the CNC machine, the same kind of reduction in demand that we're seeing, which given some of their financial structures might be more difficult for them. We do quite a bit of secret shopper. We're following what's happening with pricing in those end markets. We've seen some softening in some of that pricing, as some of those smaller mom-and-pops who are working more on just making sure they're covering their cash needs, might be picking up some business at price points that are lower than they might've historically picked up. So, we respond to those as we hear them, and induce so prudently, but we are seeing some competition there. Haven't seen any new service bureaus emerge, and the only other kind of emerging competitors are the ones we've spoken about before, which are more of the broker kind of model with e-commerce.

[Andrew DeGasperi:]

Got it. Thank you very much.

[Vicki Holt:]

Thanks.

[Operator:]

Thank you. Our next question comes from the line of Ben Rose with Battle Road Research. Please proceed with your question.

[Ben Rose:]

Yes. Good morning, Vicki and John. Few questions for me. Firstly, on the medical, in the medical device area. Could you speak to, how the business is performing ex-COVID-19? I know that this is your largest vertical, but maybe just some trends or color on the performance of that segment?

[Vicki Holt:]

Yes. So, if you take a medical segment and you pull the COVID business out, it actually declined by 14%.

[Ben Rose:]

Okay. Any general commentary there? Is it just kind of across the board or in certain?

[Vicki Holt:]

It is basically across the board. I mean, a lot of the product developers served, that we survey in our -- in the survey that I mentioned, many of them are in the med device space. And they're working from home and some of their projects have been either diverted or slowed down in this environment.

[John Way:]

Yes. And if you think about those businesses, any of the elective procedures aren’t happening right now. So, a lot of those segments that we're doing business with, their business is hurting quite a bit. So, they're trying to figure out the path forward and they're managing their costs pretty tightly right now as well.

[Ben Rose:]

Okay. And with regard to your current capacity, both in the U.S. and Europe, perhaps John, you could speak to the level of capacity that you're operating at now. And then either for John or Vicki, is there a formal policy in place with regard to furloughs or addressing specific workers that may not be needed for the complete time over the next quarter or two?

[John Way:]

Yes. So, I think from a capacity standpoint, we’ve got capacity in each of our facilities. And I think if you just go back to some of the historical trends of the revenue we had produced historically, I haven't done the actual calculations because the times when we look at it, as is when we're looking to add the machining capacity. As far as the labor, I think I will reiterate, like the team has done a great job of flexing that labor. We are built for a certain amount of variability, so we have a flexible staffing model that we can flex up and down. Unfortunately, in some of our plants, we have had to do some furloughs and take some actions like that. But, we're managing those costs to correspond with the volumes that are coming in, and are looking to drive the growth so we can bring those employees back.

[Vicki Holt:]

And we’re taking advantage of government programs in each of the areas in which we work. Germany has got a shared work program. UK has got a furlough program. And in a couple of the States that we have had to take furloughs here in the United States, they have shared work programs as well. So, really working to try to minimize the impact of our employees. We continue to cover healthcare benefits and they remain on our headcount and hope to bring them back as soon as we can, when we see the recovery occur.

[Ben Rose:]

That sounds good. And then finally, at least for now. I am intrigued by the customer survey that you took. It sounds like a great idea to get a handle on customer thinking at this point for sure. I was curious, were there any questions in the survey that addressed customer expectations heading into the fall, whether they might see a return to normal or a pickup in project activity?

[Vicki Holt:]

Yes. We did not ask that. We were really just focused on what is it that they were doing at this period of time. I'll just say, as we talk to customers, they share the same level of uncertainty that we do. So, our customers are very hesitant also to predict kind of what the next few months are going to look like. I think we're all being very responsive, being very agile and adaptive.

[Ben Rose:]

Okay. Thank you very much.

[Operator:]

Thank you. We have reached the end of our question-and-answer session. I'd like to turn the call back over to Mrs. Holt, for any closing remarks.

[Vicki Holt:]

Thank you. I would like to thank Proto Labs employees for their efforts in the first-half of 2020, and through these extremely uncertain times. I also want to thank our customers for their continued support. We are committed to pushing this company forward through the challenges and changes. We will continue to improve our offering, our company culture and our financial performance. In the near-term, we will continue to adapt and grow as an organization and over the long-term we're committed to driving great shareholder value. We look forward to reporting to you on our progress during our next call. Thank you.

[Operator:]

Thank you. This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation and have a wonderful day.