Proto Labs, Inc.
Q2 2019 Earnings Call Transcript

Published: 25 Jul 2019

[Operator:]

Greetings and welcome to the Proto Labs Second Quarter 2019 Earnings Conference Call. At this time, all participants are in a listen-only mode. A 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, Mr. Daniel Schumacher, Director of Investor Relations. Thank you. You may begin.

[Daniel Schumacher:]

Thank you, Donna, 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 30th, 2019. 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:]

Thank you, Dan. Good morning everyone. Thank you for joining us on our second quarter conference call. I will begin with an overview of our second quarter financial performance and significant accomplishments during the quarter. Then John will provide a detailed look at our financial performance, as well as our outlook for the third quarter of 2019. This morning we reported record quarterly revenue of $115.9 million, representing growth of 5.7% over the second quarter of 2018 or 7% in constant currencies. Our adjusted earnings per share were $0.71, representing a $0.02 per share sequential improvement. Revenue growth in our legacy services was approximately 9% in constant currencies with our acquired Rapid Manufacturing business declining 8.6% compared to the prior year. As we look at second quarter revenue by geography, the Americas, our largest market, produced revenue growth of 5.6% over the prior year. Year-over-year revenue growth in our legacy services in the Americas was 8% with our acquired services pulling down that growth rate. As we stated in our first quarter conference call, we're focused on improving the performance of the acquired sheet metal and expanded CNC services, and realized a sequential increase in revenue of $2.1 million. Turning to customer end market performance in the Americas, the medical industry showed strong growth, while automotive and industrial machinery and equipment end markets declined year-over-year. Our European region produced year-over-year revenue growth of 10.2% in constant currencies. However, due to currency headwinds, reported growth was 3.6%. As it relates to customer industries, we saw similar trends in Europe as in the Americas, with strong performance in medical and year-over-year declines in automotive and computer electronics.

[John Way:]

Thank you, Vicki. Revenue in the second quarter was $115.9 million, an increase of $6.3 million or 5.7% over the same quarter in 2018. Foreign currency had a slightly larger negative impact than we expected, representing a $1.4 million headwinds in the quarter, resulting in revenue growth of 7% in constant currencies. Turning to product developers. Our second quarter unique product developers served increased to 20,840 or 4.7% growth compared to the prior year. Gross profit for the quarter was $60.2 million, an increase of $1 million over the comparable quarter of the prior year. Gross margin was 52% in the second quarter, up slightly from 51.9% in the first quarter of 2019. This compares with 54% in the second quarter of 2018. Year-over-year gross margin compression in the second quarter was due to the following factors. Our Rapid Manufacturing operations represented a 100 basis point headwind to our consolidated gross margin for this quarter compared to the second quarter of 2018. The investment in our new CNC facility in Minnesota to support future growth increased our fixed costs that we will leverage over time, and are resulted in a 50 basis point decrease in gross margin. The remaining 50 basis point decrease was driven by a number of factors, including wage inflation, investments to support expanded offerings and business mix, partially offset by pricing. Operating expenses totalled $40.7 million or 35.1% of total revenue in the second quarter of 2019. This compares to $39.4 million or 34.7% of revenue in the first quarter of 2019. Sales and marketing was 16.6% of revenue in the quarter, up slightly from Q1 and consistent with our guidance. Our sales and marketing costs include investments in developing our voice of customer capabilities and trade show activity that is seasonally higher in the second quarter. Research and development was 7% of revenue, consistent with the first quarter. We will continue to invest in R&D at these levels in 2019 to expand our capabilities in each of our services and improve our customer experience and internal systems to support the future growth of the business. On a GAAP basis, our tax rate was 21.9%, up from 19.6% in the second quarter of 2018. On an adjusted non-GAAP basis, the tax rate was 22.7% in the second quarter compared to 22.5% in the prior year. On a GAAP reporting basis, net income totaled $16.2 million, resulting in diluted earnings per share of $0.60.

[Operator:]

Thank you. Our first question is coming from Brian Drab of William Blair. Please go ahead with your question.

[Brian Drab:]

Good morning. Thanks for taking my questions.

[Vicki Holt:]

Hi, Brian.

[John Way:]

Good morning, Brian.

[Brian Drab:]

Hi. First question, just on the developer count, are you concerned at all? And I assume it just has to do with the end market weakness and the headwinds. But are you concerned at all about the 5% growth in developer count that stood out to me in the numbers today?

[Vicki Holt:]

Yes. So the development -- developer count growth is pretty consistent with where we are in the revenue growth. So as you said, do you think the macroeconomic climate is having an impact on that, but pretty consistent with where we are with revenue growth

[Brian Drab:]

And -- yeah. So there's nothing else going on there, I guess. What are you expecting for the revenue per developer going forward and what ways can you increase there?

[John Way:]

Yeah. I think as we progress over time and continue to drive growth in the rapid services, actually revenue might outpace our product developer growth as we do some of that cross-selling and sell more services to those existing developers. I think we've talked in the past, injection molding -- when injection molding grows, grows strong the revenue per developer growth is strong. And just because of it, the order sizes have their relative services. I think we continue to focus on our customers, what their needs are and try to offer them the best service to meet their needs.

[Vicki Holt:]

Yeah. And I'll build on that a little bit. As on-demand manufacturing grows in injection molding, you not only get the follow on parts from that with each developer, but you also see more complex molds and structures. So that also helps also the other levers that can be pulled in terms of driving revenue growth per product developer.

[Brian Drab:]

Okay. Great. Thanks. And then just on the guidance, the mid-point of the year-over-year revenue growth guidance is 3% to 4% for the third quarter. So can you make any comments as to where you think the different segments and or regions will be directionally relative to that kind of midpoint, like above or below the midpoint?

[Vicki Holt:]

Yeah. The Americas will probably have been pretty close to the midpoint. I mean, given the fact that it drives -- it's our largest region and generally drives a lot of the growth. Europe may be a tad higher than that and of course, Japan will likely be higher as well. But the Americas being such a big percentage tends to drive it. There is also some foreign currency headwinds that we're dealing with as well, that's going to impact that temper what we've got there in Europe. Overall, as we said in our comments that we think our guidance is the best guidance we can make given the visibility we have today. It's coming off of a very tough prior year comparable that we're comparing with, coupled with what we're seeing with some of the macroeconomic slowdowns in some of our end markets. We feel this is the best visibility we've got right now on guidance.

[Brian Drab:]

Okay. And then just one last on the sheet metal. So it sounds like you feel quite a bit better about the sheet metal business now relative to how you sounded on the first quarter call. How much demand are you seeing for that three-day offering and what percentage just roughly of your business in sheet metal can you actually do with a three-day offering?

[Vicki Holt:]

I will say that the sequential growth out, we've only launched this in May, so we don't even have a full quarter there. But the sequential growth that we're seeing in our specialty services is good and we're pleased with the feedback we're getting on three-day. So it is a new offer and so it's something that the customers are learning about and learning to take advantage of. But when they do, they have been very pleased with it.

[Brian Drab:]

Okay. And is it just a fraction of the business that you can do three-day or is this kind of a pretty broad this rollout for three-day offer?

[Vicki Holt:]

No. It's pretty broad. It's very broad. Yeah, it's very broad. It captures a good percentage of the geometries that we can do in three-day, absolutely, in our specialty service.

[Brian Drab:]

Okay. Thank you very much.

[Operator:]

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

[Troy Jensen:]

Right. Hi, Vicki. Hi, John. Thanks for taking my questions here. I think I want to dive in Vicki on just the injection molding business. I mean, it's hovering around 7% growth. And I do not kind of focus on this question a lot with you guys, but just hear your thoughts on why it's not growing better organically. It seems like you guys have added a lot of new services and now it's color matching.

[Vicki Holt:]

Yeah.

[Troy Jensen:]

I mean, is on-demand manufacturing the key to really get this injection molding business growing again, or I mean, can you -- it's pretty important because it tap the business. Go ahead.

[Vicki Holt:]

Yeah. I agree. I agree. Well, first, let me say, on an adjusted for currency basis, our injection molding business grew 9% in the quarter, so approaching that double-digit. And yes, the on-demand manufacturing offer is one of the key drivers to move that and keep that injection molding business in that upper singles to low double-digit number. So we -- that's absolutely critical. And we are continuing to add things to that offering, as we learn from our customers what more they need. Now, some of the offers that we've added, I mean, we pointed out, have been really focused on a really strategic and focus accounts, not broadly offered, because we're still working to understand how best to scale those offers and how best serve those offers up to our customers in the e-commerce experience. So, there still basically, we're learning as we begin to get experience with this more expanded offer. We are very excited about the custom color offer. We're starting to see some very early interest in that, particularly in the on-demand manufactured space where there might be multiple parts that they now can bring forward in a customer color approach. So, we're pleased with that. And as we've mentioned before, when you look at our injection molding prototype business, there's been an impact there with the growth in the last three to five years of desktop printers, or maybe one of the first iterations of a part might take place with a printer down the hall. So the number of prototype iterations with injection molded mold is probably somewhat reduced. So that, again, underscores the need to really move into the on-demand manufacture space. And that's what's driving the growth today.

[Troy Jensen:]

Yes. Okay, understood. Good luck. And here -- well, just a quick one for John to -- we should assume Q4 is seasonally a down sequential quarter, right, historically, as for you guys, that of acquisition years?

[John Way:]

Yes. I think it will. As we look at the seasonality patterns and how we're trending through the year, I think it will be slightly down in Q3.

[Troy Jensen:]

Okay, perfect. And maybe just one more for either one of you guys, just -- I guess, quarters ago we thought China trade -- tariffs could be a positive for Proto Labs. It doesn't seem like we're kind of seeing it yet. But, Vicki, any conversations or any updated thoughts on that topic?

[Vicki Holt:]

Yes. So, I had several conversations with companies that are looking at their supply chains. But remember, the investments that took place over the last several decades for more extended supply chains in the Asia, are not easily unraveled and the investment to bring it back is also significant. So, although, there's a lot of discussion among manufacturers about how to -- what options they have to deal with the differences and trade tensions, I still think there is -- it's a big investment and big change. And so, those don't happen quickly.

[Troy Jensen:]

Yes. Clear. Understood. Good luck in the second half.

[Vicki Holt:]

Thanks.

[Operator:]

Thank you. Our next question is coming from Andrew DeGasperi of Berenberg. Please go ahead.

[Andrew DeGasperi:]

Good morning. Hi. I guess, my first question on Japan and Europe, I mean, growing really well, considering everything that was just discussed. I mean, anything that you can comment in terms of why you're counter cyclical, even though some of -- I think, maybe, European auto business is cutting R&D budgets and everything?

[Vicki Holt:]

Yes. So, in Europe, our auto business was down. So I think what you see there is the continued penetration that we're getting across many of the other industry segments that's helping drive that. It's a lower base, so remember, we entered in the Europe and even the Japan market far later than the U.S. market, so -- and you've got a lower base from which to grow. So we continue to drive new product developers and penetration in our key markets. Medical was a real strong market for us. In the quarter, medical was one of our -- we target as a high potential industry segment. We tend to get better close rates in the medical segment and longer lifetime value. So as we continue to enhance our go-to market model in -- across the -- globally to focus on high potential industry segments, that's helping us in Europe. Japan is also a very low base. So, you're growing from -- I mean, we have a lot of penetration there, because we're younger in that market. But what you're seeing, I think, is that the benefits that we're getting from our relationship with Misumi, coupled with our benefits of growth outside Misumi, as more and more customers in that market get used to doing business in a B2B environment in e-commerce, which is, the Japan is a little bit behind the rest of the world there. But they're recognizing, they've got to get on the Industry 4.0 bandwagon and take advantage of digital model. So we're starting to see some improvement there.

[Andrew DeGasperi:]

Great. And then, the 3D metal on-demand, I mean maybe help us understand like what kind of opportunity do you see in that business.? And -- I mean, how many part runs can you do in a month for -- with those kind of machines?

[Vicki Holt:]

Yes. So, first, let me comment a little bit about that space in total. So, it's still very, very early in the use of 3D printing for production parts, across both metals and plastics. We feel that as a leader in 3D printing, with our knowledge of the technologies and the capabilities that we are in the best position to help companies learn how to use that technology for production parts. The close cycles for those are long, because you've got to not only develop the part itself in its geometry and how it's going to be made, but you also have to develop all of the secondary operations that usually go with it, coupled with the quality control plans that would allow a product to move into a production application. So longer cycles, but we've got a lot of interest from our key industry verticals like med device and aerospace to be the ones to help them navigate this change. So it's a great offer for us. I wouldn't expect quick hockey stick changes in revenue there.

[John Way:]

Yes. And, Andrew, I think the other thing to think about there is, as we've talked about in kind of all of our services, it is in the low-volume space. So it's not like we'll start up these machines and have them run for a year producing these parts. And a lot of them, at least to date, are somewhat smaller parts and as companies are continuing to learn how to use this technology effectively. We think it will pick up over time. But we want to be the leader as it does pickup.

[Andrew DeGasperi:]

Great. Thank you.

[Operator:]

Thank you. Our next question is coming from Greg Palm of Craig-Hallum. Please go ahead.

[Danny Eggerichs:]

Hi, guys. This is actually Danny Eggerichs on for Greg today. Thanks for taking my questions.

[Vicki Holt:]

Hi, Danny.

[John Way:]

Hi, Danny.

[Danny Eggerichs:]

I know you don't specifically guide by segment. But just looking at your results here for Q2, were there any segments that significantly outperformed or underperformed against like your prior expectations?

[Vicki Holt:]

In terms of services or end markets?

[Danny Eggerichs:]

In terms of service, actually.

[Vicki Holt:]

Services, services. Not really. I think the CNC machining a little bit, but…

[John Way:]

Yes. Danny, I think the foreign currency headwinds were a little greater than we thought they were. Adjusting for that, we're kind of in the middle of our guide. CNC was a little wider, but coming off really strong growth from a year-over-year perspective. As we looked at it through the quarter, June was a little bit softer than we would have anticipated. So we ended the quarter a little softer than we had started it. So I think those three factors are really what's kind of driving, probably more so the guide for Q3, than where our results came in Q2.

[Danny Eggerichs:]

Okay. Great. I guess you just mentioned that June was a little bit softer there. Is there anything that you're seeing so far in July, any commentary that you can give there?

[John Way:]

I think it's reflected in our guidance.

[Danny Eggerichs:]

Okay. And then just lastly, given the departure of the CRO this past quarter, is there any plans to replace position? And can you kind of remind us of what some of his major initiatives were?

[Vicki Holt:]

So first let me say that, one of the things that was a major initiative was to build the team in each of the regions with really strong sales leadership in the Americas, in Europe and in Japan. And we have that in place right now. So that really takes off any pressure to immediately jump into any kind of a refill – a backfill of that role. The real initiative of continuing to evolve the go-to market model and one of the things that we've been doing here in 2019, in addition to significant amount of training for our sales team, both on the technologies, but also on – on actual selling skills – strategic selling skills and strategic partnering with customers. We've also been focusing on high potential customer segments that we've identified, based on the analysis of our data. And that's allowing our sales and marketing teams frankly to really focus where we can get the greatest return for our sales and marketing investments. And that's the major area where we continue to enhance and grow our voice of customer investment that we've gotten from our chief marketing officer that joined us recently as well. He's now got a full year with us, so it's going to allow us to continue to enhance that. So we're not rushing to fill that role at this point in time. And we will be continuing to evaluate what we need going forward.

[Danny Eggerichs:]

All right. Great. I appreciate the color.

[Operator:]

Thank you. Our next question is coming from Brian Drab of William Blair. Please go ahead.

[Brian Drab:]

Hi. I just wanted to get some further color on the outlook, if you would be willing to give it in terms of gross margin. First of all, in the second half of the year, do you expect gross margin to tick up sequentially?

[John Way:]

Yeah. I think as we're looking at it, we look to drive sequential improvement, but modest sequential improvement. Really as we're looking at it that gross margin is going to be impacted by revenue. So the – better the revenue growth, the better ability we have to drive the gross margin improvement. So flat to up a little bit is the way I would look at it.

[Brian Drab:]

And I think you gave the headwinds related to Alpha and Rapid, but what was the absolute gross margin level, at least roughly at each of those operations?

[John Way:]

Rapid actually improved and it is close to 30%. And in our 3D printing business in Europe is in the low 20s.

[Brian Drab:]

Okay. And can you just make any statement about where you think those kind of level off when they reach steady state? And I don't know if that's 12 months or two years from now, but…

[John Way:]

Well, I think what we're driving to and what we've got plans in place initially is to get the sheet metal gross margins up to the 40% range, and get the 3D printing in Europe up to the 30% range. Once we accomplish that, we will set out the next set of initiatives to continue to drive up from there. But I think the current plans are to get those two at those levels.

[Brian Drab:]

And is that you think, John, within the next couple of years or any rough timeframe around that?

[John Way:]

Yeah. I – yes, I think that's the right timeframe. I think again, revenue growth is going to be a big factor in that. And the ability to continue to pull in the revenue will help us leverage in the fixed cost and drive those margins.

[Brian Drab:]

Okay. And you talked a little bit about, I may have missed as I was taking notes here. But what specifically are you doing to further penetrate aerospace and medical markets? You mentioned those as obviously key initiative areas.

[Vicki Holt:]

Right. So we put dedicated business development resources that frankly have some experience in those end markets that are helping us build relationships, but also helping our sales and marketing teams tailor what we're doing to those segments, so both from a marketing engagement, but also sales and marketing – also on the sales team. And also this team is helping us in form our roadmap going forward, so that we can continue to meet the needs of that segment.

[John Way:]

And those are two of the industries that are looking at how to utilize metal 3D printing production, so we're working with them closely to help develop that and get their parts in those services.

[Vicki Holt:]

And the med device segment is also very excited about custom color injection molding. So that's the segment that tense uses our injection molding tooling, and to be able to do that with custom color is a welcome addition.

[Brian Drab:]

Got it. Okay. Thank you very much.

[Vicki Holt:]

Thank you.

[Operator:]

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

[Vicki Holt:]

Thanks, Donna. Thank you for joining us today. We remain excited about the outlook for Proto Labs. As we look ahead, we are confident that the current long-term Industry 4.0 mega 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 the competition. We continue to innovate with our service offerings and technology interface and features to enhance our customer experience. I want to thank the Proto Labs employees for their continued efforts as well as our customers for their support. We are committed to driving great shareholder value in 2019 and over the long term, and look forward to reporting to you on our progress during the next quarter. Thank you.

[Operator:]

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.