Proto Labs, Inc.
Q3 2019 Earnings Call Transcript

Published: 24 Oct 2019

[Operator:]

Greetings. Welcome to Proto Labs Third Quarter 2019 Earnings Call. At this time, all participants are in listen-only mode. Please note this conference is being recorded. At this time, I will turn the conference over to Daniel Schumacher, Director of Investor Relations. Mr. Schumacher. You may begin.

[Daniel Schumacher:]

Thank you, Rob 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 third quarter ended September 30, 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:]

Thanks, Dan. Good morning, everyone. Thank you for joining us on our third quarter conference call. I will begin with an overview of our overall business performance in the quarter. Then John will provide a detailed look at our third quarter financial performance as well as our outlook for the fourth quarter. This morning, we reported record quarterly revenue of $117.5 million, representing growth of 1.8% over the third quarter of 2018 or 2.5% in constant currencies. Our adjusted earnings per share were $0.76, representing a $0.05 per share improvement over the second quarter of 2019. Our business grew year-over-year in the third quarter despite an industrial environment that has continued to soften. As you are all aware in September, the ISM U.S. manufacturing purchasing managers index, registered its lowest monthly measure since 2009. Both U.S. manufacturing production and capacity utilization for the industrial sector decreased in the quarter consistent with what we have said in the past. Our business is negatively impacted by a decline in manufacturing activity and industrial production. Our customers are taking a more cautious approach in general including R&D projects and that’s reflected in our year-to-date financial results. 2018 was a very strong year for Proto Labs for our customers and for manufacturing and industrial activity. If you recall tax reform had just gone into effect and business confidence and investment were both higher than current levels. To demonstrate the impact of the economy to our business our top 100 customers grew nearly 20% in the first nine months of 2018. In the first nine months of this year revenue generated from those same 100 customers was essentially flat. All these customers remain key Proto Labs customers, but their investment levels have varied due to the economic environment.

[John Way:]

Thank you, Vicki. Revenue in the third quarter was $117.5 million, an increase of $2 million or 1.8% over the same quarter in 2018. Foreign currency represented at $900,000 headwind in the quarter due to the relative strength of the U.S. dollar. Our third quarter unique product developer served increased to 21,471 or growth of 3.3% compared to the prior year with strong growth in 3D printing continuing to allow us to engage with our customers earlier in the product development cycle. Our non-GAAP gross profit for the quarter was $60.5 million resulting in a adjusted gross margin of 51.5% in the third quarter down sequentially from 52.6% in the second quarter of 2019. Sequential gross margin compression of 110 basis points in the third quarter was due to the following factors. The acquired rapid operations represented a 70 basis point headwind to our consolidated gross margin compared to the second quarter of 2019 due to lower volumes.

[Operator:]

Thank you. We will now be conducting a question-and-answer session. Thank you. The first question is 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 I guess the difficult macro environment is well understood and well publicized. So, maybe just getting into some of the details of the business first, so with rapid that business was up significantly sequentially in the second quarter and I am wondering if you could, I didn’t hear a number for rapid overall sequential, if you could give that number and then talk a little bit about why that business would kind of decline or – now sequentially when it should be ramping?

[Vicki Holt:]

Yes. So, well John kind of sequentially, it was down slightly and so just I pulled that number for me I don’t have them on top of my head, but let me just talk a little bit as I mentioned in the call, we are going through some major changes in that business with moving forward with a defined offer and frankly industry leading – lead times and stated lead times, so big changes that are happening in that business. And therefore some of the existing customers that or with that business had very complex plus really outside of our envelope today. So, we are continuing to see that piece of the business frankly not reoccur. We are seeing some success in bringing in new product developers from Proto Labs very large set of product developers that we serve. As I mentioned that grew over 20% year-over-year, but with the lower order value that we have on that revenue growth in total is still below our expectations. So, what we are really focused on is making sure that we can continue to improve that customer experience in a way that allows us to cross-sell. And in addition as you know when we bring new customers they’re off in the first order, they’re kicking their tires to try to see what our capabilities are, and it’s the second and third orders where they begin to increase that order value. So, we’re impacted by that as well. So it’s a – I’m confident getting customer feedback. They’re very pleased with the service. There is nobody out there that offers three-day lead times on sheet metal parts, but it’s a matter of turning those customers and taking share in a macro environment that frankly the machine shops and the local mom and pops around the quarter. They now have capacity and they can service that business. So, we’ve got to take that share from those in what is a more difficult macro environment.

[John Way:]

And Brian for the numbers on that, it’s down 9% or about $1 million.

[Vicki Holt:]

Sequentially.

[John Way:]

Sequentially.

[Brian Drab:]

About $1 million, 9%, okay. And then you talked about the pressures on gross margin. Can you talk about the outlook for gross margin? What do you expect gross margin to be in the fourth quarter and trending into 2020? Is there gross margin expansion potential from here and how much?

[John Way:]

Yes. So, I think, as we look at the fourth quarter and consistent with what we’ve discussed in the past and looking at our revenue guide. With the revenue coming down a little bit, we will be able to manage the labor cost and the materials, but we will have some challenges really managing the cost structure down with revenue being sequentially down. So, as we’re looking at gross margin, it probably will be a little bit lighter than where we are currently in the fourth quarter. We are focused on gross margin across each of our services. We’re going through our budgeting process right now and looking at the actions and building up the plans for 2020. We will be looking to drive improvement in the gross margins, but we’re going through the work right now to fully flesh out those plans.

[Brian Drab:]

Okay. And then I’ll just ask one more for now. But what have you seen in October in terms of demand relative to the third quarter and in October last year?

[Vicki Holt:]

Yes, I think, what we’ve seen in demand is that it’s pretty, it’s consistent with the guidance that we put out. So, we feel comfortable with, at this point, with the revenue guidance we just gave you.

[Brian Drab:]

Alright. Okay, thanks very much. I’ll follow up later.

[Operator:]

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

[Andrew DeGasperi:]

Good morning. I just want to ask sort of a follow-up on one area you mentioned in terms of the aerospace business slowing down. Do you think that’s a temporary blip, I know, saw this morning also mentioned something of a push-out on their end or is there anything specific that you can highlight?

[Vicki Holt:]

Yes, I think, it is a temporary blip. We see strong activity, we have a very strong value proposition in aerospace. And remember where we play in aerospace it’s not so much commercial aircraft. It’s in space, it’s in satellite communications, it’s in drones, and lots of lots of activity there, so year-to-date our revenue growth in that aerospace is still 7.2%, so really strong. It’s just in that particular quarter, it was basically flat or down very slightly. So, we’re still confident that’s got long-term legs and lots of R&D activity and low volume production in that space for us.

[Andrew DeGasperi:]

Got it. And in terms of the rapid business, I know, we’re focusing on that a bit, but just sort of a question in terms of how do you see this progressing? I guess in Q4 you’re dealing with the issues in the macro side and also the sheet metal business overall, but do you see this business returning to growth starting Q4 year-over-year, I know, last year it started declining or is it really just a 2020 event?

[Vicki Holt:]

Let me step back for a minute. So, one of the things that we’ve done has significantly changed the offer and then focusing on the cross-selling efforts with Proto Labs customers and teaching them really how our offer with sheet metal and the expanded CNC offer will work for them. So, that takes time. We also are in a macroeconomic environment where the competitors which really are the mom and pops have significant excess capacity. So unseating those current vendors and gaining that share in this environment is more difficult. We are turning those customers, I mentioned the 20% increase in product developers, but it will be somewhat muted. So, we’re being cautious on the forecast there recognizing we’ve got to be able to, in addition, create a much more integrated customer experience and that will take us a little time.

[Andrew DeGasperi:]

Got it. Last question, the low volume business versus prototyping, have you seen sort of a bigger pulled back from there at this point?

[Vicki Holt:]

So, we’ve seen across – are you talking particularly about the injection molding service?

[Andrew DeGasperi:]

Yes, correct.

[Vicki Holt:]

Where we have the – there we have a stated offer for on-demand manufacturing and we continue to see that growth and injection molding witnessed by the larger orders that we’re starting to see come through in that space. So, we feel comfortable with that. But our prototyping business in injection molding is growing as well. So it’s, I would say, that between the two they’re growing at comparable rates.

[Andrew DeGasperi:]

Got it. Thank you.

[Operator:]

The next question is from the line of Troy Jensen with Piper. Please proceed with your question.

[Troy Jensen:]

Hey, good morning, John. Good morning, Vicki.

[Vicki Holt:]

Good morning.

[John Way:]

Good morning.

[Troy Jensen:]

Hey, John, just for you. Sorry if I missed it, but can we touch a little bit more on gross margins. I mean if I look at Q2 you guys grew revenues slightly sequential and kind of kept margins flat, but in this quarter it grew slightly, but we’re down about 110 bps so?

[John Way:]

Yes, yes. So, rapid, is the biggest driver of that. So, the volume shortfall in that business is 70 bps of that 110. The remaining 40 was due to some of the product supplies and repair and maintenance. So, we had in some of our facilities in the U.S. but the acquired operations was the biggest component.

[Troy Jensen:]

Okay. So, sheet metal even though it’s only down 200,000 sequentially, it had a 70 bps sequential impact?

[John Way:]

It was the sheet metal and the CNC component, the operations that we required to do.

[Troy Jensen:]

Yes, that makes more sense.

[John Way:]

Combination of the two.

[Troy Jensen:]

Alright. And then, I guess, we saw some good leverage in sales and marketing in this quarter. It sounds like it may have been seasonal with some trade events, but else that Vicki made some comments, it was a bit more intentional. So, just be curious ultimately maybe not fourth quarter, but is there any leverage in the operating lines here that you guys can do to maybe offset the sluggishness in the top line?

[John Way:]

Yes, I think we are continuing to look at all the cost and the cost structure. I think ultimately as we’re looking at it, we’re building a business for the long-term and we’re staying focused on what we need to do to continue to expand the envelope. So and I think from an R&D perspective we’ll continue kind of at the same levels that we’re at. I don’t think we’ll pull back there. Sales and marketing, I think, we’ll be prudent with some of the marketing spend. But I think we are continuing to look to drive that volume growth. The G&A area is an area we’ll continue to look at continue to scrub and we’ll manage that right now.

[Vicki Holt:]

We continue to work on driving the productivity of our sales team. I mentioned before, we’re using data and analytics in order to have our sales team focusing on the opportunities that have the greatest lifetime value for us. So, that’s industry segments and types of customer companies. We’ve taken more productively drive long-term sales growth. So, I think, that focus and that use of data is also going to give us some opportunity over the long-term to drive the productivity of the sales team.

[Troy Jensen:]

Okay, great. I understand that. So, Vicki how about for you, I’d love to hear just kind of qualitatively your thoughts on 2020. And I know we’re not going to get numbers from you, right, specific guidance, but it doesn’t seem like we’re going to see a rapid recovery and ISM data or we’re coming into election year. So, I mean, Initial thoughts on 2020 would be awesome.

[Vicki Holt:]

Yes, so you read the same things I do I wish I could predict. I think what I’m hearing out there in the marketplace is that the first quarter maybe in the second we probably still going to see quite a bit of some headwinds we’re looking at toward the second half of the year, people are expecting things to recover a little bit. Now the other thing that we’ll have in 2020 of course this will be coming off comparable that aren’t so challenging. I mean, you look at the third quarter of 2018, we had a phenomenal third quarter of 2018. So, the comparables are pretty tough there as well. So, I think, you’ll see that coming through next year.

[Troy Jensen:]

Great. Well, good luck.

[Vicki Holt:]

Thank you.

[John Way:]

Thanks, Troy.

[Operator:]

The next question comes from the line of Jim Ricchiuti with Needham & Company. Please proceed with your question.

[Jim Ricchiuti:]

Hi, good morning. I wanted to follow-up on the comments that you made about some cautiousness that you’re seeing on some of the R&D projects. And normally I don’t – I wouldn’t expect you would see that in slowing macro environment particularly something that’s fairly modest slowing. So, I wonder if you could elaborate on that or maybe talk a little bit about perhaps which verticals you’re seeing that in?

[John Way:]

Yes, I think, as we’re looking at it, Jim, and I think that’s why we gave the data point of our top 100 customers. Last year we saw strong growth in those top 100 customers and this year they’re essentially flat and what that creates is we delivered strong growth in 2018. Those customers haven’t increased their spending level from where that was in 2018. It’s flattened out more that’s kind of creating some of that challenge and putting pressure on that top line percentage growth number. Is that help?

[Jim Ricchiuti:]

It helps. I mean I would expect that R&D projects continue to get funded in this kind of environment. So I was just struck by that. I can see other parts of the business slowing. So, but maybe we could just switch gears for a second. And I’m also trying to reconcile the continued strength you’re seeing in 3D printing and I mean you called out a couple of areas metals, the multi jet and clearly those seem like good growth areas. But I’m wondering, are you – do you feel you’re just taking share or is this part of the business the market just continuing to grow beyond the core business beyond what you’re seeing in the core markets that you address?

[Vicki Holt:]

I think we’ve got a little bit of both going on. We do have a differentiated offer with respect to quality and the consistency and reliability of our offer. So, when customers are looking for high quality industrial 3D printed parts for their programs, we’re the place to go. So, I think, we’re seeing some of that, but I do think customers are learning more and more how to use 3D printing both in their product development cycle as well as how to design for 3D printing for production, and I think that’s what you see with the growth in our metal 3D printing and multi-jet fusion which are both technologies that are particularly valuable for production type programs. So, I think, it’s a little bit of both that’s happening with that business.

[Jim Ricchiuti:]

Vicki last question can you say which market verticals you seem to be getting the most traction in metals and multi-jet.

[Vicki Holt:]

We are seeing it in aerospace in med device and also somewhat in computer electronics in the multi-jet fusion plastic area. So, those would probably be the three industry verticals.

[Jim Ricchiuti:]

Okay, thank you.

[Operator:]

The next question is a follow-up from the line of Brian Drab with William Blair.

[Brian Drab:]

Hi. So, I’m just looking at the notes from the last call and the expectation for gross margin and just want to spend another second trying to understand more what has changed in terms of the trajectory because you’re really cautious. I think as you look to the second half of the year in terms of revenue growth, but you were expecting gross margin to step up sequentially. So, is the biggest factor there that’s changed in the rapid business or is it, I guess, a combination of that with increased caution on the overall top line trajectory?

[John Way:]

Yes, I think, it’s the – it’s easier to leverage cost when revenue is increasing right as revenue is lighter than we anticipated you’ve got to pull cost back and that’s just a bigger challenge. So, I think, it is the volume there and what we just experienced in rapid that’s creating that cost.

[Brian Drab:]

Okay. And then, John, can you just give us an update, just the numbers on where alpha gross margin is and where rapid gross margin is and what the overall headwind those are having not year-over-year, but just the overall headwind those have on the gross margins?

[John Way:]

Yes, so the rapid gross margin 260 basis point headwind on the overall and your 3D is about 130 basis points overall.

[Brian Drab:]

And where does that put, I guess, last quarter alpha was at a little over 20% gross margin?

[John Way:]

Yes, so we dipped down into the mid-teens in 3D printing in Europe and then in New Hampshire we’re in the 25% range.

[Brian Drab:]

Okay, got it. Thanks very much.

[Operator:]

Thank you. At this time, I will turn the call back to management for closing remarks.

[Vicki Holt:]

Thank you for joining us today. We are confident in the long-term prospects and the strength of our business model. Our differentiated technology-enabled digital manufacturing platform has demonstrated the ability to help companies and entrepreneurs get their products to market faster than their competition. We continue to innovate with our service offerings and technology interface and features to enhance our customers’ experience. I want to thank the Proto Labs employees for their continued efforts as well as our customers for their support. We look forward to updating you on our progress during our next call. Thank you.

[Operator:]

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