Stratasys Ltd.
Q4 2013 Earnings Call Transcript

Published: 3 Mar 2014

[Operator:]

Good day, ladies gentlemen, and welcome to the Q4 2013 Stratasys Earnings Conference call. My name is Ian. I'll be your operator for today. [Operator Instructions] As a reminder, this call is being recorded for replay purposes. Now I'd like to turn the call over to Mr. Shane Glenn, Vice President, Investor Relations. Please proceed, sir.

[Shane Glenn:]

Thank you, Ian. Good morning, everyone, and thank you for joining us to discuss our fourth quarter and full year 2013 financial results. On the call with us today are David Reis, CEO; Erez Simha, CFO and COO of Stratasys. Bre Pettis, CEO of MakerBot, will join us later in the call to answer questions regarding MakerBot products and strategy. A reminder that access to today's call, including the prepared slide presentation, is available online at the web address provided in our press release. In addition, a replay of today's call, including access to the slide presentation, will also be available. It can be accessed within the Investors section of our website. A reminder that certain information included or incorporated in this presentation may be deemed to be forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements are often characterized by the use of forward-looking terminologies such as may, will, expect, anticipate, estimate, continue, believe, should, intend, project and other similar words, but are not the only way these statements are identified. These forward-looking statements may include, but are not limited to, statements relating to the company's objectives, plans and strategies; statements that contain projections of results of operations or financial condition, including with respect to the MakerBot acquisition; and all statements other than statements of historical fact that address activities, events or developments that the company intends, expects, projects, believes or anticipates will or may occur in the future. Forward-looking statements are not guarantees of future performance and are subject to risks and uncertainties. The company has based these forward-looking statements on assumptions and assessments made by its management in light of their experience and their perception of historical trends, current conditions, expected future developments and other factors they believe to be appropriate. Important factors that could cause actual results, developments and business decisions to differ materially from those anticipated in these forward-looking statements include, among other things, the company's ability to efficiently and successfully integrate the operations of Stratasys Inc. and Objet Limited after their merger, as well as the ability to successfully put in place and execute an effective post-acquisition integration plan for MakerBot; the overall global economic environment; the impact of competition and new technologies; general market; political and economic conditions in the countries in which the company operates; projected capital expenditures and liquidity; changes in the company strategy, government regulations and approvals; changes in customers' budgeting priorities; litigation and regulatory proceedings; and those factors referred to under Risk Factors, Information on the Company, Operating and Financial Review and Prospects and generally in the company's annual report for 2013 filed on Form 20-F and other reports that the company files with the U.S. Securities and Exchange Commission. Readers are urged to carefully review and consider the various disclosures made in the company's SEC reports, which are designed to advise interested parties of the risk and factors that may affect its business, financial condition, results of operation and prospects. Any forward-looking statements in this presentation are made as of the date hereof, and the company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise, except as required by law. Now I'd like to turn the call over to David Reis, Chief Executive Officer of Stratasys. David?

[David Reis:]

Thank you, Shane, and good morning, everyone. Thank you for joining today's call. We are very pleased with our record fourth quarter and full year financial results. The company observed strong demand across all product categories during the fourth quarter, driven by the merger revenue synergies and our rapidly growing industry. Organic revenue growth was an impressive 36% during the fourth quarter over the fourth quarter of last year with hardware and consumable revenue, excluding sales of MakerBot products, growing by 38% and 33%, respectively. MakerBot also performed impressively, contributing revenue of approximately $25 million to the fourth quarter as the rapidly growing desktop category sustained strong growth sales momentum. Our gross margin increased both year-over-year and quarter-over-quarter, driven by the sales of our higher-margin products and operational improvements. The margin expansion, combined with our strong sales performance, contributed to a record quarter in terms of profit and earnings per share. In addition to our strong fourth quarter financial performance, we continue to aggressively expand our global market presence from channel extension and strategic partnerships. And we introduced several new systems and materials that are a result of our focused investment in R&D and product development. Finally, with the first phase of the Stratasys-Objet merger integration completed, we are now focusing our attention on better aligning additional functional areas within our company, including R&D and operations. I will return later in the call to provide you with more detail on these developments and our strategy moving forward. But first, I would like to turn the call over to our CFO and COO, Erez Simha, who will provide you details on our financial results.

[Erez Simha:]

Thank you, David, and good morning, everyone. As in previous quarters, our focus on today's call will be on the non-GAAP financial results of the combined company for the fourth quarter of 2013 and pro forma non-GAAP financial results in the fourth quarter of 2012, giving effect to the Stratasys-Objet merger as if it has occurred on January 1, 2012. These non-GAAP financial measures should be read in combination with our GAAP metrics to evaluate our performance. You should also note that we are not providing any pro forma financial result for the MakerBot acquisition. MakerBot results were included in the GAAP and non-GAAP results commencing August 15, 2013. The non-GAAP to GAAP reconciliations are provided in a table contained in our slide presentation and press release. As David mentioned in his opening remarks, we are very pleased with our fourth quarter performance. We generated $156 million in revenue in the fourth quarter, an impressive 62% increase over the pro forma results for the same period last year. Our organic revenue growth was an impressive 36% over the same period last year, driven by Stratasys-Objet merger synergies and a rapidly expanding market for 3D printing and additive manufacturing solutions worldwide. MakerBot also made a significant revenue contribution of $24.9 million to the fourth quarter, sustaining its strong positive sales momentum within the rapidly growing desktop category. Driven by our strong sales and combined with the sales mix of higher-margin products, we generated record profits in the fourth quarter. Although MakerBot product margins are slightly lower than our corporate average, we were pleased to see our margin moved higher for the quarter. Net profit grew by 59% to $25.8 million or $0.50 per diluted share over the $16.3 million or $0.40 per share -- per diluted share on a pro forma basis for the same period last year. Product revenue in the fourth quarter of 2013 increased by 66% to $135.6 million as compared to pro forma combined product revenue in the fourth quarter of 2012. System revenue increased by 80% in the fourth quarter over the pro forma results for the same period last year, driven in part by MakerBot's impressive contribution to system revenue during the period. Hardware revenue, excluding MakerBot products, was also impressive for the period, growing by 38% over last year. This strong organic growth was a result of broad-based demand across our entire product line, including the Production Series, Design Series and Idea Series of 3D printers. The demand for manufacturing in high-end prototyping applications continues to drive this growth. Consumables revenue in the fourth quarter increased by 40%, or 33% excluding MakerBot revenue, compared to the pro forma results for the same period last year. Consumables revenue continues to be driven by an acceleration in customer usage, our growing installed base of systems and our efforts surrounding application training and materials education. In addition, the strong sales of our Production and Design Series system in previous periods contributed to the strong consumable sales growth in the fourth quarter given the relatively higher consumable utilization rate. We believe that the continued strength in the Production and Design Series system sales are positive indicators of consumables revenue growth in future periods. Revenue from service offering in the fourth quarter of 2013 increased by 37% to $20.2 million as compared to the pro forma results for the same period last year. The growth in service revenue is driven by increased revenue from maintenance contracts and service parts, reflecting our growing base of installed systems. In addition, revenue from our RedEye paid parts service increased by 22% for the fourth quarter over last year, primarily due to the increasing demand for large and complex production parts, as well as the ongoing development of the RedEye sales channel. The number of 3D printers and additive manufacturing systems shipped in the fourth quarter was 10,963 units as compared to 1,136 units shipped in the fourth quarter of 2012 on a pro forma combined basis. The significant increase in unit shipments resulted primarily from the inclusion of MakerBot products. We also observed strong unit sales growth across our other product lines with organic unit sales increasing by 44% for the fourth quarter as compared to sales on a pro forma basis for the same period last year. Including all systems sold by Stratasys, Objet, Solidscape and MakerBot, since their inception, the company has now sold 75,818 units worldwide on a pro forma combined basis as of December 31, 2013. Driven by sales of our higher-margin system and consumables, the company gross margin percentage improved to 60.2% in the fourth quarter over the 57.8% on a pro forma basis for the same period last year. Gross margin percentage also improved over the level recognized in the third quarter of 2013. As we mentioned earlier, we believe that this is very impressive when you consider the impact of MakerBot on the quarter, given that MakerBot systems inherently maintains lower margin. Net research and development expenses increased by 67.7% to $15.5 million in the fourth quarter as compared to pro forma amounts for the same period last year driven by the inclusion of MakerBot R&D expenses, as well as higher spending on new projects. SG&A expenses increased by 66.4% for the fourth quarter as compared to pro forma amounts for the same period last year, driven by the inclusion of MakerBot SG&A expenses, as well as expanded headcount to support our growth plans, higher commission expenses due to increased sales, and more importantly, incremental sales, marketing and infrastructure investments. Slide 10 provides you with an overview of the major growth drivers we have discussed for the period. The following slide provides you a breakdown of our geographic sales. We witnessed strong growth in North America, driven in part by MakerBot's strong focus on the U.S. market. The Asia Pacific region was our fastest-growing region in an organic -- on an organic basis, driven by our ramping sales and marketing investments in that region. I won't be reviewing the specific reconciliations to GAAP for the non-GAAP measures we have discussed throughout our presentation today. This information is provided in the slides appearing at the end of our presentation, as well as in our earnings release. We maintain approximately $616 million cash, cash equivalents and short-term deposits and investments on our balance sheet, amounting to $12.50 per share, which was relatively unchanged versus the balance at the end of the third quarter of 2013. Net operating cash flow from operations in the fourth quarter was $15.6 million, and capital expenditure amounted to approximately $30 million in facility and equipment investments. Our significant cash balance, combined with our available $253 million revolving credit facility, provide us flexibility to fund our internal growth plans as well as future M&A projects and investments. Inventory increased to $88.4 million in the fourth quarter compared to $79.8 million at the end of the third quarter in anticipation to our company-wide Oracle implementation in January. Accounts receivable increased to $99.2 million in the fourth quarter compared to $86.6 million at the end of the third quarter, while DSO on 12 months trailing revenue was 74 for both period. In summary, we are very pleased with our fourth quarter results. We generated impressive organic sales growth, observed strong contribution from MakerBot, experienced impressive margin expansion and generated record profits and earnings per share. We have a strong balance sheet and continue to position the company for future growth through strategic investments in R&D and channel development, as well as additional acquisitions. I would like now to turn the call over to our VP of Investor Relations, Shane Glenn, who will update you on our financial guidance. Shane?

[Shane Glenn:]

Thank you, Erez. Stratasys reiterated the following information regarding the company's projected revenue and net income for the fiscal year ending December 31, 2014

[David Reis:]

Thank you, Shane. The revenue synergies that are resulting from the Stratasys-Objet merger, combined with the rapid growing market base, are once again reflected in the strong organic revenue growth that we generated during the fourth quarter. We are very pleased with the result of our sales, marketing and service team integration, which is now completed. We now turn our integration focus to align the other function areas within the company to include R&D and operations. We continue to invest effort in building and implementing the scale and infrastructure needed to execute the growth strategy in the following areas

[Operator:]

[Operator Instructions] Stand by for you first question, which is from the line of Troy Jensen at Piper Jaffray.

[Troy D. Jensen:]

David, how about quickly for you? You mentioned doing the next phase of the integration here between Objet and Stratasys, the R&D and the operations.

[David Reis:]

Right.

[Troy D. Jensen:]

I guess I'd just like to get some more details on that because, to me, it feels like FDM and jetting are a little bit different technologies. So what are the synergies in R&D? And then I do have a follow-up.

[David Reis:]

There are 2 areas of synergies. One of them has to do with the operations. We just recently restructured ourselves in a way that will allow us to benefit from operational synergies across the different platform technologies and geographies, and we are going to do it during 2014 and '15. There's a lot to do there. And on the R&D side of it, we are looking better -- we are looking mainly better on kind of, say, a global perspective of the overall portfolio of technologies and products in a centralized way, which again was driven by organization change that took place here that will allow us kind of better perspective on the overall product portfolio, technology offering, et cetera.

[Troy D. Jensen:]

All right. All right, understood. So then a follow-up either for you, David, or for Bre on the MakerBot side. If you guys achieve this minimum organic growth rate of about 25%, I think you mentioned in a prior guidance, I think that implies $105 million to $110 million for MakerBot revenues, by my estimate. So if you just kind of look at the midpoint -- or excuse me, what the company just did and a run rate at about $100 million, it seems like that's a little conservative. So could you just kind of talk about the organic growth for MakerBot, kind of reconcile these 2 numbers here?

[Bre Pettis:]

Okay. This is Bre. Thanks for asking the question. So there's a couple factors there and the first one is the MakerBot product line is subject to greater seasonality. We've had a prosumer line and we're launching -- one of the 3D printers we're launching is a consumer 3D printer. So that has more seasonality to it. In addition, some of -- several of the new products we have recently introduced will not begin shipment until later this year, so we want to factor that into our assumptions. We're really pleased -- we're really -- and I mean it, we're really pleased with our recent growth, and we're very optimistic about 2014 and the guidance reflects that. We have established a guidance that we think is achievable and -- but we -- you have to understand that we're participating in a very dynamic industry and we're exploring new territory.

[Operator:]

We have another question for you. This one's from John Baliotti.

[John Anthony Baliotti:]

David, you talked about -- following up on Troy's question, you talked about lining functions like operations and R&D given the 3 merged portfolios. And despite some market perception that MakerBot is more for consumers, we know many professional engineering departments that are using them for whether it's tooling or prototyping and seen many of them expand into either the traditional Stratasys units or the Objet or -- obviously, which is a combined portfolio. Are you expecting -- maybe this is for you and/or Bre, expecting to have a more synchronized product development, given that you're customers are using the entire breadth of your offering?

[David Reis:]

There's a part of your question that I cannot answer. There are a lot of synergies between obviously the Stratasys product and the MakerBot product are basically operating very, very same technology. So in the background, we said it early before and during the merger, we are planning to align efforts in R&D to share IT and technology. On the other hand, on the go to market, I think they are very unique products. As you can see, both of them are selling very well and we'll continue, I think, with this direction. Like we said all the way, we will integrate with exception. I mean, it's not a full integration.

[John Anthony Baliotti:]

Sure. I mean, I've just talked to some people who have started with the MakerBot, used it really aggressively and ended up buying a Fortus, which obviously you wouldn't be disappointed with and maybe not have bought a Fortus had they not had exposure with the MakerBot. And I just -- it seems like the synergies between the 2 or the complementary aspects are getting a lot tighter.

[David Reis:]

Yes. And again, I agree. The synergies around the -- for example, the size of the print, the variety of materials, the ability to use sophisticated support, so I hope that the trend that you described will become even more natural.

[Bre Pettis:]

Yes. I mean, your story makes me really happy thinking -- because getting into it is a lot about what MakerBot is, but it's also a professional-level machine that it expands in -- that story just makes me happy. I'm just -- thanks for sharing it.

[Operator:]

We have another question for you. This one's from Wamsi Mohan at Bank of America Merrill Lynch.

[Wamsi Mohan:]

Can you address the comment around the linearity across first half and second half relative to revenues? Obviously, MakerBot, given the timing of the product introductions and increased seasonality that Bre mentioned, is going to be more back half loaded. But could you maybe size the relative sort of seasonality between the first half and second half for the core business excluding MakerBot?

[Erez Simha:]

Wamsi, it's Erez. When we provided the 2014 guidance, we said that we see 2013 as more back loaded in both revenue and net income for the entire year. There are a few reasons for that and the first one was all activity around new products that we are going to introduce throughout the year. Some of it will not be available in the first part of the year. However, it requires a massive investment around R&D, marketing and sales in order to introduce those products to the market. So when we provided the guidance for 2014, we said that the second part of the year we see more revenue and more net income compared to the first part of the year. We didn't provide any size to this phenomena. And if we are talking about organic versus MakerBot, I think that the phenomena is similar. Both MakerBot and Stratasys will enjoy new product. Some of them will not be available in Q1, even not in Q2. However, the investment that we have to do in order to introduce those products to the market has to be done upfront prior to the introduction of the product, obviously, in Q1 and Q2. And this has impact on profitability, and of course, on net income -- on revenue.

[Wamsi Mohan:]

Okay. And as my follow-up, can you address the material usage dynamics that you're seeing in your installed base? It seems as though you're seeing an acceleration in materials usage, and I'm curious how sustainable you think that is and if there is a way to isolate the impact of the increased units versus increased utilization in the installed base.

[David Reis:]

That's a very good question. Thank you. It's David. You indicated correctly. There are 2 growth drivers that we see for the increased usage. One of them is let's call it the organic growth of the IB, itself. And here, the database or the statistic significance is big and we know quite well how to estimate machine consumption per industry, per geography, which is a base for our projections. There's another element, which Stratasys, for a relatively long time, maybe more than 2 years or 3 years already spending a lot of energy in, is treating the consumables as a product and promoting them via improved training, mainly application training, to customers and we witnessed an increase, which is -- in consumables demand, which is above the organic growth. And here again, it's related to training, to product introduction and to education.

[Wamsi Mohan:]

So you're saying there's some cyclicality to it and some season -- some more secular...

[David Reis:]

No, no. It's not seasonal or cyclical. It's just -- there's 2 elements. One, the growth in consumable sales is, one, related directly to the number of machines that we are selling and here it depends to where the machine is being sold, which industry and which geography. Some industries are consuming more. Some geographies are consuming more or less. And another parameter, which increases consumable itself has to do with our ability to better train customers and introduce to them new materials and make them switch to better materials, which increase in consumption. So we are dealing with both those elements through our consumable business units.

[Operator:]

We have another question for you. This one's from the line of Ananda Baruah at Brean Capital.

[Ananda Baruah:]

Hey, just 2, if I could. The first one is just, again, with regards to the 2014 revenue guidance. Could you just go through the appropriate context for us to understand the implied deceleration to 25% from mid-30s percent? And is that 25%, is that getting impacted by the seasonality in the MakerBot revenue stream? And then I have a follow-up. And I guess why would we expect the 25 -- a deceleration down to 25%? You guys have been accelerating for the last 12 months.

[Erez Simha:]

The 25% -- and it's not 25%. We said it's more than 25% and it refers to organic growth only. We said that the nature, the organic business of Stratasys -- Stratasys and Objet will grow more than 25% in 2014, and the MakerBot business will grow faster than that. I think that we feel comfortable with the guidance for 2014. Don't forget that we had a significant impact of integration in the first time in 2013 that I don't think that we will see a significant jump again in the contribution of integration results between Stratasys and Objet in 2014. And again, please, when you are looking at the number, please refer to more than 25%. We didn't say 25%, we said more than 25% organic growth.

[Ananda Baruah:]

Got it, that's very helpful. And I guess, as my follow-up, would love to just get an update on, philosophically, how you're thinking about the metals market. And then the consumer market as well, you're introducing a new sort of, let's say, a pure consumer MakerBot product. But just holistically, how are you thinking about metals and consumer going forward?

[David Reis:]

Again, my perspective of the metal market, I've said this a few times before, it's an interesting market. We need to judge our M&A strategy. We don't have metal in-house according to what we perceive to be our customers' requirements and needs. We are evaluating the market in an ongoing basis. And if and when we have something to say about it, we will announce it. We are looking at this market and we're following it up.

[Ananda Baruah:]

And the consumer?

[David Reis:]

Consumer? Bre is here and we're extremely involved. MakerBot Mini Compact Replicator is the first move into this market. Bre?

[Bre Pettis:]

Yes, I mean, this is -- we've really focused with the MakerBot Replicator Mini on an easy-to-use 3D printer. It's a one-touch 3D printer and -- but there's no compromise there. The extruder that we have in the MakerBot Replicator Mini is the same extruder that we have in the whole lineup. So it's a smaller 3D printer, but it's still you've got professional grade components and you've got most of the features of the MakerBot Replicator line in that, just a smaller -- a little smaller footprint.

[David Reis:]

I just want to add one thing to Bre's words is that when you sell [ph] consumer, I mean it's not only true for consumer, I mean, the printer is just one element in the overall picture. What I think MakerBot, led by Bre's doing extremely well, is creating the ecosystem, which will allow the usage of those printers. The hardware itself is an important element. But without the ecosystem; without the content; without the ability to share, to modify, to author, the ability to accelerate adoption is going to be limited. And what I think MakerBot is lead us, by far, is with this ecosystem, which is absolutely fundamental to the progression of this market.

[Bre Pettis:]

One example of that is that we launched the MakerBot Digital Store. What we found when we -- what we found is that some of our -- some of the people who have bought MakerBot Replicator 2s ended up using them just to entertain themselves, just to make cool stuff. And so the MakerBot Digital Store just makes it really easy for people who've never used a 3D printer to get great content that's really wonderful and download it and make it.

[Operator:]

We've another question for you. This one's from Sherri Scribner at Deutsche Bank.

[Sherri Scribner:]

I wanted to get a sense of your long-term guidance and your view of your positioning in the market. And also I wanted to get a little detail on what you're seeing from the market. So thinking about the at least 25% organic growth for you guys, do you think that the market itself is accelerating? Or do you think that you're growing faster than the market? And I wanted to get a little more detail on if you are seeing customers -- more customers and more interest in 3D printing.

[David Reis:]

Unfortunately, there's no short answer. First of all, I think we are growing faster than the market. When you talk about the market, unfortunately, I think we need to split it into 3 sections, let's call it. First one is the desktop, second is the rapid prototyping design market and the manufacturing market. Now each one of them has a different growth pattern, but all of them are growing and all of them are creating more demand than what they created in previous years. But nevertheless, each one of them has its own characteristics, so answer is a little bit complex.

[Sherri Scribner:]

Okay. Maybe I can ask you a little bit on the desktop market and the consumer -- prosumer market. What is your view on growth in that market at this point? Clearly, that's growing greater than 25%, but do you have a long-term expectation for that market's growth?

[Bre Pettis:]

It's one of those things where because it really is a new frontier, that we're going -- that I would be hesitant to make predictions on this one. What I will say is the more 3D printers that are out in the world, the more access there are to them and the more familiar people get with them. And that context just provides a fertile ground.

[Sherri Scribner:]

Okay. And then, Erez, I just wanted to ask you a little bit about the operating margins as we move through the year. Would you expect the operating margins to be at sort of the similar levels of 4Q throughout the year? Or do you think they'll be more heavily loaded to the front end because you're introducing new products toward the back end of the year?

[Erez Simha:]

I think that the operating margin will look better in the second part of the year as a result of higher top line in the second part of the year. And obviously, Sherri, most of the investment or significant part of the investment will be done in the first part of the year. Revenue from those investments we will see in the second -- mainly in the second part of the year.

[Operator:]

We've another question for you. This one's from Jonathan Shaffer at Crédit Suisse.

[Jonathan Shaffer:]

I was just wondering if the new product line at MakerBot will have any impact on kind of the profitability level there and whether that'll continue to be a drag to some degree on gross margin.

[Bre Pettis:]

Let's see. Can you ask that again to make sure I understand your question?

[Jonathan Shaffer:]

Yes, I'm sorry. I was just wondering if the new product line will change the margin profile of MakerBot in either a positive or a negative way.

[Erez Simha:]

We don't expect gross margin of MakerBot to be changed significantly as a result of introduction of those new products in 2014.

[Jonathan Shaffer:]

And then just on M&A strategy generally, I was just wondering if there's any areas of priority you guys are focusing on and just if valuations are still are higher or prohibitive to M&A right now.

[David Reis:]

You know the valuation as good as us in the market. And we have a professional process of searching for both technology, products and channel acquisitions, both on the core Stratasys business and on the MakerBot business. Nevertheless, like I said many times, we have a very professional team, which is doing it in a very professional way and we are going to decide or try to act as long as it's within our strategic long-term plan, and we are doing it on an ongoing basis.

[Operator:]

We have another question for you. This one's from Ken Wong at Citigroup.

[Kenneth Wong:]

On the 2014 guidance as well, you guys talked about flat operating margins. How should we think about gross margins in 2014? I mean, will it be closer to the 60% you guys put up this quarter or more in the high 50s that you guys have done in the past?

[Erez Simha:]

Gross margin will be similar to the entire 2013 gross margin and will be a combination of probably slightly increased in Stratasys gross margin. It's somehow muted by the lower gross margin that's generated by MakerBot.

[Kenneth Wong:]

So it sounds gross margins should be flattish or less?

[Erez Simha:]

Yes, yes.

[Kenneth Wong:]

Got you. And then on the MakerBot business, I mean, I think some of your competitors have gone pretty aggressively in terms of trying to develop a national retail footprint. How important do you guys think it is to have a similar type of a national presence? Or will you guys continue to just build out the retail channel as more of a kind of specific niche areas and building out your own MakerBot stores?

[Bre Pettis:]

Well, there's a couple parts to that. We have just launched a partnership with Dell. We have just launched a partnership with Micro Center. And we've -- and at the end of last year, we opened 2 new retail stores. So what I would say there is we really like having touch with our customers and it's one of our overall goals to have more intimacy with our users, and that's just one of the ways to do that.

[Operator:]

We've another question for you. This one's from Paul Coster at JPMorgan.

[Paul Coster:]

I just want to go back to the consumables for a second. David, you talked about how you're able to sort of work with some of your customers, I assume in rapid prototyping and manufacturing, to help them sort of optimize their use of materials.

[David Reis:]

Right, right.

[Paul Coster:]

At the entry level, desktop level, I imagine that's a bit more difficult. I'm sort of curious to know what the shape of the usage is at the desktop and also what you're doing there to try and sort of promote usage. And I've got one quick follow-up.

[David Reis:]

So for your first comment, you are right. With respect to the desktop part of it, I think that the consumable market for the desktop is evolving, okay? It's definitely different than the one that we are familiar with or are used to in the core Stratasys business. Nevertheless, I think we have the means and the tools over time to increase it in size and improve its margins, okay? So it's an ongoing process, but it's definitely different from what we and you are used when you look on the original Stratasys model.

[Paul Coster:]

Okay. I mean, what I'm sort of really driving at is do you find that there's a sort of peak usage right at the time of purchase and then it trails off and that's an issue to be addressed? Or do you find that the MakerBot community are actually ramping up their usage over time?

[David Reis:]

Again, I think the market is evolving. I can ask maybe Bre to add his comment. But we know that as we are adding new materials, new colors, new features, customers have the tendency to experience and try and build new things. So I don't think that it's kind of relaxing over time. It really depends on our ability to initiate new and attractive products for this industry and encourage more consumption. Bre?

[Bre Pettis:]

It's interesting, on the MakerBot side with folks who are getting it and using it for prosumer or professional uses, they really -- MakerBot can be like a really serious workhorse. And so for those folks, we see it's just great. They use lots of MakerBot filament, we love it. And I think what you see is more recreational users use less than that. But we really -- we've optimized this filament to just be a great experience. So it's nice and sticky.

[Paul Coster:]

Okay. My quick follow-up is that I'm not seeing any evidence of price-based competition in the rapid prototyping and the direct digital manufacturing segments. I don't really know what's happening in the entry level. Can you talk about the extent to which you see any sort of price-based behavior amongst either competitors or even amongst your consumers?

[David Reis:]

First of all, I think Erez said earlier that we do not anticipate a decrease in margin on the MakerBot side, okay? And again, I think that the way -- again, we should not look on this market as selling a hardware. It's not the case. Again, the providers of the ecosystem and the provider of the content and the tools and the accessibility in the community has an advantage. So it chooses our people which is selling less expensive, but MakerBot is able to sustain its gross margin and we -- saying that we expect it to continue into next year, and the reasons that they're able to do it is because, a, we have great product; and b, we're giving a full solution, which is the only solution -- the full solution today in the market.

[Operator:]

We have another question for you. This one's from Ajay Kejriwal at FBR Capital Markets.

[Ajay Kejriwal:]

So on Connex 3, it's a good milestone, I think. You've obviously been working on that for some time here. So give us a sense of the market size and opportunity and then where do you see the growth near term in terms of customer segments for the Connex product?

[David Reis:]

Let me get you -- I'll give you just one indication about the potential. We are serving our installed base of customers every year for the last few years. What we find out from this research is that a lot of our customers, and I'm not talking about 5%, I'm talking about in terms of percentage of our customers in the design engineering market are, at the end of the day, coloring and painting their models. So you can imagine what the potential of machines that does it off the machine. And I can say one other thing that the moment the color TV was fully available, nobody bought black and white.

[Ajay Kejriwal:]

Yes, yes. That's certainly -- that's a good analogy. And then on the launch of Z18, that's obviously a good product, large build size. Just, David, maybe any thoughts on implications for the merger? Would you expect any impact or shift in demand towards the Z18?

[David Reis:]

It's a little bit early to say. Z18 is coming to market in a few months. I think that if I judge from the short history that we have together, between the MakerBot and Stratasys, each of those machines, like the other machines, has its own space and its own customers. Nevertheless, I do think that some of them it will be kind of a "competitor," "internal competitor." But I think the module will have the space in the high-engineering precise market that requires unique materials and soluble support and the Z18 will find itself in other spaces of the market. It's too early to say, but at this point of time, I got a feeling in our analysis, is that those products will be able to live side-by-side.

[Operator:]

We've another question for you. This one's from Cindy Shaw.

[Cindy Shaw:]

First question, in the vertical market focus, is that more oriented towards direct digital manufacturing or prototyping? Or could you even say it's oriented towards one or the other?

[David Reis:]

When we're talking about vertical applications at this point of time, we have a dedicated focus, which is all the way from design manufacturing and go-to-market for 3 markets

[Cindy Shaw:]

And in terms of it, seems like it would be a fairly long process to ramp that up, really a multiyear process where you could be investing for an extended period of time and having it pay off for a period of time. Could you talk about how you're thinking about that and your expectations?

[David Reis:]

No, no. It's all in process. I mean, we are involved with the direct digital manufacturing for a few years. When we are saying vertical focus, it means that internally and externally with our channel, we are getting better organized to serve those markets, okay? So for example, in the U.S., for example, we have a dedicated, very large education market that we are now enhancing. Bre and MakerBot is developing special education initiatives and education channels, which will deal with education for MakerBot. So it's not a work starting today. In most cases, work started a few years ago, likewise in dental. But it means that the company, part of its growth plans is reorganize around this vertical in a way that we can expose them faster.

[Cindy Shaw:]

Well, in dental, you've got a special machine oriented toward that market, is that right?

[David Reis:]

Yes, we have a few specialized machines, both on the PolyJet side of the technology and Solidscape.

[Cindy Shaw:]

And Is that a big part of the focus of going after a vertical market? It's not just the marketing, but also having a dedicated machine? Or do you think there's going to be more of sales and marketing?

[David Reis:]

No, no. This is true to all the verticals. When we talk about verticals, we are talking about the total approach to market that starts from the printer, the consumables, the marketing approach and the go-to-market. So it's also, for sure, true for dental. We have machines which are dedicated for dental. We have machines which are dedicated for manufacturing. So it's all -- the idea is across all the sale or go-to-market process.

[Cindy Shaw:]

And is it fair to say that you think both the investment and the results are going to be a very long drawn-out processes so there's not going to be at some point where you say, okay, we've accelerated, we're over the hump, much like the integration of the Objet merger? Is this like a long, steady ramp over several years we should be thinking about versus kind of a...

[David Reis:]

Yes, yes, yes.

[Operator:]

We have another question. This one's from Jim Ricchiuti at Needham & Company.

[James Ricchiuti:]

Two quick questions just on the last topic. David, when would we know more about this -- some of the additional verticals you'd be going into? Would you anticipate disclosing any of that in the second half of the year?

[David Reis:]

When we have something to announce, we will announce it. I don't want to refer to exact time.

[James Ricchiuti:]

Okay. And just a question on consumables. You showed very good growth in Q4 year-over-year. If we think about the consumables business in 2014, the addition of Nylon, what seems to be a stronger revenue stream on MakerBot side from using their own filament, how should we think about the growth rate in consumables? Is there any reason to think that it won't grow at -- continue growing at this rate, just given what you're seeing in the market right now?

[Erez Simha:]

Jim, I think that the consumable analysis that you do, you should look on the entire-year picture because the impact of the utilization of the installed base on the consumables revenue has larger impact than the new sales or the materials that we introduce to the market. I think that MakerBot, at least, at this stage, the business model of MakerBot is heavily relying on the hardware sales where the consumable part is relatively small. Today, I guess, it would be also in 2014. All in all, I think that looking at the consumable picture in 2013, for us, it's a great, great, great result. And looking into 2014, for sure we'll continue to grow at least in the pace that it grew in the entire year of 2014 -- '13.

[Operator:]

Ladies and gentlemen, we've actually run out of time for our allocated Q&A today. We did have a few questions still waiting, so our apologies we're not able to answer them today. I'll now hand the call over to David Reis for closing remarks.

[David Reis:]

Thank you for joining us today. I'm looking forward to speak with you again next quarter. Thank you very much, and goodbye.

[Operator:]

Thank you, ladies and gentlemen, for joining today's conference. This concludes your presentation, and you may now disconnect. Have a good day.