Cognex Corporation (CGNX) Q3 2013 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Cognex Third Quarter 2013 Earnings Call. [Operator Instructions] And as a reminder, today's conference is being recorded. And now, I would like to turn it over to your host, Richard Morin.

Thank you, and good evening, everyone. Earlier tonight, we issued a news release announcing Cognex's earnings for the third quarter of 2013, and we also filed our quarterly report on Form 10-Q. For those of you who have not yet seen these materials, both are available on our website at www.cognex.com. They contain highly detailed information about our financial results. During tonight's call, we may use a non-GAAP financial measure if we believe it is useful to investors or if we believe it will help investors better understand our results or business trends. For your reference, you can see the company's income statement as reported under GAAP in Exhibit 1 of the earnings release and a reconciliation of certain items in the income statement from GAAP to non-GAAP in Exhibit 2. I'd like to emphasize that any forward-looking statements we made in the earnings release, or any that we may make during this call, are based upon information that we believe to be true as of today. Things often change and actual results may differ materially from those projected or anticipated. Refer to the company's SEC filings, including our most recent Form 10-K, for a detailed list of these risk factors. Now, I'll turn the call over to Cognex's Chairman, Dr. Bob Shillman.

Hey, Dick, and hello, everyone. I'd like to welcome each of you to our third quarter conference call for 2013. As you might have been able to see in tonight's news release, which we just issued, we reported simply outstanding financial results for the third quarter, with records both in revenue and in net income. Right now, I'm calling in from our R&D center in San Diego, and the team is at our Natick headquarters. For the details of the quarter, I'm going to hand the microphone over to Rob Willett, my partner, and our President and CEO. I'll be available at the end of the call to answer any questions that you might have for me. Now, Rob, the microphone is yours.

Thank you, Dr. Bob. Good evening, everyone. I'm delighted with the results we reported tonight for the third quarter of 2013. We reported record revenue and record net income during what is typically a seasonally soft quarter for Cognex. Our strong financial performance was driven by record quarterly revenue from customers in the factory automation market. We continue to execute very well on this year's strategic initiatives for factory automation, which are ID products, China and sales execution. This is particularly true of ID products. Revenue from ID products grew faster than the rest of our business in Q3 and we set a new quarterly revenue record for that product line. Gross margin was strong at 76%, consistent with the gross margin reported a year ago and in the prior quarter. Operating income increased to 26% of revenue and 23 -- from 23% in the prior quarter. And we delivered record net income equal to 23% of revenue, up from 19% in Q2. Reported earnings for Q3 were $0.23 per share, and that includes $0.02 from favorable tax credits. Let's now turn to the details of the quarter. Typically, we see a notable softness in factory automation during the third quarter, especially with our customers based in Europe. But that seasonal trend did not occur this year. Instead, factory automation revenue was a record $72 million in Q3. This level is an increase of 18% year-on-year and 7% higher than the prior record set just last quarter. Looking at factory automation from a geographic perspective, Asia, excluding Japan, was our best performing region in terms of percentage growth. Factory automation revenue from Asia increased 21% year-on-year and 7% over an exceptionally strong quarter in Q2. China continued to deliver strong growth, with sales to consumer electronics manufacturers driving factory automation revenue from Asia to a new quarterly record. The Americas also set a new quarterly revenue record, helped by large ID product orders for logistics applications in distribution centers. We are finally starting to see substantial orders after lengthy customer evaluations. Revenue from the Americas factory automation market increased 20% over the third quarter of 2012, and 8% over the prior record reported last quarter. In Europe, factory automation revenue increased at the fastest rate for that region so far this year. Revenue increased 21% year-on-year and 10% sequentially. In constant currency, the increase was 15% and 8%, respectively. In Japan, factory automation revenue decreased 13% year-on-year and 5% from the prior quarter. However, the year-on-year decline was due to the negative impact of a weaker yen on reported revenues. In constant currency, revenue increased 9% over the third quarter of 2012. Revenue from the semiconductor and electronics capital equipment market, or SEMI as we call it, was $5.7 million in the third quarter. That level represents a decrease of 17% year-on-year and 20% from the prior quarter. In the surface inspection market, third quarter revenue was $12.8 million. This represents an increase of 9% year-on-year and 5% on a sequential basis. Surface inspection revenue can be uneven due to the timing of deliveries and installations and the impact of revenue deferrals. We continue to perform well in surface inspection and demand remains at a high level. Moving on to operating expenses. RD&E and SG&A totaled $46 million for the third quarter. While this level of spending represents a modest increase over the prior quarter, it is significantly higher than a year ago due to our investments in engineering and sales to drive growth. Our willingness to invest in our business has resulted in the launch of important new products over the past 12 months in areas such as ID products, where we have great momentum. And our expanded market presence in China helped us deliver approximately 30% of our factory automation growth in the first 9 months of 2013. We feel good about these investments and we are pleased to see them deliver for us. In summary, we had a great third quarter. And things look bright for Cognex as we head into the fourth quarter. In regard to specific guidance, we believe revenue for Q4 will again set a new record, in the range of $93 million to $96 million. We have good momentum in factory automation and we expect surface inspection to have their best quarter of the year in Q4, as normal. Operating expenses are expected to increase by up to 4% on a sequential basis. There were savings in Q3 from employee vacation time that are not expected to repeat. Commissions are expected to increase due to the higher level of business and the fact that some sales engineers will reach higher bonus levels. And we expect higher professional fees related to patent infringement actions and the year-end audit. The effective tax rate, excluding discrete tax items, is expected to be 19%. Now, let's open the call up for your questions. Operator, we are ready to take questions.

[Operator Instructions] And what it looks like our first question is from Jim Ricchiuti from Needham & Company. James Ricchiuti - Needham & Company, LLC, Research Division: Wondering if you could give us the number, dollar number, for the ID business in the quarter. Looks like another strong quarter.

Sure, yes. So record ID products revenue was at $25.5 million in Q3, representing growth of 45% year-on-year, helped by lower -- large orders from customers in logistics that were received after lengthy evaluations. James Ricchiuti - Needham & Company, LLC, Research Division: Rob, where do you stand with a couple of those large contracts that you've talked about in terms of shipping against them? Is there much shipped in Q4? And maybe you could give us a sense as to how the pipeline looks for ID in general and logistics, in particular.

Yes. I think we've seen consistent strengthening in that business and we see our sales funnel building, both in ID and logistics, which we're reporting as part of our ID business. So in Q3, we announced that one retailer placed orders in excess of $1 million for Cognex DataMan 300 ID readers. And that a parcel delivery company placed orders in excess of $4 million. And we received follow-on orders from both of those companies. And revenue in Q3 includes approximately $3 million related to the orders received during the quarter from the major retailer and the parcel delivery customer of approximately $2.5 million. So these orders were built into our guidance. Sorry, Dick?

Yes, I think I'd want to make one correction. It wasn't $3 million that shipped during the quarter from the retailer, it was $3 million total between the 2.

Sorry. Yes, exactly right. So $600,000 from the retailer and $2.5 million from the parcel delivery customer, approximately. So that's kind of -- and we expect more of that business to ship again in Q4 as well. James Ricchiuti - Needham & Company, LLC, Research Division: And the -- can you talk at all about the nature of the follow-on business, with both of those customers in terms of are these for new distribution centers?

Yes. So the major retailer has facilities, new greenfield facilities they're building, and upgrades to existing lines, mostly in the U.S., but all around the world, and that they're looking to place further orders as we move into next year. The parcel delivery business, yes, we see -- we're seeing repeat orders from that customer as the months go by. So we see more potential from that customer, too. And I would say, perhaps more interesting and more exciting from our perspective is we're in trials at many other very large customers that you would recognize the names of, as our reputation is starting to build in this market. James Ricchiuti - Needham & Company, LLC, Research Division: Got it. Would you be able to say, Rob, not by name, but just in -- in aggregate, how many potential logistics customers are evaluating right now that would be of size?

I would say between 5 and 10 large, very large global players. And then I'm going to say more than 20 additional kind of smaller retailers and other organizations.

And we'll take our next question coming from Ben Rose from Battle Road Research.

Was curious to know, Rob, in terms of end-user markets during the quarter, was there any noticeable change in terms of the mix? And I guess, interested specifically in your thoughts on the automotive sector, as well as the medical device area.

Yes, Ben, well, I think in terms of markets, our best-performing markets in the quarter were consumer products, electronics products, life sciences, logistics and distribution and medical devices. And I'm talking in terms of percentage growth during that time. So all of those performed very well indeed. Our business in automotive, you asked about it, did grow in the quarter, but in the low to mid-single digits. So I think as we expected, we're -- some of our smaller, high-growth markets are where we see a lot of our growth coming from at this time. And then electronics products continue to perform very well for us, both on a percentage and dollar basis.

Okay. And was curious to know, I know you had announced a suit against Microscan back in April, and was curious to know if there was any update from the company's perspective as to the progress of that?

Yes. Correct. I mean, the latest news on that is that we have a court date in the Federal District Court of New York. It was originally scheduled for October and it's been moved to February. And we're proceeding on that basis.

Okay. And sorry, finally, just a quick question for Dick. With regard to the share repurchase program, is a specific goal of that to prevent options dilution? Or is it sort of more of an opportunistic program from your perspective?

It is more of the former than the latter. So more for offsetting the dilution as opposed to just doing it on an opportunistic basis.

And we'll take our next question coming from Jagadish Iyer from Piper Jaffray.

Two questions. First, on your logistics portion of the business, Rob, I was just wondering what is the next geography that could potentially take off? And I was just curious, how long is the evaluation cycle, other than in the U.S., which is taking you a longer time? I'm just trying to get a scale of how fast the adoption could be globally. And then I have a follow-up, please.

Yes. Well, you're right, Jagadish, that the U.S. is where we're really seeing a lot of the initial uptake of our products. And then we're really in evaluations and we're making sales, relatively small sales, in all of our other regions right now. So it's difficult to predict where the pop will happen next outside of the U.S. But I think we're well-positioned in all of the regions. And yes, so that's how I would describe it.

Yes, well, I mean, would you, spend a little time, say, maybe, could it be in Asia or in Europe? Or it's too early to tell at this point?

I mean, the answer is yes, it could be -- I mean, we've -- in a way, the dynamics that I see in those other markets are similar to the dynamics we were seeing about 18 months ago in the U.S., where, I think, the market is starting to see the significant superiority of our products. And this, they're in trials and they're in small trials, which was what happened in the U.S. And then we're expecting that news and understanding to result in significant growth in months and quarters to come.

I just -- as a follow-up, I just was curious, what kind of competitive dynamics are you seeing in the logistics space, please?

Well, the -- that's a market that's -- it's -- it has 2 significant players in it today, the German company, SICK, and the Italian company, Datalogic. And we're certainly seeing -- our reputation is growing in that market and we're starting to see integrators, and obviously, end users really adopt our product and see the superiority of it against both of those major incumbents. So that's the dynamic that I would point to.

Okay. I guess if I can squeeze one last one, from looking at your SEMIs revenue, it's almost kind of bottomed out at like 5 -- what is going on, on the SEMI space right now? And do you see some kind of a recovery happening potentially in the fourth quarter or looking at 2014?

Right. Well, Jagadish, if you've been following Cognex for any length of time, you know we'd never say that it's bottomed unless it was at 0. So we'd -- it's very hard to call. We don't expect to see much or any growth in SEMI in Q4, relative to Q3. And it's really difficult to say what will happen next year. I mean, there are longer-term dynamics that might point to the growth, that the sort of cyclical upturn in the business, but it's very hard to know when -- if and when those will come. So, yes. And I would say that the predominance of our factory automation business now, in terms of the size of our revenue and the growth -- where the growth is coming from, really gives us much more confidence in the long-term outlook of our business relative to what it would have been 5, 10 years ago when we were more dependent on SEMI.

And our next question is coming from Jeremie Capron from CLSA.

A question on your factory automation business outside of ID, which obviously seems to be driving much of the growth we've seen in the last quarter. But could you comment on those other factory automation markets, quality inspection products, et cetera? Because it seems that if we back out ID, the rest of the factory automation business seems to be growing at a much slower pace.

Yes. So our flagship In-Sight product performed relatively well in Q3, relative to more recent quarters, with revenue increasing both year-on-year and sequentially. And In-Sight revenue, our Vision Systems business, grew in the high single digits in Q3, which I would say is probably in line with how the global market for those products are performing. Now obviously, we're not satisfied with that. We're Cognex and we expect to outperform the market. But I think that kind of high-single-digit growth that you're seeing in some of these core vision markets is probably what we're achieving and what the market is achieving right now. I think where we're really focused on is accelerating growth through new product development and entry of those products into adjacent markets. So things like our displacement sensor, new products also we have coming in the Vision Systems product line, are how we expect to accelerate that growth going forward. You were asking about other things going on. Obviously, China is an area where there's a lot of vision technology being adopted and used, and where we're seeing a lot of growth. So that is certainly an area where we're pleased with the kind of growth and dynamics that we see and our execution. And then counter to that is certainly Europe, where we see less growth and less opportunity in the short-term future for vision products growth.

Great color. And if I may ask another question regarding the ID business and the logistics applications in particular, are you seeing any of your more traditional competitors in the vision space trying to come up with logistics products?

Well, it's a pretty big market. We've sized it at around $250 million, so of course, there are always new products being introduced in that market. We're seeing our competitors launch products, area-based vision products, with high resolution imagers. Where they're unable to compete with us is on software performance and optics, and some of the core vision skills that we have. So although we see them trying to compete with us, we see our performance, and particularly also, our cost structure, to be highly advantaged over anything we're seeing coming into the market right now. And obviously, we're not standing still.

Great. Just one last question on capital allocation. I'm seeing the cash pile rising quarter after quarter, and I wonder if you could give any indication on how you think is best to use that cash. And I know you have a share buyback program ongoing, but I mean, the business is obviously generating a lot of free cash flow. So what's the view here?

Well, clearly, the best use of that cash, from our perspective, would be to use it to -- in acquisitions. And we have an active program. We are looking at potential entities to buy in different markets, in different geographies. Have not been able to find anything that fits all of the criteria that we're looking for at present. So the main thing that we're doing these days is in fact the buyback.

And our next question is coming from Richard Eastman from Robert W. Baird. Richard C. Eastman - Robert W. Baird & Co. Incorporated, Research Division: Just a question, just to double back on factory automation, can you just give the growth rate of China -- for China in the quarter? And if you wouldn't mind, just sizing it in terms of dollars for the quarter?

Yes. I'm going to give you a number and then Dick can correct me, okay? So it was, factory automation, China, was about a little over $10 million in the quarter and grew around 28%. That's year-on-year, Rick.

Year-on-year, Rick. Richard C. Eastman - Robert W. Baird & Co. Incorporated, Research Division: Yes. Dick, is that okay?

Yes, Rick. Richard C. Eastman - Robert W. Baird & Co. Incorporated, Research Division: And then just a question. When I think about that growth coming out of China, you've talked to some end markets in factory automation that grew strongly, consumer products, electronic products. And I presume that, that growth in those end markets are the driver in China versus product ID in rest of world? Is that a fair...

I'm not sure I understand the last bit, product ID and rest of the world, what... Richard C. Eastman - Robert W. Baird & Co. Incorporated, Research Division: So if I'm just thinking China, I would think much of your product ID growth is coming out of Americas versus when I look at China's growth at plus 28%, presumably the growth there is more in the In-Sight products for inspection in these other markets?

Well, our business in China is -- the largest vertical market is electronics. And there, we're doing a lot of sophisticated vision activity. But what we are seeing is some important new growth vertical markets in China, for us anyway, are small and getting large quickly. And I would point to automotive and really, the broader ID business, right? So in that, we'll -- we've sold more into automotive in the first 3 quarters of the year than we sold all last year in China. And the same could be said of ID. We've sold more ID into China in the first 3 quarters than we sold all last year. And those -- both of those pieces, admittedly, they overlap, there's some ID and automotive, right? But both of those pieces are approaching $10 million, annualized. Richard C. Eastman - Robert W. Baird & Co. Incorporated, Research Division: Okay. And could I just ask, within the factory automation business, there was some commentary earlier this year about prototyping and some piloting of ID products or sensors that would go into -- more into the medical device instrument market. And I'm wondering, is that the follow-on to this logistics product uptake?

So we refer to the market for OEM engines into life sciences, Rick, which is, I think, what you're referring to. Richard C. Eastman - Robert W. Baird & Co. Incorporated, Research Division: Yes.

And that's a market we've been working on for a number of years. And we've -- we're getting designed in to significant manufacturers of OEM equipment in that market. And we have a very powerful engine that is starting to get spec-ed into some very major customers in that market. And as I think of that market, it's about a $100 million market and it has a very long sales cycle. So these life science OEM customers, they go through probably a 3-year design cycle, which includes getting FDA approval in many cases, and -- but once we're spec-ed in, there's very little change that goes on inside the product because of the regulation around it. And then it can be a 7- to 12-year product life. So it's a market we really like. It's a market we don't expect to see very significant revenue on in the next few quarters. But it is a market that we do see being a major part of Cognex's business in a few years from now. Richard C. Eastman - Robert W. Baird & Co. Incorporated, Research Division: I see. Okay. And then just one question I thought I'd maybe bounce off Dr. Bob, because I know from an M&A standpoint, technology standpoint, at least my feeling is you're the point person. And do you see in the marketplace, any significant shift in investment into 3D and perhaps away from 2D vision?

This is Bob. No, I -- well, there is a significant, I would say, a significant shift. 2D is extremely important and can handle most vision problems, but there is additional investment going on. Certainly at Cognex, it's a focus of our top R&D team right now. And a lot of engineers working on what we call displacement sensor to make it -- to distinguish it from our regular Vision Systems and 2D sensors. We are not the first into that area. And many times in our history, we have not been first. We like to think of ourselves as fast followers, which means we get technology, we develop a lot of it, keep it on the shelf until someone else perhaps verifies the existence of a profitable business. Because there are just so many opportunities for machine vision and for image processing, image analysis. But not -- but very few of them are profitable. So we like to say that we're a fast follower and we've done that many times. We were not the first with products like In-Sight, but we followed fast and took over the business, and we expect to do the same thing with displacement sensing. And displacement sensing, by the way, is not only valuable on the factory floor where they're putting assemblies together to make sure that all of the parts are in the right place and they're at the right height, et cetera. But it also turns out to be very important in logistics, where the height of something helps you determine where the box is and where the label is. So we are finding that our investment in 3D, although not yet paying off, we expect that to grow rather substantially in the coming short term. So I would say that we don't see many other companies investing in 3D. It's very complex, 3D, getting that third dimension, is very, very complex, and depending on the accuracies and the field of view that you want and the depth of field. And it's going to be companies like Cognex, and of course, some of our competitors have -- 1 or 2 of them have 3D products, that we will soon surpass on a technological basis. Richard C. Eastman - Robert W. Baird & Co. Incorporated, Research Division: Does Cognex's technical competence in 2D, when it comes to software and processing the data and processing speeds, does that transfer over to the 3D world well, or is that...?

Yes, very well. The complexity in 3D is obtaining what's called a point cloud, that means all of these local measurements, point measurements of the distance of something, and then assembling those point clouds into shapes that can then be handled by the standard 2D software. So we have a significant advantage in that we have a very large team, of course, the largest in the world, expertise, with expertise in analyzing 2D images, and ultimately, 3D is not much different from that in the software world. But the challenge to us has been manufacturing and spec-ing out an engineer -- and designing, of course, hardware that can give you very accurate point clouds. So I think what you're getting at, or what some people would get at, are there significant barriers ahead for us or do we have to continue spending even higher amounts of engineering dollars in analyzing those 3D images? The answer is no, we don't. Richard C. Eastman - Robert W. Baird & Co. Incorporated, Research Division: Because it seems like in the marketplace, the technology, the hardware to capture the point cloud data points is there, but the software is not. And that seems to be ...

Well, that's right. And that's why we will have, I think, a substantial lead.

And we'll take our next question from Jim Ricchiuti from Needham & Company. James Ricchiuti - Needham & Company, LLC, Research Division: I just wanted to go back to a comment earlier. Did you say the SISD business you're expecting, you're anticipating record revenues in Q4? So you expect it to be above Q4 of last year?

No, no.

No, we did not say record revenue. It was... James Ricchiuti - Needham & Company, LLC, Research Division: Okay, sorry.

It was going to grow. It was going to be the best quarter of 2000. For SISD, they would have their best quarter of 2013 in Q4, which is fairly typical for them. James Ricchiuti - Needham & Company, LLC, Research Division: Got it, okay. And the improvement that you're seeing there, any particular markets? And just in general, I wanted to just follow up with one question regarding the domestic business, if you saw any impact at all just from the shutdown in terms of customers possibly, temporarily pulling back a little bit?

No, we didn't really get any impact to that. And then in terms of areas that where we do see strength in surface inspection, aluminum as it relates to -- it's being used in automotive markets, is certainly a growth area. And that, particularly in China, also is an area. So metals there. But then our U.S. business is -- has performed well and continues to perform well in surface inspection, particularly in the paper market. James Ricchiuti - Needham & Company, LLC, Research Division: Okay. And Rob, just one final question, if I may, on Japan. How satisfied are you with the progress you're making there?

Well, as I tell people, I -- it's a personality problem I have, I am never satisfied, really. So, but joking aside, we kind of -- we're definitely seeing improvement in our Japanese business. And factory automation in China -- sorry, in Japan, is starting to grow again. We've had a -- we have a long-serving Cognoid, a very dynamic leader who's been with the business a long time, who's taken over as the sales lead for about a year now. And we're certainly seeing the team there drive some growth in ID and in factory automation. So -- but of course, our share in the FA market in Japan is small. So we're seeing -- we're encouraged, but we have a long way to go. James Ricchiuti - Needham & Company, LLC, Research Division: What about with the Mitsubishi channel?

Yes. So those have continued to grow and performed well in the third quarter. So definitely, the Mitsubishi channel is giving us access to a much broader base of the Japanese markets than we have otherwise had access to. So a lot more leads and a lot more opportunities to go and get those customers. And then we have been adding salespeople to our Japanese business. And that also, we believe, will help us drive growth as we move into next year, really, in factory automation.

Okay, thank you. And I'm showing no further questions in the queue at this time. So I'd like to turn the call back to Dr. Shillman for any concluding remarks.

Well, thank you. Just to wrap up, we're very happy with the results that we've reported for the third quarter. And we're looking at the order backlog and the shippable backlog, and we anticipate reporting similarly impressive results in this coming, the last quarter of 2013. And I want to thank the entire Cognex team. It starts with marketing telling us what products we should build and then engineering building them, and manufacturing and operations getting them built and delivering them from all over the world. And a lot of work, a lot of moving parts, and I just want to thank the entire team, and in particular, to my partner, Rob Willett, for running this team and fine-tuning it to the degree that it is now. Thanks for joining us and we look forward to talking to you, sometime, of course, in 2014. Take care.

Okay, ladies and gentlemen, this does conclude your conference. You may now disconnect, and have a great day.