Good day, ladies and gentlemen and welcome to the Cognex third quarter 2016 earnings call. At this time, all participants will be in a listen-only mode. Later there will be a chance to ask questions and instructions will be given at time. [Operator Instructions]. As a reminder, today's conference is being recorded. And now, I would like to turn the call over to your host, CFO, Dick Morin.

Thank you and good evening everyone. Earlier today, we issued a news release announcing Cognex's earnings for the third quarter of 2016 and we have 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 a reconciliation of certain items from GAAP to non-GAAP in Exhibit 2 of the earnings release. I would 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. You should refer to the company's SEC filings, including our most recent Form 10-K, for a detailed list of these risk factors. Now I will turn the call over to Cognex's Chairman, Dr. Bob Shillman.

Thanks Dick. Hello and Happy Halloween everyone. You know, Halloween is trick or treat time, but as you have probably seen in our earnings release today, there is no trick, just a great treat for our shareholders, the highest net income and earnings per share from continuing operations for any quarter in our 35-year history. Now I am going to be available for any questions that you have for me. But for details of this outstanding quarter, I am going to hand the microphone over to my partner, Cognex's CEO, Rob Willett. Rob, the microphone is yours.

Thank you Dr. Bob. Good evening everyone. I am pleased with our third quarter results which included the highest quarterly net income and earnings per share from continuing operations that we had ever reported in our company's history. Revenue was $148 million which is above the guidance that we gave to investors in August. It also represents substantial growth over Q3 of 2015. This strong performance was helped by our ability to deliver on large opportunities in consumer electronics. Outside of that industry, revenue grew by low double-digits year-on-year despite continuing challenging market conditions. We had strong margin performance in the third quarter. Gross margin was 78%, reflecting a revenue mix from higher margin products than in the prior quarter and in last year's Q3. Operating margin expanded to 37% from 26% a year ago. This significant increase reflects the substantial leverage that incremental revenue has on our business model. We achieved an impressive after-tax margin of 36%, helped by significant tax savings related to stock option exercises during Q3. Those positive items combined to deliver record earnings per share for the quarter of $0.61 significantly exceeding the Thomson Reuters' First Call Consensus estimate of $0.48 per share. Even excluding the $0.07 per share stock option tax benefit, earnings were well above consensus. Let's now turn to the details of the quarter. In the factory automation market, revenue for Q3 was $142 million, which represents significant growth year-on-year led by major contributions from consumer electronics. As previously discussed, large electronics orders were split this year between Q2 and Q3. Last year, the majority were recognized in Q2. On a sequential basis, consumer electronics increased while the rest of factory automation experienced a normal seasonal slowdown we see during the summer months. Looking at factory automation from a geographic perspective as…

[Operator Instructions]. Our first question comes from Jim Ricchiuti from Needham & Company. Jim, your line is open.

Thank you. Good afternoon. Happy Halloween. I know it's a special holiday for Cognoids but congrats on the quarter. I wanted to go into a little bit more detail on the guidance. You are talking about, I think, still a fairly slow growth environment for factory automation in general for the broader market. So I am wondering, what you are seeing that gives you the confidence of an 18% to 21% year-over-year growth? Is it also function of an easy comp? Or are you seeing certain areas where the growth is going to be stronger?

Yes. Hi Jim. Okay. So you are right. We do expect a good quarter in Q4 with revenue growth year-on-year around our 20% long-term growth target and with operating margin expansion. I think we are going to see further large order revenue from logistics expecting to hit in Q4. So that's certainly a tail wind for us. China factory automation revenue particularly from electronics typically softens in Q4 and Q1. So it's probably still growth year-on-year but the seasonal impact sequentially is difficult. And near-term the outlook for Europe is cautious, I would say. So there is nothing other than some good revenue handing the logistics in Q4, there is nothing really are remarkable, I don't think about our guidance, that reflects kind of the broad-based state of our business right now.

Rob, normally when I think of logistics, I think at some seasonality to that business and sometimes think that that would be stronger in Q3. It sounds like you are expecting fairly significant shipments in Q4. Is that unusual for this business?

Well, yes. Interestingly, Jim, it's a market we are still learning about and it doesn't appear as seasonal as we thought it was and we are learning that large orders can land in any quarter. I think some of the things we have thought in the past, such as not a lot of new automation is going to be put in after Thanksgiving and before Chinese New Year in that period probably still remains true, but certainly this business we are doing that's going to get installed before and even after that point. So yes, it's a little less seasonal than we had come to believe.

Okay. And I wanted to ask this last question for me and I will jump back in the queue. If you can provide any update, it's still early, but is there anything you can say about your efforts in the ID/Mobile Terminals area? How that's going?

Sure. So your question relates to the MX1000 probably, which launched early in this year.

Yes.

There's a lot of interest in that in the product that we are showing to customers now and I think our sense of the market is just as positive as it was, as we have spoken to you a lot in recent times. So we have a number of important files going on with customers that have very significant potential. I think as we settle along, it's not going to make much of a revenue contribution this year, but I think it will be interesting at what point we start to see large deployments of the product which we do expect to see but when not sure at which point those really are going to start hit the revenue line.

Okay. Thank you.

Okay. Thank you. And our next question comes from Ben Rose from Battle Road Research. Ben, your line is open.

Thank you and good evening and also my best wishes for a Happy Halloween. With just the strength that you expecting, Rob, in this fourth quarter, is it fair to say that that will be mostly in North America? Or will it be spread out perhaps to other regions?

So hi, Ben, yes. So logistics of delivering well for Cognex in both the Americas and Europe. We are seeing major successes in both of those markets and both will make important contributions to Q4.

Okay. And just a follow-up question regarding Samsung being in the news. I know that they are or have been a Cognex customer in the past and there is some indication that they may have pulled some of their factory automation in-house in the last couple of years. Could you comment generally on what you are seeing perhaps from Samsung specifically as it relates to some of their recent quality problems?

Yes. Hi Ben. In general, we don't like to comment about customers and what's going on internally with them whether we are working with them or not heavily. So I don't really feel comfortable to comment about any specific things going on there.

Okay. Thank you.

Okay. Thank you. And our next question is from Richard Eastman from Robert W. Baird. Richard, your line is open.

Yes. Good afternoon. Hi Rob, Dick.

Hi Rick.

Hi Rick.

And Dr. Bob, of course.

Hi Rick.

A very quick question around the consumer electronics strength that you are referencing. As I read through the Q and also your commentary, Rob, is the reference on the consumer electronics strength go beyond the material customer? Is this broad-based with the other half of the CE essentially also showing the same strength? Is that the message here? I was just struggling a little bit sift through that in the Q.

I would say overall that's a true statement Rick. I would say that overall, our consumer electronics business is growing well across the board range of customers and suppliers.

Okay. And then also Rob, I think you suggested that if you look at factory automation and take out CE, that the balance of the business, all other end-markets grew, did you say low double-digits?

Yes, I did.

You did. Okay. Is there any, like we have been hearing China automotive very strong, but can you just sift through that other components and maybe just flag the better growers within the collective low double-digit growth?

Yes. Well, I can. Obviously, we said logistics is growing well but I think we covered that. If I was to talk about automotive, I would say automotive continues to increase low double-digits year-on-year. We have seen that and specifically some nice growth rates in China, although slowing down slightly sequentially but still growing well and actually automotive in Europe performing well also. So automotive is right at that growth rate overall. Markets like food and beverage and consumer products and robotics also performing well, at or above that rate. So that would be a general sense of it.

And then just my last question. I wanted to ask, maybe Dr. Bob could take this one, but this EnShape acquisition on the sensor side, I understand?

Yes.

I thought it curious. You talked about kind of snapshots technology. I think Rob referenced that. But is there a shift here towards more image-based 3D versus laser-based? Or am I looking to hard here?

Well, first of all, all of the 3D that we do is image-based. The laser that's currently used in all of our products is simply used to illuminate the parts in a very special way, but an image is what is developed on an array sensor as all of our sensors are these days and then we interpret that image using 3D software. So using lasers for 3D is very different than the lasers in ID. In ID, the existing old-school method of reading ID was to use a laser and reflect that light and it was interpreted on a line basis not an image basis. But our 3D vision, all of our 3D vision is based on a flow analysis of an image. Now, the difference between the current way that we are doing at Cognex and the way that EnShape does it is rather quite different. The EnShape method requires generally, the part to be stationary and in one quick photograph or maybe two snapshots, all of the 3D image is taken, is acquired. That's different than our existing 3D where the part is supposed to be moving and usually is moving in a factory. So they are complementary technologies. One of the technology is better for certain aspects, accuracy or reliability and speed. The other technology is better for different aspect. So it's still too soon to know if any one of these methods will dominate or if it's going to be necessary to carry both kinds of product. My sense is that we are going to need two types of 3D technology, maybe even more .There maybe other ways. There are timeless light methods. So there are many ways of getting a 3D image, but they all have benefits and drawbacks based on the surface texture, on the type of material you are looking at, on the speed of the item moving by and that's why we increased our offering so that we can now serve more of the 3D market.

I see. Okay. That's a very good explanation. Thank you.

You are welcome.

Okay. Thank you. And our next question comes from Joseph Giordano from Cowen & Co. Joseph, your line is open.

Hi guys. This is Tristan Margot for Joe tonight. Congrats on the quarter and thanks for taking the question here. I was wondering, could you frame what's your level of revenue growth can mean in a CapEx environment that is not flat?

Your question is not clear.

Yes. Maybe I could rephrase. So my sense is, your customers are not spending on CapEx currently or maybe their level of CapEx is probably decreasing as we speak and there you are growing your revenue double-digits. What could happen if your customers start to -- are you here?

Yes. Of course. Okay. So I think basically you are asking is, if in a low growth or decreasing capital environment, how we grow relative to increasing capital environment? I think some points to understand would be, vision, it's a disruptive technology that is replacing tasks in many cases that are done by humans, right. So visual inspection is still very common in a lot of manufacturing activities and vision is replacing those tasks. So generally we would expect this business to grow even in weak capital spending environments. In environments when companies investing at a faster rate, obviously we will grow at a faster rate also. So I think that's what time has proven.

Sure. Thanks. And then what kind of markets and new applications your two acquisitions in 3D really allow you to go after? I know Dr. Bob talked a little bit about the technology there. But what kind of applications or end-markets you can go after?

Yes. So these are technologies that we are looking forward to applying a range of markets, certainly automotive, consumer electronics and logistics are all markets that we look forward to taking this technology to along with a number of other markets. The nice thing about this technology, it fits very well with the broad end user markets that we serve today and where we have a great reputation and we have many salespeople calling on those accounts.

Okay. Thanks. And if I can just make one last in still on M&A. When you do acquisitions this way, are you more looking talent acquisitions or more of a new technology that you don't have or maybe a mix of both?

Yes. We are a technology company. We love to acquire great technology and great engineers and engineering groups. So those would be good descriptions of the two technologies we announced today. And those are the things that we like to see and we like to see businesses that can help us with our high gross margin profile. Those are the things that we prize as we look at acquisitions.

Great. Thanks and congrats again on the quarter, guys.

Thank you.

Okay. Thank you. [Operator Instructions]. We will take our next question from Jim Ricchiuti from Needham & Company. Jim, your line is open.

Bob, back in September at the investor event, you talked about, I believe, a $200 million market for 3D vision. So I am curious, do these acquisitions target that market or do they expand it in some way?

Our sense, Jim, is that they serve that same market, right. But they help us to serve it in a more competitive way. The AQSense business is a quite better user environment for 3D. So our customers want to compare CAD drawings to machine vision data online, they have great technology. And then also machine vision tools that are complementary to what we have. And then, as Dr. Bob explains, the snapshot sensing technology is very competitive in certain types of applications, specifically products that are not moving and we see a lot of that in electronics for instance. So I think it's complementary I think our view of that market overall, 3D, that we are just serving with them more limited set of technology, our view is that that market is growing quickly and will go on doing so. And these technologies help us do better.

And if maybe looking at the acquisition separately, you hadn't been pursuing the same technologies that EnShape is currently working and is that fair to say?

No. I wouldn't say that's true. I think obviously we have user environments for 3D. We wouldn't go to sell 3D if we didn't have those. And we have vision tools in 3D, but this team, very good team of engineers with some very complementary or in some cases better technology than we have. So they are useful in many of those respects.

Okay. I think I meant the approach they are taking to 3D. It seems like it's a little different than yours. And I guess I am wondering, maybe if I look at these two acquisition, is this accelerating your expansion into this market? And if so, can you put a time frame on it? If you look at both acquisitions as you begin to develop more product solutions around this, does it accelerate?

I think it does accelerate our entry to the market certainly. We wouldn't have acquired them if it wasn't going to do that for us. Yes. And I think that technology is something we will be bringing to the market at some point in the first half of next year it will be an integrated into what we sell our are available through our salesforce or part of our salesforce. So that's certainly true. I think it's worth pointing out too that, Cognex has had a great history of acquiring innovative engineering teams in areas around the world and building on those teams. We have done that again and again in places like Aachen in Germany and Portland, Oregon. These two companies are in great locations for us. So Jena in Germany is really a center of optics in Europe, where there are a lot of great optics companies located and a great university and research culture around optics, which is key to 3D as you will look up since hearing Dr. Bob talk about laser structured light and how that's critical to the way most 3D in factory automation is done. And then Girona in Spain has an excellent research university with a lot of strength in computer vision and vision technology. And so there's is a nice beachhead for us to build on and recruit great engineering talent to work in this area.

I am going to continue with that, Rob. Thank you. Jim, if you look, most of our acquisitions are for talent. Now we are very fortunate that with these two cases, not only do we get very experienced and very deep talents and energy level with both of these, but in addition they both have products, they both actually develop products. The one in Germany is a hardware and software based product. The one in Spain is a software product. But nevertheless, these guys went out there and developed things and actually sold them to customers. And of course, we don't just rely on that. We did our own due diligence on the technology and on the people, but we didn't get a lot of revenue. We typically haven't bought companies for revenue or the distribution, although that's not out of the question. But most recently the acquisitions we do are to expand our technological breadth and both of these do that. We didn't have any expertise in the company for snapshot sensors, although I suppose we could have developed that. We have the brainpower but everybody is busy. So what we did in this case in EnShape is, we acquired that snapshot technology, which we believe is very applicable to many of the things that we are looking at.

Okay. That's helpful, Dr. Bob. Thanks a lot.

You are welcome.

Okay. Thank you. And our next question comes from Ben Hearnsberger from Stephens. Ben. your line is open.

H. Thanks for taking my question. I wanted to start on the mobile terminal product. Is this going to be sold primarily by your direct sales force or through the channel?

Yes. Hi Ben. So yes, we have a sensor sales force and a logistics sales force who are primarily selling it today. So they are calling on those kinds of customers who can most benefit from the product. We will have been channels selling it also but most of the business, I think, will be direct.

Okay. And then I had a question on the 3D side. At a high level, as 3D capabilities expand and cost come down, do you expect 3D application to over time cannibalize 2D machine vision applications?

This is Bob. I don't understand the term cannibalize. If you mean, are we going to sell more 3D over time to people in the past bought 2D? Yes, there is a good likelihood of that is that. But 3D is always going to be more expensive. It's more valuable. So whether it costs more to make or not is irrelevant. It has more value. So we are going to charge more for it. So I do expect to see a greater percentage of our revenue coming from 3D. But the overall is going to grow. So I am just making sure that the audience doesn't think that cannibalizing means holding revenue constant or even going down with the introduction of new products. That's clearly not the case here. We expect both revenue to go up and probably it might very well be that we will have to look more at manufacturing of these items. But the gross margins could go up too.

Okay. But just to be clear, so over time, will traditional 2D applications be replaced by 3D application? Or they are complementary to one another?

No. And I will give you examples. If a pharmaceutical company is putting pills in bottles and they wanted to check to see if the labels are on straight, they are going to use 2D. There is no advantage to using 3D. There are certain applications of parts where customers want to know the height of things. In addition, they want to know if all the buttons are on, let's take a calculator, I am looking at a calculator right here in front of me. And there are in 20 to 30 buttons here. 2D could easily tell you whether the buttons are there, whether they are printed correctly, but they couldn't tell you very easily whether the buttons are all the same height or not. So an inexpensive calculator, they probably don't care if the buttons are all exactly the same height but when you look at a more expensive item, you may indeed care whether the buttons on the side or the front or the back of a cell phone were flush with the case and all sorts of things like that. So no, I would think that there is still going to be a tremendous market for 2D machine vision where 3D doesn't offer any benefit, but there are many applications now where customers want to know the height of things as well as the location and the clarity of things.

Okay.

But you can ask a follow-on. Go ahead.

No. That's really helpful. I actually have another higher level question for you. I don't think thermal is an area that you guys participate in, but I guess I am just curious, given that you are a thought leader in this space, how you think about the opportunity for thermal sensors in machine vision applications?

It's a very good question. Whichever technology is used to get an image is not relevant to the analysis of that image. So whether it was an x-ray image or a CT scan image or a thermal image, we could very likely analyze that image. The question comes down to what is the application area. If you are looking for people hiding in a building, we are not using thermal imaging, it's something we wouldn't chase. But that if you are looking for components inside, for example a piece of electronics and seeing which part is heating up more then we certainly could analyze and would be interested in analyzing those kinds of images. So machine vision, at least the way Cognex sees it is, there's the optics, there's the hardware for acquiring the image, the illumination. But the core piece of Cognex's machine vision is the analysis of the resulting image, irrespective of the modality of the energy that created that image.

Okay. That's really helpful. Thanks for taking the time.

That's why we do these calls. Sure.

Okay. Thank you. [Operator Instructions]. I am showing we have another question at the moment from Bobby Eubank from Chevy Chase Trust. Bobby, your line is open.

Good afternoon everyone and thanks for taking my call. Congratulations on a great quarter, Rob and Dr. Bob. Rob, at any given -- or maybe Dr. Bob, this would be a question for you, at a given moment, how many of these smaller bolt-on type acquisitions may you be looking at are in your pipeline?

Well, hi bobby. So we run a pretty disciplined process where we map markets and spaces and look at acquisitions and competitors and technologies in those spaces. So we have a pretty large funnel of companies that we are interested in and working with. Yes, so they become actionable and available for acquisition at different rates and you can see obviously that they came through this most recent period in quite a big way. But our process continues and our approach continues at a similar flow on an ongoing basis.

Great. And let me say that the way that Rob is able to integrate these is very well done, very objective. And the fact that we don't buy, we haven't for a long time we haven't bought anything large, so it's rather easy. These are typically engineering oriented acquisitions. And we know how to manage. We have grown to know, to learn how to manage remote engineering sites. And the key people where they are, we don't aggregate them, we don't move them around the world. They are happy where they are. We leave them where they are. Furthermore that offers us a great opportunity of attracting more exceptional engineers in those remote from the U.S. places. It's a wonderful method of growing the company because it allows us to get larger, but to maintain an entrepreneurial very small company feel. And that is very key to our success.

Certainly. And you would think that maybe three years out, five years out, before any meaningful revenue contribution for your typical technology or engineer based acquisition?

No. Not at all. So in the case of the two companies we have just announced acquiring, they have products and they have teams that we should be able to integrate and turn into revenue in the first half of next year.

Yes, Bobby, it depends what you mean by meaningful. As a percentage of $450 million or $500 million, it's not going to be meaningful. But they are certainly to be measurable and I am going to assume, but Rob knows best, $5 million to $10 million for each one of these.

Great. And then my final question, keeping it rather high level here on, if you think about the industry, we are still probably in the lower left side, the favorable side of the adoption curve. If the technology is truly disruptive, as we have talked about several times, what are the barriers for accelerating that adoption and even seeing a pickup in that 20% growth rate that you are looking at for the fourth quarter? Why aren't more people knocking on the door and saying, well, I am seeing what my competitors are doing with the technology and I really want that?

I am not at all disappointed with 10% to 20% growth that we have. We certainly want to grow as fast as the market, perhaps faster than the market so we can take some of our competitors' share. But we have been around for 35 years and we are at the top of our game, primarily because we didn't have an arbitrary growth rate in mind. And let's us say we do somewhere around $450 million, %500 million this year, 20% growth is an extra $100 million. That's a lot of new business to be able to find, right. Don't forget, every year we start we have a backlog, but bookings started zero. We don't have a recurring revenue of any significant amount. We have to start with zero every year. So to add another $100 million on top of $500 million is not easy to find. And when you said that machine vision is in the lower left part of the curve, I am not sure that's true. 3D is at the lower left part of the curve, but machine vision isn't necessarily that embryonic. It's been around as we have been around 35 years and so the customers now know about machine vision and more and more of them are using it. But I don't have any expectation of growth faster than 20%.

Great. Well, thanks for a great quarter.

Bobby.

Yes.

Bobby, let me just also kind of chime in here. So generally our technology is becoming faster, less expensive, easier to use, right. And that is making it available to lots more engineers who want to use it on their production floors. So that's certainly helping the introduction of vision and these divisions become more pervasive. But in terms of limitations why it's not growing even faster than it already is, some of the limitations that we speak about are, the ability of engineers at our customers to absorb and implement the technology. So those can be challenges, particularly at our large customers to start them growing more quickly. They have other competing priorities. And then there other such challenges like security, right. Network security and concerns about Internet security and other things where if those were not concerns, we might be growing even faster than we are already. But those are some of the barriers to foster growth, I would say.

I appreciate it.

Okay. Thank you. So I am showing no further questions in the queue. I would like to turn it back to Dr. Bob for any concluding remarks.

Sure. Well, like I said, there is no trick at Cognex. Well, the trick is to keep it going and we have a full bag of tricks that help us keep it going and the main aspect of the company is hiring great people and finding great people and acquiring great people. I want to thank you for participating in our call today and I look forward to speaking, the whole team looks forward to speaking to you again next quarter. Good night.

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