Cognex Corporation (CGNX) Q3 2019 Earnings Report, Transcript and Summary

Greetings, and welcome to the Cognex's Third Quarter 2019 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce Susan Conway, Senior Director of Investor Relations. Thank you. Please begin.

Thank you. Good evening, everyone. With us today are Cognex's President and CEO, Rob Willett; Vice President and Corporate Controller, Laura McDonald; and Cognex's Treasurer Chris Stagno. I'd like to point out that our earnings release and quarterly report on Form 10-Q are available on our Investor Relations website at investor.cognex.com. Both contain highly detailed information about our financial results. During the call, we may use a non-GAAP financial measure if we believe it is useful to investors or we believe it will help investors better understand our results or business trends. You can see a reconciliation of certain items from GAAP to non-GAAP in Exhibit 2 of the earnings release. 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, however, and actual results may differ materially from those projected or anticipated. You should refer to our SEC filings, including our most recent Form 10-K for detailed list of these risk factors. With that, now I'd like to turn the call over to CEO, Rob Willett.

Hello everyone. Thanks for joining us today. I know most of you are used to hearing Cognex's Chairman, Dr. Bob Shillman welcoming participants to our earnings call. Dr. Bob is unable to join us this evening due to a prior commitment. He sends his regards and he looks forward to talking with you on our next call. Cognex delivered Q3 results, in line with our expectations, with revenue at the top end of our July guidance. That said, our revenue was down both year-on-year and sequentially, as a result of the ongoing slowdown in manufacturing investment. The decline can be almost entirely attributed to consumer electronics, which decreased by approximately $50 million, roughly 50% from Q3 of 2018. The automotive and the broader industrial sectors also continued to weaken due to persistent, global economic uncertainty and trade conflicts, particularly in Europe and China. Now that deterioration was partially offset by growth in logistics, which increased by approximately 50% year-on-year. We have confidence in our logistics strategy and we believe we can continue to grow at that 50% rate over the long term. In logistics, well-known traditional brick-and-mortar retailers are starting to invest heavily in logistics automation to compete more effectively with their e-commerce competitors. They are changing their supply chain and they are looking to Cognex's industry-leading products to help them implement their automation strategy to fulfill orders rapidly, reliably and cost effectively. Near-term market conditions, notwithstanding a long-term potential for machine vision and for Cognex, is unchanged. Our long-term operating model remains intact and - with a target of 20% compound annual growth, mid-70%s gross margin and 30% operating margin. Now, I'd like to say a few words about our recent acquisition of Sualab, an outstanding technology company specializing in deep learning software to automate inspection tasks that are currently done by human visual inspectors. Sualab is the type of acquisition that we like to do. It has an excellent engineering team, I'll expand on this in a few moments, and also is a great cultural fit. We believe that deep learning technology will be a major growth driver for Cognex in the years ahead. For the first time, machine vision is reaching a level of performance that allows it to replace tens of thousands of humans globally, who's work it is to perform highly repetitive, visual inspection tasks to identify cosmetic flaws and defects on products during their manufacture. The market we serve today, for machine vision using deep learning in factory automation, is estimated at $100 million of annual revenue and is growing rapidly, we believe by 75% per year. The largest and fastest growing segment of that market is the replacement of human inspectors in Asia, particularly for electronic components and finished products, where Sualab is well positioned. The acquisition of Sualab not only extend our deep learning capabilities for inspection application, it more than tripled the size of the Cognex team dedicated to developing and applying deep learning technology to industrial inspection tasks. Upon closing, we welcomed approximately 100 smart ambitious and energetic new employees to share our passion for machine vision, the majority of whom are in engineering departments and are highly skilled in both contemporary programming techniques and applying deep learning to inspection tasks in the manufacturing process. Led by Co-Founder Song Kiyoung, Sualab engineering team will continue to operate from its headquarters in downtown Seoul. They will work closely with our team based in Cambridge, Massachusetts, which is led by Reto Wyss, the Co-founder of ViDi Systems, which we acquired in 2017. The ViDi acquisition established our deep learning development efforts, and is the reason for our success in this area to-date. Here are a few more details on the acquisition that I'd like to share with you. The purchase price was $195 million. We paid $171 million in cash at closing. Payment of the remaining $24 million is deferred until a later date. Although Sualab's revenue is modest, the price is justified by the high value of the company's substantial engineering team, its core technology developed over the last six years, and its experience of applying that technology at very large companies in Asia. We expect technology acquisitions to be accretive within two years and it looks like Sualab will fit within that model. Moving on to the next topic. We have published an updated view of our served market. You can find it on our Investor Relations website at investor.cognex.com. Our new estimates of Cognex's totaled served market for machine vision is $4.2 billion. This is a narrow definition of what we can serve with our current product offering. This estimate is 20% higher than our previous estimate, as a result of both growth in the underlying market and new opportunities that are now addressable with Cognex products. Despite near-term challenging market conditions, we believe our served market will grow in the low teens over the long term. And we expect to continue to outperform market growth, as a result of our superior technology and the strength of our customer relationships. Now, I will turn the call over to Laura for financial details from the third quarter. Laura? The microphone is yours.

Thank you, Rob, and hello everyone. Revenue in Q3 was a $183 million, at the high end of our expected range. Revenue declined 21% year-on-year due to lower sales in consumer electronics, particularly smartphone manufacturing. Revenue from automotive and the broader factory automation market also declined from Q3 '18. Partially offsetting the shortfall was growth in logistics. Gross margin of 74% was down slightly from Q3 '18 and consistent with Q2 '19 despite lower revenue. Operating expenses declined from both Q3 '18 and the prior quarter, reflecting reduced expenses for incentive compensation plans. We continue to be prudent with the discretionary spending without changing product development plans. Operating margin in Q3 was 24%, representing a decline both year-on-year and sequentially, due to the lower revenue environment. Excluding discrete tax items, earnings per share were $0.23 in Q3 '19 compared with $0.39 in Q3 '18 and $0.27 in Q2 '19. Looking at revenue growth year-on-year from a geographic perspective, the Americas was the best-performing region increasing mid-teens year-on-year due to strong growth in logistics. The impact of this quarter's substantially lower contribution from consumer electronics was most noticable in Europe, where revenue declined by more than 45% year-on-year. Customers in Greater China continue to defer their capital spending plans, resulting in low-double digit revenue decline year-on-year. This decline would have been greater in Greater China and less extreme in Europe, If not for our procurement changes made by certain customers in consumer electronics shifting their purchases from China to China from Europe. In the Rest of Asia, revenue was relatively flat with Q3 '18. Turning to our strong balance sheet. We ended the quarter with $918 million in cash and investments and no debt. Even after purchasing Sualab, we have enough capital to support our organic growth objectives and M&A plans and for sharing our ongoing success with our shareholders through stock buybacks and dividends. In that regard, our Board of Directors has increased the quarterly cash dividend by 10% to $0.055 per share. The dividend is payable on November 29 to all shareholders of record on November 15 Now I'll turn the call back to Rob.

Thank you, Laura. Moving next to guidance. We expect revenue for the fourth quarter will be between $155 million and $165 million, making it the lowest revenue generating quarter this year. Compared with revenue of $193 million reported in Q4 of 2018 industrial markets are significantly weaker today and continued to deteriorate led by automotive. The contraction is most pronounced outside of the United States, and particularly in business that relates to China. Unlike Q3, we don't expect growth from logistics to offset the overall revenue shortfall in Q4. Even though logistics, revenue grew by approximately 50% year-on-year in Q3, we expect it to decrease year-on-year in Q4. This is the result of a major customer delaying delivery of large orders for new sites. Gross margin for Q4 is expected to be in the mid-70% range, consistent with the gross margin for Q3. Operating expenses are expected to increase by mid to high-single digits on a sequential basis, approximately 4 percentage points are attributable to incremental costs for the Sualab team, estimated amortization of intangibles and expenses associated with the acquisition. The effective tax rate is expected to be 16%, excluding discrete tax items. I'd like to make you aware of two discrete tax items expected to be recorded in 2019. The first item in both changes to our corporate tax structure, which came about because of legislation passed by the European Union. So that one, we expect a discrete tax benefit of between $100 million and $125 million and a slight increase to our 16% effective tax rate, excluding discrete events going forward. The second item is our decision to move acquired Sualab technology out of Korea to align with our corporate tax structure. This is expected to result in a discrete tax expense of between $27 million and $33 million. These items continue to be evaluated because of that we do not have more detail at this time. With that, we will open the call for questions. Operator, please go ahead.

[Operator Instructions] Our first question comes from the line of Joe Giordano with Cowen and Company. Please proceed.

Rob, could you size that big order that was pushed and is it something that you just found out recently, Is it something that you have visibility into late just delivering it after the quarter or something. I'm just trying to see how indicative is of the logistics environment in general, or this is just kind of a one-off thing that gets fixed in a few weeks ?

Yes. So it's a pretty substantial order, let me give you a bit of color on it . So overall logistics formally strong and growing, but we expect lower revenue year-on-year from logistics in Q4, as a result of this major customer delaying delivery of large orders to new sites. And the same customer did take substantial deliveries in Q4 of last year. So many of these orders are run-off books awaiting delivery, which we now expect to result in revenue next year and not in Q4, our visibility of that is quite recent for us, but we see probably that some major integrators may have had some more specific understanding of that situation earlier. So we continue to see strength in our logistics business, particularly among a broad base of customers who are growing very, very well indeed. And we remain confidence - confident that we can grow it 50% over the long run, but we now just don't expect to grow at that rate for the full year in 2019.

Can I just clarify one thing there, so this is an order you have received, right? This is not an order that you thought you might get that didn't appear, is this an order that you already have though?

So it's order that's coming in many pieces, it's very substantial, right. We don't have all of it, but we have many, much of it.

Okay. And then I guess my follow-up. Yes, go ahead please.

I was just going to sort of say that I think it's really to do with changes that the customer about their plans and the timing of their plans, which unfortunately for us is moving revenue out of this year and slowing down our overall growth rate in Q4 and for the full year for logistics.

My follow-up would be around China, obviously, a lot of talk around trade war and what does Phase 1 agreement like, might do? How much of the stuff do you attribute like any of this weakness to that specifically and if there is some sort of like, Phase 1 of 3 kind of deal coming out, does that change anything on the ground for you guys, do you think anytime - on the near term?

It's difficult to call, but I have to say, yes. I mean certainly, China is a softness region at the moment. And after being our real engine of growth for us, for so many years and your customers there have a real wait and see mindset, and they're very slow to the place orders, and they've continued to reduce in delay capital expenditures, so yeah, that's what we're seeing. And I think Laura pointed out also the revenue from China in Q3 benefited from purchases from Fed and consumer electronic customers that have started to purchase our products in China, when previously they bought them out of Europe. So that's also may be making on China numbers that the situation in China look better than it really is. Yes. So, how quickly will that turnaround on my experience with China, my experience with our business in general is that when things do change and the business can come back very quickly. I've seen that on a number of occasions. And I don't know whether this is really a different of long-term situation unlike what we've seen before. But I do happen to think if confidence could return, we see momentum in the other direction. We could see a quick recovery, but I just have no way of gauging if and when that will come

Our next question comes from Richard Eastman with Robert W Baird & Co. Please proceed.

Rob, could you put a little color around Sualab, when we looked at their website. They have a pretty impressive customer list and all the big majors on the consumer electronics side it appears. And I'm curious with very modest revenue presently how was their product deployed. Is it still kind of in a piloting phase or is it deployed at a central location? Or is it deployed on equipment itself or just kind of walk me through that, maybe just a little bit? And how quickly the - the revenue expectations can inflate given the application?

So, Sualab has a business model so like ViDi, right, so they sell SuaKIT, sophisticated deep learning machine vision software. And they have very strong team of application engineers who help customers apply it, right. So the majority - the vast majority of that business today, over the trailing 12 months, is related to that, right. But I think more excitingly, I think what we see the potential is to take that technology and they're already working on this and to deploy it through machine builders to help it scale much in the way that we have in our consumer electronics business over the last five years or so. And we, of course, have a great network of machine builders and integrators who can help them speed that up. And then they have some very nice application-specific related products in their pipeline that we think will be very powerful in changing this market. So there is a base kind of business that I would describe very much like very good technology with some relative strength and differences compared to ViDi, and then some very interesting opportunities to apply more application-specific products through machine builders in a form that should be more scalable in the coming years and where we are very well positioned to help them.

And then just a follow-up on this issue that you raised about a consumer electronics customer purchasing in China, for China versus prior - it was purchased - product was purchased out of Europe. What predicated that switch? Is it a currency issue or why is there a shift there and where the purchases are occurring, for I presume it will be the same application?

Yes. I'm sort of limited into what I can say, specifically about the internal workings of our large customers. But I think in - certainly in that case, perhaps due to some of the trading situations we're seeing and tax consequences and other things, they've - they would - they have decided they want to purchase from us locally in China rather than out of a subsidiary in Europe. It doesn't really change the nature of the work we do, nor does it really change our profitability on the business, generally speaking. But it just does mean where you see it show up in regions is different.

Okay. And now it started this quarter?

Laura?

Yes, materially this quarter. Yes.

Our next question comes from the line of Josh Pokrzywinski with Morgan Stanley. Please proceed.

I just want to follow - just want to follow-up on, on the logistics comment. Maybe some more color about some of the lumpiness there. I guess, first of all, can you talk us through kind of the concentration from a customer perspective in that case? It sounds like there was one large order that got pushed, but is this going to be something kind of analogous to the electronic side with your large customer there, where we do see lumpiness just related to one customer really driving kind of the quarter-to-quarter cadence?

Yes, okay. So your question is sort of, that's kind of customer mix in logistics and how does that play out in terms of lumpiness in the business. In our logistics business today, we have a handful of large important customers, right, who can be ordering a potential amount from us in the order of $10 million to $20 million in a quarter. It would not necessarily be unusual I think, in terms of how we see them playing out. And those orders are based often on their automation plans and how they roll them out, right. So I think that does have the potential to move revenue in and out of quarters, and I think that's probably kind of become - that is probably a reality of our logistics business going forward. And then, we have many, many smaller customers who might be buying very small amounts, up to a few million dollars. And this is good base of that business that looks much more consistent overall, and that business actually is, when we look at it, it is growing faster than our overall business. We expect that probably to go on as our technology becomes easier to integrate more widely, known and accepted, and as we develop our own capability and integrate quite a network to deliver it. But in kind of answering your question here, we have a handful of customers, and I think one we - we referenced not by name, but today and I can certainly think of others, may mean that our revenue as it plays out in the coming quarters will be lumpy in logistics, and we'll just try to give you a heads up to that. We're really in this for the long term and we see a big change going on in our 50% long-term growth strategy is all based around that. So I think we are relatively comfortable with the fact that may change, but we really as we need to explain it to you is, and as we see it, as we are doing now and sometimes that can move.

And then, just taking a step back from consumer electronics, obviously weakness there has been perpetuated for a couple reasons. Obviously, the tough comp coming off of some of the - the OLED rollouts a couple of years ago, and then your general weakness in the electronics industry in 2019. But we are starting to see kind of select green shoots from folks in the broader definition of capital equipment, maybe products that will come off a lot different from what Cognex is supplying. But some kind of early indicators that 2020 will be better. Yes, I guess from your perspective, you guys don't get a lot of that color until more the 2Q timeframe, but is there anything you can share with us either on kind of product roadmaps, any kind of technology shifts that you see out there, that would maybe help define important things to watch for 2020, understanding now that you have kind of a couple of years of easy comp starting to build out?

Yes. Okay, Josh. I think I'll point to a few things, but these are really just reprising what I've said before. We really get a better view of our consumer electronics business in Q2, when we are reporting Q1 next year. I think that's when we will have a real read on how it's shaping up. Always, I would say at this stage, there's a lot of interesting stuff in the consumer electronics pipeline that we have some visibility on. The question is that of, how well it's funded and able to be implemented as we get into the year, and obvious kind of things that could really help and be a tailwind for the business overall. Next year, 5G is a very obvious one, to what degree that is implemented and its technical challenges around implementing if there are always new features. We have a line of sight on coming in, in the electronics market. So that can really drive, but again, it's interesting to see which ones make it in each year. And then - and then as you mentioned, the rollout of OLED specifically as it relates to high-end phones, foldable screens, et cetera, that definitely has life in it as I think you can see by reading the paper, with that - some technology where - but there's a lot of value that Cognex can add. And then, I think then headwinds would remain. Those still - now there is a - one of the largest smartphone companies in the world is, one we can't sell to. So that certainly is an ongoing headwind, and I'd like that situation to change and I think so would they, but at the moment, that's a potential problem for us.

And just one final one, I'd like to squeeze in there. What are you doing business with that company before, and now you can't, is there any way to size, kind of what that missed opportunity was and I'll leave it there?

Yes, I think we don't really like to talk about customers by name specifically, but you can assume. I mean, we - we are the leading machine vision manufacturer in the world. So any company that's performing advanced discrete manufacturing is likely a Cognex customer, and you would expect a big electronics company to be doing - certainly be doing a few million dollars or more with us.

Our next question comes from the line of Joseph Ritchie with Goldman Sachs. Please proceed.

So Rob, just - just a few quick ones. Maybe just following up on that question on electronics visibility in 5G. How much visibility will you have as the year progresses and what do you think the timing of that visibility will be? Will it be kind of like early next year by 1Q? I'm just trying to get a sense for timing and visibility.

Yes, I think we'll be in a position to give you a clear view of that as we have in past years, when we report our Q1 results. I guess, that is end of April. Yeah. And that's end of April. Yeah, we may have - we'll probably have a visibility earlier than that. I think my experience now having been through a number of cycles is, there is a lot of stuff there in the funnel, but in reality, the kind of - the overall view of the market of what gets rolled out really doesn't crystallize until that kind of time frame. And that's probably different than our other markets. We sometimes liken it to - they're building the airplane as it's going down the runway in that industry. So we do have quite late visibility as to what really makes it into final build.

And then just, I know we've been - we've been talking about this topic a little bit on the call already, but the customer delaying the decision on large orders to new sites. Can you maybe give us a little bit of color on why there was a deferral?

It has to do with their plans to roll out automation - their automation plans and delays that have - are changing that right. And those are delays that are related to that company not - and their plans not to do - not related to Cognex vision and our ability to meet that demand. But I can't get more into specifically what and where that customer is finding those issues.

I guess I was just trying to get a sense for whether it was like a liquidity issue from a customer perspective or whether it was just managing too much and having no capacity all this out?

No. This is a very, very substantial company. It's really much more about engineering and automation product rollout and plan rather than anything to do with financial or anything to do with Cognex's ability to fulfill those orders that we have on our books and are expecting to complete on our books soon.

And then, one quick one, I may missed it earlier, but you mentioned on Sualab the accretion within two years. What's the expectation then from a financial perspective for next year?

I don't think we've accept to - generally, you have a policy of not talking about the forecast for next year - for the full year. So we're not currently disclosing that. But obviously, we're looking for some significant growth from them. And obviously, based on what I've said it would be dilutive to us next year.

Okay. Gotcha. Thank you.

Yes. And accretive in two years, and I think we'll be in a better position to give you more detail on that when we report the full year as well. It's still a relatively recent acquisition for us.

Our next question comes from the line of Paul Coster with JPMorgan. Please proceed.

This is Paul Chung on for Coster. Thanks for taking our questions. So, just another follow-up on the Sualab acquisition. Why now on this and is this kind of customer-driven demand or it's just part of the vision for capturing incremental offerings across your verticals? And if you could also talk about some of your cross-selling benefits here with their existing consumer base? I have a follow-up.

Yeah. Sure. I mean I think the right way to view it is at Cognex, we pride ourselves on having a deep understanding about the technology and the applications for machine vision. And we spend a great deal of time studying those then we've talked about logistics and how we see that's kind of hitting - a tip has hit a tipping point where the need for automation is changing. There is another tipping point going on currently in the world of machine vision and it has to do with the deep learning technology and its progress and it's huge technology development going on in that space. And the potential it provides to replace human visual inspectors and electronics. A few - of whom tens of thousands in Asia. And the technology is getting to the point where it's really now a very attractive market opportunity and a large customers really see that they're very interested to work with us. They faced a lot of challenges around finding people to staff human visual inspection not being very effective, human visual inspector might be 85% effective in their work and catching feedbacks while machine vision has the capability to be 99.9% effective. So this is a very good return on investment I think pretty clear to us and to the big electronics customers that we see in Asia. So I think that's the reason why this is happening now and why we are so positive about it. I think we're also fortunate in that we acquired DVT 2.5 years ago and we've really had the chance through owning them to see the potential, but seeing that potential also made us realize that we needed more engineers and we needed more reach and engineering capability in Asia where this market really is. So as we looked at that and we worked on it. We really realized that Sualab is really right in the sweet spot of all of that. There we got to know them. I think we've developed a lot of mutual respect for one another and we were so pleased to see a fantastic cultural fit, which for us is really important of Cognex because we don't - we like to buy acquisitions. We would like to buy companies that have great engineers and great growth potential and the amount of excitement that creates in us and in them is something that works very well for us and we did that with ViDi and we've done that with Chiaro and other acquisitions we've made over the years. So the more we drilled, the more we got to know each other, but what we understood the market than what we talk to large customers in this space and so where Sualab is working the more excited we got and the user was in our minds to justify making this for us pretty substantial acquisition.

And then switching gears, on free cash despite material lower revenues and earnings. Can you just talk about the puts and takes of what's driving your working cap conversion benefits this year relative to last. Is this kind of temporary in nature or is there some things more structural going on and how you see working cap trends over the next six months? Thanks.

Yes. And can we ask Laura to answer that. Do you need more clarification.

Well, let me see, if I can for you --let me know to give you more clarification. But one of the noticeable changes in our balance sheet is our client in our inventory balance, which has come down in Q3 as we delivered on large opportunities and shipped recently introduced new products. And we work that nicely from the end of the year. We believe, we now have enough inventory balance with an appropriate level. So that was a one noticeable change in working capital. It does - does that answer your question

Yes, somewhat. Thank you.

Our next question comes from line of Matt Summerville with DA Davidson. Please proceed.

Maybe just two quick questions. First, with respect to the Americas, can you provide a little bit more granular detail in terms of what you're seeing across the different end markets there? You mentioned logistics, but I could have missed it, just any more color in terms of what you're seeing there would be helpful?

Sure. Hi, Matt. Yeah. So I'm pretty much like all of our end region - The Americas region is soft, but particularly in automotive, but I would say, relative to other regions, I think we saw that helped us early this year, and now it's more stable. It's not - we're not seeing a declining rates, we're seeing elsewhere. And I think as we look at the market overall, we're seeing a lot of uncertainty and delay. And automotive is our biggest market in Americas. And we're not anticipating a sort of a significant budget flush in Americas or anywhere really that we would might expect at the end of the year. So that's kind of baked in our guidance. The Americas has relatively better growth but profile than elsewhere, also as a result of a higher weight in logistics. I mean, it's a home market, where we have relatively more business in logistics than anywhere else. And that's a business that is growing very, very strongly. So that's also helping our results in this region. Other industries in the Americas, just out of interest that other market industries that are holding up well medical-related business, food and beverage and packaging. Now they will do it, okay. There - I think they're all growing currently despite the difficult market conditions, but and logistics is growing well, but then suddenly automotive is much more challenging overall

And then are you able to parse out between what the year-over-year revenue changes would have looked like had that customer not changed geographic, I'll call it procurement strategy just trying to bridge that instead of Europe being down mid '40s, maybe what would that have been down instead of China being down low-teens, maybe what would that have been down if that changed didn't happen?

Yes. Still quite a lot of moving parts as we come through the end of the quarter. So I don't think we're going to try to do that, per se. Laurie, if you want to add some -

Yes. I think and that's kind of pro forma information that we haven't prepared to disclose.

Yes. So we're not really ready to give you a read on that yet.

Our next question comes from the line of Karen Lau with Gordon Haskett. Please proceed.

Just a quick one on OpEx. I think you mentioned about 4 points of the sequential increase is due to Sualab, but you also mentioned there is some amortization there. I just wanted to clarify how much of that what you say is sort of one-time that shouldn't really continue into next year and how much should we really put in the base number as we project forward?

So I can answer that Karen. So the 4 percentage points represents the Sualab team ongoing operating expenses and addition to an estimate of amortization of intangibles, but we're still in the process of finalizing the purchase price allocation. So we don't know exactly what those numbers will be, but I can't tell you that we expect the majority of $170 million that will allocate to be assigned to goodwill. So that 4% there was a small percent, that I would say is non-recurring, most of the 4% like, 3% of the 4% I would say would be recurring. And again, we expect most of the purchase price will be allocated to goodwill.

So parsing out the 4 points sequential increase that is related to Sualab, the core spending would be the remaining 4 points. I noticed that in the third quarter you in terms of OpEx, it looks like you understand a little bit versus your guide, is the sequential uptick more in the core OpEx spending more of a timing issue or should we read into that as maybe some of the pent-up investment coming back? Or maybe your positioning for some projects next year, how should we think about that?

Yes, I think what you saw us understanding a little compared to the guidance in Q3 related primarily to adjustments to our incentive compensation plans.

I guess - okay. Thank you. And then just I guess taking it more broadly into next year, Rob. Let's say for whatever reason whether stabilization or consumer electronics start to turn next year, I would imagine you've been doing - you guys have been doing good job in quote unquote cutting the crap. But also there is probably some pent-up spending that might have to come back at some point. So let's say, their market start to turn next year, would you expect sort of a normal type of incremental margins to be realized? Or do you think that given so many things have been kind of investment and spending wise have been delayed this year because of the environments. There is more sort of catch-up spending that needs to happen next year if things start to get better? I'm just trying to get a sense of the incremental that you would expect?

Yes. Okay. It's an interesting question Karen. At the moment, I'm not expecting sort of that kind of our markets to recover very strongly going into next year, but it's obviously and it's really too early to talk about next year. But here's what I can say, I think we run Cognex to the long-term, so we're not cutting back on important things that are essential to our three-year growth strategies. In fact we go on investing in those things that we consider essential. And I think through - what is - obviously a much lower rate of increase in spending. We've been able to keep our new products on track and our plans intact. So I'd say that's the case now. By then go back and I look at times when we have seen a big recovery in our markets or a big incremental step up in growth. And I'm talking about years like 2010, 2014, 2017, where we had growth in excess of 30%. The pull through in those years is awesome, right. What are - given our kind of gross margins, and there isn't a great need to add in additional incremental expense related to growth like that. So I would expect, if and when our markets recover and if we come back strongly as they had we should see very, very good pull through on incremental revenue.

So there is no kind of delay in spending that what have to be catch-up, kind of regardless of how much end market come back next year?

Well, I think the thing to point out would be incentive compensation relate, so that is - that fiscal year where we're not achieving our budget. And we're certainly paying out much less incentive compensation . So if we went back to a normal year, then it will be a step up in that, and we'll get back to a strong year, it will be a significant step up in that.

Our next question comes from the line of Jim Ricchiuti with Needham. Please proceed.

This is Mike Cikos on for Jim Ricchiuti. Just a couple of questions here. The first coming back to the delayed shipments for this logistics customer wanted to get a better sense it sounds like, this is one of your larger customers, and I know you kind of scoped, the large customers contributing as much as $10 million to $20 million per quarter not being unusual. Fair to assume that this customer coming in at the higher end of that range, if not higher than the $20 million boom.

We're not sure exactly where would come in and, but perhaps order of magnitude and yeah, in a range of significance, probably south not as much 20, but and it all depends on how much of that orders, we would expect them to take in a particular quarter. And I do just want to clarify, it wouldn't take that number and multiply it by 4 to get the size of the customer, right if it features more in line, Customers have plans they rolled out of this certain cadence and that may mean a quarterly revenue for any particular customer might be on that order of magnitude and that might be the kind of level of challenge that we're seeing in a headwind this quarter.

I see, okay. And I guess, if you would said that the logistics business because of this Q4 shift is not expected to grow 50% year-on-year. How fast is it growing in 2019 and based on what you currently have in end?

Yes. That's not a number where we are going to disclose at this time, right. We've said, we've told you Q3, but we're going to sort of see how things play out in Q4. And then we might have more. I'll give you a better view of that when the year is over.

I see, okay. And then just one final question, if I may, on the gross margin front. I was interested in hearing how you guys are able to maintain call it, this mid 70% gross margin versus Q3 on the lower revenue base is part of that mixed shift or is there anything else we should be thinking about in that?

Yes. That was a result of the revenue mix in the quarter.

Our next question comes from the line of Andrew Buscaglia with Berenberg. Please proceed.

Quick question. So, consumer electronics, can you - can you comment if that continued to get worse from Q2. It sounds like auto is somewhat stabilized, but how would you characterize consumer electronics?

Well - I would say, consumer electronics has kind of played out as we expected this year based on what we told you in April. I think - if I think back and we certainly, where we were I'm happy to discover back at that time that our customers in consumer electronics, where we're looking at them very dry year and I think, we kind of had eyes on that and communicated at that point, and it has played out as we expected. So annual revenue from consumer electronics is on track to decline by roughly one-third this year. And it represented 30% of our business in 2018. And particularly as a result of smartphone manufacturing and the decline you will see is most notable in European region followed by China and the rest of Asia. But it's certainly been a year of diminished investment and I think that's as we expected.

And just to confirm, you said it, I think you said in the prepared remarks that it was down 50% year-over-year?

So revenue for consumer electronics in Q3 declined by approximately 50% year-on-year, or nearly $50 million due particularly to smartphone manufacturing.

Our next question comes from the line of Ben Rose with Battle Road Research. Please proceed.

Yes. Hi, Robert and Susan. Rob, can you identify the industry of the customer in logistics - for the logistics product?

It's a large customer bonds in logistics, so you can assume - e-commerce or repo retail.

Okay. I just wanted to be sure that...

It's not a airport baggage handling or fall which might be the other - you can see from large chunk of the business, but that's not what it is.

And then just a question on Sualab's. Are the customers today for their product - are they primarily the Korean OEM manufacturers? Do they have any penetration - meaningful penetration thus far outside of Korea?

Yes. Their main markets are in Korea and China and Vietnam overall, and they're really with them, Chinese and Korean electronics or electronic components manufacturers do inspection. And something we like about them is, they're really - they like us really have close high level engineering relationships with senior engineers as those companies. So it's not, they're not trying to move that product through the OEM machine though there, it's being pulled by the end user, who really many of them are employing, many thousands of visual inspectors and are looking to see better cost and performance out of that aspect of their business.

I'm sorry, just one final perhaps have - have has the company actually validated the technology with the kind of reduction in visual inspectors that you mentioned earlier in the call, in order of hundreds or - hundreds or thousands of visual inspector is being replaced by the technology.

Absolutely, yes. Yes, I don't think we would have acquired the company, had we not done our due diligence on that for sure, right now, there is - and we ourselves on Cognex before we met Sualab opportunities where our electronics customers really are very interested and have been previously unable to replace those visual inspectors with machine vision and so we're seeing a lot of interest from them as a result of this news.

Our next question comes from the line of Karen Lau with Gordon Haskett. Please proceed.

Thanks for taking my follow-up. Rob, I'm just curious on consumer electronics or maybe broadly more in China. There has been stories about Chinese companies kind of future proofing their supply chain, I don't know if that's the right word to use, but sort of, in light of like blacklisting or often they get cut off from their US suppliers. I think that is more concentrated in like kind of chips manufacturing that sort of thing, but I wasn't sure if you are seeing any of that sentiment in areas that you participate in China maybe you can talk a little bit about that?

Yes, Karen. The answer is, we're looking for that and we're really not seeing it among our customers. I can really only think of one instance that I've where Chinese company, you didn't - and it's not a company we would - any of us would know readily didn't was concerned, I didn't want to do business because we were American, that's not widespread. And I think what we're reading about is much more components and chip and technology in that way. I think the other thing important to realize is our technology basically, it doesn't owned inside the US or sold from the US per se. Right, in terms of how we are recognized by customers. So I think that also somewhat insulates us from this. But clearly what we've seen with one of the largest and some companies where we might become unable to sell to them that if that was a real threat on a larger scale that would be a big problem for us.

So nothing beyond far away that you're seeing that concerns you in terms of Chinese companies sourcing from suppliers from other geographies?

Correct.

Our next question comes from the line of Joe Giordano with Cowen. Please proceed.

Thanks for taking my follow-ups here. On Sualab again I understand the geographic presence that bring in the engineering capabilities. Is this a fundamentally different products than BD or is this something that you foresee over time like one offering globally that's integrated as whenever you guys may call it or is it one thing or is it two kind of things?

Yes. Hi, Joe. And I should say, gentlemen, this is the last question, I think we have time for - that I'll answer it. So, a point from earlier, I think you might have asked the question, what do we bring to Sualab, and I think, what we do bring it up is a lot of customer relationships and a big sales footprint in the market. So I think I just do want to make that point, this is or not - this is very much complementary I think for both companies. And the synergies on the growth side for both of us working together. But your question related to what, can you repeat that again, I'm sorry.

Like, are these two fundamental fundamentally different things BD and Sualab, or is this something that ultimately is like one team, one integrated product that Cognex can offer to?

Yes. I'm sorry, yes. So they are quite similar products. So deep learning, so if I could do various assumptions and we've developed with VD 7 functions that really relates more to our end markets where we've been focused particularly automotive and based on our geographical presence, right. And Sualab have - has some strong tools and capabilities that relate to Asian visual inspection. So similar, but develops in different ways, right. I would say that. And then, because they have a big footprint of engineers and application engineers in Asia. They have the ability to help unlock a lot of potential that we see in that market, where we didn't have that capability. So they bring a lot of engineering application capability, which could be applied to either VD or to Sualab right. And then we have a big sales network where we have a pent-up demand that they can help unlock. So that's kind of where the complementary parts of the business go, but the product itself ViDi and SuaKIT are quite similar. There's quite a lot of overlap, but with quite a few complementary strengths around specific tools, capabilities, user interfaces and another key element.

And if you don't mind, just like a one - you can answer it in two words if you want, but the medical food and beverage and consumer at verticals that we don't spend a lot of time talking about, do you expect those to be up this year?

Yes. We do.

Thank you. We have reached the end of the call. I will now turn it back over to Mr. Rob Willett for closing remarks.

Thank you. So well, our results are not what we hoped for at the start of this year, for a confident in the future role, the machine vision and in the long-term prospects for Cognex. Thank you for joining us tonight. We look forward to speaking with you on our next quarter's call. Good luck.

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