Novanta Inc. (NOVT) Q3 2017 Earnings Report, Transcript and Summary

Good afternoon My name is Dana, and I will be your conference operator today. At this time, I would like to welcome everyone to the Novanta Incorporated 2017 Q3 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. [Operator Instructions]. It is now my pleasure to hand the conference over to Ray Nash, Corporate Finance Leader for Novanta. Mr. Nash, the floor is yours.

Thank you very much. Good morning, and welcome to Novanta's third quarter 2017 earnings conference call. I'm Ray Nash, Corporate Finance Leader of Novanta. With me on today's call is our Chief Executive Officer, Matthijs Glastra; and our Chief Financial Officer, Robert Buckley. If you've not received a copy of our earnings press release issued today, you may obtain it from the Investor Relations section of our web site at www.novanta.com. Please note this call is being web cast live and will be archived on our web site. Before we begin, I need to remind everyone of the Safe Harbor for forward-looking statements that we've outlined in our earnings press release issued earlier today, and also those in our SEC filings. We may make some comments today, both in our prepared remarks and in responses to questions that may include forward-looking statements. These involve inherent assumptions with known and unknown risks and other factors that could cause our future results to differ materially from our current expectations. Any forward-looking statements made today, represent our views only as of today. We disclaim any obligation to update forward-looking statements in the future, even if our estimates change. So you should not rely on any of today's forward-looking statements as representing our views as of any date after today. During this call, we will be referring to certain non-GAAP financial measures. A reconciliation of such non-GAAP financial measures to the most directly comparable GAAP measures is available as an attachment to our earnings press release. To the extent that we use non-GAAP financial measures during this call that are not reconciled to GAAP measures in the earnings press release, we will provide reconciliations promptly on the Investor Relations section of our web site after this call. I'm now pleased to introduce the Chief Executive Officer of Novanta, Matthijs Glastra.

Thank you, Ray. Good afternoon everybody and thanks for joining our call. Novanta delivered another record quarter, beating both our revenue and profit guidance. Our company delivered $146 million in revenue, representing 50% year-over-year reported revenue growth and 8% year-over-year organic revenue growth. This is our fourth consecutive quarter of high single digit or double digit organic growth. In addition, we expanded our EBITDA margins year-over-year by 200 basis points to 20.6% of sales. Adjusted EBITDA was $30 million, which is up nearly 70% versus last year. Our adjusted earnings per share was $0.45, which was up 55% from $0.29 in the third quarter of 2016. At Novanta, our mission is to deliver innovation that matters, providing mission critical functionality to our OEM customers, while improving productivity and enhancing people's lives for our end users. We believe that the strength of our team and our robust business model and diversified applications, with a balanced exposure to medical and industrial markets are serving us very well. In the quarter, we continue to see broad based growth momentum across the company, with all three operating segments demonstrating double digit year-over-year reported revenue growth. Our solid organic revenue growth performance is a direct result of our ability to capitalize on an improving macroeconomic climate, and our ability to execute on our strategic growth initiatives. We are experiencing broad based strength within a majority of our end markets, including lifescience, minimally invasive surgery, and advanced industrial. Examples of growth applications where we deliver innovation that matters are DNA sequencing, robotic surgery, endoscopy, advanced laser material processing and warehouse automation. We continue to make good progress on our strategic growth priorities, driving long term organic growth through commercial excellence and innovation. Year-to-date, our design wins and new product revenue increased by more than 30% year-over-year, our revenue year-to-date from China, increased by more than 25% versus last year, as we continue to expand our direct salesforce in that region. We believe that these indicators support our medium term organic growth guidance of 6% on average. You will hear more details on the quarter in the outlook for the year from Robert. But the strong third quarter results give us confidence to raise again our full year 2017 outlook. We are also well on our way to execute on our 2020 strategic direction of doubling the company in revenue to $750 million, with 20% EBITDA margin, while generating more than 50% of our revenue from medical markets. The integration of our WOM acquisition is going well, with our integration teams in full swing. We have now owned the business for a full quarter, and we are very pleased with how the business is performing. We are encouraged by the strong customer relationships and innovation pipeline of the business, as well as the strength of the team. With the WOM acquisition, our revenue from medical markets is now more than 50%. Together with existing Novanta businesses, we have created a $120 million revenue platform in the attractive, minimally invasive surgery segment, with deep relationships in endoscopic and robotic surgery applications, and an ability to cross-sell to each other's customers. We see opportunities to further strengthen our mutual relationships with those customers in minimally invasive surgery, and have identified other synergies that will become evident over time. In addition, it's good to see that the two acquisitions we closed in January of 2017, ThingMagic and Laser Quantum, are continuing to perform well. Laser Quantum revenue doubled year-over-year in the quarter, driven by increased content in the high growth DNA sequencing market. And whereas ThingMagic helped Novanta accelerate, the rate of overall RFID design wins, which has doubled year-over-year, as we now have a more complete RFID portfolio with strong demand in the healthcare market. Our recent acquisitions are also helping to accelerate our new product revenue through solid innovation pipelines. Now let me turn to our operating segments. Our Precision Motion segment continued to be a very strong growth engine for us, with 15% year-over-year revenue growth and a book-to-bill of 1.06 in the quarter. As we discussed before, the Celera Motion business within the Precision Motion operating segment, is taking advantage of structural growth dynamics, driven by favorable macro trends for Precise and Dynamic Motion Control, in automation, robotics, autonomous vehicles and robotic invasive surgery markets. Additionally, we see solid expansion potential, as our share today is relatively small, these attractive markets are fragmented and are growing at high single-digit rates. Our Celera Motion business showed double digit year-over-year growth in new product revenue and design wins. This business also saw the sixth consecutive quarter of double digit revenue growth from the motor product line, driven by new products, disciplined focus on growth markets, and cross-selling with our encoder product lines in Megatronic solutions. Our channel revenue and new product revenue in Celera Motion grew close to 30% year-to-date versus last year, as we are bringing new innovations to market, and are expanding our commercial teams. The new product growth could have been growth, were it not for supply chain challenges we experienced in the quarter. And as we reported in our last call, we are stepping up investments in engineering, operations, and commercial capabilities in Celera Motion, to capitalize on the growth potential on this business. Turning to our Photonics segment now, which delivered revenue growth in the quarter of 43% year-over-year. Bookings performance was again very strong across the board, resulting into a book-to-bill performance of 1.19. Growth was primarily driven by the Laser Quantum acquisition, our Cambridge technology beam delivery business, as well as the commercial execution in an improving industrial climate. Year-to-date design wins and China revenue in the Photonics segments were up over 20% year-to-date versus last year. Applications with strong performance were laser additive manufacturing, marking and coding, converting, via hole drilling, DNA sequencing and micromachining. Our Cambridge technology team again delivered record bookings with broad based momentum across multiple applications. Cambridge Technology is the largest business in our photonics group, and a world leader in laser beam steering for medical and advanced industrial applications. We are seeing strong demand for our market leading Lightning II scan head, which is an intelligent subsystem, ideally suited for applications such as laser additive manufacturing, cell phone production and micromachining. For example, the Lightning II scan head is enabling the world's most advanced production techniques of flexible circuitry, sensors and smart components used in LTE advanced cell phones and automotive sensing applications. The penetration of these components and modules has grown exponentially and is expected to continue in the future, driven by the explosion in mobile data and the autonomous vehicle revolution. We launched another new product in this business called the DC3000 plus, which is a digital servo driver, paired with Cambridge Technologies galvanometers, offering significant speed and performance advantages in applications such as marking. Customers also benefit from the new self-calibration feature, which streamlines integration of the DC3000 plus into customer systems, and reduces machine downtime, simplifying service requirements. We are expecting meaningful revenue from this product in late 2018 and 2019. We reported last quarter about material shortages in Cambridge Technology, as demand is outstripping supply. We are pleased to report, that while we are still in the process of catching up on demand, and are aggressively ramping capacity in our factories, our team is doing a fantastic job in delivering on 18% year-over-year organic growth in the third quarter. Laser Quantum, which was acquired in January of this year, had another great quarter, doubling year-over-year in the quarter, driven by increased clinical acceptance in Novanta content in the fast growing DNA sequencing market. Laser Quantum is the leading provider of proprietary integrated laser and laser beam shaping subsystems in high throughput next generation sequencing machines, enabling the increase of system output and precision, while lowering overall costs per sequence and per genome. DNA sequencing is an important enabler of the personalized medicine revolution, in for example, immunotherapies for cancer treatment or diagnosis and treatment of genetic disorders. As a result of rapid technological developments, new clinical applications and an improving reimbursement environment, we believe DNA sequencing will have long favorable growth dynamics. Following this year's ramp and a new generation of DNA sequencing machines, we believe growth in this business will likely return to market growth rates of 10% to 15%. Turning to our vision segment now, where we included our WOM acquisition. Within the Vision group, we now have two businesses, minimally invasive surgery technologies or MIS, in short, and detection and analysis. The MIS Group includes NDS and WOM and is focused on endoscopy and robotic surgery applications. The detection and analysis group, includes our JADAK business and is focused on reducing medical errors, improved workflow and patient outcomes, in applications such as minimally invasive surgery, patient monitoring, lifesciences and clinical lab equipment. In the third quarter, our Vision segment delivered 84% year-over-year revenue growth, primarily driven by our WOM acquisition. New product revenue year-to-date more than doubled versus last year, showing that increased investments in R&D are starting to bear fruit. In the quarter, the book-to-bill in our Vision segment was 0.80, driven by timing with customer bookings in our WOM business, which enjoyed high bookings in the first half of 2017, and softer demand on the detection and analysis business. Our WOM business delivered ahead of our expectations, driven by new products and [indiscernible] standbys due to a regulatory change in Europe. WOM recently launched two new insufflator products, the FM300 and FM303, which are seeing significant momentum with endoscopy OEMs. We are also seeing consistent expansion of their consumable business. We are very pleased with WOM's innovation pipeline of insufflators and pumps, which we expect will drive continued growth in 2019 and beyond. We are also pleased, that our NDS endoscopic displays product line has turned the corner. In the quarter, NDS continues to make a profit and deliver the third consecutive quarter of year-over-year organic growth, driven by new products such as 4K displays and wireless products. We expect the business to be a net contributor to our revenue and profit growth in 2017. Within the detection and analysis business, we saw a modest organic revenue decline, driven by old legacy product lines and regulatory changes in diabetes care. We continue to see great design win momentum in our SID, on the back of our ThingMagic and SkyeTek acquisitions. Year-to-date over 40% of our overall design wins are -- in JADAK business were RFID-based in a wide variety of medical applications. As discussed before, RDIF demand in healthcare is increasing, as there is a growing need to identify, track and connect devices, medications and patients for optimal workflow and patient safety. In wrapping up my section, we are very pleased with the organic revenue growth and profitability that we achieved in the third quarter, as well as the performance of our recent acquisitions. Novanta's leadership positions across key medical and industrial markets, combined with our disciplined approach to M&A, is providing a solid foundation for sustainable profitable growth. On the back of a very strong 2017 results and a strong outlook for 2017, we are increasing investments in our growth areas with focus on innovation, sales and operations. Our acquisitions are performing very well, and although our M&A pipeline continues to be very active, our short term focus is on integration of the three acquisitions we have closed so far this year. So with that, I will turn the call over to Robert to provide more details on our financial performance. Robert?

Thank you, Matthijs. Good afternoon everyone. We delivered $146.3 million in revenue in the third quarter of 2017, an increase of 49.5% on a reported basis. The net effect of acquisitions and divestitures resulted in increase of revenue from $40.8 million or 41.7%, whereas foreign currency exchange rates adversely impacted our revenue by $300,000 or 0.3%. Consequently, organic growth was 8.1% year-over-year. Our year-over-year and sequential revenue growth exceeded our own expectations. This was primarily driven by the acquisition of WOM, which was due to a regulatory change in Europe, and is experiencing some last time buys from a handful of our customers and in the second half of this year. This business is doing terrific and the integration is proceeding as we planned. We expect the business to deliver on the growth we planned for in our deal model and we in fact, see additional opportunities in 2019 and beyond, that we are working on now. Third quarter 2017 GAAP gross profit was $58.7 million or 40.1% of sales. This compared to $41.2 million or 42.1% of sales in the third quarter of 2016. Included in gross profit for the third quarter of 2017 was the impact of $6.5 million or 4.4% of sales of amortization of purchase developed technologies and inventory fair value adjustments associated with our acquisitions. On a non-GAAP basis, third quarter 2017 adjusted gross profit was nearly $65.2 million or 44.5% of sales, compared to approximately $42.3 million or 43.3% in the third quarter of 2016. The increase in gross margins year-over-year was driven by higher revenues in the sales mix of higher margin products. The strong year-over-year performance in gross margin, that's an underlying and temporary challenge in our Precision Motions segment. The double digit growth we have been seeing in our Precision Motions segment and service weaknesses in our supply chain and operations in that segment. These weaknesses led to production and efficiencies and quality impacts, that temporarily weakened gross margins in that segment in the quarter. We understand these issues extremely well, and have a track record for solving them. While it may take a few quarters to resolve, we are confident you will see the progress similar to what has been accomplished in our Photonics segment. R&D expenses were $11.7 million or 8% of sales versus $8 million or 8.1% of sales in the prior year. SG&A expenses were $27.7 million or 19% of sales. This compared to $21 million or 21.4% of sales in the third quarter of 2016. SG&A expenses increased in terms of total dollars, primarily due to the current prior year acquisitions. GAAP operating income was $12.3 million in the quarter compared to $11 million in the third quarter of 2016, whereas non-GAAP operating income was $25.8 million or 17.6% of sales compared to $14.7 million or 15% of sales in the prior year. Adjusted EBITDA was up nearly 70% year-over-year at $30.1 million or a 20.6% of sales versus $17.8 million or 18.2% of sales in the prior year. Interest expense in the quarter was $2.1 million versus $1.1 million in the prior year. Weighted average interest rate in our senior credit facility was 3.1%. On the tax front, our GAAP tax rate was 11.9% for the quarter. This difference in the Canadian statutory tax rate of 29%, primarily due to the recognition of net tax benefits associated with uncertain tax positions, and the mix of income earned in jurisdictions with varying tax rate. On a non-GAAP basis, our tax rate was 27.9%, driven largely by jurisdictional mix of income and tax planning initiatives over the last few years. Looking at the full year 2017, we expect roughly a 29% non-GAAP tax rate and roughly 35 million weighted average shares outstanding. Our GAAP diluted earnings per share from continuing operations was $0.00 in the quarter compared to diluted earnings per share of $0.21 in the third quarter of 2016. The GAAP diluted EPS was negatively impacted by $0.22, due solely from a further step-up in the redemption value of our non-controlling interest in Laser Quantum. This step-up did not impact net income, was non-taxable and represents a future cash outlay associated with buying the remaining 24% of Laser Quantum in 2020. Our adjusted earnings per share was $0.45 in the quarter, up from $0.29 in the prior year. The increase in adjusted earnings per share year-over-year was driven by strong operating results from the Photonics and Vision operating segments and from acquisitions. We ended the quarter with 34.8 million weighted average diluted shares outstanding compared to 34.9 million as of the third quarter of 2016. Our operating cash flow was $11.8 million for the quarter versus $10.9 million in the third quarter of 2016. Operating cash flow was driven by an increase in profit, but was partially offset by weaker net working capital performance, as a result of increases in inventory and shipments linearity, both related to our supply chain challenges. Capital expenditures were approximately $3.4 million in the quarter, up from $1.7 million in the third quarter of 2016. The WOM acquisition drove approximately $1 million of the year-over-year increase. On July 3, we closed the WOM acquisition. This acquisition was funded primarily through borrowings on a revolving credit facility. In August, we increased our borrowing capacity under our senior credit facility by $125 million, and reset the Accordion to $125 million for future expansion. The combination of borrowing available on our revolver and the uncommitted Accordion, gives us an additional $294 million of potential borrowing capacity in the future. We completed the third quarter of 2017 with total debt of $243.3 million and $92.1 million of cash. Our leverage rate was 2.35, defined as gross debt divided by the rolling last 12 months pro forma EBITDA. Whereas, our net debt was $154.5 million as of the end of the third quarter. Following the strong financial performance, we are again raising our full year 2017 outlook for both revenue and profit. We expect full year 2017 revenue to be between $518 million and $522 million. This represents approximately 35% reported growth and more than 8% organic growth in the full year 2017. We also expect adjusted EBITDA for the full year 2017 to be in the $103 million to $105 million range. Additionally, we expect adjusted diluted earnings per share in the range of $1.54 to $1.58. Adjusted gross margin should be approximately 150 basis points better for the year compared to 2016, despite some of our supply chain challenges. R&D should finish off the year around 8% of sales for the full year of 2017, and depreciation and amortization expense, which was $8.9 million in the third quarter, will be $30.7 million for the full year of 2017. Finally, we will complete the year with a non-GAAP tax rate of approximately 29% and we expect to hold this rate into 2018. Our guidance did not assume any significant gains or losses or impacts from foreign exchange rates, following the acquisition of WOM and Laser Quantum, we do expect to see slightly more exposure from Euro and the Pound going forward. Our business continues to deliver at or above our expectations. The second half of 2017 is shaping up better than we originally thought. We do have a few industrial market and customer specific tailwinds helping us this year. But as we look out to 2018, we see the business continuing its march on to our 2020 goals, which includes 5% to 7% organic growth for the next few years, and continued acquisitions to reach $750 million in revenue. Despite some near term internal challenges, we strongly believe we have the right team and the expertise to make solid progress on these strategic and financial goals. This concludes our prepared remarks. We will now open the call up for questions.

[Operator Instructions]. The first question comes from Lee Jagoda with CJS Securities. Your line is open.

Hi. Good afternoon and good quarter.

Hi Lee. How are you? Thanks.

Sure. So can we just start with -- can you go through by segment, the organic growth rate in each of the three segments?

I don't think we have ever disclosed organic growth in each of these segments. And not to say that we wouldn't do it on a go forward basis, I'd have to go back and calculate it, because that's a factor in the FX rates in each of the individual areas. I think if you were trying to get at is, what's a contribution of WOM, Laser Quantum and ThingMagic, we do disclose that in our Qs. So for the third quarter, I think, Laser Quantum, in terms of revenue, we deliver about $13.6 million for the quarter. And in terms of WOM, it was around $24.8 million. So that should pretty much get you there.

Got it. Yeah, that's where I was going. So I guess, stepping back, looking at DNA sequencing and robotics, minimally invasive surgery and things like that, can you talk a little bit about your sales cycle and your lead times as it relates to some of the bigger customers, so we can get an idea for how your sales might correlate to theirs on a lag?

You mean the correlation of our sales to some of our customers?

Correct.

Yeah. I mean, that's sometimes very hard to say. I mean, it depends on how much inventory our customers have in their chain, but it's not like there is a year in between or so, right? So when you see a pickup, typically, barring any supply chain overbuying on their side, there is a pretty strong correlation, and it could be, that there is one or two quarters of delay. So we don't -- I thought you were going more on the designing cycles. Now, those can be very long. So that when we work with certain customers, they can -- sometimes in medical space, they can sometimes be three to five years even. For the moment, we have a product to having a designing and then seeing the revenue that can last three to five years. So that [indiscernible] the lag is.

And with regard to WOM, can you talk a little bit about the timeline to see some of the cost savings and the capital investment that you guys might need to execute on that strategy to get margins back towards corporate average?

Yeah Lee, I think we commented, when we did the announcement that we won't see the main benefits until 2019. And the reason for that is, is that, again, regulatory changes, and as we -- when you go after cost productions, you need to get regulatory approval and have to go through those changes with the customers, right? So that's why circulators [ph] leadtimes of those investments as well. And we commented as well, that we see the biggest opportunity in the consumables area, and that requires in-sourcing and a few other changes that we are doing. But we have started to recruit the team actually, that is executing on those challenges and we are very thrilled with that team. Actually a COO that comes from a very strong, say, lean improvement background and gives us a lot of confidence that we will get there. Again, it won't be like next quarter, it will be until 2019, consistent with what we said at our announcement.

Sure. And Robert, just from a capital investment standpoint, obviously, if you are going to do some in-sourcing, there is going to be some capital investment there. You have talked in the past about ERP implementations, although probably smaller. If I look at sort of historical EBITDA conversion to free cash flow versus what you might do in 2018 to 2019, are there puts and takes or is there going to be some lower conversion in 2018?

It is a great question. I need to kind of work our way through that now, as we are going through our budget. I can directionally tell you that the CapEx -- we still spend very little on CapEx as an organization. But we are trending, I think somewhere closer to $9 million for this year, and I think our CapEx will go up a little bit next year. Not really that much associated with the WOM acquisition, we have some facility investments we need to make, because our volume has been growing so fast. And then in 2019, there will certainly be some higher CapEx associated with some purchases in the WOM business. So that's where I would expect to see the larger element kind of pickup. And then that should then tick back down. If you take the ratio of CapEx to sales, probably, rotate this year, that should kind of where things normalize on a long term basis.

Got it. And you gave R&D expense guidance for this year around 8% for the full year I guess. In terms of looking forward, when you are doing your 2018 budget, you are looking at that as a percent of sales, or are you looking at it in dollars and -- how should we think about that?

Yeah. So we are going right through our reviews right now. We have had a couple this week already. Disclosing too much on that, sets those guys up for -- coming up with numbers. But, I wouldn't say, all costs in our organization are kind of zero based, so we kind of start from the bottom and we work our way up and rejustify all the investments that we are making on an ongoing basis. So we avoid kind of some cost scenarios, where things just sit and accumulate and are not driving the returns that we'd expect. So everything is kind of up for discussion. So I think, as you go back to my comment in the third quarter, we were hoping R&D would be kind of closer to 9% of sales, and that's just because of the investment we are making. We didn't achieve that, [indiscernible] that the sales outpaced our investment plans. So dollar-wise we are on track, but percentage-wise we are lower, because our top line grew much faster.

Good problem to have. That's all I have. Thank you very much guys.

Okay, thank you.

[Operator Instructions]. The next question comes from Jared Berlin with Thames Capital Management. Your line is now open.

Hi. Thank you so much. Results are quite good and it's nice to see WOM, one of your larger acquisitions moving along. And the company has done such a really great job with some of these deals recently. And I was just hoping you could expand on your comments, where you said the pipelines for future acquisitions is quite good in the near term, it's going to be more about sort of integrating the recent deals and I am just curious to understand, how you plan to balance those two, to be a rough timeline for what integration looks like?

Yeah. Well I would say overall, we have always been very disciplined on acquisitions, right? With focus on cash returns and free cash flow accretion. So that's -- so no matter what, that is our focus, and you should expect us to maintain that discipline. And as you know, acquisitions are hard to time, and we are not making it a habit to get into how many are in the pipeline, and when to expect for -- what type of acquisition to come. So that's why we -- on purpose, maybe a little coy there. I do think it's important, that as we have done a few larger deals now, both with Laser Quantum and with WOM, that we make sure that we -- the integration continues to go smoothly. We are very pleased, by the way with integration, and so as you can continue to see very positive results there. So yeah, we will announce deals as they come up and as they pass our filter criteria. And again, our pipeline is very solid. But as you noticed with this success [ph], that a lot will drop out, when you have stringent filters.

That sounds great. Thank you very much.

And at this time. There are no further audio questions. I would now like to hand the conference back to Mr. Matthijs Glastra for closing remarks.

Thank you, operator. So to summarize, it's a great time to be a part of Novanta. Our focus on accelerating profitable growth and the diversity and strength of businesses was evident in our strong financial results. We are well on our way in executing our 2020 strategic direction to double the company and revenue to $750 million in revenue, with 20% EBITDA margin, growing organically 5% to 7%, while generating more than 50% of our revenue from medical markets. Our growth strategy is focused on multiple growth drivers. Relentless focus on establishing leading positions in growth markets, expansion over served markets through innovation and disciplined M&A, with focus on expanding our medical presence. Deeper market penetration globally, through stronger and larger commercial team. And all of this, while maintaining our commitment to disciplined execution and a continuous improvement. In closing, I would like to thank our customers, our employees and our shareholders for their ongoing support. We appreciate your interest in the company and your participation in today's call. I look forward to joining all of you in several months on our fourth quarter earnings call. Thank you very much. This call is now adjourned.

Thank you again for joining us. This concludes today's conference call. You may now disconnect.