Good morning. My name is Andrew, and I will be your conference operator today. At this time, I would like to welcome everyone to the Novanta Inc. 2018 Second Quarter Earnings Call. [Operator Instructions]. Please note, this event is being recorded. I would now like to turn the conference over to Mr. Ray Nash, Corporate Finance Leader. Please go ahead.

Thank you very much. Good morning, and welcome to Novanta's Second Quarter 2018 Earnings Conference Call. I am 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 have not received a copy of our earnings press release issued today, you may obtain it from the Investor Relations section of our website at www.novanta.com. Please note, this call is being webcast live and will be archived on our website shortly after the call. Before we begin, we 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 our 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 this time. 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 these forward-looking statements as representing our views as of any time after this call. 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 website after this call. I'm now pleased to introduce the Chief Executive Officer of Novanta, Matthijs Glastra.

Thank you, Ray. Good morning, everybody, and thanks for joining our call. Novanta continued its momentum and delivered another strong quarter, beating both our revenue and profit guidance. Our company delivered $150.4 million in revenue, representing 26% year-over-year reported revenue growth and 6.2% year-over-year organic revenue growth. This is our seventh consecutive quarter of mid- or high single-digit double -- digit organic growth. Our adjusted EBITDA was $30.4 million, which is up 18% versus last year. Our adjusted earnings per share was $0.51, which was up 24% from $0.41 in the second quarter of 2017. In addition, we delivered solid cash flows with operating cash flow growing by 19% year-over-year to $20 million in the second quarter. At Novanta, our mission is to deliver innovation that matters, providing mission-critical functionality to our OEM customers while improving end user productivity and enhancing people's lives. We believe that the strength of our team and our robust business model and diversified applications with a balanced exposure to medical and advanced industrial markets are serving us well. We see a converging trend and a need for our motion, vision and photonics capabilities in a large variety of applications on the back of macro trends of industry 4.0, precision medicine and health care productivity. We therefore continue to remain excited about our position and applications such as DNA sequencing, robotic surgery, metrology, advanced material processing and precision automation and robotics, supported by long-term secular market growth trends. In the quarter, we continued to see broad-based growth momentum across the company and all regions with all 3 operating segments demonstrating double-digit year-over-year reported revenue growth. We also continue to have solid order book performance with an overall book-to-bill of 1.04 after a strong bookings performance in the first quarter. We're seeing broad-based market growth in life…

Thanks, Matthijs, and good morning. We delivered $150.4 million in revenue in the second quarter of 2018, an increase of 26.3% on a reported basis. Our acquisitions resulted in an increase in revenue of $21.8 million or 18.3%, and foreign currency exchange rates favorably impacted our revenue by $2.1 million or 1.8%. Consequently, organic growth was 6.2% year-over-year. Second quarter 2018 GAAP gross profit was $65.2 million or 43% of sales. This compared to $53.5 million or 44.9% of sales in the second quarter of 2017. On a non-GAAP basis, second quarter 2018 adjusted gross profit was $67.7 million or 45% of sales compared to $55.2 million or 46% in the second quarter of 2017. Adjusted gross margins improved sequentially but came in below 2017 as a consequence of lower gross margins from our vision segment. The vision segment gross margins were driven by a higher mix of medical consumable sales in WOM, which was not part of the prior year results. As we have explained before, the medical consumables business has much lower gross margin so the strong growth in the product line has a negative mix effect. But we could not be more excited about the opportunity to improve margins here. We understand what actions to take and have added the resources in the business this quarter to start working on more concrete plans. In fact, in the second quarter, we announced Phase 1 of our 2018 restructuring program. The overall program will be focused on driving manufacturing efficiencies within our vision operating segment to improve gross margins to Novanta company averages. Phase 1 is focused on rationalizing our noncore operations, which in this case, was focused on discontinuing machining operations that were providing nonmedical product to nonmedical customers within the WOM business unit. While we are walking…

[Operator Instructions]. The first question comes from Lee Jagoda of CJS Securities.

So just starting with the vision segment. I know JADAK was a drag on your organic growth and it looks like the segment itself had some organic declines overall. Assuming all of the decline was JADAK, can you talk about some of the positive offsets and the outlook for the segment for the remainder of the year?

Yes. So as I mentioned, Lee, this was expected. So we've been communicating about the headwinds in JADAK for a few quarters now. We're going to lap the diabetes care headwind next quarter, and we are on track to returning that business back to growth. It's supported by the design win momentum that we have seen in the business. It's supported by the RFID momentum that we're seeing in the business, and it's supported by the back-op position that we have in the business. So again, consistent with what we have been saying before, and we remain on track versus that story.

Got it. And then Robert, I know you mentioned you're planning on exiting the noncore nonmedical product lines within WOM. Can you give us some insight into the revenue and the profitability of what you're exiting and whether that -- those lost sales and all those potentially lost profitability is in the revenue and EPS range that you gave for the full year?

Yes. So it's $3 million to $5 million of annualized revenue. It's already factored into our revenue forecast, and it's already factored into the EBITDA and EPS forecast that we've provided for 2018. So overall, I think you got the strength of the overall business doing well, it can more than cover for the fact that we're doing that. And from a profitability perspective, it was not a high-margin business, I would say. So it is a -- little bit of a larger revenue impact than it is a profit impact.

But it was profitable?

Just slightly, but for the most part, we'll be able to take up the -- or absorb the lost profit in that. So that's already kind of factored into the forecast.

Perfect. One last one for me just on Laser Quantum. It looks like the profitability you guys backed out was lower than it had been in prior quarters. Can you give us some just trajectory -- color on the trajectory of the business or if there was any onetimes that impacted the profitability this quarter?

No, not from a profitability perspective. Lower sales, it was kind of consistent. There are ups and downs here and they're associated with -- they're depending upon mix of other business that we do with other customers frankly. It depends -- as you know, if my concentration there was a single customer but -- if there are any sort of shifts between product lines, that can cause some -- or individual products, that can cause some shifts in the profitability.

The next question comes from Richard Eastman of Baird.

Just to kind of finish off and piggyback on the last question. With JADAK's situation and then in vision, could I just get a sense, with the WOM commentary, they have some pretty tough comps in the second half. And in JADAK, we expect to return to growth in the second half. But just when you consolidate the 2 for the second half of this year, is vision going to see any core growth at all? I mean, is it better than 0 in the second half?

We haven't gotten into kind of specifics. I think it's going to certainly see some challenge there. So from an organic growth perspective, it is -- a drop in WOM is more significant than an increase in JADAK. So there'll be a little bit of a challenge there. But it is something that, in our mind, is very temporary.

Yes, it's consistent and it's temporary, Rick, I would say. I mean, we've been talking about this, I think, since last year, the third quarter more or less. So it's something that we have factored into our guidance or forecast in the way of running the business.

Okay, okay. And just in the Q, there was a reference within vision to some -- a gross margin reference to poor quality impacts. Is that -- what was that reference to?

Precision Motion, I think.

In the vision segment you're talking about? Or is the overall company

Yes.

In the overall company, Precision Motion had some cost of poor quality that we just talked about in our script. But within the vision segment specifically, there's just -- I would just say that the manufacturing processes that are in place within WOM still are working through some maturity levels.

The most important impact there is the mix impact of higher mix in consumables, right? That's the majority effect in WOM.

We've got a very high growth in a business that's got a little bit of a lower gross margin, so just dealing with that.

Okay. And can I ask within Precision Motion, we had a very good core growth rate there. And I'm curious at Celera Motion, is the strength outsized in either the medical robotic segment versus the industrial robotics segment within kind of those end markets, Celera Motion, or is it reasonably balanced?

Yes, well so surgical robotics definitely strong but unmanned vehicles, satellite communication and in general, kind of what I call the ubiquitous mobile robotics trends, those are -- and those are a vast variety of applications of unmanned vehicles, so that's kind of was in my prepared remarks. And not only do we supply kind of the upper-end performance range of kind of the motion functionality itself in those applications, but we also provide kind of pointing and tracking capability because these -- these, call it -- these vehicles need to know where they are. They need to be able to fully digitize their environment, and they need some very accurate pointing and tracking devices to either point and track signals or light or -- and there's actually Precision Motion capability in that as well. So one of those, call it, point and tracking devices are called gimbals, and we're uniquely positioned to actually win in that space, and so we see actually quite some design win momentum there. But that's across a variety of applications of that are either in line on the factory floor, in the air or even underwater. So it's pretty vast array of different applications.

Okay. And then just the last question, just to talk to Photonics for just a second. I mean, two things. One is again, with the core growth, the call it, 11%, was Laser Quantum greater or less than that relative to Cambridge Tech? In other words, how do those two pieces come in relative to the 11% overall Photonics growth rate?

Cambridge is doing -- it's fair to say Cambridge is doing better but Laser Quantum wasn't that far off. But Cambridge was definitely doing better.

Yes, so we're very excited about the Cambridge Technology performance, which we thought was very strong and continues to be strong. And Laser Quantum, we said on the back of a pretty spectacular last year, we're kind of lapping some tougher comps, and therefore, also after the launch dynamics, will normalize growth in that business to Novanta averages over time, right? So I think just from a trajectory perspective, we've also been very consistent with that. Now if you look long term in that application over multiple years, that's a very sure grower for us. So we remain very excited about it.

Got it. And there were some read-through comments you made [indiscernible] put out. But there were some read-through comments about the heavy industrial laser market in China and Europe by IPGP. And I'm just curious if you have any comments there. I know Cambridge Tech doesn't necessarily play in that heavy industrial cutting, welding market. But nonetheless, I'm curious if you see any fault or hiccup or anything in demand around the laser market, the industrial laser market where you compete.

Yes. No, thank you. We're not going to comment on others obviously, and we can only comment on what we're seeing. I mean, we're very diversified, right, as a company to begin with. So I even commented in the script that like a business, like Cambridge Technology is what we call a horizontal technology business. It cuts across many, many, many applications. And so at a company level, not any individual application is larger than 10% of sales. We don't have any major customer concentration. Largest customer is anywhere between 5% to 7%, and we have a very limited number of those. So I would just start with that kind of dynamic because it's a very important aspect. In addition, you're very correct. Our exposure to cutting and welding is minimal. So yes, we don't see any dynamics there. What can I comment on is that we see across all regions, we see solid growth, so China for us continues to be good. Of course, we are watching trade dynamics and things can, of course, change in a pretty -- what is a pretty volatile environment now. But so far, we haven't seen any change in growth momentum or major impacts on our supply chains yet. And we're looking forward for the second half of the year. We don't see any major demand changes, as we speak. Now there have been, if we look on the semiconductor side, that there have been some reports of maybe some slowdowns in certain areas. We are not seeing that. Again this -- the exposure to the semiconductor market is fairly low, it's less than 10% of sales and our exposure is actually increasing in the faster-growth, more secular part of that market, which is extreme UV or applications that are linked to 5G deployment or electric vehicles. So -- and as you can imagine, those are increasing. So again, we're watching that too, but so far, we don't see any significant impact of that market going softer.

The next question comes from Brian Drab of William Blair.

So I think it's clear that you're updating the expectation for the consolidated gross margin for the year. Last quarter, you're still talking about the 100 basis points of expansion. I don't know if I missed it, but can you give a more precise update on what the expectation now is for gross margin for the year?

No, we haven't gotten into that. I think by the fourth quarter, we'll see -- start to see that 100 basis point improvement versus -- on a run rate basis versus 2017. But it is really what -- what effectively has happened in the first half of the year is that we've had higher growth in medical consumables that happen to be lower margin, and so they're causing a pretty significant mix shift in the business, right? So you're seeing some nice margin expansion in the Photonics segment. I think the Precision Motion business will still have some very nice margin expansion year-over-year. And both those -- but that business in there is pretty healthy. But as you look into the vision segment, you're getting growth in something that's low margin that's causing a little bit of that mix shift.

Okay. And then Robert, did you say 45.5% gross margin for the third quarter?

I did. I did.

Okay, okay. Just checking on that. And then longer term, if you look out to 2019, is the expectation for the 100 basis points expansion potential, is that still intact? And is that still the plan?

Yes, that's still the plan. I think you would have seen a little bit of a higher this quarter if we didn't have some cost of poor quality in the Precision Motion segment. That will recover when it gets into the third quarter. But I think that's still intact. That's still something that we see as very capable of doing.

Okay, great. And then so a little more -- I'm looking for a little more granularity on the model. I don't know how much you're willing to give. But in terms of R&D spend, in terms of dollars, are we kind of at a level where that should be relatively steady going forward in the next couple of quarters, at least? And then can you tell us what tax rate to expect to use going forward? I know you made some comments on the tax rate, but I'm trying to -- I'm looking for a number for like fourth quarter and into 2019, too.

Yes, from a tax rate perspective, I said 22% to 23.5%. That's what we should see next quarter. That's what it should kind of come out to in the fourth quarter as well. So if you factor that in, that will result in a little bit of a lower tax rate for the year and -- than we originally anticipated. You can just do the math on that. But I think it's -- I think we feel pretty good about where that is. From an R&D perspective, that will trend up in terms of dollars, so no, you should not anticipate it staying at 12.5. It will tip up -- I think, on a percent of sales, will go up a little bit as well, so that was as we had planned. We've been adding additional engineering resources in there, and we've been focused on getting that to something close to 9%. I think that's our objective still as we look at the back half of the year. Overall, operating expenses, we said we're going to be around 28% of sales in the third quarter, so that should give you a little bit of a perspective.

Okay, that does help. And then the last thing I have. What is the timing of the divestiture of this $3 million to $5 million of WOM revenue? Is that happening immediately?

Well, first of all, that's already factored into the forecast. It's not necessarily a divestiture. We're just shutting down some third-party sales that we do with -- that's related to machining type of functions. So we're not -- that's already kind of factored into our forecast. We already experienced a little bit of that in the second quarter. You should -- we'll continue to expect that impact in Q3 and Q4. So that has a little bit of an impact on the organic growth obviously, so just as that had tough comparisons, it's also we're adding that factor in as well. But I think overall, it's the right kind of decision to make. It's going to improve a lot of capabilities of the business, improve the margin profile and allow us to do some efficiencies that can drive some further margin expansion into '19 and '20.

Okay. Last one is just when was that first contemplated in your guidance, the winding down of that?

The first time we took it into account was this quarter, yes. We experienced a little bit of an impact, but for the first -- it's really factored in for the first time for the full year and [indiscernible] right now.

Yes, the impact to this quarter is not large. It's more the second half.

This concludes our question-and-answer session. I would like to turn the conference back over to Mr. Matthijs Glastra for any closing remarks.

Thank you, Operator. So to summarize, the second quarter of 2018 was another solid quarter. Our focus on accelerating profitable growth and the diversity and strength of our businesses was evident in our strong financial results. We see a converging trend and need for our motion, vision and Photonics capabilities in a large variety of applications on the back of macro trends of industry 4.0, precision medicine and health care productivity. We therefore continue to remain excited about the applications we play in and the positions we have. Our growth strategy is sound, based on multiple growth drivers, organically and through M&A, and we're well on our way to execute on our 2020 strategic direction. In closing, I would like to thank our customers, our employees and our shareholders for their ongoing support. I'm particularly thankful for the strong contribution and execution of our teams of committed Novanta employees. It's a true pleasure and honor to lead this great company. 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 third quarter earnings call. Thank you very much. This call is now adjourned.

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.