Good morning. My name is Debbie, and I will be your conference operator today. At this time, I would like to welcome everyone to the Novanta Incorporated 2018 Third 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 Third Quarter 2018 Earnings Conference Call. I am Ray Nash, Corporate Finance Leader of Novanta. With me on today's call are 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 a record quarter, beating both our revenue and profit guidance. Our company delivered $160.8 million in revenue, representing 10% year-over-year reported revenue growth and 8% year-over-year organic revenue growth. Our adjusted EBITDA was $34.2 million, which is up 13% versus last year. Our adjusted earnings per share was $0.61, which was up 36% from $0.45 in the third quarter of 2017. In addition, we delivered outstanding cash flow performance with operating cash flow growing to $27.4 million in the third quarter. So all in all, it was really a fantastic quarter from a revenue, profit and cash flow perspective. We continue to feel good about the positioning of our businesses around secular macro growth drivers. We see a converging trend and need for motion, vision and photonics capabilities in a large variety of applications on the back of trends in industry 4.0, precision medicine and health care productivity. Particularly, we remain excited about our position in applications such as DNA sequencing, robotic surgery, metrology, advanced material processing and precision automation and robotics. In the quarter, we did not observe slowdowns in our core markets a few well positions and applications with long-term growth dynamics. In fact, in the quarter, we continued to see broad-based growth momentum across the company and all regions, with seven of our eight businesses growing mid-single digits or higher. We also continue to have solid order book performance, with an overall book-to-bill of 1.04, a core bookings growing 10% versus the third quarter of 2017. We saw broad-based growth in both the medical and advanced industrial market segments and applications. Sales to China were up 25% year-to-date, representing roughly 11% of total Novanta revenue. However, we're staying alert…

Thank you, Matthijs, and good morning, everyone. We delivered 160.8 million in revenue in the third quarter of 2018, an increase of 10% on a reported basis. Our acquisitions resulted in an increase in revenue of 3.2 million or 2.2%, and foreign currency exchange rates adversely impacted our revenue by 500,000 or 0.3%. Consequently, organic growth was 8% year-over-year. Third quarter 2018 GAAP gross profit was 69.6 million or 43% of sales. This compares to 58.7 million or 40% of sales in the third quarter of 2017. On a non-GAAP basis, third quarter 2018 adjusted gross profit was 72 million or 44.9% of sales compared to 65 million or 44.5% in the third quarter of 2017. While adjusted gross margins were up year-over-year, they were flat sequentially. We continue to face adverse mix effects from the strong growth in our medical consumables product line as the gross margins for these products are significantly below the company average. Whereas the negative mix impact on our gross margins is significant, the impact on our organic growth and our EBITDA margins is, obviously, more favorable. In addition, we continue to experience cost and portfolio challenges within Precision Motion as the business works through their inventory and continues to transition its supply chain to vendors that can scale and grow at our growth rates. We are almost done with this transition, so we remain very optimistic that this remains a significant opportunity for gross margin expansion. Non-GAAP operating expenses in the third quarter 2018 were 42 million or 26.3% of sales versus 39 million or 26.8% of sales in the third quarter 2017. The increase in spending was associated with the 1.5 million increase in R&D spending, focused on furthering our new product development and innovation engine and 1.6 million investment in SG&A, which…

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

So starting with WOM. Looks like performance was great despite the tough comps which you pointed out. You talked about some of the headwinds, but what are the things that are driving the strength within WOM?

Yes. Hi. Good morning, Lee. So yes, particularly, the consumable business is very strong. So yes, that was explaining the much stronger quarter at WOM than we expected. Of course, it had some tempering effect on our gross margin percentages, as Robert explained. But overall, we couldn't be more pleased with how the WOM team executed this quarter.

Okay. And then looking at the comments on the tariffs, you called out the $4 million profit impact in the first half of '19. Does that incorporate, not only the announced tariffs, but the potential for increased tariffs come Jan 1 or what is that in general?

Yes, so it does. It sort of our -- like on a worst-case scenario at this point, we've been able to mitigate a lot of the impact. Tariffs are -- they are impacting us now in the back half. They will impact us at the beginning of 2019 as they step up again from 10% to somewhere closer to 25%. So we did factor that into our mitigation plans, and we’ll work our way through that by the time we get to the second half, yes.

Okay. So that 4 million is the unmitigated amount?

Portion of it, that's correct. Yes, and we'll continue to work that. I mean, honestly, this is a fluid situation, and so our teams are now working as if this is a permanent new norm that we need to deal with. And so we've really, kind of, stepped it up from an aggressiveness perspective, meeting biweekly to make sure that we're taking the right actions, making the right communications to our customers and we're moving the supply chain efforts where we need to.

Okay. And one more just, kind of, bookkeeping question. In the release, it says Laser Quantum was -- you completed the acquisition of Laser Quantum in Q3. Did -- was the non-controlling interest the full amount this quarter or was it a partial amount?

We completed it on the very last day or something like that, last couple of days of the quarter.

Okay, so that's the full amount?

The accounting is all, kind of, messed up around there because of the way that put call option had to be treated and so then we had to write down the various aspects of it and write-off and there were some gains. So it's a little complicated, but it was all, kind of, done in the last -- at the end of the quarter.

Okay. If I can just sneak one more in R&D expense as a percent of sales. I missed that in your guidance.

I gave a guidance around total operating expenses. We're still ramping up R&D. So I do expect that to, kind of, get to the 9%. But I think, overall, operating expenses will be closer to 28%.

[Operator Instructions] The next question comes from Brian Drab with William Blair.

Matthijs, I think you mentioned -- couple of times you mentioned the growth in China year-to-date. Can you give us a growth rate for China for the third quarter possibly?

Yes. So the growth in China, in the quarter year-over-year, was a solid mid-teens. I believe it was 13%, 14% or so. And so while that's obviously below the 25% year-to-date number, we just don't see that as a slowdown, because it was actually more related to one individual business with customer timing. So I think overall, I think, the important take away here is that all of our businesses to see very solid market environment in China.

Yes, got it. And then, not sure if I missed this, but your guidance for the balance of the year implies what range for organic revenue growth for the fourth quarter?

Well, it depends, anywhere between 4.5% to 5.5%. It would imply, it's probably going to be -- well, it would imply somewhere in that range.

Yes. All right. That's about what I was calculating and...

[indiscernible]

Okay. That's what I was just going to clarify. Right, that's the main headwind. Okay. And then as you look...

In Laser Quantum, right? So we highlighted those are temporary headwinds there. And comps were fine.

Right. Okay. And then related to Laser Quantum, how good is your visibility as you look into 2019 regarding product launches that the customer is there? And I know you don't want to give any specific guidance on how Laser Quantum grows in 2019, but would you expect -- can you give -- can you make any comments just directionally or like roughly, is it second half of '19 where potentially we accelerate?

Yes. So listen, we remained very excited about the mid and long-term prospects, our prospects with Laser Quantum in the DNA sequencing market and beyond. So we're just fighting some temporary launch dynamics and -- which then makes it for a very strong year one of the launch from a systems perspective with one-off kind of demand in year one that doesn't necessarily reoccur in year two and then that evens itself going forward. So therefore, if you look from a market growth perspective, yes, we couldn't be more excited about this business. Now how this exactly will play out in quarter, we're not going to get into that detail. What we care about is our position in this market, our position in our future roadmap and this market and all point, yes, at a very, very good future for Laser Quantum and the DNA sequencing market overall.

Okay. And then just the last question. On gross margin longer term, you're sticking to the 100 basis points potential improvement in gross margin annually, I think. And can you just talk about given the dynamics here to speaking about regarding tariffs, is that -- is there a risk to that target in 2019 or what should we expect?

I still think that that's an opportunity and I think that we should be executing on that. If you – if we did not have the double-digit growth in our medical consumable business, we would already be seeing the 100 basis points of expansion. So it's kind of a double-edged sword. Our highest-growth business is one of our lower-margin businesses right now. We'll work our way through that. That's the biggest headwind we, kind of, have right now, but it's, on a go forward basis, the ability to drive 100 points of margins expansion a year is something that we feel very comfortable with.

The next question comes from Chris Hillary with Roubaix Capital.

I just wanted to ask, we have a relatively new backdrop in terms of a generally cost inflationary environment. When you think about your organic growth rate, do you think there is an opportunity for a bit more growth to come from annual pricing than you might have thought, say, two to four years ago?

Listen, we're taking all aspects of our business into account always, which includes price. We think getting price with differentiated and innovative products is always on the table. Of course, with some inflation as well as the trade dynamics, of course, price is an instrument we're using, because we have to pass on inflation and both trade, let's say, impact. So I wouldn't necessarily say that there's any different in terms of running the business, but there is some specific cost elements that we have to pass on in this particular time right now. But I'll say, overall, how we run the business, price is an important element in terms of running our business.

Okay. And then maybe just another one, is there -- are there any areas within your portfolio that you anticipate increasing your rate of spend on R&D?

Yes. We do allocate capital across our businesses differently depending upon what their returns on invested capital profiles are. So I think it's important to think about our -- what managers of the portfolio and that capital gets allocated to maximize the returns. And so the R&D, while it might go up to somewhat close to 9%, is not cookie cutter to cross our individual business lines. No, we don't get into specifics of where we invest more, what business gets more dollars other than each business internally knows their role and each business internally knows how much they get allocated, and they know the allocation is based upon the return profile that they can generate.

Okay. Well, and then maybe I'll just throw out one more. Given that there's been more anxiety about trading cost and obviously, interest rates are a little bit higher, do you sense that that's impacted the M&A opportunities much in your favor as a result?

Not so much actually. I mean, again, we're focused on cash on cash returns there. And as a reminder, we source our deals proprietarily and exclusively mostly. And so the sourcing of these deals is done based on developing long-term trust relationships with the owner founders of those businesses. And so if anything, yes, it's ultimately, when they're ready to sell, that's the moment that they sell. And of course, even environment gets a little bit more uncertain, that might help for these owners to be willing to sell sooner. So if anything, it actually helps, not hinders at this moment.

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

Thank you, operator. So to summarize, the third 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 in 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 are 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 fourth quarter and full year 2018 earnings call. Thank you very much. This call is now adjourned.

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