Novanta Inc. (NOVT) Q4 2018 Earnings Report, Transcript and Summary

Hello, and good morning. My name is Chad, and I will be your conference operator today. At this time, I would like to welcome everyone to the Novanta Inc. 2018 Fourth Quarter and Full Year 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, sir.

Thank you very much. Good morning, and welcome to Novanta's Fourth Quarter and Full Year 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 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 am now pleased to introduce the Chief Executive Officer of Novanta, Matthijs Glastra.

Thank you, Ray. Good morning, everybody, and thanks for joining our call. I'm going to start with a brief overview of 2018 and what we expect to see in 2019. 2018 was an excellent year for Novanta, delivering record results in most financial metrics and delivering on both our revenue and profit promises to our shareholders. Our company delivered $614.3 million in full year revenue, representing 18% year-over-year reported revenue growth and 7% year-over-year organic revenue growth. Our full year book-to-bill was 1.07, and our organic bookings grew 9% versus 2017. Our adjusted EBITDA was $123.8 million, which is up 17% versus last year. Our adjusted earnings per share was $2.16, which was up 35% from $1.60 last year. In addition, we delivered outstanding cash flow performance with operating cash flow growing to $89.6 million, which was up 41% from last year. Our free cash flow to GAAP net income for the full year of 2018 was over 150%. We continue to feel good about the positioning of our businesses around secular macro growth drivers, with over half of our revenue in medical markets that are structurally growing. We see a converging trend and a need for motion and vision and photonic capabilities in a large variety of applications on the back of macro trends of Industry 4.0, precision medicine and health care productivity. Particularly, we remain excited about our positions in applications such as robotic surgery, minimally invasive surgery, DNA sequencing, metrology, advanced material processing and precision automation and robotics. We see excellent momentum and success in our efforts to penetrate high-growth markets and introduce new innovations to our customers. New product revenue for the full year grew over 55% year-over-year. Our vitality index, which is revenue from new products launched in the last 4 years, moved to above 20% of sales for the full year, up from 15% of sales in 2017. Our full year design wins increased by nearly 30%, and our full year revenue from China increased by more than 18% versus last year. All in all, fantastic performance by our team, and we feel we see the initial results of implementing our Novanta growth system, driving sustained growth and operating performance. Looking ahead to 2019, we continue to see robust growth in our medical end markets. With half of our revenues coming from these end markets and with strong leadership positions, we feel good about further penetrating this space with our suite of technologies. On the industrial market side, the overall global economic and geopolitical environment remains a bit fluid. Industrial spending, particularly in China, Europe and the United Kingdom, is experiencing a moderate pullback. And while microelectronics market exposure is small, we see some softness there. Despite this macroeconomic backdrop, we feel good about our full year revenue growth commitments due to our diversified portfolio of applications with secular and long-term growth dynamics. Let me briefly touch on tariffs and inflation. Our businesses, through the company's continuous improvement program, continues to do a tremendous job to address the effects of both. And while we're seeing the effects of inflation and tariffs on our material spend, I'm proud of the execution by the team, delivering solid productivity contributions through our operations net of these effects. We remain on track to completing most of our tariff mitigation steps by the end of the second quarter. Now let me turn to our operating segments. Our Precision Motion segment was a fantastic growth engine for us in 2018, with 25% year-over-year revenue growth and 22% year-over-year bookings growth. In the fourth quarter, revenue grew 24% versus the fourth quarter of 2017. We continue to like our position in precise and dynamic motion control functionality in multiple markets with structural growth dynamics such as precision automation, robotics, metrology and robotic surgery. Our Zettlex acquisition continues to perform well, and we are extremely pleased with the quality of the business, the team and with the progress of the integration. The premise of this transaction was that we could expand its technology into medical robotic applications and use it as a wedge to penetrate industrial robotic applications our existing technology base could not serve as well. And after the first year of ownership, this is proving out, so we could not feel more excited about what this technology will do for us long term. Within the Precision Motion segment, for the full year, our new product revenue grew by more than 60%, and our design wins grew more than 80% versus last year as we bring new innovations to market and are expanding our commercial teams. The Precision Motion full year book-to-bill was 1.08 and 0.95 in the fourth quarter due to medical robotics order timing and some microelectronics market softness. Turning to the full year performance of our Photonics segment. 2 of the 3 business units experienced solid mid-single-digit performance, driven by laser-additive manufacturing, advanced material processing and micromachining. For the full year, new product revenue in Photonics was robust and up double digits versus last year. Design wins increased by nearly 20% versus last year, and revenue from China for the full year was up over 20%. We're pleased to see the continued growth execution in our Cambridge Technology business, which delivered strong full year revenue growth with broad momentum across multiple applications. We're winning in the Cambridge Technology business due to our proprietary beam steering technology, packaged with customer- or application-specific solutions, enabling our customers to win with the fastest, most accurate and highest-performing solutions. In addition, we're also very pleased with the performance of our Synrad business, which delivered solid organic growth in the quarter. Finally, as we indicated before in prior calls, our Laser Quantum business continues to face challenging year-over-year comparisons after a customer launch of a new product in the DNA sequencing market last year. Laser Quantum revenue in the fourth quarter declined double digit year-over-year. This is an event we expect to repeat in the first half of 2019. As a reminder, this lumpiness in sales is related to temporary customer launch dynamics in DNA sequencing, which is unrelated to end market growth. In fact, we feel we are now securely positioned on multigenerational platforms in the space and therefore foresee a multiyear growth path in this market and business. As a result of the Laser Quantum dynamics, the fourth quarter revenue in our Photonics segment was essentially flat year-over-year. For the full year, the Photonics segment showed solid growth of 7% with a book-to-bill of about 1. Turning to our Vision segment, which includes 2 businesses, Minimally Invasive Surgery technologies or MIS for short; and Detection & Analysis. For the full year, our Vision segment delivered 27% year-over-year revenue growth, driven by full year of results from the WOM business. We are especially pleased with our Minimally Invasive Surgery business, which turned in solid growth despite tough comps at WOM related to 2017, which we have discussed in prior calls. In the Vision segment, new product revenue for the full year more than doubled versus last year, and the book-to-bill in our Vision segment was 1.14 with solid bookings across-the-board. The Vision segment predominantly serves the medical market and as previously mentioned, we see solid market momentum as well as new product launch momentum, which we expect to continue in 2019. Our WOM business performed better than we expected in the fourth quarter of 2018 despite the tough comps in the second half of 2017 and despite the fact that we exited some medical product lines. This is a testament both to the high demand for WOM's product offerings as well as commercial execution by the WOM team. In addition, we're very pleased with the continued momentum of our NDS product line in the fourth quarter. NDS delivered its eighth consecutive quarter of year-over-year core revenue growth, driven by new products such as 4K displays, wireless products and our new Video Image Management and Acquisition product, or VIMA, which addresses the integrated operating room market. In addition, the business substantially improved its profitability and was a net contributor to our full year revenue and profit growth in 2018. Finally, our Detection & Analysis business continues to show solid momentum with new product launches around medical-grade RFID and machine vision product offerings. In 2018, the business broadened its portfolio of product offerings of machine vision technologies after purchasing the intellectual property and hiring the engineering team of a small Worcester-based business, focused on medical-grade and better technologies. After the full year of 2018, we saw a decline in this business. We expect the business to return to growth for the full year of 2019. Overall, we are very pleased with the organic growth and profitability that we achieved in 2018 and how strongly we positioned ourselves for sustainable growth going into 2019 and beyond. Our teams performed well in the fourth quarter and delivered outstanding results for the full year of 2018. We're well positioned to achieve another year of solid growth and sustainable long-term success, driven by our fantastic employees and by the Novanta growth system operating model. Despite the macroeconomic climate, we're confident about our 2019 outlook as Novanta's leadership position across diversified medical and industrial markets, combined with our disciplined approach to M&A, is providing a solid foundation for sustainable profitable growth. In wrapping up my section, I would like to make a comment around M&A. Our organization is working hard at cultivating and evaluating several transactions, and we continue to see our pipeline of opportunities grow. But we also want to remain disciplined around financial returns and only move forward when the strategic fit and financial returns are right. Our balance sheet is very strong, finishing the year with growth leverage of 1.7x and net leverages of 1.0x, giving us the flexibility we need to act. So with that, I will turn the call over to Robert to provide more details on our financial performance. Robert?

Thank you, Matthijs, and good morning, everyone. We delivered $156.2 million in revenue in the fourth quarter of 2018, an increase of 6% on a reported basis. Our acquisitions resulted in an increase in revenue of $3.3 million or 2.2%. Foreign currency exchange rates adversely impacted our revenue by $1.6 million or 1.1%. Consequently, organic growth was over 5% year-over-year. For the full year of 2018, we delivered $614.3 million in revenue, an increase of 18% on a reported basis, and organic growth was a positive 7% year-over-year. Fourth quarter 2018 GAAP gross profit was $64.5 million or 41%. This compared to $62.2 million or 42% of sales in the fourth quarter of 2017. For the full year 2018, GAAP gross profit was $261.5 million or 43% of sales, and this compared to $220.5 million or 42% of sales in 2017. On a non-GAAP basis, fourth quarter 2018 adjusted gross profit was $67 million or 43% of sales compared to $65 million or 44% in the fourth quarter of 2017. Full year 2018 adjusted gross profit was $272 million or 44% of sales compared to $234 million or 45% in 2017. It's fair to say that our full year performance for adjusted gross margins came in below our expectations. The largest factor negatively impacting our adjusted gross margins continues to be the adverse mix effects from the strong growth in our medical consumable product line, which remains far below the company's average. However, we are also experiencing in the quarter disappointing cost of poor quality challenges in our Celera Motion and Cambridge Technology business segments. Both issues were related to supply chain quality with previously purchased inventory. While frustrating, it is inherently temporary and something we anticipate resolving once and for all in 2019. Total R&D and SG&A expenses in the fourth quarter of 2018 were $42 million or 26.6% of sales versus $39 million or 26.7% of sales in the fourth quarter of 2017. For the full year 2018, these expenses were $167 million or 27.2% of sales versus $143 million or 27.5% of sales. The increase in full year spending was partially driven by prior year acquisitions, along with investments in R&D in our commercial engine and our productivity programs. GAAP operating income was $16 million in the fourth quarter of 2018 compared to $19 million in 2017, whereas non-GAAP operating income was $25.5 million or 16.3% of sales compared to $25.8 million or 17.6% of sales in 2017. For the full year 2018, GAAP operating income was $71 million compared to $57.6 million in '17, whereas non-GAAP operating income was $104.7 million or 17% of sales compared to $90.8 million or 17.4% of sales in 2017. Adjusted EBITDA was $30.8 million in the fourth quarter of 2018 as compared to $30 million in the fourth quarter of 2017. For the full year 2018, adjusted EBITDA was up 17% year-over-year at $123.8 million or 20.1% of sales. This compares to $106 million in the prior year. Interest expense in the quarter was $2.5 million versus $2.3 million in the prior year. For the full year 2018, interest expense was $9.8 million versus $7.2 million in '17. The weighted average interest rate on our senior credit facility was 3.5% in 2018. On the tax front, our GAAP tax rate was 16.7% for the full year of 2018. It differed from the Canadian statutory rate of 29%, driven largely by jurisdictional mix of income. On a non-GAAP basis, our tax rate for the full year 2018 was 17.4%. This was more favorable than we anticipated as a consequence of higher U.S.- and U.K.-based income and more favorable benefits from tax planning. Our GAAP diluted earnings per share were $0.33 in the fourth quarter of 2018 compared to diluted earnings per share of 0 in the fourth quarter of '17. For full year '18, GAAP EPS was $1.43 versus $1.13 in 2017. On a non-GAAP basis, adjusted earnings per share were $0.56 in the quarter compared to $0.44 in the prior year. For the full year 2018, adjusted earnings per share was up 35% year-over-year at $2.16 versus $1.60 in 2017. The increase in adjusted earnings per share year-over-year was mainly driven by strong operating results, favorable changes from the U.S. tax laws and from prior year acquisitions. We ended the year with 35.5 million diluted weighted average shares outstanding compared to 35.3 million in 2017. For the full year 2018, our operating cash flow was $89.6 million versus $63.4 million in 2017, an increase of 41%. For the full year 2018, capital expenditures were $14.7 million compared to $9.1 million in 2017. We ended the full year of 2018 with gross debt of $210 million, and our growth leverage ratio was 1.66x. Our net debt was $127.5 million as of the end of 2018 or roughly 1x. Our balance sheet is strong with ample acquisition capacity. In addition, our acquisition pipeline is very healthy, and we continue to cultivate and evaluate potential targets while remaining disciplined and focused on driving attractive cash returns and long-term growth in our target markets. Finally, after upgrading our manufacturing expertise and investing in systems and processes over the last 2 years, we announced a restructuring action in the first quarter to reduce our operating costs and further position us for gross margin expansion in 2019 and beyond. While the bulk of the benefit will be seen in 2020, we believe this will further strengthen our ability to drive 100 basis points of gross margin expansion per year for the next few years. Turning to guidance. For the full year of 2019, the company reaffirms its previously issued guidance. We expect GAAP revenue of approximately $645 million to $655 million. For the first quarter of 2019, we expect GAAP revenue in the range of $154 million to $157 million. This represents reported growth of 4% to 6% and organic growth in the range of 3% to 5% year-over-year. The first quarter of 2019 is expected to be weaker than the full year because of a decline in revenue in Laser Quantum, impacted by product launch dynamics of a customer in the DNA sequencing market. We expect this business to return to growth in the second half of 2019 after it laps the difficult year-over-year comparisons. For the full year 2019, gross margins are expected to expand over 100 basis points compared to 2018. Total R&D and SG&A expenses are expected to be between 27% and 28% of sales for the full year. Operating expenses as a percent of sales will be higher in the first quarter of 2019, largely due to higher payroll taxes and higher R&D spending. Full year depreciation expense is expected to be around $12 million, and amortization expense is expected to be around $24 million. We continue to expect full year 2019 adjusted EBITDA to be in the range of $131 million to $135 million or around 20% of sales. In the first quarter of 2019, we expect adjusted EBITDA to be in the range of $27 million to $29 million. The guidance factors in the impact of any incremental tariff costs for tariffs already implemented and announced. Full year interest expense is expected to be around $9 million, absent any significant debt paydown or additional borrowings to fund acquisitions. We expect to see full year non-GAAP tax rate of approximately 20%. This is slightly up from 2018 as we expect slightly less favorable jurisdictional mix of income in 2019, specifically more income in Central Europe and Asia. Consequently, we expect full year 2019 adjusted earnings per share to be in the range of $2.30 to $2.36. Diluted weighted average shares outstanding will be around 35.5 million. And we expect first quarter of 2019 adjusted earnings per share to be in the range of $0.44 to $0.49. As always, our guidance does not assume any significant impacts from foreign exchange rate changes. Finally, as a consequence of our business growth and further facility improvements, we anticipate maintaining our level of capital expenditures at $14 million to $16 million in 2019, similar to the prior year. As we head further into 2019, we are very optimistic. We see very strong medical markets, which will be a significant driver of our top line growth. We are not slowing down our investments in innovations as we believe the opportunity is now to continue to introduce leading-edge products, which will continue to benefit our customers and our end markets. We are truly proud of the progress our organization has made and the strong performance they have delivered in 2018, and we look forward to delivering our commitments to our employees, our customers and our shareholders in 2019. This concludes the prepared remarks. We'll now open the call up for questions.

[Operator Instructions]. The first question will come from Lee Jagoda with CJS Securities.

So first, I guess, Robert, you mentioned some increased costs and poor supply chain quality and the idea that there should be a remedy once and for all in 2019. Can you give us some background on the steps you've taken to fix it and how we should think about the fix kind of unfolding as we go throughout the year?

Yes, well, first off, a lot of the impact that we're seeing in the back half of the year of 2018 was really a consequence of buying a lot of inventory to fix some of the issues and buy us some time to fix some of the issues. And so what I think has been disappointing us is the amount of, let's say, poor quality we're finding in those purchases that we made. And that's bleeding its way through as we're building the products, right? It's not an identifiable thing, and so that's been something that's been really frustrating. The inventory levels have come down in the organization. You can see that in our net working capital performance for 2018. And so as we start buying from those new qualified vendors, that's going to lead a large chunk of the progress that we're making. We've also allocated some additional resources on our supply chain. We've elevated that to an executive level, so we have a very senior person now focused on supply chain and the quality of our supply chain. And we've added some additional resources into the organization to really kind of focus on that, both from a commodity buy perspective as well as improving the overall operational efficiencies and driving more robustness around that supply chain.

And then, as we look out to 2019, is it more of a rolling kind of gradual fix? Or should we expect to see kind of run through everything by midyear?

Yes, I think the first quarter looks a little weaker, and the gross margins were similar to what we've really kind of delivered. And that's as a consequence of really kind of mix effects that we're seeing with the big drop, the double-digit decline in our Laser Quantum business. But as you get into second, third and fourth quarter, you'll start to see the improvement in those gross margins. So it will tick up from where it was in 2018, really kind of starting in the second quarter.

Sure. And then one more for me. Just in terms of -- on the last call, you gave us sort of a $4 million potential tariff impact to gross margin in the first half if things kind of happened as they were going to happen back then. Obviously, timing has shifted and who knows what the eventual outcome will be. But how should we think about your new guidance in relation to that $4 million that you had drawn out last quarter?

Yes, so I would say, currently, it's not impacting us at that level. It's more impacting us at the levels that we've seen in the fourth quarter and back half of the year. So there are tariffs hitting our P&L right now without getting to quantifying it, but it's nowhere near the $4 million we're anticipating. So that does, in some degree, provide some opportunity for upside, but for the most part, is offsetting some of the other issues that we're seeing as it provides us with really just kind of greater confidence in delivering on our full year results. There's a lot of things going in the right direction internally for Novanta. I think there's a lot of opportunities we're seeing, a lot of potential benefits that we're seeing. There's a lot of clouds in the general economy, and we're just trying to be mindful that some of those things need to be mitigated and we feel we have enough levers to do that.

Our next question will be from Richard Eastman with Baird.

I'll ask maybe a summary point around the gross profit margin commentary that you gave. You did suggest 100 basis points a year, and you'd be back on track. Is that kind of a statement around '19 and '20 and '21? In other words, do we expect or should we expect an adjusted gross margin improvement of 100 basis points in '19?

Yes, and I specifically stated that in the script. You'll read about it, I guess, in the -- when it gets transcribed. But yes, so we expect 100 basis points improvement in gross margin in '19, and then we're taking enough actions to make sure that we maintain that momentum going forward.

Okay. And the point you made, Robert, about in the first quarter around the sequencing and kind of new product introduction in the Photonics segment, is your point there that you have a tough comp in the first quarter of '18? Because I believe your primary customer there anticipates introducing a newer version of that NovaSeq -- of that product.

Yes, yes. We're not going to get into specifics on customers, Rick. But listen, I mean, we've been clear on previous calls that this launch dynamics was going on, and we basically had a spectacular 2017 and kind of a bit of a holding pattern in '18 that will then lap in the middle of '19, right? That's kind of how you need to think through this is translate itself as a temporary headwind of double-digit declines. If you look at our Photonics kind of growth, it was basically flat, right? Whereas actually, the other core businesses were growing very nicely but you had this temporary headwind. So if anything, right, if you want to look at our growth projected in the first quarter and actually in the first half of the year, of course, we see some softness in microelectronics, but that's a relatively minor component of our business. Actually, that temporary headwind of DNA sequencing is as big of an effect if not bigger, right? So -- but that will subside in the second half, right? It's not market-related, it's not execution-related. It's just temporary comps that will subside in the second half.

And I just want to accentuate another point that Matthijs made in his script. I think we feel very good about our position in that space. And so that area, that space, that platform is something that we feel has got a multiyear growth trajectory to it. So that's something that we feel good.

Yes, because the penetration of this high throughput DNA sequencing is still in its infancy, right? So as these platforms get rolled out to more applications, the use will grow, and therefore, our business will continue to grow. And we have a very, very solid leadership position there. So these are all kind of temporary lumpiness. We have to explain it because it -- and we want to be transparent about it, but it's not like a long-term issue.

Understood. And when you take your kind of guide for '19 and we got kind of this 5% to 7% core guide for revenue, you made some comments earlier in your script, Matthijs, around the industrial side maybe seeing a few pockets of softness. When I think of the Vision, Precision Motion and Photonics business, what strikes me is in Precision Motion and Photonics, roughly half -- more than half of the business is industrial. Vision is mostly the medical side. But the question is at a 5% to 7% core growth forecast, which of these pieces? I presume it'd still be Precision Motion that would be the leader in the growth. I mean, how do the three segments line up against the...

Yes, yes, a good question. I mean, so actually what you see is that -- so I started by saying that we see a very solid growth -- actually, accelerating growth on the medical side, and our medical markets are very strong. So Vision being predominantly medical-focused will be a significant contributor to growth in 2019. And so we expect all the businesses in there to be a solid contributor, right? So let's start with that. And so then Precision Motion, of course, comes off a spectacular year, right, at 25% growth. I mean, that's -- so we have tough comps and it's hard to continue that. In addition, there is some softness there in search and microelectronics markets, right? So overall, at the company level, microelectronics is less than 10% of our revenue, right? But that market is soft or down, right? So that's a modest headwind for us. A bit more of a headwind, I would say, in Precision Motion. So in other words, Precision Motion will -- growth will moderate as a result of both the tough comps as well as this microelectronics, call it, softness. But we still anticipate that it will be a solid contributor to Novanta's overall growth, right? We're not going to get into numbers but we still think it's a solid contributor. And Photonics is basically a tale of 2 stories, right? One is continued solid performance in actually our Synrad and the Cambridge Technology business. And then we're just fighting that headwind in the first half of Laser Quantum that will subside in the second half, right, and for the full year, right? So that's going to be the story there. But I think underlying the message that we want to make is that actually, even within industrial, right, there are many segments that are growing very, very nicely and we're part of those, right? So there are certain pockets, like we indicated, that are softer or down, but the beauty is the diversification of our portfolio, right? We're firing on multiple cylinders. And if one cylinder is not as firing as rapidly, we have multiple others to compensate. And you kind of see the power of the model here that at any particular moment, there might be some launch dynamics, there might be certain softness, but then there's other markets or other technology cycles that will help lift us again. So you kind of see us compensating very nicely, and I think the company's pretty resilient in kind of some of these macroeconomic backdrops.

Understood. And could you -- just one last follow-up. In the Vision business, the Vision segment, JADAK, you referenced some RFID wins and having some product now in market. Could you give an example or 2 of where an application there that you have taken a win and put it and commercialized it? Can you give any examples there, specifically the RFID?

Yes, I mean, it's such a vast space, right, with so many applications. But you -- basically, in a big picture way, you're talking about identifying or connecting, for example, a consumable to a piece of equipment, right, in the medical space. So wherever you need to read a consumable and it's hard to read that with a machine vision solution because there's the line of sight is obstructed, then you could better do that with RFID. You see another example of wins is on patient monitoring, right, where you have actually a combination of barcode and RFID at the identification station. Again, patient monitoring is happening typically in terms of care and emergency settings, so there's not a lot of time to type in data and identifying people or medication, right? So the quicker you can point and shoot and get the data into the system, the better it is. Sometimes, it's -- actually, those labels are nowadays RFID labels, and it's actually much easier to scan and identify, for example, a nurse then a medication then the patient, then you have to actually do it with barcoding. So that's another application that we like. And then you can combine that actually with access control as well in a hospital. So we do see that. So applications that we like are kind of access control, surgical consumables parts as well as in vitro diagnostics. Those are kind of core applications we kind of have momentum into. But there's many other applications. Yes, and the other thing I want to point out is that we're expanding our machine vision portfolio as well, and we do see an increased need for smarter machine vision and better machine vision solutions in kind of these applications as well.

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

This might fall into the category of splitting hairs but I just want to see if there's something that we should understand here. Your midpoint to guidance for 2019 implied 20.5% adjusted EBITDA margin, and that'll be up 40 basis points from 2018. And can you just help me reconcile that with the comment that gross margin should expand 100 basis points in 2019? Is there something going on in terms of operating expense as a percentage of sales? Or am I just splitting hairs here?

Can you repeat? What you're saying the point is 50 basis points.

40 basis points. I mean, it gets you to like 20.5% EBITDA margin but you did 20.1% this year...

As it stands, the gross margin is 100 basis points then where -- what element of your operating expenses are kind of going off kind of offsetting it.

Yes, yes.

So you were exiting Q4 at 8.5% R&D spend. We expect to be closer to 9%. So that compares to like something closer to 8% in overall full year 2018. So if there's one element that -- I think we've been pretty consistent with saying we really think the portfolio should be closer to 9% off. And it's just -- it's taking time to kind of ramp that up. In the first quarter, it'll ramp up a little bit because of material spend. And then for the full year, we should be kind of sitting close to 9-ish percent level, a little bit above.

Yes. And the reason being, Brian, is that you hear us reporting on the benefit side, right, the increasing of the revenue from the products by over 50% last year. We see tremendous momentum. We actually see windows of opportunity in searching for more growth markets that we want to capture. And so we're actually very confident about capturing those where we need to drive -- continue to drive innovation to maintain our leadership -- innovation leadership there. So we're -- so that is what's behind that.

Got it. And on the gross margin, kind of putting together everything that I've heard so far here, it sounds like gross margin is down year-over-year in the first quarter but up maybe more than 100 basis points later in the year to get you to that 100 for the full year. Is that a fair assessment?

I'm not sure down year-over-year, but it is a -- it's not a strong quarter in the full year.

Okay, okay. And is there any way that you can quantify somewhat in terms of basis points of headwind the impact of this cost supplier quality issue in the fourth quarter?

In the fourth quarter, I would say it was the bulk of the myth in our expectations. So it was -- both businesses happened to simultaneously go through it. I guess, in hindsight, it may not be surprising. You're in, you're trying to bleed through all the inventory that you purchased before. But it was the bulk of it. So that was a -- that's where I kind of associate that. Q3 was already being impacted by the higher mix of our medical consumables. Q4 dropped down from Q3, and that was all driven by the cost per quality issues.

Okay. So your gross margin was down. I mean, you have the WOM issue going on too, so I'm trying to parse these out. I mean, your gross margin was down 200 basis points sequentially. Is it fair to like roughly estimate this is like 100 basis points issue, this cost per quality?

Yes, yes. A little higher but yes, yes, that's about it.

And then on the other issue that you said is affecting gross margin, the WOM consumables business, that's kind of an ongoing challenge. Where are you in adjusting how and where you make those WOM consumables? And what sort of a headwind do you think goes away? And what's the opportunity for gross margin when you fix that, is the question?

So I think the MIS segment and the Vision overall is a growth driver in 2020 and beyond. So I think you'll see gross margins expand in Photonics and the Precision Motion segment in '19 and '20. But as you get outside of that, then the big driver's really kind of the Vision segment. We are taking actions now to improve the margin profile of that business, so we do expect to start getting at this in '19. But like any quarter, real meaningful changes are really like a 2020 and beyond kind of effect. So one of the first things we're doing is we're putting more into our German factories, so we're trying to leverage the cost structure there, and we're doing that both by consolidating NDS production into that facility as well as expanding the production capacity of our medical consumables from that side. And then third is identifying a low-cost manufacturing facility to manufacture the higher-volume products and in-source our supply chain on that. We're still working our way through those elements of it, that latter kind of Phase 2 approach, but we feel good about the progress that we've made and we think we're on the right track.

But in the end, when you get that -- through that Phase 2 and you've got the manufacturing adjusted, is this -- like on a consolidated basis, is this 100 basis points plus opportunity for gross margin?

So I think the next two years of gross margin expansion is -- which is overall Novanta, about 100 basis points a year, is really driven by Photonics and Precision Motion. And then as you look at where you're going to get that 100 basis points of expansion thereafter, it's going to come from the Vision segment. Where does it cap out, I think, is where you're kind of leading overall? It's difficult to say because of the acquisition pipeline. You're constantly changing that mix profile. If you assume all being constant, the -- we believe, overall, this company should be kind of closer to a 50% gross margin. So that's the overall opportunity that we're going after, but that can change depending upon the types of acquisitions you do.

Okay, got it. And then just one more for me. Robert, at the end of your comments, like the second to last sentence in your script, you made a comment that you expect that you're very optimistic about the second half or like later in 2019. Can you add any color to that? I think we've got a sense now from listening to the call what segments and business lines you're expecting that. But can you put a finer point on where you expect to see that step-up, which end market later...

I don't mean to imply first or second. I think the big issue in Q1 and then also going into Q2 is really the headwinds that we're seeing in our Laser Quantum business. And then that business returns to growth in the back half of the year, and so that has a big impact on the Photonics segment overall because I think the overall businesses underlying are performing extremely well, particularly given the climate. So I think that it's really an indication that, that business has got big headwind right now on the overall company and on that segment, and that we lap that by the time we get to Q3 and Q4 so that's no longer an issue. I will say that medical, in general, is kind of growing very robustly. And so -- and there's a lot of opportunities that we're seeing and that we're embedded on. So I think we feel good overall about the stability of the portfolio as a consequence of our exposure on that. So even though we see things like microelectronics not doing too well or small segments of industrial, we have that kind of covering for us and enabling us to continue to deliver. So internally, we have a lot more positives going on, and there's a lot of different things that we can -- a lot of different levers that we can pull. We're also just mindful that externally, the noise level is getting louder and louder, and so we want to be careful about getting too ahead of ourselves. And we think being prudent, being conservative is sort of the right approach at this stage.

Okay, great. Can I ask, are there people on the queue after me? Because I don't want to ask another question, but I've got one more important one.

You'd be surprised that we don't know, so you can go ahead.

I think people would be interested and you've only got -- you don't have enough analysts yet, so I just want to make sure we get the answers to some of these in the transcript. But can you just talk a little bit about your European exposure? I mean, this is obviously -- I've been taking a lot of questions on this with respect to your business and every one of my companies. You've got the head of the German Central Bank today saying that he expects GDP to be revised downward for Germany. So 15% of your revenue roughly is in Germany. Is that correct? And Europe is close to 30%. What is kind of the end market exposure you have? And I know you said you're somewhat cautious on the region. But can you just talk through your end markets and what your exposure is and the risk there?

Yes. I mean, listen, we sell into players that are based in Europe, and then they sell then to players that are across the world. So it's a -- I don't want to deflect the question, but it's -- you cannot one-on-one correlate our revenue numbers into Europe versus kind of GDP numbers. Now having said that, if you look in the European climate overall, of course, you see any indicators softening, right? Automotive, semiconductors, those types of segments are all not doing so well. But we got, for example, laser-additive manufacturing is growing very rapidly. Medical is doing great. So it's very hard to comment on a generic economic indicator. You really got to be mindful of the different components of growth in the different markets. So medical doing well. Microphotonics, not so much. Automotive, not so much. We don't have any major exposure in either of these markets. Microphotonics is less than 10%. Automotive is even included in that number, I would say. So -- and that's no different from Europe. The -- so that's kind of how I would answer the question. We have included kind of the -- we're looking at this more from a global industrial and/or medical per segment basis and then what OEM customers are telling us that happen to be based in Europe that run a global business. And if anything, there's correlations with -- not surprisingly, with the rest of the world, right? So these European OEMs do sell to the U.S., which is very, very buoyant. They also do sell to certain -- to China, which for medical is very buoyant, for industrial not so much, right? So kind of it's a bit of a mixed bag. So far, we actually feel we're watching the situation very carefully. We're seeing softness where we've indicated it, but we've included that in our overall guidance, Brian.

Okay. Did you say how your European revenue did in the fourth quarter, up or down?

No, we're not splitting that out.

One of the things I want to caution you about a little bit, because if you look at our 10-K, you have disclosures around end market, about being geographical end market at the sales, that's a little misleading. Because I think, as to Matthijs' point, those sales are to manufacturing centers, right? So that is not telling you the picture that I think you're trying to get at, which is ultimately a big chunk of our products are heading into U.S. and heading into Europe and more developed type of regions. The China sales are actually a little bit more specific to China markets. And from that perspective, it's difficult for us to break out in a disclosures sense where our products ultimately end up after our OEM ship them out of their factories. We will say that we're seeing general strength in the medical area of the market, which is half our portfolio, and we are seeing some strengths in a select group of industrial end markets like laser-additive manufacturing or metrology-based applications that are industrial-based. So we feel good about those things offsetting some of the risks out there, and our exposure again in microelectronics/automotive is very tiny. So that's another benefit for us.

Ladies and gentlemen, this concludes our question-and-answer session. I would like to turn the conference back over to Matthijs Glastra for any closing remarks.

Thank you, Operator. So to summarize, 2018 was another great year for Novanta. Our focus on accelerating profitable growth and the diversity and resilience of our businesses were evident in our strong financial results. We continue to feel good about the positioning of our businesses around secular macro growth drivers, with over half of our revenue in medical markets. Novanta's diversification and relentless focus on leadership position across a variety of medical and industrial growth markets is providing us solid foundation for sustainable profitable growth in the current macroeconomic backdrop. We see converging and long-term need for our motion, vision and photonics capabilities in a large variety of applications, in Industry 4.0, precision medicine and health care productivity trends. 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 long-term strategy and the 2020 direction we articulated 3 years ago. 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 the 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 first quarter 2019 earnings call. Thank you very much. This call is now adjourned.

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