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…

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…

[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.