Good morning. My name is Chad and I'll be your conference operator today. At this time, I would like to welcome everyone to the Novanta Incorporated 2019 First Quarter Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. [Operator Instructions] 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 First Quarter 2019 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've 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 performed very well in the first quarter of 2019, delivering on both our revenue and profit promises to our shareholders. Our company delivered $157.2 million in revenue, representing 7% year-over-year revenue growth on both a reported and organic basis. Our adjusted earnings per share was $0.53, which was up 13% from $0.47 last year. Adjusted EBITDA was $28.2 million. We remain confident 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 continue to see a long-term trend and need for motion vision and photonics capabilities in a large variety of applications on the back of macro trends of Industry 4.0, precision medicine and healthcare productivity. Particularly, we remain excited about our position in applications such as robotic surgery, minimally invasive surgery, DNA sequencing, advanced material processing and precision automation and robotics. In the first quarter, we continued to see solid momentum and success in our efforts to penetrate high growth markets and introduce new innovations to our customers. New product revenue for the first quarter grew over 20% year-over-year. Our Vitality Index, which is revenue from new products launched in the last four years remains well above 20% of sales for the first quarter. Our first quarter design wins increased by over 50%, with broad-based design win growth in all of our operating segments. All in all, we had a very strong performance by our team in the first quarter as we continued to see the early benefits of implementing our Novanta Growth System driving sustained growth and operating performance. Now, let me touch on what we're seeing in our markets in the overall macroeconomic climate. Our medical markets are very…

Thank you, Matthias and good morning everyone. We delivered $157.2 million in revenue in the first quarter of 2019, an increase of 7% on a reported basis. Our acquisitions resulted in an increase in revenue of $3.8 million or 2.6% and foreign currency exchange rate adversely impacted our revenue by $3.9 million, 2.6%. Consequently, organic growth was also 7% year-over-year. Organic growth came in higher than we anticipated as a result of customer timing, which we believe was partially caused by Brexit planning by our customers. First quarter 2019 GAAP gross profit was $66.3 million or 42% of sales. This compared to $62.2 million or 42% of sales in the first quarter of 2018. On a non-GAAP basis, first quarter 2019 adjusted gross profit was $68.6 million or 43.6% of sales compared to $64.6 million or 44% in the first quarter of 2018. First quarter R&D expenses were $14 million or 9% of sales compared to $12 million or 8% of sales in the first quarter of 2018. We now believe we have reached the level of investment required to drive our new product engine and to further penetrate high-growth markets. SG&A expenses in the first quarter were $32 million or 20% of sales versus $29 million or 20% of sales in the first quarter of 2018. The increase in year-over-year spending was partially driven by prior-year acquisitions and higher stock compensation expense. GAAP operating income was $14 million in the first of quarter 2019, compared to $17 million in 2018, whereas our non-GAAP operating income was $22.8 million or 14.5% of sales compared to $23.4 million or 15.9% in 2018. Adjusted EBITDA was just over $28 million in the first quarter of 2019 and this compared to $28 million in the first quarter of 2018. Interest expense was $2…

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

So I guess, first and foremost, can you -- I don't think you commented on full year revenue guidance. Did you reiterate that guidance?

We did, we reiterated.

Okay. And then given the dynamic you described in Q2, I guess, pulling a little bit forward to Q1 because of Brexit, can you talk about some of the visibility you have into the back half with regard to new product launches and other things that give you the confidence to, I guess, reiterate the full-year revenue and then raise the EPS piece?

Lee, this is Matthijs. So, first of all, we will lap the year-over-year tough comps in the first half in Laser Quantum, right. So we expect that business to return back to growth in the second half. Secondly, we continue where we commented on in the prepared remarks, a continued momentum in our medical markets, which give us confidence to reiterate our guidance.

Okay. And then, Robert, can you maybe talk a little bit more about the working capital impact in Q1? I know you have taken some time to rationalize some inventory as you bought a whole bunch more than you needed last year for cushion. So, can you talk about what's going on there and some of the efficiencies you're achieving as you're getting things going, moving through the system better?

Yes, sure. I mean -- so, first and foremost there were two unusual things that happened in the quarter, absent the net working capital, one of which is the Zettlex earn-out was paid out of our operating cash flows. And just as a consequence the type of earn-out [indiscernible] structure. The other is we moved our bonus payments from a semi-annual plan to an annual plan, which therefore resulted in a larger cash outlay in Q1 on a year-over-year comparables. And then finally, it was net working capital. So effectively net working capital was driven by shipments occurring later in the quarter. So our customers really retimed their shipments to the latter part of the quarter, which then flips back as you get into the second quarter. So if we look at the full-year 2019, we expect to get back on to our cash flows and similarly have a ratio close to where we were last year, meaning that roughly around 60% of EBITDA will convert down into cash flows.

The next question comes from Richard Eastman with Robert W. Baird.

Matthijs, could you maybe just speak to within the precision motion business just where we are from an adjusted gross margin standpoint? I mean did that, the 42.8%, did that come out kind of as modeled here for the first quarter, was it a bit low? And maybe just what the progression will look like there as you address some of the issues in that with the inventory side of things?

Yes. It's probably a little lower than we wanted, but I would say we have more confidence now in kind of the sequential improvement in that business. We know exactly what we need to do. We've kind of lapped some of the supplier issues that we think will subside after the second quarter and I think the team has a very solid plan to start addressing sequential improvement in gross margin. So a little lower than we wanted, but confident about the improvement trajectory.

Okay. All right. And then was there a Photonics book to bill that you could provide us in the quarter?

Yes, it was a little bit below 1. So I think, what is it, 0.98 order of magnitude.

Okay.

So again, it's a mix of a little bit of softness in bookings from the industrial side compensated with good bookings on the medical side. Mind you photonics is a bit more exposed to the industrial side.

A lot of that is due to the dynamics of the Laser Quantum business in there. So that [indiscernible].

Yes. Is there an insight on, again realizing the first half tough comps at Laser Quantum, is there any insight into the, I mean, when would you might see orders kind of pick up there? You kind of on a one-quarter ship schedule or might we start to see orders pick up in the second quarter around Laser Quantum for second half shipment?

We expect to, yes, no, we expect to, those orders to pick up in the third quarter, Rick.

Okay, third quarter. Okay. And just maybe, just a last thought around Photonics. Could you just give a, give us a sense of how does Photonics look for the full year from a growth rate standpoint? I mean, we have spoken to maybe core growth around 5% to 7% for the full year for all of Novanta. Does this, does the Photonics play catch-up in the second half? Do they get to the low end of that kind of core growth or will they fall presumably a bit below that this year, just as we try to play catch-up?

Yes, so we see Photonics returning to growth in the second half and that's largely as a consequence of Laser Quantum business normalizing. And so you're going to go from the negative year-over-year performance in the first half to a positive performance in the second half. I think our Vision segment for the first half is more of a double-digit growth business and then as it laps into the second half, you'll see it get into the high single-digit type performance as it faces more normal comps. And then Precision Motion will probably be in the low single digit territory, really kind of impacted by difficult year-over-year Q3.

Okay.

Yes. So to summarize, Rick, Vision is stronger, right, is having a much higher momentum, yes, than we initially modeled, on the back of new products as well as overall market momentum. Photonics having a little bit more headwind.

Yes. And we speak to, we speak to the overall business and kind of the growth rates by the, literally by the technologies here. But I'm curious is there any particular inflection whether it would be in the U.S. or Europe or are we really kind of speaking to the right thing here with the customers and the technologies versus the geographies, if you follow me?

Yes. So what is the question?

Yes, what is the question, [indiscernible]. But just curious between the U.S. and Europe, I think you kind of addressed China and that seemed reasonable. But between U.S. and Europe, just in local currency, so currency aside, any inflection in the business that surprised you, whether it be medical or industrial?

Yes. So, medical is robust across geographies, right. So, we don't see any geographical, let's say, differences. I mean, obviously the U.S. is very strong in medical, but -- so are other geographies, right. As I mentioned in my prepared remarks, we do see -- we saw softening in China for us, but we do see that spreading. You see that confirmed through the rest of Asia, Japan, Europe, Germany. You do see it backed up by economic indicators in the last 30 to 60 days, right. And then of course what we also would say, it's not like every application across the board. I would say though that even in certain markets that we feel have long-term secular trends like factory automation have been affected, right. So that's different from what, I would say, our view 90 days ago, right. So that's a little bit more subdued. Now, over the cycles longer term, the trends are indisputably positive there. But it's fair to say that there is a little bit of a lull in that area. Germany is not doing great. Overall, we are growing facet in the market, but we're doing that against a tide that is increasingly more uncertain.

[Operator instructions] Our next question is from Brian Drab with William Blair. Please go ahead.

Hi. This is [indiscernible] on for Brian today. I want to talk about consolidated margins. What were the main drivers of the headwind in the first quarter, both gross and EBITDA margins and how do you see those progressing over the remainder of the year and what will be the main drivers of expansion or headwind for the remainder of the year?

Yes, I think for the most part our first quarter gross margins came in where we expected and similarly on the EBITDA front. As we look, it would be a sequential uptick as we get into the second quarter both in the gross margins as well as the EBITDA performance, it's evident in the guidance that we provided. And as we look at the full year, we're still kind of on track to that 100 basis points improvement in gross margin. And that's being driven by a combination of things; one, the cost of poor quality, we've gotten a handle on now, we're starting to reduce the cost implications of that; and then two, our continuous improvement initiatives are starting to make some headway; and then three, we've taken some restructuring actions to ensure that we really ground that and get certainty around achieving that gross margin performance. So, for the most part, we feel pretty good about that 100 basis points a year type of expansion and what we expect for 2019.

Thank you. And just on the poor quality issue, can you give any more detail around what steps are being taken to correct that and when that will be fully corrected?

Yes. Well, so, this is Matthijs, Joe. So, we've commented in the past we were struggling in our Precision Motion segment. We do have a handle on the core issues there now and are transferring our supply chains towards the, kind of the new targeted situation. We expect to have that fully done by the end of Q2, after which we will feel that the majority of the issues in that segment are behind us. And I would say in the rest of the segment, it's part of our continuous improvement efforts, right. It's just kind of basically steadily chipping away at the issue in an incremental fashion, yes. Of course there is many other drivers of gross margin improvement, whether it's productivity, material productivity as well as cost of poor quality, right, as well as volume and volume leverage.

Sure. Thank you. And just one more. Where are you in restructuring the consumables business and what's the plan and timing for margin expansion related to that?

Well, I think one of the first thing that you'll notice in the Vision segment is that the gross margins, they ticked up a little bit from the fourth quarter and that we continue to expect to see some margin expansion in that segment on a year-over-year basis as we look at the full year. So, that is first and foremost conditional on the restructuring benefits that we see leading into the second half of the year and I think that we feel pretty good about that. Also, the increased volume that we're seeing in that business in the first half is helping drive that expansion, which means that we are getting additional leverage out of our overhead structures and so we feel pretty good about that. So even though, it's got a little bit of a negative mix shift there, we've been able to bring more of that volume in-house into our own factories versus with the contract manufacturers. So overall, we feel good that that segment is going to improve the gross margins if we look at 2019 and then it's on that track for that improvement for the foreseeable future. In terms of like step function change in that segment, that's really conditional upon us building out a low-cost manufacturing facility. We will make a final decision on that by the end of the year.

Yes. And I would like to comment the restructuring actions that you mentioned that they are not necessarily targeted at the consumable business. We're basically consolidating manufacturing operations over NDS display and integrated OR product facility into our German facility. So, that's a gross margin enhancer for 2020 an the latter part of 2019.

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.

So to summarize, in the first quarter of 2019 Novanta delivered a solid performance in an uncertain macroeconomic environment. Our focus on accelerating profitable growth and the diversity and resilience of our businesses was 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 a solid foundation for sustainable profitable growth in today's current macroeconomic backdrop. We see a long-term need for our motion, vision and photonics capabilities in a large variety of applications on the back of macro trends of Industry 4.0, precision medicine and healthcare productivity. We therefore continue to remain excited about the applications we play in and the positions we have and continue to invest in long-term organic growth and innovation. 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 three years ago. In closing, I would like to thank our customers, our employees and our shareholders for their ongoing support and 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 second quarter 2019 earnings call. Thank you very much. This call is now adjourned.

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