Novanta Inc. (NOVT) Q4 2020 Earnings Report, Transcript and Summary

Good morning. My name is Andrea and I will be your conference operator today. At this time, I would like to welcome everyone to the Novanta Inc.’s Fourth Quarter and Full Year 2020 Earnings Call. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Ray Nash, Corporate Finance leader for Novanta. Please go ahead.

Thank you very much. Good morning and welcome to Novanta’s fourth quarter and full year 2020 earnings conference call. I am Ray Nash, Corporate Finance leader of Novanta. With me on today’s call is our Chief Executive Officer, Matthijs Glastra and our Chief Financial Officer, Robert Buckley. If you have not received a copy of our earnings press release issued today, you may obtain it from the Investor Relations section of our website at www.novanta.com. Please note this call is being webcast live and will be archived on our website shortly after the call. Before we begin, we need to remind everyone of the safe harbor for forward-looking statements that we’ve outlined in our earnings press release issued earlier today and also those in our SEC filings. We may make some comments today, both in our prepared remarks and in our responses, to questions that may include forward-looking statements. These involve inherent assumptions with known and unknown risks and other factors that could cause our future results to differ materially from our current expectations. Any forward-looking statements made today represent our views only as of this time. We disclaim any obligation to update forward-looking statements in the future even if our estimates change. So you should not rely on any of these forward-looking statements as representing our views as of any time after this call. During this call, we will be referring to certain non-GAAP financial measures. A reconciliation of such non-GAAP financial measures to the most directly comparable GAAP measures is available as an attachment to our earnings press release. To the extent that we use non-GAAP financial measures during this call that are not reconciled to GAAP measures in the earnings press release, we will provide reconciliations promptly on the Investor Relations section of our website after this call. I 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. Before we start our normal review of the company’s results, I would like to thank all Novanta employees again for everything they are doing to deliver to our customers. Our operations teams are doing a great job in being agile in this environment, and I admire how our R&D teams are finding creative ways to bring innovations to market, all while maintaining a relentless focus on keeping our teams safe. It’s great to see that the Novanta spirit is alive and that our culture has been a strong foundation to help weather this crisis. We take great pride in knowing that our mission-critical technologies are embedded into diagnostic and antibody test equipment, detecting COVID-19; into ICU and patient monitoring equipment used in hospitals to help in the fight against the pandemic; or in DNA sequencing equipment, helping to detect and monitor new virus variants. Now let’s move on to our normal results review. I will focus my remarks on the overall company, and Robert will speak to more specifics on the segments and then our overall financial results. We are pleased with Novanta’s performance in the fourth quarter of 2020. Our teams executed very well in the face of challenging circumstances and delivered above our expectations for revenue and profit with record cash flows. Our company delivered approximately $147 million revenue, representing an 8% year-over-year revenue decline on a reported basis and a 10% decline on an organic basis. For the full year of 2020, we delivered $591 million in revenue, which represents a year-over-year revenue decline of 6% on a reported basis and an 8% decline on an organic basis. We are extremely pleased with how our teams drove exceptional operating performance throughout the year using the Novanta Growth System tools. Adjusted EBITDA was $32 million or 22% of sales in the fourth quarter, expanding nearly 300 basis points versus 2019. For the full year 2020, our adjusted EBITDA was $121 million or 20% of sales, which was flat versus 2019 on a dollar basis, yet expanding 100 basis points on lower sales. Our teams delivered record free cash flow performance in the fourth quarter at over $43 million, up 32% year-over-year at a ratio of over 340% of GAAP net income. Our free cash flow for the full year of 2020 was $130 million, up 147% versus 2019 at a ratio of over 290% of full year GAAP net income. This is record performance and is a terrific reflection of the rigorous management by our teams of the company’s operations and working capital. We saw bookings momentum improve throughout the fourth quarter with sequential bookings growth of 26% versus the third quarter, driven by our Photonics and Precision Motion segments. In the fourth quarter, our book-to-bill was 1.09, and our full year 2020 book-to-bill ratio was about 1. We are starting to see some very nice momentum building in some of our advanced industrial end markets and also across multiple regions. This improvement in demand has continued in January and February of this year, and we expect another positive book-to-bill in the first quarter of 2021. Furthermore, our backlog supports a strong sequential revenue improvement versus the fourth quarter, and we expect to return back to year-over-year revenue growth with performance trending towards the upper end of our guidance range. Robert will discuss our guidance for the first quarter in more detail later in this call. Now, let’s turn to what we’re seeing in our markets. 56% of Novanta’s total sales went into medical end markets in the fourth quarter as well as on a full year basis. On a full year basis, sales to medical end markets experienced mid-single-digit declines versus 2019 as a consequence of the deferral of elective surgical procedures and deferrals of high throughput instrumentation for clinical and research laboratories. Considering the significant impact of these macro events, we are actually very pleased with the resilience of our business. We continue to see pockets of strength during this downturn, such as in our medical consumables business with integrated smoke evacuation and our integrated data collection products for clinical test equipment. Looking forward to 2021, overall, large medical OEMs have shown a temporary pause in the recovery of their demand signals in the short-term. Corresponding to the rise in COVID cases in multiple regions the associated deferral of elective medical procedures, along with solid inventory positions for some key platforms. We do expect to see sequential improvement of elective procedures towards pre-COVID levels in the second half of 2021 and are seeing initial signs of sequential improvement in our DNA sequencing end market as labs are learning how to operate during a pandemic and sequencing of COVID variances driving some near-term momentum. Novanta sales to advanced industrial markets were 44% of total sales in the fourth quarter and for the full year. Sequentially, in the fourth quarter, our sales into these markets started to rebound across multiple applications areas. This was consistent with the very strong bookings momentum that I commented on earlier. We also continued to experience higher demand specific to microelectronics investments in 5G, high-speed networking and cloud-based infrastructure as well as higher demand from EUV-based applications. We expect the increased microelectronics demand that we saw in 2020 to be sustained heading into 2021. Our vitality index, which is revenue from new products launched in the last 4 years, continues to be healthy at above 25% of sales for both the fourth quarter and the full year versus mid-single-digit percentages just a few years ago. Looking forward, we expect significant growth in our total NPI sales in 2021 versus 2020. We will be launching approximately 25 new products in 2021, which is double that of 2020 and a record number of launches for Novanta in a single year. As we have said throughout the past year, we’ve stayed the course on our innovation investments despite a downturn caused by the pandemic. We continue to believe that our long-term secular growth drivers are even more relevant post-pandemic with particular focus on industrial and surgical robotics, minimally invasive surgery, precision medicine and diagnostics and Industry 4.0. While we have seen some customers or NPI programs experienced delays as a result of COVID, most of our NPI programs continue to be very active and on track, and we are extremely excited about the new launches that will be happening this year. We also saw significant NPI success in this most recent quarter. In the fourth quarter of 2020, we launched 4 new products in our Precision Motion group, further strengthening our value proposition for compact, high-precision motion control in industrial and surgical robotics applications. Design wins in the fourth quarter grew over 50% versus the prior year with multiple wins in most of our businesses. This was in line with our expectations, and it is another encouraging sign of future growth as our customers continue to partner with us to bring new innovations and platforms to the market. We expect to see continued momentum with our design win activity during the first quarter of 2021. The Novanta Growth System is developing rapidly with the core goal of enabling higher performance of Novanta teams in all our sites worldwide. And in 2020, we conducted over 3,700 individual trainings. Our vision is to transform Novanta into a learning culture, anchored in continuous improvement applied to all business areas, including, but not limited to, structurally improving customer satisfaction, gross margin, inventory management and the efficiency of our manufacturing sites. In short, it means growth and benefits for our customers, our employees and our shareholders. The results of the Novanta Growth System are already appearing in our financial results as evidenced by our strong cash flow, reduced inventory and gross margin improvement in the fourth quarter of 2020. Robert will speak to more specifics on these financial results, but we are very pleased with how our teams have leaned in to adopt this common way of working. And we see excellent opportunities in 2021 and beyond to continue to transform our operations and customer engagement using the Novanta Growth System. We also continue to work at making Novanta an employer of choice in the marketplace. As we have spoken of in previous calls, during 2020, we gave a onetime equity grant to our employees as a way to keep them motivated and engaged during the economic downturn. This had extremely positive results, and we saw significant employee engagement and a record low employee turnover even despite the difficult circumstances and remote work situations. In 2021, our Board of Directors has approved a similar equity grant as a way to continue to support and motivate our employees. This grant will be smaller than the one issued in 2020 and will be coupled with a more traditional bonus plan as an overall package to incentivize our leaders and employees. In addition to this, Novanta is working hard to make significant strides in our environmental, sustainability and corporate governance, or ESG, as we strongly feel we need to do our part in being a responsible corporate citizen. We will be publishing our first ESG report in the coming weeks, which will include multiple topics, including environmental protection, product quality and safety and also diversity, equity and inclusion in our workforce. In summary, our fourth quarter played out slightly better than expected, and we remain very confident about our long-term strategic positioning. We are experiencing sequential recovery and are emerging from this crisis with a strong balance sheet and an exciting innovation pipeline. These results show that Novanta is very well positioned with exposure to long-term secular trends in robotics and automation, health care productivity and precision medicine. You can also expect us to lean in on acquisition opportunities, which is the primary focus of our capital deployment, provided they fit our stringent financial returns and strategic criteria. We are very actively engaged in pursuing M&A opportunities even within the constraints imposed by the pandemic. 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. I’ll start by giving some details on our operating segments, starting with the Vision segment. This segment predominantly serves the medical end market and saw a revenue decline of 9% year-over-year in the quarter. The book-to-bill in our Vision segment in the fourth quarter was 0.92. Our large medical OEMs experienced a temporary pause of demand corresponding to the rise in COVID hospitalization rates and the resulting deferral of elective medical procedures. Clearly, this is a temporary impact, but we anticipate this will put pressure on the first half of this year. However, the vitality index of this segment remained above 30% of sales with new products being a key driver of the resilience we have been seeing in this business unit. Within the Vision segment, we continue to see solid sales from our smoke evacuation technology and from the associated medical consumables offering. Smoke evacuation continues to be in high demand in today’s climate with medical staff around the world demanding safe, COVID-free work environment during laparoscopic procedures. We remain very excited about the continued progress with this product offering and continue to see this platform as a long-term growth opportunity, particularly as we work with a multitude of customers on their next-generation platforms. We are also very pleased with our Detection & Analysis business, which continued fantastic performance in the fourth quarter. This business unit predominantly serves the diagnostic testing and patient monitoring markets with RFID, barcoding and machine vision technologies. This business benefited from the rapid uptake in PCR molecular testing as well as patient monitoring equipment purchases tied to the pandemic. Turning to our Precision Motion segment, this segment saw a 6% growth in revenue in the fourth quarter of 2020, bookings growing 50% sequentially versus the third quarter and up 19% year-over-year with a book-to-bill of 1.17 in the quarter. The fourth quarter continues to experience strong demand for microelectronics markets, particularly investments in 5G infrastructure and cloud-based infrastructure. These near-term trends continue to remain robust as we enter 2021. In addition, we began to see strength in robotics and automation space, both with our existing customers and new product introductions. While the medical portion of this business remains under near-term pressure, we are seeing signs of growth returning in 2021. Finally, the segment experienced more than 50% growth year-over-year from its customers in China, giving us confidence in the sustained recovery from the pandemic. Within the Precision Motion segment in the fourth quarter, new product revenue more than doubled and now comprises a double-digit percentage of total sales for the segment. Turning to the performance of the Photonics segment in the fourth quarter of 2020, our revenue was down 14%, in line with our expectations, but up 8% sequentially. Throughout the fourth quarter and now into January and February, we have seen significant positive signals of sequential recovery from our customers. Bookings in the fourth quarter were up 50% sequentially and were up low single-digit year-over-year. Book-to-bill in the fourth quarter was an impressive 1.26, reflecting a rebound in a multitude of industrial applications, giving us confidence in a positive outlook for this segment in 2021. We continue to feel very confident in the robust innovation pipeline in our Photonics segment. As a result, we continue to invest into the headwinds, and we anticipate introducing multiple new product platforms in 2021, which are expected to help us gain share in adjacent high-growth application areas. Examples of markets we expect to grow share in are via-hole drilling for 5G mobile devices, laser additive manufacturing, material – battery material processing for electronic vehicles, fine material processing and microelectronics for industrial and medical applications and high-speed automation and processing of sustainable packaging, known as converting markets. New product revenue stayed strong at greater than 20% of sales in the fourth quarter, and total NPI sales were up mid-single-digit year-over-year. Design wins were up 60% year-over-year in the quarter. Sales to China were also up mid single-digit despite the overall sales for the segment being down double digits year-over-year. But most importantly, we are on track to launching 9 new products in 2021, which is a record for this segment in a single year and double the number of launches we had in 2020. Turning to the operating results, we delivered $147.5 million in revenue in the fourth quarter of 2020, a decrease of 8% year-over-year on a reported basis and 10% decline on an organic basis. For the full year of 2020, we delivered $590.6 million in revenue, which is down 6% year-over-year on a reported basis and 8% on an organic basis. Despite the year-over-year decline, we are pleased with our sales performance in the fourth quarter and for the full year, beating our own expectations and our previously issued guidance. Turning to our operating results, our fourth quarter non-GAAP adjusted gross profit was $65 million or 44.3% of sales compared to $70 million or 43.6% in the fourth quarter of 2019. For the full year 2020, adjusted gross profit was $256 million or 43.4% of sales compared to $274 million or 43.8% of sales in 2019. In the fourth quarter, adjusted gross margins increased 100 basis points sequentially and 70 basis points year-over-year. This strong result was encouraging and comes as a result of the significant work of our operating teams to drive the Novanta Growth System deeper into our day-to-day work. In addition, this performance came despite the continued pressure from high operating costs in our factories that were caused by the pandemic. To maintain a safe working environment, we continue to incur significant temporary costs that pressure our gross margins. In spite of these incremental costs and the difficulty of operating our facilities during the pandemic, we are extremely proud of our teams and have developed a strong acumen in managing through these risks and disruptions. And while we are implementing tools and processes that presume the virus is here to stay and at elevated cost levels, we also feel we can manage these costs going forward while driving gross margin expansion in 2021. Moving on to operating expenses, fourth quarter R&D expenses were $16 million or 11% of sales compared to $15 million or 9% of sales for the fourth quarter of 2019. For the full year, R&D expenses were $61 million or 10% of sales compared to $56 million or 9% of sales in the prior year. We continue to have confidence in our innovation pipeline, and therefore, we continue to invest into the economic climate. As Matthijs said earlier, we view the current pandemic as an opportunity to take market share and capture significant customer platforms. Our new product pipeline is strong, and we feel our new product launches in 2021 will contribute meaningfully to Novanta’s overall growth trajectory. Fourth quarter SG&A expenses were $27 million or 19% of sales compared to $29 million or 18% of sales in the fourth quarter of 2019. For the full year, SG&A expenses were $110 million or 19% of sales compared to $118 million or 19% in the prior year. We are very pleased with the flexibility our business teams have demonstrated in responding to the current market conditions. Moving on to other financial results, GAAP operating income was $17 million in the fourth quarter of 2020 compared to $13 million in 2019. For the full year, GAAP operating income was $56 million or $55 million in the prior year. Non-GAAP operating income in the fourth quarter was $22 million or 15% of sales compared to $25 million or 16% of sales in the prior year. For the full year, non-GAAP operating income was $85 million or 14% of sales compared to $100 million or 16% of sales in the prior year. Adjusted EBITDA was $32.4 million in the fourth quarter of 2020, a 22% EBITDA margin compared to $30.5 million in the fourth quarter of 2019 or a 19% EBITDA margin. We are very proud of achieving flat EBITDA year-over-year despite the 8% drop in organic revenue and the significant headwinds from the economic and pandemic environment. We see this as a huge testament of the commitment of our employees and our culture. On the tax front, GAAP tax rate was 14% in the fourth quarter of 2020. It differed from the Canadian statutory rate of 29%, driven mainly by jurisdictional mix of income, along with tax credits related to higher R&D spending. The full year GAAP tax rate was 8%. On a non-GAAP basis, our tax rate in the fourth quarter was 8% and in the full year was 12%. This was driven largely by jurisdictional mix of income and higher tax credits from R&D spending. Our GAAP diluted earnings per share was $0.35 in the fourth quarter of 2020 and $1.25 for the full year. This compared to diluted earnings per share of $0.26 in the fourth quarter of 2019 and $1.15 for the full year of 2019. On a non-GAAP basis, adjusted earnings per share, was $0.53 in the fourth quarter and $1.95 for the full year. Our adjusted earnings per share were down year-over-year primarily from higher stock compensation expense from the all employee equity grant. Stock-based compensation expense was $7 million in the fourth quarter or $22.5 million for the full year. Fourth quarter operating cash flow was $47 million compared to $35 million in the fourth quarter of 2019, a 31% increase year-over-year. Full year operating cash flow was $140 million, which is up more than 120% year-over-year. Novanta’s free cash flow generation for 2020 was clearly a highlight, representing the strongest year of free cash flow in the last 10 years. This result was driven by strong profit, continued improvement in net working capital and a variety of actions we took to preserve cash in response to the pandemic. We ended the year with gross debt of $205 million. Our gross leverage ratio was 1.7x. Our net debt was $80 million as of the end of the fourth quarter of 2020 or roughly 0.7x. Turning now to guidance, as we look at the first quarter, we are seeing good signals that industrial capital spending markets are beginning to rebound from the downturn caused by the pandemic. The near-term strength in the industrial sector will help us overcome the short-term weakness in the medical markets caused by a drop in elective medical procedures caused by the high hospitalization rates from COVID cases. While this will impact our business in the first half of 2021, it’s clearly a temporary impact, and our confidence continues to build around a recovering demand environment. With demand shaping up largely as we expected, we are seeing some green shoots of opportunities. The single largest near-term challenge is expected to be electronic material shortages in our supply chain and logistics disruptions caused by the pandemic. While we continue to build muscle memory around these topics, it continues to represent a near-term challenge. Given all these dynamics, we feel we have sufficient visibility to guide the current quarter, but we are going to refrain from providing full year guidance for another quarter. For the first quarter of 2021, as we stand here today, we expect GAAP revenue in the range of $155 million to $157 million. As we discussed earlier in this call, we are expecting to see a strong sequential improvement in revenue. This will be driven largely by a sequential and year-over-year revenue growth in our Precision Motion and Photonics segments. Similarly to our end market commentary, we expect these segments will see strength in industrial capital spending, microelectronics and continued robust in vitro diagnostic growth. Whereas our Vision segment will experience weakness from the short-term downturn in elective medical procedures, which is already showing signs of stabilization. Moving on to adjusted gross margins, we expect gross margins to be nearly flat sequentially versus the fourth quarter. The improvement from ongoing productivity programs and cost leverage from higher volumes will be dampened somewhat by a seasonal uptick in compensation expense, which is in part caused by the reintroduction of incentive compensation structures and in part from higher payroll taxes. We remain committed to delivering upwards of 150 basis points of gross margin expansion in 2021, driven by continued progress in the Novanta Growth System productivity program, strong cost controls and better volumes. So we expect gross margins to climb sequentially starting in the second quarter. R&D expenses in the first quarter will be approximately $17 million to $18 million. This increase sequentially and year-over-year reflects seasonal uptick in compensation expense, which, again, is the reintroduction of incentive compensation structures and also payroll taxes as well as increased project spending to support the execution of our planned NPI projects. We expect R&D expenses to stay at a slightly higher level for the next few quarters to ensure we have successfully launched our new products across a variety of segments. SG&A expenses in the first quarter of 2021 will be approximately $31 million to $32 million, increasing sequentially on a dollar basis, predominantly driven by the seasonal uptick in compensation expense, which, again, is from the reintroduction of incentive compensation and higher payroll taxes and from the uptick in selling expenses related to the higher revenue. Moving on to the remainder of our guidance, depreciation expense, which was about $3.5 million in the fourth quarter of 2020, will be similar in the first quarter. Amortization expense, which was $6.4 million in the fourth quarter, will be similar in the first quarter. Stock compensation expense, which was about $7 million in the fourth quarter, will be similar in the first quarter. In addition, as a result of the new equity grants in 2021, our stock compensation expense will continue to be higher than it was historically, a step down from the 2020 levels to something closer to $18 million for the full year of 2021. For adjusted EBITDA, we expect a range of $27 million to $29 million. Interest expense, which was about $1.5 million in the fourth quarter of 2020, is expected to be similar in the first quarter. We expect our first quarter non-GAAP tax rate to be around 18%, absent significant changes in jurisdictional mix of income and other variability of our eligible tax benefits. Diluted weighted average shares outstanding for the first quarter will be approximately 36 million. For adjusted diluted earnings per share, we expect a range of $0.35 to $0.39 in the first quarter. Finally, we expect our cash flows in the first quarter of 2020 will be lower than what we saw in the last few quarters. This is primarily driven by higher net working capital needs caused by the higher revenue and from building of inventory to derisk the global material shortages occurring around electronic parts as well as from higher cash taxes in the first quarter. The inventory buildup is expected to affect us in the first half of the year but will subside by the second half of the year. Ultimately, it’s very encouraging to see that the view that we had throughout the pandemic is starting to be realized. The effects of the pandemic were temporary and a rebound of demand is beginning to occur. We are thankful that during these difficult economic times, our customers have shown tremendous partnership with us, both with current sales and the delivery of product as well as with our innovation pipeline, where we’re partnering with our customers to bring a record number of innovations to market in 2021. We do expect the full year to show solid organic growth, gross margin expansion and our balance sheet to continue to strengthen. We look forward to giving more details around this in our first quarter earnings release. We are very proud with the performance of our employees, their commitment to helping us weather a difficult environment. And most importantly, we remain excited about our future and look forward to continuing to deliver on our commitments to our employees, our customers and our shareholders. This concludes the prepared remarks. We’ll now open the call for questions.

[Operator Instructions] Our first question will come from Lee Jagoda of CJS Securities. Please go ahead.

Hi, good morning.

Good morning, Lee.

So starting with the new product introductions and sort of the cadence of those this year and next year, how should we think about that in terms of additions to organic growth? And obviously, COVID will impact the organic growth in terms of a catch-up in 2021. But given that these new products don’t usually hit revenue for, call it, 12 to 18 months after launch, kind of putting COVID aside, shouldn’t that accelerate your core organic growth in 2022 and 2023 versus what it’s historically been just given the ramp of these new products?

Yes. Thanks, Lee. Yes, we’re very excited for the launches we’ve lined up. And as I mentioned, it’s approximately 25 different products that we’re bringing to market. And these products are spread nicely across our 3 segments with some significant opportunities in beam steering, machine vision, motion control, integrated OR technologies. And so while we’re not going to specifically quantify the amount of 2021 sales, I’ll repeat what we said in our prepared remarks that we feel these launches will contribute to the overall trajectory of the company starting in 2021 and beyond. And so like you said, it’s important to keep in mind that with the normal product life cycle of capital equipment, that year 1 of any launch is typically smaller as the OEMs start to see the market and then gradually ramp up production. So you’re right that from that NPI perspective, the larger contribution in sales is more often seen in year 2 and beyond, right? So – and we expect that our launches this year will follow a similar pattern. So yes, while these launches contribute to our growth, the more significant opportunity indeed will become visible in the outer years. That’s – we agree with that, but we’re not going to be specific at this stage on the amount.

Okay. One more on new products and I’ll hop back in and let others ask some. But in terms of the product – the new product portfolio that’s coming, can you talk to sort of the percentage of products that are geared towards subsystems versus components? And maybe speak to how the percentage has shifted towards subsystems over the last couple of years. And if you could maybe speak to the margin differential between a component and the subsystem that you guys would sell.

Yes. Yes. So heading into, let’s say, the COVID pandemic, what we commented on is – so pre-COVID, call it that way, we commented on that 30% of our revenue was originating from intelligent subsystems, and that’s up versus 5%, let’s say, in 2016. So we’ve gradually increased our exposure to intelligent subsystems. And yes, I’m not going to get into specifics in terms of the exact percentages of the NPI, but there is a large chunk that is geared towards intelligent subsystems, particularly around beam steering, but also other things we’ve commented on. So strategically, Lee, you’re correct that, that is where we’re gearing a large chunk of our investment dollars because we see the opportunity there. And we also – I think we’ve said in the past that we expect gross margins to be accretive in those intelligent subsystems.

And I lied because I have one more based on that answer. Just would you have a long-term target for percentage of revenue from intelligent subsystems if you were at 30% today or 30% pre-COVID versus 5% in 2016?

Yes. Also there, we have not given a number, but it will be – our target is to be substantially higher than that 30% for sure.

I would say, Lee, it’s also part of the path to – we have a multitude of levers that we can pull. But as we migrate more and more new products into the marketplace and migrate into more intelligent subsystems that helps us get to the ultimate target of 50% gross margins.

Sure. That makes sense. Thanks very much.

Alright. Thanks, Lee.

The next question comes from Richard Eastman of Robert W. Baird. Please go ahead.

Yes, good morning and thanks for the questions. Just a quick question around the gross margin in the Vision business, could you just maybe dissect that just a little bit and speak to maybe the opportunity there from a cost standpoint versus a mix standpoint as we move forward?

You mean why were the gross margins lower in the segment or not really?

Yes, that’s a more straightforward question. But I guess I’m – yes, I’m kind of thinking about just the benefit here as we see elective procedures start to pick up. Is that volume going to be significantly incremental to the gross margin? Or just maybe talk about the opportunity set in Vision from a gross margin standpoint. What’s volume driven versus mix driven?

Yes. So I would say that the majority of the gross margin expansion that occurs in this segment will be less from a volume uptick and more from some of the cost actions that we’re taking as well as driving additional leverage in our consumables production. So I think the combination of those things really kind of drive the gross margin expansion in 2021. From a volume perspective, this is – it’s fair to say that elective procedures will be a little bit weaker in the first half of the year they will be stronger in the second half of the year. And so we wouldn’t necessarily bank on that for our gross margin expansion.

Yes. Yes. And if you think about – Matthijs, I know you’re not going to speak specifically to any kind of revenue guide. But if I think about ‘21 here, I look at Photonics and some of the momentum there and certainly Precision Motion and the momentum there. Vision – would one expect Vision – the Vision business to be kind of a plus mid-single-digit type of revenue growth in ‘21 with, again, some headwinds in the first half, but the second half rebounding more strongly? Or – because you’re going to get a fair amount of gross margin leverage out of the growth rates here between segments, I presume, in ‘21.

Yes. Well, there is multiple things at play, of course, Rick, right? So you have some tougher comps potentially at the medical consumable side and the – also the diagnostic equipment side, yes? But then – of course, then the positive is you have a recovery in the markets, as you suggest, in the second half of the year, and that’s going to be a positive. So how exactly that play out in kind of the overall segment, yes, we’re probably not prepared to comment. But I think the overall drivers that you’re highlighting, we agree with. And yes – and then on top of that, we have, in the second half, some momentum from new products as well that hopefully will further support that acceleration in the second half. So yes, definitely, to Robert’s point, a stronger second half and a bit of choppy waters in kind of medical markets in the first half.

Okay. Okay. Fair enough. And just my last question. Robert, when we think of the OpEx here in the first quarter, just when you load the incentive comp in there, the options, expense number, does the first quarter represent a reasonably kind of straight-lined operating expense number for the balance of the year? Or is there some loading issues there around the first quarter being bigger or smaller than...

Yes. The first quarter would generally be a little bit bigger than the preceding quarters, and that’s mostly tied to some of the taxes that are paid out as well as the loading of the incentive comp schemes. But I would say that it will tick down a little bit as we get into the second quarter, not – mostly in SG&A perspective. That’s probably the way you should think about it.

Okay. Okay. Fair enough. Great, thank you.

Alright. Thanks, Rich.

The next question comes from Brian Drab of William Blair. Please go ahead.

Hey, Brian.

Hey, good morning. It’s Brian Drab. The first quarter guidance obviously indicates a nice sequential improvement. Can you – and I don’t know if you did say, but should all 3 segments improve sequentially? And I guess that implies still maybe a year-over-year slightly down in maybe Photonics and Vision year-over-year and a pretty strong year-over-year growth rate in Precision Motion for the first quarter. Is that right?

Well, we didn’t get that specific. What we said was Photonics and Precision Motion would certainly continue to trend upwards. You’ll see the result of that, obviously, in Precision Motion is that it will demonstrate some year-over-year growth in the first quarter. In the case of Photonics, without – if it’s going to trend up, I don’t want to get kind of too specific, it can trend itself into growth as well. The Vision segment is where there will be some challenges. On a year-over-year basis, you could actually have a little bit better top line on a sequential basis, but the reality is, on the year-over-year, it’s going to be a tough comp.

Right. Okay.

Recall that in the first quarter of last year, there was quite a bit of, I’d say, pull-in but pull-forward from – just to secure the supply chain, particularly in the Vision segment. So these comps are a little tougher.

Right, right. Yes. Okay. Yes. Thanks for that reminder. And then as you move through the balance of ‘21, and I hesitate, I guess, because you will probably just say we’re not guiding here, but it sounds though like from what we’re talking about is sequential improvement is the expectation, though, across the three segments as you move through ‘21. Am I kind of connecting the dots correctly there?

Well, I think what we’re saying is the business will – from a growth perspective, the overall company will continue to get better. So as we migrate into the second quarter, you’ll start to get into organic growth profiles again, and I think the gross margins will also continue to perform. So I think there is a lot of positives from a demand environment, there is a lot of momentum that we have in the Novanta Growth System on some of the programs there. The one caveat which is why we’ve kind of steer clear of the full year guide right now is that the disruptions in logistics continue to stay with us and then the electronic material shortages. Now we are working hard to counter that and including understanding where the potential risks might lie and then pre-buying or building up safety stock of any sort of parts that we are worried about. But those are disruptions that we need to plan on in the first half of the year and just get ourselves better – get a little more confidence around that, I should say, before we go out with a full year comparison. So it’s not a demand perspective that we have right now. It’s just more dealing with the hand-to-hand combat around buying the right materials and getting the product out to our customers without any sort of logistic disruptions.

Right. Okay. And then just the last question around M&A, with the market where it is and where valuations where they are, I’m just wondering, are you seeing still a pipeline of opportunities with reasonable valuations that you can execute on? Because I would imagine some of the companies that were in your pipeline 18 months ago, like those same companies probably have 2x to 3x the valuation that they had just given what’s going on in the market?

Yes. I mean, listen, we’re actually very active in terms of discussions, and we have a strong pipeline of opportunities, which we feel has good potential. Yes, you’re right that we, of course, see, in some cases, valuation expectations to be high. And the market overall, you can characterize as maybe hot. And so it’s really important to stay disciplined and focused in where you want to move and where you maybe need to pause and wait. The other thing that I would say is, of course, yes, corporation and diligence efforts are not necessarily straightforward in this environment, right, because you cannot meet easily face-to-face. Now we are using and we are evaluating all kinds of creative ways on how to keep progress in these cultivation efforts, but yes, so that’s another note to keep – yes, to keep in mind. But overall, Brian, listen, I think, yes, we feel good about the amount of conversations we’re having versus the, let’s say, what is it, the first part of last year. So you clearly see intensity increasing. It remains a top capital allocation priority. But you can also expect us to stay very disciplined in this environment so that we can meet our return surplus, right? So it’s – so yes. So nothing necessarily different from, I think, our approach we have shared with you in the past.

Okay. Thanks very much.

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

Thanks, operator. So to summarize, it’s fair to say that the year 2020 was an unprecedented year with the global pandemic causing a significant economic downturn. We’re pleased to see early signs of markets rebounding and the economies of the world beginning to return to growth. Despite this very difficult macro environment, Novanta delivered a very solid performance. We’re extremely pleased with our positioning and performance of our portfolio. I’m proud of the performance and agility of our teams. Novanta’s balance sheet is strong. We have an exciting innovation pipeline. Our portfolio is diversified with exposure to long-term secular macro trends that we’ve shared with you before, such as robotics and automation, precision medicine, minimally invasive surgery and Industry 4.0. And we continue to invest in our innovation pipeline and are very excited about the record number of product launches that will be happening in 2021, which we believe will contribute meaningfully to our growth trajectory this year and beyond. So in closing, I would like to thank our customers, our employees and our shareholders for their ongoing support. I’m particularly grateful for the dedication and strong contribution of our teams of committed Novanta employees. They are showing such tremendous agility and resilience during these difficult times. And 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 2021 earnings call. Thank you very much, and this call is now adjourned.

The conference has now concluded. Thank you for attending today’s presentation and you may now disconnect.