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. 2022 Second 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 Ray Nash, Corporate Finance Leader for Novanta. Please go ahead.

Thank you very much. Good morning and welcome to Novanta's Second Quarter 2022 Earnings Conference Call. I am Ray Nash, Corporate Finance Leader of Novanta. With me on today's call is our Chair and 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 Chair and Chief Executive Officer of Novanta, Matthijs Glastra.

Thank you, Ray. Good morning, everybody. And thanks for joining our call. Novanta achieved impressive results in the second quarter of 2022. We delivered another quarter of terrific financial performance with double-digit growth in revenue, bookings, adjusted EBITDA, and adjusted EPS. And we ended the quarter with another record level of backlog. We continue to see very robust demands from our customers in the medical and advanced industrial markets we serve. Novanta's portfolio is well positioned in medical and advanced industry applications, with long-term secular tailwinds such as robotics and automation, healthcare productivity and precision medicine. We continue to invest for growth in a disciplined manner to strengthen our commercial teams, our innovation pipeline and manufacturing capacity to capitalize on these tailwinds. In the second quarter, the company delivered $215 million in revenue, representing 29% year-over-year revenue growth on a reported basis and 13% growth on an organic basis and up 5% on a sequential basis. In addition, our operating profit in the second quarter was fantastic, with adjusted EBITDA of $45 million, up 22% year-over-year and adjusted diluted earnings per share of $0.78, up 26% versus prior year. We saw strong demand and healthy orders across all our segments and in many of our applications, with each segment having solid book-to-bill in the quarter. In the second quarter, our book-to-bill was 1.34 with year-over-year bookings growth of 25% versus the second quarter of 2021. We ended the quarter with a record backlog of $653 million, up 11% sequentially as demand continues to be gated by supply constraints. The excellent year-to-date financial performance gives us confidence to raise our financial guidance for the full year, which Robert will cover in detail in a few minutes. We're doing this in the face of significant amount of uncertainty and macroeconomic and supply…

Thank you, Matthijs. And good morning, everyone. Our second quarter non-GAAP adjusted gross profit was $98.8 million or 46% adjusted gross margin compared to $76.9 million or [Technical Difficulty] gross margin in the second quarter of 2021. For the quarter, adjusted gross margins were flat year-over-year and sequentially. Considering the environment of high inflation, supply chain shortages and currency exchange volatility, we feel quite good about this outcome. We continue to experience supply chain shortages and inflationary pressures with semiconductor parts, but we're also seeing solid productivity from the deployment of the Novanta growth system and we are experiencing the impact of our pricing initiatives helping to offset the inflation. Moving on, the second quarter R&D expenses were $21.6 million or roughly 10% of sales. Second quarter SG&A expenses were $40.5 million or 18.8% of sales. The sequential increases in operating expenses, which were in line with prior guidance, were the result of the impact of variable compensation programs as well as planned R&D investments. Adjusted EBITDA was approximately $45 million in the second quarter of 2022 or a 21%. adjusted EBITDA margin. Our adjusted EBITDA performance beat our expectations and our previously issued guidance. On the tax front, our non-GAAP tax rate in the second quarter of 2022 was 18%. This is different from the statutory rate, driven mainly by jurisdictional mix of income. Our non-GAAP adjusted earnings per share was $0.78 in the quarter compared to $0.62 in the second quarter of 2021, an increase of 26% year-over-year. The strong increase in adjusted EPS was achieved despite the higher financing costs and higher tax rate. Second quarter operating cash flow was approximately $24 million, which was in line with our expectations. The second quarter cash flow continued to be impacted by anticipated increases in working capital, which was…

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

So just starting with the sequential increase in backlog, can you kind of parse out how much of that is volume from existing OEM products that your customers are trying to get out the door versus potentially some initial sell in for some of the new products in the pipeline? And to the extent it's any of the latter, is there a quarter – one quarter, two quarter, three quarters out from now – where you expect that backlog to release? Or is it really just supply chain constraints holding everything back?

Lee, this is Matthijs. It's primarily supply chain constraints holding the backlog back. Demand is just outstripping our ability to supply. And despite all that, we delivered very, very strong results. So let me start by saying that. The other question, we haven't really disclosed the split in our sequential backlog in kind of existing customers and new opportunities. But it's fair to say that, as we continue to report on design wins that are incremental to our business, so it will be a mix. And of course, also the increased, let's say, exposure of our business to high growth application. So it's being both in the right spot, which then drives the existing business to move faster, as well as winning gradually new business and increasing content in those high growth markets.

I think I know the answer to this question, but I have to ask it anyway. In terms of your customers' order patterns, I assume we're not seeing evidence of safety stock or over ordering, and it's just ordering to demand and you can see that in their inventories.

That's right. We do not see much evidence of over ordering, quite frankly. So, many of our customers has given us feedback that they're kind of hand to mouth, quite frankly, with their suppliers, including us. And they're shipping all finished units as soon as they can complete them. Now, of course, we do have less visibility what happens further down the chain and we're watching that closely. But again, at this moment, we do not see much evidence of over ordering. So, overall, we have a large backlog, and we cannot keep up with the demand. So, yeah, our focus is quite frankly reducing that backlog to our customers because they really desperately need our products.

One more for me and I'll hop back in the queue here. I know you had mentioned you're seeing an uptick in the WOM consumables just driven by elective procedures. What needs to happen to kind of see or start to see an uptick in the equipment side? And when do you see that kind of playing out?

That's typically the logical sequence. The procedures need to go up first. And that typically will be followed by capital purchases as hospitals need to bring more capacity online. We do see a healthy hospital capital spend environment. Our customers are reporting on that as well. So, it will be the gradual, logical next step to follow. And so, I think we're very encouraged by what we see happening. And what we expect to happening is a sequential increase of and gradual rebound of the elective procedure rates, which we expect to continue to progress in the second half of this year.

And just to be clear, the big backlog you have here, if I look at the WOM equipment, which should be an important growth driver over the next two, three years, I would assume that piece is under indexed versus all the rest of the stuff in the current backlog just because we haven't seen those orders yet.

That's right. So, again, we expect that demand will continue to build gradually in the foreseeable future. But, again, if you look, short, mid, long term, as we commented in our prepared remarks, we feel very good about the future of that business as we're gaining share with our smoke evacuation insufflator, both in the laparoscopy as well as robotic surgery markets, and we're also expanding share in pumps for arthroscopy. So all that makes for a very exciting future of that business. And yeah, what we're just seeing right now is just hospitals just battling through staff shortages, which we expect over time will resolve itself.

The next question comes from Brian Drab of William Blair.

First, I'm just thinking back to the back half of 2019 when challenges in China, Europe business slowed down, Germany was a challenge for you? And can you talk to us a little bit about comparing that market environment to what you're seeing now in China and Europe? There was a lot of differences there. I would just love to hear you talk about that and how that influences how you're viewing the second half of 2022?

It's hard to compare, quite frankly. But, of course, when you put yourself in the second half of 2019, we just had massive trade wars and uncertainty on where trade tariffs would land and, therefore, basically, people stopping investing, right> And that had impact in in multiple end markets. Right now, what we're seeing is we're emerging out of the pandemic. And in areas like automation and robotics, where there are secular growth trends that are accelerated that were there already, but they're accelerating, call it, post pandemic. And we continue to see demand for our medical and DNA sequencing products that also are kind of entering into the next phase of their adoption. So, we feel that, quite frankly, where we've put our business, including acquisitions, we have high exposure to markets that have accelerating sequential tailwinds versus where we were in 2019. The other thing that I would say is that we have a higher percentage of new products that are coming to market. So, in 2019, if you recall, we just did some technology acquisitions, but we're now seeing the impact of the product pipeline gradually starting to appear in the latter part of this year and 2023. I would just say, we're on our firm feet, so to speak, dealing with the challenges head on and being in the right spot. And so, where we are and where we play and how we win is really essential. Now, of course, what is maybe similar and we're not naïve is, of course, there are signs of slowdown in some parts of the semiconductor market. Of course, everybody's reading the newspapers about the uncertainty. And of course, we're watching that very carefully. But what we can do is, of course, place our business in the right spots, so we can ultimately serve and thrive through what will surely be some additional challenges coming our way in the future.

Can you comment on where you are in the in-sourcing of the WOM consumables, still on target for getting the margin expansion there?

First, I would say that the in-house manufacturing facilities have done an excellent job at expanding margins and continuing to bring more and more volume into the facility. Because of the way their manufacturing footprint works, getting that volume in is really what's key. So pull it out of our contract manufacturers and bring it in-house, that allows us to better leverage the fixed cost structure that we have there and thereby expand the margin profile. We are simultaneously pursuing some opportunities that are external in nature. And we have a couple of different avenues there that we are continuing to work. We feel pretty good that at least one of those will come to fruition relatively soon. And then, that will enable us to start bringing even additional products in-house to expand the margins. At this stage, I think we feel pretty good that there's enough options in front of us that we can start to continue to bring product in-house and expand the margins.

The next question comes from Rob Mason of Baird.

I wanted to go back to, I guess, the question around the backlog. And understanding that your customers may be somewhat hand to mouth currently, but is it fair to assume there are some inventory stocking orders within your backlog, the $653 million? Is there any way to give us a percentage of what you would think would be shippable next 12 months, absent any kind of supply chain constraints?

Well, most of it is shippable. All of it is shippable in the next 12 months. It's all being held back with the supply chain constraints themselves. Right? We don't have any backlog that's cancellable. And we don't have backlogs that's scheduled out greater than a year being reported in that number. So, that's all 12 months kind of demand flows. It is fair to say that there's some requests to try to build safety stocks there. We're nowhere near those levels of delivery. And so, we're not able to do that. And so, we're more than trying to prevent line downs at our customers and their manufacturing processes than we are about building stock. If we were to estimate it, I'm sure about 20% of it is definitely tied to stocking because they don't really have anything whatsoever on their shelves. But we're nowhere near the delivery of that. At least as we look at 2022, it provides us with some confidence, and then the revenue numbers should be relatively firm, regardless of some macroeconomic conditions.

And the other thing that I would say, Rob, is that we do expect kind of our bookings and our book-to-bill to normalize, right, because I do think the backlog represents very solid coverage for our customers. We need to deliver on that backlog. But, yeah, again, we expect book-to-bill and bookings to normalize from here onwards.

You mentioned price a couple of times, just perhaps getting a little bit better traction as that works through the backlog as well. Could you just update us where you think you are currently on a price cost metric, positive, negative, or just where we sit currently?

Our philosophy has always been one that we're leaning in hard on our Novanta growth system, which is about driving material productivity and labor productivity in our manufacturing facilities, and then coupling that with a pricing strategy that focuses on sharing some of the inflationary pressures. So, we have not taken the stance that our customers really have where they've dramatically raised price in an effort to get margin expansion on top of the inflationary pressures that they have. We have not taken that stance. What we've really done and said, okay, the Novanta growth system is going to drive X amount of productivity, pricing is going to drive Y amount, and the combination of those two things will allow us to at least neutralize the inflationary pressures, and then the introduction of new products at higher gross margins will allow us to expand those gross margins further. And so, as a net-net, you're seeing that in the results. First half of the year, we have the 46% gross margins. If we look at the back half and the full year, we're going to drive gross margin expansion 100 basis points. That's a combination of those activities – Novanta growth system, pricing strategy that focuses on sharing some of that costs and new product introductions, and then frankly, driving some of the consumable inhouse.

Last question I had was, there's obviously a lot of uncertainty, particularly in Europe, and in particular, in and around their energy situation. Germany seems to be ground zero for that concern, it seems like. And given your facility there, I'm just curious how you're approaching that dynamic as we go into the back half of the year and into early next year, what perhaps you can do to make sure that you've insulated yourself, protected yourself against any kind of interruptions that may come down that way?

What happens if the grid goes down is not an easy thing to mitigate. So, let's presume that there's some energy production based upon what they can get in. I think we'd take a number of actions, so with everything from building in backup generation to reducing our over energy consumption. Our facility in Germany is ISO 14001 and 45001. It's probably leading the way from an ESG perspective. So, they continue to look at ways to reduce their energy consumption. We have also built in some redundancy into our heating systems. And so, we can pivot to a multitude of different fuel sources, depending upon where the shortages might lie. So if there's a shortage of natural gas, we can pivot to oil. If there's a shortage of oil, we can pivot again. And so, there's a multitude of different angles that we've invested in to try to add that redundancy and that robustness. And we're also simultaneously trying to build, as you know, require additional capacity vis-à-vis an acquisition strategy. So there's a number of different tactics that we are taking to try to increase that redundancy in that facility.

Our next question comes from Andrew Buscaglia of Berenberg.

I was hoping to focus on Precision Motion for a bit. So that's growing organically very strong on a pretty tough comp, much better than I was expecting. Now you have this M&A that's going to roll into your core growth kind of starting next quarter, but we're definitely in Q4. And I'm looking out, it's hard to – you talk a little bit about the cyclical versus secular in some of your businesses. It's hard to determine what is a long-term growth rate for this new segment as we exit the year. Can you help us think about that and what are the puts and takes going forward?

We've always kind of said that the overall end markets in which we participate in are this 5% to 7% organic growth profile. And then, as a consequence of some of the new things that we're doing, the innovation, the design wins, new product introductions, and whatnot, we've been driving that kind of higher single-digit organic growth contribution. Obviously, we've been outperforming that in a number of different areas of this environment. But structurally speaking, those tend to be where the end markets slow. I would say cyclicality wouldn't impact the kind of long term growth expectations of an end market participation. So, the API business does have a little bit more cyclicality than most of our other businesses. It tends to have a weaker Q3 than Q4. And that's just because of the upgrade cycles and investment cycles associated with some of the end markets in which it participates. Generally speaking, that business performs relatively well. And we had guided when we acquired the business that it was certainly participating in that high-single digit type of end market. Arguably, in this environment, like kind of low-double digit. And the overall motion segment itself tends to be a higher growth area as well. So, kind of a lower double digit. We have to just be realistic here that the overall portfolio here is one of diversification. And what we try to do is diversify out the risk elements and volatility and cyclical changes and macroeconomic differences between businesses and whatnot to drive that sustained organic growth overall. So, we run the business very much like a portfolio manager would run their portfolio of stocks. We do very similar things in how we invest in our end markets and our application areas and our business units that drive a more sustained organic growth profile for the company.

Just to add to that, it's important to repeat what the end market exposure really is because then you can kind of get a guess for, yeah, how good we feel about this. Obviously, very strong exposure to automation and robotics, surgical robotics, increasing exposure, also with the ATI acquisition, electric vehicle production, which is going through a supercycle, EUV lithography which is a semiconductor market, but which is also going through a supercycle, [indiscernible] warehouse and logistics automation in general. This segment also has the highest semiconductor exposure, so you can kind of expect as a result, a little bit more volatility from that. Within that market, we are, as stated, geared more towards the less technical parts of the semiconductor market, for example, EUV. So, many of these applications, we feel, are still very early in their adoption cycle. We feel good about the long term growth potential in that segment for that reason.

And what about regionally for that segment combined? Is there any greater influence of China exposure, maybe either direct or indirect?

That's a good question. I think there is an element of that. It has a little bit more China exposure than some of our other segments. We've never kind of broken that out. But it is fair to say that there is a little bit more China exposure there.

The other just reminder is that when we played out regional sales, it is shipped to locations. So, in other words, we could ship to a German OEM who then ships to China, right? You've got to be a little bit cautious about correlating one to one what truly is the end market exposure?

Maybe just one last one. Any update on the legislation around smoke evacuation insufflators? And anything we should be on the lookout for to the fall?

I think, also there, gradually, there is continued adoption of the legislation of smoke evacuation in the US as well as abroad. So, I think that trend overall is very positive. I think the additional trend that is positive, outside the legislation per se, is how to integrate smoke evacuation as part of the workflow. So, we feel we have a very strong solution there, and that is basically confirmed by a very strong pool of multiple major customers. So, we see, as a result, that product category of ours driving strong adoption in the coming years, which was confirmed by design wins that we had last year. We also see an opportunity and we see convergence between basically laparoscopy and robotic surgeries, so that smoke evacuation will play a stronger role there as well. So, we see multiple growth drivers, both from a legislation perspective, product category, as well as adoption in new applications.

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

Thank you, operator. So, to summarize, Novanta delivered very impressive results in the second quarter of 2022. We saw double-digit growth for sales bookings, adjusted EBITDA, adjusted EPS, and we hit a new record high backlog. We achieved all of this while managing supply chain disruptions, rising costs and a more uncertain macro environment. We're excited to see the continued strength in the advanced industrial sector and also in the medical sector. Novanta is very well positioned in these sectors, with diversified exposure to long term secular macro trends in robotics and automation, precision medicine, minimally invasive surgery and Industry 4.0. In closing, as always, I would like to thank our customers, our employees and our shareholders for their ongoing support. I continue to be especially grateful for the dedicated efforts of all our great Novanta employees who work so hard every day to tackle each new challenge. 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 third quarter 2022 earnings call. Thank you very much. This call is now adjourned.

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