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 Incorporated 2023 Third 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 third quarter 2023 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'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 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 had a solid third quarter with strong operating performance, delivering profit and cash flow above our expectations. Our revenue was in line with previously issued guidance. In the quarter, we delivered $222 million in revenue, representing a 1% year-over-year revenue decline on a reported basis, a 3% decline on an organic basis. Excluding microelectronic applications, our growth in the quarter was up low single digits. We recorded gross margins of 47% in the quarter and an adjusted EBITDA margin of nearly 24%. In addition, our cash flow was up over 2x the prior year and at more than 175% conversion to net income. This operating performance reflects excellent execution by our teams in an increasingly challenging macroeconomic environment. The Novanta business model, with diversified exposure to secular high-growth markets has proven resilient under multiple geopolitical and macroeconomic scenarios. Our proprietary products and technologies are well positioned in medical and advanced industrial applications with long-term secular tailwinds such as robotics and automation, healthcare productivity and precision medicine. Medical applications now make up nearly 60% of our sales versus single-digit percentage of sales a decade ago, which we believe provides Novanta with greater resilience during fluctuating macroeconomic conditions. We feel that our strong customer relationship with the leading OEMs in these medical and advanced industrial applications, the strength and diversification of our portfolio and our sticky business model will allow Novanta to deliver and drive better performance through the economic cycles. In the third quarter, the Novanta team has made excellent progress in bringing down lead times to our customers. The consequence of this change is that customers do not need to place long-term orders anymore, resulting in a book-to-bill of 0.8, which was in line with our expectations.…

Thank you, Matthijs, and good morning everyone. Our third quarter non-GAAP adjusted gross profit was $105 million, or 47% adjusted gross margin, compared to $102 million, or 46% adjusted gross margin in the third quarter of 2022. For the quarter, adjusted gross margins were up year-over-year by over 160 basis points and up sequentially by 30 basis points. This outcome was better than our expectations and represents strong execution by our teams to achieve this result. Our continued progress with gross margin expansion in 2023 is being largely driven by the deployment and successful adoption of the Novanta NGS productivity tools in our factories. The 47% gross margin puts us on a solid track to achieving our full-year goal of expanding gross margins by 100 basis points. Moving on to the operating expenses. R&D expenses were roughly $22 million, or approximately 10% of sales. Third quarter SG&A expenses were $40 million, or roughly 18% of sales. Overall operating expenses as a percent of sales were flat year-over-year in the quarter. While we continue to invest in new product innovations and prepare for the launch of multiple new product platforms, the organization also demonstrates strong cost management. Adjusted EBITDA was approximately $52 million in the third quarter of 2023, or 23.6% adjusted gross -- adjusted EBITDA margin, versus $49 million in the prior year. On the tax front, our non-GAAP tax rate for the third quarter of 2023 was 15%. This differed from the statutory rate due to jurisdictional mix of income and some timing-related tax benefits. Our non-GAAP adjusted earnings per share was $0.85 in the quarter compared to $0.81 in the third quarter of 2022. Third quarter operating cash flow was approximately $45 million, which is up greater than 200% versus the prior year. We are pleased with this…

We will now begin the question-and-answer session. [Operator Instructions]. Our first question comes from Lee Jagoda of CJS Securities. Please go ahead.

Hi, good morning.

Good morning, Lee.

So just, I guess starting with you had referenced that there's this temporary push out or deferral and customers are sort of leaning on you to carry their inventories, at least temporarily. Should we view this as a one-quarter push and something as simple as when the calendar flips, they'll be back to ordering and taking product? Or is there something else in the macro that we have to keep an eye on and it could be a multiple quarter push out?

I think there's a bit of a -- little bit of an overreaction by some customers in the fourth quarter to deal with the rapid rise in rates and the uncertainty in the environment. Obviously, the war in the Middle East sent some shivers through people's backs that they needed to adjust for or they felt the need to adjust for. So I think the fourth quarter definitely has a more deferral than what we would expect in 2024. So I do think things will begin to recover a little bit as we get into 2024. I think customers are really looking and taking the opportunity to focus in on those product launch cycles and really make sure that they're successful in the back half of the year. So even today, we have customers in our facility going through the qualification of product launches to make sure that those things are on track and to make sure that we're taking the necessary actions to ramp up to the volumes that they're looking for. But most of that is looking at as a second-half pickup in demand associated with those innovations.

Okay. And then specifically on the microelectronics business, I know you've won a whole bunch of stuff in EUV and deep EUV that should kind of drive multi-year secular growth. Can you give us some sense of the timing of those new products coming online during '24?

Yes. Well, first of all, we're extremely excited about this development. We feel even more confident about the long-term potential and growth in this application. You know, there were some public remarks by, I would say, a major player in this industry and our customer, which indicated a slight shift in their demand profile in 2024 from, let's say, early 2024 to more later in 2024. So this is more of a timing thing than a fundamental thing. And actually, as a matter of fact, we feel more confident as we're solving a pretty big problem for our customers. So, slight shift towards the latter part of 2024, long term even more excited about this opportunity.

Matthijs, if you would maybe just spend a minute or two on the problem you're solving and why the Novanta solution is the right solution in the area of microelectronics to solve this problem?

Yes, I got to be a little bit careful with this. I would say, I will answer it more holistically. You know, when we say that Novanta provides mission-critical technology solutions for our customers, it basically means that we fundamentally solve or improve, let's say, throughput. So, therefore produce a significantly higher level of parts per time unit, yield or cost of quality, right. So, in terms of -- and that's, again, a throughput and a cost environment or enhance basically their capability to produce something that has never been done before. I would basically say, this solution offers all three, right? And it has a tremendous impact on end user, basically yields, productivity, throughput, uptime. And so, we feel very good about it. But this is a typical Novanta solution that we employ also in robotics or broader material processing or I would argue DNA sequencing, right? So, we enable productivity improvements for the end user and customers. So for example, in DNA sequencing is really driving the cost per test and genome down as a result of our core engine into those applications, right? So it's a very similar trend and approach across these applications and customers, which is why we're intrinsic and detailed and very differentiated part of their supply chain. So when we give all these examples, the themes typically or the solutions typically head on many of these themes in parallel, right, which is ultimately why we're extracting value from it. Our customers are extracting value from it and the end users are extracting value from it.

The only thing I would add there is that we have used an acquisition strategy as well to acquire in technologies that allow us to redefine the competitive landscape. And so, as a consequence, we don't offer solutions that a competitor can match. We offer solutions that we've uniquely combined through a number of different acquisitions that our competitors haven't even thought of or looked at, that allows us to really offer a solution to a customer from their lens, from their eyes. And so, I think that's ultimately been the big differentiation that we've had, is that we don't offer solutions based on the widget that we offer. We offer solutions based on what the customer is looking to solve.

Got it. And just, I guess one more and I'll hop back in queue. As it relates to M&A. You kind of teased we'll see something before year end. Can you give us any framework around you know size, mix of business that you're looking at? Anything to kind of lead us down a path in terms of what you're looking to acquire at this point?

Yes, I think what we've said is that, listen, we're leaning into these macro trends that we've discussed, right? The overall growth framework is we get more content and solve more unique ways of solving our problem. Like what Robert suggested, right in his previous remarks into these high-growth applications. And so, of course, you know, we have had a tendency over the years to be more geared towards medical end markets as well as growing advanced industrial end markets, robotics and automation. So, you can expect us to continue to lean into those trends and further enhance, I think, our exposure into those end markets. As a reminder, 60% of our business is now or close to is in medical end markets. That's up from, I would say, mid-single digits 10 years ago. That's both organically as well as through acquisition, and we like that general exposure. So, let me leave it at that.

Okay, thanks very much.

Thanks, Lee.

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

Hi, thanks for taking the questions.

Hey. Good morning.

Good morning. Robert, you said and I just kind of missed all the context, but you said acceleration in 2024 potentially. Can you just restate that and elaborate on the drivers that you're talking about at the moment?

Yes, so I would say regardless of how the market performs, our second half of the year of 2024 will be accelerating on the back of new product launches. So, we have a number of customer launches that we've talked about in the past. We have launches now associated with our second generation smoke evacuation platform. There are a handful of customers launching products in the back half of 2024 around that. We have customers looking to launch and ramp as Matthijs just spoke about our next-generation lithography solutions. And we have a couple of new design wins around integrated operating room-based technologies and some precision medicine-based technologies. And so, a lot of these things were meant to be spread out across 2024. I think what we're looking at now is a little bit more of a backend loaded, 2024 as a consequence of people really taking the time to make those launches successful. I think the urgency around customers has increased to make sure they're successful, to make sure that we don't have slips as we launch the products, make sure there's no quality fallout, to make sure supply chains are in the right places in order to meet their needs, making sure our facilities are there, making sure the people are there, and so forth. And so, that's the activity that we're really looking at. Obviously, in this uncertain environment around the macro and the geopolitical and the interest rates, it was easy for a lot of customers to take a pause for the remainder of the year, but that is not an indication of them taking a pause in their innovation. Their innovation is clearly accelerating and they want to make sure it's done right. And so we're expecting the ramp up in the second half of the year.

Got it. Okay. And that's what I thought you were saying, that maybe it's a little more back-end loaded and this is all related to -- You know, you'd been talking about the 50 million in incremental revenue opportunity. I guess that's part of what you're talking about. It sounds like this is even broader kind of you know, second half of '24, like some other stuff moving in from the first half to the second half as well.

Yes, that's correct. And some additional stuff too, right? So, we are basically, yes we call that Brian, our new product Super Cycle because there's a lot of different products and application launches coming together later in 2024 and 2025. So, you know, the message is, listen, we got a short-term macro that is a bit more of a temporary headwind, but we're staying just razor-focused on these new product launches with our customers that really drive our long-term growth. So that's the upshot.

Got it. And looking at the gross margin and you're really having a good year in terms of gross margin this year, how much can you tell us about 2024 in terms of gross margin? Because you have this project that's this transition of the consumables manufacturing that should get you a healthy margin boost next year, I think. And can you talk about the timing of that? And you know, is it going to be tough to get 100 bps of gross margin in '24 after such a solid step up in '23?

I don't think so. I think we'll be able to still expand gross margins, another 100 basis points. You know, I think obviously, you know, there'll be a little choppiness in the quarters as a consequence of new products being launched and the mix ratios associated with that. You know, you rightfully point out the consumables are a lower gross margin than the rest of the business. However, there are other parts of the business. A lot of our new product innovation is being launched at a 50% or greater gross margin. And so, that mix effect will be choppy throughout the year, but overall for the full year, we should be able to expand the gross margin to 100 basis points, all else being equal. Now obviously, if we do an acquisition that can change things, but you know, for the most part, the base businesses, their performance, particularly as they have been really embracing and institutionalizing the NGS process, I think that gives us the confidence that they can continue to deliver these results.

Yes, in addition, I think Brian, what we said in the prepared remarks is that we'll also continue to apply 80-20 portfolio management tools, which is basically rationalizing our portfolio, focusing for gross margin and profitability as well as creating the capacity for the growth, right. So that we basically phase out lower margin, less productive products that are you know, either commoditized or more end of life. So that's another aspect that is an ongoing process within the company that we're looking specifically in 2024 to execute on.

Okay, are we seeing the benefit from that consumables transition already or is that something that is really just going to be felt in the first half of '24?

Yes, first and second half of 2024, so the products start ramp, full production will probably go roughly around in the end of December. So the full effects of that really won't be felt until 2024. And then the launch cycle around production of the medical consumables will be very customer-specific. And so, it depends upon how customers want to stock safety stocks around that. It depends on how their qualifications work out, their FDA processes. And so, the full effects were really a back half of the year is the easiest way of thinking about it, where we start all new products, all new medical consumables are launched out of that facility. Now, similarly, in our Manchester facility, we will be launching all new products out of that facility as well. So, that facility will be up and running, really by the end of the first quarter, fully in production phase. And so, products will be coming out of the second half out of that facility, again putting us in a great position to deliver a higher gross margin.

Yes, and then you have in some of the other product categories more and more intelligent subsystems, which, you know, have a higher margin profile as well. Also that will launch in the second half. So think about laser beam steering or precision motion related intelligence subsystems, right, that are starting to gear up in the second half of 2024 as well.

Okay, thanks for answering those questions.

Absolutely.

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 recap, Novanta had a solid operating performance in the third quarter of 2023. We beat our own expectations for margins, profit and cash flow, and saw solid sales in medical markets, helping to offset declines in industrial markets. We've maintained a robust level of backlog coverage while reducing our past-due backlog, and we see continued tailwinds in our medical businesses that should help partially mitigate growing pressures in the industrial capital spending. We're progressing our innovation pipeline and are excited for the large product launches happening later next year. Novanta remains very well positioned in the medical and advanced industrial end markets with diversified exposure to long-term secular microtrends in robotics and automation, precision medicine, minimally invasive surgery and Industry 4.0. In 2023 and beyond, we will continue to focus on executing our new product Super Cycle, design wins in high-growth applications and doubling down on the Novanta growth system, driving cash flows and gross margin expansion. In closing as always, I would like to thank our customers, our employees and our shareholders for their ongoing support and commitment and continue to be impressed and specifically grateful for the dedicated efforts of all our Novanta employees, who work diligently every day to tackle new opportunities, manage through new challenges, and make Novanta a great place to work. 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 fourth quarter and full-year 2023 earnings call. Thank you very much. This call is now adjourned.

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