Greetings. Welcome to Proto Labs Fourth Quarter and Full Year 2019 Earnings Call. At this time, all participants are in listen-only mode. [Operator Instructions] Please note that this conference is being recorded. At this time, I will turn the conference over to Dan Schumacher, Director of Investor Relations. Mr. Schumacher, you may begin.

Thank you, Rob and good morning, everyone. With me today is Vicki Holt, our President and Chief Executive Officer; John Way, our Chief Financial Officer and Rich Baker, our Chief Technology Officer. This morning, before the market opened, Proto Labs issued a press release announcing its financial results for the fourth quarter ended December 31, 2019. The release is available on the company’s website at protolabs.com. In addition, a prepared slide presentation is available online at the web address provided in our press release. Before we begin, I would like to remind everyone that our discussion will include statements relating to future performance and expectations that are or may be considered forward-looking statements and subject to many risks and uncertainties that could cause actual results to differ materially from expectations. Please refer to our earnings press release and recent SEC filings, including our annual report on Form 10-K for information on certain risks that could cause actual outcomes to differ materially and adversely from any forward-looking statements made today. The results and guidance we will discuss include non-GAAP financial measures consistent with our past practice. Please refer to our press release and the accompanying slide presentation within the Investor Relations section of our website for a complete reconciliation of non-GAAP to GAAP results. Now, I would like to turn the call over to Vicki Holt, President and Chief Executive Officer of Proto Labs. Vicki?

Thanks, Dan. Good morning, everyone. Thank you for joining us on our fourth quarter conference call. I'll begin with an overview of our overall business performance in the quarter and John provide a detailed look at our fourth quarter and full year financial performance. Rich Baker and I will then provide an overview of a major initiative for 2020 and finally, John will conclude with our financial outlook. This morning we reported 2019 annual revenue of $459 million or growth of 4% in constant currency, despite a challenging global economic environment. The fourth quarter played out as we expected with quarterly revenue of $112 million and earnings per share of $0.63 at the midpoint of the guidance ranges we provided in our Q3 call Macroeconomic headwinds across various industries and all the geographies we operate in have resulted in less activity from our customers in 2019. As we expected with the softer year, we did not see a push from customers to complete projects by the end of the year resulting in a relatively weak demand through the fourth quarter. Providing further color on the quarter, revenue was down 1% year-over-year in constant currency. Slide 5 in our Investor Presentation highlights fourth-quarter revenue by geography. Revenue in our largest market, the American declined 1% versus the prior Q4. Demand was especially sluggish in our aerospace and manufacturing end markets while automotive grew in the mid-teens as relatively easy comparable in 2018. Our European region produced Q4 year-over-year revenue growth of 4% in constant currency. Revenue in our medical end market showed strong growth while automotive and consumer electronics declined. Our Japan region quarterly revenue declined 12% in constant currency and Japan business environment exports have weakened with the trade war between US and China having an impact. Softer business spending…

Thank you, Vicki. I'll start with our Q4 financial results and then transition to the full year results for 2019. Revenue in the fourth quarter was $111.9 million a decrease of $900,000 or 0.8% compared to the fourth quarter of 2018. Foreign currency represented a $250,000 headwind in the quarter due to the relative strength of the US dollar. Our fourth quarter unique product developer serve increased to 20,600 or growth of 1% compared to the prior year. As we look at the expense portion of the income statement, it is best to look at the sequential performance as we go from quarter-to-quarter as presented on Slide 14. Certain costs we attempt to flex with volume such as cost of goods sold while others are more of the long-term investment like sales and R&D. Our non-GAAP gross profit for the quarter was $57.5 million, resulting in adjusted gross margin of 51.4%, down sequentially from 51.5% in the third quarter of 2019 as we managed our cost of goods sold to correspond with the revenue. Adjusted operating expenses totaled $36 million or 32.2% of total revenue for the fourth quarter of 2019. This compares to $35.1 million or 29.9% of revenue in the third quarter. Adjusted sales and marketing expense was $16.8 million or 15% of revenue in the quarter. The expense was flat with the third quarter, but increased as a percent of revenue due to the lower revenue base. Adjusted R&D expense was consistent with third quarter at $7.8 million. We continue to invest in research and development at this level to expand our capabilities in all services and improve our customer experience and internal systems in order to support the future growth of the business. Adjusted general and administrative expense was 10.2% of revenue in the fourth quarter,…

Thanks, John. As we enter 2020, the long-term future for Proto Labs is more exciting than ever. Our ability to fulfill our customers' prototyping and low-volume manufacturing needs through our unique e-commerce and digital manufacturing solution puts us at the forefront of the Manufacturing 4.0 revolution. However, our customers have been telling us they want more. They want more in terms of services and capabilities, and they want more in terms of the e-commerce experience we offer. Proto Labs was founded 20 years ago, with the mission of providing custom injection-molded parts to entrepreneurs who found it difficult to obtain prototypes to advance their inventions. As we have progressively added more services and capabilities, our customer base has evolved and broadened, in addition to servicing individual product developers making individual products, we now also serve companies that are working on projects consisting of multiple parts in different services. In order to continue to provide an excellent experience for the broad used cases of our customers, we need to evolve the way we engage and serve our customers. With our digital Ecommerce model, our customer interface and supporting system are essential to the customer experience. As we look forward to the new decade and beyond we have realized that we need to evolve our systems to capitalize on the market opportunity and properly serve the long term needs of our customers. With that, I am going to turn the call over to Rich Baker, Chief Technology Officer to speak about an exciting development for Proto Labs that will impact 2020 and beyond. Rich?

Thank you, Vicki and good morning to everyone on the call. I am here to discuss the project, which is a step change in our digital thread, we call, Proto Labs 2. As Vicki mentioned, Proto Labs 2.0 is a project that we've undertaken to enhance and evolve our systems and processes to support our customers and our strategy for the next decade and beyond. We've been -- having been responsible for re-architecting systems in the past. I've seen that the right systems and architecture are critical to customer experience, sales effectiveness and financial success. Proto Labs 2.0 off the digital manufacturing model that is at the core of the company and update the customer interface and supporting systems that will allow us to expand our offerings efficiently. I joined Proto Labs in 2016 because I saw so much potential to expand the business to better serve customers. I've been a Proto Labs customer since 2007. I was well aware of the capabilities as well as the limitations of Proto Labs' offerings. After I joined Proto Labs, I did an assessment of the state of our systems. I was struck by the amount of energy and resources required to make even relatively small changes to our offering. I pretty quickly came to realize that the systems, largely homegrown, had evolved over the past 20 years, mostly tied to a narrow concept of Proto Labs' initial manufacturing process. The system was incrementally refactored and expanded that functionality as the company's capabilities evolve. But this created technical debt. Continuing down this path would have been painfully slower, maybe even impossible. We needed a different approach so our systems could support and evolve -- evolving customer needs in a scalable fashion. So now let me share some of the exciting details of this…

Thanks, Rich. I am very excited to share with you some of the benefits of Proto Labs 2.0. As outlined on Slide 22 of our earnings presentation. As Rich described, this project was initiated by our desire to better serve our customers and was expanded when I presented the opportunities to better serve our employees. We are building out a customer-facing and back-end systems to support our strategy now and into the future. The long-term benefits of this important project include tremendous improvements in the customer experience, our internal productivity, the speed and scalability of the business and expanded internal business insights. The first benefit Proto Labs 2.0 will offer is a much improved customer experience. Proto Labs' go-to-market strategy continues to evolve to be more customer-focused, and this project is an example of that. The new e-commerce platform will be more intuitive than the legacy platform with fewer clicks required to place an order and an overall better buying experience. We're also adding enhancements, which will make Proto Labs more valuable to our customers when managing and executing their projects to take their ideas from concept to production. These improvements are examples of how we're listening to our customers and evolving our business to support their needs. The rewards of these improvements will be higher customer satisfaction and improved customer retention. Proto Labs 2.0 will also enable improved internal efficiencies over time. In addition to improving the customer experience Proto Labs' 2.0 will equip our employees to more efficiently do their jobs. One area in which we see these improvement is in our sales and customer support functions with the reduction in manual work associated with service expansion. Additionally the system's enhancements will allow us to eliminate some of the manual process we've had in place on recent couple…

Thank you, Vicki. Our guidance for the first quarter of 2020 is summarized on Slide 24. We currently expect first quarter revenue to be in the range of $111 million to $117 million. This revenue guidance reflects the current global economy, specifically the muted manufacturing and industrial production data. We've also estimated the foreign currency will not have a significant increase on our first quarter revenues compared to the prior year. Moving to earnings guidance, our compensation expense will increase sequentially driven by a recurring incentive compensation closer to target as we begin the new year. The seasonality of payroll taxes in the first quarter and the partial quarter of our annual merit increase. The impact of these items is currently estimated at $0.08 to $0.10 per share. Our non-GAAP add backs for the quarter will include stock compensation cost of approximately $3.5 million and amortization of approximately $750,000. We currently estimate our non-GAAP tax rate to be approximately 21% to 22% in the first quarter. Taking into consideration of all of the above, we expect our quarterly non-GAAP EPS to be between $0.50 and $0.58 per share in the first quarter. In addition to the first quarter guidance, we also want to provide some guidance on the financial impacts of Proto Labs 2.0 as we prepare to launch in the second half of the year. We estimate that the project will result in increased expenses of approximately $10 million during the course of 2020. These expenses consist of costs we will incur related to system preparedness such as training and change management activities, including overtime, travel and contractor support. They also include consultant support leading up to the system launch for a period of time after we go live. These costs will largely be capitalized until we go live and expense during the support period. We will have a software asset on our balance sheet that we estimate will be approximately $40 million that we will begin amortizing when the system is placed in service. The recurring quarterly amortization is estimated at $1.3 million to $1.5 million. Earlier in the call, Vicki discussed the benefits associated with this project. These benefits are longer-term in nature with the amount realized in 2020 expected to be minimal due to the second half timing of the system launch. We are managing the business for the long term. We have embarked on the Proto Labs' 2.0 project to provide the foundation that will allow us to serve our customers more holistically and capitalize on the current and expanding market opportunities. Proto Labs' 2.0 will impact our financial performance in 2020. However, the project is necessary for us to realize our full potential as a business. That concludes our formal remarks. Now we'd be happy to take your questions. Rob, can you please open up line question-and-answer session.

[Operator instructions] Our first question is from the line of Brian Drab with William Blair.

So John, first question, just related to one of your last comments there. You said that in your Proto Labs' 2.0 would affect financial performance in 2020. You gave the $10 million in expense, but how does this affect financial performance, more broadly, gross margin? I mean, is it going to take some of the focus off of revenue growth and just can you talk a little bit how it affects financial performance more broadly?

Yes. So I think I've quantified the direct impact of the project. And that will be spread out kind of throughout the year as we approach the go-live date. It is a significant project for the company. And with that, we've got resources on it, and I've had resources on it in 2019 as well. So it does have an impact to the business. We are continuing to manage around it. We still are delivering deliver parts and serving the customers and making sure we keep our focus there.

I'll add a little color to that, Brian. This is a transformational project for the company that's going to set us up for the next decade. And it's one that we have prioritized because we know that it is necessary for us to be able to continue to service our customers the way they want to be serviced and also be able to expand our service offering for the growth that our investors expect from this company. So we prioritized that over, frankly, other priorities in 2019. And we'll be doing the same in 2020. Now that's not to say that we've -- we have continued to add service expansions as your -- as we've outlined, but the ability to fully realize the benefits of those service offerings have been impacted by the fact that our systems have not allowed us to create the kind of seamless customer experience that our customers expect from Proto Labs. So this new system will allow us to do that, allow us to capitalize more on the market opportunity that our service offerings have created. And then on the margin side, as we've added these things, we've had to put manual processes place to supplement some of the deficiencies in the system. With Proto Labs' 2.0, we'll be able to automate a lot of those manual processes, both in sales and customer service as well as some that are in the fulfillment, back end side, that's going to give us the productivity improvements to begin to really drive some of that margin. So yes, we've prioritized this and for a very, very good reasons to set us up for the next decade.

All right. And can you just say again what the timing is? Or when does this project get completed and it's fully implemented?

Yes. So we're expected to still live in the second half. And as we proceed throughout the year and meet milestones, we'll be able to be more clear, and you'll hear more about that.

Okay. But this isn't something that you would expect to -- the work on this project to be continuing into 2021, 2022, this is something you're going to get done this year?

The go-live will be this year. Now there's always work once we go live. So for example, the rapid manufacturing acquisition is not in scope on go-live that will come after we've talked about the fact that this system will allow us to integrating acquisitions much more efficiently. So it made sense to get this in place before we put -- we did that integration. In addition, we've been working on some of the software enhancements and quoting and handle in the sheet metal business that will be able to be rolled into that when we bring that business into the fold after the go-live.

Okay. And then just one follow-up related to that. One of the benefits as you're saying here is going to be easier integration of acquisitions. Obviously, it's been some challenges with the last two acquisitions. Can you just tell us a little bit about what types of acquisitions you'd be looking at this point? And also, as you answer that, I'm just thinking about what services you can add at this point, given you're operating off a much bigger base now. And I'd imagine any new service that you would go out and look to acquire would just be, by definition, would have a lower -- smaller addressable market than things that than the ones that you've added in the past?

So I'll take that, Brian. So I think right now, our focus is on getting this project done. We are continuing to look at our strategy, and ultimately, how we serve our customers better over the long-term in helping them get their products to market. There's a lot of things that could go into that. As we look at those strategies, we'll continue to evolve that. But right now, I wouldn't expect acquisitions to be our primary focus. The primary focus is going to be on getting this project up.

Next question is from the line of Andrew DeGasperi with Berenberg.

Yes. Can you hear me?

Yes.

I just wanted to quickly ask one on the follow-up on Proto Labs 2.0. Will that help you potentially accelerate your on-demand business longer term? And then secondly, I'm not sure if someone addressed this already, I was on another call. Are you seeing any impact in terms of demand from the coronavirus outbreak, even though you're not in China?

Yes. Okay. I'll take a stab at that, Rich, you might want to add some additions as we talk about the production business. Clearly, one of the things we're addressing in the Proto Labs 2.0 e-commerce experience is the fact that we service more than just a product developer. We service a number of personas, particularly as you launch into the production business. So we serve supply chain managers in procurement and the new -- and, by the way, we need to serve up our production offer in a way that's understood by those buyers. So we knew that coming in. And we've designed those kinds of enhancements in the new e-commerce experience to make it easier for our customers to understand the offer to buy the offer and to take advantage of it. Rich, I don't know if you want to add anything to that on on-demand manufacturing or production?

Thanks, Vicki. A couple of things. One, there are a lot of requirements for production that are not directly related to the part that we produce. So the quality of part we produce is quite good. But once you go into production, there are a lot of things related to quality and certifications that need to be managed. And if you can't demonstrate that you've kept your process under control, and you have all the documentation to back that up, that represents risk for someone in their supply chain. And so we need to be able to show all of those other things that supply chain type people need, and we need to also be able to deliver those on our back-end in a digitally enabled way. And so that's what we're building out here. And so that should help us across all services, adding production capabilities.

Yes. Good. And then I'll just address coronavirus. So let me just answer that by saying, as you know, one of the advantages that the Proto Labs' rapid turn model provides our customers is an ability to respond to supply chain disruptions. So that's clearly a value proposition that we deliver customers. That being said, as of this date, we have not seen a major impact because as a result of the Corona virus. We -- but we do want to make sure that our customers understand that this is something we can do to help them, should they have a supply chain disruption that presents challenges because our injection mold tooling, our injection mold parts, CNC parts, are all made in country. And we can respond pretty rapidly.

Our next question is from the line of Greg Palm with Craig-Hallum.

So thanks for all the details on Proto Labs 2.0. So I mean, I think, you've given us enough where the why behind this makes sense. It's not entirely clear of the why now. So was there a specific trigger that really influenced the timing of this announcement? Or maybe a little bit more color on the why now would be helpful?

Why the announcement? The why, we've been working on this for a while. We recognized, really back in 2017, we needed to evolve our e-commerce experience. And so this has been a project we're we've been working on for some time. The why now is -- we've really bought -- we're going to be going live this year. We really wanted you to be aware of how this event will impact our 2020 financial performance. But also, we're so excited to talk about how it's going to set us up for the next decade as well. So it's -- why now as we're pretty firm on where the time line is for go-live, and it's going to impact our performance. John, I don't know if you want to add anything to that?

No. I think that's -- that covers it.

Well, yes, sorry, I guess [indiscernible], not necessarily just the announcement, I'm just more curious, it sounds like you've been making some investments in -- over the past few quarters, but you're certainly accelerating things here with a pretty big investment spend. So the question is why now in terms of really accelerating those investments? Or was this sort of the plan all along?

Yes. I think, as Vicki mentioned, we're looking at the system. And as we were trying to make changes, and Rich addressed this on the call as well, as we are trying to make changes, it was just cumbersome and not efficient. And we weren't building on a stable foundation. So I think maybe, Rich, I'll turn it over to you and let you add some further color.

So everyone on this call is either an investor or thinking about being an investor, and so we all appreciate what a good business it is. So how do we get more of that business? This is a thing that will help us get more of that core business that has nice margins, and then we can expand and that customers are asking for. So sooner would have been better, but it's only so fast you can produce and test and validate these types of business systems. And so now we're at a point where we have some confidence and we have dates and we can estimate what the impact is on the full year. And so it's time to talk about it. And we've been going, I would say, about as fast as is prudent. As I mentioned, we've done a lot of things to accelerate that with staff augmentation with other people we brought in. So we've gone about as fast as possible. It would have been even better to have it done 2 years ago or 5 years ago, but I can't -- I don't have a time machine.

The other thing I'll just add is this transformation that we're going to is not atypical of startup e-commerce digital businesses. You often start a business, and we started back in 1999, and it was basically a homegrown architecture and software base. Now there's been -- technologies evolved over the last 20 years. And there's modern technology, state-of-the-art technology that we can deploy that's really going to speed up our ability to respond and build this robust e-commerce experience that customers, they definitely expected in a B2C world, and more and more, we're going to be leading that in a B2B world. And we are really excited to be able to be in a position to do that.

Okay. Makes sense. And John, to be clear, I mean, in terms of financial performance implications, are we expecting any top line hit from this? Or is it really too early to make that estimate?

Yes. I think it's tough to assess that right now. And we provide our quarterly guidance. I think as we go through the year and assess how the markets performing. We'll keep you updated on what that guidance will be. But as of right now, we're looking at it as a benefit for customers. I think they will like the changes in the experience, but we'll continue to assess that.

Okay. And so the Q1 '20 guidance for revenue, there's no inherent impact, either positive or negative?

No. That's correct. No, it won't impact Q1 at all.

No, no. Q1 forecast is based upon our best available information at this point in time, based on where we are in the quarter. And as you know, we're an on-demand manufacturer with only a 6- to 7-day backlog. So we look at the projections in industrial activity. In the regions in which we operate in a number of other indicators to come up with what we believe is the best quarterly revenue forecast based on where we sit today.

Okay. And just last one as a follow-up on that. I mean, any change in sort of the broader macro or at least order environment relative to kind of what you saw in Q4?

Yes. The only thing I'll say is, as you -- we typically, in our seasonality, January starts pretty soft. And this week, where the holidays fell, the first week of January was incredibly soft. So we haven't really, in total, seen a bib pick up from where we were in the fourth quarter. John, I don't know if you have anything to add on?

I think the only thing I'd add is that's not atypical from any other year. January always starts a little slow for us and it ramps as we go through the quarter. They're difficult. Part for us is what's the slope of that ramp through the quarter? We don't have great visibility to March. So yes, we've given you the best information we have right now.

Our next question is from the line of Jim Ricchiuti with Needham & Company.

So it sounds like you're being purposely big on when this goes live, I think I can understand why. Would you anticipate some benefit from this 2.0 in Q4? Or is this the benefit that you're anticipating is really looking out to 2021?

Yes. I think -- again, I think as we view it, we think it will be a positive change for our customers. But it will be a change, right? And in general, people don't always like change at the beginning. They do over the long term. I think for modeling purposes, as we're looking at it. And as I said in our prepared remarks, I'm not anticipating a big benefit in 2020. I think the benefits will come in 2021 and beyond.

And is this going to be phased in. I think if I heard you correctly earlier, the rapid piece of this will be implemented in 2021. Do you anticipate having this phase in for the 3D printing portion of the business? Or is this really focused mainly on the core legacy business?

Yes. 3D printing is in store for the like. So that will be -- we'll see the benefits of that in our integrated system with customers right from the beginning. It's just the sheet metal and expanded C&C [ph] offering from the rapid manufacturing which will be integrated first.

Okay. And John I heard you earlier I thought I heard you say that the expense associated with this which I guess you call that in 2020 is $10 million spread out over the course of the year. Can you give us some sense some as to some of that expense that is being incurred as it relates to your guidance for Q1?

Yeah there is a little bit of expense in Q1, it actually starts to pick up more in Q2 as we're doing testing and training and getting ready for go live in the back half and then during the period right after go live you’ve got a support period and the amortization. So I think we'll be able to provide more color as we go through the year and move visibility as we get into the guidance for Q2.

And is this being implemented outside of the US and Europe.

Yeah, so it will be implemented in Europe and in North America. Japan will in the second phase, so would just be Europe and North America.

And the timeline for Europe is the same as North America?

We'll provide those details as we go further and progress towards our go live date.

Thank you. At this time we'll turn for closing remarks.

Great. Thank you for joining us today. We are confident in the long-term prospects and the strength of our business model. Our differentiated technology enabled digital manufacturing platform has demonstrated the ability to help companies and entrepreneurs get their products to markets faster than their competition. With Proto Labs 2.0, we continue to innovate with our technology interface and service offerings to enhance our customer's experience. I want to thank the Proto Labs' employees for their continued efforts as well as our customers for their support. We look forward to updating you on our progress during our next call. Thank you.

Thank you. This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.