Proto Labs, Inc. (PRLB) Q3 2021 Earnings Report, Transcript and Summary

Greetings and welcome to the Protolabs Third Quarter 2021 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Dan Schumacher, Vice President of Investor Relations. Thank you, Dan. You may begin.

Thank you, Paul and good morning everyone. With me today are Rob Bodor, Protolabs’ President and Chief Executive Officer and John Way, our Chief Financial Officer. This morning, Protolabs issued a press release announcing its financial results for the third quarter ended September 30, 2021. The release is available on the company’s website. 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 maybe 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 at the Investor Relations section of the company website for a complete reconciliation of non-GAAP to GAAP results. Now, I would like to turn the call over to Rob Bodor. Rob?

Thanks, Dan and good morning everyone. Thank you for joining us today for our third quarter 2021 earnings conference call. We are currently operating in an unprecedented environment. The effects of the COVID pandemic are resulting in labor, material and equipment shortages worldwide. Furthermore, in Europe, we are managing changes in trade norms due to Brexit. These factors are impacting our financial results. Although our third quarter revenue was within our guidance range, earnings were below our expectations. Well-documented labor and material shortages are driving inflationary pressures in our business, resulting in lower than expected gross margin performance. We are disappointed with our third quarter earnings performance and I will outline the actions we are taking to address these headwinds. But first, I will summarize our third quarter revenue performance. In the presence of these challenges I mentioned, we generated record quarterly revenue of $125 million, representing year-over-year growth of 17%. Hubs contributed $9 million of revenue in the third quarter, representing strong year-over-year growth of 35%. Hubs third quarter revenue was relatively flat sequentially, primarily due to challenges in the European market and a short-term decrease in organic online search performance. In May, we transitioned the 3D Hubs brand to Simply Hubs to more accurately reflect the broader nature of services provided beyond 3D Printing. This brand change caused a temporary decline in customer acquisition and impacted our third quarter revenue. Although this branding shift impacted our near-term results, we believe it is the right move for the long-term success of the business. Continuing with our third quarter revenue performance by geography, outlined on Slide 8, our largest region, the Americas, generated revenue of $100 million in the quarter, representing growth of 17% year-over-year or 11% organic growth. This represents all time record revenue for our legacy business in the Americas. This strong growth demonstrates the continued customer evolution of digital manufacturing and the large opportunity that is ahead of us. In Europe, third quarter revenue of $22 million represents growth of 17% year-over-year. Excluding Hubs Europe revenue and the impact of foreign currencies, our Europe revenue declined 7% year-over-year, reflecting continued supply chain constraints, which are negatively impacting the European manufacturing environment. Lastly, our Japan region generated $3 million of revenue in the third quarter. As we move to earnings, we reported third quarter non-GAAP diluted earnings per share of $0.35. Earnings came in below our expectations, driven by lower than expected gross margins. The labor shortage resulted in greater than anticipated wage inflation, increased over time and increased recruiting costs for our manufacturing workforce. In addition, we continue to manage through internal inefficiencies resulting from the launch of our Protolabs 2.0 systems. The labor shortages and supply chain issues impacting our financial performance are likely to persist through the remainder of the year and into 2022. To address our near-term challenges, we are taking several measures, including: thoughtful pricing changes to offset labor cost inflation, investing R&D resources to increase internal operating efficiency in the Protolabs 2.0 environment, and investing in robotics automation to reduce the need for additional labor to support growth. These near-term actions may not all have immediate impact on our financial results and the benefits maybe muted in the fourth quarter due to lower seasonal revenues, continued macro weakness in Europe and additional costs incurred during the holiday season. While it may take some time to achieve the financial benefits, we are confident these are the right actions to improve the financial performance. In addition to improving our results in the short-term, we also remain focused on long-term growth and capturing the opportunity that is in front of us. The contract manufacturing market is very large and it is evolving and becoming ever more digital and customers are seeking alternatives to address the supply chain challenges they are facing. We created the e-commerce model for custom manufacturing over 20 years ago and we are still the only company to digitally manufacture parts across a range of services, both additive and traditional. Through our in-house digital manufacturing process, we have eliminated much of the upfront costs and labor through the automation of non-recurring engineering. Unlike others that have applied a digital face to traditional operations, Proto Labs is the only company to have transformed the actual manufacturing processes, enabling us to be the fastest and most reliable custom parts manufacturer. Protolabs is the world’s leading provider of digital manufacturing services, having manufactured approximately 400 million parts since our founding in 1999, making us the largest player in the space by far. Furthermore, we have served hundreds of thousands of customers, ranging from entrepreneurs to startups to midsized firms and over 85% of the Fortune 500 companies in our target industries. As recognition of our best-in-class digital manufacturing capabilities and industry leadership, the World Economic Forum announced our introduction into the World Economic Forum’s Global White House Network, recognizing our industry leading efforts to implement Fourth Industrial Revolution technologies. Protolabs joins this exclusive network as one of only 10 Lighthouse manufacturing facilities in the United States and we share the honor with Fortune 500 companies like Johnson & Johnson, Procter & Gamble, Unilever, Western Digital and Schneider Electric. Our U.S. injection molding facility was inducted into the World Economic Forum’s network because of our transformation from a prototype provider to a full production provider through technologies connecting our e-commerce experience to the manufacturing shop floor. As a technology driven manufacturer, we provide injection molding production lead times and as fast as 1 day instead of the traditional 2 or 3 months. This recognition is a reflection of the innovation and capabilities throughout the entire digital thread that is intrinsic to our model. While our award winning internal manufacturing capabilities offer unprecedented speed, we acquired Hubs in January to broaden our offerings and serve more customer used cases. Hubs’ premium network of manufacturing partners will allow us to broaden our pricing and lead time options as well as offer capabilities outside of our legacy part envelope, including larger parts, tighter tolerances, increased finishing options and much more. The combination of Protolabs’ internal manufacturing capabilities and Hubs network of premium manufacturing partners is the superior model together providing the broadest set of manufacturing capabilities and lead times in the world. Looking forward, we will continue to make investments in the business focused on capturing the long-term opportunity guided by our three priorities. As a reminder, those priorities are: first, to create a world class customer experience for digital manufacturing; second, to expand our portfolio of customer offerings to meet the broadest set of customer needs; and third, to further invest in our employees. We have made significant progress on all three priorities for the first 9 months of this year, while continuing to set quarterly revenue records. As it relates to our goal of providing world class customer experience, we launched Protolabs 2.0 to deliver a new e-commerce experience in the Americas in the first quarter. Customer response to the new platform continues to be positive. And recently, our revamped digital coding platform was honored with the first place finish in the software category of Design World’s 2021 Leadership in Engineering Achievement Program awards. This is a testament to the fantastic development work our teams have done over the past few years, designing a best-in-class digital coding and ordering user experience. However, as I referenced earlier Protolabs 2.0 has impacted our internal operational efficiency. We are focusing our software teams on addressing our internal systems to improve their performance. Next, our customer offering has greatly expanded in 2021 through acquisition and organic innovation. Hubs manufacturing partner network allows us to serve more customer needs. And organically, we launched a flexible lead time offering in our internal CNC machining service as well as an enhanced quality offering for injection molding production offers. These new offerings contributed to record revenue in the third quarter and we will continue to invest in future offering expansions. Finally, Protolabs employees drive our success and we continue to invest in our employees in several ways. We invest in training and development – and developing employees to fuel innovation and challenge employees to continually enhance their skills. In 2021, we materially expanded our training content and resources, with a focus on remote learning to support our flexible workforce. Our diversity, equity and inclusion leadership council partners with our leadership team to help us leverage the diversity of our workforce in a meaningful way and create a culture of inclusion for all employees. Now, John will provide an in-depth look at our third quarter financial performance and our outlook for the fourth quarter. John?

Thanks, Rob. Our detailed third quarter financial results begin on Page 11 of our presentation. As Rob stated, there are few factors impacting our current financial performance. I will spend some time providing additional detail on these factors. Starting with revenue, our third quarter revenue of $125.3 million was at the low end of our guidance range and represents a 16.6% year-over-year increase or 8.1% organic growth in constant currencies. Hubs generated $8.8 million of revenue in the third quarter, representing growth to 35% year-over-year. Changes in foreign currency had a $400,000 favorable revenue impact in the quarter. As Rob mentioned earlier, our revenue in Europe was lighter than we anticipated driven by supply chain interruptions and impacting the economic environment. We served 23,450 unique product developers in the third quarter, up 24.8% year-over-year. This growth was driven by the acquisition of Hubs and growth in our legacy business. The growth in developers outpaced revenue growth due to business mix with strong growth in our CMC services. Turning to our detailed income statement, our non-GAAP gross margin in the quarter of 44.9% compares to 46.8% in the second quarter of 2021 and was below our guidance range. Our personnel costs are the primary driver of our lower gross margins. The labor shortages in the markets where our manufacturing operations are located are driving inflationary costs in the form of higher wages, increased recruiting costs and increased over time. In addition, we are incurring some additional labor due to inefficiencies as our employees continue to adapt to operating in our new systems. Higher medical cost is also a contributing factor as our employees are obtaining care that was deferred during COVID. The higher personnel costs, combined with lower revenues than expected in Europe, resulted in gross margins below our expectations. Hubs gross margin in the third quarter improved sequentially to 17.2%, up from 12.9% in the second quarter. For the quarter, Hubs represented a 200 basis point headwind to our overall gross margin due to the lower margin nature of the outsourced manufacturing model. Under GAAP accounting, our cost of goods sold for Hubs includes payments to our manufacturing partners, logistic costs and operations and support costs associated with serving our manufacturing partners. In the long-term, we will continue to drive gross margin improvements in Hubs through the expansion of our manufacturing partner network and improvements to the pricing algorithms. However, in the near-term, we are encountering headwinds related to logistics, labor and material cost inflation. Our total non-GAAP operating expenses were $43.6 million compared to $42.8 million in the second quarter of 2021 and slightly below our guidance range of $44 million to $46 million. Third quarter 2021 non-GAAP operating expenses increased from $33.3 million in the third quarter of 2020. The Hubs acquisition added $3.8 million of operating expense in the quarter. Other year-over-year increases include Protolabs 2.0 amortization and license costs of $1.9 million, investment in R&D of $1.7 million, and investment in sales and marketing of $2 million. Consistent with the prior quarter, our GAAP operating expenses include the impact of a revaluation of contingent consideration associated with the Hubs acquisition. GAAP accounting requires that we revalued the contingent consideration on a quarterly basis until the contingent consideration period concludes. The third quarter adjustment was primarily driven by fluctuations in our stock price as a portion of the contingent consideration is payable in equity. We have reversed the impact of the revaluation in our non-GAAP reporting. Moving to taxes, our non-GAAP effective tax rate in the third quarter was 25.3% compared to 26.7% in the prior quarter and up from 22% in the third quarter of 2020. The year-over-year tax rate increase is primarily due to the mix of earnings in our tax jurisdictions, resulting in fully reserved net operating losses. The net result was non-GAAP diluted earnings per share in the quarter of $0.35, representing a $0.32 per share decrease from the prior year and a sequential decrease of $0.04 per share. The year-over-year change in non-GAAP earnings per share is presented on Slide 13 and consisted of the following components. First, the net impact of our revenue growth and the increased labor costs in our legacy business resulted in lower gross margin, contributing a $0.06 reduction in our earnings per share. The lower than anticipated gross margin was the primary driver of earnings below our expectations. As we continue year-over-year, increased sales and marketing and general and administrative expenses, primarily driven by personnel related costs, including wage inflation, incentive compensation and medical costs had a $0.05 per share impact. As Rob stated, we are investing in the business to better serve our customers, which will drive long-term growth and shareholder value. These investments were part of our business plan and had a $0.20 per share negative impact on our financial results this quarter compared to the third quarter of 2020. The investments include the following: first, we acquired Hubs to fulfill a broader range of our customers’ needs. We are continuing to invest in the business to operate at scale and are currently incurring operating losses during this stage. The operating result related to this investment represents a $0.09 per share impact to our earnings, including the impact of the equity issued in conjunction with the transaction. Next, we have discussed the investment in our systems in prior calls. This investment was required to modernize our architecture and support the long-term growth of our business. The depreciation and license cost associated with Protolabs 2.0 represented a $0.05 per share impact year-over-year. We also continue to invest in R&D to improve our systems and expand our product offering to serve our customers. Protolabs 2.0 has been well received by our customers. However, the system requires improvements to support the efficiency of our internal operations. We are also investing in R&D to expand our capabilities in each of our services. Our increased investment in R&D resulted in a $0.06 per share decrease. And finally, the increase in the effective tax rate had a $0.02 per share unfavorable impact on the quarter. Transitioning now to the cash flow statement and balance sheet summarized on Slide 15. We generated $11.5 million in cash from operations in the third quarter. Our operating cash flow continues to be impacted by the timing of cash receipts and payments, resulting in an increase in our working capital, including an increase in our accounts receivable balance. We also repurchased $11.8 million under our stock repurchase program in the quarter. On September 30, our cash and investment balance was $83.9 million and our balance sheet remains debt free. Turning now to our outlook for the fourth quarter of 2021 outlined on Slide 17, we expect to generate revenue between $112 million and $122 million in the fourth quarter representing year-over-year growth of 7% to 16%. Our fourth quarter revenue assumption includes the seasonality we generally experienced in our business in the fourth quarter and anticipates continued softness in the European economic conditions. We expect foreign currency to have an approximately $500,000 favorable impact on revenue compared to the prior year assuming foreign currency rates remain at current levels. Turning to gross margin, we expect fourth quarter non-GAAP gross margin of approximately 45% plus or minus 100 basis points. Our gross margin projection remains in line with the third quarter results as we anticipate continued wage and raw material cost inflation, which are working to mitigate through pricing and other operating efficiencies. The benefits of these actions will be offset by incremental costs we will incur in the fourth quarter as a result of holiday pay. Business mix will also continue to be variable in our gross margin performance due to the addition of Hubs as the outsourced manufacturing model gross margin is lower than our internal manufacturing operations. We expect total non-GAAP selling, general and administrative expenses to be between $43 million and $44 million in the fourth quarter consistent with recent quarters. We estimate our fourth quarter non-GAAP effective tax rate to be approximately 11% compared to 25.3% in the third quarter. The lower tax rate is the result of the anticipated release of uncertain tax position reserves, for which the statute of limitations has expired. Now, I would like to turn the call back to Rob for closing remarks.

Thank you, John. In summary, our financial performance is currently below our expectations. We are actively working to drive near-term financial improvement, while we continue to invest and innovate to maintain our leadership position and capitalize on the long-term opportunity. I am confident that Protolabs has the best employees in the industry, the most recognizable brand and the best long-term strategy to expand our customer offerings and drive strong profitable growth. The two awards that we received in the quarter from the World Economic Forum and Design World recognized our leadership in digital manufacturing. Our speed, scale and manufacturing experience put us in an optimal position to lead the digital manufacturing evolution. That concludes our prepared remarks. Now, John and I will gladly take your questions. Operator, can you please open the line?

Thank you. [Operator Instructions] Thank you. Our first question is from Brian Drab with William Blair. Please proceed with your question.

Hi, good morning. Thanks for taking my questions.

Good morning, Brian.

Good morning. I don’t know if you mentioned I might have just missed the – missed this, but the 3D Printing expansion that you announced about a week ago or a few days ago. Can you talk about what you are seeing in the 3D Printing industry that’s giving you the – that’s making you want to invest in expanding that, what’s the cost can be with the timing and how big is it? I think your facility in North Carolina right now is about 80,000 square feet and you are adding 120,000. So, that seems like a pretty big expansion. I was wondering if you can just comment on that? Thanks.

Yes. And we are really in the initial stages of that and haven’t even broke ground on the facility. So we have contracted essentially that to have that facility built. And in the 3D Printing market, it’s been growing nicely since the acquisition really back in 2014 and we continue to see a lot of opportunities in the 3D Printing space. And with that demand and as it transitions from just prototyping into more production opportunities, we see tremendous opportunity. So, we are investing in order to realize that. It will take a year or so in order to construct that facility and will be online sometime in 2023. With production, we expect greater news for space.

Right. And the revenue capacity at the existing facility, I guess – I mean I guess, you are approaching that, I mean you are going to do about $75 million in 3D Printing revenue this year, is that running pretty close to full capacity?

We are projecting it will be by the time that the facility is completed and we have to wait, so yes.

Right. And then just wondering if you could just comment on you mentioned, there is an increasing selling and marketing expense, and just in the context of this whole industry becoming more competitive, right. So, a lot of companies spending a lot of money on Google AdWords and what – can you comment on what you are seeing there and how competitive that is? How much of a challenge it is kind of to keep pace with all of these. I mean, it’s kind of surprising. 8 years ago, I wouldn’t have plugged in rapid in injection molding into Google and had anything except Protolabs come back now. You people, I think find your AdWords etcetera. Can you just talk about how big a headwind or challenge that is?

Yes, I can start. Maybe John can pick up. So, I think as we think about competition, right, you got to remember, we got our four services. And it’s not equal across those services, right. First of all, across all our services, in our fastest lead time category, we are absolutely the winners, right. We are the fastest manufacturers in the world. And across all our categories, we can make parts in as little as one day. I think that’s a very well protected space for us. And we really don’t run into much competition in injection molding and sheet metal. Where, like Hubs, what we are seeing others in the longer lead times is in CNC and to a lesser extent 3D Printing right now.

Yes. It is impacting our sales and marketing and cost of acquisition. I think we continue to deploy innovative solutions and other methods in order to attract new customers. But certainly the cost of search has increased over the years that searches got more active.

Okay. And then – but my last question if I could is just around pricing trends in the raw materials. How are you managing through this? And how big a deal is this? John, you and I discussed some, but a, you have the competitive environment resulting in the need to experiment with pricing a little bit more particularly in CNC. And then b, you have these raw materials that are spiking. And then just as I guess the – I am thinking about also how in new parts business and the injection molding, you have some, I think fixed pricing that you promised the people if they come back for parts of existing molds, like how does that all – how do you manage through that in this environment? I don’t know that you have seen this kind of confluence of negative events or challenges in the past?

I think you have hit it right on the head, right, like there are a lot of variables we are playing with. And different materials have different levels of price inflation as well that adds another factor there. I think as we are looking at it and looking at our cost structure, try to break it down to what are probably more permanent or long-term type increases in cost and those we will look to recover with pricing and what are the ones that are more temporary. And how do we absorb or manage those out of the business related to it and flex related to that. But it is – it’s a delicate balance and as much art as it is science I would say.

Brian, you brought up material cost headwinds, which I think are real. But in addition, as we described, in the quarter, we saw labor and wage increase headwinds as well. So, I think on both of those, for those that are longer term, we will be taking pricing actions in order to offset those. And we didn’t take enough in this past quarter, we underestimated that change. And we will be taking more.

Got it. Okay. Thank you.

Thank you. Our next question comes from Greg Paul with Craig-Hallum Capital. Please proceed with your question.

Yes. Thanks. This is Danny Eggerichs on for Greg today. Thanks for taking the question.

Good morning.

I was hoping to dig in a little bit more on the on the 2.0 inefficiencies and maybe go into a little bit more on that. Is that something, is that a problem with specific to the platform, or is it simply just integration and adaptation by the employees? And would that be like a sales level or manufacturing level, just hoping to dig in a little bit more there?

Absolutely. So, we launched 2.0, earlier in the year. And we expected that there would be things that we have to work through with large systems, a launch like that, both for customers to adapt to using the new system and for our employees to adapt to using the new system. And that’s what we saw. And we worked through that. And with customers that worked very well. And they are very happy with it now. With employees, we made headwind, but we are seeing some of those inefficiencies persist. And so that’s a real focus for us now, as you know we have changed some of the workflows for our employees. And in some cases, those workflows are less automated than they were in 1.0. So, we are addressing that head on. We have got – we are working with the business leaders in those areas and the subject matter experts, we have identified the areas and the workflows that where those inefficiencies remain. And we are targeting our software teams specifically to address those to drive those improvements.

Got it? And is it safe to say that Hubs is still operating separately from the core business?

Yes. So it is…

I think that gets – they gets pushed down the line a little bit as you are working to improve the 2.0?

Yes, that’s exactly right. So, you recall the timing. We did the acquisition of Hubs and launched 2.0 within a few months of each other, right. We launched 2.0 first in Europe in November and then in the U.S., in February. We did the Hubs acquisition in January. So, at the time, right, we indicated that our intent was to operate Hubs as a standalone entity for a period. And that’s what we have done this year, kind of consistent with that. We want to make sure that when we integrate them, we are integrating them into – we have got 2.0 in a place where it’s efficient. And we are integrating Hubs into that, that efficient system. So, you got it right.

Got it. It makes sense. Maybe just one more looking at the current supply chain environment, do you think it’s something that could drive more business to your platform as a result of the re-shoring, the second sourcing and so on? Have you seen any indication of new customers or activity resulting from this?

Yes, we have and we have talked about our injection molding service and particularly on the parts side of the business, how we are seeing the increased demand. And so that we attribute a lot of that to exactly those affects.

Got it. Thanks. That’s all for me.

Thank you. Our next question comes from Gary [indiscernible] with Berenberg. Please proceed with your question.

Hey, good morning, guys. Thanks for taking my questions.

Good morning.

First question, you guys mentioned investing in robotics and automation. And I know you already do some of this. So, I am just – I am wondering, this new technique you are investing in, is it different? What might the timeline look like there? And then how you are thinking about how much it might cost, just any color you can provide on that?

Sure. So, to improve our gross margins, right, there is a couple of things we are doing. One is pricing, which we have already talked about. And the other is efficiencies. And the efficiencies come in two forms. One is workflow efficiency, which our software teams are helping to drive. And I just kind of described that. And the second is production, floor efficiency and automation, right. And that’s going to come from the work of our software teams and from additional robotics and other kinds of automation that we are exploring. And have started to put in place on the factory floor. And these are things that help us to scale our operations without needing to add incremental labor at the same rate that demand is scaling. So, we have gone to put those in place and we are looking at a number of different solutions there.

Okay. But this is kind of a combination of adding some to your existing facilities and then also probably investing in more for that new North Carolina expansion?

Yes. I think it’s more in the existing operations. And the increase in production in our injection molding allows us to research and look at new opportunities to use robotics and things like that in the process. So, that’s where the focus is.

Got it. Okay. Thanks. And then I was wondering, can you guys just touch a little more on the European business, it seems like this obviously impacted kind of the base business, but also had a pretty big impact on Hubs. I am just wondering if you could kind of touch on how – what the factors are here and then how big they are relative to each other, so we can kind of estimate what might happen there?

Yes. I think in general, we are just seeing macro softness in Europe over this period. And demand has generally softened. And we saw that consistently in the organic business and in Hubs.

Okay, great. And then one more for me, if I can, I know you guys, you called out kind of specifically in the press release that $84 million in cash and investments with no debt. I am just wondering if you can elaborate on the near-term plans you have for that capital? I know you did some repurchases, but kind of looking forward is going to be more of that or are anything different? What are you guys thinking next?

Yes. I don’t think it’s hard capital allocation changes. We will continue to invest to support the growth of the business and do opportunistic share repurchases.

Great. Thanks guys.

Thank you.

Thank you. There are no further questions at this time. I would like to turn the floor back over to Robert Bodor for closing comments.

Thank you for joining us on our third quarter conference call. We are not satisfied by our financial performance in the quarter and are taking actions to drive improved results. I remain very confident in our long-term strategy. And I am pleased with our record revenue this quarter in the presence of supply chain and labor shortages. We have the winning model to capture the tremendous opportunity in the market for digital contract manufacturing. To drive long-term shareholder value, we will continue to evolve a world class customer experience for digital manufacturing, expand our portfolio of offerings to serve customer needs and invest in our employees. Furthermore, I would like to thank the Protolabs employees for their continued efforts as we close out 2021. I also want to thank our shareholders for their continued support in Protolabs. We look forward to updating you on our performance next quarter. Have a great day.

This concludes today’s conference. You may disconnect your lines at this time. Thank you for your participation and have a wonderful day.