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Faro Technologies
2007 Summary

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By TMFPlatoish
February 26, 2008

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Greetings,

Phil - It is probably not much of anything new, but imyoung asked me to post it here, so here it is. Some of us still hang out in Gems.

With a strong fourth quarter push, Faro managed to beat its revenue growth target range and came in at the top of the gross margin guidance. These are the only two numbers that they project into the future. They grew revenue at 25.7% for the year compared to the 20-25% range. Gross margins were 60% for the year and the target range was 58-60%. They maintained these ranges as guidance for 2008. There were a couple of questions about whether they had considered lowering this guidance due to macro economic concerns. Freeland was adamant that he believed it was still valid judging from customer forecasts and the low degree of penetration that CAM2 has achieved to date.

While the fourth quarter is traditionally the strongest because of the "use it or lose it" mentality with corporate capital equipment budgets, this quarter really begins to show where this company is headed in terms of ability to generate good bottom line margins. I'm going to make a table comparing Q4 results and FY2007 results and then explain what I'm seeing.

[See post for table.]

We can see some fall off in North America late in the year, but the pick-up in the other geographic regions more than offsets domestic softness. The large growth in Asia that has been anticipated, but slow in materializing, finally is beginning to show up. This should be particularly encouraging to long term holders who suffered through the expenses of getting this sales team hired, trained, and seasoned. It looks like it will end up being a good investment.

When we get into the expense categories, I'm sure everyone will begin seeing some things that they like. I already mentioned that they hit 60% gross margin for the year and quarter. This is a 130 basis points improvement over last year and comes from higher volume economies of scale, as well as production efficiencies resulting from the company's continuous improvement programs. S&M expenses were 27.3% of sales in the fourth quarter. This compares to 29.2% in the prior year's quarter and 29.3% for the 2007 year. This, along with the Asia numbers, are the highlights of the report for me. This is the single biggest area that will drive bottom line profitability in a sustainable manner. Jay said they are working to drive this to a 25% run rate by the end of 2009. Expect incremental improvement in this number over upcoming quarters.

G&A expenses were 11.8% of sales for the quarter, compared to 14.2% in last year's fourth quarter and 13.3% for all of 2007. What you are seeing here is a combination of fixed cost leverage due to higher revenues, and the lack of expenses having to do with the FCPA investigation. R&D trended higher at 5.4% of sales, compared to 4.2% last year. For all of 2007, R&D was also 5.4% of sales. The increase was driven by the introduction of the new products - the Quantum Arm and the Fusion Arm. Jay indicated that the company intended to maintain R&D expenses in the 5-6% of revenue range to keep up the pace of innovation and new product introductions.

Taken all together, this produced operating margins of 13.8% for the fourth quarter compared to 8.8% last year. Improvements are apparent across the board. Net income was $0.50 per share for the quarter and $1.15 for the year, more than doubling the 2006 number. Cash is up to $103.2M from $31.5M a year ago. This is a result of operating cash flows and the $53M secondary stock offering in August. Faro is sitting in good shape to take advantage of opportunities and is approaching acquisitions very cautiously. It must be a good technology fit, as well as a good cultural fit.

Jay had an interesting stat on the sales efficiency that I wanted to pass on. In 2007, the sales per account manager was $1.3M, this compares to $850K in 2005. It is an example of the seasoning effect that we have been anticipating. In terms of the sales content, Jay has always said that for the time being they anticipate a 50/50 mix between new and existing customers. New customers accounted for 52% of sales in Q4. This is good and while they an in the evangelical stage, new customers are important. This technology hasn't reached the mainstream and the more new customers the better.

Faro has customers like Boeing, Caterpillar, and Volkswagen who have incorporated the products into their manufacturing processes. They just call up and order a few more. This is the Crossing the Chasm thing and the wider this spreads, the better margins Faro can expect. The initial thesis here was correct. The patience to wait for it to play out was lacking. It is finally coming to fruition.

Jay was effusive about his Power of One initiative. I'm not sure how big of a deal this is, but it has definitely united the employees. They are now up to 90% participation. The concept is to make a suggestion that will save $2000 for the company. They saved $6M this year compared to $3M last year. Some of this goes toward other endeavors, some flows to the bottom line. It is a good idea, and gets employees involved in the company's successes.

I would be remiss in a long analysis like this if I didn't delve into the dark side. The good news is that is becoming less dark by the quarter. The FCPA issue is almost settled. Faro has reserved what is apt to be more than sufficient funds to cover any penalties. It will probably cost them $1M a year or so, for the next two years to deal with the monitoring requirements. The class action suit is slowly moving forward. It isn't clear where this will end up. The deductible amount has been reserved for a long time. Their D&O insurance should cover the rest. These are all done deals in my estimation.

I was interested in Jay's comments on the Scanner product. He admitted to being overly optimistic earlier in the year and not recognizing how early they were in the initial adopter phase. He is beginning to see some traction and sees an amazing parallel to the Tracker which is now producing significant revenue. That is music to my ears, as I was never sure that this acquisition was going to pay off. If the Scanner can climb the same sales curve that can only help out. Jay still thinks that CAM2 is only 5% penetrated. This company has a lot ahead of it and I plan on enjoying the ride.


Regards,
Stan