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FARO Technologies (NASDAQ:FARO)
Q4 2019 Earnings Call
Feb 20, 2020, 8:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:


Operator

Good morning, ladies and gentlemen. Thank you for joining today's Faro Technologies fourth-quarter and fiscal-year 2019 earnings release conference call and webcast hosted by Michael Burger. And next, I will turn the call over to Mr. Mike Funari at Sapphire Investor Relations.

Please go ahead.

Mike Funari -- Partner, Sapphire Investor Relations

Thank you, and good morning. With me today from FARO are Michael Burger, chief executive officer; and Allen Muhich, chief financial officer. Yesterday, after the market closed, the company released its financial results for the fourth quarter and full year of 2019. The related press release and Form 10-K for the fourth quarter and full year are available on FARO'S website at www.faro.com.

In order to help you better understand the company and its results, management may make forward-looking statements during the course of this call. These statements can be identified by words such as expect, will, believe, anticipate, plan, potential, continue, goal, objective, intend, may and similar words. It is possible the company's actual results may differ materially from those projected in the forward-looking statements. Important factors that may cause actual results to differ materially are set forth in yesterday's press release and the company's Form 10-K for the year ended December 31, 2019.

During today's conference call, management will discuss certain financial measures that are not presented in accordance with U.S. generally accepted accounting principles or non-GAAP financial measures. In the press release, you will find additional disclosures regarding these non-GAAP measures, including reconciliations to comparable GAAP measures. While not recognized under GAAP, management believes these non-GAAP financial measures provide investors with relevant period-to-period comparisons of core operations.

However, they should not be considered in isolation or as a substitute for a measure of financial performance paired in accordance with GAAP. Now I'd like to turn the call over to Michael.

Michael Burger -- Chief Executive Officer

Thank you, Mike. Good morning, and welcome to our call. As you're aware, I've joined FARO approximately eight months ago, and we immediately embarked on the strategic planning process that included extensive conversations with employees, customers, investors and suppliers as we sought to identify both where the company can provide sustained and differentiated customer value and where opportunities existed to improve operating efficiencies with the underlying objective of enabling long-term shareholder value. While we provided some early insights on our last call, with the completion of our strategic planning process, we're now in a position to communicate our plans and future expectations for the business.

Included in this is our new targeted success model of delivering a 20% adjusted EBITDA margin, without the need for material revenue growth from current levels. This dramatic improvement would represent a profitability level, which is more than double the highest annualized level achieved in our recent history. What has become clear to me during this planning process is that FARO has a meaningful market share in large and growing markets, driven by a legacy of technology differentiation that customers value. Also, FARO is very fortunate to have an exceptional and talented employee base, who are passionate about what we do.

This is a solid foundation from which to build. As we begin to implement our strategic plan, it is important as an organization that we continue to focus on protecting and increasing our market share in the large and growing core markets we presently serve. We strongly believe these markets and close adjacencies will provide the base from which we can deliver strong shareholder returns for the foreseeable future. Let me touch on each of these markets.

In 3D metrology, where we estimate the total available market at $4.2 billion in 2019, we expect the continued demand for precise 3D measurement, driven by automotive, aviation and other capital-intensive manufacturing environments that will enable annual market growth of roughly 6% through 2022. In the architecture, engineering and construction market, we estimate the total available market to be about $1.1 billion and growing at 6%, given the accelerating adoption of advanced 3D measurement solutions. Finally, in public safety analytics, we estimate the overall technology spend to be about $6 billion and growing at a 16% cumulative rate through 2022. However, our solutions currently only serve about $80 million in this large and vibrant market.

We believe that the adoption of our technology related to capturing, analyzing and displaying accident and crime scene data in 3D creates a compelling opportunity for accelerated growth. Taken together, and aftermarkets return to its level of normalcy, we expect our target markets to grow between 6% and 8% annually through 2022. It is in these markets where FARO has the largest concentration of its roughly 15,000 active customers and where we'll focus virtually all of our attention in the foreseeable future. Building upon the strength in our core markets and leveraging our extensive customer base, our first strategic initiative is to increase the value of products through our software and solutions strategy.

We will continue to focus on enabling our customers with high-reliability hardware products that have differentiated performance. However, we believe this is no longer enough. As an organization, we are increasing our focus on understanding what problems our customers are trying to solve, and in turn providing them with a solution that not only captures or provides the 3D data but also gives them the ability to easily turn the captured data into workflow-based information. In other words, we need to move up the food chain and transition from a hardware-centric company to one that provides complete solutions, which enables our customers to realize the full potential of a virtualized world.

We have a long legacy of developing software products at FARO, with multiple teams working on multiple hardware-centric software platforms. I believe we have a unique opportunity to transform these discrete software platforms into a common environment in which FARO customers can easily make use of the data collected by their FARO device. By doing so, we have an opportunity to increase the value we provide to our customers while also enabling us to capture new revenue streams without cannibalizing our traditional revenue sources. This initiative will have the added benefit of streamlining our software development efforts and yield greater productivity from our talented global R&D resource.

Moving beyond product innovation. We also have an opportunity to significantly streamline how we run our business. As I outlined last quarter, our second strategic initiative is to change our go-to-market strategy. This change enables our sales resources to sell the breadth of the product line while increasing the ownership of our customer base.

This change is made possible by leveraging a large and very talented pool of application engineers globally. We plan to support this industry-tested sales model with a refocused marketing function. Our new marketing leadership team is focused in two areas. First, in product marketing, our priority is to gain an increased understanding of customer applications and workflow, then translating that knowledge into value-based positioning, which considers and optimizes our customers' total cost of ownership.

We aim to have a deep understanding of the problems our customers are trying to solve so that we can more effectively deliver full solutions that meet or exceed those needs. And secondly, we are transforming our lead generation process to utilize best-in-class technology to provide our sales organization with higher-quality leads, which, in turn, are expected to drive higher sales productivity. We believe that pivoting to this well-established sales model, supported by a retooled marketing engine, will focus our sales team on better understanding our customer base. It also provides a foundation for a significantly lower cost and scalable sales model that will enable us to cost-effectively grow revenue faster than our markets.

Starting today, we are transitioning to this new sales model, led by our new senior VP of sales and service, Kevin Beadle. Finally, our third strategic initiative is centered on organizational optimization. The company has a long legacy of strong geographic organizations with decentralized decision-making. On top of this was overlaid a business unit structure.

This matrix structure with the requisite infrastructure to support each led to an overly complex structure that is simply too expensive for our business. Therefore, as part of our strategy, we are eliminating our vertical business unit structure and moving to a globalized functional organization that enables centralized management and clear process ownership while eliminating layers of management and redundant resources. When looked at as a whole, I strongly believe these strategic initiatives, combined with our solid foundation in our core markets, will generate long-term growth, while at the same time enabling a significant improvement in profitability. While shifts in product strategy often take time to build momentum, we believe our operating initiatives will result in dramatic reductions in business complexity in the near term, and will enable $40 million in annualized cost savings when our transformation is complete.

These improvements are key to achieving our targeted success model of 55% to 60% non-GAAP gross margins, 40% to 43% non-GAAP operating expenses, which will yield an approximately 20% adjusted EBITDA margin. With that, I'll turn the call over to Allen for an overview of our fourth-quarter financial performance.

Allen Muhich -- Chief Financial Officer

Thank you, Michael, and good morning, everyone. Total sales were $104.1 million for the fourth quarter of 2019, as compared to $112.8 million for the fourth quarter of 2018. As a reminder, non-GAAP Q4 2018 revenue, which excludes a $4.8 million reduction for our previously reported GSA matter, was $117.6 million. Similar to what others in our space have indicated, this 11% year-over-year reduction on a non-GAAP basis is primarily the result of continuing softness in many of the company's served markets, with particular softness in the automotive and broader Asian markets.

Product sales were $80.3 million, as compared to $95.3 million in Q4 of 2018 on a non-GAAP basis. This decrease primarily resulted of the previously mentioned softness in the automotive and broader Asian market. Additionally, we received approximately $3 million of bookings late in the quarter that we were unable to ship, given customer requested ship dates. Service revenue of $23.9 million grew 12% when compared to $21.3 million in Q4 of 2018 as a result of continuing efforts to ensure customers maintain calibrated tools through paid annual maintenance.

New order bookings were $116.9 million for the fourth quarter of 2019, down 4% as compared with $122.2 million for the fourth quarter of 2018. As a result of today's announced strategy and business transformation, we expect to incur approximately $75 million to $85 million in nonrecurring charges, beginning with $49 million booked in the fourth quarter and the remaining amount to be incurred in the first half of 2020. This overall charge includes about $18 million to $22 million of cash charges with the remaining balance being noncash and comprised of tangible asset write-offs of about $21 million, and the remaining balance related to intangible asset and goodwill impairments. GAAP gross margin was 41.9% and included approximately $15 million in inventory writedowns.

Non-GAAP gross margin was 55.7% for the fourth quarter of 2019 as compared with 57.7% for the same prior-year period. The reduced gross margin is a result of the overall reduction in revenue, which adversely affected our fixed cost absorption. GAAP operating expenses were $91.8 million and include approximately $35 million of the previously mentioned restructuring charges, as well as $3 million in acquisition-related intangible amortization and stock compensation expenses. Non-GAAP operating expenses of $53.3 million were $1 million lower than Q4 of 2018 as a result of lower commission expenses associated with lower revenue.

GAAP operating loss was $48.2 million for the fourth quarter of 2019 as compared with operating income of $5.8 million for the fourth quarter of 2018 driven by the lower demand environment. Adjusted EBITDA was $8.1 million or 8% of sales in the fourth quarter of 2019. Our GAAP net loss was $49.7 million, our non-GAAP net income was $3.1 million or $0.18 per share for the fourth-quarter 2019 compared to non-GAAP earnings of $0.62 per share in Q4 of 2018. We continue to maintain a strong capital structure with high liquidity and no debt.

In the fourth quarter of 2019, we generated $14.5 million in cash, resulting in a cash balance of $150.9 million exiting the year. I should note that as a result of eliminating our vertical business unit structure, which was the basis for our segment reporting, we will no longer be reporting segment results. As Michael mentioned, we believe the restructuring efforts outlined today will yield approximately $40 million in annualized cost savings from our 2019 expense levels that will be realized by the fourth quarter of 2020. These reductions are expected to enable our targeted financial model of 55% to 60% non-GAAP gross margin, and 40% to 43% non-GAAP operating expenses and yield adjusted EBITDA levels of approximately 20% of revenue.

We do not believe meaningful revenue growth from current levels is required to realize our new financial model. Beyond these near term actions, we believe we are making the necessary structural changes in both product evolution and go-to-market, led by new sales and marketing leadership in all areas to drive outsized growth in our core markets in the years ahead. Finally, we are closely monitoring the potential impact the coronavirus outbreak may have on our business. Given our limited operational footprint in Southeast Asia, we do not presently expect a material impact to our operations.

That said, and consistent with what others are reporting, it is too soon to say what impact it may have on our already relatively soft demand environment. This concludes our prepared remarks. And at this time, we'd be pleased to take any of your questions.

Questions & Answers:


Operator

[Operator instructions] We'll take our first question from Jim Ricchiuti with Needham & Company. Please go ahead.

Jim Ricchiuti -- Needham and Company -- Analyst

Hi. Thank you. Thanks. Good morning.

Just a quick question. I may have missed it, but when you talk about some of the targets with respect to margins, any time line associated with it? How should we think about the time frame on that, particularly that 55% to 60% gross margin?

Allen Muhich -- Chief Financial Officer

Well, I think from an overall profitability standpoint, we expect to, again, realize the targeted adjusted EBITDA or at least realize the $40 million worth of savings in the back half of the year, more toward Q4, as we indicated. From a margin impact, from a gross margin impact and moving toward the higher end of the range, we would expect to again see some gradual improvement throughout the year starting at kind of presently where we are. As you know, our fourth-quarter non-GAAP margin of 55.7% is toward the lower end of the range. So frankly, we don't need any improvement to be within the range, and that's kind of the current operating assumption there, Jim.

Jim Ricchiuti -- Needham and Company -- Analyst

Got it. And the company has had some previous targets, as I'm sure, you know that we're looking for gross margins in excess of 60%. And clearly, that's not your guidance, but I wanted to just kind of square that with what you're trying to do with the increased software solutions focus. Is there any way to maybe think about longer term, how we might think about gross margins?

Michael Burger -- Chief Executive Officer

No. I actually think the software solutions space should yield higher margins as the mix. It really comes down to the mix of revenue, hardware to software. And I think we're trying to be very conservative about giving forward guidance as it relates to that.

But I do believe the software and solutions strategy should be accretive to the current gross margin. So I think there's potential upside, but we haven't really talked about it publicly yet.

Allen Muhich -- Chief Financial Officer

And I think just in terms of the time line around software and solutions, as you probably are aware, Jim, making that transition and making that pivot does take some time. And at the same time, we're going to be transitioning from a perpetual license model more toward a subscription model, as we've indicated in prior calls. And again, everybody is aware that, that creates a little bit of a drag. It will temper that software revenue growth.

So again, that mix change and the impact that it might have on gross margin will likely take some time.

Jim Ricchiuti -- Needham and Company -- Analyst

OK. That makes sense. Last question, I'll jump back in the queue. It sounds like you're not necessarily seeing an impact from coronavirus.

But what I'm also curious about is just what you guys are seeing or hearing from the standpoint of any key components, supply chain issues, logistics issues, while you may not have a lot of exposure, direct exposure revenue-wise in Asia, in China, what are you seeing in the supply chain?

Michael Burger -- Chief Executive Officer

Actually, a bulk of our supply chain is pretty much focused in Europe and in North America, so we're a bit isolated from it. I do believe that we are concerned about the coronavirus and the impact that, that will have on demand, just as many of the companies that we would -- that would be purchasing equipment from us have been shut down or delayed openings. So I think that has actually not worked its way through. And as you know, a big part of our revenue in a quarter is turned.

So it's not like we're seeing a huge effect on backlog, it's kind of a real-time event for us. So that's kind of why we've got the disclaimer in there. We're reading the same stuff you guys are reading. Our supply chain has not really impacted.

We don't really have a big operational footprint in China. But we are concerned about the buying habits of our current customer base.

Jim Ricchiuti -- Needham and Company -- Analyst

Got it. Thanks very much.

Michael Burger -- Chief Executive Officer

You're welcome, Jim. Thank you.

Operator

And we'll take our next question from Andrew DeGasperi with Berenberg. Please go ahead.

Andrew DeGasperi -- Berenberg Bank -- Analyst

Thanks for taking my question. First, on the restructuring of your sales force or your marketing efforts. Is there any possibility that this could potentially impact your sales near term, given it seems like a relatively large change into how you are marketing these products?

Michael Burger -- Chief Executive Officer

Of course, there's always risk anytime you change an interface with the customer base. I will say, however, this is not about new customers. This is really about existing customers. Our situation today is, we have, in some situations, multiple salespeople calling on a particular account.

And what we're doing is we're eliminating the multiple sides of that. So we're not basically uncovering any customers, we're basically focusing, and I think that has a less risky footprint, if you will, than going, for example, from a direct sales force to a rep or vice versa. That's not our intent. We're still utilizing our direct sales force.

We're focusing and giving clear ownership to a particular individual and then backing up that individual technically. But the answer is, Andrew, there's always risk anytime you make any change, not just with the sales force.

Allen Muhich -- Chief Financial Officer

The other thing I might add is, again, because of our vertical business unit structure, we essentially had four different sales teams with the requisite management structure to support each, and therefore where a lot of the change comes from eliminating that redundancy that wasn't necessarily calling exactly on specific customers as well.

Andrew DeGasperi -- Berenberg Bank -- Analyst

Got it. And then maybe secondly, I know you're no longer giving segment information, but from a, I guess qualitative standpoint, could you maybe tell us -- and I guess, 3D metrology probably was weaker, but how did the AEC, or architecture, engineering, and construction market do for this quarter and so far in Q1?

Allen Muhich -- Chief Financial Officer

Yes. What I would say there is, again, we are not providing that information on a go-forward basis. But I would say if you looked at prior quarters and what the growth rates have been, there was not a lot of change in the fourth quarter compared to what we reported recently. And so where we were soft, we continue to be soft and where we had pockets of strength or at least moderate performance, that remained unchanged.

Andrew DeGasperi -- Berenberg Bank -- Analyst

That's helpful. And then lastly for me, one of your peers is thinking about making their hardware kind of a recurring revenue element were potentially setting up payment plans. Is that something you're considering as well?

Michael Burger -- Chief Executive Officer

We're looking at a lot of different models. Leasing is one of them. Our average selling price is such that leasing may make sense for some of our more expensive stuff. But in reality, we've not seen a huge demand for it.

I think we're looking at all sorts of different reoccurring revenue stream ideas. But right now, we're seeing not a lot of demand for, for example, leasing of hardware today.

Andrew DeGasperi -- Berenberg Bank -- Analyst

Got it. OK. Thank you very much.

Michael Burger -- Chief Executive Officer

Thanks Andrew.

Allen Muhich -- Chief Financial Officer

Thanks, Andrew.

Operator

[Operator instructions] And we'll take our next question from Greg Palm with Craig-Hallum Capital Group. Please go ahead.

Greg Palm -- Craig-Hallum Capital Group LLC -- Analyst

Yes. Good morning. Thanks for all the details around this. So just following up on a previous question, just want to make sure we're understanding this right.

So if you do the math, you assume $40 million in cost savings and maybe a consistent gross margin inside the range, I mean, you get close to a 20% EBITDA margin just from that alone, which is your targeted model. So is that what the math implies? I just want to square that up.

Michael Burger -- Chief Executive Officer

That's correct.

Greg Palm -- Craig-Hallum Capital Group LLC -- Analyst

And so I guess the question is is that a starting point? I mean, I guess, longer term, if we assume that revenue growth gets more to this kind of targeted rate where your markets are and you assume may be some upside or incremental contribution in gross margin from software and solutions, you would obviously get upside to that. So is that the right way to think about this that 20% is a starting point?

Michael Burger -- Chief Executive Officer

Correct. That's the way we're thinking about it.

Greg Palm -- Craig-Hallum Capital Group LLC -- Analyst

Got it. And as it relates to the revenue impact, are there any product lines that you are completely walking away from? And I guess, if you are, what is the revenue level contribution of those so we can factor that into our models?

Michael Burger -- Chief Executive Officer

Actually the revenue contribution to our focusing on the three primary markets is de minimis. We actually don't believe that it will have a significant revenue impact. That being said, I think, from a support perspective, from a focus in the field, from a focus in our service organization, it's pretty dramatic. So I don't think, Greg, that it has a material financial impact from a revenue perspective, but internally, from a focus perspective, it's huge.

Greg Palm -- Craig-Hallum Capital Group LLC -- Analyst

OK. And in terms of the actual headcount reductions, are most of those salespeople or how will the 500 number be spread out across as the company?

Michael Burger -- Chief Executive Officer

I think the way to think about it is, it's primarily SG&A.

Greg Palm -- Craig-Hallum Capital Group LLC -- Analyst

OK.

Michael Burger -- Chief Executive Officer

The R&D remains pretty much untouched, and our manufacturing organization at large remains pretty much untouched.

Greg Palm -- Craig-Hallum Capital Group LLC -- Analyst

Got it. I guess just last one. I mean, you threw a lot of sorts of numbers at us, and there's a lot of detail here, which, I think, we all can appreciate. But I mean, Michael, you've been with the company for more than eight months now.

So I mean, if you could sort of wrap up what your last eight months have been and sort of what excites you most about sort of the go-forward period, I think it'd be really helpful for us?

Michael Burger -- Chief Executive Officer

I have never been involved in a company with 15,000 customers that are asking us to do more. It's a very exciting opportunity for us. And I think assuming that operationally we can get out of our own way, I think that there's a huge opportunity to satisfy even within just the three markets that we're talking about. Assuming that we can live up to our potential, I think we have a very, very, very bright future.

And now that we have a business model that is scalable, it's a great basis from which to start. So actually, I'm more excited about it today than I was when I joined.

Greg Palm -- Craig-Hallum Capital Group LLC -- Analyst

All right. I appreciate the color. Good luck going forward.

Michael Burger -- Chief Executive Officer

Thank you, Greg. I appreciate it.

Operator

And there are no further questions at this time. So I'll turn it back to the speakers for any closing remarks.

Michael Burger -- Chief Executive Officer

Well, we're very excited about where we are. We've done a lot of work. And I think we have now a business model that is extremely scalable. So we look forward to updating you in future quarters on how we're doing with the changes and the strategy.

We appreciate your interest, and we'll talk to you again next quarter. Thank you very much.

Operator

[Operator signoff]

Duration: 32 minutes

Call participants:

Mike Funari -- Partner, Sapphire Investor Relations

Michael Burger -- Chief Executive Officer

Allen Muhich -- Chief Financial Officer

Jim Ricchiuti -- Needham and Company -- Analyst

Andrew DeGasperi -- Berenberg Bank -- Analyst

Greg Palm -- Craig-Hallum Capital Group LLC -- Analyst

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