Proto Labs, inc (PRLB) Q2 2021 Earnings Call Transcript

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Proto Labs, inc (PRLB 2.90%)
Q2 2021 Earnings Call
Jul 29, 2021, 8:30 a.m. ET

Contents:

• Prepared Remarks
• Questions and Answers
• Call Participants

Prepared Remarks:

Operator

Greetings. Welcome to the Proto Labs Second Quarter 2021 Earnings Call. [Operator Instructions]

I will now turn the call over to Dan Schumacher. You may begin.

Dan Schumacher -- Director of Investor Relations and Financial Planning and Analysis

Thank you, Stacey, and good morning everyone. With me today are Rob Bodor, Proto Labs President and Chief Executive Officer; and John Way, our Chief Financial Officer. This morning, Proto Labs issued a press release announcing its financial results for the second quarter ended June 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 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 at the Investor Relations section of the Company website for a complete reconciliation of non-GAAP to GAAP results.

Now I'd like to turn the call over to Rob Bodor for a summary of our second quarter performance. Rob?

Robert Bodor -- President and Chief Executive Officer

Thanks, Dan, and good morning everyone. Thank you for joining us today for our second quarter 2021 earnings conference call.

I will begin with commentary on recent industry developments and an overview of second quarter business performance. John will then provide details on our second quarter financial results and our outlook for the third quarter.

During the first half of 2021, several emerging companies that offer online access to manufacturing have entered or announced plans to enter the public markets. This is not unexpected given the trends for manufacturing 4.0 in recent years. These recent developments further highlight the very attractive digital contract manufacturing space, an industry that Proto Labs created in 1999. Proto Labs remains unique as the only company to digitally manufacture parts across a range of services, both additive and traditional. We remain the only company to have transformed these manufacturing processes, enabling us to be the fastest and most reliable manufacturer of custom parts in the world.

We began to revolutionize manufacturing in 1999 and have over 20 years of experience and manufacturing data to drive continuous improvement in our systems and processes. With the acquisition of Hubs earlier this year, our ability to offer market-leading speed and consistency, with a premium network of manufacturing partners will allow us to serve nearly all customer use cases by combining our unique digital thread with the Hubs' digital network. We believe the combination of Proto Labs internal manufacturing capabilities and Hubs' network of premium manufacturing partners is superior to competing offerings, provides the broader set of capabilities and lead times in the world. We are focused on serving our customers in a sustainable manner that will in turn deliver long-term shareholder value.

Proto Labs has the best in class financial profile, driven by our software-enabled manufacturing and superior customer offerings. Through the continued integration of Hubs and further expansion of our internal capabilities, we will also have the broadest digital manufacturing offered in the market to serve our existing customers and to attract new customers.

We invented the digital manufacturing space two decades ago. Our combination of the digital thread for manufacturing and our premium digital network is the winning model, and we will outperform other companies in this space long-term. We are very excited about the future.

Turning now to our second quarter performance. Strong order growth resulted in record quarterly revenues of $123 million, within our guidance range and representing year-over-year growth of 15.5%. As a reminder, in the second quarter of 2020, we generated $12 million of revenue from parts with COVID-19 related applications, including testing supplies, personal protective equipment, and lifesaving medical devices. Excluding net revenue, year-over-year growth was 30%. Our results include a full quarter of revenue from our recent acquisition of Hubs. Hubs produced strong growth of 45% over the prior year and contributed $8.9 million in revenue in the second quarter.

Consistent with many businesses that have been surging demand, we are also experiencing tight supply in markets for labor and certain materials. Labor shortages, especially in the U.S., are well documented and have led to wage inflation and difficulties in adding staff to service the healthy order volumes. Despite these challenges, we generated record quarterly revenue in large part due to our software-enabled digital manufacturing processes, that are far less labor intensive than our peers.

Continuing with our second quarter revenue performance by service, outlined on Slides 6 and 7. Injection Molding revenue was a record $58.2 million in the second quarter, excluding the COVID-19 related Injection Molding revenue in the second quarter of 2020. This service grew 27%. We continue to experience very high demand in our Injection Molding business. During this period of tight supply, our value proposition of best-in-class lead times has resonated with customers. The impacts of labor and material shortages have been most pronounced in our Injection Molding business, creating a substantial backlog of orders that will be carried into next quarter.

CNC Machining revenue was a record $41.6 million in the second quarter. CNC Machining revenue in the quarter was up 45% over the second quarter of 2020. Excluding Hubs, our legacy CNC Machining business grew 23% due to strong order volume as market demand continues to improve from the historic lows of 2020. Additionally, during the second quarter, we launched a new flexible lead time manufacturing option in our Protolabs CNC service. We still offer the fastest lead times in the market through our standard and expedite options, and we've now expanded our CNC offerings with an economy offer, that provides customers with a broader range of lead time and price point options, and make the decision that best suits -- and allows them to make the decision that best suits their specific use case. Furthermore, this offering expansion benefited from our new Protolabs 2.0 platform. Protolabs 2.0 enabled us to launch this new offer to the market faster than would have been possible in our prior environment.

3D printing revenue was a record high of $18.2 million in the second quarter. 3D Printing revenue increased 28% year-over-year or 12% excluding Hubs, indicating continued strong demand for our 3D Printing services.

Lastly, Sheet Metal increased 1% year-over-year. During the second quarter, we consolidated our Sheet Metal operations in New Hampshire into one facility to help create operational efficiencies. This move impacted Sheet Metal revenues and lead times briefly during the second quarter, but will provide benefits for our business going forward.

Moving to earnings, we reported second quarter non-GAAP diluted earnings per share of $0.39. Labor and certain resin availability issues have constrained product shipments as we continue to emerge from the economic impacts of the global pandemic, impacting both our reported revenue and earnings this quarter. Due to higher than anticipated labor costs and medical expenses, our second quarter non-GAAP gross margin was lower than the guidance range we provided in May. As we move forward, we will continue to deploy innovative strategies to fill openings in our manufacturing operations and deliver quality parts to our customers. In addition, we will continue working to actively mitigate labor and material cost impacts through pricing and other operating efficiencies.

Transitioning now to Hubs, the business we acquired in January. Hubs recently rebranded and dropped the 3D from its name. Since its founding in 2013 as a peer-to-peer 3D Printing service, Hubs has evolved to offer ProtoLabs full range of manufacturing services by a network of premium manufacturing partners. The Hubs brand better reflects the full range of manufacturing services and capabilities currently offered. The rebrand occurred in early May and had been planned since before the acquisition in January. We're very excited with how the rebranding went and I want to thank the Hubs' team for their great work on this.

In addition to the rebrand, our priority is the integration of Hubs' capabilities into our broader customer offering. After launching Protolabs 2.0 in the first quarter of 2021, the integration is now our top priority for the remainder of the year. While both organizations continue to operate semi-independently and execute on their respective business plans, we continue to work together to incorporate Hubs' capabilities to provide one unified seamless customer experience with the broadest digital manufacturing offer for custom parts in the world.

At our May 20th, Virtual Investor Day, we provided further insight into our long-term strategy and our plan for execution over the next five years. The presentation included prepared remarks with supporting slides, as well as a 45-minute light Q&A session with several members of our executive leadership team. This was our first Investor Day event since late 2017 and we included a great amount of detail on our strategy, including forward-looking financial targets. If you've not already seen it, I welcome you to watch the recording of this presentation, which you can access via the Investor Relations section of our website.

Now, John will provide a detailed summary of our second quarter financial performance, as well as our outlook for the third quarter. John?

John A. Way -- Chief Financial Officer

Thanks, Rob.

Our detailed second quarter financial results begin on Page 11 of our presentation. With the Hubs acquisition occurring during the first quarter, this was our first full quarter reflecting the impact of the Hubs' financials. Second quarter revenue of $123 million represents a 15.5% year-over-year increase or 5.3% organic growth in constant currencies. Hubs produced strong results, contributing $8.9 million of revenue in the second quarter, representing growth of 45% in this business. Changes in foreign currency had a $1.9 million favorable impact on the second quarter revenue, in line with our expectations. We served 23,250 unique product developers in the second quarter, up 6,200 or 36% year-over-year, and 650 or 3% sequentially. Year-over-year product developer growth was driven by approximately 4,000 developers served on the Hubs platform and with the remainder representing growth in our legacy business.

Turning to Slide 12 and our detailed income statement. Our non-GAAP gross margin in the quarter of 46.8%, compared to 48.5% in the first quarter of 2021, and our guidance range of 47.5% to 48.5%. Our second quarter gross margin was impacted by higher personnel costs in the form of medical costs, and overtime in contractor spend in our manufacturing facilities, due to the tight labor markets, as Rob referenced earlier in the call. In addition, Hubs' second quarter gross margin was slightly lower than our projection for this business, as global logistics costs including freight and customs costs remained at elevated levels. Overall Hubs' represented 260 basis point headwind on second quarter gross margins due to the lower margin nature of the outsourced manufacturing outlook.

Our total non-GAAP operating expenses were $42.8 million, slightly below our expectations, and consistent with $42.4 million in the first quarter of 2021. Our non-GAAP operating expenses increased from $34.6 million in the second quarter of 2020. The Hubs acquisition added $3.2 million of operating expense in the quarter. Other year-over-year increases included Protolabs 2.0 depreciation of $1.4 million, investment in R&D of $1.3 million, and investment in sales and marketing of $1.4 million.

Our GAAP operating expenses in the second quarter include the impact of a revaluation of contingent consideration associated with the Hubs acquisition. GAAP accounting regulations require that we revalue the contingent consideration on a quarterly basis, until the contingent consideration period concludes at the end of 2022, which may introduce some volatility in our GAAP financials. We have adjusted the impact of the revaluation in our non-GAAP reporting as this is a non-cash financial benefit and does not relate to the ongoing operations of the business.

Moving to taxes. Our non-GAAP effective tax rate in the second quarter was 26.7%, above our expectations, and up from 22.7% in the prior quarter, and 18.1% in the second quarter of 2020. The sequential increase in our effective tax rate was primarily due to the tax law changes in the U.K., increasing the tax rate from 19% to 25% in 2023. This tax law change requires us to revalue our deferred tax assets and liabilities and resulted in a one-time expense of $300,000. The net result was non-GAAP diluted earnings per share in the quarter of $0.39, representing a $0.21 per share decrease from the prior year, and a sequential decrease of $0.01 per share. Our non-GAAP adjustments are consistent with our prior practices with the addition of the contingent consideration adjustments described earlier and are detailed in the appendix of our presentation.

The year-over-year change in non-GAAP earnings per share consisted of the following components. First, volume in our legacy business represented a year-over-year increase of $0.04 per share, partially offset by gross margin compression of $0.02 per share. The addition of the Hubs business represented a $0.09 per share decrease, as we continue to invest in scaling that business. The increase in Protolabs 2.0 depreciation represented a $0.04 per share impact. Our increased investments in R&D, resulted in a $0.04 per share decrease. And finally, the increase in the effective tax rate had a $0.05 per share unfavorable impact in the quarter.

Transitioning now to the cash flow statement and balance sheet summarized on Slide 13. We generated $14.3 million in cash from operations in the second quarter. Our operating cash flow this quarter was impacted by investments to continue to build out and scale our manufacturing partner model and their product offer, as well as 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 $1.2 million under our stock repurchase program in the quarter. On June 30th, our cash and investment balance was $89 million, and our balance sheet remains free of debt.

Turning now to our outlook for the third quarter of 2021. Consistent with past practice, we will provide formal revenue range and a qualitative summary of our cost expectations for the quarter, as outlined on Slide 15. We expect to produce record quarterly revenue in the third quarter in the range of $123 million to $133 million, representing year-over-year growth of 14% to 24%, and sequential growth of up to 8%. We expect foreign currency to have approximately $1.5 million favorable impact on revenue compared to the prior year, assuming foreign currency rates remain at current levels.

Now turning to expenses. We expect our third quarter non-GAAP gross margin to be approximately 47%, plus or minus 50 basis points. Our gross margin projection remains in line with our second quarter results, as we anticipate continued wage and raw material inflation costs, which we are actively working to mitigate through pricing and other operating efficiencies. As a reminder, business mix is a larger variable in gross margin performance with the addition of Hubs, as the outsourced manufacturing model carries a lower gross margin than our internal manufacturing operations.

Turning to operating expense, we expect total non-GAAP selling, general and administrative expenses to be between $44 million and $46 million, and we currently estimate our non-GAAP effective tax rate to be approximately 24%.

That concludes our prepared remarks. Now, Rob and I will gladly take your questions. Can you please open up the line for Q&A.

Questions and Answers:

Operator

[Operator Instructions]

Our first question comes from Greg Palm with Craig-Hallum Capital Group. Please go ahead.

Danny Eggerichs -- Craig-Hallum Capital Group -- Analyst

Yeah. Thanks. This is Danny Eggerichs on for Greg today.

Robert Bodor -- President and Chief Executive Officer

Good morning.

Danny Eggerichs -- Craig-Hallum Capital Group -- Analyst

I guess just digging into gross margin a little bit more. I appreciate the color on I guess the labor shortage, wage inflation, that kind of stuff. Obviously compressed in Q2, looks to be more or same in Q3. I guess just looking out beyond that, if it's not going to be necessarily revenue growth, what's -- I mean what's going to be the drivers behind that starting to expand again toward that 50%?

John A. Way -- Chief Financial Officer

Yes, Danny. I think as I stated before mix is going to play a bigger role in our gross margin as we go forward. And then the Hubs business and the outsourced manufacturing model, carries a lower gross margin profile than our internal operations. So as you look at mix, and that business is growing nicely, and we expect that to continue. So that growth in that business as you look at just peer percentages, is going to put pressure on that gross margin number. I think, as we look at in the internal operations, as we stated, we are experiencing some inflationary costs in both labor and some of the materials, and we're actively working with customers on the pricing, as well as our internal efficiencies and expect to continue to do so as we manage through this.

Danny Eggerichs -- Craig-Hallum Capital Group -- Analyst

Okay. That's helpful. I guess just jumping into Hubs now. I mean that integration, how should we think about that progressing? I guess initial synergies you are realizing, any initial feedback from the customer base?

Robert Bodor -- President and Chief Executive Officer

Yes, sure. I can take that. So the Hubs integration has gone well. Two teams are working together on the integration plan. As you think about this, we're going to be rolling out customer-facing capabilities incrementally, and our primary objective is to make sure that it's a really seamless and great customer experience. And so, those are things that we're working right now together. At the same time, we're still running the companies pretty independently. Hubs has their own set of growth targets that they are working toward, that just grew 45% in the last quarter, and we're happy with that. So we're working the two in parallel, as we work through the systems and back end to be able to present these capabilities to our customers on the front end, and we'll be doing that incrementally by service.

Danny Eggerichs -- Craig-Hallum Capital Group -- Analyst

Yeah. Any change in the way you're thinking about that Hubs' contribution for 2021?

John A. Way -- Chief Financial Officer

No. I mean I think the growth that we talked about, 45% growth this quarter is kind of in line with our expectations, and it's trending. I think the gross margins are a little bit softer than we had originally anticipated and we're working through solving that challenge.

Danny Eggerichs -- Craig-Hallum Capital Group -- Analyst

All right. I appreciate the color. I'll hop back in the queue.

Operator

[Operator Instructions] Your next question comes from Ben Rose with Battle Road Research. Please go ahead.

Jonathan Rowe -- Battle Road Research -- Analyst

Hi, this is Jonathan Rowe going in for Ben. I'm just wondering if you can highlight any trends in average order size at Proto Labs during Q2?

Robert Bodor -- President and Chief Executive Officer

I'm sorry, could you repeat that? We had some trouble hearing you.

Jonathan Rowe -- Battle Road Research -- Analyst

Yeah. Yeah. Can you hear me now?

Robert Bodor -- President and Chief Executive Officer

Yeah.

John A. Way -- Chief Financial Officer

Yes.

Jonathan Rowe -- Battle Road Research -- Analyst

Hi. So I'm wondering if you can highlight any trends in average order size during Q2?

Robert Bodor -- President and Chief Executive Officer

The trends in average order size.

Jonathan Rowe -- Battle Road Research -- Analyst

Yeah.

Robert Bodor -- President and Chief Executive Officer

Yeah. So I think the way I would look at it like that average order size on our individual services remain pretty much in line with what they have been historically. I would say that in our Injection Molding service, we are experiencing strong orders, and those orders tend to be a little bit larger in quantities and size. And given that we've kind of built up the backlog, and it's a little bit of a shift in the mix during this quarter, but as you look at the individual services and the underlying data that the average order sizes are remaining relatively consistent.

Jonathan Rowe -- Battle Road Research -- Analyst

Okay. Great. Thank you. And then I'm just wondering, if there's been any recent trends toward customers being willing to pay a premium for a faster turnaround on different parts or prototypes?

Robert Bodor -- President and Chief Executive Officer

Well, I mean our our historical model, right, is to offer the fastest lead times in the world and our standard pricing does have premiums as you increase the speed of that delivery. So whether that's in Injection Molding or CNC or 3D Printing or Sheet Metal, right, there is a premium that's -- for example in CNC as you move from three day to two day to one day to same day, there are premiums at every level there, and so that's very standard for us.

Jonathan Rowe -- Battle Road Research -- Analyst

Okay. Great. Thank you so much.

Robert Bodor -- President and Chief Executive Officer

Yeah. Thank you.

Operator

Your next question comes from Brian Drab with William Blair. Please go ahead.

Brian Drab -- William Blair & Company -- Analyst

Okay. I did dial back in some technical difficulties here. Thanks for taking my questions. And Hubs, it seems John, you haven't mentioned what the gross margin is. Have you yet? Can you tell us what gross margin was in the second quarter?

John A. Way -- Chief Financial Officer

Yeah. Gross margin was in the low-teens.

Robert Bodor -- President and Chief Executive Officer

So in that 12% to 13% range frame for this quarter.

Brian Drab -- William Blair & Company -- Analyst

Okay. And can you...

Robert Bodor -- President and Chief Executive Officer

A little lower.

Brian Drab -- William Blair & Company -- Analyst

And why is that again? What are the main issues?

Robert Bodor -- President and Chief Executive Officer

It is the main issues are the freight costs and customs, and duties things that we're incurring.

Brian Drab -- William Blair & Company -- Analyst

Okay. And that doesn't include at this point any of the -- have you sorted out the movement of some of the cost between, like COGS and SG&A.

Robert Bodor -- President and Chief Executive Officer

Yes.

Brian Drab -- William Blair & Company -- Analyst

I mean is that sorted out or these are just...? Okay.

Robert Bodor -- President and Chief Executive Officer

Yeah. That's also consistent with how we report our gross margin.

Brian Drab -- William Blair & Company -- Analyst

Got it. Okay. And the $8.9 million at Hubs is a solid revenue number. Can you just remind me or like explain how that company -- how Hubs is or is not benefiting from being part of the Proto Labs platform at this point? It's still -- I mean when I go to look from close, it still it looks like an independent company...

Robert Bodor -- President and Chief Executive Officer

That's right.

Brian Drab -- William Blair & Company -- Analyst

Instead of Proto Labs company. But I mean I need to go to their website to order something. Right. So are they benefiting from being part of Proto Labs, do you think at all in the quarter?

Robert Bodor -- President and Chief Executive Officer

Yeah. So, Brian, as we talked about it, we're still running the two independently as we're working through the platform to integrate them. Right. So the plan is that we'll bring them on, try and expose capabilities to the Proto Labs' customers through the Proto Labs' website. We have not done that yet, that's not the stage that we're at. So they are operating independently at this point.

Brian Drab -- William Blair & Company -- Analyst

Are they able to offer any additional services now being --- and capabilities being part of the Proto Labs family now?

John A. Way -- Chief Financial Officer

At this stage, we're still working through the integration and how to plug those in effectively. There is -- a few orders that are being passed back and forth, but for the most part, I think that both businesses are relatively organic in Q2.

Brian Drab -- William Blair & Company -- Analyst

Okay. Got it. And then just quickly on the Sheet Metal. I missed what the reasons were why that was down sequentially, but also I'm just wondering if you could maybe elaborate on that. And then -- and also remind us when that should be tied in to Protolabs 2.0?

Robert Bodor -- President and Chief Executive Officer

Yeah. So on the first question, we consolidated our operations in Sheet Metal. Over the last quarter we were operating out of two facilities, we consolidated into one, which I think is really the right long-term move for us, so that we can improve operational efficiencies and also believe that we'll be able to improve our lead times as a result of that, but that did cause some disruption in the quarter, which impacted revenue and lead times for a period. We're now fully back.

Oh and then...

Brian Drab -- William Blair & Company -- Analyst

Got it.

Robert Bodor -- President and Chief Executive Officer

Your question...

Brian Drab -- William Blair & Company -- Analyst

On 2.0, yeah.

Robert Bodor -- President and Chief Executive Officer

On 2.0. Yeah. So we're evaluating that. The plan is that we will integrate Sheet Metal into 2.0 and have a consolidated offer across, including Sheet Metal and integrating Hubs. Right now with the integration planning, we're working through the prioritization of that, and so I'm not -- we're not announcing that time of integration right now.

Brian Drab -- William Blair & Company -- Analyst

Right. And Rob, what's the biggest challenge in incorporating Sheet Metal into Protolabs 2.0?

Robert Bodor -- President and Chief Executive Officer

Well, it's simply a matter of a prioritization, right. We've got a set of resources that we are working on building out the front end, and we want to add Hubs into it. We want to add the legacy business into it. Remember that when we launched 2.0 that was scoped to not include Sheet Metal at the time, right. So we've launched with our first our three services. Sheet Metal is always going to follow on and it's -- that's still in the plan.

Brian Drab -- William Blair & Company -- Analyst

Got it. And then just last question. You gave the guidance for the third quarter for gross margin. I mean how do you -- can you look a little bit farther out and like fourth quarter you expect gross margin to kind of continue to improve or should we think about the Hubs' growth and the lower gross margin, that is weighing on gross margin somewhat through the balance of the year?

John A. Way -- Chief Financial Officer

Yeah, I think -- Brian, I think it is going to be mix dependent. And yeah, I think it will continue to introduce variability into that gross margin as we look at projections. So depending on growth rates and things like that will impact those percentages. I think, what I would say overall is we would anticipate gross margins to be relatively stable through the remainder of the year as we worked to mitigate some of the labor and inflationary costs that we're incurring in our internal businesses and then there will be some headwinds from the strong growth that we're seeing in the Hubs business.

Brian Drab -- William Blair & Company -- Analyst

Okay. Thanks for taking the questions.

Operator

I will now turn the floor over to Rob Bodor for closing remarks.

Robert Bodor -- President and Chief Executive Officer

Thank you for your time this morning. I'm pleased with our performance in the second quarter of 2021 and remain confident in our long-term strategic objectives. We're focused on creating long-term shareholder value through continued integration of Hubs and improvements to our customer offer. I'd like to thank our employees around the globe for their continued efforts as we move into the second half of 2021, a very important year for our business. I also want to thank our shareholders for their continued support of Proto Labs. We look forward to updating you on our performance next quarter. Thank you very much. Have a great day.

Operator

[Operator Closing Remarks]

Duration: 33 minutes

Call participants:

Dan Schumacher -- Director of Investor Relations and Financial Planning and Analysis

Robert Bodor -- President and Chief Executive Officer

John A. Way -- Chief Financial Officer

Danny Eggerichs -- Craig-Hallum Capital Group -- Analyst

Jonathan Rowe -- Battle Road Research -- Analyst

Brian Drab -- William Blair & Company -- Analyst

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