Form 10-Q for FARO TECHNOLOGIES INC
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6-Aug-2008
Quarterly Report
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
The following information should be read in conjunction with the Consolidated Financial Statements, including the notes thereto, included elsewhere in this Form 10-Q, and the Management's Discussion and Analysis of Financial Condition and Results of Operations included in the Company's 2007 Annual Report, Form 10-K, for the year ended December 31, 2007.
FARO Technologies, Inc. ("FARO", the "Company", "us", "we", or "our") has made "forward-looking statements" in this report (within the meaning of the Private Securities Litigation Reform Act of 1995). Statements that are not historical facts or that describe our plans, beliefs, goals, intentions, objectives, projections, expectations, assumptions, strategies, or future events are forward-looking statements. In addition, words such as "may," "will," "believe," "plan," "should," "could," "seek," "expect," "anticipate," "intend," "estimate," "goal," "objective," "project," "forecast," "target" and similar words, or discussions of our strategy or other intentions identify forward-looking statements. Other written or oral statements that constitute forward-looking statements also may be made by the Company from time to time.
Forward-looking statements are not guarantees of future performance and are subject to a number of known and unknown risks, uncertainties, and other factors that could cause actual results to differ materially from those expressed or implied by such forward-looking statements. Consequently, undue reliance should not be placed on these forward-looking statements. The Company does not intend to update any forward-looking statements, whether as a result of new information, future events, or otherwise, unless otherwise required by law. Important factors that could cause a material difference in the actual results from those contemplated in such forward-looking statements include, among others, and those elsewhere in this report and the following:
� the Company's inability to further penetrate its customer base;
� development by others of new or improved products, processes or technologies that make the Company's products obsolete or less competitive;
� the Company's inability to maintain its technological advantage by developing new products and enhancing its existing products;
� the Company's inability to successfully identify and acquire target companies or achieve expected benefits from acquisitions that are consummated;
� the cyclical nature of the industries of the Company's customers and the financial condition of its customers;
� the market potential for the computer-aided measurement ("CAM2") market and the potential adoption rate for the Company's products are difficult to quantify and predict;
� the inability to protect the Company's patents and other proprietary rights in the United States and foreign countries;
� fluctuations in the Company's annual and quarterly operating results and the inability to achieve its financial operating targets as a result of a number of factors including, without limitation (i) litigation and regulatory action brought against the Company, (ii) quality issues with its products,
(iii) excess or obsolete inventory, (iv) raw material price fluctuations,
(v) expansion of the Company's manufacturing capability and other inflationary pressures, (vi) the size and timing of customer orders, (vii) the amount of time that it takes to fulfill orders and ship the Company's products,
(viii) the length of the Company's sales cycle to new customers and the time and expense incurred in further penetrating its existing customer base,
(ix) increases in operating expenses required for product development and new product marketing, (x) costs associated with new product introductions, such as product development, marketing, assembly line start-up costs and low introductory period production volumes, (xi) the timing and market acceptance of new products and product enhancements, (xii) customer order deferrals in anticipation of new products and product enhancements, (xiii) the Company's success in expanding its sales and marketing programs, (xiv) start-up costs associated with opening new sales offices outside of the United States,
(xv) fluctuations in revenue without proportionate adjustments in fixed costs,
(xvi) the efficiencies achieved in managing inventories and fixed assets,
(xvii) investments in potential acquisitions or strategic sales, product or other initiatives, (xviii) shrinkage or other inventory losses due to product obsolescence, scrap or material price changes, (xix) adverse changes in the manufacturing industry and general economic conditions, (xx) compliance with government regulations including health, safety, and environmental matters,
(xxi) the ultimate costs of the Company's monitoring obligations in respect of the Foreign Corrupt Practices Act ("FCPA") matter; and (xxii) other factors noted herein;
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� changes in gross margins due to changing product mix of products sold and the different gross margins on different products;
� the Company's inability to successfully maintain the requirements of Restriction of use of Hazardous Substances ("RoHS") and Waste Electrical and Electronic Equipment ("WEEE") compliance into its products;
� the inability of the Company's products to displace traditional measurement devices and attain broad market acceptance;
� the impact of competitive products and pricing in the CAM2 market and the broader market for measurement and inspection devices;
� the effects of increased competition as a result of recent consolidation in the CAM2 market;
� risks associated with expanding international operations, such as fluctuations in currency exchange rates, difficulties in staffing and managing foreign operations, political and economic instability, compliance with import and export regulations, and the burdens and potential exposure of complying with a wide variety of U.S. and foreign laws and labor practices;
� the loss of the Company's Chief Executive Officer or other key personnel;
� difficulties in recruiting research and development engineers, and application engineers;
� the failure to effectively manage the Company's growth;
� variations in the effective income tax rate and the difficulty in predicting the tax rate on a quarterly and annual basis; and
� the loss of key suppliers and the inability to find sufficient alternative suppliers in a reasonable period or on commercially reasonable terms.
Overview
The Company designs, develops, manufactures, markets and supports portable, software driven, 3-D measurement systems that are used in a broad range of manufacturing, industrial, building construction and forensic applications. The Company's FaroArm, FARO Scan Arm and FARO Gage articulated measuring devices, the FARO Laser Scanner LS, the FARO Laser Tracker, and their companion CAM2 software, provide for Computer-Aided Design ("CAD")-based inspection and/or factory-level statistical process control, and high-density surveying. Together, these products integrate the measurement, quality inspection, and reverse engineering functions with CAD software to improve productivity, enhance product quality and decrease rework and scrap in the manufacturing process. The Company uses the acronym "CAM2" for this process, which stands for computer-aided measurement. As of June 2008, the Company's products have been purchased by approximately 7,800 customers worldwide, ranging from small machine shops to such large manufacturing and industrial companies as Audi, Bell Helicopter, Boeing, British Aerospace, Caterpillar, Daimler Chrysler, General Electric, General Motors, Honda, Johnson Controls, Komatsu Dresser, Lockheed Martin, Nissan, Siemens and Volkswagen, among many others.
The Company operates in international markets throughout the world. It maintains sales offices in France, Germany, Great Britain, Japan, Spain, Italy, China, India, Poland, Netherlands, Malaysia and Vietnam. The Company added a new regional headquarters in Singapore in the third quarter of 2005 along with a new manufacturing and service facility there in the fourth quarter of 2005. In 2006 the Company closed its South Korean office and established a third party distributor relationship for serving that market, and in December 2006, the Company established a sales office in Thailand.
The Company derives revenues primarily from the sale of its FaroArm, FARO Scan Arm, FARO Gage, FARO Laser Tracker and FARO Laser Scanner LS 3-D measurement equipment, and their related multi-faceted software. Revenue related to these products is generally recognized upon shipment. In addition,
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the Company sells one and three-year extended warranties and training and technology consulting services relating to its products. The Company recognizes the revenue from extended warranties on a straight-line basis. The Company also receives royalties from licensing agreements for its historical medical technology and recognizes the revenue from the sale of the technology by the licensees.
The Company manufactures its FaroArm, FARO Gage, and FARO Laser Tracker products in its manufacturing facility located in Switzerland for customer orders from the Europe/Africa region and in its manufacturing facility located in Singapore for customer orders from the Asia/Pacific region. The Company manufactures its FaroArm, FARO Gage, and FARO Laser Tracker products in the Company's manufacturing facilities located in Florida and Pennsylvania for customer orders from the Americas. The Company manufactures its FARO Laser Scanner LS product in its facility located in Stuttgart, Germany. The Company expects all its existing plants to have the production capacity necessary to support its growth through 2008.
The Company manages and reports its global sales in three regions: the Americas, Europe/Africa and Asia/Pacific. In the six months ended June 28, 2008, 37.9% of the Company's sales were in the Americas compared to 44.4% in the first six months of 2007, 44.2% were in the Europe/Africa region compared to 38.8% in the first six months of 2007 and 17.9% were in the Asia/Pacific region, compared to 16.8% in the same prior year period (see also Note M- Segment Reporting, to the financial statements above). In the second quarter of 2008 new order bookings increased $8.3 million, or 16.5%, to $58.7 million from $50.4 million in the prior year period. New orders decreased $0.3 million, or 1.5%, in the Americas to $20.2 million, from $20.5 million in the prior year period. New orders increased $6.8 million, or 32.9% to $27.5 million in Europe/Africa from $20.7 in the second quarter of 2007. In Asia/Pacific new orders increased $1.8 million, or 19.6% to $11.0 million, from $9.2 million in the second quarter of 2007.
The Company's effective tax rate increased to 20.2% for the six months ended June 28, 2008 from 19.9% in the prior year period. The Company currently estimates that its effective tax rate will approximate 18% to 22% for the remainder of 2008. The Company's tax rate continues to be lower than the statutory tax rate in the United States primarily as a result of favorable tax rates in foreign jurisdictions. However, the Company's tax rate could be impacted positively or negatively by geographic changes in the manufacturing or sales of its products. The Company has received a favorable income tax rate commitment from the Swiss government as an incentive to establish a manufacturing plant in Switzerland. In 2006, the Company received approval from the Singapore Economic Development Board for a favorable multi-year income tax holiday for its Singapore headquarters and manufacturing operations subject to certain terms and conditions including employment, spending and capital investment.
Accounting for wholly-owned foreign subsidiaries is maintained in the currency of the respective foreign jurisdiction. Inter-company transactions are eliminated in consolidation. Fluctuations in exchange rates may have an impact in the Company's consolidated financial statements upon the expected settlement of these inter-company accounts. The Company is aware of the availability of off-balance sheet financial instruments to hedge exposure to foreign currency exchange rates, including cross-currency swaps, forward contracts and foreign currency options (see Foreign Exchange Exposure below). However, it does not regularly use such instruments, and none were utilized in 2007 or the six months ended June 28, 2008.
The Company has had twenty-four consecutive profitable quarters through June 28, 2008. Its sales and earnings growth have been the result of a number of factors, including: continuing market demand for and acceptance of the Company's products; increased sales activity in part through additional sales staff worldwide, new products and product enhancements such as the FARO Gage and Laser Scanner; and the effect of acquisitions.
FCPA Update
As previously reported by the Company, the Company learned that its China subsidiary had made payments to certain customers in China that may have violated the FCPA and other applicable laws. The Company's Audit Committee instituted an internal investigation into this matter in February 2006, and the Company voluntarily notified the SEC and the DOJ of this matter in March 2006. The Company's internal investigation into this matter, which has been completed, identified certain improper payments made in China and deficiencies in its controls with respect to its operations in China in possible violation of the FCPA.
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Results of the investigation revealed that referral fee payments in possible violation of the FCPA were $165,000 and $265,000 in 2004 and 2005, respectively, which were recorded in selling expenses in its statements of income. The related sales to customers to which payment of these referral fees had been made totaled approximately $1.3 million and $3.24 million in 2004 and 2005, respectively. Additional improper referral fee payments of $122,000 were made in January and February 2006 related to sales contracts in 2005. The Company had sales in China of $9.0 million in 2005 and $4.2 million in 2004, approximately 7% and 4% of total sales, respectively. The Company incurred expenses of $3.8 million in 2006, $3.1 million in 2007 and $0.3 million in the six months ended June 28, 2008, including $2.95 million in fines, penalties, and interest to the DOJ and SEC, relating to the FCPA matter.
The Company has entered into settlement agreements and documents with the SEC and DOJ concerning the FCPA matter, pursuant to which the Company has paid an aggregate of $2.95 million in fines, disgorgement of associated profit, and interest. The Company also has a two-year monitoring obligation and other continuing obligations with the SEC and the DOJ with respect to compliance with the FCPA and other laws, full cooperation with the government, and the adoption of a compliance code containing specific provisions intended to prevent violations of the FCPA. Failure to comply with any such continuing obligations could result in the SEC and the DOJ seeking to impose penalties against the Company in the future.
The Company is currently involved in a class action securities fraud lawsuit and has been served with a shareholder derivative complaint. (See Part II. OTHER INFORMATION: Item 1. Legal Proceedings). None of these actions to date has had a material impact on the Company's business, financial condition, liquidity, or results of operations. The potential impact on the Company's business, financial condition, liquidity, or results of operations from these actions in any future period cannot be predicted.
Results of Operations
Three Months Ended June 28, 2008 Compared to the Three Months Ended June 30, 2007
Sales increased by $10.1 million or 21.4% to $57.7 million in the three months ended June 28, 2008 from $47.6 million for the three months ended June 30, 2007. This increase resulted primarily from an increase in unit sales and an increase in average selling prices. The effect of changes in foreign exchange rates on sales was an increase of $4.5 million in the three months ended June 28, 2008. Sales in the Americas region increased $0.3 million or 1.9% to $20.2 million for the three months ended June 28, 2008 from $19.9 million in the three months ended June 30, 2007. Sales in the Europe/Africa region increased $7.9 million or 41.3%, to $27.0 million for the three months ended June 28, 2008 from $19.1 million in the three months ended June 30, 2007. Sales in the Asia/Pacific region increased $1.9 million or 21.9% to $10.5 million for the three months ended June 28, 2008 from $8.6 million in the three months ended June 30, 2007.
Gross profit increased by $7.0 million or 24.0% to $36.2 million for the three months ended June 28, 2008 from $29.2 million for the three months ended June 30, 2007. Gross margin increased to 62.8% for the three months ended June 28, 2008 from 61.3% for the three months ended June 30, 2007. The increase in gross margin is primarily due to a change in the sales mix resulting in an increase in unit sales of product lines with a lower than average cost of sales.
Selling expenses increased by $3.1 million or 21.8% to $17.1 million for the three months ended June 28, 2008 from $14.0 million for three months ended June 30, 2007. This increase was primarily due to an increase in commission and compensation expense of $2.1 million, an increase in marketing and advertising costs of $0.4 million, and higher travel related costs of $0.5 million. Worldwide sales and marketing headcount increased by 42 or 13.7% to 348 from 306 between June 28, 2008 and June 30, 2007. Regionally, the Company's sales and marketing headcount increased by 29 or 29.6% in the Americas, to 127 from 98; remained unchanged in Europe/Africa at 127; and increased by 13 or 16.0% in Asia/Pacific, to 94 from 81 between June 28, 2008 and June 30, 2007. The Company intends to continue to selectively increase its sales and marketing headcount as the market demands. As a percentage of sales, selling expenses increased to 29.6% of sales in the three months ended June 28, 2008 from 29.4% in the three months ended June 30, 2007. Regionally, selling expenses were 30.0% of sales in the Americas for the quarter, compared to 24.7% of sales in the year-ago quarter, 30.1% of sales for Europe/Africa compared to 34.4% of sales, and 27.3% of sales compared to 29.1% of sales for Asia/Pacific.
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General and administrative expenses increased by $1.5 million or 27.6%, to $7.0 million for the three months ended June 28, 2008 from $5.5 million for the three months ended June 30, 2007, primarily due to an increase in compensation costs of $0.7 million, increased costs related to the additional leased space to expand the Company's corporate offices of $0.3 million, an increase in the allowance for doubtful accounts of $0.3 million, and higher travel related costs of $0.2 million, offset by a reduction in professional and legal fees of $0.5 million related to the Company's FCPA investigation and patent litigation.
Depreciation and amortization expenses increased by $0.1 million to $1.1 million for the three months ended June 28, 2008 from $1.0 million for the three months ended June 30, 2007.
Research and development expenses increased to $3.2 million for the three months ended June 28, 2008 from $2.3 million for the three months ended June 30, 2007 primarily as a result of an increase in compensation expense. Research and development expenses as a percentage of sales increased to 5.5% for the three months ended June 28, 2008 from 4.8% for the three months ended June 30, 2007.
Interest income increased by $0.12 million to $0.46 million for the three months ended June 28, 2008 from $0.34 million for the three months ended June 30, 2007, due to an increase in cash and short term investments.
Other (income) expense, net decreased by $0.8 million to $0.42 million of expense for the three months ended June 28, 2008, from income of $0.38 million for the three months ended June 30, 2007, primarily as a result of foreign exchange transaction losses.
Income tax expense increased by $0.1 million to $1.5 million for the three months ended June 28, 2008 from $1.4 million for the three months ended June 30, 2007. This increase was primarily due to an increase in pretax income. Total deferred taxes for the Company's foreign subsidiaries relating to net operating loss carryforwards were $9.4 million and $7.7 million at June 28, 2008 and December 31, 2007, respectively. The related valuation allowance was $8.0 million and $6.3 million at June 28, 2008 and December 31, 2007, respectively. The Company's effective tax rate decreased to 19.3% for the three months ended June 28, 2008 from 19.6% in the prior year period primarily as a result of an increase in taxable income in jurisdictions with higher tax rates. The Company currently estimates its effective tax rate will approximate 18% to 22% for the remainder of 2008. The Company's tax rate continues to be lower than the statutory tax rate in the United States primarily as a result of favorable tax rates in foreign jurisdictions. However, the Company's tax rate could be impacted positively or negatively by geographic changes in the manufacturing or sales of its products and the resulting effect on taxable income in each jurisdiction.
Net income increased by $0.6 million to $6.4 million for the three months ended June 28, 2008 from $5.8 million for the three months ended June 30, 2007 as a result of the factors described above.
Six Months Ended June 28, 2008 Compared to the Six Months Ended June 30, 2007
Sales increased by $15.9 million or 18.2% to $103.8 million in the six months ended June 28, 2008 from $87.9 million for the six months ended June 30, 2007. This increase resulted primarily from an increase in unit sales and an increase in average selling prices. The effect of changes in foreign exchange rates on sales was an increase of $7.7 million in the six months ended June 28, 2008. Sales in the Americas region increased $0.2 million or 0.8% to $39.3 million for the six months ended June 28, 2008 from $39.1 million in the six months ended June 30, 2007. Sales in the Europe/Africa region increased $11.8 million or 34.6%, to $45.9 million for the six months ended June 28, 2008 from $34.1 million in the six months ended June 30, 2007. Sales in the Asia/Pacific region increased $3.9 million or 26.4% to $18.6 million for the six months ended June 28, 2008 from $14.7 million in the six months ended June 30, 2007.
Gross profit increased by $10.8 million or 20.5% to $63.9 million for the six months ended June 28, 2008 from $53.1 million for the six months ended June 30, 2007. Gross margin increased to 61.6% for the six months ended June 28, 2008 from 60.4% for the six months ended June 30, 2007. The increase in gross margin is primarily due to an increase in unit sales in product lines with lower unit costs than the prior year period.
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Selling expenses increased by $5.2 million or 19.7% to $31.5 million for the six months ended June 28, 2008 from $26.3 million for six months ended June 30, 2007. This increase was primarily due to an increase in commission and compensation expense of $3.2 million, an increase in marketing and advertising costs of $0.4 million, and an increase in travel expense of $1.1 million. Worldwide sales and marketing headcount increased by 42, to 348 from 306 between June 30, 2007 and June 28, 2008. Regionally, the Company's sales and marketing headcount increased by 29 or 29.6% in the Americas, to 127 from 98; remained unchanged in Europe/Africa at 127; and increased by 13 or 16.0% in Asia/Pacific, to 94 from 81 between June 28, 2008 and June 30, 2007. The Company intends to continue to selectively increase its sales and marketing headcount as the market demands. As a percentage of sales, selling expenses increased to 30.3% of sales in the six months ended June 28, 2008 from 29.9% in the six months ended June 30, 2007. Regionally, selling expenses were 29.3% of sales in the Americas for the six months ended June 28, 2008, compared to 25.4% of sales in the year-ago period, 31.4% of sales for Europe/Africa compared to 34.9% of sales and 30.0% of sales compared to 30.6% of sales for Asia/Pacific.
General and administrative expenses increased by $2.2 million or 20.4%, to $12.7 million for the six months ended June 28, 2008 from $10.5 million for the six months ended June 30, 2007. General and administrative expenses as a percentage of sales increased to 12.2% for the six months ended June 28, 2008 from 11.9% for the six months ended June 30, 2007 due to an increase in compensation expense of $1.3 million, increased costs related to the additional leased space to expand the Company's corporate offices of $0.7 million, an increase in the allowance for doubtful accounts of $0.4 million, and higher travel related costs of $0.3 million, offset by a reduction in professional and legal fees of $1.1 million related to the Company's FCPA investigation and patent litigation.
Depreciation and amortization expenses increased by $0.1 million to $2.1 million for the six months ended June 28, 2008 from $2.0 million for the six months ended June 30, 2007 as a result of a increase in purchases of property and equipment.
Research and development expenses increased to $5.9 million for the six months ended June 28, 2008 from $4.2 million for the six months ended June 30, 2007 primarily as a result of an increase in compensation expense. Research and development expenses as a percentage of sales increased to 5.7% for the six months ended June 28, 2008 from 4.8% for the six months ended June 30, 2007.
Interest income increased by $0.49 million to $1.08 million for the six months ended June 28, 2008 from $0.59 million for the six months ended June 30, 2007, due to an increase in short term investments.
Interest expense increased by $0.4 million to $0.4 million for the six months ended June 28, 2008 from $0.0 million for the six months ended June 30, 2007, due to interest accrued on the estimated fines and penalties to the SEC and DOJ related to the FCPA matter.
Other (income) expense, net decreased by $0.89 million to $0.18 million of expense for the six months ended June 28, 2008, from income of $0.71 million for the six months ended June 30, 2007, primarily as a result of foreign exchange transaction losses.
Income tax expense increased by $0.3 million to $2.5 million for the six months ended June 28, 2008 from $2.2 million for the six months ended June 30, 2007. This increase was primarily due to an increase in pretax income. Total deferred taxes for the Company's foreign subsidiaries relating to net operating loss carryforwards were $9.4 million and $7.7 million at June 28, 2008 and December 31, 2007, respectively. The related valuation allowance was $8.0 million and $6.3 million at June 28, 2008 and December 31, 2007, respectively. The Company's effective tax rate increased to 20.2% for the six months ended June 28, 2008 from 19.9% in the prior year period primarily as a result of an increase in taxable income in jurisdictions with higher tax rates. The Company currently estimates its effective tax rate will approximate 18% to 22% for the remainder of 2008. The Company's tax rate continues to be lower than the statutory tax rate in the United States primarily as a result of favorable tax rates in foreign jurisdictions. However, the Company's tax rate could be impacted positively or negatively by geographic changes in the manufacturing or . . .
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