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Seeing as so many of the old guard are lurking out here, I’ll cross post my call notes from Gems. The old Gems Faro board ain’t what it used to be.

Greetings,

It’s probably too early to invoke the old “hockey stick” metaphor as Jay says the market is still only 5% penetrated, but they are continuing to get about 60% of sales from repeat customers. There has also been strong initial uptake for the new Faro Focus 3D laser scanner. Jay says that there isn’t any viable competition on the market and they sold more Focus scanners in Q4 than they had any previous scanner product in an entire year.

It was a strong comeback year in 2010 with annual sales growth of 30% producing $192M in revenue. Q4 sales were up 27% to $58.5M, so it’s clear sales are accelerating and comping well against what was a solid quarter in 2009. Moving down the income statement, we see all kinds of good news. Gross margin improved by 450 basis points in 2010 to 59.1%. Product gross margins were 65% and service margins were 31%. This comes from selling more of the higher margin products. Selling expenses declined from 32.9% in 2009 to 26.4% this year. G&A fell to 14% from 16.9% last year. This is despite a couple of million spent to work with their FCPA monitor and increased legal fees due to the patent suit by Nokia (from Metris acquisition), which should be reduced next year. They held R&D at 6.6% of sales for both quarters. Jay repeated several times that he felt their decision to keep up the R&D efforts during the recession was beginning to really pay off.

Slamming that all together results in operating margin of 8.8% in 2010 compared to -7.4% in 2009. To see how things are trending, operating margin was 10.6% in Q4. At the bottom line, they earned $0.29 per share in Q4 and $0.68 for the year, compared to losses in both comparable periods last year. New orders are also accelerating with increases of 30% in the year and 27% in Q4. New orders by geography looked like this:

Europe - +15% ($76.7M)
US - +36% ($75.3M)
Asia - +53% ($45.9M)

Europe would have been in the 20’s on a constant currency basis. Asia was strong across the board in Japan, China, and India. FARO is opening a sales office in Korea and expects that to add to the organic growth in 2011. They are also opening a sales office in Brazil and will go direct to cut out the distributor take.

As I said above, new customer sales represented 40% of the total. Jay felt that existing customers already knew the FARO advantage and were quicker to come back as purchasers once the recession began to fade. They want to get back to the 50-50 level to continue the expansion of their customer base. The top ten customers accounted for less than 6% of total sales, so customer breadth remains strong.

In addition to the Focus scanner, they also introduced the Faro AMP, which is their new non-contact 3D imaging product. This is the first product coming from the IP purchase from the MIT spin-off in 2007-2008. It is at a $85K price point currently and only applicable to a handful of specialty situations. But if you need high accuracy and rapid capture speed, it is the best out there. They will continue to refine this new technology in their R&D labs.

The Focus scanner is five times smaller than their previous product, four times lighter, fits in a backpack and had a 60% reduction in price. I guess that explains the huge orders in the first quarter of availability. Jay thinks this product line could easily become the largest for the company, exceeding even the basic ARM products by a substantial amount. They also have a new generation ARM that apparently was sneak-previewed on American Choppers a few weeks ago.

It wouldn’t be Faro if we didn’t have a few loose ends to cover. The DOJ finally got around to assigning a monitor as a result of the FCPA decision in 2007. She completed her first review in Q3 and they are implementing some recommendations, but they are overall pleased with the results review. This cost about $1M. There will be a second review in 2011. It should cost less and barring anything unforeseen, they should put this one to bed.

There is also the patent suit with Nokia. This was originally brought by a competitor – Metris. In the interim, Nokia bought Metris. It has to do with a Metris patent concerning a laser line probe, a non-contact device that is placed on an ARM. They have filed counter claims and believe there is no infringement. They have tried to settle out of court, but Nokia’s demands are deemed unreasonable. We’ll see where this goes. The FARO counterclaims will be heard first.

Cash sits at $115M and is mainly targeted at acquisitions. It is hard to find a good fit at the right price and Jay remains patient. They have a good record with acquisitions so far and a key to that is not over paying. While they aren’t providing any specific guidance, Jay did slip in the fact that they should achieve growth in the 20% to 25% range on an annual basis, similar to historical growth rates. I’ve been waiting awhile for a quarter like this and it looks like we are on the right track.

Jay talked a bit about long term targets, though would only say his target time frame is not the next couple of years, but that he wasn’t talking about ten years out either. They want sales growth of 20%-25%, gross profit in the 60% to 65% range, selling expense around 25%, G&A at 10% or lower, and R&D in the 5% to 7% range. That leaves operating margins at 18% to 23% and net income in the 13% to 16% range. He thinks they are realistic targets and I’d love to have this financial vision finally become reality.

Regards,
Stan
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