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Edited Transcript of PRLB earnings conference call or presentation 25-Jul-19 12:30pm GMT

Q2 2019 Proto Labs Inc Earnings Call

Maple Plain Jul 25, 2019 (Thomson StreetEvents) -- Edited Transcript of Proto Labs Inc earnings conference call or presentation Thursday, July 25, 2019 at 12:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Dan Schumacher

Proto Labs, Inc. - Director of IR and FP&A

* John A. Way

Proto Labs, Inc. - CFO & Executive VP of Development

* Victoria M. Holt

Proto Labs, Inc. - President, CEO & Director

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Conference Call Participants

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* Andrew Lodovico DeGasperi

Joh. Berenberg, Gossler & Co. KG, Research Division - Analyst

* Brian Paul Drab

William Blair & Company L.L.C., Research Division - Partner & Analyst

* Danny Eggerichs

Craig-Hallum Capital Group LLC, Research Division - Equity Research Analyst

* Troy Donavon Jensen

Piper Jaffray Companies, Research Division - MD and Senior Research Analyst

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Presentation

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Operator [1]

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Greetings and welcome to the Proto Labs Second Quarter 2019 Earnings Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. (Operator Instructions) As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host, Mr. Daniel Schumacher, Director of Investor Relations. Thank you, you may begin.

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Dan Schumacher, Proto Labs, Inc. - Director of IR and FP&A [2]

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Thank you, Donna, and good morning everyone. With me today is Vicki Holt, our President and Chief Executive Officer and John Way, our Chief Financial Officer. This morning before the market opened Proto Labs issued a press release announcing its financial results for the second quarter ended June 30 2019. The release is available on the company's website at protolabs.com. 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 within the Investor Relations section of our company website for a complete reconciliation of non-GAAP to GAAP results.

Now I'd like to turn the call over to Vicki Holt, President and Chief Executive Officer of Proto Labs.

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Victoria M. Holt, Proto Labs, Inc. - President, CEO & Director [3]

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Thank you, Dan. Good morning, everyone. Thank you for joining us on our second quarter conference call. I will begin with an overview of our second quarter financial performance and significant accomplishments during the quarter. Then John will provide a detailed look at our financial performance, as well as our outlook for the third quarter of 2019. This morning, we reported record quarterly revenue of $115.9 million, representing growth of 5.7% over the second quarter of 2018 or 7% in constant currencies.

Our adjusted earnings per share were $0.71, representing a $0.02 per share sequential improvement. Revenue growth in our legacy services was approximately 9% in constant currencies with our acquired Rapid Manufacturing business declining 8.6% compared to the prior year. As we look at second quarter revenue by geography, the Americas, our largest market, produced revenue growth of 5.6% over the prior year. Year-over-year revenue growth in our legacy services in the Americas was 8.0% with our acquired services pulling down that growth rate.

As we stated in our first quarter conference call, we're focused on improving the performance of the acquired sheet metal and expanded CNC services and realized a sequential increase in revenue of $2.1 million. Turning to customer end market performance in the Americas, the medical industry showed strong growth, while automotive and industrial machinery and equipment end markets declined year-over-year. Our European region produced year-over-year revenue growth of 10.2% in constant currencies. However, due to currency headwinds reported growth was 3.6% as it relates to customer industries. We saw similar trends in Europe as in the Americas, with strong performance in medical and year-over-year declines in automotive and computer electronics. Our Japan region grew 25.6% in constant currencies. We continue to execute our go-to market model, including our partnership with MISUMI to drive demand to Proto Lab services in Japan.

Transitioning to revenue by service, injection molding produced record revenue in the quarter increasing 7.5% compared to the second quarter of 2018.

During the second quarter, we introduced a new color matching system with our injection molding service which will allow us to provide customers with cost-effective, precise custom color manufactured parts at our signature best in class lead times. We also recently began to offer several other new injection molding capabilities to our strategic and focused customers, including pad printing, laser engraving, threaded inserts, mold texturing, [part assembly]. Testing the market and gaining experience with outsourced vendors represents initial steps in building our product roadmap to further our position as a single source supplier for our customers from prototyping to low volume production.

CNC Machining year-over-year growth was 2.9%, second quarter growth was partially impacted by our strong organic growth of over 30% in the second quarter of 2018, creating a difficult comparison in 2019. The CNC growth rate was also impacted by foreign currency exchange rates and flat revenue in our acquired CNC services. Adjusting for these items, CNC growth was 5.3%.

Second quarter 3D printing revenue was also a Proto Labs record and increased 15.2% over the prior year. During the quarter, we launched a new metal 3D printing production offer highlighting our efforts to advance industrial 3D printing beyond prototyping.

Our new production offer includes close customer engineering collaboration secondary processes to improve the strength, dimensional accuracy, and cosmetic appearance of metal parts, as well as parts specific quality control plants. 3D printing specifically metals is becoming more prevalent in production applications in many of our largest end markets, while Proto Labs is still the best source for prototype parts, we are now well positioned to serve customers' production needs in metal 3D printing. This launch is representative of our commitment to expand services to meet our customers' needs in both prototypes and production parts across all our service lines.

Finally sheet metal contributed $5.5 million revenue in the quarter, representing a decline of 13.3% year-over-year. While year-over-year growth was challenged, we did drive sequential improvement in this service.

Now for an update on our 2019 priorities. Our first priority relates to the evolution of our go-to market model. We are investing in our voice of customer capability to develop deeper understanding of how we can serve our customers better. We've added dedicated business development resources focused on growing two of our top customer industries, medical and aerospace. These industries are leading the growth so far in 2019.

Proto Labs is recognized as a leader in digital manufacturing, but we still have opportunities to improve our brand awareness. We continue to find new and innovative ways to create buzz about Proto Labs and promote our leadership as the emerging digital manufacturing market leader. During the quarter, we collaborated with renowned fashion designer Zac Posen and GE Additive on fashion pieces for the 2019 Met Gala.

Our 3D printing team, in North Carolina, did a wonderful job producing the dresses, and the event generated significant media attention displaying our thought leadership in 3D printing. In addition, Proto Labs has once again [sponsored] DUCK as a participant in the Discovery channel’s BattleBots program. Proto Labs provides 3D printed CNC machined and sheet metal parts to bring this BattleBot to life. This program is a direct match to Proto Labs target customers and provides energy to our employees watching DUCK compete.

As it relates to enhancing our customer experience, we continue to invest in it to improve our e-commerce platform and provide a best-in-class customer experience. As we continue to add to our capabilities, we also need to ensure that our customer experience remains intuitive and engaging.

Our next priority for this year is improving overall efficiency. We continue to invest in making our processes and systems more efficient in order to scale our operations and support future growth. Our organization is also focused on software functionality and interconnectivity of our internal systems to include additional capabilities, and drive improvements in our overall business efficiency.

Our teams have really embraced the Proto excellence continuous improvement program, which helps us ensure Proto Labs remains innovative and efficient as we serve our customers.

Lastly, we continue to focus on improving the performance of the acquired Rapid services. On our first quarter earnings call, we described four primary areas of focus relating to the acquired sheet metal and expanded CNC machining services. We've made meaningful progress in each of these areas and we'll continue to execute on our plans.

First, we continue to advance sales training across all sales teams in the second quarter. We have also integrated our CRM instances enabling better collaboration and customer insights across all sales teams and unlocking new sales enablement tools for sellers. Second, as it relates to marketing, we increased our investment in search engine optimization and pay-per-click driving increased impression share and customer conversions. We continue to market our new offerings through our multiple channels.

Third, on our last call, we indicated that we were working to reduce the standard lead times for sheet metal parts. I'm very proud to report that in May, we launched three day lead time and now offer the fastest sheet metal part service in the world. Our teams have been working for months to ensure that our operations can uphold the Proto Labs’ brand promise of unprecedented speeds and reliability that our customers value in all our services. Initial feedback on our three day sheet metal offer has been very positive.

And finally, we continue to test, value-based pricing in our core sheet metal offering. We are confident that the execution of these focused areas will lead to continued sequential performance improvement in the Rapid services.

In summary, Proto Labs is not immune to softening macroeconomic environment. We have continued to generate revenue growth through the first half of 2019 despite weakening macro conditions. Aside from the economic environment, we continue to drive forward and take advantage of our position as a leader in the Industry 4.0 digital manufacturing revolution. There are three mega trends associated with Industry 4.0 that are disrupting product growth models and Proto Labs stands to benefit from these mega trends.

First shorter product lifecycles have increased the importance of being first to market with new products. Second, increasing adoption of the Internet-of-Things requires product design changes as more products become connected resulting in rapid, innovative product development. And finally personalization and customization results in a shorter product production runs and just in time manufacturing. These three trends offer significant opportunities for continued long-term growth for our business and Proto Labs is extremely well positioned through our mission of helping companies accelerate product development, reduce risk and optimize their supply chains.

We created the digital manufacturing space in 1999 and have been the leader ever since. Our ability to serve customers from individuals to Fortune 500 enterprises with quality parts at unprecedented speed is unmatched in our industry. We continue to invest in our business to serve our customers and drive future growth. We are confident in and excited about the long-term prospects for this company, focusing on the needs of our customers will drive growth for the business and result in value creation for our shareholders.

Now I'd like to turn the call over to John for more information on our financial results.

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John A. Way, Proto Labs, Inc. - CFO & Executive VP of Development [4]

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Thank you, Vicki. Revenue in the second quarter was $115.9 million, an increase of $6.3 million or 5.7% over the same quarter in 2018. Foreign currency had a slightly larger negative impact than we expected, representing a $1.4 million headwinds in the quarter, resulting in revenue growth of 7% in constant currencies.

Turning to product developers. Our second quarter unique product developers served increased to 20,840 or 4.7% growth compared to the prior year. Gross profit for the quarter was $60.2 million, an increase of $1 million over the comparable quarter of the prior year. Gross margin was 52% in the second quarter, up slightly from 51.9% in the first quarter of 2019. This compares with 54% in the second quarter of 2018.

Year-over-year gross margin compression in the second quarter was due to the following factors. Our Rapid manufacturing operations represented 100 basis point headwind to our consolidated gross margin for this quarter compared to the second quarter of 2018. The investment in our new CNC facility in Minnesota to support future growth increased our fixed costs that we will leverage over time, and resulted in a 50 basis point decrease in gross margin. The remaining 50 basis point decrease was driven by a number of factors including wage inflation, investments to support expanded offerings and business mix, partially offset by pricing.

Operating expenses totaled $40.7 million or 35.1% of total revenue in the second quarter of 2019. This compares to $39.4 million or 34.7% of revenue in the first quarter of 2019. Sales and marketing was 16.6% of revenue in the quarter, up slightly from Q1 and consistent with our guidance. Our sales and marketing costs include investments in developing our voice of customer capabilities and trade show activity that is seasonally higher in the second quarter.

Research and development was 7% of revenue consistent with the first quarter. We will continue to invest in R&D at these levels in 2019 to expand our capabilities in each of our services and improve our customer experience and internal systems to support the future growth of the business.

On a GAAP basis, our tax rate was 21.9% up from 19.6% in the second quarter of 2018. On an adjusted non-GAAP basis, the tax rate was 22.7% in the second quarter compared to 22.5% in the prior year.

On a GAAP reporting basis, net income totaled $16.2 million, resulting in diluted earnings per share of $0.60. Adjusting for the after-tax cost of stock compensation, amortization of intangibles and unrealized foreign currency losses, our non-GAAP diluted earnings per share in the second quarter was $0.71, representing a $0.02 per share decrease from the second quarter of 2018. The year-over-year decrease in EPS is mainly due to lower volume in the Rapid services and investments in sales and marketing and R&D. Earnings per share improved $0.02 sequentially principally driven by increased volume.

Now turning to cash flow. Our business continues to produce strong cash flows, generating $36.9 million in cash from operations during the quarter. Capital spend in the second quarter was $21.4 million and consisted of investments in equipment, IT infrastructure and systems, and initial facility investments in Europe to ensure capacity for future growth. We also returned capital to shareholders by repurchasing $4.1 million or 41,000 shares of common stock.

In May, our Board of Directors approved a $50 million increase to our authorized stock-repurchase program and extended the expiration date to December 31, 2023. This authorization increases the stock repurchase program to $100 million. To date, we have repurchased an aggregate dollar value of $38 million resulting in $62 million remaining available to purchase common stock under our stock repurchase program.

We ended the second quarter with a cash and marketable securities balance of $151 million, up from $139 million at the end of the first quarter.

Now I would like to provide our expectations for the third quarter of 2019. We currently expect third quarter revenue to be in the range of $116 million to $122 million, a growth in the range of 1% to 6%. This revenue guidance reflects the following factor. Revenue in the third quarter of 2018 was very strong aided by the strong economy. The current economic growth has moderated and with limited visibility in our business, we are taking a cautious approach. We have analyzed our current year-to-date performance and are placing more weight on the sequential trends in the business. We estimate foreign currency will have approximately $1 million negative impact on our third quarter revenues compared to the prior year.

Moving to earnings guidance. Our non-GAAP add-backs for the quarter will include stock compensation costs of approximately $3.9 million and amortization of $900,000. We currently estimate our non-GAAP tax rate to be approximately 22% to 23% in the third quarter. As a reminder, our Q3 2018 EPS included a favorable outcome of a tax audit, resulting in a 19.6% of effective tax rate. Taking into consideration all the above, we expect our quarterly non-GAAP EPS to be between $0.69 per share and $0.77 per share in the third quarter. That concludes our formal remarks. Now Vicki and I'd be happy to take your questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question is coming from Brian Drab of William Blair.

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Brian Paul Drab, William Blair & Company L.L.C., Research Division - Partner & Analyst [2]

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All right. First question just on the developer account. Are you concerned at all -- and I assume it just has to do with the end market weakness and the headwinds, but are you concerned at all about the 5% growth in developer account that stood out to me in the numbers today.

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Victoria M. Holt, Proto Labs, Inc. - President, CEO & Director [3]

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Yes, so the developer account growth is pretty consistent with where we are in the revenue growth. So as you said that, do think the macroeconomic climate is having an impact on that but pretty consistent with where we are with Rapid growth.

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Brian Paul Drab, William Blair & Company L.L.C., Research Division - Partner & Analyst [4]

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And yes, so there is nothing else going on there, I guess, what are you expecting for the revenue per developer going forward? And in what ways can you increase that?

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John A. Way, Proto Labs, Inc. - CFO & Executive VP of Development [5]

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Yes, I think as we progress over time and continue to drive growth in the Rapid services, actually revenue might outpace our product developer growth as we do some of that cross selling and sell more services to those existing developers. I think, we've talked in the past injection molding -- when injection molding grows strong, the revenue per developer growth is strong, just because of the order sizes, the relative services. I think we continue to focus on our customers, what their needs are, and trying to offer them the best service to meet their needs.

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Victoria M. Holt, Proto Labs, Inc. - President, CEO & Director [6]

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Yes. And I'll build on that a little bit, as on-demand manufacturing grows in injection molding you not only get the follow on parts from that, with each developer, but you also see more complex molds and structures. So that also helps us with the other levers that can be pulled in terms of driving revenue growth per product developer up.

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Brian Paul Drab, William Blair & Company L.L.C., Research Division - Partner & Analyst [7]

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Okay, great, thanks. And then just on the guidance, the midpoint of the year-over-year revenue growth guidance is 3% to 4% for the third quarter. So can you make any comments as to where you think the different segments and/or regions will be directionally relative to that kind of midpoint like above or below the midpoint.

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Victoria M. Holt, Proto Labs, Inc. - President, CEO & Director [8]

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The Americas will probably be pretty close to that midpoint. I mean, given the fact that it drives -- it's our largest region and generally drives a lot of the growth. Europe may be a tad higher than that, and of course, Japan will likely be higher as well, but the Americas being such a big percentage, tends to drive it. There is also some foreign currency headwinds that we're dealing with as well. That's going to impact that (inaudible) we've got there in Europe. Overall, as we said in our comments that we think our guidance is the best guidance we can make given the visibility we have today. It's coming off of a very tough prior-year comparable that we're comparing with coupled with what we're seeing with some of the macroeconomic slowdowns in some of our end markets. We felt this is the best visibility we've got right now on guidance.

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Brian Paul Drab, William Blair & Company L.L.C., Research Division - Partner & Analyst [9]

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Okay, and then just one last one on the sheet metal. So it sounds like you feel quite a bit better about the sheet metal business now relative to how you sounded on the first quarter call. How much demand are you seeing for that three-day offering? And what percentage, just roughly, of your business in sheet metal can you actually do with a three-day offering?

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Victoria M. Holt, Proto Labs, Inc. - President, CEO & Director [10]

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I will say that the, that sequential growth – we only launched this in May, so we don't even have a full quarter there. The sequential growth that we're seeing in our services, and we're pleased with the feedback we're getting on three-day. So it is a new offer. And so it's something that the customers are learning about and learning to take advantage of. But when they do, they have been very pleased with this.

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Brian Paul Drab, William Blair & Company L.L.C., Research Division - Partner & Analyst [11]

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Okay. And is it just a fraction of the business that you can do in three-day or is this kind of a pretty broad, this rollout.

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Victoria M. Holt, Proto Labs, Inc. - President, CEO & Director [12]

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No, it's pretty broad, it's very broad. Yes, it's very broad. It captures a good percentage of the geometries that we can do in three-day, absolutely at our Express Service.

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Operator [13]

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Our next question is coming from Troy Jensen of Piper Jaffray.

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Troy Donavon Jensen, Piper Jaffray Companies, Research Division - MD and Senior Research Analyst [14]

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I think I want to dive in with you Vicki on just the injection molding business. It's hovering around 7% growth. And I do know I kind of focus on this question a lot with you guys, but just your thoughts on why it's not growing better organically? It seems like you guys have added a lot of new services and now it’s color matching, is on-demand manufacturing the key to really get this injection molding business growing again? Or, I mean to me it’s pretty important to tap the business.

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Victoria M. Holt, Proto Labs, Inc. - President, CEO & Director [15]

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Yeah, I agree. Well, first, let me say, on an adjusted for currency basis our injection molding business grew 9% in the quarter. So approaching that double-digit and, and yes the on-demand manufacturing offers one of the key drivers to move that and keep that injection molding business in that upper single to low double-digit number. So we, that's absolutely critical. And we are continuing to add things to that offering as we learn from our customers what more they need. Now, some of the offers that we've added, we pointed out, have been really focused on a really strategic and focus accounts not broadly offered because we're still working to understand how best to scale those offers and how best to serve those offers up to our customers in an e-commerce experience. So still basically we're learning as we, as we begin to get experience with this more expanded offer. And we are very excited about the custom color offer. We're starting to see some very early interest in that particularly in the on-demand manufactured space, whether it might be multiple parts that they now can bring forward in a customer color approach. So we're pleased with that. And as we've mentioned before, when you look at our injection molding prototype business, there has been an impact there, with the growth in the last three to five years of desktop printers or maybe one of the first iterations of apart might take place with a printer down the hall. So the number of prototype iterations with injection mold is probably somewhat reduced. So that again underscores the need to really move in to the on-demand manufacturing space. And that's what's driving the growth today.

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Troy Donavon Jensen, Piper Jaffray Companies, Research Division - MD and Senior Research Analyst [16]

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Okay, understood. Good luck. Just a quick one for John to, we should assume Q4 is seasonally a down sequential quarter, right? Historically it is for you guys [that have] acquisition years.

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John A. Way, Proto Labs, Inc. - CFO & Executive VP of Development [17]

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Yeah, I think it will. As we look at the seasonality patterns and how we're trending for the year, I think it will be slightly down to three.

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Troy Donavon Jensen, Piper Jaffray Companies, Research Division - MD and Senior Research Analyst [18]

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Okay, perfect. And maybe just one more for either one of you guys, just I guess quarters ago with the China trade, tariffs could be a positive for Proto Labs? It doesn't seem like we're kind of seen it yet, but Vicki any conversation or any updated thoughts on that topic.

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Victoria M. Holt, Proto Labs, Inc. - President, CEO & Director [19]

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Yes , so I had several conversations with companies that are looking at their supply chains. But remember, the investments that took place over the last several decades for more extended supply chains in the Asia are not easily unraveled and the investment to bring it back is also significant. So all although there is a lot of discussion among manufacturers about how to -- what options they have to deal with the differences and trade tensions, I still think there is, there is -- it's a big investment and big change. And so, those don't happen quickly.

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Troy Donavon Jensen, Piper Jaffray Companies, Research Division - MD and Senior Research Analyst [20]

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Understood. Good luck in the second half.

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Operator [21]

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Our next question is coming from Andrew DeGasperi of Berenberg. Please go ahead.

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Andrew Lodovico DeGasperi, Joh. Berenberg, Gossler & Co. KG, Research Division - Analyst [22]

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I guess my first question on Japan and Europe, I mean growing really well considering everything that was just discussed. I mean anything that you can comment in terms of why you're counter cyclical, even though some of I think about the European auto business is cutting R&D budgets and everything.

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Victoria M. Holt, Proto Labs, Inc. - President, CEO & Director [23]

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Yes. Well, so in Europe, our auto business was down. So I think what you see there is the continued penetration that we're getting across many of the other industry segments that's helping drive that. It's a lower base. So remember, we entered in the Europe and even the Japan market later than the U.S. market, and you've got a lower base from which to grow. So we continue to drive new product developers and penetration in our key markets, medical was a real strong market for us. In the quarter, medical was one of our -- we target as a high potential industry segment. We tend to get better close rates in the medical segment and longer lifetime value. So as we continue to enhance our go-to market model in across the global, to focus on high potential industry segments that's helping us in Europe. Japan is also a very low base here. So you're growing from a lot of penetration there because we're younger in that market. But what you're seeing, I think, is the benefits that we're getting from our relationship with MISUMI, coupled with our benefits of growth outside MISUMI as more and more customers in that market get used to doing business in a B2B environment in e-commerce, which is – Japan is a little bit behind the rest of the world there, but they’re recognizing they've got to get on the Industry 4.0 bandwagon and take advantage of digit model. So we're starting to see some improvement there.

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Andrew Lodovico DeGasperi, Joh. Berenberg, Gossler & Co. KG, Research Division - Analyst [24]

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Great. And then the 3D metal on-demand. I mean maybe help us understand, like what kind of opportunity do you see in that business? I mean how many parts can you do in a month with those kind of machines.

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Victoria M. Holt, Proto Labs, Inc. - President, CEO & Director [25]

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Yes. So, first let me comment a little bit about that space in total. So it's still very, very early in the use of 3D printing for production parts across both metals and plastics. We feel that as a leader in 3D printing with our knowledge of the technologies and the capabilities that we are in the best position to help companies learn how to use that technology for production parts. So closed cycles for those are long because you've got to not only develop the part itself and its geometry and how it's going to be made, but you also have to develop all of the secondary operations that usually go with it, coupled with the quality control plans that would allow a product to move into a production application. So longer cycles, but we've got a lot of interest from our key industry verticals like med device and aerospace to be the ones to help them navigate this change. So it's, it's a great offer for us. I wouldn't expect quick [cocky] changes in the revenue though.

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John A. Way, Proto Labs, Inc. - CFO & Executive VP of Development [26]

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Yes. And Andrew, I think the other thing to think about there is, as we've talked about in kind of all of our services. It is in the low-volume space. So it's not like we'll start up these machines and have them run for a year producing these parts, and a lot of them at least to date are somewhat smaller parts as companies are continuing to learn how to use this technology effectively. We think it will pick up over time, but we want to be the leader as it does pickup.

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Andrew Lodovico DeGasperi, Joh. Berenberg, Gossler & Co. KG, Research Division - Analyst [27]

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Great. Thank you.

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Operator [28]

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Our next question is coming from Greg Palm of Craig-Hallum. Please go ahead.

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Danny Eggerichs, Craig-Hallum Capital Group LLC, Research Division - Equity Research Analyst [29]

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This is actually Danny Eggerichs on for Greg today. I know you don't specifically guide by segment, but just looking at results here for Q2, were there any segments that significantly outperformed or underperformed verses against like your prior expectations?

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Victoria M. Holt, Proto Labs, Inc. - President, CEO & Director [30]

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In terms of services or end markets?

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Danny Eggerichs, Craig-Hallum Capital Group LLC, Research Division - Equity Research Analyst [31]

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In terms of service actually.

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Victoria M. Holt, Proto Labs, Inc. - President, CEO & Director [32]

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Services. Not really, I think the CNC machining a little bit, but.

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John A. Way, Proto Labs, Inc. - CFO & Executive VP of Development [33]

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Yes, Danny. I think the foreign currency headwinds were a little greater than we thought they were. Adjusting for that, we're kind of in the middle of our guide. CNC was a little lighter, but coming off really strong growth from a year-over-year perspective. As we looked at it through the quarter, June was a little bit softer than we would have anticipated. So we ended the quarter a little softer than then we had started it. So I think those three factors are really what's kind of driving, probably more so the kind of guide for Q3 then where our results came in Q2.

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Danny Eggerichs, Craig-Hallum Capital Group LLC, Research Division - Equity Research Analyst [34]

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Okay, great. I guess you just mentioned that June was a little bit softer there. Is there anything that you're seeing so far in July? Any commentary that you can give there?

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John A. Way, Proto Labs, Inc. - CFO & Executive VP of Development [35]

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I think it's reflected in our guidance.

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Danny Eggerichs, Craig-Hallum Capital Group LLC, Research Division - Equity Research Analyst [36]

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Okay. And then just lastly, given the departure of the CRO this past quarter, is there any plans to replace that position? And can you kind of remind us of what some of his major initiatives were?

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Victoria M. Holt, Proto Labs, Inc. - President, CEO & Director [37]

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So, first let me say that one of the things that was a major initiative was to build the team in each of the regions with really strong sales leadership in the Americas, in Europe, and in Japan. And we have that in place right now. So that really takes off any pressure to immediately jump into any kind of a refill, a backfill of that role. The real issues of continuing to evolve the go-to market model, and one of the things that we've been doing here in 2019, in addition to significant amount of training for our sales team, both on the technologies, but also on actual selling skills, strategic selling skills and strategic partnering with customers. We've also been focusing on high potential customer segments that we've identified, based on the analysis of our data and that's allowing our sales and marketing teams frankly to really focus where we can get the greatest return for our sales and marketing investments. And that's the major area where we continue to enhance and grow our voice of customer investment that we've gotten from our Chief Marketing Officer that joined us recently as well. He has now, now got a full year with us. It is going to allow us to continue to enhance that. So we're not rushing to fill that role at this point in time, and we will be continuing to evaluate what we need going forward.

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Danny Eggerichs, Craig-Hallum Capital Group LLC, Research Division - Equity Research Analyst [38]

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All right, great. I appreciate the color.

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Operator [39]

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(Operator Instructions) Our next question is coming from Brian Drab of William Blair.

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Brian Paul Drab, William Blair & Company L.L.C., Research Division - Partner & Analyst [40]

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I just wanted to get some further color on the outlook, if you would be willing to give it in terms of gross margin. First of all in the second half of the year, you expect gross margin to tick up sequentially?

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John A. Way, Proto Labs, Inc. - CFO & Executive VP of Development [41]

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Yes, I think as we're looking at it. We look to drive sequential improvement, but modest sequential improvement. Really as we're looking at it, the gross margin is going to be impacted by revenue. So, the better the revenue growth, the better ability we have to drive the gross margin improvement. So flat to a tad up a little bit is the way I would look at it.

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Brian Paul Drab, William Blair & Company L.L.C., Research Division - Partner & Analyst [42]

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I think you gave the headwinds related to Alpha and Rapid but what was the absolute gross margin level? At least roughly at each of those operations?

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John A. Way, Proto Labs, Inc. - CFO & Executive VP of Development [43]

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Rapid actually improved and it is close to 30%, and in our 3D printing business in Europe, is in the low 20s.

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Brian Paul Drab, William Blair & Company L.L.C., Research Division - Partner & Analyst [44]

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Okay. And can you just make any statement about where you think those kind of level off when they reach steady state? And I don't know if that's 12 months or two years from now, But?

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John A. Way, Proto Labs, Inc. - CFO & Executive VP of Development [45]

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Yes. Well, I think what we're driving to and what we've got plans in place initially is to get the sheet metal gross margins up to the 40% range and get the 3D printing in Europe up to the 30% range. Once we accomplish that, we will set out the next set of initiatives to continue to drive up from there. But I think the current plans are to get those two to those levels.

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Brian Paul Drab, William Blair & Company L.L.C., Research Division - Partner & Analyst [46]

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And is that, do you think John, within the next couple of years or any rough timeframe around that?

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John A. Way, Proto Labs, Inc. - CFO & Executive VP of Development [47]

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Yes, I think that's the right timeframe. I think again, revenue growth is going to be a big factor in that, and the ability to continue to pull in the revenue. It will help us leverage the fixed cost and drive those mergers.

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Brian Paul Drab, William Blair & Company L.L.C., Research Division - Partner & Analyst [48]

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Okay. And you talked a little bit about, I may have missed as I was taking notes here, but what specifically are you doing to further penetrate aerospace and medical markets, you mentioned those as obviously key initiative areas.

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Victoria M. Holt, Proto Labs, Inc. - President, CEO & Director [49]

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Right. So we put dedicated business development resources that frankly we have some experience in those end markets that are helping us build relationships, but also helping our sales and marketing teams tailor what we're doing to those segments. So both from marketing engagement but also sales and marketing also on the sales team. And also this team is helping us in forming our roadmap going forward. So that we could continue to meet the needs of that segment.

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John A. Way, Proto Labs, Inc. - CFO & Executive VP of Development [50]

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And those are two of the industries that are looking at how to utilize metal 3D printing production. So we're working with them closely to help develop that and get their parts in those services.

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Victoria M. Holt, Proto Labs, Inc. - President, CEO & Director [51]

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And the med device segment is also very excited about custom color injection molding. So that's a segment that tends to use our injection molding tooling and to be able to do that with custom color is a welcome addition.

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Operator [52]

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At this time, I'd like to turn the floor back over to Ms. Holt for closing comments.

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Victoria M. Holt, Proto Labs, Inc. - President, CEO & Director [53]

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Thanks, Donna. Thank you for joining us today. We remain excited about the outlook for Proto Labs. As we look ahead, we are confident that the current long-term Industry 4.0 mega trends are favorable to our strengths and our business model, our differentiated technology enabled digital manufacturing platform has demonstrated the ability to help companies and entrepreneurs get their products to market faster than the competition.

We continue to innovate with our service offerings and technology interface and features to enhance our customer experience. I want to thank the Proto Labs employees for their continued efforts as well as our customers for their support. We are committed to driving great shareholder value in 2019 and over the long term, and look forward to reporting to you on our progress during the next quarter. Thank you.

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Operator [54]

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Ladies and gentlemen, thank you for your participation. This concludes today's conference. You may disconnect your lines at this time and have a wonderful day.