Earnings Call: Q2 2021

Jul 29, 2021

Greetings. Welcome to the Proto Labs second quarter 2021 earnings call. At this time, all participants are in a listen only mode. A question and answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. Please note this conference is being recorded. I will now turn the call over to Dan Schumacher. You may begin. Thank you, Stacy, 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 30th, 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? 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 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 trend 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 broadest set of capabilities and lead times in the world. We're 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 offer 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. We will outperform other companies in the 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 life-saving medical devices. Excluding that 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 continued 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 we will carry 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% through the strong order volume as market demand continues to improve from the historic lows of 2020. During the second quarter, we launched a new flexible lead time manufacturing option in our Proto Labs 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 allows them to make the decision that best suits their specific use case. This offering expansion benefited from our new Proto Labs 2.0 platform. Proto Labs 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 at $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. 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 Proto Labs full range of manufacturing services via 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 Proto Labs 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 live 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? 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, 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% compares to 48.5% in the first quarter of 2021, and our guidance range of 47.5%-48.5%. Our second quarter gross margin was impacted by higher personnel costs in the form of medical costs and overtime and 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 a 260 basis point headwind on second quarter gross margins due to the lower margin nature of the outsourced manufacturing model. 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 Proto Labs 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 adjustment 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 and scale that business. The increase in Proto Labs 2.0 depreciation represented a $0.04 per share impact. Our increased investment in R&D resulted in a $0.04 per share decrease. Finally, the increase in the effective tax rate had a $0.05 per share unfavorable impact on 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 our 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'll 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-$133 million, representing year-over-year growth of 14%-24% and sequential growth of up to 8%. We expect foreign currency to have an 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%, ±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. 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? Thank you. We will now be conducting a question and answer session. Our first question comes from Greg Palm with Craig-Hallum Capital Group. Please go ahead. Yeah, thanks. This is Danny Egrych on for Greg today. Great. 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 of the same in Q3. I guess just looking out beyond that, if it's not going to be necessarily a revenue growth, what's going to be the drivers behind that starting to expand again towards that 50%? Yeah, Danny, I think as I stated before, mix is going to play a bigger role in our gross margin as we go forward. The Hubs business and the outsourced manufacturing model carries a lower gross margin profile than our internal operations. As you look at mix and that business is growing nicely, and we expect that to continue. That growth in that business, as you look at just pure %, is going to put pressure on that gross margin number. I think as we look at the internal operations, as we stated, we are experiencing some inflationary costs in both labor and some of the materials. We're actively working with customers on pricing as well as our internal efficiencies and expect to continue to do so as we manage through this. Okay. That's helpful. I guess just jumping into Hubs now and that integration, how should we think about that progressing? I guess initial synergies you're realizing, any initial feedback from the customer base? Yeah, sure. I can take that. The Hubs integration is going well. The 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. Our primary objective is to make sure that it's a really seamless and great customer experience. Those are the things that we're working on 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're working towards. They just grew 45% in the last quarter. We're happy with that. 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. We'll be doing that incrementally by service. Yeah. Any change in the way you're thinking about that Hubs contribution for 2021? No. I think the growth that we talked about, 45% growth this quarter is kind of in line with our expectations. It's trending. I think the gross margin's a little bit softer than we had originally anticipated, and we're working through solving that challenge. All right. Appreciate the color. I'll hop back in the queue. Your next question comes from Ben Rose, Battle Road Research. Please go ahead. Hi, this is Jonathan Rowe filling in for Ben. I'm just wondering if you can highlight any trends in average order size at Proto Labs during Q2. I'm sorry. Could you repeat that? We had some trouble hearing you. Yeah. Can you hear me now? Yeah. Yeah. Hi. I'm wondering if you can highlight any trends in average order size during Q2. Trends in average order size. Order size. Yeah. Yeah. I think the way I would look at it, like the 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. Those orders tend to be a little bit larger in quantities and size. 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. As you look at the individual services and the underlying data, the average order sizes are remaining relatively consistent. Okay, great. Thank you. I'm just wondering if there's been any recent trends towards customers being willing to pay a premium for faster turnaround on different parts or prototypes? Well, our historical model 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, whether that's in injection molding or CNC or 3D printing or sheet metal. There's a premium, for example, in CNC, as you move from 3-day to 2-day to 1-day to same-day, there are premiums at every level there. That's very standard for us. Okay, great. Thank you so much. Yep. Thank you. Your next question comes from Brian Drab with William Blair. Please go ahead. Okay. I had to dial back in, some technical difficulties here. Thanks for taking my questions. On Hubs, it seems you haven't mentioned what the gross margin is. Have you yet or can you tell us what gross margin was in the second quarter? Yeah. Gross margin was in the low teens. In that 12%-13% range, Brian, for this quarter. Okay. A little lower. Why is that again? What are the main issues? The main issues are the freight costs and customs and duties, things that we're incurring. Okay. That doesn't include, at this point, have you sorted out the movement of some of the costs between like COGS and SG&A? Yep sorted out? These are just Okay. Yep. Okay consistent with how we report our gross margin. Got it. Okay. The $8.9 million at Hubs is a solid revenue number. Can you just remind me or explain how that company, how Hubs is or is not benefiting from being part of the Proto Labs platform at this point? Is it still When I go to look for quotes, I mean, it still looks like an independent company. It says a Proto Labs company, but I mean, I need to go to their website to order something, right? Are they benefiting from being part of Proto Labs, do you think at all in the quarter? Yeah. Brian, as we talked about it, we're still running the two independently as we're working through the platform to integrate them. The plan is that we'll bring them on and expose those 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, they're operating independently at this point. Are they able to offer any additional services though, and capabilities being part of the Proto Labs family now? At this stage, we're still working through the integration and how to plug those in effectively. There's 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. Okay, got it. 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 Proto Labs 2.0. Yeah. 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. That did cause some disruption in the quarter, which impacted revenue and lead times for a period. We're now fully back. 2.0, yeah. 2.0, yeah. 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. We're not announcing that timing as of right now. Right. Rob, what's the biggest challenge in incorporating sheet metal into Proto Labs 2.0? It's simply a matter of prioritization. We've got a set of resources that 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. We've launched with our first three services. Sheet metal was always going to follow on, and that's still in the plan. Got it. Just a last question. You gave the guidance for the third quarter for gross margin. I mean, can you look a little bit farther out into like fourth quarter? Do you expect gross margin to kind of continue to improve, or should we think about the Hubs growth and the lower gross margin there as weighing on gross margin somewhat through the balance of the year? Brian, I think it is going to be mix dependent. I think it will continue to introduce variability into that gross margin as we look at projections. Depending on growth rates and things like that will impact those %. 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 work to mitigate some of the labor and inflationary costs that we're incurring in our internal businesses. Then there will be some headwinds from the strong growth that we're seeing in the Hubs business. Okay. Thanks for taking the questions. I will now turn the floor over to Rob Bodor for closing remarks. 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. This concludes today's conference. You may disconnect your lines at this time, and thank you for your participation.