Greetings. Welcome to Proto Labs' third quarter 2019 earnings call. At this time, all participants are in listen-only mode. A brief question and answer session will follow the formal presentation. If anyone today should require operator assistance during the conference, please press star zero from your telephone keypad. Please note that this conference is being recorded. At this time, I will turn the conference over to Dan Schumacher, Director of Investor Relations. Mr. Schumacher, you may begin.
Thank you, Rob, and good morning, everyone. With me today is Vickie Holt, our President and Chief Executive Officer, and John Way, our Chief Financial Officer. This morning, before the market open, Proto Labs issued a press release announcing its financial results for the third quarter ended September 30th, 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 Vickie Holt, President and Chief Executive Officer of Proto Labs. Vickie?
Thanks, Dan. Good morning, everyone. Thank you for joining us on our third quarter conference call. I will begin with an overview of our overall business performance in the quarter. John will provide a detailed look at our third quarter financial performance, as well as our outlook for the fourth quarter. This morning, we reported record quarterly revenue of $117.5 million, representing growth of 1.8% over the third quarter of 2018, or 2.5% in constant currencies. Our adjusted earnings per share were $0.76, representing a $0.05 per share improvement over the second quarter of 2019. Our business grew year-over-year in the third quarter, despite an industrial environment that has continued to soften. As you are all aware, in September, the ISM U.S. Manufacturing Purchasing Managers' Index registered its lowest monthly measure since 2009.
Both U.S. manufacturing production and capacity utilization for the industrial sector decreased in the quarter. Consistent with what we've said in the past, our business is negatively impacted by a decline in manufacturing activity and industrial production. Our customers are taking a more cautious approach in general, including R&D projects, and that's reflected in our year-to-date financial results. 2018 was a very strong year for Proto Labs, for our customers, and for manufacturing and industrial activity. If you recall, tax reform had just gone into effect, and business confidence and investment were both higher than current levels. To demonstrate the impact of the economy to our business, our top 100 customers grew nearly 20% in the first nine months of 2018. In the first nine months of this year, revenue generated from those same 100 customers was essentially flat.
All these customers remain key Proto Labs customers, but their investment levels have varied due to the economic environment. Dissecting our revenue a little further, the year-over-year revenue growth in our legacy services in the quarter was approximately 4% in constant currencies. Our Rapid Manufacturing business in New Hampshire declined 14.3% compared to the prior year. As we look at third quarter revenue by geography, the Americas, our largest market, produced revenue growth of 2.4% over the prior year. Excluding the acquired services, our legacy services in the Americas grew 5.0% year-over-year. In the Americas, medical, our largest customer industry, continues to grow nicely, while the biggest year-over-year decline was in automotive. Aerospace also declined slightly compared to the third quarter of 2018. Our European region produced year-over-year revenue growth of 2.1% in constant currencies.
However, due to currency headwinds, we reported a decline of 2.6% in dollars for the region. As it relates to customer industries, we saw strong performance in medical and aerospace, and year-over-year declines in automotive, manufacturing, and computer electronics. Our Japan region grew 7.4% in constant currencies. Transitioning to revenue by service, Injection Molding revenue increased 2.8% compared to the third quarter of 2018. CNC Machining declined 1.5% year-over-year, impacted by foreign currency exchange rates and a decline in our acquired CNC services. Third quarter 2018 CNC organic revenue growth was 29% and produced a record quarterly Proto Labs record, creating a difficult comparison for the most recent quarter. 3D Printing revenue in the third quarter of 2019 was a Proto Labs record and increased 14.8% over the prior year.
The 3D Printing market continues to expand, and we continue to rapidly produce 3D-printed parts with outstanding quality and repeatability. Since our acquisition of FineLine in 2014, we've continued to add new 3D Printing technologies and capabilities to meet our customers' needs for both prototypes and production parts. Two particular 3D Printing technologies that have been extremely successful for us recently are our metal 3D Printing offer and Multi Jet Fusion technologies. These technologies expand our ability to deliver production solutions. Our offerings continue to provide exceptional value to customers as industry demand for metal 3D Printing and Multi Jet Fusion parts grows. We will continue to aggressively pursue new and differentiated 3D Printing technologies to serve our customers as the 3D Printing market continues to evolve and expand. Lastly, Sheet Metal contributed $5.3 million of revenue in the quarter, representing a decline of 18.2% year-over-year.
As we stated previously, our Rapid acquisition has not met our expectations. Following the acquisition in December of 2017, we spent 2018 adjusting the offer and manufacturing operations to one which is aligned with an e-commerce scalable digital manufacturing model. Consequently, in 2019, we moved away from some complex business, which was not scalable and did not fit into the envelope of our new offer. The intended result was an increase in volume through our cross-selling efforts and a lower average order value. We are experiencing some success in our cross-selling efforts, with greater than 20% increase in the number of product developers using the acquired services. However, the drop in average order value was greater than anticipated. Even with the increase in product developers utilizing the acquired services, the penetration into our existing account base is in the single digits, which creates a significant opportunity in the future.
While the opportunity remains strong, we are finding that unseating existing Sheet Metal vendors in this difficult macroeconomic environment has proven to be a challenge. The difficult environment will not last forever, as we create a differentiated service in the market by integrating Sheet Metal into our customers' buying experience while achieving market-leading on-time delivery results with stated lead times, we will ultimately drive the necessary volume through these operations. We are very confident we have the right actions in place to improve the performance of these acquired services. I've been personally responsible for several major business turnarounds in my career, and the key to success are a keen focus on the earnings drivers of a business.
In Proto Labs case, this resides in driving the cross-selling across our vast customer base and developing innovative ways to flex costs with the variability of demand, which is inherent in an on-demand manufacturing business. There are actions underway in both these areas, which I am confident will yield results. Feedback from our customers confirms these services are valuable to them, and they value the accelerated innovation and reliable on-demand manufacturing services at unprecedented speeds. We will remain focused on improving this business over the long term and delivering to our customers the outstanding Proto Labs experience they expect from us. In summary, due to a weakening macroeconomic environment and difficult comparisons after a tremendous 2018 for Proto Labs, our 2019 year-over-year growth rates have been lower than historical levels.
Although we continue to invest in the business to allow for future growth, we are taking a disciplined approach in managing expenses during this time of macroeconomic uncertainty. When business optimism and capital investment in our geographic markets increase, we believe Proto Labs will demonstrate tremendous growth because of our scalable model and the value we bring to our customers. We have built our leadership position in the digital manufacturing space by focusing on the needs of our customers, and we remain steadfast in our mission, and I'm very confident and excited about the long-term prospects for Proto Labs. Now, I'd like to turn the call over to John for more information on our financial results. John?
Thank you, Vickie. Revenue in the third quarter was $117.5 million, an increase of $2 million or 1.8% over the same quarter in 2018. Foreign currency represented a $900,000 headwind in the quarter due to the relative strength of the US dollar. Our third quarter unique product developers served increased to 21,471 or growth of 3.3% compared to the prior year, with strong growth in 3D Printing continuing to allow us to engage with our customers earlier in the product development cycle. Our non-GAAP gross profit for the quarter was $60.5 million, resulting in adjusted gross margin of 51.5% in the third quarter, down sequentially from 52.6% in the second quarter of 2019. Sequential gross margin compression of 110 basis points in the third quarter was due to the following factors.
The acquired rapid operations represented a 70 basis point headwind to our consolidated gross margin compared to the second quarter of 2019 due to lower volumes. As we have stated in the past, it is difficult to adjust our cost structure in the short term when volumes are lower than anticipated. The remaining 40 basis point decline was primarily due to increased repair and maintenance and higher production supply spend in our CNC and Injection Molding operations in the Americas during the quarter. Adjusted operating expenses totaled $35.1 million, or 29.9% of total revenue for the third quarter of 2019. This compares to $37.1 million, or 32% of revenue in the second quarter, a reduction of $2 million. Adjusted sales and marketing expense was 14.3% of revenue in the quarter, down sequentially from 16.1% of revenue.
The largest component of the sequential decline relates to the second quarter seasonality of marketing spend, including expenditures associated with several trade shows. Adjusted R&D was 6.6% of revenue, consistent with the second quarter of 2019. We continue to invest in research and development at this level to expand our capabilities in all services and improve our customer experience and internal systems in order to support the future growth of the business. Adjusted general and administrative expense was 8.9% of revenue in the third quarter, down slightly from 9.3% in the second quarter, largely driven by lower incentive compensation expense and favorability in our self-insured medical expenses compared to last quarter. The net result was adjusted EBITDA in the quarter of $32.3 million, or 27.5% of revenue, an improvement of 80 basis points over the second quarter.
Our non-GAAP effective tax rate was 21.5% in the third quarter of 2019, compared to 19.6% in the prior year. Our third quarter 2018 effective tax rate was lower with favorable results of an IRS tax audit. After adjustments, our non-GAAP diluted earnings per share in the third quarter was $0.76, resulting in a $0.05 per share sequential improvement in EPS, principally driven by lower SG&A. Non-GAAP EPS was down $0.10 per share compared to the third quarter of 2018. The lower effective tax rate in the third quarter of 2018 represented a $0.03 per share benefit last year. The remaining $0.07 year-over-year decrease in EPS was driven by investments in our R&D activities and gross margin compression, including lower volumes in our acquired operations, the investment in our CNC facility in the Americas, and wage inflation. Now turning to cash flow.
Our business continues to produce strong cash flows, generating $28.9 million in cash from operations during the quarter. Capital expenditures totaled $12 million in the third quarter, consisting of investments to drive future growth, including IT systems and infrastructure, expansion of our facilities in Europe, and production equipment. We also returned capital to shareholders by repurchasing $12.1 million, or 128,000 shares of common stock during the quarter. To date, we have repurchased $50 million under our stock repurchase program, resulting in $50 million remaining available under the plan. We ended the quarter with a cash and marketable securities balance of $155 million on September 30th. Now I'd like to provide our expectations for the fourth quarter of 2019. We currently expect fourth quarter revenue to be in the range of $109 to $115 million. This revenue guidance reflects the current global economy, specifically the muted manufacturing and industrial production data.
As we have stated in the past, the fourth quarter, particularly the impact of the holiday season on the end of the quarter, is difficult for us to forecast. That is especially true this year in this environment. We estimate foreign currency will not have a significant impact on our fourth quarter revenues compared to the prior year. Moving to earnings guidance. In the fourth quarter, each year we incur holiday pay during the Thanksgiving and Christmas holiday seasons that results in increased labor costs. Our non-GAAP add backs for the quarter will include stock compensation costs of approximately $2 million and amortization of $900,000. We currently estimate our non-GAAP tax rate to be approximately 21%-22% in the fourth quarter. Taking into consideration all the above, we expect our quarterly non-GAAP EPS to be between $0.59 and $0.67 per share in the fourth quarter.
That concludes our formal remarks. Now, Vickie and I'd be happy to take your questions.
Thank you. We'll now be conducting a question and answer session. If you'd like to ask a question, please press star one from your telephone keypad and a confirmation tone will indicate your line is in the question queue. You may press star two if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. One moment please while we poll for questions. Thank you. The first question is from the line of Brian Drab with William Blair. Please proceed with your questions.
Hi. Good morning. Thanks for taking my questions.
Good morning.
I guess the difficult macro environment is well understood and well-publicized. Maybe just getting into some of the details of the business first. With Rapid, that business was up significantly sequentially in the second quarter, and I'm wondering if you could I didn't hear a number for Rapid overall sequential, if you could give that number and then talk a little bit about why that business would kind of decline or flatten out sequentially when it should be ramping.
Yep. While John sequentially it was down slightly, John's going to pull that number for me. I don't have it off the top of my head. Let me just talk a little bit. As I mentioned in the call, we're going through some major changes in that business with moving forward with a defined offer, and frankly, industry-leading lead times and stated lead times. Big changes that are happening in that business. Therefore, some of the existing customers that were with that business that had very complex parts are really outside of our envelope today. We're continuing to see that piece of the business, frankly, not reoccur. We're seeing some success in bringing in new product developers from Proto Labs, a very large set of product developers that we serve. As I mentioned, that grew over 20% year-over-year.
With the lower order value that we have, that revenue growth in total is still below our expectations. What we're really focused on is making sure that we can continue to improve that customer experience in a way that allows us to cross-sell. In addition, as you know, when we bring in new customers, they often, the first order, they're kicking the tires to try to see what our capabilities are. It's the second and third orders where they begin to increase that order value. We're impacted by that as well. I'm confident when we get customer feedback, they're very pleased with the service. There's nobody out there that offers three-day lead times on Sheet Metal parts.
It's a matter of turning those customers and taking share in a macro environment that, frankly, the machine shops and the local mom and pops around the corner, they now have capacity, and they can't service that business. We've got to take that share from those in what is a more difficult macro environment.
Brian, for the numbers on that, it's down 9% or about $1 million.
Sequentially.
Sequentially.
About $1 million, 9%. Okay. You talked about the pressures on gross margin. Can you talk about the outlook for gross margin? What do you expect gross margin to be in the fourth quarter and trending into 2020? Is there gross margin expansion potential from here, and how much?
Yeah. I think, as we look at the fourth quarter and consistent with what we've discussed in the past and looking at our revenue guide, with the revenue coming down a little bit, we will be able to manage the labor cost and the materials, but we will have some challenges really managing the cost structure down with revenue being sequentially down. As we're looking at gross margin, it probably will be a little bit lighter than where we are currently in the fourth quarter. We are focused on gross margin across each of our services. We're going through our budgeting process right now, and looking at the actions and building up the plans for 2020. We will be looking to drive improvement in the gross margins, but we're going through the work right now to fully flesh out those plans.
I'll just ask one more for now, but what have you seen in October in terms of demand relative to the third quarter and October last year?
Yeah, I think what we've seen in demand is that it's consistent with the guidance that we put out. We feel comfortable at this point with the revenue guidance we just gave you.
All right. Okay. Thanks very much. I'll follow up later.
Thank you. Our next question is from the line of Andrew DeGasperi with Berenberg. Please proceed with your questions.
Good morning. I just want to ask, sort of follow up on one area you mentioned in terms of the aerospace business slowing down. Do you think that's a temporary blip? I know Dassault this morning also mentioned something of a push out on their end. Is there anything specific that you can highlight?
Yeah. I think it is a temporary blip. We see strong activity. We have a very strong value proposition in aerospace. Remember where we play in aerospace, it's not so much commercial aircraft. It's in space, it's in satellite communications, it's in drones, and lots of activity there. Year to date, our revenue growth in that aerospace is still 7.2%, so really strong. It's just in that particular quarter, it was basically flat or down very slightly. We're still confident that that's got long-term legs and lots of R&D activity and low volume production in that space for us.
Got it. In terms of the Rapid business, I know we're focusing on that a bit, but just a question in terms of how do you see this progressing. I guess in Q4, you're dealing with the issues in the macro side and also the Sheet Metal business overall, but do you see this business returning to growth starting Q4 year-over-year? I know last year it started declining. Is it really just a 2020 event?
Yeah. Let me step back for a minute. One of the things that we've done is significantly change the offer and then focusing on the cross-selling efforts with Proto Labs customers and teaching them really how our offer with Sheet Metal and the expanded CNC offer will work for them. That takes time. We also are in a macroeconomic environment where the competitors, which really are the mom and pops, have significant excess capacity. Unseating those current vendors and gaining that share in this environment is more difficult. We are turning those customers. I mentioned the 20% increase in product developers. It will be somewhat muted, so we're being cautious on the forecast there, recognizing we've got to be able to, in addition, create a much more integrated customer experience, and that will take us a little time.
Got it. Last question. The low volume business versus prototyping, have you seen sort of a bigger pullback from there at this point?
Are you talking particularly about in the Injection Molding service where we have?
Yes.
There we have a stated offer for on-demand manufacturing. We continue to see that growth in Injection Molding witnessed by the larger orders that we're starting to see come through in that space. We feel comfortable with that. Our prototyping business and Injection Molding's growing as well. I would say that between the two, they're growing at comparable rates.
Got it. Thank you.
The next question is from the line of Troy Jensen with Piper. Please proceed with your question.
Hey, good morning, John. Good morning, Vickie.
Morning.
Hey, John, just for you, sorry if I missed it, but can we touch a little bit more on gross margins? If I look at Q2, you guys grew revenues slightly sequential and kind of kept margins flat, but then this quarter it grew slightly, but we're down about 110 basis points.
Yeah. Rapid's the biggest driver of that. The volume shortfall in that business is 70 basis points of that 110. The remaining 40 was due to some of the product lines and repair and maintenance that we had in some of our facilities in the U.S. The acquired operations was the biggest component.
Okay. Sheet Metal, even though it was only down $200,000 sequentially, it's at a 70 basis points sequential.
It was the Sheet Metal and the CNC component, the operations that we [crosstalk] .
Yeah, that makes more sense.
Combination of the two.
We saw some good leverage in sales and marketing this quarter. It sounds like it may have been seasonal with some trade events, but I also thought Vickie made some comments that it was a bit more intentional. Just be curious, ultimately, maybe not in fourth quarter, but is there any leverage in the operating lines here that you guys can do to maybe offset the sluggishness in the top line?
I think we're continuing to look at all the costs and the cost structure. I think ultimately as we're looking at it, we're building the business for the long term, and we're staying focused on what we need to do to continue to expand the envelope. I think from an R&D perspective, we'll continue kind of at the same levels that we're at. I don't think we'll pull back there. Sales and marketing, I think we'll be prudent with some of the marketing spend, I think we are continuing to look to drive that volume growth. The G&A area is an area we'll continue to look at, continue to scrub, we'll manage that line item.
We continue to work on driving the productivity of our sales team. We mentioned before, we're using data and analytics in order to have our sales team focusing on the opportunities that have the greatest lifetime value for us. That's industry segments and types of customer companies where they can more productively drive long-term sales growth. I think that focus and that use of data is also going to give us some opportunity over the long term to drive the productivity of the sales team.
Great. I understand that. Vickie, how about for you? I'd love to hear just kind of qualitatively your thoughts on 2020. I know we're not going to get numbers from you, right, specific guidance, but it doesn't seem like we're going to see a rapid recovery in ISM data or we're coming into an election year. Initial thoughts on 2020 would be awesome.
Yeah. You read the same things I do. I wish I could predict. I think what I'm hearing out there in the marketplace is that the first quarter, maybe even the second, we're probably still going to see quite a bit of some headwinds that we're looking at. Towards the second half of the year, people are expecting things to recover a little bit. Now, the other thing that we'll have in 2020, of course, is we'll be coming off comparables that aren't so challenging. You look at the third quarter of 2018, we had a phenomenal third quarter of 2018. The comparables are pretty tough there as well. I think you'll see that coming through next year.
All right. Well, good luck.
Thank you.
Thanks, Troy.
As a reminder, to ask a question today, you may press star one. The next question comes from the line of James Ricchiuti with Needham & Company. Please proceed with your questions.
Hi, good morning. Wanted to follow up on the comments that you made about some cautiousness that you're seeing on some of the R&D projects. Normally, I wouldn't expect you would see that in a slowing macro environment, particularly something that's fairly modest slowing. I wonder if you could elaborate on that or maybe talk a little bit about perhaps which verticals you're seeing that in.
Yeah. I think as we're looking at it, Jim, and I think that's why we gave the data point of our top 100 customers. Last year, we saw strong growth in those top 100 customers, and this year they're essentially flat. What that creates is when we delivered strong growth in 2018, those customers haven't increased their spending level from where that was in 2018. It's flattened out more. That's creating some of that challenge and putting pressure on that top-line percentage growth number. Does that help?
It helps. I would expect that our projects continue to get funded in this kind of an environment. I was just struck by that. I can see other parts of the business slowing. Maybe we could just switch gears for a second. I'm also trying to reconcile the continued strength you're seeing in 3D Printing. You called out a couple of areas, metals, the Multi Jet, and clearly those seem like good growth areas. I'm wondering, do you feel you're just taking share, or is this part of the business, the market, just continuing to grow beyond the core business, beyond what you're seeing in the core markets that you address?
I think we've got a little bit of both going on. We do have a differentiated offer with respect to quality and the consistency and reliability of our offer. When customers are looking for high-quality industrial 3D printed parts for their programs, we're the place to go. I think we're seeing some of that, but I do think customers are learning more and more how to use 3D Printing, both in their product development cycle, as well as how to design for 3D Printing for production. I think that's what you see with the growth in our metal 3D Printing and Multi Jet Fusion, which are both technologies that are particularly valuable for production type programs. I think it's a little bit of both that's happening with that business.
Vickie, last question. Can you say which market verticals you seem to be getting the most traction in metals and Multi Jet?
We're seeing it in aerospace, in med device, and also somewhat in computer electronics in the Multi Jet Fusion plastic area. Those would probably be the three industry verticals.
Okay. Thank you.
Our next question is follow-up from the line of Brian Drab with William Blair.
Hi. I'm just looking at the notes from the last call and the expectation for gross margin, and just want to spend another second trying to understand more what has changed in terms of the trajectory. You were really cautious, I think, as you looked to the second half of the year in terms of revenue growth, but you were expecting gross margin to step up sequentially. Is the biggest factor there that's changed in the Rapid business, or is it, I guess, a combination of that with increased caution on the overall top-line trajectory?
I think it's easier to leverage cost when revenue is increasing, right? As revenue is lighter than we anticipated, you've got to pull cost back, and that's just a bigger challenge. I think it is the volume there and what we just experienced in Rapid that's creating that caution.
Okay. Then, John, can you just give us an update, just the numbers on where Alpha gross margin is and where Rapid gross margin is and what the overall headwind those are having, not year-over-year, but just the overall headwind those have on the gross margin?
Yep. The Rapid gross margin, 260 basis point headwind on the overall, and Europe 3D is about 130 basis points overall.
Where does that put, I guess, last quarter Alphaform was at a little over 20% gross margin.
Yeah.
Where is that now?
We dipped down into the mid-teens.
Okay
in 3D printing in Europe. In New Hampshire, we're in the 25% range.
Okay. Got it. Thanks very much.
Thank you. At this time, I will turn the floor back to management for closing remarks.
Thank you for joining us today. We are confident in the long-term prospects and the strength of 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 their competition. We continue to innovate with our service offerings and technology interface and features to enhance our customers' experience. I want to thank the Proto Labs employees for their continued efforts as well as our customers for their support. We look forward to updating you on our progress during our next call. Thank you.
Thank you. This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.