Novanta Q3 2023 Earnings Call Transcript

Quartr
Provided by Quartr
November 7, 2023

There are 6 speakers on the call.

Operator

Good morning. My name is Andrea, and I will be your conference operator today. At this time, I would like to welcome everyone to the Novanta Incorporated 2023 Third Quarter Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question and answer session.

Operator

To withdraw your question, please press star then 2. Please note this event is being recorded. I would now like to turn the conference over to Ray Nash, Corporate Finance Leader for Novanta. Please go ahead.

Speaker 1

Thank you very much. Good morning, and welcome to Novanta's Q3 2023 earnings conference call. I'm Renesh, Corporate Finance Leader of Novanta. With me on today's call is our Chair and Chief Executive Officer, Matthijs Glastra and our Chief Financial Officer, Robert Buckley. If you've not received a copy of our earnings press release issued today, you may obtain it from the Investor Relations section of our website at www.novanta.com.

Speaker 1

Please note this call is being webcast live and will be archived on our website shortly after the call. Before we begin, we need remind everyone of the Safe Harbor for forward looking statements that we've outlined in our earnings press release issued earlier today and also those in our SEC filings. We may make some comments today both in our prepared remarks and in our responses to questions that may include forward looking statements. These involve inherent assumptions with known and unknown risks and other factors that could cause our future results to differ materially from our current expectations. Any forward looking statements made today represent our views only as of this time.

Speaker 1

We disclaim any obligation to update forward looking statements in the future even if our estimates change. So you should not rely on any of these forward looking statements as representing our views as of any time after this call. During this call, we will be referring to certain non GAAP financial measures. A reconciliation of such non GAAP financial measures to the most directly comparable GAAP measures is available as an attachment to our earnings press release. To the extent that we use non GAAP financial measures during this call that are not reconciled to GAAP measures in the earnings press release, we will provide reconciliations promptly on the Investor Relations section of our website after this call.

Speaker 1

I am now pleased to introduce the Chair and Chief Executive Officer of Novanta, Matthijs Quastrop.

Speaker 2

Thank you, Ray. Good morning, everybody, and thanks for joining our call. Novanta had a solid Q3 with strong operating performance, delivering profit cash flow above our expectations. Our revenue was in line with previously issued guidance. In the quarter, we delivered $222,000,000 in revenue, represented a 1% year over year revenue decline on a reported basis and 3% decline on an organic basis.

Speaker 2

Excluding microelectronic applications, our growth in the quarter was up low single digits. We recorded gross margins of 40 7% in the quarter and an adjusted EBITDA margin of nearly 24%. In addition, our cash flow was up over 2 times the prior year and at more than 175 percent conversion to net income. This operating performance reflects excellent execution by our teams in an increasingly challenging macroeconomic environment. The Novanta business model with diversified exposure to secular high growth markets has proven resilient under multiple geopolitical and macroeconomic scenarios.

Speaker 2

Our proprietary products and technologies are well positioned in medical and advanced industrial applications with long term secular tailwinds, such as robotics and automation, healthcare productivity and precision medicine. Medical applications now make up nearly 60% of our sales versus single digit percentage of sales a decade ago, which we believe provides Novanta with greater resilience during fluctuating macroeconomic conditions. We feel that our strong customer relationship with the leading OEMs in these medical and advanced industrial applications, The strength and diversification of our portfolio and our sticky business model will allow Novanta to deliver and drive better performance through the economic cycles. In the Q3, the Novanta team has made excellent progress in bringing down lead times to our customers. The consequence of this change is that customers do not need to place long term orders anymore, resulting in a book to bill of 0.8, which was in line with our expectations.

Speaker 2

However, this change in lead times improves customer satisfaction and allows the business to better trend with end market demand dynamics. Speaking to the business environment more broadly, in the past couple of months, we start to see more caution in some of our customers' ordering behavior. With the rapid rise in interest rates in the last months, continued weakness in China and expanding geopolitical unrest, Our OEM customers have seen their customers slow down ordering, particularly in industrial and more recently some life science applications. While this had clearly been while this has clearly been evident in the global purchasing managers indices for industrial spending, The rapid rise in interest rates has caused other capital equipment markets to be more cautious as well, deferring purchases until the New Year. Given the strong secular growth drivers behind our markets and our customers' engagements on innovation, we see these current dynamics as temporary despite the impact on the Q4.

Speaker 2

Robert will discuss these dynamics in more detail when he covers guidance. It is important to note that the Novanta playbook and business model have demonstrated ability to effectively navigate short term headwinds. We've accomplished this while at the same time staying focused on making investments that expand our presence in secular high growth markets. We continue to see active engagement and urgency with our customers to ensure their new product launches are a success. As a result, we're seeing a broad new product super cycle entering late in 2024 and in 2025 and beyond with key drivers including smoke evacuation insufflation, robotic surgery, next generation lithography, laser beam steering for advanced material processing such as laser additive manufacturing and micro machining, robotic end effector sensors and mobile robotics.

Speaker 2

Given our sticky business model in these long lifecycle growth applications, we strongly believe the mid and long term outlook of our business, our end markets and the Novanta organic growth algorithm to be intact. Looking back to the Q3, the broader end market themes were That medical markets continue to be strong, industrial markets are decelerating in line with the PMI indices and interest rate environment and Microelectronics is bottoming at a low level. Excluding Microelectronics, Novanta revenue growth would have been up low single digits year over year in the quarter. Going into more detail, sales to medical markets remained strong in the quarter, growing 12% versus the prior year and making up approximately 57% of total Novanta sales. During the quarter, we saw increased shipments to many of our medical OEM customers with noteworthy strength in minimally invasive surgery equipment and consumables, surgical robotics, DNA sequencing and integrated operating room equipment.

Speaker 2

These categories all saw double digit growth in sales year over year, where long term secular growth is driven by patient surgical procedure growth rates and advancements in biopharma technologies, including next generation DNA sequencing. We continue to find new growth opportunities in our medical markets. For example, We see opportunities to expand our presence in DNA sequencing to the broader precision medicine market, including spatial biology, multiomics and other clinical life science applications by combining the proprietary Novanta technologies into unique solutions for solution. In doing so, we believe we can help our customers win by shortening their time to market and enhancing their differentiation. In addition, we continue to remain very excited about the long term secular growth in minimally and robotic surgery markets with Novanta continuing to win with our next generation smoke evacuation, endoscopic pump technologies, Precision Motion Drives and our 4 stroke sensors.

Speaker 2

Turning to advanced industrial markets, our sales in the 3rd quarter excluding microelectronic were down 6% year over year and made up approximately 36% of total Novanta sales. This sales decline was slightly more than we expected Due to the rapid rise in interest rates and continued weakness in China impacting the industrial robotics and automotive sectors. While these trends are expected to worsen somewhat in the Q4, customers remain very engaged and are using the slowdown to catch up on next generation innovations. As a reminder, Novanta plays in advanced industrial applications with mid to single digit growth driven by secular growth We represented less than 8% of sales in the quarter. The dynamics are roughly the same as we said in our last call.

Speaker 2

In the quarter, we saw nearly a 40% decline year over year from the cyclical downturn in this market, particularly driven by our PCBA TBA vehicle drilling business, which is now run rating at just a couple of $1,000,000 of revenue per quarter, which is immaterial to overall company results. We estimate that the overall drop in the microelectronics market will be a 400 basis point headwind on total Novanta sales growth for the full year. Again, excluding microelectronics, Novanta revenue in the Q3 will be up low single digit year over year. As we look out into 2024 and 2025. We do, however, remain excited that the composition of our exposure to this market will be a more secular growing and less volatile business.

Speaker 2

As we mentioned in prior calls, we believe our exposure to next generation lithography will continue to grow, positioning us well to capitalize on a less element of the industry with at least a decade's worth of growth still ahead of us. From a regional perspective, in the 3rd quarter, sales to North America grew 11% year over year and sales in Europe declined by 2%, which reflects the challenging market economic commissions in this region and its connections with the China market. Sales in China, which represented about 7% of overall sales declined 35% year over year, which was caused by the decline in microelectronics revenue, the industrial robotics pause and overall macroeconomic uncertainty in China right now. These regional trends are expected to continue in the 4th quarter.

Speaker 3

Now let me touch on

Speaker 2

some of Novanta's strategic growth metrics. For our design wins in the quarter, we saw significant progress with numerous large customer wins. We had another large win with the leading minimally invasive surgery OEM, where their platform will now incorporate our next generation smoke evacuation insufflated technology. Based on our design wins in this market, we expect Novanta's technology to be the standard of care for minimally invasive surgeries for at least the next decade. In addition, in the quarter, our Medical Solutions segment also had a large design with a leading player in the integrated operating room market, where our video and data management product will be integrated into a new platform launching in 2025.

Speaker 2

Finally, this business closed the design win within The sports medicine aerothroscopy market with our proprietary pump technology, which is also expected to launch in late 2025 and In the Precision Medicine and Manufacturing and Robotics and Automation segments, we also had several exciting wins. We continue to make significant progress expanding our exposure to next generation lithography equipment in area which has a decade long growth outlook. Given recent customer announcement, growth in this application is now expected in late 2024, which will accelerate in 2025. We're also very excited by recent design wins in our Forester Sensor product line, which enables a sense of end of arm touch for robots in industrial and medical applications. After significant effort, this business has started shipping into the medical space, representing a significant milestone and the realization of a critical value driver for the ATI acquisition.

Speaker 2

In addition, within our Robotics and Automation segment, we recently won a new multimillion dollar project with a leading robotics player, who's planning to integrate our miniaturized high performance server drives into their next generation of advanced mobile robotics. This opportunity will start to ramp up in 2025. We're excited by the impressive accumulation of customer design wins and our strongest innovation pipeline in a decade. We remain highly focused on executing our new product super cycle starting late in 2024 and into 2025 and reiterate with confidence our overall long term growth framework of consistent mid to high single digit organic growth through the business cycles. Next, our vitality index in the Q3 was about mid teens percentage of sales, which is roughly the same as prior quarter and in line with our expectations.

Speaker 2

Our new product pipeline is geared towards intelligent subsystems in applications such as minimally invasive surgery, robotic surgery, Next Generation Precision Medicine, Laser Beam Steering for Micro Machining, Electric Vehicle Robotic Tool Changers, Precision Motion Solutions for Mobile Robotics and warehouse automation. After our next generation products start launching with customers in late 2024, we expect vitality index to rebound to above 20%, driving sustained growth in secular growth markets. Moving on, I'm proud to say How our teams are embedding the Novanta Growth System or NGS into the way we work. During the Q3, we held the President's Kaizen Week in our Medical Solutions segment, bringing together dozens of our senior leaders and many other team members to focus process improvements and problem solving in critical areas for the business, such as the ramp of manufacturing of our in house medical consumable products at our new Czech Republic factory. We're also using NGS project management tools to compress our time to market of NPI launches and compensate for delays due to supply chain shortages in the last 18 months.

Speaker 2

A critical tool we're deploying is eightytwenty portfolio management. We're using this approach to rationalize our portfolio, reducing our exposure to products that are commoditizing or nearing end of life. We're taking these actions to decrease complexity, improve profitability in light of near term market conditions and to allow teams to focus more on ramping the new the multiple new products that will be coming online late in 2024. Overall, these tools and Kaizen events are becoming a critical part of our NGS deployment, our culture and demonstrating our commitment to continuous improvement and our ability to solve complicated problems that benefit our operating performance as well as improve customer satisfaction. Next, I'd like to give you a brief update on Novanta's acquisition activities.

Speaker 2

Acquisitions remain Novanta's top priority for capital allocation and you should expect this to continue to be a critical part of our growth strategy. We have multiple active conversations underway today and would expect at least one of these materializing before year end. You can expect us to lean in on expanding our presence in the megatrends I talked about earlier. We view disruptive macroeconomic environments as an opportunity to take advantage of for M and A activity as sellers changed their expectations in light of higher interest rate environment. As such, we expect to be an active acquirer in this environment.

Speaker 2

In conclusion, we had a solid Q3 with excellent operating performance delivering profits and cash flow ahead of expectations and sales in line with expectations. Despite the short term macro outlook, we believe Novanta's long term strategic positioning continues to be extremely strong and we're staying the course on executing our strategy and capital deployment model. With that, I will turn the call over to Robert to provide more details

Speaker 4

Profit was $105,000,000 or 47 percent adjusted gross margin compared to $102,000,000 or 46 percent adjusted gross margin in the Q3 of 2022. For the quarter, adjusted gross margins were up year over year by over 100 and 60 basis points and up sequentially by 30 basis points. This outcome was better than our expectations and represents strong execution by our teams to achieve this result. Our continued progress with gross margin expansion in 2023 is being largely driven by the deployment and successful adoption of the Novanta NGS productivity tools in our factories. The 47% gross margin puts us on a solid track to achieving our full year goal of expanding gross margins by 100 basis points.

Speaker 4

Moving on to the operating expenses. R and D expenses were roughly $22,000,000 or approximately 10% of sales. 3rd quarter SG and A expenses were $40,000,000 or roughly 18 percent of sales. Overall operating expenses as a percent of sales were flat year over year in the quarter. While we continue to invest in new product innovations and prepare for the launch of multiple new product platforms, the organization also demonstrates strong Adjusted EBITDA was approximately $52,000,000 in the Q3 of 2023 or 23.6 percent adjusted gross adjusted EBITDA margin versus $49,000,000 in the prior year.

Speaker 4

On the tax front, Our non GAAP tax rate for the Q3 of 2023 was 15%. This differed from the statutory rate due to jurisdictional mix of income and some timing related tax benefits. Our non GAAP adjusted earnings per share was $0.85 in the quarter compared to $0.81 in the Q3 of 2020 2. 3rd quarter operating cash flow was approximately $45,000,000 which is up greater than 200% versus the prior year. We are pleased with this result, which results in strong profitability in the quarter and some progress in reducing our inventory balances.

Speaker 4

We ended the quarter with gross debt of $357,000,000 versus gross debt of $413,000,000 in the Q2 of 2023, and our growth leverage ratio was 1.8 times. Our net debt was $281,000,000 putting the company in a great position to fund further acquisitions. Turning to backlog and bookings, our team again made great progress reducing our past due backlog to customers by more than 24% sequentially, While still ending with a backlog of $536,000,000 which is nearly 2 times pre pandemic coverage levels. Our remaining past due backlog is now immaterial and so we have started to pivot to reducing lead times and on time shipments of our new orders to historical levels. Our book to bill in the Q3 was 0.8, which is in line with our expectations.

Speaker 4

I'll now turn to an update about the performance of our operating segments. First, I'll speak to the Precision Medicine and Manufacturing segment for the Q3 of 2023. This segment demonstrated strong financial performance overall with strong gross margins and strong EBITDA margins despite weaker than expected revenue growth. While the segment delivered 1% year over year growth, this was lower than we expected as industrial customers delayed purchases due to the higher interest rate environment and new geopolitical disruptions. The book to bill was 0.72x in the Q3, which reflects continued normalization of lead times as customers adjusted their level of backlog coverage to pre pandemic levels and some softening of demand from life science, precision medicine end markets, which also experienced the impact of higher interest rate environment.

Speaker 4

Within precision medicine, new product revenue stayed greater at 20% of sales in the 3rd quarter. Design wins in the segment were down year over year driven by timing and difficult comparisons as in the last few quarters. Despite For the full year of 2023, we still expect solid design win growth in the range of 10% to 20% year over year. We're excited about the progress being made with multiple strategic customers. For example, we recently completed new key milestones to grow our exposure to next generation lithography applications.

Speaker 4

These customer opportunities gives us confidence we will continue to see growth in this segment heading into future years. The Precision Medicine and Manufacturing segment adjusted gross margin was nearly 52% in the quarter, which was up 100 basis points, 180 basis points year over year. We are proud of the performance of our manufacturing operation teams, particularly as they embrace and institutionalize the Novanta Growth System. Turning to Robotics and Automation segment. This segment experienced a revenue decline of 15% year over year, which is in line with our expectations and our prior guidance.

Speaker 4

This decline continues to be mainly driven by steep year over year declines in microelectronics applications, particularly our PCBA mechanical via hole drilling applications, call. In the quarter, this segment saw an impact from weakness in the sales of industrial robotics, largely caused by China and the slowdowns in the automotive manufacturing. The overall book to bill ratio in this segment was 0.79, again driven by the microelectronics decline and industrial demand dynamics in China. Microelectronics experienced a negligible level of bookings in the quarter. On the positive side, our ATI business saw a book to bill greater than 1 in the Q3 indicating that the decline in industrial robotics is stabilizing.

Speaker 4

New product revenue was roughly 10% of total sales in this segment in the quarter. As a reminder, this ratio is lower than 2022 because the metric now includes new product sales from our ATI business line, which is having a dampening effect on the overall segment ratio. Adjusted gross margin for Robotics and Automation segment came in at roughly 51%, which was roughly flat sequentially and up year over year by 200 basis points. Again, we are proud of the progress our teams were making by adopting The Novanta growth system to drive strong margin performance, while reducing lead times, improving on time delivery and improving product quality despite year over year revenue declines. A further testament to our progress, this segment achieved a rare preferred supplier rating from a top 5 medical customer.

Speaker 4

Finally, in Medical Solutions, this segment experienced reported revenue growth of 14% year over year, which was stronger than our expectations. Growth in this segment continues to be driven by strength in elective surgical procedures as well as our JADAC business line, where the business continues to perform well The Medical Solutions segment saw a book to bill of 0.87 in the 3rd quarter with bookings up 2% year over year. The vitality index in this segment was reduced versus prior year and is at mid teens percent of sales level in line with our expectations. As we mentioned in prior earnings call, this is largely driven by our first generation smoke evacuation insufflator product reaching its 4 year milestone. We expect this metric to rebound in 2024 as we launch our 2nd generation smoke evacuation insufflators and new endoscopic pumps.

Speaker 4

Design win activity in this segment was very robust Q3 despite tough comps in prior year. This was driven by another impressive design win in the minimally invasive surgical space related to our next generation insipulator technology and an impressive design win with our integrated operating room technology products with a leading OEM in that space. Overall, our business performed as we expected in the quarter. This is a testament to high caliber of talent in our business teams and their ability to navigate and work together to deal with numerous challenges despite rapidly changing economic circumstances. We are proud of the team's performance.

Speaker 4

Now turning to guidance. While we still have historical high backlog coverage heading into a more uncertain demand environment. We are working closely with our customers to schedule shipments in a manner that avoids our customers building inventory which is in line with their end market demand. We feel this approach avoids any unnecessary revenue volatility in the future and avoids our revenue from being disconnected from end market demand. This is factored into the 4th quarter revenue guidance and we expect will lead to a book to bill ratios in the 4th quarter comparable to the 3rd quarter.

Speaker 4

From an end market perspective, We continue to expect to experience growth in our medical end markets despite temporary weakness materializes in precision medicine and life science end markets due largely to the interest rate environment. Despite these near term customer deferrals that we expect will manifest in the Q4, we remain confident in the long term demand in these markets and the medium term demand we expect from customer launches of new products in the second half of twenty twenty four. As an example, we continue to see strong customer demand and urgency for our 2nd generation smoke evacuation technologies, A new endoscopic pump platform, a new integrated operating room technology platform and new optical subsystems for customers in the precision medicine market, including spatial genomics and bioprocessing. Therefore, we continue to invest with confidence to better position ourselves to serve these secular growing markets. In our advanced industrial end markets representing slightly more than 40% of overall sales, Global Purchasing Manager Indices remain below 50 indicating industrial capital spending remains in contraction.

Speaker 4

We are now lapping the Q4 in a row of PMIs falling into contraction territory led by a cyclical downturn in the microelectronics Capital spending slowed more broadly in the Q3 of 2023 following a significant spike in interest rates, particularly in the U. S. And further weakening in China. As we enter the Q4, the geopolitical environment has worsened, particularly in the Middle East And industrial spending has slowed further as industrial manufacturing customers have deferred purchases and are still starting to feel the pressure of the spike of interest rates. While there are signs of capital spending stabilizing by year end after what will be 5 quarters of PMIs below 50 And of interest rates stabilizing at these elevated levels, the combination of volatility in the macroeconomic and geopolitical environment and the lead times of our business compels us to revise our Q4 financial expectations down from our original expectations and also down sequentially from the Q3.

Speaker 4

Starting with revenue guidance, for the Q4 of 2023, we expect GAAP revenue in the range of $208,000,000 to $212,000,000 which represents a revenue decline of approximately 5% on a year over year basis. In the full year of 2023, we now expect GAAP revenue in the range of 8 $78,000,000 to $882,000,000 This represents low single digit growth for the full year, which is below our original expectations for the second half 2023. However, based on deep conversations with our customers, we expect this to be a temporary deferral in demand, which further emphasizes the need to focus and allocate our resources to the secular growing and less cyclical end markets. On a segment level in the Q4, we expect Precision Medicine and Manufacturing segment revenue to be flat to down 4 organically on a year over year basis. While there are aspects of our business doing well, demand deferrals in industrial applications and some life science applications are impacting the segment's growth in the Q4.

Speaker 4

Although near term demands remain softer than expected, customer activities, Our Robotics and Automation segment is expected to be down 9% to 14% year over year in the 4th quarter. The year over year decline is mainly driven by the continued pause in industrial robotics spending, particularly in China and continued weakness in microelectronics. While there are signs that demand is starting to stabilize, the higher interest rate environment needs to further normalize at these elevated levels before demand fully recovers. Finally, our Medical Solutions segment is expected to demonstrate year over year revenue growth in the 4% to 6% range in the 4th quarter. While there are more difficult comparisons to the prior year, overall demand in this segment continues to align with global surgical and procedure growth rates.

Speaker 4

Customers in this segment are working with urgency to accelerate and finalize launches of the 2nd generation smoke evacuation technology and to focus their product portfolios on their new innovations. Our medical technologies continue to incent strong demand from our customers, resulting in full year 2023 revenue growth in the mid teens territory. Moving on to overall Novanta's adjusted gross margin. We expect gross margins in the 4th quarter to be approximately 46.5% to 47%. Gross margins in this segment will largely mirror the margins achieved in the Q3.

Speaker 4

Increases or decreases per segment will only be based on changes in sales volume. Regardless, overall margin should meet or exceed our full year expectations of 100 basis point improvement year over year. For the full year 2023, we now expect adjusted gross margins to be approximately 46.6% to 46.8%, a testament of our team's adoption of the Novanta Growth System. Turning to R and D and SG and A expenses, they are expected to be approximately $64,000,000 to $65,000,000 in the 4th quarter. The increase in cost year over year is largely driven by labor cost increases and further investments in our innovation pipeline and some further investments in our commercial engine as we increase our investments in some upcoming precision medicine applications.

Speaker 4

Depreciation expense, which was about $3,000,000 in the 3rd quarter, will be closer to $3,700,000 in the 4th quarter from the increased investments in our facilities. Stock compensation expense, which was roughly $6,000,000 in the 3rd quarter, will be roughly the same in the Q4. For adjusted EBITDA, The Q4 of 2023, we expect range of $42,000,000 to $45,000,000 For the full year of 2023, for adjusted EBITDA. We expect a range of $193,000,000 to $196,000,000 Interest expense, which was nearly $7,000,000 in the 3rd quarter is expected to be roughly $6,500,000 in the Q4 of 2023, driven by the continued rise in interest rates, partially offset by good success we had in the Q3 paying down our debt balances. We continue to focus on paying down debt to mitigate the impact of rising rates.

Speaker 4

We expect our non GAAP tax rate to be about 18% in the Q4 of 2023 and we expect our non GAAP tax rate to be approximately 16% for the full year of 2023, largely in line with 2022. Diluted weighted average shares outstanding will be approximately 36,000,000 shares and adjusted diluted earnings per share, we expect a range of $0.59 to $0.66 in the 4th quarter. For the full year 2023, adjusted earnings per share is now expected to be in the range of $2.98 $3.05 Finally, we expect cash flows to stay strong in the Q4 as we continue to focus on our efforts of bringing down our inventory levels and from strong customer collections. In addition, our new Manchester, U. K.

Speaker 4

Optical subsystem manufacturing facility and our new Czech Republic medical consumables manufacturing facility are both on track and scheduled to be completed on time. Despite some launch stage Shifting slightly remain under increasing pressure from our customers to accelerate our readiness, which includes completing these two facilities and qualifying the production of our product for our customer product launches. These facilities are expected to see the launch of significant new revenues tied to our 2nd smoke evacuation insulators, new precision medicine products and next generation lithography based applications. As always, this guidance does not assume any significant changes to foreign exchange rates. In summary, Novanta's performance in the Q3 of 2023 was solid and reflected excellent execution by our teams.

Speaker 4

We beat our own expectations for margin expansion, profit performance and cash flow. We saw continued growth in our medical end markets, which offset a growing softness in industrial markets. This dynamic was yet another testament to diversification and resiliency of our business portfolio. Despite an increasing challenging interest rate environment and macroeconomic weakness, We are confident in our ability to navigate the short term and deliver on an accelerating secular growing strategy. Overall, despite industrial capital spending environment in contraction territory for 5 quarters longer than historical down cycles, Our business has held up reasonably well.

Speaker 4

While the economic climate is not expected to worsen nor improve significantly over the next couple of quarters, We do see our long term growth prospects remaining strong and even accelerating on the back of exciting new product launches in the second half of twenty twenty four and our exposure to high growth end markets in both the medical and advanced industrial applications. We remain very grateful for the outstanding performance of our employees and their efforts to help us be successful in a dynamic environment. We remain grateful to our customers' confidence and faith in our ability to deliver to their needs the innovation they need to be successful. We look forward to continuing to deliver on our commitments to our employees, our customers and our shareholders. This concludes the prepared remarks.

Operator

Our first question comes from Lee Jagoda of CJS Securities. Please go ahead.

Speaker 3

Hi, good morning.

Speaker 2

Good morning, Lee.

Speaker 3

So just I guess starting with you had referenced that there's this temporary push out or deferral and customers are sort of leaning on you to carry their inventories at least temporarily. Should we view this as a 1 quarter push and something as simple as when the calendar flips, they'll be back to ordering and taking product? Or is there something else in the macro that we have to keep an eye on and it could be a multiple quarter push out?

Speaker 4

I think there's a bit of a little bit of an overreaction by some customers in the Q4 to deal With the rapid rise in rates and the uncertainty in the environment, obviously, the war in the Middle East sent Some shivers through people's backs that they needed to adjust for or they felt the need to adjust for. So I think the Q4 definitely has a more deferral than what we would expect in 2024. So I do think things will begin to recover a little bit as we get into 2024. I think Customers are really looking and taking the opportunity to focus in on those product launch cycles and really make sure that they're product launches, make sure that those things are on track and to make sure that we're taking the necessary actions to ramp up to the volumes that they're looking for. But most of that is looking at as a second half pickup in demand associated with those innovations.

Speaker 3

Okay. And then, specifically on the microelectronics business, I know you've won a whole bunch of stuff in EUV and DPUV, that should kind of drive multiyearseculargrowth. Can you give us some sense of the timing of Those new products coming online during 2024?

Speaker 2

Yes. Well, first of all, we're extremely excited About this development, we feel even more confident about the long term potential and growth in this application. I mean, there were some public remarks by, I would say, a major player in this industry and our customer, which indicated a slight shift in their demand profile in 2024 from, let's say, early 2024 to more later in 2020 tour. So this is more of a timing thing than a fundamental thing. And actually, as a matter of fact, we feel more confident as we're solving a pretty big problem for our customers.

Speaker 2

So slight shift towards the latter part of 2020 for long term even more excited about this opportunity.

Speaker 3

And Matthias, if you would, maybe just spend a minute or 2 on the

Speaker 2

Yes. Yes, I got to be a little bit careful with this. I would say, I will answer it more holistically. When we say that Novanta provides mission critical technology solutions for our customers, it basically means that we fundamentally solve or improve, let's say throughput, so therefore produces significantly higher level of parts per time unit, yield or cost of quality, right? So in terms of and that's Again, a throughput and a cost environment or enhance basically their capability to produce something that has never been done before.

Speaker 2

I would basically say this solution offers all 3, right? And it has a tremendous impact on end user, basically yields, productivity, throughput, uptime. And so we feel very good about it. But this is a typical Novanta solution that we employ Also in robotics or broader material processing or I would argue DNA sequencing, right. So we enable productivity improvements for the end user and our direct customers.

Speaker 2

So for example, in DNA sequencing is really driving the cost per Protestin genome down as a result of our core engine into those applications, right? So it's a very similar trend and approach across these applications and customers, which is why, yes, we're an intrinsic and detailed and very differentiated part of their supply chain. So when we give all these examples, The themes typically or the solutions typically hit on many of these themes in parallel, right, which is ultimately why We're extracting value from it. Our customers are extracting value from it and the end users are extracting value from it.

Speaker 4

The only thing I would add there is that we have used an acquisition strategy as well to acquire in technologies that allow us to redefine the competitive landscape. And so as a consequence, we don't offer solutions that a competitor can match. We offer solutions that we've uniquely combined through a number of different acquisitions that our competitors haven't even thought of or looked at that allows us to really offer a solution to a customer from their lens, from their eyes. And so I think that's ultimately been the big differentiation that we've had is We don't offer solutions based on the widget that we offer. We offer solutions based on what the customer is looking to solve.

Speaker 3

Got it. And just I guess one more and I'll hop back in queue. As it relates to M and A, you kind of teased we'll see something before year end. Can you give us any framework around size, mix of business that you're looking at? Anything to kind of lead us Down a path in terms of what you're looking to acquire at this point.

Speaker 2

Yes. I think what we've said is that Yes. Listen, we're leaning into these macro trends that we've discussed, right? The overall growth framework is we get more content and So more unique ways of solving our problem like what Robert suggested right in his previous remarks into these high growth applications. And so of course, we have had a tendency over the years to be more geared towards medical end markets as well as growing advanced industrial end markets robotics and automation.

Speaker 2

So You can expect us to continue to lean into those trends and further enhance, I think, our exposure As a reminder, 60% of our business is now or close to is in medical end markets. That's up from, I would say mid single digits 10 years ago. That's both organically as well as through acquisition and we like that general exposure. So Let me leave it at that.

Speaker 3

Okay. Thanks very much.

Speaker 2

Thanks, Lee.

Operator

The next question comes from Brian Drab of William Blair. Please go ahead.

Speaker 5

Hi. Thanks for taking the questions.

Speaker 2

Hey, good morning.

Speaker 5

Good morning. Robert, you said and I just kind of Missed all the context, but you said acceleration in 2024 potentially. Can you just restate that and Elaborate on the drivers that you're talking about at the moment.

Speaker 4

Yes. So I would say regardless of how the market performs, our 2nd half of the year of twenty twenty four, we'll be accelerating on the back of new product launches. So we have a number of customer launches that we've talked about in the past. We have launches now associated with our 2nd generation smoke evacuation platform. There are a handful of customers launching products in the back half of We have customers looking to launch and ramp as Matthijs just spoke about our next generation lithography solutions.

Speaker 4

And we have a couple of new design wins around integrated operating room based technologies and some precision medicine based technologies. And so a lot of these things were meant to be spread out across 2024. I think what we're looking at now Is a little bit more of a back end loaded. 2024 is a consequence of people really taking the time to make those launches successful. I think the urgency around customers has increased to make sure they're successful to make sure that we don't have slips as we launch the product, make sure there's no quality fallout, to make sure Supply chains are in the right places in order to meet their needs and making sure our facilities are there, making sure the people are there and so forth.

Speaker 4

And so that's the activity that we're really looking at. Obviously, in this uncertain environment around the macro and the geopolitical and the interest rates, It was easy for a lot of customers to take a pause for the remainder of the year, but that is not an indication of them taking a pause in their innovation. That innovation is clearly accelerating and they want to make sure it's done right. And so we're expecting the ramp up in the second half of the year.

Speaker 5

Got it. Okay. And yes, so that's what I thought you're saying that maybe it's a little more back end loaded. And this is all related You'd been talking about the $50,000,000 in incremental revenue opportunity. I guess that's part of what you're talking about.

Speaker 5

It sounds like this is even broader kind of second half of twenty twenty four, like some other stuff moving in from the first half to the second half as well.

Speaker 2

Yes, that's correct. And some additional stuff too, right? So we're basically yes, we call that, Brian, our new product Super Saco, because there's a lot of different products and application launches coming together in the later in 2024 2025. So the message is listen, we got a short term macro

Speaker 5

That is

Speaker 2

a bit more of a temporary headwind, but we're staying just razor focused on these new product launches with our customers that really drive our long term growth. So that's the upshot.

Speaker 5

Got it. And Looking at the gross margin and you're really having a good year in terms of gross margin this year. How much can you tell us about 2024 in terms of gross margin? Because you have this project that's This transition of the consumables manufacturing that should get you a healthy margin boost Next year, I think. And can you talk about the timing of that?

Speaker 5

And is it going to be tough to get 100 bps of gross margin in 2024 after such a solid step up in 2023.

Speaker 4

I don't think so. I think we'll be able to still Expand gross margins another 100 basis points. I think there are obviously there'll be a little choppiness in the quarters as Consumables are a lower gross margin than the rest of the business. However, there are other parts of the business, a lot of our new product innovation is being launched 50% or greater gross margin. And so it really that mix effect will be choppy throughout the year, but overall for the full year, we should be able to expand the gross margins to 100 basis points, all else being equal.

Speaker 4

Now obviously, if we do an acquisition, that can change things. But for the most part, the base businesses, their performance, particularly as they have been really embracing Institutionalizing the NGS process. I think that gives us the confidence that they can continue to deliver these results.

Speaker 2

Yes. And in addition, I think, Brian, what We said in the prepared remarks is that we're also continue to apply eightytwenty portfolio management tools, which is basically rationalizing our portfolio, focusing for gross margin and profitability as well as creating the capacity for the growth, right? So that we basically phase out lower margin, less productive products that are either commoditized or more end of life. So that's another aspect. That is an ongoing process within the company, that we're looking specifically in 2024 to execute on.

Speaker 5

Okay. Are we seeing the benefit from that consumables transition already or is that something that is really just going to be felt in the first half of twenty twenty four? Yes.

Speaker 4

It's 1st and second half of twenty twenty four. So the products start ramping. Full production goes will probably go roughly around in the end of December. So the full effects of that really won't be felt until 2024. And then the launch cycle around production of the medical consumables will be very customer specific.

Speaker 4

And so it depends upon how customers want to stock, safety stocks around that. It depends on how their Vacations work out their FDA processes. And so the full effects were really a back half of the year is the easiest way of thinking about it, where we start all new products, all new medical consumables are launched out of that facility. Now similarly, in our Manchester facility, we will be launching all new products out of that facility as well. So that facility will be up and running really by the end of the Q1, fully in production phase.

Speaker 4

And so products will be coming out in the second half out of that facility, again, putting us in a great position to deliver a higher gross margin.

Speaker 2

Yes. And then you have in some of the other product categories more and more intelligent subsystems, which you know have Higher margin profile as well. Also that will launch in the second half. So think about laser beam steering or precision motion related intelligence subsystems, right, that are starting to gear up in the second half of twenty twenty four as well.

Speaker 5

Okay. Thanks for answering those questions.

Speaker 2

Absolutely.

Operator

This concludes our question and answer session. I would like to turn the conference back over to Mr. Matthijs Blostroff for any closing remarks.

Speaker 2

Thank you, operator. So to recap, Novanta had a solid operating performance in the Q3 of 2023. We beat our own expectations for margins, profit and cash flow and saw solid sales in medical markets, helping to offset declines in industrial markets. We've maintained a robust level of backlog coverage while reducing our past due backlog and we see continued tailwinds in our medical businesses that should help personally mitigate growing pressures in the industrial capital spending. We're progressing our innovation pipeline and are excited for the large product launches happening later next year.

Speaker 2

Novanta remains very well positioned in the medical and advanced industrial end markets with diversified exposure To long term secular macro trends in robotics and automation, precision medicine, minimally invasive surgery and Industry 4.0. In 2020 3 and beyond. We will continue to focus on executing our new product super cycle, design wins in high growth applications and doubling down On the Novanta growth system driving cash flows and gross margin expansion. In closing, as always, I would like to thank our customers, our employees and our shareholders for their ongoing and commitment. I'm continuing to be impressed and specifically grateful for the dedicated efforts of all our Novanta employees who work diligently every day to tackle new opportunities, manage through new challenges and make Novanta a great place to work.

Speaker 2

We appreciate your interest in the company and your participation in today's call. I look forward to joining all of you in several months on our Q4 and full year 2023 earnings Thank you very much. This call is now adjourned.

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Earnings Conference Call
Novanta Q3 2023
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