Good morning. My name is Keith, and I will be your conference operator today. At this time, I would like to welcome everyone to the Novanta Inc. 2022 Third Quarter Earnings Call. [Operator Instructions] Please note, this event is being recorded. I'd now like to turn the conference over to Ray Nash, Corporate Finance Leader for Novanta. Please go ahead.

Thank you very much. Good morning, and welcome to Novanta's Third Quarter 2022 Earnings Conference Call. I am Ray Nash, 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 have 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. Please note, this web call is being webcast live and will be archived on our website shortly after the call. Before we begin, we need to 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. 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. I'm now pleased to introduce the Chair and Chief Executive Officer of Novanta, Matthijs Glastra.

Thank you, Ray. Good morning, everybody, and thanks for joining our call. Novanta achieved record results in the third quarter of 2022. We delivered another quarter of terrific financial performance with double-digit growth in revenue and adjusted EBITDA as well as solid growth for adjusted EPS. We ended the quarter with our backlog still at near-record level as we continue to see strong demand from our customers in the medical and advanced industrial markets we serve. In the third quarter, we delivered a new record high $223 million in revenue, representing 25% year-over-year revenue growth on a reported basis and 21% growth on an organic basis and up 4% on a sequential basis. In addition, our operating profit in the third quarter was fantastic with adjusted EBITDA of $49 million, up 22% year-over-year and adjusted diluted earnings per share of $0.81, up 8% versus tougher comps in the prior year. The excellent year-to-date financial performance means we will once again raise our full year 2022 financial guidance, which Robert will cover in detail in a few minutes. We are extremely pleased with our company's performance and the resilience of our portfolio in an ever-changing and challenging macro environment. November's portfolio is well positioned in medical and advanced industrial applications with long-term secular tailwinds such as robotics and automation, health care productivity and precision medicine. We feel good about our strategy, and we're staying focused on where we play and how we win. We continue to build and grow quality businesses with proprietary IP and attractive secular growth markets with a vibrant culture and great talent. And I continue to be very proud of our teams around the world who are using the Novanta growth system to drive exceptional operating performance, no manner of the environment. Now let's turn to what…

Thank you, Matthijs, and good morning, everyone. Our third quarter non-GAAP adjusted gross profit was $101.7 million or a 46% adjusted gross margin compared to $80.3 million or 45% adjusted gross margin in the third quarter of 2021. For the quarter, adjusted gross margins were up year-over-year and close to flat sequentially. We continue to have good success counteracting the high inflationary pressures, which further demonstrates the resiliency and overall strength of our business. In addition, we also continue to make strong progress in institutionalizing the Novanta growth system across our factories and in our commercial channels. The deployment of Kaizen essential tools, particularly around standard work, problem-solving, value stream mapping and the 80-20 principle are taking root and explains our ability to continue to deliver strong financial results despite the macroeconomic environment. Third quarter R&D expenses were about $21.3 million or roughly 10% of sales. Third quarter SG&A expenses were $40.3 million or 18% of sales. Overall operating expenses were roughly flat sequentially, which is slightly better than expected due to the timing of new hires, which were later in the quarter than expected and project spending delays. Operating expenses on a percent of sales also improved with a better-than-expected revenue performance. Adjusted EBITDA was approximately $49 million in the third quarter of 2022, a 22% adjusted EBITDA margin. Our adjusted EBITDA performance beat our expectations and our previously issued guidance due to higher-than-expected revenue, timing of the new hires and the associated project spend. On the tax front, our non-GAAP tax rate for the third quarter of 2022 was 19%. This differed from the statutory rate due to jurisdictional mix of income. Our non-GAAP adjusted earnings per share were $0.81 in the quarter compared to $0.75 in the third quarter of last year, an increase of 8% year-over-year.…

[Operator Instructions] And today's first question comes from Lee Jagoda with CJS Securities.

Just starting with the Vision segment, can you kind of parse out the mix of consumables versus capital equipment in the quarter? And then how we should think about the lag between increasing consumables and capital equipment purchases kind of bouncing back in medical?

Yes, I would say that both were roughly the same in the third quarter. So they both had a very, very strong period of growth. As we get into the fourth quarter, I think that's where the volatility might lie from an ordering pattern behavior. It's the hospital systems still have some labor shortages, which impact their ability to take deliveries of some products. And so that results in some volatility that could be expected. I would still expect consumables to be growing in the double-digit rate in the fourth quarter. So that should still hold relatively steady, but the volatility will be more on the pumps in the insufflator side.

Yes. The other thing that I would say, Lee, is that we see the environment improving sequentially, also on the capital. And actually, some of the volatility is also related to our OEMs not finding all the right components, right? So there's going to be some timing effect there. But if you look past that immediately, we feel very good about 2023 also on the capital side.

Got it. And in terms of just the consumables portion of the growth, is all of that being used relatively quickly? Or is there some restock that has to take place of consumables coming out of the pandemic?

There's always a -- I wouldn't say that there's a big element of restocking per se, but there's always an element of shipping the product to distribution centers that serve as their safety stock. So it's fair to -- you're asking a question more on the double-digit growth, how is that aligned to surgical procedure rates. I think surgical procedure rates, which have historically been somewhere around 6% are definitely growing at a higher rate right now. And so there is a little bit of a combination of both, but this is something we expect to hold relatively steady not only for the remainder of this year, but going into 2023 as well. So that same level of demand profile is still expected for a little bit, just not on elevates.

And then I appreciate the announcement on the new facility that you guys acquired. How do you view its current capacity relative to your current consumables production outside of that facility and sort of the time line to get things moved over there?

Yes. So of course, yes, they -- first of all, we're indeed very, very excited about this acquisition. We talked about this for a few years now that we would need at a lower cost, highly capable production side and we had multiple options either to kind of greenfield it or acquiring. We're very pleased we were able to agree to add MPH to our portfolio, very, very experienced, very capable team, state-of-the-art facility. Now they're making certain products today that they have a certain capacity. We obviously need to expand their capacity with our production processes, et cetera. So we are using 2023 predominantly to transfer production lines, qualify production lines and then start to ramp these production lines towards the latter part of 2023. So then, therefore, in 2024 and beyond, you will start to see a more gradual, but increasingly significant contribution of this site.

Got it. One last one for me and I'll hop back is embedded in your Q4 revenue guidance, what's the headwind from currency that you're assuming?

The same that we experienced in the third quarter.

Okay. So that's 7%, 8% range. Okay.

[Operator Instructions] And the next question comes from Brian Drab with William Blair.

So just kind of building on that last question, just to be clear, was it embedded in the 4Q guidance for organic revenue growth overall?

The organic revenue growth that I spoke to, I think it was 7% to 9% in the fourth quarter. So yes, there's still similar FX headwinds expected in the fourth quarter that we experienced in the third quarter. But despite that, I think from an organic basis, we'll be up about 12% for the full year and in the range of 7% to 8% -- 7% to 9% for the quarter, 7% to 9%.

Okay. And we're lapping the larger acquisitions of Schneider and ATI we have already. So that's not to be -- is there acquisition revenue in the -- how should we think about the acquisition that you just made in revenue related to that, I don't know if you said -- but that's in the revenue?

Yes. You're trying to get at the reported growth versus the organic reported organic should be at themselves. The only difference is the impact of foreign exchange. So the acquisition we did was not material from a revenue perspective. It was -- obviously, we didn't bid for that, but that -- whatever revenue comes with is not going to have an impact on us. And you're right, we lap IMS and ATI, so won't have that revenue growth anymore in the top line.

Okay. Got it. And then I don't know how I can go about getting you to make some comments on 2023, without upsetting you. But I'm going to track -- I think in the prepared remarks, correct me if I'm wrong. You made a comment about expecting continued acceleration. I think you can use the word acceleration in procedure volumes. Or what was the comment you made about that market?

Yes. I think what we're seeing right now is microelectronics, which will represent about 9% of our sales in the fourth quarter is decelerating at a double-digit rate. But the medical -- on the medical side, we see acceleration. So we're seeing double-digit type of growth in some of the medical consumables that we have right now and even some of the capital equipment, while there's some volatility expected there. Overall, that's an area that continues to strengthen as we get into 2023. So the big question is the effects on the rest of the industrial piece of the portfolio and then haven't that all pulled out. I would just say that as we look out in 2023, we expect microelectronics to be weak, and we expect the medical markets to more than offset that. And then it's a question that we'll talk about in January where the rest of it is. But overall, we feel like the cylinders in the engine are appropriately balanced.

So the expectation is that the medical market collectively for you would grow in 2023, just to see that.

That's correct.

Okay. And your backlog and you're going -- you're likely going to enter 2023 with significant backlog maybe at least double, I would imagine, maybe almost triple what you've had in the past. How does that break down across the different segments? And how does that help you weather some of the pullbacks that you're seeing on the industrial side?

Yes, I don't think we're -- we have ever broken down backlog by segment. But obviously, it's helping to buffer, right, whatever potential headwinds, there might be heading towards us. So yes, we feel good about where we play, the markets that we play. You see the diversification of our portfolio and the resilience of portfolio really playing out also in this part of the cycle. And on top of that, we have a strong backlog position that could be used as a buffer for potential shocks. So we'll leave it at that in terms of the further breakout.

Okay. And then, one last one on 2023. So we've made the acquisition, and congrats on that. Now my understanding, I think maybe you'll correct me on how to phrase this exactly, but is that -- that should significantly help the margins, the gross margin that you're able to generate on the consumables within the WOM business. And bring it up, I think, in line with the segment average, so that in any case, what I calculate it at one point, this is potentially going to get to -- when you get it ramped up with 100 basis points to consolidated gross margin, and I'm just wondering if you can comment on that and the timing, given now we know when you close the acquisition?

Yes. So your commentary is directionally accurate. It's -- we -- this facility serves 2 purposes. One, it allows us to facilitize and capacitize ourselves so we can get all the volume out that we're expecting. Matthijs spoke about how the wins in MIS drive about $50 million worth of incremental revenue in 2025. Well, now we've solidified that, and this facility is needed in order to drive that volume in. And then by moving it in-house versus having an outsource, we're able to improve the gross margins. Now it takes about, I would say, a year to get the facility fully capacitized and qualified manufacturing needs medical consumables or obviously FDA-registered products. And so we expect roughly this time at the end of next year that, that facility will be fully qualified and then we'll be driving the margin expansion thereafter.

Okay. So the margin expansion associated with that is really more to come in 2024 before it's fully realized. Is that fair?

Yes, because it closely -- it's going through a qualification period in 2023. And so therefore, you're not going to really drive material margin improvement or material volumes until you get to 2024.

Okay. All right. I'll save my other questions for later.

And the next question comes from Andrew Buscaglia with Berenberg.

In the Precision Motion segment, you guided 8% to 10% in Q4. Just want to get a little bit more than I was expecting. First, that's an organic growth number in there. And then, I guess, beyond Q4, I guess, talk about how -- I know you don't give 2023 guidance, but how should we expect that to trend? Or maybe you can talk about like an absolute level or something related -- some baseline start to grow that off?

Yes. So what I said was that the overall segment is expected to be down 8% to 10% in the fourth quarter and that is being driven by our Westwind product line. The Westwind product line itself is down 60%. The Westwind product line serves the China PCBA drilling market. And so it is by definition a microelectronics based application. So if you exclude the Westwind product line, the Celera Motion and the ATI businesses are expected to grow mid-single digit year-over-year in the fourth quarter. And I don't see any of that kind of changing as we get out further from here. So I think those are growth businesses, and they're expected to stay in a growth category. There's just a little bit of a headwind on the Westwind business. I think the Westwind will have a larger headwind in the fourth quarter versus any other period. And I think most likely is again to 2023 look more similar to the dynamics of the third quarter.

Okay. And then overall, you're talking about microelectronics, not depriving down double digits and into next year too. What will electronics be as a percentage of total sales when you finish the year? What's the expectation built into the guide?

Yes, 9% of sales.

9%, down double digits. And then 50% roughly is medical, and that's going to continue to grow and offset that kind of the idea.

Correct.

Okay. And then one more, if I may. You talked about that you've been spending a lot of R&D to capture that minimally invasive surgery opportunity. And you talk -- correct me if I'm wrong, you talked about $50 million incremental revenue through 2025. Will that continue? Will that require a similar level of R&D spend? Or should we expect overall R&D spend to kind of taper?

So I'll answer part of the question and I'll let Matthijs also interrupt me, but I would say that we've been floating around 10% of sales for the last 2 years. I don't see that dynamic changing in 2023 or 2024. So I still expect us to make some shifts there because I think there's plenty of opportunity to make investments even as those propanes fall off. Now I will say we're driving $50 million worth of incremental sales from those programs, but they don't all kick in at once with the same exact loan cycles. And so there will be continued spend associated with that in order to fully commercialize them.

Yes. And we just factored a number of $50 million incremental business in 2025. And of course, that will continue to grow afterwards, both on the capital side as well as on the consumables side. So the majority of that $50 million will be more capital placements, right, because you're early in the cycle and then the consumables will gradually kick in, but that will ultimately become more of an exponential growth aspects because you certainly have increased your installed base dramatically with capital equipment, right? So there is between '25 and 2030, there's going to be further sustained growth that we're super excited about.

And the next question comes from Rob Mason with Baird.

Listen, I joined the call late, so apologies if this is redundant information. But could you explain why the Vision gross margins came [indiscernible] sequentially and below what I was expecting and what maybe you're expecting on the fourth quarter?

Sorry, I had a -- sorry, I didn't hear you, kind of difficult to hear, so I didn't hear it right away. So the Vision gross margin, why they came down?

Down sequentially. The reason for that is that you're expecting for the fourth quarter there?

Yes. It's difficult to hear you, but I would say that in the fourth quarter, I expect gross margins of Vision segment to tick up a little bit. So in each of the individual segments in the fourth quarter, gross margins will pick up a little bit from the third quarter level. And in the third quarter, specifically in Vision, I would say that it was largely driven just by a little bit of a change in mix. With the medical consumables business grew at a double-digit rate, and so that has an impact on our gross margins. And so even though that's actually that same dynamic that's happening in the fourth quarter, our JADAK business will not deteriorate in the fourth quarter. And so that has a favorable mix shift for us, which helps to improve the margin profile.

Okay. And then maybe just last question. Is there any semiconductor micro exposure to peak level in the Photonics segment that we should also be aware of in terms of getting softer, another semiconductors closer there? I think it's newer content, newer wins, but just the trend line on the business in that segment?

Yes. So there is a little bit of exposure there. It's, at this stage, throughout most of 2022, it's been relatively small in the Photonics segment. And the reason being is that some of its larger exposure had been associated with flexible PCBAs and smaller PCBA type of via-hole type applications. And that market actually went down in 2021. And so it hasn't actually been a big contributor in the 2022 calendar period. So the largest element of the exposure in that segment has not manifested itself and been a growth driver in 2022. And so we don't expect the same level of impact. Overall, microelectronics is going to be about 9% of sales in the fourth quarter and probably going forward on a run rate basis. I would say almost all that exposure is really sitting in our Precision Motion segment at this point.

The other point, Rob, I want to make is that, yes, our content in extreme UV lithography is steadily increasing. And it's -- yes, public knowledge that, that application is growing double digit, actually against the microelectronics trend. So even within that 9% of sales, an increasing amount of revenue over time will be in that kind of faster secular growth trajectory.

And this concludes our question-and-answer session. I would like to turn the conference back to Mr. Matthijs Glastra for any closing remarks.

Thank you, operator. So to summarize, Novanta delivered very impressive results in the third quarter of 2022. We saw a record level of sales and profitability, double-digit growth for sales and adjusted EBITDA. And we maintain a near record high backlog. We've achieved all of this, while managing a challenging market macro environment. We're excited to see the continued strength in the medical sector and also the resilience in advanced industrial sector. Novanta is very well positioned in these sectors and with diversified exposure to long-term macro trends in robotics, automation, precision medicine, minimally invasive surgery and Industry 4.0. In closing, as always, I would like to thank our customers, our employees and our shareholders for their ongoing support. I continue to be especially grateful for the dedicated efforts of all our Novanta employees who work so hard every day to tackle each new challenge. 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 fourth quarter and full year 2022 earnings call. Thank you very much. This call is now adjourned.

Thank you. As mentioned, the conference has now concluded. Thank you for attending today's presentation. You may now disconnect your lines.