FARO Equity Research Report

7/29/2019 FARO Equity Research Report

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Kevin Rippey, Analyst

[email protected]

219-775-5075

Stock Report forTHE REESE FUND

RatingPrice Target

BUY$44.00

FARO Technologies, Inc. FARO NASDAQ

Investment Thesis

After reporting disappointing results in 2012, FARO is poised to grow

EPS by 31% in 2013 driven by accelerating sales growth and operating

margin improvement. The company is supported by a strong balance

sheet with no debt and $8.57 per share in cash. Current valuations

provide a historically attractive entry point at less than 20x my 2013

earnings forecast.

Key Catalysts

+9% y/y sales growth driven by expanded distributionchannel and new market entry: New agreement with leading

survey equipment supplier Trimble Navigation (TRMB)

provides FARO new access to survey/planning market.

Improving sales mix/Operating margin: Gross marginssuffered in 2012 as low margin service sales accounted for

greater than usual mix of revenue. Top line growth shouldreverse this trend back to historical norms. Increased sales

through distributors should drive OM expansion.

Price:

Fully Diluted Shares (mm) :

52-Week High:

52-Week Low:

Market Cap (mm) :

Avg Daily Vol:

Debt/Cap:

Cash/Shr:

Dividend Yield:

Book Value/Shr:

$36.64

16.97

$59.66

$31.98

$620.94

181,181

0.0

$8.57

0.0%

$16.07

EPS 2011A 2012E 2013E

Mar

Jun

Sep

Dec

FY

P/E

Rev

$0.20A

$0.25A

$0.38A

$0.56A

$1.39A

23.7x

$254 2M

$0.39A

$0.28A

$0.21A

$0.38E

$1.25E

29.3x

$267 0M

$0.38E

$0.39E

$0.37E

$0.56E

$1.69E

21.7x

$291 8M


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Rev $254 2M $267 0M $291 8M

Stock report forThe Reese FundFebruary 8, 2013NASDAQ: FARO [email protected] (219) 775-5075

Thesis

FARO is the leader in the CAM2 market (Computer assisted measurement and manufacturing) and faces a long run

way for growth. Recent Trimble OEM agreement could generate incremental $200 million by 2015 from 2012 base of

just over $250 million in total sales. Longer term management sees industry sales going to over $4 billion by 2017.

Current valuations provide an attractive entry point into FARO shares. The stock is down 40% from its 52 week highsreached in early 2012. FARO trades at less than 20x my 2013 EPS forecast. Historically, the stock has traded at an

average of 29.5x FY1 earnings. While management poorly managed investor expectations as the demand environment

deteriorated in Europe, an improvement in the European macro environment would prove a significant catalyst near

term. Global PMI indicators which lead FARO sales growth by six months have recently shown marked improvement.

Operating leverage is poised to improve in 2013. The major catalyst for operating margin expansion should be a

reduction in selling expenses as a % of sales. The recent agreement between FARO and leading survey equipment

supplier Trimble (TRMB) should drive 150bps operating margin expansion. Further, with the patent case between FARO

and Nikon now closed, G&A leverage should further increase OM by 70bps this year.

Longer term wage inflation in China will necessitate a shift from labor to capital intensive production methods

While Chinese manufacturing has enjoyed a multi-decade growth period as result of low labor costs, wage inflation over

the past two years has become a serious issue. If China wishes to maintain its competitive position as a global

manufacturing power, it will need to offset rising labor cost with the type of efficiency gains derived from FARO sproduct offerings.

Overview


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Managements refusal to provide guidance and unwillingness to break out revenues by product line make forecasting

growth especially challenging

While this is not a new practice for FAROs management team, investors may be slow to return to the stock without

several quarters of evidence demonstrating that the company has returned to its previous growth profile. However,

should the company produce strong results in 2013; there is an excellent opportunity for significant share price

appreciation.

Industry Overview

FAROs management estimate the addressable market for their products is between $3-5 billion per year. If thisestimate is correct, it is likely FARO and its competitors have reached slightly more than 1/3 of the market. Currently,

total sales between FARO and its competitors are closer to just over $1 billion. FARO and Hexagon each generate annual

CAM2 sales of around $250 million. Market research suggests that smaller product specific competitors comprise the

remaining $500 million.

Gross margins in the industry are fairly high and historically exceed 50%. This reflects the high barriers to entry provided

by intellectual property. FARO alone holds more than 150 patents related to CAM2 technology. The technological

sophistication and sensitive calibrations required to produce CAM2 products limits potential new entry by rivals. For

perspective, FAROs measuring arms are accurate to the micron level or a fraction of the diameter of human hair. As

such, potential for new entrants is limited based on FARO s IP portfolio and the specialized processes required to

Computer Assisted Measurement and Manufacturing (CAM2) Industry


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market as FARO has only recently entered the space. However, FARO s new distribution deal with leading survey

equipment supplier Trimble could likely change the competitive dynamics in the scanner market in favor of FARO

Nikon (NINOYADS): Nikon is a leading manufacturer of optical instruments. It began competing with FARO in 2009

following its acquisition of Metris, a player in the CAM2 market place. Nikon produces arm based measuring devices as

well as fixed coordinate measuring machines (CMMs). For the previous two years Nikon and FARO have been locked in a

patent dispute. In August 2012 the judge ruled in favor of FARO.

Carl Zeiss (Private): Carl Zeiss is the leader in fixed CMMs. These machines offer comparable if slightly more accurate

measurements than FAROs products but at greater cost and lack portability. Zeiss actively markets FARO products on its

own website.

Products


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Laser Tracker

For larger scale measuring tasks requiring a highly precise degree of accuracy, FARO offers the laser tracker. This deviceuses a laser projected toward a reflective target. Based on the angles and distance between the laser base station and

target the laser tracker delivers measurement data that is accurate to the micron level. The tracker has an ASP of $99k.

Its applications include highly precise measurement of large scale items such as aircraft wings or wind turbine blades.

Laser Scanner

The latest offering in FAROs product portfolio, the laser scanner was technology acquired from Qvolution in 2005. While

available for sale for the most of the past seven years, significant breakthroughs lead to a major reduction in size and

sales price in 2010. The scanner can capture 3D images of large objects from a distance of over 500 feet. For example,

EA sports uses the Scanner to capture 3D images of all major college football stadiums for its NCAA series. The scanner

has an ASP of $40k. New applications for the scanner should be a significant driver of sales growth over the next 24

months. Through a recent distribution agreement for the scanner under the Trimble brand name, FARO should gain

better penetration in the architectural survey market. Additionally, FARO recently hired an individual with previous highlevel experience at a major insurance company with the aim of selling scanners to insurance companys so they can have

3D models of facilities for which they insure policies.

FARO 3D Imager

The 3D Imager captures complex shapes in three dimensions at short distances. The device works by projecting a light

dot matrix on to an object and using a specialized camera to capture a precise three dimensional of the object captured

by the camera. The ASP of the Imager is $85k

FARO has consistently updated its product lineup with enhanced features and functionality as shown in the chart below.


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FARO serves a wide range of manufactures both small and large as its end market. As shown in the chart above FARO

products can be found in most of the worlds top manufacturers. FAROs customer base is diverse without overreliance

on any major accounts. This diversity insulates them from reporting disappointing results due to timing issues for a

single large order. They are further insulated from any firm specific risk borne by any single large customer.

End Markets


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Revenue

FARO breaks out sales by geography but not by product line. Revenues are split between product revenue which

comprises between 81-84% depending on the quarter. Strong sales periods show a greater degree of product sales.FARO sales are closely linked to global PMI readings as shown in the following exhibits. After posting top line growth in

excess of 32% y/y in 2011, growth stalled in 2012. The key driver of this sales growth slowdown is economic weakness in

h f k h h ll l h f h d f h

Financial Performance Analysis


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Europe

Sales to Europe, primarily core EU countries plus the UK represent approximately 40% of FARO s total sales. Sales in

Europe during Q2 were flat y/y. They deteriorated significantly in Q3 with the region posting -17% sales growth y/y.

However, PMI readings in recent quarters have shown stabilization and modest recovery. This provides a historically

accurate leading indicator of FAROs regional sales growth.


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Americas

Overall, the Americas represent 40% of FAROs total sales. Sales in the region during Q3 came in flat y/y. Uncertainty

regarding the so called fiscal cliff likely acted as a headwind especially with respect to FAROs small and medium

business customers (75% of sales). While a fiscal cliff related drag is likely to carry into Q4, the ultimate resolution of the

issue should result in demand being pushed into Q1 of 2013. Further, while PMI readings pointed to mild US growth inQ412 and Q113, the most recentmonths reading of 55.7 would indicate a dramatic pickup in sales growth towards the

middle part of 2013.


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Asia

Asia sales have held up relatively well in Q3 with mid-single digit growth y/y. The region represents only 20% of total

company revenues. Going forward, PMI readings indicate a continuation of trend from recent quarters. Taking a longer

term perspective, Asia likely represents the biggest opportunity with respect to secular growth as manufacturers in Asia

trade capital for labor to offset the negative impacts of wage inflation.

Wage inflation in China should provide a catalyst for secular demand for FAROs product offerings. Cheap labor relative


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Gross Margin

Gross margins historically have been in excess of 55% for FARO with best years nearing 60%. Gross margins for product

sales typically hover just over 60% while service gross margins are significantly lower in the mid-30s. In strong sales years

product sales represent a larger share of total sales. Thus, strong sales years create a revenue mix that is accretive togross margin. Gross margins in weaker sales periods are further eroded as product ASPs decline as result of discounting.

This scenario typifies Q3 2012 where heavy discounting coupled with a service heavy sales mix compressed gross

i 300b / Di i i h i d i ll d d i f ld i f h


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Operating Margin

From 2010, 2011, and 2012 operating margins for FARO have been 8.8%, 12.9%, and 11.0% (estimate) respectively. I

forecast operating margins to improve 300 bps for 2013. The key drivers of this operating margin expansion are a150bps reduction in selling expense as a percent of sales driven by an increase in the level of sales through distributors,

a 70bps reduction in G&A as a percent of sales as legal expenses decline, and a 40bps reduction in R&D as a percent of

sales as the absolute level of R&D spend grows slower than revenues


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Balance Sheet

FAROs balance sheet is exceptionally strong. The company has $145.5 million of net cash including short term

investments. The company carries just over $25 million in goodwill and intangible assets it has acquired through a

number of acquisitions over the years.

FARO has a substantial portion of its balance sheet tied up in net working capital. As of Q3 2012, the company had $75

million in net working capital. This figure has crept higher throughout 2012 as receivable turns have declined in light of

k Th h l b f t t b k d Th ll ff t h b d li i th


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5 Year Chart FY1 P/E and P/CF

My 43.50 price target is based on a composite of a two stage DCF valuation and assigning a 25x earnings multiple to my

2013 EPS estimate of $1.69.

In my DCF, I derive a price target of $44.80. The methodology use to arrive at this target price is by starting with the

current cash on the balance sheet and adding the discounted value of my FCF estimates from 2012-2015. At this point, I

take my 2015 FCF estimate of $43.2 million and assign a 15% annual growth rate. This medium term growth period isassumed to last through 2022. At this point, I treat the companys residual value as a growing perpetuity with a growth

rate of 3%. I assume a cost of capital of 12%. Sensitizing my medium term growth and WACC assumptions produces the

following result:

Valuation


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Comparable company valuation

Finding true comps for FARO is difficult. Its closest competitor Hexagon (HEXA.B- Sweden) has a variety of other businessunits that do not offer the same growth profile or profitability. Other competitors pose similar problems with respect to

peer valuations. Like Hexagon, Nikon (NINOY- ADS) is very large with respect to its CAM2 offerings. Other CAM2 players

Carl Zeiss and Zoller + Frohlich are private. I believe 3D printer makers 3D Systems (DDD) and Stratasys (SSYS) cater to

similar high tech manufacturing end users and offer better pure plays on high tech manufacturing devices when

compared to Hexagon. Autodesk (ADSK) while a software manufacturer rather than device maker has similar leverage

to manufacturing growth and caters to many of the same end users.


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Income Statement for FARO TechnologiesDollars in millions except per share

Historical Data 4 Year

FY 2010A FY 2011A Q1 2012A Q2 2012A Q3 2012A Q4 2012A FY 2012E Q1 2013E Q2 2013E Q3 2013E Q4 2013E FY 2013E FY 2014 FY 2015 CAGR

Sales

Americas

Product $59.4 $81.6 $20.5 $21.5 $20.2 $26.8 $89.0 $20.5 $22.4 $23.1 $30.8 $96.7 $111.4 $124.8

Service 13.0 15.9 4.6 4.2 4.7 4.7 18.2 4.8 4.9 5.2 6.8 21.7 21.2 23.8

Total 72.4 97.5 25.1 25.7 24.8 31.6 107.2 25.3 27.3 28.3 37.6 118.5 132.7 148.6

Europe/Africa

Product 61.3 83.3 18.8 19.4 17.1 23.3 78.6 17.5 19.0 19.7 27.2 83.5 93.6 103.0

Service 13.5 16.2 4.2 4.2 4.0 4.1 16.5 4.1 4.2 4.5 6.0 18.7 17.8 19.6

Total 74.7 99.6 23.0 23.2 21.0 27.5 94.7 21.7 23.2 24.2 33.2 102.3 111.5 122.6

APAC

Product 36.6 47.8 14.0 14.9 12.1 12.9 53.9 14.6 15.4 14.0 15.0 59.0 75.8 91.0

Service 8.0 9.3 3.1 2.9 2.8 2.3 11.1 3.4 3.4 3.2 3.3 13.3 14.4 17.3

Total 44.7 57.1 17.1 17.8 14.9 15.2 65.0 18.0 18.7 17.2 18.3 72.2 90.3 108.3

Sales Total 191.8 254.2 65.2 66.8 60.7 74.2 267.0 65.0 69.2 69.7 89.0 292.9 334.4 379.5 9.2%

Cost of sales (excluding depreciation)

Product 54.6 82.4 20.5 22.3 21.1 26.5 90.4 20.4 23.3 23.3 28.8 95.8 112.4 124.3

Service 23.8 28.1 7.5 7.4 7.3 7.6 29.9 8.5 8.2 8.4 11.1 36.1 35.8 40.7

Total COGS 78.4 110.5 28.0 29.7 28.4 34.1 120.3 28.9 31.5 31.7 39.9 131.9 148.2 165.0

Gross Profit 113.4 143.7 37.2 37.1 32.3 40.1 146.7 36.1 37.7 38.1 49.1 161.0 186.2 214.5 10.0%

Selling 50.7 62.1 16.0 15.8 14.2 16.3 62.4 14.5 15.2 15.3 19.1 64.3 70.2 77.8

General and administrative 26.8 26.8 6.6 8.1 7.3 8.9 30.9 6.8 7.1 7.7 9.8 31.3 36.8 41.7

Research and development 12.7 15.2 4.4 4.5 4.1 4.1 17.1 4.3 4.6 4.3 4.5 17.6 20.1 22.8

EBITDA 23.3 39.6 10.1 8.6 6.8 10.8 36.3 10.4 10.9 10.8 15.7 47.7 59.1 72.2 18.8%

Depreciation and amortization 6.3 6.7 1.7 1.7 1.8 1.8 6.9 1.7 1.7 1.7 1.7 6.7 6.4 7.2

EBIT 16.9 32.9 8.4 6.9 5.0 9.0 29.4 8.7 9.2 9.1 14.0 41.0 52.8 65.0 22.0%

Other expense (income) 2.7 1.2 (0.2) 0.4 (0.1) 0.0 0.1 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Pretax Income 14.2 31.7 8.7 6.5 5.1 9.0 29.3 8.7 9.2 9.1 14.0 41.0 52.8 65.0

Income taxes $3.1 $8.3 $1.9 $1.7 $1.4 $2.4 $7.5 $2.4 $2.5 $2.5 $3.8 $11.1 $14.2 $17.6

Net Income $11.1 $23.4 $6.8 $4.7 $3.7 $6.6 $21.8 $6.4 $6.7 $6.7 $10.2 $30.0 $38.5 $47.5 21.5%

Diluted weighted average shares ( in mil lions) 16.321 16.809 17.163 17.140 17.406 17.471 17.471 17.536 17.601 17.666 17.731 17.731 17.796 17.861

Earnings Per Share $0.68 $1.39 $0.39 $0.28 $0.21 $0.38 $1.24 $0.36 $0.38 $0.38 $0.58 $1.69 $2.16 $2.66 20.9%

Projections


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Balance Sheet for FARO TechnologiesDollars in millions except per share

FY 2010A FY 2011A Q1 2012A Q2 2012A Q3 2012A Q4 2012A FY 2012E Q1 2013E Q2 2013E Q3 2013E Q4 2013E FY 2013E FY 2014 FY 2015

Cash and short term investments $115.7 $129.5 $138.6 $139.7 $145.5 $156.7 $156.7 $162.4 $174.3 $180.6 $190.0 $190.0 $231.3 $279.7

Accounts receivables, net 51.9 57.5 48.7 53.2 51.0 64.3 64.3 50.5 52.3 51.9 63.3 63.3 65.0 69.7Inventories 28.2 49.9 56.3 54.1 53.3 51.2 51.2 57.1 56.3 57.0 62.1 62.1 65.9 73.3

Other current assets 12.5 14.5 16.7 16.8 16.5 16.3 16.3 16.1 16.9 18.7 19.6 19.6 21.7 22.8

Total Current Assets: 208.3 251.5 260.4 263.8 266.3 288.5 288.5 286.1 299.7 308.2 335.0 335.0 383.9 445.5

PP&E, net 15.2 16.2 16.0 16.1 15.8 16.1 16.1 16.0 16.1 15.9 15.9 15.9 17.9 20.2

Intangible assets and goodwill 26.2 25.5 25.8 25.0 25.2 25.2 25.2 25.2 25.2 25.2 25.2 25.2 25.2 25.2

Service inventory 13.7 17.3 18.5 18.2 19.5 20.0 20.0 19.7 19.9 20.6 22.4 22.4 21.4 24.3

Other long-term assets 2.5 2.3 2.3 2.2 2.3 2.3 2.3 2.3 2.3 2.3 2.3 2.3 2.3 2.3

Total Assets: $266.0 $312.8 $322.9 $325.4 $329.2 $352.2 $352.2 $349.4 $363.2 $372.2 $400.9 $400.9 $450.8 $517.5

Accounts payable 12.0 13.4 10.7 9.3 8.0 14.4 14.4 10.6 11.5 11.6 14.6 14.6 18.5 21.1

Accrued liabilities 15.2 18.1 16.8 15.7 16.2 19.1 19.1 17.3 17.6 17.7 22.3 22.3 20.7 24.8

Current portion of unearned revenue 13.4 15.6 16.5 16.8 17.2 20.5 20.5 16.2 18.9 19.0 23.9 23.9 25.2 28.1

Other current liabilities 4.9 6.8 4.7 6.8 4.0 4.1 4.1 4.6 5.0 5.1 6.4 6.4 7.4 8.3

Total Current Liabilities: 45.5 53.9 48.7 48.5 45.4 58.1 58.1 48.7 53.1 53.5 67.3 67.3 71.9 82.1

Unearned revenue less current portion 6.8 9.5 9.6 9.2 9.6 10.9 10.9 9.2 10.1 10.1 12.8 12.8 11.9 13.2

Other long-term liabilities 1.3 1.4 1.6 1.3 1.3 1.3 1.3 1.3 1.3 1.3 1.3 1.3 1.3 1.3

Total Liabilities: 53.5 64.9 59.8 59.1 56.3 70.3 70.3 59.3 64.5 64.9 81.4 81.4 85.1 96.7

Total equity 212.5 247.9 263.1 266.3 272.9 281.8 281.8 290.1 298.7 307.3 319.5 319.5 365.7 420.9

Total Liabilities and Equity: $266.0 $312.8 $322.9 $325.4 $329.2 $352.2 $352.2 $349.4 $363.2 $372.2 $400.9 $400.9 $450.8 $517.5

ProjectionsHistorical Data


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Cash Flow Statement for FARO TechnologiesDollars in thousands except per share

FY 2010A FY 2011A Q1 2012A Q2 2012A Q3 2012A Q4 2012A FY 2012E Q1 2013E Q2 2013E Q3 2013E Q4 2013E FY 2013E FY 2014 FY 2015

Operating ActivitiesNet Income $11.1 $23.4 $6.8 $4.7 $3.7 $7.0 $22.2 $6.4 $6.7 $6.7 $10.2 $30.0 $38.5 $47.5

Stock-based compensation expense 2.4 2.7 0.8 1.1 1.1 0.6 3.6 0.6 0.6 0.6 0.6 2.5 2.5 2.5

Depreciation & Amortization 6.3 6.7 1.7 1.7 1.8 1.8 6.9 1.7 1.7 1.7 1.7 6.7 6.4 7.2

Provision for bad debts 2.4 2.2 0.0 (0.1) (0.1) 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Deferred income tax expense (benefit) (0.7) (0.7) (0.0) (0.7) 0.1 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

(Increase)/decrease in working capital (6.5) (25.6) (4.9) (4.3) 0.0 1.7 (5.8) (1.3) 2.6 (1.8) (3.5) (3.9) (3.1) (2.9)

Cash Flow from Operating Activities: 15.0 8.7 4.3 2.4 6.6 11.1 26.9 7.4 11.7 7.1 9.0 35.2 44.3 54.2

Investing Activities

Capital expenditures (4.0) (4.5) (0.7) (1.8) (0.6) (2.0) (6.8) (1.6) (1.7) (1.5) (1.7) (6.5) (8.4) (9.5)

Additions to intangibles (1.0) (0.9) (0.2) (0.3) (0.3) 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Additions to other assets 0.0 0.0 0.0 0.0 0.0 0.8 (1.4) (1.4) 0.6 (0.6) 0.8 (0.5) 0.1 (1.5)

Cash Flow from Investing Activities: (5.0) (5.4) (0.9) (2.1) (0.9) (1.2) (8.2) (3.0) (1.1) (2.1) (0.9) (7.1) (8.2) (11.0)

CASH FLOW AVAILABLE FOR FINANCING ACTIVITIES 10.0 3.3 3.4 0.3 5.7 9.9 18.7 4.4 10.6 5.0 8.2 28.2 36.1 43.2

Financing Activities

Issuance / (repayment) of credit facility 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Issuance of long-term debt 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

(Repayment) of long-term debt 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Issuance/ (Repurchase) of equity 1.4 9.2 5.3 0.3 0.5 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Payments on capital leases (0.1) (0.2) (0.1) 0.0 (0.0) 0.0 (0.1) 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Option proceeds 0.1 1.6 1.1 0.1 0.0 1.3 8.5 1.3 1.3 1.3 1.3 5.2 5.2 5.2

Cash Flow from Financing Activities: 1.5 10.6 6.2 0.4 0.5 1.3 8.4 1.3 1.3 1.3 1.3 5.2 5.2 5.2

Effect of foreign exchange rate change 4.2 (0.1) (0.6) 0.5 (0.4) 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Net Change in Cash 15.6 13.8 9.0 1.2 5.8 11.2 27.1 5.7 11.9 6.3 9.5 33.4 41.3 48.4

Beginning cash balance 100.1 115.7 129.5 138.6 139.7 145.5 129.5 156.7 162.4 174.3 180.6 156.7 190.0 231.3Ending cash balance $115.7 $129.5 $138.6 $139.7 $145.5 $156.7 $156.7 $162.4 $174.3 $180.6 $190.0 $190.0 $231.3 $279.7

FARO Equity Research Report

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