Proto Labs Inc: Form 10-Q for the period ended Jun 30, 2017

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our unaudited consolidated financial statements and related notes appearing elsewhere in this Quarterly Report on Form 10-Q and our Annual Report on Form 10-K for the year ended December 31, 2016.

Forward-Looking Statements

Statements contained in this report regarding matters that are not historical or current facts are “forward-looking statements” within the meaning of The Private Securities Litigation Reform Act of 1995. In some cases, you can identify forward-looking statements by the following words: “may,” “will,” “could,” “would,” “should,” “expect,” “intend,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “project,” “potential,” “continue,” “ongoing” or the negative of these terms or other comparable terminology, although not all forward-looking statements contain these words. These statements involve known and unknown risks, uncertainties and other factors that may cause our results to be materially different than those expressed or implied in such statements. Certain of these risk factors and others are described in Item 1A. “Risk Factors” of our most recent Annual Report on Form 10-K as filed with the SEC. Other unknown or unpredictable factors also could have material adverse effects on our future results. We cannot guarantee future results, levels of activity, performance or achievements. Accordingly, you should not place undue reliance on these forward-looking statements. Finally, we expressly disclaim any intent or obligation to update any forward-looking statements to reflect subsequent events or circumstances.

Overview

We are an e-commerce driven digital manufacturer of quick-turn, on-demand injection-molded, CNC-machined and 3D-printed custom parts for prototyping and short-run production. We provide “Real Parts, Really Fast” to product developers and engineers worldwide, who are under increasing pressure to bring their finished products to market faster than their competition. We believe custom parts manufacturing has historically been an underserved market due to the inefficiencies inherent in the quotation, equipment set-up and non-recurring engineering processes required to produce custom parts. Our proprietary technology eliminates most of the time-consuming and expensive skilled labor conventionally required to quote and manufacture parts in low volumes, and our customers conduct nearly all of their business with us over the Internet. We target our products to the millions of product developers and engineers who use three-dimensional computer-aided design (3D CAD) software to design products across a diverse range of end-markets.

Our primary manufacturing product lines currently include Injection Molding, CNC Machining and 3D Printing. We continually seek to expand the range of sizes and geometric complexity of the parts we can make with these manufacturing processes, extend the variety of materials we are able to support and identify additional manufacturing processes to which we can apply our technology in order to better serve the evolving preferences and needs of product developers and engineers.

Injection Molding

Our Injection Molding product line uses our proprietary 3D CAD-to-CNC machining technology for the automated design and manufacture of thermoplastic or liquid silicone injection molds, which are then used to produce custom injection-molded parts utilizing commercially available equipment. Our Injection Molding product line is used for prototype, on-demand and short-run production. Prototype quantities typically range from 25 to 100 parts. Because we retain possession of the molds, customers who need low-volume production often come back to Proto Labs’ Injection Molding product line for additional quantities typically ranging up to 10,000 parts or more. They do so to support pilot production for product testing or while their tooling for high-volume production is being prepared, because they need on-demand manufacturing due to disruptions in their manufacturing process, because their product will only be released in a limited quantity, because demand for their product is unpredictable, or because they need end-of-life production support. These additional part orders typically occur on approximately half of the molds that we make, usually accounting for approximately half of our total Injection Molding revenue.

CNC Machining

Our CNC Machining product line uses our proprietary 3D CAD-to-CNC machining technology on commercially available CNC machines to cut plastic or metal blocks or bars into one or more custom parts based on the 3D CAD model uploaded by the product developer or engineer. Our efficiencies derive from the automation of the programming of these machines and a proprietary fixturing process. The CNC Machining product line is well suited to produce small quantities, typically in the range of one to 200 parts.

3D Printing

Our 3D Printing product line includes stereolithography (SL), selective laser sintering (SLS), direct metal laser sintering (DMLS) and PolyJet processes, which offers customers a wide-variety of high-quality, precision rapid prototyping and low-volume production. These processes create parts with a high level of accuracy, detail, strength and durability. 3D Printing is well suited to produce small quantities, typically in the range of one to 50 parts.

Key Financial Measures and Trends

Revenue

The Company’s operations are conducted in three geographic operating segments in the United States, Europe and Japan, which we believe are three of the largest geographic markets where product developers and engineers are located. Revenue within our United States and Europe markets is derived from our Injection Molding, CNC Machining and 3D Printing product lines. Revenue within our Japan market is derived from our Injection Molding and CNC Machining product lines. Our historical and current efforts to increase revenue have been directed at gaining new customers and selling to our existing customer base by:

• increasing marketing and selling activities;
• offering additional product lines such as 3D Printing through our acquisition of FineLine Prototyping, Inc. in April 2014 and expanded through our acquisition of certain assets, including shares of select subsidiaries, of Alphaform AG (Alphaform) in October 2015;
• improving the usability of our product lines such as our web-centric applications;
• expanding the breadth and scope of our products, for example, by adding more sizes and materials to our offerings such as liquid silicone rubber (LSR);
• expanding the breadth of manufacturing capabilities, for example, by adding rapid overmolding and insert molding technology to our Injection Molding product line and PolyJet technology to our 3D printing product line; and
• adding a suite of capabilities designed to address the on-demand needs of the low-volume, high-mix product segment.

During the three months ended June 30, 2017, we served 16,174 unique product developers and engineers who purchased our products through our web-based customer interface, an increase of 18.8% over the same period in 2016. During the six months ended June 30, 2017, we served 24,255 unique product developers and engineers who purchased our products through our web-based customer interface, an increase of 19.3% over the same period in 2016. The information does not include 3D Printing and Injection Molding customers resulting from the Alphaform acquisition who do not utilize our web-based interface.

Cost of Revenue, Gross Profit and Gross Margin

Cost of revenue consists primarily of raw materials, employee compensation, benefits, stock-based compensation, equipment depreciation, facilities costs and overhead allocations associated with the manufacturing process for molds and custom parts. We expect cost of revenue to increase in absolute dollars, but remain relatively constant as a percentage of total revenue.

We define gross profit as our revenue less our cost of revenue, and we define gross margin as gross profit expressed as a percentage of revenue. Our gross profit and gross margin are affected by many factors, including our pricing, sales volume and manufacturing costs, the costs associated with increasing production capacity, the mix between sales by product line, the mix between domestic and foreign revenue sources, and foreign currency exchange rates.

Operating Expenses

Operating expenses consist of marketing and sales, research and development and general and administrative expenses. Personnel-related costs are the most significant component in each of these categories.

Our recent growth in operating expenses is mainly due to higher headcounts to support our growth and expansion, and we expect that trend to continue. Our business strategy is to continue to be a leading online and technology-enabled manufacturer of quick-turn, on-demand injection-molded, CNC-machined, CNC-turned and 3D-printed custom parts for prototyping and low-volume production. In order to achieve our goals, we anticipate continued substantial investments in technology and personnel, resulting in increased operating expenses.

Marketing and sales. Marketing and sales expense consists primarily of employee compensation, benefits, commissions, stock-based compensation, marketing programs such as electronic, print and pay-per-click advertising, trade shows and other related overhead. We expect sales and marketing expense to increase in the future as we increase the number of marketing and sales professionals and marketing programs targeted to increase our customer base.

Research and development. Research and development expense consists primarily of employee compensation, benefits, stock-based compensation, depreciation on equipment and other related overhead. All of our research and development costs have been expensed as incurred. We expect research and development expense to increase in the future as we seek to enhance and expand our product line offerings.

General and administrative. General and administrative expense consists primarily of employee compensation, benefits, stock-based compensation, professional service fees related to accounting, tax and legal and other related overhead. We expect general and administrative expense to increase in the future as we continue to grow and expand as a global organization.

Other Income, net

Other income, net primarily consists of foreign currency-related gains and losses and interest income on cash balances and investments. Our foreign currency-related gains and losses will vary depending upon movements in underlying exchange rates. Our interest income will vary each reporting period depending on our average cash balances during the period, composition of our marketable security portfolio and the current level of interest rates.

Provision for Income Taxes

Provision for income taxes is comprised of federal, state, local and foreign taxes based on pre-tax income. We expect income taxes to increase as our taxable income increases and we expect our effective tax rate to remain relatively constant.

Results of Operations

The following table summarizes our results of operations and the related changes for the periods indicated. The results below are not necessarily indicative of the results for future periods.

(dollars in thousands)

16

Stock-based compensation expense included in the statements of operations data above for the three and six months ended June 30, 2017 and 2016 was as follows:

(dollars in thousands)

17

Comparison of Three Months Ended June 30, 2017 and 2016

Revenue

Revenue by reportable segment and the related changes for the three months ended June 30, 2017 and 2016 was as follows:

(dollars in thousands)

Our revenue increased $7.1 million, or 9.4%, for the three months ended June 30, 2017 compared to the same period in 2016. By reportable segment, revenue in the United States increased $8.0 million, or 14.5%, revenue in Europe decreased $1.1 million, or 6.6%, and revenue in Japan increased $0.2 million, or 8.3%, in each case for the three months ended June 30, 2017 compared to the same period in 2016.

Our revenue growth during the three months ended June 30, 2017 was the result of an increase in the volume of the product developers and engineers we served through our web-based customer interface. During the three months ended June 30, 2017, we served 16,174 unique product developers and engineers through our web-based customer interface, an increase of 18.8% over the same period in 2016. The information does not include certain 3D Printing and Injection Molding customers resulting from the Alphaform acquisition who do not utilize our web-based interface.

Our revenue increases were primarily driven by increases in sales personnel and marketing activities. Our sales personnel focus on gaining new customer accounts and expanding the depth and breadth of existing customer accounts. Our marketing personnel focus on marketing activities that have proven to result in the greatest number of customer leads to support sales activity. International revenue was negatively impacted by $0.9 million during the three months ended June 30, 2017 when compared to the same period in 2016 as a result of foreign currency movements, primarily the strengthening of the United States dollar relative to the British pound.

Revenue by product line and the related changes for the three months ended June 30, 2017 and 2016 was as follows:

(dollars in thousands)

By product line, our revenue growth was driven by a 4.5% increase in Injection Molding revenue, which was partially offset by our decision to discontinue Metal Injection Molding (MIM) and Magnesium Thixomolding (Thixo) during the second quarter of 2016, a 21.8% increase in CNC Machining revenue and a 19.5% increase in 3D Printing revenue, in each case for the three months ended June 30, 2017 compared to the same period in 2016, as well as a $1.1 million decrease in Other Revenue driven by our decision in 2016 to exit our non-core resin resale business in Europe.

Cost of Revenue, Gross Profit and Gross Margin

Cost of Revenue. Cost of revenue increased $3.0 million, or 9.0%, for the three months ended June 30, 2017 compared to the same period in 2016, which was slower than the rate of revenue increase of 9.4% for the three months ended June 30, 2017 compared to the same period in 2016 reflecting the realization of productivity improvements. The net increase in cost of revenue resulted from the growth of the business and was due to raw material and production cost increases of $0.3 million, an increase in direct labor headcount resulting in personnel and related cost increases of $2.6 million and equipment and facility-related cost increases of $0.1 million to support increased sales volumes.

Gross Profit and Gross Margin. Gross profit increased from $42.2 million, or 56.4% of revenue, in the three months ended June 30, 2016 to $46.4 million, or 56.5% of revenue, in the three months ended June 30, 2017. Gross profit increased primarily due to increases in revenue and realization of manufacturing productivity improvements, partially offset by the volume- and mix-related increase in cost of revenue as discussed above.

Operating Expenses, Other Income, net and Provision for Income Taxes

Marketing and Sales. Marketing and sales expenses increased $3.2 million, or 27.7%, during the three months ended June 30, 2017 compared to the same period in 2016 due primarily to an increase in headcount resulting in personnel and related cost increases of $3.1 million as well as marketing program cost increases of $0.1 million.

Research and Development. Our research and development expenses increased $0.3 million, or 4.6%, during the three months ended June 30, 2017 compared to the same period in 2016 due to an increase in headcount resulting in personnel and related cost increases of $0.2 million and operating cost increases of $0.1 million.

General and Administrative. Our general and administrative expenses decreased $0.9 million, or 8.6%, during the three months ended June 30, 2017 compared to the same period in 2016 due to a decrease in administrative costs of $1.5 million and professional services cost decreases of $0.1 million, which were partially offset by an increase in compensation resulting in personnel and related cost increases of $0.3 million and stock based compensation cost increases of $0.4 million. The decrease in administrative costs was due to expenses recorded in 2016 related to our decisions to exit MIM and Thixo manufacturing processes and vacate existing facilities and move to new facilities in the U.S. and Japan.

Other Income, net. We recognized other income, net of $1.2 million for the three months ended June 30, 2017, an increase of $0.1 million when compared to other income, net of $1.1 million for the three months ended June 30, 2016. Other income, net increased primarily due to a $0.4 million favorable legal settlement in the second quarter of 2017 and an increase of $0.1 million in interest income on investments, which were partially offset by a decrease of $0.4 million in foreign currency gains.

Provision for Income Taxes. Our effective tax rate of 31.2% for the three months ended June 30, 2017 decreased 1.7% compared to 32.9% for the same period in 2016. The decrease in the effective tax rate is primarily due to changes in taxable income in our geographic regions in the quarter ended June 30, 2017 compared to the quarter ended June 30, 2016. Our income tax provision increased by $0.2 million to $5.5 million for the three months ended June 30, 2017 compared to our income tax provision of $5.3 million for the three months ended June 30, 2016.

Comparison of Six Months Ended June 30, 2017 and 2016

Revenue

Revenue by reportable segment and the related changes for the six months ended June 30, 2017 and 2016 was as follows:

(dollars in thousands)

19

Our revenue increased $14.7 million, or 9.9%, for the six months ended June 30, 2017 compared to the same period in 2016. By reportable segment, revenue in the United States increased $13.7 million, or 12.5%, revenue in Europe increased $0.2 million, or 0.7%, and revenue in Japan increased $0.7 million, or 14.8%, in each case for the six months ended June 30, 2017 compared to the same period in 2016.

Our revenue growth during the six months ended June 30, 2017 was the result of an increase in the volume of the product developers and engineers we served through our web-based customer interface. During the six months ended June 30, 2017, we served 24,255 unique product developers and engineers through our web-based customer interface, an increase of 19.3% over the same period in 2016. The information does not include certain 3D Printing and Injection Molding customers resulting from the Alphaform acquisition who do not utilize our web-based interface.

Our revenue increases were primarily driven by increases in sales personnel and marketing activities. Our sales personnel focus on gaining new customer accounts and expanding the depth and breadth of existing customer accounts. Our marketing personnel focus on marketing activities that have proven to result in the greatest number of customer leads to support sales activity. International revenue was negatively impacted by $1.9 million during the six months ended June 30, 2017 when compared to the same period in 2016 as a result of foreign currency movements, primarily the strengthening of the United States dollar relative to the British pound.

Revenue by product line and the related changes for the six months ended June 30, 2017 and 2016 was as follows:

(dollars in thousands)

By product line, our revenue growth was driven by a 7.7% increase in Injection Molding revenue, which was partially offset by our decision to discontinue MIM and Thixo manufacturing processes during the second quarter of 2016, a 19.2% increase in CNC Machining revenue and a 15.1% increase in 3D Printing revenue, in each case for the six months ended June 30, 2017 compared to the same period in 2016, as well as a $2.3 million decrease in Other Revenue driven by our decision in 2016 to exit our non-core resin resale business in Europe.

Cost of Revenue, Gross Profit and Gross Margin

Cost of Revenue. Cost of revenue increased $4.9 million, or 7.5%, for the six months ended June 30, 2017 compared to the same period in 2016, which was slower than the rate of revenue increase of 9.9% for the six months ended June 30, 2017 compared to the same period in 2016 reflecting the realization of productivity improvements. The net increase in cost of revenue resulted from the growth of the business and was due to raw material and production cost increases of $0.9 million, an increase in direct labor headcount resulting in personnel and related cost increases of $3.6 million and equipment and facility-related cost increases of $0.4 million to support increased sales volumes.

Gross Profit and Gross Margin. Gross profit increased from $81.9 million, or 55.5% of revenues, in the six months ended June 30, 2016 to $91.6 million, or 56.5% of revenue, in the six months ended June 30, 2017. Gross profit increased primarily due to increases in revenue and realization of manufacturing productivity improvements, partially offset by the volume- and mix-related increase in cost of revenue as discussed above.

Operating Expenses, Other Income, net and Provision for Income Taxes

Marketing and Sales. Marketing and sales expenses increased $5.2 million, or 23.3%, during the six months ended June 30, 2017 compared to the same period in 2016 due primarily to an increase in headcount resulting in personnel and related cost increases of $5.1 million as well as marketing program cost increases of $0.1 million.

Research and Development. Our research and development expenses increased $0.8 million, or 6.9%, during the six months ended June 30, 2017 compared to the same period in 2016 due to an increase in headcount resulting in personnel and related cost increases of $0.6 million and operating cost increases of $0.3 million, which were partially offset by a decrease in professional services cost of $0.1 million.

General and Administrative. Our general and administrative expenses decreased $0.3 million, or 1.9%, during the six months ended June 30, 2017 compared to the same period in 2016 due to a decrease in administrative costs of $1.3 million and professional services cost decreases of $0.1 million, which were partially offset by an increase in compensation resulting in personnel and related cost increases of $0.7 million and stock based compensation cost increases of $0.4 million. The decrease in administrative costs was due to expenses recorded in 2016 related to our decisions to exit MIM and Thixo manufacturing processes and vacate existing facilities and move to new facilities in the U.S. and Japan.

Other Income, net. We recognized other income, net of $1.5 million for the six months ended June 30, 2017, a decrease of $0.2 million when compared to other income, net of $1.7 million for the six months ended June 30, 2016. Other income, net decreased primarily due to a $0.9 million decrease in foreign currency gains, which was partially offset by a $0.4 million favorable legal settlement and a $0.3 million increase in interest income on investments.

Provision for Income Taxes. Our effective tax rate of 31.7% for the six months ended June 30, 2017 decreased 1.0% compared to 32.7% for the same period in 2016. The decrease in the effective tax rate is primarily due to changes in taxable income in our geographic regions in the six months ended June 30, 2017 compared to the six months ended June 30, 2016. Our income tax provision increased by $0.9 million to $11.3 million for the six months ended June 30, 2017 compared to our income tax provision of $10.4 million for the six months ended June 30, 2016.

Liquidity and Capital Resources

Cash Flows

The following table summarizes our cash flows during the six months ended June 30, 2017 and 2016:

(dollars in thousands)

Sources of Liquidity

Historically, we have primarily financed our operations and capital expenditures through cash flow from operations. We had cash and cash equivalents of $99.2 million as of June 30, 2017, an increase of $30.4 million from December 31, 2016. The increase in our cash was primarily due to cash generated through operations and proceeds from maturities of marketable securities, which were partially offset by repurchases of common stock and investing activity.

Cash Flows from Operating Activities

Cash flows from operating activities were $39.4 million during the six months ended June 30, 2017 and primarily consisted of net income of $24.3 million, adjusted for certain non-cash items, including depreciation and amortization of $8.7 million, stock-based compensation expense of $4.0 million, deferred taxes of $1.6 million, amortization of held-to-maturity securities of $0.6 million and other adjustments of $0.1 million. Cash flows from operating activities increased $0.9 million during the six months ended June 30, 2017 compared to the same period in 2016, primarily due to increases in net income of $2.9 million, depreciation and amortization of $0.5 million driven by an increase in capital investments, an increase in deferred taxes of $1.2 million and an increase in other adjustments of $1.2 million primarily due to changes in foreign currency. These increases were partially offset by a decrease in changes in operating assets and liabilities of $4.9 million driven by general growth of the business and timing of cash receipts and payments.

Cash flows from operating activities of $38.5 million during the six months ended June 30, 2016 primarily consisted of net income of $21.4 million, adjusted for certain non-cash items, including depreciation and amortization of $8.1 million, stock-based compensation expense of $3.5 million, deferred taxes of $0.4 million, loss on impairment of assets of $0.5 million and amortization of held-to-maturity securities of $0.6 million, which were partially offset by other adjustments of $1.1 million.

Cash Flows from Investing Activities

Cash used in investing activities was $8.7 million during the six months ended June 30, 2017, consisting of $13.3 million for the purchases of property and equipment, $20.1 million for the purchases of marketable securities and $0.5 million for the purchases of other investments, which were partially offset by $25.2 million in proceeds from maturities of marketable securities.

Cash used in investing activities was $32.0 million during the six months ended June 30, 2016, consisting of $22.4 million for the purchases of property and equipment and $38.3 million for the purchases of marketable securities, which were partially offset by $28.7 million in proceeds from maturities and call redemptions of marketable securities.

Cash Flows from Financing Activities

Cash used in financing activities was $0.6 million during the six months ended June 30, 2017, consisting of repurchases of common stock of $4.4 million, which were partially offset by proceeds from exercises of stock options of $3.8 million.

Cash provided by financing activities was $3.3 million during the six months ended June 30, 2016, consisting of proceeds from exercises of stock options of $3.7 million, which were partially offset by $0.4 million for acquisition-related contingent consideration payments.

Off-Balance Sheet Arrangements

Since our inception, we have not engaged in any off-balance sheet arrangements, including the use of structured finance, special purpose entities or variable interest entities.

Critical Accounting Policies and Use of Estimates

We have adopted various accounting policies to prepare the Consolidated Financial Statements in accordance with accounting principles generally accepted in the United States of America (U.S. GAAP). Our significant accounting policies are disclosed in Note 2 to the Consolidated Financial Statements included in our Annual Report on Form 10-K for the year ended December 31, 2016. There were no material changes in our significant accounting policies during the six months ended June 30, 2017.

Recent Accounting Pronouncements

For information on recent accounting pronouncements, see Note 2 to the Consolidated Financial Statements appearing in Part I, Item 1 in this Quarterly Report on Form 10-Q.

Foreign Currency Risk

As a result of our foreign operations, we have revenue, expenses, assets and liabilities that are denominated in foreign currencies. We generate revenue and incur production costs and operating expenses in British Pounds, Euros and Japanese Yen.

Our operating results and cash flows are adversely impacted when the United States dollar appreciates relative to foreign currencies. Additionally, our operating results and cash flows are adversely impacted when the British Pound appreciates relative to the Euro. As we expand internationally, our results of operations and cash flows will become increasingly subject to changes in foreign currency exchange rates.

We have not used forward contracts or currency borrowings to hedge our exposure to foreign currency risk. Foreign currency risk can be assessed by estimating the change in results of operations or financial position resulting from a hypothetical 10% adverse change in foreign exchange rates. We believe such a change would generally not have a material impact on our financial position, but could have a material impact on our results of operations. We recognized foreign currency gains of $0.4 million and $0.3 million in the three and six months ended June 30, 2017, respectively. We recognized foreign currency gains of $0.8 million and $1.2 million in the three and six months ended June 30, 2016, respectively.

Evaluation of Disclosure Controls and Procedures

Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (Exchange Act)) as of the end of the period covered by this report. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of the period covered by this quarterly report, our disclosure controls and procedures are effective and provide reasonable assurance that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported accurately and within the time frames specified in the SEC’s rules and forms and accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.

Changes in Internal Control over Financial Reporting

There have been no changes in our internal control over financial reporting (as such term is defined in Rule 13a-15(f) under the Exchange Act) during the period covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

There have been no material changes from the risk factors we previously disclosed in Part I, Item 1A. “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2016.