Novanta Inc

NASDAQ:NOVT

Earnings Call Transcript 2020-Q1

[Operator]

Good morning. My name is Chuck, and I will be your conference operator for today. At this time, I would like to welcome everyone to Novanta Incorporated 2020 First 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 instructions] Please note, this event is being recorded.

I would now like to turn the conference over to Ray Nash, Corporate Finance Leader. Please go ahead, sir.

[Ray Nash, Corporate Finance Leader]

Thank you very much. Good morning, and welcome to Novanta’s first quarter 2020 earnings conference call. I’m Ray Nash, Corporate Finance Leader of Novanta. With me on today’s call is our 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 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 have 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 also 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 Chief Executive Officer of Novanta, Matthijs Glastra.

[Matthijs Glastra, Chief Executive Officer]

Thank you, Ray. Good morning, everybody. And thanks for joining our call. I hope all of you and your families are healthy and safe. Before we start our normal quarterly results review, I would like to first talk about the topic on everybody’s mind which is the COVID-19 pandemic.

I want to take a moment to thank our employees, our customers and our suppliers all of whom are making extraordinary efforts to maintain supply of our mission critical products to the people who need them most. I have been extremely impressed and I could not be more proud of how my colleagues around the world have stepped up and pulled together in the face of adversity.

Obviously, the world has changed dramatically since our last earnings call. Novanta is not immune to the impact of the pandemic but we are well positioned to weather the COVID-19 crisis.

Our balance sheet is strong, our innovation engine is strong. And our portfolio is diversified across 45 different applications with exposure to long-term secular growth trends in robotics and automation, healthcare productivity and precision medicine.

In a high uncertainty climate like this, we feel it is best to stay focused on what we can control and what we have invested in over the years. Our employees, our culture and delivering mission critical technologies to our customers.

Our four guiding principles in managing through the pandemic follow this focus. One, keeping our employees, their families and our community safe. Two, ensure business continuity for our customers. Three, ensure a bright future and emerge out of this crisis stronger. And four, deliver values.

Let me dive a bit deeper in each one of these. First a primary goal at Novanta continues to be the safety and wellbeing of our employees, their families and the communities in which we operate. Our China facility was the first to have operations impacted by the Coronavirus outbreak, and we were able to swiftly implement the learnings of our Chinese teams to our other sites worldwide.

Globally, the majority of our non-production employees are working from home. And we have enacted rigorous safety measures in all of our sites, including temperature checks, social distancing protocols, providing masks to those employees who must be physically present, spreading work over more shifts and frequently disinfecting our workspaces.

To-date over the roughly 2200 employees at Novanta that we have had two employees who contracted the virus and who fortunately have fully recovered since. Our absenteeism is low at around 1%.

And we are going to remain very vigilant and mindful of our employees safety when societies around the world decided to gradually reopen. We are also committed to providing non-monetary support to our communities. For example, we donated 10,000 facemask that were sourced from our factory in China to a local U.S. hospital.

Our second guiding principle is to maintain business continuity so we can support our customers. With the COVID-19 outbreak, our vision and purpose to delivery innovations that matter is more relevant than ever.

We take great pride that our mission critical technologies are embedded into diagnostic and antibody test equipment detecting COVID-19 into ICU and patient monitoring equipment, DNA sequencing equipment to sequence different mutations and strains of the virus, laser coding equipment for critically packaged food supply or production of PPE and cloud infrastructure equipment.

As a result, all of our production sites have been qualified as essential manufacturing operations. Once the pandemic hit, we immediately established global and local response teams. And I’m pleased to say that our ovations and supply chains have experienced minimal disruptions thus far.

Another critical aspect of our business continuity plans is to ensure proper liquidity and cash flow. We have decisively implemented additional actions and processes to improve cash flow and Robert will provide further details here.

Our third guiding principle is to ensure a bright future and emerge out of this crisis stronger. We have invested aggressively over the years to build great capability and a great culture with incredibly talented teams. And we are committed to keep these capabilities in place.

If anything, we believe that our long-term secular growth drivers are even more relevant post pandemic. We have the best innovation lineup that we have ever seen to catch the secular growth waves and we are staying the course on priority innovation programs.

Finally, our fourth principle is to live our core values. Now more than ever, at Novanta we believe that a healthy company culture is the ultimate competitive advantage in the face of opportunity and adversity. This means trusting each other being comfortable with constructive conflict for the good of the company, and holding each other accountable to deliver.

Our version of a healthy performance culture is called Novanta Way, which institutionalizes how we work together in cohesive teams, how we behave and interact through our five core values, and how we execute through the Novanta growth system.

The proactive cost measures we have taken are reflective of our values in a shared gain shared pain approach that Robert will further elaborate on. But what I can say here is that I’m very proud and excited that through our approach, all Novanta colleagues are now shareholders in the company which we feel is driving a tremendous engagement and alignment of our teams.

Now let’s move to our normal quarterly review. As you can read in our press release, in the first quarter of 2020, we exceeded the top-end of our guidance in both revenue and earnings. Our company delivered over $155 million in revenue representing a 1% year-over-year revenue declined on a reported basis and a 4% decline on an organic basis.

Adjusted EBITDA was $28 million in the first quarter down 2% versus the first quarter of 2019. In the first quarter our book-to-bill was 1.06 and we saw strong bookings across the Board, mostly driven by customers who wanted to secure inventories and protect against COVID-19 supply disruptions.

In the first quarter 58% of our revenue came from our medical markets that are structurally growing long-term, and that grew 6% year-over-year in the quarter. On the back of the innovation investments that we have made, we feel our innovation pipeline as a strong as it is ever been with significant opportunities and growth applications highlighted to you before.

Despite having a large portion of our engineering teams working from home, our NPI programs haven’t slipped. In the first quarter of 2020, our new product revenue grew double-digits year-over-year. Our fatality index, which is revenue from new products launched in the last four years continues to be healthy at over 25% of sales versus mid-single digit percentages a few years ago.

Design wins grew over 10% in the first quarter of 2020. And while some customers have temporary delayed new platforms, we are seeing others accelerate. As we look at it right now, we will be able to accelerate our innovation pipeline with multiple products hitting the market end of 2020 and in 2021.

We continue to have the confidence to invest in our innovation pipeline and drive our businesses to capture emerging new customer opportunities. I will let Robert explain the implication of the pandemic to our financials and then also on our outlook for the rest of the year. But let me briefly touch on what we are seeing in our markets.

Obviously, the environment is highly uncertain, but there are a few high-level observations we can share. First, it is important to realize that Novanta’s revenue might lag our customers by 60 to 90-days, or sometimes even more. So the declines that our customers are reporting on in their second quarter will likely be a third quarter effect for Novanta.

Second, with close to 60% of sales in medical market we feel that Novanta is well positioned for a post-pandemic world. And while in the short-term elective minimally invasive and robotic surgery medical procedures have been deferred. Most of these procedures cannot be deferred for very long given the often chronic and progressive nature of the conditions impacting these patients.

In diagnostics and ICU markers, we are seeing a relatively stable business overall as a rapid uptake in PCR molecular testing, patient monitoring and critical care equipment is being offset with a decline of non-COVID-19 related diagnostic tests.

On the industrial side, the bright spot so far is our electronics related business which is growing as a result of 5G, high-speed networking and cloud-based infrastructure. The rest of our industrial businesses are expected to move with over PMI trends but with different demand curves, with for example, coating for packaged foods relatively stable and converting for textile end-markets being deferred with shelter in place.

While short-term the industrial capital spending climate is depressed. We believe that in the mid to long-term, our thesis of secular growth in factory automation and industry [Indiscernible] remains intact.

Now let me turn to our operating segments starting with a vision segment. This segment predominantly serves the medical market and delivered 5% year-over-year revenue growth. The book-to-bill and our vision segments for the quarter was 1.11. And the vitality index in the second remained well above 30%.

Within the vision segment, we continue to see nice momentum in our one business unit on the back of the smoke evacuation technology we reported on earlier. The smoke evacuation insufflators technology is in particular demand in today’s climate as medical staff around the world are demanding as safe COVID-free work environment.

We secured our leading position in insufflator and pump technologies through design wins and development agreements with multiple minimally invasive and robotic surgery OEM platforms, which we expect to launch in the next two to three years. As a result, we are stepping up our R&D investments in the one business. In short-term however the MIS business will be affected by the deferral of elective procedures.

Our detection and analysis business unit within division segment primarily serves the diagnostic testing and patient monitoring markets with RFID barcode and machine vision technologies. We are seeing a relatively stable business overall as a rapid uptick in PCR molecular testing and patient monitoring equipment is being offset with the decline non-COVID-19 related diagnostic tests.

Moving to precision motion, our precision motion segment revenue declines [22%] (Ph). In the first quarter of 2020, with a book-to-bill of 1.09 and bookings growing 15% versus the first quarter of 2019. In the first quarter, we did see an upward trend in demand for 5G and cloud-based infrastructure as well as autonomous vehicles offset by a reduction in industrial aerospace or robotic surgery.

We believe that the long-term secular trends with the precision motion segments are very much in fact. We like our position and precise and dynamic motion control technology serving markets, restructure growth dynamics such as precision automation, robotics and robotic surgery markets.

As it relates to the surgical robotics markets, we continue to see our technology being validated and our position grow with the largest players. In the short-term however, surgical robot procedures are mostly deferred and recovery of big capital expenditures in hospitals are expected to take some time to recover. Within the precision motion segment in the first quarter, new product revenue more than doubled from a small base and our design wins grew more than 50% versus last year.

Turning to the performance of our photonics segment. For the first quarter of 2020, our revenue was down 7% driven by laser quantum and a deteriorating industrial capital spending climate. Laser quantum revenue had a double-digit decline for the first quarter of 2020 as expected and as previously communicated, due to dynamics in DNA sequencing which we have widely discussed in the last few quarters.

We expect COVID-19 to damp demand for DNA sequencing capital equipment in the short-term as research labs have largely been closed and clinical tests reduce in-line with the overall decline in hospital visits, procedures and diagnostic tests due to the pandemic.

The photonics segment in the first quarter saw bookings decline year-over-year by 4% in the first quarter with book-to-bill of 0.99. Design wins continued their momentum and grew over 50% year-over-year in the first quarter.

As we reported in our previous earnings call, the innovation pipeline in our photonics segment is the best it has ever been and has been accelerated by our recent Arges acquisition in beam delivery.

We are still anticipating to introduce six new product platforms in 2020, which is double the amount we introduced in 2019. And which are expected to help us gain share in adjacent high growth application segments.

To wrap up, we are very proud of the performance, resilience and agility over teams in an uncertain environment. Novanta’s overall position is favorable and our portfolio resilient to weather to COVID-19 pandemic. Close to 60% of our revenue comes from medical markets that are resilient and structurally growing long-term.

Our balance sheet is strong as is our innovation pipeline and our portfolio diversified with exposure to long-term secular trends robotics and automation, healthcare productivity and precision medicine. We believe that the secular trends will be even more relevant to post-pandemic.

So in summary, we feel we are well positioned to emerge strong from this crisis with a strong innovation pipeline and in a good position to execute on M&A opportunities, which remains our first priority for capital allocation.

So with that, I will turn the call over to Robert to provide more detail on our financial performance. Robert.

[Robert Buckley, Chief Financial Officer]

Thank you, Matthijs. And good morning everyone. We delivered $155.5 million in revenue in the first quarter of 2020, a decrease of 1% year-over-year on a reported basis and a decline of 4% on an organic basis.

As Matthijs already indicated, demand in the first quarter ended up being slightly better than we previously guided largely under the basis that some of our customers were concerned with disruptions in supply chains, and hence requested early shipment of product to build finished goods safety stock to weather the pandemic.

In the first quarter, our revenue continue to shift more towards our OEM customers who serve medical end market. Sales to these end-markets rose to 58% of total sales and increased by 6% year-over-year in the first quarter. This was despite a double-digit decline in the DNA sequencing market in the first quarter.

Key end-markets have performed well include our medical consumables business with integrated smoke evacuation and our integrated RFID and barcoding products. We also saw continued strong growth in new products introduced into the medical end-markets such as our new integrated OR Informatics products.

The industrial capital spending environment and the overall economic climate saw declines, as evidenced by the latest PMI trends. Novanta’s sales to all industrial markets was 42% of total sales and declined 10% year-over-year in the first quarter.

The decline was broad based across the majority of industrial end-markets, with many seen high double-digit declines which is consistent with our expectations and what our industrial OEM customers are seeing in those same markets.

One area we are seeing increased demand is with our semiconductor microelectronics customers based on the adoption of 5G, high-speed networking and cloud-based infrastructure. This market is still are a low-single digit decline in the first quarter. But that is a significant improvement for the declines we saw in 2019. Sales specific to the microelectronics market made up a little less than 10% of our total company sales in the first quarter.

On a geographical basis, our first quarter sales to China were actually up 2% year-over-year despite the disruptions caused by the pandemic. Sales to the U.S. and Europe were down 3% year-over-year reflecting the weakening industrial climate in those countries.

Our overall mix of revenue shifted with only 38% of total sales in the U.S. versus 41% in the first quarter of 2019. As a reminder, the locations of our sales are based on where the product is shipped to, which can sometimes be different than where a customer is headquartered. Nevertheless, we feel these figures represent channel directional trends.

Turning to profit .Our first quarter GAAP gross profit was $64.4 million or 41% of sales, compared to $66.3 million or 42% of sales in the first quarter of 2018. On a non-GAAP basis adjusted gross profits was $67 million or 43.3% of sales, compared to $69 million or 43.6% in the first quarter of 2019.

For the first quarter 2020, our adjusted gross margins were roughly flat compared to 2019. The lack of gross margin expansion was mainly impacted by continued growth at our medical consumables product line, which drove unfavorable mixed effects during the quarter.

We are seeing record demand for medical consumables particularly those that incorporate our smoke evacuation technology. This is a key innovation which will keep doctors and hospital staff safe from infection in the operating room. Thanks to the incredible efforts of all our employees, all of our factories remained open and producing products for our customers.

Despite the significant challenges around lockdowns, supply chains, disruptions, travel restrictions and logistics challenges. As of today, we are maintaining an extremely low absenteeism from our employees and a high level of engagement.

Moving on to operating expenses. First quarter R&D expenses were $15 million or 9.9% of sales, compared to $14 million or 8.9% of sales in the first quarter of 2019. We continue to lean into the headwinds and invest in our innovation pipelines.

The current economic climate, in our view, provides us with the opportunity to take market share and capture significant growth opportunities to drive our growth in 2021 and beyond. The more significant customer programs remain on track both within Novanta and our customers despite the challenges.

First Quarter SG&A expenses were $31 million or 19.8% of sales compared to $32 million or 20% of sales for the first quarter of 2019. Moving on to other financial results, GAAP operating income was $13 million in the first quarter of 2020, compared to $14 million in 2019.

And non-GAAP operating income in the first quarter was $21 million or 14% of sales compared to $23 million or 14% of sales in the prior year. Adjusted EBITDA was $27.6 million in the first quarter of 2020, compared to $28.2 million in the first quarter of 2019.

On the tax front or GAAP tax rate was nearly zero for the first quarter of 2020, differed from the Canadian statutory rate of 29% driven largely by jurisdictional mix of income, and the windfall tax benefits from stock based compensation awards.

On a non-GAAP basis our tax rates in the first quarter with 8%. This is more favorable than we anticipated, as a result of wind fall tax benefits from stock based compensation awards. This only impacts the first quarter and will not reoccur for the rest of the year.

On a GAAP diluted earnings per share was $0.34 in the first quarter compared to diluted earnings per share of $0.35 in the first quarter of last year. On a non-GAAP basis adjusted earnings per share was $0.51 in the quarter compared to $0.53 in the prior year.

First quarter operating cash flow was $17.8 million compared to $5.5 million in the first quarter of 2019. This result was driven by good operating profit and a moderate reduction or net working capital need.

At the end of the first quarter with growth - of $217 million and our gross leverage ratio was 1.8 times. Our net debt was $143 million as of the end of the first quarter, or roughly 1.2 times. Following our December 2019 amendment and extension of our credit facility, we extended the maturity date until the end of 2024, while also reducing our interest expense.

At the end of March 2020, we amended our credit facility again and exercised the accordion option to our revolving credit facility. This amendment increased the revolving credit facility committed under the credit agreement by $145 million from $350 million to $495 million and reset the committee’s accordion features $200 million for potential future expansion.

Because of all these actions, our overall liquidity is now $449 million which consists of more than $73 million of cash on hand and nearly $375 million of unused revolver capacity. This gives us capacity to weather the economic climate and give us a immediate capacity quickly is the right acquisition opportunity presented itself. The consequence of this actual result in our full-year 2020 interest expense being slightly more than $7 million, and our weighted average interest rate is anticipated to be around 2.6%.

I’ll now take a moment to speak to what we are seeing beyond the first quarter results. Due to the impact of the COVID-19 pandemic and Novanta’s business, the uncertain duration and the scope of that pandemic, and the uncertain timing of the global public health and economic recovery, we are not able at this time to reliably estimate the future impact of the current environment or operations and other financial results, including for the full-year 2020.

Thought we can give you at least some perspective around what we are seeing today in terms of demand. As we look at the second quarter, the implications of customers behaviors in the first quarter, and the economic closures of the worldwide economies in March and April, are clearly going to impact our second and third quarter more than our first quarter.

Novanta’s revenue could lag our customers revenue by 60 to 90-days. So while we were expecting second quarter revenue to be weaker than our first quarter, the majority of the impact rationally felt in the third quarter.

As we stand here today, we expect second quarter revenue to be in the range of $130 million to $142 million. The bottom end of the range reflects the risks of supply chain disruptions and/or customer disruptions at their factories more than it does demand risks from our customers.

In other words, from a customer demand perspective, we are trending to the upper end of the range. As we discussed before, the majority of our products are sold in the capital equipment, which is either for the advanced industrial markets or for the more prevalent medical end-markets.

Over the last years, we have relentlessly focused on applications we feel have secular growth and longevity to them. Knowing we have two year design win cycles. And because we want to maximize our return on investment.

As the consequences and thus far, we do feel that most of the revenue drops we are expecting to see are best characterized as demand deferrals as our customers experience push outs of capital expenditures to conserve cash. Absent resurgence of the public health measures taken in April we do expect a majority of our customers to rebound and return to growth.

Despite the challenges, there are many exciting aspects of our business where we see momentum building, particularly around new products and design win activities. We are seeing China’s industrial capital spending markets stabilizing and some early signs of growth returning particularly around 5G infrastructure investments and laser based material processing applications. As mentioned previously, despite the pandemic impacting China in our first quarter, we still manage to show growth there.

While we are expecting to see the second or third quarter drop in our medical business tied to the halt of elective surgical procedures for two plus months, we feel strongly that this will rebound quickly. Whereas the term elective might imply that this type of surgery is optional and elective procedure is simply one that is planned in advance, rather than one that is done in an emergency situation.

Surgical suites are the profit centers of hospitals and when we reemerge from these lockdowns, the pent up demand for patience will start to drive our consumable growth and then the new equipment growth.

As a point of reference, more than 70% of our medical end market sales are tied to surgical procedures both elective and emergency base as this business is expected to come back faster than some of our industrial markets. It is possible that sales to medical end-markets will finish the year at 60% of more of their total sales.

However, despite our competence in the business, our strategy and the long-term growth prospects of the company we recognize we need to take measures to control our costs, improve our cash flows and maximize our profitability without impairing our capabilities, disenfranchising our employees or damaging our ability to recover quickly.

Therefore, we have taken the following actions. First off, we the officers of Novanta, have agreed to a $1.6 million or approximately 50% reduction in our 2020 cash compensation. This includes the elimination of our cash bonus plans and reduction in base salaries.

Second, across the entire company, we have eliminated our planned annual base pay increases for 2020. And most importantly, we have eliminated the annual bonus plans across all of Novanta for all roles.

But for every single employee of Novanta other than the four officers, we have made a special onetime restricted stock unit grant in April totaling $14.4 million, which is fully vesting in February of 2021.

We decided on the equity grants, because we strongly believe this grant will keep employees focus through this time of crisis. Create an ownership mindset amongst our employees and allow us to maintain our talent, culture and our capabilities so we can quickly recover from the inevitable end of this pandemic.

We also strongly believe this equity grant helps to keep our factories running and our employees actively engaged, even from work-from-home environments while maximizing the Company’s adjusted EBITDA and minimizing cash outlays.

I should note that because of the accelerated investing, our earnings per share will be impacted by the amortization of this one-time grant. For the full-year of 2020, we now expect stock compensation expense to be approximately $22.5 million.

These changes to employee compensations is one way we are working to strengthen the profitability and cash flow of the company during the economic downturn. In other areas, we have also implemented travel bans for our staff globally, reduced discretionary spending across our business lines.

Frozen non-critical new employee recruiting and hiring activity for the year. Differed upwards of $10 million in capital expenditures, including the expansion of our time in the UK manufacturing facility that we mentioned in the last call.

We implemented a companywide furlough program. We are deferring cash payments of certain U.S. payroll taxes in accordance with the new Cares Act. And finally we have temporary stop to Company’s share repurchase program since the end of March.

Our focus over the next few months will be on protecting our capabilities in terms of our employees or innovation and our customers, and preserving our priority R&D programs, while at the same time maximizing adjusted EBITDA and cash flow. This focus is critical to help us navigate the temporary impacts of the pandemic on our customer demand, as well as the incremental cost to operate in these extraordinary times.

In the first quarter, we spent a little less than 300,000 in incremental costs specifically to mitigate the challenges stemming from the COVID-19 outbreak. These costs were incurred to ensure the safety of our employees, keeping our factories open and continuing shipping our products to our customers. As we look to the second quarter, we expect these costs may be materially higher.

We recognize that predicting the potential disruptions remains a moving target, and therefore have analyzed the model a multitude of potential financial scenarios in the company, the actions we took thus far were aimed to protecting the company under the worst case scenarios we can conceive, while recognizing the economic consequences of pandemics are temporary.

Based on this, we strongly believe are more than $73 million of cash-on-hand and nearly $375 million of available borrowing capacity under our revolving credit facilities, as well as the anticipated cash flows from operating activities would be more than sufficient to meet our needs over the next 12-months.

In addition, we believe that the global economies recover is secured and now have ample cash available to continue to execute and aggressively pursue acquisition strategies. We are thankful for our customers represent some of the financially strongest companies in the world. With more than 3500 customers selling into more than 45 different niche application areas. The diversity of our portfolio positions us well to weather the current environment.

Finally, in the spirit of never letting a crisis go to waste, we have aggressively institutionalizing and progressing the Novanta growth system operating model across our business units, and deep into the cultural fabric of this Company.

The Novanta growth system is a common way of working through a set common tools and processes vigorously applied to accelerate and drive sustained growth and operating performance.

We feel that by rigorously applying in Novanta growth system will assist us enormously in achieving our goals in 2020, especially in areas of customer satisfaction, speed-to-market, gross margins and inventory optimization.

In summary, we are very proud of the performance of our employees and their commitment to helping us weather this difficult environment. And most importantly, been excited about our future and look forward to continuing to deliver on our commitments or employees, our customers and our shareholders.

This now concludes our prepared remarks and we will open the call up for questions.

[Operator]

Thank you. We will now begin the question and answer session. [Operator Instructions] And our first question will come from Lee Jagoda with CJS Securities. Please go ahead.

[Lee Jagoda, CJS Securities]

Hi, good morning.

[Matthijs Glastra, Chief Executive Officer]

Hey, Lee.

[Robert Buckley, Chief Financial Officer]

Hey, Lee.

[Lee Jagoda, CJS Securities]

So I really appreciate you trying to give us a shape for the year in terms of Q3 likely being the worst of it from a revenue perspective. From a gross margin perspective, typically, your margins have been driven more by product mix versus overall volume. Can you talk about the current expected mix and how that might impact your gross margin? Understanding that a lot of the incremental costs from COVID probably hit the cost of goods sold line.

[Robert Buckley, Chief Financial Officer]

Yes. So that would be the larger variable that it would be impacting the gross margins as we get through the year. So it is relatively small in the first quarter, as I talked about, about 300,000. But as we get into the second and third quarter, or at least in the second quarter that could be upwards of 10 to 20 times higher than that.

So, it is a significant headwind that we need to still kind of work our way through, which is the variable that really prevents us from going out there with any sort of build guidance on the profitability side.

The gross margin in the first quarter generally lower. We would hope to improve from here we are focused on driving the performance of the business to maximize our EBITDA. You can’t do that through operating expenses alone.

And so we do anticipate driving gross margins in order to achieve our goal here of maximizing cash flows and EBITDA. To get into specifics I would rather not just because there is just too many variables right now that are outside of our control.

[Lee Jagoda, CJS Securities]

That is fair. And then switching gears to R&D. Has the R&D budget in dollars changed versus prior expectations? Or should we just think about it as the same dollars you are looking at spending to kind of capture some of these opportunities. And it will just end up being a higher percentage of current sales?

[Matthijs Glastra, Chief Executive Officer]

Yes, Lee, this was Matthijs. I mean directionally, as I commented in the prepared remarks. I mean, all our NPI programs are actually on-track, despite people working-from-home as well as our customers working-from-home.

What we do see is that the mix of programs might shift around a little bit in terms of priorities, because for some customers are actually accelerating, some others are delaying. And so I would say as an aggregate, we are shooting for a similar amount.

Being at that the mix might slightly change and we have also intensified our focus on what we call priority programs given let’s say that certain markets are expected to have more tailwinds and others in this climate.

[Lee Jagoda, CJS Securities]

Sure. And then one last one and then I will hop back in queue. You are one of the few companies that is out there continuing to pursue acquisitions in this market. What are you seeing from a I guess a price a competition and then probably more importantly, a seller willingness perspective at this point?

[Matthijs Glastra, Chief Executive Officer]

I would just say Lee I mean, overall, I mean, acquisitions are and remain a vital part of our strategy and our capital allocation in the Company. And we do feel that this climate is going to create opportunities for M&A. But, you also I’m sure seeing this elsewhere that that the first half of the year we will not expect much activity, basically for two reasons.

One is we want to be make sure that we stay focused on our own company health and our employees and until the pandemic stabilizes a bit. And second, sellers are also in pause mode right now for essentially the same reasons right. But we expect that as the year progresses, that there will be more openness from sellers to consider potential transactions.

And one of the major reasons that we why we switch to pursue the actions to reinforce our liquidity position as Robert mentioned, including the additional capacity of our credit facility is to be ready to take advantage of the M&A markets, right.

So when an opportunity arises, you can expect us to aggressively lean in during the second half of 2020 and 2021. So, we are staying very active yet disciplined in the M&A space, that is a way to characterize it.

[Lee Jagoda, CJS Securities]

Okay. Thanks very much.

[Operator]

The next question will come from Richard Eastman with Baird. Please go ahead.

[Richard Eastman, Robert W. Baird]

Yes, good morning Matthijs and Robert. Thank you.

[Matthijs Glastra, Chief Executive Officer]

Good morning Rick.

[Richard Eastman, Robert W. Baird]

Matthijs just to maybe think through the three platforms. And again, we are impacted here with the 60 to 90-day lag. But including new products that you hope to ship in the fourth quarter expect to ship in the fourth quarter. How would you look at the cadence of improvement among the three platforms, photonics vision and precision motion? Slowest to recover and kind of -.

[Matthijs Glastra, Chief Executive Officer]

Yes. It is a tough question, Rick. Let me just answer it directionally in terms of the overall markets and kind of market based and then not necessarily in the tree platform space. I’m just so basically what we will be setting our prepared remarks is that, our medical markets, which are close to 60%, of current sales, of course are impact a tour current. And you see our customers being impacted pretty materially in their second quarter.

We expect that to be a third quarter event for us. Yes, but we also as we speak, you see actually hospitals reopening. And so we do expect that hospital procedures to recover at the end of the second quarter and into the third quarter.

And as you will first see, basically medical consumables picking up as a result. And then followed by capital equipment as hospitals are first want to generate let’s say cash flow with procedures.

So that is kind of at a high level from kind of a surgical perspective. 70% of our medical business, and our customers are based on the elective and emergency procedures in endoscopy robotic surgery or fluoroscopy and ophthalmology, right. So we will follow I think a very well articulated trends that our customers have reported on.

There is a smaller market of ophthalmology that is slightly different. It is not the super high percentage of our revenue and ophthalmology is of course, eye doctors and I surgery. 50% of that market is private practice based. So that will that will follow a different trajectory kind of similar to dentist offices and so much. So that is the only exception I would say to the trend of elective procedures.

If you then look at the remaining part of the medical business. It is primarily diagnostics, DNA sequencing, ICU markets. And there is a tale of two cities. On one hand, you are seeing products that are obviously being accelerated prematurely because of the demand for COVID-19 related equipment.

But then on the other hand, you see that as a result of dramatically reduced hospital visits and associated tests that the non-COVID-19 related tests are down materially. The net effect to us is actually in that business. Our businesses are relatively stable business throughout the year.

And then in the industrial side, there is a wide range as well depending on end-markets. So you have on one hand you see - it is a relatively small exposure we have to electronics and in 5G. So Robert commented that less than 10% of our overall revenue. That is a bright spot right now. And we expect that to continue.

We see a wide range of industrial end-markets that were part of and you see for example, laser coding for packaged foods is heading in there. I mean, it is down but it is not down as much as let’s say, markets that has an aerospace component or which is small in our case, but there are some. There are some laser additive manufacturing, exposure that has exposure to aerospace. Obviously, that is impactful.

So I would just say, what we have done internally to maybe just summarize it, you almost need to draw a 45 different demand curves, right of each of these end-markets. And, basically the aggregate takeaway of these demand curves is that we believe that, yes, Q2 will be lower than Q1 and Q3 will be lower than Q2. And it is too early to comment let’s say on a Q4 trajectory.

Now on your question of innovation. Strategically, as well as practically. Yes we believe that is an asset to have. And we actually believe that in this climate, and we have commented on that in our last earnings call, and that that hasn’t really changed, that our customers, they are pulling for innovations and they are looking to introduce and compete and I think strong customers see this climate as an opportunity to gain share.

The answer now, how much impact that will have in Q4 in this climate is really tough to say. But strategically we feel that it provides an opportunity to gain share, take hold of leading platforms with very strong customers that we believe have long-term secular growth trends. So for us, that is why we are not holding back on these investments, because we feel that these customers in their platforms are very well positioned. So unfortunately, I cannot be more specific on few Rick.

[Richard Eastman, Robert W. Baird]

No. That is very good. You have a pretty good model, but I don’t actually model the 45 different demand curves. So, I tightened that up a little bit.

[Matthijs Glastra, Chief Executive Officer]

Yes, you do.

[Richard Eastman, Robert W. Baird]

Just want one last question. Robert, your comments about the COVID related expenses of 300,000 in the quarter, and maybe that spikes to three million to six million in the second quarter. Is that being absorbed in the cogs line?

[Robert Buckley, Chief Financial Officer]

Yes. Predominantly in the cogs line. It would be between like $3 million and let’s say $4 million, I think. It is really where we kind of end up a few percentage points of the total revenue. And then what portion of that kind of gets recovered remains to be an open question meaning, being some of that cogs is likely absorbed by our customers.

But it is what we are seeing in terms of like, higher costs associated with logistics, sometimes that is paid for by the customer, which is an advantageous situation. And then there are situations where we have a higher decontamination cleaning or higher PPE cost and whatnot. So, we are trying to manage that as best we can and we are also looking at sharing some of that costs with our customers.

[Richard Eastman, Robert W. Baird]

Okay, alright. And does that $3 million to $4 million, is it going to be kind of a quarterly run rate, does that carry into the third?

[Robert Buckley, Chief Financial Officer]

Well, it is really it is tied mostly to disruption, from the lockdowns and the disruptions in the airline industry, specific around how you move freight to and from location. So, to the degree of lockdowns begin to let up and the restrictions begin to ease and things begin to normalize doesn’t need to normalize that much frankly but just needs to normalize more than the costs begin to fall back off.

So no, I don’t think it is something that will go with us for the remainder of the year, absent some sort of resurgence of the pandemic in the back half of the year. So, I think it is something that is definitely temporary, for us to deal with and moving stuff around in particular down in the United States, but with our supply chains spread out globally, dealing with how to get product out of countries is sometimes in an expensive endeavor.

[Richard Eastman, Robert W. Baird]

Got you. Okay, great. Thanks again for the questions.

[Robert Buckley, Chief Financial Officer]

Yep.

[Operator]

Our next question will come from Brian Drab with William Blair. Please go ahead.

[Brian Drab, William Blair]

Hey good morning. Thanks for taking my question.

[Matthijs Glastra, Chief Executive Officer]

Hey good morning Brian.

[Brian Drab, William Blair]

Can you just in spirit of housekeeping here the small questions, but you have an idea for us how much was pulled forward from the second quarter is it hard to parse that?

[Robert Buckley, Chief Financial Officer]

It is hard to parse it out, but you know, we gave a range and we beat the range a little bit and I think, why we came in, beating the range and is more as a consequence of that. Again, I made a comment on as we looked at that second quarter, you know our demand profile would say we are at the upper end of that range. Meaning that the bookings are there, the support is there, backlog is there to deliver on that upper end of the range.

We provided a broader range, because, it is sort of what I just comment with Rick. There has been a lot of disruption on moving product around, logistics, getting products in and out of countries. And then sometimes with some of our customers, they have had a COVID case in their factory and have shutdown the factory. And we get caught in that in between a stage where we can’t ship the product out to them.

And so it is really kind of taking that into account. So if you think about it from that context, if you even out those two quarters a little bit more maybe that is a better perspective on the overall demand.

[Matthijs Glastra, Chief Executive Officer]

Yes, I think that is a good way to look at it. And the other thing that I would say, Brian is that yeah. I mean again our book-to-bill was 1.06 for the first quarter. We typically comment on that on average it is going to be - you can expect that to be one.

I mean, certain quarters can swing around a little bit. But if then look into the three segments, you basically see that precision motion and vision had book-to-bills of higher than one in photonics of about one actually 0.99.

So that is another clue on where and how much of kind of maybe a pool forward that we saw. But I think what Robert is saying is right, you just need to look at the kind of those two quarters combined to kind of really make your judgment.

[Brian Drab, William Blair]

Okay, thanks. Now that is really helpful. And then, can you talk a little bit more about the business that may have arisen specifically from the outbreak? You talked about some of the COVID related testing, you mentioned some other categories. Is this revenue related to the crisis activities meaningful and some of it is sustainable and creating new long-term opportunities for the Company.

[Matthijs Glastra, Chief Executive Officer]

Yes. I mean that is a question right? We feel let’s say first and foremost, we are extremely excited about the smoke evacuation insufflator technology we have. Even pre-pandemic we commented on this because we feel with eruptive technology where we are the technology leader.

We see penetration in adjacent markets, including robotic surgery. So pre-COVID, we commented on that this is a multiyear growth engine for us. And as a result, we are stepping up our investments in this area.

And now during COVID-19 and as we are in the middle of this crisis, I mean what customers are telling us and actually hospitals is that staff is demanding the smoke evacuation technology because it basically guarantees it filters out CO2 gas that comes out of the patient right.

So it is a way to keep medical staff safe. And you could kind of understand that this might become a part of a requirement and actually there are independent medical bodies that are highly recommending or even strongly suggesting that this should become a standard part of care going forward. So there are signs that this type of category might be here to stay and actually that that becomes part of a new normal.

Now on the other hand, of course, you see demand on patient monitoring and ICU related equipment that particularly is related to COVID-19. That we feel is more temporary. Of course countries will increase their strategic stockpiles of ICU capacity and maybe that has some positive field, but we are not going to count on that.

So, I would just say that that has helped, basically the way to think about it in the diagnostics and ICU business and detection and analysis business that has helped to stabilize the business as the large chunk of non-COVID-19 related diagnostic tests basically had of material decline. Now that is temporary too. So those two just evened out. And so it helps to stabilize the business, we don’t think it is necessarily a strong recurring trend.

On the smaller side, I would saying just 5G cloud based infrastructure, I mean it is a small part of our business, we hope it is being careful not to have a large exposure to it. But you can of course expect that, investment in high performance computing cloud based infrastructure is going to be a longer term trend and in 5G as well. So those are things that that we are seeing.

And I think, if you look beyond the kind of the thesis of the of the investments in the Novanta’s stock, I think we still very much intact and if anything could accelerate. So the need for healthcare productivity, and the need for precision medicine, and a need for automation and robotics to make supply chains more resilient and COVID resilient we feel is a trend that is very much intact. So I think macro wise, that is how we are looking at it. I think we are playing in markets that are structurally going to remain very relevant post pandemic.

[Brian Drab, William Blair]

Okay. Thanks for all that detail. And just one more question. I have in my notes and I can’t remember, specifically or an impression that have. The first quarter we are expecting about 33 million in SG&A, you did about 31 million. And I was just wondering if you can give us any insight into - I know, you mentioned some cost cutting in limiting costs, but what part of that discrepancy between my estimate and what you ended up doing was related to cost cutting and kind of what should we expect for the run rate going forward, including the stock count that you mentioned?

[Robert Buckley, Chief Financial Officer]

Yes. I mean, obviously, I know you want to fill out your model, but I want to be -.

[Brian Drab, William Blair]

Directionally it is all I would expect. Yes.

[Robert Buckley, Chief Financial Officer]

So like, there is a cost cutting that we have done. It was most of those actions started at the end of March and therefore benefit of on a Q2, Q3 basis. So will SG&A step down as we get into the second quarter, most likely, as the consequences some of the cuts in discretionary spending, some of the reductions in travel and the bands around that as some of the reductions in compensation expense. Offsetting that would be the grant, but for the most part, you should expect it to tick down a little bit.

[Brian Drab, William Blair]

Okay. Thanks and I will just mention too, I think the issues with that grant was really a brilliant idea. It is great move for the company too.

[Matthijs Glastra, Chief Executive Officer]

Thank you Brian.

[Robert Buckley, Chief Financial Officer]

Yes. We agree. Thanks Brian.

[Operator]

This concludes our question-and-answer session. I would like to turn the conference back over to Matthijs Glastra for any closing remarks. Please go ahead.

[Matthijs Glastra, Chief Executive Officer]

Thank operator. So to summarize, in the first quarter of 2020 Novanta delivered a solid performance in an uncertain macro environment. We are very pleased with our positioning and performance of our portfolio and proud of the performance and agility of our teams.

Novanta is not immune to the impact of this pandemic, but we are well positioned to weather the COVID-19 crisis. Our balance sheet is strong, as is our innovation lineup. And our portfolio is diversified with exposure to long-term secular trends in robotics and automation, healthcare, productivity and precision medicine.

While the short-term outlook is uncertain with a health pandemic, we are investing into the headwinds and remain focused on the long-term growth drivers in our business on the back of the macro trends in industry [Indiscernible], precision medicine and minimally invasive surgery.

In closing, I would like to thank our customers, our employees and our shareholders for their ongoing support. I’m particularly grateful for the dedication and strong contribution all of our teams have committed and Novanta employees that are showing tremendous agility and resilience during these unprecedented times.

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 in the second quarter 2020 earnings call. Thank you very much. This call is now adjourned.

[Operator]

The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.