Novanta Inc

NASDAQ:NOVT

Earnings Call Transcript 2018-Q2

[Operator]

Good morning. My name is Andrew, and I will be your conference operator today. At this time, I would like to welcome everyone to the Novanta Inc. 2018 Second Quarter Earnings Call. [Operator Instructions] Please note, this event is being recorded.

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

[Ray Nash, executive]

Thank you very much. Good morning, and welcome to Novanta's Second Quarter 2018 Earnings Conference Call. I am 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've outlined in our earnings press release issued earlier today and also those in our SEC filings. We may make some comments today, both in our prepared remarks and in our responses to questions, that may include forward-looking statements. These involve inherent assumptions with known and unknown risks and other factors that could cause our future results to differ materially from our current expectations.

Any forward-looking statements made today represent our views only as of this time. We disclaim any obligation to update forward-looking statements in the future even if our estimates change, so you should not rely on any of these forward-looking statements as representing our views as of any time after this call.

During this call, we will be referring to certain non-GAAP financial measures. A reconciliation of such non-GAAP financial measures to the most directly comparable GAAP measures is available as an attachment to our earnings press release. To the extent that we use non-GAAP financial measures during this call that are not reconciled to GAAP measures in the earnings press release, we will provide reconciliations promptly on the Investor Relations section of our website after this call.

I'm now pleased to introduce the Chief Executive Officer of Novanta, Matthijs Glastra.

[Matthijs Glastra, executive]

Thank you, Ray. Good morning, everybody, and thanks for joining our call. Novanta continued its momentum and delivered another strong quarter, beating both our revenue and profit guidance. Our company delivered $150.4 million in revenue, representing 26% year-over-year reported revenue growth and 6.2% year-over-year organic revenue growth. This is our seventh consecutive quarter of mid- or high single-digit double -- digit organic growth.

Our adjusted EBITDA was $30.4 million, which is up 18% versus last year. Our adjusted earnings per share was $0.51, which was up 24% from $0.41 in the second quarter of 2017. In addition, we delivered solid cash flows, with operating cash flow growing by 19% year-over-year to $20 million in the second quarter.

At Novanta, our mission is to deliver innovation that matters, providing mission-critical functionality to our OEM customers while improving end user productivity and enhancing people's lives. We believe that the strength of our team and our robust business model and diversified applications, with a balanced exposure to medical and advanced industrial markets, are serving us well.

We see a converging trend and a need for our motion, vision and photonics capabilities in a large variety of applications on the back of macro trends of industry 4.0, precision medicine and health care productivity. We, therefore, continue to remain excited about our position and applications such as DNA sequencing, robotic surgery, metrology, advanced material processing and precision automation and robotics, supported by long-term secular market growth trends.

In the quarter, we continued to see broad-based growth momentum across the company and all regions, with all 3 operating segments demonstrating double-digit year-over-year reported revenue growth. We also continue to have solid order book performance, with an overall book-to-bill of 1.04 after a strong bookings performance in the first quarter. We're seeing broad-based market growth in life science, minimally invasive surgery and advanced industrial, with our growth in any particular quarter more driven by customer technology launches or phase in, phase out dynamics than structural market dynamics.

We continue to make strong progress on our strategic growth priorities, driving long-term organic growth through commercial excellence and innovation. New product revenue year-to-date doubled year-over-year. Our vitality index, which is revenue from new products, launched in the last 4 years is now above 20% of sales. Our year-to-date design wins increased by more than 25%, and our revenue in the second quarter from China increased by more than 30% versus last year. We believe these indicators support our medium-term organic growth guidance of 5% to 7% on average.

On the productivity side, I'm proud of the execution by the team, delivering solid contributions to our operations savings. We're starting to see some initial impact of the recent tariff changes, but we expect to either mitigate or pass on the costs to our customers, so we do not expect the impact to be significant on our bottom line. You will hear more details on the quarter and the outlook for the year from Robert, but the strong second quarter results give us confidence in the full year 2018 outlook.

On the M&A front, we reported a nice tuck-in acquisition, Zettlex, in the previous earnings call, which closed early May. The integration of Zettlex is going smoothly, with positive reactions from our customers and sales teams as we are deploying Zettlex' inductive encoder technology through our precision motion sales channels. The inductive encoder technology is a great fit for industrial robotics and medical applications, and we therefore believe it expands our addressable markets considerably. We expect the Zettlex acquisition to have a meaningful impact on the long-term growth trajectory of our Celera Motion business.

Our balance sheet is strong, with ample firepower, and our acquisition pipeline is healthy. In terms of acquisitions, we remain disciplined and focused on cash and cash returns and acceleration of long-term growth in our target markets.

Now let me turn to our operating segments. Our precision motion segment continues to be a strong growth engine for us, with 20% year-over-year revenue growth and a solid order book, with book-to-bill of 1.08 in the quarter. We discussed before that our precise and dynamic motion control functionality plays very well into multiple markets with structural growth dynamics such as precision automation, robotics, metrology, autonomous vehicles and robotic surgery markets.

We see a broader trend of ubiquitous and mobile robotics, in line, on the factory floor, in the air and underwater, with embedded precision measurement and inspection capabilities to enable big data and full digitalization. In addition to enabling precise motion in the upper-end performance range of these robots, these applications often include sophisticated pointing and tracking devices such as gimbals that require precision motion solutions as well.

These solutions need to be a small in size, lightweight, energy-efficient and able to operate in demanding environments. We are in a sweet spot and winning here because of our ability to design and deliver the optimal combination of high precision, performance, power and compact form factors, enabling our customers to create pointing and tracking capabilities in a wide range of applications and operating conditions.

Within the precision motion segment, year-to-date, our new product revenue grew by more than 50% and our China revenue grew by more than 40% versus last year as we're bringing new innovations to market and are expanding our commercial teams. As we reported earlier, we are invested -- investing in commercial innovation and operations capabilities to drive sustainable growth in this attractive business.

The teams are steadily working through the supply chain issues we reported on earlier, and while delivery performance has significantly improved, our gross margins have not improved as fast as we initially expected, as we are working through some remaining manufacturing inefficiencies for the rest of the year. The team knows what to do, so it is time on task.

Turning to our Photonics segment, which delivered revenue growth in the quarter of 11% year-over-year, growth was primarily driven by our beam delivery business as a result of strong commercial execution in an improving industrial climate. Our book-to-bill performance year-to-date was 1.02. New product revenue to date was up more than 40% versus last year. Applications with strong performance were laser additive manufacturing, via hole drilling, micromachining and OCT.

We're very pleased to see the continued growth and operations execution in our Cambridge Technology business, which again delivered record bookings and revenue, with broad momentum across multiple applications. The team has done a tremendous job on demand execution and diversifying the business while improving the core of the overall products in demanding applications. The breadth of Cambridge applications and customers has given us a more sustainable and predictable revenue stream.

We are winning in the Cambridge Technology business due to our proprietary beam steering technology packaged with customer or application-specific solutions, enabling our customers to win with the fastest, most accurate, highest-performing and most efficient solutions. The core Cambridge Technology are horizontal technology business as it cuts across many advanced industrial medical markets. It is agnostic to which laser source, power or wavelengths is being used, which makes it a terrific business with well-diversified growth potential.

In the second quarter, the Cambridge Technology business launched the next-generation ProSeries Plus 3-Axis Scan Head family at the laser show. These products are primarily designed for demanding large field, micromachining, laser additive manufacturing and converting applications. The ProSeries Plus family offers a reliable solution for long processing runs and has expanded tuning options to meet application-specific needs. These next-generation models offer our OEM customers greater accuracy, flexibility, best-in-class stability and an ability to integrate with higher-power lasers.

Laser Quantum had a solid quarter and was a strong contributor to the Photonics results. As we reported in previous calls, following last year's tremendous ramp in a new generation of DNA sequencing machines, the growth in this business has started to normalize towards Novanta average growth rates. We remain very positive about the mid- and long-term outlook of this business as we view the DNA sequencing space as attractive and our leadership position strong. Finally, we're pleased with the productivity, operations and mix execution of the Photonics segment, as evidenced in their gross margin performance.

Turning to our vision segment, which includes 2 businesses, Minimally Invasive Surgery technologies, or MIS for short, and Detection & Analysis. The MIS group includes NDS and WOM and is focused on endoscopy and robotic surgery applications. The Detection & Analysis group includes our JADAK business and is focused on reducing medical errors, improving workflow and patient outcomes in applications such as minimally invasive surgery, patient monitoring, life sciences and clinical lab equipment.

In the second quarter, our vision segment delivered 58% year-over-year revenue growth, primarily driven by our WOM acquisition. New product revenue in the second quarter more than doubled versus last year. The book-to-bill in our vision segment was 1.12 with solid bookings in MIS.

Our WOM business continues to make great traction in penetrating new customers, driving a new product introduction program and strategically focusing its business on its core competences in minimally invasive surgery applications. In the quarter, the business announced its intention to exit its noncore and nonmedical product lines to decrease the asset intensity of the business while improving its strategic focus on pure medical applications. This program will better position the business to fully capitalize on its growth opportunities.

Despite the tough comparison in the second half of 2018 caused by a European regulatory change in 2017, WOM continues to perform as we expected and remains on track to delivering at Novanta's average growth rates in 2019.

WOM's recently launched insufflator and pump products are seeing good momentum with endoscopy OEMs. In addition, we're also seeing very strong expansion of their consumable business, which as we explained before, has lower gross margins than the capital equipment side of the business. Our plans for addressing this remain on track. We added resources during the quarter to begin working out concrete plans, which will include a low-cost manufacturing capability to drive improvements in 2020 and beyond.

While this business will be a drag on gross margins for the next few years, we are excited about the opportunity to significantly improve the gross margins, the strong organic growth we're seeing and expect to see for years to come and the noncyclical nature of the business.

We're also pleased with the continued momentum of our NDS product line. In the quarter, NDS delivered our sixth consecutive quarter of year-over-year core revenue growth, driven by new products such as 4K displays, wireless products and our new video image management and acquisition product, which addresses the integrated operating room market. In addition, the business substantially improved its profitability and remains on track to being a net contributor to our revenue and profit growth in 2018.

Finally, consistent with our previous earnings call, our Detection & Analysis business saw organic revenue declines, driven by old legacy product lines and regulatory and reimbursement changes in diabetes care. We are on track with working through these headwinds and expect the business to return to growth in the second half.

Despite this, we're seeing terrific design win activities in the Detection & Analysis business, with double-digit revenue momentum in RFID. In the second quarter, we launched a high-performance, compact, programmable 4-antenna port UHF RFID reader called IZAR. This product expands our addressable market to those customers who need a high-performing RFID reader solution with minimal engineering integration effort.

The IZAR reader has a read rate of over 750 tags a second and a read range of over 9 meters, which makes it uniquely suitable for medical and industrial asset tracking, inventory controls, smart medical cabinets and access control. This product is a great example of integrating software and middleware-based intelligence into a complete module for seamless integration with our OEM customers.

Early customer reactions are very positive and launch momentum of this product is ahead of schedule, so we're very excited about the potential here. And as discussed before, RFID demand in health care is increasing as there is a growing need to identify, track and connect devices, medications and patients for optimal workflow and patient safety. Because of our strong focus in the medical markets, we believe we are uniquely positioned to capitalize on this opportunity and are seeing that through the increasing demands on our business.

In wrapping up my section, we're very pleased with the organic revenue growth and profitability that we achieved in the second quarter. We are confident about our 2018 outlook as Novanta's leadership position across key medical and industrial markets, combined with a disciplined approach to M&A, is providing a very solid foundation for sustainable profitable growth.

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

[Robert Buckley, executive]

Thanks, Matthijs, and good morning. We delivered $150.4 million of revenue in the second quarter of 2018, an increase of 26.3% on a reported basis. Our acquisitions resulted in an increase in revenue of $21.8 million or 18.3%, and foreign currency exchange rates favorably impacted our revenue by $2.1 million or 1.8%. Consequently, organic growth was 6.2% year-over-year.

Second quarter 2018 GAAP gross profit was $65.2 million or 43% of sales. This compared to $53.5 million or 44.9% of sales in the second quarter of 2017. On a non-GAAP basis, second quarter 2018 adjusted gross profit was $67.7 million or 45% of sales compared to $55.2 million or 46% in the second quarter of 2017. Adjusted gross margins improved sequentially but came in below 2017 as a consequence of lower gross margins from our vision segment. The vision segment gross margins were driven by a higher mix of medical consumable sales in WOM, which was not part of the prior year results.

As we have explained before, the medical consumables business has a much lower gross margin, so the strong growth in the product line has a negative mix effect. But we could not be more excited about the opportunity to improve margins here. We understand what actions to take and have added the resources in the business this quarter to start working on more concrete plans. In fact, in the second quarter, we announced Phase 1 of our 2018 restructuring program. The overall program will be focused on driving manufacturing efficiencies within our vision operating segment to improve gross margins to Novanta company averages.

Phase 1 is focused on rationalizing our noncore operations, which in this case, was focused on discontinuing machining operations that were providing nonmedical product to nonmedical customers within the WOM business unit. While we are walking away from roughly $3 million to $5 million in annual revenue, we see this decision as a way to increase the strategic focus of the business on medical-only products, to increase the capacity of the organization to expand its manufacturing of medical products, to decrease the asset intensity of the business and, finally, to put the business on a path to increasing gross margins.

Phase 2, which we would like to talk about more in detail the next earnings release, will be focused on maximizing facility utilization of our German manufacturing center in creating a German-based manufacturer center of excellence. One of the core tenets of the WOM acquisition was increasing our presence and competencies in Germany, a strategically important market for Novanta. We are excited about the next step and how it positions us with our customers and our ability to increase -- to address demanding applications in the minimum invasive surgery market.

The final phase of the program will be in 2019 and into 2020. As we have discussed before, to truly address the gross margin issue with WOM, we believe we need a low-cost manufacturing facility to address the growth of WOM's medical consumable products. While we added resources in the quarter to start working on more concrete plans, we're in a better position to talk about this phase of the program in 2019.

One final topic on gross margins is the impact of the recently enacted tariffs primarily between the U.S. to China. While we are seeing a minor amount of incremental costs in our supply chain from these tariffs, we are confident that we can either mitigate these cost increases through changing suppliers or pass these costs on to our customers in the form of surcharges. However, it's possible there may be differences in timing between when tariff costs are passed on to us from our suppliers versus when we're able to pass these costs through to our customers. But we would not expect this to exceed $1 million in incremental costs in the short term.

Moving on, R&D expenses for the second quarter of 2018 were $12.6 million or 8.3% of sales versus $9 million or 7.6% of sales in the prior year. R&D as a percent of revenue came in lower than expected as a consequence of delivering higher-than-expected sales in the quarter. We continue to make strong progress on the hiring side, our new product introduction programs are making great progress, and we continue to expect R&D to ramp up in the second half of 2018.

SG&A expenses for the second quarter were $29.2 million or 19% of sales. This compared to $23.8 million or 20% of sales for the prior year. The majority of SG&A expenses increased in terms of total dollars due to the acquisitions within the last 12 months.

GAAP operating income was $17.1 million in the second quarter of 2018 compared to $15.7 million in the prior year, whereas non-GAAP operating income was $25.9 million or 17% of sales compared to $22.4 million or 18.8% of sales in the prior year. Adjusted EBITDA was up 18% year-over-year at $30.4 million or 20.2% of sales in the second quarter of 2018, which compared to $25.7 million in the prior year.

Interest expense in the quarter was $2.6 million versus $1.4 million in the prior year. The weighted average interest rate on our senior credit facility was 3.7% in the second quarter of 2018.

On the tax front, GAAP tax rate was 20.8% for the second quarter of 2018. It differed from the Canadian statutory rate of 29%, driven largely by jurisdictional mix of income as well as changes in the U.S. tax laws. On a non-GAAP basis, our tax rate for the second quarter was 19.8%, which was driven by a favorable jurisdictional mix of income and favorable rate impacts from the U.S. Tax Cuts and Jobs Act. When looking at the full year, we see the tax rate normalizing at around 20% to 21% due to further jurisdictional mix changes and continued favorability from the U.S. Tax Reform.

On GAAP, diluted earnings per share was $0.32 in the quarter compared to diluted earnings per share of $0.16 in the second quarter of 2017. On a non-GAAP basis, adjusted earnings was $0.51 in the quarter, up from $0.41 in the prior year. The increase in adjusted earnings per share year-over-year was driven by strong operating results and from acquisitions.

We ended the quarter with 35.5 million weighted average shares outstanding compared to 35.5 million in the second quarter of 2017. Our operating cash flow was $20 million for the quarter versus $16.8 million in the second quarter of 2017. This was driven by higher profitability and lower working capital requirements.

Capital expenditures were approximately $4.3 million, up from $1.4 million in the second quarter of 2017. This level of spend, which is higher than our historical average, was driven by the previously communicated capital expenditures related to our manufacturing facility expansions in our precision motion business.

We ended the second quarter of 2018 with gross debt of $240 million, and our consolidated leverage ratio of 1.99, defined as gross debt divided by rolling 12-month pro forma EBITDA, whereas our net debt was $132.9 million as of the end of the second quarter.

Turning to guidance. For the full year of 2018, we're expecting -- updating the guidance we provided you in May of this year. We now expect GAAP revenue of approximately $600 million to $607 million, which represents approximately 15% to 16% reported growth and 5.5% to 6.5% organic growth compared to 2017. Depreciation expense is expected to be more than $11 million, and amortization expense is expected to be around $26 million for the full year.

We now expect full year 2018 adjusted EBITDA to be in the range of $121 million to $125 million or around 20% of sales, and we expect full year 2018 adjusted earnings per share to be in the range of $1.96 to $2.02 per share.

Turning to the third quarter of 2018. We expect GAAP revenue in the range of $153 million to $156 million. As mentioned previously, growth in the second half of 2018 looks closer to 5% organic growth due to our WOM business unit, which is seeing very difficult comparisons with the second half of 2017 as a consequence of regulatory changes in 2017 that drove sales higher than anticipated. As Matthijs mentioned in his remarks, this is a temporary challenge as the business will return to Novanta growth rates in early 2019 and in line with the global patient procedural growth rates.

Adjusted gross margins will continue to improve sequentially and are expected to be around 45.5%, and overall operating expenses are expected to be around 28% of sales. Depreciation expense is expected to be roughly $2.8 million, whereas amortization expense is expected to be roughly $6.5 million. Interest expense is expected to be approximately $2.5 million for the third quarter of 2018. For taxes, we expect to see a third quarter non-GAAP tax rate of approximately 22% to 23.5%.

For adjusted EBITDA, we expect a range of $31 million to $33 million. Finally, we expect adjusted EPS to be in the range of $0.50 to $0.53 compared to $0.45 in the third quarter of 2017. Diluted weighted average shares outstanding will be around the same as it was for the second quarter. As always, our guidance does not assume any significant impact from foreign exchange rate changes.

We are truly proud of the progress our organization has made and the strong performance so far this year. We look forward to delivering on our commitments to our employees, our customers and our shareholders. This concludes the prepared remarks.

We'll now open the call up for questions.

[Operator]

[Operator Instructions] The first question comes from Lee Jagoda of CJS Securities.

[Lee Jagoda, analyst]

So just starting with the vision segment, I know JADAK was a drag on your organic growth. And it looks like the segment itself had some organic declines overall. Assuming all of the decline was JADAK, can you talk about some of the positive offsets and the outlook for the segment for the remainder of the year?

[Matthijs Glastra, executive]

Yes. So as I mentioned, Lee, this was expected. So we've been communicating about the headwinds in JADAK for a few quarters now. We're going to lap the diabetes care headwind next quarter, and we are on track to returning that business back to growth. It's supported by the design win momentum that we have seen in the business. It's supported by the RFID momentum that we're seeing in the business, and it's supported by the back-up position that we have in the business. So again, consistent with what we have been saying before, and we remain on track versus that story.

[Lee Jagoda, analyst]

Got it. And then, Robert, I know you mentioned you're planning on exiting the noncore nonmedical product lines within WOM. Can you give us some insight into the revenue and the profitability of what you're exiting and whether that -- those lost sales and all those potentially lost profitability is in the revenue and EPS range that you gave for the full year?

[Robert Buckley, executive]

Yes. So it's $3 million to $5 million of annualized revenue. It's already factored into our revenue forecast, and it's already factored into the EBITDA and EPS forecasts that we've provided for 2018. So overall, I think you've got the strength of the overall business doing well, and it can more than cover for the fact that we're doing that. And from a profitability perspective, it was not a high-margin business, I would say. So it is a little bit of a larger revenue impact than it is a profit impact.

[Lee Jagoda, analyst]

But it was profitable?

[Robert Buckley, executive]

Just slightly, but for the most part, we'll be able to take up the -- or absorb the lost profit in that. So that's already kind of factored into the forecast.

[Lee Jagoda, analyst]

Perfect. One last one for me. Just on Laser Quantum, it looks like the profitability you guys backed out was lower than it had been in prior quarters. Can you give us some just trajectory -- color on the trajectory of the business or if there was any onetimes that impacted the profitability this quarter?

[Robert Buckley, executive]

No, not from a profitability perspective, where sales, it was kind of consistent. There are ups and downs here and they're associated with it, depending upon mix of other business that we do with other customers, frankly. It depends -- as you know, there is -- it is some high concentration there with a single customer but -- if there are any sort of shifts between product lines, that can cause some -- or individual products, that can cause some shifts in their profitability.

[Operator]

The next question comes from Richard Eastman of Baird.

[Richard Eastman, analyst]

Just to kind of finish off and piggyback on the last question, with JADAK's situation and then in vision, could I just get a sense, with the WOM commentary, they have some pretty tough comps in the second half. And in JADAK, we expect to return to growth in the second half. But just, when you consolidate the 2 for the second half of this year, is vision going to see any core growth at all? I mean, is it better than 0 in the second half?

[Robert Buckley, executive]

We haven't gotten into kind of specifics. I think it's going to certainly see some challenge there. So from an organic growth perspective, it is -- a drop in WOM is more significant than the increase in JADAK. So there will be a little bit of a challenge there. But it is something that, in our mind, is very temporary.

[Matthijs Glastra, executive]

Yes, it's consistent and it's temporary, Rick, I would say. I mean, we've been talking about this, I think, since last year, the third quarter, more or less. So it's something that we have factored into our guidance, our forecast and the way of running the business.

[Richard Eastman, analyst]

Okay, okay. And just in the Q, there was a reference within vision to some -- a gross margin reference to poor quality impacts. Is that -- what was that in reference to?

[Matthijs Glastra, executive]

Precision motion, I think, right?

[Robert Buckley, executive]

No -- in the vision segment you're talking about? Or in the overall company?

[Richard Eastman, analyst]

Yes.

[Robert Buckley, executive]

In the overall company, there was -- precision motion had some cost of poor quality that we just talked about in our script. But within the vision segment, specifically, there's just -- I would just say that the manufacturing processes that are in place within WOM still are working through some maturity levels.

[Matthijs Glastra, executive]

The most important impact there is the mix impact of higher mix in consumables, right? That's the majority effect in WOM.

[Robert Buckley, executive]

We've had very high growth in a business that's got a little bit of a lower gross margin, so just dealing with that.

[Richard Eastman, analyst]

Okay. And can I ask, within precision motion, we had a very good core growth rate there. And I'm curious, at Celera Motion, is the strength outsized in either the medical robotic segment versus the industrial robotic segment within kind of those end markets, Celera Motion, or is it reasonably balanced?

[Matthijs Glastra, executive]

Yes, well so surgical robotics definitely strong, but unmanned vehicles, satellite communication and general kind of what I call the ubiquitous mobile robotics trends, those are -- and those are a vast variety of applications of unmanned vehicles, so that's kind of was in my prepared remarks. And not only do we supply kind of the upper-end performance range of kind of the motion functionality itself in those applications, but we also provide kind of pointing and tracking capability, because these -- these, call it -- these vehicles need to know where they are. They need to be able to fully digitize their environment, and they need some very accurate pointing and tracking devices to either point and track signals or light or -- and there's actually precision motion capability in that as well. So one of those, call it, point and tracking devices are called gimbals, and we're uniquely positioned to actually win in that space. And so we see actually quite some design win momentum there. But that's across a variety of applications that are either in line on the factory floor, in the air or even underwater. So it's a pretty vast array of different applications.

[Richard Eastman, analyst]

Okay. And then just the last question, just to talk to Photonics for just a second. I mean, 2 things. One is, again, with a core growth of, call it, 11%, was Laser Quantum greater or less than that relative to Cambridge Tech? In other words, how do those 2 pieces come in relative to the 11% overall Photonics growth rate?

[Robert Buckley, executive]

So Cambridge was doing -- it's fair to say Cambridge was doing better, but Laser Quantum wasn't that far off. But Cambridge was definitely doing better.

[Matthijs Glastra, executive]

Yes, so we're very excited about the Cambridge Technology performance, which we thought was very strong and it continues to be strong. And Laser Quantum, we said on the back of a pretty spectacular last year, we're kind of lapping some tougher comps, and therefore, also, after the launch dynamics, we'll normalize growth in that business to Novanta averages over time, right? So I think just from a trajectory perspective, we've also been very consistent with that. Now if you look long term in that application over multiple years, that's a very sure grower for us. So we remain very excited about it.

[Richard Eastman, analyst]

Got it. And there were some read-through comments -- you might have saw something that we put out. But there were some read-through comments about the heavy industrial laser market in China and Europe by IPGP. And I'm just curious if you have any comments there? I know Cambridge Tech doesn't necessarily play in that heavy industrial cutting, welding market. But nonetheless, I'm curious if you see any fault or hiccup or anything in demand around the laser market, the industrial laser market where you compete.

[Matthijs Glastra, executive]

Yes. No, thank you. We're not going to comment on others, obviously. I mean we can only comment on what we're seeing. I mean, we're very diversified, right, as a company to begin with. So -- and I even commented in the script that, like a business, like Cambridge Technology is what we call a horizontal technology business. It cuts across many, many, many applications. And so at a company level, not any individual application is larger than 10% of sales. We don't have any major customer concentration. The largest customer is anywhere between 5% to 7%, and we have a very limited number of those. So I would just start with that kind of dynamic, because it's a very important aspect. In addition, you're very correct. Our exposure to cutting and welding is minimal. So yes, we don't see any dynamics there. What can I comment on is that we see across all regions, we see solid growth, so China, for us, continues to be good. Of course, we are watching trade dynamics and things can, of course, change in a pretty -- what is a pretty volatile environment now. But so far, we haven't seen any change in growth momentum or major impacts on our supply chains yet. And we -- looking forward for the second half of the year, we don't see any major demand changes, as we speak. Now there have been, if you look on the semiconductor side, there have been some reports of maybe some slowdowns in certain areas. We are not seeing that. Again, this -- the exposure to the semiconductor market is fairly low, it's less than 10% of sales, and our exposure is actually increasing in the faster-growth, more secular part of that market, which is extreme UV or applications that are linked to 5G deployment or electric vehicles. So -- and as you can imagine, those are increasing. So again, we're watching that too, but so far, we don't see any significant impact of that market going -- growing softer.

[Operator]

The next question comes from Brian Drab of William Blair.

[Brian Drab, analyst]

So I think it's clear that you're updating the expectation for the consolidated gross margin for the year. Last quarter, you were still talking about the 100 basis points of expansion. I don't know if I missed it, but can you give a more precise update of what the expectation now is for gross margin for the year?

[Robert Buckley, executive]

No, we haven't gotten into that. I think by the fourth quarter, we'll see -- start to see that 100 basis point improvement versus -- on a run rate basis versus 2017. But it is really -- what effectively has happened in the first half of the year is that we've had higher growth in medical consumables that happen to be lower margin, and so they're causing a pretty significant mix shift in the business, right? So you're seeing some nice margin expansion in the Photonics segment. I think the precision motion business will still have some very nice margin expansion year-over-year. And both those -- but that business in there is pretty healthy. But as you look into the vision segment, you're getting growth in something that's low margin that's causing a little bit of that mix shift.

[Brian Drab, analyst]

Okay. And then Robert, did you say 45.5% gross margin for the third quarter?

[Robert Buckley, executive]

I did. I did.

[Brian Drab, analyst]

Okay, okay. Just checking on that. And then longer term, if you look out to 2019, is the expectation for the 100 basis points expansion potential, is that still intact? And is that still the plan?

[Robert Buckley, executive]

Yes, that's still the plan. I think you would have seen a little bit of a higher this quarter if we didn't have some cost of poor quality in the precision motion segment. That will recover when it gets into the third quarter. But I think that's still intact. That's still something that we see as very capable of doing.

[Brian Drab, analyst]

Okay, great. And then just a little more -- I'm looking for a little more granularity on the model. I don't know how much you're willing to give. But in terms of R&D spend, in terms of dollars, are we kind of at a level where that should be relatively steady going forward in the next couple of quarters, at least? And then can you tell us what tax rate to expect to use going forward? I know you made some comments on the tax rate, but I'm just trying to -- I'm looking for a number for like fourth quarter and into 2019, too.

[Robert Buckley, executive]

Yes, from a tax rate perspective, I said 22% to 23.5%. That's what we should see next quarter. That's what it should kind of come out to in the fourth quarter as well. So if you factor that in, that will result in a little bit of a lower tax rate for the year and -- than we originally anticipated. You could just do the math on that. But I think it's -- I think we feel pretty good about where that is. From an R&D perspective, that will trend up in terms of dollars, so no, you should not anticipate it staying at 12.5%. It will tip up -- I think, on a percent of sales, it will go up a little bit as well, so that was as we had planned. We've been adding additional engineering resources in there, and we've been focused on getting that to something close to 9%. I think that's our objective still as we look at the back half of the year. Overall, operating expenses, we said were going to be around 28% of sales in the third quarter, so that should give you a little bit of a perspective.

[Brian Drab, analyst]

Okay, that does help. And then the last thing I have. What is the timing of the divestiture of this $3 billion (sic) [ $3 million ] to $5 billion (sic) [ $5 million ] of WOM revenue? Is that happening immediately?

[Robert Buckley, executive]

Well, first of all, that's already factored into the forecast. It's not necessarily a divestiture. We're just shutting down some third-party sales that we do with -- that's related to machining type of functions. So we're not -- that's already kind of factored into our forecast. We already experienced a little bit of that in the second quarter. You should -- we'll continue to expect that impact in Q3 and Q4. So that has a little bit of an impact on the organic growth, obviously, so just as it had tough comparisons, it's also -- we're adding that factor in as well. But I think, overall, it's the right kind of decision to make. It's going to improve a lot of capabilities of the business, improve the margin profile and allow us to do some efficiencies that can drive some further margin expansion into '19 and '20.

[Brian Drab, analyst]

Okay. Last one is just when was that first contemplated in your guidance, the winding down of that?

[Robert Buckley, executive]

The first time we took it into account was this quarter, yes. We experienced a little bit of an impact, but for the first -- it's really factored in for the first time for the full year in -- right now.

[Matthijs Glastra, executive]

That impact to the quarter is not large. It's more the second half.

[Operator]

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

[Matthijs Glastra, executive]

Thank you, operator. So to summarize, the second quarter of 2018 was another solid quarter. Our focus on accelerating profitable growth and the diversity and strength of our businesses was evident in our strong financial results. We see a converging trend and need for our motion, vision and Photonics capabilities in a large variety of applications on the back of macro trends of industry 4.0, precision medicine and health care productivity. We therefore continue to remain excited about the applications we play in and the positions we have. Our growth strategy is sound, based on multiple growth drivers, organically and through M&A, and we're well on our way to execute on our 2020 strategic direction.

In closing, I would like to thank our customers, our employees and our shareholders for their ongoing support. I'm particularly thankful for the strong contribution and execution of our teams of committed Novanta employees. It's a true pleasure and honor to lead this great company. We appreciate your interest in the company and your participation in today's call. I look forward to joining all of you in several months on our third quarter 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.