One Guy's Investments: Reconsidering Faro Technologies (FARO)

I wrote a few weeks ago that I was putting FARO in the doghouse. Well, today I think I'll let him run around the yard a little more -- I've looked into their business a little further, and I'm not as concerned as I was initially over the erosion of their business and their difficulties in providing guidance.

It cannot be denied that Faro Technologies' stock (FARO -- free real time quote from ADVFN) has had a bad twelve months. The company ramped up to very fast growth over the past couple of years and really stalled this year. Earnings during the first half of the year deteriorated significantly from what was expected, and management's stubborn insistence that they could hit their annual targets seems, in retrospect, to have been very unfortunate indeed.

I've spend some time in the last few weeks revisiting my investment in FARO and reconsidering whether or not I still feel comfortable with the company as a long term investment. I found out about FARO from the Motley Fool originally, and they've been following this disappointing year pretty well -- the most recent article of significance was quite negative, with one of the Fools selling on December 1.

So should I hold?

I think so. After carefully reading the conference call transcript from the third quarter, which is when they finally realized they couldn't come close to meeting their guided numbers for this year and would have to guide down next year as well, I have a lot more confidence in the viability of the company as a continuing growth investment for the long term.

And after listening to a good interview with Simon Raab, the CEO, that the Fool released as a podcast a few weeks ago, I remain pretty confident that the CEO has the best interests of shareholders at heart and has learned his lesson about the provision of guidance (ie -- don't give guidance if you don't have to, and if you must, guide conservatively).

So what were FARO's problems this year, and why do I feel confident going forward?

The problems were several -- but I think there were two major ones that led to the problems with guidance.

First, the company failed to predict very well the way that their much broader product mix would sell this year. They now have three major sales vehicles in the Faro Arm and Gage, the Laser Tracker, and the Laser Scanner (that last one being the major contribution of their purchase of IQvolution). Management was a bit surprised by the mix of sales that went to the lower-margin products like the Gage and the Laser Tracker this year, and they were also caught flat footed by sharply lower European sales and the fact that seasonal patterns in their sales didn't follow the usual back-loaded trend this year (at least, not in the third quarter).

And second, the company had significant problems with inventory management and timely order fulfillment.

The problems with product mix are not going to work themselves out -- and it's arguable that it's even a problem, as long as management acts a little more conservatively in the future. I definitely got a strong sense from Raab that the sales underperformance was unacceptable, however, and they're really refocusing their European sales force to get those sales back in line.

The problems with fulfillment and inventory are going to be worked out, or at least they are being worked on significantly. The Singapore headquarters for Asian sales is now opening and should be able to much better serve their fastest growing markets, which will help them to manage their fulfillment better. And FARO has spent the last several months implementing a new inventory management solution that they believe will solve their problems.

Much of my assessment is personal. I am disappointed that the growth reached this "hiccup" point this year, especially since my average cost for my FARO holdings is around $27 and is well under water.

But I remain quite impressed with the management team and their resolve to fix the problems that surfaced this year and to be much more conservative in promising future growth.

And as importantly, I don't think that we can ascribe FARO's recent problems to a saturation of the marketplace. I think this computer aided measuring and manufacturing area is still ripe for dramatic growth over the very long term -- while automation is certainly no new thing in the world of manufacturing, this kind of computerized and precisely automated measurement and control is still very much underutlized. FARO believes they have only reached a small piece of the market, and I'm inclined to agree with them.

There are certainly still plenty of risks out there for FARO.

I could be wrong about management, and Raab might be angling for a way out. I don't think so, and even after his controversial sales this year he is still by far the major owner, but it's certainly a risk.

FARO's competition might catch up and take leadership from them while the business is still relatively in its infancy. FARO is fighting to hold its patents and keep its customers, but I can't tell from here whether or not they'll succeed.

Stock price wise, the Hidden Gems newsletter service at the Fool might recommend selling FARO (or maybe they already have, I don't know) -- I imagine that might significantly impact the stock price in the short term, at least.

FARO might be further from turning around its sales and inventory issues than I think they are, and another tough year would be hard to take.

And finally, FARO has a very diversified base of customers but they are also quite focused on a few specific sectors -- heavy manufacturing, aerospace, and automotive manufacturing make up a large part of their customer base. They might continue to be able to drive sales to these industries even if they hit hard times because of the ROI argument that FARO can make for their products (they're still selling well to GM right now, according to Raab), but there's certainly a risk in their reliance on these cyclical industries.

I've decided to accept those risks for now and hold my FARO stock -- I think in a few years they'll be much stronger than they appear right now. I'll let you know if I change my mind.

Labels: FARO