FARO - FARO Technologies: Software Is No Saviour

2024-01-03 01:34:15 ET

Summary

• FARO Technologies is facing structural headwinds as its hardware is becoming commoditized.
• The company's focus on software and cloud deployed solutions aims to offset hardware weakness, but software revenue growth is only modest.
• While FARO's stock may seem reasonably priced, flat revenue and margin compression make it a likely value trap.

While the stock is up significantly from the lows of early 2023, FARO Technologies ( FARO ) is facing structural headwinds that transformation efforts are unlikely to offset. Hardware is likely to become increasingly commoditized and FARO's software doesn't appear to be gaining traction in the market. FARO's stock may appear reasonably priced, but flat revenue and margin compression make the stock a likely value trap.

Market

FARO offers technology that enables 3D data to be captured, visualized and analyzed. Historically this has primarily been hardware solutions, but the company is increasingly focused on software and cloud deployed solutions. Demand for this type of technology is driven by a need to reduce costs and improve the efficiency of operations across industries like manufacturing and AEC.

Within manufacturing, 3D data can improve productivity, reduce costs and decrease time to market. 3D metrology refers to scanning technologies used for quality control, amongst other applications. Manufacturing has traditionally been served by a range of measurement tools, including fixed-base coordinate measurement machines, check fixtures and handheld measurement tools. Tighter tolerances in the automotive and aerospace industries are pushing the metrology market to provide higher accuracy results though, providing a tailwind for automated and integrated equipment solutions that provide real-time feedback.

Growing adoption of Building Information Modeling is a tailwind within AEC as there is a need for improved 3D documentation, coordination and simulation across the building lifecycle. 3D mapping can be used to help build digital twins, which can be updated in real-time and compared to designs. FARO believes that the ability to obtain accurate, real-time 3D measurements will lead to the replacement of existing methods in AEC. Modular and prefab construction are also tailwinds, as the construction process more closely resembles traditional manufacturing. In these cases, 3D measurements can reduce costs associated with the re-work of materials and poor quality.

Laser scanning technology for the capture of crime scenes is also an end market for FARO. 3D point cloud data can be used to analyze things like bullet trajectory, blood spatter and cast off.

FARO believes that 3D metrology provides roughly a 1.5 billion USD serviceable addressable market for its tools, although this market offers limited growth. AEC, O&M and Public Safety provide an additional 2.3 billion USD serviceable addressable market.

There is a larger opportunity if FARO's digital tools can find broader adoption in AEC workflows though. Mapping for construction, real estate and infrastructure may represent large opportunities, but competition is fierce, and it is not clear that FARO brings any advantage.

FARO's business has been facing headwinds from softening demand in China and ongoing manufacturing weakness. Given the fact that the majority of FARO's hardware revenue comes 3D metrology, manufacturing weakness is likely material. This should have been cushioned by FARO's relatively high exposure to the automotive and aerospace industries though. FARO has also stated that there has been some softness within AEC due to a decline in commercial projects, but industrial applications are still an area of relative strength.

FARO

FARO’s technology enables customers to capture data from physical objects using a combination of hardware and software. Solutions are targeted at the 3D metrology, AEC, Operations and Maintenance and public safety analytics markets. This is a secular growth opportunity, but data acquisition hardware is becoming commoditized, and competition is increasing. To counter this, FARO is increasing its focus on software, although its efforts have had only modest success so far.

Products

FARO offers a range of 3D capture technologies, ranging from high accuracy laser scanners to lower accuracy photogrammetry. Use cases include the inspection of components, assemblies and structures, rapid prototyping, reverse engineering, surveying and construction, as well as the investigation of crime scenes.

• FaroArm Portfolio - combination of a measurement arm, a computer, software, and optional laser line probes for scanning larger objects. These products provide high speed, non-contact part inspection and target customers in the automotive and aerospace industries, amongst others. Software allows dimensional analysis and enables parts to be compared to CAD files.
• FARO Laser Tracker - combination of large-volume laser measurement tool, a computer and software. These products accelerate inspection cycle times and help guide manufacturing and assembly. Laser Tracker products are primarily sold to customers in the aerospace and automotive industries.
• FARO Laser Projector - the FARO Tracer projects a laser outline, which provides a template that can be used to guide manufacturing and assembly. This product targets customers in the aerospace, metal working and AEC industries.
• FARO Laser Scanning Portfolio - laser scanning products are used to acquire 3D point cloud data, allowing objects and spaces to be mapped. This technology is used in applications like facility life-cycle management and forensic analysis.
• GeoSLAM ZEB Handheld 3D Laser Scanners - use LiDAR technology and SLAM technology to enable fast and accurate 3D scanning. As this solution is highly mobile, it can be used in complex environments and attached to devices like drones.
• FARO Software - is used to manage and analyze data generated by FARO's hardware.

Customers

FARO has a diverse base of over 15,000 customers . The company's ten largest customers by revenue only contributed 2.9% of total sales in 2022 . Roughly 85% of FARO's revenue came from existing customers in 2022.

Restructuring

FARO has been undergoing a restructuring over the past few years, targeted at improving efficiency and positioning the company for future success (increased focus on software). This has now largely been completed, with FARO achieving approximately 40 million USD in annualized savings . Actions included a 390 person decrease in headcount, consolidating manufacturing in Thailand and divestiture of FARO’s Photonics business and 3D Design related assets obtained from the acquisition of Opto-Tech SRL.

FARO has also been an active acquirer in recent years, to help support its increased focus on software and reality capture for AEC and O&M:

• ATS AB (2020) a provider of 3D digital twin software.
• Holobuilder (2021) has a software platform which delivers hardware agnostic 360° image capture, allowing contractors to virtually manage construction progress.
• NGH Holdings (2022) is a provider of mobile scanning solutions with proprietary simultaneous localization and mapping software. This enables mobile mapping of enclosed environments without GPS.
• SiteScape (2022) is a provider of LiDAR scanning software solutions for the AEC and O&M markets. SiteScape’s software allows LiDAR equipped mobile devices to map indoor spaces.

Software Strategy

FARO’s software strategy is now based around its cloud-based Sphere platform. FARO is leveraging the cloud to enable data upload and access from any location, along with elastic data analysis capabilities.

In late 2023 FARO released Sphere XG , a unified cloud platform that enables users to view and analyze 3D data. Sphere XG also allows users to combine 360° photos, 3D point clouds, and BIM models in one platform.

Software revenue was 38.3 million USD in 2020, 45.1 million USD in 2021, 44.4 million USD in 2022 and will probably be something like 46 million USD in 2023. While software is providing FARO with some growth, it is disappointing in light of FARO's internal initiatives and market demand.

Financial Analysis

An increased focus on sales, along with stabilizing market conditions and improved material availability led to better-than-expected results in the third quarter. FARO's revenue increased 2% YoY to 86.8 million USD in the third quarter. Hardware revenue was up 1% YoY, contributing 64% of sales. Software revenue increased 6% YoY but was negatively impacted by customers moving from perpetual licenses to subscriptions. Service revenue increased slightly on the back of recent hardware shipments and an increase in the installed base. Unsurprisingly, 3D metrology demand from automotive and aerospace customers has been an area of strength. From a geographic perspective, China is contributing to soft results, and this is expected to persist going forward. Fourth quarter revenue is expected to be 92-100 million USD, representing roughly an 8% decline YoY.

FARO has been engaged in cost reduction initiatives which are expected to result in 12 million USD of annualized savings. Activities include:

• Reduced footprint
• Reduced cloud investment
• Integration of prior acquisitions

Despite these efforts, FARO’s margins remain under pressure. FARO has attributed this to high raw material costs and relative strength of the US dollar. The company’s gross profit margin did improve sequentially though, in part due to supply chain localization efforts.

Non-GAAP operating expenses decreased by 2.8 million USD YoY on the back of restructuring efforts. Expense reductions are now largely complete, and FARO is targeting non-GAAP operating expenses of 40-43 million USD going forward. FARO is unlikely to be profitable with this level of operating expenses though.

FARO often has to displace well entrenched existing solutions, which can require significant customer education. As a result, sales and marketing expenses are relatively high and have been increasing. FARO's R&D investments have also been rising as the company tries to maintain a relevant product portfolio. This is causing a steady decline in profitability, which I don't see reversing, even if cost cutting measures provide temporary relief.

Conclusion

FARO believes that by focusing on software it can maintain differentiation and expand its addressable market. Integrated hardware and software solutions could help FARO to build a more attractive stream of software revenue over time, but there is limited evidence of this so far. FARO may appear undervalued, but investors need to consider that the company's profit margins have been steadily declining over the past decade and that growth prospects are questionable.

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