Earnings Call Transcript - KRNT Q1 2022

Operator, Operator

Greetings, and welcome to Kornit Digital’s First Quarter 2022 Earnings Call. As a reminder, this conference call is being recorded. I’d now like to turn the conference over to our host, Andrew Backman, Global Head of Investor Relations for Kornit Digital. Mr. Backman, you may begin.

Andrew Backman, Global Head of Investor Relations

Thank you, Operator. Good day everyone, and welcome to Kornit Digital’s first quarter 2022 earnings conference call. With me today are Ronen Samuel, Kornit Digital’s Chief Executive Officer; Alon Rozner, Kornit’s Chief Financial Officer; and Amir Shaked-Mandel, Executive Vice President of Corporate Development. Before we begin, I would like to remind you that forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and other US securities laws, will be made on this call. These forward-looking statements include, but are not limited to statements related to the company’s objectives, plans, strategies, statements of preliminary or projected results of operations or our financial condition, and all statements that address activities, events, or developments that the company intends, expects, projects, believes, or anticipates will occur in the future. Forward-looking statements are subject to known and unknown risks and uncertainties, and are based potentially on inaccurate assumptions that could cause results to differ materially from those expected or implied by the forward-looking statements. I encourage you to review the company’s filings with the Securities and Exchange Commission, including the company’s Annual Report on Form 20-F filed on March 25, 2021, which identifies specific risk factors that could cause actual results or events to differ materially. Any forward-looking statements are made as of this call hereof, and the company undertakes no obligation to publicly update or revise any forward-looking statements, except as required by law. Additionally, the company will be making reference to certain non-GAAP financial measures on this call. The reconciliation of these non-GAAP measures to the most directly comparable GAAP measures can be found in the company’s earnings press release which was published today, and is also posted on our website in the Investor Relations section. At this time, I would like to now turn the call over to Ronen. Ronen?

Ronen Samuel, CEO

Thank you, Andy, and good day, everyone. Thank you for joining us on today's call. I'm pleased to share that we delivered a good start to the year, with revenues coming just about the high end of our guidance, and operating margins in line with our expectations. For the first quarter, total revenues grew by 26% year-over-year to $83.3 million, net of $8 million in warrants related to our global strategic account. System revenue growth was very strong, and overall system contribution to the revenue mix was very high. We saw diversification across the business within our top 10 customers, with very strong performance of our global strategic account that continues to execute on its aggressive expansion initiatives throughout 2022 and 2023. We saw a record quarter in Asia Pacific, and a strong quarter in both EMEA and the Americas. We continue to make progress with major brands, including one of the largest retailers in the world, which acquired several Atlas MAX systems this quarter. This major retailer is focused on their ability to scale and automate massive quantities of production, in addition to leveraging the incredible benefits of KornitX and our global fulfillment network. On the product side, we see a strong pipeline and adoption of the Atlas MAX with existing and new customers. We are moving along through the initial stages of the Atlas-to-Atlas MAX upgrades, which will continue to gain pace throughout the year and into 2023. We also received tremendous customer feedback on the automation upgrades, which will be selectively available in the second part of this year, with commercial availability in 2023. We had an exceptional quarter for the Presto, especially in Europe and Asia Pacific, and see a lot of excitement and momentum around the Presto MAX, which now represents the majority of the DTF pipeline. We also see an increasing backlog for Presto MAX upgrades, as customers tell us that enhancing the decorative capabilities for dark colored fabrics is a massive benefit. On KornitX, we continue to engage in several very interesting initiatives with some of the largest digital platforms, marketplaces, and brands in the world. We are particularly enthusiastic about the upcoming launch of our strategic partnership with Wix, one of the leading SaaS and e-commerce platforms in the world, with over 220 million users globally. Wix is the leading platform for creators and enterprises of all sizes that are looking to build a digital presence. With KornitX, the Wix platform will enable its massive community to seamlessly add on-demand fulfillment services, opening to them exciting commerce and merchandising opportunities. We expect to go live later this quarter, and are excited about our joint roadmap ahead. In addition to this massive opportunity in our pipeline of new partners, some of our existing KornitX customers and partners continue to scale volumes and the total GMV running on the platform, and we are very satisfied with our progress. As mentioned on our last call, 2022 will be an exciting year of groundbreaking new product introductions. In early April, we hosted the extremely successful Kornit Fashion Week Tel Aviv, where we officially unveiled the Atlas MAX Poly, and demonstrated our evolutionary game-changer, Kornit Apollo. The Apollo is the most comprehensive digital single-step system targeting screen print mass production markets, and the perfect solution for nearshore mid-runs mass production, with best-in-class MAX quality, the lowest TCE, and the highest output per operator. Apollo uses smart curing from our recently completed Tesoma acquisition. We expect early customer engagement for Apollo in the second half of this year, and commercial availability mid-2023. We see strong movement and growth in the market from brands and retailers shifting traditionally mass-produced offshore jobs to nearshore and onshore short-run production, supporting the lean inventory, fast replenishment, and in-season reactivity needs. Our strong portfolio of mass production MAX solutions, and soon-to-come Kornit Apollo, all powered by our unique KornitX platform, place Kornit in a remarkable position to cater to these evolving market opportunities and trends. While we see these tremendous and growing tailwinds fueling our business, our customer and us are not fully immune to the overall macro headwinds and certain post-pandemic dynamics. We started this year with a strong backlog and robust pipeline, but as we move deeper into the first quarter, we begin to see the macroeconomic volatility weigh on the pace of consumer purchases and on capital allocation decisions of certain customers. As such, some of these purchases and expansion plans are now shifting out into later quarters. We remain excited about our growth plan for the full year, and continue to expect the second half of this year to be much stronger than the first half, in terms of both revenue and profitability. Considering the near-term volatility of the topline, and the continuing investment in major marketing events and sales activity this quarter, we expect operating profitability in the second quarter to be lower than the first quarter, as Alon will discuss shortly. We are extremely energized heading into KornitX Fashion Week London, which will take place next week. We expect over 600 brands, designers, retailers, influencers, investors, and Presto to attend, where we will demonstrate how virtual and physical fashion worlds intersect. This coming event, as well as the FESPA event in Berlin at the end of May, will be a catalyst to develop our funnel and pipeline for the coming quarters. In summary, we remain focused on our mission to build the operating system for on-demand fashion and the massive opportunities ahead. And as I mentioned, while we are not fully immune to overall macroeconomic headwinds and near-term volatility, we continue to expect to deliver ahead of plan the $125 million run rate business we originally targeted for the fourth quarter of 2023, and remain confident in our journey to become a $1 billion business by 2026. We are working extremely hard to mitigate the external macro factors, and I remain extremely confident in our team and the value we deliver to our customers. Thank you again, and we hope to see you next week in London. With that, let me turn the call over to Alon for a closer look at the numbers and the guidance. Alon.

Alon Rozner, CFO

Thanks, Ron, and good day to everyone. We are pleased to report first quarter revenues of $83.3 million, net of $8 million non-cash warrant impact related to a global strategic account, which is just above the top end of our guidance range of $87 million to $91 million. As a reminder, our guidance assumes zero impact from warrants. As Ronen shared, we saw good diversification across the business in the first quarter. Systems revenues were very strong, primarily due to very strong sales for both Atlas and Presto. Services revenues increased 32% year-over-year to $10.8 million, and were 13% of total revenues net of non-cash warrant impact of approximately $350,000. Top 10 customers accounted for approximately 53% of total revenues this quarter. Looking at the regions, Asia Pacific had another record quarter, with good mix of both Atlas MAX and Presto systems, including several Prestos in Japan and a first Presto MAX system in India. We continue to see very good interest in the region for both DTG and DTF systems in addition to KornitX, with opportunities unfolding in Korea, China, Japan, Australia, and India. EMEA delivered one of its best quarters ever, including upgrades from Atlas MAX. Building upon the strong go-to-market foundations executed over the past several years, we saw continued interest and momentum across the entire region for both Atlas MAX, Presto MAX, and KornitX. In the Americas, new customers included a major swim and sports apparel company, which will be utilizing our Atlas Poly, a licensee for major professional sports leagues, and a direct mailing solutions provider, both utilizing Atlas. We continue to see strong momentum in Central America and Mexico as a result of nearshoring, including additional wins for Atlas MAX and a robust pipeline for Presto Systems. Moving to margins, non-GAAP gross margin net of the impact of the warrants was 41.5% compared to 47.1% in the same period last year. This was due to several factors, including a higher mix of systems as a percentage of total revenues, including sales to our largest strategic account, which has experienced significant growth in and beyond the US, and higher DTF sales in both Europe and Asia Pacific. In addition, we had lower consumables revenues as a percentage of total revenues. During the first quarter, we moved to mass production in our new ink manufacturing facility. We believe as consumable sales pick up throughout the year, we will gain operational efficiencies on the fixed costs in the business. Looking forward, we expect gross margins in the second half of this year to revert back to similar levels we saw in the second half of 2021, primarily driven by new product introductions and increasing percentage of revenues from our recurring revenues consumable business, operational efficiencies, and longer term, the acceleration of KornitX and other software-driven initiatives. Looking at macroeconomic issues and supply chain, we, like our customers, are not fully immune to overall macro pressures, including impacts from inflation and higher interest rates. In this environment, we are working hard every day to proactively address and mitigate these impacts on the business where possible. These include focused cost reduction projects, continued supply chain initiatives, including dual-sourcing strategies and long-term commitments, design adaptation, as well as selective price increases. Given our proactive supply chain initiatives, we remain confident in our ability to deliver on all our 2022 customer commitments, and utilizing our strong balance sheet, continue with our efforts to secure our 2023 supply chain requirements. Turning to expenses. Total first quarter operating expenses were $35.2 million, a decrease of 8% from the fourth quarter, and an increase of 43% year-over-year. As I stated last quarter, we continue to invest in R&D to support our array of industry-leading new product introductions, as well as in sales and marketing, as we see meaningful opportunities to generate long-term acceleration and revenue growth. Research and development expenses were $12.8 million in the first quarter or 15.4% of revenue, as compared to $8.9 million or 13.5% of revenue in the first quarter of 2021, primarily due to continued investments in new product introductions and KornitX. Sales and marketing expenses were $14.6 million or 17.6% of revenue, as compared with $9.9 million or 14.9% of revenue in the same period last year, due to continued expansion of our go-to-market strategy and capabilities in all regions, including the transition to direct sales model in some regions, including EMEA. We continue to invest in brand awareness initiatives, including KornitX Fashion Week Tel Aviv, and Fashion Week London, as well as other customer-focused events, which will impact sales and marketing expenses in the second quarter. General and administrative expenses in the first quarter were $7.8 million or 9.4% of revenue, as compared to $5.8 million or 8.8% of revenue in the first quarter of 2021. The increase was due to staffing and other investments to support the overall business infrastructure. Non-GAAP operating loss was $0.7 million, net of $8 million non-cash warrant impact. Excluding the impact of the non-cash warrants, operating margins were in line with our guidance of 7% to 9% for the quarter, which again, assumes zero impact of the warrants. We ended the first quarter with 913 employees, a year-over-year increase of 213, and an increase of 31 employees from the previous quarter, primarily in R&D and sales and marketing. Non-GAAP net income for the first quarter was $0.2 million or $0.00 per share on a fully diluted basis, as compared to $7.7 million or $0.16 per share in the first quarter of last year. First quarter GAAP net loss was $5.2 million or a loss of $0.10 per share, as compared to GAAP net income of $5.1 million, or profit of $0.11 per share for the first quarter of 2021. Adjusted EBITDA for the first quarter was $9.5 million, as compared to $10.8 million in the first quarter of 2021. Our cash balance, including bank deposits and marketable securities at quarter end, was $734 million, a decrease of approximately $64 million versus last quarter, primarily due to cash used in operations of $47.1 million, and capital expenditures of $7.5 million in the first quarter. We came off a strong peak season in the fourth quarter and ramped order during the second half of the first quarter. The timing of sales later in the first quarter to our largest strategic account grew receivables materially quarter-over-quarter, producing a drag on cash flow. I want to emphasize that we see no collection issues in our receivables, and we anticipate cash collections to improve over the next several quarters. We also used our balance sheet to secure our supply chain, including building up key categories of inventory due to long lead times and shortages. This includes components for Atlas MAX and automation upgrades, which we expect to begin materializing in 2022 and into 2023. We also made advance payments for key go-to-market programs. Turning to guidance. As Ronen mentioned, given the macroeconomic impact on consumables and capital allocation decisions of certain customers, and overall near-term volatility, we currently expect second quarter revenues to be between $85 million to $95 million. We expect revenues in the third and fourth quarters to be stronger than the second quarter. In addition, considering the near-term volatility on the topline and the continued investments in the business, including investments in multiple new product introductions and significant events like Fashion Week Tel Aviv and London, and industry events, including FESPA, we expect operating profitability in the second quarter to be lower than the first quarter. Specifically, we expect operating margins in the second quarter to be between -2% to 2%, and EBITDA margins of 0% to 4%. Further, we expect higher operating margins in the second half of the year, with operating margins in the third and fourth quarters to be in the low to mid-teens. I want to reiterate that all guidance assumes zero impact from fair value of issued warrants in the quarter with our global strategic account. With that, let me turn it back to Ronen.

Ronen Samuel, CEO

Thank you, Alon. Operator, we are now ready for the Q&A session.

Operator, Operator

Thank you. The first question comes from Jim Suva from Citigroup. Please go ahead with your question, Jim.

Jim Suva, Analyst

Thank you very much. I have a few questions. When you mention the slowdown, is the slowdown primarily related to your global strategic customer, or is it not that and it's actually absolutely not that, and it's more the other accounts and customers that you're dealing with? Then I have a follow-up.

Ronen Samuel, CEO

Thank you, Jim. Actually, it's a mixed view. The slowdown that we see is coming mainly from the e-commerce segment. We have many customers that are building their business based on e-commerce, and we see different views from different customers. You were referring to our global strategic account. Actually, in this case, we see tremendous growth, tremendous growth in Q1, tremendous growth in Q2, and we have very high expectations of continued growth, not only in 2022, but also in 2023. On the other hand, we see some other customers, they saw during Q1 and now during Q2 a slower growth on e-commerce, which impacts their business. By that, delayed decisions on the acquisition of new systems. And we saw a slowdown in specific customers also on the supplies during Q1, and now also during Q2. On the other hand, we see a very strong tailwind in other segments that we are serving. For example, in the retail market, customers that are serving the retail space, we see major growth. We see momentum moving jobs from offshore, from China, from Bangladesh, to onshore and nearshore, and those customers enjoying it and growing really fast. We see also other small customers and strategic customers that are working with both retail and e-commerce that continue to grow. DTF specifically, and the Presto MAX specifically, are growing very fast. It was a very strong quarter for Q1, and we continue to see momentum into Q2 with the Presto MAX. Interesting to see the momentum that’s coming from Asia. Asia had a record quarter, but also in EMEA, while other businesses see a slowdown in EMEA, we actually see major growth coming from EMEA, and we expect a very strong Q2 also from EMEA due to some of the major activities that we are doing there, with Fashion Week in London and FESPA. Atlas MAX, we see adoption. We see great feedback from customers, and we’re also starting to see a very nice growth coming from KornitX. And with the announcement today on the Wix partnership and a few other partnerships that we are developing, we expect continued growth into H2 and material revenue coming into 2023. So, Jim, to summarize, it’s a mixed view, but definitely we saw, and we see now in Q2, a few customers that are serving in e-commerce deciding to delay purchases of new systems in Q2 to a later stage. Some of them will buy in H2 and some of them will delay even to 2023.

Jim Suva, Analyst

Okay, thank you. And then my last or my follow-up is, you talk about an improvement in the second half of this year. What gives you the confidence or the conviction of that, as opposed to what you're kind of giving for Q2 right now? Because about three months ago, it seemed like this downshift wasn't likely to happen. And so, I'm curious about your second half conviction. Thank you so much.

Ronen Samuel, CEO

Yes. So, actually we see Q2 as kind of a bump on the road. We believe in the $500 million run rate earlier than expected in Q4 2023. We believe in the long-term vision of reaching $1 billion by 2026 or before. All the fundamentals of the business are growing and accelerating. We see the offshore moving onshore. We see consumer trends toward unique clothing. We see overall e-commerce is growing. It’s just slowing down versus last year, where it was growing very, very fast. So, all the major trends that we were talking about, and definitely the sustainability and short runs printing, short run production, are major drivers of our growth. And you were asking why we believe that H2 will be stronger. It will be much stronger than H1, and will be much more profitable, as Alon mentioned, than H1. First of all, we have a line of sight to major orders. Some of them are from our global strategic account. So, you will continue seeing revenue coming not only in Q2, but in Q3 and Q4, and definitely also in 2023. We have major product introductions during Q2, which are the Atlas Poly and the Presto MAX that we’ve already got orders for, and the implementation will be during H2. So, we have very high visibility on orders. And remember that H2 always is much stronger in terms of consumption. Q4 is always peak season. So, you will see much stronger H2 versus H1.

Jim Suva, Analyst

Thank you so much. Thank you.

Andrew Backman, Global Head of Investor Relations

Thanks, Jim. Next question, please.

Operator, Operator

Yes. The next question comes from Tavy Rosner from Barclays. Please proceed with your question.

Tavy Rosner, Analyst

Hi. Thanks for taking my questions. I wanted to first talk about the progress with print. You mentioned in the opening remarks that you're seeing significant progress. How does it compare, the level of interest compared to last quarter? And I'm just curious to also get a sense of the conversation you’re having with brands. Are they still talking about why adopting Kornit, or are they moving into rather when to adopt Kornit?

Ronen Samuel, CEO

Yes. Thank you. Very good question. So, we see accelerated engagement and growth on the brand side. We specifically see very strong growth in EMEA, with some of the biggest brands in the world. The brands that I mentioned in my opening remarks is one of the top fashion brands of the world. They decided, first of all, to grow vertically. They acquired a few Atlas MAX machines, and they're running them, and they're picking up production. They will also start working through KornitX. We see different behaviors from different brands. Some of them adopt KornitX as the main vehicle. Some of them would like to be fully vertical, and some of them have kind of a hybrid mode. We are working with, I could tell you, tens of major brands and hundreds of mid-size brands across the world. Many of them will be next week in London Fashion Week, and are fully engaged with the vision to transform the business directly to consumer, on-demand, and sustainable. So, the main driver for the brands, first of all, nobody wants to deal with the supply chain crisis that they were facing in the last two years, both in terms of the waste generated and being able to focus on what they need to deliver and when they will get their products, and the increased costs. So, they all want to move production locally or nearshore. They would like to control the supply chain, and they would like to do it sustainably, without waste and in sustainable production. This is why they would like to use digital, and specifically Kornit. So, those are the major trends. And of course, the entire behavior of the consumer is totally different from what it was in the past. Consumers today would like to be unique and would like to have different clothing options, and by that, brands need to react proactively and allow consumers to choose much wider SKUs, even up to customization and personalization, and we see it across the board. So, those are the main drivers for the brands to adopt digital, and specifically Kornit. One more thing that I would say why they're adopting specifically Kornit and why Kornit is the one that is talking with the brands is quality. We are the only one that has the highest quality in terms of both appearance and durability that the brands need. In the past, it was difficult to get there. Screen was better quality. With the MAX technology, Kornit has surpassed screen quality and we’re by far better in terms of appearance, durability, application range. Now, it's very attractive with all the tailwinds of the different market trends to adopt digital.

Tavy Rosner, Analyst

Right. Thanks for that. And I wanted to talk about KornitX. So, you mentioned the partnership with Wix, and I'm assuming that this will be helpful on the front end of the business. I'm just looking down the road, what are the next stages for KornitX and the ramp-up?

Ronen Samuel, CEO

Yes. So, on KornitX, we see really nice progress. The progress is both from the demand generation. Companies like Wix, and I will touch maybe on other areas that we are focusing on, but also on the global fulfillment network that’s fulfilling it everywhere around the world in consistent quality. So, we see progress in those two forms. And of course, we are always improving the platform and the capability as well as the ease of use of the platform. In the last few months, we have had many discussions, management discussions about areas of focus. Right now, we are focusing on KornitX with the main focus on the fashion industry, the fashion brands, but we’re also focusing on major platforms, platforms like Wix. We are working with a major gifting platform, one of the leading gifting platforms in the world starting to use us. Canva is a great example of a platform that’s already running through KornitX. So, we’re starting to see major adoption. We are talking with many platforms around the world, think about music platforms, TV platforms, and movie platforms. All of them have the potential to use KornitX to monetize their platforms to create merchandise mainly around the fashion industry, leveraging KornitX. We see major progress. As I mentioned, in H2 this year, we will start to see meaningful revenue coming from KornitX, and we expect KornitX to really accelerate growth in 2023.

Tavy Rosner, Analyst

Thanks. And just the last one, if I may. Off of that competition, I'm starting to see more press releases from manufacturers of screen-printing equipment going into digital DTG solutions. Is that something that you're seeing as well? Are you concerned at all?

Ronen Samuel, CEO

The answer is that I'm not concerned. Actually, I believe that we have built a very strong new moat around our technology and our products. In the last two years, we’ve developed our products and created a much bigger gap compared to any of our competitors. We always had competition, and we always will have competition. This is a very interesting market space, but I don't see anyone else there with the quality that we have. We are far beyond anything comparable with the print quality that we have with MAX, the durability, the ease of use, and the automation. The productivity we are bringing with Apollo, as well as the mix of the platform that we have, both DTG and DTF, with the leading Presto technology, on top of that, the KornitX platform that connects demand to fulfillment. We are creating something different from many of our competitors. We are creating a platform, an end-to-end operating system, and none of our competitors are looking at it in this holistic manner. We are already dealing with most of the major players in the market. It’s the fulfillers, brands, marketplaces fully committed to us. I believe this is just the start. The technologies we are launching this quarter with the Atlas Poly, with the Presto MAX, with unveiling the Apollo, which will be ready next year, which is a game-changer, not only in the current segments that we’re addressing but in really going after the replacement of the screen market. This is a game changer. This will accelerate the goals of Kornit, and I’m more confident than ever in our technology and ability to reach a billion dollars by 2026.

Tavy Rosner, Analyst

Great. Thank you very much. I will see you in London.

Andrew Backman, Global Head of Investor Relations

Thanks, Tavy. Claudia, next question, please.

Operator, Operator

Thank you. The next question comes from Rod Hall from Goldman Sachs. Please proceed with your question, Rod.

Rod Hall, Analyst

Yes, thank you. Morning, guys. So, I wanted to dig into the demand situation a little bit more with you, Ronen. It sounded like there were large e-commerce customers that pushed out purchases. Do you think - so you think that they're seeing lower demand for products themselves, their revenues are being impacted by macro, and then they're pushing these out? I guess the reason I want to dig into this is, we thought that as people travel more, as they get out more this year, the demand for t-shirts and fashion more broadly would probably go up, not down. So, just wanted to dig a little bit more into what you think's going on with that dynamic, and what those customers are seeing on the ground. And then I have a follow-up.

Ronen Samuel, CEO

It's an interesting dynamic, and I'm not sure that I have the full answers. In terms of consumer demands, we see different behavior in different segments. As I mentioned, in the retail environment, we see customers serving the retail market that actually experience massive growth. So, I wouldn't say that consumer demands are declining for t-shirts and hoodies and across the board. And as I mentioned also, with our strategic global customers, they see tremendous growth across the board, not only in the US but also in Europe. We have some customers, without getting into names, that are mainly driven and driving their business on B2C, which see slowdowns. Some of them gained capacity during the last two years by purchasing additional systems, yet they don't see the same level of productions that they are used to. Some are seeing a plateau, some a decline in their business. A few of them were planning to place orders in Q2 to be ready for the peak season of Q4, but at this stage, they decided to delay their decisions due to the current situation they’re experiencing. If it’s a bump on the road, they will continue to purchase during H2. If not, it could be pushed to 2023 from those specific customers. E-commerce is not going to disappear. It’s growing. It’s growing now and will continue to grow. This is the right direction. It’s just a bit of a slowdown they are feeling right now, and I’m sure that we will see it coming back.

Rod Hall, Analyst

Okay, that's great, Ronen. And then, I wanted to ask you, Alon, if you could talk a little bit more about the margin mix in the quarter. I get that Amazon, or I should say the strategic customer, was stronger than we thought it would be. So, that was very strong. So, I get that mix effect, but then I wonder what happened to ink and consumables. Did you see lower ink and consumables demand than you thought? And can you quantify what happened with ink and consumables at all for us? Thanks.

Alon Rozner, CFO

Yes, sure. So, first, just to continue Ronen's answer from the previous question, which also relates to the margin, we don't see any dramatic change in the mega trends and the fundamentals in the market. I mean, we clearly see growth, and we have a very solid business model to support this growth. We are strong enough to deal with some volatility and uncertainty. Yes, we see some uncertainty now in the market, mostly related to macro processes which go deeply into our margins. I think that the results in Q1 of margins are related to mix, volume, and the timing of the deals. The mix in Q1 was heavily towards systems, which is very good for us because it increases our install base. We also had a very strong quarter for DTF. And then, in terms of volume, consumables were lower. In terms of percentage, we saw growth in consumables, but it was lower than we expected. And there enter the volume factors into the game, and we have capacity in our new ink manufacturing. When we’re manufacturing less, we take the heat on the fixed costs. That’s why we say that as we go throughout the year where consumables portion will be higher, then we will get back to the levels of margin that we saw in the second half of 2021.

Ronen Samuel, CEO

So, our business, when you look at H2, will be similar to H2 2021, which means around the 50% plus on the gross margin. We are fully confident that we will continue to see expansion into 2023 on the gross margin on the way to reach 54%-55% gross margin as we promised to our investors.

Rod Hall, Analyst

Great. Okay. Thank you very much.

Andrew Backman, Global Head of Investor Relations

Great. Thanks a lot. Claudia, next question, please.

Operator, Operator

Yes, the next question comes from Jared Maymon from Berenberg Capital Markets. Please go ahead, Jared.

Jared Maymon, Analyst

Hey, good morning, guys. Congrats on the good quarter and great news on Wix. That's really reassuring for the KornitX business. First question for me.

Ronen Samuel, CEO

Thank you, Jared. Thank you.

Jared Maymon, Analyst

So, yes, absolutely. So, first question for me, just on the excess capacity that you guys have mentioned, I remember back in, I think it was Q3 ‘21, you guys mentioned that you had placed the entirety of your order for 2022 with your contract manufacturers. I'm wondering if you thought this kind of excess capacity could be a problem back then when you made that order, if there has been kind of an incremental shift since then, and if it’s impacted that order, and how heavily this has been a weight on your near-term guidance.

Alon Rozner, CFO

Yes. So, we don't see any dramatic change in our plans going forward. There is a timing issue now and we have higher raw materials or inventory at the end of Q1. All of the increase in inventory was raw materials. We are not stuck with stock of systems that are waiting for sale. We are building our raw materials to be ready with the new product introductions, the upgrades, and we are prepared for growth in the second half of this year. We don't see any risk at this point for excess inventory.

Jared Maymon, Analyst

Okay, got it. That's great. Thanks, Alon. And then, I'm just curious, with the kind of near-term volatility that you guys are seeing. I'm wondering, is there any kind of decrease in appetite for M&A, or do you think maybe you're even a little bit more eager now that valuations have probably come down in the private market?

Ronen Samuel, CEO

So, we are engaged and looking very closely at all kinds of opportunities, particularly on the software side and M&As. The market now is more interesting, and we are looking deeply into that. Our strategic direction is very, very clear. We are not changing anything from the directions that we are taking as a company. We believe in the future. We believe in becoming the operating system for the fashion industry. In areas that we need to invest in M&A, we will continue to invest. There is no change in our plans.

Jared Maymon, Analyst

Got it. Okay. That's great. And then just one last quick one for me. I'm just curious, what - so sequentially, it looks like service gross margins declined. So, I'm just wondering, what happened there? I assume maybe it's related to the Atlas-to-Atlas MAX upgrades, but I'm curious what happened there, and then what the outlook is for the next couple of quarters.

Amir Shaked-Mandel, Executive Vice President of Corporate Development

The decline year-over-year, sequentially, quarter-over-quarter.

Alon Rozner, CFO

So, in the service business, there are different components, and it's very much related to which projects we do at each quarter. Overall, we continue to invest and build our service organization, and it depends on specific projects. Overall, we continue to see continuous growth and improvement in service profitability. This is the way we plan it going forward.

Ronen Samuel, CEO

This year, we expect to see significant growth in the service sector, both in revenue and margin. You'll start to see more adoption of the upgrades kits in Q2 and definitely in H2, which will influence the service P&L, both on the topline and bottom line on gross margin. So, you will see major improvement there.

Jared Maymon, Analyst

Got it. Thanks, Ronen.

Andrew Backman, Global Head of Investor Relations

Great. Thanks, Jared. Claudia, next question, please.

Operator, Operator

Okay. The next question comes from Brian Drab from William Blair. Please go ahead, Brian.

Brian Drab, Analyst

Hi. Thanks for taking my questions. I just want to clarify one thing. I know you said you're seeing some customers in the second quarter delaying decisions. Are you - it sounded like, Ronen, that you're saying you're not sure what some of those customers are going to do in the second half of the year. Or are there some of those customers that are saying, we're delaying second quarter, we'll see you in the third quarter, or with all this economic uncertainty, or is it really an unknown? And then getting back to where does the confidence come from for the second half of the year? I guess, is it more related to some of these customers knowing that they're coming back, or is it more related to just the momentum from all the new product introductions and seasonality, et cetera?

Ronen Samuel, CEO

Yes, it's - Brian, thank you. It's a mix. Look, it's a few customers that were planning to purchase in Q2 and decided to delay the purchase. It’s not a significant number of customers. We see overall on the supplies some kind of slowing down in Q1 and some slowing down also in Q2. Actually, in the last week, we started to see a different trend on supplies. Hopefully, these trends will continue in a positive direction, but those customers decided they were planning to buy in Q2 and decided to delay. A few of them, we have set a date with them for H2, but a few of them have yet to decide if they will buy at all this year or delay it to next year. The confidence that comes for H2 is not based on those customers. The confidence for H2 is based on the fact that we have recurring revenue. Almost 50% of our revenue is recurring, and H2 is higher than H1. This is the basis of our business trends. On top of that, we have a few strategic customers, including our global strategic customers, for whom we already have orders and commitments and we are producing the systems. So, we don't see any risk regarding those. We see a growing pipeline on new product introductions, mainly on the Presto MAX that we are now producing, and many of them will be shipped only in Q3 and Q4. The same situation applies to the Atlas Poly, which we will be releasing only by the end of this quarter, Q2. The main impact will be felt in H2 revenue. Additionally, we are starting to see revenue coming from KornitX, mainly in H2. Therefore, our confidence level for H2 is that it will be much stronger, in both topline and operating profit, and also gross margin will look very different, very similar to the gross margin we saw in H2 of last year, which was very high.

Brian Drab, Analyst

Got it. Okay. And then, there's been some discussion around - I mean, in the past, you've had certain customers attend your Analyst Days and highlighted some strong relationships that you've had in the past. I'm curious, can you update us on any specifics around the strength of your relationship with Fanatics and Delta Apparel?

Ronen Samuel, CEO

Yes, it's a good question. I was anticipating it. First of all, we have a great relationship with both Fanatics and Delta Apparel, specifically DTG2Go. I cannot get into the specifics of their business. I recommend you approach them directly; they will provide you all the answers. In general, Fanatics decided to change their business model. Fanatics is a brand and they decided instead of being vertical and producing by themselves, to outsource the production to DTG2Go, but also to other customers. I think this is the direction we were foreseeing, and this is exactly why we have KornitX, to enable those brands like Fanatics and like many others, to fulfill through a network of fulfillers, but using Kornit technology. As for Delta Apparel, Delta Apparel is one of our largest customers. They have a fleet of Kornit systems. In the last two quarters, we’re aware that they decided also to acquire a few systems from one of our competitors. Mainly, they look at it as more of a replacement for screen, not for short runs, not for on-demand, not for direct-to-consumer, more for long runs. We know they are testing it. We know more about that, but I will not get into specifics. Again, we believe that our solution, and definitely what we are bringing to the market with Apollo, will be the best solution. I am sure that we will work closely with Delta Apparel, Fanatics, and others to make sure that they continue with us in strong partnerships. We have a strong relationship with them and we will continue to support them for many years to come.

Brian Drab, Analyst

Okay. Thanks very much.

Andrew Backman, Global Head of Investor Relations

Thanks, Brian. Claudia, next question.

Operator, Operator

Thank you. The next question comes from Jim Ricchiuti from Needham & Company. Please go ahead, Jim.

Jim Ricchiuti, Analyst

Thank you. I wanted to go back to this global brand that purchased Atlas machines. How are they using these Atlas machines? Are they using it for an e-commerce application, or are they using it as kind of a hub to supply some of their retail stores? I'm not entirely clear on that.

Ronen Samuel, CEO

It’s actually, I cannot get into too many details because then it will unveil who the customer is and they would like this to be kept confidential at this stage. They’re building a unique business model combining both. But in the end, they would like to address directly the customers. It's a hub that they're building, but I cannot say more than that.

Jim Ricchiuti, Analyst

To what extent, Ronen, can you say if some of the ESG-type benefits of your technology played at all into their decision?

Ronen Samuel, CEO

Yes. I would say two things that played into their decision. First of all is quality. They would like to have the best quality on printing on garment. They were testing our solutions. They’re developing special garments for those solutions to have the best quality in the market. So, quality is number one. Definitely sustainability is a key issue in the supply chain. Making closer onshore production is also very important for them.

Jim Ricchiuti, Analyst

And I want to do also a follow-up question just with respect to the upgrade of the Atlas fleet, the install base, in light of some of the changing dynamics that you're seeing in the market. I think in the past, you've talked about as much as three quarters of the existing Atlas fleet potentially upgrading to MAX. Has that - correct me if that's correct or not. Are you seeing any change in light of the market environment? And just with respect to the market environment, am I correct in assuming this is mainly in the US? It sounds like you're seeing good momentum in APAC and good momentum still in EMEA. And I'll jump back in the queue. Thank you.

Ronen Samuel, CEO

So, in terms of momentum, Q1 was very strong as well in the Americas. We actually seen Americas in Q2 experiencing a different mix. We see a very, very nice growth in Latin America coming from Brazil and Mexico. So, more of the nearshore production is growing. We see a few customers producing for retail in the Americas growing. But we see also some slowdown in Q2 from customers that are primarily in the e-commerce side. And indeed, it’s more right now in the Americas. But again, I believe it’s a very short-term bump on the road. As for the upgrades of the Atlas-to-Atlas MAX, we are on a journey right now. First of all, we are not changing our focus of 75% of the install base upgrading their Atlas-to-Atlas MAX. We are on the journey to create a new standard of quality. We believe that the MAX will set a new standard of quality for the industry. We are working closely with the major brands to define that this is the standard. KornitX will be based on the standard of Atlas MAX on the MAX technology. Therefore, we are putting a lot of emphasis on that, and you will start to see more adoption of the upgrade kits in Q2 and mainly in H2, while we're ramping up our service and support organization to implement it with our customers.

Jim Ricchiuti, Analyst

Thank you.

Operator, Operator

Thank you. The next question comes from Chris Moore from CJS Securities. Please go ahead, Chris.

Dan Moore, Analyst

Thank you, and good morning. It's actually Dan in for Chris. You've talked quite a bit about nearshoring on this call. Can you give some specific examples? Is it happening yet? Where do you see it accelerating, and how big of an impact do you see it having long-term on the business? Thank you.

Ronen Samuel, CEO

Yes, we see it a lot, both in EMEA. We see it definitely in the US inside, but also in Mexico very strongly. So, we have a few customers in Mexico that are growing very quickly and doing nearshore for North America. We have a few customers in North America that are starting to receive bulk jobs that they were not accustomed to getting in the past, moving directly from brands that used to produce in China and in the Far East and are now producing onshore or nearshore. It's very obvious. It's a clear trend we see both on the digital side, but when we are talking to our customers, they see it also on the conventional side. So, a lot of large orders are moving onshore, both in EMEA and in the Americas.

Dan Moore, Analyst

That's great. And one more for us. Given the slate of new product introductions, MAX, Poly, Apollo, others, can you talk about the impact on Kornit’s ASP and gross margin profile over time? Thanks again.

Ronen Samuel, CEO

Yes. So, on ASP, actually overall ASP of systems in Q1 went up. Our focus is to sell more high-end products, and you will continue to see the ASP improving throughout the year, because we will sell more of the Atlas Polys and more of the Presto MAX. Additionally, we had to implement some price increases, which will also impact the ASP. In terms of the gross margin, what you’ve seen in Q1 is what I would call a one-off, and it came mainly from a very low mix between supplies to systems. We had a relatively low revenue from supplies in Q1. Some of this was due to customers acquiring supplies in Q4, focusing on making Q4 stronger, and using them for Q1, leading to a lower order for supplies in Q1. We are starting to see, as I mentioned, different trends right now. We're starting to get larger orders for supplies. So, hopefully, let's wait a few more weeks to see these trends continue. The major impact on gross margin for Q2 will be considerably better than Q1, and H2 will very much resemble last year, around 50% or higher in gross margin, and you should expect expansion on gross margin in 2023 as well.

Alon Rozner, CFO

And just to add, longer term, we keep our target in the long-term model to have gross margin between 50% to 54%.

Dan Moore, Analyst

Very helpful. Thank you, again.

Operator, Operator

Thank you. The final question comes from Greg Palm from Craig-Hallum Capital. Please go ahead, Greg.

Greg Palm, Analyst

Yes. Thanks for fitting me in here. I guess, on gross margins specific to systems, it sounds like shipments were better than expected. I know there were some mix issues between Presto and Atlas, but just trying to get a sense on how system margins were relative to expectations for prior quarters.

Alon Rozner, CFO

Yes. So, system margins were according to our expectations; actually, they were a bit better than we planned. We expected a mix of DTG and DTF from sales. We indicated in previous quarters that we invested a lot in DTF, so we had a strong quarter for DTF. Overall, system margins were slightly better than what we planned.

Greg Palm, Analyst

Okay, good. And then, on the receivables comment, for my follow-up, I think you blamed that on late quarter sales. I think you said specifically to the global strategic. Was that a pull-forward of activity into Q1 from Q2? Or was it, I don't know, maybe a push-out of shipments from maybe mid-quarter to late quarter? I wasn't exactly clear what happened there.

Alon Rozner, CFO

No, it was a timing issue with making decisions and getting the paperwork. The start of the year and the quarter was relatively weak after a very busy peak season. So, people took some time off to relax. Then we saw the quarter building up in the second half when we got the purchase orders for the planned business for the quarter, and we shipped relatively close to the end of the quarter. It's a matter of timing; most of the accounts receivable are just not due and will be collected mostly in the second quarter.

Greg Palm, Analyst

Yep. Makes sense. Okay. Thanks.

Operator, Operator

Thank you. Mr. Samuel, we have no further questions. I will turn the call over to you for closing remarks.

Ronen Samuel, CEO

Yes. Thank you, Operator, and thank you all for joining us on today’s call. As mentioned earlier, we remain laser-focused on execution across the board to capture the massive opportunity we see in front of us. I would like to thank all of you, and I would like to thank Kornit’s team for their amazing work, hard work, and passion, and to all the stakeholders for their continuous support and confidence in us. I'm looking forward to seeing many of you next week in London. We'd like to thank you and have a great day. Thank you very much.

Andrew Backman, Global Head of Investor Relations

Great. And thank you, Ronen, and thank you, Alon, and thank you all for joining us today. As always, if you should have any follow-up questions, please do not hesitate to reach out to me directly, and we hope to see you in London.

Operator, Operator

Thank you. This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.