Novanta Inc Q2 FY2020 Earnings Call

Good morning. My name is Laura, and I will be your conference operator today. At this time, I would like to welcome everyone to the Novanta Inc. 2020 Second Quarter Earnings Call. Please note, this event is being recorded. I would now like to turn the conference over to Ray Nash, Corporate Finance Leader for Novanta. Please go ahead, sir.

Thank you very much. Good morning, and welcome to Novanta's second quarter 2020 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 it 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. And 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.

Thank you, Ray. Good morning, everybody, and thanks for joining our call. Before we start our normal quarterly results review, I would like to thank all Novanta employees for how they stepped up. Their unwavering commitment to ensure the safety of their teammates and their families, as well as to ensure business continuity for our customers, has been impressive. We are very pleased with the resiliency, engagement and productivity of our teams through the pandemic. It's great to see that the Novanta spirit is alive and that our culture has provided a strong foundation to weather this crisis. While Novanta is not immune to the impact of the pandemic, I would like to reiterate, we are strategically and financially well positioned to navigate the COVID-19 pandemic and the resulting economic weakness. Our balance sheet is strong. Our innovation engine is robust. Our teams are secure and safe. And our portfolio is resilient due to our diversification across approximately 45 different applications, exposing us to long-term secular trends in robotics and automation, healthcare productivity and precision medicine. Now let's move to our normal quarterly results review. We are very pleased with Novanta's performance in the second quarter of 2020. Our teams executed exceptionally well in the face of adversity and delivered above our expectations for revenue, profit and cash flow. Our company delivered approximately $145 million in revenue, representing a 7% year-over-year revenue decline on a reported and an organic basis. We are particularly pleased with how our teams managed profit decrementals. Adjusted EBITDA was $31 million in the second quarter, essentially flat compared to the second quarter of 2019 and up 11% sequentially despite the 7% lower sequential revenue. The power of the diversification of our portfolio was again evident in our results. In this particular crisis, the advanced industrial part of our portfolio has been significantly impacted, showing high single-digit revenue declines year-over-year. However, our medical business, which accounts for close to 60% of our revenue year-to-date, along with our exposure to the 5G cloud infrastructure and EUV equipment markets helped to mitigate that decline. Additionally, we did see some bright spots of growth. Specifically, we experienced double-digit year-over-year growth with our smoke evacuation medical consumables, our medical barcode solutions for ICU, patient monitoring and diagnostic test equipment, our integrated operating room solutions, and our motion solutions for EUV, 5G and cloud infrastructure equipment. We are also very pleased to see growth accelerate in China, where we achieved a 14% year-over-year increase. In the second quarter, our book-to-bill was 0.90 and, as expected, we saw significantly reduced bookings in most of our businesses, driven by the delayed demand in both the industrial and medical capital spending markets as a result of the pandemic's shelter-in-place orders and economic closures. As a reminder, our revenue trails our customers' revenue by about 90 days. Furthermore, as communicated in the first quarter's earnings release, our customers pulled forward bookings into the first quarter. Our year-to-date book-to-bill is 0.98, with the strong first quarter offset by a weaker second quarter. We do feel that the lower-than-normal bookings ratio in the second quarter indicates continued weakness as we head into the third quarter. This aligns with our expectations and what we previously communicated on our last earnings call. Robert will discuss our expectations for the third quarter in more detail later on in this call. From an overall market perspective, our medical customers reported elective surgical procedures and diagnostic test volumes at about 80% to 90% of pre-COVID levels, while the advanced industrial market experiences a wider range of dynamics, generally reflecting high uncertainty. While we are confident about our long-term strategic positioning and are encouraged that the second quarter results and the third quarter outlook are better than previously thought, we remain cautious about our immediate outlook given this uncertainty. In the last call, I highlighted our four guiding principles for managing through the pandemic while focusing on what we can control. Let me briefly touch on each of these. First, our primary goal at Novanta continues to be the safety and well-being of our employees, their families and the communities in which we operate. Globally, the majority of our non-production employees continue to work from home, and we continue to enact and further expand rigorous safety measures at all of our sites. All of our factories have remained open throughout the second quarter. Year-to-date, only seven of our employees, out of approximately 2,200 total employees, contracted the virus, and all have fully recovered since. Additionally, of those seven who contracted the virus, only three entered a Novanta facility, and in all three cases, our safety protocol successfully prevented the virus from spreading to others. This gives us and our employees confidence that our safety measures are effective and that we’re doing the right things to keep our employees safe and our factories operational. We are further expanding our safety measures with accelerated testing capabilities, technology-enabled distancing and tracing methods, and improved air quality and circulation in our buildings. As a result, our absenteeism remains low, well below 1%, as we have worked hard to continue to build our trusting relationship with our employees. Our second guiding principle is to maintain business continuity so we can support our customers. We take great pride knowing that our mission-critical technologies are embedded into diagnostic and antibody test equipment detecting COVID-19, and into ICU and patient monitoring equipment used in the pandemic fight in hospitals. I am also continually impressed by our operations and supply chain teams who have shown agility in responding to rapidly changing demand and supply patterns with minimal disruptions to our customers. While we have experienced significantly increased costs to serve our customers and ensure a continuity of supply, we strongly believe these actions will solidify our long-term relationships with our customers and truly differentiate us from our competitors. Another critical aspect of our business continuity plan is to ensure strong cash generation. We have decisively executed on our profit decrementals and undertaken a number of actions to conserve and improve our cash flows. The results of both efforts were demonstrated by the strong financial performance of this quarter. Robert will provide further details here, but these results are another testament to the way our teams have stepped up. Our third guiding principle is to ensure a bright future and emerge from this crisis stronger. As mentioned in our previous call, we believe that our long-term secular growth drivers are even more relevant post-pandemic. We have the best innovation lineup that we've ever seen to ride these secular growth waves. Despite the difficult circumstances, we have not pulled back on our innovation investments or customer engagement. During the second quarter, our teams kept our innovation programs on track. While a few of our OEM customers have extended the timelines for their next-generation product launches due to the pandemic, we believe these delays are relatively modest in the big picture. Our main NPI programs remain active with multiple new product launches over the next 12 to 18 months. Our vitality index, which represents revenue from new products launched in the last four years, continues to be healthy at about 25% of sales compared to mid-single-digit percentages a few years ago. Design wins grew over 25% in the second quarter of 2020. While some customers have temporarily delayed new platforms, we are seeing others accelerate, reflected in the strong growth of design wins. Finally, our fourth guiding principle is to deliver core values. Now more than ever at Novanta, we believe that a healthy company culture is the ultimate competitive advantage in the face of both opportunity and adversity. Our version of a healthy performance culture is known as the Novanta Way, which institutionalizes: one, how we work together in cohesive and diverse teams; two, how we behave and interact through our five core values; and finally, three, how we execute through the Novanta Growth System. Now let me briefly touch on our operating segments. Starting with the Vision segment. This segment predominantly serves the medical market and saw a revenue decline of 2% year-over-year. The book-to-bill in our Vision segment for the second quarter was 0.92, with bookings down 5% year-over-year. This decline in sales and low bookings reflect the dynamics in the medical end markets, where the deferral of elective surgical procedures has delayed capital investments. The vitality index in this segment remained above 30% of sales, with new products being a key driver of the strong growth we've seen in this segment over the previous several quarters. Within the Vision segment, we continue to see nice momentum in our WOM business unit, building on the smoke evacuation technology we've reported on for the last few quarters. This growth comes despite a temporary downturn in overall demand due to the pandemic, with our WOM consumables product offering seeing double-digit growth in the second quarter, even as some of the other MIS products experienced declines. The smoke evacuation insufflator technology is, in particular, in high demand in today's climate. Medical staff worldwide are demanding a safe, COVID-free work environment, and our smoke evacuation tube set innovation helps provide hospital staff with an operating room free from contaminants during laparoscopic procedures. In addition, we continue investing in the R&D pipeline of WOM, where we have secured exciting opportunities in insufflator and pump technologies through design wins and development agreements with multiple minimally invasive and robotic surgery OEM platforms. These platforms are expected to launch in the next two to three years as they navigate the regulatory process. While thoughtful management of the near-term demand drop in the segment is necessary, we could not be more excited about the long-term potential for our MIS business. Our Detection & Analysis business also performed well, growing mid-single digits year-over-year in the second quarter, with exceptional profit performance driven by the Novanta Growth System. This business unit primarily serves the diagnostic testing and patient monitoring markets with RFID, barcode, and machine vision technologies. The counter-cyclical growth in the second quarter is driven by the rapid adoption of PCR molecular testing and patient monitoring equipment, somewhat offset by the decline in non-COVID-19 related diagnostic tests. Turning to our Precision Motion segment, revenue grew by 4% in the second quarter of 2020, with a book-to-bill of 1.07, and bookings increasing 32% year-over-year compared to the second quarter of 2019. Strong demand this quarter came for 5G and cloud-based infrastructure, as well as autonomous ground vehicles, which were partially offset by reductions in industrial, satellite communications, and robotic surgery. This led to excellent top-line performance in this segment, helping offset challenges elsewhere. Much of this growth is attributed to our OEM customers based in China, who are seeing the majority of demand for 5G base stations right now. Sales to China almost doubled year-over-year in the quarter. We continue to favor the long-term secular trends of the Precision Motion segment, serving precision automation, robotics, and robotic surgery markets. Regarding the surgical robotics market, we will keep expanding our content and position with the largest players in the coming years as new platforms are launched. Short-term, recovery of significant capital expenditures in hospitals is expected to take some time. Still, the surgical robotics market remains an attractive long-term growth opportunity for the company. Within the Precision Motion segment, in the second quarter, new product revenue grew more than 70% and now constitutes a strong double-digit percentage of total sales in the quarter. On to the performance of our Photonics segment for the second quarter of 2020, revenue was down 18%, which is in line with our expectations. The Photonics segment is feeling the most significant impact from the economic downturn caused by the pandemic. The depressed industrial capital spending is driving a decline in sales of our beam delivery and laser products. Moreover, deferred demand in medical markets is also contributing to lower sales, particularly in the ophthalmology segment and production-scale sequencers in the diagnostic and research space as doctors' offices and labs were closed for most of the second quarter. We expect the COVID-19 pandemic to dampen demand for these types of capital investments in the short term, in line with the overall decline in hospital visits, procedures, and diagnostic tests due to the pandemic. In the second quarter, the Photonics segment saw bookings decline year-over-year by double digits, with a book-to-bill of approximately 0.8. Regardless of these near-term slowdowns, design wins continued to thrive, growing over 50% year-over-year in the second quarter. We continue to be confident in the robust innovation pipeline in our Photonics segment. As a result, we are committed to investing into these headwinds and anticipate introducing several new product platforms in 2020 and 2021, helping us gain market share in adjacent high-growth application areas. In conclusion, I am incredibly proud of the resilience and agility displayed by our teams in this uncertain environment. The team managed profit decrementals and cash flow exceptionally well, without sacrificing our innovation efforts. Strategically, Novanta's position is strong, and our portfolio's resilience enables us to weather the COVID-19 pandemic. Close to 60% of our revenue year-to-date comes from medical markets, which are structurally growing long-term. Our balance sheet is as robust as our innovation pipeline. Lastly, our focus on portfolio diversification allows us to not only increase our exposure to long-term secular growth trends in robotics and automation, healthcare productivity, and precision medicine—areas that are becoming increasingly relevant post-pandemic—but also maintain the resilience necessary to navigate the economic environment shaped by the pandemic. You can expect us to pursue acquisition opportunities, which remain the primary focus of our capital deployment, provided they align with our stringent financial returns and strategic criteria. So with that, I will turn the call over to Robert to provide more details on our financial performance. Robert?

Thank you, Matthijs, and good morning, everyone. We delivered $144.7 million in revenue in the second quarter of 2020, a decrease of 7% year-over-year on both a reported and organic basis. As Matthijs already covered, despite the year-over-year decline, we are pleased with our sales performance in the second quarter, exceeding our own expectations and our previously issued guidance. To provide additional insights on our sales, revenue continues to shift toward our OEM customers who serve medical end markets. Sales to these end markets in the second quarter accounted for 55% of total sales and declined 5% year-over-year. On a year-to-date basis, sales to medical end markets were 57% of total sales. Considering the significant deferral of elective surgical procedures and laboratory delays in capital spending for specialized life science equipment, such as production-scale DNA sequencers, our sales to medical end markets performed better than expected. We continue to observe pockets of strength within the downturn, particularly in our medical consumables business, with integrated smoke evacuation, integrated data collection products for clinical test equipment, and new products such as integrated operating room informatics. Conversely, the industrial capital spending environment and overall economic climate continue to face high levels of uncertainty, significantly impacting demand as evident in the latest PMI trends. While there are pockets of growth and recovery, there are also areas where uncertainty has intensified. Novanta's sales to advanced industrial markets was 45% of total sales in the second quarter, declining 8% year-over-year. The decline was broad-based across the majority of industrial end markets, consistent with our expectations and what our industrial OEM customers are experiencing in those markets. One area within advanced industrials where we continue to see solid demand is within our microelectronics customers, specifically due to China's investment in 5G, high-speed networking, and cloud-based infrastructure. In the second quarter, this end market still saw a strong double-digit increase, accounting for approximately 10% of total company sales, though this is largely a result of the broader industrial decline. Overall, we are proud of the application and end market diversity we have developed over the years with our portfolio of technologies, which has clearly proven its resilience in one of the most severe economic downturns in history. Additionally, regarding geographical performance, our second quarter sales to China were up 14% year-over-year, despite the pandemic's disruption. Sales to the U.S. and Europe were down 8% year-over-year, reflecting the pandemic's impact in those regions. As a reminder, our sales locations depend on where the product is shipped, which can differ from customer headquarters. Nevertheless, we feel these figures represent general directional trends. Moving on to our operating results. Our second quarter GAAP gross profit was $59 million or 41% of sales, compared to $66 million or 42% of sales in the second quarter of 2019. On a non-GAAP basis, our second quarter adjusted gross profit was $61 million or 42% of sales, compared to $68 million or 44% in the second quarter of 2019. For the second quarter of 2020, our adjusted gross margins were down over 150 basis points compared to 2019. A significant driver of this margin decline is the increased operating costs across our global factories, which are due to the pandemic. To support a safe working environment, our factories are conducting multiple sanitizing cleanings per day, conducting daily health screening of all workers entering the facility, proactively testing employees when there is a risk, implementing changes to our HVAC systems to better filter the air and increase outside air circulation, running multiple shifts to create social distance, and deploying personal protective equipment daily for all employees in our facility. These measures have led to labor inefficiencies and higher overhead costs. Furthermore, we continued to encounter vendor disruptions in the form of longer lead times and logistics disruptions, causing increased freight and handling costs. While these disruptions are gradually subsiding, we expect it will take another quarter or two to fully mitigate the effects. The combination of our safe working environment protocols and elevated logistics costs resulted in approximately 200 basis points of gross margin impact in the second quarter. We also took the opportunity in the quarter to review our broad product range to identify opportunities for rationalizing any low-profit or low-returning products, allowing us to reallocate resources and efforts more effectively toward higher-returning avenues. This effort resulted in about $1.5 million of inventory write-offs for discontinued products. As a technology company, we always have some products that meet this criterion, which we manage through our product life cycle processes. However, given the economic climate, we wanted to take this opportunity to become more focused, so we are better positioned for 2021 and beyond. Moving on to operating expenses, second quarter R&D expenses were $14 million, or 10% of sales, compared to $13 million, or 9% of sales, in the second quarter of 2019. We continue to invest in our innovation pipeline amid headwinds. The current economic situation, in our view, provides us an opportunity to capture market share and significant customer opportunities driving growth in future years. While we are seeing some customers push their product launches into mid-2021 to create more distance from pandemic impacts, we decided to bring our R&D teams back into the facilities to maintain progress and momentum, and also to seek opportunities to accelerate programs. Engagement with our customers remains very high, regardless of the circumstances, and our sales team is performing excellently in creating new opportunities. Second quarter SG&A expenses were $25 million or 17% of sales, compared to $29 million or 19% of sales in the second quarter of 2019. The majority of this $4 million year-over-year savings can be attributed to the cost actions that I outlined in the first quarter earnings release that we've implemented in response to the pandemic. We are pleased with the flexibility demonstrated by our business teams in adapting to the current market conditions. Time for other financial results. GAAP operating income was $14 million in the second quarter of 2020, compared to $15 million in 2019. Non-GAAP operating income in the second quarter was $22 million or 15% of sales, compared to $26 million or 17% of sales the previous year. Adjusted EBITDA was $31 million in the second quarter of 2020 with a 21% EBITDA margin compared to $31 million in the second quarter of 2019 with a 20% EBITDA margin. On taxes, our GAAP tax rate was nearly 0% for the second quarter, differing from the Canadian statutory rate of 29%, largely due to the jurisdictional mix of income and a one-time release of a valuation reserve. On a non-GAAP basis, our tax rate for the second quarter of 2020 was 15%. This differed from the statutory rate due to jurisdictional income mix and some tax benefits related to our temporary cost actions. We expect our tax rate to climb throughout the year, but the environment has made it quite difficult to predict specific rates. Our GAAP diluted earnings per share was $0.33 in the second quarter of 2020, compared to diluted earnings per share of $0.29 in the second quarter of 2019. On a non-GAAP basis, adjusted earnings per share was $0.48 in the quarter compared to $0.54 in the prior year. Adjusted earnings per share declined year-over-year, primarily due to higher stock compensation expense from the all-employee equity grant. Second quarter operating cash flow was $33.8 million versus $15.4 million in the second quarter of 2019. This result was driven by strong profit, continued improvements in net working capital, and a range of actions we executed to preserve cash in response to the pandemic. At the end of the second quarter, we reported gross debt of $222 million. Our gross leverage was 1.9 times, and our net debt was $124 million, or roughly 1 times. We are very pleased with our cash flow and financial position for the second quarter. Based on these results, we believe our over $97 million cash on hand, as well as nearly $375 million available under our revolving credit facility, coupled with anticipated cash flows from operating activities, will be more than sufficient to meet our needs during the economic downturn and, most importantly, position us well for acquisitions. Now before moving to guidance, I would like to briefly update you on the Novanta Growth System or NGS. As a reminder, NGS is a common operating model implemented through a set of shared tools and processes designed to accelerate and drive sustained growth and operating performance. As mentioned on our last call, we are actively incorporating the NGS operating model across our business units. During the second quarter, we trained 100 employees on the various tools and processes that will become cornerstones of this operating model. For example, we trained approximately 90% of the total organization on structured problem-solving and value-stream mapping tools and disciplines. We are confident that by rigorously applying NGS, we will greatly assist in achieving our goals this year and beyond, particularly in areas of customer satisfaction, speed to market, gross margin, and inventory optimization. We are very pleased with how our employees have embraced the tools and mindset of the Novanta Growth System, which will help instill a strong, consistent culture organization-wide. Regarding guidance, due to the continued impact of the COVID-19 pandemic on Novanta's businesses, and the uncertain duration and scope of both the pandemic and the public health and economic recovery, we cannot reliably estimate the long-term impact on our operations and financial results for the full year 2020. However, we believe we have enough visibility into customer demand and operational performance to provide partial guidance for the third quarter of 2020. For the third quarter, we expect GAAP revenue in the range of $135 million to $142 million. As mentioned in the first quarter earnings release, we believe the economic closures from March to June will have a more significant impact on the third quarter. The guidance reflects this expectation. We are observing signs of market strengthening, such as the return of elective surgical procedures; however, the resurgence of the virus in parts of the United States and Europe warrants a cautious and conservative approach. We participate in capital investment-driven markets, which inherently benefit buyers in the long term. Therefore, these buyers must have confidence in their growth plans and strategies under a reasonably certain economic climate. It is fair to characterize the current economic environment as still uncertain due to the ambiguous effects and duration of the virus's spread. Nevertheless, we remain confident that the capital spending markets we operate in are not seeing demand permanently destroyed; rather, the demand is simply delayed. As customer confidence grows, and as the virus attenuation occurs, we anticipate our business will recover, potentially even stronger than before the crisis. However, the pressing question remains when the effects of the virus will fully subside. Concerning additional guidance, we expect adjusted gross margins to improve sequentially in the third quarter, although this could be negatively impacted if revenue hits the lower end of our projected range, driven by the tougher decremental margins. R&D expenses for the third quarter are expected to remain roughly flat sequentially on a dollar basis. Sequentially, SG&A expenses are anticipated to increase on a dollar basis, primarily due to higher stock compensation resulting from a full quarter of the all-employee equity grant. It is important to mention that both R&D and SG&A expenses will remain flexible if significant changes occur in our sales or gross margin outlook. Therefore, these estimates could vary depending on how the monthly results pan out. Regarding the rest of our guidance, depreciation expense, which was approximately $3 million in the second quarter, will be similar in the third quarter. Amortization expense, which was $6 million in the second quarter, will also be comparable in the third quarter. Stock compensation, which totaled around $5 million in the second quarter, is expected to rise to nearly $7 million in the third quarter. Interest expense, which amounted to $1.7 million in the second quarter, is anticipated to be similar in the third quarter. Adjusted EBITDA is expected to be in the range of $25 million to $29 million. Due to the short-term uncertainty surrounding our jurisdictional income mix and tax rate, we will not be providing EPS guidance. Lastly, as Matthijs previously noted, two of our guiding principles involve maintaining business continuity and ensuring a bright future. To achieve these goals, our current focus is on protecting our capabilities regarding employees, innovation, and customers; preserving our priority R&D programs; and maximizing adjusted EBITDA and cash flow to manage the uncertain environment. This focus is critical to navigate the temporary impacts of the pandemic on customer demand, as well as the incremental operational costs in these extraordinary conditions. Ultimately, our view aligns with our previous call; the economic implications of the pandemic will be temporary, and demand rebounds in both medical and industrial markets will occur, despite the ongoing uncertainties around recovery trajectories. We are thankful that, during these struggling times, our customers have demonstrated tremendous partnership with us, both with current sales and product deliveries as well as in our innovation pipeline, where we co-develop future products. We remain very proud of our employees' commitment to helping us weather this challenging environment. Above all, we are excited about our future and eager to fulfill our commitments to our employees, customers, and shareholders. This concludes our prepared remarks. We will now open the call for questions.

Thank you. We'll now begin the question-and-answer session. And our first question will come from Joe Jagoda of CJS Securities.

So I guess to start, relative to the 14% increase in China and then the declines of 8% in the U.S. and Europe collectively, can you speak to the trends you're seeing in those geographies in July? And if you have it for early August?

I made some general remarks around not geography-wise, but more end market-wise, that our customers in the medical end markets have reported that elective surgical procedures, depending on the exact modality, are at 80% to 90% of pre-COVID levels. We see, I think as recently as today, that within Europe, Germany’s rebounding from a factory orders perspective, but other parts of Europe are not so fortunate. Both medical and industrial activity in China have obviously picked up; semiconductor microelectronics are very strong; medical procedures have recovered to pre-COVID levels; however, some industrial markets still lag a little due to demand for Chinese-based production often being driven by Europe and the U.S. Those are some high-level insights regarding our current perspective. In terms of dynamics, I won't comment on anything out of the ordinary; the declines in the U.S. were likely the steepest, but there is a relatively quick, ongoing recovery. The uncertainty lies with the resurgence of the virus, which has led to some signs of a pause in recovery. In Europe, the decline was less steep, but the recovery is also slower.

So then just going at it a different way, related to the medical elective surgical market being at 80% to 90% of pre-COVID levels, can you sort of provide details on the slope of recovery, specifically how bad it got in April, and where we were in June versus July, if July is 80% to 90%?

Well, it was extremely bad for our customers. They're reporting declines around 55% for certain procedures overall. There’s a considerable variability in procedures, of course. Elective procedures that are critical, such as cancer-related ones, could not be deferred and were down about 25% to 30%. Overall, in the U.S., it seems like we hit about 40% to 50% decline, followed by a rapid rebound. What remains uncertain is the trajectory from the 80% to 90% back to pre-COVID levels, which is where we stand today.

I guess the second question would be, is there any information that you're getting from your customers about their level of component inventory that we can use to say whether they're over-inventoried or under-inventoried relative to what their current shipment levels are?

I believe, looking towards the third quarter and considering the range we provided, which is $135 million to $142 million, the upper end reflects the current demand we are observing. The lower end accounts for potential disruptions in our supply chain. From a demand perspective, we seem to be sitting at the upper end. Thus, within the quarter, we see an organic decline similar to what was observed in the second quarter. We've seen diversification of our portfolio helping to lessen the overall impact from declines in elective procedures or shutdowns. Customers did not drastically alter their vendor relationships in response to the extreme conditions we faced in those months. However, the impact of the shutdowns in April and May will predominantly hit us in the third quarter. Therefore, the fourth quarter won't be a V-shaped recovery; rather, it remains filled with uncertainties.

Yes. We maintain close communication with our major customers about their inventory levels. We aim to prevent excess inventory in the supply chain while also ensuring customers are strategically positioned for recovery—they do not want to be short on products.

Last question from me. Robert, you mentioned that SG&A and R&D could flex. Assuming that there could be a snapback or sudden increase in demand, would this lead to any negative operating leverage as costs might have to ramp up quickly due to the extensive cuts that were made?

I wouldn't be able to flex costs significantly in that scenario. Meaning that if demand surged, significant reinvestment back into the business would be essential. However, bulk spending is primarily on personnel, which would not be feasible to scale back rapidly. Thus, while I have more flexibility for decreasing costs, I admittedly have less capacity for increasing them drastically.

We would need to manage our costs effectively, especially if the situation unexpectedly worsens again.

The next question will come from Rick Eastman of Robert W. Baird.

Just a follow-up on that particular point. So Robert, again, you mentioned SG&A might drift up a little sequentially. Can we assume that this is reflecting the upper end of your revenue guide for the third quarter? And then flat at the midpoint? I mean, is that the range you're discussing for flexing SG&A?

In terms of dollars, if we're at the upper $142 million range, we could see SG&A rise, but I don't expect it to go lower than what we saw in the second quarter.

I think you made that clear on the revenue trends there. Okay. Can I just ask, did you see any pull forward of revenue into the second quarter from what might have occurred in the third, especially with elective procedures ramping up? Was this upside reflected in your revenue number?

Reflecting back on our previous earnings call, the upper end of our guidance for the second quarter assumed no significant disruptions to our supply chain and demand materializing as anticipated. We slightly exceeded that, as we experienced counter-cyclical growth that turned out better than expected, and our supply chain and operations teams performed admirably. Thus, this is not about any pull forward; instead, it's about those dynamics.

Is that shift more focused on the industrial side? Your micro-e business is obviously performing well, and might some of this upside lean towards the industrial side where you thought conditions could be worse?

Yes, that's accurate. Our smoke evacuation is selling significantly better than anticipated, reflecting that stronger demand contrast. However, it's essential to note that the medical side of our business also exhibited rapid demands especially in the context of COVID related equipment.

Lastly, can I ask if, when looking into the third quarter guidance for revenue, are any of the three business groups anticipated to see a sequential increase? Specifically, I’m interested in the Precision Motion business.

It's possible that the third quarter reflects some seasonality with vacation schedules impacting dynamics, leading to a slight slowdown. Therefore, the anticipated revenue is likely closer to flat on a sequential basis.

There are not any significant elements within the company that remarkably rise or fall. On average, expect similar dynamics across the board.

The next question will come from Brian Drab of William Blair.

I want to discuss SG&A more in depth. It declined from $31 million to $25 million. Can you elaborate on the levers that were initiated to achieve this? How does that breakdown further? I'm also interested in how this reflects on our models for 2021. Specifically, I want to identify which elements are temporary, and what’s expected to return.

Most actions executed in the first half of the year were temporary. Therefore, expect the return of eliminated incentives, furloughs, and travel expenses. While we haven’t hired significantly, new hiring remains primarily focused on critical roles. If the recovery solidifies, our margin profile should improve due to our strategy of reallocating resources to higher-returning ventures. That said, it's speculative as to how precisely this will unfold as market recovery remains uncertain.

To clarify, the geographic breakdown indicated that both EU and U.S. saw declines, which averaged around 8%. Is this indicative of both regions individually declining by that same percentage?

Yes, both the U.S. and EU individually reflect declines around 8%. Nevertheless, certain areas in Europe, such as Germany, showcased growth amidst the downturn.

Lastly, can you share your insights on the additive manufacturing and 3D printing markets?

Yes, looking at it by end market is essential. We sell into laser additive manufacturing, which in the aerospace sector is currently under pain. Conversely, the market for medical implants shows growth potential, as investments continue. Thus, our confidence in structural growth remains despite the current headwinds, which we see as key applications for our strategy moving forward.

I would like to emphasize that Matthijs's comments primarily reference the metals-based market, rather than the plastic side. Our exposure to plastics remains quite limited.

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

Thank you, operator. To summarize, in the second quarter of 2020, Novanta delivered a solid performance amid an uncertain macro environment. We're certainly pleased with our positioning, the performance of our portfolio, and incredibly proud of our teams' agility. Novanta is not immune to the pandemic's impact; however, we are strategically and financially well positioned to navigate through this crisis. Our balance sheet is strong, our innovation pipeline is robust, and our diversified portfolio is aligned with long-term secular trends we've discussed. Although the short-term outlook remains uncertain in light of the public health crisis, we continue investing into the headwinds, focusing on long-term growth drivers related to Industry 4.0, precision medicine, and minimally invasive surgery. In closing, I'd like to thank our customers, employees, and shareholders for their ongoing support. I am especially grateful for the commitment and significant contributions of our dedicated Novanta employees, who are displaying remarkable agility and resilience during these challenging times. We genuinely appreciate your interest in the company and your participation in today's call. I look forward to continuing this discussion with all of you in a few months during our third quarter 2020 earnings call. Thank you very much. This call is now adjourned.

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