Cognex - Q2 2014
July 28, 2014
Transcript
Operator (participant)
Good day, ladies and gentlemen, and welcome to the Cognex second quarter 2014 earnings call. At this time, all participants will be in a listen-only mode, but later there will be a chance to ask questions and instructions will be given at that time. If anyone should require audio assistance, you can press star, then zero, and an audio operator will assist you. And as a reminder, today's conference is being recorded. And now I would like to turn it over to your host, CFO Dick Morin.
Dick Morin (CFO)
Thank you, and good evening, everyone. Earlier tonight, we issued a news release announcing Cognex's earnings for the second quarter of 2014, and we also filed our quarterly report on Form 10-Q. For those of you who have not yet seen these materials, both are available on our website at www.cognex.com. They contain highly detailed information about our financial results. During tonight's call, we may use a non-GAAP financial measure if we believe it is useful to investors or if we believe it will help investors better understand our results or business trends. For your reference, you can see the company's income statement as reported under GAAP in Exhibit 1 of the earnings release, and a reconciliation of certain items in the income statement from GAAP to non-GAAP in Exhibit 2.
I'd like to emphasize that any forward statements we made in the earnings release or any that we may make during this call, are based upon information that we believe to be true as of today. Things often change, and actual results may differ materially from those projected or anticipated. You should refer to the company's SEC filings, including our most recent Form 10-K, for a detailed list of these risk factors. Now, I'll turn the call over to Cognex's chairman, Dr. Bob Shillman.
Bob Shillman (Chairman)
Thank you, Dick, and hello, everyone. I'd like to welcome each of you to our second quarter conference call for 2014. As you can see in the news release issued earlier today, we reported fantastic results for the second quarter, with the highest revenue, net income, and earnings that we have ever reported in our 33 years of business. Right now, I'm in San Diego, the headquarters of our R&D facility, and everyone else on the phone is at the Natick headquarters. For details of the quarter, I'll be soon handing the microphone over to my partner, Rob Willett, who's our President and CEO. But before I do that, I want to remind each of you that we will not be providing any details about the major customer that we referenced in both our news release issued on April 23 and also in tonight's earnings release.
We have a strict nondisclosure agreement with that customer, and we intend to fully respect that agreement. I'll now hand the mic over to Rob for his presentation, and I'll be available at the end of the call to answer any questions that you might have for me. Rob, the microphone is yours.
Rob Willett (President and CEO)
Thank you, Dr. Bob. Good evening, everyone. I'm pleased to report our results for the second quarter of 2014. Revenue was a record $108.8 million, representing significant growth over both the second quarter of 2013 and the prior quarter. It was also higher than the guidance we gave investors in April. This strong performance was driven by record revenue from the factory automation market and higher than expected revenue from SEMI. The quarter also benefited from some surface inspection revenue that had been deferred. Gross margin was strong at 76%, even with our less profitable surface inspection products reporting a record quarter. Operating margin was 28%, and net margin was 24%.
These two important ratios showed a strong increase over both Q2 of 2013 and the prior quarter, illustrating the substantial leverage that incremental revenue has in our business model. Reported earnings for Q2 were $0.29 per share, and they set a new quarterly record and were $0.07 higher than the Thomson Reuters First Call consensus estimate.
Turning to the details of the quarter, factory automation revenue was $83.8 million in Q2 and accounted for 77% of total revenue. Factory automation grew 25% year-on-year and 12% on a sequential basis due to strong performances by both ID and vision products. Looking at factory automation from a geographic perspective, our strong execution drove growth year-on-year in each region.
Europe showed the largest increase in both percentage growth and absolute dollars over a sluggish year in 2013. Accelerating growth in automotive, consumer products, food, and electronics drove factory automation revenue from Europe to a record quarterly level. Currency exchange rates also contributed somewhat to the increase. The Americas had another strong quarter, reporting a substantial increase in factory automation revenue over Q2 of 2013. Sales to customers in logistics and consumer products drove growth in the Americas over the record quarter, reported a year ago. In Q2, we saw a significant increase year-on-year in factory automation revenue from Asia, excluding Japan.
The automotive industry was the largest contributor to growth in Asia, which demonstrates our strong progress in this high potential region. In Japan, we continued to make progress, reporting factory automation growth in the mid-single digits over Q2 of 2013 in constant currency. On a reported basis, revenue continued to be negatively impacted by a weaker yen. Moving on. Surface inspection revenue was a record $16.5 million in the second quarter and 15% of our total business. This level represents a substantial increase of 36% year-on-year and 72% over the prior quarter. Our surface inspection division had an outstanding revenue quarter, with the metals industry accounting for most of the growth. As expected, we were able to report revenue related to a new software release that had been deferred until final testing at customer sites.
That higher revenue translated into significant operating margin expansion for surface inspection. Revenue from the semiconductor and electronics capital equipment market, or SEMI, as we call it, was $8.5 million in Q2, increasing 20% year-on-year and 38% over Q1. This marks the first year-on-year and sequential increase in five quarters, which may be a signal that the market is beginning to recover from its slump. Although this is encouraging, SEMI represented only 8% of total revenue in Q2 and is less significant to the overall performance of Cognex. You may notice that we invested a significant amount of working capital during Q2, which was for our major customer and is expected to result in significant revenue in Q3.
We are encouraged by the relationship that's developing with this customer, and we believe it will bring substantial revenue in future years. In summary, Cognex had an outstanding quarter in Q2, and if you like that, just wait until you see Q3. We expect revenue to increase by more than 50% over the record level reported tonight for Q2, due in large part to the major customer that I just referenced. Our expected revenue range for Q3 is between $165 million and $170 million. Gross margin is expected to be in the mid-70% range, slightly lower than it has been trending in recent quarters. Operating expenses are expected to increase by approximately 25% on a sequential basis. Part of this increase is due to expenses that we expected to record in Q2, but will now occur in Q3.
During Q3, we intend to continue to invest in areas where we see opportunities for long-term growth. Some of those incremental costs are not expected to repeat in Q4. As a result, we expect that operating expenses for Q4 will be approximately 10% higher than the level reported tonight for Q2. The effective tax rate is expected to be 19%, excluding discrete tax items. Now, let's open up the call for your questions. Operator, we are ready to take questions.
Operator (participant)
Okay. So, ladies and gentlemen, if you do have a question, you can press the star followed with the one key, and we'll take your questions. So again, to queue up for any questions, press the star followed with the one key, and that will place you into a live question queue. And I do show numerous questions. We'll take our first from Jim Ricchiuti from Needham & Company.
Jim Ricchiuti (Senior Analyst)
Hi, good afternoon. I was wondering if you can help us with the amount of SISD deferred revenue. Can, Dick, is it possible for you to provide that number just so we know what the business might have grown next at?
Dick Morin (CFO)
Well, part of the problem is that every quarter, SISD has deferred revenues for different reasons or whatever. And we don't intend to get into the discussion of any deferred revenue for that specific reason.
Jim Ricchiuti (Senior Analyst)
Is it fair to say that the SISD business, except that, though, was, you know, again, you guys have talked about what you think the growth rate for that business is. I'm just trying to get a sense if there was anything unusual in addition to that deferred revenue component that drove the growth in the business.
Dick Morin (CFO)
Well, the business did, did grow during the quarter, as well, so it benefited from two things. It benefited from, basic growth and also from some of that deferred revenue that we had talked about relative to getting, the software release tested in actual real-world conditions.
Jim Ricchiuti (Senior Analyst)
Got it. The factory automation business clearly, you know, grew at a much faster rate, both, I think at least than I was expecting in North America and Europe. Rob, you highlighted some of the areas that contributed to the growth in Europe. Is there any reason to think that, some of the drivers that you saw, and I don't know if you could elaborate on, on maybe the growth, also in the U.S. portion of the factory automation business, what contributed to that, and is there any reason to think, that wouldn't continue to be the case in Q3?
Rob Willett (President and CEO)
I think we're seeing, you know, a lot of broad growth across different markets. Certainly, you know, we're seeing strength in some of the markets I referenced, notably logistics and consumer products. But a lot of the new markets that we're starting to where vision is starting to get traction. I think we see continued growth and good prospects in those markets that you've referenced. But I would point out that we traditionally see a slowdown in Europe in the third quarter due to just the cyclicality and the summer vacation periods over there, and we do expect that to happen again this year.
Jim Ricchiuti (Senior Analyst)
You've been seeing that in the U.S. to some extent as well. Do you anticipate that as well in the U.S.?
Rob Willett (President and CEO)
No, I too, you know, not to the same degree at all, no. And we really haven't been seeing that kind of a slowdown in the U.S. market.
Jim Ricchiuti (Senior Analyst)
Okay, thanks for clarifying that. I'll jump back in the queue.
Operator (participant)
Okay. Thank you for your question, and we'll take our next from Ben Rose from Battle Road Research. Ben, please go ahead.
Ben Rose (President)
Yes, good afternoon. With regard to the revenue mix, thinking about the third quarter, services revenue hasn't traditionally been a significant portion of the company's revenue. But, you know, could we expect that to uptick considerably in the current quarter?
Rob Willett (President and CEO)
Hey, Ben.
Ben Rose (President)
Hi.
Rob Willett (President and CEO)
I think, you know, I think we may see some growth in service revenue, but I don't think substantially in the quarter. Dick, would you like to comment?
Dick Morin (CFO)
I think, well, you know, in answering your question, there will be substantial growth in service revenue Q3 over Q2. If you take a look at the percentage of service revenue to the total revenue when we're looking at a revenue range of getting up to $165 million-$170 million, most of that revenue growth is in fact gonna come from, you know, FA product revenue as opposed to service revenue. But service revenue will clearly increase, fairly substantially over Q2.
Ben Rose (President)
Okay, thank you. And then, Rob, I know in the first quarter, you had referenced some seasonal factors that would impact growth in China, that had impacted growth in China in the first quarter. And, you know, as you look out to the second part of the year, are you seeing some normalization or pickup in demand in that country in particular?
Rob Willett (President and CEO)
Well, Ben, we're really talking more about Asia overall than China, but business activity in Asia picked up as expected during Q2. Factory automation revenue from Asia was at a record level, led by growth in automotive and consumer electronics. And we would expect, you know, those, that kind of trend to continue in Q3, you know, where we would normally expect revenue to be seasonally high in Asia, and we see no reason to expect anything different this year. So, you know, I think what we saw was what we expected, a soft Q1, which we've seen, and I think many companies in similar industries see around Q1 in Asia and particularly China, in Chinese New Year, and then, you know, strong rebound in Q2 and Q3. So I think we expect the same this year.
Ben Rose (President)
Okay, thanks very much.
Operator (participant)
Thank you. Our next question comes from Richard Eastman from Robert W. Baird. Richard, your line is now open.
Richard Eastman (Managing Director and Senior Analyst)
Sorry, good afternoon.
Rob Willett (President and CEO)
Hey, Rick.
Richard Eastman (Managing Director and Senior Analyst)
Rob, could you just speak... I just want to double back on Asia Pac. The suggestion is, you know, very good growth, and you had mentioned auto as part of Asia Pac. I presume, is the auto piece of that in China, same with the consumer electronics? I mean, was there growth? If you take China out of Asia Pac, was the, how was the growth then?
Rob Willett (President and CEO)
Okay. So I think, you know, we saw a strong return to growth in Q2 in Asia, as I said, and automotive, you know, is certainly, it's Cognex's largest end user market. It's one where traditionally, you know, the market in China and in Asia has been smaller, but where there's a lot of growth. And certainly we expected that, and we saw it, and we keep seeing it. So, yeah.
Richard Eastman (Managing Director and Senior Analyst)
Okay. And then, it was noted in the press release that the revenue for this large customer, you know, increased about 50% from $40 million-$60 million in the third quarter, is the expectation. And can you just put any color around that step up? I mean, was that, you know, again, more content? Is it, you know, more service related to that? I'm just curious. I mean, is that contract expanding before we even deliver the first units?
Rob Willett (President and CEO)
Well, you know, we're very restricted in terms of what we can say about that customer, but, you know, as a relationship with them develops, you know, we're seeing, we've seen more business come our way. And, you know, we're pleased with the way it's developing, and we do expect to see substantial revenue from that customer in future years.
Richard Eastman (Managing Director and Senior Analyst)
Yeah. Yep. Now, And again, I'm trying to just be intuitive here, but I mean, we kind of, you know, have a pretty good sense of what's scaling up to that magnitude. But I still would think that, you know, going forward, we would have, you know, more of a product line extension type follow-up than anything of that size. Because I think of, you know, if we were at $40 million, we're now at $60 million, you know, on this contract that's still related to, you know, the scale-up project, I would think, relative to a typical follow-on order here, correct?
Sorry, it's kind of an odd question, a typical follow-on order in out years, you know, would be sizable, but, but not $20 million, correct?
Dick Morin (CFO)
We've never had a single—until this order came around, we never had a single order that was $20 million, Rick.
Rob Willett (President and CEO)
I mean, Rick, I would take us at our words, which we've, you know, we've crafted carefully and with some thought, you know. Subsequent, you know, in answer to some of the first part of your question, subsequent orders increased the total amount above our initial purchase orders. And we don't believe this is a one-time deal, rather, it's the beginning of a long-term relationship with the potential for substantial revenue in future years.
Richard Eastman (Managing Director and Senior Analyst)
Okay. Okay, well, fantastic. And then, Dick, could you just without really speaking to in the Q, when we're talking about SISD, sorry, in the Q, it does, you know, the text in the Q suggests that virtually all the upside or all the growth in SISD was this deferred piece? I mean, that's just text around the description. And could you just explain or just remind me, when we account for the profit on the deferred revenue, is it 100%? Because again, we defer the revenue.
Dick Morin (CFO)
Oh, we defer a cost as well.
Richard Eastman (Managing Director and Senior Analyst)
Oh, okay. So it would be at more of a typical profit, would be the deferred profit contribution as well.
Dick Morin (CFO)
Yeah.
Richard Eastman (Managing Director and Senior Analyst)
Profit margin.
Dick Morin (CFO)
But we do, whenever, whether it's for whatever reason, whether it's at SISD or MVSD, when we defer revenue, we also defer the costs. And, if you take a look at the balance sheet that's in exhibit three of the press release you will see that other assets, you know, at year-end, I think we're $42 million. Right now, they're around $59 million, and that includes a lot of the deferred costs relative to all of the contracts that we have deferred revenue on.
Richard Eastman (Managing Director and Senior Analyst)
I see. Okay. All right. I can make some assumptions from there. Great. And then maybe just, if Dr. Bob's on, I just maybe could he just get us a little bit of an update, or could you please give us a little bit of an update on any kind of, you know, acquisition pipeline, or is there anything out there that you're exploring?
Bob Shillman (Chairman)
Yeah. Hi, Rick. Unfortunately, well, we are exploring, but unfortunately, we have not found any candidates that meet our exceptionally high standards for potential profit or technology or market share, or culture. So we continue to search for this. We have one, probably one and a half people full-time, searching not only on websites, but going to trade shows, looking for interesting acquisitions, 'cause now would be a great time to add more bench strength, the more technology, more markets, more new products to our salesman's bags. But to answer your question, there is nothing that is on the front burner.
Richard Eastman (Managing Director and Senior Analyst)
Okay. Great. Well, thanks so much.
Bob Shillman (Chairman)
You're welcome.
Richard Eastman (Managing Director and Senior Analyst)
Very nice quarter.
Bob Shillman (Chairman)
Thank you.
Operator (participant)
Okay, thank you. Our next question comes from Jeremie Capron. Please go ahead, Jeremy.
Jeremie Capron (Director of Equity Research)
Good evening, Bob, Rob, and Dick, and congratulations on this outstanding growth that you've delivered again. I wanted to follow up on Rich's question regarding the large customer order and how we should think about how that will affect or even distort your growth profile going into next year. Do you still expect that we'll see substantial revenue growth in 2015, given the high base that you're establishing here?
Rob Willett (President and CEO)
Hey, Jeremie. Well, I think it's a little early to talk about 2015 at this point. What I would, you know, repeat is that we don't believe this is a one-time deal. Rather, it's the beginning of a long-term relationship with this customer that has the potential for substantial revenue in future years. On top of that, I would say, though, you know, we do expect currently to grow the top line of Cognex next year.
Jeremie Capron (Director of Equity Research)
Okay, great. Great. And could you give us a little more color on the long-term investments that you've talked about for the next couple of quarters? Any specific targets here or areas of investment in particular?
Rob Willett (President and CEO)
Well, broadly speaking, we're very excited about the opportunities we see for Cognex and for vision in general, and we're investing behind those opportunities. In general, they're in new product development, so we're picking up the pace in terms of our R&D efforts and our investments in technology and in sales channel. We're certainly adding a significant number of salespeople to Cognex currently, particularly in ID, and particularly in markets where we see a strength, such as logistics. But in general, we're investing in growth opportunities.
Jeremie Capron (Director of Equity Research)
Okay. Okay, and as for the gross margin going into Q3, so you called out a somewhat of a decline compared to previous quarters. And should we think that this is related to that large customer's order?
Rob Willett (President and CEO)
Well, the downward pressure comes from the mix in the business that we expect to see in Q3, so it's not necessarily one specific thing. You know, we will expect another strong Surface Inspection quarter, but there are a number of different factors that will result in that slightly lower than recent quarters reported gross margin.
Jeremie Capron (Director of Equity Research)
Okay. And maybe finally, on the ID product line, what sort of growth are you seeing right now here? I know you don't wanna disclose the details anymore, but just to get some color here in terms of whether the business is growing in line with your earlier targets of 30% per annum.
Rob Willett (President and CEO)
Yeah, so, what we said is the ID products grew in excess of 30% in 2013. We're seeing a strong continued growth in ID. Logistics is part of ID, and that's certainly a very high performing part of our business. So we're very, you know, we're pleased, and we continue to invest behind growth. You know, ID products are our leading performer and an important focus for Cognex, and we have growing momentum in the ID market, where we are gaining share. So from a geographic perspective, ID products have the strongest momentum in the Americas currently, and we've also been launching a number of new products into that market, notably the DataMan 8050, which expands the market we serve for handheld readers to lower price point and more broadly in the market.
So, you know, the market for ID products, we size at about $900 million. So our share in that market is not much more than 10% currently, so we still think we have a lot of headroom to keep growing at that 30% rate or more for a number of years.
Jeremie Capron (Director of Equity Research)
Excellent. All right, I'll back in the queue. Thank you.
Rob Willett (President and CEO)
Thank you.
Operator (participant)
Thank you. Our next question comes from Holden Lewis from BB&T. Please go ahead.
Holden Lewis (Managing Director)
Great. Thank you. Good evening. Could you just let us know, was there—what was the effect of the single large order in Q2, either on revenue or cost? And then what is sort of the expected impact in Q4? Do any of the revenues carry into Q4? Are there costs that carry over into Q4? How do we view that in sort of the bookend quarters?
Rob Willett (President and CEO)
So it was not significant in Q2, and I think it's too early to comment on Q4, but we don't anticipate it to be particularly significant in Q4 either, currently.
Holden Lewis (Managing Director)
Okay. Excellent. So the, the growth that you saw, obviously the upside surprise that you saw in Q2 to revenue, that's all market-based? I mean, can you just comment on what markets you're seeing that are strong versus weak, if there's any way to sort of characterize those broadly?
Rob Willett (President and CEO)
So we saw a strong performance from factory automation during Q2, and that was well above our 20% growth target. We saw particular strength really across a broad range of markets, logistics, as you would expect, consumer products, you know, markets like, use of diapers, tobacco products, toys, where we're seeing, you know, certainly strong adoption of machine vision in markets, in some of those markets where machine vision is perhaps starting to reach production lines, in large degree for the first time. So we're certainly seeing that. We saw, you know, good, good strength in automotive, in the quarter, slightly below our overall factory automation growth rate, but still very strong and very sizable for us. So I would say that the growth was pretty broad-based, Holden.
Holden Lewis (Managing Director)
Okay. And then just so the last thing, on sort of the operating percentage, you talked about investing in new products, investing in personnel. That, of course, I think is pretty boilerplate. You know, my impression was that you were sort of coming off a period of unusually high spend, and you were sort of in farm mode. And so we're looking at a Q2, which is primarily operational, doesn't have a lot of the sort of discrete order event in it, and you're already kind of at a 28% operating margin, which in recent years has kind of marked a peak. You know, are you at the point where you think you have to sort of rekindle a more aggressive spend, and therefore, this type of margin, Q3 aside, is still something we should view as a peak?
Or are you comfortable with the idea that, you know, 28% is not a peak, and you can probably go north of 30, you know, based on the investments you've already got in the book and the growth that you're seeing?
Rob Willett (President and CEO)
So we invest in the business where we see opportunity, and you know, right now we see lots of opportunity both in the near and long term. So we're investing behind our great technology and our leading sales channel in order to achieve that. You know, operating margins were very strong at 28% in Q2. We saw significant expansion, you know, both year-on-year and sequentially, due to the substantial leverage that we have in our business model. I would say, you know, there is room for expansion above the 28% operating margin reported for Q2, but we really keep our eye on the long term, and we don't plan to shy away from investing.
So, you know, we're really very pleased by the kind of growth and the opportunities we see and the response in the market to our products and to our sales force, and the way we're improving both of those, and we're gonna go on investing for growth. You know, there's potential for margins to move higher, but not necessarily always consistently, because we're gonna go on investing with a long-term future of Cognex in mind.
Jim Ricchiuti (Senior Analyst)
Okay. All right, thank you.
Operator (participant)
Thank you. So again, ladies and gentlemen, I would like to remind you how to get back into the question queue. You can press the star followed with the one key, and we'll take your questions. So our next question is coming from Jim Ricchiuti from Needham & Company. Jim, please go ahead.
Jim Ricchiuti (Senior Analyst)
Rob, you mentioned that ID was a particular driver in the Americas and the performance in the quarter. Is that true of logistics as well? Was logistics you know, a major driver of the growth in the ID business in the Americas in the quarter?
Rob Willett (President and CEO)
Well, our ID business is growing very well overall, but logistics is making substantial contributions to it, and we're seeing outstanding growth in logistics, particularly in the Americas, where we're really, really getting great traction in our logistics business, but also now increasingly in Europe.
Jim Ricchiuti (Senior Analyst)
Can you give us a sense of the growth that you're seeing in ID, and probably more so in logistics? Is it a case of, it sounds like it's a case of market share gain. Is that a fair way to characterize it?
Rob Willett (President and CEO)
Yeah.
Jim Ricchiuti (Senior Analyst)
The market's not that healthy, right?
Rob Willett (President and CEO)
Absolutely right. You know, it's a $900 million market that's probably growing in the mid-single digits, and we're growing, you know, we're expecting to and achieving 30% growth. So we have disruptive technology. You know, it's just the best barcode reading technology in the world, and we're investing heavily behind it and taking a lot of market share. And we've been doing that for quite a few years, and we're gonna go on doing it, expanding into new adjacencies like logistics, and continuing to drive growth in that core ID market.
Jim Ricchiuti (Senior Analyst)
Within logistics, is it, can you say whether the share gains, the growth that you're seeing in that market is uniformly across the market? And by that, I mean, both large customers as well as potential small customers, smaller customers.
Rob Willett (President and CEO)
Well, we're certainly selling to large and medium-sized customers in the logistics market. Yeah, I think they're, I would say, the most savvy consumers of logistics barcode reading technology, recognize the, the performance of our products and are adopting them. And there are integrators too, that serve the mid-sized customers in that, in that market. I wouldn't, you know, I wouldn't say we're getting, you know, we're, we're selling a lot of that business to small onesie-twosie customers. It's, it's more to the mid and large customers, I would say, at this time.
Jim Ricchiuti (Senior Analyst)
Yeah, and then that's actually what I meant is I'm thinking in terms of retail, the distribution centers. Are you seeing traction in, maybe the larger mid-sized retailers, if you will, where you're gaining ground there? We know there's been some very large orders and presumably with some very marquee-type customers. But are you, you know, at the medium-sized, retail customers who maybe have distribution center, are you making inroads there as well?
Rob Willett (President and CEO)
Yes. We're definitely, you know, if I look at our customer lists and our pipeline, just we're seeing lots of kind of, you know, mid-sized retail companies, the kind of companies that, whose names you see at the mall, basically. But, you know, I would also add that we have, you know, strong and growing pipeline of ID products for logistics that include not only well-known retailers, but package delivery companies and postal accounts. So, you know, those are the three pillars of the logistics market: retailers, package delivery companies, and postal accounts. And the funnel is developing nicely, with all those three types of prospects.
Jim Ricchiuti (Senior Analyst)
Got it. And one final question, I'll jump back in the queue. You alluded to the, obviously, the size of the order with this large customer, but in general, order sizes, it appears that some of the orders have been growing for Cognex over the past year, year and a half. Just looking at what you're seeing in the market, for instance, is there something unique about the orders that you're getting of late that are perhaps gonna make it challenging to maybe go to other verticals and be able to, or even within the same vertical, to be able to generate orders, not necessarily of the size that you've just announced, but just larger orders in general?
Rob Willett (President and CEO)
So I would say over the last, you know, couple of years, we've seen some, you know, larger customers, you know, emerge for Cognex. Obviously, the major one we've been referencing, but also, you know, quite a few larger customers in areas like logistics, specifically. I would say we see the markets emerging in these areas and, you know, what we can do for those markets. And, you know, we're building teams of people to serve and products to serve those markets. And, you know, that is driving some of our investment, obviously.
I would say nothing we've seen to date is overly problematic, but it's a matter of building that capability and understanding those markets and building our reputation in those markets. Because obviously very large customers don't, you know, they don't, they don't give, they don't give huge amounts of business just immediately. There's a lot of trials that go on and a lot of a lot of requirements. You know, I think we're doing a nice job of building our capability to serve that. I'm not talking specifically about any one customer, but quite a few customers that we're starting to work with now, who have the potential to be very sizable for us in future years.
Jim Ricchiuti (Senior Analyst)
Okay, thanks very much. Congratulations on the quarter!
Rob Willett (President and CEO)
Thank you.
Operator (participant)
Thank you. Our next question is from Richard Eastman from Robert W. Baird.
Richard Eastman (Managing Director and Senior Analyst)
Sorry, round two here. Just two quick things. One is, I was kind of looking at the OpEx, and you know, per the commentary, post the first quarter, you know, the operating expense came in, you know, below target, and it sounds like some of that was maybe pushed into the third quarter a little bit. But when I look at the second half of the year, you know, we're giving up some operating leverage there. Third quarter is gonna be fine because we've got a, you know, a boatload of revenue coming in on this large order.
But when we get up to the fourth quarter, you know, it appears as though it's gonna take away a little leverage out of the model in the fourth quarter, and presumably, then as we roll into next year, we'll be looking for the sales gains to kind of satisfy and justify the cost investment.
Rob Willett (President and CEO)
Okay. Well, you know, I think as we look at the business, you know, we're investing behind the growth opportunities that we see in the market. Obviously, we have substantial assets and substantial capabilities behind us, and, you know, we very much believe in these growth prospects. So, you know, we're going on investing behind them. And I think the growth that you'd seen in this quarter and the one we expect next quarter, you know, say that that's a good strategy. That said, there will be times when, you know, we're investing ahead, you know, where we're growing expenses ahead of revenue growth. And, you know, I think we're comfortable with that because we see the long-term potential for major top-line organic growth and margin expansion.
So, that's how we're looking at it, rather than trying to manage any particular quarter on a short-term basis.
Richard Eastman (Managing Director and Senior Analyst)
Sure, sure. And beyond, again, the third quarter and the mix issue, again, there's no reason that our gross margins don't continue to maybe drift higher with, you know, with the new products, once we get beyond, you know, this large order.
Rob Willett (President and CEO)
Yep. I think, I think we've reported some pretty nice gross margins in the last few quarters, and, you know, we've kind of highlighted some mixed issues and other issues that may hit us in the third quarter. But I would say in the long run, you know, in the long run, you know, we do expect, you know, to keep reporting margins in the mid-70s to mid-70% range.
Richard Eastman (Managing Director and Senior Analyst)
Sure. Okay, and then just one last question, Rob. On the, on the logistics business in general, it sounds like, again, we're just maintaining the, the, the excellent traction we have there. Has there been any shift, you know, as, as you've rolled out the, the ID product, targeting logistics, with some of these new products that we've seen at some of the trade shows, has there been a shift in your ability to sell more of that product through the indirect channel, the systems integrator channel?
Rob Willett (President and CEO)
Well, we've been in the logistics market for about a couple of years now, and I think, you know, we've been learning a lot as we've moved forward. I think initially we thought, you know, we could rely on integrators and third parties to sell the product. We then realized we really needed to get the major players and end users in the market to recognize our technology. And when we did that, we started to see real traction. That's when you started to see real traction about a year ago.
And I think now that we have that traction and that recognition and, you know, a recognition from the industry in general, that we have superior products, now we're able to get integrators to really take on the sale of our products more themselves, and that then takes us more broadly in the market. So, I think it begins with the big end users and the big influencers and some of the big integrators, and then it builds from there. And I think that's kind of where we are in the evolution right now.
Richard Eastman (Managing Director and Senior Analyst)
I see. Okay, great. Thanks so much.
Operator (participant)
Thank you. Our next question comes from Jeremie Capron. Please go ahead, sir.
Jeremie Capron (Director of Equity Research)
Thank you. Can you talk a little bit about Japan? I think there were some concerns that the VAT hike over there could, you know, maybe depress the market a little bit in Q2. Obviously, you've grown nicely there. So what are you seeing in Japan, and maybe give us an update on your relationship with Mitsubishi over there?
Rob Willett (President and CEO)
Sure. Yeah, Jeremy. So I would say we didn't see a notable impact from the VAT thing. We thought we might. We studied it pretty carefully, but didn't see a big, you know, a big pulling forward or change in order patterns around that event. Our business in, you know, in Japan has performed, you know, better in recent quarters. The recent quarter has quite a lot to do with the SEMI market, where, you know, we're seeing a large improvement. And in fact, of our improvement in semi, Japan is probably the leader in what we're seeing there. But, you know, our FA business, our factory automation business in Japan, is. It's, I would say it's building strength.
and capability, but there are a couple of, you know, there's particularly one very strong local competitor in Japan, and our market share is still relatively small. You asked about Mitsubishi. You know, we continue to see sales through the Mitsubishi channel and some growth through our relationship with them. And our relationship with Mitsubishi continues to go very well, and both firms are, you know, firmly committed to its success. They certainly give us significant additional reach into the Japanese market, and it's a relationship that's been building over now more than four years and continues to grow.
Jeremie Capron (Director of Equity Research)
Okay. And speaking of Japan, your Japanese competitor also reported pretty impressive growth in the U.S., in Q2, I think over 50%. Is it the case that you see them more than before in your core factory automation market here in the U.S.?
Rob Willett (President and CEO)
Well, you know, you're referencing a competitor, Keyence, and I think Keyence's business is much more broad than Cognex's. So I'd caution against drawing conclusions about their results specifically into our part of the market. Maybe we only compete head to head within 10% of their business. But what I would say is, yes, I would say both Cognex and Keyence are investing in these markets. We clearly both see the opportunity for growth and are executing on it. Clearly, we're the market leader in vision and industrial ID in the Americas and in Europe. They are clearly the market leader in Japan, and we're head to head in the Japanese market.
Jeremie Capron (Director of Equity Research)
Okay. And finally, a question on capital allocation. There’s now almost $500 million of cash and investments on the balance sheet. And even with the increase in the investment intensity that we’ve seen in the past two years or so, the business is still generating a lot of cash to the point that the balance sheet is starting to look overcapitalized, and return on equity is sort of capped by that cash. So, what’s the thinking in terms of what would be an appropriate cash level, and how to get there going forward?
Dick Morin (CFO)
We really haven't set any specific cash level targets. Our primary goal would be to use cash for acquisitions. You know, the availability of our cash provides us with good firepower in any particular acquisition that we might have. It was also a good benefit to us in this past quarter in that we were able to invest in all of the working capital needs that we had to satisfy the major customer contract that'll be revenue here in Q3. So we don't have any particular targets, but as Dr. Bob mentioned earlier, there's nothing really on the acquisition front at this particular point. But we continue to be in the market, buying back company shares.
Bob Shillman (Chairman)
This is Dr. Bob. I just want to expand a bit on that. There is certainly no upper limit as to how much cash we have or want to have. Cash is just a positive result and a measure of how effective we are at running a growing company, and we're very proud of the cash that we have. The best use of cash, of course, would be, as Dick just alluded to, to buy, to do acquisitions, and we would like to do acquisitions. And if we find them, we've done them. We've done about 13 to date. The next good use of cash, and I don't know if it's in direct order, but is to buy stock back.
As you know, as most Cognex shareholders know, we believe in the value and the power of stock options, and we understand that some shareholders believe that they are dilutive to earnings. In respect to that, with respect to that, we are using cash to buy back stock to compensate for any possible dilution. The third use of cash that we have used it for is to reward our shareholders with dividends. And we did such about two years ago. We paid two years of dividends in advance, and I can tell you that at every board meeting we discuss whether or not to restart that. I can't predict when or if we will, but that's another good use of cash.
So it is not something that worries us. It's something that we are very happy to have and are very happy if we just accumulate it.
Jeremie Capron (Director of Equity Research)
All right. Thanks very much.
Bob Shillman (Chairman)
You're welcome.
Rob Willett (President and CEO)
Okay. Thank you.
Operator (participant)
Thank you. So I will remind everyone how to place yourself back into the question queue. You can press the star followed with the one key if there are any following questions. Our next question is from Holden Lewis, from BB&T.
Holden Lewis (Managing Director)
Thanks again. A couple things. First, you know, we've talked a lot about logistics. I think we get the sense of that, but are there any updates, traction, anything that we can talk about on some of your other big new product initiatives, the image engine, the 3D side? Anything to report there in terms of progress, customers, traction, anything of that sort?
Rob Willett (President and CEO)
Yes. So those two new markets that you referenced, the displacement sensor, 3D market, is moving along well for us. You know, the business is still small, but we're in many trials, and our product is performing well, and we're very optimistic about what that product can do for us in the long term. It's not gonna make much of a contribution to this year's revenue, a few million dollars, possibly, but I think by next year, you know, we do expect some growth contribution to start coming from that product.
Similar in some ways, the image engine business, as I've referred to many times, this is a business where we're targeting the life science market, and the name of the game at this point is design wins. We now have several design wins with large manufacturers of OEM equipment, and some of this equipment is in the final development stage, with production units expected to ship next year. So, that's a $100 million market. Our share is very small today, but as these machines from large suppliers start to come out into the market, you know, we think it's going to be a nice, stable, and a growing source of revenue for Cognex.
When I joined the company, and a lot of people ask me, "Hey, does Cognex have any consumables revenue?" I'd come from an industry where we used to sell printers and ink, and the answer was no, but I'd like to figure out how to get consumables revenue. I think these image engines are about the nearest thing to consumables revenue, where essentially every time a large customer sells a piece of machinery, we can sell a number of these image engines over what should be a seven to 12-year life of that product. And since these customers are FDA regulated, most of the time, you know, there's very little change that goes on to those machines.
So it should be we continue to see it as a very good source of stable revenue for us in future years. And the traction is on schedule, I would say.
Holden Lewis (Managing Director)
So this year, we've had a lot of contribution from logistics. We still feel you're gonna begin to pull in, you know, meaningful revenue from these two new products. Perhaps as the comps get harder for logistics, these things begin to kick in, so we can sort of think about that in terms of how this thing sort of pulses through your results?
Rob Willett (President and CEO)
Yeah, I think you'll see the beginning of it starting to come next year, yes. But I think, I think that's the... If you think of it, it's an S curve, I still think it's pretty low down on the S curve, and we'll start to see it ramp possibly, possibly a little bit next year, but I would think more in out years.
Holden Lewis (Managing Director)
Okay. And I just wanted to ask a question. If you sort of take your, your order for this quarter or for the third quarter, which is gonna be $60 million plus, and you look at your guidance, you know, is it possible, just thinking about sort of the, the sequential change, that, that you're looking at a Q3 revenue stream that is below the Q2 revenue stream in a market which seems like it's strong, maybe getting stronger, where you're seeing increasing contribution from new product? You know, should we read anything into the potential of a sequential decline in revenues from Q2 to Q3, or is there some, you know, you know, rational explanation for why you would have a sequential step down?
Rob Willett (President and CEO)
No, I wouldn't read anything into it. The sequential increase in factory automation, excluding the large customer, is harder to predict given the softness we see, particularly in Europe during the summer months. I think that's the key thing. I would encourage you to look at it more year-on-year, and if you look at last year, I think you should see you know, significant growth in the base business, you know, excluding the large customer, certainly. And then, of course, Surface Inspection had a strong second quarter, again, which is unlikely to increase in Q3.
Holden Lewis (Managing Director)
Okay, great. Thank you.
Operator (participant)
Okay, and I'm showing no further questions in the queue at this time. I'd like to turn the call back to Dr. Bob Shillman for closing remarks.
Bob Shillman (Chairman)
Yeah. Thank you. Well, it's a simple thing to wrap up. We reported outstanding results tonight for the second quarter, and we expect to deliver even more spectacular results for Q3, with another record-breaking quarter for revenue, net income, and earnings. And I look forward to reporting on that with the team next quarter at about this time. Thank you very much for your continued interest in Cognex and for joining us tonight.
Operator (participant)
Ladies and gentlemen, this does conclude your conference. You may now disconnect and have a great day.