By Gail Kailing August 4, 2003 -- Creo Inc. (NASDAQ: CREO; TSX: CRE), provider of digital prepress solutions for the graphic arts industry, reported financial results, in U.S. dollars, for the third fiscal quarter ended June 30, 2003. For the 2003 third quarter, revenue was $143.5 million, up 9 percent from $131.8 million in the same quarter last year and compared to $141.5 million in the prior quarter. For the nine months ended June 30, 2003, revenue was $427.8 million, an increase of 7 percent from $401.4 million for the same period in 2002. Creo recorded GAAP net earnings of $2.8 million compared to a loss of $2.8 million in the 2002 third quarter and a loss of $1.2 million in the prior quarter. For the nine-month period ended June 30, 2003, GAAP earnings were $3.1 million compared to a loss of $24.9 million for the same period in 2002. Topics in this earnings call included: * Market Summary * Financial Summary * Outlook * Update on New Market Segments * Analyst Q & A Market Summary Revenue was up from both the previous quarter and the same period last year. While fluctuating currency rates brought challenges, reduced expenses provided balance and the company was still able to exceed their earnings forecast, even with the targets extended for both the top and bottom line. "It was a pretty good quarter," stated Amos Michelson, CEO. "But we still have more to do." * EMEA (Europe, Middle East, Asia) is once again the leading region. Sales results have improved since Israel Sandler, Managing Director of Creo EMEA, took over the sales effort for the region. * The US market is recovering slowly and the company scaled back sales and marketing expenses to match the revenue projections. * In the Asia Pacific region, there was very little real effect from SARS, and Creo's products are generating excitement in Japan. The company is encouraged about the outlook. * CTP bookings - in all formats - are ahead of last year. Financial Summary Revenue was up $11.8 million, or 9%, over the same quarter last year. While the currency impact was about $2.8 million, it was nearly offset by a reduction of $2.5 million in general and administrative costs resulting from ongoing cost reduction activities. Revenues by Economic Region   Q3 2003 $ Change % Change Q3 2002 Americas $52.6 ($2.5) - 4.5% $55.1 EMEA $58.3 $2.4 4.1% $56.0 Asia-Pacific $19.0 $2.7 16.6% $16.3 OEM/Other $13.6 ($0.5) - 3.5% $14.1 Americas: Revenue was down due to the economic conditions. EMEA: This is the second quarter where the revenue was greater than the Americas. Revenue was up 29.2% over the same period last year, particularly from higher consumables sales. Asia-Pacific: Revenue was up 17%% over third quarter 2002. OEM/Other: Down slightly though the decrease in revenue from thermal heads was offset by software sales. Revenues by product group were: $87.7 million (61.1%) from Products; $43.7 million (30.4%) from Services, and Consumables contributed $12.2 million (8.5%). Gross margin was about 45.2%, up slightly from 45.0% the previous quarter, and up from 44.6% the same quarter last year. "Other income" was $2.7 million resulting from quarterly interest income from Printcafe, the gain realized on the donation of a VLF CTP device to the Rochester Institute of Technology graphic arts school, and gain on Euro and Canadian-based net assets. "Treading water is not satisfactory," stated Mark Dance, CFO/COO of Creo. R& D expenses were up while General and Administrative (G&A) costs were down, showing good traction as a result of cost reduction activities. About $1 million was paid in severance due to reductions in headcount. Bad debt was the lowest it has been in two years, the default rate in leasing was one quarter that of a year ago. The balance sheet is healthy, with about $77.2 million of cash and cash equivalents. A number of cost reduction actions have begun to generated savings of about $4.5 million per quarter: * Consolidation of North American back office operations to Vancouver is projected to save $1 million/quarter. * Transfer of inkjet engineering and manufacturing to Vancouver resulted in a savings slightly under $1 million/quarter. * Reductions instituted at the beginning of the year including reductions in IT, travel, and marketing as well as elimination or scaling back of some R&D programs. * Disciplined integration of ScenicSoft. * Continued rightsizing of the business in the US and efforts to further reduce non-core activities in R&D. Changes in the exchange rate added about $5 million to expenses and the return to market rates for pay added to operating expenses. To offset the currency expense, Creo worked hard to control other expenses and is looking for more ways to reduce costs without limiting growth opportunities. Outlook Guidance for the end of the fiscal year 2003 is positive; the last quarter should trend up to revenues of $144 - $149 million. Performance in Europe and Asia has been good and North America has stabilized. Guidance does not include any effect if Printcafe shares should be tendered in the pending sale. Creo would receive more than $20 million for shares owned. (Editors note: taking into account EFI's exercised option, Creo now owns 37% of Printcafe and EFI owns 31%.) The company will continue to manage operations prudently to improve return to the shareholders. Update on New Market Segments Since last quarter Creo has seen a pickup in the packaging sector and has gained ground in the flexo packaging sector. The company introduced a new large format flexo plate imager with sleeve capability in April, and has sold more flexo units in the third quarter than in all of last year. Just last week Creo won its ninth Intertech award from the Graphic Arts Technical Foundation for Hyperflex - a unique screening technology that provides better highlight detail for flexo. Gravure printing is used for packaging and long run publication printing where ink is carried in small indentations on the surface of a metal cylinder. While gravure delivers very long runs, especially on thin or rough paper, with vivid reproduction of graphic images, the printing method is expensive and complex, especially the making of metal cylinders, and offers limited detail when printing text and fine lines. In order to eliminate these limitations from the gravure printing process, Creo has been developing a new technology where a thermal resist on top of the gravure cylinders is imaged very using Creo's SQUAREspot technology and the exposed areas on the metal cylinders are etched precisely to the right depth. This new technology can resolve inconsistency problems, reduce the time and expense needed to prepare the cylinders, and provide high-resolution text. Creo has also been developing a complete digital gravure system from end-to-end that has generated a lot of interest from packaging companies as well as from some of the largest gravure publication printers. The new systems are going into beta testing in Europe, and a system should be installed in North America before the end of the year. The newspaper segment market share in North America continues to be above 50% and there are more than 170 Trendsetter NEWS CTP devices installed worldwide. The Trendsetter NEWS CTP has also met with success in non-newspaper applications like such as book printing, specialty publications, retail inserts and coupons. It is the fastest thermal machine on the market, making up to 200 plates per hour, and with SQUAREspot technology, 1200 dpi provides more than enough quality and stability for many commercial applications. Pricing on newspaper plates in the U.S. has become very competitive, and Southern Litho, the parent company of Spectratech International (a major newspaper plate supplier), announced they would be offering their new Viper thermal plate at less than 60 cents per square foot. That is fully competitive with conventional plate prices and in a market and has resulted in several new newspaper customers for the thermal Trendsetter NEWS CTPs. Creo's partnership with NEC Engineering in Japan to develop a machine specifically suited to the size and resolution of the Japanese newspaper market is going well and the company expects to ship an additional five units this quarter. The quality advantage of Staccato and the reliability of the Creo engines are very appealing in the Japanese market. Since introducing its bundling strategy nearly two years ago, Creo's bundling percentage in North America has increased to about 30% of commercial sales. The price of thermal plates is dropping below the price of visible light plates and the premium for CTP plates of all types over conventional plates is getting smaller. Creo's goal is to increase the supply of competitively priced thermal plates to support effective bundling. Several new third-party suppliers are bringing thermal plates to the market and will be in place in the fall quarter. The company's current partners in the Americas include Lastra, Spectratech and Presstek for plates as well as with Du Pont and Fuji for halftone proofing material, and partners in Europe are Kodak Polychrome Graphics, Ipagsa, Lastra and Dupont. In other product news, Creo has released Brisque Version 4.1, which will drive revenue-bearing upgrades from the thousands of version 3 systems still in the field. The company also released Prinergy Version 2.2, the leading PDF-based workflow system. The Veris inkjet proofer is ramping up in production and will continue to scale up on a straight line to the end of the calendar year. Early customers are very impressed with the balance of speed, quality and color consistency with this system. The Networked Graphic Production (NGP) initiative continues to gain momentum - two more ERP vendors, Hiflex GmbH of Germany and Prism Group of Companies in the UK, have signed up. Several additional ERP vendors are already working with Creo. There are a couple of major tradeshows in late September, just before Creo's fiscal year end: IGAS in Tokyo and Graph Expo in Chicago. In May of 2004, is Drupa, in Dusseldorf, Germany. Most of the industry focuses their product release cycle on these events. "Creo's prospects are great - we have a great team, a compelling vision of where we are going and an unbeatable product portfolio," stated Mr. Michelson. "We have demonstrated the ability to grow by delivering unique and innovative solutions to our customers, and everything that we do is directed to that end." Q&A 1. The foreign exchange equation kept changing and, as a result, incurred some expenses that were transient in nature. While the financial income changes reflected transitory changes, some were "steady state" expenses that the company has been trying to neutralize with cost reduction initiatives. The adjusted earnings would have been the same even if the exchange rates had stayed the same. The top line was up by about $2.8 million, quarter over quarter, due to improvements to the Euro primarily. That would have brought the revenue to around $140.5. There would have been about $1.2 million less gross profit for the European side if the Euro hadn't improved. At the same time there was about $2.5 million increased operating expenses in Europe in the back office and sales and marketing side. These increased costs were primarily in the fixed cost side of Canada and Israel. Creo has spent a lot of time focusing on how to improve that over the last couple of quarters. If Creo hadn't seen the $2.5 million increase in operating expenses, they would have had earnings from operations of more than $1.3 million more than seen in the third quarter. Earnings from operations would have improved, but the company wouldn't have had the financial income of about $1 to $1.5 million from the exchange changes. If you cancel all those things out, Creo would have ended up with about the same adjusted earnings and would have ended up with about the same adjusted EPS. 2. Under "other income" are two elements: a quarterly Printcafe accretion (interest) entry and financial income for the margin made on the donation of a VLF to RIT. The other half is gain on Euro- and Canadian dollar-based assets. 3. Stochastic printing is gaining momentum, but there are no significant new competitive entries as yet. All competitors are trying to develop competing solutions, however it will be very difficult for visible light CTP machines to provide something similar to Staccato. Thermal machines have a better chance of competing with Staccato, however the most difficult part about Staccato is imaging it consistently in production without extremely high resolution. Creo has not identified anyone that is imaging plates above 2400 DPI, while Creo is imaging at 10,000 DPI. It may take several years for the competition to close that gap. 4. Creo has treated Staccato as an upgrade for existing customers. Competing machines are moving into the Creo camp as a response to print buyer requests for stochastic printing. In all new sales campaigns effort will be directed to explain to the customers that Staccato will be an absolute requirement for them to succeed in the future. 5. Gravure printing is used to print about 20% of all pages printed in the world, so while it may appear a niche market, but actually it is almost as large as the flexo printing market. It is a widely used technology where a few very potential buyers in the publication area, but every sale can be a large on with very high gross margins. In the packaging market, there are a lot of small printers that are printing with gravure and each sale will be slightly smaller. The gravure/offset decision-point is about 800,000 impressions. Many offset jobs can go gravure or vice versa, but when it comes to packaging, the production method depends on the ink and the substrate. Sometimes there is no choice but to go with gravure because offset would not be able to print it. Because of the long runs, the number of make-readies is much lower, but the price of those systems is tremendous so every gravure machine can include the cost of 5 or 6 VLF machines. Creo offers gravure printers a unique technology directed to resolve the main technical issue that no other method is capable of resolving and has almost no competition. 6. Packaging and newspapers in North America made up about 20% of the units. Customers over $10 million in size account for about 30%, which has declined from what it was a few years ago. Commercial printers under $10 million account for about 50% and the fastest growing segment is printers under $5 million in revenue. 7. Creo's market for newspapers and packaging is very large. In North America only there are customers for about 1000 CTP machines for newspapers. Packaging consists of a lot of small companies so it can be a substantial business into the future. And both markets in are beginning to move to CTP now. In the packaging market, the requirements of print buyers in the big consumer companies are pushing a move into Staccato printing. For example, a new Kleenex package released this month was printed using Staccato. Packaging printers using conventional plates plus film now not only have to move into a CTP machine, but to a CTP machine capable of Staccato. Staccato will provide the quality that is required by the buyer but the combination of Staccato and hexachrome (the six-color color space) will enable the packaging printers to eliminate spot color printing except for metallic colors - specifically gold. Creo is just starting to drive this technology into the field. Once it is in full production, the benefits of the technology and the reduction in print costs is so tremendous that packaging printers not moving to this technology will find it difficult to compete. 8. Veris is continuing to roll out as scheduled; the rollout plan has not changed over the last few quarters. Creo is testing and ramping slowing to make sure everything is under control, but will continue on a linear basis to increase production to the highest level planned by the end of December. Revenues will begin in the December quarter. While Creo could not break out contribution by Spire specifically, its contribution in Q3 was about equal weight to that in the previous quarter. In the back half of the calendar year the sales of POS products, including Spire, normally increase. Creo is doing very well in terms of market share on the Docucolor based on licenses, especially the 6060s. 9. The growth projected in the fourth quarter includes a small portion from the Veris, while a majority of it is from sequential improvements in Asia, a little from North America, and some from Europe. 10. Creo is seeing more and more of sales coming from small printers, about 35% of sales last quarter came from printers below $5 million in revenue. A big chunk of it is coming from the 4-page machines. The company is putting more emphasis on this market, and has set up a dedicated segment of the sales force in North America to handle this market segment 11. The operating expenses guidance described a run rate of $60 million by the end of fourth quarter. The published target is $62 million or below for the fourth quarter. Creo has taken number of steps to reduce expenses, and based on second quarter rates would have been almost below $60 million, except for the currency shift. Even since July 16, when the guidance was issued, the Euro has improved by about 2%. The targets are still in Creo's sights. Creo targeted three areas in the restructuring: a. Discretionary expenses, including travel and marketing b. Reduction in the IT groups c. Reduced staff in sales and marketing in North America in response to the drop in bookings in the second quarter d. Reduction in R&D groups in both Canada and Israel e. Reduced operational G&A All the severances, about $1 million, were taken in the third quarter. There may be a small amount taken in the fourth quarter though that's still to be decided. The impact on operating expenses will be difficult to see depending on exchange fluctuation; the restructuring was completed to advance Creo toward its target a $60 million quarterly run rate for fiscal year first quarter. The number of people impacted was about 2% of the company's headcount - nearly all in the fixed cost area as opposed to variable cost areas. 12. Now that the pricing on plates is now at or below visible light, Creo's bundling package is getting more competitive by the day, in all markets not only in the 4-page market. In fiscal quarter one, the company expects to see a much lower transfer price from plate partners that will provide increased profitability and market share in all segments. Market share in the 4-page market is in the high teens the company is projecting growth to levels similar to that in the 8-page market. While there might be reports that small commercial printers are still in the wait and see mode, about 35% of Creo's sales came from printers below $5 million in revenue - so clearly those people that bought from us decided to move. There will always be people who sitting and waiting, and there will always be people that decide to move forward, to improve their efficiencies, to improve the quality of the products they can deliver to the print buyer and be more competitive this way. 13. Many Brisque users do not have a service contract mainly because it is such a reliable system that people thought they'd be just better off buying the upgrades instead of taking the service contract. Creo expects expect thousands of users who are not on service contracts to buy the 4.1 Version to take advantage of all the new features they can get. Most of the Printergy users have service/maintenance contracts so when a new version is released; they get it for free. Every version has new options that are charged options. 14. G&A expenses declined from the second to the third quarter. The big drop came from having a very high G&A level in the second quarter resulting from some bad debt accruals in the Middle Eastern group that didn't recur this quarter. The third quarter had surprisingly low bad debt and lease default plus a reversal of some legal reserves due to the end of the Heidelberg joint venture/OEM relationship that reduced the G&A. It is expected that it will rise next quarter but not to last quarter's level because of the cost reduction initiatives taken in the last couple of quarters. Product revenue, discounting the foreign exchange effect, was down a couple of million from the previous quarter, primarily in North America. It was pretty much weak across the board. The third quarter revenues are from orders taken in the first calendar quarter, when North America went through a difficult time with war concerns and the economy. Sales activity has increased slightly since and the company believes that was the bottom of the year and things have picked up a bit since then. Growth in the fourth quarter is projected from Asia, especially Japan, from seasonal server business, some slight increase due to the Veris roll out, and a slight increase quarter over quarter in North America and Europe. 15. Creo bundles workflow software with hardware, so when analyzing the gross margin from a sale of an 8-page VLF system with workflow software, for example, the software would not have a big effect on the margin. The margin is a function of the size of the hardware system. So all together, when you look at the revenue mix, you would not see a huge difference in the gross margin. In the future, as the company moves into "software only" sales you will see an increase in the gross margin, but a decrease in the overall revenue, since each product will not be sold with hardware anymore.