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Good afternoon and welcome to Impinj's Third Quarter 2018 Earnings Conference Call. [Operator Instructions]. Please note, this event is being recorded. I would now like to turn the conference over to Chelsea Lish, Investor Relations for Impinj. Please go ahead.
Thank you, Operator. Thank you all for joining us to discuss Impinj's third quarter 2018 results. On today's call, Chris Diorio, Impinj's Co-Founder and CEO, will provide a brief overview of our market opportunity and performance. Eric Brodersen, Impinj's President, COO and Principal Financial Officer will follow with a detailed review of our third quarter 2018 financial results and fourth quarter 2018 outlook. We will then open the call for questions. Impinj's CFO consultant, Linda Breard; and Impinj's Executive Vice President of Sales and Marketing, Jeff Dossett, are also on the call, and will join Chris and Eric in the Q&A session. Please note that management's prepared remarks along with quarterly financial data for the last eight quarters, are available on the company's website.
Before we start, note that we will make certain statements during this call that are not historical facts, including those regarding our plans, objectives and expected performance. To the extent we make such statements, these are forward-looking within the meaning of the Private Securities Litigation Reform Act of 1995. Any such forward-looking statements represent our outlook only as of the date of this conference call. While we believe any forward-looking statements we make are reasonable, our actual results could differ materially because any statements based on current expectations are subject to risks and uncertainties. Please see the Risk Factors section in the annual and quarterly reports we file with the SEC for additional information about these risks. We do not undertake and expressly disclaim any obligation to update or alter our forward-looking statements, whether as a result of new information, future events or otherwise, except as required by applicable law.
Also, during today's call, all financial numbers we discuss, except for revenue or where we explicitly state otherwise are non-GAAP financial measures. Balance sheet metrics and cash flow metrics are on a GAAP basis.
Before moving to the financial results, I'd like to announce that the company will attend ROTH's Fourth Annual Corporate Access Day in New York on November 14. We hope to see many of you there.
I will now turn the call to Chris Diorio, Impinj Co-Founder and Chief Executive Officer. Chris?
Thank you, Chelsea. Thank you all for joining the call. Third quarter revenue was a record $34.4 million above the high end of our guidance and reflecting a return to growth on a year-over-year basis. Endpoint IC sales increased sequentially, in line with our expectations. We maintained steady supply in lead times while continuing to reduce our internal inventory. We also completed our channel inventory correction and expect to return to more typical unit volume growth rates going forward.
Our systems business had a record quarter, driven by strength in reader ICs and gateways. We shipped our 2 millionth connectivity device, another milestone toward our mission of connecting items in our everyday world. APAC systems revenue continued to increase as our new APAC team ramps productivity. We are energized by the opportunities for our systems business and remain focused on execution.
Turning to product introductions, we field-tested a significant ItemSense update, which we released in early October that includes improved reader management capabilities, algorithmic enhancements for shipment verification, and improved security for enterprise customers. With this latest version of ItemSense, our partners can leverage our entire platform, including endpoint ICs, readers, gateways and algorithms to verify product shipments across the supply chain. This release, like all our product introductions, is focused on innovations that solve end customer problems.
Turning to the market, I'm encouraged by many use cases highlighting the strategic and economic benefits of RAIN-enabled item connectivity in the supply chain. Reynolds, a leading wholesale fresh food provider, generated a positive ROI within three months using Impinj xSpan gateways and Monza-based tags to improve their supply chain.
The Impinj gateways track reusable crates, each including a Monza-based tag, as they transition through dock doors, are loaded on the trucks and back through the dock doors again when they return. Reynolds projects annual savings of more than $450,000. And a study from Auburn University on project Zipper that used RAIN in retail supply chains to track item-level inventory from point of manufacturing, through a distribution center, to a fulfillment center, highlighted a 3x improvement in order accuracy when comparing data from RAIN-based item scans to UPC data from barcode scans. These examples highlight the value that RAIN delivers a transition point throughout a supply chain.
And in retail apparel, we continue to see new world-class retailers adopting RAIN and existing retailers expanding their deployments. For the latter, we see retailers both expanding tagging to adjacent product categories like beauty and expanding their deployments to additional use cases like self-checkout and loss prevention.
In another positive move for the industry, the European Commission harmonized the availability of additional spectrum for RAIN operation in the EU, in a frequency range common to North America and most of Asia. In addition to simplifying system design, the added spectrum roughly doubles RAIN read speed and increases read range by 40% for readers that use the new spectrum. Impinj supported the efforts of multiple industry bodies and end-user companies in effecting this change.
As a RAIN technology leader, we continue advancing the depth and breadth of our patent portfolio as we innovate new technologies, products and solutions that our competitors try to mimic. We ended the quarter with 246 issued and allowed patents, as we focus on extending our technology lead across our entire product line.
In summary, the Impinj team delivered another quarter in which we outperformed our guidance on revenue, EPS and adjusted EBITDA. Even as we head into the seasonally slower fourth quarter, we feel a strong momentum as we pursue our vision of identifying, locating and authenticating trillions of everyday items and forecast another quarter of year-over-year revenue growth.
In closing, I would like to thank each and every Impinj employee for their focus, execution and dedication this quarter. I would like to extend a special thanks to our CFO Consultant, Linda Breard, as she continues providing strong and steady financial support and guidance.
I will now turn the call over to Eric for our detailed financial review and third quarter outlook. Eric?
Thank you, Chris. Except for revenue or unless we explicitly state otherwise, today's statement of operations is on a non-GAAP basis. All balance sheet and cash flow metrics are on a GAAP basis. A reconciliation between our non-GAAP and GAAP measures as well as how we define our non-GAAP measures is included in our earnings release available on our website.
Third quarter 2018 revenue was $34.4 million compared with $28.5 million in the prior quarter and our highest quarterly revenue on record. Revenue mix was 69%, endpoint ICs and 31% systems compared with 70% and 30%, respectively, in the prior quarter. As a reminder, the latter includes reader ICs, modules, readers, gateways and software. Endpoint IC revenue increased 18% and systems increased 26% compared with the prior quarter. One element of our solid systems growth was our reader IC sales, benefiting from improved supply, which was constrained in the first half of the year and is now caught up.
Third quarter gross margin was 50%, consistent with the prior quarter. We took an excess and obsolescence charge related to the EU spectrum expansion, which may have slow demand for EU systems products that remain salable but don't leverage the additional spectrum. We continually evaluate our inventory relative to market conditions, such as the spectrum expansion. Our current inventory comprises approximately 25% systems and 75% endpoint ICs, with the affected EU systems a subset of the 25%. Endpoint ICs operate over a very broad frequency range, so our endpoint IC inventory is unaffected by the spectrum expansion.
Total third quarter operating expense was $18.1 million compared with $18.3 million in the prior quarter. We incurred approximately $1.4 million in expenses for the audit committee investigation, which is now concluded. That amount, which represents most of the investigational cost, is excluded from our non-GAAP operating expense.
Research and development expense was $7.4 million. Sales and marketing expense was $6.5 million, general and administrative expense was $4.2 million.
Adjusted EBITDA was a loss of $895,000 compared with the loss of $4 million in the prior quarter and better than our guidance of a loss of $3.4 million to $2.4 million for the quarter. GAAP net loss was $7.1 million or $0.33 per share and non-GAAP net loss was $1.1 million or $0.05 per share, using a weighted average diluted share count of 21.4 million shares.
On the balance sheet, we ended the third quarter with cash, cash equivalents and short-term investments of $54.7 million compared to $52.8 million in the prior quarter. Net cash used in operations was $393,000 compared to $4.8 million in the prior quarter, primarily due to a $4.1 million sequential inventory decline. Our accounts receivable balance was $19.6 million, slightly down from $20 million in the prior quarter. Inventory totaled $49.2 million, down $4.1 million from the prior quarter. We continue to expect overall inventory to decline through the remainder of 2018.
Before I transition to fourth quarter guidance, I would like to remind you of the seasonality trends we typically see in our business. In the fourth quarter, lower endpoint IC volumes are partially offset by stronger system sales. In the first quarter, annual endpoint IC pricing negotiations typically impact both revenue and gross margin, while system sales are seasonally lower. Although these are typical trends, any number of factors can mask that seasonality in any given year.
Turning to the fourth quarter. We expect revenue to be between $31 million and $33 million, impacted by endpoint IC seasonality and reader IC supply fulfilling backlog in the third quarter. We're also incorporating the recent macro industry trends and guiding prudently. We expect adjusted EBITDA to be a net loss of between $3.5 million and $2 million. On the bottom line, we expect a non-GAAP loss of between $3.8 million and $2.3 million, and a non-GAAP loss of between $0.17 and $0.10 per share based on a weighted average diluted share count of 21.45 to 21.55 million shares.
I will now turn the call to the operator to open the question-and-answer session.
[Operator Instructions]. The first question comes from Troy Jensen with Piper Jaffray.
So maybe, I guess, either Chris or Eric. European spectrum, I get the balance sheet implications. Are you implying that there is going to be any like near-term revenue growth kind of pause with this change in spectrum over in Europe?
Go ahead, Eric.
Yes, Troy, the spectrum change really isn't associated at all with any changes in overall revenue outlook. This is really just specific to the European Commission expanding spectrum.
And actually, Troy, I think we see longer-term, some additional opportunities because, as I said, the additional spectrum, which the industry got for free. I mean, normally industries have to pay for spectrum, the European Commission allocated the spectrum for free, and it doubled the read speed, increases the read range of readers. So it enhances the opportunities available to us in the European Union.
Understood. And Chris, how about for you, it seems to be a couple of different approaches for this cashierless checkout model. Can you just update us on the benefits of using RFID versus alternative approaches? And maybe if you could source a couple of example customers that are trialing RFID, that would be great.
Sure. So there's a number of benefits for using RAIN in self-checkout. And by self-checkout, I assume you mean, everything from food to retail, apparel and other use cases. Is that correct, Troy?
Absolutely.
So the benefits of using RAIN for self-checkout are: number one, you can track the individual item and uniquely identify the item as being sold; number two, in the case of food products, you can also track the expiration date of those products because there's information that you can get from reading the identifier, you can store the information on the tag or have it in the network and so you track expiration date for products, which is difficult to do without the RAIN-based system; and number three, you get the supply chain benefits of having RAIN in the supply chain and so you get visibility from point-of-manufacturing all the way through to point-of-sale. So there are a large number of pilots going on worldwide as well as some actually use cases today for RAIN in self-checkout. I personally have bought items at a -- at GU store, which is part of UNIQLO brand in Japan, where you go into store and you can -- you do a self-checkout, you buy an item. And we see that self-checkout use case being deployed more broadly in retail. We see that food use case especially in Asia, you know the METI announcement in Japan for the five large convenience store operators to deploy self-checkout. So for us, self-checkout's a big opportunity heading into the future.
All right. Perfect. Last question from me. Can you just give us an update on just pricing trends for the tag ICs?
Troy, this is Jeff. I'll answer this particular question. We haven't seen any recent changes in the competitive environment with regard to pricing in the prior quarter.
The next question comes from Craig Hettenbach with Morgan Stanley.
Just picking up on the comment, Eric, about just some of the macro uncertainty, which we can see across the markets and then how that influences guidance. Are you seeing any changes to customer behavior due to this? Or is this just trying to get out in front of the potential for that?
Thanks, Craig. Probably closer to the latter. I think it's important to stock up a little bit and note that there are a couple of factors that differentiate Impinj versus the rest of the semi-market. RAIN is, to our knowledge, from our perspective, the first market for consumable silicon. Moreover, roughly 30% of our business is systems. And we've just really worked through our -- the completion of our inventory correction. So when we talk about the macro environment, we're really looking at the macro trends affecting the global economy, rather than just the semi-market. And that's really driving and emphasizing our prudent guidance.
Got it. And then, just a follow-up for Chris. Understanding that health care is kind of vertical that will take time to see adoption in ramps. But any updated thoughts in terms of the type of progress you're seeing there and things happening for RAIN in health care?
Yes. We continue to see health care as a big opportunity for us. We see the need for RAIN-enabled visibility, both for medical devices, for assets as well as for supplies. We see a lot of the pickup now happening in hospitals, where hospitals initially want to track their assets and then move onto additional use cases after that. And so you see us producing steady announcements in terms of hospital deployments, both us and our partners. So we see the health care use case as a marathon, not a sprint, or I'd say the health care vertical as a marathon, not a sprint, with huge upside opportunity for the future. But as you might expect with things in health care, they tend to move at a measured pace.
The next question comes from Mike Walkley with Canaccord Genuity.
Great to see the return to year-over-year growth. Chris, just a question, with the channel inventory complete, you made comments in the script about more typical unit volume growth rates going forward. Can you help us just think about what are some of those more normalized growth rates going forward in terms of units?
Yes, so we've spoken in the past about the unit volume growth rates on and that we see steady growth in the industry. And so we expect to return to those unit volume growth rates that we and others see, now that we've ended our inventory correction.
Okay. No chance you could quantify, is that double-digit unit growth on the long-term basis, any color you can give on unit growth longer term.
Yes, longer term, I think it's best if we rely on the analysts that publish their projections at the end of the year. And we're guiding on a quarter-by-quarter basis, so yes. Go ahead. I'm sorry.
I know. Understood. I thought I'd try again. Just -- you made some comments in your script about expanding RAIN into new parts of the retail market. Can you just update us on penetration for RAIN into retail? And how you see the growth opportunities in that market?
Yes, so we've spoken about the size of the retail opportunity in the past, which we estimate at roughly 80 billion units per year, and we've spoken about that for a while. By our best estimate, right now, we'll probably say the retail market is roughly 10% penetrated. And I guess, I'll be very -- I need to be more precise, they're really talking about retail apparel. Retail apparel roughly is about 10% penetrated. So there's huge upside on the retail apparel side. And then, adjacencies. For example, the beauty, cosmetics use cases and other items in retail, home goods and others offer further opportunities beyond the retail use case.
Okay. Last question for me, and I'll pass it on. Just in terms of your Q4 guidance, I guess the revenue guidance on the seasonality, just in terms of overall bottom line, is there a negative impact, impacting gross margin in the quarter? Or does operating expenses go up higher in Q4? Just trying to reconcile the cost base, how you get into the bottom line?
Yes, Mike. This is Linda. So overall, we typically guide at the revenue in the EBITDA line. I would say, revenue's down sequentially, so you'll have more pressure on the EBITDA line. And you typically sometimes see some increases in year-end spend with product-based timing.
The next question comes from Charlie Anderson with Dougherty & Company.
Just for the addition of the European -- with the spectrum in Europe, wondering, if you can speak to -- is there any impact on the IC business? Do you need a new design? I mean, it's ramping, so it looks like maybe that there's growth back there. And then, it sounds like it also improves the performance. I wonder, what you think is the market impact of that change in terms of maybe new in this third option? And then, I've got a follow-up.
Sure. So this is Chris. Thanks, Charlie. So the first question, the impact to the IC business. Our IC is a very broad band, so they operate over a very broad frequency range today, from 860 to 960 megahertz, quite a broad band. What happened with this EU spectrum expansion is, just like Japan did in the past by migrating to the same frequency band ranges as the U.S. FCC. The European commission has now given us additional spectrum in that same band. So what it means is that the ICs actually get to operate over an hour of frequency range, and so we can tune them for better sensitivity. So overall, it's a positive in that benefit because you can actually make simpler designs that operate over an hour of range, plus the spectrum allows more transmit power, so you can read at longer range. So overall, it's just a win-win for the entire industry. And in terms of opening up additional use cases, it definitely does. With the additional transmit power, broader bandwidth, higher speeds, we can actually perform better on use cases in the shipment verification industry by tracking more items on a pallet, for example. Or in retail use cases, more rapid inventory of items in a store. So it's just all positive.
Okay, great. And then, for my follow-up. I just want to ask about ItemSense. I know coming out of IPO, you guys had very big ideas around ItemSense and the ability of that to be a new revenue stream. With the new updates that you have, I wonder, maybe, if you just sort of reset where our expectation should be for ItemSense both in the short term and long term?
This is Jeff. What I will say is that the number of ItemSense pilots and initial deployment continues to grow. But as we've said before, ItemSense as a percentage or fraction of overall revenue will remain relatively small in the near term.
[Operator Instructions]. The next question comes from Mitch Steves with RBC.
I just wanted to kind of maybe talk about the seasonality a little bit and try to figure out from a modeling perspective. I realize you only do 1 quarter guide but starting with kind of December quarter, given that mix is going to be more towards readers than ICs, is it fair that gross margin's probably the highest in December quarters going forward? And then secondly, when I look through the year, could you guys maybe just put us directionally, which quarters will have the highest and lowest gross margin?
Let's see, Mitch. Let's break this down a little bit. There are a couple of different things that you're driving at in there. I'd say just, generally, with respect to seasonality itself, there is a range of factors that I highlighted in the script that relate to the systems and endpoint ICs and how they compare quarter-on-quarter. But, as you know, any number of factors can negate that impact, when we just look at that, that overall seasonality trend. On a gross margin level, there's a range of things that impact gross margin. So Linda, maybe just step through how we're thinking about that.
Yes, Mitch, from a gross margin perspective, obviously, our overall revenue will be impactful to the gross margin percentage. So given the 31% to 33% guide coming off the 34.4%, you'll see some compression on that. Also think about ASPs, our mix, and how we alluded to a little bit this quarter, some E&O in this past quarter. So there's a number of factors that can drive margin various ways. So we look at all of them as we think about our overall guidance, the EBITDA level. And regarding the...
That's fine. And then the last one just for me is on the macro comment you guys made. So I realize the stock market is volatile but I mean, was that -- was the comment about the macro environment more of a geo comment? Or is that more of like a vertical comment? Maybe you guys can give us a little bit more on what exactly you guys are seeing?
Really just -- it's a broader economic environment, not any specific vertical or market.
This concludes our question-and-answer session. I would like to turn the conference back over to Chris Diorio for any closing remarks.
Yes, I'd like to close by thanking all of you for your support and for joining us on the call today. Thank you very much.
The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.