IPG Photonics Corporation (IPGP) Earnings Call Transcript & Summary

Okay. We're going to start our next presentation, which is going to be a fireside chat with IPG Photonics. My name is Jim Ricchiuti. I'm the analyst -- equity analyst at Needham who's been following IPG for a while. I'm delighted to have this company's CFO, Tim Mammen here as well as Jim Hillier, who is -- and many of you know, heads up IR. So with that, why don't we get going?

Tim, let me just swing over here. So why not you maybe just start off spending a few moments with a short overview? I think most folks know IPG, but there may be some who want to get reacquainted with the story, and then we'll jump into Q&A.

Sure. Good morning, Jim. Good morning, everybody. So IPG is credited with being the company that really commercialized fiber laser technology. Fiber lasers are devices that improve the productivity, precision and the flexibility of many industrial applications historically and now trying to address many nonindustrial and emerging applications, processing nonmetals and other areas, and for example, medical or even entertainment and display. The company is well renowned for being very vertically integrated. So we produce all of the key optical components that are used in the lasers in-house. Probably most notably, things like the diodes, where we've taken a tremendous amount of cost out of diodes over time, increased the power that we can get out of the components, including the diodes. Produced very high-quality glass fiber. That's a key aspect of the very precise beam quality that we get out of the device and then are also very well known for being able to combine the power of the light source, the diodes, together to produce high-power modules, which in turn are combined together to produce very high-power lasers, where the highest power lasers that IPG has produced are in excess of 100 kilowatts. We were the first company to produce a kilowatt single laser back in 2003 and very quickly ramped that up to multiple kilowatts of power level. I'd say the other thing that the company is very well known for doing, apart from producing very reliable lasers at high power and even with different pulse durations, for example, is taking cost out of the product. And over time, that has made laser technology much more compelling as a machine tool to displace nonlaser applications and technologies. So for example, in cutting applications, displacing punches, presses, dyes, sores, shares; displacing traditional welding applications in additive processes; deposition technologies such as cladding; marking applications, obviously, one of the earliest applications we're displacing, more traditional marking processes. So that's a very short and high-level summary of what the company strengths are.

That's fine. I think if we look at this past year, clearly, companies in the industrial markets have experienced some weakness. And your revenues, through the first 9 months, I guess, down around 11%, and your guidance is for Q4, revenues somewhere around 9% to 18% down. So there's the macro environment, which [Audio Gap] but you've also experienced, I think, fair to say, some increased competitive pressure from some of the local Chinese suppliers. It led to some pricing pressure. And I'm wondering which of these dynamics has played a bigger role in the slowdown that you've experienced?

So I think if you look really back on 2019, it was a tale of 2 halves almost. In the first half of the year, particularly in China, you actually started to see a rebound in demand following a weak end to 2018. At that point in time, pricing had come down in '18, but it remained relatively stable. So as you saw the macro environment perhaps strengthened a little bit. You saw actually better stability around pricing in the first half of the year. And IPG started to get some traction back into the business and some reasonable performance. Having said that, it's the macro environment -- has weakened into the second half of the year. There's no resolution to the trade war in site. Certainly in China, pricing has had a significant impact on the overall size of the dollar market as well as in terms of impacting our gross margins a bit. There's been other things that have impacted the gross margins as well. Overall, pricing is probably taking about 200 basis points out of our gross margins. I'd say in China, pricing and macro are very closely entwined, but the pricing has probably contributed to half of the impact in growth. Elsewhere around the world, pricing does migrate, but to a lesser degree, into some of the other geographies. Certainly, in Europe, macro has been primarily the reason why revenues are down. And the impact in Europe has been -- it does vary a little bit from quarter-to-quarter, but it's probably been, in itself, half of the impact on revenue. So it's not just China. I mean China -- our European revenues have been down by 25% to 30% compared to the peak, and the macro environment in Europe has been particularly weak. We called that out as getting weak at the beginning of 2018. So you're 2 years into a down cycle in Europe and perhaps seeing a bit more stability. So it's a mixed bag. Certainly, pricing has had a significant impact, but it's mainly China-driven, and that's where the competitive dynamics are the strongest.

And it seems like mixed bag also defines the current environment because we're seeing some puts and takes. There's some PMI readings a little better. China's showing a little better improvement, but there's still weakness in places like Germany. Even news from your [ lower ] customer, was it last week, Han's, a little bit more cautionary. We all look at -- you typically give guidance for a quarter out. There's seasonality to your business. And so I guess what I'm asking is, how far into the year do you really look at getting a better picture possibly of what the year is going to look like? Is it April, is it May? How far out as you go through the year? Because Q1 is not always a good reading for you, is that fair to say?

Correct. So in terms of the reading, I think we really need to get through into the second half of Q1 to see how order flow is trending. Chinese New Year is a bit earlier this year. It's at the end of January. So maybe we'll start to see some pickup into February by the time we announce our results. But I would expect really the tone for the year to be set by the solidity of order flow in March and even into early April because that will clearly define how Q2 and Q3 are shaping up. It'll also demonstrate how not just the underlying macro environment is trending globally, but whether some of the more project-driven investment cycles are going to be stronger or weaker this year. So for example, the consumer electronic cycle, some of the electric vehicle investment cycles. That can layer on a nice amount of revenue looking at how the welding business is going to materialize during the year. So those are things that we've been looking towards. I think with Han's, it's interesting. I think that the industrial business with Han's have been weak since the end of the second quarter. We were actually getting questions as to why our guidance was weak in Q4 relative to Han's guidance being strong. And my view on that was at the time that Han's was probably being a bit too optimistic about the outcome for Q4. I also think they called out areas of strength. They were hoping to see -- materialize where we were not -- or not yet supplying high volume of lasers to them. So they called out like PCB. I think they called out consumer electronics being stronger in Q4, and I don't think that materialized. They didn't have to specifically say they didn't. But some of that PC board and some of their flat panel display applications, they thought would be stronger. So we think they're probably a bit too optimistic given what we were seeing in China.

And the pattern, sometimes with that consumer electronics business, 1 year, it's fairly healthy, another year, it potentially falls off. What's been the pattern or the cadence in the last couple of years in that business for you?

So historically, it was really a biannual investment cycle. The last real strength that we saw in consumer electronics was 2017. So we would have expected '19 to be a strong year, right? And it really wasn't. It was a very weak year in terms of the overall laser volume that was taken into consumer electronics. Some of that may have been driven by total volumes of smartphones being more moderate in terms of growth or even flattish. Some of it may have been delay in some of the consumer investment cycle because there's a major upgrade that's expected now with 5G phones being introduced. So we have to wait and see whether that's going to materialize with a stronger investment cycle this year. And then again, that's something we will not see until -- that will probably even be in the beginning of Q2 before we see whether that's really going to happen or not. I think in general, people are a bit more moderate in their expectations around that. But certainly, the biannual cycle has become a bit more -- less reliable in terms of being able to pick that as being a benefit in certain years.

Let's talk about market share for a moment. Historically, I think you guys have had very good share, I think, even going back to '18, -- 2018, you've talked about market share in the neighborhood of 70%. But we're wondering, I think some of us are wondering, just on the competitive front, has there been much of a share shift? Certainly, at the low end of the market, it appears to have been the case. But I guess there's also this concern that as some of these players in China get potentially more advanced in their technology, could they begin to also move up market? And what's the competitive threat there as we look out over the next couple of years?

So certainly, there is more competition out there. The competition has moved up from like just being pulse lasers to initially medium power and then the lower end of the kilowatt scale. And now potentially getting up to -- I mean people have announced 20-kilowatt lasers. Commercially, some of them are selling 6- and 8-kilowatt lasers, right? Overall, IPG's share is still, if you look at the global market and you look at the entire fiber laser market, about 60%. And even in the cutting market in China, in terms of volume, it's a bit below that, but in terms of dollars, it's at 60% still. If you go back to 2017, we probably had a 70% share of the total market. So there's been some degradation in that. But you also have to put that a little bit in context, right? So some of the areas where we have high share, so for example, in Europe, we have a higher share than we would in China or in Japan, we have potentially a bit of a higher share there. Those markets have been weak. So they're tending to mask a bit or our potential share losses being a bit overstated. In addition to that, in some of the applications where we have strength, so welding was very, very strong in 2017. Consumer was very, very strong in 2017. EVs being more volatile and not even. Whereas the low end of the cutting market in China, where some of the competitors have strength, has actually grown very well even through this downturn. It did -- it surprised me that the unit volumes are still relatively strong. So we would expect to see some improvement potentially in our share as some of those other areas which require more sophisticated lasers, better application capability, a deeper relationship with the end customers to be as important, whereas cutting is a pretty basic application, particularly at the low end, it's become almost a commoditized...

And then I did want to ask that as well, I mean cutting seems like it's a mature market. What is the growth rate in that market mid-single digits, possibly in a good economic environment stronger than that? But the opportunity for you guys is with some of these applications, some of the new feature sets. But I won't say a hit for us on the cutting market, since it's historically been a big part of that materials processing business.

Yes. I mean by and large, I think this shift within the laser applications towards fiber, that secular shift has happened, and we said it was going to get to a point of maturity. So fiber has about 80% of the total cutting market. Interestingly, though, if you start to look at total machine tools and total amount of metal that's processed with things like punches, presses, dyes, shares, waterjet, plasma, the overall share of laser cutting within those applications is, if you first strip away that the total machine tool market, laser share may be for example, in German data, less than 10%, in other data, 17% or 18%. If you start to then look at really what laser could address, because some of those applications we can't do, you start to see laser penetration probably in the range of 25% to 30%. So in a stronger macro environment where you see displacement of those nonlaser technologies, I think that's when you may see the growth rate of the cutting market increase above 10%, maybe into the low double-digit level. Outside of that, the growth in the cutting market is in the single digits, right, and 7%, 8% in a more normal macro environment and potentially below that in a weaker environment is what to expect. So it's very important for IPG to develop the applications outside of cutting and industrial applications.

Right. And we want to hit those in. I want to also talk a little bit about over the -- some of the newer products in terms of the Adjustable Mode Beam lasers, the HPP lasers. And in some cases, I'm not -- and maybe this is the wrong way to look at it. This is not going to be all incremental, but it's clearly differentiating you in the market, right?

Yes.

Is that a way to think about it?

I think the ability to add feature sets around the lasers, so anything that enables you to enhance the beam delivery capability. So it revolves around -- I mean we've been doing process fibers for many years but have particularly developed some of the optical heads for cutting and welding applications, particularly at ultrahigh-power levels, higher-power scanning capability that enables us to compete with some of the companies that were a bit stronger perhaps on the overall welding capability that they had. The acquisition of Laser Depth Dynamics for real-time world monitoring capability. And then the AMB and the HPP capability as well is another refinement of that feature set and capabilities. So HPP improves the speed with which the initial penetration of metal can happen within the cutting process. It means that parts can be nested more closely together on a piece of metal, so it reduces some of the scrap. The AMB, actually, we think, has more capability on improving welding quality, particularly for some of the finer welding and thinner metal welding applications, for example, in battery processes, than necessarily having a particular -- it has some benefit on cutting thicker materials, but we think the AMB actually has more of a welding benefit than that do. But it's all around like the feature sets that you can deliver with the laser, which is very closely incorporated with the application capability that you have. And that really is helping solve -- helping customers solve problems and also developing your competitive strength relative to what other suppliers in the market are able to do.

Right. Okay. Applications are expanding, and I think that also appears to be key to the IPG story going forward, maybe outside some of the nontraditional applications that we normally associate with IPG. Maybe talk a little bit about those applications. And do we think of them in aggregate? Or are there a couple that really stand out?

Yes. I think there are -- I think the nonmetal part of the market, if you look at the laser source, is larger than the traditional industrial applications at the moment. So there's a very large sets of applications outside metal. Within that, you do have to break that market down. So if you looked at microelectronics and microprocessing, in general, that total market is about $1.7 billion. A lot of that, though, is lithographic and flat panel display and needling applications. So if you strip that away, there's about $400 million that's primarily addressed by -- increasingly addressed by ultrafast lasers and continues to have some UV applications that you need to get to a little bit higher power levels than 5- to 10-watt UV. That's probably one of the most exciting application because it's a fast-growing area. It's growing at 10% or more a year. We have got product that is increasingly capable of addressing those applications. One of the issues we've had is getting enough energy out of the ultrafast lasers. So the basic lasers, we've got have been well accepted by the customer in terms of their form factor, robustness, cold start times, overall reliability, electrical efficiency, but we needed to get more energy out of that. And even with our UV pulse lasers that need to get more energy out opens up the applications that we can address. And we're starting to get with the 100 microjoule ultrafast laser. We're starting to be able to get to that capability in new, higher-power UV lasers being reduced. So I'd say that's a very exciting area. Other areas that are starting to gain some traction are the entertainment and display in the cinema, which a lot of people have been very skeptic about. That market is actually fairly large already in terms of the complete systems that are delivered for that. Some of the market data claims, it's as high as $200 million. I'm not sure it's quite that big, but we have ramping demand for our RGB system capability. That's a very -- a market, which is very, very sensitive to reliability, though. We're a little bit cautious at the moment because you're going to have suddenly screens deployed all around the world. You're certainly going to have -- if you have problems with reliability, you're going to have to find a service guy who wants to go work in Kazakhstan or Western China or something like that or just even getting service capability out there. The other area where we're starting to see some increasing traction is on the medical side. So a lot of the work we've done is on the urology applications. The lithotripsy kidney stone removal applications starting to get some traction. It's still very small, but it's starting to grow fairly rapidly. There's a lot of talk around some of the defense applications, where we do the diodes, we do the narrow line amplifiers, and we do the single-mode lasers. Other people in the market are doing the diodes and the narrow-line amps. We're really the only company that can produce high-power single-mode lasers. There's a little bit of -- there's a lot of talk around at the moment, there's a lot of the -- there's sort of lines in the budget that are dedicated to it. There's one application we know with one of our customers that's commercialized. I think it's still a couple of years away from a really meaningful ramp in that application. There's a little bit more talk than there is -- we've got a sort of steady-state $20-odd million a year in revenue, but it hasn't ramped to $50 million or $100 million.

And that was going to be one of the questions. I mean yes, I think every laser and photonics company is talking about directed energy and yes, we're pointing to different line items. It still seems like it's very much an emerging market. It sounds like you have a very credible competitive position. But how long is it going to take before we see who some of the winners are going to be in this market? It sounds like it could be a couple of years at least.

I think it'll be a couple -- I mean you basically got to look at who gets qualified from the defense contractors and supplying the complete system. And then within that, who's supplying the laser source, right? Because they developed the beam delivery and the tracking capability that actually enables the beam to be focused on whatever the threat is out there. And then most of the defense companies are working on some capability in that area, and IPG is also working with them as some of our competitors are as well. But I think it is a couple of years before you really can determine what the total opportunity is going to be, and how quickly it's going to ramp, and we certainly think we're going to be one of the leading companies in that area. I think one of the interesting thing is that the increasing threat for drones may accelerate some of this. And it may also limit the need to get to very, very high-power levels, right? Bringing down a drone is different from bringing down a surface-to-air missile, and you don't necessarily need 100 kilowatts of power. And the real volume in that market may come at single-mode lasers of anywhere from 3 to 20 kilowatts, right? If we can get our 20-kilowatt single-mode laser developed, there's very definitely demand out there for a single-mode laser of that power.

And it does seem like DoD is very concerned about potential threats posed by drones, including the Navy and whatnot.

Now I don't think it's just a military one, I think it's the commercial aerospace threat as well. I mean you've seen airports in the U.K. and even, I mean New York was shut down for a bit with a perceived threat from a drone. So there's commercial applications for it, too.

You touched on medical in the urology application. Is there a way to think about all-in medical? Because you guys really play in medical in a couple of different areas, and you're also involved in medical device.

Yes.

So if we think that the perception is IPG, heavily materials processing, heavily skewed toward cutting. But all-in medical, what's that now? And where could that go?

So from -- I mean it's only at IPG, if you take into -- if you include the medical device systems supplied by ILT, some of the ramping lithotripsy, we've got that aesthetic business that continues to exist. So if you include the systems, it's probably getting to between $40 million and $50 million a year. Within the surgical, there's the lithotripsy, there's also a urology application that we sell into. The total medical market -- this doesn't include the devices, the total market for medical applications outside of the device is actually about $1 billion, most of which is the aesthetic applications. So there's a lot of hair removal, tattoo removals, skin rejuvenation, some ophthalmology applications in there. The challenge that I think the aesthetic market is that, one, it's discretionary spending. Two, there's an awful lot of sales and marketing dollars that go into promoting a lot of those applications. So the one thing we like about the surgical side, which is where we're kind of focused a bit more, is one, we have lasers that are very well suited to the surgical applications. Secondly, it's a bit less of a discretionary spending, if qualified, it becomes more of a discretionary or nondiscretionary opportunity that potentially will ramp and has a bit more leverage around the profitability on it.

Let's take a moment just and look at some of the M&A. And the one I wanted to focus on was Genesis. And more broadly, also talk a little bit about the systems business. Number one, Genesis, is that -- did that -- has it met your expectations since the acquisition? Or was this the case of just some of the macro environment deteriorated and consequently, that's been a tougher business for you?

So I think we have to look at this in terms of where we want to go with Genesis over the next 5 years, and the strategic importance of that acquisition and the capability it brings us in terms of welding systems, the ability to produce very complex, sophisticated, automated systems, right? So the integration of Genesis within the business and starting to leverage that has met our expectations. They've done a lot of work in starting to pull in some of these sort of more organic developments that we've had that were more in the lab rather than being commercialized. And they give us some credibility in being able to commercialize those. In terms of sort of some of the quote data that we talked about, where historically, Genesis was only doing 10% or 15% in terms of laser, our quote log has got about 30% of laser-based activity in it, starting to look at how we really leverage some of the titanium welding and the pipe welding applications. So the credibility from that perspective that Genesis brings to us has been very good. I think the end market has been a little bit challenging this year. So we haven't said where the total business was -- ended up in the year. But I'd say there's been some challenges around the end market, but they've got a very strong pipeline of business that they're working with -- and we will judge the success of that over the next couple of years, I think, it's...

And that fits into this overall systems business, which going back a couple of years, you guys laid out some targets and goals with that, and I think, refresh my memory, it was something like $200 million in 2020. Is that still a target? And obviously, there's...

Did I say that, did I give that number? Or did someone else did that?

And there's also an inorganic piece to that. But maybe in generically, the systems business, talk about it from that standpoint. How important -- how is that focus on the M&A side for you?

I think it's part of the whole philosophy that you've got to work out how you deliver more value with the lasers, right? And we're not trying to get into producing cutting systems or marking systems. We're really looking for high-value applications, whether they be welding or deposition technologies or ablated technologies in cleaning, and Genesis adds tremendously to that. If you took the entire systems business through the first 9 months of the year, it was just over $100 million worth of business. Some of that's nonlaser-based applications. If you look at purely the pure laser side of things, the first half of the year -- or the first 9 months was probably about $45 million. So it's still -- it's starting to become more meaningful, and it's growing at a double-digit rate, but we're still a little bit way off of having a $200 million purely laser-based systems business. But I think you have to look at also in the context of like LDD being incorporated. We've got a lot of significant orders for battery processes that are using the real-time weld monitoring capability. There's a lot of work being done. And then also it's not a complete system. It's the same way that we're adding value around the laser and trying to create more of a competitive moat around the optical capability rather than just having to compete with people around the resonator.

One of the strengths of the company has obviously been what vertical integration has brought to it. The average gross margins, going back a couple of years, 2012 to 2018, 55%. But we've clearly seen margin compression. And I think your longer-term target is 45%, 50% gross margins.

Yes.

So maybe talk a little bit to what's led to this compression. Those are still pretty healthy gross margins versus the industry. But...

Yes. I think there's obviously -- we talked a bit about how pricing -- it impacted things, and I said that was about 200 basis points. If you take 55% is our -- it was slightly above 55% of peak margins. The acquisition of Genesis itself has taken about -- just the consolidation of the systems business, about 200 basis points out of margin. And then the -- in Q -- well, the first 9 months of the year, just the lower level of activity relative to peak revenues in excess of $400 million has reduced the absorption of fixed cost to the degree that they've reduced gross margin by about 275 basis points. And then we've been running some higher inventory provisions this year that have -- the incremental inventory provision is about 100 -- just over 100 basis points. So if you get back to more normal absorption and more normal inventory provisions, you got a pathway to recover close to 400 basis points on that. In order to recover some of the pricing stuff, you kind of want pricing to be more stable and to be able to keep in hand some of your cost reduction benefits and initiatives. If you're having to give up all the gains that you're making on cost reduction because the pricing continues to be, particularly in the industrial, low end of the cutting market, a drag then recovering that 200 basis point becomes more difficult. Some of the things that could help that there would be a recovery in the macro would shift the market back up like ultra-high power in the cutting. Growth of some of the welding applications, for example, incorporating the real-time weld monitoring capability. The new laser sales in Ultrafast and UV. And even the medical has very good margin on it, would all potentially be a mix shift that would be a bit of a benefit to us.

Last question is just on the balance sheet. You guys have a ton of cash on the balance sheet, right, close to $1 billion. In your M&A, while you've been acquisitive, it's been relatively small, relatively modest. So how do we think about capital deployment going forward?

Yes. So I mean just to frame it in terms of -- we've done a number of smaller different transactions, but the total spend has been about $230 million. In fact, I think the amount that we've committed on buybacks exceeds that that's including all the buybacks that we've completed and what's still available, we've got another $300 million, that's $350 million. So the total cash that's been used in those 2 is over $500 million. Capital expenditures, since 2016, about another $500 million; and R&D, about $400 million. The great benefit of the business model that even in a difficult year that we've had in 2019, we still generated a significant amount of cash through the first 9 months of the year. And with our business model, you generally see cash accelerating during the course of the year. So we generated a tremendous amount of cash. And we're still looking for acquisitions. It's been more difficult to find larger acquisitions that really fit technologically and strategically with what we do, but we're on the lookout for them. And I think overall, our communication around our capital allocation strategy and our execution has been reasonable around it. We haven't stood still, and we have deployed some cash there. But we -- the other way to look at it, we stand a very, very strong position that, with the balance sheet that we have. I mean certain people inside are coming together have been obsessed with the balance sheet, and I kind of like it. So anyway, it's a very strong company in that regard.

Questions out there? We've got a couple of minutes. It's the lunch break so...

Have you seen some recent improvements in the price degradation in China?

In the second half last year, in Q3, when the macro environment weakened again, you saw pricing kind of stepped down a bit more in Q3. We haven't given an update on Q4. I think what's critical, though, is to see the macro environment improved and at least stabilized in China. So it started to get to a point where the PMIs have been a bit more positive in China. We'd like to see that strengthen and the overall demand environment of it strengthens it. You saw in the first half of this year, a much better price stability when that demand environment was stronger. In a weaker environment, you've become a bit more uncertain about that.

Do you think it's fairly a macro factor and not -- you have one very aggressive competitor in China who's been hammering prices, but it feels like they might have been pulling back on that, is that...

They've made numerous statements about being more rational around pricing. I think the issue is, is that they're trying to get share in the markets not particularly strong. The only way they can really get share is by continuing to be aggressive around pricing. And that's why you need to have some strength around the underlying macro to offset some of that.

Okay. And I think we will have to end it there.

Okay.

But thank you.

Thank you, everybody.