IPG Photonics Corporation (IPGP) Earnings Call Transcript & Summary

All right. Good morning, everyone. Thanks again for coming. We're delighted, as I was kind of giving a pre intro to IPG Photonics here, to do a fireside chat format. Delighted to have the company's Chief Financial Officer, Tim Mammen, here to talk about the story and go through some of the questions I have. We will open it up for audience questions at the end here.

Tim, I really wanted to just level set the story for the audience here and maybe have you give us a brief history of the company, talk about some quick reference points for how people should view the laser industry or the machine tool industry and really what IPG lasers are used for.

Sure, Brian. Thank you, everybody, for attending. I said to Jim I can probably spend the whole half hour on that question, but I'll try not to. So just really to summarize it and try and do it concisely. IPG is really credited with revolutionizing the laser industry with the development of fiber laser technology at higher and higher power levels over the last 2 decades. The company is renowned for being very vertically integrated. So we produce all of our core and key optical components internally from our semiconductor diodes; packaging the diodes together and all of the very high-quality fiber glasses that are used to take the light out of the diodes, transmitted into the glass, converted into a very, very high-quality beam; and then combining all of these technologies together. The company is pretty unique in that there's a tremendous amount of technology in every single one of those components as well as the way that they combine together. There's a lot of technology that's also been added around not just the laser but the ability to deliver the light to the workstation and the path that's being processed. So we're producing more and more of the accessories in-house, cutting heads, welding heads, high-speed scanners; and then also adding more technology around, for example, real-time weld monitoring capability. So this is all enhancing the ability of the laser to perform more efficiently in different applications and processes. Outside of all these technology capabilities, I think the other thing the company really has as part of its DNA is this ability to reduce the costs of the technologies over time. I mean everybody looks at the diode costs. And over the time that I've been with IPG, we've taken out 99% of the costs on the diodes and that's enabled the costs of the lasers to come down. So a fundamental philosophy that Valentin has is that laser technology always had these significant productivity improvements and advantages, but it was always too expensive compared to non-laser technologies. And as the costs of the lasers come down, we've started to see an increasing ability to displace non-laser applications.

That's very helpful. Maybe if we just give folks too a little bit of a flavor for some of the end markets you serve, geographical mix and really this broad range of products you have across the fiber spectrum.

So I think, primarily, if you look at the applications that we sell into, the growth of the company has primarily come from serving metal processing, industrial applications that include cutting, welding, deposition technologies such as additive and cladding, marking applications across many, many different industries. So anyway, you can think the metal is processed, whether it be automotive, aerospace, white goods, furniture, light fixtures, elevator manufacturing, anywhere where metal is joined in different industries. These are all markets that we serve. So there's a tremendous amount of diversity in that. It's a bit difficult to get down to a granular level on like what the actual demand is and market is within automotive or consumer electronics or specific industries because we just don't have insight into that because, one, we're one step removed from it. It's also the industry is always very much focused on looking at like what the size of an application is. So all of the market research that you find out there looks at what's the size of the cutting market, what's the size of the welding market. So it's potentially better to talk about that. So total industrial applications are slightly over $3 billion. Cutting applications is about $1.5 billion, welding about $400 million, marking about $800 million. Other fine processing applications are about $700 million of that. So fine processing will incorporate lower-power cutting, marking, additive application processes. Outside of industrial, which has been our main growth driver, there is other nonmetal applications that in total are about between $5 billion and $6 billion. So nonmetal is a huge market that covers things like medical, which is over $1 billion; microelectronics, which is $1.6 billion, $1.7 billion. Some of those applications are lithographic and annealing, where we're not strong and don't really play at the moment, but there's a part of that market that uses UV and ultrafast lasers that we're trying to get into. The other part of that market is almost $2.2 billion. $0.5 billion of that is entertainment and display, where we're starting to sell our RGB lasers. There's a lot of applications in instrumentation, sensing. Defense is an area where IPG clearly has a very strong position given the power of the devices that we can supply. So the basic message is we're -- a lot of the success has come from industrial. Our other applications are only 5% of total sales. But as we develop new lasers for those -- they're not even emerging applications. They're just -- they're markets that use different wavelength or laser with different pulsed durations where we were not particularly strong. 1 micron is very good for metal processing. It's not so widely used on nonmetals. That represents a very significant opportunity for future growth of the company by developing and enhancing our capability in those areas. And we are starting to get more meaningful traction in those areas. It's taken time, but the execution over the last year was substantially improved, I think. And we're well positioned coming into this year to start to grow them more meaningfully.

And I definitely got the sense of that as I've visited some trade shows over the past several months. Let's maybe dig into a couple of topics that I get a lot of questions on. And one of those is on the competitive front. Can you maybe talk a little bit about the competitors maybe by products, by geography; and really how you see that developing over time; and how you might measure the competitive intensity kind of that you've seen over the last few months versus what you may have seen 3 years ago, 1 year ago and really on a historic basis?

So I mean, competitively, the most intense competition is within China from a couple of the companies there. Outside of China, on the more global scale, the industrial competition for welding applications is probably most intense from one of the largest German laser manufacturers. Some of the other suppliers in the U.S., for example, really haven't made meaningful progress on the industrial application sets. They even, sort of to a certain extent, seem to be pivoting away from the industrial and starting to focus on some of the other areas like in defense or selling some of the diodes. So that seems to indicate to us that they're just not -- I mean the financial numbers also show that they're not executing so well in those areas. I'd say that globally some of the Chinese competitors had tried to sell more meaningful numbers of lasers in Europe, for example; even marking lasers, for example, in the U.S.; or trying to get into Turkey. I think, what's happened in the last month or so around the coronavirus thing, I think it may lead people to really evaluate whether they want to rely on a key technology being supplied out of China, and that may be one of the benefits to IPG with people coming back to us. Or they haven't started to do so yet, but there may be a bit of an advantage to us. Most of the competition tends to be at lower power. So within each product category, there's a higher power and a lower power level, whether it be a pulsed laser, a kilowatt-scale laser. QCW really doesn't have any competition because that's driven by the uniqueness of the diodes we supply. So within kilowatt-scale lasers, most of the competition is in below 6 kilowatt, primarily in 1 to 3. Some of the competitors, though, have announced and are selling products at significantly higher power levels than that, 6 to 10 kilowatts. What we are seeing, though, is that as you get into higher power levels and even at 3 kilowatt, the important sort of things like the quality of the glass that you supply are fundamental to retaining the power stability of the lasers. So we have started to go in and demonstrate to customers that have bought these higher-power lasers in China that even after a couple of hundred hours use, they're seeing meaningful degradation in power output from these devices, sometimes in the 10% to 15% range. And over a few hundred hours of power output, that is pretty fundamental, all right? You buy a 10-kilowatt laser. It's running at 8.5 kilowatts. Now there's some part of the market that just doesn't care, right? They bought a laser that -- 8 kilowatts and 10 kilowatts, they probably do care. But if they bought a 3- or 2-kilowatt laser and there's a 10% to 15% power degradation, they just -- they don't care about it. And if in 2 years it's running at 500 watts, they're just scrapping the laser and buying a new one. And so there is a bit of bifurcation there. Even within the pulsed market it's interesting. There are tens of thousands of lower-power pulsed lasers sold where we don't really -- we will not sell and compete in that market just because there's no point of putting the effort into doing so. The pricing [ is so important ]. But we still have -- 40% to 45% of our pulsed lasers are at that lower power level, where we'll supply the higher-quality device at a higher price point to customers that want the quality. But there's also 50-plus percent of our pulsed laser sales that are significantly higher power level where the margins are very, very good. So these emerging applications, for example, in cleaning, deeper engraving applications where they need higher power levels and some more specialist applications where people are using pulsed lasers with hundreds of watts and even kilowatts of average power and getting very, very high peak powers out of that. So that's where most of the competition is on a product line and geographic basis. In terms of like the tone of the competition, I think, the last 6 months, the competition has been pretty fierce. And sometimes people, I think, get the impression that we're dismissive of it. We're not. We're very cognizant that it's here to stay and -- but we're also -- like, we're going to continue advancing our product by producing higher power levels product with improved specifications, differentiation on features, whether it be high peak power or AMB, adding processing capability around the lasers that I talked about earlier on, like the accessories, the weld monitoring capability. I'd say, in the last 6 months, those have been more characterized by macro rather than the competitive dynamics so much. But compared to 3 years ago when competition was much more low-power pulsed and 500- and 700-watt lasers and 6 or 7 years ago when it was just low-power pulsed, the competitive dynamics have changed. But that's the nature of technology as well, right? I mean you don't retain necessarily the absolute leadership by just continuing to produce one type of device. You need to constantly enhance and evolve in that manner.

You mentioned the macro and that's kind of the direction I wanted to take this next. Can you maybe talk to us a little bit about how China has progressed? Certainly, it was a peak kind of year in 2017. 2018 and '19 had their challenges. And it felt like we were starting to see a little bit of resumption in demand back in December, January. And certainly, coronavirus seemed to halt any type of momentum that there might have been. Can you maybe just talk about how you're feeling about the macro, maybe how you're thinking about the rhythm of this year given where we're coming out in -- with a bunch of these both macro events and events that really clearly weren't predictable?

Sure. I think the last 18 months has been characterized by volatility, right? The positive outsized growth we saw in '17 really continued into the first half of '18. And then when the trade war started to ramp up, that kind of like collapsed in June. And you had that very difficult 6-month period at the end of '18, where for the first time pricing pressure started to exacerbate in China in the cost of lasers. Selling prices came down as Raycus tried to gain share more meaningfully in the market. Then you saw some rebound and recovery in demand in the beginning of last year, and we started to see that in an improving revenue environment into Q2. So last year was really starting to improve quite nicely. And then that also hit a wall in June. And you've seen the -- yes, the macro environment also deteriorated. It wasn't just the trade war, all right? It became more uncertain. Towards the end of last year, albeit off a weak revenue guide in Q4, we came in at the top end of that range. We also saw bookings of -- book-to-bill of 1. So there was certainly some indication that things were starting to improve again. Some of the PMIs in China were slightly above 50. The underlying macro in Europe were starting to look a bit more -- a bit better. Order flow in January was very strong in China. It was also stable in Europe, in fact, if not improving a bit. The U.S. performed well at the end of last year. And then now you're just into a completely uncertain position, right? You're kind of guessing what's happened. I mean it's China has basically been shut down for a 4-week period. And we tried to keep within our guidance, obviously. It wasn't just a guess. There was some -- there was actually some thought that went in to try to work out what revenue was going to be in China, sort of feedback from our general managers and salespeople on the ground there. But to tell you the honest truth, we won't know whether we're right or wrong on that until we know whether we're right or wrong on that. I mean it's that kind of a situation. I mean there's a general sense that people want to get back to economic activity in China, right? There's the sort of dynamism and entrepreneurial spirit that exists there. I think people have been clearly suffering tremendous -- when you shut down an economy of that size for 4 weeks, there's economic losses. Employees are still being paid. And people want to start getting back to trying to make some money. I think there are things you've got to watch out for, though, really. What's -- how stressed is the underlying financial situation? I think there's been no collection of receivables in February. There is certainly some indication that demand is coming back, like our guys are expecting some revenue out of China in March, which is good because we have some of that in the guidance. So in the sense that there's a bit more of a -- not normalization, but things are starting to get back to normal. Our offices are more fully functioning at this point in time, except for people who are definitively quarantined. Like all of our offices are open right now. So it's getting more normal.

Okay. Yes. I think it's people are still trying to figure out exactly what all this means and how it's going to shape out, shape up. So that's certainly helpful commentary. I know, some of the vertical markets, you don't have -- you're one layer removed from them, but how is your general perception of maybe a little bit of improvement in the consumer electronics cycle for you, also maybe the automotive space and maybe even some subsegments of that like EV battery welding which has kind of been up and down at different points in their cycle and subsidy driven in many cases? How do you feel about those markets?

I think, first of all, where we stood, some of the global macro and the PMI indicators were starting to show some improvement in general demand. I think on the traditional automotive the numbers even before this hits in China were not strong, right? They were pretty weak. European automotive also is weak. I think the other thing that European automotive is dealing with is this struggle to transition from the traditional combustion engine to these mandated manufacturing and output requirements that have got to be ramped up very quickly. And that's kind of people are just struggling to understand how much capital they've got to deploy in order to transition to more of an electric vehicle capacity capability. And certainly, for us, the EV was expected this year to be strong. It had been fairly strong towards the end of last year. That is, if really this transition is going to happen, it's a decade-long investment cycle that should [ drive ] very significant demand for lasers on an annual basis. Turning to consumer electronics. There's a lot of talk about 5G being a driver this year for investment. On some of the smartphone manufacturing processes, we're not actually expecting this year to be like '17 in terms of very, very strong QCW demand for welding lasers. There may be some demand there, but we're hearing that lasers are being repurposed and used for a longer period of time. I think the total demand for handset is more muted, so people have been cautious about that. There are parts of it that will necessarily benefit, I think, from 5G, right, chip manufacturers. There's a fundamental change there and some of the displays. People are starting to say there's some pickup in investment there. But on the basic metal processing applications like cutting, welding and marking, we're not expecting a huge -- I shouldn't even use the word huge. We're not expecting a material improvement in that investment cycle for consumer electronics. Some of the other areas where we're starting to emerge in -- additives started to come back a little bit in Europe, but it's not rebounded very strongly. I think there are still challenges on additive where they need to improve the repeatability of the processes so that it could really go into high-volume manufacturing and there's still a bit of a struggle not just with speed but really repeating the making of a part so that it's exact in the same way that you can achieve with machining and costing. So I'd say that application has probably lagged a bit behind expectations. Our medical business is starting to get some significant traction in it. U.S. automotive has kind of been okay, not too bad. I think the acquisition of Laser Depth Dynamics is helping there. We've got several strategic initiatives where, for example, I can see back welding. We're doing a lot of work on deploying the laser with the weld monitoring capability as well.

Great. I want to transition maybe to we've talked a lot about the demand side of the ledger. Maybe move over to profits. Clearly, a vertically integrated model is going to be sensitive to the volumes from both an up and down perspective. Can you maybe talk through some of the headwinds to gross margins over the last 18 months as those volumes have come in a little bit and as mix has shifted and then how we might see a path to pushing those margins higher over the next couple of years?

So absorption of fixed costs at the revenue levels we're currently at and even in the fourth quarter have reduced gross margins by 500 or 600 basis points. Relative to our revised guidance range even, we're below that level because that was expecting to be more above $300 million consistently. The acquisition of Genesis and some of the systems businesses have reduced gross margins by about 200 basis points. So that's more of a structural shift that's not really recoverable. And then pricing and FX, given where it is, has impacted gross margins by about 300 basis points. So the other way to think about it is turning it around. If we can get back to $350 million in revenue, we'd be very comfortable at this point to being in the midpoint of our 45% to 50% range. If we get revenues back closer to $400 million, everything we run on the model shows us getting back to 50%, which would be the equivalent of about 52% ex Genesis. So the model has changed a bit, but if we can get the volume and throughput and demand to come back, we're relatively comfortable that we're going to have a very strong business model to be able to report on. I think that $400 million operating expenses are still going to be running at 20%, 21%. So underlying operating margins coming back towards 30% but still below the 36%, 37% when we were at peak when we were really leveraging the model. And I mean there's continued divestments in different areas that are required still.

Okay. I think this is going to be the last one for me. But your model has amassed a lot of cash on the balance sheet. Should we -- how do we think about capital deployment? You're a really good free cash flow generator as well, particularly as things slow down and you're not growing the top line as quickly. How do we just think about the combination of those things and maybe M&A or buybacks and really just the arsenal of tools at your disposal?

So yes, we do have a lot of dry powder available at the moment. I think it was pleasing to see that, exiting last year, operating cash flow accelerated some -- we actually generated some cash out of inventory. We didn't see in a poor macro environment material issues with accounts receivables. So we generated about $330 million of operating cash flow by the end of last year and free cash flow of $200 million. So the great thing about the model is even in these difficult environments there is a lot of cash generated from it. I'd say our capital allocation policy has certainly matured and evolved over the last 3 years or so. We've made 4 or 5 acquisitions, where we've deployed almost $300 million of cash. So we've tended to look for things where there's either a technology add, a core competency. So Genesis [ is around ] the systems side but has a lot of core competencies on welding. Laser Depth Dynamics adds a lot on welding processing capability. OptiGrate adds really core glass fundamental technology around compressing pulses so that it enables the ultrafast lasers. ILT enabled us to get into being more fundamentally tied to the medical device manufacturing applications and ILT started to get some real traction on revenue in last year. It's taken a couple of years to get there, but it started to get much more meaningful as we've started to sell their product more globally and have leveraged some of our capability there. I'd say we struggle a little bit with finding meaningful and larger acquisitions at this time that culturally fit, where we see there's a real technology enhancement, but we're also starting to address that $5-plus billion market where there's a lot of different niches and applications that potentially, when we start to get some traction out of the sales of lasers, may be areas where we should be a bit more aggressive around acquisitions, so whether it be in medical or microprocessing, microelectronics applications, instrumentation. So we're also very patient around that, but we're also inherently fairly -- we're not here to financially engineer the balance sheet either. We want to have that stability. I think things like this coronavirus show you that there's -- there are things that can happen in the global economy that can be very disruptive. And the strength of our balance sheet is something that's very important to us. Clearly, you need to deploy some of that cash. It's we're not just trying to build it to sort of exorbitant levels. It has to get a return on it at some point in time, but you have to also be patient about finding out where to deploy. And then we have done some buybacks, right? So -- and part of the buybacks have been [ actually ] dilutive. Some of them [ were even ] a bit more aggressive [ with that ]. So the total buybacks that have been executed approached $260 million or $270 million. There's another $80 million that's approved, so there's $350 million. By this next -- by the time this next buyback is done, it will have been used for that as well. But even with that, cash has continued to grow.

Right. Absolutely. That's great. That's all the time we have for this. We are going to adjourn to the breakout session down in Cordova 4. It's down the stairs, in Cordova 4. And Tim and Jim will be available to answer further questions. Thanks so much, Tim.

Thank you, Brian.