IPG Photonics Corporation (IPGP) Earnings Call Transcript & Summary

Great. Good morning, everyone, and thank you for joining us here today. We're fortunate to have IPG Photonics presenting with us. And with us this morning is Tim Mammen, who's Senior Vice President and CFO of the company. Tim, I was hoping maybe you could just start off with a brief overview of the company for those investors who may or may not be as familiar with the story. And then we'll just jump right into Q&A. So with that, Tim, why don't you go ahead and take it away?

Good. Thank you, John, and good morning, everybody. I will try and keep the overview short, given the short time frame we have for this presentation. So IPG is regarded as being the market leader in fiber laser technology and the preeminent company in the commercialization of fiber lasers. Fiber laser technology historically has really focused on materials processing application with a 1-micron wavelength. IPG is very well-known for producing lasers with much higher powers than everybody else, lasers with much greater degrees of reliability. We have a global footprint and service and support network. Our lasers have a great deal more electrical efficiency than other devices in the market. They're very robust and well suited to industrial and other applications being deployed in the field. The laser technology is extremely easy to use, so it's simplified lasers being able to displace non-laser machine tools and other applications and technologies. Aside from that, I think 2 or 3 other parts of IPG's DNA are that we are a very vertically integrated company. That's both from a technology and manufacturing perspective. So all of the key technologies that we use across a broad variety of different types of lasers we make are made in-house from a -- developed and made in-house. From a manufacturing perspective, we make those components in North America, in Europe and also in Russia and smaller manufacturing operations elsewhere. So as we've developed the technologies, that vertical integration has limited the ability of other companies to develop really competing technologies. It's also enabled IPG, and this is another key part of our DNA, to take tremendous amount of cost out of the devices. That then complements the usability of the laser by bringing the cost of ownership down and making it more compelling as a technology to displace traditional machine tools or other devices used across different applications, indeed, whether it be in emerging areas, in surgical applications, in medical, entertainment and display, advanced applications for directed energy where lasers are used to destroy materials. Microelectronics and microprocessing applications are all growth areas as well that we're pursuing. So I think those are sort of 4 or 5 key characteristics of the company.

I appreciate that, Tim. Maybe starting on the just sort of recent COVID recovery efforts and how things are progressing there. Can you just comment on sort of where you are from a supply chain side? I know that you mentioned that from a manufacturing standpoint, you really didn't miss any time within your own operations. But how is the supply chain set up? Do you feel comfortable in terms of where we are in terms of your capability to meet demand? Or do you think you have to carry maybe some elevated inventory levels here over the intermediate term to protect against some shortages and make sure that you can meet demand?

So I would actually say that IPG is kind of the poster child of where potentially other companies want to go. We've produced and pursued a vertical integration strategy for the better part of a 20-plus years. That means that our supply chain is basically internal. The products that we buy on the open market, our basic raw material inputs including basic semiconductor, the wafers that are used in our semiconductor process but it's the basic raw wafer, some electronic components that we use to build our PC boards and circuit boards, some basic amounts of metal, but really, the rest of what we do is internal. So we were not fundamentally impacted by supply chain issues, except perhaps the ability to actually move product around the world where logistically, given the reduction in air freight availability, you've seen that impacted. And we've had to move some of our inventory from, for example, the U.S. to Germany earlier or U.S. to Russia earlier than we might otherwise have done so. But so our supply chain has really not been that fundamentally affected. We have always carried a relatively high level of inventory, in part because we make a lot of the components internally. So we need to ensure that we have a certain amount -- a certain number of months of supply on hand. But also because historically, we've always wanted to be ready to respond to what has traditionally been an increasing demand environment that's sometimes difficult to predict, and what you want to be able to do is as demand recovers or increases for new product offerings, you want to be able to offer customers short lead times and you want to be able to respond to that demand and create the value that arises out of it. So we haven't really seen -- apart from the logistics, the specific logistics side of it, which is probably abating in terms of its impact a little bit at the moment, well, we've not really been impacted on the supply chain side of things.

Got it. And then maybe shifting a little bit to the demand side. We saw China come back probably a little bit quicker than we were expecting. Just curious, in your mind, as you're looking at that market, do you think that demand recovery in China is really more about China returning back to sort of the normalized demand level that it was at, say, at the end of the calendar year? Or is it an effort to sort of restart the economy and we've run into some risk maybe in the second half of the year as we get to more of a steady state demand that may be lower than this initial surge may indicate? I'm just curious how you're seeing that demand in China start to level out, if you will.

So we haven't given any specific updates as to where demand has been since we had our Q1 earnings announcements, and we generally don't do that. We did make some commentary though about that, that I'll get to in a second. I think there's a couple of things here. First of all, second half last year, overall demand in China was fairly weak. In January, that had started to pick up, so you've seen more aggressive sort of stimulus and fiscal policy from the Chinese government that was driving good order flow in January. Then obviously, February was almost a complete -- well, it was a completely lost month with this very strong rebound in March and April. The Chinese economy is one where the business community is used to it operating in these sort of waves of peaks and troughs of demand. And we've seen that over the last even 5 years or so. So when demand starts to recover, people are not shy about building up inventory and ensuring that they can meet the demand that's being generated from the economy. So we've certainly seen that recovery come back very strongly in March and April. Our view on this when we gave our earnings announcements was that it was probably going to level out at a slightly lower level of demand. And had it continued at the level it was at, it was -- it would have been an extraordinary recovery that it's difficult to envisage it going on for 6, 9 months. So I think the issue is that even if it never gets to a sort of steady state level that we were expecting beforehand, what's more important is actually to see North America and Europe as well recover after a slow April. It's still too early to say what the -- what that recovery will look like in Europe and North America and then see sort of China operating in more at a steady state level. I wouldn't like to see it carry on in the way that it was with China being exceptionally strong and then weakness basically being pervasive in the rest of the world. I think underlying strength in China tends to benefit particularly European export markets and also some of the Japanese market. It benefits the U.S. less so. But -- so we'd expect -- what I'd like to see is a bit more of a normalization, right, with the recovery in North America and Europe. But as I've said, it's too early to say what that recovery will look like there yet because we are 4 weeks to 6 weeks behind where China was dealing with this crisis.

Right. Okay, okay. And then I guess, all else being equal, Tim, as you think out about the longer term, in China, we've seen obviously a tremendous amount of cost pressure at the lower power levels. And you've made an effort, I think, to continue to work up that curve and focus more and more on higher power. When you think about the sort of fiber laser market globally maybe ex China, is that same dynamic playing out? Is it more important to continue to work up the power curve? Or is the programmability and the flexibility that you're now bringing out more important, just as important? I'm just kind of thinking, as you're looking out longer term, what the key factors for continued growth in some of these different markets are geographically?

So in China, it's actually that the market is very large, both at the lower end and their adoption at the high end of the market, so greater than 6 kilowatts has -- and development of those technologies and cutting systems has actually been quite rapid. So in China, you can't negate the sort of 1- to 4-kilowatt part of the market in cutting because the volumes in it are very high. Outside of China, the low end of the market is probably not quite so big. So it's more at levels 4, 6, 8, 10, 12, 15 kilowatts. So the shift to using higher-power lasers in cutting applications has happened both in China as well as the rest of the world. The lower end of the market though in terms of volumes is also very important in China. And they tend to use a more basic rack-mounted laser at the low end of the market. And at the low end of the market is where the competitors in China have some volume applications. I'd say that if we talk about power and volume, first of all, there's 2 things. First, as the cost of the laser has come down over the last couple of years, it has shown just how much elasticity of demand there is for lasers to displace non-laser technologies. If we look back on it though, I think that the way the competitive dynamics have played out and the behaviors of some of the Chinese competitors there, it's been somewhat of a Pyrrhic victory for them because the market in total dollar value has been relatively stagnant even as these volumes have grown very rapidly. And if pricing had been a little bit more disciplined, you may have given up a little bit on volume but you would have gained a huge amount of value, and that's something that we realized in the second half of last year is that the end game of just pursuing price down on that competitive basis is not a good one. So the other thing that's important to understand as well is that from a cost perspective, the Chinese competitors are a bit more of a limitation in where they can go on pricing, we believe, absent continued subsidies or government support that they get because their margins are already severely impacted and would be impacted further. Coming back to the power and tunability question, I think it's not just power. I think power is probably the more important aspect of this in total, regardless of where you are, whether it be in China or outside of China. But coupled with power, it's actually the reliability, usability, electrical efficiency, beam quality of the laser that's also very, very important. So our ability to deliver the beam through a 50-micron fiber instead of 100- or 200-micron fiber, our ability to have lasers with 50% electrical efficiency and -- as compared to 25% are very important. The tunability is also not a geographic thing. The tunability comes down to an application and process capability. And the tunability, we think, is less important, particularly the beam, the change -- the ability to change the beam is less important for cutting applications because cutting is primarily -- if you want to cut thicker materials, you drive higher power levels. Cut quality with a laser for the thicknesses of metal that laser is primarily used on is already very good. So that ability to change the beam profile and characteristics doesn't fundamentally add a lot of value. Where the ability to change the beam profile does add value is actually on some of the more advanced applications. For example, our more specialized welding of alloys, in particular, things like aluminum or other alloys, where there's a reduction in spatter and the weld quality is fundamentally improved. And that's very important in things like battery manufacturing or emerging areas where they're trying to reduce the weight or improve -- or just use different types of materials to drive efficiency. The other aspect of tunability is something that's already been fairly widely available in the industry, whether it's within the laser or outside the laser using beam deliveries. So it's nothing really particularly new and is more application-specific, I'd say. But it also has to be delivered in conjunction, for example, with IPG's weld monitoring capability where we can actually determine the quality of the weld on the fly. So as you combine the tunability with the quality of the laser with other aspects of processing such as weld monitoring, you actually deliver a very complete value proposition there.

Got it. And then maybe as a follow-on to that, Tim, as I think about the efforts that you've recently made and to push a little bit more into the systems market, how should we think about that over the longer term in terms of the opportunity set that you're really going after or the applications that it addresses? And what that may mean for margins over the longer term as we get back up to maybe more normalized volume levels for the company?

So the strategy around the system side of things has been really to develop laser technologies for core areas that are not well served by the existing OEM base. So these are things like welding applications, deposition technologies at higher power levels, not so much on additive manufacturing and ablative processes where the laser is easily integratable, for example, with a robot on a production line or for use remotely in a field deployment situation as in pipe welding applications, or you may use it for cleaning storage containers, production molds within -- using an ablative process there. So as to -- in the other area we've made investments is also on micro processing applications -- oh no, sorry, fine processing applications in medical device manufacturing, so you've got more specialized welding or cutting capability for producing things like pacemakers or cutting stents. And so you're looking at areas where the laser can be combined with automation, multi-access movement, positioning and sensing technologies to produce high-quality or displace existing non-laser technologies. In some instances, the payback on the laser is extremely short, and the price point that you can achieve on the system is quite high and the margins are quite high. In other instances, you're competing against non-laser technologies where you may have to price a bit more aggressively and the margins where it may be lower. But in some of those applications, particularly at the higher end, the margins can be very reasonable and quite strong, approaching 50%, in other applications maybe more in the 35% to 40%. In terms of the overall impact on margins, systems would have to become a huge part of revenue to be very detrimental in a recovery because we're also looking for the recovery to come from selling significantly higher volumes of higher power lasers, selling lasers outside of systems into some of those other materials processing applications, growing the advanced applications where you're using single-mode lasers and even selling 30-, 50- and 100-kilowatt lasers, growing the medical business, growing microprocessing applications using shorter wavelength, green, UV and ultrafast lasers. And if the growth comes from a mix rather than a particular concentration in those areas, you recover absorption of fixed manufacturing costs as you grow that scale, and you get significant margin benefits from selling higher-power lasers, more specialized lasers that would also, with a very strong growth in the systems business, then the gross margin recovery would be perhaps a little bit moderated by that strong growth in the systems business. So it's not an all-or-one strategy. There is very much a multi-pronged diverse growth strategy that the company is pursuing over multiple different applications. Where there will be, to an extent, a variation in the total gross margin that's achievable, but many of those applications have a strong gross margin profile.

Got it. And then maybe just following up on that a little bit, Tim. Are we really just at a volume situation here relative to returning margins to more normalized level? I mean is there anything that is, say, structurally changed or that's different for you moving forward? Or as we get revenue climbing back up to more normalized ranges, we should see that gross margin return back to those sort of more normalized averages?

So there are a couple of structural changes, I think, in the model compared to where we were on peak margins. First of all, if you look compared to the middle of 2018, pricing has probably cumulatively affected margins by 250 basis points. In addition to that, the acquisition of some of the systems businesses has also reduced margins by another couple of 100 basis points. So really structurally, that would equate to sort of approximately a 50%, 51% peak margin if you've got a recovery in scale absorption and manufacturing cost. Lower inventory provisions. Lower inventory provisions in the last couple of quarters, I wouldn't call them a structural shift but they have been elevated, given where the demand environment is. And you want to see those drop back to being 1% to 1.5% of revenue instead of running at more than 3% of revenue as they have been. But fundamentally, it's a question of recovering absorption, the lower gross margins. And then how do you recover maybe some of the 250 basis points that relates to pricing, and that would come from some of the cost down, continued cost-down initiatives, being able to achieve those without seeing them eaten away by further price degradation and then starting to see growth come back from some of the higher-margin product at high-power levels, advanced and the other areas that I talked about. So it is -- there's a couple of structural things. I think the results in the first quarter and the implied margin guidance for Q2 gave people some comfort that with a recovery in revenue, our margins would start to be more accretive to the business and start to show some leverage where we have been more impacted negatively for the last 18 months or so.

Right, okay. And then as I think about investment going forward, what areas, whether it's market or whether it's continuing on the high-power side, how do we think about sort of the focus for investment for the company over the next 12, 24 months? And as we think about where you see the biggest opportunities for growth?

So I think continued investments and focus on R&D dollars going into these emerging markets with shorter wavelength or shorter pulse duration lasers, even continuing to invest actually in some of the longer -- so everyone talks about shorter wavelength. There's also significant opportunities in longer wavelength applications. So for example, the medical uses a 2-micron laser. There's actually some microprocessing applications that are starting to be evaluated with 2-micron lasers. We have a group that produces very specialized devices that are starting to get some revenue at 2 to 20 microns. So these are potential spectroscopy and sensing and analytic-type applications there. We have an ongoing significant investment on the telecom side to develop the high-speed data transmission, DSP capability and ASIC chip capability that we hope will start to differentiate and enable us to grow the telecom revenue significantly faster. You then have some of the advanced applications. We don't need a lot of investment in them, but sort of developing -- continue to increase the power of our single-mode lasers would be a huge benefit to us in terms of potential revenue growth. Outside of that, investment in the sales and marketing function, we have built a very significant global footprint. So we do find ourselves, more probably from a service rather than a sales perspective, having to incorporate subsidiaries in different countries but we try and do that on a more limited basis. There's not a huge amount of investment that's required there. Headcount additions, though, as you ramp some of the newer applications would require some moderate investment, again not a significant amount. We've already invested in salespeople who are focused on the medical, microelectronics, microprocessing. As you build scale in those, you'd want to add headcount incrementally. And then we have some CapEx expansion going on related to capacity to build some of the new products, in particular, adding some capacity around diode manufacturing and then a couple of other new buildings in different locations. So CapEx, I think, as a percentage of revenue will come down a little bit relative to where it has been. I think the bottom line though is that if you see revenues recover from where they were in Q1, you see margins sustain. You'll see our discipline around working capital has been a bit better. So operating cash flow is strong. The amount of free cash flow generation, given potentially a slightly lower level of CapEx, will remain strong as well. So you have a profitable business that continues to generate significant amount of cash. And we're investing already adequate amounts of dollars in those different areas. It's more a question of getting execution and product delivered to the market and starting to grow them a bit more quickly.

Got it. And I guess along those lines, we talked about position growing them a bit more quickly. When you think out over the next, let's call it, 3 years, a little bit of a longer-term time frame, is the larger opportunity, penetrating new markets or displacing non-laser technologies with fiber lasers? Or is it sort of the continuation of moving up the power curve or really targeting and getting deeper into the markets that you already serve?

It's a combination of the two, and I think moving up the power curve, developing more of the materials processing applications outside of cutting to higher volumes is very important. So the welding, deposition, ablative technologies, ablation outside of marking and engraving, those are very important growth drivers. The cutting market continuing to displace non-laser separation technologies where there's still very significant growth opportunities, displacing punches, presses, dyes, plasma and other separation mechanical source, other separation technologies represent very significant opportunities. Those, as I say, happen both at the higher power level and the lower power level. But absolutely fundamental to the growth of the company is also the strong growth of the newer application and devices that address microprocessing, microelectronics, medical, advanced research and development, entertainment and display applications as well because those markets are, in total, they're actually significantly larger than the source market for materials processing applications. If you look at the areas where we'd fundamentally be focused, so you exclude some of the -- exclude all of the lithographic applications and some of the more specialized areas in annealing applications, we would view the subset of those applications that we can address to be, at this point in time, slightly smaller than the materials processing, but as we develop lasers with higher energy and higher power, getting up to be the equivalent of the materials processing market. So that over time -- and we're talking -- it takes time, it took us 5-plus years to really gain traction in the metal processing market. But having a business that is more reflective of materials processing being, say, 50% or 60% of the business and these other applications being 40-plus percent of them, and that's been a stated strategic objective that Valentin has set out.

And I guess along those lines, do you anticipate continuing to look for M&A opportunities as a way to accelerate the move into some of those markets? Or is it much more an internal development process at this point?

I'd say on the M&A side, the real success we've had has been making more specialized specific acquisitions where you bring in-house a technology, whether it be on backward integration or forward integration. So on backward integration, some of the component technologies around Bragg gratings; on forward integration, some of the systems groups where we acquired a company that had a specialized capability in medical device manufacturing. Someone else we acquired that was a specialist on weld and I wouldn't just characterize it as weld monitoring, it has capability in lazy-use monitoring in terms of processing capability or the welding capability that was acquired with Genesis. So it's really got to look at the technologies that are incorporated there. The greatest return we get to if it can be achieved without -- and sometimes these are core fundamental technologies that you want to bring in-house. The greatest return is nearly always on internally developed technologies that are successful just because of the total amount of dollars that you're deploying relative to the revenue and profit growth that you ultimately achieve, even if it takes a bit longer, is much bigger. So you're looking for something that complements that internal development rather than necessarily layers in a completely new business.

Understood. Understood. Well, unfortunately, that's all the time we have this morning. Tim, I thank you very much for the time and wish you all the best of luck as you continue to navigate what has been a very challenging market here.

Thank you, John, and it's a pleasure to talk to everybody today.

Thanks very much.

Thank you. Bye.