IPG Photonics Corporation (IPGP) Earnings Call Transcript & Summary

Welcome. I am Jed Dorsheimer, one of the senior analysts at Canaccord Genuity, focused on the sustainability and ESG sectors for the U.S. And as part of that, you've heard so far, for those who have been following us from our focus on the transport sector, we've heard a little bit on the energy sector and also on the manufacturing sector, in terms of making things more efficient. So we're pleased to have with us IPG Photonics. One of the leaders in enabling laser-based systems, fiber lasers actually and really pioneering that from -- in the manufacturing industry to make products cheaper and more efficient. So I've got Tim Mammen, CFO of IPG; and James Hillier, Head of Investor Relations to tell us more.

So Tim, let me turn it to you for a second, if you wouldn't mind, if you just take a minute. Some are new to the story, some have been around the story for a while. And so before we kind of dig into some of those questions, if you wouldn't mind just taking a few minutes to frame out how you see the business at this point in time and what you think is really the most relevant takeaway is you want investors to think about IPG?

Thank you, Jed. Good afternoon, everybody. I think that -- you mentioned one of the things is that we're the sort of pioneers in the fiber laser industry. I think the way that I think about the company is that we've really been a catalyst for changing the market and commercializing laser technology and particularly fiber laser technology to a degree not previously seen. Over the last 15 years or so, main thesis has been that laser technology was too complex to use and too expensive to use. And whilst it had many advantages in terms of processing and performance, those limitations somewhat reduced the deployments of lasers way, way, way within the potential that they could have. So the IPG's mission statement, if you like, has been to improve the ease of use and lower the cost of laser technology. We believe that fiber laser was the most appropriate way to do that. Fiber lasers are an extremely compact monolithic device that are easy to use and integrate with industrial applications and other applications. They have a small form factor. They have significantly better electrical efficiency, as you mentioned. They drive because of the wavelength and the variety of wavelengths they can operate at. Improvements in processes and efficiencies, so productivity. They're very easily integratable within automated manufacturing systems. And all of those have been catalysts for the growth. The other things that I think are really part of the DNA of the company are, we've always been famous for supplying lasers with higher power levels. So we've continued to build on that over the years. I mean the first 100-kilowatt laser we supplied was actually 4 or 5 years ago to a customer in Japan. We supplied now 4 100-kilowatt or 5 100-kilowatt lasers to the market. We've seen the cutting market move up, as Valentin mentioned on our call recently, not just the 10- and 12-kilowatt, 15, 20 and 30 kilowatts. And those lasers, again, drive improvements in productivity. There are many welding applications that use higher power lasers, too. But it's not just there. We've increased the power of our pulsed lasers. Our high-power pulsed lasers segment performed very well in the second quarter, enabling applications, for example, in foil cutting and cleaning within EV battery manufacturing and outside. So the power and the diversity of the product offerings we have and then the ability to take cost out of them is really interesting. So you've got this scientific -- deeply scientific DNA of the company that's coupled with a very commercial bent where we've taken tremendous cost out of all of the optical components, the most well-known of which is obviously the diodes, which you've gone from. If you go back a long time ago, $80 a watt to less than -- significantly less than $1 per watt. More recently, we've released our YLR-U laser that addresses the lower end of the kilowatt scale market at 1 to 3 kilowatt. And we estimate that we're going to be able to take 20% to 25% out of the bill of material cost for that device. Not from the optics, we've taken that cost out of the electromechanical design, simplifying that. So that whole cost structure and that part of the DNA is very important. And then we're also very much a vertically integrated company, where we have a lot of the technologies that are incorporated in our core lasers used in materials processing, but also in our lasers that are being deployed for medical and microprocessing and entertainment, display, instrumentation, many of the -- in fact, all of the key technologies around those developments are internal to the company. So it's really the ability to scale up power, commercialize devices, take the cost down and the diversity of the product offerings we have that, I think, are really key to IPG's strength.

Yes. I've always heard that some of the most positive feedback is your systems understanding and expertise in not just having the most powerful diode, but how to make that diode work more efficiently within the systems. And as I think about the markets and the different value propositions and you have so many different products that are addressing, is looking at it from a power perspective the right way to think about that segmentation and then -- or end application, the right way to think about that. What I'm trying to drive after is just the -- helping investors with the value proposition to your end customers?

It's probably a combination of power and application. And if you look at that, for example, within the cutting application, which uses different types of lasers, both CW high-power lasers at 1 to 3 kilowatts as well as CW lasers now as high as 30 kilowatts. With half of our sales into cutting applications being at 6 kilowatts or more and half below that level, the market of the -- the low end of the power spectrum is very large in terms of unit volumes and has been driven by the reduction in cost of those lasers. And then as you go up the power spectrum, these huge improvements in productivity are a very significant part of the value proposition. At the low end of the market, you're displacing -- and then, actually, even at the high end, you're displacing many other machine tools. You're driving improvements in the speed with which metal can be processed. You're improving the flexibility of a system, so it can cut many different types of materials. And as you got the power scale, cutting different thicknesses, not just different types but different thicknesses of material. So it's the combination of productivity gains, the flexibility. And that's driven by different types of lasers. So you've got the higher power, the lower power. I mentioned, though, in a very fine cutting applications, they're using higher power pulse lasers for foil cutting in EV battery manufacturing. So the application combined with power is an important aspect. Within the welding market, you see the value proposition is driven by, again, different types of lasers. But again, you're focused on the application there. So welding speed, the quality of the welds, which can reduce the number of welds that's required to join a piece of material together. You can join different types of materials with the laser more easily than you can with traditional technologies. So you could join different types of steel or you can join aluminum to copper, that's enabling different materials to be used in applications in transportation and elsewhere. There are numerous examples in welding we can give. Even though welding is an industry, an application that is transitioning towards lasers at a slower rate than we would like, there are very many applications and solutions there where we can point to a significant advantage. We know, for example, the system that we delivered to make a tank within a harvesting process enabled the design of the tank because of the welding was going to be done with a laser on a more continuous basis to be changed and simplified. So the throughput on the harvesting process was actually increased. And the payback for the laser, both in the design process, was very, very short. We have other examples of lasers being incorporated on automotive production lines where they've been welding -- transition to welding roof seams. That has enabled the laser to improve the productivity of the weld, but it's actually enabled the whole manufacturing line to run at a more optimal level. In instances like that, the payback that you get on the laser is considerably less than a year. So often, the laser will enable, within welding applications, the design of a part to be reconfigured and made more simple so that the actual cost of manufacturing goes down or the process that is being used in can be speeded up. In other applications, there are also examples. Like if you go back to the early days in marking applications, you were displacing inks and dyes, for example, and you went to a noncontact, high-speed process where the laser could mark very consistently. In cleaning applications, you're displacing abrasives or plastic media blast or solvents and chemicals that may be used to clean storage tanks or even molds used in manufacturing processes, where the laser actually transitions to, again, a noncontact, very repeatable process. You're seeing lasers used, for example, to remove coating on metal prior to it being joined or welded together. So all of these are areas where you can actually quite clearly, as the cost of the laser technology comes down, identify a very strong value proposition. Even within our new medical application for lithotripsy, which is a process whereby it's called dusting of a kidney stones, you're reducing the kidney stone to very small particles so that it can be passed in -- passed more easily and painlessly. The process of -- the actual ablative process around dusting the kidney stone is 2x faster than the current processes. So that improves the patient's experience in -- the patient's experience is also improved because of the particles that are generated from the process are a lot smaller. So there's a lot less pain felt by it. So you can actually get into some of the esoteric areas where there's even improvements in the speed which a process can be achieved through using this new and -- we use a thulium laser there, which is 2 microns and slightly longer in wavelength than the existing holmium laser applications. I mean I can come out with numerous examples where you can clearly see a value proposition being driven by the laser in that regard.

Well, I guess, just to simplify, and may be using incredibly crude and simplistic example. But if we looked at the industry overnight, shifting to EV from internal combustible engines in a manufacturing perspective, given the fact that you have exposure to both. How does that -- I'm guessing that a lot of what's in traditional is probably on ground, but maybe not. I'm just wondering how that would affect the business. I'm assuming that, that would be a positive, but I guess we just want to understand that a bit more. And that's only one example, right? And you've got numerous in terms -- what you talked about in terms of the medical. But you had mentioned a few times the foil and that in really a different manufacturing methodology around EVs. So I just took that example in terms of that shift?

Overall, a more material and fundamental shift to EV would be actually a significant driver for the laser industry because of the laser content in battery manufacturing. Now there's even differences between the types of batteries. So prismatic battery uses more than pouch, then pouch uses more than cylindrical. But overall, there's a tremendous amount of not just the cutting of the foils, but you've got cutting of the cases as well, which is a more simple process, would use a more standard cutting machine there. But the welding of different contact points, busbars, there's cleaning applications for the electrodes and things like that. The other side of it, though, is that if you think about it, perhaps a bit of on traditional side, then a takeaway would be there's been tremendous development in developing powertrain and transmission, and a lot of that uses lasers in welding as they've gone from 3 speed automatic to 8 speed, and trying to keep the weight and they use different types of alloys and the welding done on the gears is very, very complex. But the rest of an EV vehicle is basically the chassis. So that's tailor-welded blanks, there's a lot of lasers used in that. There'll still be demand for that. The main body welding often is transitioning, say, towards using more aluminum. So historically, that would have been riveted, but that potentially is a driver for lasers. But there are other things like welding of airbag detonators, that's going to be the same, whether it's an EV or a combustion engine. Seat back-welding, where the weld quality is very, very important on seats. That's going to be the same, whether it's a combustion engine or an EV vehicle. So there's -- it's not just the body, and there's very little welding done within the actual engine, right? There's the transmission that has welding in it. But there's also potential use of lasers increasing in the manufacturer of electric motors, which have -- there's work we're doing in that direction to see what kind of applications lasers could be used in on the electric motor side of that, which would be a driver as well to us. Overall, a fundamental shift towards electric vehicle manufacturing would probably be a net benefit. And it would be investment that would be globally driven, not just in China as it were, and it would be driven by even some of the traditional automotive manufacturing companies.

Are you starting to see -- so 2 questions for you. One, all of this sounds like a very technical sale with COVID. I'm just wondering, I mean, with our conference, we're able to kind of keep things running and adapt to Zoom and what the technology allows. But this does sound like a very technical sale, particularly in conversion, where you have somebody that might be on the fence of converting legacy technologies over to laser. So while you've seen in the last quarter the benefit on your OpEx, do you think -- how do you think about how much opportunity cost is being left by the restrictions of travel? Or do you see none at all?

No. There is certainly some impact to that. I think Valentin referenced to this particularly with regard to the rollout of really some of the newer product at ultrafast for microprocessing applications, where there's 50 different projects we're working on. There is a lot of application work and technical work that happens between the company and the customer with regard to that. With some of the more developed applications, like EV sales were very strong in Q2. Welding and cutting is not so much driven by the application development. It's had an impact on more of the leading edge, newer application developments that we have been involved in. And then they certainly were stalled over the last quarter or so. So there is an opportunity cost to it. And we've got our application labs up and running a bit more. There's clearly limitations on visits that can be made. And -- but at least we can start processing things. But undoubtedly, there's an impact on that given the technical nature of some of the newer applications, it's less of an impact on more developed applications and the impact diminishes so long as we can run our application labs, which at the beginning of last quarter we couldn't even do that.

So how should I think -- I guess, I want to just spend -- it's a financial conference, I want to touch on some of the finances for a bit. And just focus on some of the leverage points and how to think about that, Tim. So first, just from a product perspective, how should we be thinking -- you've mentioned the climb on the power curve, how should I think of the balance between continuous engineering on -- versus share that you're going after in terms of -- as it relates to product margins? Yes.

So I think -- the continuous engineering in terms of cost reductions is very important, right? You've been through a severe dislocation in the market in terms of pricing over the last 2 years. That's even been in excess of how we would drive cost down and decrease pricing to drive laser demand. There's -- year-over-year, pricing has been down as much as 30%. Those pricing changes have moderated a bit. So if we really hadn't done the work that we have done over the last 2 weeks and taking -- 2 years, not 2 weeks, taking cost out of diodes, introducing some of the new designs around the YLR-U, where we've changed the electronic -- an electromechanical design of the laser and that's benefiting the 1- to 3-kilowatt. Ultimately, we'll take it out, [ advance it in the quarter ] to 8-kilowatts of power. So it has the opportunity to benefit things. That's always been and continues to be a very, very important part of it. I mean given the changes in pricing, our impact on margin would have been fundamentally greater than it is. We've said that compared to a year ago, really pricing had only reduced margin by a couple of 100 basis points. Most of the impact was really related to absorption of fixed costs. So on the other side of the equation, it's very important to take cost out from an engineering perspective. Apart from -- not just from competitively it's a fundamental part of our thesis about improving adoption of lasers, but the other side, it is also to make sure that your absorption of your fixed manufacturing cost is improved and that can be driven by scale. And then there's sudden element of this, there's a mix benefit in it the more highly value-added product with better specification and features that you sell. So for example, as you go up the power spectrum on high-power lasers, there's a benefit there with a 15 kilowatt. But you'll not be able to price those lasers at a massive premium to a 3-kilowatt laser. But you got a bit of scale relative to a 15-kilowatt laser that sells at 5x the price of a 3-kilowatt laser, even though the ASP per kilowatt may be relatively comparable. But you can also start to add a lot of value around lasers in the newer product offerings. So in welding applications, real-time weld monitoring capability, there's a tremendous amount of technology and value-add with that, that has good margin on it. Some of the newer product has very good margin on it, whether it be UV, green or ultrafast. So as we transition to having more of that product in the market. And we saw a little bit of this in Q2, there was both puts and takes in Q2. We had very, very strong sales in China relative to total sales. So it was very good to see margins strong relative to where they've been on the back of that. But there was also some mix benefit with the higher power pulse lasers for foil cutting and cleaning, the recovery in some of the higher power sales for cutting applications. Some -- a bit better sales of QCW. So mix, absorption of fixed costs and then taking cost out of bill of material is very important. OpEx obviously benefited from some of the lower levels of activity in the quarter, which was good to see. Underlying OpEx, excluding FX, was back to just about 20% -- operating margins rather. And so there's a bit of leverage still if we can get revenue back up to $350 million and OpEx will climb a little bit, but it will come down from being 26% or 27%, maybe down to 22% or 23%. Then if you can grow from there. We've historically exhibited an ability to get into some really accretive growth that operating margins, we can generate some leverage off that as well.

So we have 2 minutes left. Last question, I guess. The move downstream that you've made in terms of some vertical integration. Have those costs -- have those cost benefits been fully recognized but clouded by the lack of scale that we just haven't seen play out? Or do you think that there's still more to go in terms of leverage from the vertical integration?

Yes. The challenge at the moment has been that with the revenue level where it is, you've got volatility in the amount of throughput on the manufacturing side. I think, in general, the manufacturing cost structure has been managed quite well. So the overall impact on that is relatively muted. And the moment, we're kind of looking at it the other way around, you're kind of maybe looking at it from if you see a big strong recovery. Where could peak margins go? And we said that at the moment, we're targeting getting back to the top of 50% range. So you start to see a bit more of a benefit from the price down initiatives not being offset by the cost down. The way I'm kind of looking at it at the moment is that I'm actually pleased to see the way the margins are improving, some of which is on Q2, a bit better absorption compared to the second half of last year, relatively stable from Q1. But if some of the benefit there is coming from the cost reduction initiatives feeding through, although still being masked by the relative scale we're operating at, I think I've answered your question in that way. It's not all visible yet in terms of you're not at an optimal level of revenue, you're not at an optimal level of new product introductions or mix was a lot better in Q2. But there are certain things being masked, just given where revenue is relative to where we'd like to be.

Got it. Listen, guys, thank you so much. I really appreciate the time. Tim, thanks for answering all the questions. Jim, thank you very much. And yes, so I appreciate it.

Thank you, Jed. Good to talk to as well. Thank you.

Thanks, Jed. Bye-bye.