IPG Photonics Corporation (IPGP) Earnings Call Transcript & Summary

All right. I think we're live now. So good morning, everyone. This is Paretosh, I'm an analyst here at Berenberg. We're pleased to welcome IPG today at our conference. From the company, we have Dr. Eugene Scherbakov, who's the Chief Executive Officer; Tim Mammen, who's the Chief Financial Officer; and Eugene Fedotoff, who's the Director of Investor Relations. Gentlemen, thank you very much for your time today. And perhaps I'll turn the call over to Eugene and Tim for maybe just a quick 3-, 4-minute introduction to IPGP.

Okay. I was asked to present some introduction about IPG [indiscernible] 25 years experience and companies who exist more than 25 years [indiscernible] to a company which now has more than 6,000 -- 6,500 people total worldwide [indiscernible] countries like United States and Germany, in Europe and also in Russia. We participated in many different applications [indiscernible]. But first of all, IPG produced the best lasers in the world. [indiscernible] high-performance fiber lasers from IPG is the same [indiscernible] quality as produced by IPG. It's absolutely a world record. And now we have participated in many different applications, first of all, applications in different countries, [indiscernible] applications, EV applications and many, many others. And we passed [indiscernible] for small power amplifiers for telecom. Then we introduced a new technology [indiscernible] laser diode production. And now we have produced millions of chips -- laser chips every year. [indiscernible] laser diodes from outside of company. And company demonstrated a very good results. I mean [indiscernible] gross margin, net profit. And our evaluation about $9 billion today. And we will see a really good perspective for our company in the near several years without any problem. Because first of all, we are producers of best laser. We are growing much faster than all other competitors. And we are much faster [indiscernible] new products or new applications. And this is our main advantage. We have a very strong research and development team, and we also have a very well-organized and very disciplined production in different countries. I think this is our main advantages. And this is a very good opportunity for our company, for our business during this next 5, 10 years.

This is very good. So Dr. Scherbakov, you have been now the CEO for 5, 6 months. We all heard about the passing away of Dr. Gapontsev, and he will be missed by everybody who's followed the company. But now as you look ahead, what are the main strategic priorities for you over the next 2, 3 years?

My strategic priorities is the same, which we discussed with Dr. Gapontsev [indiscernible] produce the best product, to satisfy our customers' business such kind of products and to create innovative business and to run much more faster and produce much better product with better service for our customers.

Maybe just talk about the recent results, Q3 results. They came better than at least consensus expectation. And it looks like even though you've continued to face weakness and some products in China cutting applications to be more precise, but you were able to offset that because of stronger performance other parts of the portfolio. Is that kind of the big takeaway of this Q3 results? Or any other thing that you think worth highlighting to investors as you -- what you learned or what you wanted to show with this last set of results?

First of all, this [indiscernible] maximum 6 kilowatt, but for lower end application, lower end customers [indiscernible] We're talking about China and also special application cutting. But you'll see, it was our other products. [indiscernible] also in China. You will see outside China. And outside China, we have much more stronger position. Approximately, our estimation [indiscernible] about 80% of all fiber laser activity is IPG outside the China. On this point of view, again, IPG demonstrates a very strong position for many, many applications.

I would like to make a couple of additional comments there. I think to reinforce the strategy that Dr. Scherbakov is carrying on, but is reinforcing to people internally. First of all, I think Q3, [indiscernible] the trajection, just directionally want to see the overall business going, right? China was a bit weaker, but still performed well. The applications in China were diverse. There's very strong growth from emerging products and applications globally, which are about 30% of total revenue. China revenue is under 40% of revenue at 36%. So you had very strong growth geographically in other areas and that shows diversification. You had strong growth from emerging areas like medical. You saw some recovery in the systems business. All of that really is the whole diversification strategy that the company has been pursuing, introducing new leading-edge products for different applications. The other key things that I think were a standout in Q3 were gross margin almost at the top end of our range, which is definitively being stated as a target of Dr. Scherbakov to optimize pricing, optimize manufacturing efficiency. Operating margin was actually above 25% for the first time in a while. So that was another real standout. So you've got product mix driving that, some return on operating expenses. And then we also had a very good cash flow, strong cash flow during the quarter. So there were a lot of things in the Q3 results that are reflective of the strategy that were started by Dr. Gapontsev, but are really being carried on and optimized by Dr. Scherbakov.

That's great. And I guess 1 more thing that I caught in the results was your comments about the book-to-bill ratio. It was slightly better than 1. But given that this was end of Q3 number, that sounds really good. Like it sounds like this is the first time in the last 5 years that you've had -- you finished end of Q3 with a book-to-bill above 1. So can you talk about your order book and the visibility that you have right now?

Sure. There's -- Q3 was very good in terms of order flow because revenue was actually quite strong, right? So getting a book-to-bill above that. So at a very high level, there's a couple of things on backlog. We're trying to get more -- a bit more visibility beyond like 3 months of shippable orders. We've got some visibility into Q1 and Q2, particularly with some of the strength in North America and Europe. Some of the -- this is a little bit of a structural shift. So recovery in the systems business, obviously, has a longer lead time to it. A very strong backlog for medical applications. There's some emerging semiconductor applications where the order visibility we get with committed purchases extends beyond the current quarters. So that was the first thing. But outside of that, we saw very strong bookings in North America and Europe, recovery in Japan as well. And overall, the total order flow in China was even quite reasonable given some of the softness there and it was coming from some of those other applications. So yes, we were pretty pleased with the total order flow. The odd thing was that it's not driving a reasonable Q4, right? There's a little bit of a disappointment on total revenue in Q4. But it kind of gives us like real optimism about the sort of medium-term growth prospects for the company rather than just some of the shorter-term visibility.

Yes. Yes, that sounds great and makes sense. So maybe talk about China a little bit. So that's clearly very often the #1 question or pushback we get from investors as to what's happening in China. Are prices still falling? So could you just describe the current competitive landscape in terms of what pricing is doing? And are you seeing competition in the welding applications as well? And are the Chinese companies increasingly maybe approaching or trying to enter the high-power market? So any kind of color you could provide on that market and what you're seeing, maybe that would be 1 way to start.

Most of the competition we see is within the cutting market. And the cutting market is really comprised of a very low end part of the market and a high end part of the market. We participate a very, very high share in the high end part of the market and a smaller share in the low end part of the market, but we do sell thousands of lasers even at less than 6 kilowatts. So of course, the competition is making moves into higher power levels and even you're claiming that they're selling some significant volumes at those levels. Pricing is -- you have to differentiate between what IPG is doing on pricing, what the competition is doing on pricing. The competition continues to be very aggressive about pricing. There's basically a price war going on between the 2 major competitors in China. In one of those, it's public. You saw their results where compared to Q1 there, gross margins are down 600 basis points as compared to IPG that's actually improved gross margins over the last 12 months or so. You saw some even increase, if you look at their balance sheet, increase in days receivables. So they're providing a lot of combinations to the end customer there. Whereas with IPG, we've really been much more disciplined and stable around pricing, even on cutting applications. On welding and foil cutting is a very specialized application. We've developed our high-power pulsed laser in conjunction with the end customer, even several versions and iterations of that. We're not at the first iteration of that device. It's 4 or 5 different versions that have been improved over time. With the welding applications, you've got the AMB laser [indiscernible] we're delivering the laser with our beam delivery and well monitoring capability. And then the really interesting thing in some of the other China demand was that we saw this increase in demand for marking and engraving applications that use low-power pulsed lasers. And that's really because customers are coming back to IPG because of the reliability. And then we qualified some additive manufacturing, which is -- you think that the competition -- now these are 500 and 700 watt lasers, they're very bright lasers. It's a very good beam quality. And that seems that, that coupled with the reliability is the reason why we've been qualified for those additive applications, which, for example, go into aerospace, which is an area where manufacturing quality and consistency are very, very important.

Got it. Got it. Just going back to the gross margin, you already talked about how mix is basically 1 of the raise and some cost reduction as well that has taken place, your driving margin expansion. So what target are you comfortable with in terms of guiding or aiming for gross margin in the near term? And is mix the biggest driver for that? Or what's really going to drive that gross margin evolution in the next 6, 12 months?

So we're increasingly comfortable of getting towards and have got towards the top end and upper half of our range, right? So Q2, we were in the upper half. This last quarter, we were actually close to right at the top end of that range. Our stated target is on average to get to the top end of that range. We're not really moving significantly above that at this point in time. There's some structural change in the business compared to 2017 and '18, where pricing has obviously come down significantly since then. There are clearly benefits on mix with more of the welding business and the light weld opportunity. We're adding features around that device that enable us to increase the price by charging for those options and improve the margin. Things like the foil cutting applications have got very good margin. Medical has got very good margin. But it's a balance between -- we're not just trying to displace laser-based applications. We're trying to displace non-laser applications. The hugest opportunity is in those non-laser applications, whether it be not just welding, but surgical applications in medical or in cleaning, displacing solvents, chemicals, abrasives. And there's a balance between like having an optimal and very strong operating model but ensuring that you're growing at a reasonable level. And the way I articulated is I prefer to consistently grow at a double-digit range and have margins at that upper half of that range rather than unnecessarily getting obsessed with margins, trying to increase them to 55% and giving up the growth opportunities. I think we've got operating margins on a GAAP basis. Don't forget, operating margins in the -- slightly above 25% in the last quarter. I think that coupled with the strong cash flow, you can't really ask for a much better business model. Clearly, we've experienced a business model -- better business model in 2017 when things really took off and the competitive dynamics are a little bit different. But we're pretty pleased with the execution in different areas at the moment.

Right, right. Maybe we can switch into the automotive business. Can you talk about that? And I'll have a follow-up on the EV part, but just what percentage of the business do you think is automotive? And I realize that sometimes it's not -- you don't know that number that precisely depending on how you're selling it. But just what percentage it is and where do you think it could -- how big it could become?

At the moment, traditional automotive is below 10%. Historically, it's been at the sort of 10% to 15% range. In concept, bifurcating this entirely is a bit difficult, right? Because you've got a lot of traditional automotive manufacturers that are moving towards EV. And you can't really distinguish between an EV body-in-white application and traditional body-in-white application, right? We're starting to see some demand for that. We've got some of the traditional automotive companies actually with a load -- older installed base of lasers [Audio Gap] body-in-white and the main body applications, it's pretty similar to traditional automotive. The EV battery and motor manufacturing is a bit difficult. Only difference is there's a lot of investment now coming into the EV applications than traditional. But some customers ask us about optimization of the lasers, not only to -- for replacement but also make some optimization. For example, [indiscernible] main investments are coming to EV applications.

And within EV, where are your products used? And any kind of way you could -- which one is the biggest piece of that pie out of the 2, 3 areas where your products are used?

Tim already mentioned that [indiscernible] as usual, our customer uses set of our lasers like AMB, up to 6 kilowatt; single operators, up to 2 kilowatt; and some additional components like scanners, LDD monitors; in some case, special welding cutters. And in some cases, some customer asking about -- to make integration of these components and lasers [indiscernible] different kind of battery. Battery for automotive is one. Battery for small devices like mobile, telephones, other applications. But definitely, for automotive, battery applications is one of the important part of our business.

And for the EV battery business, you are the dominant supplier in North America and Europe, but even in China, you have the biggest market share?

Yes, definitely. But I mentioned about [indiscernible]. Its vital customer is a Chinese customer.

And so I think it was -- Tim it was you who mentioned on the last call that one of the reasons why you have such high market share is because the cost of downtime in making a battery, it's just so excessive that prohibitive for these guys to be looking for cheaper options. So number one, if you could just elaborate on that a little bit? And then second, which other markets you think have this kind of dynamic? I think you mentioned aerospace earlier in your remarks. But just if you kind of give us a sense like which are these markets where you think just lower price is not going to get these guys more market share?

[indiscernible] I mean it obviously applies to EV, but I was actually referencing other entities. A lot of the EV is really based upon the specification of the lasers, right? AMB or combining it with scanners and the real-time weld monitoring on the pulsed laser, it's the specification of the pulsed laser. The power, the beam characteristics. As I said earlier on the call, I think we're on our fourth or fifth iteration of pulsed lasers for foil cutting being optimized for the end customer. Similarly, for cleaning. On the automated side, I was referencing even on cutting applications or other welding applications. If you've got a production line and you have a failure on any aspect of that production line, laser or anything else, downtime on that production line, even if for a few hours, can run to tens or hundred thousands -- hundreds of thousands of dollars. If you've got a production line that's down for a day, it's a huge loss in output. And in that regard, when you think about it that way, the cost of the laser is kind of irrelevant, right, whether you're paying $10,000 or $15,000 per kilowatt or significantly less than that from a Chinese, it's not relevant really on an automated production line. So it was a broad-based comment about all kinds of automated production, not just EV.

Understood. Understood. So yes -- so your -- more automation should be good for your top line. I guess that's the -- 1 of the key takeaway here. Is there a large consumable or services component to your business? I know you've talked about medical as maybe one of the businesses where you might supply consumable fiber. But maybe let's -- on the EV side, is that all tied to capital spending? Or do you have anything that is more kind of a recurring in nature in that revenue stream?

On EV, no, it's mainly capital equipment spending. There isn't a significant amount of recurring revenue there. Our total service and support revenue runs at 5% to 7% of total revenue. The real new business that has some consumable element to it is the -- primarily the medical applications where consumable fiber could be -- if you do 1 procedure a day, be about 30% of the system's value each year, not over the system, like about 30% of the system value share.

Got it. I also just wanted to mention, if any investors listening in, they have a question, just please e-mail it to me, [email protected], and I'll ask that question on your behalf. The medical business, maybe if you could jump on that for a minute. I believe it was about $30 million, $40 million, somewhere in that range last year. What -- how big you think it could become in the next few years? And -- and -- or what sort of market size or market share aspirations do you have in that part of the business?

You see, medical applications, there is a lot of difference and to make this evaluation of market share is difficult. [indiscernible] from this point of view, of course. In some applications, yes, we have a good position [indiscernible] kind of applications.

Got it. And the other one that you talked about earlier, the other end market is the additive manufacturing. So I guess 2-part question, the types of products that you're supplying there? And then we had a big cycle in 2018. Where we are versus whatever your revenue run rate was back then? And what do you see ahead in the next few years?

[indiscernible] distribution from outside of fibers. But requirements for these applications: the laser must be stable and [indiscernible] I mean, in some cases, asking about a special guarantee for 5 or in some cases up to 7 years. And for some customers, we've given such kind of guarantee. But before, several years ago, and usually for 1 machine, they asked for 1 laser; 1 machine for 1 laser. Recently, they started to use much more complicated, much more sophisticated machines, where in 1 machine they can install up to 12 lasers [indiscernible] China and also from Europe, such application. The output power for such application is not more than 1 kilowatt, may be [indiscernible].

Got it. Maybe switching gear, one of the common question these days has been on the supply chain issues and inflation. Can you talk about that? How you're navigating that? I think in second quarter, you called out, call it, $10 million or so impact, but I don't think you called out anything in the previous quarter. So just kind of how much you have been affected? And maybe in that context, you can also talk about your vertical integration, how that's helping you to a certain extent in terms of insulating you from those supply chain issues?

First of all, [indiscernible].

I think in Q3 [indiscernible], you saw some increase in inventory. So we -- whenever we get allocations of electronic components from distributors, we are buying them. So we'll benefit from, obviously, the vertical integration of all the optical components, and we don't have any shortages in relation to that. But on electronic components or metal parts, particularly, some of the machine parts are coming out of Southeast Asia where there had shutdowns. Whenever we were getting allocations, we've built some inventory around those. So supply chain didn't really impact us in Q3. We were able to meet any customer demand that was out there. It did have an impact, for example, on the cutting business, more in China than elsewhere where the supply chain issues, shipping costs even and freight limitations we heard were reducing some of the demand. The power shortages in China as well, factories running 1 day a week, which is a 20% capacity, obviously, [indiscernible] they're cutting back on investment if they're only utilizing 20% of capacity due to some of those other issues there.

Right, right. Okay. I guess on the freight side also, you -- that's probably also included in that -- your earlier comments. So that was probably another source of inflation. Okay. We have actually 1 question from our investors. So we discussed electric battery, medical, additive manufacturing also. Anything else in the pipeline that you're developing, where maybe it's not as big, but it's something you feel like could be very exciting in 3, 4, 5 years?

Yes. [indiscernible].

And Eugene, I apologize if I missed that, but where is the LightWELD being used? Like what is the -- what are the markets that you're selling it to?

LightWELD is for welding. LightWELD is an instrument and it's very efficient, small. And you must [indiscernible] people without any experience can weld with very high quality. It's absolutely not possible for [indiscernible] welding, especially for such kind of material like aluminum, copper or combination of these materials. But with our LightWELD system, it's possible, already demonstrated. And following application for many customers. This is why we have penetrated this market very fast. And also important thing is that, first of all, we have a huge opportunity for United States, first of all, and also for Europe. [indiscernible] some delays because we have to provide much more detailed certifications according to European requirements. But definitely we will start to introduce, I think, in the first quarter of next year. And it's very good opportunity for welding applications. [indiscernible].

I see. And in terms of the -- so I guess it's -- in terms of the market size, I should think about some of the numbers you have for the welding opportunity. That's the market you're looking to gain increasing penetration and substituting traditional welding methods, right? So I don't know how big that market is, but that's probably what you're targeted with this LightWELD, in terms of sizing the opportunity?

Not only LightWELD, okay? Again, we're looking for different kind of welding applications. [indiscernible].

Okay. There was a follow-up from the other question. You're expanding into newer opportunities, EV, medical, LightWELD. Do you think you have sufficient sales team coverage for these new areas? Or would this be an investment area, you'll need to add more firepower in your sales team to address these newer opportunities?

[indiscernible].

Very good. Maybe just...

LightWELD, we're using as well a lot of distributors. So -- where they've got like hundreds of outlets around North America looking for distributors, looking at distributors in Europe and partners in Japan and places like that. So there's a slight -- the LightWELD has a slightly different distribution network as compared to our historic OEM end user market.

I see. Okay. Maybe last, just 1 or 2 questions before we wrap up. Capital allocation. I mean you have a good amount of cash on the balance sheet. So how should we think about the capital allocation going forward? Any projects -- major projects you're looking to invest in? Or how is the M&A landscape? If you could talk about those capital allocation priorities from here?

Of course, we're looking for [indiscernible] and looking for some potential acquisitions in different areas. And for us, very important to find partner that can be easily integrated into our structure. And also to -- easy to iterate our product to their system [indiscernible]. This is why we are looking different kind of areas [indiscernible] and I think 1 of the decisions will be made in the first half of next year.

One kind of question we always get for high growth, and this might be a question for you, Tim, is about valuation. How we -- how to think about it? Because you're kind of a unique stock. When you think about the stock's fair value, intrinsic value, what do you think are some of the comps, some of the right businesses you compare yourself against in terms of valuation, growth profile and margins?

Definitely. Try not to get drawn on valuation questions because there's no good answer to this, particularly at the moment with its very, very low interest rates, multiples and being where they are, discounted cash flow analysis. But we look at really the industrial tech environment, as you know, a number of different companies that play in that space, some of them are larger than us. [indiscernible] we think have got similar characteristics in terms of technology leadership and then often deal with in the same end markets that we deal with, the same sort of verticals that we deal in, whether it be automotive or consumer electronics or some of the other areas. These were mainly the comps that we focus on. We tend not to look at like -- historically, a lot of [indiscernible] we're not a semiconductor in the way that other companies are semiconductor companies, even though we've got a semiconductor fab, right? We produce a different type of chip as compared to some of those. But really industrial tech is where our automation, robot manufacturers, some of the larger robot manufacturers out there, couple of big Japanese guys, right? Swiss guys.

Right, by the way, [indiscernible].

Okay. No, that's useful, Tim. I guess I'll just -- we've finished over 45 minutes. I'll just turn the call back to you guys for any last concluding part as to why this is a great time to be investing in IPGP stock.

I think you were in Q3, and I think the answer on that question is with the diversification of the business, many growth opportunities in different end markets and applications, strong growth in our emerging products and emerging applications, very strong results in terms of margin profile, operating leverage starting to demonstrate as we get back up to this revenue level, hopefully more consistently, strong operating cash flow generated, strong free cash flow generated over the last couple of years relative to net income. We've certainly matured on our capital allocation strategy. I mean by the time we're done with this current $200 million of buyback, we will have bought back about $0.5 billion worth of stock. We've done some successful acquisitions with really looking at technologies that add value to what we do. And as Dr. Scherbakov said, that's [indiscernible] growth, it's really -- how do you bring together synergies rather than trying to do a financial transaction that's really based upon like financial leverage as it were. The leadership position the company continues to have across the component-based vertical integration and the quality of the products I think is absolutely instrumental to the position that we find ourselves in today.

Okay. This is great. So thank you, once again, Dr. Scherbakov, Tim and Eugene. Thank you very much for your time today. I'm sure our investors enjoyed the conversation. And all the best for the next earnings.

Thank you. Bye-bye.

Thanks.

Bye.