IPG Photonics Corporation (IPGP) Earnings Call Transcript & Summary

Good afternoon, everyone. I'm Brian Gesuale, senior analyst at Raymond James, covering the industrial technology space. Delighted to have Tim Mammen here to present the IPG story. A lot going on. We've seen a broadening of the end markets beyond China, a lot of new product introductions. And certainly, geopolitical events impact the Russian operations. We'll talk about all of those as we get through this in our fire chat format. We'll try to save a few minutes at the end to go through some Q&A from the audience, and then we'll head to the breakout session. With that, Tim, welcome.

Thank you, Brian. Good to be here after 2 years.

Yes, it's great to see everybody. I want to really level set the audience to the IPG story. Would you maybe take investors through your strategy, the markets you serve, talk about your competitive advantages, which are significant and maybe talk about the geographic mix of business.

So everything, basically.

All of it. And you have 30 seconds.

So first of all, I want to remind everybody that IPG is a U.S.-headquartered company. We have major manufacturing operations in North America as well as in Germany. And we do have a manufacturing operation in Russia. And looking at the whole strategy, the company is around the IP and the technology very vertically integrated. So that's the first thing to understand, is that we produce all of our main optical components in-house. And as a result of that, have managed to drive the cost of laser technology down and also produce a, what we call a monolithic device that is extremely reliable, extremely compact, has very high energy efficiency, low electrical utilization. The devices are extremely flexible, so they'll process different types of materials. And they're easy to integrate in automation systems. So just from those sort of core elements of the device themselves, the demand for them is being driven by many of the macro trends that you see today where other people are trying to save energy or changing the type of materials they're using in building different products. So there's increasing amounts of aluminum, reflective materials used in automotive and other manufacturing. So you can weld those materials a lot better, join them a lot better with the laser. The flexibility and productivity improvements have obviously driven fundamental changes in the metal cutting market, so separating procedures. So not only have we displaced, over time, all of basically CO2 lasers, we're also displacing increasingly -- well, not increasingly, but displacing nonlaser applications. And so regardless of whether it's cutting or welding or cleaning in materials processing, additive manufacturing or medical, the core strategy is really to deliver a laser technology that displaces non-laser technologies, growing the total market for the laser opportunity. And it does that by either improving productivity or quality. In medical, you're reducing the invasiveness to the procedure with removing kidney stones. You're actually reducing the kidney stone to finer particulate so it can be expressed from the body more painlessly so. Again, it's really a process that's being improved with the laser and compared to other laser processes and certainly, compared to something like a surgical procedure to remove the kidney stone, which is highly invasive, right? In welding, you're displacing all kinds of traditional welding technologies, and lasers can perform most of those welding technologies to, again, higher quality, faster speeds. So the strength of the weld, the quality of the weld is better. The types of materials that can be welded is more diverse. So it's not just steel, but reflective materials, copper, aluminum. In cleaning applications, you're displacing often chemical solvents, media blast, other abrasives to clean the surface of materials either prior to them being used in the manufacturing process. So you may be cleaning the surface of metal before welding it. It's obviously a much more environmentally friendly way to do it because you're not using those sometimes quite contaminating other consumable elements. You're also able to clean, for example, production molds used in different processes instead of, again, using a chemical or some other compounds to do so. You can clean storage vessels. So we actually think cleaning is a significant opportunity that the company has. So this is -- really the strategy is about how to expand the market of lasers, given their inherent advantages, both on a productivity and posting capability as well as the environmental benefits that they bring to many of those different processes. And for example, as you see, in a highly competitive Chinese market, an interest, not only there but worldwide in our echo lasers, which have more than 50% electrical efficiency. That very high electrical efficiency is more important as you get to higher power levels, right? Electrical consumption in 1 or 2-kilowatt laser is -- there's a benefit to it. But at a 20-kilowatt laser, the benefit of having higher electrical consumption is significantly greater. So that's sort of the broad-based strategy is to expand the total market, address these different areas, continue to focus on the vertical integration, which means that we're able to bring the cost of the device down, improve the amount of delivery capability around the lasers. So whether it be real-time weld monitoring capability, cutting heads, welding heads, high-speed scanners. So those will be things that are enabling us to gain a significant share in the EV market. So we're doing welding, foil cutting, which is very different from the 2D cutting that's historically the company has been involved in, and cleaning applications are a large part of that opportunity as well. Geographic spread of sales, historically, a lot of growth came out of China. So if you went back to peak sales in the first half of 2018, 50% of sales was from China. A lot of it was driven by the growth in the cutting market. And China was a very rapid adopter of fiber laser technology, in particular. We think actually that as the cost of lasers has come down now, the rest of the world, if they can actually transition to using lasers in the volume that China is, there's a tremendous growth opportunity even in cutting in the rest of the world, in welding applications and the cleaning applications as well. Last year, China performed very well in the first half of the year, both from a macro and competitive dynamic. The market was more difficult in the second half of the year. So China's sales were down to about 30%. So that represents now 70-plus percent, 70% of sales coming from Europe, North America and the rest of Asia. We also saw very strong growth from our emerging products and applications. So some of those are being driven by EV, where you've got the AMB laser, high-power pulse, which was used on foil cutting, medical performed very well. Some of the microprocessing applications, renewable energy grew very strongly. The systems business started to recover. So those also help to diversify the company geographically as well as diversify the total number of applications that we're addressing. So the whole diversification strategy is not something we started like last year. Sometimes people think we started diversification last year. It's a strategy that was really implemented and started really 5 years ago to expand the market opportunity that we can address. LightWELD is, again, that would be another product within that emerging growth product family. And LightWELD actually opens up a large part of the welding market because a huge amount of welding is still done manually. And the LightWELD is a manual weld that has got numerous benefits in terms of ease of use, in particular, so you can train people to use it for equipment. And the diversity of materials that can be welded is broader. You can buy the system with a cleaning capability. So both pre-welding and post welding you can actually clean the weld or the surface. So there's a few other areas on the emerging growth product side that we've been telling people about.

We're definitely going to double-click on some of those markets and new products that you have. Wondering if you could just maybe help people understand the competitive dynamic as you push on that kind of geographic thread, the competitive and pricing dynamics in China versus what you see rest of the world, where it seems to be a much more rational set of competitors in pricing dynamics.

Yes. Certainly, outside China, I'd say the competition has not made any meaningful progress, and we still have very high share in all of the materials processing applications, even the cutting applications, which are more competitive in China. So you have a number of different companies that -- in North America primarily that are in the market, but they haven't really made significant progress in, for example, even the cutting area. And certainly, have had more limited capability in welding and some of the more advanced applications where the process is very important, often you're delivering the laser with more complex specifications and more optical delivery around it. So either at a subsystem level, which is very important for us, or obviously, we have some system capability. We've seen a number of companies that were trying either on a pure fiber labor basis to get into the market. One of them actually in Asia announced they were shutting down that attempt. There's another company in Southern Europe that was trying to build an in-source capability that announced they shut that down just the beginning of last year, and I think that announcement was made. So outside of China, really the competitive dynamics have not shifted. Because in China, the sole way that they're competing is on price, right? And they have a lower quality device. And actually, even recently, one of our General Manager of India was visiting and I asked him about there's quite a few laser systems from China sold in India. And even at the low power level, the reliability issues still exist and they continue to be more significant at the higher power levels where the Chinese competitors are selling. So without that ability to sell on price, they have driven a massive expansion and explosion in the total unit volume, but it's not a very profitable in some aspect, part of the market you're going to sell at that price up.

Right. No, that makes a lot of sense. Let's maybe double-click on some of these vertical markets, starting with auto. It's one of your bigger end markets that your product gets to. Would you help investors maybe size that market, talk about its performance for perspective in '21, how it's shaping up in '22? And then the questions we get quite frequently are, how does that business ebb and flow with overall auto production? And then how significant of an opportunity is EV?

So for us, traditional automotive has probably been pretty weak for the last couple of years, in part because of this transition to EV, right? And there's a huge amount of CapEx that's required to support that. But historically, traditional automotive applications on the welding side for an internal combustion engine would cover tailor welded blanks, the main body and white applications, Seebeck welding, complex welding around things like airbag detonators and transmissions. That typically would be 10% to 15% of revenue. And then there's some aspect of the automotive supply chain which we don't see where cutting has -- obviously, cutting systems are being deployed there and even marking and engraving. So we would say that our total exposure to automotive was probably in excess of 20%. That traditional automotive has been weaker more recently, though there has been demand. We've actually started to see some companies replace their older lasers. But it's really been now transitioned to being really EV applications. One of the questions we get is, first of all, what's the difference between an ICE and EV -- and the only real change is why they've all got seats, they all got tailor-welded blanks. They've got a main body in them. It's the transmission where a lot of welding was and is done with lasers on traditional. But that's replaced by the battery, which has got a much higher laser content on it and even electric motors, so certain applications on electric motors. So within battery, we're doing the welding, the foil cutting and cleaning applications. There are different estimates in terms of how many dollars per gigawatt of laser investments are required, they've been as high as like $3 million. We think that's overstated. We think the range of 1 to 3 we think is more at the bottom end of that range. So it's really more a question of tracking the total gigawatts that are being added. And if you went back 4 -- 3 or 4 months ago, the view was it was going to be more of a steady state of, say, 300 gigawatts of capacity being out of the year without any significant growth in that. Some of the latest data though shows the expected capacity additions this year are closer to 400 gigawatts. And then there were some very high numbers that have not been able to validate yet for 2023 and '24 that demonstrated a significant increase in that capacity like going up rather than it being a steady state. So that would obviously drive a lot more laser demand. The laser content is also increasing within that. So sometimes, if you can actually -- in certain areas, they're still using mechanical cutting processes because of the materials. So we can qualify the laser for process around that as an opportunity to expand the foil cutting opportunity. The welding is really being supplied with our AMB and got single-mode lasers being used on that, so you get to very, very high-quality welding. Tend to communicate -- compete there with some of the -- not the Chinese so much, but some of the German machine tool manufacturer is a competitor of ours. So it's really -- like we said last year, EV was just over 10% of total sales across all those applications. So clearly has the opportunity to be a significant driver of revenue and if total capacity being added each year increases a driver of growth. And then the other side of it is really on motor manufacturing, there's going to be more lasers used on motor manufacturing. That's a bit earlier stage than the battery side of it at the moment, though.

That's fantastic color. Maybe sticking to the demand front, you've cultivated and ceded a bunch of new products over the last 4 or 5 years. A lot of those are kind of hitting parts of scale where you're starting to really see some material and measurable benefits to the launches of these or the adoption, I should say. Can you talk about what's going on in the welding market. You've got some new product that seems to be hitting some different areas on the market like spot welding. And then maybe if there are another product or 2 that you wanted to talk about that you're particularly excited about a few years out as being meaningful franchises for the company.

So what we call our emerging growth products and opportunities was about 38% of revenue last year, grew at more than 50%, so it performed very well. Some of them are -- there are materials processing applications like sort of the EV opportunities. So AMB would be in there, the high-power pulse. High power pulse has also got non-EV cleaning applications. I think on the materials processing side, I think cleaning is an -- the welding and cleaning are both very exciting. And I think we're starting to see more meaningful execution in both of those areas. EV is clearly helping on the cleaning, but even outside of cleaning saw good growth. The welding is an area where we've said that lasers have a very strong benefit that they can bring to the end market. But the end market has historically been a bit more fragmented and conservative. So it's interesting with these newer industries where they've not been using older technologies, they're very rapid adopters of lasers for welding applications. And that shows you how compelling the laser is on the welding side of things. So you're starting to see perhaps more acknowledgment of that and even in some of the older industries. And LightWELD will help with that because a large part of the welding market is manual welder, right? It's still not automated systems where we've had more of our success. There's a huge amount of fabrication done in job shops, but also a huge amount of welding done on site when people are fabricating infrastructure and that kind of thing. So we think that LightWELD is a game changer for us on the welding side. And we're targeting selling thousands of units of that device. And if you can build that up to a level where, in unit volume, it gets up to being -- it's not going to be quite as large as the cutting business at this point in time. But if you can start to sell thousands of those units and starts to drive a meaningful amount of revenue for that. We said -- I think medical is another area we're excited about, and that business grew very well last year. It's the kidney stone application. There are other applications where you bring benefits so soft tissue rejuvenation is an application we're looking at getting qualified and releasing that would again reduce potentially highly invasive surgery. So if you can rejuvenate tissue in different joints like the knee or even the spinal column without having to go and perform very invasive. It may defer surgery. So that's an application we're looking at there. We're trying to grow the medical business to $100 million. So there is a total percentage of revenue perhaps not -- still be less than 10%, but it was very profitable. The other aspect of the medical that I like has a consumable element to it. So we sell a fiber that delivers the light to the kidney stone. And if there's one procedure done on that system a day, the consumable revenue would be about 30% of the CapEx value of the system. So over 2 or 3 years, you can see 50% of your medical revenue coming from a consumable element of it. The other thing that's performed well is there's the green lasers, so for renewable energy. And that's exciting, too. The systems is doing well. All of the emerging growth products are pretty good. But really welding, cleaning, I think medical, some of the green. And the area where we'd like to see more success is, I think if you look at everything we've done, which has not yet performed as well as we'd like, would be to get more micro processing revenue from ultra-short pulse lasers. And that's a key focus this year. Our budget has a significant growth in those of a small level, but it's a critical year for executing into that market, I think.

Great, I want to maybe now transition to maybe a little bit more of a somber topic in the geopolitical instability. You have a large facility in Russia that provides both end products and components to other facilities of yours. Would you describe maybe -- would you help set the table with that, talk about the size of that business, what functions it serves, and maybe just give investors context to what occurs at your Russian facilities?

Sure. So I think the first point to make on this is that none of the core technologies that are owned in Russia, right? Everything was either -- it was really developed outside, starting in Germany with the core laser technology, all the diode technologies in North America, the packaging is there. So the Russian operation is really an in-house subcontract manufacturer, if you like. They supply, as we put in our press release, about $100 million of product to the China market. There's about $30 million of sales that go into Russia at the moment. We have to have very strict controls even before any of this happened as to evaluating the end customers. There's a commercial aspect to that, but I have to consider at the moment in terms of like making sure -- if we choose to consider -- continue with that business, the accounts receivable element of it has to be taken into account. We're quite a little bit unique in this sort of geopolitical environment. So we've got to look at outside of the China sales where we said we've built up inventory of diodes. And in Russia really as part of our normal contingency planning before any of this happen. We don't like to keep all of the diode inventory in the U.S., right? We keep a significant inventory in Germany and some in Russia as well. We've got 6 or 7 months of diode capacity there to satisfy the China sales. So it really comes down to some of the other components that are made in Russia which are capacity that we have there, and there are sort of low-cost manufacturing area. Some of those components are more basic, and they're actually available on the market. The downside of China competition is Chinese competition. The upside of the Chinese competition is there, there is an ecosystem of certain optical, more basic components that's available that you can source even in Europe, some of them but you can source them in Asia. So we're starting to look at those as contingency planning. And then there's sort of some of our more key components where we do rely on a meaningful amount of -- significant amount of capacity from Russia. At the moment, the sanctions don't, as we've said on our earnings call, we didn't think they would target them. And they're not -- they're basic. Even though they're more complex with our IP and then they're basic glass components, right? So we can still ship them out of Russia to Germany and the U.S. That's not impacted from a legal perspective. And really, what we're facing at the moment is more of the practical aspect of evaluating the financial sanctions, obviously making sure we're complying with them. Making sure that logistically, we're having to work out how to get product out of Russia because of the Fly Zone, the tit for tat fly bans. So looking at moving stuff out through Turkey or even the Middle East. So the major impact to us at the moment is on the cost of cargo, which is up 50-plus percent. There isn't a capacity issue at the moment that we're dealing with. And so we've stated we want to derisk that, and we've already, for example, on certain of those components, we make them -- all of those critical components are made in Germany and the U.S. we're expanding capacity. Already started like a second shift in Germany around and evaluating, leveraging our Italian operation, which has manufacturing capability they used -- they make telecom amplifiers. So we can -- looking at expanding that for some of these components we're running over time, obviously, in North America around some of them as well. And as long as the sanctions don't become more drastic or there isn't an embargo, we're very confident of being able to manage through the current situation. Notwithstanding how terrific it all is, right? We're trying to just deal with this on a day-to-day basis. And it's very difficult -- anything beyond what the actuality is today is kind of speculation. There's a lot of contingency planning going on, and there's a -- we acknowledge geopolitically de-risking that exposure and potential overhang has to be an absolute priority of the company. And it is at this point in time.

That's helpful. So I guess if I think about some of the operations over there, I think this has been generally an ability to have low-cost production with still safeguarding your IP. When you start to think about shifting manufacturing capacity around, how do you think about the overall cost longer term? Forget about the very near term in shifting production elsewhere. And then is there anything that was unique to the Russian operations that can't be replicated in Germany or the U.S., but after a little bit of time you spent to ramp the capabilities, I suppose.

So -- the first question. no, there is nothing, I mean, if you look at all the diode, production is done in the U.S. If you look at fiber drawing the main fiber facility was always in Germany. That's actually as part of our CapEx spend is being expanded. So we do draw some fiber in Russia. If you look at crystals growth that actually happens in the U.S., if you go through every of the components as they're not solely in Russia. There's one optical component that's used in pulse lasers, which is available widely in Asia, which we can source on the open market and maybe a bit of higher cost on that. So there's nothing that's particularly there. The cost side of it will be more interesting, right? Inevitably, you're using washes Russia's low cost area, so you could either evaluate other low-cost areas to expand investments in that have got less risk around them. In the near term, expanding production in Germany and somewhere like Italy, your labor costs are going to be higher. So -- but it's a necessary consequence. It's just a fact of life right now that we've got to deal with. I think what it does actually is [ Dr. Shoback ] often talked about, he wanted to -- one of his main strategies in the way that we've used more and more automation on our diode manufacturing, which -- on the packaging side, it's quite a labor-intensive process, right? If you look at how much automation we have around diode packaging as compared to even 2 or 3 years ago with the latest generation of packages with very high-speed pick-and-place machinery and equipment in there. One of his strategies even before any of this happened was to look at bringing more automation to our component manufacturing base. And that will also reduce the total labor input. We actually think it actually brings some other benefits in terms of quality and repeatability, right? If you're using more automation around that, that automation in the medium term would be a way to drive some of the cost out. And then the other way is, obviously, continued R&D and looking at trying to get more power out of individual components relative to a relatively fixed bill of material. And the more power you get out of an item, the cost per watt will come down in that regard there. So near term, there's obviously an impact. I mean just on shipping and freight. And I mean globally, that with oil where it is, everyone -- respite on that one is going to be a longer-term challenge that everyone is dealing with.

You're definitely not allowed on that. So my last question here, let's talk a little bit about the balance sheet. It's loaded. I think, at this price point for the stock, your cash adjusted share price is in the 70s. Traditionally, you haven't leaned on buybacks much, but can you talk maybe about buybacks as an instrument to drive shareholder value? And then maybe talk about M&A as another instrument to continue to kind of broaden the business and build scale in some of these markets you talked about.

Maybe I'll take them in reverse, right? I'll take the M&A because that's going to be the first consumer of cash. no, not the first one though. If you find opportunities where you should be deploying, right, in growth opportunities. We're still not -- we don't view ourselves as a consolidator in the industry. We are looking at more bolt-on acquisitions that can add value and integrate with our technology. I think that larger acquisitions are difficult to integrate. It's not historically what the company has done. If you can develop something internally, you get a much bigger return on it. But we've still got a pipeline of acquisitions. They're not necessarily the priority right now, right? There's other stuff going on. Yes, so the way -- we just announced another $200 million buyback on the earnings call. We've run that on an opportunistic way. I've never really done an ASR. But the way we do that, we look at our long-term discounted cash flow valuation of the company. And if we're trading what we perceive as a discount to that, the number of shares we're buying on a daily basis goes up. And if we trade at a premium to that, it comes down. So you can assume that we're actually in the market buy more shares. And we're intending to actually carry on with -- despite what's going on in, the $200 million will -- the further $200 million, we're going to put in a plan for that as well. I think we've obviously got a lot of things in the near term to look at and manage through, including like establishing a strategic acquisition pipeline, which would then drive your more fundamental capital allocation policy. And you don't have to be a rocket scientist on capital allocation after that, if you got excess cash.

Right. All right. That's going to do it for the formal presentation. Tim, thank you so much. We will be adjourning to the breakout room, which is downstairs for some Q&A. Thanks, Tim.

Thank you, Brian.