IPG Photonics Corporation (IPGP) Earnings Call Transcript & Summary

Good morning, everyone. I'm Patrick Ho, Semiconductor Capital Equipment and Lasers Analyst here at Stifel. I want to thank everyone for attending both live and on the webcast this morning to the beginning of our Cross Sector Insight Conference again live in Boston. I'm really happy to kick off our agenda this morning with IPG Photonics, the leader in fiber lasers in the marketplace today. And I'm really happy to welcome CFO, Tim Mammen here for our fireside chat session. So Tim, first off, thank you very much. I know it's been a busy few quarters for you. So thank you for attending and taking some time out this morning.

No problem. It's good to be here, Patrick.

Great. Before we go into the details of the IPG story itself and some of the key near-term issues there, I wanted to first get an update and your thoughts on the near-term market environment given a lot of the uncertainty, both in terms of the situation in Russia as well as the macro environment. Last quarter, you actually did very well in terms of your financial results. Have you've seen any changes given a lot of the volatility that we've seen in the marketplace? And then after that, we'll go into the Russian operations itself. But in terms of the near-term environment, how do you see that right now?

Yes. We typically don't provide an update midway through the quarter on order flow or anything like that. But you're right, there's a lot going on, right? You've got the Ukrainian war. You've got some resurgent COVID in China with lockdowns that have started to mitigate a little bit. You got a rising interest rate environment, right, that's concerning people and a strong dollar environment. Overall, though, particularly through the -- I mean, we gave some update through April, we're very pleased with the way the business is performing and the demand trends that are out there. It's not so much of demand impact that we've seen in relation to all of those issues. We had very strong order flow in the first quarter, book-to-bill above 1, significantly above 1, in fact. It's interesting, the composition of backlog has changed a bit both because of the emerging and new businesses that we have. So we actually have some better visibility into deliveries in the second half of the year. So not all of the backlog was in bookings in Q1 were for Q2. So our guidance had they been, would have been a bit stronger. So those are sort of positive trends we've said through April that the order flow had held up pretty well. So again, pretty positive. I think when you look at China, our concern was that with some of the lockdowns around COVID, you may see business sort of almost come to a standstill there. And prior to giving guidance, we had got some additional feedback from our China team. And they were actually not that pessimistic, but they saw business carrying on. And we factored into the guidance range some of the downside analysis. With regard to China, so then we certainly -- there we're not expecting serious standstill. And that's because a lot of the industrial investment happens in areas where there weren't any of the lockdowns. So you talk about Shenzhen or the other industrial areas. We also turned to airfreight stuff around the world. So if the ports were clogged up, we're not shipping stuff by containers. So that wasn't really affecting us. I think the other thing that's come out of this is that the Chinese government has acknowledged that those lockdowns have had a meaningful impact on economic activity there. And they're now at a point in time when everybody else is tightening monetary policy, there's actually a very definitive move by the Chinese to significantly loosen policy both on a monetary and fiscal basis. And as you saw PMIs, I think, in the last couple of weeks, the latest PMI data from China had actually -- it was still negative, contractual, but it had improved a bit. In the rest of the world, I think as we were watching what's happening in Europe, given -- I mean, Europe is sort of closer to the conflict and particularly with relation to energy prices. And then in North America, I think it's more of a medium-term rather than short-term issues to where the U.S. economy is in 2023. Having said that, I think there's some other -- we'll probably get into about it, with some of the secular shifts and drivers, I think, both EV and energy cost and then the overall diversification of our business that are pretty positive for us.

Great. The other issue, as I mentioned, is if you can give an update to the audience regarding your Russian operations. The war itself is tragic in it of itself. But from a business end, how are you guys reacting to it? You gave a little bit of an update on the earnings call. So I wanted you to give the audience a little more of an update on where you guys stand.

Sure. So maybe to frame that, it's better to explain what we do in Russia, right? So Russia probably 3 parts to the IPG business. They produced last year about $100 million worth of product for the China market. That was generally the lower-cost lasers. So for the lower power end of the cutting market or for pulse lasers, about 2% of our sales were directly into the Russian markets, all for civilian applications. No military sales at all there. And in fact, given a lot of the sanctions and entities that have been restricted since 2014, there's a huge compliance process that we've run in Russia for a long time around those sales. But then there's the other -- the more significant part of what Russia does is support the German and U.S. operations with more -- not necessarily basic optical components. Some of them are pretty basic optical components, modulators, isolators, fiber couplers, which basically take the lights out of the diode and cover it into the active fiber and then we produce fiber blocks and other things there. So those tend to be higher labor content parts. And that's the reason we're making them in Russia, right? Russia has been a big benefit to the company over time with the lower cost, very little leakage of IP, high-quality manufacturing. We've started to already move some of the China laser sales that went through Russia to Germany and the U.S. I think actually, over the longer term, that's a part of the business that could stay in Russia. But in the near term, we're derisking that by supplying a lot of that product from Germany and the U.S. have already moved orders. And then we've got to really derisk the optical component supply chain, and there's 2 ways we're doing that. So for some of the more basic optical components, like AOMs, which are used in pulsed lasers or isolators, there are third-party suppliers that are available out there. So we've got to go and qualify them. It's more probably a quality issue from some of those suppliers. But the benefit of having a bit more competition around the world for fiber lasers is that there's actually an ecosystem out there that can supply some of the more basic optical components. And then we're starting to, over time, shift the production of the fiber couplers, fiber blocks, even the isolators and AOMs, but we can also source them in third parties. We've stated that, that would take several quarters to do. So initially, we're running second shifts, more overtime to produce those components outside of Russia and then actually shifting production in this quarter and Q3 and Q4, but it will take 9 months or more to do that more completely.

Great. That's really helpful in terms of providing an update. Before we get into specific areas of market and product expansion that you guys have seen, I wanted to get your big picture take on the strategic shift that's been occurring at the company for some time now. You've talked about diversification in the business. I think it's not so apparent in your financials where you've seen the percentage of China revenues decline over time, while at the same time, growing revenue. So it's highlighting a lot of these diversification efforts. Can you from a big picture perspective, first, give the audience a little bit of the strategic initiative itself, how you looked at it and today, the progress you've made in reducing the overall percentage of the Chinese cutting market?

Yes. I mean the strategic initiatives around diversifying the business and qualifying fiber laser technology for other industrial and nonindustrial applications has been going on for probably 5 years or so. So there were initiatives started well before the competitive dynamics changed in China to develop new products. In the industrial arena, a couple of the key areas are obviously in the welding market. You've got EV investment cycles driving that. But you've also got more traditional welding applications, for example, in the fabrication area where we've introduced the handheld LightWELD. You've got other applications in EV include foil cutting, which is a much more specialized cutting application, cutting very, very thin foils. It's very, very different from 2-dimensional flat metal sheet cutting or even 3D metal cutting. You've got cleaning applications in EV and in other areas as well. So for example, in entire manufacturing, there are cleaning applications that we got -- the cleaning and the foil cutting use high-power pulsed lasers. The EV welding uses an AMB laser, mentioned LightWELD for the handheld processes. You're seeing some recovery in the additive manufacturing market a little bit as well, both in Europe and then we've actually qualified by a customer in China as well for additive, which is interesting because they use single-mode. So lasers with very, very high beam quality, but generally, add less than 1-kilowatt of power. But they need an extremely stable and reliable laser because -- some of those systems have like 12 lasers in them. So you're growing parts from 12 dimensions, right? You can't have 1 laser fail within that system, and then be growing apart from 11 dimensions. So all of that, not only in China but globally has led to a diversification of the business. Historically, in China, the 2D or the metal cutting business was actually larger than our corporate average. We didn't disclose specifically what it is. But corporate average cutting was about 50%. If you take into account now that a significant part of the cutting is also the foil cutting, we're actually well below that corporate average of cutting sales in China. And there are parts of that business in China that performed well within the higher end. And the higher end is not just ultra-high power but also at less than 6 kilowatts. So for example, we've introduced our -- we call our ultra-compact laser, which is at, at the moment, up to 3 kilowatts very shortly to be at 6 kilowatts of power. And then in the second half of this year, we'll introduce an 8-kilowatt laser. So that makes us more competitive at the high-volume, lower-power markets. And we generally will see those lasers used in more automation, highly automated factory-type environments. We're also seeing in China increasing demand, for example, of what we call our ECO lasers, which have more than 50% electrical efficiency. And we've introduced those at higher power levels. So the ECO laser was first introduced at maybe 8 kilowatts of power. And it's now been introduced to 20 kilowatts of power. So when you get to very, very high power levels and you have increasing electrical efficiency, that's a big benefit to that electrical efficiency. So all of those things, we were pleased actually with the performance of the cutting business in Q1. It was pretty stable, but you also saw this diversity. You're also seeing a lot more diversity coming on an overall geographic basis. In fact, in the first quarter, the total order flow in North America was greater than it was in China. We booked more orders in North America and Europe was a close second on that. Some of the drivers in North America were like the medical applications where we took a lot of orders, both for systems and consumable fibers in the welding business. We set the cutting business outside China, in Europe and North America, we think has -- is still relatively underpenetrated. If you look at the total number of systems that are sold in China, it's probably 3x the total cutting systems that are sold in the rest of the world. And you're starting to see some more meaningful displacement of traditional cutting processes, punches, presses, dyes, plasma, waterjets. We can give you an examples around the performance benefits that you get out of that. So the overall diversification of the business was one of the most pleasing things, I think, in the first quarter.

Right. Maybe following up on that. One thing you and I have talked about in the past is the commoditization of the Chinese cutting market, which you just highlighted. But you are seeing, as you just mentioned, a pickup in cutting applications in both North America and Europe. How have those marketplaces not become as commoditized you're able to sell the value to those type of customers? What's kind of the big difference in terms of other regions where it's been a contributor to the diversification you just highlighted?

Really, I think it was the -- there's probably a couple of things. First of all, Chinese industry was very rapid -- very rapidly adopted fiber laser technology when it was first introduced. They didn't really have a CO2 laser ecosystem out there, right? So when fiber lasers came along, they were very aggressive in, even before the competitors arrived, in adopting that technology and recognizing the benefits it had for processing of metals. So you've seen in Europe and North America perhaps a more of a conservatism approach to that, right, which is perhaps been -- it's characterized a bit of those sort of industrial technology adoption processes. The other thing I'd say is that the -- what the competitors in China, even though we've argued, they've gone way too far, we'd like the rate at which they drop pricing rate, it has shown that there is a very, very strong elasticity of demand for laser usage, displacing non-laser technologies the more compelling the cost proposition is. And certainly, that has driven some part of that multiple of difference in total unit sales there. And I think now you're starting to see a couple of things: higher energy costs in Europe and North America, increasing ex appreciation for the actual productivity gains that can be had from the cutting processes, and that's starting to drive a bit more of a tipping point for rest of the world cutting sales.

Right. Sticking to the market expansion story for a second. The second market I wanted you to kind of discuss with the audience is the electric vehicle market and how that's driven -- many multiple welding applications. You talked about it in your last earnings call that, that was a key driver of growth, particularly for welding. Can you give the audience a little more color of how the company sees the EV market opportunity as a whole and whether it can further expand off of these welding applications to more applications over time?

Yes. The EV investment cycle is going to be very important for IPG. First of all, over the next 8 years or so, the total battery capacity is forecast to increase by 5x. So it's not only -- we think it's a longer-term driver of growth. On the battery side, the different applications are the welding. So there's a lot of different welding applications in battery processing, both within more basic stuff around the packages but also within the batteries and then connecting all the batteries together, the busbars, and tends to be hundreds of welds done in a single package, if not thousands of welds done. The other main 2 applications on the battery side are the foil cutting where they're using a very specialized pulsed laser that we've actually developed in conjunction with some of the end users. And the foil cutting application there is one where we've got exceptionally high market share. On the welding, there's a bit more of competitive dynamic around it. But the AMB laser, which has got this very, very high weld quality capability, is certainly very widely accepted. The third application on battery is actually cleaning. So there's some cleaning of the electrodes primarily. There may be some other cleaning applications in there. As that whole EV investment cycle expands though, we're starting to see demand for electronic motor applications. And then within the main body of the vehicle, compared to an internal combustion engine vehicle, you see a decrease in welding related to the transmission and drivetrain primarily. The offset to that obviously is a huge increase relative to the battery, right? The combustion engine itself didn't use -- there was very little laser processing in the combustion engine, right, whereas the battery and the motor there's significantly greater. But the rest of the vehicle is pretty similar, right, whether you're talking about your tailor-welded blanks or the AMB pillars, seatback welding, airbag detonators. So as people were investing in actual manufacturing of the main bodies, there's also a laser demand there. And often, lightweighting is driving more laser usage. So they're using more aluminum, for example. Aluminum is more difficult to -- well, practically impossible to weld with traditional technology. So you'd be displacing actually riveting or even adhesives in that kind of application.

Great. And probably my final question in terms of the market opportunities. You talked about it here, you talked about on your last earning call, the medical opportunity. Medical has a lot of different, whether it's dentistry, surgery. What are the key drivers there? Because I know it takes you into a different type of laser from your traditional fiber lasers. How do you see the medical opportunity contributing to the overall long-term growth of the company?

We think it can be a significant driver. So it is actually a pure fiber laser that -- the laser that's used. There is just a different wavelength. So it's a longer wavelength laser. And that longer wavelength is absorbed better within the human tissue. So it's called a thulium laser. But it is a pure fiber laser. We do build a lot more of a complete system around it. We're distributing -- the first application that we've got out there is for kidney stone removal. It's called lithotripsy. We've got a major partner that we work within that. The lithotripsy application has really been accepted as the gold standard. So the interesting thing is, whether it's an industrial application, micro processing or medical, you're effectively replacing either an existing laser application or a non-laser application. So in kidney stone removal, it would be ultrasound or even surgery. By far, the most kidney stones are removed with a very invasive surgical procedure, right? So there's not only if we got the opportunity to replace some of the whole -- a large part of the whole holmium lasers, but you could see a significant expansion in laser usage for this application. There are other applications we're working on within surgery that include, for example, soft tissue rejuvenation in the major joints that, if ultimately successful be defer at least major surgery, for example, in the knee or the back. There are more isometric applications in rejuvenating even heart tissue. So you get -- what we like about it is, we're focused more on the surgical area, first of all, because it's not a nondiscretionary spend, right? A lot of the traditional laser applications have been very discretionary, whether they were wrinkle removal or hair removal, tattoo removal. So the good thing about the surgical area is, it's very much more nondiscretionary. And then if you've got a process that is better, you actually drive quite rapid demand. The other part of the medical business is very interesting is that there's a consumable element to it. So we're supplying a single-use fiber. And ultimately within the kidney stone removal, if you have one surgery done a day, 200 a year, approximately you'd have about 1/3 of the system's value in consumable revenue each year. So we state that we want to build that medical business within 2 to 3 years to $80 million to $100 million. It's kind of a $40 million at the moment. So it's got some meaningful traction in the sort of year and a bit there we have [ 2 ] years since the system was -- first system was introduced.

Right. And now maybe the final part in terms of your diversification strategy and something that's really caught my eye is, the product expansion. I'm probably going to combine a few of them together here. You talked about your ABM. And just for the webcast, it's adjustable beam -- adjustable mode beam lasers. And you've also talked about growth in your ultrafast lasers. From a product perspective, can you give the audience why you're getting traction? So we just went over the marketplace and then some of the opportunity there. But why are your products gaining traction in the overall marketplace?

Because we provide a laser that whatever the application is, you're trying to meet the specification and performance requirements of the end user, right? If you don't do that, you're not going to drive laser sales out of it. So for example, the high-power pulsed lasers for some of the cleaning and foil cutting applications have often been -- not often, they've been developed in conjunction with the end-users to meet their specific performance requirements. The medical, the thulium laser is better than the holmium laser because it ablates the kidney stone to much finer particles, leaves less particulate residue within the kidney. So there's less likely that a kidney stone will reform. The particles can be expressed from the body more painlessly. On the welding side, the AMB where you can shape the beam has very, very high welding quality, very, very little spatter around the weld. The green lasers for renewable energy have been adopted because they've got the right power requirement and are enabling the efficiency of solar cells to actually be improved. The ultrafast lasers are taking -- this would be an example where we need to get the power. We've got a very good compact ultrafast laser. We're working on about 50 projects globally with those systems. And we have a good revenue forecast for that this year, but it hasn't quite taken off yet in the way that we'd like to because we need to get more energy out of that laser, right? So it's an example where we haven't perhaps succeeded as much as we want to with the ultrafast technology. But over this year with the increasing energy and power that we're going to get out of the device, we think we're going to drive more meaningful sales there. So that's probably the demonstration of where you need to have a very specific and exact technical specification that meets the end market. Otherwise, no matter how good your basic device is, you're not really going to drive significant sales in that area.

Great. This has been a really great conversation. It looks like we're already at the end of our time limit. So Tim, thank you very much because, again, I know you guys are very busy. Really appreciate the update and looks like the long-term story of IPGP looks very bright with a lot of these market opportunities we discussed. So thank you again.

Yes. We're certainly optimistic as well. Thank you, Patrick. Thanks, everybody, for attending.