IPG Photonics Corporation (IPGP) Earnings Call Transcript & Summary

Hey. Good morning, everyone. I'm Brian Gesuale, senior analyst at Raymond James, covering the industrial technology space. Thank you for joining us today. We're going to be doing a fireside chat with IPG Photonics' CFO, Tim Mammen. We think the time is very interesting to take a look at the story. He's got a great lens on the overall macro. The business is really nicely diversified away from China, and they've certainly built a big platform in EV and the medical businesses. So with that, Tim, welcome.

Thank you, Brian.

Maybe we level set here to start the day, just give people a brief history of IPG. What it is you do and how you've captured the dominant share in fiber lasers and really what the vision is for the company over the next few years?

Sure. Good morning, everybody. I'll try not to take too long over this question, leave you some time with some of the other ones. IPG is really the pioneer and the global leader in the manufacturer of fiber lasers. Fiber lasers are a monolithic device, so comprise basically of optical components that are combined together, so there's no moving parts in the laser at all. It's a laser that is extremely electrically efficient. It's very robust. It's well suited to being used in industrial applications. It's a smaller form factor than a typical laser. It's very easy to scale the power of the laser or change and shape the beam using the optical components that you make the laser from so that from that capability, you can change the specification of the different types of lasers and therefore, adapt the technology to be used across a wide range of different applications. . Historically, we've been very strong in materials processing applications. The core driver of growth over the last decade for the company has been cutting applications. But as you mentioned, we spent the last at least 5 years or so, enhancing the technology and adding to the capability that the company has. So rather than just producing the core laser capability, we can now deliver the laser with a lot of the beam delivery, so the accessories, so process fibers, scanners, welding heads, real-time weld monitoring capability. And that, in turn, can be integrated in a complete system. So there's a lot more value that we add around the laser and a tremendous more -- tremendous amount of additional capability that we add around it. So in addition to all of that, often you're delivering the application know-how as well that helps the customer resolve the problems that they've got. The company has been well known. I think that not only the scientific side of it, which is obviously a very deep part of the culture, but from a commercial perspective, taking a lot of cost out of the device. So when it was first introduced, I mean it's no longer a new technology, more than a decade ago relative to other laser technologies and other non-laser technologies, which form fundamentally very large part of the market opportunity for lasers. The technology was really very expensive. So as we've taken the cost down not only have you displaced laser technologies from a wide variety of applications, but the use of lasers in what were non-laser applications. So many -- all of the welding applications you're displacing it, there often non-laser applications, things like cutting, punches, presses, dyes. In cleaning applications, you're replacing things like chemicals, solvents, abrasives, media blast that's used to ablate the surface of the material, whereas, the laser is ablating it with the energy. So there's the sort of breadth of application set as the cost has come down and the laser capability has been enhanced to enable those applications to transition to lasers away from traditional technologies that are often more expensive, less efficient, sometimes in many instances, environmentally a lot less friendly as well.

Fantastic. That's a great intro. I want to pull on these next few questions about the diversification that you've done. Let's maybe start geographically. Remind people of the mix of business by region today. But then also, I think even within some of your markets, particularly China, there's been a real big growth in welding versus cutting applications. Maybe just talk about how that's all played out.

So geographically, if you went back to 2017, '18, approximately 50% of total revenue came from China. Europe was probably 30% of that and North America and the rest of the world, less than 20%. At the moment, China is down to about 35% of total revenue. Historically, a very high proportion of the total Chinese revenue came from cutting applications. We stated in Q2 that Chinese cutting applications were less than 10% of total revenue, so down to less than 30% of China revenue. So although the China revenue has dropped as a proportion of the total, as you point out, it has also become more diversified. So even despite some of the significant competitive headwinds in the cutting market, we've actually performed very well in other areas. EV is clearly one of those areas, which drives growth not just in China, but we believe it will be on a much more global basis, a lot of battery investment historically has happened in China, but it's starting to happen in Europe and in North America more fundamentally. You've got actually good performance in China, not just from that. So the EV applications at welding, foil cutting, which is a much more specialized cutting application, is very, very different from flat metal cutting, cleaning applications. And it's not just on the battery, but for example, on EV motors, for example, you can do welding of the hairpins and also cleaning applications in that. We've also seen good performance in China on some other applications, which are interesting in part because they're not -- the examples aren't necessarily very, very high-power lasers, which people would think we'd have an immediate advantage against the competition. Sometimes this is lasers less than a kilowatt. So in additive manufacturing where quality and reliability are fundamental to the technology, we've actually performed very well in China on that, both because of the reliability of the device but also the beam quality, so they want a single-mode laser. They're incorporating up to 10 lasers within a single system. So you can't have one of those lasers fail because you can't grow the part from 9 out of the 10 dimensions, right, you lose all the benefit. And even last year, when we had some stronger performance from consumer electronics, basic market and engraving applications actually performed well. This year on consumer electronics has been a bit weaker. And that was with, again, pretty low end pulse lasers where we were chosen because of the quality and reliability that we have. So there are examples in China where effectively where the lasers being used in very high volume throughput or automated applications, we continue to have significant share. Then the other side of it is, obviously, we've seen this tremendous performance outside of China, which has been positive. So there are some macro headwinds, which we may talk about a bit later, but we've had good performance in Europe. We're starting to see more diversity there on welding as well away from cutting. We've -- our North American business is even more diverse, and that's actually been a bit more resilient as well. So you've got some of the cutting -- medical applications in addition to the strong performance on cutting. You've got welding, both for EV and non-EV. You've got sort of some of the advanced applications there as well. We've got LightWELD, which was first introduced in North America and now is being rolled out globally. So LightWELD is really the first time a laser application. It can address a very large part of the welding market, which continues to be handheld welding. And in many instances, that LightWELD application brings many of the similar benefits you'll find for other applications, right? So ease of use. You can train someone to weld with the LightWELD extremely quickly. So that reduces the level of skill and it also helps to offset a tremendous shortage of qualified welding people, not just in North America, but even on a global basis. So you can train people very quickly to use the LightWELD. You can weld a very wide range of different types of materials, both in terms of like reflective materials, non-reflective materials, different thicknesses. We delivered the system with 60 or 70 different recipes. We delivered the system with a cleaning application on it as well, so you could actually clean the surface of the material either before you're welding it or clean the weld after it's been completed. So that technology has really has been a very successful launch we've had for LightWELD. And it's another example of trying to diversify the revenue stream.

I want to pull -- I want to tag on a couple of these threads here. Let's maybe start in kind of the auto vertical. Can you maybe talk about the size of the auto business but then really drill down into the EV business? Size that out from how it's grown from a few years back to today, and then how we might think about your opportunities on a revenue per gigawatt hour basis and how big that market can be for you?

Sure. So I mean traditional automotive has been pretty weak for quite a while in part because most of the automotive companies are focused on what they're going to do with their EV offerings, and that's where most of their investment has been going in. Offsetting that, though, if you went back 2 or 3 years, our EV sales were probably low single digits as a percentage of the total. We said that last year, EV was about 10% of our sales. And then in Q2 and Q3, we said that EV was approaching 20% of sales. So you can see just how dramatic that shift has been, and we believe we're relatively early still in this investment cycle, right? So total installed battery capacity is somewhere around 600 gigawatts. I mean it changes on a monthly basis at the moment. The next 2 to 3 years, battery capacity is expected to get to more than 2 terawatts, 2.5 terawatts, and then ultimately, by 2030, potentially in excess of 5 to 6 terawatts. So there's a huge ramp-up in battery capacity that's required if the transition to electric vehicles is going to happen in the way that governments and others...

When the transition happens.

When the transition happens. So that's -- in terms of each gigawatt of power, battery power that's installed, we estimate that probably the laser source element of it is about $1 million. If you're supplying a complete system, it could be multiples of that. Some people have said as high as $3 million of total laser-based processing equipment. Our view is that similar to other industries, over time, the number of different laser applications will expand. Perhaps sort of on the cleaning side, you'll be cleaning more of the materials. You'll be doing more of the welding. And then there's -- the welding covers a very -- many different aspects of the battery process itself. And then you've got sort of the expansion in things like motor manufacturing and then the actual growth in the main body applications for EV as well. So the point to understand there, I think, is that if you look at an internal combustion engine vehicle, the actual engine itself doesn't have a lot of laser processing in it, right? The cylinder head is a cost block. The transmission had quite a lot of laser-based applications in terms of welding and on the gears and the drivetrain because of the strength of the weld that was needed. So that goes down, but there's a huge increase related to the battery in the motor. And then if you think about the rest of the vehicle, if you're doing seats or welding the seat back or the AB pillars, the major vehicle structure, the airbag detonators, there's no real change in relation to that part of it. So you see a decrease related to transmission, but a huge increase related to the equivalent part of the engine and drivetrain in an EV vehicle. And then the rest of the body really remains similar in terms of laser up. It probably increases some of the laser opportunity because there's more aluminum being used, some of the structures where the batteries are held, there's a lot of welding in those for rigidity and the strength of the laser world would help with that as well.

Great. I want to also maybe talk now about welding outside of EV applications. If we think about the market opportunity for you there, you mentioned the LightWELD product, which we think has just gotten a fantastic reception and adoption. Can you talk about how big that market is for you today and how big it can be in the future?

I mean, we've -- we were cautious about what we sell in the market just from a competitive perspective. But the total welding market for equipment is in excess of $5 billion, and lasers are still only maybe 50% penetrated into that. The benefit of the laser technology is that a very large part of non-laser welding applications is driven by the use of consumable wire and the consumable wire is 75% of the total annual welding market. So you can reduce the amount of wire that you use with a laser application. Generally, you're not using the wire to join the material, using the wire only to fill gaps in that because most of the time, your laser welding the 2 different pieces of metal together rather than using the wire is the joining mechanism within that. So you reduce weight, for example, in that, you simplify the welding process. So we think there's a tremendous opportunity for lasers still to gain share because almost every single welding technology can be done by a laser to a degree where the weld is stronger, the weld is faster. In particular, when you're doing the quality of the weld if you're getting a first-time pass on the world, that's very good. You're obviously reducing your cycle times and improving your productivity because you don't have to redo the weld. We're helping with that through our real-time weld monitoring systems. So we're actually assessing the quality of the weld on the fly. So the opportunity is very significant. It's a bit more of a challenging market to drive adoption than, for example, the cutting market because there's a lot of different industrial standards and certifications that you have to adhere to. So if you're welding a pressure vessel as compared to a pipe, you have to qualify for those different standards. So sometimes people will ask us why it's taken longer for welding to be adopted? And you'll find that some of the older industries are more conservative in their adoption of welding, whereas, EV is a prime example or even historically consumer electronics with sort of finer welding applications where they hadn't used a lot of the older technologies, then they weren't beholden to them. Immediately, they started to develop their own processes. They transition to laser welding whereas, some of the older industries, it does take time to transition them to newer technologies.

Makes sense. One other end market I want to talk about is medical. You've done a really nice job growing that. It's still a bit smaller than some of the stuff that we've been talking about. But can you give the audience maybe a flavor of the type of applications that you're excited about that's driving revenue? And again, if we looked out several years, what percentage of revenue could that be? Or would you like that to be as a kind of a noncyclical attachment to the IPG revenue streams?

Yes. So we've said that we want to grow that revenue -- the medical revenue to be, I think, close to $80 million to $100 million within a 2- to 3-year time frame. We're actually already close to that on a run rate basis. So historically, we've done some esthetic applications, mainly through OEM partners of ours, and the medical business was relatively small in that arena. So a lot of the work we've been doing and the successful product launch we've had recently was on more surgical applications. So we think that surgical applications are clearly less discretionary spending-driven compared to some of the esthetic applications. And the large application that we're having a lot of success with at the moment is on kidney stone removal lithotripsy application. So the laser is basically ablating the kidney stone down to dust and enabling it to be passed relatively painlessly through the human body, and it's -- we can reduce the kidney stone to finer particular -- and another major benefit of it is leave less residue behind that is a substrate for the kidney stone to reform, which is a big problem. So clearly, compared to surgery to remove a kidney stone laser technology is a vast improvement. It's still a sort of overnight stay, but it's a lot less invasive than a surgical application. But our laser technology is also better than the existing laser technologies such as holmium and some of the other technologies, I think they use ultrasound and things like that. So our focus is really trying to look at surgical applications. We're looking at some applications in soft tissue rejuvenation in major joints within the human body that may differ, more invasive surgery again. Some of the other stuff gets a little bit more esoteric in terms of some of the cardiovascular applications. And then there are some applications that sort of cross over a little bit between aesthetic and surgical things like varicose veins and even some of the acne type applications that lasers have been used in historically. But will also, in that instance, they're not purely aesthetic as well. So we think that medical business can continue to grow at a very strong rate. And if we can successfully execute on it, we'd like it to be a business that is in excess of 10% of revenue, and I think that will happen if you diversify the number of applications you're addressing. The other good thing about the medical business is there is a consumable element to it. So for example, each with the kidney stone application, there's actually a consumable fiber that's used on each surgical procedure. And historically, they would use multi-use fibers, but the cost of disinfecting and sterilizing them is actually higher than the cost of utilizing a new piece of glass for that process. So ultimately, if you pick up to like a couple of hundred procedures per year per system, about 30% of the system's value can be driven in consumable revenue from the fibers.

Great. Maybe we pivot now a little bit to the supply chain. I thought one of the bigger pieces of news coming out of your last quarter was that you announced strategic alternatives for some of the Russian manufacturing. Can you maybe give us an update there, whatever you can say? I understand you're going to be limited there. But can you talk about where you build excess capacity in the near term? How you think about it long term? And maybe what this means to gross margins over the next few quarters?

Yes. We said we're going to go through a strategic review of the Russian operation. We don't have anything to disclose on that at this point in time. But effectively, we'd said that the effect of sanctions is becoming more difficult to manage, whether it's on the financial side or on import regulations, tariffs, duties. So the ability to rely on that Russian operation is going to diminish significantly in the near term. . We have already started to increase capacity of key components outside of Russia, so in Europe and even in the U.S. We're starting to add additional capacity in other areas in Europe. So for example, we said in Poland, we wanted to start -- not we want to, we are going to start expanding capacity for certain critical components there. And the benefit of somewhere like Poland is that is relatively low cost on the manufacturing side. In Italy, we've got a capability to produce optical components where we're increasing their capacity to offset some of the Russian capacity. We've also obviously built significant amounts of inventory in the near term to help transition through this. And we've qualified some third-party vendors for noncritical components. So the fact that there is more competition out there means that the ecosystem and the supply chain for some of the more basic components has improved. So we're able to leverage that, and the cost side of that actually is even with the third-party supply. So it's interesting. Sometimes these things mean that you evaluate some of your strategies like we've been very vertically integrated, and we're now being able to assess that there are some of these components available at not a fundamentally and even equivalent cost to what we were making them for, particularly from low-cost regions. So we think that in the first half of next year, we're going to have some still. We've got to go through this strategic review and decide what's going to happen with that business. We've got to transition through ramping up some of the capacity. If anything, the gross margins with revenue being a bit weaker with all the currency headwinds in Q3 weren't great, we expect gross margins in the near term to be challenged somewhat until we sort of hurdle this period. And then I think we'll have much more clarity probably coming into Q1 as to what that strategic review outcome is going to be. It will then take some months still to execute around whatever the decision is. And so I think coming into the second half of next year, we'll have a much better visibility on gross margins. In the longer term, as I said, like places like Poland, the cost structure is not that different. We're also working on a lot of different automation strategies. So we've had a history within our diode manufacturing of using a lot of automation to bring costs down, we never off-shored our diode, even the packaging, which has more labor content in it. And over time, we've used a lot more automated pick-and-place machinery within that and here, I changed the design of the diodes to enable that automation to be used more effectively and efficiently. So we want to bring some of that capability to some of the other component manufacturing and even subassembly manufacturing that we do and try and automate some of that. And ultimately, if you successfully automate stuff, it may take you a bit more time to do it. The cost benefit from automation, it always far exceeds, I think, going to even a low-cost manufacturing area. So it's a huge benefit if you actually successfully can execute on it.

Yes. No question about it. We'll stay tuned for that news with Russia. Maybe give us a health check on some of the regions that you operate in, maybe China, Europe, North America, in particular? And then any other regions you want to point out, what you're seeing? There's a lot of news around PMIs. Certainly, it's an interesting time, and you have a really good lens into that. So why don't you give us an update there?

Yes. I'm not going to in -- I won't give an update, Brian or...

Long term, tell us what you're seeing.

Where we are. We very really provide updates sort of in the middle of the quarter. But you're right. I mean, our guidance on Q4 was not strong, right? And we said that reflected some of the challenges around the world. PMI certainly have been weaker. I haven't seen anything that's really strengthened. I think there continues to be some uncertainty around there. I think everybody is trying to work out where the Fed is going in terms of their tightening cycle, whether that's going to be less aggressive than it was. I think the benefit is that if it is slightly less aggressive than where we've had this very strong currency headwind that could ameliorate a bit over the coming year. And it has changed very slightly, right? The euro has got a little bit stronger. And I think the more interesting region will be something like China, where they're obviously struggling with like zero COVID and an increasingly struggling with that policy and seem to be rolling it back. And China has been very weak for over 18 months now, right, particularly the non -- the benefit is that some of these other applications have been performing well. And one of my point is that even in a weaker environment with the EV investment cycle and some of the growth in welding and medical, we think that we can continue to perform relatively well even with those headwinds out there. So China has done well. But if China sort of starts to open up a bit, maybe that's going to be actually a bit of a benefit next year because it has been weak for about 18 months. I think the U.S. still is relatively resilient in terms of compared to the rest of the world. And I think Europe is the area that everybody is watching both from a geopolitical perspective, fiscal monetary perspective as well. That's probably the area that's most difficult to pick as to where it's going to be.

Great. If I can maybe think, if we go one layer underneath the macro, your systems are very interesting from an ESG and a power consumption standpoint, an efficiency standpoint. Can you talk about how that's becoming more of a factor in your customers buying or converting to your laser products?

Yes. I mean we certainly got -- for example, so the electrical efficiency is extremely high on the lasers. We've got sort of 50% electrical efficiency on the highest power lasers. So as people transition to higher power lasers, electrical consumption becomes even more fundamental, right, 30-kilowatt laser compared to a 1 kilowatt laser. We've had instances where companies have bought those lasers on the basis of the electrical efficiency not just from the perspective of the cost of power, but even the availability of electricity, right, so that you can run on that. We've actually got some interesting things, not with very high power lasers, but a couple of other customers that are looking to replace some of their older lamp-pump YAG technology that has like 2% electrical efficiency with some of our other offerings. So we think that -- I can't point to a huge amount definitively around the electrical sub but it's certainly a driver there with the efficiency that we have on it. And then in other areas of ESG, right, I mean we're -- I mentioned cleaning applications where you're displacing chemicals and solvents or media blast and other abrasives. It's a much cleaner process. No LightWELD in itself in terms of the quality of the welding, the ability to use reflective materials, the fact that you could weld aluminum more easily, so it enables the lightweighting of vehicles, reduction in the amount of wire that you're using, again, the reduction in the consumable wire. So either from an electrical or sometimes from the processing aspect, we certainly think there's a significant environmental benefit from a fiber laser in particular.

We just have time for a couple of more quick ones. Maybe give us a quick read on the balance sheet, it's loaded. Talk about capital deployment. You've been buying back more stock over the last year or so. How do we think about your priorities on capital deployment?

So yes, we said all along that if we felt there was an opportunity where the stock was trading at a discount to what we thought the intrinsic value is, we'd be more aggressive around buybacks. I think we've been pretty disciplined in that regard. We started doing buybacks back in 2016. Almost 50% of the total has been done this year. Historically, we're tending to do anti-dilutive if there was a point in time where there was some volatility we're doing a bit more than [ anti-diluted ]. Certainly, this year, we bought back a significantly larger number of shares. So I think we've executed in that regard in exactly the way that we said we would. We're continuing to sort of evolve the capital allocation policy. We've now got to really look at what we want to do on the inorganic side and identify the strategy on acquisitions. And historically, we've not been a company that's been interested in consolidating. We're more interested in looking at technologies that we can add on to our capability that drive future opportunities. So the -- for example, LDD was a very small acquisition, but has driven a tremendous amount of value with our welding offerings. So once you sort of decide what your -- more fully what your acquisition strategy is then you can come out with a more complete and holistic capital allocation strategy. I mean my view on that is that you probably sort of set a minimum level of cash that you're going to keep and make a commitment return above that amount, which is effectively what we're doing at the moment.

Sounds good. I wanted -- you've got 30 seconds. I'm going to give you to drop-the-mic moment. Tim, what message, no follow-up for me, do you want the investors to kind of take as they walk out of here this morning.

I think we've covered a lot of those things, right? So First of all, there's a tremendous opportunity from the EV investment cycle, the growth in the medical applications and the generally, the -- our sort of emerging growth products of 40% of total sales growing at 35% to 40%, depending upon the quarter. So the company has done a great job of diversifying its revenue stream. It's evidenced by the fact that the most competitive part of our market, the China cutting business was less than 10% of total sales. That strategy has been pursued for the last 4 or 5 years. It's not something that we started to do in the last couple of years. I think some of those thematic growth areas also enable, as I just mentioned, the company to perform very well even in a more difficult market from a macro perspective. And then on the supply chain, I think we've done a good job of managing through not just the Russian side of it, but some of the electronic supply chain issues, and we think that we can continue to execute positively in that regard with both the diversification and satisfying customer demand next year.

Perfect. Tim, thanks so much. Audience, thank you for showing up early today, and we'll see you around.

Great. Thanks, Brian.

Thanks, Tim.