IPG Photonics Corporation (IPGP) Earnings Call Transcript & Summary

Great. Good morning, everyone. We're going to get started here. I'm Brian Gesuale, senior analyst covering the industrial technology space for Raymond James. Delighted to have IPG Photonics here to present their story. We have the company's Chief Financial Officer, Tim Mammen, here. We're going to do a fireside chat format. And so you're going to hear we think the timing is really interesting. There's a lot going on, both from a macro perspective as well as some of the idiosyncratic things that are going on at IPG. So we think it's a fantastic time to hear the story.

Tim, let me just start off. Why don't we level set the audience here, give people a sense for what IPG does, a little bit of the corporate history and how you position yourself in the marketplace?

Sure, Brian. Well, good morning, everybody. To begin with, thank you for being here to listen to this. IPG laser, IPG Photonics is a company that produces fiber laser technology. Fiber lasers compared to other lasers have several significant advantages. They're extremely electrically efficient for a start. They're a very compact device, which is basically monolithic without any moving parts in it. So that makes it extremely reliable. Because you can deliver the light source through a flexible fiber. It's extremely well integrated into automated manufacturing systems. The other sort of benefits of -- in the way we think about the laser is that it's not -- it hasn't -- it has been replacing other laser technologies over the last 15 years that were dominant in various industrial applications, whether it be CO2 or YAG lasers. Increasingly, we think about the opportunity and have for a long time, think about the opportunity for fiber lasers given their inherent advantages, is really to displace non-laser applications often in similar areas. So if you're separating metal, it's not just displacing a laser, but mechanical processes, punches, presses, dyes, plasma cutting, waterjet cutting, mechanical stores, a laser will weld better and faster. So the quality and the speed of the weld is often significantly better than traditional technologies, whether you're talking about MIG, TIG, electron beam welding, friction welding, brazing applications where you're using a lot of metal where metal joint wire is used to join all of those materials together. So the laser has a lot of advantages on welding, not just from the productivity and the quality of the weld, but the diversity of materials that you can join with the lasers. You can join highly reflective alloys. You can join different types of materials together, so welding copper to aluminum, for example, and that's something that many traditional technologies are not capable of doing. Other areas where you're seeing significant growth are in things like cleaning applications. So there, the lasers, power is used to ablate the surface of the material, whatever that may be to remove coatings or residue that may be left behind during the manufacturing process. We're removing zinc coatings from metal before it's welded together, so that the weld quality is better. We work with manufacturers in the tire industry, both for moving material within the tire molds, removing surplus materials from the tires after they've been made. You can also use the laser in cleaning applications for tanks, storage vessels where you're displacing often chemical solvent acids. So the actual process with the laser is significantly more environmental friendly. And we see that as, I think, cleaning applications have an opportunity to be a fundamental driver for the company going forward. So in that sense, you've got the sort of fundamental laser, which is very electrically efficient, very robust, very reliable. And reliability is a key thing. If you're putting a laser in an automated production line, it's not often the cost of the laser that's the issue. But if you have downtime on an automated production line that can run to an automated production line being down for one day or even a few hours, the cost of the end user can run to tens, if not hundreds of thousands of dollars. So that reliability is extremely important. What we've taken is that core technology, and we can produce lasers with a very wide bandwidth of power and different wavelengths. So you can address many, many different applications in that regard. And we're increasingly seeing, for example, very strong growth in welding applications, sometimes driven by emergent and newer industries, which are less conservative and more aggressive in adopting newer technologies, right? They're not used to using or making a new decision in a greenfield site, and that will often revert to the best technology that's available. So we're seeing tremendous growth from applications in EV manufacturing, primarily in battery, but also in motor manufacturing, even the body-in-white applications on EV, and that's sort of driving some of the -- clearly, a very strong driver for welding, but there's also -- interestingly, there's more specialized cutting applications there and cleaning applications as well in EV. So that's how you sort of can expand the use case of the laser. We believe that we are really more of an industrial tech company trying to deliver solutions to the end customer and trying to help the customer solve the problems they have and improve the productivity of their processes rather than being an optics company as people may have thought about us over the history of our lifetime.

That's great. Maybe you set the table on kind of the mix of business here. Talk about some of the key verticals and how they kind of add up to your footprint and then also maybe give folks an appreciation for the geographical representation.

So we tend to think about the verticals more in terms of applications because it's sometimes difficult for us to accurately identify specific industries that the lasers are going into because we're often one step removed from the final customer because we've got a big OEM supply chain. In terms of those initial applications, verticals, cutting applications were about 35% of sales last year. Welding for the first time was equal to and I think in Q4, slightly larger than cutting. So we've always said that welding has a tremendous opportunity to address a market that in total is about $20 billion, including some of the wire. The equipment part of that market is 30% of it. A subset of that equipment market is the handheld welder market. So we've introduced a device that addresses handheld welding in many of the fabricator and job shops, and that's growing very significantly. It brings many of the benefits of the laser to the end user there. Again, the number of different types of materials, the compactness of the device, its electrical efficiency. We're actually delivering that device with some options that include cleaning capability. tens of recipes to weld different types of material. And the real benefit, even though the price point of that is higher than a MIG or TIG laser -- MIG or TIG welder is that you can train someone to be a welder on it in a very short period of time. The estimated shortfall of welders just within the U.S. is approaching 400,000 people. So if you can train someone to weld accurately and well very quickly, there's a significant advantage to that. And the payback on the system apart from the improvement in the quality of the welding is really if you can save, $5 or $10 on your welding cost, all employ somebody who's never done really any welding before, right, and train them to use this so that you can now increase your throughput through your factory for the business, you'll pay back on that device at $10 an hour savings is less than a year. At $5, you sort of 1.5 years to 2 years payback on that. So the welding has grown significantly, that's addressing many fabrication and job shop areas. And then -- so that makes up about 70% of the business. The smaller application sort of cleaning is growing, but still less than 10%. We've got numerous other areas like marking and engraving that's been historically a big part of the business, probably about 7% or 8%, and then more specialized applications in advance, so government, whether using the laser in a defensive capacity or to destroy material. Other advanced applications, we're working -- doing a lot of work with the semiconductor industry, not on lithography, but other applications. And if you see sort of this significant increase in investment that's happening around some of the semiconductor and chip production that should be a tailwind for IPG there. In terms of geographies, last year, China was about 34% of total sales. Europe and North America are about 25%. And then the other 20% really coming from Southeast Asia, Japan, Korea, other parts of Asia and Southeast Asia and the rest of the world. The good thing is that we've seen that concentration of revenue in China come down. So historically, for example, North America was as low as 15% of our sales, that's grown very strongly. Europe in the second half of last year was a bit weak, given some of the macro, but that's also a strong contributor to the business. And we like that geographic mix change that we're seeing where there's less exposure to the China end market and strength elsewhere. In China itself, there's also a much greater diversity of applications that we sell into than if you went back 3 or 4 years where that business was -- 60% was cutting applications, right. And now the cutting -- flat metal cutting applications are about 30% of Chinese sales or less than 10% of our total sales. We've been trying to drive a lot of diversity from both the application set and the geographic set to reduce some of the sort of volatility and risk profile around the business.

Great. Let's kind of maybe keep pulling on some of those applications, talk about those applications in the auto market. I get a lot of questions. We've got kind of 2 dynamics, right? We have production, it's kind of growing again as supply chain has started to improve. And then we've got this massive mix shift or adoption of electric vehicles. Can you maybe talk about the applications in kind of core auto and EV and really how you play in those markets?

Yes. So historically, sort of internal combustion engine, ICE sort of investment, we'll be able to identify in any quarter, 10% to 15% going into older automotive. On top of that, a lot of cutting applications would go in there. So we'd say that 20-plus percent of our total sales was probably going into automotive. We wouldn't be able to always identify specifically on the cutting -- flat metal cutting, how much was ending up in automotive, it was also other transportation areas. What you've seen over the last 2 to 3 years is that the investments into traditional automotive clearly have been significantly lower because most companies have been focusing on the strategic shift towards EV. And our EV sales have gone from low single digits 3 or 4 years ago. Exiting '21, they were about 10% of consolidated sales, and last year, about 20% of consolidated sales. And within EV, the battery applications, which I mentioned that are welding, cleaning, foil cutting. We're introducing new applications. We've just introduced a special diode laser with very high power for some drying applications within certain areas of the manufacturing process. We're looking at some of the motor manufacturing, so there's cutting and welding applications within motor. And then within an EV vehicle compared to an internal combustion engine, if you look at the main body, there's not much difference in labor content around the main body, whether it's a seat back or an airbag detonator or the tailor-welded blanks, for example. There are some people who are doing more casting of certain parts of the vehicle, which would obviously reduce some of the welding. But you have a decrease in welding on the transmission side, which was a big driver of laser use because transmissions became increasingly sophisticated and lightweighting of them was important. Alloys were being used, and you went from 3 speeds to 7 or 8 speeds. But the increase in usage relatively speaking for batteries as compared to transmissions is several times greater, right? So the overall EV automotive opportunity is much greater than historical use of lasers within the ICE ecosystem even though that had increased significantly.

Yes. Let's maybe pull back out the geography. I get a lot of questions on what does a China reopening mean for IPG Photonics? Maybe talk about how that Chinese market has been for you over the last couple of years and what your crystal ball says here if China reopens?

Yes. China clearly has been -- even over the last couple of years, it's been from a macroeconomic perspective, particularly at the end of last year, really very weak. I'd say it's been weak for almost 18 months. There was some indication that it was going to be a bit -- was a bit stronger in the first half of last year. In the first half of 2021, it was also stronger and then kind of died off again. So particularly on the core industrial end markets or whether there's a significant amount of infrastructure investment or heavy equipment manufacturing, for example, that's certainly been weak. The strength we've had is the sort of diversification of that business, not just into EV, but we've had meaningful customer wins on things like additive manufacturing in China, which is interesting because that uses a relatively low power laser but requires a very, very good beam quality and beam quality drives the productivity of the application and the reliability when you're in storing, say, 10 lasers on an additive manufacturing machine, you can't have 1 of those lasers fail, right? So it's interesting compared even to the local competition. We did well in qualifying on additive. So the business in China itself has been much more diversified. The benefit of that is if you look at the -- some of the industrial -- core industrial applications, whether they be into flat metal cutting or say, even some of the traditional welding or marking, engraving applications. If you do see a pickup in the underlying strength of Chinese activity, some of those businesses are really running at a trough level. Now we don't expect the cutting business to get back to the level it was, but at least if some of the automated manufacturing investment picks up in other transportation as well in elevator manufacturing, for example, which is something people maybe not thinking about if construction picks up. White goods, which obviously, again, is serving a lot of the tail end of the construction industry when you fit white goods in a new apartment, for example, that should drive demand for even some of the basic cutting applications of this sort of trough level. I think the latest PMI data for China came out yesterday or the day before and that for the first time in quite a long time, showed some expansionary tone to it. It was 51 I think, compared to 47 in the last reading. So certainly, there's -- from a PMI perspective, there's optimism around that opening up. I do think it's going to be more gradual. It's not going to be -- and I prefer to see it this way. I don't want to see like a huge pickup in Q -- end of Q1 that drives Q2 and then it falls off in the second half of the year. I prefer a sort of more even pickup and we think the strength is more in the second half of this year rather than the first half of this year. But the first positive was that PMI number, I think, that came out in the last couple of days.

That's great. Let's maybe pivot now to your manufacturing footprint. A lot going on there. Maybe just help us understand where you're adding capacity, reducing capacity, whether you need to add some new geographies from a manufacturing standpoint over time. And also, you've talked a little bit about potentially unwinding just a little bit of the vertical integration that IPG has had, as you look to outsource a little bit of the componentry. Maybe just take us through all those and unbundle those.

Sure. So we had 3 main manufacturing locations around the world, even at the end of last year, right, in North America, in Europe and then in Russia, which was our sort of subcontract manufacturing for components that require a lot of labor input given the war and sanctions. The ability to supply components out of that Russian entity has become severely limited to basically some medical product. And if you can supply other product, import duties, for example, into North America was as high as 45%, right? So there's just no cost advantage to doing that. We've been focused over the last year or so since this crisis arose, and sometimes these crises actually force you to look at the business in different ways and there's often a positive outcome, I think, out of this. We've been -- firstly, we were continuing to use that Russian operation to ensure we have an adequate supply within inventory of some of their components. So we're carrying an elevated level of inventory at the moment related to that. But we've also started to expand manufacturing within Europe and North America, not just in Germany -- and within Europe, not just in Germany. But also in Italy, where the cost base is actually slightly better than Germany, but we're also looking at making some of the core -- not looking at, we have started to -- started making those fiber blocks and fiber couplers in Poland as well, where actually the manufacturing cost is even on a fully loaded basis is not dissimilar to Russia. So if you can continue to execute upon that. And the key issue there will be ensuring over time that you get to equivalent yields, for example, on productivity, right? But even at the beginning, if the productivity isn't exactly equal to Russia compared to the cost base elsewhere, you're going to have a significant benefit from there. The benefit of our Italian operation is that they've been producing optical components for a long period of time related to our telecom business. We shut our telecom business down. So that freed up some of the capacity there, but they're also hiring people. In North America, we're using -- we're expanding in some of the manufacturing around the key optical components. We're considering whether utilizing low-cost areas in North America, such as Mexico would have some benefit to us. We may look at that more on the system side. But I kind of -- I've -- in terms of low cost and like geographic proximity to our manufacturing in Germany, I mean, if Poland can be made to work, it's got a lot of advantages. The other aspect of what we're doing is looking at automation. So trying to look at how to automate more broadly some of the assembly processes that we've had internally. We've successfully done that on a lot of the diode manufacturing. So we never outsourced our diode assembly of the packages. We've automated them and brought the cost of those down through automation. If you're successful with automation, the gains that you get are far exceed a low-cost manufacturing area. In terms of outsourcing, we have identified some of those components that were being sourced from Russia as being available from third-party suppliers in China and elsewhere. They're not just in China and the cost of them is either actually pretty much equal to the Russian manufacturing cost, obviously, they're coming out of China or even sometimes slightly lower. In the long term, you've got to make sure, though, given some of the geopolitical tensions in -- with China, right, that you're not going to be totally dependent or you've got other sources of supply that can offset that external outsourcing that you're doing at the moment. But as I said, I think when you go through these crises, you have to look at all different aspects of the business and work out what the opportunities are that you can get from resolving those problems rather than kind of sticking your head in the sand and not thinking about it more broadly and laterally, right? The benefit of Chinese competition is that there are these components available. The downside of Chinese competition is Chinese competition.

That's great. Maybe a lot of moving parts with manufacturing have executed really well in a difficult environment. How do we think about gross margins? You've typically talked about this 45% to 50% range been running at the lower end of that for obvious reasons. How do you think about this newer footprint and how you're producing product? FX was also a big burden to you as well at times. Maybe just remind people of the FX impacts and really how you think about the business going forward?

Yes. So I mean, you're right, FX was a significant headwind throughout last year with the dollar being so strong. Just on the revenue side, it took about $80 million out of reported revenue on a year-over-year basis with equivalent foreign exchange rates that had an impact on gross profit and gross margin. But we're still relatively comfortable about getting back into the 45% to 50% range. Even if you just look at Q4, we clearly had these very significant inventory provisions related to the Russian operation but if I even excluded those, and I did not add those back to arrive at the 40% gross reported gross margin, we had elevated provisions elsewhere in the world, given the amount of inventory that we're carrying. And in Q4, they were almost 400 basis points. The real target has to be getting back to having -- I think a manufacturing company is doing well if they're at 150 basis points or less on your inventory provision. So we've got the stated goal of focusing on inventory management and really trying to get inventory down because whenever it's running at an elevated level, no matter how strategically you think your purchases are, there's always issues that you'll find within that inventory. So even getting provisions down on average to say, below 150 basis points takes that 40% gross margin, and you can add 250 basis points to that. Import duties are continuing to run at an elevated level in Q4 and will in Q1. You've got higher shipping costs. We actually are starting to look more in detail at shipping costs as well, whereas last year, you just focused on moving product around, right, rather than looking at how to optimize certain things like that. And then we've got all of our similar cost reduction initiatives around product, whether it be looking at new diode designs, which they're looking at, adding more capability around the laser. So we talked about providing solutions to customers, right? I mean you get into that rather than just supplying the laser. We're certainly looking at that and ability to price that solution relative to the benefit the customer is getting, right? So we've got those cost reduction initiatives, which often reduce just the bill of material cost of the device and then looking at the value that you're delivering to the end customer, right? And we're constantly trying to run ahead of where the competition is, like any technology company and provide a better solution and a better product to them. And then the automation over the medium term, as I said, if you succeed in automating different elements of the production process, your advantage in cost reduction from that is often much greater than simply looking at a low-cost manufacturing area to manufacture in.

Great. Maybe we're moving towards the end here, but maybe your balance sheet is loaded, talk about capital deployment, dividends, buybacks, M&A. How do you think about deploying capital strategically?

So I mean, at a high level, capital allocation, it's not that complicated, right? If you're generating free cash flow, you can utilize that on acquisitions for inorganic growth. We haven't done a lot of that recently. Again, given everything else we've been focused on trying to deal with. But more recent things that we have done that have been successful are really looking at how we can acquire technologies that integrate well with our solutions and enhance the capability that we can deliver to the end customers. So I'd say the acquisition of Laser Depth Dynamics, which introduces its real-time weld monitoring capability has been exceptionally positive in driving some of the real traction that we're seeing on the EV side. Outside of acquisition -- so we're continuing to look for that kind of strategic acquisition that really can leverage the ongoing sales of the company. In terms of other capital allocation, you're right. We've got a very strong balance sheet. And if we look actually at the amount of free cash flow that we've returned through buybacks over the last 5 years, its about 90%. Having even having done that obviously we still got a lot of cash. I really like the way we were patient around a lot of those buybacks. I mean we didn't know that there's going to be a war, but there's always an opportunity, I think, in the capital markets, you're going to do your buybacks on an opportunistic basis to wait until you can really drive better value out of that. And $500 million of the buybacks that we've done in total were -- and that was about 60% or 70% of the total was done in the last year, reducing the share count by 8% or 9%. So we were patient in waiting to do that. Capital allocation gets talked about regularly, but I certainly think if you look at some of the metrics, we've done a lot of what we said we'd do and being disciplined and have a good opportunity to make that capital deployed, actually have a significant return to shareholders, particularly it was done over the last year or so. But yes, we've got a pretty flexible policy as well at the moment, but have demonstrated a commitment to returning it when we think there's value to add from it.

Yes, definitely. I think the returns are going to do quite well from these buybacks. Hey, we're going to end up with this. Drop the mic moment for you, Tim. You've got 30 seconds, direct message to the audience. What message do you want them to take away? No follow-up from me and [ have at it ].

I think the main thing is that the diversification that we've been pursuing within the company is really reaping benefits. It's still a little bit hidden because of the headwinds around the cutting business that we've experienced over the last year, 18 months -- 24 months, but emerging growth products last year had very, very strong double-digit growth. They're approaching almost 45% of total sales. There are new product introductions that are coming to -- double digits, I think we are above 25% year-over-year growth, right? So that whole diversification strategy that the company is pursuing is really starting to take hold and some of the risks related to competition, I think because of that are becoming more muted.

Perfect. Tim, thanks very much. We will be adjourning to the breakout room down in the Cordova's. So we can take the discussion down there. Thanks so much.

Thank you.