IPG Photonics Corporation (IPGP) Earnings Call Transcript & Summary

Okay. I've gotten the clock here, we're going to get started with the last session of the day. Thank you, everyone, for sticking around till the end of the day here. I'm really excited about this session. My name is Ruben Roy. I cover Applied Tech here at Stifel. And this is a story of IPG Photonics that I've been talking with investors quite a bit about over the last several months, and I'm really pleased to have Tim Mammen here, CFO, to run through the story. Tim, thanks for joining us. I think just to level set some of the investors here that might be newer to the story, a high-level overview of IPG Photonics would be useful kind of the technology, markets and customers that you sell to would be a great start, and we can go from there.

Sure. Good afternoon, everybody. I'll try and get through the quite quickly that broad-based question. So basically, fiber lasers are a highly efficient light source that is -- basically it's monolithic and design, very robust, easily integrated in automated manufacturing systems. We view the fiber laser as displacer of many legacy processes. A lot of those historically have been in industrial end markets, but they're not just limited to industrial end markets. So for example, historically, a lot of our growth had come from the cutting market where you had a very flexible system that drove huge improvements in cutting speeds. Within the welding market now, we've started to see the welding business has increased almost to the same size, which is actually about the same size as the cutting business. The cutting business got some headwinds. I'm sure we'll talk about those. But a laser can do all different types of welding. And actually, again, welding speeds can be improved by up to 4x. You can weld different types of materials, so you can weld reflective materials. You can join aluminum to aluminum, you can join aluminum to copper, high-strength steels. We've seen a tremendous growth in that business from the very specialty type welding that you've got on the battery manufacturing process, both for EV and storage. Other sort of industrial type applications that have performed very well recently at cleaning. So displacing of chemicals, solvents, abrasives, there's billions of dollars spent on cleaning there. It's actually because the laser is a much less hazardous process, you're seeing cleaning grow very robustly. Many of the other processes are both environmentally hazardous and hazardous to the operator. In other areas that we've diversified the business, for example, in medical, you're either displacing an existing laser application or displacing a surgical application, right? So it's a better patient experience and outcome. The growth driver on our medical has been in kidney stone removal. So you're again ablating the kidney stone down to very fine particular that can be expressed from the body. It leaves a smaller substrate behind on which the kidney stone can reform. So 80% -- sorry, 90% of the business is basically industrial-type applications, about 10% of it is either in the medical or advanced applications. Industrial is still a core part of the business. Geographically, we've transitioned historically, China with the cutting business. There was a very strong growth driver for the company. China peak reached about 50% of revenue. It's about 20 -- just under 30% in Q1. So 70% of the revenue comes from the Rest of the World. In Q1, we had good performance in Europe, Japan, Korea, so the rest of Asia outside China and North America year-over-year was a little bit flat because the cutting business was a bit weaker. But again, the diversity of that business meant that the -- I think the North American business was about 20% of total revenue.

Why don't we spend a minute on cutting because that's kind of where it started, right? And you mentioned welding now a little bit -- or about the same size, maybe a little bit bigger than cutting. But I think when you look at China and down to 29% of revenues, cutting had been a much bigger part of the China revenues. Maybe you could touch on that and how you view 2 things. China, longer term, obviously, it's been a very competitive market for you. It has been price competitive with competitors and in some cases, irrationally. So we could touch on that. And then are there other markets in China, whether it's welding or otherwise, additive manufacturing or other areas of industrial tooling, that you think can end up being good growth markets for IPG as cutting continues to become a lower percentage of your mix?

Yes. So in China, the cutting business is less than 30% of total revenue. At peak, that was 60% and China revenue is higher, right? So there's been a very significant headwind. In total cutting last year was down 20%, whether it's China or the Rest of the World, these emerging growth products, which cover some of those applications you talked about last year, those grew in total by about 30%. If you stripped out FX, our revenue would have actually been up slightly rather than down slightly. So you're almost at the point where you're offsetting these really strong competitive dynamics in the cutting business in China. My view is the cutting business in China is basically much more of a niche business now where the lasers are used in automated processes where there's very high throughput or heavy equipment manufacturing, even some of the OEMs who export systems out of China use our lasers on their export systems. But -- is China going to be returned to being 50% of the cutting business -- 50% of revenue, no. So the real growth in China has to come from the similar emerging growth products, right? So a lot of the EV investment cycle historically has already happened, but it has been concentrated to date in China, you're starting to see a more meaningful pickup in the rest of the world. We've got a strong additive business in China, the cleaning applications have grown strongly there, both related to EV and non-EV. The additive is being driven by sort of the emergence of the aerospace industry there. So these sort of the remaining applications in China have grown equally as strongly as they have in the Rest of the World. And then in Welding, for example, we don't really compete with the local manufacturers. We're competing with a large German company more so there's a tremendous amount of technology delivered around the welding application, right, whether it's a different type of laser with adjustable beam or a single mode beam, so a very, very stable beam you're then delivering the laser with a scanner, the real time, not only is it testing the weld, it's actually measuring the well. So that's enabling these very, very sophisticated welds to be performed to a very, very high degree of quality. That's driven by the Laser Depth Dynamics system, that drives very, very significant improvements in yield. We've seen some customers go from like 60% yield on battery to 90% yield on battery. So it's the full complement of that technology that drives the welding. On additive manufacturing, it's more the reliability and stability of the laser because those are not very high power lasers. So you'd expect the competition locally to be potentially a supplier to that industry where we've been qualified ahead of them in part because they're building systems with maybe up to 10 lasers in them. If 1 of those lasers fails, you can't be growing the part from 9 dimensions and not from the tenth dimension. So in these different applications cleaning is driven by very, very high-power pulse lasers and pretty unique technology there. We've got a bit of a medical business in China as well that does similar urology type applications. That's a bit more obviously ring-fenced and protected from the different type of laser in that, so both from an IP and qualification process. So yes, we view the rest of the business in China as being very important, but the dynamics around it are very similar. There's significant growth opportunities for all of those applications globally as well.

That's helpful, Tim. I want to drill into welding in a second. But just thinking about cutting for a few more minutes and you think about non-China, China, obviously, is a pretty big portion of industrial manufacturing globally. If you look at kind of global what's going on, are there opportunities? How far along are we with cutting in other geographies? And do you think there are growth opportunities in Europe, North America, Japan or elsewhere with cutting applications for IPG?

Yes. We remain pretty optimistic about cutting applications in the Rest of the World. I think first of all, China accounts, I think, for like 29% of industrial output, more than 50% of cutting lasers globally are sold in China, right? So the proportionate number of cutting systems and lasers sold in China is far greater relative to their total industrial output. I mean they were a major industrial output proportionately, but 70% of that is on a global basis. So we actually, in Q1 had very strong sales of cutting applications in Japan, in Europe. North America was a bit weaker, but that was not competitively driven. That was more -- some caution on investments being made the job shots application, not application centers, but fabricators not making investments given some overhang on the macro and the higher interest rate environment certainly slowed down the cutting business in North America, but much less that was not so much competitively driven. So I think that the cutting business globally, the forecast is that it will still grow at about 5% per year. I think most of that growth will come from outside of China. So we're continuing to be optimistic about it. And then in the Rest of the World, they're still moving to higher power levels, right? So 15, 20, 40 kilowatt systems, again, the Chinese were ahead in adopting those very, very high power levels, and you're starting to see that more migration a bit more in the Rest of the World.

Great. So let's move to welding. What -- how are you looking at the TAM? And there's various as you mentioned, there's a lot of different areas of welding, EV. There's just a lot of different types of welds that go into the chassis or the battery and different parts of the battery, different need different welds. I guess, in a few minutes, can we talk about the TAM overall for welding and what the most attractive end markets are? And then I also wanted to get into your hand welding products and if that's something we should think about separately from kind of the broader welding opportunity.

Yes. The total welding market is extremely large. I think, right, if you include the wire consumable, it's more than $20 billion a year. I think total equipment side is about $8 billion, the handheld in total is about $2 billion of that. Laser penetration into the equipment side is probably somewhere around 15%, but a laser will do every single welding process that exists out there and to a better quality and a higher speed and enable you to well different materials together. So in terms of joining, you're also displacing things like riveting, right, which people want to use aluminum to reduce weight, if you're adding rivets, you're adding weight. With the laser welding, you're not -- you're actually fully benefiting from the weight. So you've seen these sort of industries that have not -- it's the newer industries that have been very rapid adopters of laser welding even more than looking at older technologies. In some of the older industries, there is a sort of intransigence to move more quickly to welding. And it's difficult to pick why that necessarily is. Sometimes there's different certifications you have to achieve for welding pipelines or pressure vessels, for example. Sometimes the upfront CapEx equipment cost is quite high even though the payback is may be lower. We've seen a rapid uptake of the handheld system. We believe about half of the total handheld market could be addressed by the laser because the rest of it is very, very low cost. Our penetration into that is still very small. If we could get to sort of 20% or 25%, you'd have a $200 million handheld welding business, that would be a meaningful part of total revenues and that would be a significant growth driver for us. We're continuing to work very hard on driving more deeply into broad-based welding applications, but some of the industries are more conservative around that. But just even on the EV side, if you look at total capacity additions, that in itself should expand the total laser-welding market very, very dramatically.

But -- okay. And we're seeing that. It's showing up in the numbers. But to your point, on some of these other more legacy markets, if you will, for whatever reasons, it's tough to change sort of methodologies that have been put into use for many, many years, but you do believe longer term without putting words in your mouth, that there are opportunities to take away some share from maybe a big tick welding in certain markets or certain areas of welding just kind of areas that you just will not be able to sell into longer term.

No, I don't think any area is unattainable. I think it's a question of time and working with the end users. I mean, for example, we've sold lasers into heavy equipment manufacturing for welding into agricultural equipment for manufacturing into fabricators. So into the traditional automotive industry for body-in-white applications, into consumer durable goods. But it will take -- none of it is unattainable. I mean, even like pipeline welding, you -- people have done huge amounts of research into that. You'll sometimes find that the welding speed and benefit can't be fully realized because the other processor feeding material in can't actually keep up with the laser. So at this point in time, there's a reticence to invest in the laser because they can't realize the full benefit of it, right? So sometimes as the other processes around a construction or fabrication that will limit the adoption of the laser initially. And then a lot of welders themselves, particularly when you get on to the handheld stuff, they're probably against laser welding come into focus because you can train people to do laser welding very, very easily. But yes, I think the whole market is open to lasers.

That's helpful. All right, one more minute on the -- on some of these end markets. When you talked about some of the new markets, cleaning is something that sounds like you're excited about, even newer than that, potentially drying of things, like battery foils, how are you thinking about those markets as you look out over the next 24 or 36 months? Do you think you'll see those markets grow faster than, say, welding? Or is it still too early to tell sort of how those markets ramp?

Well, I mean I think the welding market is going to just grow very robustly because of a lot of the EV investments and not just EV battery investments for storage and EV, but the growth out of cleaning, it's still relatively small part of our business, it's sort of like 5% of total revenues. But that has grown dramatically over the last year. Again, some of that's EV driven. Some of it is aerospace, where our lasers are used to clean tire molds, you can clean storage tanks and vessels, you're removing corrosion. I mean there's tens of billions of dollars spent ideally removing corrosion of materials, you're removing coatings of metals prior to them being welded, for example, or used in some other production process. I've always said, I think cleaning can be a very significant application. And the interesting thing about cleaning is that it's not just being -- it's not even really being driven by the economics. It's actually being driven by the hazardous nature of existing cleaning processes. And I mean, some of the feedback we've had from customers is that they find it hard to even employ people to do those cleaning processes. They're so hazardous, right? So it's not as though on cleaning, you need to get to sub 2-year payback before people will look at the application. It's sort of almost from a health and safety perspective that it's being adopted.

Got it. All right. I'd like to shift gears now and talk a little bit more about manufacturing and the model. And I think one of the questions we get quite often from investors is around your exposure to Russia and manufacturing facilities there. Obviously, there's -- with the conflict last year sanctions and a transition into manufacturing more elsewhere. So maybe you can just walk us through where you are on that roadmap of increasing output from factories elsewhere and what's left that needs to be done in Russia?

So at a high level, we believe that we have derisked the supply chain, right? We were able to ship components out of Russia through the end of last year, and we've built a significant inventory of those components. As we transitioned, we started ramping up production in Europe and North America during this -- primarily during the second half of last year, accelerated that into the end of the year. So now you've sort of got this Russian inventory of components is coming down as production is ramping in other areas. For example, in Italy, they're already up to producing at the capacity levels that we targeted. They're actually at a cost point that we'd already targeted at the end of last year on some of the fiber blocks. They are at a cost point on supplying some of the lower medium power lasers into China. Their costs are higher than they would be in Russia. In Germany, there's obviously -- there's a huge amount of manufacturing expertise there. And we didn't have to transfer any technologies. We're just expanding production. Costs in Germany are quite a bit higher than they are in Russia. But in Poland, our labor costs on manufacturing, even engineering are basically very similar to Russia. The issue is that Poland was a greenfield site. We've never done any manufacturing there, right? It was just service and support. So they're running at probably 25% or 30% of the ultimate target level that we want to get them to. They think they can get to the full capacity run rate during the second half of the year. So then you have got a big cost benefit that comes out of that. But we are basically not reliant on nor can we be dependent upon Russia to supply optical components. And we chose not to -- apart from some medical products, use them to continue to supply anything material in terms of like medium power lasers to China. They're doing some small quantity of pulse lasers, but that's basically it. And then we said that we were restructuring those Russian operations. We started to do that at the end of last year. We continue to restructure those operations and try and get them down to basically being EBITDA neutral. They're continuing to supply lasers locally, but yes, the supply chain is derisked from our perspective.

Without speaking to a detailed number, is there a headcount ballpark kind of, I guess, a better way of phrasing that question -- it takes time to restructure operations in a lot of areas of the world. How should investors think about timing to get to EBITDA breakeven in Russia?

Yes. And I think we -- in Q1, they were still running at some small EBITDA losses, but relatively speaking, even in the last month of 2022 headcount in Russia went down from 2,200 down to 1,600 people. You know probably a couple of months to get to where we are, so we continue to make progress this year on that. Yes, a couple of more months for that.

Do you think longer term, that's going to end up being a stub kind of manufacturing operation facility for IPG that continues to supply the local Russian market? Or do you think -- I mean maybe it's too early to really have a kind of target on this, but do you think that it's necessary to have operations in Russia?

Yes. We've been very cautious on what we say about this. I mean at the moment, we're focused on the restructuring efforts. And then I mean you either leave it as a stub business or you -- I mean a lot of people try to exit Russia rights and there's a process that's complex to do to exit from. And until you have a definitive answer on it, we haven't really said what we're going to do kind of jumping ahead of -- you don't know how long it's going to take or where you're ultimately going to end up there.

Got it. So let's think about gross margin, right? Germany is a little bit more expensive. Poland is coming up and you're getting utilization levels, hopefully by the end of the year, the targets that you're looking to get to. You've got this longer-term target range of gross margin. If you can get Poland to where you want to get Poland to by the end of the year, and Germany continues doing what it's doing. How are you thinking about gross margin relative to your target in that sort of outcome?

Yes, we can get Poland to where we want to be. I mean, I think it's even a bit simpler than that if you step back, like because we're carrying the significant amount of inventory, not just related to Russia, but some of the electronic supply chain issues that we faced, our inventory provisions were still quite elevated in Q1. They were 350 basis points, right? I think as a manufacturing company, you get those down to 150 to 200 basis points, you're doing well. So that would be a 150 basis point pickup. We're trying to generate cash out of inventory at the moment. So some of our utilization of the fixed cost was a bit of a headwind in Q1, and I expect that to persist during the course of the year, but it was probably another 100 basis points. So just those 2 things kind of get you another 250 basis point improvement. There's a lot of stuff as you ramp up Poland, you start to get the cost benefit from that. We're looking at automation within different manufacturing process. Again, that's probably more of a medium-term investment. You're looking at new designs of different components, whether they be diodes or other optical components that have more efficiency. If you got a brighter diode, if you can generate a brighter diode to more coupling efficiency, you need fewer diodes to produce a finished laser, you can simplify the architecture of the laser. That takes the bond cost down. The mix towards welding, particularly on the more complex welding processes where you're driving real value to the end customer. I mentioned the yield improvements that people get. That's -- those kind of sales have a higher margin on them than the low end of the cutting business. I mean, ultra-high power lasers for cutting have a good margin on them. The medical business has a good margin on it. So from a mix perspective, that should help. But there's a lot of levers, right? You have to get over these different hurdles, whether it be the inventory or ramping up Poland and ultimately adjusting the cost structure down further in Russia. So over time, we will get those back and then get back within our above 45% range. I think scale on the business helps as well, right? Revenue has been relatively flat for quite a while, right? We've had good quarters and less good quarters. But if you can get revenue, so the headwinds around the cutting businesses they can be moderated and continue to grow these other businesses and get yourself above $375 million to $400 million, just that scale helps in terms of drop through absorption of fixed costs as well.

So with that in mind, at sort of that range of revenue, whenever that happens, we get back to that level and we're done with sort of these transitions and the inventories come down. The -- I mean, you've kept your target, your longer-term target. But do you think that's the scale of the business to get to the higher end of the target? Or is there sort of more work to do?

Yes, I mean the higher end of the target, I mean, we'd like to be just above the 45% in the middle of that range, right? I think that would be significant improvement from where we are right now. So I think it's just important to get back into that range and stabilize the business model. And if you can get back into some -- in order to create value, I would say like if you can get gross margin stabilized and a moderate amount of growth out of this business, given the cash generation and earnings generation of the model and there's a huge return potentially to come from that.

Sure. We have a few minutes left. Any questions from the audience? Okay. We'll keep going. Why don't we talk about cash -- cash generation, and you guys have been pretty aggressive, I'd say, on the share repurchase. What's the philosophy on capital allocation. And you've done a few M&A transactions over the last 5 or 6 years. Maybe you can just give us an update on kind of how you think about cash longer term?

Sure. I mean, first of all, I think given all the challenges we've had to deal with, we haven't really been focused on M&A. I think also valuation expectations have been pretty high there. We still don't view ourselves as like a consolidator within the industry. We want to look at -- we do want to go back to looking at M&A on a sort of more programmatic basis. I mean some of these things like the Laser Depth Dynamics acquisition, which has driven a huge amount of the EV was quite a small application, but it's driving tens of millions of dollars of revenue now, right? That's like almost the perfect kind of acquisition, that we'd be prepared to look at bigger stuff as well, a few hundred million dollars in revenue. So we want to preserve firepower on the balance sheet and borrowing capacity for that. Having said that, we have kept a very strong balance sheet whilst returning almost $600 million of capital in the last 15 months or so to shareholders, reducing the share count by more than 10%. And that was because I always think these opportunities arise somehow that if you can be patient, you're going to be able to deploy capital opportunistically and hopefully create greater value rather than -- if you think the stock is trading at a premium, we generally do only anti-dilutive buybacks, right? Given the overhang related to the Russian and the war issues, we felt that there was a significant discount that we're trading at. And became much more aggressive relative to what we've done over the previous 5 years or 6 years even. So yes, I think we're definitely looking at acquisitions and carefully and really has to be technology-driven or end market-driven rather than just trying to consolidate disparate technologies together.

Right. And You did divest the telco business.

We did get with the telecom business last year, yes.

Last year or so. Okay. We've got 2 minutes left in. Did I miss anything? Are there any takeaways you want the investors in this group to leave with here today that I missed?

No. I mean I think the welding market and the EV, these other applications that are growing very robustly. I think I mentioned at the beginning, like you almost offset the headwinds around the cutting business last year with the growth in the emerging growth products and these sort of secular investment cycle now is not like 1 or 2 years. It's the next 5 to 7 years. And just around battery. We didn't touch on the things like drying where you've got the energy efficiency of the laser potentially displacing an infrared light source in drying applications. These are all pretty strong growth drivers for the company and in the coming years.

Right. Exciting stuff. We have a minute. Any last questions? Looks like everyone's tired, Tim. End of the day. Thank you, everyone, for coming, Tim. Thanks so much. Great story, and we look forward to following along.

Thank you.