IPG Photonics Corporation (IPGP) Earnings Call Transcript & Summary

All right. Good afternoon, everyone. I'm Brian Gesuale, senior analyst at Raymond James. Thanks so much for joining us. We have Tim Mammen here, the CFO of IPG Photonics to take us through their story. This is a story that we think is operating near trough earnings with an awful lot of earnings power and drivers to the business over the next few years. So we think the timing is great to have you visit with us, Tim. Thanks so much for joining us.

Thank you, Brian. Thank you, everybody, for listening in.

Well, let's just jump right in, Tim, maybe level set the audience here, give people a sense of what IPG Photonics does a little bit on the corporate history very briefly and maybe how you position yourself in the marketplace and what your competitive advantage is?

I'll try and get through that one briefly. At the heart of basically what IPG is doing is, we have a very compact, reliable electrically efficient laser that often improves productivity, improves quality, can process many more disparate types of materials than traditional technologies, has better electrical efficiencies, more reliable, extremely robust. And the core of what we're doing, and this goes back to even at the beginning of the company's penetration of the industry is really displacing existing technologies with this better mousetrap. The number of technologies that we are starting to displace is, is becoming more diverse and more interesting. But if you go back even to the marking and engraving, which was one of the earliest applications out there, you are displacing inks, chemicals, basic marking processes, in cutting applications, which were a very strong driver for the company from 2008 until 2021, 2022, even the beginning of '22, the cutting market performed well. You're displacing punches, presses, tools, mechanical saws, plasma cutting, any separation processes. So -- and then you can take that into other areas, additive manufacturing, which is probably one of the more disappointing applications in terms of displacing reductive process, so machining or casting, but there's still capital being deployed in additive manufacturing to try and improve the speed and repeatability of growing parts. So you can basically grow more complex products, if you can make that application successful, you're eliminating a lot of scrap metal that's created in a machining process. Other applications, which are performing very well for us, cleaning is an application that I'm a very, very strong proponent of because when you clean surfaces with a laser, you're eliminating chemicals, other abrasives and those chemicals and abrasives themselves get contaminated during the cleaning process, whereas the laser energy is basically ablating the surface of production molds, tanks that are used in storage, cleaning corrosion off parts before you're processing them, removing paint or coatings of materials. So you're taking a highly impactful from an environmental perspective process and trying to make that cleaner. It's a less hazardous process for the operator. That market is extremely large. It potentially runs to several tens of billions of dollars. It's probably larger than the total welding market is. But you're trying to change the entire market, right? This is an evangelical process, and you're going up against many of the incumbents who produce those chemicals or other abrasives, and you can't really partner with them because you're kind of cannibalizing their own businesses, and that's similar to the welding market where it's taken time for lasers to be adopted in welding, even though they can perform just about every welding process to a higher speed and better quality, but there's an inherent resistance to adopt the laser because you're being destructive to the existing processes. Other interesting areas are just introduced a system for heating and drying applications replacing ovens and furnaces that has, again, a broad set of users in drying coatings or even in food manufacturing, drying a pasta. I mean we've even baked the cookie with the laser. And the speed with which you can bake the cookie is multiples of the times faster if you're drying foils within the EV industry, the speed with which you can dry the slurry that's coated the foils is, again, multiple times faster than the existing technologies. Even in the medical, you're displacing invasive surgical procedures where with the laser, you have a better patient outcome, you may have -- it's almost an outpatient procedure, not quite with the lithotripsy, the kidney stone removal. So the laser again, it improves the experience and often with the lithotripsy application, it ablates the kidney stone down to very fine particulate that can be expressed out. So it leaves less substrate for a kidney stone to reform on it. So I mean, that's basically at the heart of what we do without going into like the original development of the diodes and all that kind of stuff. This is the core strategy is really to find these large end market opportunities that you can drive secular growth of lasers into them and in that way, start to hopefully drive a recovery in our business, which was very successful and based upon the cutting business, but obviously has had significant headwinds, partly driven by -- well, in China, all driven by competition. And more recently in the rest of the world, the cutting business has been challenged with some of the weaker global investment -- industrial investment activity.

That's a good point on the markets by geography. Can you maybe talk a little bit about how your market by region has changed over the last 6 or 7 years and maybe the complexion of what that business was serving in each of those end markets.

Yes, sure. So right now, last year, China was just under 30% of total sales. In Q4, they were 25% of sales. Europe is about 30%; North America, about 25%. So those 3 make up 85% of sales. The remaining 15% is the 2 other large markets, Japan and South Korea with the rest of the world making up the rest of it. The biggest change we've seen over the last 3 to 4 years is China used to be -- I mean, I think the peak revenue, 1 quarter, China was over 50% of total sales. So that's come down fairly significantly. It was also dominated by cutting applications. Those cutting applications in China now are really a very small part of China sales in a very small part of our total sales. So the cutting business, unfortunately, in China has had these very strong competitive issues that we've had to face, whether the Chinese competition is basically pricing their product at a real -- a huge discount to where we're at. A lot of that is we believe it's unfair in terms of the subsidies in other ways. So the China decrease as a percentage of the total and the complexion of the China business has also changed. So cutting is a very small part of that, but other applications like the welding, cleaning, additive manufacturing is actually doing very well there, other fine processing applications, some microprocessing applications using more specialized lasers make up most of those China sales. Some of them are driven by the investment cycle in EV. Some of them general industrial, some of the more specialized type areas in like renewable energy or micro processing would be processing of sort of nonmetals, ceramics, silica, different types of glasses. So it's much more -- it's a diverse business. It's unfortunately a smaller business. The rest of the world hasn't changed the complexion of the business and the rest of the world hasn't changed nearly as dramatically like cutting is still an important part of it. Welding certainly growing very dramatically. So if you look at the applications globally, last year, 36% was from Welding. Welding actually grew by 13%. The cutting applications in total ended the year, I think, at like 25%. For the full year, they were like 28% as well. You've got marking engraving is still 7% or 8%. So those three make up 60% of the total, and then you've got a bunch of different applications that are emerging like medical is another 7%, and then cleaning the other applications that range between 2% to 5%. So can cover a very fairly diverse area. But I wouldn't say that there's been a fundamental shift in the same way that we've seen in China and the rest of the world. Certainly, welding has become more important in that business and the rest of the world has certainly become more diverse, but cutting is still an important part of the Rest of the World business.

Is India a market, it's a market we hear a lot about. Is that a market that could open up and be interesting to you in a few years?

I mean India performance -- it's still a small market for us. India is part of that remaining 15%. It's 2% to -- I think, 2% of sales. So one of the challenges in India, if you're talking about like cutting and marking engraving despite the geopolitical tension between China and India, there's a lot of really low-cost lasers and systems that end up in the Indian market from China, some of them coming across a very porous border. So India is an opportunity. You started to see some investments in some of the more advanced manufacturing areas there. EV investment in India would represent an opportunity as well. There's quite like a large -- that's a medical opportunity to and sort of some of the advanced applications and micro processing. But at this point, I don't anything I haven't got a visibility on India becoming like despite the population being similar equivalent size market to China at this point in time.

Okay. Fair enough. I know you don't have perfect visibility, but as you kind of think about your vertical markets, whether it's automotive, consumer electronics, you slice the applications, the regions, what's your best shot at kind of the vertical markets?

General industrial applications are about 50% of total sales. Total automotive is like 30%, 2/3 of that is probably EV. So like more than 20% of our sales come from EV. Automotive has always been in that range of 20% to 30%. So even prior to the EV transition, it was one of the most important end markets. The general industrial can be covering anything from consumer durable goods to heavy equipment manufacturing, other transportation, railcar, elevator manufacturing, infrastructure spending, medical then would be medical applications. That's sort of probably -- if you include medical system sales and not just the surgical applications, the medical end market is probably 10-plus percent. And then you've got all of the other ones like semiconductor, renewable energy, directed energy, sort of government defense, micro processing, consumer electronics, such as -- yes, those are all between, say, 3% and 6% or 7% on those areas.

Great. Let's maybe pull on one that we certainly have a lot of interest in and a lot of investors that I talked to ask about the electric vehicle market and the battery market. Can you explain to people exactly what it is you do in that market, the breadth of your customer base and really who you compete with in this marketplace.

So we're an enabling processing. We've got a number of enabling processing technologies for producing batteries. They include welding, cleaning, foil cutting and now the heating and drying applications. We also -- whether you're producing an EV or an ICE, there's a lot of laser-based processes in tailor-welded blanks, the body and white applications, seatbacks, airbag detonate. That's not a fundamental change between an ICE and an EV. So we still play in the main body applications. We've recently been working and won a contract on welding of motors. So it's a pretty diverse set there. We deal with every single major player in the market around the world, whether it's in China, in South Korea, Japan, North America, Europe. The companies we compete with in that area, probably more on the welding side with one of the big German machine tool companies, to a more limited extent, some of the other western laser companies, I mean, I think everybody is trying to make a push into this area. But when you talk about welding applications, it's not just the laser, there's a tremendous amount of process know-how. There's a lot of other equipment we deliver around the laser, including some of the measuring technologies, which really drive the improvements in yield. We've got customers who've gone from 60% yield to 90% yield, a huge reduction in their scrap rates. And that's not just the laser. It's really incorporating the laser with the measuring technologies. So we deal with everybody in the market. In China, less so competing with the main Chinese competitors because they're not apart from in foil cutting, where one of the companies has got some -- it's basically producing a lower-end pulse laser that's used in foil cutting. They're not really that wide spread at the moment in competing in those other applications. Because of the complexity of the applications or the quality of the lasers that are required in that. And it's not EV but I sometimes call this out with additive manufacturing where we're qualified with the main additive companies in China, even though they're only using like 701 kilowatt lasers. So these are very basic CW, they're not pulse lasers, but where the beam quality, the reliability, the brightness of the beam is extremely important and where they're building systems that may have 10 or 50 lasers in them, you can't have 10% of those lasers failing at any given time because you're then growing the part from 90% of the dimensions that you're trying to grow the part from. So in a lot of these other applications, the quality of the laser and the technology that's delivered around it is extremely important. Yes, we deal with everyone who's within the EV supply chain across all of these geographies. Interestingly one of the comments we made recently was that we're actually starting to see some increased interest from some of the European automotive companies who were probably more closely aligned with one of the major European machine tool manufacturers. And based upon some of the work we've done on improving yields, we've got some R&D projects running with different European auto manufacturers who are certainly looking more closely at IPG's capability as compared to some of the other incumbents in the market.

Interesting. If we think about the -- if we just back out to the EV macro, it's '20 to '22, the market really grew rapidly. Your business doubled in each of those years, '23, the second half of the year, things slowed down. And it looks like CapEx is going to be a bit down in '24. How do you see '24 kind of shaping up? Do you have visibility that there's a stabilization that's occurring? Or how do you really expect that market to develop over the next '24, '25, '26?

Yes, we're going to have a slow start to the year in the first half, which we called out. We do expect to start to see some recovery in that in the second half of the year. If you look at the data that's out there, I mean, it really -- it's not that difficult mathematically to drive this, right? You can look at the total number of vehicle sales and you look at like a vehicle that's got 300 miles range. It's probably got 100 kilowatts of battery power in it, something with 200 miles range. It's got 70 kilowatts of battery power. You talk about suddenly in the last 3 weeks, literally, I think like that's all to hybrids, the way to go. I mean, I think in the U.S. market, there's a lot of confusion about what's happening. EVs have become heavily politicized. One of the states I read was going to start introducing legislation banning EVs to protect the fossil fuel industry. I mean, some of what you're reading about is a bit nuts, but EVs have got their issues around some of the environmental impact of the batteries and stuff like that. But you basically got to look at the number of vehicles sold, multiply the average battery capacity and then look at what the installed capacity and estimates of utilization is there. In China, I think they're very intent on trying to be the global leader on EVs. I mean, some of the commentary is that they never really succeeded on ICE vehicles, but they've got this sort of leadership in EVs, part of which, by the way, was a strategic mistake that the U.S. made selling A123 to the Chinese back in 2008. I mean all of that battery technology was U.S. developed, and it was A123 was kind of before their time. And I mean that was bought by the Chinese. So the Chinese seem to be able to accept a lot lower capacity utilization. I think in the West, there's more of that marrying that utilization with demand and growth. But even some of the headwinds, there was -- I mean, I think the overall EVs last year in China grew by -- I mean they were just under 40% of sales. I think the growth rate was above 30%. Europe grew by 25%, they're 20% of total sales. Even in North America, EVs grew by 50%, but they are still only 8% or 9%. So that transition is still going to happen. I mean, if the average vehicle had a 100 kilowatts of power in it and everything was light vehicle was EV, you'd need like 6 terawatts. And in addition to that, you need storage, one of the Chinese manufacturers said that 30% of their capacity in Q3 was for storage batteries. So the market for storage is also growing, utilizing -- capturing renewable energy sources as well. But right now, there's a little bit of a slowdown because of the capacity that's being built out needs to be growing into. I actually think -- my view is that -- there's data out there that says 2 terawatts has been built and installed. We're trying to run those numbers internally. I think that's a bit overstated. I just can't get there even if you just look at -- I mean take the largest manufacturer in China and back into a number, I think it's most probably 1.5 terawatt that's built so far, which implies the utilization is actually higher than it really is, which implies then that potentially a recovery -- looking for a recovery in the second half of this year and then more robust demand in '25 and '26 is not unreasonable, basically on that basis.

Yes. None of those estimates consider the storage or...

Storage is still very difficult to get data on, I mean I tried -- I mean, like all of us were on the Internet and spend our afternoon searching for this stuff and it's difficult to get any good data on storage. So I mean one of the Chinese stated that 30% of their capacity was being used for storage. That was a pretty definitive data point, but the only one I've seen that's that definitive.

Yes, I think we'll stick in the anecdotal domain for now when it comes to storage. Let's -- I want to -- you get such a good view of the macro and the demand environment, demand has been pretty challenged. PMIs have been very weak typically. If you could rate your major kind of geos on a scale of 1 to 5 for what your demand indicators are, one, obviously, being weakest 5 strongest. How do you think about your regions?

Yes. Sometimes, I think people like to hear me talk because I just talk about the macro that's going on.

You can talk on those more if you want.

We do a lot of work internally on the macro. But yes, I mean, we follow PMI data. We follow Manufacturing Index Data. We look at Japanese Machine Tool Data. We see what we're hearing from our customers on the ground. And yes, I mean at the moment, China is very weak. There's this announcement -- I mean, things are very fluid at the moment, yesterday the Chinese government came out and said they want to try and get the economy to grow at 5%, but they're actually in deflation at the moment, so I'm not sure how they're going to get to that point this year. Europe still -- Europe is kind of at a trough level hasn't worsened. I think it's actually started to stabilize and improve a bit. The PMI data is a little bit better. We're hearing from our customers that they are working through, starting to work through some of their inventory, which was unusual for them to have and that they expect the demand to be more normal relative to that inventory and then maybe pick up if they see an improvement in the underlying demand. I think in North America, the Manufacturing Index Data has started to improve a bit. Japan was pretty resilient in the last year. They've slowed down a bit. We actually had some very good demand out of Korea across some very -- South Korea out of very diverse application set. Medical is doing well there. The EV investment cycle has been quite strong, actually had some directed energy and advanced application demand as well for more high-power lasers in South Korea, too. So that's been pretty good so far, yes.

One of the things that's been a positive surprise to me over the last couple of years is your gross margins. I think you've managed through a lot of challenges and even though gross margins have come down from their peaks, they've hung in there relative to volumes and other things that you've dealt with. Can you remind people of some of the transitory headwinds that you've had on the gross margin side of things and what type of volumes or demand factors you need to see to get back to your kind of target range?

Yes. I mean we've had a lot of challenges apart from the Chinese competition rate, which was a structural shift in gross margin, bringing that from the 50s down into the above about the 47%, 48% range. Subsequent to that, the Ukrainian war, we lost our low-cost production in Russia. So we haven't been able to utilize that for over a year. We've had to restructure that business. We've started to make some of those more intensive labor-intensive components in countries like Poland and Italy. They're actually running now at pretty good capacity and starting to get better yield out of that. So the cost level is starting to come down. So that's a good improvement. But that was a real challenge. And then you've had some of the supply chain issues like we're running quite high inventory days. So in Q4, gross margin was very weak, it was like 38%, for the year, it was about 42%. If you sort of looked at Q4, almost 400 basis of that was our desire to try and get some working capital out of inventory. We generated some cash out of inventory. So you add that back, you're at sort of 42%. And then inventory provisions. Again, this whole inventory thing is a bit of an overhang. We're about 100 basis points higher than Q3. So that brings you back to like closer to 43%. So even at this revenue around $300 million, 43%, 44% at $300 million of revenue, we're continuing to try and get cash generated out of inventory, so there's going to be a bit of an ongoing headwind. Q1 guidance has really impacted because of where revenue is as well as some of the desire to continue to generate cash, that -- so if you add all of that back, we're not seeing a shift on degradation on product gross margin, which is really important to understand. So you can get the sort of inventory headwinds behind us, and we stated an intention to take 15% to 20% out of the cost of high-power lasers this year. They still make up 40% of our total sales. So that will roll into the product line during the course of the year. And the new design that we've got will be used on lasers with up to 20 kilowatts of power. So it's going to cover a very high percentage of high-power laser sales. If we can make those achievements, continue to introduce some of the automated manufacturing, continue to get yields up in some of the newer low-cost manufacturing areas as revenue recovers above $300 million, we'll get -- we should be pretty solidly getting back into above 45% gross margin. I think the other thing though to point out is despite the challenges at the moment, the business is still very cash generative. Last year, even on a free cash flow basis, we were still close to $4 a share. We did dispose of a couple of assets. If you add those back and net that against the CapEx, it was over $4 a share in free cash flow, and we're targeting -- if we can get inventory down and cash generated from inventory this year, we should again have a very strong free cash flow generation year even though CapEx is quite high because we've replaced some of the fiber production that we've lost in Russia, that investment is really picking up this year.

I want to talk about -- so the business has been generating a lot of free cash, as you said, balance sheet is absolutely stacked. Can you talk a little bit about capital deployment. I've gotten tinges of wanting to do some M&A. You've obviously been active with buybacks and your share price at these levels has got to be very compelling. Maybe just prioritize a little bit of what you're thinking going forward?

Yes. So we've been -- we've done quite a lot of buyback activity over the last couple of years. Our view obviously is that we think the stock is trading at a discount to the potential opportunities out there. So I mean we bought back like $850 million worth of stock in the last 2.5 or 3 years, reduced the share count by, I think, 12 -- maybe approaching 13%. We just announced another $300 million buyback. So there's a tremendous amount of capital that's been allocated to that. M&A, given that we've been dealing with Russia and some of those other challenges has kind of been on the back burner, but we've hired a couple of people who are business development specialist who's looking at stuff there. And we're really looking at areas where there's a whole host of new opportunities we're trying to grow into. We're not looking at this on a consolidation perspective. We're looking at it from either a technology or a distribution perspective or accelerating the scale that we have in some of these emerging areas. And we're definitely looking to deploy some capital in -- on M&A within the next 12 months or so. But again, it's not like on the consolidating level. It's more on where can value from a technology and distribution -- and we want to sort of -- I think we're approaching this programmatically is very important because you build up experience and learn your capabilities and what resources you need to add, particularly on integrating and driving value from the acquisitions as you go forward. But it's certainly an area one. Otherwise, we've got a pretty much overcapitalized balance sheet. We're not going to use cash in inorganic opportunities.

Absolutely. Last question for me. Tim, no follow-up. Just maybe talk directly to the audience here on why they should consider investing in IPG Photonics. Demand has been challenged. I think there's a lot of earnings power, a lot of value in what you're doing as a disruptor still in the marketplace, but speak directly to them.

I mean I think we've covered a lot of that, and you just summarized it pretty well. I mean there's -- the core strategy of the company is to displace many different legacy applications that often are environmentally impactful, electrically inefficient. You can bring higher productivity, substantially improve yields. Some of those markets are difficult to break into because you're an evangelical change in them. But if you do succeed in them, you're going to get back into meaningful levels of growth. That's going to be pretty accretive to the earnings power of the company. And we continue to -- and they're pretty big markets, some of these that we're trying to address and break into. You've seen it within the welding business where that's now 35% of our sales, lasers are still only 15% of total welding sales, so there's significant opportunity to continue to expand that as evidenced by the relationship with Miller Electric that we've just -- we've signed and announced. So that really confirms the validity of welding technologies. And then it comes back to the fact that if you -- as you grow and generate earnings power, the cash flow generative ability of the company is very, very strong. So some reasonable execution from here on in with these new markets should see as a meaningful recovery in the business and some nice earnings power.

Great. Tim, thanks so much for joining us. Thanks for your interest, everyone.

All right. Thank you.

Thank you.