Ipg Photonics Corp Q1 FY2022 Earnings Call

Good morning, and welcome to IPG Photonics' First Quarter 2022 Conference Call. Today's call is being recorded and webcast. At this time, I’d like to turn the call over to Eugene Fedotoff, IPG's Director of Investor Relations, for introductions. Please go ahead sir.

Thank you Rob and good morning everyone. With us today is IPG Photonics CEO, Dr. Eugene Scherbakov; and Senior Vice President and CFO, Tim Mammen. Statements made during the course of this call that discuss management's or the company's intentions, expectations or predictions of the future are forward-looking statements. These forward-looking statements are subject to risks and uncertainties that could cause the company's actual results to differ materially from those projected in such forward-looking statements. These risks and uncertainties are detailed at IPG Photonics' Form 10-K for the period ended December 31, 2021, and other reports on file with the Securities and Exchange Commission. Copies of these filings may be obtained by visiting the Investors section of IPG's website or by contacting the company directly. You may also find copies on the SEC's website. Any forward-looking statements made on this call are the company's expectations or predictions as of today, May 3, 2022, only. The company assumes no obligation to publicly release any updates or revisions to any such statements. For additional details on our reported results, please refer to the earnings press release, earnings call presentation and the excel-based financial data workbook posted on our investor relations website. We will post these prepared remarks on the investor relations website following the completion of this call. With that, I'll now turn the call over to Eugene Scherbakov.

Good morning, everyone. We are pleased to report a strong start to the year with the first quarter revenue above the top end of our guidance. Revenue increased 7% year-over-year, benefiting from higher demand in Europe, North America and Japan. We are particularly pleased to see that growth was driven by many emerging applications across all major geographies. As we stand back, we can identify several macro trends such as automation and miniaturization as well as the focus on sustainability, renewable energy and energy efficiency including EV, which are driving this increased demand. In the first quarter, we saw strong sales in welding, marking, systems, cleaning, 3D printing, semiconductor and medical applications. Sales outside of China grew to 65% of our total revenue, showing our progress in achieving a better geographic balance in our business. Our welding revenue was a record in the quarter and has become almost as important as our revenue from high power cutting applications in some regions or even outgrowing it as we saw in China. This was driven primarily by opportunities in electric vehicle batteries and automotive production that we are pursuing, as well as increasing demand for laser welding in general manufacturing, medical device applications and the adoption of our handheld laser for manual welding applications. Laser enables faster, more precise welding for a wide range of materials, including thin foils and highly reflective materials like copper and aluminum, that are difficult or impossible to weld with traditional MIG and TIG welding. The strong growth in welding, foil cutting, marking and 3D printing applications nearly offset the expected drop in high power cutting applications in China, which stabilized at a lower level. As a result, high power cutting applications accounted for a much smaller portion of our revenues in China compared to a year ago. There is a different dynamic in the same application elsewhere. In Europe and North America, we see increasing adoption of lasers in cutting applications as global manufacturers redirect investments in local supply chains and increase adoption of automation in manufacturing processes. Markets and applications that value our commitment to quality, innovative technology, reliability and global customer support are now IPG's focus. We are pleased with the growth that we are seeing in medium power and pulsed lasers, which are primarily driven by higher demand in emerging applications. These lasers are used in foil cutting, 3D printing, solar cell manufacturing, manufacturing of electronics and semiconductor applications. These applications require high beam stability, quality and stability as well as reliable lasers, characteristics for which IPG's devices are known by customers. In the first quarter, emerging growth product sales were 36% of our total revenue. Many of these products are benefiting from global macro trends such as automation, miniaturization as well as focus on sustainability, renewable energy and energy efficiency. Our lasers are widely used in manufacturing of electric vehicles. We are seeing increasing investments by automakers and suppliers in e-mobility worldwide and continue to see strong growth in demand for our high power pulsed lasers, adjustable mode beam lasers and real-time welding monitoring capabilities that together can provide a highly customized and engineered solution to address many challenges in this complex manufacturing process. We expect the investments in e-mobility to continue. Additionally, manufacturers are increasing spending on automation to address shortages of labor and wage inflation. Lasers can provide great productivity improvements and a significant return on investment. We are seeing increasing demand for LightWELD, because it is easy to use and only requires hours of training for an inexperienced welder. This compares to months of training for a typical MIG and TIG welder. We have launched a third generation of the device, including an extended range of welding and cleaning capabilities for more diverse materials. The focus on sustainability and energy efficiency plays well into laser cleaning applications that can reduce use of toxic materials. At the same time, high energy costs are driving demand and increased interest in our premium ECO lasers that provide wall-plug efficiency of greater than 50% and can meaningfully reduce energy consumption in high power applications. Before I turn the call to Tim, let me provide an update on impacts from the conflict in Ukraine which we all hope will come to a peaceful resolution soon. To help with the humanitarian crisis, IPG allocated $0.5 million to provide financial aid to our employers who help refugees from Ukraine. We are proud to hear that many of our employers have opened their homes to the refugees and provided clothes, food and temporary housing. In response to the current situation, IPG stopped all new investments in Russia and already terminated some existing projects. As we announced on March 3, we are executing on our contingency plans, increasing manufacturing and inventories of critical components in the United States and Western Europe. In the first quarter, we started hiring additional employees, allocating workspace for increased production and running second shifts in the US, Germany and Italy. We have also been qualifying third-party suppliers for certain components. These activities, which will accelerate during the second and third quarter this year, would significantly reduce IPG's reliance on Russian components by year-end. We are using this situation as an opportunity to introduce new production technologies and automation to increase yields and productivity. We recognize the risks of operation in the region as an escalation of sanctions would potentially have a significant impact on our business because the large capacity for critical components that many of our lasers rely on is currently in Russia. As we are making these decisions, we are doing our best to protect the interest of our employees and their families. I'll turn the call over to Tim to discuss financial highlights in the quarter.

Thank you, Eugene and good morning, everyone. My comments generally will follow the earnings call presentation which is available on our investor relations website. I will start with the financial review on slide 4. Revenue in the first quarter was $370 million, up 7% year over year driven by growth in most of our key product lines and geographies, and increased 2% sequentially mainly due to higher revenue in China. Revenue from materials processing applications increased 7% year over year and revenue from other applications increased 9%. First quarter GAAP gross margin was 46.4%, a decrease of 110 basis points year over year, due to increased shipping charges, higher cost of product sold and higher inventory reserves, partially offset by reduced manufacturing expenses as a percent of sales. Excluding foreign currency gains, operating expenses increased slightly year over year, primarily in sales and marketing, to support higher revenues. GAAP operating income was $93 million and operating margin was 25.2%. Net income was $70 million or $1.31 per diluted share. The effective tax rate in the quarter was 25%. During the quarter, we recognized a foreign exchange gain of $6 million primarily related to the balance sheet impact as a result of depreciation of the Russian Ruble and the Euro as compared to the US dollar. If exchange rates relative to the US Dollar had been the same as one year ago, we would have expected revenue to be $10 million higher and gross profit to be $4 million higher. Moving to slide 5. Sales of high power CW lasers decreased 2% and represented approximately 45% of total revenue. Sales of ultra-high power lasers above six kilowatt represented 49% of total high power CW laser sales. Pulsed lasers sales increased 21% year-over-year, with continued growth in high power pulsed lasers used in EV battery manufacturing and increased demand in cleaning applications. Systems sales increased 28% year-over-year driven by growth in laser systems and higher sales of LightWELD. Medium power laser sales increased 49% on growth in welding, 3D printing, electronics and semiconductor applications. QCW laser sales were down 6% year-over-year. Other product sales increased slightly year-over-year driven by higher sales in medical, which were offset by lower sales in telecom and advanced applications. Looking at our performance by region on slide 6, revenue in North America increased 5% driven by growth in cutting and welding revenue as well as increased revenue in medical applications and systems. We saw strong revenue in Europe this quarter. Sales increased 27% in the region, as a result of higher demand across many different applications, including cutting, welding, cleaning, solar cell manufacturing and advanced applications. We believe that about 10 percentage points of this growth was attributed to pull forward of demand from the second quarter as customers were securing supply. Revenue in China decreased 7% year-over-year. As expected, revenue in high power cutting applications stabilized at a lower level, but we saw strong growth in welding, foil cutting, marking and 3D printing in China. Other Asia benefited from increased sales in cutting applications in Japan and good growth in Korea this quarter. Moving to a summary of our balance sheet on slide 7, we ended the quarter with cash, cash equivalents, and short-term investments of $1.4 billion and total debt of $33 million. Cash provided by operations was $16 million during the quarter and capital expenditures were $25 million in the first quarter. Cash generation was negatively impacted by a further increase in strategic inventory during the quarter to offset ongoing supply chain constraints for electronic components and to build inventories of critical optical components outside of Russia. We expect 2022 capital expenditures will be in the range of $130 million to $140 million for the full year. 2022 CapEx includes facilities and capacity expenditure to support additional capacity for critical components in Europe and the US. CapEx previously budgeted to be spent in Russia will now be spent on investments to de-risk our internal supply chain. During the quarter, we repurchased over 600 thousand shares for a total of $79 million, a record quarterly share repurchase number for the company. Since the end of the quarter, we have repurchased an additional 675,000 shares for $66 million. Moving to our outlook on slide nine. First quarter book-to-bill was above 1. And we're pleased with the order flow across all regions, which was in part driven by customers placing orders with requested delivery days – dates that extend beyond the second quarter. While our ability to ship products was not impacted in the first quarter, there are ongoing supply chain constraints worldwide that may impact us or our customers. In China, COVID-19 outbreaks and restrictions to control the spread of COVID-19 have resulted in a weaker economic outlook. There are also trade restrictions and economic sanctions on Russia in general that impact our operations there. The risk of a full Western embargo on Russia, the probability of which we cannot assess, continues to represent a material downside risk to the financial results and operations of the company, until new capacity for critical components is built in Europe and the US. While we are managing through the current situation, we expect higher import duties and tariffs on Russian source components, as well as ongoing elevated shipping costs to negatively affect our margins. Looking at the global demand environment, macroeconomic indicators have been moderating globally. And despite strong indicators from the US and Europe, we saw the March PMI in China indicated contraction. That makes forecasting our business challenging in the medium term and our second quarter guidance remains subject to significant uncertainties, including the impact on the global business environment from geopolitical events, trade restrictions and sanctions, COVID-19, economic trends, growth from emerging product revenue, competition and the lack of long-term binding order commitments. With that said, we feel optimistic, as we continue to benefit from growth opportunities created by major macro trends, such as automation, miniaturization and sustainability, that drives growth from electric vehicle battery manufacturing, LightWELD and medical sales. In the second quarter of 2022, IPG expects revenue of $355 million to $385 million. The company expects the second quarter tax rate to be approximately 26%. IPG anticipates delivering earnings per diluted share in the range of $0.95 to $1.25 with 53 million diluted common shares outstanding. As discussed in the Safe Harbor passage of today's earnings press release, our guidance is based upon current market conditions and expectations, assumes exchange rates referenced in our earnings press release and is subject to risks outlined in the company's reports with the SEC. With that, we'll be happy to take your questions. Thank you.

Thank you. At this time, we’ll be conducting a question-and-answer session. Our first question comes from Nik Todorov with Longbow Research. Please proceed with your question.

Hi, can you hear me? Thanks, and congratulations on the impressive results despite the uncertainties and headwinds. I have a question about China. It seems that EV sales have gained significant traction there and now represent a larger percentage of your sales in that market. Could you clarify what portion of your sales in China currently comes from high-power cutting? Historically, it has been slightly over 50% of your China business; can you share where it stands today and your expectations for the future?

Yes, Nik, we haven't provided a specific number on that. The traditional cutting, excluding specialty foil cutting, has decreased significantly from that 50% level. The real growth and performance in China are being driven by emerging areas such as electric vehicles and additive cleaning applications, which continue to see strong demand from consumer electronics and other sectors. We are very pleased with the diversification of the business there.

Okay. And as a follow-up question Tim, can you give us some sense of what is the implied gross margin in the second quarter guidance? I think we're getting to anywhere from 44% to 45%. And maybe help us understand the puts and takes you talked about the duties and the higher logistics cost. And also is that the full impact of the gross margin given the situation with headwinds with getting products in and out of Russia? Because I know you have secured inventory there. So do you anticipate to see incremental headwinds potentially into 3Q as you may have to rebuild inventory from China from Russia and into United States and Europe?

In the presentation, the gross margin guidance is set at 44% to 46%, which is slightly higher at the upper end than previously indicated. This figure accounts for import duties and tariffs that have risen in the US but remained stable in Europe. It considers the relatively high inventory provisions we have maintained during the ongoing supply chain crisis stemming from COVID. We experienced significant inventory provisions in the second quarter. Additionally, higher shipping costs are factored in. However, this guidance does not encompass all potential costs for the near term, as the situation regarding import duties and tariffs in Europe will influence Q3 and Q4. As we start producing more components in Europe and North America, import duties and tariffs should decrease. In the short term, some other costs, especially salaries, may increase. Despite the challenges we expect in the near term, our long-term goal for gross margin remains in the 45% to 50% range as we continue to enhance component quality, increase automation, and improve yields.

Okay. Got it. Helpful. Thanks, guys. Appreciate it.

Our next question comes from Chris Grenga with Needham & Company. Please proceed with your question.

Hi. Good morning and thanks for taking my question. Congrats on the quarter. Are you able to quantify the headwind on gross margins during the quarter in connection with reducing the Russian manufacturing operations? And could you talk about the types of workaround measures that you're taking and any associated costs?

On the first quarter, I'll deal with the cost side of it and Dr. Scherbakov can look at – discuss the plans that are being implemented. There wasn't really much impact on gross margin in Q1 related to that. We were starting to implement the different strategies and contingencies to derisk that. The main impact to gross margin on Q1 were the elevated inventory provisions. To a certain degree, the shipping cost is partly related to the challenges that are faced. But those shipping costs were even elevated in Q4 due to all of the supply side and logistics constraints coming out of COVID, right? We were hoping that some of the shipping would ameliorate at the beginning of this year but that's kind of been overtaken by where fuel costs for example are and then some of the logistics challenges of moving product into Europe and the US from Russia. In terms of some of the contingency planning and shifting our production, Dr. Scherbakov can talk about how we're progressing there.

First of all, we're starting still in Germany or the United States. Additional shift for production this kind of very important components for us, of course, and also not only second street but also in some places third street. For these components of course it also increased our labor cost. It's clear. But according to our plan, we'll introduce a complete production for some components. I'm not talking about the old component but first of all for example fiber blocks and some isolators. I think we will be less in light of Russia in third and fourth quarter definitely. And for some companies like fiber block I think will be absolutely independent to the end of this year. But after now of course, we are working hard to reduce this and increase our inventories in different countries. You'll see what are the final results. But we are seem optimistic.

Got it. And in terms of the impact from COVID-related disruptions in China, what are you seeing there in light of the lockdowns, vis-a-vis revenue and gross margins in the quarter? And what are your expectations there for Q2?

It's difficult to say because some high cost approximately one month completely lockdown. The same – not the same but the processing situation in Shenzhen. What will be the next action from the China government? I don't know exactly. But definitely in some cases it will be the low activity production and also we'll be using our lasers in China. But situation is now uncertain and to make them any forecast, any predictions it's very difficult today.

In terms of like the guidance, the overall number given by China is actually fairly robust and that's factored into the sort of top end of the range. We did even get a low-end forecast assuming shutdowns become more pervasive. And the demand there was assumed they could continue shipping and it wasn't a catastrophic fallout of revenue right? It wasn't that the expected activity to come to a standstill. But the bottom end of our range kind of factors in some of that uncertainty there.

Got it. And then just last one for me and I'll hop back in the queue. But any color on the book-to-bill by region would be helpful? Thank you.

Yeah. I think that was actually really interesting in terms of look at the source of the bookings in Q1 which were very strong. We mentioned that there's a number of different orders that we've got to give us visibility into second, third and fourth quarter order flow. So that's kind of the first sort of structural change a little bit on the bookings. But the really good thing was that it was made up of order flow in North America, in Europe and other Asian countries. And relatively speaking, if you compared it to a year ago where bookings out of China were much higher percentage of revenue, the bookings out of China this quarter was significantly lower as a percentage of the total and the total was higher. So for example, in North America you had very strong bookings on some of the medical applications, materials processing applications. They had some strong order flow from telecom, which should help with that business a little bit in the second and third quarter in Europe. It was really broadly about the materials processing across all the different applications. It's good to see some recovery in Japan. And then the Korean business is always quite diverse. We've got some good orders for the solar cell application as well. So that would start to ship in the second and third quarter as well. I really like the diversity of the backlog that was received and booked and really the diversity in the rest of the world I thought it was a real positive.

Great. Thank you very much. Very helpful.

Our next question is from Tom Diffely with D.A. Davidson. Please proceed with your question.

Yes. Good morning. Thanks for the question. I was hoping you could talk a little bit about your R&D efforts in Russia, maybe what the percentage of the total effort is there and the ability to move some of that activity to other regions over time?

About LNG outside Russia, of course we have a very strong team in the United States and Europe and Italy and some other places. Of course, we now have some independence but it depends is very small in comparison to all our activity in different products. Our main products for emerging applications we are now developing mainly in Europe and in the United States. For example, LightWELD, we develop in the United States and demonstrated very good results. High-power pulse lasers also made such kind development in Europe, in Germany in particular. For example, one early type of this pulse laser about 200, 300 average power can give us this year about $100 million revenue. It's only one train mainly again it's very important in China, but also we have a very big potential in other countries. And from this point of view again, I would like to underline our main development activity now are not in Russia, but outside Russia in the United States also in Europe.

Okay. That's very helpful. I appreciate that. And then maybe Tim, a long-term question. When you look at the growth and perhaps getting back to double-digit growth over time, when you look out a few years is welding or cutting the bigger driver of that growth?

So in terms of growth rates, I think you're going to have to – you look at welding and some of the other materials processing applications, like, we're very optimistic on things like cleaning, the additive market, if it can really solve the issues that it has. And so the growth rates of that in the total market, I expect to be higher than the cutting market. I do think though the cutting market is quite interesting, because whilst it has grown very dramatically in China in terms of unit volumes, when you look at the number of cutting systems that are actually sold in the rest world, it implies that cutting in the rest of the world is still very underpenetrated against some of the historic and legacy machine tools that are used in a similar way right bunches resides and so there is a very – plasma cutting even. There is we think a very considerable runway for cutting systems growth in the rest of the world, particularly if it's even going to be similar in terms of usage to China. So there's an interesting dynamic there where potentially, if you get to more of a tipping point on that laser adoption, you could actually see the rest of the world cutting market expand more meaningfully.

Appreciate the color, and thanks again for the question.

Our next question comes from Mark Miller with Benchmark Company. Please proceed with your question.

Thank you for the question. Your margin projection, the midpoint at least is below the last couple of quarters. I'm wondering, what's driving the expectations for lower margins in the June quarter?

Yes. Sure Mark. We mentioned at the beginning of the call a little bit about that. So the major impact in Q2 would be taking into account some higher import duties and tariffs related to products imported into North America, continuing to see – expect to have inventory provisions a little bit higher elevated level shipping costs. They have got continued inflationary headwinds and pressures around basic component costs as well. Those would be the drivers in the guidance number. So there's a number of different challenges out there.

Just a follow-up question, what percent of sales are you attributing the recently introduced products last quarter?

It was 36% last quarter.

Our next question comes from Michael Feniger with Bank of America. Please proceed with your question.

Yeah. Thanks for taking my question. I apologize, if I missed this earlier. So what is the capacity utilization at your Russian facilities today? Are you still producing at that rate in the second quarter? And when does that – when do we expect that to ramp down?

Our production again, it depends what kind of components. For some health components, definitely, it will decrease our realized as in the second and third quarter. But to the end of this year, main components we will produce outside. We will produce outside. And also, we are now looking for some additional suppliers from outside components, which we are using in our for example small power rates and so on. Our projections such kind of, they have to again, we have to decrease our rate in Russia in the third and fourth quarter. Up to now, we are producing some components not any important products. Some components yes, they're producing to satisfy requirements from our customers.

Got it. Your inventories were up 23% year-over-year, which is a record, while your revenue increased by 7%. I understand you are building a lot of stock. Can you explain if you are comfortable with these inventory levels? Are you planning to increase these levels because you expect demand to rise? Please help us understand the inventory buildup and how we should view it for the remainder of this year.

There are various factors to consider regarding that question. First, the company has encountered numerous supply chain challenges, both external and internal. Specifically, on the external front, we've faced issues with PC boards and electronic components. When we analyze our inventory, it's evident that some of the increase is due to investments in these areas, which are tied to external supply chain issues. For instance, we've established inventory of diodes and diode chips in Russia to facilitate local production for China. Additionally, we're accumulating stock of other optical components to mitigate supply chain risks and ensure we can meet customer demand. From a financial standpoint, it may seem concerning that our inventory turns are below two. However, considering the opportunity costs and risks we are addressing, this investment is not only necessary but also justified. It's important to focus on the intent and planning behind our actions and how we are managing this within our contingency plans, which I believe we are executing effectively. Reflecting on the COVID-related supply chain challenges, we only faced one quarter where we couldn't ship several million dollars' worth of products due to supply chain issues. In general, we've managed the COVID supply chain impacts quite efficiently. While it's challenging to quantify the benefits based on opportunity risk, the advantages related to inventory are substantial. The potential downside, however, is that we may encounter higher inventory provisions over time until we navigate through this phase. As a CFO, I would prefer to see lower inventory levels, but there are significant operational and risk considerations at play here.

Yes. From the perspective of the CEO, it's essential to minimize the risk of delaying our product to customers, which is why we guarantee timely shipments. Typically, our shipments occur about four to six weeks after an order is placed. We aim to keep all necessary components in stock, and in some instances, we purchase these components for one or even two years of production. This enables us to ensure stable shipments to our customers. However, it's important to note that the prices for these components, especially chips, have increased dramatically over the past year. In some cases, prices have risen by only 10% or 20%, while in others they have surged by up to ten times. To support our customers, we need to maintain this inventory; there's no other way.

Thank you for that. That makes sense. And just lastly on Europe, obviously Europe was really strong. You mentioned high demand, but you also mentioned Tim some pull forward you felt for customers just to cure supply. Just curious what you're seeing maybe just in April, like that told you that was a pull forward. You're seeing headlines about Germany, in terms of some implications on the auto sector and truck sector with Russia/Ukraine. I'm just curious, what you're kind of seeing there in your Germany and European markets right now?

Some of the pull forward seems similar to building inventory. Companies want to ensure their supply chains for components and devices are more secure, which contributed to this trend. We didn't think it was a significant amount. Looking at Europe after the quarter, the overall sentiment worldwide is stable. Although China appears a bit weaker, we are still experiencing quite strong order flow at this time. I haven't noticed any major changes in the sentiment in Europe or North America. The situation in the rest of Asia remains relatively stable as well, despite the challenges from energy supply issues. Over the long term, there could be some advantages for us since electricity costs and other energy prices are rising sharply in Europe. Considering we offer one of the most efficient machine tools in laser technology, this could work in our favor.

We've reached the end of the question-and-answer session. I'd now like to turn the call back over to Eugene Fedotoff, for closing comments.

Thank you for joining us this morning and for your continued interest in IPG. We will be participating in a number of investor events this quarter and looking forward to speaking with you, over the coming weeks. Have a great day everyone.

Thank you.

Thank you.

This concludes today's conference. You may disconnect your lines at this time. And we thank you for your participation.