Earnings Call Transcript - IPGP Q3 2023

Operator, Operator

Good morning, and welcome to IPG Photonics Third Quarter 2023 Conference Call. Today's call is being recorded and webcast. At this time, I'd like to turn the call over to your host, Eugene Fedotoff, IPG Senior Director, Investor Relations, for introductions. Please go ahead with your conference.

Eugene Fedotoff, Senior Director, Investor Relations

Thank you, Rob, and good morning, everyone. With me today is IPG Photonics' CEO, Dr. Eugene Scherbakov; and Senior Vice President and CFO, Tim Mammen. Let me remind you that 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 in IPG Photonics' Form 10-K for the period ended December 31, 2022, and our 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 the SEC's website. Any forward-looking statements made on this call are the company's expectations or predictions as of today, October 31, 2023. And 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 financial data workbook posted on the Investor Relations website. We will also post these prepared remarks on the website following the completion of this call. With that, I'll now turn the call over to Eugene Scherbakov.

Eugene Scherbakov, CEO

Good morning, everyone. Our third quarter revenue was negatively impacted by softer demand in industrial markets and a further decline in sales in China. Lower demand from industrial customers and reduced e-mobility applications drove revenue declines in cutting, welding and marking applications. We also continued to see strong competition in addition to soft demand in the flat sheet cutting market in China. But even with lower revenue, we are pleased with our operating performance this quarter and delivered gross margin improvement and earnings per share at the high end of our guidance. While the uncertainty in macroeconomic conditions continues to weigh on capital equipment spending, customers in Europe, North America and Japan are increasingly utilizing high-power lasers for cutting. We believe that laser adoption in these geographies is significantly behind China, and this market remains less competitive with IPG holding a strong market position. We're also seeing the adoption of laser technologies in the automotive and general industrial markets across many geographies. Laser welding provides high-speed precision and accuracy as well as low heat input and the ability to join similar materials. Our real-time welding measurement system is a great complementary technology for adjustable mode beams in the lasers and IPG welding systems that provide fast and reliable welding solutions for a broad range of applications across many different industries. Emerging growth product sales accounted for 42% of total revenue in the third quarter. We saw a decline in AMB and high-power pulsed laser related to lower demand on e-mobility applications due to decreased investment in EV battery capacity in China. We stated in the past that the EV battery investment is likely to fluctuate quarter-to-quarter. Our production expansion projects can be sizable and provide some lumpiness in our e-mobility services. As a result, some quarters, even years, may be better than others. However, we expect the EV investment cycle to continue, providing a great opportunity for IPG in the next 3 to 5 years. Adoption of electric vehicles continues to grow in China, Europe, and North America, and battery manufacturers will need to build additional capacity to support higher EV sales. Additionally, energy storage is growing and may potentially require even more batteries to support the transition to sustainable energy in the future. Our handheld welder sales continued to grow, driven by a rollout in Europe and LightWELD, which operates at four times the speed of traditional MIG and TIG welders and does not require extensive training. We are seeing high interest in the welding community and held five simultaneous live demonstrations of the device at the FABTECH show this year to satisfy this interest. We are still early in the adoption curve and continue to promote LightWELD in the welding market in the U.S. and other geographies. We are also seeing a significant increase in demand for our lasers in 3D printing applications. Industry reports suggest that technology is being tested for manufacturing consumer electronic devices. Growth in metal 3D printing technology has outpaced many expectations. However, it seems like there is a new catalyst that can potentially drive further adoption. 3D printing is using high-quality lasers to melt metal powder to create parts, and we hold a strong position in this market, providing lasers with higher stability beam characteristics. We have recently introduced a new AM laser design, specifically for additive manufacturing. This laser can be adjusted mode and can switch from single mode to multi-mode output, achieving six times higher build-up rates. Finally, sales in our medical business improved as expected after the inventory reduction by a large customer in the prior quarter. Growth in medical continues to be driven by the adoption of our laser systems and consumable fibers, which are considered the gold standard in medical applications. We are also seeing strong growth in aesthetic applications, which is a much larger market, and our fiber laser technology is significantly more advanced compared to the traditional lasers used in medical and aesthetic applications. Our goal is to gain market share by replacing older technologies. We are working on multiple new opportunities to broaden our medical portfolio and to further grow the business, making it a more meaningful contributor to IPG sales. In summary, I remain optimistic about the growth driven by our products and continued diversification of IPG revenue in the long term. We have introduced a new product for our laser cleaning and drying applications this year and are promoting our high-efficiency eco-lasers that help reduce environmental impact for our customers. I would like to thank our employees for their strong contributions in the quarter. I will now turn the call over to Tim to discuss financial highlights.

Timothy Mammen, Senior Vice President and CFO

Thank you, Eugene, and good morning, everyone. My comments will generally 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 third quarter was $301 million, a decline of 14% year-over-year. Foreign currency headwinds reduced revenue growth by approximately 2%. Revenue from materials processing applications decreased 15% year-over-year, while revenue from other applications was nearly flat. GAAP gross margin was 44.1%, an increase of 100 basis points year-over-year, which was driven by lower inventory provisions and reduced shipping costs and tariffs, as well as an improvement in absorption of manufacturing costs as a percentage of sales. On a sequential basis, gross margin continued to improve despite lower revenue as we focused on reducing costs, managing inventory, and improving manufacturing efficiency. Despite the headwinds to our revenue from a challenging operating environment and reduced capital equipment spending worldwide, I am pleased with the resilience of our financial model and the company's ability to improve margins while continuing to generate ample cash flow from operations to support current and future investments. Foreign currency headwinds also had a negative impact in the quarter. If exchange rates relative to the U.S. dollar had been the same as one year ago, we would have expected revenue to be $6 million higher and gross profit to be $4 million higher. GAAP operating income was $56 million, and operating margin was 18.5%. Net income was $55 million, or $1.16 per diluted share. The effective tax rate in the quarter was 19% and benefited from certain discrete items. Foreign currency transaction gains related to remeasuring foreign currency assets and liabilities to period-end exchange rates had a small positive impact on operating income of $400,000 or $0.01 per share. I'd like to remind you that last year's results benefited from $22 million or $0.32 per diluted share gain on the sale of the telecom transmission business. Excluding the currency transaction gain, asset impairments, and recovery of a restructuring charge related to our Russian operations, as well as the gain on the sale of the telecom business last year, operating expenses were nearly unchanged year-over-year. Sequentially, operating expenses increased primarily in research and development and sales and marketing as we invested in resources to drive future growth while still controlling expenses. Moving to Slide 5. Sales of high-power CW lasers decreased 22% and represented approximately 40% of total revenue. Sales of ultra-high power lasers above 6 kilowatts represented 46% of total high-power CW laser sales. The decline in revenue was primarily due to lower demand in flat sheet cutting applications in China and Europe. We continue to see customers outside of China adopting laser technology, but demand has been impacted by the economic uncertainty, with OEMs delaying purchasing and reducing inventories. Pulsed laser sales decreased 25% year-over-year due to lower sales in marking and solar cell applications. System sales increased 4% year-over-year, with growth in LightWELD offsetting a decline in non-laser systems. Medium power laser sales increased 1%, driven by increased demand in welding and higher sales in 3D printing applications. QCW laser sales were down 4% year-over-year, and other product sales decreased due to lower revenue in advanced and telecom applications. Looking at our performance by region on Slide 6. Revenue in North America decreased 13%. We saw strong growth in welding and cleaning applications, as well as higher parts and service sales. However, this growth was more than offset by lower sales in cutting, medical, advanced and telecom applications. In Europe, sales increased 3%, and the region continued to perform well, given the weak macroeconomic environment. Revenue growth was driven by welding and semiconductor applications. Revenue declined in cutting, marking, and cleaning applications, which were impacted by lower industrial demand and destocking by some OEM customers. Revenue in China decreased 28% year-over-year as demand declined across most industrial applications, including cutting, welding, and marking. Additionally, revenue was negatively impacted by competition in the flat sheet cutting market and lower demand in e-mobility applications due to a decline in new battery projects and delayed capacity expansions. Moving to a summary of our balance sheet and cash flow on Slide 7. We ended the quarter with cash, cash equivalents, and short-term investments of $1.1 billion and no debt. Our inventories continue to decrease sequentially, and we target further reductions in inventories in the fourth quarter. Cash provided by operations was $86 million, and capital expenditures were $26 million during the quarter. We sold two buildings in the quarter, realizing $29 million in proceeds, meaning net capital expenditures are just under $55 million year-to-date, well below the same period last year. While maintaining a strong balance sheet, we have been returning a significant amount of capital to shareholders through opportunistic share repurchases. We spent $46 million on share repurchases in the third quarter and approximately $160 million this year. Moving to our outlook on Slide 9. The third quarter book-to-bill was below 1 with macroeconomic uncertainty resulting in project delays and reduced orders in all major manufacturing regions. Leading manufacturing indicators in Europe are trending to the lowest level since the 2008 recession. While economic indicators in China are mixed, we believe the Chinese cutting market is down 20% to 30%, and the timing of an overall recovery in demand remains uncertain despite some government stimulus. Competition from Chinese manufacturers remains stiff. Additionally, project delays related to battery capacity expansion in China provide further uncertainty to the outlook. Although we have limited visibility into orders beyond the fourth quarter, we continue to believe that battery investment in China should restart in 2024 as electric vehicle sales continue to increase. Investments in battery capacity outside of China are in the early stages and should increase in the next several years as well. We also expect some benefits from government spending and onshoring activities to boost industrial activity in the U.S. For the fourth quarter of 2023, we expect revenue of $270 million to $300 million. The fourth quarter gross margin estimate is between 41% and 43%. We anticipate delivering earnings per diluted share in the range of $0.80 to $1.10 with approximately 47 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 safe harbor and the company's reports with the SEC. With that, we'll be happy to take your questions.

Operator, Operator

Our first question comes from Ruben Roy with Stifel.

Ruben Roy, Analyst

Dr. Scherbakov, I wanted to start on China. And Tim just mentioned that at this point, it sounds like there's a lot less visibility. I wanted to make sure I was understanding that commentary right because Tim said that potentially battery investment should restart in 2024. I think 90 days ago, the tone of your call and your commentary was a little more positive in terms of when you thought we would get a catch-up on some investment for batteries in China. And it sounds like that's probably weakened from 90 days ago and there's a lot less certainty. So maybe if you could just walk us through how you're thinking about that maybe for the first half of 2024 to start, that would be helpful.

Eugene Scherbakov, CEO

Thank you for your questions. During these 90 days, I had visibility to visit China and discuss with our potential and existing customers for many applications. And of course, our main question is about the e-mobility applications. Total opinions indicate that battery manufacturing production is temporarily saturated. Forecasts are not 100% certain, but they account for somewhat lower activity in the first half of the year. However, they are expected to increase in the second half of the year. It will strongly depend on environmental conditions, political situations, and more. But in summary, the outlook for EV applications in China is not so optimistic.

Ruben Roy, Analyst

Okay. Well, that's helpful. And then, Tim, I think you mentioned the cutting market was down 20% to 30% in aggregate. I think your cutting exposure in China is a lot lower than that. Just wanted to make sure I had that right. And if you can give us an actual number, that would be helpful.

Timothy Mammen, Senior Vice President and CFO

So we talk about the 20% to 30% decline as the overall decline in the total Chinese cutting market. I think that's shown in some of the numbers reported by other Chinese public companies who had a weak Q3. Our China flat sheet cutting sales are still well below 10% of our total consolidated sales. This quarter, having seen that remain stable in Q1 and Q2, it was a little bit down in Q3. But really, the weaker performance in China on a year-over-year basis is showing up on the cutting side. The softness in EV demand reflects our original guidance and didn't really strengthen during the quarter.

Ruben Roy, Analyst

Yes, absolutely. And if I could sneak in a last question here. It's great to see the gross margin holding up in light of the lower revenue run rate and even with the guidance. And some of the inputs there, Tim, that you talked about, didn't have too much to do, I don't think yet with getting some of the factory utilizations on the new factories and the expanded factory in Germany up. Maybe you could just walk us through medium-term gross margin thinking from here as revenues potentially start to recover next year?

Timothy Mammen, Senior Vice President and CFO

Yes, I have set a slightly lower gross margin guidance at 41% to 43%. This is mainly because we are still working to reduce inventory in Q4. Total absorption might be a bit lower, and I'm being somewhat conservative regarding inventory provisions as we approach the end of the quarter, but not significantly. Q3 shows that we are nearing the 45% to 50% range as we expect revenue recovery. Interestingly, we have seen two consecutive quarters of gross margin improvement despite lower revenue each time. In Poland, for example, we are experiencing better yields and production volumes in Q3, leading to cost reductions. While we're not yet at our target price for our fiber block, there is a noticeable contribution. Italy is also doing well in reaching its manufacturing and cost targets. We are also focusing on initiatives to significantly cut costs associated with some high-power lasers in the next six months and have new generations of diodes coming soon. Overall, the improvement in our revenue mix should be beneficial, especially with stronger performances in medical applications and stable pricing in Korea and Japan.

Operator, Operator

Our next question comes from James Ricchiuti with Needham & Company.

James Ricchiuti, Analyst

I would like to follow up a bit more on what you're seeing in the 3D printing space. It's an area you have been discussing more positively over the past year. I'm curious if the demand you're experiencing is mainly coming from hardware vendors in China, and if these are primarily for consumer electronics applications, as that seems to be what we are hearing more about.

Timothy Mammen, Senior Vice President and CFO

Jim, there is good demand coming out of the hardware vendors in China. The European additive market has been fairly strong through the first couple of quarters, although it was somewhat flat in Q3. Nobody has visibility into the consumer electronics demand at the moment, however. A lot of the activity in China is still centered around aerospace.

Eugene Scherbakov, CEO

During my visit, I observed a system with 50 lasers operating simultaneously, which indicates strong growth in the metal 3D printing market.

Timothy Mammen, Senior Vice President and CFO

We do not have clarity regarding potential demand for consumer electronics. It seems that this sector is still under evaluation.

James Ricchiuti, Analyst

And a while back, Tim, I have to try to find it somewhere in my notes, but you guys did size the 3D printing business. And I'm wondering, where are you in relation to where it was at the peak a few years ago when you were seeing quite a bit of activity, at least encouraging activity early on?

Eugene Scherbakov, CEO

Definitely some years ago, there was more activity in 3D printing or additive manufacturing. But now it seems that the market was overestimated previously. Currently, I think we have a much more realistic estimation of this technology for future industrial laser applications. IPG holds a strong position as customers require a very stable laser for such applications, often necessitating lasers to operate continuously for over a month. For this reason, our products are significantly reliable. Recently, we introduced a new AM laser with adjustable power and much more stable characteristics. Our customers can increase productivity using up to 50 concurrently operating lasers with the current technologies.

James Ricchiuti, Analyst

And final question, and maybe Tim, if I could just clarify on the book-to-bill, was that similar in all your major regions? Or did it vary a bit in certain regions, with some being a little bit weaker and others stronger? And then the follow-up is just on the emerging business. Excluding e-mobility, are you seeing sustainability in the medical sector, which seems to have picked up? And clearly, on 3D printing, you're getting some momentum. How should we think about emerging growth going forward?

Timothy Mammen, Senior Vice President and CFO

Qualitatively, I would say the book-to-bill ratio was probably not significantly weaker, but Europe is facing some challenges. The cutting business had performed well at the beginning of the year; however, it has softened. Even though revenue in Europe was quite reasonable throughout Q3, bookings have slowed down. China continues to struggle. I am skeptical about the veracity of their PMIs being at 50%. More positive developments were noted in Japan, and Korea performed particularly well, with significant orders for medical aesthetic products. North America may not have a huge amount of traction, but it is likely to be stronger than Europe. Regarding emerging growth products, medical has rebounded, and LightWELD has performed positively, particularly with its rollout on a global scale. We continue to develop new versions of LightWELD and look to expand our distribution network. Some advanced applications in semiconductors also performed well, particularly in Europe. While e-mobility showed weakness, cleaning applications had strong growth, together contributing to over 40% of our revenue.

Operator, Operator

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

Michael Feniger, Analyst

Tim, on the inventory side, you made some nice improvements, and I think you mentioned you're really focusing on that in the fourth quarter. Do you think you'll reduce it early in 2024 if demand levels remain the same? Or will you be able to complete most of that by the fourth quarter? I'm curious how you're thinking about that.

Timothy Mammen, Senior Vice President and CFO

No. It's just going to take several quarters to get it to the levels we'd like to see. We're still running at a high level in terms of days given the current level of activity. We'll keep working on it in Q4. It's a work in progress. I'm pleased with how we've stabilized it, and we're moving in the right direction. Some of that inventory is related to purchased electronic parts, and those purchases have started to slow down. But running down that inventory will not lead to immediate absorption impact, as it involves components sourced from third parties rather than internally produced parts. It's certainly going to be a multi-quarter journey.

Michael Feniger, Analyst

That makes sense, Tim. I know there's a lot of focus on the EV build-out capacity in China. I'm curious about how exposed you are to that in the U.S. I've seen headlines about Ford reallocating around $12 billion of capital expenditures right now. GM has a new plant, and Tesla seems to be pausing due to some EV demand issues in the U.S., which could also be related to recent strikes. I'm interested in what you're observing in that area and how important it is to you at this moment. Are you viewing this as more of a pause rather than something that indicates a trend moving forward?

Timothy Mammen, Senior Vice President and CFO

Our view is that there is a bit of a pause. You've seen several announcements made even in the last couple of weeks. However, if the transition to electric vehicles is to continue and reach a significant level, total investments will need to increase. We believe that starting to prepare for the capacity needed in 2025 and 2026 should lead to improvements in the second half of the next year. Our exposure in North America can vary greatly by quarter. We have projects where we’ve delivered significant equipment for EVs. There is some EV revenue expected in North America in our Q4 guidance. Our business is not entirely dependent upon EV, but it certainly was a key driver for us, and we will need a rebound in EV investment to occur, which we hope to see in 2024 with a focus on the capacity required in 2025 and 2026.

Eugene Scherbakov, CEO

For North America, EV applications are intriguing for us because the requirements are not only for lasers or components. We are also beginning to provide complete systems to our customers for cleaning applications, with one of the largest EV manufacturers starting to utilize our cleaning applications. Our new product is already in the pipeline, with additional orders forthcoming, which is essential for us to demonstrate our new technologies.

Timothy Mammen, Senior Vice President and CFO

Additionally, we're broadening our applications. The first meaningful revenue from drying applications will be realized in Q4. Feedback from the market on this is very positive, not just for EV but for a variety of different applications where lasers can be used for drying, whether it's for coatings or in other niche sectors. We're also looking into other specialized cutting applications within battery technology.

Michael Feniger, Analyst

That's helpful color. Following up on that, Tim, with the expansion of application sets, it seems like you are making progress on gross margin given some of the production changes. I'm curious if you think that perhaps taking the margin range down could unlock more growth, since historically that has been a lever on pricing?

Timothy Mammen, Senior Vice President and CFO

I think the overall pricing of lasers and integrated beam delivery systems drives significant productivity benefits for end customers. Even in the EV sector, when you combine this with LDD and non-EV applications, welding is providing substantial returns on investments. The value proposition of the technology remains strong. We are looking at reducing costs out of some higher power lasers, and we could be more aggressive around pricing while still increasing margins if we achieve those cost decreases over the next couple of quarters.

Eugene Scherbakov, CEO

Of course, those cost reduction initiatives are crucial, but it is equally important that we start introducing a new technological platform for the standard or next-generation lasers for welding and cutting applications. This represents a significant cost reduction in the manufacturing of such lasers and will be introduced to the market over the next two to three quarters.

Mark Miller, Analyst

Just wondering what drove the sequential improvement in other sales?

Timothy Mammen, Senior Vice President and CFO

Rebounds in the medical business and strong performance in some advanced applications around semiconductors were the primary drivers.

Mark Miller, Analyst

Okay. Emerging products, green lasers continue to do well there. What else is performing strongly?

Timothy Mammen, Senior Vice President and CFO

Actually, green was a bit weaker this quarter, but we are working on a whole bunch of new green projects. The strong performance among emerging products was primarily in medical applications, advanced applications, LightWELD's continued strong performance, and cleaning applications, which did very well, even though the overall quarter for welding was weaker.

Operator, Operator

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.

Eugene Fedotoff, Senior Director, Investor Relations

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 look forward to speaking with you again soon. Have a great day, everyone.

Operator, Operator

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