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Edited Transcript of IPGP earnings conference call or presentation 2-May-17 2:00pm GMT

Thomson Reuters StreetEvents

Q1 2017 IPG Photonics Corp Earnings Call

OXFORD May 10, 2017 (Thomson StreetEvents) -- Edited Transcript of IPG Photonics Corp earnings conference call or presentation Tuesday, May 2, 2017 at 2:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* James F. Hillier

IPG Photonics Corporation - VP of IR

* Timothy P. V. Mammen

IPG Photonics Corporation - CFO and SVP

* Valentin P. Gapontsev

IPG Photonics Corporation - Founder, Chairman and CEO

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Conference Call Participants

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* Jagadish Kalyanam Iyer

Summit Redstone Partners, L.L.C - MD and Senior Analyst

* James Andrew Ricchiuti

Needham & Company, LLC, Research Division - Senior Analyst of Advanced Industrial Technologies and Display, Vision and Imaging Technologies

* Joseph A. Maxa

Dougherty & Company LLC, Research Division - VP and Senior Research Analyst

* Joseph Helmut Wittine

Longbow Research LLC - Research Analyst

* Mark S. Miller

The Benchmark Company, LLC, Research Division - Research Analyst

* Patrick M. Newton

Stifel, Nicolaus & Company, Incorporated, Research Division - VP and Senior Analyst

* Robert Joseph Burleson

Canaccord Genuity Limited, Research Division - MD and Analyst

* Sreekrishnan Sankar

BofA Merrill Lynch, Research Division - Director

* Thomas Lloyd Hayes

Northcoast Research Partners, LLC - MD and Senior Research Analyst

* Thomas Robert Diffely

D.A. Davidson & Co., Research Division - SVP and Senior Research Analyst

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Presentation

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Operator [1]

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Good morning, and welcome to IPG Photonics' First Quarter 2017 Financial Results Conference Call. Today's call is being recorded and webcast. (Operator Instructions)

At this time, I would like to turn the call over to Mr. James Hillier, IPG's Senior Vice President, General Counsel and Secretary, for introductions. Please go ahead, sir.

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James F. Hillier, IPG Photonics Corporation - VP of IR [2]

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Thank you and good morning, everyone. With us today is IPG Photonics' Chairman and CEO, Dr. Valentin Gapontsev; and Senior Vice President and CFO, Tim Mammen.

Statements made during the course of this conference 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 known and unknown 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 include those detailed in IPG Photonics' Form 10-K for the year ended December 31, 2016, 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 only as of today, May 2, 2017. The company assumes no obligation to publicly release any updates or revisions to any such statements. We will post these prepared remarks on our website following the completion of the call.

I'll now turn the call over to Dr. Valentin Gapontsev.

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Valentin P. Gapontsev, IPG Photonics Corporation - Founder, Chairman and CEO [3]

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Good morning, everyone. IPG first quarter 2017 revenue and EPS were well above the high end of our guidance ranges, driven by rapid growth across our core products, applications and geographies. This quarter, orders came in at a record level, and based on our current backlog, we believe we are in an excellent position to deliver another strong quarter in Q2.

As a reminder, we are focused on 3 key initiatives for 2017: enhancing our leadership position within our core material processing markets, expanding into new products and applications and generating industry-leading profits and cash flow.

Starting with our core markets. We've had our strongest Q1 ever. The pace at which our fiber lasers are replacing conventional lasers and non-laser-based technologies is accelerating. At the same time, the competitive environment seems to have shifted more in IPG's favor as the competition is finding it increasingly difficult to match our power advantages, global scale, low cost and high quality.

And we continue to drive adoption with a goal of making fiber lasers the preferred tool of quality. And we continue to drive -- sorry, preferred tool of choice across both typical lasers and non-laser material processing applications. Over the last 18 to 24 months, we have made considerable investments to enhance our product portfolio, our sales staff and our services capabilities. These investments, we believe, played a crucial role in our ability to execute this quarter, helping us better identify opportunities and win business in our core markets.

Sales of high-power lasers increased 42% year-over-year due to rapid growth in cutting and welding, our 2 largest applications. Total kilowatts of high-power lasers sold in first quarter increased by more than 60% over -- year-over-year in revenue and improved 70% in units. In addition, more than 30% of our high-power laser sales were at 6 kilowatts and above compared with 20% a year ago.

Demand for 6- to 10-kilowatt laser for cutting applications continues to gain significant momentum. With IPG's [revival in] cost-effective lasers, customers use the higher-power kilowatt lasers to cut faster and develop new applications. In fact, some customers have [gone into] introduce cutting systems with 12-kilowatt lasers. Our results suggest that the higher productivity [and lower operating cost of] fiber lasers are accelerating the replacement of the installed base of CO2 cutting systems.

I'm pleased to report total welding sales, driven by high-power and QCW lasers, increased nearly 60% year-over-year to a record level. Especially, we found an enormous market demand growth for our QCW lasers, where, during first 4 months of the year, we have shipped about 2,000 units or more than during the full year '16. We believe this validates our thesis that laser welding has tremendous opportunity, displacing existing lasers, such as (inaudible), and non-laser technologies in drawing applications.

Demand within our core business was especially strong in China, which, despite being our largest geographic market, grew 89% year-over-year. We're also continuing to expand in the systems markets, where sales have increased year-over-year, thanks to strong growth in systems for micro material processing and our [seam stepper] and other technologies, which replace traditional spot welding technology.

Outside our core material processing market, we grew sales in our silicon product by 221%, driven both by our Menara acquisition and solid organic growth. Advanced application grew 148%, thanks to strong uptake in fiber laser technology used for R&D and defense applications. We're also pleased to report the first sales of RGB laser, which now are being used in cinemas with our OEM projection partners.

As Tim will explain, our first quarter was a very strong one from a profitability perspective, highlighting the strong returns generated from our double-digit revenue growth and industry-leading margin. Earnings per diluted share of $1.38 increased 50% year-over-year.

We are off to a fast start in 2017, demonstrating our execution across our end markets. Our order flow remained strong. Although our visibility into the second half of the year, particularly Q4, remains somewhat limited at this time, we continue to benefit from the secular growth of fiber lasers within material processing and other applications. Our capabilities within this market are currently unmatched while the competitive landscape appears to be shifting in our favor. Our vertical integration and process know-how drive our technology and [process wins], which, when combined with our manufacturing sales and service scale, enable us to continue share gain in material processing. [Our time expensive] advantages to drive similar gains within [item] material processing applications and new industries like displays, medical, R&D and defense.

With that, I will turn the call over to Tim.

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Timothy P. V. Mammen, IPG Photonics Corporation - CFO and SVP [4]

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Thank you, Valentin, and good morning, everyone. Before I begin my comments on the quarter, I'd like to make a few opening remarks.

First, I'd like to welcome Jim Hillier, our new Vice President of Investor Relations. Quite a few of you have met Jim already, and we believe he will be a valuable addition to the IPG team. While Angelo Lopresti, our General Counsel and Corporate Secretary, no longer needs to make the introductory comments on these earnings calls, he remains actively engaged in our Investor Relations process and a valued member of the IPG senior leadership team. I'd also like to thank Sharon Merrill Associates for 10 great years of IR advisory service to IPG.

Finally, I want to draw your attention to the financial data workbook posted to our Investor Relations website in conjunction with our earnings release. The Excel-based model contains IPG historic financial results and key metrics over the last 10 years. We hope you find this to be a valuable resource as you update or build your financial models on IPG. Because much of the data we typically review in our prepared comments can be found in this model, I will focus our prepared comments on the key highlights and significant changes during the period. We believe this change in format will enable us to spend more time addressing your questions on our earnings calls.

Turning to the results. First quarter revenue grew 38% to a record $286 million. Materials processing sales increased 33% year-over-year and accounted for approximately 92% of total sales during the quarter. Year-over-year growth rates accelerated in applications for cutting and welding, our 2 largest end markets, while mark and engraving grew by single-digit percentage year-over-year. Notably, fiber laser sales for welding applications were at a record level, growing nearly 60% versus the year ago period. Sales to other markets were up 140% year-over-year, driven by strength in telecom and advanced applications. Menara generated $5 million revenue during the quarter.

China, our largest geographic region from a revenue standpoint, was also among our fastest-growth areas, up 89% year-over-year. We believe this is being driven by secular growth across several different industries, multiple applications and a healthy consumer electronics investment cycle. In addition, China-based machine tool customers are rapidly adopting our high-power fiber lasers as the product of choice for their cutting systems due to the faster performance, lower power consumption, greater versatility and higher reliability of our solutions over conventional lasers and other competing products.

As Valentin noted earlier, we have invested considerable resources in China to enhance our sales coverage, our service capabilities and our applications development work. We believe these investments are enabling us to better identify opportunities, build and expand customer relationships and enhance our overall execution. In the first quarter, we saw some results from our investments through new OEM customer wins and displacing other fiber laser makers at other customers.

Beyond China, other areas of strength included Korea and Russia, where we are gaining sales in the cutting market. In the U.S., welding sales were particularly strong this quarter, the result of considerable work done by our application engineers to demonstrate the power performance and flexibility of our solutions within advanced automotive welding applications. In Europe, despite a subdued auto market, we saw strong growth driven by high-power laser sales into cutting applications. Sales in Japan were down double-digits due to seasonal softness and expected lower volume at one of our largest cutting OEMs due to the timing of orders. We expect sales in Japan to rebound during the remainder of the year.

High-power laser sales increased 42% year-over-year to a record $168 million, driven by cutting and welding applications. A key element of our strategy is to drive an increase in demand for high-power lasers in new and existing applications, which we believe will expand the total market for our fiber lasers over time.

QCW was another standout in the quarter, with record sales of $21 million, growing 148% year-over-year from strength in fine welding for consumer electronics applications and percussion hole drilling for aerospace applications. We are encouraged by the rapid growth of QCW in the quarter and expect another strong quarter in Q2. However, a moderation in the consumer electronics cycle, with the completion of key capacity additions later this year, for example, could cause our rate of growth in QCW to slow.

Medium-power laser sales declined 13% due to decreased demand for fine cutting applications and the transition to higher-power lasers at 1 kilowatt and above.

Working our way down the income statement. Gross margin of 55% was down 20 basis points from Q1 2016 and at the top of our guidance range of 50% to 55%. We were able to largely offset declines in average selling prices with: one, improved manufacturing efficiency; two, component and material cost reductions; and three, a larger proportion of our sales coming from high-power CW, high-power pulse and QCW lasers, which carry a higher gross margin.

First quarter operating income was $101 million or 35.5% of sales compared with $70 million or 33.8% of sales in the first quarter of last year. Excluding foreign exchange, operating margins increased to 37.1% from 36.2% in Q1 of 2016 as we leveraged our cost over higher sales volume.

As a percentage of revenue, sales and marketing expenses decreased to 3.8% from 3.9% in the same quarter last year. R&D expenses decreased to 8% from 8.4%, and G expenses decreased -- G&A expenses decreased to 6.2% from 6.7%. We were able to achieve leverage in all 3 areas despite higher spending related to product development, new applications and manufacturing processes as well as the expansion of our sales force.

Our tax rate in the first quarter was 26%. The tax rate in Q1 2017 was lower due to the adoption of the revised accounting guidance, whereby the excess tax benefit arising from equity grants is now recognized in net income. This benefit was $4 million in Q1 and benefited the tax rate by 4 percentage points. In Q2, we expect the tax rate to be approximately 30%, excluding any effects relating to equity grants.

Net income for the first quarter increased by 51.9% to $75 million. On a diluted per-share basis, we reported $1.38 for the first quarter compared with $0.92 a year ago. In Q1 2017, the foreign exchange loss decreased EPS by $0.06 as compared with the same quarter last year decrease of $0.06 while the change in accounting standard related to stock option exercise tax benefit increased EPS by a net amount of $0.07, including the impact of the increase in diluted shares related to the same accounting standard. If exchange rates relative to the U.S. dollar had been the same as 1 year ago, we would have expected revenue to be $10 million higher, gross profit to be $7 million higher and operating expenses to be $1 million lower.

We continue to maintain a strong balance sheet, ending the quarter with $863 million in cash, cash equivalents and short-term investments and $40 million of debt. Our current level of inventory on hand amounts to approximately 183 days, which is just slightly above our target range of 2 turns or approximately 180 days and above the 2016 year-end level of 176 days. Days sales outstanding was 57 at quarter end compared with 51 at the end of Q4 2016 and 64 days a year ago.

Cash provided by operations during the quarter was $51 million. The $14 million decrease in operating cash flow versus Q1 2016 primarily stems from a $31 million increase in cash used for receivables and a $19 million increase in cash taxes paid. Receivables, which are impacted by the timing of when revenue is recognized during the quarter, can fluctuate from period to period. Cash taxes can also fluctuate depending on the timing and amount of estimated tax payments. It's also worth noting that Q1 operating cash flow tends to be below the annual run rate due to the payment of cash bonuses during the quarter. We expect to see a significant increase in operating cash flow during the remainder of the year.

Capital expenditures totaled $22 million for the quarter, and we continue to expect $90 million to $100 million of CapEx for the full year, including up to $15 million to upgrade our corporate aircraft, net of proceeds from selling the existing one.

During the quarter, we purchased 108,000 shares for $13 million as part of our share repurchase program to mitigate the dilutive impact of shares issued under our various employee and director equity compensation and employee stock purchase plans. We have now repurchased 210,000 total shares for $21 million since the program began last July.

Moving on to guidance. For the second quarter of 2017, we expect revenues to be in the range of $320 million to $340 million. We anticipate Q2 earnings per diluted share in the range of $1.50 to $1.70. The midpoint of this guidance represents quarterly revenue and EPS growth of approximately 31% and 28%, respectively, year-over-year. The magnitude of our Q1 outperformance and current Q2 revenue guidance has exceeded our expectations when compared to those assumed in our annual guidance of 10% to 14% revenue growth in 2017. As such, we believe the stronger-than-expected performance and guidance for the first half of the year should be treated as additive to our full year revenue growth outlook. However, it should not be used at this time as an assumption for outperformance in the second half of the year. While order flow remains strong, our visibility into the back half of the year, particularly Q4, remains somewhat limited.

As discussed in more detail in the safe harbor passage of our news release today, actual results may differ from both our full year and quarterly guidance due to various factors including, but not limited to: product demand, order cancellation and delays, competition and general economic conditions. This guidance is based upon current market conditions and expectations and is subject to the risks outlined in the company's reports with the SEC and assumes exchange rates relative to the U.S. dollar of EUR 0.94, RUB 56, JPY 112 and CNY 6.9, respectively. As a reminder, we do not attempt to forecast changes in foreign exchange rates.

With that, Valentin and I will be happy to take your questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from the line of Patrick Newton with Stifel.

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Patrick M. Newton, Stifel, Nicolaus & Company, Incorporated, Research Division - VP and Senior Analyst [2]

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I guess the first one is just on the full year guidance commentary, and understanding that the first half should be additive to your original guidance. If we just take the results, the midpoint of your June quarter guidance and then what would appear to be normal seasonality in the back half of the year, it would seem to indicate that growth could be 25%-plus for the full year. Is that the right way to be thinking about the revenue potential this year?

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Timothy P. V. Mammen, IPG Photonics Corporation - CFO and SVP [3]

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We're taking -- when we look at that, we're looking at the midpoint of the guidance range we gave at the beginning of the year, and adding the outperformance in, we get to a slightly lower number than that. If you went to 25%, Patrick, you'd be factoring in continued outperformance in the second half of the year, which, at this point in time, we are not providing guidance around. I think one of the challenges as well is you had an exceptionally strong Q4 a year ago when the momentum that we're seeing now really started to pick up. That started in Q4 -- started in Q3, accelerated into Q4. So we're bearing in mind that we actually have a pretty difficult comparison in Q4. Nonetheless, the thing that we do want to call out is that order flow right now remains very strong through April, and that's reflected in the Q2 guidance. And the strength of order flow through Q1 is reflected in that as well. So I'm not going to get drawn on the 25%. I think I've given enough color around that. But if you add the amount that we estimate should be added to the midpoint of the original guidance, it's quite a bit below that 25% number.

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Patrick M. Newton, Stifel, Nicolaus & Company, Incorporated, Research Division - VP and Senior Analyst [4]

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Great. And then, I guess just shifting to the high-power growth. It was really impressive, moving to 40%-plus year-over-year. Could you speak a little bit more to the underlying unit growth that you saw in the quarter? And then maybe speak a little bit to pricing trends. I think that you've recently alluded to them being relatively stable compared to some pricing erosion that happened at this time in 2016.

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Timothy P. V. Mammen, IPG Photonics Corporation - CFO and SVP [5]

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So the first [fall], I think kilowatts of units sold was up by about -- kilowatts of power sold was up by 60%. And [then bounds and] reference unit sales was up by approximately 70%. So you've got a couple of trends that we're seeing there. First of all, yes, degradation in ASPs. Particularly compared to Q1 a year ago, the ASP situation has been much more stable recently. But within that trend, you've also got a couple of interesting things. First of all, ASPs can be impacted because the actual increase in 6- and 10-kilowatt lasers, the ASP per kilowatts on those is slightly lower. We've also seen unit volume increases in the 1 and 2 kilowatts, driven by some of the fine processing cutting customers in China, in particular, moving up from 500 and 700 watts to our compact [YLR] 1 and 1.5-kilowatt lasers. And we've also seen, in the 3D printing and additive business, a transition from some of the medium-power to the 1 and 2 -- 1- and 1.5-kilowatt lasers for that. So those would also contribute to the increase in unit volumes at the lower power level. So there's a number of different dynamics that are happening there. I'd say the really pleasing aspect of that is the general move up in power across several different applications and then the real acceleration that we're seeing in the 6 to 10 kilowatts and now with customers demonstrating 12-kilowatt cutting systems.

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Valentin P. Gapontsev, IPG Photonics Corporation - Founder, Chairman and CEO [6]

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I can also add here that you have to track the recent published -- recently published Strategies Unlimited market review that now -- or last year, we control more than 86% total sales of high-power kilowatt [class] lasers in the world, 86%. This year, as our share in this business should increase (inaudible). We -- it should be increased essentially.

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Patrick M. Newton, Stifel, Nicolaus & Company, Incorporated, Research Division - VP and Senior Analyst [7]

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And Tim, just one qualification, or Valentin. I think in the prepared remarks, I just want to make sure I heard this correctly, you said over 50% of high-power units are now at 6 kilowatt and above compared to 20% a year ago. Was that accurate?

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Valentin P. Gapontsev, IPG Photonics Corporation - Founder, Chairman and CEO [8]

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30%.

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Timothy P. V. Mammen, IPG Photonics Corporation - CFO and SVP [9]

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30% is the number.

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Operator [10]

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And the next question comes from the line of Krish Sankar with Bank of America Merrill Lynch.

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Sreekrishnan Sankar, BofA Merrill Lynch, Research Division - Director [11]

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Tim, I had a couple of them. I understand you don't give forward guidance beyond the current quarter. But since you said [you don't have order visible] into Q4, but I'm guessing you have some visibility into Q3. Should we assume Q3 levels stay at June quarter levels?

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Timothy P. V. Mammen, IPG Photonics Corporation - CFO and SVP [12]

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So we've given -- the color we've given around this is that order flow remains very strong. We're choosing, at this point in time, to not give guidance on Q3, but state that the outperformance in the first half of the year should be added to the initial guidance that we gave. If order flow remains where it is, we're going to have -- I mean, just talking about this in a qualitative manner, a good strong Q3 performance as well. I've mentioned that order flow through April was in no way diminished from what we saw in the first 3 months of the year. So the overall trends behind the business are very strong. We're choosing to give the guidance on Q2 rather than get drawn into the second half of the year at the moment. When we get to having that visibility in the second half of the year, if necessary, we'll provide an updated range to annual guidance. I'd say, overall, the tone of the business is as good as I have seen it. Even though we performed very well over the last couple of years, it's been an extraordinary period for us. And I think that just is a testament to the execution, the quality of the product, as we mentioned, and the acceleration of the adoption of fiber as compared to other technologies.

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Sreekrishnan Sankar, BofA Merrill Lynch, Research Division - Director [13]

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Got it. That's very helpful. And then 2 other quick questions. The CapEx [expectation] of $90 million to $100 million, as you guys said, is there a way to quantify what your revenue capacity or what -- how much revenue your diode capacity can generate with that?

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Timothy P. V. Mammen, IPG Photonics Corporation - CFO and SVP [14]

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Do you want to talk about that a bit more?

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Valentin P. Gapontsev, IPG Photonics Corporation - Founder, Chairman and CEO [15]

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As you see in the [announcement], market demand for our product is growing very fast. So of course, it's huge challenge for us because we have to [increase produce] this year to ship to customer. A lot of new [lasers need] additional capacity. So 30%, 40% growth per year in production sales, it's a very serious challenge to any company. IPG up to now has demonstrated enough power to meet this demand. And we -- our capital expenses, we [promote] to grow our capacity, to build new facility, to new equipment and so on. I believe we can meet any request of market.

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Sreekrishnan Sankar, BofA Merrill Lynch, Research Division - Director [16]

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Got it. That's really helpful. And then final question I had was, is there a way to kind of like parse through -- like looking at your products, how much of the growth is coming from your traditional fiber laser versus what I'd call as new market that you entered in the last 1 year? Is there a way to figure like how much the core business is contributing to the revenues?

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Timothy P. V. Mammen, IPG Photonics Corporation - CFO and SVP [17]

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The core business is still fundamentally driving the revenues at the moment. So the newer products are still really just starting out the -- we mentioned some sales of the RGB for the cinema. That was a few units, but it's good to see that happen. So it was a very small contribution. There's some acceleration in the telecom business, which is helping a little bit, but that's more, I'd say the -- a thin layer of icing on a large cake at the moment. So if we can continue to execute around getting these newer products into the market, into addressing a broader part of the micro materials processing business, we are seeing some penetration in micro materials processing even with our core 1 micron product. But we hope to see significant improvement in that with some of the ultrafast product and the UV application. So there's still -- the great thing is, there's still not much contribution from those. And when they start to come to bear on revenue, it should be a good backup that we have.

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Valentin P. Gapontsev, IPG Photonics Corporation - Founder, Chairman and CEO [18]

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You see the experience (inaudible) market typical (inaudible). I will, for example, set an example with QCW laser. We introduced QCW laser to the market 6 years ago, even 7 perhaps, claim 7 years ago. Despite it was a great product at all, quality was (inaudible) better than existing flash pump YAG exist in market, was a very large market, like 20,000 units per year and so on. But acceptance by market was very small. Only 2015, first time we exceed 1,000 units, despite we estimate that our sales should reach and we hoped would reach 10,000 units. In 2016, it was the same even -- it was in 2015. Only this year, we see this market start to grow as a rocket. First, our OEM customer accepts start to use [instead of] flash pump YAG. And now many other people with companies, especially in China where other OEMs start immediately alter the (inaudible) over in the Europe and the United States, and so on. And we believe we will reach these numbers, 10,000-plus units soon. But if you see how many years, you need to [deal with] market to accept even highest quality new product. The same situation with other which we introduced now. We now are not so naive to think that market immediately will accept even much better products than exists in the market. But you would see, when you 3 or 5 years [to deal with new] -- each of these new products will show real essential contribution to our total revenue. But you have to work, introduce or [run very fast and] try to [work with this] introduction, but it takes time. It's any new product, any sales need very serious time before you really will have one of the major [force] in your business.

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Operator [19]

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Our next question is coming from the line of Joe Wittine with Longbow Research.

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Joseph Helmut Wittine, Longbow Research LLC - Research Analyst [20]

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Dr. Gapontsev's commentary on share gains was interesting, since the number of competitive offerings obviously is not shrinking. So what is the principal driver, if you had to isolate it to 1? Are you more seeing competitors struggle to keep up at 6-plus? Or is it more using price as a weapon? I think Tim referenced some price takedowns in the prepared comments. So I mean I know the products are great, but I'm just trying to get a better sense of the timing and what's driving this inflection now?

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Timothy P. V. Mammen, IPG Photonics Corporation - CFO and SVP [21]

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I think the competition is finding it extremely difficult to compete across the leading edge of the technology of the product, which drives the different performance parameters in terms of electrical efficiency being one, beam quality, the tremendous scale we have on manufacturing, the service and support we have around the world, the application laboratories that support that service and sales, the investment that's gone into that. All of those things put us in a pretty enviable position. I think in terms of applications, a couple of the highlights are the welding, whilst it can be a bit uneven quarter to quarter, it depends a bit more on projects, they're starting to get some more momentum into it. I think that's great. And it's not just a consumer electronics cycle spend this year. We talked about some of the automotive and other areas, for example pipe welding. On the cutting side, I think this is a difficult thing to state without -- there's very little data behind it, but one of the things we've said is that you shouldn't just focus on the annual sales of high-power lasers for cutting applications. You should look at how deeply penetrated fiber is into the installed base. And there are different numbers in terms of total installed base of cutting system, 60-or-plus thousands of them around the world. Fiber, a year ago, was probably less than 30% of that installed base. Now we're being, perhaps aggressive, maybe only 25%. We think there's an acceleration of the replacements of some of the older CO2 lasers, because job shops just cannot be competitive with our technology as more and more fiber lasers are deployed in the field, right. So they're competing increasing against job shops that have a fiber laser. The CO2, even if it's older and fully depreciated with high maintenance and running costs, is just no longer a viable alternative. And we've seen that commentary come out from a couple of cycles -- commentary coming out of a couple of surveys that we've seen. So it's a number of different things across different applications. And you've got some of the other applications in ablation, the cleaning, the hole drilling was a good contributor on the QCW, so QCW wasn't just welding. And these are all areas that we're looking for growth. So it's across a variety of different things that we're succeeding at.

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Joseph Helmut Wittine, Longbow Research LLC - Research Analyst [22]

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Great. And then I'll also ask on the sustainability of the current trend. I mean, I know you suggested we don't carry this forward in the second half, which is prudent. And Tim, I know you're not going to guide the first half of next year, but at least qualitatively talk us through. How much of this first half upside in total that you're seeing, if any, is either onetime in nature, or perhaps represents any sort of catch-up from last year, like on the CE investments that kind of skipped the year? Or is this trend you're executing on here purely organic? I know it's tough to answer, but any comments could help us kind of not get a -- too out in front of our skis as we adjust our models for next year.

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Timothy P. V. Mammen, IPG Photonics Corporation - CFO and SVP [23]

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So the great thing is that it's across a variety of applications, and a lot of those applications are genuinely sort of organic with what we think are sustainable trends in the market. The one thing that's just -- it's always a 2-year cycle, is the consumer electronics stuff. But certainly, the outperformance that we're showing in the first half of the year isn't just driven by that. And that's really -- no, a relatively, even small, part of it. Of course that's probably a bit of a thicker layer of icing on the cake than the newer applications, but it's not just that. It is the cutting, the welding, those ablative processes, the drilling, which are shifts that you're seeing across a variety of different industries. So it's difficult to call it out for next year yet, but we think we're in an exceptionally strong position relative to the other technologies and even non-laser technologies at this point in time.

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Operator [24]

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Our next question comes from the line of Jagadish Iyer with Summit Redstone.

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Jagadish Kalyanam Iyer, Summit Redstone Partners, L.L.C - MD and Senior Analyst [25]

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My first question is how should we be thinking about gross margin? I would imagine that if you look at your revenue profile and how we are guiding and compare it with last year, your mix is clearly moving to a favorable, high-power laser types. I thought your gross margins would have picked up. Can you talk about the puts and takes for gross margins as we move forward? And I have a follow-up.

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Timothy P. V. Mammen, IPG Photonics Corporation - CFO and SVP [26]

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Well, we continue to remain in that range of 50% to 55% and are very, very pleased with executing at the top end of that range. We mentioned that you're always trying to balance the declines in ASPs across different product lines with new product introductions and getting a benefit from the higher power lasers in different product categories that we get to. We also are adding manufacturing capacity. Valentin mentioned that we've got a tremendous uptick in unit and kilowatts of power that we have to keep up with. So you're also trying to balance your manufacturing efficiency with the semifixed labor costs that are brought on, the fixed costs that are brought on with increasing depreciation as you're placing buildings and equipment into service. So I'm delighted with where gross margins are at this point in time, and I think Valentin would probably second that. On the cost side of things, one of the interesting things here is that we think the market price of diodes is still around $10 per watt. Of course, some companies' manufacturing is below that. Our bill of material, fully loaded on a large part of our kilowatt lasers, is now at less than the market price, but the entire bill of material on a cost per watt basis is less than the market price of diodes at the moment. So if nothing else, that should be taken as a point of tremendous advantage in the company.

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Valentin P. Gapontsev, IPG Photonics Corporation - Founder, Chairman and CEO [27]

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[If we use all] advantage of our [full control of most] technology, which is a need for our -- the product. It's a result we are working [very hard to increase the] cost of which can (inaudible) -- for example, that same diode, last year again [we drop for] 15% with raw cost per watt. And so all-in-all the price (inaudible) to compare it was only 5 years ago, with our cost per 1 watt for diodes around 2x cheaper than it was 4 years ago. And [if you want to] improve technology automation and the process and so on, as we're going down, down, much faster than other people doing this. The same other components, perhaps its own.

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Jagadish Kalyanam Iyer, Summit Redstone Partners, L.L.C - MD and Senior Analyst [28]

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Okay. So as a follow-up question, Tim, specifically on Q2, what is providing the strength and which geography? And by the way, did you disclose any backlog information?

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Timothy P. V. Mammen, IPG Photonics Corporation - CFO and SVP [29]

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No, we didn't disclose any backlog information. As usual there's sort of strength on order flows really reflected in the guidance number. It's pretty similar to what we're seeing in Q1. It's -- we'll get another good quarter out of China showing strong year-over-year growth. The momentum in Europe continues to be good. We'll see a pickup in Japan in Q2. Less meaningful, but good backlog in Korea and Russia. The U.S. as well has a good opening backlog. So there's no fundamental change, it's just a continuation of the overall trends.

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Operator [30]

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Our next question comes from the line of Bobby Burleson with Canaccord.

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Robert Joseph Burleson, Canaccord Genuity Limited, Research Division - MD and Analyst [31]

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So just curious if there's any particular vertical or geography you're watching more closely to get a read on Q4?

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Timothy P. V. Mammen, IPG Photonics Corporation - CFO and SVP [32]

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Nothing in particular. I think it's just waiting for the overall trends on order flow through Q -- end of Q2 and into the beginning of Q3, seeing how those are going to materialize. You can see -- about 50% of the year, you see Q4 being lower than -- 50% of the time rather, you see Q4 being lower than Q3. And that's generally driven by, in these years when you have a strong consumer electronics cycle, you can see China revenue a bit lower in Q4. So we'll watch that, but we watch everything, Bobby, in terms of the different geographies and applications. So...

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Valentin P. Gapontsev, IPG Photonics Corporation - Founder, Chairman and CEO [33]

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My personal opinion, Tim was very careful, much more careful than he is with (inaudible). Because you see consumer electronics may be second half of the year sometime could be with business. But in the sales, our consumer electronic in our business, it's only 20%, 25%. Even if it drops twice, it would very small impacted our total overall revenue. So I don't worry about that what happened in the second half of the year with Chinese consumer electronics, like happened some other people. So it's -- I don't see serious impact on our business situation.

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Robert Joseph Burleson, Canaccord Genuity Limited, Research Division - MD and Analyst [34]

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Okay, great. And then just thoughts on automotive, looks like there's some mixed data points out there on demand, depending on where you look. Just curious how much visibility you have for that particular vertical? I know you don't have always -- look through to the actual end applications, but any thoughts on automotive from here?

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Timothy P. V. Mammen, IPG Photonics Corporation - CFO and SVP [35]

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Though on automotive, I think it's strong. And it's certainly strong and weak, it's strong in some areas, and weaker in others. So the real strength on automotive at the moment is North America and China. In particular, Europe's okay, not showing tremendous growth year-over-year on the automotive applications. And Japan might be an area where we're starting to get some indications from some of the major customers there that maybe in the second half of the year, the automotive investment cycle may start to improve there where it's been -- I'd call Japan, as well, sluggish like Europe over the last year or so. But you're right, we don't have -- it's not like the traditional OEM business where you can rank your predictive visibility more fundamentally.

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Operator [36]

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Our next question comes from the line of Joe Maxa with Dougherty & Company.

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Joseph A. Maxa, Dougherty & Company LLC, Research Division - VP and Senior Research Analyst [37]

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I was wondering if you could remind us on your relative size of your cutting versus welding business and then the growth rates of those.

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Timothy P. V. Mammen, IPG Photonics Corporation - CFO and SVP [38]

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Sorry, I think we've disclosed in the K, and this is a very approximate number because I have to caution you again. The application data that we get sometimes is not the most accurate. But in all cutting applications, both high power and mid power and even some of the QCW, is about 50% of total revenue. The welding is about 20%. And then marking and engraving will be the next biggest application after that. But yes, the 2 main ones, cutting and welding, are those levels. And that's across multiple products, Joe, not just high power.

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Joseph A. Maxa, Dougherty & Company LLC, Research Division - VP and Senior Research Analyst [39]

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Okay. And you saw some strong growth in welding, so what I was trying to get at is, what do you think the growth rate is of these 2 segments now? And what are your opportunities? I mean, I know there's still a big market out there, but where are you going to see the most growth coming here in the next say year or 2?

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Timothy P. V. Mammen, IPG Photonics Corporation - CFO and SVP [40]

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Trends on cutting continue to be very strong, if you continue to see the displacement of the installed base of lasers and the move towards higher power, both for fine metal, and that should continue to provide some sustained growth for the company. Clearly, the welding market is one that we are -- have called out. We see that over a 3-year horizon as being a fundamental area where we want to execute, not just on high-power but on QCW as well. In terms of like a 3- to 5-year time horizon, welding -- the welding market, we are targeting, growing substantially by displacing not only existing laser, but non-laser welding technology as well.

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Valentin P. Gapontsev, IPG Photonics Corporation - Founder, Chairman and CEO [41]

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With the welding market still penetration of laser is very low, very low. It's due to much more difficult to work in this direction because each customer needs customized solution to most of these. [Welding place] companies, they still, many of them, even don't know about opportunities, [and laser is a new opportunity] which is open for them. So it's a more difficult market to build, but it has huge potential, in our opinion. We repeat, said it before, we only can confirm this, but it's absolute different approach than cutting. In cutting market, you still worked with -- 20 or 30 years (inaudible) CO2 cutters with CO2 lasers. Now it works -- it's still a couple years ago, [it was a lot of people argued different] advantage [CO2 or 5]. But now all market practical and this fiber provides an enormous advantage to CO2 laser. In other words, recognize not only is it cheaper, better, easy to use, but productivity with fiber laser now with 2 or 3x is becoming higher than productivity the same cutting machine with CO2 laser. It's major engine for future. And the people, we expect will start mass replacement of CO2 machine, even if they could be using -- still working by fiber. Because the companies who use CO2 approach now will generate more. It's not able more to use of technology. (inaudible) only started (inaudible) volume in (inaudible) market now, in our estimation, 10x more than current penetration, still big opportunities. But with -- there were many [other] again, each of them with separately in terms of new application, even outside of the -- on metal weld processing. But each of them still small, few $10 million over. But during some years, we expect each of them will contribute $100 million multiple by 10 different, it will be very essential growth for our nonmetal applications. But it takes time, not during one -- (inaudible) unique new products. It's only first step. That you know one way to introduce, providing them to build the market and the distribution network and so on. Only medical for this year, for first time, we reached an excellent result in, for example, in [neurology] to replace traditional [Holmium:YAG] with our new tooling approach. It's so big advantage (inaudible) statistic in operation, 1000 operation, very successful (inaudible). And now to what we expect only this neurology . It's only one for many medical applications we're working now to create new business. It is some $100 million business. And we qualified (inaudible) prolonged for use (inaudible) for people (inaudible) and (inaudible) fantastic new results.

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Operator [42]

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Our next question comes from the line of Tom Hayes with Northcoast Research.

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Thomas Lloyd Hayes, Northcoast Research Partners, LLC - MD and Senior Research Analyst [43]

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Tim, I guess regarding China, I know last year you mentioned that some of the growth in that region came from signing new OEMs. Is some of the growth you saw this quarter and the expectations for the second quarter, just an indication that you're continuing to gain traction with those relationships? Or maybe just talk about the growth drivers in that market?

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Timothy P. V. Mammen, IPG Photonics Corporation - CFO and SVP [44]

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Yes, I think it's -- that's part of it. We continue to gain traction with those relationships, continuing to compete fiercely against even the local companies like Raycus and other competitors there. You've actually seen a -- also a rebound in the business with our largest OEM there this year, and that's benefiting from recovery in their cutting market. So that customer continues to be very much sourcing their fiber laser technology at high-power and QCW from IPG. So there's different end market dynamics there. So you've got the welding market for EV, electronic vehicles, for batteries and other applications continues to be a driver too.

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Operator [45]

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

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James Andrew Ricchiuti, Needham & Company, LLC, Research Division - Senior Analyst of Advanced Industrial Technologies and Display, Vision and Imaging Technologies [46]

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Just a follow-up to again the question about China. I mean the revenues said you started the year in China significantly above the high-water mark last year. How much of a surprise was the start that you got off to in China? I mean obviously you had bookings -- good bookings and backlog. But just wondering were there some other issues in the quarter? And has that -- it sounds like that momentum has continued through April?

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Timothy P. V. Mammen, IPG Photonics Corporation - CFO and SVP [47]

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Yes, definitely has continued through April. There's clearly a surprise of the strength with which China started out that, because you always think that in January, China orders can be slow before China New Year. And that order flow was very strong and then it carried on through February and March. So yes, it's difficult to quantify, like clearly relative to guidance and the outperformance, you can see how much of a surprise that has been to us. I think sometimes, the inflection points on the upside, Jim, are some of the most difficult things to forecast regardless of how good your relationships are with the OEMs. And I think the OEMs themselves find it very difficult to forecast sometimes the adoption curve that they see on some of the applications, for example, the move towards higher power levels. And that's not just in China. It's even in Europe as well.

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Valentin P. Gapontsev, IPG Photonics Corporation - Founder, Chairman and CEO [48]

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But at least OEM customer in China and for last couple of years increased dramatically, before it was only a couple of serious OEM in China. Now we have tens OEM. The competition with -- is growing there very fast and all of that start to purchase in quantity, serious quantities. It's for us, it's about a new OEM customer in China, not only China but in China as well. So it's not only -- we're talking about shippable order with fixed date of delivery date and so on. But it's to include also the frame order. It's fantastic growth. It's [100%] growth for frame work, that we don't take them in account in our (inaudible), but the frame orders that never before we even talked about, such large quantities.

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James Andrew Ricchiuti, Needham & Company, LLC, Research Division - Senior Analyst of Advanced Industrial Technologies and Display, Vision and Imaging Technologies [49]

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Has the customer concentration, the profile of the customer base, changed? Did that change much dramatically in the quarter in China?

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Timothy P. V. Mammen, IPG Photonics Corporation - CFO and SVP [50]

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No, fundamentally I think that this is pleasing actually. You'll see from our largest customer, we'll report some stronger sales this year. So relatively speaking, a little bit more of a concentration there, but also as Valentin mentioned, many new OEMs across a variety of applications as well.

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Valentin P. Gapontsev, IPG Photonics Corporation - Founder, Chairman and CEO [51]

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In many cases, we don't know the application as well. We don't know.

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Operator [52]

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Our next questions come from the line of Mark Miller with The Benchmark Company.

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Mark S. Miller, The Benchmark Company, LLC, Research Division - Research Analyst [53]

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I'm just wondering, you cited a number of reasons for the upside numbers in guidance. And you did say China was stronger than expected. How much of the upside in the expectations is driven by overall macro improvements globally?

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Timothy P. V. Mammen, IPG Photonics Corporation - CFO and SVP [54]

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I'll tell you a thing that's happening, a benefit you're seeing overall, I think global PMIs are at or close to 5-year highs or that level coming into the end of the year and through Q1. You continue to see some improvements in the European economic environment, and there is a little bit of a -- a bit more momentum there. The U.S. economy clearly at the moment is pretty strong. China credit remains available. So yes, I mean, I think the global economy is as strong as it has been for a while, and that helps with the industrial investment cycle.

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Mark S. Miller, The Benchmark Company, LLC, Research Division - Research Analyst [55]

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While it's not a big part of your sales, there is some concern about slowing optical telecom business in China. You said China was very strong. Is that too small to be concerned about for you guys?

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Timothy P. V. Mammen, IPG Photonics Corporation - CFO and SVP [56]

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Yes, we're not big on telecom in China at the moment. It's a very small part of our business. Most of our telecom is outside of China.

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Mark S. Miller, The Benchmark Company, LLC, Research Division - Research Analyst [57]

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Finally, the UB fiber laser, any more color you can provide there? You said new products were coming, but not as quickly as some people believe in terms of sales.

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Timothy P. V. Mammen, IPG Photonics Corporation - CFO and SVP [58]

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You're talking about UV?

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Valentin P. Gapontsev, IPG Photonics Corporation - Founder, Chairman and CEO [59]

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Yes, UV, it's very difficult product because what to introduce. You compete with the same (inaudible) people (inaudible) enormous service [concerns], service and so on. (inaudible) lifetime of crystals and so on. We don't like to go this way. Our culture supervised with highest quality absolutely is a great product, we build, we develop, [a whole family of UV] product and still prolong in longtime in (inaudible) improving and so on. But now we introduced it's also to most critical for this new highest-quality crystal growth facility, and not only growth crystal, but also process increase to make new (inaudible), higher-grade crystal element for UV. And we've opened this now facility. And we developed new technology for nonlinear crystals, which provide order a very better quality and the lifetime also then exists in other sources. With this new crystal, we will become the UV business on absolutely new level with quality lifetime costs and so on. But it's a process going very well. But takes time to [deal with, introduce] and qualify people. And then after that, the major (inaudible) disintegrated it need also time then for test and for qualify for the application and to rebuild the system, it takes couple years. But we introduce this product now with much higher quality than all existing in this market segment. And we based on new technology for (inaudible) crystal and also higher policy in technology, (inaudible) and so on (inaudible) we fetch new technology. Of course, we'll change situation on UV laser -- market. The same, by the way, with ultrashort pulse lasers, the same situation today. We're now near the (inaudible) ultrashort pulse laser will be available. So it's new unique patent pending with much higher performance than all existing in this market segment (inaudible). But takes time. (inaudible) in hundred millions, it take some years, not immediately.

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Operator [60]

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Our next question comes from the line of Tom Diffely with D.A. Davidson.

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Thomas Robert Diffely, D.A. Davidson & Co., Research Division - SVP and Senior Research Analyst [61]

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So obviously, it looks like you're getting some nice momentum here at the high end of the market competitively. But what are you seeing at the low-power market from a competitive point of view? And in particular in the Chinese market?

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Valentin P. Gapontsev, IPG Photonics Corporation - Founder, Chairman and CEO [62]

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(inaudible) Market stagnate in China. It became absolutely not profitable, particularly with people working with 0 margin. Even major player in this market, Chinese, said -- actually, we don't like to provide names, they support was still or have (inaudible) for them this market or support its welding when situation will change when it's more competitive (inaudible) compatible destroy all the price quality and so on. Will disappear, will become bankrupt, then they will deal with remaining only few players (inaudible) this recover this market. But now the market practically don't generate any real profit. We're still more competitive, but we have to follow the prices and so we dropped the essential prices. Still enough profitability here, but the total price now for them, traditional 20 to 30 watts (inaudible) lasers (inaudible) market dropped 10x to less than $3,000. So not able to generate profit in Chinese company, not able to generate any profit.

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Thomas Robert Diffely, D.A. Davidson & Co., Research Division - SVP and Senior Research Analyst [63]

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So you're seeing a lot of those companies start to drop off then? Or do you think that's coming?

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Valentin P. Gapontsev, IPG Photonics Corporation - Founder, Chairman and CEO [64]

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We still (inaudible) quantity we increase units. But in revenue, it stabilized now, not growing practical for us. We start the growth with American business due to new high-grade lasers which still high power and much more perfect and managed pulse. [So this laser still not] -- Chinese not able to compete with us to produce it and so on. Then we have normal start to grow in sales, but for standard lasers, for mass market. We (inaudible) in quantity, but the revenue not growing stabilize situation today. Despite with products it's still profitable because our manufacturing costs, minimum price cheaper than any Chinese company.

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Operator [65]

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Okay. Thank you. This concludes our question-and-answer session. I would like to turn the floor back to Dr. Gapontsev for closing comments.

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Valentin P. Gapontsev, IPG Photonics Corporation - Founder, Chairman and CEO [66]

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Okay. Thank you again for joining us this morning. Again, we look forward to speaking with you next quarter call. Have a great day.

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Operator [67]

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