Q2 2023 IPG Photonics Corp Earnings Call

Participants

Eugene Fedotoff; Senior Director of IR; IPG Photonics Corporation

Eugene A. Scherbakov; CEO & Director; IPG Photonics Corporation

Timothy P. V. Mammen; Senior VP & CFO; IPG Photonics Corporation

James Andrew Ricchiuti; Senior Analyst; Needham & Company, LLC, Research Division

Mark S. Miller; Senior Equity Analyst; The Benchmark Company, LLC, Research Division

Michael J. Feniger; Director; BofA Securities, Research Division

Ruben Roy; MD & Equity Research Analyst; Stifel, Nicolaus & Company, Incorporated, Research Division

Presentation

Operator

Good morning, and welcome to IPG Photonics' Second 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, Mr. Eugene Fedotoff, IPG's Senior Director, Investor Relations, for introductions. Please go ahead, sir.

Eugene Fedotoff

Thank you, Rob, and good morning, everyone. With me today is IPG Photonics CEO, Dr. Eugene Scherbakov; and Senior Vice President and CFO, Timothy 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 updated by visiting the Investors section of IPG's website or by contacting the company directly. You may also find copies on the SEC's website. Any forward-looking statements made on this call are the company's expectations or predictions as of today, August 1, 2023, only.
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 site. We will post these prepared remarks on our Investor Relations website following the completion of this call.
With that, I'll now turn the call over to Eugene Scherbakov.

Eugene A. Scherbakov

Good morning, everyone. I am pleased with our performance this quarter. Second quarter revenue came and is the point of our guidance range. Despite of increased macroeconomic uncertainty, which resulted in project delays and impacted sales and outlook in industrial markets across many geographies.
We reported another quarter of solid revenue growth in welding and cleaning applications. Now that were driven by strong sales and e-mobility and handheld welding solutions. Additionally, revenue improved in 3D printing and solar cell manufacturing applications as investment in these markets increased. Sales in flat sheet cutting applications declined year-over-year, mostly due to economic uncertainty and an increased competition in China, and continued to negatively impact on our results. However, cutting sales were up sequentially in China, North America and Japan.
Emerging Growth product accounting for 41% of our total sales in the second quarter. We saw continued growth in AMB lasers, LightWELD, green and ultrafast lasers as well as the beam delivery, but sales declined in medical and advanced applications as well as in laser-based system and high-power pulse lasers. We have shipped our first 50-kilowatt AMB laser during the quarter and continue to invest in the international sales platforms for LightWELD. As we said on our first quarter conference call, our medical business was impacted by a large customer working through the inventory, which reduced sales in the second quarter. We expect medical sales to return to a more normal level in the third quarter and continue to focus on additional growth opportunities in the medical market.
Despite a challenging operating environment, the positive results were driven by our progress in diversifying revenue and reducing our exposure to low-margin and highly competitive business. We have been focusing on products and applications, which benefits from global investment in e-mobility and renewable energy, and this strategy is yielding good results. IPG had another quarter with strong sales and e-mobility applications driven by an increase in sales to geographies outside China, primarily in North America, Europe and South Korea. EV-related investments in China slowed during the quarter, particularly into traditional prismatic cell batteries. But we are seeing the increased investment into new technologies such as large cylindrical sales and also more investment into batteries for storage applications. Our team is working on a new business opportunity for all cutting applications and electrical motor assembly. With continued adoption of electric vehicles and growth in energy storage globally, demand for batteries should quickly catch up with recent capacity additions, and we expect investment in battery manufacturing in China to be stronger next year. Meanwhile, we are seeing the increased investment in EV battery capacity outside of China and expect e-mobility orders to remain strong in the third quarter.
Our welding sales are benefiting from growth and e-mobility applications where our complete solution, which includes AMD lasers and welding heads combined with our real-time weld monitoring and measuring technology, which has become as an industrial standard. LDDs real-time measurement can significantly reduce testing time, scrap costs and failed parts for the customer, making a very strong value proposition and exceptional return on investment given the yield and cost benefits. LDD also getting great acceptance in applications outside of batteries, where the final cost of defect can be very high and lead to significant recalls. We are proud to deliver multiple solution, which can significantly reduce environment impact for our customers, including our high-efficiency ECO lasers, its industry-leading wall-plug efficiency over the 50%, environment-friendly cleaning solutions and high efficiency laser diode drying and heating system.
During the quarter, we continued to see strong results in our laser cleaning solutions in e-mobility and other automotive and nonautomotive applications. Laser cleaning provides sustainability benefits by reducing the use of abrasives, chemicals and dry ice cleaning. Unlike chemicals, abrasive and heat treatment cleaning process, laser cleaning doesn't impact the material that has been cleaned, does not leave toxic waste and also create a safer and cleaner environment for employees. It can be also significantly reduced water consumption, and we are seeing an increase in interest in our laser cleaning solutions for a number of different processes and applications, including the paint and corrosion removal. Another recently introduced laser solution, which is replacing the less efficient infrared bulbs for the drying and heating is gaining interest, and we have booked our first order for EV battery applications, which will be shipped in the third quarter.
The drying solution are well-received by customers and are gaining market acceptance because they significantly cut down energy consumption and reducing environment impact on legacy processes. And today, I'm happy to announce that the Board of Directors has elected Kolleen Kennedy as a new Director of the company. I'm looking forward to working with Kolleen and believe she will be a great contributor to IPG's strategy, particularly with our growth in medical applications, given her 25 years of experience in the medical system manufacturing industry.
I would like to thank our employees for their strong contribution in the quarter, and will now turn the call over to Tim to discuss financial highlights.

Timothy P. V. Mammen

Thank you, Eugene, and good morning, everyone. My comments generally will follow the earnings call presentation, which is available on our Investor Relations website. I will start with the financial review on Slide 4.
Revenue in the second quarter was $340 million, a decline of 10% year-over-year, partially due to foreign currency headwinds, which accounted for approximately 2% of the decrease and the telecom divestiture that reduced revenue by approximately 1%. Revenue from materials processing applications decreased 8% year-over-year while revenue from other applications decreased 23%.
GAAP gross margin was 43.4%, a decrease of 230 basis points year-over-year due to higher cost of products sold and charges for scrap, which were partially offset by lower inventory reserves, 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 as we focused on reducing costs and improving manufacturing efficiency. We also benefited from slightly lower inventory provisions and shipping costs.
As mentioned before, FX headwinds also had a negative impact in the quarter. If exchange rates relative to the U.S. dollar had been the same as 1 year ago, we would have expected revenue to be $9 million higher and gross profit to be $5 million higher. GAAP operating income was $72 million, and operating margin was 21.2%. Net income was $62 million or $1.31 per diluted share. The effective tax rate in the quarter was 24% and was benefited by certain discrete items.
Foreign currency transaction expense related to remeasuring foreign currency assets and liabilities to period-end exchange rates had a negative impact on operating income of $1 million, with net of a tax benefit had no material impact on earnings per share. Excluding the currency transaction loss and a restructuring charge, operating expenses declined year-over-year, primarily in research and development and general and administrative categories as we reduced spending on telecom product development implemented tighter cost controls and reduced expenses.
Moving to Slide 5. Sales of high-power CW lasers decreased 10% and represented approximately 43% of total revenue. Sales of ultra high-power lasers above 6-kilowatt represented 50% of total high-power CW laser sales with customers outside of China moving to higher powers. The decline in revenue was primarily due to lower demand in flat sheet cutting applications as a result of softer demand and competition in China. Pulse laser sales decreased 24% year-over-year as strong growth in cleaning and solar cell applications was offset by lower demand in foil cutting and marking applications. System sales declined 1% year-over-year with growth in LightWELD, offset by a decline in other laser and non-laser systems. Medium power laser sales increased 18% driven by increased demand in welding and 3D printing applications, while QCW laser sales were down 2% year-over-year. Other product sales decreased due to lower revenue in medical and advanced applications.
Looking at our performance by region on Slide 6. Revenue in North America decreased by 11% with strong growth in welding and cleaning applications, offset by lower sales in advanced and medical applications, lower cutting revenue and the divestiture of the telecom business. In Europe, sales increased 4%, driven by growth in welding and cleaning applications despite overall uncertainty in the economy. At the recent laser show in Europe, the tone of our business was muted with most customers expecting a slowdown in the second half of 2023. Revenue in China decreased 28% year-over-year as demand declined across most markets and applications compared to the prior year with the exception of cleaning and 3D printing.
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 repaid $16 million of debt in the quarter. Cash provided by operations was $67 million, and capital expenditures were $26 million during the quarter. We now expect capital expenditures to be between $130 million and $140 million this year. Our inventories decreased slightly, and we continue to target further reduction in inventories during the second half of the year. While maintaining a strong balance sheet, we have been returning a significant amount of capital to shareholders over the last year and in the first quarter. We did not repurchase shares in the second quarter. As previously reported, the Board announced a new $200 million share repurchase authorization in May, and we have a new 10b-18 repurchase plan in place. We intend to repurchase shares opportunistically.
Moving to our outlook on Slide 9. Second quarter book-to-bill was below 1. We continue to see uncertain macroeconomic condition and soft orders in all major manufacturing regions. Leading indicators in North America and Europe point to contraction in the industrial markets, while the timing of demand recovery in China remains uncertain. However, despite the weaker business conditions overall, the e-mobility sector was not affected in Europe and North America, and we're still seeing solid activity in orders in e-mobility for the third quarter. Furthermore, we expect to see normalizing demand in medical and advanced applications as well as the systems business, which should help to offset headwinds in the rest of the business.
For the third quarter of 2023, IPG expects revenue of $300 million to $330 million. The company expects third quarter gross margin to be between 40% and 42%. IPG anticipates delivering earnings per diluted share in the range of $0.85 to $1.15 with approximately 47.5 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, assume 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.

Question and Answer Session

Operator

(Operator Instructions) Our first question comes from Ruben Roy with Stifel.

Ruben Roy

Tim, I wanted to drill in a little bit further into the commentary around cutting. It sounded like the weakness was sort of weighted more towards the softer demand than competition in China. But can you remind us where -- kind of as a percentage of revenues in China cutting stat stands? And was the comment on competition in China broader, meaning that did it encompass EV as well?

Timothy P. V. Mammen

No, the comment on competition in China was really around the cutting market and not around the EV market. We continue to have a very strong presence on foil cutting, cleaning and welding applications globally. Our cutting within China is certainly a much smaller share of the total sales there now. We had said at the end of last quarter that it was less than 10% of consolidated sales, and it remains quite well below that level, the high-power cutting business in China. It was pretty stable from Q1 to Q2, but it certainly didn't perform well.

Ruben Roy

I appreciate that. And as a follow-up, Tim, can we talk a little bit about gross margins and some of the puts and takes? Good quarter here. Obviously, we're going into a little bit of a lower revenue environment in Q3. So thinking through sort of the rest of the year, you've got potentially some improving productivity coming up in the new factory in Poland and potentially New Hampshire. How are you thinking about gross margin playing out through the rest of the year?

Timothy P. V. Mammen

Yes. We were actually very pleased with the sequential improvement in gross margin following the sequential improvement in Q1. So getting back up to a more reasonable level, certainly below our longer-term target level still. In Q3, really, the difference is just on lower revenue levels, the absorption of manufacturing costs will be lower. So going through the remainder of the year, it will really depend upon where the tone of the business ends up and into next year, hopefully, with an improving outlook, we'd expect to see gross margins pick up again. But it really is just on the fixed cost base. You start to see some under-absorption at the guidance level we're at in Q3.

Operator

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

James Andrew Ricchiuti

So it sounds like you're seeing -- you've seen some softening in the EV-related business in China. I'm wondering if you could talk more broadly about what you're seeing in the market outside of China. And Tim, maybe you could help size this EV business in Q2, how it fared just versus Q1? And to the extent you can, what that represents of that EV business, how much is battery welding right now?

Timothy P. V. Mammen

Yes. So the -- we are seeing some softness in the demand cycle in China really related to the capacity additions that have already been built out there. You also started to see a transition more of the cylindrical battery investment. We think that's actually going to be a big driver next year as capacity utilization picks up. In the rest of the world, the demand cycle for EV has actually been pretty robust and strong. I'd say it's strongest in North America and then followed by Europe. There's good demand out of South Korea and even in Japan as well. It's still dominated by battery applications. We're diversifying the battery applications. Again, we've got the first orders for the drying equipment. We're starting to see some demand for additional foil cutting applications. There are some cleaning applications on some of the main body in -- mainly in North America, that's coming from, and there are some complete systems. We're selling into that. I'd still say, though, it's still very much battery-driven motor manufacturing is still a sort of ancillary application in that area.

James Andrew Ricchiuti

And this where (inaudible) is roughly -- what is your rough...

Timothy P. V. Mammen

Yes. So we're still well above 20% of went above 20% of sales in Q2.

Eugene A. Scherbakov

And also we'll see in Europe trend to achieve this production, shift production or better it to the final production of cars. And you see it indefinitely for a few of our customers in Europe and also in the United States.

James Andrew Ricchiuti

Got it. And my follow-up question is on the bookings trends. You mentioned book-to-bill below 1, and I'm wondering if you could provide any more granularity on that. And how it may be varying by region and including what you're seeing perhaps in the consumer electronics market, which I don't think you mentioned at all in your prepared text?

Timothy P. V. Mammen

Yes. We said that it was softer, of course, all of our major industrial geographies that would be Europe, U.S. and China. We actually had some pretty positive order flow out of Japan, which is holding up quite well. And South Korea also performed pretty well too. That's sort of the -- sort of married up to what you're seeing on some of the PMI data out there. Sorry, James, what was the second part of your question?

James Andrew Ricchiuti

Well, just on some of the end markets, I mean, I assume that the legacy automotive is slower. I didn't hear any comments about some of the other end markets, including consumer electronics, which in the past, you've seen some seasonality in terms of orders. What does that market look like for you?

Timothy P. V. Mammen

Yes. I mean that will be reflected mostly in the QCW sales, which were down slightly year-over-year. So there's no great traction in consumer electronics. The other positive areas on applications were really cleaning and then additive manufacturing was actually -- cleaning was very strong globally. Additive manufacturing is okay in Europe and was actually very strong in China with a couple of the OEMs that we work very closely with there, and additive there, we've been qualified because of the quality and the reliability of the lasers.

Eugene A. Scherbakov

And cleaning application for us is very important because we are shipping not only pump laser or CW laser for the size kind of applications, but final systems for cleaning.

Operator

(Operator Instructions) Our next question comes from Michael Feniger with Bank of America.

Michael J. Feniger

The inventories came down 3% quarter-on-quarter. I know that's been a target for you guys to make improvements there. But with book-to-bill less than 1x and some of the PMIs low, I'm just curious to how you're thinking about inventories in the back half? Do we need to take out more? Are you trying to position to get to a certain level to get -- just to position yourself for 2024, any ways to kind of think about that in the back half?

Timothy P. V. Mammen

Yes, we continue to be very focused on managing inventory. And we're not seeing some of the same supply chain issues that we had experienced for the last couple of years. So we continue to target bringing inventory down during the second half of the year and generating cash out of that. In the medium term, let's say, we want to get down to less than 200 days inventory on hand and ultimately get back to a more normalized inventory level, which would be somewhere around 180 days, but that may take a bit longer to get to. But we're definitely looking to take some additional cash out of inventory and are pleased with the progress that we've made to date this year. And certainly, it's a significant change as compared to the investment in inventory we felt that was necessary last year.

Michael J. Feniger

Great. And Tim, just following up on the question around the production footprint. It sounds like what's weighing on the gross margin, among other things, is the under-absorption that you kind of talked about the volumes. Are you still confident with the change with the Poland and raising production in the U.S. that -- with your cost base as we think about those gross margin targets, maybe not for obviously Q3 or Q4, just maybe longer term?

Eugene A. Scherbakov

Definitely, our goal to optimize our cost. First of all, for production of some of components like fiber blocks and others for our lasers. And of course, working (inaudible) this way. By the way, in Poland, we will increase our production dramatically and we will increase further to the end of this quarter. The same situation in Italy. We also increased our production for these components and also in Germany. And every time we -- of course, it's under our control to cost of these components because it's influenced finally exactly to our gross margin. Situation in the United States, much more farther because it's an expensive country. But nevertheless, we are looking forward to make the final optimization of our cost first of all, for fiber components production.

Michael J. Feniger

Great. And then just on Europe, Europe, we're hearing from other industrial companies that kind of are flagging a weakening in Germany and Europe, the last month or so. Your growth was pretty resilient, even up a little bit in Germany. Just curious what you're kind of seeing there with the underlying demand versus your ability to offset that it looks like in some areas?

Timothy P. V. Mammen

Yes. I mean, certainly, during the quarter, Europe was performing pretty reasonably and particularly compared to a year ago. The weaker guidance reflects some of the softness that other people are seeing. For us, that's translating into Q3. There are positives and negatives, right? Some of the industrial OEM business is a bit weaker, where some of the welding applications have held up quite well and things like cleaning are also performing well in Europe. But yes, I mean the PMIs in Europe are at 43%. They're some of the weakest they've been for quite a long time. And I think that the German economy is quite weak at the moment. So we'll have to see how long it takes for that to turn around.

Operator

Our next question comes from Mark Miller with The Benchmark Company.

Mark S. Miller

You mentioned there was a large customer inventory adjustment in the U.S. Could you give a little more color what type industry was that from?

Timothy P. V. Mammen

Yes. Mark, obviously, medical applications, which we'd called out on Q1 would be weaker in the second quarter, and now we're expecting a recovery in medical application sales in Q3, the customers worked through their inventory adjustment that they've signaled to us would happen in the second quarter.

Mark S. Miller

Any opportunities such as in the consumer or consumer electronics area related to AI UC coming up?

Timothy P. V. Mammen

I mean there's some announcements out there that there's one of the major smartphone manufacturers -- is going to be using more additive manufacturing in their processes. That would be an opportunity for us, given the strength that we have within the additive manufacturing processes around the world. I think -- I mean that would be one of the more significant opportunities that's been talked about. As you mentioned, the consumer electronics investment cycle overall with QCW lasers and even pulse lasers being relatively anemic is not strong outside of that right now.

Operator

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

Eugene Fedotoff

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

Operator

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