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Executives

Angelo Lopresti – General Counsel, Secretary and VP

Valentin Gapontsev –Chairman and CEO

Tim Mammen – VP and CFO

Analysts

C.J. Muse – Barclays Capital

Antonio Antezano – Macquarie Capital

John Harmon – Needham & Company

Rahul Kanvarker – Jefferies & Company

Ajit Pai – Thomas Weisel Partners

Jiwon Lee – Sidoti & Company

IPG Photonics Corporation (IPGP) Q3 2008 Earnings Call Transcript November 6, 2008 10:00 AM ET

Operator

Good morning, and welcome to IPG Photonics third quarter 2008 conference call. Today's call is being recorded and webcast. At this time, I'd like to turn the call over to Angelo Lopresti, IPG's Vice President, General Counsel and Secretary, for introduction. Please go ahead, sir.

Angelo Lopresti

Thank you. And good morning, everyone. With us today is IPG Photonics’ Chairman and Chief Executive Officer, Dr. Valentin Gapontsev, and Vice President and Chief Financial Officer, 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, 2007 and other reports on file with the Securities and Exchange Commission. Copies of these filings may be obtained by visiting the Investor Relations section of IPG’s website at www.ipgphotonics.com or by contacting the company directly.

Any forward-looking statements made on this call are the company’s expectations or predictions only as of today, November 6, 2008. 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 after the completion of the call. Please go to www.ipgphotonics.com to review these remarks.

I will now turn the call over to Dr. Gapontsev.

Valentin Gapontsev

Good morning and thank you for joining us today. IPG Photonics is very proud to report again a new very strong quarter, the eighth consecutive quarter of year-over-year growth since we’ve been public. Despite obvious recession trends in macroeconomic environment, we delivered new record growth in revenue, net income, and earnings per share, which exceeds our guidance range given.

The sales for the third quarter increased by 29% to $62 million, and net income increased by 27% to $10.9 million compared to quarter three ’07. Earnings per share also increased to $0.23 from $0.19 in Q3 ’07. Our primary driver for the quarter continued to be our materials processing market, which increased sales by 47% over last year’s third quarter, combined with the fact that we saw strength across all of our geographic markets. This resulted in financial performance that exceeded the top of our guidance range.

In addition, our gross margin continued to improve year-over-year. Gross margin was 37.4% and improved by approximately 2 percentage points over the quarter of last year. These results are testament to this disruptive nature of our technology, and its clear benefits to manufacturers. In the world's major markets for industrial laser systems, customers have recognized that IPG's fiber lasers can lower their costs and improve the way they manufacture their product. And in many cases, the advantages of our fiber lasers create new application where lasers have never been used before. This is the transformative power for power fiber lasers and we are determined to further grow our position in the overall laser market worldwide with this fantastic technology.

Before I turn the call over to Tim Mammen, let me review some accomplishments. This quarter, we grew our top and bottom lines strongly despite challenges in a few of our end markets. Pulsed lasers continued their impressive growth in solar and marking applications. Medium-power laser sales more than doubled, thanks to continued growth in microelectronic applications. High-power fiber lasers saw continued acceptance from automakers and suppliers throughout the world and for other heavy industry applications. And sequentially we saw improved demand in the US and strong demand in Japan in quarter three. This complemented to the trends we saw in Europe and other Asian markets in the first half of the year and in the quarter.

I will now turn the call over to our CFO, Tim Mammen.

Tim Mammen

Thank you, Valentin. And good morning, everyone. I will start with operational remarks and I will then review our financial highlights. Our 29% revenue growth in the third quarter over the prior year shows the traction that IPG’s fiber lasers continue to experience. Our growth was driven by a 47% increase in sales and materials processing, our largest application and one where we have the greatest diversity of uses for our products.

I would like to comment on the positive developments in the market acceptance of fiber lasers for cutting, which is the largest application for high-power lasers. We have significantly increased the number of OEMs involved in cutting, as indicated by the quantity of fiber cutters displayed at the recent EuroBLECH Show in Hanover, Germany, the largest fabrication show in the world, and also at the FABTECH Show in the US. At EuroBLECH alone, five companies demonstrated 2-D fiber laser cutting systems, five more showed 3-D fiber laser cutting systems, and another five demonstrated hybrid cutting and welding fiber laser systems.

We believe that this show has transformed the market’s perfection of fiber lasers for cutting applications because these companies demonstrated that the cut quality over a full range of metal thickness with fiber lasers is competitive with CO2, where previously there was some doubt about the ability of fiber to address both thin and thick metal companies. This is we believe no longer the case.

Now let me provide you with some information about how we performed in the four markets that we serve. Materials processing, which is IPG’s largest market, contributed 82% or $51 million of the revenue we reported in Q3 and grew by 47% year-over-year. Sequentially, materials processing sales grew by 9%. The materials processing market encompasses several end markets, such as general manufacturing, photovoltaic, automotive, aerospace, heavy industry, consumer, semiconductor, and electronics.

The advanced applications market represented 8% of total revenue during the third quarter. While sales of these laser systems decreased by 13% in comparison with the prior year, should be noted Q3 2007 benefited from $1.9 million of high power laser sales to the US Navy. Although order flow is less predictable in this market, we have recently received large orders for this market, including an order for two high power laser systems. Advanced applications include test and measurement instrumentation, sensing, and defense applications, as well as scientific research and development.

The communications market comprised 7% of our revenues in the third quarter. Revenues in communications declined by 8% over the third quarter of 2007, but increased sequentially by 69% from Q2 2008. Sales in the communications market were again driven by demands for integrated DWDM systems and broadband access products. Sequentially we saw an increase in orders from customers in Russia, Japan, and to a lesser extent, the US.

Lasers for the medical application market comprised 3% of revenue in the third quarter with a sharp drop-off in orders due to business and operational conditions from our main medical OEMs. Sales were down 41% from the third quarter of 2007. However, sequential sales were up by 62%. We made some progress is customer diversification during the quarter with shipments to a growing number of OEMs. We also booked a number of laser diode orders from aesthetic laser OEMs for our packaged laser diodes.

Turning to the performance of our laser types in the third quarter. Pulsed laser sales increased by 42% from the third quarter of 2007. As a percentage of revenue, pulsed lasers represented 34% of revenue, with $21.1 million in Q3 ’08. This is our initial product line and it continues to be one of the best producers for us. We saw growing demand for our pulsed lasers used in photovoltaic manufacturing.

Marking applications also continued to help drive sales of our pulsed laser during the quarter as well as other material processing applications. Recently, we introduced three new pulsed laser lines, covering new applications such as marking different kinds of plastics.

High-power fiber lasers used in materials processing and advanced applications continued to be a key growth driver. In the third quarter, on a year-over-year basis, sales of high-power lasers increased by 36% and represented 29% or $18 million of total revenue in Q3 2008.

Overall, we expect high-power laser sales to continue to be an important growth driver for us, while low growth from high-power lasers may fluctuate from quarter to quarter. High-power fiber lasers saw continued acceptance by automakers and suppliers throughout the world and for other heavy industry applications where our lasers’ power, beam quality and flexibility create meaningful gains in productivity.

While order patterns can be volatile in this high average selling price lower volume business, year-over-year sales for the quarter increased by 36%. Sales of medium-power lasers grew 101% during the quarter from 2008 over 2007 and represented 13% over $8 million of total revenue in Q3 ’08. We saw continued demand for centering and commercial printing applications, but the primary driver in the past several quarters for these products has been strong sales to a new customer in the microelectronics industry.

We also saw new applications for these lasers in the welding of platinum, titanium and other alloys, which are difficult to process. Low-power laser sales used primarily for medical applications and micro materials processing increased sequentially by 14%, but was still down 21% from last year. We are starting to see modest increases in sales from our primary OEM medical customers and we are also selling to new international customers.

Looking at our geographic performance during the quarter, we reported 38% of revenue from Asia and Australia, 37% from Europe, and 25% from North America. European sales increased 18% year-over-year driven by strong growth across the region. Sales in Asian markets increased by 55% compared with the third quarter of 2007, primarily driven by Japanese sales which increased by 110%.

Continued growth in China, India, and South Korea also contributed to this increase. Despite the significant decline in medical sales, North American sales grew by 16% from the third quarter of 2007. Based upon exchange rates prevailing in the third quarter of 2007, we estimate that exchange rates positively affected our revenue by approximately $2.1 million in Q3 2008.

As I mentioned earlier, gross margin for the third quarter was 47.4%, which is 2 percentage points better than the 45.3% gross margin we reported in the third quarter of 2007. This improvement was due to higher revenues, favorable product mix, and the increased production, which we achieved without building an increase in inventories.

Inventory declined by $1.3 million even after excluding the benefit to inventory valuation, which resulted from the depreciation of the euro. Sequentially, gross margins were slightly low due to inventory write-downs and reserves, which totaled $1.4 million. It remains our goal to increase gross margin in 2009 and achieve a balance between production, capacity utilization, and inventory levels.

SG&A expenses increased to $8.2 million or 13.2% of sales compared with $6.5 million or 13.6% of sales in the third quarter of 2007. While this is slightly below our SG&A target range of 15% to 18% of sales in the short to mid-term, Q3 2008 SG&A benefited from a gain related to foreign exchange transactions of $1.6 million. Excluding this amount, SG&A would have been approximately 16% of revenue, which is within the target range. We continue to invest in selling expenses with the expansion of our sales force, application engineers and demonstration laboratories. In the quarter, legal expenses related to ongoing litigation were lower because of patent-free examinations and the related litigation stays in the district courts.

R&D expenses were $4.1 million or 6.7% of Q3 ’08 revenues. This compares with $2.4 million or 4.9% of revenues in Q3 ’07. This is within our target range for R&D of 5% to 7% of revenue. Research and development primarily relates to research into new and improved components and products. We have historically been able to keep IPG's R&D expenditures low as a percentage of revenue due to the efficiency and strategic focus of our R&D activity. Based upon exchange rates prevailing in the third quarter of 2007, we estimate that exchange rates adversely affected cost of goods sold and operating expenses by approximately $1.8 million.

Operating income for Q3 ’08 increase by 33% compared with the same period last year. IPG generated operating income of $7.1 million or 27.6% of revenue compared with operating income of $12.8 million or 26.7% of revenue in the third quarter of 2007. Excluding the gain on foreign currency transactions described in SG&A above, operating margin would have been approximately 25%.

Operating income includes charges related to stock-based compensation of $461,000 and $396,000 in the third quarters of 2008 and 2007 respectively. In the third quarter of 2008, $80,000, $274,000, and $107,000 of stock-based compensation charges related to cost of goods sold, SG&A, and R&D respectively. Our tax rate for the third quarter of 2008 was 31.6%. We actually made an overall effective tax rate of 31.5% for the year. The effective rate for 2007 was 32.6%.

Net income for the second [ph] quarter of 2008 increased by 27% and was $10.9 million, or $0.23 per diluted share, compared with net income of $8.6 million, or $0.19 per diluted share, for the third quarter of 2007.

Let me turn now to our balance sheet, where cash and cash equivalents at September 30, 2008 stood at $44.3 million compared with $38 million on December 31, 2007. Not included in cash and cash equivalents are $1.4 million in auction rate securities at September 30, 2008. For the year-to-date, cash flow from operations was $25 million and cash used of investing in activities was $25.1 million.

In Q3 2008, we are pleased to note that cash flow from operations improved significantly to $13.4 million, which exceeded by $3 million cash used in investing activities of $10.4 million. In Q3 2008, investing activities included capital expenditures and investments in intangible assets of $9.2 million and were primarily related to facilities and equipment in the US, Russia, and Germany.

During the quarter, we substantially completed facilities in Germany and Russia, and our new US sales and demonstration facilities in Massachusetts and Michigan are on track to be completed by the end of the year. As a result, we continue to expect to see a gradual reduction in capital expenditures in Q4 2008 and a more substantial reduction in 2009. In Q3 2008, we also used approximately $1.2 million to acquire an additional part of the minority interest in our Russian subsidiary and for certain other small investments. Minority interest in this subsidiary now stands at 34%, which we have an agreement to acquire as disclosed in our prior earnings call.

Accounts receivable increased to $39.5 million in September 30, 2008 from $33.9 million at December 31, 2007. Accounts receivable days outstanding though decreased 59 days at the end of Q3 from 61 days at the end of Q2 2008. Historically, our accounts receivable have been strong as measured by both low bad debt and accounts receivable aging. Although we increased our accounts receivable reserve in the third quarter, we continue to believe that the accounts receivable are at a high quality.

Inventory increased by $12.4 million to $72.8 million at September 30, 2008 from $60.4 million at December 31, 2007. Sequentially inventory decreased by $3.8 million in par due to a benefit related to exchange rates of approximately $2.5 million. The remaining decrease was due to consumptions and the transfer of certain high-power lasers to demo units, including the 50 kilowatt laser we built earlier in the year.

For the year-to-date, the increase in inventory was primarily due to an increase in work in process related to production of value-added components, including packaged ice and fiber modules, as well as major sub-assemblies in finished products. During the quarter, we wrote down $1.4 million of excess and obsolete inventory.

With regard to our line of credit facilities at the end of the third quarter, we had a total of $16 million drawn on our US, German, and Italian credit facilities. We will continue to use these facilities from time to time in order to finance our short-term working capital requirements. At September 30, 2008, our total available liquidity, including cash and cash equivalents and undrawn committed credit lines, was approximately $89 million. Our largest committed credit lines are with Bank of America and Deutsche Bank in the amounts of $35 million and $21.7 million respectively, and neither of them are syndicated.

I’d like to provide you with our guidance for the fourth quarter of 2008. For the fourth quarter, IPG expects revenues in the range of $37 million to $62 million. The company anticipates earnings per diluted share in the range of $0.19 to $0.23. That is based on 46,375,000 diluted common shares, which include 44,685,000 basic common shares outstanding and 1,690,000 potentially diluted options.

For the fourth quarter, we expect high-power laser sales to remain strong. However, we expect that this strength will be offset by lower sales of our pulsed laser products in certain Asian markets. Also the effect of the weaker euro has lowered our revenue estimates by approximately $3 million. This guidance is subject to the risk we outlined in our reports with the SEC and assumes that the exchange rates remain at present levels.

Before we open the call to questions, I’d like to sum up. We’ve continued to see growth as a result of the market’s recognition of the superiority of IPG’s products for a variety of traditional laser applications as well as a novel and innovative uses of laser technology. We believe IPG has a product application and geographic diversity that will enable us to weather the challenging market conditions.

And with that, we’ll open the call up to your questions.

Question-and-Answer Session

Operator

Thank you. (Operator instructions) We’ll go first to C.J. Muse at Barclays Capital.

C.J. Muse – Barclays Capital

Yes, good morning. Thank you for taking my question. I guess first question, considering the current macro backdrop, can you track a little bit about I guess where your visibility stands at today in terms of your backlog as well as design wins that you’ve made over the last three to six months, as well as what you expect in the next three to six months and how that will support you through this crisis?

Tim Mammen

Hi, C.J. Tim. Let me just address some of the backlog and bookings order flow, and then Valentin probably can talk about some new products and design wins, which we’re expecting. Throughout Q3 of bookings, order flow remained strong. And even to date in Europe and the US we haven’t really seen a downturn. So part of the bookings actually that we took in Q3 was also related to shipments out into 2009. So, our total order backlog has increased since the beginning of the year. We do see some good visibility into the first quarter. In particular, we’ve actually seen resilience on the high power laser sale market and I think that is a clear indication that technological benefits of those products despite the high ASPs continuing to drive some growth in the business. With regard to some of the pulsed laser products, that’s really – there seemed to be some structural changes going on in China that has impacted our Q4 visibility, but we are working on a couple of major projects in China that hopefully will bear fruition in the first quarter. Perhaps in terms of design wins and new products, Valentin, you could outline some stuff there.

Valentin Gapontsev

I could also note that regarding backlog, this year we have backlog growth and booking much higher growth than our revenue growth. So it gives us very strong position now with what I would call (inaudible). Regarding this, we’re also of course restructuring some of our business, taking in account the recession and market trends. And we worked very hard this year to develop new line of products and new applications. We are very successful we hope during this quarter four and quarter one next year. So the trend is very – some new impressive line of products, which will additionally diversify our business and will give us a wealth of new opportunities, which we believe can take some (inaudible) drop for some current sales with current products, and we hope to grow further without any serious damage from the market environment.

C.J. Muse – Barclays Capital

That’s great.

Tim Mammen

Just some examples on that, C.J., is within the microelectronics we’ve seen some good growth this year. We’re expecting some new orders that will come into play in the first half of next year from that. On solar, that does seem to be a bit of a – if you fill orders for one big project and then those lines are brought up, we're expecting the solar to also continue to be strong in the beginning of next year. Some other examples of stuff, hybrid battery welding where our fiber lasers are particularly well suited. So there are some industries that appear to be relatively resilient even in the current climate where we are working very well.

C.J. Muse – Barclays Capital

Great. And if I could move over to the gross margin line, if we back out that inventory write-down and reserve of $1.4 million, it looks like you would have been very close to 50% gross margin. And so I guess the question here is, should we think about ongoing write-downs on the inventory front, or are we at the revenue run rate and you’re at the efficiency side of things where you can achieve 50% gross margin from here on out?

Tim Mammen

I think we’re very close to that. I think the leverage in the model is clearly being demonstrated. I was a bit more cautious about getting there. At like $62 million of revenue, we’re saying 65 would be where more stability would occur. But I think that first of all we did a very thorough review on inventory. And just putting in a caveat there, so long as you don't see something major happen with the growth rates or actual inventory levels. I think we’ve got a good handle on excess and obsolete. We will see smaller write-downs I think over the coming quarters, just some stuff pages. But yes, I think that the model in terms of the way we’ve tried to articulate to it, has gone to that point with the leverage on gross margin at sort of $60 million of revenue. We’ve seen some balance on the inventory side. So the target generally is definitely to get to that 49%, 50% over the longer term.

C.J. Muse – Barclays Capital

Great. And I guess last question here. Can you share what you wrote down on the inventory side?

Tim Mammen

Optical components, some of that we’ve looked at how many – the quantities that we had. Some of them are still being used, some of which have determined to be excess, some older fiber modules. So where we've transitioned, for example, from using high-power modules as against lower-power modules, some of the modules built using the old PLD-50 diodes. There's a selection of different items that we looked at in a lot detail. It was a detailed review done in June, but some of this stuff, as it ages, comes under our rules for writing them down.

C.J. Muse – Barclays Capital

Very helpful. Thank you.

Operator

And next we’ll go to Antonio Antezano at Macquarie Capital.

Antonio Antezano – Macquarie Capital

Good morning.

Valentin Gapontsev

Good morning.

Tim Mammen

Good morning, Antonio.

Antonio Antezano – Macquarie Capital

I just wanted to follow-up on the cost side, regarding SG&A and R&D, what is your flexibility to reduce the spending in the event of revenue slowdown?

Tim Mammen

In my view, the SG&A and R&D, obviously you can cut those if you go forward. And if you look at SG&A, I’ve mentioned the benefit on FX that it had brought it down this quarter. There were also some write-downs related to bad debt. I don't think those are really fundamental to our ability to conserve cash at this point in time given the revenue levels. I think the important thing to understand about our business model right now is where we stand in our CapEx investment cycle. And on the CapEx investment cycle, we are clearly at the end of some major projects. We don’t have any significant projects committed out there, and our ability to run the business on very limited CapEx in 2009 and to generate free cash flow. I think we stand extremely well positioned in that. Of course, if we see a decline in revenue or something material happen, we can always look at our SG&A expenses. And there is probably a little bit of room there, not a huge amount. And R&D, you can sort of hiring people. We could move people from doing some R&D applications to managing some of the manufacturing rather than hiring new people there. So there is some flexibility in the model. But I draw attention, I think, to the point we are in our CapEx cycle and the leverage we see on that I think positions us well for ’09.

Antonio Antezano – Macquarie Capital

On CapEx, what is your CapEx forecast for next year?

Tim Mammen

We’ve talked about numbers in the range of $15 million to $20 million. We are revising and reviewing that at the moment. So I think come the beginning of the year, we’ll give a revised number on that. My view is that things are really bad next year. You can run the company on less than $10 million of CapEx. There is a little bit of investment in Russia. And this is a – it depends how our outlook looks as we do the budget process over the next coming months.

Antonio Antezano – Macquarie Capital

Okay. And then just final question, on the merchant diode business, if you could share an update on that?

Tim Mammen

In terms of sales, last quarter was about $200,000. Valentin, your view on the merchant diode that is developing next year.

Valentin Gapontsev

(inaudible) So we’ve started this diode business only recently, and we spent some time to define our policy and price policy and also the sales policy. Now we see very good acceptance with when we negotiate with some very big customers. We negotiate long-term contracts. So we’ll deliver [ph] next year. We have started talking about on many (inaudible).

Antonio Antezano – Macquarie Capital

Thank you.

Operator

We’ll go next to John Harmon at Needham & Company.

John Harmon – Needham & Company

Hi, good morning.

Tim Mammen

Good morning, John.

John Harmon – Needham & Company

I'd just like to discuss your guidance a little bit. On the top, it was slightly down a little bit, but you said currency was going to hurt you by $3 million. But I believe you have the one-time BMW order for maybe mid-single digit millions. So if you tax all that out, maybe down a little bit – and the quarter historically has been seasonally strong. So what pieces – does that mean that the quarter is reflecting a slowdown in sort of your end markets?

Tim Mammen

Yes. And I think we articulated that. Really the thing that – you’ve got all that benefit from BMW, but even outside of that, we’re going to have a very strong quarter on high-power lasers. The real item that has taken the guidance down a little bit in terms of product performance is really the pulsed lasers. So particularly in some of the Asian markets, in China, there is also a little bit of a timing – different timing issue on orders to be shipped into the solar business where there will be a pickup in pulsed in Q1 related to solar, but we’re going to be a little bit lighter because of call downs already during the year on some products. And the real gap on this though is on pulsed, and it's primarily driven by searching aspects of the Chinese market.

John Harmon – Needham & Company

So it seems like that the small amount of weakness that you are seeing is more geographical based, even though you are selling to some industries like that you mentioned automotive and aerospace that are – and of course, semiconductors that are really hurting right now.

Tim Mammen

Yes. Right now, that’s a geographic issue in Asia. And I think we’re working on resolving that. Our general manager there is actually trying to build some relationships with more of the bigger players on the laser systems marking side in China. We’ve had some orders for high power lasers even into this fourth quarter from the auto manufacturers. The exposure to semiconductors should not be restated. It’s relatively small. I mean, we sell a few units for the blowing out memory chip repairs – repairing memory chips, rather, in the manufacturing process. So we just never had a huge amount of exposure to semiconductor.

John Harmon – Needham & Company

Okay, thank you. And you said you purchased an additional piece of that minority interest. I think you said before that you expected minority interest to go down by about 80%. Does it go to zero now or just something between 80% and 100%?

Tim Mammen

It won't go to zero because there continues to be a minority in certain of the other subsidiaries as well, the sales subsidiaries. But it should be – it will be basically after the end of this quarter much smaller.

John Harmon – Needham & Company

Thanks. And can you provide some guidance on that next – end of next quarter?

Valentin Gapontsev

Regarding guidance, we take into account also these very unpredictable situations in market. So we have to be much more careful today in forecasting and therefore take into account any unpredictable situation in the US market. But we still will have booking, and so don't show as a serious problem. So we're going very well, but nobody now knows what happens tomorrow.

John Harmon – Needham & Company

Thank you. And then finally, are your CO2 lasers still on track for a launch early next year?

Tim Mammen

We still expect to launch CO2 and – Q1 or is it –?

Valentin Gapontsev

With CO2 laser, we pass a good way in qualification, but still not finished with testing in quarter one with that to sale, but maximum quarter two. But we never plan to put in our forecast is the sales were – good improvement in sales due to CO2 lasers compared to fiber lasers. It will be a small – very small add in any case.

John Harmon – Needham & Company

Okay. Thank you very much, and congratulations.

Valentin Gapontsev

Thank you.

Operator

(Operator instructions) We’ll go next to John Lau with Jefferies & Company.

Rahul Kanvarker – Jefferies & Company

Hello. This is Rahul Kanvarker calling in for John Lau. I was just curious to know at current capacity levels what kind of revenue run rate can you support.

Tim Mammen

We’ve reiterated – well, not reiterated. We’ve stated before that we could probably without significant capital expenditure over the next 18 to 24 months, we think we can get close to probably $90 million or $100 million.

Rahul Kanvarker – Jefferies & Company

Okay.

Valentin Gapontsev

I’m more optimistic (inaudible) with current capacity, with very small, maybe, addition, we can double the revenue without any problem.

Rahul Kanvarker – Jefferies & Company

So if that is the case, then that means that currently you are earning at some 60% to 65% of capacity utilization. So – and still your gross margins are pretty impressive. So could you just explain a little bit the relationship between capacity utilization and gross margin? I mean, should we expect it to go even higher if capacity utilization goes up?

Tim Mammen

As C.J. pointed out, I think it was clear that the underlying gross margin for the product that was sold during the quarter was approaching 50%. So that's a significant improvement over the eight quarters since we've been going public. So we're seeing as revenue grow up, some of the leverage improve. We have stated that we think we can target a gross margin that continues to stay close to 50%. The issue that I think you got into is really want to expand the sale of the high power lasers and you get into volume unit orders is that you will see pricing pressure not related to the single-unit orders. But if people are going to buy 10 and 20 – to 20 units of our fiber lasers in the high power levels, pricing would have to come down. What we have stated is that the business model is very well positioned to absorb that pricing pressure without seeing any detrimental effect on gross margin. If prices stayed exactly stable as they were and revenue went to $70 million or $80 million, the company would be able to get additional leverage in the business model.

Rahul Kanvarker – Jefferies & Company

Okay. So in Q3, how was the pricing environment?

Tim Mammen

It was still pretty strong, because we are still – we don't have a significant number of customers out there who are buying 20 units of our pulsed lasers. So on single units, we don’t give any additional discounts to the ones we’ve been providing before for two or three-unit sales. It’s only the expectations you get into higher volume that you will see pricing discounts related to those higher volumes.

Valentin Gapontsev

From our side, we worked this year very hard in the last quarter also to decrease our cost of such lasers, and we were very careful during this year practically. We decreased cost of high-power laser minimum for 20%, 25%. So it will give us additionally opportunity. So I don’t see – we don't worry at all with even some able to contemplate our price, but still mention [ph] that high-power laser now growing very fast, not decrease, but growing very fast.

Rahul Kanvarker – Jefferies & Company

Okay. That was very helpful. Thanks a lot.

Valentin Gapontsev

And then also here it is very important because before we provide only laser source itself, but we have a drop of margin due to the termination like optical switches, copper-based cables (inaudible) and other, which were used from outsourcing. Now we practically develop all these items and producing (inaudible) with better quality (inaudible) available from the market, and we now – it's obvious what we provide additional share of this in total cost of high-power fiber lasers from 15% to even 30%, 40%. So now we have started to get from these parts of the sales margin, high margin which we have from laser source itself. So total margin, of course, of these high-power now is becoming much higher.

Operator

And next we’ll go to Ajit Pai of Thomas Weisel Partners.

Ajit Pai – Thomas Weisel Partners

Yes, good morning.

Tim Mammen

Good morning, Ajit.

Ajit Pai – Thomas Weisel Partners

A couple of quick questions. The first one is just looking at the acquisition of SPI, can you give us some commentary as to how the competitor dynamics might have changed with the acquisition?

Valentin Gapontsev

The situation changed, so we lost one small but a competitor because we don’t believe the TRUMPF will prolong [ph] the sales of lasers. They review this on many of the small and mid power and low-power lasers they will use for their integrated solution mainly, not just for sales in the market.

Ajit Pai – Thomas Weisel Partners

Right. But are you seeing TRUMPF use it much more actively trying to ramp that business? Or you haven’t seen any material change as of yet?

Tim Mammen

No material change as of yet. I mean, maybe on some of the pulsed laser stuff, we've seen customers again come back to us this quarter.

Valentin Gapontsev

Yes. I see that most of the SPI customers will – now returning to us.

Ajit Pai – Thomas Weisel Partners

Right. The others, but TRUMPF had sales in their own products, are they vertically integrating very rapidly or very gradually?

Tim Mammen

We don’t have an insight into that.

Valentin Gapontsev

They need some years only to reach the level that we have today. So they are not able to immediately make this. And we're not also sleeping. We're working very hard to improving (inaudible) product.

Ajit Pai – Thomas Weisel Partners

Got it. And as some of the broader markets start slowing, the end markets, are you – what's going on with the pricing environment for your lasers right now?

Tim Mammen

They continue to remain pretty stable, Ajit. Particularly, we’re not making any concessions on single-unit sales. I think the issue that we've always talked about is as you get into these multiple-unit sales, you will see some pressure there. Pulsed lasers next year, we’d probably see a decline of – which would be in line with this last year, a few percent. Very good stability on the high – on the mid-power lasers still. So, pricing continues to be relatively stable.

Valentin Gapontsev

Now our price is (inaudible) so low to compare to. So nobody from competition now in near future would be able to compete with this price. As you know, the SPI, they sold their laser with our recent (inaudible). They never generated any profit at the low cost. As you know, even big players, I don't like to mention their names, they sell in a competitive laser for high power without practical profit. It was not available from laser rival because they don’t have any profit today. They are trying to save their positions in market. In low and high power – pulsed lasers, also our price level not achievable to any competition today. We don't need to drop price now. But from other side, we decrease costs for during – even pulsed laser, low-power pulsed laser, during this year, we dropped price for 25%. So our margin for low-power pulsed laser now increased compared to last year is very essential.

Ajit Pai – Thomas Weisel Partners

Got it. And then just looking at your telecom business, can you give us some color outside of – like in North America and in Western Europe, whether you have made any progress in trying to grow your business there recently?

Tim Mammen

Telecom in the US, there is still stuff we are working on on the US side. I think we’ve actually seen outside of some of the bigger stuff we’re working on, we have seen an improvement in sort of the order flow from existing OEMs into Q4. In Western Europe, telecom is still relatively weak.

Valentin Gapontsev

In Western Europe, telecom very weak. In the US, we’ll see the improvement for quarter three, quarter four, beginning of quarter four. For example, we received now the big order from Harmonic again, after one year practical program orders. We – it’s now two quarters. (inaudible) to grow very fast with orders throughout. We are working with some additional big guys in this American market. And we’ve also developed very special communication project in Caribbean Island. So we hope next year we’ll double, triple telecom sales in the US. And there are regions like Asia, and Russia is also growing fast.

Ajit Pai – Thomas Weisel Partners

Okay. Thank you so much.

Operator

Your next question comes from Jiwon Lee of Sidoti & Company.

Jiwon Lee – Sidoti & Company

Thanks. Can we talk a little bit more about the traction that you are seeing in the cutting applications? How many OEMs are we talking here, or the dollar contribution that you are expecting this year or next?

Tim Mammen

I mean, we’re not going to provide any guidance on the dollar contributions from these cutting lasers over the next year. I think that just the – what we’ve seen at the recent shows is a clear indication that fiber lasers are now very widely accepted on cutting. I will provide – with regard to one of the longer term OEMs we’ve had, they have already placed a significant order for the next year with us for the supply of multiple units of lasers. That order came in in the third quarter of 2007. Many of the other OEMs are not necessarily giving us long-term contracts, but we’re seeing improved order flows on the cutting side from them. Valentin, what else on the cutting –?

Valentin Gapontsev

I can say in 2007 we’ve had only two integrated very small companies that will only introduce what’s the system in the market. Only these two shows we have in October in – it was FABTECH in the US and the EuroBLECH in Hanover, Germany. (inaudible) was the hit of these important exhibitions, big shows. They have fiber laser cutter. And more than ten companies demonstrated this, and it’s not only small guys, but (inaudible) in this market segment. And the biggest players in the market like (inaudible) industry is now very worried about this situation. And also they have started to become very active in this direction. So we see – we expect next year would be booming. Fiber laser, at last, now positions sales [ph] as practical with the future of laser cutting.

Jiwon Lee – Sidoti & Company

Okay. Well, that’s helpful. And what’s your current expectation from the auto industry for next year, I mean, understanding pretty dismal industry outlook?

Tim Mammen

I mean, again we’ve – we are as cognizant of what’s going on out there as anybody else is. I think that at this point, in trying to make a judgment call on the outlook, what the outcome next year is going to be is pretty difficult to do. We have actually, as I mentioned, not only seen reasonable order flow from the auto, in fact in Q3, we’ve actually seen some additional orders in Q4 for high power. There are a number of other different projects we're working on. I think undoubtedly right now there's a lot of instability in that. And you can’t really put a judgment on that business. I think hopefully as that stabilizes the value of the technology next year, we will continue to see us benefit from sales into that sector.

Jiwon Lee – Sidoti & Company

Okay. And finally, roughly how many lasers would you be selling this year?

Tim Mammen

In terms of quantity of lasers this year?

Jiwon Lee – Sidoti & Company

Yes, in terms of units.

Valentin Gapontsev

What kind of lasers?

Tim Mammen

We’ll give you a number here. Through the third quarter of 2008, it’s just under 9,000 lasers. So we’re averaging 3,000 lasers a quarter at the moment, just over 3,000 lasers a quarter.

Jiwon Lee – Sidoti & Company

Okay, great. Thank you.

Operator

At this time, we have reached the end of the Q&A session. I will now turn the conference back over to Mr. Valentin Gapontsev for any closing or additional remarks.

Valentin Gapontsev

Thank you, everyone, for joining us today. We continue to make progress in our operation on financial growth during 2008. The quarter's strong financial results were at the top end of our guidance, indicating that we are executing well on our growth strategy. Moreover, the strategic investments that we have made over the past year position IPG to leverage our superior technology to capitalize and opportunities across diverse markets around the world. We look forward to speaking with you again in the fourth quarter with new exciting results. Thank you much.

Tim Mammen

Thank you.

Operator

And that concludes our conference call. Thank you for joining us today.

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Source: IPG Photonics Corporation Q3 2008 Earnings Call Transcript
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