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IPG Photonics Corporation (NASDAQ:IPGP)

Q4 2008 Earnings Call Transcript

February 24, 2009 10:00 am ET

Executives

Angelo Lopresti – VP, General Counsel, and Secretary

Valentin Gapontsev – Chairman and CEO

Tim Mammen – VP and CFO

Analysts

C. J. Muse – Barclays Capital

Antonio Antezano – Macquarie Capital

Ajit Pai – Thomas Weisel Partners

Jiwon Lee – Sidoti & Company

John Harmon – Needham & Company

Mark Douglas – Longbow Research

Tom Bishop – B. I. Research

Operator

Good morning, and welcome to IPG Photonics’ fourth-quarter and year-end 2008 conference call. Today's call is being recorded and webcast. At this time, I would like to turn the call over to Angelo Lopresti, IPG’s Vice President, General Counsel and Secretary, for introductions. 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, February 24, 2009. 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’ll now turn the call over to Dr. Gapontsev.

Valentin Gapontsev

Good morning. And thank you for joining us today. We are very proud of our accomplishments in 2008, which was a year of financial, strategic, and operational achievements.

Our 2008 revenue grew 21% to a record $229 million. In terms of end markets, key growth drivers for the year included general manufacturing, automotive, electronics and solar. The aerospace, research, scientific and telecom markets were all stable. The applications that were key to our success in 2008 included cutting, welding, marking and engraving, printing, annealing, and drilling for microelectronics.

Earnings outpaced revenue, increasing 23% to $36.7 million. Diluted earnings per share grew to $0.79 from $0.65 cents in 2007. Our full-year performance was driven by our success in the materials processing market, our largest market. We grew 34% year over year in materials processing due to the recognition of the value of our fiber lasers compared to the traditional lasers and other tools, as well as to the broad diversity of uses for our products.

We are very proud of IPG’s ability to generate cash. In fact, cash flow from operations increased more than 200% to $34.7 million in 2008. An essential achievement for 2008 was breaking into metal cutting. IPG now has numerous cutting OEM customers. Last year, laser cutting represented 22% of industrial laser unit sales, and is even larger than laser welding, which was 12%.

2008 also was a year of exciting new product development. Last year, we substantially increased our R&D spending and we are proud to discuss with you the results of our efforts. These include our recently launched green pulsed and CW fiber lasers, new high energy pulsed lasers, 5 kilowatt single mode lasers and an improved generation of our multi-mode kilowatt lasers, called the YLS family, as well as new powerful diodes. These lasers will enable us to enter new markets and applications. And we entered the merchant diode business with the most powerful and brightest line of diodes in the industry. We also developed a line of products that are used with our fiber lasers, including high power couplers, beam switches and delivery cables that we have offered this year.

We strengthened our infrastructure, grew our capacity and enhanced our sales capabilities by completing IPG’s new sales and demonstration facilities in Massachusetts, Michigan and Moscow; expanding our manufacturing facilities in Germany and Russia; and opening a sales office in Singapore.

In 2008, we enhanced our intellectual property position with the purchase of more than 100 key U.S. patents and 340 foreign counterparts, and we filed almost 30 patent applications to further expand our protection.

In summary, during the year, we made excellent progress in growing our position in the overall laser market and we continue to sell our lasers for new applications, expand our product portfolio, and broaden our geographical reach. An increasing number of customers are using IPG’s fiber lasers due to their superior laser performance, substantial energy savings, and lower cost of ownership.

We are in a time of uncertainty due to the difficult worldwide economic conditions. However, we remain committed to profitability, controlling costs, managing working capital and substantially reducing capital expenditures from historic levels. In addition, we will continue to introduce new products, invest strategically on R&D to ensure that we emerge from this period well positioned for renewed growth with an enhanced competitive position.

I will now turn the call over to Tim, who will discuss the details of our fourth quarter, provide details of our planned response to the current economic environment, and provide guidance for the first quarter of 2009.

Tim Mammen

Thank you, Valentin, and good morning everyone.

Capping the strong year that Valentin just reviewed was a solid fourth-quarter performance. We reported our ninth consecutive quarter of year-over-year revenue growth since we’ve been a public company – growing sales by 6% to $58.2 million and meeting our guidance. Our primary driver for the quarter continued to be the materials processing market, which increased sales by 16% over last year’s fourth quarter. This is a testament to the transformative power that our lasers have, and their ability to provide valuable productivity gains to our customers at a time when everyone is looking to lower costs.

Despite a difficult global economic environment, we also met our guidance on the bottom line, reporting a 9% increase in net income to $9.1 million, or $0.20 per diluted share.

Our gross margin continued to improve year-over-year. Gross margin was 45.6% for the recently ended quarter, and improved by approximately 3 percentage points over the fourth quarter of last year.

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 78%, or $45.6 million, of the revenue we reported in Q4, and grew by 16% year-over-year. Materials processing encompasses diverse end-markets, including general manufacturing, automotive, aerospace, heavy industry, consumer, semiconductor, electronics and solar.

The advanced applications market represented 15% of total revenue during the fourth quarter. Sales of these laser systems decreased by 10% compared with the prior year, but increased 65% compared with Q3 2008. Advanced applications include test & measurement, instrumentation, sensing and defense applications as well as scientific research & development. Order flow has been historically less predictable in this market. While the year-ago quarter benefited from large sales for a U.S. government project, last quarter we sold a high-value, 20 Kilowatt laser in Europe. We would also like to report that recently the Boeing Laser Avenger, using an IPG high power fiber laser, successfully shot down three unmanned aerial vehicles.

The communications market comprised 5% of our revenues in the fourth quarter. Revenues in communications declined by 24% over the fourth quarter of 2007. Lasers for the medical application market comprised 2% of revenue in the fourth quarter. Sales were down 58% year over year and 44% sequentially, reflecting business and operational conditions at our main medical OEM. We continue to focus on customer diversification and hope to make progress with medical customers that are currently in various stages of testing our lasers.

Let’s turn to the performance of our laser types in the fourth quarter. As we expected, we continued to see nice growth for our high power fiber lasers. In the fourth quarter, on a year-over-year basis, sales of high power lasers increased by 32% and represented 43%, or $24.8 million, of total revenue in Q4 2008. Key drivers for high power laser growth were welding, cutting, general manufacturing and advanced applications. Our high power lasers’ power, beam quality and flexibility provide tremendous value to customers at a time when manufacturers around the globe are seeking ways to enhance productivity. We saw new applications for these lasers in Q4, such as deep penetration stainless steel welding with a Russian customer, which replaced electron beam welding, as well as welding batteries for hybrid automobiles.

Pulsed laser sales, as we had forecast, decreased in the fourth quarter by 11% year over year. As a percentage of revenue, pulsed lasers represented 27% of revenue, or $15.8 million, in Q4 08. We have been seeing softening pulsed lasers sales, primarily as a result of weaker demand for marking in general and completion of a large order from a solar photovoltaic customer. The drop in marking demand was particularly evident in China. We expect that some of our new products can start contributing in the second quarter of this year after we start to place demo units with customers in the coming months.

Sales of medium power lasers grew 13% during Q4 of 2008 over Q4 of 2007, and represented 10%, or $5.9 million, of total revenue in Q4 08. Demand for medium power lasers in the quarter was driven by microelectronics drilling, commercial printing, cladding and micro materials processing applications.

Our low power lasers saw a 30% decline year over year and 35% sequentially, primarily due to reduced sales from our primary OEM medical customer.

Looking at our geographic performance during the quarter, we reported 42% of revenue from Europe, 27% from Asia and Australia, 25% from North America and 6% from the Rest of the World.

Our 6% growth in Europe was due to strength in Germany, which benefited from our order with automaker BMW. This was offset by softness in other European geographies as a result of economic weakness.

Sales to Asian markets declined 10% compared with the year-ago quarter. While we saw continued growth in Japan driven by high power sales, weakness from marking applications in China and diamond cutting and engraving applications in India contributed to the year-over-year decrease.

North American sales were essentially flat in the fourth quarter, even though we had a significant decline in medical sales.

Based upon exchange rates prevailing in the fourth quarter of 2007, we estimate that exchange rates negatively affected our revenues by approximately $1.5 million in Q4 2008.

Our gross margins continued to improve on a year-over-year basis in the fourth quarter, increasing nearly 3 percentage points to 45.6% compared with the 42.9% gross margin we reported in the fourth quarter of 2007. The increase was due to higher revenues and increased production. Sequentially, gross margin in Q4 was lower by about 2 percentage points as a result of lower sequential revenue and product mix. In Q1 2009 gross margins will be lower because of decreased sales.

SG&A expenses decreased to $7.4 million, or 12.7% of sales, compared with $8.6 million, or 15.7% of sales, in the fourth quarter of 2007. This was due to a benefit related to exchange rates and lower litigation expense. Excluding transaction exchange rate gains, underlying SG&A expenses in Q4 2008 were $8.3 million.

R&D expenses were $4.4 million, or 7.5% of Q4 08 revenues. This compares with $2.7 million, or 4.8% of revenues, in Q4 07. R&D expenses increased due to diodes, green lasers, high energy pulses lasers and additional development of single-mode lasers.

Based upon exchange rates prevailing in the fourth quarter of 2007, we estimate that exchange rates benefited cost of goods sold and operating expenses by approximately $2.2 million.

Operating income for Q4 ’08 increased by 20% compared with the same period last year. IPG generated operating income of $14.8 million, or 25.4% of revenues, compared with operating income of $12.4 million, or 22.4% of revenue, in the fourth quarter of 2007. Operating income includes charges related to stock-based compensation of $542,000 and $419,000 in the fourth quarters of 2008 and 2007, respectively. In the fourth quarter of 2008, $83,000, $348,000 and $111,000 of stock-based compensation charges related to cost of goods sold, SG&A and R&D, respectively.

Our tax rate for the fourth quarter of 2008 was 33.4%. The effective rate for 2008 was 32%. The effective rate for 2007 was 32.6%.

Net income for the fourth quarter of 2008 increased by 9% and was $9.1 million, or $0.20 per diluted share, compared with net income of $8.3 million, or $0.18 per diluted share, for the fourth quarter of 2007.

Let me turn now to our balance sheet, where our cash position has improved. Cash and cash equivalents improved by $13.3 million to $51.3 million at year end. This compares with $38 million at December 31, 2007.

Not included in cash and cash equivalents are $1.3 million in auction rate securities at December 31, 2008, which is included in other long term assets.

For the year to date, cash flow from operations was $34.7 million, cash used in investing activities was $33.7 million and cash provided by financing activities was $12.5 million. We reported a substantial improvement in cash flow from operations from $10.7 million in 2007 to $34.7 million in 2008. In Q4 2008, investing activities of $7.6 million were primarily related to facilities and equipment expenditures in the U.S. During the quarter, we completed our new sales and demonstration facilities in Massachusetts and Michigan. As previously planned, we expect to see a substantial reduction in capital expenditures in 2009 to approximately $15 million. In Q4 2008, we completed the acquisition of IPG’s minority interest in Italy. We now own 100% of that subsidiary. We are on track to acquire the remaining 34% minority interest in our Russian subsidiary in the current first quarter of 2009.

Accounts receivable increased to $41.8 million at December 31, 2008 from $33.9 million at December 31, 2007. The $7.9 million increase was due to higher sales as well as timing of revenue, which was heavily weighted to the final month of the quarter, when we shipped a significant number of high power lasers. We collected a large multi-million dollar receivable in January of 2009.

Accounts receivable days outstanding were up slightly to 62 days at the end of Q4 from

59 days at the end of Q3 2008. The slight increase is due to the timing of shipments and a receivable in India which is insured under an export guarantees program. We have provided reserves for specific collection issues and in the current economic environment we have tightened our credit policies and we will continue to monitor our receivables and credit policies very closely.

With sales up 21% year over year, inventory increased 20% to $72.6 million at December 31, 2008 from $60.4 million at year end 2007.

We have no changes with regard to our credit facilities this quarter. At the end of the fourth quarter, we had a total of $19.8 million drawn on our U.S., 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 December 31, 2008 our total available liquidity, including cash and cash equivalents and undrawn committed credit lines, was approximately $92.2 million.

Backlog, which we report annually, was slightly down to $69.3 million at December 31, 2008 compared with $72.6 million a year ago. All countries reported a higher backlog as compared to December 31, 2007 except for China and Italy. In China, we have experienced a sharp drop in orders for pulsed lasers. However, we expect some of this decline to be offset by high power laser sales which we have initiated in China in 2009.

The decrease in Italy is due to the timing of orders from our largest Italian customer and we anticipate their backlog to increase in Q1 2009.

That leads us to our expectations and plans going forward. We plan to continue to see opportunities as a result of the market’s recognition of the superiority of IPG’s products for a variety of conventional laser applications, as well as for novel and innovative uses of laser technology. We also see challenges that face the global economy and our customers.

In response to the current business conditions, management has developed a response that I would like to outline for you today. These measures include four elements: cost and expense reductions, maintaining ample liquidity, pursuit of new sales opportunities for existing and new products and investing in R&D for the future.

First, cost reductions. Last year, we worked hard to reduce the cost of many critical components and to develop and produce in house some strategically important and expensive parts that we used to outsource. Now we expect to benefit from these investments. For example, we finished certification and started mass production of powerful chips and 30 Watt packaged diodes, which allow for cost reductions by up to 30%. We are starting high volume production of our own family of high power process fibers, fiber couplers, optical switches and other accessories that can save us substantial sums in addition to improving the performance of our lasers. Another benefit we will see is an investment we made in 2008 in our own thin film facilities, other new in-house technologies and metal job shops to reduce the cost of housings for our products.

Moreover, we have upgraded and simplified the design of our mid and high power systems that allows us to improve quality and decrease costs. Relative to expenses, we have frozen hiring except for strategic hires, drastically limited overtime and curtailed bonuses, and we are reducing headcount through attrition.

Additionally, we will re-allocate our trained staff to products and components that are in demand. We also expect lower legal and litigation costs in 2009 and are reviewing all outside advisor costs. We estimate that these simple and immediate measures will reduce cost and expenses by approximately $4 to $6 million per year.

The second element is to maintain the financial health of the company through preserving a conservative capital structure and generating cash even in these difficult times. Since our public offering in 2006, we have made substantial investments in facilities, equipment and technology, which peaked in 2008. As we planned previously, capital expenditures will substantially decrease, by more than 50% to approximately $15 million in 2009. Further, in 2009 we will strive to control and reduce inventories which should benefit our cash flow. None of our debt or major committed lines of credit in the US or Germany mature in 2009.

Third, we have a winning technology that is gaining market share from conventional lasers and we are pursuing new opportunities with our current product line and new products. I want to present some interesting data for you to consider: the global laser market grew by 3.7% in 2008 according to Laser Focus World. IPG’s total revenue grew by 21.4% in 2008 and our material processing revenue grew 34% in 2008.

In January 2009, IPG introduced two new green fiber lasers that allow us to enter new markets and applications. Applications for this laser include photovoltaic processing, biomedical, pumping of Ti sapphire lasers, welding copper and gold and processing translucent materials. We estimate this market to be in excess of $150 million.

Also, we have introduced new cladding lasers and high energy pulsed lasers. We developed a two-way EDFA to enable cost effective deployment of triple play Fiber to the Home and RF over glass networks. To help us capitalize on the many opportunities we see in this area, we are investing in new sales and applications personnel and we are bringing on board several high quality veterans. I want to mention that we also opened a new sales and application office in California to better serve the microelectronics and solar industry and our West Coast customers.

Lastly, we plan to continue our commitment to develop technological breakthroughs in lasers, amplifiers, components and complementary products that will help us capture new sales opportunities, reduce cost and position us well for growth when the economy recovers. We have implemented some of these measures, but most will take full effect in future quarters. Management will review this plan and adjust our operations through the year to adapt to business conditions.

With that as background, I’ll provide you with our guidance for the first quarter. This guidance is subject to the risks we outline in our reports with the SEC, and assumes that exchange rates remain at present levels.

For the first quarter, IPG Photonics expects revenues in the range of $45 million to $50 million. The Company anticipates earnings per diluted share in the range of $0.09 to $0.14. That is based on 46,337,000 diluted common shares, which includes 44,886,000 basic common shares outstanding and 1,451,000 potentially dilutive options.

And with that, we will open the call up for your questions.

Question-and-Answer Session

Operator

(Operator instructions) and we will take our first question from C. J. Muse with Barclays Capital.

C. J. Muse – Barclays Capital

Good morning. Thank you for taking my question. I guess first question, Tim, when you look at your guidance, the mid point, you are down about 10% year over year versus many of your competitors in the laser space, down 26% I guess on average or worse. And I guess the question first off is, as you look to 2009, do you expect that that kind of performance for IPG can continue and if we are seeing, it is sort of a down 30% for the overall laser market that you will be more like down 10%?

Tim Mammen

Yes. And I think clearly we expect to outperform the overall market and the way you are framing, what we are targeting I think is very reasonable. I think within the fiber laser market, we felt we have even made better gains over the last year. And I think that is a very reasonable way to look at it.

C. J. Muse – Barclays Capital

Okay. And then I guess secondly, on the cost side, when you look at the planned OpEx savings, when should we see the full benefit of that? And I guess, can you put numbers around that? I know you did about $11.7 million in OpEx in Q4. Do we get down to the sort of $10 million run rate by March or June?

Tim Mammen

Yes. I mean, we are going to see most of that come through in the first quarter. So if for example, the reducing bonus accruals is immediately effective coming into the end of January, we are managing overtime very, very closely and obviously, some of the benefit on legal and litigation expenses will already be in there, since they have come down since the first quarter of a year ago. We have got specific numbers in each of those three areas and those ranges add up to like $4 million to $6 million in each of those. And they are not insubstantial amounts.

C. J. Muse – Barclays Capital

Okay. And then I guess last question. When you look out to 2009 in the advanced side of things, particularly around the high power segment, could you provide any color on – I guess, how that could change as a percentage of overall sales, just sort of any framework to help us understand how that will proceed throughout the next year?

Tim Mammen

I think that in general, we expect advanced to grow this year. We are definitely on track. I think we have talked before about trying to sell a couple of ultra high power lasers. And I think we are optimistic that that will continue to happen. And even if at the single mode level, as we go from 5 kilowatts to 10 kilowatts, there is tremendous interest in that laser family. I think Valentin perhaps can provide more color on the advanced areas as well as its expectations. He is more closely involved with the technical side of it.

Valentin Gapontsev

(inaudible).

C. J. Muse – Barclays Capital

Perfect. Thank you.

Operator

And we will take our next question from Antonio Antezano with Macquarie Capital.

Antonio Antezano – Macquarie Capital

Good morning. Just a follow-up on the prior question in terms of your outlook by each of your four markets. If you could expand in terms of the guidance for the first quarter, what do you expect for each of those four businesses?

Tim Mammen

We don't give a lot of guidance by product line or business area. But I think that I mean, right now obviously there is a lot of volatility around industrial segments and materials processing but there are – we look at our pipeline, a huge number of opportunities that exist out there. We believe that particularly at the high power level, where the value add of our lasers obviously to consume more power or process. Deep and thicker metals really start to translate into higher productivity gains. We believe that – for example, in North America, our competitors are getting very few orders for high power lasers, and that the orders that are coming out are coming to IPG. So there is a sort of little bit of uncertainty right at the beginning of the year, on that I think that hopefully if we get to some stability within the credit markets, we will see that industrial laser business pick up. I think there is definite optimism around advanced applications for the year. That can be volatile quarter on quarter, and our telecom group is actually pretty optimistic about some of the projects they are working on with major OEMs. So we would actually expect telecom in Russia and North America to grow for the year. The medical business will continue to remain a little bit volatile this year; I wouldn't expect a huge amount out of medical, particularly in the first half of the year.

Antonio Antezano – Macquarie Capital

Right. And then in terms of your gross margin, you said that it would decline in Q1. Will you provide a range at least on what kind of level we should expect for gross margins?

Tim Mammen

The top of our revenue range, we expect to be relatively stable. The problem is that the bottom end of the range is that some of the benefits that we are talking about coming through on products, lower accessory costs will be offset by lower absorption. So the range we will give is about sort of 41% to 46% in the first quarter. But it is really the lower fixed cost absorption at the bottom of the range with some benefit coming through on, ultimately hoping Q2 and later on on the diodes and sort of the other accessories, which really should start to save significant amounts of money on the high-power lasers.

Antonio Antezano – Macquarie Capital

Thank you. I will go back to the queue.

Operator

And we will take our next question from Ajit Pai with Thomas Weisel Partners.

Ajit Pai – Thomas Weisel Partners

Good morning. Just sort of addressing the gross margin question again, I think you talked about the low end and the high end of the range. But a lot of the sort of product innovations you have talked about, you know the 30 watt laser, diode as well as the (inaudible), a lot of these new facilities, I think are going to be driven – the economies of some of this integration as well is going to be driven by scale. So is it fair to assume that you will still be able to capture on flat revenues sequentially over the next two or three quarters of revenue, stay at this current level, but you would have seen a gross margin improvement, even though volumes aren’t really ramping that rapidly as far as some of these initiatives, or do you think that you would still be able to capture significant improvement in your gross margins over time by these vertical integration as well as some of the new innovations?

Tim Mammen

To answer the first part of the question, absolutely and even a stable revenue environment, say coming off the fourth quarter, we would have seen an improvement in gross margins driven by the lower costs related to these accessories. So we wouldn't really require additional scale to get those gross margin improvements. When we get back into a phase of growth hopefully, we will see that leveraging and the benefit from the lower accessory costs drive to the gross margin line and I would expect to see those gross margin starts pickup again quite nicely. So I think the answer to the question is yes, Ajit.

Ajit Pai – Thomas Weisel Partners

Got it. And then the second question, looking at the pricing front, so far, I think IPG has been a price leader, the one that has actually been sort of setting the price for fiber laser in the market. Have you seen any change in that trend, are you seeing your competitors respond in a way that has been different for the past couple of years as far as pricing, either with fiber lasers or even competing technologies in any of your vertical markets?

Valentin Gapontsev

Yes, we see some trends, some of the competitors trying to save their predictions of market cutting the prices for their products, sometimes even according to our information, even below the court. But they could not go the direction a long time. So we have, up to now, as normal it is there in our price and we have to dictate price in the markets, saving a very good gross margin.

Ajit Pai – Thomas Weisel Partners

Got it. And then the last question would be just sort of the quality of your backlog. I think you talked about a modest fall in backlog, but it is still greater than your quarterly revenue. So what is the timeline for the shipment of the current backlog and has there been any change in the – any cancellation that you have seen in that backlog that contradicted to the drop off, mainly shipping being greater than orders?

Tim Mammen

We haven't had any cancellations, but we had some order deferrals. We have scrubbed that backlog number pretty clean. I think it is a pretty high quality number. So you know we have gone through some of that and we have seen if we want frame agreements with customers, but haven't been calling them off. We have called those customers and said that these orders continue to be active. So we put a lot of work into that. I think the backlog provides us with good visibility into Q1.

Obviously, order flow is, given the economic environment – is not as great as it was in the fourth quarter last year as it was a year ago. So we are managing the business within those challenges. But I think we really have put a lot of work into ensuring that backup number is a good number. I think part of it was the decline in China, we are really making some good progress with one of the major laser manufacturers there, that we hope to sell our pulsed lasers to instead of selling those pulsed lasers to a lot of the smaller companies. We're trying to develop a deeper relationship with them as well on the high power, as well as targeting a lot of single-unit high power sales in China to universities and R&D institutions as well as the auto industry in China, where there continues to be investment.

In Japan, very good-quality backlog there with all the high-power lasers. The marketing business will be a bit volatile. And even in India I think in the last couple of weeks, we have had some indication that once we get through the difficulties with the narrow marking engraving, the second half of the year we may see some orders from them as well. So it is a good solid backlog, not as high as we would love to see it, but I think we're doing pretty well.

Ajit Pai – Thomas Weisel Partners

Got it. Thank you.

Tim Mammen

Valentin had additional commentary there.

Valentin Gapontsev

(inaudible).

Operator

And we will take our next question from Jiwon Lee with Sidoti & Company.

Jiwon Lee – Sidoti & Company

Good morning. First off, what areas where the other than your segments there are predominantly –

Tim Mammen

Geographically or by product or by –

Jiwon Lee – Sidoti & Company

Geographically please.

Tim Mammen

Geographically, just the rest of the world, we have made progress in sort of the Mediterranean parts of Europe, we have had some sales, not in Q4 in South Africa. That was earlier, some little sales in South America and Israel as well.

Jiwon Lee – Sidoti & Company

Okay. And could you talk a little bit about if we combine welding and cutting sales together, roughly what percentage of your sales would that be?

Tim Mammen

We have actually done a little work on getting some more granularity on this. I don't plan to talk about it in a lot of detail. I recall that, welding and cutting now are getting up to the – probably about 30% of sales is all.

Jiwon Lee – Sidoti & Company

Okay. And similarly, what about the auto exposure?

Tim Mammen

Auto exposure is not that bad. Everyone is very worried about it. I think we have got, obviously in Q4 with the large order to BMW, the total sales were about 20% at auto, but specifically identified auto sales for the year were actually about just below 15%. And the important thing to understand about that auto industry is it is not just the traditional auto applications we are working on. Some of those sales are coming out of hybrid battery welding, battery welding for hybrid vehicles and fuel-cell welding, some of the other – maybe battery and fuel-cell are some of these. But also cutting high strength steel is very important and the fiber lasers are high strength steel cutting are also a key driver, replacing dies.

Jiwon Lee – Sidoti & Company

Okay. And lastly, following on your Boeing comment, could you talk at all about any of the similar prospects there?

Tim Mammen

There just continue to be numerous advanced application prospects. I think there are ongoing qualifications and tests with customers at the moment that I think we will be able to report on at the end of this quarter. But we made progress not just in the US with some of these advanced applications but also in Europe as well.

Valentin Gapontsev

(inaudible).

Jiwon Lee – Sidoti & Company

And one last question please. Where do we stand in terms of your litigation with Imra?

Tim Mammen

That case is still currently stayed and the patent is continuing to be reviewed by the patent office. There is no further update to give to that. We hope that we will have not much activity on that case for the year.

Jiwon Lee – Sidoti & Company

Okay, fair enough. Thank you.

Operator

And we will take our next question from John Harmon with Needham & Company.

John Harmon – Needham & Company

Good morning. A couple of questions please. First of all, regarding your minority interest, you said at one point I think you expected about 80% of that to come out and it looks like it was down about a third in December. So is that kind of roughly correct, about a third of it came from the business that you bought back in Italy; and maybe there is another 50% more to come out in Q1, is that looking to the numbers correctly?

Tim Mammen

Not really quite, because of the timing of when these acquisitions took place. If you look at the total minority interest for the year, about $1.4 million of that would have not been incurred had all of these transactions been completed during 2008.

John Harmon – Needham & Company

Okay. But the rest will be done – you expect in Q1 and –

Tim Mammen

Yes. It will be finished in Q1 on Russia. So the only minority interest that is left out there is a small amount in Korea and a small amount in Japan.

John Harmon – Needham & Company

Okay, thank you. And regarding your expense reductions, it sounds like the majority of what is going to hit the cost of goods sold line is there and how should we look at R&D spending for the year? We think you have a lot of projects going on, do you expect R&D spending to be up or flat or down a little?

Tim Mammen

First off, most of it is there. It is not really reflected. If you mean by there then we are ready to start introducing these components and develop them, that is correct. So they should start to benefit 2009. R&D expenses I think in absolute terms will track relatively flat with the fourth quarter of 2008.

John Harmon – Needham & Company

Okay, thank you. And just a comment or question here, your guidance range seems pretty wide with respect to you just having a month left in the quarter. Are there a couple of big orders that could go either way, Q1 or Q2 or why is the range so wide?

Tim Mammen

It is really significant orders that are swaying it, but I think that now along with the sort of economic uncertainty out there, we want to be appropriately cautious and not over said expectations. I think on the bottom end of the range on the earnings side, there is tremendous volatility out there on exchange rates at the moment. And we're trying to factor in some of that. So we still have reasonable good gear. We've got reasonable visibility into the quarters orders based upon backlog, but it is an appropriate time to be measured I think right now.

John Harmon – Needham & Company

Sure and then just finally, please confirm for me – I believe your green laser is shipping and when do you think you might start to book revenues for your CO2 laser?

Valentin Gapontsev

(inaudible).

John Harmon – Needham & Company

Does that mean you are delaying production of your CO2 laser or –

Valentin Gapontsev

We are ready to produce but we build for these (inaudible) we’ll see market demands from such plans today. It is not –

Tim Mammen

I think it is fair to say, John, that we are much better off focusing sales, resources and personnel on where the real market opportunity is in this difficult environment and you might have to employ a separate CO2 sales guy or divert those hired in each group into selling CO2s, which right now in the environment is not going to provide us with the best return on money. I think it potentially could be opportunities when the market stabilizes there. On green, we haven't actually got any orders in-house. We expect to have probably a few orders in Q2 and demos going out to customers, so we have built a number of units and then hopefully see some more meaningful revenue on the green coming into the third quarter.

John Harmon – Needham & Company

Great. Thank you very much.

Operator

We will take our next question from Mark Douglas with Longbow Research.

Mark Douglas – Longbow Research

Good morning. In your quarterly guidance, I know you talked about the full year. What are your expectations right now on currency, assuming no changes from today?

Tim Mammen

We have basically forecast at the word the dollar-euro and ruble-dollar rates are. Those are the two main ones, and also Japanese yen-dollars. So we use the exchange rates to last week. And if you are going to ask me to predict what is going to happen to the exchange rates, because I'm willing to do that.

Mark Douglas – Longbow Research

No but in your guidance, did you update minus 5% currency, minus 3%.

Tim Mammen

We said the dollar-euro, whatever it was last week. So as you put it off, the average for the year to date and we took the ruble to whatever it was the average year to date. So I don’t think it is. We don’t bake in like further currency swings. We give out guidance over – effective as of whatever the currency was for the period to the quarter to date.

Mark Douglas – Longbow Research

Right. Okay. Can you repeat for me the sales by application again?

Tim Mammen

Our script will go up on our website. It is probably not the most best use of time today with those numbers now, but you will have access to the scripted all the data through in a couple of hours time.

Mark Douglas – Longbow Research

Okay. It is still not up yet. Okay. The BMW sales; when do you expect the sales to start flowing through? Any of them included in the 1Q guidance or is it going to be –

Tim Mammen

We shipped a large order to BMW in Q4. We had another order for one order in Q4 and we have got another order for one unit for this brazing application. So that is going into like preproduction and R&D testing. So we booked the major part of the revenue from BMW in the fourth quarter. Valentin was alluding to new projects that we are being qualified on and it is not clear as to when we will see significant order flow from BMW for that.

Mark Douglas – Longbow Research

Okay, so is there –

Valentin Gapontsev

This year, but second half, we discussed about the – not only was BMW, now practically working with all German car makers. We now manufacture for all German auto industry, now come to fiber laser.

Mark Douglas – Longbow Research

Right. So your comments on getting a lot of product up for the end of the fourth quarter, was that necessarily talking about BMW or just kind of across the board with the high-power lasers?

Tim Mammen

It was across – BMW was obviously a large part of it, but there were significant other orders as well that were high power that were shipped in early December and through December.

Mark Douglas – Longbow Research

Okay. Any idea if any of those were in order to take advantage of the depreciation for the end of the year?

Tim Mammen

No, in Germany, the tax rule –

Mark Douglas – Longbow Research

These are all German?

Tim Mammen

Not all of them; but that rule is not benefitting the German and other European sales. So I don’t think that anybody who has certainly bought stuff at the end of Q4 that we are aware of that was simply just taking advantage of that tax benefit.

Mark Douglas – Longbow Research

Right. And finally, what tax rate are you assuming right now?

Tim Mammen

About 32% effective rate for this year. It would be pretty similar.

Mark Douglas – Longbow Research

Similar. Okay. Thank you.

Operator

We will take our next question from Tom Bishop with B. I. Research.

Tom Bishop – B. I. Research

I am interested in the high-powered military laser trials and these are big dollars and some orders could really help revenues. Could you expand a little on the recent trials? I mean, have they just only shot down unmanned aircraft or were they missiles yet?

Tim Mammen

No, the Boeing Avenger was an unmanned aerial vehicle, a UAV. So a relatively small vehicle, but the important thing to understand about that is that the tracking and beam optics technology was developed to enable the laser to track a moving object. And I think some of the other trials that are underway, we are obviously limited on what we can say about them but coming into the end of this quarter, I think we will have more information to provide on those.

Tom Bishop – B. I. Research

They were not yet tried on missiles?

Tim Mammen

No, they have not tried yet.

Valentin Gapontsev

We can mention only published results, but of these tests and so on, unpolished is not discussed.

Tom Bishop – B. I. Research

Okay. How likely is IPG to be part of the solution to make the auto industry more competitive, especially in the near term, I mean I know they have near-term problems but are they all of a nature to solve them that would not be – where the solution would not be to order your lasers or are you part of the solution to help them out of there?

Tim Mammen

I think there are numerous examples where we are already helping with improved productivity in the auto business, whether it be cutting of the new high strength steels, which basically people were using dies for before, or other cutting technologies. They were wearing out the dies very quickly. The flexibility of our optical delivery system, the ability to attach it very cheaply to a robotic arm and cut irregularly-shaped parts, it has helped the auto industry on welding and cutting side. People have replaced CO2 lasers, where their use of helium as a process gas was prohibitively expensive and if you couple that in, they were getting to pay back in extremely short periods of time. In terms of welding speeds, there are numerous studies out there now where compared to a make welding station, fiber laser is actually cheaper. And there are numerous examples of all of these projects that are actually not full cost sale, but have already made some impact. I think obviously given the tremendous instability in the auto industry, particularly in the US around the major players, we have seen some deferral of orders, even for products where we are already qualified, because people just don’t know whether some of these entities are going to be around. And maybe better unfortunately, if some of them bankruptcy, because then we actually get to some coherent recovery plans and some of our best customers in the auto industry have been those who are in chapter and are looking to implement new technology. So, there are many, many examples where we have already made good progress.

Tom Bishop – B. I. Research

Thanks. And finally, you mentioned some I thought a 20 kilowatt laser which is not quite as big as the 40 watt laser the military is using. What are 20 kilowatts used for?

Tim Mammen

Similar applications, as well as other industrial applications. On the industrial side like deep penetration welding, but also they are used on the military side of things, where lower power levels are required.

Valentin Gapontsev

We have (inaudible) such kinds of lasers are used. (inaudible) they are used for some of the cases.

Tom Bishop – B. I. Research

Okay, thank you.

Operator

And we will take a follow-up question from Antonio Antezano with Macquarie Capital.

Antonio Antezano – Macquarie Capital

Have you provided, I don't know if I've missed this, but any comment in that merchant diode business and then secondly, if you could expand on your expectations for cash flow this year, maybe talk about the actions that are being taken on what can be done.

Tim Mammen

Valentin, you want to talk about merchant diodes first and then I will talk about cash flow?

Valentin Gapontsev

Merchant diodes came the year that we started to sell our diodes but it was time to develop the sales network, suitable sales for these applications for this target. And we developed special models for such sales, now introduced in the market in (inaudible). So we are sure that we will be very successful with the merchandise. This can bring tens of millions. We did not put in our (inaudible)

Tim Mammen

If you look at the Q1 guidance for diodes, we are looking at how best to continue to execute on that market. We sold last year probably $200,000 or $300,000 worth of – $600,000 worth of PLDs and similar type products.

On the cash flow side, I think that, you know, first of all, cash flows are primarily driven by the profitability of the company and we are very committed internally to ensure that we remain profitable through 2009, even though in fairly difficult – at a difficult time, we have run a lot of sensitivity now. We are looking at other ways to reduce costs. So first of all, maintaining profitability, obviously ensuring that the sales you are generating, you are collecting the cash on that. So it is very important to manage the working capital side of receivables.

And potentially, whilst we are in a more turbulent time in terms of revenue, managing inventory, maybe a little bit of the expense obviously of gross margin, that we are committed to try to generate some cash out of the inventory. Overall even in a – we have won sensitivities where revenues are down; operating cash flow will be positive and strong. And then if you come to the fact that we are going to cut CapEx by more than 50%, we believe that we can actually generate free cash flow. In the event that the economy really takes even a worse turn, as difficult as it may be to imagine, I think that a lot of our CapEx projects are very discrete items, so there is no item out there that is like a $10 million project. And we can turn these projects on and off depending upon how the company is performing. So if necessary, we are also targeting – potentially looking at some of those other CapEx products and delaying them to 2010 and the operations people and the finance people are actively reviewing that.

So to summarize, we have got to maintain profitability throughout the year, manage expenses, manage working capital. I think the two key components of working capital are receivables and inventory, and then very closely monitor CapEx during the year.

Antonio Antezano – Macquarie Capital

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 ended a year of excellent performance with solid results in Q4. We continue to execute on our strategy and we are confident that the investments we have made in our technology and our infrastructure will serve us well as we seek to meet the challenges presented by the worldwide economy and capitalize in opportunities across diverse markets around the world. We look forward to speaking with you again in the first quarter. Thank you very much.

Operator

That concludes our conference call. Thank you for joining us today.

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Source: IPG Photonics Corporation Q4 2008 Earnings Call Transcript
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