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IPG Photonics Corp. (NASDAQ:IPGP)

Q1 2009 Earnings Call

May 5, 2009 10:00 am ET

Executives

Angelo Lopresti - VP, General Counsel and Secretary

Valentin Gapontsev - Chairman and CEO

Tim Mammen - CFO

Analysts

Antonio Antezano - Macquarie Capital

Avinash Kant - D.A. Davidson

Mark Douglass - Longbow Research

Ajit Pai - Thomas Weisel Partners

Jiwon Lee - Sidoti & Company

C.J. Muse - Barclays Capital

Operator

Good morning and welcome to IPG Photonics's first quarter 2009 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.

Angelo Lopresti

With us today is IPG Photonic's 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 details in IPG Photonic's Form 10-K for the year ended December 31, 2008, or other reports on file with the Securities and Exchange Commission.

Copies of these filings can be obtained by visiting the investor section of IPG's website at www.ipgphotonics.com or by contacting the company directly. You may also find copies on the SEC's website at www.sec.gov.

Any forward-looking statements made on this call are the company's expectations or predictions only as of today, May 5, 2009. The company assumes no obligation to publicly release any update or revision to any such statement. We will post these prepared remarks on our website after the completion of the call. Please go to www.ipgphotonics.com and select Investors to review these remarks. I will now turn the call over to Dr. Gapontsev.

Valentin Gapontsev

Our first quarter performance reflects the impact of the global economic downturn. Revenues of $45.4 million came within the low end of our guidance and were down 14% on a year-over-year basis. The decline was mainly due to lower sales of our pulsed laser, our second largest product line, which are primarily used for marking and solar manufacturing.

As you know, marking and engraving applications have been significantly affected by the downturn, while our solar manufacturing sales are volatile from quarter-to-quarter. However, there is a good news that our high power fiber laser sales increased over the last year.

We increased revenue by 18% in high power and more than 55% in the total sold laser power. The growth in high power fiber laser now makes this our largest product line and represents our largest market opportunity.

We observed an essential sales growth in medical and government sectors also, as well as bright signs for fast growth beginning in telecom applications.

Geographically, the downturn was large in Central Europe and China. However, we saved our position practically in Japan and Russia, and we increased sales in North America, Italy and Korea, essentially.

Regarding EPS, IPG reported its 9th consecutive profitable quarter. However, earnings dropped down to $0.03 per diluted share this quarter compared to $0.18 per diluted share in the first quarter last year. In addition to the effect from the fall-off in revenues, the EPS decline reflected inventory write-downs, a swing in foreign exchange and some bad debt expense.

Further, I am pleased to report to you another good news that we've strengthened our balance sheet, including generating a record $17.5 million in operating cash flow. As a result, our net cash position increased by $10.7 million to $22.8 million.

During the first quarter, we have developed and have started to implement a very efficient economic crisis response program, which includes, from one side, reducing or managing costs, working capital and capital expenditures to remain profitable and generate cash through the downturn. And from the other side, an acceleration of development and introduction in the market of an impressive collection of new unique products, which should compensate the sales losses we have found with some of our standard products like pulse marking lasers.

The major element of the cost cutting program includes the following. The first is an essential decrease in manufacturing costs of our major products. At the high power end, we will benefit by 10% to 20% due to use of new more powerful pump diodes and 15% to 30% due to introduction of our own processing cables, which will start from Q1, couplers from Q2, optical switch from Q2, optical heads Q3, and chillers from Q1. Before the accessories of our kilowatt laser, we were buying from suppliers.

During Q1, we have decreased the cost of low power laser, also including pulsed ones, by 15% to 20%. In total, this element will provide IPG multi-million savings.

The second element of savings is by cutting of 2009 bonus program and transfers to a short working week of about one-third of IPG employees. The essential savings we will reach by cutting our accounting, legal, shipment, IT and other expenses also. We have started the savings program in the Q1. However, the benefit will be seen later, mainly in Q2 through Q4.

Regarding another segment of the economic crisis program, new products, we have to report to you a very impressive portfolio, which we have developed during the last quarters or we are finishing now.

The main horses of this portfolio: Number one, pulse green lasers. We have reported the product in January. During Q1, we have made the qualification. In Q2, first 25 units will be delivered into application labs and, most important, OEMs for test. We have started to see some interest in the product for solar, marking, semiconductor and micromachining industries.

Number two product is nano-pulsed fiber laser with energy per pulse up to 100 million joules and average power up to 1 kilowatt. The unique family has been delivered to Audi and a couple other customers now. There has also been optimism for sales in the LCD industry.

Number three product, cladding lasers with power up to 4 kilowatts. We're starting deliveries in Q2. They will replace direct diode multi-kilowatt systems as more reliable, universal, flexible and cost effective.

Number four product, single frequency CW green lasers. It will be implemented in the market in quarter three. They will replace YAG lasers in Ti Sapphire pumping and open new opportunities in solar and micromachining.

Number five product, new family of long pulse high power fiber lasers, will be implemented Q3 and will start to replace lamp pumped pulsed solid state lasers in applications with market sizes estimated above $100 million.

Number six product, a new family of radiofrequency on PON systems, based on a unique IPG two-way EDFAs for fiber-to-the-home applications.

And number seven product, new high power DWDM EDFAs for cable TV transmitters based on new unique 2 watt power 980 single-mode pumps delivered by IPG. This is a record power from 980 single-mode pumps.

We will introduce some other products, including powerful red lasers and a set of direct diode modules with a power of 50 watts to 1,000 watts.

The products should compensate abovementioned losses and position IPG for renewed growth when the economy begins to recover. Also, it is too early to say that we have turned the corner, our sales force is beginning to report increased customer activity in some of our hardest-hit markets. Tim will provide additional details on some of the bright spots that we have seen for the second half of the year.

Our fiber laser provides customer with a value-add unmatched by our competitors. As you move up in the power spectrum, more productivity is gained and new applications are possible. It is attractive to customers, particularly as they are looking now, more than ever, for ways to be more efficient with less energy requirement. Our diversity in terms of end use application, product lines and geographic markets adds stability to our business model.

I will now turn the call over to Tim Mammen, who will discuss the first quarter in more details and then provide guidance for the second quarter of 2009.

Tim Mammen

While sales decreased compared to a year ago, our performance by end markets and laser type was, in fact, mixed. Sales of pulsed lasers declined substantially, but high power laser sales increased. The decrease in pulsed lasers accounted for all of the decline in our materials processing sales.

Excluding the decline in pulsed laser sales, materials processing sales increased by 2%. Sales of applications other than materials processing grew by 22%.

As mentioned in the last quarter, we announced new initiatives intended to control costs, manage working capital and substantially reduce capital expenditures. Most of these were implemented during the quarter and should have greater affect on our bottom line during the second quarter.

At the same time we have continued to invest in IPG's future growth. We commissioned a new high power application center in Oxford, Massachusetts and opened a new sales and application center in Silicon Valley. This application center will focus on micro applications, solar and merchant diode sales. We also continue to commit R&D dollars to our product pipeline, as Valentin mentioned.

Our strategy for 2009 is to ensure that IPG weathers the storm and is positioned for further growth when the economy recovers. We also maintained our conservative capital structure and continued to generate cash this quarter, strengthening our liquidity and balance sheet. Cash and cash equivalents improved by $20.3 million to $71.6 million.

From a revenue perspective we met the low end of our guidance range for the first quarter of $45.4 million compared with $52.9 million in Q1 2008. Gross margins for Q1 were 35%, a lower number than expected as a result of $2.7 million or 6% of revenues in inventory write-downs.

Net income for the quarter was $1.3 million or $0.03 per diluted share, which was below the low end of our guidance range. This compares with net income of $8.1 million or $0.18 per diluted share for the first quarter last year.

As Valentin mentioned, in addition to the $2.7 million in inventory write-downs for effective cost of sales, our bottom line was impacted by $1.5 million in foreign exchange losses and $0.4 million for bad debt. Together, these items reduced net income by $3.2 million after tax or $0.07 per diluted share this quarter.

In the first quarter of 2008, we had inventory write-downs of $0.7 million, foreign exchange gains of $0.6 million and bad debt expense of $0.1 million. Together, these items netted out and did not affect net income in the first quarter of 2008.

Looking at the competitive landscape, the weakness in customer demand is leading to some pricing pressure for high power lasers and materials processing applications, particularly below 4 kilowatt, but this is, by and large, case-by-case. There is less competition from legacy laser technology above this power band. Despite claims from competitors, we still have not encountered fiber laser competition at 1 kilowatt or above.

Now let's take a look at the four markets we serve. Materials processing, which is IPG's largest market contributed 76.6% or $34.8 million of the revenue reported in Q1, down 21% year-over-year. Substantially, all of the decline in this application resulted from lower sales of pulsed lasers. Orders for pulsed lasers began slowing in the third quarter of 2008 particularly from large customers in China and other Asian countries for marking and engraving.

Pulsed laser sales for solar applications have been more mixed, with some weakness in North America, offset in Q1 2009 by a substantial order for a solar application in Japan, part of which shipped during the quarter. The overall decline in pulsed laser sales, particularly for marking and engraving, continued into Q1 2009.

Overall sales for solar applications actually increased compared to a year ago. As Valentin mentioned, excluding the decline of pulsed lasers, the materials processing market grew slightly.

The advanced application market represented 15.7% of total revenues or $7.1 million during the first quarter. Sales of these laser systems grew by 34.7% compared with the prior year. Advanced applications include test and measurement, instrumentation, sensing and defense applications, as well as scientific research and development.

During Q1, we leased a 50 kilowatt laser to a major defense contractor as part of a rent-to-buy agreement. Although order flow has been historically less predictable in this market, we have significant interest for advanced applications that may benefit the second half of 2009.

The communications market comprised 5.9% or $2.7 million of our revenues in the first quarter and declined by 9% from the first quarter of 2008. However, our sales force is optimistic about Russian and US telecom sales in the second half of the year. We are already seeing early interest in some of the products that IPG introduced last year and in Q1 '09. This includes the two-way EDFA, which enables a cost effective deployment of triple play Fiber-to-the-Home and RF over glass networks. We are also optimistic about additional opportunities as a result of government initiatives and a growing OEM and integrator customer base.

Sales for the medical application market comprised 1.8% of revenue and were up 78.4% year-over-year, with Q1 2008, being the quarter in which sales to our main medical OEM materially declined. Our outlook for the medical business has improved because of better visibility from two of our OEMs in North America, a new contract we have signed with a customer in Korea, and new opportunities elsewhere in Asia.

Now, let's look at the business in terms of product lines. Sales of our high power fiber lasers grew by 18% year-over-year in Q1 to $18 million, representing 4% of total revenue. As Valentin mentioned, the total kilowatts of output power shipped to customers increased by 35.6% in Q1 '09. We continue to see increasing demand for cutting, welding and cladding applications, which all grew strongly in the quarter.

In Germany, there is increasing interest from automotive OEMs and end users, especially for brazing applications. We also have a German automaker qualifying our high power lasers for gear box and remote welding.

In terms of new applications we've had several shipments for our multi-kilowatt lasers from companies manufacturing wind turbine blades, towers and other parts. There is also increasing interest from many OEMs around the world in hybrid and other battery manufacturing.

As expected, sales of pulsed lasers continued the decline we began to see in the fourth quarter of 2008. From the first quarter pulsed laser sales were down 46% year-over-year to $11.2 million and represented 25% of revenues. We expect a sequential decline in Q2 2009 for pulsed laser sales. Our pulsed laser sales have been greatly impacted in Q1 2009 by limited expansion of manufacturing capacity. This has had a significant effect on the business of our three largest OEMs. However, our long-term relationships with these OEMs leave us well positioned when capacity expansion resumes.

On a positive note, our solar applications actually increased slightly in Q1 '09, and it appears our customers are starting to look at additional build-outs in solar in the second half of 2009. However, sales for solar applications will probably be a little bit weaker in Q2 '09 than one year ago.

With regard to our recently launched green pulse lasers, customer tests for solar applications with the new lasers have yielded excellent results. We look forward to reporting further progress as 2009 unfolds.

Sales of medium power lasers decreased 7% in Q1 '09 from Q1 '08 and represented 12% or $5.4 million of total revenue. Areas that once saw significant demand such as microelectronics drilling and commercial printing have been slow. For some applications, including centering and micro materials processing, while orders are low, relatively speaking, those businesses are more stable.

Our low power lasers, which are primarily used for medical applications and micro materials processing, were down 21% and accounted for 6% of revenue or $2.9 million in Q1 2009. We will continue to target new OEMs, particularly overseas where we see opportunities to capture additional sales for this product line.

From a geographic perspective, we reported 35% of revenue from Europe, 31% from Asia and Australia, 28% from North America and 5% from the rest of the world.

Sales and order flow in North America was good, and year-over-year sales are up 39% for the first quarter of 2009. Despite a difficult capital equipment sales environment in the U.S., we saw strength from typical material processing applications as well as new applications, including battery welding and wind turbines.

Europe was down 33% in Q1 compared with the same period last year. Germany was particularly weak, mostly related to decreased sales from the marking, welding and printing applications.

Sales to Asian and Australian markets declined 27% compared with the year-ago quarter. Order flow in Japan started strong at the beginning of the quarter, but then tailed off a little as the global economy continued to deteriorate. On a positive note, we have shipped our first high power lasers in China. Our recently hired high power sales director for China is aggressively targeting large OEMs and end users for traditional and new materials processing applications.

Now, turning to the income statements. In terms of sales, we estimate that if exchange rates had been approximately the same as one year ago, our Q1 '09 sales would have been $2.1 million higher. On the cost side, gross margins were 35% in the first quarter compared with 46% in the first quarter of 2008.

Inventory related items amounted to $2.7 million or 6% of revenue, significantly affecting gross margin and our EPS. These related to write-downs of older inventory, cost revaluations and obsolescence of certain components. Historically, such charges have been absorbed within cost of goods sold without having a material effect on gross margins. However, the impact from the period of declining sales is magnified.

We estimate that if exchange rates had been approximately the same as one year ago, our Q1 '09 gross profit would have been $0.5 million higher.

SG&A expenses, excluding foreign exchange losses, were $8.2 million or 18% of sales in Q1 2009 compared with $9.6 million or 18% of sales in Q1 2008. We estimate that if exchange rates had been approximately the same as one year ago, our Q1 '09 SG&A expenses would have been $0.6 million higher.

R&D expenses were $4.1 million or 9% of revenues in Q1 2009. This compares with $2.9 million or 5% of revenues in the first quarter of 2008. The increase is consistent with our strategy to strengthen our product offerings in anticipation of a recovery in demand.

Investments in R&D is across a number of different areas, including development of the new generation of diode chip and the high power laser diode package with better performance and lower cost, new products operating at different wavelengths, for example, the green lasers, high energy pulse lasers and high power laser accessories such as chillers, cables, combiners, beam switchers and optical heads.

We estimate that if exchange rates had been approximately the same as one year ago, our Q1 '09 R&D expenses would have been $0.4 million higher.

In addition to the inventory write-downs, foreign exchange and an increase in our bad debt reserve also affected our performance in the quarter. In Q1 '09, exchange rate losses on transaction and the revaluation of financial assets and liabilities were $1.5 million compared to a gain of $0.6 million in Q1 '08. About $1 million of the impact can be attributed to the depreciation of the Russian ruble during Q1 '09.

Although we reduced receivables by $12.1 million and improved our days sales outstanding in Q1, we increased our bad debt reserve by $0.4 million or 1% of revenue in response to a few customer accounts past due.

The amount of accounts receivables greater than 60 days past due not covered by export insurance or bad debt reserve was 1% of total accounts receivables after the bad debt charges we took in the quarter. Historically, we have demonstrated the ability to ultimately collect a good percentage of the amounts that we have previously reserved, and we are continuing to vigorously pursue the amounts we provided for this quarter.

IPG generated operating income of $2 million or 4% of revenue in the first quarter of 2009 compared with operating income of $12.5 million or 24% of revenue in Q1 last year. Operating income includes stock-based compensation related charges of $635,000 and $387,000 in the first quarters of 2009 and 2008 respectively.

In the first quarter of 2009, $124,000, $389,000 and $122,000 of stock-based compensation charges related to cost of sales, SG&A and R&D respectively. Our tax rate for the first quarter of 2009 was 31%. We estimate an overall tax rate of 31% for the year. The effective rate for 2008 was 32%.

As Valentin mentioned in his opening remarks, we are pleased with our efforts to strengthen our balance sheet during the quarter. Cash and cash equivalents improved by $20.3 million to $71.6 million at yearend. Net cash increased to $22.9 million at March 31, 2009, compared with $12.2 million at December 31, 2008. Not included in cash and cash equivalents are $1.3 million in auction rate securities at March 31, 2009, which are included in other long-term assets.

Cash flow from operations in the first quarter was $17.5 million. Cash used in investing activities was $4.7 million, and cash provided by financing activities was $9.6 million. We intend to manage the business and working capital, so that we generate cash flow from operations that is greater than capital expenditures for the remainder of the year. At current business levels, we are now targeting capital expenditures to be less than the $15 million estimate we provided on our yearend call.

After the close of the quarter, we completed construction of an application center in Italy which we opened in early April. This facility will serve IPG's cutting applications customers in that region. We also opened an expanded application and production facility in Massachusetts and a sales and applications office in California focused on low power applications.

In Q1 2009, we also completed the previously announced acquisition of the non-controlling interest in our Russian subsidiary.

Although managing receivables becomes more challenging in a turbulent economic environment, accounts receivables decreased to $29.7 million at March 31, 2009, from $41.9 million at December 31, 2008. Days sales outstanding were 59 days at the end of Q1, down from 65 days at the end of Q4 2008.

Aside from the inventory write-downs, we made progress in reducing inventory this quarter by consuming it. Inventory decreased by $6.2 million to $66.4 million at March 31, 2009, from $72.6 million at yearend 2008. Of this decrease, $2.7 million related to write-downs and other adjustments to inventory, approximately $2.6 million related to foreign exchange and $0.9 million related to inventory that was consumed.

We strategically drew down $10 million from our US credit facility during the quarter, increasing our borrowings to $29.8 million. We invested this $10 million in US treasuries and increased our cash and cash equivalents. We will continue to draw on our credit facilities from time to time, in order to finance our short-term working capital requirements and preserve and enhance our liquidity.

This leads us to our expectations and plans going forward. We are committed to remaining profitable for the full year 2009 and beyond despite the weak economy, uncertain demand conditions and volatility in foreign exchange rates. As previously disclosed, we have taken action to reduce bonus accruals, limit overtime and reduce other expenses such as legal, accounting and consulting, and we are looking for further opportunities to cut costs. We expect the full year effect of these reductions to be more than $3.5 million.

In addition, beginning at the end of Q1 2009, we have instituted reduced work weeks in Germany and Russia. We should see the benefit of these actions increase in the second quarter. We've also reduced spending on manufacturing supplies and tooling, and have reduced the number of diodes undergoing burn-in testing to reduce electrical consumption.

In total, we now expect the combined benefit related to the reduction of operating expenses and manufacturing expenses to be at the upper end of the range of $4 million to $6 million for 2009 we targeted on our previous call.

We have also begun internal production of cables, couplers, beam switchers and optical heads which will increase the profitability of these items. As Valentin mentioned, historically our margin on these items have been much lower than the gross margin on our lasers, because we purchase them from outside suppliers and we only earned a pass-through profit. As our high-power laser sales continue to grow, the benefit related to the accessories should increase to several million dollars per year starting in 2009 and growing in 2010.

One positive sign is that our global sales force is reporting more customer inquiries and requests for quotation. That said, there is a sales cycle involved and it will take a few months for new orders to materialize and visibility remains a little bit weak. So we're hopeful that the second half of the year will be better than the first.

In the meantime, we will continue to pursue all available options for strengthening our balance sheet and our competitive position. IPG is well prepared when the economy returns to growth.

These are, indeed, challenging times even for IPG, which has proven to its customers that its products provide significant advantages over competing lasers and other technologies, but I want to add some perspective.

An industry analyst estimates that fiber lasers accounted for only 7%. Of $210 million of the total laser market for materials processing, she estimated at $3 billion in 2008. The same analyst expects that the market potential for fiber lasers in 2015 could be over 30% for high-power welding, cutting and marking, three large applications for industrial lasers.

Historically, laser sales have grown at a compounded annual growth rate of over 5%. We feel that fiber lasers, which offer a compelling value proposition, are at an early stage of adoption in high volume applications like high-power welding and cutting.

We cannot predict the future, but I can say that given the strength in high-power laser sales in Q1 and our improving balance sheet, we will be well poised to benefit from the groundwork we have laid over the last few years when demand conditions improve.

With that as background, I will provide you with our guidance for the second quarter. For the second quarter IPG Photonics expects revenues in the range of $39 million to $45 million. The company anticipates earnings per diluted share in the range of $0.01 to $0.07. That is based on 46,152,000 diluted common shares, which include 45,094,000 basic common shares outstanding and 1,058,000 potentially dilutive options.

At this level of revenue a $1 million increase or decrease in revenue will change gross profit by approximately $750,000, given our fixed manufacturing cost base and rates of absorption. At $45 million of revenue, we would expect gross margins of approximately 41%.

This guidance is subject to the risks we outlined in our reports with the SEC and assumes that exchange rates remain at present levels. I want to reiterate that we do not attempt to forecast gains or losses related to exchange rates. As evidenced by Q1 of '09, if exchange rates are volatile. Their impact on results can be material.

And with that we'll open the call for your questions.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question today comes from the line of Antonio Antezano with Macquarie Capital.

Antonio Antezano - Macquarie Capital

I was wondering, your guidance for Q2, you are saying that if you reach revenues of $45 million, gross margin could be around 41%, but yet your EPS guidance is for a range between $0.01 and $0.07. So I was wondering what is your outlook for the SG&A and R&D? Compared to Q1 how would you envision those items?

Tim Mammen

First of all, within cost of sales, in order to be conservative, we have made some allowances for further inventory charges outside of product that's sold. And in addition to that, given the current economic climate, we have, also within SG&A, made some allowances for, potentially, additional bad debt. Having said that we could also collect some of the amounts we've previously reserved on bad debt so the actual magnitude of those impacts could be a bit less.

In terms of the cost reductions, the way we disclosed up on the face of the P&L, you can see that there are significant reductions in SG&A that we've already achieved in the first quarter, so we don't expect those to be, outside the bad debt, materially different. We think we've also got to a position of basic stability on R&D and selling expenses as well. So there is a number of different factors that we have taken into account in trying to arrive at a very reasonable EPS range that may not reflect a pure income statements if you look at it outside of those charges.

Antonio Antezano - Macquarie Capital

Then if you could provide more color in your outlook, I guess, by business or market for the second quarter in terms of materials processing, advanced applications?

Tim Mammen

The marking and engraving continues to be weak in the second quarter, so pulsed laser sales will probably decline a little bit. Just anecdotally, I'll give you an example of just how volatile and little visibility there is out there. A couple of weeks ago our main Japanese customer visited us and claimed that their outlook for the remainder of the year was very poor and weak. Two weeks later they rang to say that they were potentially seeing a little bit of an improvement in the business environment. So in terms of pulsed laser sales, hopefully, in the second half we'll see some recovery, but they will be weak in Q2.

Solar, compared to a year ago, the second quarter of 2008 was very strong. Probably solar will be a little bit weaker in the second quarter of this year, but again, strengthening into the second half of the year. We've had an indication from one major customer that in relation to a capacity build-out that they are making in China, we could see a order for a couple of hundred unit pulsed lasers.

In terms of the other product lines, the high-power lasers will remain relatively strong. The issues you get into on high-power is that we're getting into a situation now where the number of orders that we're booking and shipping during the quarter has increased, so there's a little bit more risk around the range on revenue and that's why we've broadened it a little bit. But we're tracking very, very closely the orders that we've forecast in our guidance against when they are received and we think that the new measures we've instituted with regard to forecasting revenue should help.

On the medium-power lasers I think we may see some recovery in the micro electronics. We're expecting an order for micro electronics drilling in the second quarter, which is positive. Our centering customer in Germany continues to place good orders. Clearly, the printing applications that everyone sees, newspapers are dying every week, so printing is probably a weaker part of the business. At a high level, I hope that provides you with some reasonable color of our stuff.

Valentin Gapontsev

And to follow-on, now we have very big demand for (inaudible) so it is a fast-growing business, and we have new facilities now in development worldwide solar and how lasers are more suitable for fast duplication of the (inaudible) and samples where we made excellent potential customer sales.

Operator

Our next question comes from the line of Avinash Kant with D.A. Davidson.

Avinash Kant - D.A. Davidson

The first question was when you gave your Q1 guidance at the end of Q4 for EPS of $0.09 to $0.14, were you talking about GAAP numbers or you were talking about just the operating number?

Tim Mammen

No, we were talking about the GAAP number.

Avinash Kant - D.A. Davidson

So you had anticipated some of these charges that you are taking in the quarter?

Tim Mammen

We had anticipated about $600,000 of the inventory. We had not anticipated the bad debt, and we had not anticipated the foreign exchange. We don't forecast foreign exchange.

Avinash Kant - D.A. Davidson

So could you give the EPS impact to those tax of the inventory correction, the $2.7 million. You gave the overall impact of all three charges were roughly $0.07, I believe. Right?

Tim Mammen

If you exclude the amount that was forecast, the total inventory impact was $2 million. These are gross amounts. So you'll have to calculate the tax effect of 31% on the EPS. So, inventory net of the amount forecast was $2 million. Foreign exchange was $1.5 million, and the bad debt was $0.4 million. Those amounts were not in the guidance that we issued.

Avinash Kant - D.A. Davidson

So basically, of the overall charges, you had forecast only $0.7 million in inventory?

Tim Mammen

Yes.

Avinash Kant - D.A. Davidson

And the rest of everything was not forecast?

Tim Mammen

Yes.

Avinash Kant - D.A. Davidson

And we can take a safe 31% tax rate to get to the EPS impact of that?

Tim Mammen

Yes.

Avinash Kant - D.A. Davidson

But the guidance that you are giving now for Q2, what kind of charges have you incorporated in that already?

Tim Mammen

As I just said to Antonio, we put $600,000 for inventory outside of products sold and take account of the age and potentially other excess quantities that we may encounter, and we have about $400,000 related to bad debt, given the current economic environment. In better economic environments, that bed debt amount will be lower, because we have a very, very strong history of collecting receivables. Nothing is forecast for FX in that guidance.

Avinash Kant - D.A. Davidson

So, close to a million in charges? The tax rate should be pretty similar?

Tim Mammen

Yes.

Valentin Gapontsev

Take in mind the inventory write-down is mainly diodes, but (inaudible) where we use the diodes (inaudible) make run-down, but we will sell these diodes. To decrease inventory of diodes, we're now decreasing temporary production of new diodes only to sell this inventory. So this money will return back.

Avinash Kant - D.A. Davidson

Also, in terms of business improving, do you have much confidence in the second half recovery? Should we be looking at the manufacturing activity or what should we be looking at to see that there is some confidence in the second half recovery?

Tim Mammen

I think some of the anecdotal evidence I am giving you with regard to specific applications. I just gave you an example in the solar. I think some of the recovery we're expecting in the micro electronics on the drilling side. The increasing interest in battery welding, we're dealing with numerous different customers on that end market, not just one customer that we had initially developed.

The high power lasers in the second half of the year will generally benefit more from the sale of multi-kilowatt lasers for advanced applications. We have several very serious inquiries for lasers in the range of 20 kilowatts to 50 kilowatts and even more.

On the manufacturing side, I think as manufacturing activity starts to stabilize and capital expenditure comes back a little bit, we would expect to see that benefit our sales and to benefit it greater than the other laser technologies that we're seeing out there.

Avinash Kant - D.A. Davidson

One or two housekeeping questions. Did you give the depreciation number?

Tim Mammen

It's on the cash flow statement.

Avinash Kant - D.A. Davidson

Okay. I can look it up. And you said the CapEx guidance is going to be less than $16 million?

Tim Mammen

We are vigorously pursuing different options to make sure we come in at below $15 million. We did have $4.6 million in the first quarter. So that means limiting stuff to $10 million and below.

A lot of the first quarter stuff was remaining payments on the buildings in the U.S. and Germany and a couple of the app centers that we were finishing off.

Now, the projects that we're looking at are all very, very small, and we can turn them on and turn them off as need be. We're looking at potentially delaying the building of a building in Russia, limiting capital equipment that we need to absolutely essential stuff. So, we think we've got a very good chance of coming in 10% to 20% below $15 million.

Avinash Kant - D.A. Davidson

10% or 20% below $15 million, perfect. I'll let other people ask questions. Thank you.

Operator

Our next question comes from the line of Mark Douglass with Longbow Research.

Mark Douglass - Longbow Research

Can you explain a little bit, if you can, what April has been like relative to March just overall? Are we looking at the similar run rates as what you were coming out of March, what you've been seeing is possibly an uptick in orders? Is that a decent way to interpret it? The sales sequentially have bottomed, but you're seeing more order intake?

Tim Mammen

So, just in terms of order flow, if you look at it from like December and January, we're actually pretty reasonable. The only really weak month we've had is February. We saw things improve again in March, and that trend has exhibited some stability into April.

That's basically where the picture comes out at. So, out of the last five months, we've had only really one bad month of bookings. The other months haven't exhibited growth, let me assure you of that, but they haven't been disastrous.

Valentin Gapontsev

And we have been reaching out to increase in the May, June order from Japan, because the new financial year has started now with (inaudible). Now, big time we'll try increasing our sales of high-power lasers in China also. Before we did not sell high power lasers to China, but now we've opened doors. There is a lot of the interest in China. So we expect big orders from China.

Mark Douglass - Longbow Research

With those lasers, are we talking 1 to 3 kilowatt type sizes?

Tim Mammen

1 to 6 probably, and also some of the lower power stuff for China as well should recover a bit.

Mark Douglass - Longbow Research

Looking into the second quarter, are you expecting with your initiatives some continued sequential declines in inventory and receivables?

Tim Mammen

Yes. We definitely focused on making sure that, first of all, we're reducing purchases of raw materials. Secondly, as Valentin mentioned, we have a significant number of people who are on a shorter working week initially when that's happened in Germany and Russia.

The benefit from those in the first quarter, in Germany, for example, in March it was very, very small. It was only like $45,000 in March. The numbers I've just received from Germany for April show that that number should triple in April, so a much better benefit from that shorter working week.

So that will reduce capacity, meaning we're not producing an excess quantity of components. Also, we're obviously looking to make sure we're managing our chip production and package diode production to closely match demand.

So some of the real benefits on adjusting manufacturing capacity through a shorter working week policy will really only benefit the second quarter and did not benefit the first quarter that much.

Mark Douglass - Longbow Research

So, you should be able to harvest some more working capital in the cash flow statement?

Tim Mammen

We would hope to do so, yes. Obviously, receivables will go down a little bit because of forecasting at the bottom end of our range, a lower level of sales, but we're trying to ensure that days sales outstanding does not get out of control.

One issue we are finding, given the difficult credit environments out there, is that it seems that suppliers and customers are really providing credit to each other in order to generate sales. So we have had demands on us to extend credit limits. We evaluate that on a case-by-case basis.

As you can imagine, some of the bigger players in the market are trying to push out their payment term. So that could be a little bit of an issue coming into Q2 and Q3, but it's not a reflection of anything underlying that's wrong with the receivables. It's just that everybody is demanding slightly longer payment terms.

Mark Douglass - Longbow Research

What's the status right now of your CO2 laser? Is it out of the prototype stage and the beta site testing? Do you expect to have it out in time for Munich?

Tim Mammen

It's fair to say that project is really on hold at the moment, given the extremely poor performance of the CO2 market as a whole, and we want to just focus our resources on the fiber laser development. There would be some additional development work that we're required on CO2. We don't think it warrants to spending that cash at this time, so you should not expect to really see anything from IPG on the CO2 front.

Valentin Gapontsev

Within CO2, it was a one and half year goal when we did not expect the fast generation for cutting market by fiber laser. But now the situation has changed fully. Now fiber laser in cutting is recognized by everybody, it is growing, our penetration very fast. In this case we have to reconsider our process projection. And so from other sides comes price of CO2 laser (inaudible), last year by special due to Japanese (inaudible), Mitsubishi laser and other, which in fact use much more cheaper CO2 laser, and it changed situation in the market.

So we finished the prototypes. We have some prototypes in testing and so on, but up to now our estimation is that it would be difficult competency also with new price situation in the market. So we've now put on hold this project, and are waiting how the situation in the market will change. Now, forecast more and that fiber laser has much more prospective in the cutting markets, major market for CO2, because in welding applications practically CO2 is always (inaudible) use of CO2. In cutting now there is a good chance that fiber laser will soon reach (inaudible) of this market (inaudible).

Mark Douglass - Longbow Research

Okay. You said that was Mitsubishi?

Valentin Gapontsev

Mitsubishi Fanuc. They are cheap, price per 1 kilowatt power is up to $25,000. So it would be difficult for German manufacturers to compete with such price.

Mark Douglass - Longbow Research

Right. And then final question; any update on the IMRA litigation?

Tim Mammen

Nothing specific to report at the moment.

Valentin Gapontsev

There are some improvements, do you want to report Angelo.

Angelo Lopresti

There was an office action recently by the Patent and Trademark Office that rejected the independent claim.

Operator

Our next question comes from the line of Ajit Pai with Thomas Weisel Partners.

Ajit Pai - Thomas Weisel Partners

Couple of quick questions; I think the first one is on the 50 kilowatt laser that you shipped; the high-power laser to the large defense contractor. But you mentioned that it's on some kind of lease, so I would love to get what the terms of that lease are, when do you expect to recognize that revenue? And in the meantime when it's on lease, how are you calculating what that lease payment is?

Tim Mammen

The lease is for an 18-month period and we are recognizing revenue on a monthly basis. The lease starts in March. We're recognizing revenue on a monthly basis and a share of the cost over the same period of time.

Ajit Pai - Thomas Weisel Partners

So in your cost of goods sold within this quarter you haven't taken the total cost of the laser, you're just amortizing it over that 18-month period?

Tim Mammen

Correct, because we continue to have title to the laser. The title to the laser will transfer at the end of the lease. The revenue per quarter is about $500,000 per quarter.

Ajit Pai - Thomas Weisel Partners

So its $500,000 per quarter?

Tim Mammen

Yes. There is very little in Q1 related to that. The lease was signed towards the end of the quarter.

Ajit Pai - Thomas Weisel Partners

Got it. So over 18 months that would be six quarters, so that would be about $1.5 million is the total price?

Tim Mammen

No. More. $500,000 a quarter.

Ajit Pai - Thomas Weisel Partners

Got it. So it would be $3 million. $3 million would be the total price for the laser?

Tim Mammen

Yes.

Ajit Pai - Thomas Weisel Partners

And is there any fee at the end of the 18 months or its just amortized over these 18 months?

Tim Mammen

It's amortized over those 18 months. One point to note, because lease can be terminated by the lessee if they don't have funds, but we're very comfortable that they are hopefully going to go through the entire term of the lease and actually own the laser at the end of the period.

Ajit Pai - Thomas Weisel Partners

Okay. But if it's a large defense contractor, it's a fairly small sum of money for them. Right?

Tim Mammen

It is. Well, everyone tries to save cash flow at the moment and reduce risk. Right?

Ajit Pai - Thomas Weisel Partners

Right. Got it. And then what made IPG decide to do it this way? Was it a last minute decision or was it preplanned right when you were producing the unit?

Tim Mammen

No. We've been working on this over the first quarter, so it became pretty effective way for us to monetize the value of that asset that we were depreciating it as a demo unit.

Ajit Pai - Thomas Weisel Partners

Got it. And then when you're looking at the application that it's being used for, what kind of application is it being used for?

Tim Mammen

We don't have a clear idea, but as far as the advanced materials processing and directed energy applications.

Ajit Pai - Thomas Weisel Partners

Got it. And was this laser set up in a similar way to the one that you shipped and recognized revenue I think in the fourth quarter of '07?

Tim Mammen

No. That's a different type. That was a series of eight lasers combined together to have more than 40 kilowatts of power. That went to the navy. We actually had a positive meeting with them with regard to that system. They were very enthusiastic about it. They claimed to us they've collected a tremendous amount of test data, more so than they've been able to collect in the previous decades testing lasers.

Ajit Pai - Thomas Weisel Partners

And does that opportunity have the possibility of scaling at some point in '09, '10?

Tim Mammen

Probably not that soon, it would be towards the end of '011 that navy opportunity, potentially into '12. We would hope to get maybe a couple of smaller orders. But the real scale opportunity will take time to come through.

Ajit Pai - Thomas Weisel Partners

Got it. And then when you're looking at your credit facility, I mean you drew down about an additional $10 million within this quarter, but given the fact that you're generating so much cash, why would you do that?

Tim Mammen

Well, we drew that down at the beginning of the quarter when there was a lot of turbulence within the markets and we really wanted to ensure we preserved our liquidity. The interest rate on that borrowing was basically very small. Of course, it had some impact, but the interest rate we got on it was less than 2% for a six-month draw-down.

Ajit Pai - Thomas Weisel Partners

Got it. And then you talked a little bit, I think, in answer to the previous question about credit terms that you are providing to some of your customers and also I think you mentioned about the $0.4 million that you reserved for bad debt. Could you give us some color as to any patterns that you are observing in terms of geographies or particular markets where you are seeing increased bad debt and where are they asking for these credit facilities?

Tim Mammen

The payment terms, primarily Europe and the US were seeing extended terms. In Italy and Japan terms have always been quite long already. But we're seeing the North American turns and European turns extend out to like payments of 75 or 90 days. In terms of the bad debt, part of it was related to an Italian customer, who continues to be a customer. We are going to pursue them for the money that they owe us. And part of it relates to Russia as well, about $300,000 relates to Russia.

We had started to move towards providing some credit to Russian customers given the vibrancy of that market coming into 2008 and through that year. We're now moving back and we've addressed some of the issues in Russia by moving back to demanding a pre-payment policy of at least 50% and if customers are weaker going to more than 75% prepayment. That could affect the timing of revenues in Russia a little bit, but we think it reduces our risk substantially.

Ajit Pai - Thomas Weisel Partners

Got it. And then when you look at your high-power applications it was pretty strong in this quarter. What was sort of driving most of the strength?

Tim Mammen

High-power strength was on the advanced applications, so we did sell a 20 kilowatt laser for some directed energy applications.

Ajit Pai - Thomas Weisel Partners

And was that to a defense agency?

Tim Mammen

No. It was a customer who works in the defense field. We sold, actually, to a customer in the US for some research they are doing on welding of the wind turbine towers and also they are actually using it for some research in the nuclear industry as well. We actually saw pretty good activity on other battery welding applications, like 4 kilowatt lasers, good cutting applications. In Italy we sold numerous cutting lasers in Italy. So it was sort of across the board. We also had a good quarter for high-power in Japan, some of which was automotive, some of which was other manufacturing in Japan as well.

Operator

Our next question comes from the line of Jiwon Lee with Sidoti & Company.

Jiwon Lee - Sidoti & Company

Can we just get back to the defense opportunity from the previous question? The 20 to 50 kilowatt opportunities, how far is this opportunity? When would we know the results of your ultimate win?

Tim Mammen

In terms of multiple unit orders going to more than 10 or 20 units, in the U.S., we're still probably 18 to 24 months being able to, at this point in time, provide an estimate of when that's going to arise. There is a customer in the European region who we think we could actually get the orders in the last half of this year for delivery in 2010.

That customer has actually already taken more than 15 lasers from us that range in power from 1 or 2 kilowatts up to 20 kilowatts. So that customer is probably moving forward a little bit faster and could provide us with meaningful revenue next year.

Aside from that, we've got a lot of inquiries from different entities for one and two unit sales for further product development and qualification. So, we'll continue to have the sort of general underlying business quarter-to-quarter, although it can be a little bit volatile.

Jiwon Lee - Sidoti & Company

In terms of the pulse laser sales, in your service, is there any market share loss that you have seen or is that just generally the extreme poor condition?

Tim Mammen

It's the poor conditions. We can tie this back to three or four customers, and they are all IPG customers. They are not buying lasers from anybody else. We continue to have dialog with them and indeed developing other products for them to develop new applications. So, we do not believe that we've lost any of those customers to the competition.

We actually think we've got other customers returning to IPG. In Korea, the medical contract we signed was probably a win from a competing supplier.

Valentin Gapontsev

About 10 OEM customers were in marking applications. (inaudible) from other customers as you still so obviously see. So, we can increase our OEMs network in marking also, but each of them puts as much (inaudible) with us, they did not turn to other suppliers.

Jiwon Lee - Sidoti & Company

Finally, you mention in the high power category you have seen some pricing pressure. Can you talk a little bit more about which geography in particular that might be, which market, and what type of lasers you're seeing more aggressive pricing?

Tim Mammen

It's definitely in the solar materials processing and it's being driven by some very aggressive pricing by one of our solid state competitors. We don't believe that they are actually selling the lasers at a sustainable price. That pricing pressure is coming probably more in the US.

We won a couple of orders in the second half of the year in India, a little bit of pricing pressure in India and Germany, obviously. There is less pressure probably in Japan and some of the special applications.

Valentin Gapontsev

But we can say now that (inaudible) with our major competitors in the high power solid state lasers. Now we (inaudible) according to our estimation of between 4 to 8 times more power than our major competition. Three times more power is practical. We're doing this much.

Operator

Our next question comes from the line of C.J. Muse with Barclays Capital.

C.J. Muse - Barclays Capital

I guess the first question, Tim, when you look at the revenue guide down about $3 million to $4 million down at the midpoint sequentially is it fair to say that most of that's going to come from material processing?

Tim Mammen

Yes. And a significant part of it is, again, from the pulsed, which is going to be weak in Q2.

C.J. Muse - Barclays Capital

And so if I add up the first half, you're running at about material processing down kind of 30% year-over-year, so I guess the question is given that down-tick year-over-year coupled with the evals and design wins that you have looking into the second half of the year, does that give you confidence that 2Q marks a trough for material processing or is the visibility just not there?

Tim Mammen

Given through the anecdotal stuff that we're hearing out there and as you point out the new products we're introducing, I think we feel that we're getting to the bottom of this and we certainly hope that the second half of the year in total and revenue is stronger.

C.J. Muse - Barclays Capital

Then the OpEx side came in around $12.3 million, excluding FX. You talked about some cost cuts getting to the higher end of the range of $4 million to $6 million. Where do you see OpEx in June and then where should we see that exiting in the December quarter?

Tim Mammen

We don't really provide that granularity of guidance on that, C.J. In terms of the OpEx, specifically, I've said in the script in about $3.5 million on an annualized basis, spread across the operating expenses and another minimum of $2.5 million on manufacturing capacity through short work weeks. My actual annual estimate is above the $6 million top of the range, but a little bit will depend upon the timing of where that is. So I'm a little uncomfortable with actually specifically saying that SG&A will be down to X-million by December. I think we'll have a better feel for that coming into the end of this quarter.

C.J. Muse - Barclays Capital

Okay. I guess in Q1, though, you didn't really see much savings on the OpEx front, so that annualized $3.5 million will be seen in the next three quarters?

Tim Mammen

I think one of the things that's masking a little bit of this was, Q2 '08 R&D expenses actually increased significantly when we moved more resources into development of all of these new products and accessories. So relatively speaking, our R&D expense in Q1 of '09 when comparing them to Q1 of '08, in terms of a cash benefit, that's hiding some of the expected cost savings that you'll see on operating relative to the end of last year. Is that clear?

C.J. Muse - Barclays Capital

Well, I guess for comparison sake, so the $3.5 million savings in OpEx is relative to December Q4 '08?

Tim Mammen

Yes.

C.J. Muse - Barclays Capital

And last question, on the advanced application side of things it looks like you've got some longer term contracts in there, longer visibility given that. Do you see that holding steady through calendar '09? Can that grow? What are your thoughts there?

Tim Mammen

We are targeting growing advanced applications. Clearly, it grew a lot off the first quarter. That growth rate may be a little bit difficult to sustain, 35%, but you know, and I'm not going to give a growth rate for the year, but we want to grow advanced applications this year. We also want to grow telecom this year.

In the advanced applications, again, we're just not sure of the timing when this order is going to come, but we know in Germany that the 50 kilowatt laser, potentially will be placed as an order. The timing is really around final authorization and final funding, but that would provide a very nice benefit to the second half of the year.

We know of intent by another customer in Europe who is definitely looking to place orders in the second half of the year. Whether we manage to ship any of those, we're not sure.

We actually got a good order for advanced applications. It was a very special 10 kilowatt single-mode laser that is going to be for shipment in Q3. That came in a couple of days ago. That's a very nicely priced laser, really leading edge. There is numerous examples on the advanced side that I can give you that will probably grow that nicely during the year.

Operator

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

Valentin Gapontsev

Thank you for your time and questions this morning. We continue to believe that our fiber laser offers customers the chance to create new and improved applications. We (inaudible) have never used our traditional laser where once the norm. We expect to further expand our position in the laser market worldwide during the challenging economy. Our diverse new products will continue to work with our customers' needs in order to improve productivity.

Thank you everyone for joining us today. We look forward to speaking with you again following the second quarter. We believe our news would be better than this quarter.

Operator

Ladies and gentlemen, that concludes our conference call. Thank you for joining us today.

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Source: IPG Photonics Corp. Q1 2009 Earnings Call Transcript
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