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IPG Photonics Corporation (NASDAQ:IPGP)

Q2 2009 Earnings Call

August 4, 2009 10:00 am ET

Executives

Angelo P. Lopresti – Vice President, General Counsel & Secretary

Valentin P. Gapontsev Ph.D. – Chairman & Chief Executive Officer

Timothy P.V. Mammen – Vice President & Chief Financial Officer

Analysts

Avinash Kant – D.A. Davidson & Company

C.J. Muse – Barclays Capital

James Ricchiuti – Needham & Company

Joseph Maxa – Dougherty & Company

Jiwon Lee – Sidoti & Company

Sven Eenmaa – Thomas Weisel Partners

Operator

Good morning and welcome to IPG Photonics' second 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. Please go ahead sir.

Angelo P. 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 included – include those details in IPG Photonics' Form 10-K for the year ended December 31, 2008 and other reports on file with the Securities and Exchange Commission. Copies of these filings may be obtained by visiting the Investors section of IPG's website 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, August 4, 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 P. Gapontsev

Good morning. And thank you for joining us today. As you know already our, second quarter revenues of $40.4 million came in at the low end of our guidance range, down 28% year-over-year. We also reported a loss of $1.2 million for the quarter, or $0.03 per share. And while we fell short of our bottom-line guidance, we continued to cut expenses and capital expenditures, and we also continued to generate cash.

Overall, our financial performance continues to reflect the global economic downturn. The good news from this quarter is that high power lasers, which are now our most significant contributor to sales, continued to grow on a year-over-year basis. We are seeing growing market acceptance of fiber lasers in high power applications as users continue to move away from traditional lasers and turn to IPG’s superior high power sources for cutting, welding, brazing, cladding, and other applications. We also continue to see new applications for our high power lasers.

Please note that high power lasers for cutting and welding is the largest available market for industrial lasers, much larger – larger than the market opportunity for marking lasers. Let me discuss some operational highlights for the quarter. First, we sold our first pulsed green lasers and we are now accepting customer orders. We have strong customer interest and several units are in customer tests now, including solar. We have also started to ship two other new exciting product families. One of them provides high energy per pulse, up to 50 million joules in nanosecond pulses. This unique laser family opens exciting new opportunities in LCD display processing, automotive, and other applications.

The second new product family is our long pulse fiber lasers targeted at replace – at replacing lamp pumped YAG lasers. These lasers have pulse durations from hundreds of microseconds to multiple milliseconds, and energy per pulse up to 50 joules. That market is approximately $300 million now. More recently, we announced the successful development of 10-kilowatt single mode laser, which is a great milestone for IPG and the laser industry in general. We have accepted an order for this unique laser, which has tactical directed energy applications and many others.

Also we are now offering a first 100-watt fiber-coupled laser diode, the most powerful high brightness single-emitter based laser diode. At the lowest cost per watt, the new diode is well ahead in performance of any existing fiber-coupled laser diodes available in the market. We are hopeful that these new products can compensate for some of the impact from the global economic downturn. Second, I want to highlight that we hired additional experienced sales staff that will solely focus on the merchant market for our best-of-class laser diodes. Also, we now have an additional sales representative in Brazil focusing on high power and the automotive market there. We have added skilled sales personnel in China, as well as other locations internationally. Third, we completed the purchase of the remaining 20% minority interest in our Japanese subsidiary, further simplifying our structure.

In total, IPG’s value proposition remains strong. Customers continue to choose IPG’s fiber lasers for their superior performance, reliability, usability, and lower total cost of ownership, compared with conventional lasers. We are taking the right actions to ensure that we are an even stronger company when our markets rebound. Our continued investment in sales infrastructure and our aggressive product development strategy will allow us to maintain our technological edge and leadership position. We expect to be well positioned for renewed growth when the global economy recovers. I will now turn the call our – to our CFO, Tim Mammen for details.

Timothy P.V. Mammen

Thank you, Valentin. Good morning everyone. I want to provide an overview on financial results before I review our markets and business lines. As Valentin mentioned, we reported a net loss of $1.2 million or $0.03 per share in line with our announcement on July the 23rd but below our original guidance range. Our Q2 earnings were lower than expected for three primary reasons.

First, we had lower absorption of fixed costs due to lower sales volumes and a reduction in the level of inventory during the period. Second, we experienced pricing pressure for our high power and pulsed lasers because of the macroeconomic and competitive market. We expect pricing for kilowatt lasers to stabilize at current demand levels. Third, we increased R&D expenses in the quarter in order to get new products ready for production and to accelerate the development of other products and product enhancements.

I’d like to now provide a brief update on our cost reduction initiatives. In the second quarter, we reduced expenses by $1.5 million, compared to the average quarterly expenses for 2008. These reductions are due to lower bonus accruals, short workweek programs, workforce reductions and other expense savings. We have also reduced general and administrative expenses such as legal, accounting, and consulting.

However, some of these cost savings have been offset by lower absorption of fixed costs and an increase in certain R&D expenses as I mentioned above. While we have reduced our cost structure, we will continue to review the business in order to identify other potential expense reductions and, in particular to track how the remainder of the year is trending in terms of any potential recovery in sales volume. Also, because many of our cost reductions, such as reduced workweeks are temporary in nature, we will continue to evaluate whether more permanent changes to our cost structure may be necessary.

Now let’s take a look at the four markets we serve. Materials processing, which is IPG’s largest market, contributed 74.3% or $30 million of the total revenue we reported in Q2, down 36% year-over-year. As Valentin mentioned earlier, the vast majority of this decline stems from significant order reductions for our pulsed laser business, which began slowing in the third quarter of 2008. The decline was primarily related to marking and engraving applications. After a slight uptick in business for pulsed laser sales for solar applications during Q1, solar sales were slightly weaker in Q2, sequentially and year-on-year, as we continue to wait for several projects to restart.

In Q2, we also saw a reduction in sales of our medium power lasers, although this is compared to high sales volume in Q2 2008. The advanced applications market, which includes test & measurement, instrumentation, sensing and defense applications, as well as scientific research & development represented 14.1% of total revenue or $5.7 million, during the second quarter. Sales of these laser systems were relatively stable, growing modestly by 2%, compared with the prior year. The communications market, which comprised 7% or $2.8 million of our total revenues in the second quarter, increased by about 10% compared with the second quarter of 2008. The increase was driven by sales in Russia, where we recently became qualified as a Tier 1 supplier to several Russian telecom providers, including the largest one.

These qualifications present large opportunities for us as Russian optical network spending is robust. Sales for the medical application market comprised 4.7% of revenue, or $1.9 million, compared with $940,000 in the second quarter of 2008, an increase of more than 100% year-over-year. We’ve been discussing our efforts – our efforts to diversify our customer base in this segment for several quarters now, and we are now seeing some real success as we win OEM orders from the competition. In addition to orders from new customers in Korea and China, we are also seeing opportunities in the U.S. Although, still a relatively small component of our total sales, we expect the recovery in this market to continue.

Now, let’s look at the business in terms of product lines. Sales of our high power fiber lasers increased by 6% year-over-year in Q2 to $15.6 million and represented 38.6% of total revenue. The total kilowatts of output power shipped increased by 42.3% in Q2 '09. Sales for high power were down sequentially from Q1 '09. The demand we’re seeing for high power lasers continues to be for cutting, welding and cladding applications, right now, we’re seeing increasing interest from automakers to qualify our high power lasers for welding aluminum parts in automotive industry applications. And we are expecting to receive additional orders to be used in electric battery welding in the second half of the year.

In terms of new applications during the quarter, we shipped a 20-kilowatt laser for leading edge research in the energy sector. We also shipped 4-kilowatt laser for a magnet scribing application. As mentioned previously pricing pressure for high power and pulsed lasers affected our Q2 gross margins. However, now fiber lasers are competitive with CO2 lasers on an upfront cost basis, and offer an even lower total cost of ownership proposition when you factor in the lower operating costs. At these demand levels, we expect pricing on kilowatt lasers to stabilize. When we look at the numbers, and see the growing number of OEM cutting customers, we are increasing market share in high power materials applications during difficult economic times and positioning the company to be in a good position when higher level of capital expenditures occur.

What is meaningful is that high power laser market represents a substantially larger market opportunity with fewer competitors than pulsed laser markets. It was estimated that in 2008, revenues for all lasers for high power materials processing was $950 million, compared to $201 million for marking and engraving. About 75% of the high power materials processing market was for cutting lasers. The dollar figures would be lower for 2009 given where the world economy is today, but we feel there is a silver lining in our report to be taken from the growing penetration of fiber lasers in high power laser applications.

As I mentioned earlier, sales of pulsed lasers significantly declined. For Q2 '09, pulsed lasers were down 55% year-over-year to $9.9 million, representing 25% of revenue. The year-over-year decline was driven from our OEM marking customers who are experiencing reduced demand in their end markets. We are seeing some pricing pressure for our pulsed lasers as well, but mostly on the lower end. We remain confident that we are not losing market share in pulsed lasers and that quality of our products and the relationships we have with our major OEM customers will position us for growth when the market rebounds.

Sales of medium power lasers decreased 54% in Q2 of '09 from Q2 of '08, and represented 11%, or $4.3 million of total revenue. Much of the weakness stems from the weak economic conditions including low demand from microelectronics drilling, commercial printing and micro-materials processing applications. We do not believe that drop is due to a loss of market share or customers. It should also be noted that Q2 and Q3 of 2008 were strong quarters for sales of medium power lasers as new customers came on line.

Our low power lasers, which are primarily used for medical applications and micro materials processing were down 35% year-over-year and accounted for 7% of revenue or $2.8 million in Q2 2009. Low power lasers are stabilizing because of the recovery we’re seeing in our medical business. From a geographic perspective, we reported 37.5% of revenue from Europe, 32.6% from Asia and Australia, and 29.8% from North America. Our sales in North America appear to have been least affected by the global economic downturn, reporting only an 8% sales decline.

In North America we continued to see resilience from traditional material processing applications, such as cutting and welding in general industries as well as demand for new applications such as battery welding and drilling. This suggests that our high power fiber lasers are gaining in terms of market adoption versus traditional lasers. Europe was down 33% with Germany contributing a majority of the decline due to lower sales from marking, solar, and printing applications. Asia and Australian markets declined 30%, compared with the second quarter a year ago. Pulsed laser sales in Japan were particularly weak, while Korea had a good quarter due to strong medical orders.

Although still down year-over-year, Q2 sales in China marked an increase in quarterly sales, compared to the previous two quarters, driven by marking and cutting sales of some large laser systems manufacturing OEMs. As we mentioned last quarter, our new General Manager in China is aggressively targeting large OEMs and end users for traditional and new materials processing applications including high power applications. Turning now to the income statement. Sales for the quarter were down 28% year-over-year to $40.4 million. We estimate that if exchange rates had been approximately the same as one-year ago, our Q2 sales would have been $2 million higher.

Gross margins were 29.1% in the second quarter of 2009, compared with 48.1% in Q2 ’08. Gross margin was negatively affected by lower absorption of manufacturing costs due to lower sales volumes and reductions in inventory levels, product mix, due to lower sales of medium power lasers and the impact of pricing pressures on average sales prices, particularly for pulsed lasers and certain high power lasers. In addition, despite our cost reduction programs, which reduced costs in absolute dollar terms, manufacturing costs were higher as a percentage of sales than those of Q2 2008. Inventory write-downs totaled $1.4 million for the second quarter of 2009. We estimate that if exchange rates had been approximately the same as one-year ago, our Q2 gross profit would have been $1.4 million higher.

SG&A expenses excluding foreign exchange losses were $8.6 million or 21% of sales in Q2 '09, compared with $9.4 million or 17% of sales in Q2 '08. The reduction in SG&A expenses were primarily due to reduced cost for salaries and benefits as well as lower legal, accounting, and consulting fees. We estimate that if exchange rates had been approximately the same one-year ago, our Q2 '09 SG&A expenses would have been $0.3 million higher in Q2 '09 although, still lower than Q2 '08. I want to update you on recent activity in the lawsuits involving IMRA America. In July, the United States Patent and Trademark Office confirmed the patentability of all of the claims in the IMRA America patent over the prior art cited in the re-examination, as well as of new claims added during the re-examination.

The Federal Court in Michigan previously stayed the litigation until the conclusion of the re-examination. As a result, we expect to incur higher legal expenses in the coming quarters after the stay is lifted and litigation resumes. At this stage, we do not have more information on timing. As we have stated in our 10-Ks and 10-Qs, we have defenses in the lawsuit that we will pursue when the litigation starts again. The CardioFocus patents remain in re-examination at the Patent and Trademark Office. R&D expenses were $4.7 million or 12% of revenues in Q2 2009. This compares with $4.4 million or 8% of revenues in the second quarter of 2008. The real dollar increase in R&D is driven by our push to get certain new products ready for production.

In Q2 '09 exchange rate gain on transactions and the revaluation of financial assets and liabilities were $0.5 million, compared to a loss of $0.3 million in Q2 ‘08. IPG’s operating loss in the second quarter of 2009 was $1.3 million, compared with operating income of $12.8 million in Q2 of last year. Operating income includes stock-based compensation related charges of $569,000 and $617,000 in the second quarters of 2009 and 2008, respectively. In the second quarter of 2009, $126,000, $436,000 and $7,000 of stock-based compensation charges related to cost of sales, SG&A, and R&D, respectively. Our tax rate for the second quarter of 2009 was 31%. We estimate an overall tax rate of 31% for the year. The effective rate for 2008 was 32%.

Our second quarter net loss attributable to IPG was $1.2 million or $0.03 per share, compared with net income of $8.6 million or $0.19 per diluted share for the second quarter a year ago. Year-to-date cash generated from operations has exceeded the amount spent on investing activities by more than $16 million. In the second quarter, we reduced capital expenditures to $3 million and in total to $7.8 million for the year-to-date. As a result of these actions, our cash and cash equivalents net of debt have increased to $28 million, compared with $12.2 million at December the 31st, 2008. Cash and cash equivalents improved from year-end by $26.8 million to $78.1 million at the end of the quarter.

Not included in cash and cash equivalents are $1.3 million in auction rate securities at June 30, 2009, which are included in other long-term assets. In Q3, we will use some of the cash built up during the year to pay down part of our revolving credit lines. Going forward, we intend to target gross cash on the balance sheet of between $55 million and $65 million and use any cash on hand in excess of that amount to reduce short-term debt. Cash flow from operations in the second quarter was $6.3 million. Cash used in investing activities was $3.1 million and cash provided by financing activities was $1.6 million. At current business levels, we are still targeting capital expenditures to be less than $15 million for the year. Accounts receivable decreased to $32 million at June the 30th, 2009 from $41.8 million at December the 31st, 2008.

Days' sales outstanding were 71 days at the end of Q2, compared to 65 days at the end of 2008. The increase primarily reflects the timing of shipments during the quarter and to a lesser extent some longer payment terms for certain customers. Finally, on the balance sheet, inventory decreased by $10.4 million to $62 million at June the 30th, 2009 from $72.6 million at year-end 2008. This leads us to our expectations going forward. Visibility remains limited for most of the markets we serve, although it is better in Q3 than it was at the equivalent point in Q2. While we are hopeful for a modest recovery in the second half of 2009, we expect that the weakness in the materials processing market may limit meaningful improvement in our revenue and net income for the remainder of the year.

We also expect that we will continue to experience pricing pressure for the foreseeable future. However, there are some bright spots. We expect continued resilience in demand for high power lasers, which we believe to be the results of increasing market share and the enabling of new applications at higher powers. Moreover, we are seeing some strength in the medical, telecom, and advanced applications markets. We expect the recoveries in those markets to continue gradually throughout the year.

Let me now provide you with our guidance. For the third quarter, IPG Photonics expects revenues in the range of $39 million to $44 million. The company anticipates earnings per share in the range of a loss of $0.02 to a profit of $0.03. That is based on 46,518,000 diluted common shares, which include 45,431,000 basic common shares outstanding and 1,087,000 potentially dilutive options. This guidance is subject to the risks we outline 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.

Before I close, let me also reiterate that we are optimistic about the long-term prospects of IPG with every challenge there comes an opportunity. While the global recession is having a negative effect on our sales and net income for the near-term, we are taking strategic actions to position IPG for strong growth when our markets recover. Our employees are making extraordinary efforts as we continue to offer a compelling value proposition for our customers. With our growing penetration in high power, a large market, strong focus on R&D, our technological edge, a strong balance sheet, and our solid infrastructure, IPG will continue to capitalize on the opportunities available to us despite the current economic and financial crisis.

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

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). Our first question comes from Avinash Kant with D. A. Davidson. Please proceed with your question.

Avinash Kant – D.A. Davidson & Company

Good morning, Valentin and Tim.

Valentin P. Gapontsev

Morning.

Timothy P.V. Mammen

Good morning, Avinash.

Avinash Kant – D.A. Davidson & Company

Quick question first on in terms of the outlook that you’re talking about, its remaining kind of at the same level. Do you mean that in Q4 also you would have similar revenue as you have in Q3 or you’re talking about second half versus the first half?

Timothy P.V. Mammen

I think we are talking about the second half versus the first half. We can't at this point in time provide specific guidance about Q4 just it's a little early to do that. Where we stand coming into Q3 though, if I look at the equivalent period we were at, at the beginning of Q2. In terms of shippable orders in hand, we are in a better position and I think have greater confidence in the guidance we’re providing right now compared to the beginning of the second quarter.

Avinash Kant – D.A. Davidson & Company

And I believe there were some larger orders that you were expecting to close on have you received those orders already or you are waiting on them, especially from the auto side?

Timothy P.V. Mammen

We've had another new order for example from BMW, so that confirms strengthening that relationship. I would say that, we've had a couple of orders as well from Ford, we’ve definitely seen some activity on positive movement on Daimler in Germany. Also some activity with people like Audi but we hadn’t talked about expecting any 10 or 20 unit orders in the immediate future. I think we are still looking at 2010 for that, but I would say right across the board, there has been a strengthening of our relationship with just about every single automotive manufacturer. And interesting I was just looking at some of the numbers, our automotive sales this year, both direct and to OEMs are actually up on the first half of last year despite the tremendous weakness in that market. Valentin can probably add some stuff on any other relationships that we are seeing strength from.

Valentin P. Gapontsev

We're practically now working with all, practically 90% of all the major automotive companies and with all of them, test result and the use of our laser they use now that will have very positive return back. So we don’t have any problem with any of these automakers, to compare with other players in the market who have a very big problem.

Avinash Kant – D.A. Davidson & Company

Okay. And Tim you talked about the margin decline and of course you could expect some pressure from competition. And you said you see this in the foreseeable feature, so do you mean that, if you were to return at similar levels as you had in the past, your margins will be lower than what you achieved in the past cycle?

Timothy P.V. Mammen

In the near term if we were to get back up to like $55 million right now with the component cost base, yes margins would be a little bit lower I would say, you would be targeting like 42 to 45 rather than 45 to 48, but we are working on several areas where the component cost base should come down as we run through existing inventory, so for example, we announced the introduction of these very high powered diodes. That will reduce the cost per watt on the diodes. It will reduce for example also production time because fewer splicers are required.

Avinash Kant – D.A. Davidson & Company

Right.

Timothy P.V. Mammen

We are also introducing other lower cost components. We will also see in 2010 real benefit from the introduction of our beam combiners and…

(Multiple Speakers)

Avinash Kant – D.A. Davidson & Company

Now taking about diodes though, overall it looks like the prices of diode have come down significantly. Now could you talk a little bit about the differential that you still have, compared to the diode prices out there and the one that you are making?

Timothy P.V. Mammen

I mean, probably diode prices in the open market are down, but there is still a significant advantage that we have, we would say we’re probably somewhere between 20% to 30% of the cost in the open market. There is nobody really out there, who is buying in the volume though that we use, so it's very difficult to put a definitive number on that. In the low volumes that people buy, the price of the diodes in the market is much, much higher than we are at right now. It remains a key competitive advantage of ours.

Avinash Kant – D.A. Davidson & Company

And then final question, could you give us the depreciation and the headcount number at the end of the quarter?

Timothy P.V. Mammen

The depreciation and amortization number is on the release on the cash flow. It was.

Avinash Kant – D.A. Davidson & Company

Okay.

Timothy P.V. Mammen

We have…

Avinash Kant – D.A. Davidson & Company

4.7 I believe.

Timothy P.V. Mammen

I haven't got it at hand right now.

Avinash Kant – D.A. Davidson & Company

That's fine, I'll look it up, yeah, and what was the headcount?

Timothy P.V. Mammen

We don't disclose headcounts on a quarterly basis.

Avinash Kant – D.A. Davidson & Company

Okay. Perfect. Thank you so much.

Valentin P. Gapontsev

We try to save our key people so we don't use up to now any essential labor cut.

Avinash Kant – D.A. Davidson & Company

Thank you so much.

Operator

Our next question comes from C.J. Muse with Barclays Capital. Please proceed with your question.

C.J. Muse – Barclays Capital

Yeah. Good morning. Thank you for taking my question. I guess on the first part, sort of thinking medium/longer-term on the competitive landscape, aside from the marking market, can you comment on where you're seeing increased competitive pressure within fiber lasers. And then I guess in terms of your bread and butter higher power segment, can you talk about, what you're doing there to continue to separate yourself from your competitors?

Timothy P.V. Mammen

So I’d say the competition is really still primarily focused on pulsed lasers. There are numerous people out there manufacturing, there is a couple of people who bought a lower quality device to market in China. Across the other products in terms of fiber lasers, even at the medium power level and the high power lasers the competition is very, very much more limited. I would say that where we are seeing more of the pricing pressure, it's particularly from TRUMPF and their disc laser that we are having to compete on certain customer wins there. So the competition is really coming from some of the other more legacy laser systems rather than on fibre at those higher power levels.

C.J. Muse – Barclays Capital

So, as you have those discussions with customers then on pricing and clearly your cost of ownership is a nice tailwind for your customers, I guess can you talk about how you're positioning pricing, because it sounds like you're now flat, was that really necessary given the competitive advantages of your tools?

Timothy P.V. Mammen

In this environment it really yes, it was C.J. I mean customers are putting, particularly where they were going they had TRUMPF point into them. Customers are putting pressure on the all sides of the partnership and in order to win some very key customer relationships we did have to become competitive on the upfront pricing cost. The other strategy though is well is that particularly in this environment the lower total cost of ownership to be earned over a period of years. You also have to be it becomes a more difficult proposition I think just to simply sell on that basis in order to really penetrate the market particularly on cutting and these high volume units. You do have to become upfront competitive on an upfront cost basis as well as offer those lower operating, lower total ownership cost.

C.J. Muse – Barclays Capital

Okay.

Timothy P.V. Mammen

And that will really drive significant volume increases here. We don’t want to just be selling 300 or 400 high-power lasers a year. We want to be getting into selling thousands and more than a 1,000 high-power lasers a year.

C.J. Muse – Barclays Capital

Okay, it makes sense. And then I guess on your geographical mix, U.S. holding up much better than Europe and Asia. And I guess my question is here, why do you think that is that because of your larger footprint here, you’ve had more years here, more years for your customers to get their arms around fibre lasers and I guess as a follow on to that when will we start to see the breadth of ordering from non-U.S. customers?

Timothy P.V. Mammen

I think it’s the other way round. First of all, it’s probably an earlier stage of penetration in the U.S. and also some newer applications and industries particularly in battery welding the 20-kilowatt we sold into a very advanced materials processing application. In Asia and Europe we had far more OEMs selling lower power and pulsed laser devices. So when those sales drop down relatively speaking they have a bigger impact in Asia and Europe. If you strip out the pulsed laser side of it and you look and focus on the high power lasers in Europe and Asia there is probably an equivalent amount of stability. So, the U.S. just had less wider adoption on the pulsed laser sales. They haven’t got to the level like for example [TRUMPF] was a 7% or 8% cuts from about a year ago in Japan. The first half of this year had just been very, very weak for them, so it’s more of the impact on the pulsed and low power that tends to give a indication of a steeper drop in sales in those other areas.

C.J. Muse – Barclays Capital

Okay. It's helpful. And last question for me, can you provide some help or guidance around the gross margin and OpEx levels for September?

Timothy P.V. Mammen

I am a little bit worried about it about, doing that. I think we factor that in when we give the guidance, I would say at the bottom end of our guidance we are factoring in continuing to take inventory levels down, which is why we still see a loss there. And gross margins would be probably around the 30% level as well. As we come into, and its very difficult on the inventory planning right now to tell you exactly what we are going to do, because as we see order flow coming through August and September, we will then make production decisions on what we need for Q4. So, if we see Q4 with some additional strength instead of taking inventory down, we may stabilize inventory and increase productions to meet that demand in the fourth quarter. If we did that and we got to the top end of our guidance range, I would expect to be above 35% in gross margin.

C.J. Muse – Barclays Capital

It's helpful. And on the OpEx, I'd think that would be a little easier?

Timothy P.V. Mammen

OpEx levels will basically be R&D and SG&A will basically be flat with the quarter.

C.J. Muse – Barclays Capital

Perfect.

Timothy P.V. Mammen

During the quarter. In Q4, you should probably take into account some higher legal expenses. They won't be that material in Q3, but Q4 should probably factor in about $750,000 potentially on legal expenses.

C.J. Muse – Barclays Capital

Thank you very much.

Operator

Our next question comes from Jim Ricchiuti with Needham & Company. Please proceed with your question.

James Ricchiuti – Needham & Company

Hi, thank you. You mentioned that Q3 started off better than Q2. Then I wonder how do you characterize the first month of Q3 say with the month of June. And I recognize you see a lot of activity probably late in the quarter?

Timothy P.V. Mammen

So just in terms of book-to-bill, we had a book-to-bill in excess of Q, in excess of one in the second quarter. So in terms of shippable backlog right into the beginning of Q3, we had a greater percentage of shippable backlog relative to guidance. It was probably up to about 75%, whereas at the beginning of Q2 it was 65%. In the second quarter, we knew we had some big orders that we’re coming in towards the end of the quarter those it did come in. And July, the first few weeks of the quarter in terms of order flow show relative stability with April, May, and June as well. So that stability we talked about has continued to be maintained.

James Ricchiuti – Needham & Company

Okay. That’s helpful. Based on your guidance that you’re giving at the low end roughly, sequentially flat, I’m just curious do you see much of a seasonal downtick in business in Europe and if so, are you anticipating some improvement in some of the other geographies possibly in Asia, Australia, which was down year-over-year quite a bit?

Timothy P.V. Mammen

I would say we’re a little bit worried about, August just being a very slow month or could be a slow month for orders, just with all the vacation time particularly in Europe, but the guidance really reflects, I think a couple of things that sort of timing of export licenses for orders that we already have in hand for China and a lot of those are the kilowatt scale lasers. If some of those export licenses has even slipped by four or five weeks. We could see a couple of million dollars revenue slip related to those. We’ve also got some revenue recognition on a couple of high dollar items in Japan for the schedule to be delivered at the end of the quarter. So we just want to provide some comfort that we are going to be able to, if those slip as well, we are going to be able to manage around that.

James Ricchiuti – Needham & Company

Okay. Then just regarding the last point you made about Japan are you seeing some signs of improvement there, or was this just a customer that has been very weak and just came back with an order late in the quarter?

Timothy P.V. Mammen

Well, it's actually customers that placed orders for specific delivery in September.

James Ricchiuti – Needham & Company

Okay.

Timothy P.V. Mammen

The Q, the pulsed laser orders through Q2 were weak. The remaining order flow in Japan was relatively stable coming into the beginning of this quarter we actually got our first meaningful order from the major marking customer in Japan. And that’s for delivery, those are lower power units, so they don't affect revenue recognition so much, but they are for delivery at the end of this quarter and the beginning of Q4. So its pleasing to see that order come in, I would say the first few weeks of the quarter in Japan in terms of order flow have been a little bit weak, but then just over the last couple of days, there has been some pick up there a little bit.

James Ricchiuti – Needham & Company

Okay. Thank you.

Valentin P. Gapontsev

And the pulsed laser in Japan, our major customer, they’re have done with now, with the order, so for second half of the year, pulsed laser from Japan would be much higher order than it was.

James Ricchiuti – Needham & Company

All right. Thank you.

Operator

Our next question comes from Joe Maxa with Dougherty & Company. Please proceed with your question.

Joseph Maxa – Dougherty & Company

Thank you. I just wanted another update on the high-power lasers, the 10-kilowatt you sold, I was wondering what application and then an update on your expectations for perhaps the number of these multi-kilowatt lasers you may sell in the second half?

Timothy P.V. Mammen

Hi, Joe. I think you're referring to the 20-kilowatt. That was a very advanced materials processing application that we cannot talk about.

Joseph Maxa – Dougherty & Company

Okay.

Timothy P.V. Mammen

We are under an NDA with that. And then in sort of the multiple unit I think well, specifically on the high-power side, we will see some pickup in high-power laser sales coming into Q3. There is no sort of 10 or 20 unit order that’s driving out at the moment, there are numerous orders coming in from new customers. For example, on the cutting side, like Salvagnini, Prima, this customer that’s developed this application for scribing magnets is going to place some multiple unit orders. Those are sort of in the order of like three to four units. Some of the auto manufactures are still talking 40 to 60 units, but the likelihood of those are still 2010, not the second half of this year at the moment.

Joseph Maxa – Dougherty & Company

When Valentin mentioned the 10-kilowatt single-mode laser, I thought did I understand you, did he say you accepted the first order?

Timothy P.V. Mammen

Yeah, sorry. That we do have an order for that it's in the advanced government application arena for directed energy.

Joseph Maxa – Dougherty & Company

And you expected that this second half?

Timothy P.V. Mammen

The order is already in hand. Yeah that will ship sometime during the second half of the year.

Valentin P. Gapontsev

A clear demonstration that its possible to get from fiber lasers 10-kilowatt single-mode. Nobody even one-year before, nobody believed it’s possible in principle. Now we have demonstrated this critical point in practical way overcome the result of application and directed then into the application with fiber lasers. So but we need to still qualify this laser, because we are careful, we’ll have now equates from some other people to ship that actually, but we still need some time to make specification to finish development.

Joseph Maxa – Dougherty & Company

Okay.

Valentin P. Gapontsev

But it’s very perspective in ways of some application.

Joseph Maxa – Dougherty & Company

Okay. And then another topic, I was just wondering did you breakout what percentage of your revenue comes through your system integrators or OEMs versus direct?

Timothy P.V. Mammen

No we don't, we view the system integrators and OEMs as direct, we don’t view them as a distribution relationship.

Joseph Maxa – Dougherty & Company

I see. Okay. Thank you.

Operator

(Operator Instructions). Our next question comes from Jiwon Lee with Sidoti. Please proceed with your question.

Jiwon Lee – Sidoti & Company

Thanks for taking my question. Just two quick ones, I understand your frustration towards the market, but as the upfront cost as well as the overall cost of ownership become more competitive with the legacy lasers, when the market does come back I’m wondering, which applications do you expect to pick-up better for you, whether it is cutting, welding, or cladding and sort of relatedly if that scenario materialize, what end-market would end-up being the biggest for you like auto or general industrial?

Valentin P. Gapontsev

We are sure that material gross margin would be the biggest in the nearest future and so we are sure that our position in the major today, major application is cutting, the cutting up to $800 million to $900 million is the biggest application for laser today, for high power lasers. And we have – about this year we have penetrated this market, we are growing very successful, we built now the price structure and all other performance, very competitive with traditional CO2, which dominates in this market niche. Other applications we were sure, we will be very successful in new application is for example, our long pulsed laser, which now is still crystal laser, YAG laser, it's a 300 million market for some applicants that people need a high energy, but powerful like many joules per pulse. Before fiber laser did not compete at all in this market such company like TRUMPF and now they have very good business. Now we introduce this market, new fibre laser. We assure you in a couple of years, we will be a dominant player in this market segment also. From other application, we are sure that, we will turn back very aggressively on the telecom market, however, we create now what new platform and complete solution that before we talked only parts for this market segments. Now we develop very perfect complete solution, complete DWDM system for long haul, also broadband application for digital TV and we very aggressively go in rebound back for this market. We are building our telecom market, share of telecom will rebound back not from few percent, but will be 20 plus percent in our total growing revenue. In medical market also we have very serious perspective. Before we worked practically only with one customer OEM. It was [Reliant]. We now have more than 10 OEM customers and this business start to grow again. So medical market also increased share in our total revenue, very essential, in spite of growth in industrial application.

Jiwon Lee – Sidoti & Company

Okay, Valentin, that’s helpful. And then on the defense side earlier this year, there were couple of opportunities to procure the laser-based weapon system. Can you give us an update as to where those opportunities stand?

Timothy P.V. Mammen

There is nothing really specific to report on that, there is continued developments and process work being done by people. We continue to speak to just about every defense contractor out there. I think our lasers are being used in some areas where people are not prepared to talk about them. I think that there is an indication even at the lower power level on the 2-kilowatt side that we could see some orders, the IED and mine destruction capabilities coming into 2010. So there is really no specific update to provide on that, Jiwon, I think that it just continues to develop.

Jiwon Lee – Sidoti & Company

And one more thing, what about some updates on the solar side of the business?

Timothy P.V. Mammen

Coming into the second quarter, solar was a little bit weaker than a year ago. I think we are waiting to hear on a couple of projects, which are supposed to come back on stream at the end of this year, and hopefully one order that should be a couple of hundred units that would be for delivery in the first quarter of next year. We’ve actually had some good order flow outside of Europe and the U.S. with some of the – we got in with a Japanese integrator these are supplier to Sharp. And we've had some decent order flow on that on the first half of the year, but the solar market remains choppy at the moment.

Valentin P. Gapontsev

We have a lot of request for pulsed lasers, and we claim before we develop such a laser, but it took the time to finish specification to prepare for mass production. Now we're ready for this. We're starting to ship this pulsed laser, and we believe during the couple of quarters, the pulsed laser will bring us lot of revenue. For a special for solar application, because of people require the pulse this green wavelength.

Jiwon Lee – Sidoti & Company

Excellent. That's helpful. Thank you.

Operator

Our next question comes from Sven Eenmaa with Thomas Weisel Partners. Please proceed with your question.

Sven Eenmaa – Thomas Weisel Partners

Yes. Hi this is Sven Eenmaa calling in for Ajit. Couple of questions, first one is on the gross margin side, you mentioned that you took an inventory write-off around $1.4 million. What components or products did that pertain to?

Timothy P.V. Mammen

General, I mean, older style optical components we also looked at the specific diode chip and identified some potential excess quantities on an older style chip, so that was where our focus was. It's always optical components that are sort of older and that are not being consumed at the moment for the next quarter as well, we looked at a little bit of excess that could potentially arise on an older style chip, Sven.

Sven Eenmaa – Thomas Weisel Partners

Okay. So in terms of, if you look at the September quarter, you guys expect to take, put in inventory write-downs?

Timothy P.V. Mammen

I'd hope that they're more moderate than Q2.

Sven Eenmaa – Thomas Weisel Partners

Okay.

Valentin P. Gapontsev

Take in mind this component is still good quality, so we will plan to use in the future, but according SOX rules we have to make this.

Sven Eenmaa – Thomas Weisel Partners

Okay. And in terms of, if I look at the gross margin range for the next quarter I think you mentioned 35% as the high end, where do you expect it to be at the low end?

Timothy P.V. Mammen

I mentioned about 30%, but that would also factor in a further reduction in inventory.

Sven Eenmaa – Thomas Weisel Partners

Okay.

Timothy P.V. Mammen

But I characterized that, because we have to make our production planning decisions coming into the end of August for September and that will be driven by outlook for Q4.

Sven Eenmaa – Thomas Weisel Partners

Great. That’s very helpful. And in terms of, if I think of the R&D spending levels going forward here is, are you currently at the run rate where we expect to be through the end of the year or is the current level just associated with a couple of products, you are launching in near-term?

Timothy P.V. Mammen

So, I think Q3 still be relatively the same level of R&D and then coming into Q4 as we move into actually a high level of production particularly, hopefully of the green lasers, and also start to increase production in some of the newer diode chips, we should see R&D come down a little bit in Q4.

Valentin P. Gapontsev

Of the Prima, which we've done in from a development to the production level we sold, I expect R&D in quarter four would be less.

Sven Eenmaa – Thomas Weisel Partners

Okay. And my final question just to clarify in terms of the pricing impact going into the second half of the year, do you see the primary pricing pressures then in the medium power and pulsed laser side, it sounds like in the high-power side did I see stabilization?

Valentin P. Gapontsev

You have to understand that pulsed laser on lower end, pulsed laser becoming commodity product, so a lot of competition and price will go down in such cases, usually in the market. So, but to compensate that introduction market, high energy with pulsed laser, which is still unique nobody has similar products, we don’t except they will able to introduce a similar product during couple of next year. So they're much more productive in applications than low power lasers, and we believe that will compensate and they also would be much more profitable.

Sven Eenmaa – Thomas Weisel Partners

Okay, great. Thank you very much.

Operator

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

Valentin P. Gapontsev

Okay. Thank you for joining us today. We plan to continue to make progress in executing on our operational and financial goals during the second half of 2009. Moreover, we expect the strategic decisions that we have made internally and externally should help ensure that IPG is able to capitalize on our growth opportunities. We look forward to speaking with you again following the third quarter with I believe I hope with much better results.

Operator

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

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Source: IPG Photonics Corporation Q2 2009 Earnings Call Transcript
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