IPG Photonics Corporation Q1 2010 Earnings Call Transcript

May. 3.10 | About: IPG Photonics (IPGP)

IPG Photonics Corporation (NASDAQ:IPGP)

Q1 2010 Earnings Call

May 3, 2010 10:00 am ET

Executives

Angelo Lopresti –Vice President, General Counsel, Secretary

Dr. Valentin Gapontsev – Chairman, Chief Executive Officer

Timothy Mammen – Vice President, Chief Financial Officer

Analysts

Avinash Kant – D.A. Davidson & Co.

James Ricchiuti – Needham & Company

Paul Thomas – Bank of America

C.J. Muse – Barclays Capital

Mark Douglass – Longbow Research

Joe Maxa – Dougherty & Company

Ajit Pai – Thomas Weisel Partners

Jiwon Lee – Sidoti & Company

Operator

Welcome to IPG Photonics’ first quarter 2010 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

Good morning, everyone. With us today is IPG Photonics Chairman and Chief Executive Officer, Dr. Valentin Gapontsev and Vice President and Chief Financial Officer, Tim Mammen.

Statements made during the course of this conference call that discuss management’s or the company’s intentions, expectations or predictions of the future, are forward-looking statements. These forward-looking statements are subject to known and unknown risks and uncertainties that could cause the company’s actual results to differ materially from those projected in such forward-looking statements.

These risks and uncertainties include those detailed in IPG Photonics’ Form 10-K for the year ended December 31, 2009 and other reports on file with the Securities and Exchange Commission. Copies of these filings may be obtained by visiting the investor section of IPG’s website at Investor.ipgphotonics.com/sec.cfm or by contacting the company directly. You may also find copies of 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 3, 2010. The company assumes no obligation to publicly release any updates or revisions to such statements. We will post these prepared on our website following 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

We are pleased to report that earnings per share are at the high end of our guidance range on revenue that was in-line with guidance for the first quarter of 2010. IPG executed well on its business plan and improved sales and gross margins.

We were also pleased that our book to bill ratio was in excess of one and this is reflected in our guidance for the second quarter. In addition, we generated $7.9 million in cash flow from operations.

Now, I would like to touch on some recent highlights before turning the call over to Tim.

The macroeconomic recovery appears to be underway as we saw improvements in most major geographic markets across the globe.

Much of IPG’s first-quarter year-over-year growth was driven by increased sales of IPG’s pulsed lasers for materials processing applications, and low-powered lasers for medical applications.

In fact, the materials processing market grew by 23% year-over-year and the medical applications market delivered its second-consecutive quarter of triple-digit year-over-year growth.

On the market front, I am pleased to inform you that the 2009 fiber laser market results from the firm Optech Consulting are in, with associated positive conclusions for fiber lasers and IPG. According to Optech the global fiber laser market decreased last year by 24% from $317 million in 2008 to $242 million in 2009 compared to the total global laser market that decreased by 31% from $7.5 billion in 2008 to $5.5 billion in 2009.

These results demonstrate increased momentum for fiber laser solutions versus traditional CO2, YAG and diode lasers in material processing, medical and advanced applications. For our largest market, materials processing, the most recent market data also shows that fiber lasers represented nearly 10% of the material processing laser market in 2009 up from 7% fiber laser penetration in 2008. According to Optech estimates, the overall material processing laser market is predicted to grow by 15% in 2010.

We continue to believe that fiber lasers should grow even faster by playing an increasing role in many key applications and continuing to displace traditional lasers. In terms of new technology, we recently announced two acquisitions that expand our product portfolio and provide us with an entry into complementary markets.

During the first quarter, we acquired Photonics Innovations, an Alabama-based maker of active and passive laser materials and tunable lasers. The technology we acquired with Photonics Innovations enables IPG to expand our portfolio to the middle-infrared spectral range by combining it with our fiber laser technology to build new hybrid laser sources for various applications.

These applications include scientific, biomedical, material processing, and eye-safe range-finding. The middle-infrared market is an exciting and emerging space, which we believe represents an attractive opportunity for us to increase market share. The immediate benefit of this acquisition is reflected in the level of inquiries we are receiving from prospective customers for new Zinc Sellenide Single Frequency Tunable Lasers.

Subsequent to quarter end, we also acquired Germany-based Cosytronic KG, or COSY. COSY is a specialist in joining technology with an emphasis on engineering know-how in automated welding turnkey solutions.

Through this acquisition, we expect to expand our product offerings to include an innovative welding tool laser-seam-stepper that integrates seamlessly with our fiber lasers. We believe this is a promising complementary market for IPG targeting the automotive industry, sheet metal production and other material processing applications.

Finally, on the new product introductions, our new quasi-pulsed CW lasers have been well received in the market and the first customer recently placed a multiple unit order for these devices. We are optimistic that they will start to contribute meaningfully in the second half of the year.

After a rigorous testing process, we have now started to sell green pulsed lasers to customers covering a broad range of microelectronics and solar cell applications. Our high-power cladding lasers are gaining good momentum with customers and we are hopeful that cladding will become a meaningful material processing application going forward.

With that, I will turn the call over to Tim.

Timothy Mammen

Good morning everyone. It was nice to see the year over year improvement in sales in Q1, 2010 as Valentin had mentioned. Also significant was that the sales increase drove an improvement in our gross margins evidencing the leverage in our business model that continues to exist.

First, I’ll begin by taking you through our various markets, products and applications and then review our income statements and balance sheet.

Materials processing recovered nicely during the quarter, increasing 22.9% on a year over year basis and 4% on a sequential basis. In total, materials processing which is IPG’s largest market contributed 83.5% of $42.7 million to the consolidated revenue we reported in Q1.

Much of the growth for the materials processing market can be attributed to a substantial improvement in demand for pulse lasers used in marking and engraving and high power lasers used in cutting.

The advanced application market which includes test and measurement, instrumentation sensing and defense applications as well as scientific research and development represented 9.1% of total revenue or $4.7 million in the first quarter. This was a 34.3% decreases year over year and a 31.3% sequential decrease. This is a timing issue, as order flow and shipments have been historically less predictable in this market.

For example, we have orders in place for several sophisticated 10 kilowatt single mode lasers which will benefit sales when they are shipped later this year. The first quarter of 2009 in addition, benefited from the sale of a high value, 20 kilowatt laser which makes for a year over year comparison that is more difficult.

For the first quarter of 2010, medical sales comprised 3.8% of total revenue or $1.9 million. Sales for the medical application grew by 133.1% on a year over year basis, but were down 36.1% from an unusually strong Q4.

The year over year increase was due to demand from OEM’s worldwide, particularly in the U.S., Korea and Germany for both cosmetic and surgical applications. During the past few quarters, we have had some success diversifying our customer and increasing unit sales of low power lasers for medical applications.

The communications market, which decreased 30.5% year over year and 45.3% on a sequential basis comprised $3.6 million or $1.9 million of our total revenues in the first quarter. We had a weak quarter in Russia due to the timing of orders for long haul, broadband access and cable TV, and due to the planned merger between long distance provider, Ross Telecom with seven regional telecom operators.

The merger is delaying orders that we expect to receive in the first quarter. We do expect our Russian telecommunications sales to improve in the second half of the year.

Now let’s look at the business in terms of product lines. Sales for high power fiber lasers were $17.5 million, down approximately 3% compared with the same quarter last year and a sequential decrease of approximately 15% from the fourth quarter of 200.

The year over year comparison was SKU’d by a large order for high power lasers for advanced applications which was delivered in Q1 2009. The sequential decline was due to order timing and seasonality as Q1 is typically our slowest quarter for high power lasers.

We had a particularly strong quarter for pulse lasers with sales of $17 million driven by the improving demand for materials processing applications, particularly marking and engraving. Pulse laser sales grew 30% sequentially and 51% on a year over year basis. Our OEM customers in this product line are returning to healthy pre crisis levels.

Our low power lasers, which are primarily used for medical applications and micro materials processing were up 56% year over year to $4.5 million, yet decreased 14% on a sequential basis due to a strong Q4. We expect low power laser sales growth to be strong on a year over year basis, but sequential sales volume could vary. Also, note that rates have changed and calculated from a relatively small base.

Sales of medium power at $4 million for the quarter were down 24% compared with the first quarter of 2009, and decreased 8% from the sequential fourth quarter. Even though sales in total dollars decreased on a sequential basis, we believe that sales in this product line have stabilized. This is evidenced by a recovery in sales for micro electronics, printing and centering applications.

From a geographic perspective, our revenue benefited from an improved macro economic environment across the globe. Asia and Australia made up 39% of our total revenues. The region’s revenues increased on both a year over year and a sequential basis, by 40.6% and 1.6% respectively.

We had particularly strong quarters in China and Korea, mostly related to electronics and also general manufacturing OEM’s.

In Europe, including Russia and the CIS, we reported an increase of 10.8% on a year over year basis or 34.7% of total revenues. On a sequential basis, Europe was down 16.1% mostly related to a soft quarter in Russia. As I mentioned earlier, softness in the Russian telecom market is primarily related to order timing and restructuring of the Russian telecom sector.

On the other hand, Italy continues to perform well, especially because of its development of several cutting OEM’s.

Our North American market grew by 3.8% on a year over year basis, amounting to 26% of total revenues for the quarter. Sequentially, North American sales were up 9.5%. The year over year growth in the U.S. benefited from increasing sales of low power lasers for medical applications and the sequential improvement was driven by an increase in sales of high power lasers.

The rest of the world made up 0.2% of sales.

Now turning to the income statement, total sales were up 12.8% year over year to $51.2 million, within our guidance for the quarter of $48 million to $53 million, but down slightly by 5.7% on a sequential basis.

The fourth quarter is typically our strongest quarter, and this was true in 2009. We typically experience a seasonal downward demand trend in the first quarter as compared to the fourth quarter due to budget and spending patterns in some of our major countries such as Russia, China and Japan.

We estimate that exchange rates have been approximately the same as one year ago. Our reported sales would have been $1.2 million lower in the quarter.

Gross margins were 40.1% in the first quarter compared with 34.9% in Q2 2009. Benefiting gross margins were 1) the impact of providing for inventory reserves that was lower in this quarter than in the same quarter of 2009, 2) we benefited from somewhat better absorption of manufacturing costs and product mix, and 3) a recovery in demand and unit elasticity catching up with pricing strategy we started implementing in Q1 2009 as a response to the competitive environment.

For the first quarter of 2010, inventory was $52.1 million, $0.7 million lower than at year end 2009. If you exclude FX, inventory increased slightly which will tend to improve absorption of manufacturing costs because we build more products over the same amount of fixed costs.

If exchange rates had been approximately the same as one year ago, our Q1 gross profit of $20.5 million would have been $0.3 million lower.

SG&A expenses in Q1 were $11.2 million or 21.8% of sales compared with $8.2 million or 18% of sales in Q1 2009. G&A was higher in the quarter as a result of legal expenses related to the increase in activity in the IMRA litigation as well as higher salaries and benefits.

In addition, our selling expenses rose due to increases in salaries and benefits and demo unit depreciation. The increase in salaries and benefits of both G&A and selling is largely due to the accrual to bonuses in 2010 because of an improvement in the company’s financial performance, whereas no bonuses were accrued in 2009.

We estimate that if exchange rates had been approximately the same as one year ago, our Q1 2010 SG&A expenses would have been $0.4 million lower.

As we indicated during our previous calls, the IMRA litigation has recommenced. Fact, discovery and depositions are complete, but there has yet to be any court action on any substantive matter to date.

Due to a recent change in the trial judge, the Markman hearing has been moved to June 2010. The trial is still on track to begin in August 2010. We continue to expect to incur significantly higher legal expenses this year related to this case as we vigorously defend IPG against the claims in this lawsuit.

With respect to the CardioFocus litigation, the district court last week lifted the stay of the litigation. As a result of the patent re-examination as filed, the plaintiff abandoned one patent entirely and the patent office rejected many claims from the two other patents.

As we have mentioned in the past, these patents have expired. Consequently, the number of products alleged to have infringed has been significantly reduced and is immaterial in our opinion. Activity in this case will increase for the remainder of the year starting in Q2 2010.

R&D expenses were flat for the first quarter of 2010 at $4.2 million or $8.1% of total revenues. If exchange rates had been approximately the same as one year ago, we estimate that R&D expenses would have been $0.1 million lower.

Total operating expenses for the first quarter of 2010 were approximately $15.2 million. We continue to expect quarterly operating expenses to be approximately $15 million going forward.

In Q1 2010, we had exchange rate gains of $108,000 compared to losses of $1.5 million in Q1 ’09. IPG’s operating income in the first quarter was $5.3 million compared to operating income of $2 million in Q1 of last year. Operating income includes stock based compensation charges of $770,000 and $635,000 in the first quarters of 2010 and 2009 respectively.

In the first quarter of 2010, $160,000, $503,000 and $107,000 of stock based compensation charges related to cost of sales, SG&A and R&D respectively. Our tax rate for the first quarter of 2010 was 32.3%.

Finally, our bottom line results were at the high end of our guidance range of $0.02 to $0.07 per diluted share. We reported first quarter net income of $3.4 million or $0.07 per diluted share compared to net income of $1.3 million or $0.03 per diluted share for the first quarter a year ago.

Now turning to the balance sheet, our cash and cash equivalents increased by $1.5 million to $84.4 million at quarter end. We drew down our credit line by $1.2 million in the quarter so cash net of the change in the credit line was up slightly.

Cash generated from operations was $7.9 million. Capital expenditures were $5.5 million for the first quarter in line with our expectations. During the quarter, we acquired a building in Korea that will be used for sales and service and expanding our application center in Korea to add high power fiber laser applications.

The purpose of the new application center is to advance our penetration of the Asian automotive, electronics, medical manufacturing and heavy industry markets.

Looking ahead, we are targeting CapEx for the year to be approximately $25 million which includes some budget spending for future acquisitions.

Accounts receivable were $30.1 million at March 31, 2010 compared to $30.4 million at December 31, 2009. Day sales outstanding were 53 days at the end of Q1 2010 compared to 50 days at December 31, 2009.

This leads us to our expectations going forward. We started with year off with a solid quarter during which we executed quite well on our strategy and we are encouraged by our prospects for the remainder of 2010. Our global sales force is reporting growing activity in customer inquiries and requests for quotations in almost all geographic areas.

We continue to see the rate of adoption of fiber lasers in line with our expectations and some stability in pricing. This coupled with our positive book to bill ratio in the quarter and signs of a general economic recovery, provide reason for some optimism for us in the coming quarters.

We are also taking actions to position IPG for longer term growth and ahead of the competition. We are broadening IPG’s suite of innovative fiber laser products through our progressive product development program and acquisitions such as Photonics Innovation. We are also beginning to expand into complementary markets such as those provided by the acquisition of COSY.

As always, we will continue to identify new profitable opportunities to expand our customer base and displace existing laser and other non laser technologies in a wide range of applications.

Now let me provide you with our guidance for Q2. For the second quarter, IPG Photonics expects revenues in the range of $57 million to $62 million. The company anticipates earnings per diluted share in the range of $0.10 to $0.15. That is based on 47,191,000 diluted common shares which include 46,098 basic common shares outstanding and 1,093,000 potentially dilutive options.

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.

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

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Avinash Kant – D.A. Davidson & Co.

Avinash Kant – D.A. Davidson & Co.

In the guidance that you are giving for Q2, what’s your gross margin assumption and what kind of operating expense should we view?

Timothy Mammen

As far as gross margin, I think the business model continues to track as we expected. At the top end of the range with the drop through and total gross margin I expect to get above 43% and depending a little bit on product mix, maybe a little bit higher than that.

On operating expenses, we continue to believe that operating expense will be about $15 million during the quarter.

Avinash Kant – D.A. Davidson & Co.

That’s where you were at in the current quarter so with higher revenues you don’t see much change in your OpEx, right?

Timothy Mammen

No, that also factors in the legal expenses that we incurred in the first quarter. We’re not planning a lot of head count additions right now. We have also moved a few people back out of R&D into manufacturing in the first quarter, so we’re targeting in the short term to be stable on operating expenses.

Avinash Kant – D.A. Davidson & Co.

On acquisitions, both acquisitions that you have made at this point, they look like more for the technology side. What should we expect from these? Will they contribute much to 2010 or will there be more new products coming based on what they have?

Timothy Mammen

Meaningful contribution from them will probably start in 2011. We are optimistic I think that they will not be dilutive to earnings. They don’t have a huge cost structure, either of them, so they shouldn’t be dilutive to earnings this year.

They are both acquisitions that represent significant opportunities in different areas. Technically, Valentin can talk about the infrared spectrum and some of the areas and applications that we’re targeting there.

Valentin Gapontsev

In second quarter this year we will spend reduced [inaudible] devices, new material which are the Photonics Innovation Company that we bought. So we’re set to deliver in the third quarter, in quarter four and next year we will call $9 million to $10 million.

Regarding the Photonics, we introduced now and we’re started to ship to customers one of the custom products this year. We’re getting the orders for this machine with big expectations next year, so we expect to sell many foundries and machines for automotive industry, not only automotive.

Operator

You're next question comes from James Ricchiuti – Needham & Company.

James Ricchiuti – Needham & Company

I was wondering if you could talk a little bit about the bookings thus far in Q2. It sounds like you’re seeing pretty good activity, but I wonder how you characterize the bookings.

Timothy Mammon

They have continued through April to remain very resilient and strong. In terms of geographic perspectives, Asia continues to be strong. Europe is also tracking along very nicely, particularly with both northern and southern Europe.

We’re optimistic about a little pickup in Russia. I would say the one area where things are a little bit weak in the quarter has been the start to order flow in the U.S. There is a lot of stuff in the pipeline here, but April was a little bit down in the U.S. The rest of the world continues to be extremely strong.

James Ricchiuti – Needham & Company

You mentioned the U.S. Is there any particular area where it’s been a softer and conversely you think the pipeline is strong? Where do you see that coming back?

Timothy Mammen

It’s not any particular area. I think it’s probably more due to timing of orders. We have been qualified and we’ve got quite a lot of orders for the auto industry in the first quarter. Two areas that are a little bit weak. One is, order flow on the micro electronics where we have a good customer on the west coast actually qualifying some of the new longer pulse lasers, but we haven’t seen anything meaningful out of that customer for quite a long time.

And then on the advanced application side, the view of the head of sales there this year is probably likely to be more of a year of consolidation. He has attended recent conferences where he was mobbed by many different people looking to buy the lasers but I think there are funding issues that people still have to resolve before we see order flow out of that.

So that’s a bit of color on two of the areas in the U.S. The medical market should continue to perform well this year.

James Ricchiuti – Needham & Company

Would you be able to break out legal in the G&A line for Q1?

Timothy Mammen

The only guidance we’ll provide on legal is that it tracked a little bit higher than our budget number in Q1. Our overall target for the year remains the same, so for reasons of confidentiality we don’t want to break it out specifically.

James Ricchiuti – Needham & Company

You’re not changing; I think you were saying $3.4 million or so for the year?

Timothy Mammen

For the year, about $3.6 million was the number we put out. We’re not changing that at this time.

Operator

You're next question comes from Paul Thomas – Bank of America.

Paul Thomas – Bank of America

I just wondering on the cost side, looking at gross margins, last quarter you said that we hadn’t really seen any benefit yet from the higher power pump laser diodes, so looking at the Q2 guide in reference to the gross margin, are we seeing any benefit from that yet or is that still to come in the second half?

Timothy Mammen

That started to come through. We’ve transitioned to using some of the higher power packages with the new chips. The older chips are basically being used on the pulse lasers and we’ve almost consumed all the supply. So there is some benefit coming through from that.

We’ve also seen an increase in chip production coming into the end of the first quarter and we are forecasting a substantial increase in chip production for the rest of the year and that does help to improve the absorption in that area which is really a process driven one with high fixed costs whether you’re producing 200,000 chips or 500,000 chips a year.

Paul Thomas – Bank of America

On the revenue side, you said that obviously this was a seasonally low quarter, so at this point do you think you’re going to see sequential growth going forward or you mentioned there’s some timing issues also. After the June quarter, could we see some flattening out or do you still think there will be sequential growth after that?

Valentin Gapontsev

It should very substantial sequential growth we hope. We have now both from the market. We’ll be very substantial growth.

Operator

You're next question comes from C.J. Muse – Barclays Capital.

C.J. Muse – Barclays Capital

With book to bill tracking above one and I guess you talked here about positive order momentum through April and the last comment there growth sequential I guess. Can you talk where lead times are today and how far your visibility extends to?

Timothy Mammen

Lead times have not really changed at all on the high power laser. We continue to quote eight to twelve weeks on pulse lasers. We’re still at a lower level than that. Probably built a little bit of pulse laser inventory in our unit volume on pulse lasers was up to 1,400 lasers in the first quarter and could climb up as high as 2,000 lasers at some point in time this year, so no real change on lead times.

The disruption related to the volcano was temporary for us. We don’t think that’s going to impact this quarter. We did have some delays in shipment of product that had been produced and some delays in shipping components from Germany to the U.S., but those have all been resolved and we don’t think they’re going to impact us.

Valentin Gapontsev

Lead time of six to eight weeks including high power lasers, but after we will receive the license because more and more our laser requires license and the license is unpredictable so it’s a questions of what [inaudible] with respect to China and now Brazil and so on, they wait much more than six to eight weeks, but now they’ve brought it to licensing going much faster so with the licenses for the order in the quarter [inaudible].

C.J. Muse – Barclays Capital

On your outlook for potential sequential growth in Q3, can you comment on what areas you see driving that as well as geographically where you have higher levels of optimism?

Timothy Mammen

It’s really across the board. We’re going to clearly expect a pickup up in the high power lasers from what is traditionally a weaker start to the quarter. I just mentioned that pulse lasers, we’ve sold about 1,400 units in the first quarter and coming into the second half of the year we want to be shipping closer to 2,000.

In terms of geographies, Asia, China, Korea, we’ve seen some improvement in India. German laser business has recovered very well. The sales of cutting lasers to companies in Italy, in China, in the U.S. and other parts of Europe has continued to track very well.

We’ve seen an improvement in some of the medium power lasers in Europe in the printing business. That’s come back quite nicely as well as an improvement in the centering applications.

The key question will be to see whether we can get an improvement in the U.S. sales. I think this quarter; we’re just going to track that a little bit further.

C.J. Muse – Barclays Capital

Could you talk a little bit about gross margins? First off, is the excess inventory write downs behind us and from here, can you talk about what kind of incremental gross margins we should assume? I know mix plays a heavy role there, but trying to understand where we are today and as we add revenues to the top line, what kind of incremental dollars will flow through?

Timothy Mammen

First of all on the inventory write downs, I believe that, I hope that to a greater extent we are behind, we’ve put that behind us. We have continued to consumer our G mount guides and brought those inventory levels down to a much lower level so there’s a lot less risk around that.

And inventory reserves this quarter were about $600,000. They were the lowest they’ve been for almost eight quarters, so that was a positive trend. A little bit higher than we’d still like to see them, but there is an element of that that is just part of our business model given the vertical integration and the number of components we make internally.

In terms of gross margin improvement, I did do some analysis on the drop through comparing the first quarter of 2010 to Q1 2009 after adjusting for items like inventory reserves and other valuation adjustments that we book a year ago, and then I also adjusted the 2009 manufacturing expenses to a more normalized level because they were a lot lower due to the short work week programs.

My estimates on the benefit was that about 65% of revenue dropped down to gross margin. And that is I think at the bottom end of the range that we said we’d see in leverage. So 65% and a little bit above hopefully as we get to really utilizing capacity.

Operator

You're next question comes from Mark Douglass – Longbow Research.

Mark Douglass – Longbow Research

Can we go back to the gross profit? Obviously that’s a big deal for a lot of us. You mentioned, and obviously mix has a lot to do with the gross margin improvement. With high power lasers picking up likely through fiscal ’10, do you think they’re kind of neutral to the gross margin drop through that you’re expecting or is there a better absorption with pulse versus some of the other laser sources. Should we think about it that way?

Timothy Mammen

It’s sort of difficult to split it out for modeling purposes to such a granular level. I wouldn’t get so hung up that it was just product mix in Q1 that benefited. It was also the fact that absorption had improved as well as the total scale of the business compared to a year ago.

The statement I made about gross margin as well is that as you tend towards the top end of the guidance range, we would hope that gross margins would be tending from 43% and above and that’s irrespective we factored in the different product mix in relation to that.

So we’re on target as we get the business back onto decent level of scale I think to get ourselves back up to closer to 45% gross margins and as you get to higher than $62 million in revenue, our operating expenses should come down below 25%. So we can see a part of operating margins improving from up above 15% to closer to 20%.

Valentin Gapontsev

This year price is right so we don’t plan to go down with pricing this year. Last year as you know, it was correctional prices and we’re working to gain and with the success of the quarter, the manufacturing quarter, so our target is much higher with gross margin continues this year the same with total revenue. We’ve been very successful with new prices which we install now in our products. We’re extremely competitive so we believe [inaudible] so the situation for us now is very hopeful.

Timothy Mammen

And then the final though about it is that some of the new product offerings where we are bringing new and additional technologies, we would hope that those benefit the model for the second half of the year.

Mark Douglass – Longbow Research

I was also thinking that despite a sequential revenue decline, the gross margins improved nicely.

Timothy Mammen

That’s mainly related to the fact that in Q4 you remember, inventories were down by $6 million and this quarter inventory, if you strip out the FX were a little bit up. You can actually see that on the cash flow statement where there’s a less amount of cash outflow related to inventory. So we build inventory or we keep inventory stable. At given revenue levels, you absorb your fixed costs better and that benefits gross margins.

Mark Douglass – Longbow Research

Switching to the cutting markets and opportunity there, any regions that you’re seeing right now picking up faster than others or right now are your OEM opportunities still more focused in Italy and China or do you see a significant opportunity to expand that at this point?

Timothy Mammen

I think it’s all around the world. As Valentin mentioned, we’ve got enquiries and orders coming out of Brazil. A lot of that is cutting equipment. Even though some of these customers are based in Italy, we know for example that one of them has sold lasers in Asia.

It’s China definitely. I think we had an order as well from one of the major cutting companies in Japan who historically uses CO2 lasers. They’re being forced to transition to fiber because their customers want it, so it’s a pretty broad range of customers and end users around the world.

Valentin Gapontsev

Right now, turning to fiber laser for them it’s a situation, it’s a danger because all of them produce [inaudible] but now the situation, all of them have to use fiber laser. Fiber will become [inaudible].

Mark Douglass – Longbow Research

A couple others that have reported have noted that solar is starting to pick up for them. Are you seeing improved order rates or sales in your solar applications?

Timothy Mammen

We have seen some pick up in that area. We’ve had two meaningful orders, but that’s still relatively small. They weren’t the key driver of year over year growth, but there is some improved activity there.

Mark Douglass – Longbow Research

Is it somewhat of a long term market for you to go after then?

Valentin Gapontsev

The schedule depends on integrators. [Inaudible] some new very attractive process for solar application and now we own complete solution for machine for some processes. It takes some time, but we will get a solution for this market segment.

Operator

You're next question comes from Joe Maxa – Dougherty & Company.

Joe Maxa – Dougherty & Company

I believe you indicated you had several orders in your multi kilowatt lasers and that hadn’t shipped yet. Do you have any visibility or time when you expect to see some of these start to go through the order book?

Timothy Mammen

I mentioned some orders for some very sophisticated ten kilowatt single mode lasers which almost have a perfect non-divergent beam. We’re hoping, I would think we’re hoping to ship one of those towards the end of this fiscal quarter and then the remainder during the rest of the year.

Valentin Gapontsev

Last year we that each ten power single mode lasers, people would expect [inaudible] that people need for direct applications and this year, last year made for the tests and now we continue this process and final design. End of the quarter we had three orders and we hope to fulfill this order in this quarter, quarter two and a lot of people staying in the line waiting when we open door for new orders.

Joe Maxa – Dougherty & Company

If I understood right, you said you had three orders for Q2?

Valentin Gapontsev

Yes we have three orders for Q2 and from last year. With the way delivery characterization and the [inaudible] they will go into May, June all three orders.

Operator

You're next question comes from Ajit Pai – Thomas Weisel Partners.

Ajit Pai – Thomas Weisel Partners

Just looking at the auto industry in the U.S., I think in the first half of ’08, one of the things that you talked about as well as some of the large steel manufacturers were talking about high strength steel and the re-tooling of the auto industry for high strength steel and fiber lasers benefiting from that. A large number of the auto manufacturers are talking about re-tooling their factories right now more on the engine side than the body side, but are you seeing any trends over there improving for your business over there but transition into high strength steel.

Timothy Mammen

Yes, I think that’s a clear trend that we’re seeing. The one area where the high power laser business picked up in Q1 from Q4 was in the U.S. and a lot of that was driven from increased order flow from the auto sector.

I think we’re qualified now with two of the three largest auto manufacturers, domestic manufacturers here as well as numerous manufacturers overseas. So I’d say that trend continues to help us.

Ajit Pai – Thomas Weisel Partners

And fairly early in the trends right now, so we could expect revenue to ramp quite materially if the trend, like levels of penetration are still fairly low, is that fair to say?

Timothy Mammen

Yes, the levels of penetration are very low. It’s difficult to predict how quickly people will adopt. We still haven’t had someone buy 100 lasers to fit out a completely new line. We’ve had people buy tens of lasers to adapt existing lines, so it’s just very difficult to predict when the real traction starts to gain hold in that sector.

In Germany we’ve had another repeat order, significant volume from one of the major manufacturers and we’ve been qualified as well by one of the other Japanese major manufacturers as well very recently, and COSY has been working with a different German manufacturer for a number of months with this new joining and technology process so there’s a huge amount of work that continues to go on and continues to be some decent order flow from around the world in the auto sector.

Ajit Pai – Thomas Weisel Partners

Going back to the directed energy comment from Valentin a few minutes ago, he talked about three orders late last year. Were all the orders from different agencies and were all of them for defense applications and then the Navy I think about three years ago now, had taken a very large order, could you give us some color as to if the Navy was one of these three orders and should expect to see any greater traction here. And Valentin also mentioned that he had closed his books because he said he’s opening the books for orders right now. In the interim why did he close the book? Was it just some of the qualification issues or was it something else that prevented you from keeping your books open for orders.

Valentin Gapontsev

As you know, we’ve mentioned many times short lead time, no six month, no one year, only six to eight weeks so when we are not sure we are able to ship on time, we close the books. In this case we agreed because to ship for these three customers. It’s not for experiment. It’s that we’re making a deal for orders. So we believe with three orders, wait when we will see qualification. Now we have qualification and have great design and so we will be ready to open the gate for orders.

Ajit Pai – Thomas Weisel Partners

If you’re opening the books, do you expect the orders to come flooding in? Do you already have high levels of interest and the average order is still going to be in the multimillion dollar range because these are high power applications?

Valentin Gapontsev

We don’t expect [inaudible] units, but within ten units ordered to get this year.

Ajit Pai – Thomas Weisel Partners

Ten units of?

Timothy Mammen

Five and ten kilowatts.

Ajit Pai – Thomas Weisel Partners

Revisiting the business model in terms of the operating income statement and operating and gross margins, in mid ’08 you had high 40’s gross margins and you had mid to high 20’s operating margins on a pro forma basis. Since then of course you’ve had pricing declines. You’ve also added on more cost structure and you’ve made acquisitions. At some level, you’re still having a 65% flow through to the gross margin line from incremental sales, so at what point do you think you can reach back to those metrics, like a $70 million quarterly level or $75 million. Do you think it’s possible to get back to a high 40’s gross margin and mid to high 20’s operating margin?

Timothy Mammen

I think you’ve got to be cautious about talking potentially where this business model could be in a year’s time when revenues get to $70 million. I think our initial target is to get them back up into the mid 40’s and then improve manufacturing efficiency and leverage that we’re generating, introduce some of these new products and then see where we can go from there.

In terms of operating margin, I provided I think a pretty clear feeling that we can get back to like 20%. Getting back to the mid 20’s and actually be stellar operating margins, of course if you run a business model right now, and you put $70 million of revenue in there, it’s going to flush out in operating margins at 25% plus.

But you’ve got to factor in we’ve got potential geographic areas we want to expand into, maybe starting a bigger service and sales offices in Brazil where we use a distributor, working more closely with that distributor, some investments in the manufacturing capacity that will need to be made in Russia.

So there’s a lot of different variables rather than just sitting here and smugly saying that we’re going to climb above 45% when we hit $70 million in revenue. I prefer to be a bit more cautious about that right now.

I think that we’d be very happy with 20% in operating margin and you’ll see a very healthy net income and positive momentum in the business model. Of course we’d like to target to getting to higher levels. We’ll be very much more optimistic.

Valentin Gapontsev

I believe this year we can reach high 40’s in gross margin.

Ajit Pai – Thomas Weisel Partners

And the driver of that, just to clarify, you’ve managed to shift your production but can you give us some color to additional CapEx like your fabs, is your fab utilization fairly high? Is it close to 50%? Is there no CapEx required on that side? I know your manufacturing overhead you’ve got tremendous capability for assembly etc. that’s much greater than what you’re using right now, but what about on the fab side?

Timothy Mammen

The fab doesn’t require a huge amount of CapEx. We’re talking $2 million on the fab side. The major investment on the fab is we ramped chip and packing production. We’ll be adding assemblers and technicians, so it’s direct labor, and that’s not a huge cost and we do that as we ramp up. There’s no $20 million required in that area at the moment.

Ajit Pai – Thomas Weisel Partners

The M&A environment, you’ve talked about M&A a couple of transactions that you’ve done recently and it seems like you’re integrating vertically as well as getting some interesting technologies. When you look at the telecom side, your relative scale to many players is actually been falling quite rapidly. Is that an area that is of strategic interest for you for your longer term? Is it not of interest to you anymore? Business over there has been fairly challenges. You’re watching your customer base consolidate. So why is that still a part of IPG and do you expect to be more active in that area?

Valentin Gapontsev

We’re not looking to become a player but in some geographical regions like in Russia, we feel a big opportunity is there and we can do business in this region, and this year we’re completing the introduction of a whole complete system in the market and we’re successful certification of a new system in the 40G solution [inaudible] operating here to control up to 80% of all phone calls in Russia. We were recommended by Minister of Communication Russia for all Russian systems. I believe we would have a good chance to compete in this market.

[inaudible] orders in Brazil with power company, long distance [inaudible] to compare with our system and we’re also [inaudible] revenue.

Ajit Pai – Thomas Weisel Partners

But you’re not looking at any M&A in this area.

Timothy Mammen

We’re not looking to acquire any M&A. Internally developed products.

Operator

You're next question comes from Jiwon Lee – Sidoti & Company.

Jiwon Lee – Sidoti & Company

Taken Valentin’s comments on pricing trends, I wonder whether there was an area where you sold more staple or perhaps a little more favorable pricing during the quarter?

Timothy Mammen

Compared to a year ago, prices have come down but compared to Q3 and Q4 of ’09, we have seen them stabilize. There was nothing in particular on any of the product lines that was vastly different, so it was stable really across the spectrum of products.

Jiwon Lee – Sidoti & Company

Was there any 10% customer during the quarter?

Timothy Mammen

No.

Operator

There are no further questions at this time. I will now turn the conference back over to Mr. Gapontsev for any additional or closing remarks.

Valentin Gapontsev

Thank you all for joining us today. We continue to make progress in executing on our operational and financial goals during the second quarter of 2010 and we look forward to speaking with you again with much better results. Thank you.

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