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Executives

Angelo Lopresti - General Counsel, Secretary and VP

Valentin Gapontsev - CEO and Chairman

Timothy Mammen - CFO and VP

Analysts

Avinash Kant - D.A. Davidson & Co.

Paul Thomas - Bank of America

Mark Douglass - Longbow Research

Jim Ricchiuti - Needham & Company

Jiwon Lee - Sidoti & Company

Joe Maxa - Dougherty & Company

Ajit Pai - Stifel Nicolaus

Mark Miller - Noble Financial Group

Tom Bishop - BI Research

IPG Photonics Corporation. (IPGP) Q2 2010 Earnings Call August 3, 2010 10:00 AM ET

Operator

Good morning and welcome to IPG Photonics Second Quarter 2010 Financial Results Conference Call. Today's call is being recorded and webcast. There will be an opportunity for questions at the end of the call. (Operator Instructions).

At this time, I would like to turn the call over to Mr. Angelo Lopresti, IPG's Vice President, General Counsel, and Secretary for introductions. Please go ahead sir.

Angelo Lopresti

Thank you and good morning everyone. With us today is IPG Photonics' Chairman and Chief Executive Officer, Dr. Valentin Gapontsev; and Vice President and Chief Financial Officer, Tim Mammen. Statements made during the course of this conference call that discuss management's or the company's intentions, expectations, or predictions of the future are forward-looking statements.

These forward-looking statements are subject to known and unknown risks and uncertainties that could cause the company's actual results to differ materially from those projected in such forward-looking statements. These risks and uncertainties included 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 investors.ipgphotonics.com/sec.cfm 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 3, 2010. The company assumes no obligation to publicly release any update or revisions to any such statement. We will post these prepared remarks on our website following the completion of the call.

Please go to www.ipgphotonics.com and select Investors to review these remarks.

I’ll now turn the call over to Dr. Gapontsev.

Valentin Gapontsev

Good morning and thank you for joining us today. The financial results that we had reported during the first quarter have been improved in the second quarter of 2010. Despite underlying uncertainties in the vulnerable market environment in the second quarter, many of our end market are benefiting from its particular recovery.

IPG reported record revenue in 67.7 million up nearly 67% over the same quarter last year, 31.4% over the first quarter of 2010. Reported revenue in earnings per share exceeded our guidance range essentially.

These factors contribute to our robust quarterly performance. First strong growth couple of material process and applications

Second, outstanding results from China and third, IPG vertical integration which derive operating that leverage in the responsive increase in unit volume

I will briefly touch on each of these, materials processing represented approximately 85% of our quarterly revenue and grew by more than 90% year-over-year, increasing demand of high power and powerful laser and of course this vibrant growth of customers that have continued their adoption of fiber laser given the distinct advantages including great performance superior being quality, reliability, profitability qualification maintenance cost.

Q2 represents a record quarter for IPGP pulsed laser in the second highest level of quarterly high power laser sales. To put this numbers in perspective the unit growth of high-power and low-power laser each more than doubling this quarter, with this Q2 ‘09. And this unit growth of pulsed laser more than tapering.

In addition, we serve a record for this quarter to optical power in the unique quantity sheet, China experienced this tremendous growth during the second quarter, driven by customer demand for high-power and pulsed laser, China’s revenue more than (inaudible) Q2 ‘09 and China accounted a gain for more than 10% of our [renewal] during the quarter. Our OEM in China continued to see strong end demand for 2D and 3D high-power cutting and welding applications. This new Greenfield built; by the way this seems to be preferred white source for material processing applications. We are also replacing the disc and YAG and CO2 lasers, given our superior product performance, reliability and efficiency.

We currently experience the slow down in the Chinese economy and the demand for our products is robust. However, we see that availability of certain components [indiscernible] and receiving third-party licenses, so the potential constraint in the future given to the particular growth of this region.

Our second quarter gross margin of 55.3% reflect the strong growth in our higher ASP product line in combination with leveraging IPG fixed core structure due to our vertical integration strategies.

Kilowatt of high-power lasers formed by IPG nearly doubled this quarter versus the same quarter last year benefited margin. By leveraging the advancement we can make in diode performance within core component cost, we can now target gross margins that are still able to preserve pre-recession. This quarter, gross margin also benefited from lower inventories reserves related to the same quarter a year ago.

Now, for a new product update. We are encouraged to buy contribution from the new product such as TCV laser, lasers which generated almost $1 million revenue in its initial release quarter. QCW lasers will be directly competitive with existing legacy lead pump solid-state lasers.

Green pulse lasers are in variance reduced stage also, with some large potential for module customers. Green CW lasers are in the final internal testing stage and I expect it to be in the customer's hand before the end of the year. We have an increasing book of quotes and customer inquiries for our unique single frequency tunable laser, leveraging our acquisition of Photonics Innovation in January.

And finally we are pleased to report that we have fully integrated the previously announced Cosytronic acquisition. The prototype is in final months or for lasers still first integrated high-power welding tools are progressing very well.

In conclusion, I would like to mention that we believe that the recent announcement by our competitors often increased focus on fiber laser development will only benefit IPG sales. IPG helped pioneer the field of fiber laser for high-power (inaudible) applications in metals processing for almost a decade and beat competitors, only now turning their attention to this opportunity. We believe this will help relegate the commercial market opportunities and help IPG distinguish itself with superior products offering versus the potential competitors. Fiber lasers continue to gain traction and have a distinct advantage to raw materials such as aluminum, copper, brass, stainless steel and non metals that cannot be cut effectively with traditional lasers. IPG collaborates with many OEMs and integrators worldwide o deliver best-in-class processes and systems for many applications. With that, I will turn the call over to Tim.

Tim Mammen

Thank you Valentin and good morning everyone. Our results for the second quarter reflect an improvement in our end market’s growth within material processing, excellent Chinese results, growth in Europe, the US and the rest of Asia excluding Japan and continued adoption of our fiber lasers which still only represent approximately 10% of the total materials processing laser market according to Optech consulting.

Furthermore, the operational leverage and profitability that IPG demonstrated this quarter is evidence of our differentiated laser technology, strategic pricing strategy and vertically integrated business model.

I will review our end markets, products and application next. Afterwards, I will follow with the summary of our income statements and balance sheet and close with our guidance.

Materials processing reported an outstanding second quarter, growing revenue 90.8% on a year-over-year basis and 34% on a sequential basis. In total, materials processing which is IPG’s largest market contributed 85.1% or $57.3 million to the second quarter’s consolidated revenue.

Within this segment, IPG’s manufacturing, automotive, heavy industrial, aerospace, consumer and electronics end markets. Growth in demand for high power lasers for cutting and welding and pulse lasers for engraving and marking applications were the major drivers behind this period’s robust performance.

For the second quarter, the advanced applications market which includes test and measurement, instrumentation, sensing and defense applications as well as scientific research and development represented 8% of total revenue or $5.4 million.

Revenue decreased 5.3% year-over-year and increased 15% sequentially. As we have stated previously, orders are less predictable in this market. We do continue to have a number of 10 kilowatt single-mode lasers, laser orders in hand that when shipped to customers later this year will meaningly contribute to revenue.

Medical sales comprised 3.7% of total revenue or $2.5 million. Sales to the medical application market grew by 31.9% on a year-over-year basis and 28.6% sequentially. This solid performance comes on the heels of the first quarter where medical sales more than doubled on a year-over-year basis. We’ve had some success in diversifying our medical customer base driving sales of low power lasers. We will continue to seek in our earnings with strategic medical device vendors and other OEMs. For the second quarter, sales to the telecommunications market decreased 24.2% year-over-year and grew 15% on a sequential basis. This segment comprised 3.2% or $2.1 million of our total revenues. We continue to experience weakness in Russia due to the timing of orders from long-haul broadband access and cable TV resulting from the merger between Ross Telecom and seven regional telecom operators which received shareholder approval at the end of the quarter.

However, sequentially the telecommunication sales improved and we did receive a sizeable Japanese telecom order in July and look forward to additional orders in the coming quarters. The catalyst for growth in this sector will depend on our ability to sell complete 10 Gig and 40 Gig DWDM systems in the CIS region.

From a product line perspective, high power fiber lasers rebounded nicely from the first quarter coming in as $23.6 million or 51% year-over-year growth and reflecting a 39% sequential improvement from Q1 2010. Strength across materials processing including cutting applications underscored these results as did our exceptional performance in China with added strength in Europe and Latin America.

We had a very strong quarter for pulsed lasers with sales of $22.8 million driven by the improving demand for materials processing applications particularly marking and engraving pulsed laser sales grew 129% year-over-year and 34% sequentially.

As Valentin mentioned earlier, we are pleased to report that second quarter sales of pulsed laser represents an all time record for IPG. Our low power lasers which are primarily used for medical applications and to micro materials processing were up 70% year-over-year to $4.8 million and increased 7% on a sequential basis.

Medium power laser sales had $4.8 million for the second quarter grew by 12% year-over-year and 19% sequentially. Microelectronics, printing and centering applications continue to support performance of this product line.

All of our geographies posted stronger results against the back drop of an improving macro economy. Asia and Australia contributed 41.7% of total revenue, the regions revenues increased on both the year-over-year basis and a sequential basis by a 112.7% and 40.3% respectively.

China, in particular, generated exceptionally strong results driven by high-power and pulsed lasers used throughout materials processing activities to support that countries double-digit economic growth.

Keep in mind that IPG started selling high-power lasers in China only in 2009 and therefore the prior year results reflected lower sales volumes of high-power lasers. We do remain a bit cautious on Japan which under performed the overall Asian geography due to continued delays in Japan’s overall economy.

Europe represented 34.3% of overall revenue during the second quarter. Revenue increased 52.3% on a year over year basis, and the 29.7% sequentially after a soft first quarter of 2010. Germany and Italy continued to deliver consistently solid results.

Our North American market grew by 31.4% on a year-over-year basis and 18.6% sequentially, amounting to 23.5% of IPG sales, growth in materials processing and specifically high powered cutting lasers and pulse lasers for marking engravings, contributed to this quarter’s performance.

As with Japan, we continue to remain a bit cautious with United States given continued macro head wins although recent order flow has improved and we are waiting on a few significant orders.

In the advanced applications, on going projects R&D and the timing of funding has limited activity in 2010. The rest of the world made up 0.6% of total sales.

Now turning to the income statement, total sales of $67.3 million increased nearly 67% year-over-year and 31.4% sequentially and exceeded our guidance for the quarter of 57 million to 62 million. Gross margins improved to 45.3% for the second quarter, compared with 29.1% in Q2, 2009 and 40.1% in Q1, 2010.

Gross margins benefited from an increase in sales and production part of which was placed in inventory as well as lower inventories compared to the same quarter in 2009. In addition, we are starting to benefit from improved margins on new products and accessories which we are manufacturing in greater quantities.

SG&A expenses in Q2 were $12.3 million or 18.3% of sales, compared with 8.8 million or 21.8% of sales in the second quarter of last year. Though inward patent litigation expenses were lower in the second quarter than in the first quarter of 2010, these legal costs increased year-over-year.

I have mentioned before these elements of our expenses can vary from quarter-to-quarter based on the level of activity.

Furthermore, with IPG’s improving financial performance, we continue to accrue for performance related bonuses as compared to 2009 when we did not. Keep in mind that we did not accrue for performance rate bonuses in 2009. We had a 2.3 million net foreign exchange gain during the quarter, compared with a 0.5 million net foreign exchange gain during the same period last year. With regards to the indemnification, the Markman hearing was held early in June 2010, but to-date, the district court has not issued a decision on the claim constructions asserted by IPG and IMRA. As such, there has been no court action on any substantive matter so far. The trial is still on track to begin on August, the 24th, 2010.

We continue to expect to incur significantly higher legal expenses this year especially in Q3 related to this case as we vigorously defend IPG against the claims in this lawsuit. We are pleased to report that IPG has settled all patent infringement claims made against the company by CardioFocus as well as IPG’s counter claims against CardioFocus by mutual agreements. The settlement did not and will not have any impact on IPG’s financial statements or condition. This settlement brings to a close. The claim is filed against IPG in February 2008.

R&D expenses were consistent year-over-year at $4.7 million or 7% of total revenues versus $4.7 million or 11.7% of total revenues for the second quarter 2009. The two reporting periods are comparable on an absolute dollar basis as IPG continues to invest in new products and internally develop complementary accessories.

Total operating expenses for the second quarter of 2010 were $14.8 million compared with $13.1 million for the same period last year. Again, incrementally higher litigation costs, bonus accruals and selling expenses contributed to this increase. We continue to expect quarterly operating expenses to be approximately $15 million going forward.

We estimate that if exchange rates had been the same as one year ago, sales in Q2 2010 would have been $2.6 million higher, gross profit would have been $1.4 million higher and operating expenses in total would have been $0.1 million higher.

Second quarter operating income was $15.7 million or 23.4% of sales compared with an operating loss of $1.3 million in the second quarter of last year. Operating income includes stock-based compensation charges of $793,000 and $635,000 in the second quarter of 2010 and 2009 respectively.

In the second quarter of 2010, $151,000, $520,000 and $122,000 of stock-based compensation charges related to cost of sales, SG&A and R&D respectively. Our tax rate for the second quarter of 2010 was 33.2%. The slight increase in the effective tax rate is due to the settlement of prior year taxes related to a change in the registered status of our Chinese subsidiary.

We expect our full year effective tax rate to be approximately 32.5%.

Finally, we are pleased to report second quarter net income of $10.3 million or $0.22 per diluted share compared with a net loss of $1.2 million or $0.03 per share for the second quarter a year ago. The $2.3 million net foreign exchange gain during the second quarter benefited diluted earnings per share by $0.03 after tax.

Now turning to the balance sheet. Our cash and cash equivalents increased by $6.2 million sequentially to $90.7 million at the end of the second quarter. Cash generated from operations in the second quarter was $15.6 million. For the second quarter of 2010, inventory was $54 million, up 2% from yearend excluding the impact of foreign exchange. As IPG continues to see improving global demand for our products, we will incrementally add to inventory to meet the needs of our customers.

Accounts receivable were $39.9 million at the end of the second quarter or 59 days sales outstanding compared to 30.4 million at December 31, 2009 or 50 days sales outstanding. The accounts receivable increase is due to higher sales this quarter and the timing of the shipments at quarter end.

Capital expenditures totaled $12.8 million for the first half of 2010 including the Korean building that we acquired during the first quarter for $2.5 million to aid with the selling of high power fiber lasers throughout Asia. While, we continue to target capital expenditures for 2010 of approximately $25 million including a portion for acquisitions, this amount could increase slightly towards the end of the year if sales growth continues and capacity utilization improves further.

This leads us to our expectations going forward, we exited the first half of 2010 with solid momentum in most of our end markets, product lines and geographies, underscored by a book-to-bill greater than one and over 500 kilowatts of high-power lasers sold.

Global adoption for fiber lasers continues to favorably impact our pipeline of opportunities while pricing has been more stable. IPG business model is well positioned to meet the increasing global demand for fiber lasers, introducing new and innovative lasers, penetrate complimentary markets, service our installed customer base and as always capitalize on new opportunities to expand our customer base and displace existing laser and non-laser technologies in a wide range of applications.

Now, let me provide you with our guidance for the upcoming quarter. For the third quarter of 2010, IPG Photonics expects revenues in the range of $69 million to $75 million. The company anticipates earnings per diluted share in the range of $0.19 to $0.25 that is based on 47, 333,000 diluted common shares which include $46, 220,000 basic commuters outstanding and 1,113,000 potentially dilutive options. The EPS guidance includes higher plant legal expenses related to the upcoming IMRA America pattern trial.

This guidance is subject to the risks we outlined in our reports with the SEC and assumes that the exchange rates remain at present levels. I want to reiterate that we do not attempt to forecast gains or losses related to exchange rates.

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

Question-and-Answer Session

Operator

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

Avinash Kant - D.A. Davidson & Co.

First question, about China. Clearly China has seen a very strong growth. Could you give us a little bit of color about whether that growth has been a bit gradual or has it been a result of some recent wins that you've had over the past quarter or so?

Tim Mammen

It clearly it is not gradual. The rate of growth there has accelerated. I would say that there are several main OEMs who have substantially increased their purchasing of both high power lasers for cutting and welding applications and also pulse lasers for marking applications. We have fined large agreements for multiple 100 unit orders of pulse lasers and that has helped really propel the result from that area forward.

Avinash Kant - D.A. Davidson & Co.

So, Tim, if you were to say, your design and wins have been much stronger lately in China?

Tim Mammen

The design winds?

Avinash Kant - D.A. Davidson & Co.

Yes, or the wins at the customers have accelerated?

Tim Mammen

Yes, I think the penetration overall in China has really started to train to gain traction don’t forget as well that we only started selling the high power lasers there in the last year or so. So, there is a lot of process development work that our customers have been doing, there is a lot of R&D being going on in relation to that and as we have expanded the service and support and sales people, we have been able to penetrate quickly in the last six months or so the high power laser market as well as see a rapid rebound and increase growth of pulse lasers.

Avinash Kant - D.A. Davidson & Co.

So would you say that the growth in China is driven primarily by high power or pulse, or both at this time?

Tim Mammen

It’s right across all the product line; its high power, its pulse lasers, it’s the new QCW Lasers and there are also significant orders for some of the medium power lasers as well. One thing we have started to make progress with is obtaining blanket order export permits and licenses for certain customers that has enabled us to ship more frequently although there are a number of export licenses for other customers we are still waiting on.

Valentin Gapontsev

Yes whichever more those (inaudible) which still wait in licenses so this only cuts the growth in China sales.

Avinash Kant - D.A. Davidson & Co.

Okay and any color on adoption at the key automotive manufacturers? I know you were expecting some meaningful orders or expansion at some of the European guys. Any color on that?

Tim Mammen

I think the automotive sector had a solid quarter in Q2. There’s no 20 or 30 units sales out there, but our traction and our penetration across the board whether it be in Europe, in the US of course the final assembly plants the Tier 1 and Tier 2 suppliers and indeed in China and Japan continues the pace. We are not going to report on any specific customers.

Operator

Our next question comes from Paul Thomas with Bank of America. Please proceed with your question.

Paul Thomas - Bank of America

So, on the September quarter guidance, that $72 million at the midpoint. In the past, you've talked about gross margin targets that would have been in the high 40s, maybe 48%, 49% range. What sort of range should we be thinking here? And then, in addition to that, I guess, what would get us kind of up into that 48%, 49% range? Is it further ASPs or is it more inventory turns or what might make that happen?

Tim Mammen

So first of all, certainly we are really pleased to get the margins back up above 45% I think it’s quite remarkable given some of the ASP declines we’ve seen over the last 18 months. So it’s very pleasing. I think the cost initiatives that Valentin has put in place to reduce the cost of diodes, improve the efficiency of the diode so we can use fewer of them and develop the accessories has really driven that and then we’ve capacity utilization improve. Of course, in the near term as revenue step up, we would expect and hopefully gross margins will improve beyond the 45%. I'm not going to provide specific guidance or a target of 48% or 49%, I think we'd like to see some incremental improvements, as revenue grows and then one thing I will caution about coming into next year and after which is we may have to start adding a little bit of capacity, because clearly our utilization levels are improving, but if you run a model as I said on the last call, on the current cost base, of course you can see gross margins coming up to 47%, 46% and then the near term, we would hope to get up to that level.

Again as well as though some around product mix can change from quarter-to-quarter if we suddenly see a ramp-up and medium power related sales which have nice margin profiles, so then we could see some benefits to that. So it’s a real mix, and its number of different factors go into it.

Paul Thomas - Bank of America

Okay, and then maybe on the utilization rate. You commented about having to expand capacity. Where is your utilization rate at right now and at what level would you think about adding more capacity?

Tim Mammen

Overall, utilization has moved up from just about 50% to closer to 70%, we previously said that as revenue tends to about $80 million a quarter, we'll need to stop planning to add capacity. At the moment we have some plants which are operating at higher capacity and others at lower capacity, so our first strategy which has already been implemented as being to move production a little bit out of Europe and into the US where capacity utilization is lower to meet that demand, if we are going to start producing some of the products for Asia over here for example. So, the immediate plan is to improve the efficiency of those plants that are underperforming a little bit and take some of the stress off those plants at the moment that are having to supply product. I would say that coming into the end of this year you will see our CapEx plans for next year step up from where they are right now. We cannot at this time provide specific numbers or even estimates of where we think that will go to.

Operator

Our next question is from Mark Douglass with Longbow Research. Please proceed with your question.

Mark Douglass - Longbow Research

Good morning gentlemen and nice quarter; you're already back above prior peak. Tim, I assume orders were tracking through July similarly to what they were like in the second quarter?

Tim Mammen

We have not seen any significant change in order flow through July and we mentioned actually that we've actually seen some improvements in the US through the first four to five weeks of the quarter, and yes, no significant changes in trends around the rest of the world.

Mark Douglass - Longbow Research

Where in the US are you seeing it pick up? Is the lack of credit also hampering these things just overall, sales to laser-cutting OEMs?

Tim Mammen

No, I wouldn’t say that. I think first of all in [arts] equation, it’s across the board to pick up in the US. Again is across to all of the product lines, pulse lasers, low-power lasers. There are opportunities out there for medium power lasers and also the high-power lasers. The other part of it is that some of our European OEMs which we don’t see this is coming into the US but there is a lot of cutting equipments start coming from some of the European OEMs directly into North America. I wouldn’t say that, I haven’t heard of anybody say that the lack of access to credit has delayed an order. I think people potentially remain a little bit cautious through the second quarter.

(inaudible) any hearsay in the market about people not having credit to access the credit lines for leasing.

Mark Douglass - Longbow Research

Okay, that’s helpful. And then, also in the US, do you think people are just within terms are kind of waiting for the trade shows to kind of see what's out there and when people place orders? Do you hear a buzz that people might be kind of delaying plans to the back half of the year and it should really pick up in the US?

Tim Mammen

We haven’t heard of the specific, I think part of it was just the timing of stuff in the second quarter with projects taking a little bit longer, few more weeks to get approved. We haven’t heard of anything that’s been delayed by four or six months. I think is more just a process issue in terms of ordering. And I think they are waiting for the trade shows.

Valentin Gapontsev

And I can add only that we're now watching what is happened to develop new products, new applications. We are very successful in the very high-volume application with some of them we developed for US customers, so we expect that in next couple quarters ready to just order from these customers.

Operator

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

Jim Ricchiuti - Needham & Company

Tim, did you actually give a dollar number for legal expense you are anticipating for Q3 and I wasn’t if you provided that for Q2?

Tim Mammen

We did not provide it for Q2 and we did not update the number for Q3, for various reasons. I weren’t be giving a number right now.

Jim Ricchiuti - Needham & Company

Did you expected to be up significantly and it’s basically in your guidance?

Timothy Mammen

Yes.

Jim Ricchiuti - Needham & Company

And just with respect to the bookings strength that you are seeing, you mentioned that you see pick up in the US. It sounds like China continues to be strong. What are you seeing in Europe, in light of some people's concerns about the macro economy over there?

Tim Mammen

No real change in Europe. I think the whole credit crisis and euros own problems really have not affected day to day manufacturing in Europe. I think also in Europe, given in particular with Germany, the exports later of that economy, is continuing to benefit from the strength in the Far East. So we really haven’t seen any significant change in trends in Europe either.

Jim Ricchiuti - Needham & Company

Okay, and then, you made a comment about price stability. Is pricing stable both in the high-power laser as well as pulse?

Tim Mammen

I think the overall pricing strategy that we’ve implemented has remained stable as we see unit volumes to some of these OEMs step up. I mentioned there a couple of OEMs that we’re shipping probably or ramping up to ship 500 units a quarter on pulse lasers and on the high powered lasers, they’ve got customers who are taking five to 10 units a month. There is, because of those higher unit volumes, slightly lower ASPs but then we offset that as we’ve always hoped to do so by improving the absorption, by increasing output.

Operator

Our next question comes from Jiwon Lee with Sidoti and Company.

Jiwon Lee - Sidoti & Company

Now, you've made two acquisitions this year. Remind us again how do you expect those acquisitions to help to expand product line, and I think you were expecting some meaningful revenue contributions from this side sometime in next year. Are we on target?

Valentin Gapontsev

We expected from this acquisition very serious in Korea, in the sales, even this year we have started such [options] that we received from our very potential, very prospective customer. So ultimately very high, so next year, we expect very high returns from these two bolt-on acquisition especially from acquisition of Cosytronic acquisition.

Jiwon Lee - Sidoti & Company

That's helpful. Since you are still gunning for more acquisitions, what is on the horizon for you?

Tim Mammen

Specially, talks about any other acquisitions, our overall strategy remains to look our companies that we can easily integrate that have a technology that we could use with our light source, potential other acquisitions maybe to expand our global reach and also for the duration of both the acquisitions we made this year fall into those categories with the COSY Seam-Stepper providing us an entry into the welding market and the Photonics innovation expanding the product line today into different wavelength.

We do not envisage at this point in time making a large channel type of acquisition because we think that difficult to integrate there are cultural issues around that so want to make a success of these two acquisitions and then hopefully identify other value adding propositions out there.

Jiwon Lee - Sidoti & Company

And on pricing, obviously the ASP year over year is on a down trend. But given the demand outside of the volume discount you're giving out on large orders, has it stabilized?

Tim Mammen

Yes, that the pricing has basically stabilized within the discount parameters that we gave we have not seeing a need to reduce those prices any further. We believe furthermore that value that we’re now providing with the technology high powered laser being priced between $30 and $70 depending upon the final output power has really driven some of the acceleration and adoption and then given the lower maintenance cost and lower total cost of ownership, it’s a particularly propelling, particularly compelling case that we can present to potential customers now.

Jiwon Lee - Sidoti & Company

On the competitive landscape, in the past there were some competitions on the pulse laser side. Could you talk a little bit about that competitive landscape changes at all, and/or anything on the high-power horizon?

Tim Mammen

So I think the pulse laser customers are still out there. The only way they can try and compete is on price that we stood at. They can't really compete on prices that we’ve got all of the volume manufacturing and ability to price our product and make a profit on it. So, they are out there but I’d say there’s a lot of our customers who have continued to buy from market because we’re the only people who can meet the total unit volumes and the quality and reliability of the product.

Valentin Gapontsev

And this year, we expect increase in sales price for pulse laser minimal three to four times to compare to 2009 twice carried than it was 2008 when we had the fixed sales. It decreased the rate of cost, decrease a little price on this laser is not practical out of constitution at both. And see here, but the decrease of price wasn’t for the count from lower margins, it was a result of where you’ve had worked to decrease cost manufacturing, cost of such pulse laser that’s a very good decrease savings last year and this year for forward pressure, we're seeing the same margin, very high margin but we won’t market so now our trends in market the pulse laser increase very essentially this year.

Jiwon Lee - Sidoti & Company

And lastly for me, in the past within materials processing, you've given some insight as to which end markets are showing strength or weaknesses. Could you sort of provide similar colors within your materials processing, especially with the cutting and welding in mind?

Tim Mammen

General trends in terms of sector, the automotive general manufacturing are all stronger than its really cutting, welding and marking and engraving that are the key drivers of the growth.

Operator

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

Joe Maxa - Dougherty & Company

Tim you mentioned you expect OpEx level to remain around $15 million per quarter. Does that include the legal expenses?

Tim Mammen

Yes, it does.

Joe Maxa - Dougherty & Company

So with $15 million and gross margins around your 45%, I'm just looking at the model, you're going to have, I'm coming up mid to higher end of your guidance, there was some thought that, or some talk, that your gross margins could expand from 45 in the near term. So are we looking at we should be near the high end?

Tim Mammen

Of what?

Joe Maxa - Dougherty & Company

Of your guidance? What would get you down to the lower end I guess?

Tim Mammen

Joe I can’t make any determinations on whether you should be building a model of the high or low end product mix as it depends how much inventory is that it will consume, because that will drive the absorption rates we clearly are adding some indirect label depends how quickly they become efficient or not efficient. So it’s a number of different factors in there.

Joe Maxa - Dougherty & Company

Are you expecting a typical fourth quarter seasonality this year?

Tim Mammen

There is nothing at the moment to assume that it’ll be any different than the (inaudible) blows up like it did in Q3, 2008. Typically we see increased traction in the CIS and then some budget spending throughout the world. So there is no reason to think that that would not happen at this point in time.

Joe Maxa - Dougherty & Company

Right. Also wanted to ask on your new products, that you touched on them briefly, million dollars in one of the product lines, I think. Can you give us an overall update of how those new products are tracking, again? Maybe refresh what you said earlier?

Tim Mammen

Say the QCW lasers which are a low average power laser with a high peak power that runs into the kilowatts that is probably the most successful product launch in the first quarter. That’s the one that hit to almost a $1 million in sales. There are lot of applications there in the micro processing arena that should quickly displace (inaudible) pump lasers which are particularly inefficient. So we are very hopeful how that’s going to trend quickly and then we’ve got the pulsed green laser is released as a few unit sales of that sort have occurred that those ongoing testing, and on the continuous way of green laser, that’s close to completion. With one of the acquisitions we just hope you got a small order, nice ASP order for let’s say for one of the new products at the low power special signs to a single frequency to work single frequency lasers. Some of those new products that are clearly performing better than others, but we are hopeful that they would all over the next 12 months start to improve through dramatically.

Operator

Our next question comes from Ajit Pai with Stifel Nicolaus.

Ajit Pai - Stifel Nicolaus

A couple of quick questions, actually three. The first one is on China. You saw some pretty significant strength there. So. could you discuss your China channel strategy a little bit, about what's changed over there in terms of the mix? And on China itself, you talked about getting open orders for certain customers where you can ship much faster and not for other customers. So, could you give us some color as to the significant orders? I think you mentioned hundreds of units from one customer, an OEM there, what kind of OEM is it? And also, you know, Han's Laser, whether you consider them more of a competitor or more of a customer in China, and then I have two other questions

Valentin Gapontsev

This is more trended by (inaudible) so we have such big orders as they growing very fast. And in terms with all competition but all power (inaudible) customers.

Tim Mammen

I think your first part of the question Ajit was what sort of changed, now first of all we did make a management change in China over a year ago and Bolton somebody as we did in Japan it has been in the laser industry for 20 years, they have built out substantially the sales and service and support and also use that knowledge and industry experience to really drive us forward as a serious supplier of lasers in that country. I think on top of that there is a lot of developments and process work to different applications that’s happened over the last six to nine months and often when those developments in process is come to an end, you do see a initial step up in revenue as people start ordering multiple units and the last side of the strategy has been to start selling the high-power lasers where for a couple of years we’re already selling pulse lasers. So it’s a combination I think of all of those issues and strategies reaping benefits.

Ajit Pai - Stifel Nicolaus

Got it. The second question would be sort of looking at the advanced application side. I think while on a year-over-year basis your revenues were down, on a sequential basis it was up. I think Valentin has talked about a couple of very large high-power orders over there. Have those orders shipped already and what are the potential of further sort of momentum in this particular area, especially for defense applications, what's the probability of something happening over there in 2011?

Tim Mammen

The answer to the first part of the question is the single-mode high-power lasers have not shipped yet. We’re expecting or hoping to ship one of them this quarter and the remaining two, or maybe three in backlog by the end of the year. So that should help the advanced application revenue in the second half of the year. I think that forecast at the beginning of the year was more of a year of consolidation around advanced. There’s no clear visibility into anything in 2011 at the moment. I think there are some funding constraints and ongoing R&D. There is a one multiple kilowatt opportunity, its below 20 kilowatts but I think we’d hope to get an order for before the end of this year, but there’s nothing specific we can provide about the multiple ten units orders for 2011 at this point in time.

Valentin Gapontsev

And that’s very advanced application, perhaps a tight walk. We need to in our business plan, we never take in take in account the one application business and see it.

Ajit Pai - Stifel Nicolaus

Got it. But it has potential to become very material if you start getting defense-oriented orders, right, as a percentage of your business, when they start coming in, and right now they haven't started coming in high volume. The question is do you expect them to start coming in, in the next 18 to 24 months? Or you think that the timeline is going to be greater than that?

Tim Mammen

Just only we can say at this point in time as to when it will be. I mean it would hopefully increase that as advanced applications revenue but, the largest part of the market that we categorize continues to be materials processing which is already a multibillion dollar market so we have to contribute to execute on penetrating that. You are right that if you suddenly get 10 unit orders for single mode kilowatt lasers that should increase the advanced fiber. I don’t think advance will ever get up to 40% or 50% of our revenue at least you can’t even make that determination right now.

Ajit Pai - Stifel Nicolaus

Got it. Then the last question is just looking at the cost structure. There were two initiatives that you talked about over the past couple of years in improving your margins. One initiative was increasing the wattage per diode, and there were transitions going on over there, so could you give us some idea of the pipeline and the mix right now in terms of 9 watts versus other diodes, as well as in the future, whether there are already even higher-powered diodes that are on the calendar for 2011-2012, and whether they save costs or they don't.

And the second initiative you talked about was integrating the number of components that you are buying externally, trying to produce them in-house. So I wanted to get some color as to whether most of the initiatives that you had on your plate have already sort of been reflected in margins or they are going to continue to be reflected in margins going forward?

Tim Mammen

So on the downside, I think we’ve transitioned now for the pulse lasers to the new chips which are being packaged into a 10-watt package and then on the high power lasers, we’ve now moved up from the 20-watt to 30-watt.

I think all of you is that 30-watt is probably optimum for all the CW high power lasers. For example on the QCW lasers, we’re planning in using the newer PLD 60. So that 60-watt diode, so that transition is coming to full implementation. We were still using some of the older PLD 20s during the first half the year, but the proportion has come down significantly.

In terms of the other accessories, we really are seeing those start to flow through into the business model and let’s say we’re using 80% our own accessories now? Probably something like 80% of our own accessories in this point in time.

Valentin Gapontsev

And with diodes also take in mind that with increase of volume, price per watt is going down very essentially. This year we will produce two times more diode than last year, in terms of price per watt, we maybe 50% compared to last year. If not we still have enough reserve and probably grow the volume also would give us a very big benefit in the margins. Other parts and also components in the parts we produce in the (inaudible) also margin depends and cost depends only from volume. So to increase the volume of margins have to go up, it is very essential.

Ajit Pai - Stifel Nicolaus

So, if you've seen this drop in cost and it's not being fully recognized in this quarter, it's going to come through in the third and fourth quarter, and you're talking about stable pricing and you're looking at much higher volumes, there's no reason why your gross margin should be expanding materially over the next couple of quarters, is there?

Tim Mammen

I think we did say that we would hope to achieve some gains on gross margins, I think we are just cautious about giving specific numbers out there. As we have always said with the capital equipment business that we think is going to be difficult to get up into the upper 40s and then 50s, we don’t think on a capital equipment business is necessarily sustainable in the long run.

I do think we have done this huge amount of work on the cost side, I think it was Andrew Carnegie who said that if you after the cost, the rest of the business will look after itself. So I can give Valentin no higher compliment that he must have been now reading some of his books or decided to follow him.

Operator

(Operator Instructions). Our next question comes from C.J. Muse with Barclays Capital.

Unidentified Analyst

Hi, it’s [Olga] calling in for C.J. thanks for taking the question. On the prepared comments, you talked about potentially constraint components in the Chinese end of the market and that might limit the ramp there.

Can you talk about which components they are and how you see those limitations getting abated a little bit either through yearend or into 2011? And then in terms of acquisition Cosytronic and production of your new welding tool that’s fully integrated, are you seeing any sort of pushback from previous integrators or OEMs you had sold in to only from the laser side not that you are essentially competing in certain parts of the business?

Tim Mammen

In terms of components supply chain overall talking about specific components I think it revolves around trying to manage a ramp up in production of all of the vertically integrated components that we have. So, it is clearly a challenge when revenue growing that quickly to ensure that we don’t step in the wrong direction in that management process. There is a big ramp in chip production, there is a big ramp in direct packaging production, the manufacturer for example; modulators for the pulsed lasers, couple was isolated. So it’s more a question of us having to manage all of that given our vertical integration. And then your second question is about the COSY Seam Stepper, we haven’t heard anything from any of the other OEMs directly. I think the reason we acquired COSY was it was a new welding process that had specific applications. And I think it’s targeted really to displace spot welding more than anything else while they necessarily compete directly with some of our OEMs.

Valentin Gapontsev

We are working in the application integration for new solutions, which were in the application when practical now with no competition at all. And we’re staying the way we look at the solutions up for the hour integrator to in the market application which now exists in the market.

Operator

Our next question comes from the line of Mark Miller with Noble Financial Group. Please proceed with your question.

Mark Miller - Noble Financial Group

Just a real quick question. There is a developing opportunity. One laser firm said it's become a sizable market in terms of the LED manufacturing opportunities in China. I was just wondering if any of your newer products will address that market or what's your thoughts about that market in terms of applicability for your firm?

Tim Mammen

In LED manufacturing, we are not addressed that…

Valentin Gapontsev

I never said, that would be different products and different application. Its commodity products, we are not interested in, we are not looking for. And the to the one product, that LED is not a commodity product for a big company like Sony.

Mark Miller - Noble Financial Group

I was thinking more about the manufacturing process, the scribing application. Just finally, in terms of your growing cash position, I understand you might want to leverage that for your growth opportunities. Is there a point when you start thinking about buying back shares?

Tim Mammen

We have not contemplated that at this time I think the rate of growth and working capital requirements have to be managed, so we don’t know specific plans to buy-back shares at this point in time.

Valentin Gapontsev

I didn’t get your LED question, I think there are some process it’s particularly know in China but in Korea on the OLED which is being used in the manufactures some of the new flat screen TVs where we are supplying equipments into that manufacturing process I have not heard of anything specifically on the mass manufacture of LEDs in China that we’ve got any wind there.

Mark Miller - Noble Financial Group

I think that's for scribing and dicing applications, what people are focused on, some of the other laser firms.

Tim Mammen

Just an insight into this fund.

Operator

Our next question comes from the line of Tom Bishop with BI Research.

Tom Bishop - BI Research

With regards to the ultra high-powered lasers that for defense applications, I was just sort of wondering how the testing is going and are you doing anything up in the 40 kilowatt and even 50 kilowatt range?

Tim Mammen

I mean we have supplied several lasers in the last two to three years in the 40 kilowatt and 50 kilowatt range. The testing and R&D is ongoing there. We’ve got a 50 kilowatt laser that’s in the field and I think it’s at 44 kilowatt laser with the Navy. There’s nothing specific to report on that at this point in time. They have had various trials with successfully shooting down drones and unmanned aircraft over the last 18 months or so. I think they’re very pleased with the performance of the lasers. We’ve heard reports that they got more uptime in testing these lasers than they’ve ever had in the last 10 years with other technologies.

Tom Bishop - BI Research

Nothing with, like, missiles? Or is that too far out there?

Valentin Gapontsev

It’s not our business at all. We in (Inaudible) in ways that some military people use for some experiment for, wanted for, okay. They buy and pay us money, that’s all but we’ve got to participate in that project we don’t plan to participate and you’ll see this in the next quarter.

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 Gapontsev

Ok thank you for joining us today. We look forward to speaking with you after the conclusion of this quarter for 2010 and we also report to you on great result in this quarter and also end of the year.

Tim Mammen

Thank you.

Operator

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

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Source: IPG Photonics Corporation. Q2 2010 Earnings Call Transcript
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