IPG Photonics CEO Discusses Q3 2010 Results - Earnings Call Transcript

Nov. 1.10 | About: IPG Photonics (IPGP)

IPG Photonics Corporation (NASDAQ:IPGP)

Q3 2010 Earnings Call

November 1, 2010 10:00 AM EST

Executives

Valentin Gapontsev – Chairman and CEO

Tim Mammen – VP and CFO

Analysts

Avinash Kant – D.A. Davidson & Co.

Jim Ricchiuti – Needham & Company

Paul Thomas – Bank of America Merrill Lynch

Joe Maxa – Dougherty & Company

Mark Douglass – Longbow Research

Olga Levinson [ph] – Barclays Capital

Jiwon Lee – Sidoti & Company

Ajit Pai – Stifel Nicolaus

Mark Miller with Noble Financial

Operator

Good morning and welcome to IPG Photonics Third 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 the management's or the company's intentions, expectations, or predictions of the future are forward-looking statements.

These forward-looking statements are subject to known and unknown risks and uncertainties that could cause the company's actual results to differ materially from those projected in such forward-looking statements.

These risks and uncertainties include those details in IPG 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 Investors section of IPG's website at investors.ipgphotonics.com/sec.cfm or by contacting the company directly. You may 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, November 1, 2010. The company assumes no obligation to publicly release any updates or revisions to any such statements. We will post these prepared remarks on our website 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. Valentin Gapontsev.

Valentin Gapontsev

Good morning, and thank you for joining us today. IPG turned in an excellent performance in the third quarter. Revenue grew by 74% year-over-year and 18.7% sequentially, and earnings per share grew by $0.28 cents from $0.05 cents a year-ago.

We also demonstrated the strength of our business model, achieving gross margins of 50%, up from 36.5% a year-ago and 45.3% in Q2. The demand for our pulsed and high-power lasers, which increased 87.7% and 83.3%, respectively year-over-year, was the chief growth driver for the quarter. We are continuing to see strong demand for high-power lasers for materials processing applications, which were up to 93.1% over the prior year.

The results of last quarter reflect the growing market acceptance of high power fiber lasers for cutting, which is the largest application for high power lasers, and welding also. This is indicated in part by the number of fiber laser cutters and welders displayed at the recent EuroBLECH Show in Hanover, Germany, one of the largest fabrication shows in the world.

At EuroBLECH alone, 17 companies demonstrated fiber laser cutting systems and 14 showed fiber welding systems and systems for other applications. The growing number of our cutting and welding OEMS shows how the perception of high power fiber lasers for materials processing applications has changed.

1.5 years ago, IPG highlighted the potential of fiber lasers for the 3 billion flat bed cutting market. Our competitors questioned this based on the alleged inferior quality of the metal surface after fiber laser cut. It is clear now that the problem is resolved. Our customers have achieved excellent results even with the thick steel of 20 millimeters to 35 millimeters. Therefore we believe that there no more technical obstacles for fiber lasers to win a substantial share of the laser cutting market over the next few years.

Also, we are working on new partnerships to further our application scope. One recent example is our strategic development project for hybrid fiber laser-MIG welding solutions with Lincoln Electric, the world leader in arc welding products.

During Q3, other new excellent results with high power fiber lasers have been demonstrated, including paint stripping, large surface cleaning, solar silicon implantations, battery welding, large scale construction, organic thin film processing for a new generation of large size flat screen displays, and high speed ultrasonic thick layer titanium cladding of metals parts.

In addition, we have delivered the first seam stepper welding systems which are being evaluated in a high volume automotive application. We believe that these new steppers can have a dramatic impact on the automotive welding market.

Growth was strong across all of our geographic regions in the quarter, with sales in Germany and China both growing at more than 90% compared to one year ago, primarily due to materials processing demand.

On past calls, I have discussed our expectations for some of our new products. Some of these products has begun to contribute to total revenue in the third quarter in a meaningful way, in particular our high power pulsed lasers and QCW lasers. We are a seeing significant interest from companies in the US to use our QCW lasers for retrofitting old lamp-pump YAG welding systems and the use of high power pulsed lasers in flat panel display manufacturing and deep engraving applications.

A new generation of our state-of-the-art green lasers and mid infrared lasers has started to contribute in IPG revenue at Q3 also. At last, our multiyear efforts to develop a new generation of world-class DWDM telecom systems have started to bring us some returns.

In Q3, telecom sales increased by 160% year-over-year and 144% sequentially. Our new 40G transponders and state-of-the art line of muxponders, multiponders and add-drop devices have passed field tests and were certified for use by our largest Russian operator, Rostelecom. We saw an essential improvement in US and Japanese telecom sales also.

Finally, I would like to take a moment to discuss our new partnership with the Russian

Corporation of Nanotechnologies, or RUSNANO, and our agreement to sell a minority interest in our Russian subsidiary, IRE-Polus, to RUSNANO.

RUSNANO was founded under Russian law in 2007 to advance Russia’s leadership in the field of nanotechnology. RUSNANO is focused on commercializing nanotechnology projects through its funding by the Russian Government.

According to the agreement, RUSNANO will purchase up to 12.5% ownership in IRE-Polus for $25 million. They have the right to purchase up to another 12.51% for an equal amount.

This partnership provides two major benefits to IPG that we believe improves our ability to grow sales in the Russian industrial and telecom markets. First, the capital from RUSNANO enables IRE-Polus to make significant investment in R&D and CapEx, further strengthening our position in this market. Second, we believe our partnership with RUSNANO should multiply the number of telecommunications, industrial and other important commercial relationships we have in Russia.

Under the term of the agreement IPG will maintain majority ownership and control of

IRE-Polus, and IPG has a call option after three years to buy back the minority stake at a predetermined value.

RUSNANO has a put option after five years to sell its minority stake to IPG at a predetermined value. A standstill is also in place limiting purchases of our common stock by RUSNANO. We expect this transaction to close in 30 to 90 days.

In summary, we believe that this new partnership with RUSNANO will help IPG to increase our penetration in Russia.

With that, I’ll turn the call over to Tim.

Tim Mammen

Thank you, Valentin, and good morning, everyone.

I’ll start off with a review of our end markets, products and geographic regions. After that I’ll follow with a summary of our income statements and balance sheet, and close with our guidance.

Our largest market, materials processing, continues to grow at an impressive rate. For the third quarter of 2010, revenues increased by 93.1% year-over-year and 17.9% from a strong Q2 2010. We are seeing a significant increase in demand from several of our major OEM customers for marking and engraving applications, particularly in China and

Japan. Worldwide sales for cutting and welding applications have also helped to drive much of the increase in materials processing revenue.

As numerous industries increase their acceptance of fiber laser technology, we have been effective in continuing to penetrate the materials processing market which is the largest parts of the addressable laser market.

The telecommunications market delivered the most impressive increase in sales of the quarter, growing a 160.5% year-over-year and 144.1% sequentially. After a slow start in the first half of the year due to the timing of orders for long haul, broadband access and cable TV, we had a stronger Q3 in Russia and also saw an improvement in US and Japanese sales compared to one year ago.

Advanced applications, for which order flow can be more uneven, declined 18.3% year-over-year, while growing by 5.6% sequentially. The year-over-year comparison showed a decrease in sales because of a strong Q3 2009, which included shipments of high value kilowatt lasers to two customers.

This market includes test and measurements, instrumentation, sensing and defense applications, as well as scientific research and development. We expect advanced applications performance will improve in Q4 as we expect to ship at least one of the 10-kilowatt single mode lasers that are currently on order. In addition, order flow for advanced applications in Q3 2010 improved, including orders for our proprietary diodes.

Medical sales were down 26.8% year-over-year and 44.4% sequentially. The weaker performance in Q3 2010 was primarily related to the timing of some high-volume orders for a major OEM customer in the US. Overall, even with the year-over-year decline in

Q3, sales to the medical market have continued to improve for the year-to-date compared to the prior year.

We have increased sales volume to a major US OEM customer and have been successful in diversifying our customer base, including sales to medical customers in Germany and Russia for surgical applications. We plan to continue to diversify our customer base with new strategic medical device vendors and other OEMs.

From a product line perspective, both pulsed and high power fiber laser sales were very strong in Q3. Pulsed laser sales increased 87.7% year-over-year and 33.5% sequentially, and high power sales increased 83.3% year-over-year and 6.5% sequentially.

Demand for marking and engraving applications for numerous industries continues to drive pulsed laser sales. Industrial manufacturers are increasingly demanding marking systems capable of applying serialized alphanumeric, graphic or bar code identification directly onto their manufactured components to reduce product liability and prevent falsification.

More recent high power pulsed lasers application sales are for flat panel display manufacturing and deep engraving including vehicle identification numbering. Orders for cutting and welding applications for general manufacturing and automotive drove much of the high power sales growth.

Cutting has been a particularly exciting growth area for IPG. The growth trend in cutting began in Italy more than one year ago and has led to increased penetration throughout the rest of Europe, China and the US. We have also received orders recently from machine tool customers in Japan for cutting applications.

As mentioned by Valentin, we have now developed a significant number of cutting OEM customers around the world, each of which recognizes fiber lasers as their preferred technology solution. These OEMs lever our sales force and a strong base from which we can further expand our customer base and grow sales of the largest application in materials processing.

In terms of welding, we are seeing growing interest in the US automotive sector for door and other body welding. We’ve sold many high power units to Tier 1 suppliers for welding of high strength steel for car seats in the US, China and India.

Medium power laser sales, which primarily consist of microelectronics, printing, consumer and sintering applications, increased 82.6% year-over-year and 7% sequentially. Specific sales in the quarter included medium power lasers for micro welding, thin metal cutting and marking for consumer electronics products.

Low power laser sales, used for mostly medical and micro materials processing applications, were down slightly year-over-year and 17.7% sequentially. The year-over-year and sequential declines were primarily related to the timing of orders for medical applications, which I mentioned earlier.

I will now review our major geographic regions. We had strong growth across all major geographic regions during the third quarter, reflecting the rebound in the general economic climate. Europe was up 71.8% year-over-year and 34.3% on a sequential basis. Q3 2009 was particularly weak because the European markets had just reached the bottom due to the recession.

With that said, during the past year, we have made significant progress in penetrating the market for cutting applications and that business, which I discussed earlier, has been very strong. In addition, European sales have been helped by growth in marking and engraving, welding and printing.

The North American market grew by 73.1% on a year-over-year basis, but was down slightly on a sequential basis by 5.6%. Much of the growth came from materials processing for welding, marking and engraving applications, and cutting. In addition, the telecommunications business in the US improved slightly in Q3 2010.

The sequential decline in North American sales was the result of a decrease in medical sales and a decrease in welding sales due to the fact that Q3 opening backlog in the US was a little weak. It should be noted that North American bookings in Q3 2010 were the strongest they have been for at least the past two years.

Asia and Australia grew by 76.7% year-over-year and 20.2% sequentially. China had particularly strong growth in Q3 due to the economic rebound and expansion of our existing low power and pulsed business for marking and engraving applications. In addition to OEMs in China purchasing lasers, we believe a number of our European customers are exporting our lasers in their systems to China.

Asia and Australia sales growth was also helped by stronger Japanese sales, which grew by 43.4% year-on-year and by 43.5% sequentially. Marking and engraving and welding applications were, in particular, strong performers in Japan. We also sold a 25 kilowatt laser in Japan for testing with copper welding and nuclear facility decommissioning applications.

In other Asian regions, we are seeing sales growth in Korea and in India driven, again, by marking and engraving and welding. Over for the year-to-date sales in Singapore, Taiwan and Malaysia have also improved.

The rest of the world, which represents less than a percent of our business, increased by a 126.4% year-over-year, but was down 33.1% sequentially.

Now turning to the income statement, total sales of $79.8 million increased 74.2% year-over-year and 18.7% sequentially, and exceeded our guidance for the quarter of $69 million to $75 million.

Gross margins improved to 50% for the third quarter, compared with 36.5% in Q3 2009 and 45.3% in Q2 2010. Several factors have driven this improvement in gross margin.

First, our total cost of sales only increased by 37.1% from Q3 2009 while sales increased by 74.2% due to the fact that absorption of manufacturing expenses has significantly improved with an increase in capacity utilization.

Second, lower-cost high power packaged diodes developed in 2009 are now being used widely in our products, particularly in high power lasers.

Third, product mix benefited from sales of medium power lasers and new products, which include high power pulsed lasers and QCW lasers. The cost of these high value-adding devices relative to their sales prices is lower.

Fourth, the volume of our lower cost, internally-produced high power laser accessories, which we previously sourced from outside vendors, has increased.

In addition, gross margin benefited from the fact that part of the increase in absorbed manufacturing expenses related to products that were placed in inventory and not sold in the quarter.

I’d like to mention that as part of the management and utilization of our worldwide manufacturing capacity, we have enhanced our capacity in Germany by shifting the manufacturing of certain components and products to the US and Russia. Russia is now manufacturing pulsed lasers in volume, and the US is manufacturing more pulsed lasers as well as key components used in the assembly of high power lasers that were previously made in Germany.

SG&A expenses in Q3 were $12.3 million or 15.4% of sales, compared with $8.5 million or 18.7% of sales in the third quarter of last year. Operating expenses include a $2.1 million net foreign exchange loss during the quarter compared with a $40,000 dollar net foreign exchange gain during the same period last year.

While SG&A expenses decreased as a percentage of sales, in absolute terms SG&A expenses increased, primarily due to an increase in salaries and benefits and accounting and legal expenses.

Salaries and benefits increased due to the accrual of performance-related bonuses while accounting and legal expense were higher in Q3 2010 compared to Q3 2009 due to litigation expenses related to the IMRA trial.

The IMRA trial did not begin on August the 24th, 2010 as originally scheduled. At this point, the court has not issued a Markman order on claim construction and it has not set the dates for a summary judgment motion hearing or the trial. Although a good amount of

pre-trial work has been done, we expect to incur significantly higher legal expenses when activity in this case picks up again as we vigorously defend IPG against the claims in this lawsuit.

R&D expenses were up slightly year-over-year on a real-dollar basis, but down as a percentage of sales at $5 million or 6.2% of total revenues, versus $4.6 million or 10% of total revenues, for the third quarter of 2009.

Our research and development efforts are focused on designing and introducing new and improved products, by increasing power levels, improving beam quality and electrical efficiency, decreasing the footprint and lowering the cost per watt of our lasers.

Total operating expenses for the third quarter of 2010 were $19.4 million compared with $13.1 million for the same period last year and include the $2.1 million foreign exchange loss mentioned above.

We estimate that if exchange rates had been the same as one year ago, sales in Q3 2010 would have been $1.7 million higher, gross profit would have been $0.2 million higher and operating expenses in total would have been $0.3 million higher.

Third quarter operating income was $20.5 million or 25.7% of sales, compared with $3.6 million or 8% of sales in the third quarter of last year. The foreign exchange loss mentioned was 2.6% of sales.

Operating income includes stock-based compensation charges of $914,000 and $783,000 in the third quarters of 2010 and 2009, respectively. In the third quarter of 2010, $272,000, $530,000 and a $113,000 of stock-based compensation charges related to cost of sales, SG&A and R&D, respectively.

Our tax rate for the third quarter of 2010 was 33%. We expect our full-year effective tax rate to be approximately 33%.

Finally, increased sales, manufacturing efficiencies, as well as relatively flat costs in other operating expenses increased third quarter net income to $13.2 million, or $0.28 per diluted share, compared with $2.3 million, or $0.05 per diluted share for the third quarter a year ago.

The $2.1 million net foreign exchange expense during the third quarter negatively affected earnings per share by $0.03 per share after tax.

In Q3, the German tax authorities completed their examination for the years 2003 to 2008. The tax settlement amounts related to agreed audit findings was less than the amounts accrued for uncertain German tax positions and had no material impact on the company’s financial results.

Now, turning to the balance sheet, our cash and cash equivalents increased by $6 million sequentially to $96.6 million at the end of the quarter.

For the third quarter of 2010, inventory was $64.9 million, up 22.8% from yearend, including the translation effect of foreign exchange. The increase in inventory is less than the increase in sales. We continue to invest in building our inventory in order to accommodate rising demand and unit sales.

Accounts receivable were $53.7 million at the end of the third quarter or 61 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 higher levels of shipments at quarter-end which also negatively affected days sales outstanding.

Despite the increase in inventories and accounts receivables, for the year-to-date we were able to generate cash from operations of $29.6 million and reduce our credit lines and long-term debt by $2.5 million. Cash generated from operations in the third quarter was $6.2 million.

I would also like to mention that in Q3, we extended our existing $55 million credit facility with Bank of America to June 2015. Before the amendment, the $35 million line of credit expired in June 2011 and the original $20 million term loan expired in August 2013. The outstanding balance on the term loan is $17.7 million as of September the 30th, 2010.

Capital expenditures and acquisitions of businesses totaled $17.8 million for the first nine months of 2010, including $5.1 million related to acquisitions of businesses. And we remain on target to spend approximately $25 million in capital expenditures for the full-year 2010 – sorry, including $5.1 million in Q3 of the $17.8 million.

Before I sum up and turn to guidance, I would also like to note that going forward the initial minority investments by RUSNANO in IRE-Polus that Valentin discussed earlier will initially result in approximately $0.02 per share reduction to earnings on a quarterly basis starting in Q1 2011, assuming a close date of January 1st.

This estimate has been calculated with reference to the following benefits and costs that we will have to account for. An increase in interest income in relation to the investment proceeds; offset by the following three items.

Changes in the value of the RUSNANO put and IPG call attached to the RUSNANO right to acquire an additional 12.51% of IRE-Polus; changes in net income attributable to the minority interest; and accretion and interest relating to the RUSNANO put on the original 12.5% investment.

In the future we expect that the increase in revenue and net income IRE-Polus achieves as a result of the strategic advantages of this partnership would more than offset this initial dilution.

The sales growth that we have achieved thus far in 2010 is the result of our continued focus on driving the proliferation of fiber lasers in existing and new applications, while further extending our leadership position in the markets we serve.

We expect that the sales momentum we have been building will continue through the end of the year and into 2011. Demand for our fiber laser technology is growing and our outlook is positive.

We will continue to focus on maintaining the high quality of our laser products while volumes continue to ramp up globally. And as sales grow, we expect to benefit from the significant leverage in our business model.

Now, let me now provide you with our guidance for the upcoming quarter. For the fourth quarter 2010, IPG Photonics expects revenues in the range of $80 million to $86 million. The company anticipates earnings per diluted share in the range of $0.30 to $0.35. That is based on 47.7 million diluted common shares, which includes 46,533,000 basic common shares outstanding and 1,167,000 potentially dilutive options.

This guidance is subject to the risks we outline 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 for your questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions).

Tim Mammen

It’s faded out.

Valentin Gapontsev

Hello.

Operator

Our next question is from Avinash Kant with D.A. Davidson & Co. Please proceed with your question.

Avinash Kant – D.A. Davidson & Co.

Good morning, Valentin and Tim.

Valentin Gapontsev

Good morning.

Avinash Kant – D.A. Davidson & Co.

Quick question; could you talk a little bit about the capacity that you have overall at this point and the capacity utilization [inaudible] examined your revenue growth, I was trying to figure out what kind of revenue growth can you achieve without requiring much capital investment in the near-term.

Tim Mammen

So, right now, on average for the year-to-date capacity utilization is between 70% and 75%. In the fourth quarter, I would say that it’s getting above 75%. We are now at the level where a year or so ago we said we would need to start investing again in capacity approximately $80 million of quarterly revenue.

We expect to make those investments, first of all, next year in Russia, where we will build a new facility. We will make some investments in Germany to a lesser degree and some investments probably on the diode fab in the US.

In addition to that, we plan to buy a new building in Italy, which will help with some of the manufacturing capacity for telecom products. So we are at a point in time now where we start to need to look at on those capacity investment decisions.

Avinash Kant – D.A. Davidson & Co.

So Tim, in that regard, would you have some idea about the CapEx that you could have for the next year? How should we model that?

Tim Mammen

We have not established a formal budget at the moment. I think we’ve discussed spending in the region of $35 million to $40 million, but that’s subject to a final budget.

Avinash Kant – D.A. Davidson & Co.

Okay. And did you give out the bookings number for the quarter? And could you talk a little bit about the book-to-bill that you had? And what do you expect in Q4 also in terms of bookings?

Tim Mammen

We did not give specific bookings number. The book-to-bill again was above 1. And I think that that is also reflected in the guidance that we provided. We are not providing a forecast on what we expect the book-to-bill ratio to be for Q4. The momentum that we’re seeing on order flow around the world has continued in October and that’s similar to the update that we provided I think on the last call.

Avinash Kant – D.A. Davidson & Co.

Perfect. Thank you so much.

Valentin Gapontsev

Our backlog increased very essentially and it’s enough to support our guidance in Q4 and Q1 next year also.

Avinash Kant – D.A. Davidson & Co.

Thanks.

Valentin Gapontsev

Also Q1 next year.

Avinash Kant – D.A. Davidson & Co.

Thank you so much, Valentin.

Operator

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

Jim Ricchiuti – Needham & Company

Hi, thank you, good morning. The question I have is with respect to selling expense down sequentially, and yet you showed very strong revenue growth. I wonder if you could just maybe elaborate on that and give us a sense as to where you see selling expense going forward?

Tim Mammen

It’s down sequentially a little bit because of the timing of certain trade shows and fairs, and also we had some demo unit reduction – a little bit of a reduction in demo unit depreciation, and we will continue to invest those demo units around the world. But it’s really a timing on certain of those expenses.

In general, I would expect sales and marketing expenses to increase in absolute terms as we invest in sales personnel around the world as we expand some of our footprint geographically. But those increase is in general, but much more moderate than the increase in total sales.

I think we’ve have spent a lot of money hiring sales people with specific specialties in the US, in Germany, in China in particular, in Italy, and in Japan. I think potentially one area we’re about to may invest in sales expenses now will be Russia, as we seek to increase the telecom and in particularly the industrial sales in Russia.

Valentin Gapontsev

And Brazil also.

Tim Mammen

And Brazil as well.

Jim Ricchiuti – Needham & Company

Okay. And while we’re talking about geographies, I wonder if you would give us a sense as to how big China represents as a market for you. I guess was it around 10% last quarter?

Tim Mammen

I mean China is it should be on the geographic sales map is almost 17%.

Jim Ricchiuti – Needham & Company

Okay. And then, final question, sounds like you’re making very good progress with cutting OEMs, and I wonder if you could tell us how many OEMs you have right now in the cutting market and say where that was a year ago?

Tim Mammen

I can’t specifically disclose or I haven’t calculated it exactly, but we’ve got tens of cutting OEMs and that continues to increase each quarter. For example, we know that there are four to five companies in Japan who has started to use our lasers in their equipment, who are transitioning from CO2. So we must be running at somewhere between 20 and 30 cutting OEMs, major cutting OEMs around the world. What was the second part of the question?

Jim Ricchiuti – Needham & Company

Tim, I think you’ve kind of answered it. I was just getting – trying to get a sense of it year ago that was a much smaller number. And I assume you guys will be ramping up over the course of 2011.

Tim Mammen

We hope so. Yes.

Valentin Gapontsev

I can say that year-ago we have not more than 1% or 2% of cutting market. Now we’re above 10% with our [inaudible] sales. We hope if we can reach, it will multiple many times is probably –

Jim Ricchiuti – Needham & Company

Okay, that’s helpful, Valentin. Thank you.

Operator

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

Paul Thomas – Bank of America Merrill Lynch

Hi, good morning. Sorry, I had some technical difficulties there earlier. The question came up earlier about bookings strength, and you mentioned that your strength continues through the end of the year and gives support to 1Q. I know you’re not going to give any guidance for the beginning of next year. But I’m just wondering at this point do you guys feel like you’re going to be sort of above seasonal growth going into next year or do you think we’ll return to more a of a seasonal pattern?

Tim Mammen

It’s very difficult to say at this point in time. But I think that given that we were relatively low on revenue in Q1 2010, the potential increase you’ll see year-on-year in Q1 2011 would be more than a normal growth rate. But we still – are always a little bit cautious about in the first quarter of the year in terms of like sequential growth.

Russia can always be very weak in the first quarter and then as well certain of the Asia economies with public holidays and other national events can also be a little bit weak. But I’d actually expect our year-on-year a bit stronger than normal growth, because Q1 2010 was still, relative to Q2 and Q3, a weaker quarter.

Paul Thomas – Bank of America Merrill Lynch

Thanks, that’s helpful. And then, maybe on the pulsed laser side, has the growth there been from existing customers are ramping their orders or has there been new customers coming into the mix?

Tim Mammen

Primarily existing relationships, some of which have been dramatically expanded this year in Asia, and also then a ramp back up of a lot of OEM, some of them have been our customers for over a decade. So in Japan, existing relationships saw a big rebound in the third quarter, as well as in Germany and the US. I don’t think there’s like a major new marking and engraving OEM out there, I think most of them have already been our customers for a long period of time, and there are no new entrants into the market.

Valentin Gapontsev

In Asia, we increased – we doubled practical quantity of our OEM customers. And in total – in quantity pulsed lasers this year, we tripled production from beginning of the year, practically tripled production and sales.

Paul Thomas – Bank of America Merrill Lynch

Okay, great. Thanks a lot guys.

Operator

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

Joe Maxa – Dougherty & Company

Thank you. Tim, I just want to talk a little bit about the gross margins. Where do you see that going from here? With a strong Q4, it looks like we might see that expand. What should we think about – I know it’s early, but next year as you start adding capacity, are we going to able to stick around with 50% level?

Tim Mammen

So first of all, I think we had some benefit in Q3 from inventory growth. The underlying gross margin was a little bit lower. I think in Q4, given that we’re not going to see a big uptick in our cost base, we have an opportunity to at least maintain and potentially improve a little bit the gross margins.

But coming into next year, as we’ve mentioned with the capacity additions, we remain – and I don’t want to start providing medium-term forecast about gross margin. I think we remain sort of optimistic as long as the business remains ready as we can still target being at the upper 40s and that sort of level.

There will be a lot of capacity that does start to get out and it’ll take us time to start to use that. Offsetting that then will be an increase in sales with some of the newer products that I mentioned have a lot of value add attached to them and good pricing and if volumes continue to increase. We certainly do not expect a deterioration in gross margins in the near term.

Joe Maxa – Dougherty & Company

Got it. Then just on this IMRA lawsuit, is that in your Q4 guidance, if that were to pick back up?

Tim Mammen

No, at the moment, because there is just no information out there about the trial and the trial dates, and absolutely nothing that we’ve received when that will happen. We actually have relatively low legal expense numbers estimated for Q4, just because we don’t think there will be much activity. I think it’s unlikely at this point in time that suddenly there will be a trial date set in at the beginning of December, particularly coming up to the holiday season. It may happen, but we think it’s unlikely.

Joe Maxa – Dougherty & Company

Okay. And lastly, can you give us – has there been a change in what’s called the – your end – kind of the end market verticals over last year or what has the change been? I’m just thinking of the – if we think about auto manufacturers or solar customers as far as if you can tell who the end users and what shift you may have seen, maybe you see your top –

Tim Mammen

I think we haven’t seen any real shift in terms of end use. We’ve just seen a continued expansion of a lot other relationships that we have, whether it’d be in the automotive, in general manufacturing, particularly in the diversification of the cutting OEMs, the rebound in marking and graving.

I think there are more and more applications that lasers are being used. And even in some of the more simple applications like marking and graving are now getting into deep engraving for vehicle identification number, that’s the newer application. We’ve seen the pulsed lasers used. And certainly initial stages of more diverse solar applications as well as this flat panel display opportunity.

We see a diversification of some of the applications. No real fundamental shift in the source of the business. So we haven’t got millions of dollars being generated from a industry that we didn’t have last year.

Joe Maxa – Dougherty & Company

Okay, thank you.

Operator

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

Mark Douglass – Longbow Research

Good morning, gentlemen.

Tim Mammen

Hi Mark.

Mark Douglass – Longbow Research

You were talking about EuroBLECH, what’s the – what was the tone of your BLECH, if you can kind of flush it out. And you talked about the number of – the increased number of OEMs incorporating your lasers. Was there a pickup of orders at the show or are people still being relatively cautious just in general about ordering high power cutting systems?

Tim Mammen

I don’t actually have much specific feedbacks from the show. I haven’t had a chance to get [inaudible] have any of the salespeople spoken to.

Valentin Gapontsev

Just typical, we do not sign any immediate with a big contract. But it’s very huge interest in this [inaudible] development of continued businesses that we have to EuroBLECH and now with the new show which would be [inaudible] business growth and our sales growth.

Mark Douglass – Longbow Research

Okay. On the sales and marketing side of things, Tim, can you talk about – it was mentioned before it decreased sequentially and some of that was just due – you said to depreciation and like. But how much of your sales are commission based? Is this not that high of a percentage, such that it really doesn't grow substantially with sales growth?

Tim Mammen

We have a program here which is more based upon growing sales. We don’t generally reward people by commissions; they get more of a bonus based program based up on the growth rates that they achieve. And those sort of accruals and payments in relation to that had already substantially got to the maximum amounts halfway through the year, so there was no sudden fundamental pickup in that amount in Q3.

I do note though that the year-to-date even though there was a little bit of a decline sequentially, selling expenses are up about 30% to year-to-date. So there is a little bit of a depth in Q3 shouldn’t be taken as a trend.

Mark Douglass – Longbow Research

Right. But then would you think anything incremental in 4Q, there shouldn’t again then be a large step up, because of –

Tim Mammen

No, the variable part of the compensation plans is all being accrued at the full amounts to sales people and who’s paid out halfway through the year. So it just didn’t result in a big pickup in the third quarter, because they had already started to perform extremely well through the first half of the year.

Mark Douglass – Longbow Research

Right. No, that’s fair, that resets beginning of fiscal ’11, then?

Tim Mammen

Yes.

Mark Douglass – Longbow Research

Okay, that’s helpful.

Tim Mammen

Some of the other comps, variable comps did pickup a little bit in Q3, because of the improved performance though. So that’s where it went to G&A amount, G&A lines.

Mark Douglass – Longbow Research

Okay. So we’re still looking $17 million a little bit higher maybe in 4Q operating expenses then?

Tim Mammen

I think it’d be pretty similar to Q3, yes.

Mark Douglass – Longbow Research

Yes, it was Q3, yes it seems to be implied in your guidance. And then, again, your incremental margins were 65% and your guidance looks to assume again very, very high incremental margins. Incremental margins assumed are, it looks like 65% in the 4Q. What kind of sustainability, probably not that sustainable, but still that’s a pickup from Q3, that’s kind of surprising.

Tim Mammen

Yes, those, we targeted before incremental margins I think in around the 60% range. There was a little bit of benefit, because you saw some utilization of capacity to build inventory. But anyway from 55% to 60% of this point in time is pretty reasonable.

When you start to add capacity next year, those incremental gross margins will come down a little bit for every dollar of revenue added. But we’re really are building or using our capacity at about the most efficient level that we have since the middle of 2008. And in 2008 we were continuing to add capacity before the downturn occurred using the funds from the IPO.

So there was a lot of investment that was putting to the business not just on manufacturing, but selling expenses, and now we’re really starting to see the return on that investment come through into the business model. And the rate of growth means though that we’re actually going to have to start investing again. So you’ll see some of that moderate a little bit coming into 2011.

Mark Douglass – Longbow Research

Right.

Tim Mammen

We’re very pleased. I can’t say anything else than other that. Both, gross margins and then operating expenses as a total percent of sales, even though we had to absorb some legal expenses in July and August, and the $2 million FX, negative FX impact in Q3. The results we’ve achieved even with those items I think was pretty good.

Mark Douglass – Longbow Research

Yes, I know that’s a pretty good incremental margins. Just final on working capital, obviously a big step up, certainly if you look at trailing 12 months sales at 43% or so. Would you expect that to kind of trend down? Do you have a kind of a target you like to work at for working capital maybe as a percentage of sales or cash conversion cycle?

Tim Mammen

The interesting thing was accounts receivable is not part of that due to shipments towards the end of the quarter. The timing of the accounts receivable can be a little bit skewed because of that.

Our accounts receivable days outstanding were actually no different really from June, although they’re up from December. In the fourth quarter of last year we actually managed to ship stuff out earlier in the fourth quarter. That benefited the days sales outstanding as of December. But June to September, we’ve not seen any real change in that number. And clearly we are consuming some working capital in relation to inventory. Hope that the increase in inventory, because we’re not seeing such a big step up in sales will moderate. We also have a lot of finished product that’s sitting in China that we hope to ship out in Q4.

In total, our cash cycle, this is interesting though, has actually come down, because offsetting the increase in accounts receivable and inventory, we’ve seen some benefit in relation to accruals which have gone up, because we haven’t paid those out. We actually have some deferred revenue and we’ve also collected quite a lot of customer deposits and prepayments which has helped to finance the inventory side.

We do expect some of that to turnover in the Q4, in particular in the Far East, where we will ship again some of those customers that wanted some prepayment. So there are two sides to the working capital equation. It’s not just the investments and inventory and accounts receivable, but offsetting that has been our managements on the liability side, which means that we have actually reduced our own cash cycle, the analysis that we’ve done shows.

Mark Douglass – Longbow Research

Year-over-year, yes. I just wonder if you have a kind of a target that you’re trying to work.

Tim Mammen

In inventory, we’re trying to target 2 times per year turning it.

Mark Douglass – Longbow Research

Okay.

Tim Mammen

And accounts receivable anywhere from an average of 60. To get the accounts receivable down to 50 is very, very good.

Mark Douglass – Longbow Research

Great. Okay, thank you.

Operator

Our next question is from Olga Levinson [ph], Barclays Capital. Please proceed with your question.

Olga Levinson – Barclays Capital

Hi, thanks for taking my question. I was wondering if you could talk about your current outlook for the overall laser – underlying laser market into 2011. Do you expect some level of growth? And also, where does fiber laser penetration currently stand and where do you see that moving into next year?

Tim Mammen

We’re going to have – the market surveys about next year are out. So I think given the overall optimism of all companies are demonstrating and the results that are being reported, there’s clearly been a significant rebound in the laser market. I think that overall people target a growth rate that is above GDP significantly for general – the general laser market anywhere from 7% to 9%, and for fiber to grow at a minimum of 20% within that.

We’re seeing nothing at the moment that would lead us to believe that that kind of growth rate in 2011 will not continue. I would estimate that you’re going to see fiber penetration probably have increased to between 12% and 15% from I think an average of 8% or 9% last year. And there is market analysis out there that shows that fiber laser penetration could get to an average of 30% in the medium term.

So none of those trends have really changed.

Olga Levinson – Barclays Capital

Got it. And then in terms of your OpEx outlook into 2011, any thoughts as to how that would track relative to your revenue growth?

Tim Mammen

Yes, I think we’re pretty much as we’ve targeted maintaining operating expenses in total below 25% of revenue. At the moment they’re at sort of 20% range. I think that continues to be a reasonable target for the company.

The thing we’ll have some unevenness on operating expenses depending upon when the IMRA trial actually occurs, but we’re not – we’re definitely not factoring again an increase operating expenses that will bring back above 25% of revenues. Our target is to make sure that we keep them below that level.

Olga Levinson – Barclays Capital

Got it. Thank you.

Operator

Ladies and gentlemen, due to time constraints and in order to reach everyone’s question, we ask that you limit yourself to one question and one follow-up at this time. Our next question is from Jiwon Lee with Sidoti & Company. Please proceed with your question.

Jiwon Lee – Sidoti & Company

Thanks and good morning. Could you comment a little bit more about the competitive landscape, especially on the high power front, cutting and welding, whether or not you are seeing some new products or players into this space? And if you could also comment on the pulsed laser side.

Tim Mammen

Clearly, people are making announcements about bringing out higher power fiber lasers. In truth, right now, we have not really seen anything at all from those people who have made those announcements. It remains very unclear as to the price points they can enter the market and the quality and reliability of their products.

I think that there is continued and increasing interest in trying to penetrate the fiber laser market, because the technology has been fully validated. It continues to argued that it’s going to be very difficult for people to compete with us given the quality of the light sources that we have and the cost basis that we’ve achieved, the electrical efficiencies, the performance of the lasers.

On the pulsed laser side, I’d say yes, there are more people who claim to be able to compete with us. But Valentin mentioned that we’re seeing a three-fold increase in pulsed laser sales. I think that’s probably an indication of they’re not doing particularly well.

Valentin Gapontsev

Yes, we do not do within market for pulsed laser increased in three times, maximum 50% to 70%. But our sales increased in three times, practical in quantity. So our market share even increased not decreased its price off about 40 companies which claim they have also pulsed laser fiber laser.

Jiwon Lee – Sidoti & Company

Terrific. Some laser companies recently have highlighted some opportunities in the LED space. If you can talk about on whether or not you are seeing some traction there or how do you feel about some potential revenue stream next year and beyond?

Tim Mammen

Okay. It’s a bit too granular for us, Jiwon. I don't think we've heard anything specific about the LED market opportunity I think in Korea and in a different market sector where we are more opportunistic about stuff as this. But it is the OLED market for flat screen display manufacturing we’re not sure about any manufacturers we’re speaking who are using our lasers for mass manufacturing of LEDs or where they maybe out there.

Valentin Gapontsev

LED market is absolutely different. It’s in fact is becoming commodity market. But the future volume – volume [inaudible] price, it’s not our field of activity. We’re making high power diodes and that so it’s different technology than LED technology.

Tim Mammen

People who maybe using our laser, we don’t know people using our laser.

Valentin Gapontsev

No, it’s different.

Jiwon Lee – Sidoti & Company

Okay, that’s helpful, thank you.

Operator

Our next question comes from Ajit Pai with Stifel Nicolaus. Please proceed with our question.

Ajit Pai – Stifel Nicolaus

Yes, good morning, and congratulations on a very solid quarter.

Tim Mammen

Thanks Ajith. Good morning.

Ajit Pai – Stifel Nicolaus

Yes, a couple of quick questions. I think the first one is just about the telecommunication sales. How sustainable is that to the rebound that you’re seeing? And you talk about both Russia and the US, so what’s going on in the US?

Tim Mammen

Diversification of some of the customer base introduction of new products, improvement in sales to some of our main – outside of the US to our main OEM in Japan. Those are the two main markets that we have. In Russia, we’re seeing really some initial penetration from these new products that we’ve developed and the deepening of our relationships there.

Valentin Gapontsev

We have a different product market approach in the US, in Russia, and some other countries. In the US, we still sale in the unique but high power amplifiers, the other new kinds of amplifiers [inaudible] sources and so on. It’s so part of the telecom fiber optic system.

In Russia, we implemented the market will complete solution, complete system, after which we – we were certified there and now becoming very competitive with bigger system manufacturers like Alcatel, Huawei and so. [inaudible] process to implement such system also has geographical market, for example, South America into what we have products and services.

Ajit Pai – Stifel Nicolaus

So are you comfortable with those modeling, the telecom business growing up sequentially the next four to five quarters?

Tim Mammen

I think in any quarter and which can’t be weak as Russia in Q1 and there is still not absolute clarity on that in general. On an annualized basis, yes.

Valentin Gapontsev

And then we’ll hope to multiple many times with the sales in telecom next year in total if not first quarter.

Ajit Pai – Stifel Nicolaus

But the trend will be an improving one on a sequential basis other than Q1, you would expect that at least from these elevated levels, you will still continue to see growth?

Tim Mammen

I think we’re going to be disappointed if we don’t continue to execute in this manner, particularly given the improvements that we’ve seen.

Ajit Pai – Stifel Nicolaus

Okay. And then the next question is just on the advanced applications. Can you give us some color as to when you expect some of the high power more defense related lasers? Do you expect any more of those to ship over the next four to six quarters?

Tim Mammen

We’ve got several orders on hand that we’re going to ship at least one of which maybe more in Q4. There are odd orders that still come in, they are just – that market is still not big for us, and there’s still a lot of R&D that’s required, and I’d just if not in a situation where you certainly going to see sales of 20 units accrued for anything like that. There are still orders expected and we continue to work with a fairly diverse number of customers in that area.

Ajit Pai – Stifel Nicolaus

Got it. Thank you.

Operator

Our next question is from Mark Miller with Noble Financial. Please proceed with your question.

Mark Miller – Noble Financial

Just wondering if you can just – I don’t need exact figures, but can you just give us a little more color about bookings? I think you mentioned North America was strong for the September quarter. Any other color you can give us about geography or products or application area would be beneficial.

Tim Mammen

[inaudible] I’d like to think, overall, we continue to see very strong bookings around the world and it was pleasing to see the US had its best quarter in bookings for a long time that I mentioned.

We also saw across different applications some improvement in general and the advanced application business compared to where it had been between first six months of the year. And then all of the other geographies, Europe, China, Japan, India off a small base, it’s really across the board, everything else has continued to be improving.

Mark Miller – Noble Financial

You mentioned high powered diode cost coming down was the driver of your margin improvement. Do you feel there are still a lot more coming? I know that was one of your hopes for the coming quarters that you’re going to be able to grab continued significant reduction in your diode costs which are a major part of your product cost.

Tim Mammen

Yes, I mean, we’ve seen that cost come down this year. And there are additional strategies that run out not just until the next two or three quarters, but there is a longer term target to drive the cost off the diodes that we use internally down. And as we ramp volumes, we think we can continue to achieve significant milestones in that regard. We don’t want to put any targets out there, but I think we’ve demonstrated an ability already to be pretty effective in that regard.

Valentin Gapontsev

And, of course, [inaudible] from volume at this year we have reached 6 megawatt of – probably 6 megawatt of total diode power. It’s practically two times more than last year, it’s – and the cost of diodes really will only depends from volume which is further increase of volume of diode production if the cost will have an opportunity to develop price per watt were essentially additional.

Mark Miller – Noble Financial

Thank you.

Operator

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

Valentin Gapontsev

Okay. Thank you for joining us today. We look forward to speaking with you in February next year when we report our fourth quarter and full-year results.

Tim Mammen

Thank you, everyone.

Valentin Gapontsev

Thank you, everyone.

Operator

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

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Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

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