IPG Photonics' CFO Presents at 14th Annual Needham Growth Conference (Transcript)

| About: IPG Photonics (IPGP)

IPG Photonics Corporation (NASDAQ:IPGP)

Needham Growth Conference

January 10, 2012 11:20 a.m. ET


Tim Mammen - CFO


James Ricchiuti - Needham & Company


James Ricchiuti

Okay. Good morning. We're going to start our next presentation, which will be from IPG Photonics. The leader in fiber lasers and delighted to introduce the company's Chief Financial Officer, Tim Mammen.

Tim Mammen

Thank you, Jim. Good morning, everyone. Just a couple of words first of all around the Safe Harbor. I'm not going to read this but we will maybe making some forward-looking statements here. Actual results could differ from those forward-looking statements. I also draw your attention to the risk factors outlined in our 10-Q and 10-K.

IPG Photonics is the fiber laser company. We are credited with innovating and commercializing this exciting new technology. The company has grown revenues and earnings spectacularly over the year as the acceptance of fiber technology has accelerated and we have continued to displace older, CO2 and other legacy technologies. There is also a transition happening within the way that people process materials that is benefiting the laser market as a whole.

I think there are three main themes that really characterize IPG's business. The first is the depth of the technology that we have. The second is the scale that we have within our manufacturing. And the third is the diversity of the business.

As I mentioned, lasers are increasingly being used in different types of materials processing and other applications. We have a large available market. The market for laser sources is about $3.8 billion and that is growing at about 7% to 9% per year. Within that, fiber is gaining market share and up until 2010 grew at an average growth rates of about 28%. And last year we estimate grew at a growth rate of about 60%.

The significant competitive advantages the company has mean that we have industry-leading margins and when you couple that with the diversity of the end markets and applications we address, we think that makes the company a compelling investment.

I’ll talk about some of those advantages in the markets as I go through this presentation. As I said the total available market for the company is large. And at the moment we only sell products into the laser source market. The total market for laser sources in 2011 is estimated to be about $3.8 billion. The largest part of that is materials processing, is expected to grow 7% to 9% to more than $5 billion by 2015. Within applications like materials processing, the transition to for example producing automobiles with great fuel efficiency, improved safety using high strength steels, transmissions that have three -- eight automatic speeds rather than three automatic speeds is all benefiting the laser industry. You require lasers to weld and cut those materials and produce compact and lightweight transmissions. There are other industries as well like shipbuilding and locomotive manufacturing that will benefit from that.

The largest part of the available market is represented by materials processing. The market can be divided up into five main categories, the largest of which is cutting and welding, using high power lasers, which is about a billion dollars. Metal marking, which is about $270 million. And fine processing, which is about $400 million. Within this market there are also a couple of future opportunities that we don't really address at the moment. The first of which, in the green segment, marking non-metals. Things like plastics. And we're developing lasers at a different wavelengths to start to address that. And a very significant future opportunity is in micro processing. Where if you can develop a fiber laser that's produced at green or UV, you should see tremendous penetration into those markets and competing with other manufactures with whom we do not directly have product to compete with at the moment.

A lot of the fine processing applications are for example in PC board drilling or in the semiconductor business. And we need to develop lasers -- we actually have in house and R&D UV laser that was recently run at about five watts of output power. We need to get the output power of that UV laser up tremendously. We've also qualified and commercialized our green laser, which is also another good wavelength for fine processing.

Within the materials processing market you can see here the amount of each individual sector that we have penetrated. The highest rate of penetration is in the metal marking, the second two columns along where we have about 60% market share. The largest market, that high power, we've only penetrated about 20% to date. The view is that fiber should get to 60% or 65% of that market. So even at a $1.1 billion, it represents additional revenue opportunity for the company of over $500 million. That market though is also growing. So by the time you get to 2015, the actual opportunity in materials processing will be significantly higher.

We've recently started to sell lasers into fine processing so using our new QCW and medium power lasers for fine welding and fine cutting and drilling of thinner materials, fiber has probably got about 15% market share there but has a very significant runway. And then I'd mention that the other significant areas which we start to address then provide additional headway for the company to grow into are, micro processing and also marking of non-metals.

The fiber laser market as I said has started to gain tremendous traction and acceptance. Between 2010 and 2011, the overall growth rates of the market was about 60% and materials processing in that period grew at about 71%. Everybody was forecasting based upon acceptance about a year ago that we would grow the laser market for fiber at about 35%. So, the growth rates here have been significantly higher. We believe that translates over the next four to five years into a CAGR that should be around 25% when everybody was expecting a CAGR going into the future of only about 20%. So, the general acceptance and penetration of fiber into different areas and applications is gaining traction and we think these longer-term growth rates for the market are very supportable.

I mentioned the diversity we have in our business. There are a number of broad end applications and end users for IPG's products. The largest part of our sales is reflective of the market and it is into materials processing. Within materials processing we sell into automotive, shipbuilding, locomotive manufacturing, appliance manufacturing, heavy industry for -- in the nuclear industry for welding and annealing thick metal pipes and plates. Within each of those industries we serve a huge diversity in application, whether it be welding, cutting, drilling, cladding, marking and other deposition technologies. So that's a very important part of our business, we think is the diversity we have there. We also address the other markets that are available, both advanced applications, which includes things like sensing, using lasers to shoot missiles out of the sky and within medical for example, we have an esthetic medical business as well as some new OEMs who are selling surgical lasers primarily for urology-type applications.

What are some of the future applications that we're targeting? I've mentioned in brief a couple of these. First of all on the right hand side of this slide here a breakdown of the non-metal marking and micro processing market, which is about a billion dollars. What do we have to do to succeed in those markets? As I mentioned we have to develop lasers with new wavelengths to process plastics and semiconductors. We also need lasers with shorter pulses and higher energy pulses particularly for micro processing. You get into addressing areas like cold processing where the speed of the laser is so fast it doesn't impasse any heat to the material. We actually have some OEMs already who are working using our fiber laser as the light source to pump different types of technologies to address those markets.

The other interesting part of the market is actually the systems market. So, if you look at the laser market as a whole, a laser source or the engine represents only about 30% of the value of the system sold worldwide in 2010. The total market for laser systems is about $8 billion. We intend to enter in selective areas of this market particularly where we can leverage the technology and where the value we can add is significantly greater. So, for example in fine processing applications we're using our QCW lasers in welding applications and selling the complete welding system where the laser is the high part of the value add and the total value of the system and margin on the system is high. We intend to develop that business.

In certain geographic areas, which are not well represented at the moment by existing OEMs, for example in selling 2D and 3D cutting systems in Russia where we have a unique capability to manufacture and service and support the customer, we're likely to also start selling in the next couple of years 2D cutting systems there. In this way we believe that we continue to grow the company very rapidly and expand the available market that we can address.

In terms of the way we get to market, we have a nice business model here as well. Our OEM customer relationships leverage or sales. So, when we qualify our laser to be used in someone else's system every time they sell a system, we sell a laser. So our sales force is made up of all of the OEM sales forces as well. Even with direct sales, when you qualify with an end user that relationship is generally for a period of five years. So we have many automotive companies with whom we've qualified in welding applications to whom we started to sell lasers, for example in 2008 and those relationships continue to exist today. With one of them we sold them 18 lasers in 2008. We now have shipped in total about 70 lasers to that company.

We've recently qualified with Toyota in Japan to use fiber lasers for welding, cutting and braising applications. That qualification process happened over the last year and we expect sales to Toyota to start in the second quarter of 2012. So those relationships help to leverage our sales and mean that our operating expenses and operating leverage is significant.

We've continued to invest in expanding our global reach. As you can see here the investments in sales and marketing headcount since 2008 has been substantial. We increased the total number of people from about 50 to over 90. We've opened new offices around the world. Different offices in China, Japan. We've expanded on the West Coast in the US. Opened an office in Detroit since 2008. And different overseas offices around Europe. We've also invested in our applications laboratories. Application labs are very important because they bring the customer closer to IPG. We help to solve their problems and when we solve their problems you develop a deeper relationship and also accelerate your sales into those areas.

In some instances we've actually developed applications ourselves. Or chosen to try and improve applications that exist in the industry today. One of those as an example is the drilling of holes in turbine blades and fans used in manufacturing of jet engines. Jet engines require millions of holes to aid the cooling of the alloys and enable the engines to operate at extremely high pressure and temperature.

Traditionally using a CO2 laser, each hole would take more than a second to drill. Internally at IPG we've developed processes that mean that we're drilling multiple holes per second and can reduce the cycle time in the manufacture and drilling of those holes very, very substantially. We're now taking that process with the laser out to every single manufacturer of jet engines in the world. So in that way the application lab forms an extremely important part of the sales process.

I mentioned the diversity of the use of lasers in the manufacture of products, many of which touch the daily aspects of our life. We produce automobile doors, main chassis, cell phones, batteries, solar cells and do so using a number of different applications.

Why do customers choose IPG fiber lasers? Why are we getting all this tremendous acceleration in sales and adoption in the market? We have significantly better electrical consumption. The beam quality of our lasers means that people can process faster or to a great degree of quality. The laser will work on a wide range of materials and we're continuing to expand that range of materials. It's an extremely compact and robust device that has little maintenance requirements and enables people critically to run their manufacturing lines at the optimal speed for the line and not the laser.

We have numerous examples of people retrofitting our lasers now where they've actually been able to improve the running speed of some of the manufacturing lines and optimize those rather than having to limit the manufacturing speed to the speed of the laser.

We're a very vertically integrated company and this drives the depth and technology that we have. Vertical integration enables us to significantly reduce our costs, control quality, shorten lead times, focus our R&D on the areas that are really commercially value adding and also crucially limits the spread of trade secrets and limits the ability of people outside of our business to develop scale in their manufacturing that might benefit other suppliers.

We have a very vertically integrated business model as I mentioned, but we also have other defensive positions that benefit us. A very strong IP portfolio that doesn’t just revolve the diodes. We also produced more than 200 additional types of very specialized fibers around the world. We use unique technologies to couple the light from the diode into the fiber. Increasingly we started to develop the technologies around delivering the light to the end user and also to broadening the wavelength of the products that we have.

And crucially and more importantly, almost equally importantly over the last couple of years the scale that we built in our manufacturing has been tremendous. We have 1,700 people around the world focused on building optical components and finished fiber lasers. None of our competitors who claim that they are entering the fiber laser market come close to having that ability. Nor have they even begun to make the investment that would put them close to where we were four or five years ago.

I think is really articulated in this slide here where we look at what has happened to the cost per watt on diodes since 2003 when we used to source them from an outside supplier and how we've ramped the production volume of chips internally. Our cost per watt on diodes has come down from about $80 in 2003 when we started manufacturing diodes in house to about $30 in 2004 and 2005. Exiting 2011 our diode cost is $3 per watt and we have a roadmap to get that down to $2 per watt.

Part of that is driven by the design of the diode and the design of the package but it's also driven by the tremendous increase in volume and throughput that we've generated in our diode facility, increasing production to over $1.2 million chips per year.

Even if you assume that IPG has 80% of the materials processing market, which is primarily where the high (inaudible) are the remaining 20% implies that production of diode chips by the rest of the industry is around 200,000 chips. That would put them where we were in 2005. So, it's very difficult for people to generate the kind of scale that we have by simply trying to enter the market with IPG with the significant leadership and advantages that it has.

Financially the company has demonstrated an ability to continue to improve gross margins even as we have significantly brought down the selling price of our high power and other lasers. The need to reduce the selling price of the lasers was first of all to make fiber competitive with CO2 and YAG technologies, removing a barrier that the sales force encountered. When we first started selling fiber lasers we were selling them at a premium to other products and telling the end user they would only start to realize those cost savings over the full life of the laser.

Now people can buy a fiber laser at an equivalent price to a CO2 laser or a YAG laser, actually cheaper than the disk lasers in the market and realize those cost savings immediately. We've brought that price down while reducing our internal component cost and improving our capacity utilization and driving gross margins up to industry-leading averages approaching 55%.

As mentioned, the operating leverage we have on the sales cycle. The company is also pretty unique in the way that we manage R&D. R&D is extremely focused on commercially valued adding components and products. Our return on R&D is one of the highest in the industry. Our average R&D expenditure over the last four or five years is about 7% of revenue. During that course of time we've reduced our diode costs, we've brought more products to the market, we've substantially increased the number of internal components that we're manufacturing, as well as develop a whole host of accessories and laser welding heads for example for the satisfying the needs of the industry.

One of the unique things about IPG's R&D is it's very statistically and database orientated. We collect tens of millions of hours of test data in relation to the components that we build in order to determine that the performance characteristics and reliability. That database for example in diodes extends to more than a billion hours. There's nobody in the industry who has that kind of a database to rely upon to determine the reliability or if their production processes are not working as well as they should be. And their yields and qualities are dropping. We have a very rapid methodology to be able to determine that.

So the R&D leverage, the sales leverage and then the (efficience) we have on G&A all mean that we have dropped the improvements in gross margin down to the operating margin level and result in operating margins that are also industry-leading standard.

I mentioned that IPG is the fiber laser company. 91% of all the product we sell is fiber lasers. We do have a small business that does diode and diode lasers. There is a view in the market being articulated by some of our competitors that diode lasers will start to grow because they're more cost effective than fiber. Our view is the main component that goes into a diode laser is the diode. We have the lowest cost diodes in the market. Our fiber laser is able to compete directly with any diode laser.

The other problem that diode lasers have is the beam quality is poor. The spot size is large. It is good -- they are good for processing certain materials and certain applications. For example braising is one where diode lasers have gained some market share. I mentioned recently that we've qualified with the largest automobile manufacturer in Japan. One of the processes we qualified for was braising and that qualification happened in direct competition with someone else's diode laser. We were told that there was no comparison between the quality and speed of processing they were able to achieve and there was no discernible difference in the average selling price.

So, our view is that diode lasers have a limited opportunity within the market but given the cost points at which fiber is at, and the benefits that you can achieve out of the better beam quality, diode lasers are not going to gain a significant part of the market share.

The other parts of the business that are smaller here are telecom amplifiers and devices and also a small part is our parts and services revenue, which is about 5%.

Earlier on in the presentation you saw that the largest part of the market is high power lasers. There's about a billion dollars worth of high power lasers sold. As we have grown our high power laser business, high power devices become our largest product line. It used to be pulse lasers on the left here. A lot of that growth has come this last year as we penetrated more welding and cutting applications. You're also seeing as we get into the fine processing area growth in medium-power lasers. They've grown by almost 100% in Q3 year-on-year. So, we're starting to penetrate that fine processing business in a nice way.

The margin profile of these products is broadly similar. The pulse and the high-power is about the same. Medium-power lasers actually have a higher margin profile because the average selling price per watt is significantly higher but the number of diodes and optical components used in them goes up in a linear fashion. If you can grow the medium-power business you'll be able to maintain or even maybe improve margins slightly.

I talked about the scale that we have on diode manufacturing. The scale that we have on finished product assembly is also significant. Year-to-date through September we shipped about 17,000 lasers. We're one of the single largest manufacturers of lasers in the world at about 2.4 megawatts of high-power lasers. So there's real scale not just in the components but also the manufacturing of finished products.

IPG's balance sheet is strong. At the end of September we had about $196 million of cash. Very limited amount of debt, about $17 million, $18 million of long-term debt. And $8 million of credit lines outstanding. The next cash per share on the balance sheet is about $3.50 at the end of September. We generated even after spending $37 million on CapEx in the first nine months of the year, a significant amount of free cash flow. We expect to have about $50 million of CapEx for the full year. And on a going-forward basis long-term CapEx should be trending below 10% of revenue.

I've mentioned where those investments are happening. Mainly in manufacturing and technology improvements as well as finished product capacity expansion.

As we grow in the business and you've seen the margins improve you've also seen earnings per share increase very nicely. Earnings per share increased from about $0.28 in Q3 2010 to almost $0.66 in Q3 2011. This really is a very profitable business and we think that profitability is sustainable.

And just to conclude the investment highlights, as I mentioned we have a large available market. Penetration into that market is growing. Estimated growth rates in the future should exceed 25% on an average basis over the next five years. And I'd like to reiterate as well that the competitive advantages we have are very deep and very broad and the end markets we serve are very diverse. As well as the applications.

And with that, that concludes the presentation. So, thank you for your attention and we've got a few minutes to open the floor up for questions. Maybe just before I face them, a little bit of tone on how order flow at the end of the year transitioned. I think we saw a nice improvement in orders coming into the end of November and in December. That was pleasing to see because we'd been through a period of a few weeks at the end of September and October where there'd been some volatility. We’ll be providing Q4 results on February 10 I think it is. And also we'll provide a full update on book-to-bill and our guidance for the first quarter.

But I think the laser industry as a whole saw some solid order flow in December from what I've heard and IPG has certainly transitioned into a strong month coming into the end of the year, which was pleasing to see. Europe continues to hold up well. We sell product mainly into Germany and Northern Europe and even in Italy, where we have a lot of OEMs. Those OEMs are primarily exporting product around the rest of the world. So, the European credit crisis has not really affected our sales to date.

And with that, I will open the floor up to questions.

Question-and-Answer Session

Unidentified Analyst

How sustainable are the operating margins in the business? How do you think about pricing (inaudible) et cetera.

Tim Mammen

So, the question is around the sustainability of operating margins and pricing. On pricing historically what we've done is always price stuff on a cost-plus basis. So, as we reduce our component costs we then reduce the selling prices. Historically, we've had to pass all of those component cost reductions on to the end user to get ourselves to an equivalent price to CO2 and YAG lasers. The need to pass on now the entire amounts of cost savings on components is not so great. And if we can continue to utilize the capacity of the business, the degree we're doing, we're pretty comfortable in maintaining margins -- gross margins where we are.

On the operating margin side, in the near-term we will see some benefit in 2012. For example, last year we spent $4 million on legal expenses defending a patent litigation related to infringe against someone else's fiber laser patent. We do not expect those legal expenses to recur. The rate at which we were accruing bonuses in 2011 because we're so far ahead of budget, will fall in 2012 because the budget target that will be put out there by the Board will be a tough one. It will not be an easy one to meet. So, there's two ways to look at it.

First of all, we’ll have an absolute decrease in some cash operating expenses, which will enable us to reinvest those in other areas. For example maybe expanding into South America. So, I expect to see some leverage in 2012 on the operating side. Longer-term, this is a complex business. We're clearly going to have to invest and continue to invest on the operating side. I've stated before that in two or three year's time OpEx might increase to 20% of revenue. That may be a little bit conservative. I think it's best to focus initially on 2012 and the benefits that are there.

Unidentified Analyst

Can you talk a little bit more about cyclicality in your business?

Tim Mammen

So, the question is about cyclicality in the business. Typically the first thing is that Q1 can seasonally be a little bit weak. In China for example you have Chinese New Year. In Japan, you have various public holidays there. Very little happens in Russia in January. Sequentially Q1 can be flat to down 5%. The other cyclicality in the business really revolves around the macroeconomic cycles on certain products. So, not so much on high-power or medium-power where we're at the early stages of adoption. But on the metal marking business, the pulse lasers, if you have a very weak or weaker macroeconomic environment that product line will grow less quickly or could be flat. And we've seen that in China in Q3 and Q4 where we said our pulse laser sales where a little bit weaker and we factored that into the guidance that we gave.

Unidentified Analyst

What percent of the bill of materials is the diode part?

Tim Mammen

It's come down to -- we don't talk about it in terms of percent of bill of material in terms of selling prices. It's less than 10% of the selling price. So. The question was about the percentage of diodes of the bill of material, which we do not disclose but as a percentage of selling price it's less than 10% now.

Unidentified Analyst

What is your end market breakdown in terms of your exposure to auto versus other end markets?

Tim Mammen

So there's stuff that we can specifically identify and then there's stuff that we sort of have to extrapolate out. We can identify about 15% directly going into automotive. About another 50% going into general manufacturing. I would say of the general manufacturing, if you took the amount of general manufacturing that's going into automotive it would mean that the automotive exposure was about 30%.

The remaining part of general manufacturing is into consumer electronic devices and marking and engraving applications, flat sheet metal cutting, production of home goods and customer appliances. Semiconductor and solar are a very small part of our business at the moment, less than 1%. Electronics is probably around 5%. Shipbuilding and the aerospace industry are at 2% or 3%. Oil pipeline welding, 1% or 2% end market at the moment. And then you've the advanced applications, which are around 8%. And then telecom at 5%.

Unidentified Analyst

How much visibility to you have on the introduction of new competing products?

Tim Mammen

From our competitors or internally that we can compete with?

Unidentified Analyst

[Question inaudible]

Tim Mammen

You get a feel for what's happening in the industry and then people will be giving demo units out to some of your OEMs to use and you'll hear a whisper about how that’s performing. People make a lot of product introductions at trade shows and fairs. Our competitors have been claiming they're going to have kilowatt lasers available since 2007. A lot of them are only just now trying to get a commercial device to the market. So, there is I wouldn't say there was a lot of surprise to date about it at the moment. And people have not really executed against us when they have announced a product. And if they have got some traction, it's taken them a long time to get there.

Unidentified Analyst

What percent of the business comes from selling integrated tools directly to a factory or a buyer and what percent comes from sales to OEMs (inaudible)?

Tim Mammen

So, the OEM sales at the moment is probably 60% to 70%. The direct sales are the remaining -- actually it's OEM is 70% and direct sales is about 30%. A lot of the direct stuff is for welding. So, you're not so much going through OEMs on the welding business particularly at the high-power level. So, you're selling directly into the automotive manufacturers or the manufacturing companies. Mainly because the laser is a lot more of the value add in the welding application than it is for example in an extremely complicated 3D or 5D cutting system.

Unidentified Analyst

So what's the design win sort of cycle in an OEM?

Tim Mammen

So, is there qualification process?

Unidentified Analyst

(Inaudible) the product, you go into an OEM, you pitch it to them. How long before it's actually in the hands of the customers?

Tim Mammen

In a marking/engraving application you have people adopting the pulse lasers in a matter of months, maybe even three or four weeks they can make that decision and integrate it immediately. On the cutting side, the cycle to win a new customer is probably a three to four month process. And then it may take them another three months to finalize the developments of their system. In welding applications internally, non-OEM direct sales, two years ago it was taking us a year to qualify the lasers for use in an automotive process. It's probably taking now six months.

Unidentified Analyst

On the diodes, you have a great competitive advantage and where do you think the next best guy is in terms of price for diodes? And are they coming down the curve?

Tim Mammen

So the question is where is everybody else in terms of price per watt on diodes. We don't know what they're internal manufacturing costs are but we believe based upon press releases given by other people the market price at the moment we know is like $15 to $20 per watt. So, they are at $3 per watt five times more expensive than us.

And the interesting thing though is we've got this tremendous advantage on diodes, there are other areas on our product now where can actually gain better cost advantages. For example, by simplifying and redesigning the power supplies that are used in there. The cost of the power supply in a kilowatt laser is now per kilowatt -- (inaudible) in the diode cost of a kilowatt, but the cost of the power supply for example of some of the electronics and cabinets has got to the point where instead of just focusing on diodes we're starting to focus on some of those other areas to reduce cost. And particularly as you build the volume on the high-power lasers, two or three years ago we were buying 150 chillers in the market. Now we need 1,500 chillers. We need 1,500 power supplies. There's a certain amount of scale we're building into the high-power business as well that is benefiting the non-optical components as well.

Unidentified Analyst

[Question inaudible]

Tim Mammen

Our view is that lasers as a whole when you're competing against many machine tools, are still quite expensive. So, the strategy the company will pursue is in general to reduce prices over time. But not necessarily having to pass all of the component cost reduction onto the end user. In particular, if you look at welding system incorporating a spot weld or automated arc welding system, the cost of those systems is very low. And in order to displace the large part of that market, you either have to develop technologies which we already have where you can take a single laser and use that to run multiple workstations. So, replacing four or six or eight spot welders. Or you have to continue to bring down the cost of the laser to penetrate that market. We'll pursue both of those strategies.

But there is less need to have to achieve the kind of price reductions we did historically in order to continue to generate sales.

Unidentified Analyst

Is there any consideration of where the next manufacturing plant will be?

Tim Mammen

We are not going to expand significantly anywhere else in the world. We've put a lot of investments in the US, Germany and Russia. The semiconductor facility will always be based in the US. At the moment we've got a highly automated process there that achieves great (inaudible) and great yields. So there's no need to kind of move that into a low cost manufacturing environment. In Russia we produce a lot of our optical components that require a lot of labor. The cost of direct labor in Russia is 25% of what it is in the US and it's only marginally greater than it is for example in China.

But what you have in Russia is a lot of IP protection. You don't have people trying to copy what you're doing. In general assembly, we may -- it won't be major investments here but you may choose to do the final assembly of some product in different areas around the world. So ship the optical components there and then use locally designed electronics and hardware. And we do that in the Far East, whether it's China or another area of the Far East. That may be a strategy we look at going forward.

Unidentified Analyst

Is it possible to characterize your sales in terms of how much is kind of rip and replace and because of the better ROI and how much is new factory builds where you're making (inaudible) CO2 and YAG and --

Tim Mammen

So, the way I look at that question is how much of the ongoing annual market have we penetrated and how much of the existing installed base have we penetrated. To date about 80% of sales is really being green field where people are choosing between CO2 fiber and YAG. And we've won a lot of that. Coming into the end of last year we were seeing an increase in retrofit. So, people taking still relatively old CO2 lasers -- I haven't heard of anybody taking a two year old CO2 laser and replacing it with a fiber but taking a relatively old CO2 laser, instead of repairing that or buying another CO2 laser, implementing a fiber technology.

The way I actually analyze that is I look at the installed base of cutting systems around the world. And there are about 45,000 cutting systems that use lasers. Our total volume of high-power lasers sold into the cutting industry would imply that we have about 3% penetration of that installed based even though we've grown to about 20% of the annual revenue of high-power lasers. So there's a significant runway on the installed base that still has to be addressed by the company.

Unidentified Analyst

And just to follow-up, on that kind of rip and replace, how do you characterize the return on investments? How much of that installed base do you really think you have a reasonable --?

Tim Mammen

On the welding industry it's a lot easier to do. We've got numerous examples of actually retrofitting lasers for welding and the return is less than a year in many instances. We’ve done it for locomotive engines. We've done it for welding roofs with cars. The issue on the cutting business is not so much the ROI because it would be again very quick and very rapid. You have complex systems delivered by another customer and integrate it, (you) have all the specialization in that system manufacturer.

We have to work out a way to develop relationships with those customers to encourage their customers to retrofit and for them to continue to support that machine and to reprogram that machine to cut with a fiber laser. And we're not at the point where we've got a developed enough strategy to really say how quickly we can do that. It's too early stages at the moment.

Unidentified Analyst

Do you have on your radar (inaudible) any indication of the penetration opportunities in 3D, (inaudible), which is now starting to move (inaudible)?

Tim Mammen

I don't have a lot of visibility into those specific end markets. We've got a couple of OEMs on the printing, pre-press printing side and also on the (centering) side particularly in Europe for rapid prototyping who have been customers of the company for almost a decade. We probably do $8 million or $9 million worth of business in that area. I would agree with you though in the fine processing area that is a potential area of growth for the company going forward.

One more question at the back.

Unidentified Analyst

How much of the order (inaudible) is because of the (inaudible) and how do you (inaudible) industry is becoming?

Tim Mammen

Very little of -- this question is about the (inaudible) and order strength (inaudible). I don't believe much of it was at all. We've historically not sold many lasers into Thailand. If they're making a decision to replace older equipment with new lasers or newer type lasers, I think it's way too early for those decisions even to have been made. We've only got one customer really in Thailand of magnitude who does hard drive flexure and I haven't heard exactly what the state of -- situation is with their manufacturing facility. So, I don't think that that benefit really came out of Thailand.

Unidentified Analyst

[Question inaudible]

Tim Mammen

We've got very little stuff sourced out of -- you mean, do we source stuff out of Thailand? Very immaterial affect on us.

This really is the last one.

Unidentified Analyst

Can you just talk about your (inaudible) margins. [Question inaudible]

Tim Mammen

You'd have some benefit on -- probably going to articulate this better on the earnings call. I'll have to do a bit more (inaudible). But you'd see some benefit on OpEx falling due to the variable elements of it. There is some variable element even within manufacturing. For example you limit overtime. You stop replacing direct labor where there's a natural attrition around that. A 5% decrease in revenue would not have a material affect on gross margin or operating margin.

The issue you'd have to get into would be getting down into like a 25% or 30%, 25% decrease in revenue before -- going down to that level you'd see some degradation. But before any really big impact you'd see a significant decline in revenue.

Thank you very much.

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