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IPG Photonics Corporation (NASDAQ:IPGP)

Q4 2011 Earnings Call

February 10, 2012 10:00 a.m. ET

Executives

Valentin Gapontsev - Chief Executive Officer and Chairman of the Board

Timothy Mammen - Chief Financial Officer and Vice President

Angelo Lopresti - General Counsel, Secretary and Vice President

Analysts

Zach Larkin - Stephens, Inc.

Krish Sankar - Bank of America Merrill Lynch

Joe Maxa - Dougherty & Company

Avinash Kant - D.A. Davidson

James Ricchiuti - Needham & Company

Mark Douglass - Longbow Research

Olga Levinzon - Barclays Capital

Mark Miller - Noble Financial

Jiwon Lee - Sidoti & Company

Ajit Pai - Stifel Nicolaus

Operator

Good morning, and welcome to IPG Photonics’ Fourth Quarter and Year-End 2011 Financial Results Conference Call. Today’s call is being recorded and webcast. There will be an opportunity for questions at the end of the call. (Operator Instructions) At this time, I would like to turn the call over to Mr. Angelo Lopresti, IPG’s Vice President, General Counsel and Secretary, for introductions. Please go ahead, sir.

Angelo Lopresti

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

Statements made during the course of this conference call that discuss management’s or the company’s intentions, expectations or predictions of the future, are forward-looking statements. These forward-looking statements are subject to known and unknown risks and uncertainties that could cause the company’s actual results to differ materially from those projected in such forward-looking statements. These risks and uncertainties include those detailed in IPG Photonics’ Form 10-K for the year ended December 31, 2010, 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 investor.ipgphotonics.com/sec.cfm, or by contacting the company directly. You may also find copies on the company’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, February 10, 2012. 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, everyone. The fourth quarter culminated a very successful 2011 for IPG. For the year, we grew revenues by 59%, gross margins increased to 54% and net income more than doubled. For the fourth quarter, revenues increased 22% compared to Q4 a year ago. Our growth continues to be driven by high-power laser sales for materials processing applications. Gross margins were 54% and earnings were $0.64 per diluted share in the most recent quarter.

We made significant progress in 2011 and you could say that last year marked a real turning point in fiber laser adoption. According to a recent leading industry expert publication, last year, fiber lasers were estimated to account for 25% of worldwide industrial laser sales and up to 20% of total laser sales except communications and other milliwatt scale diodes.

It is great achievement. However, fiber lasers are still at early stage of penetrating the large parts of the laser market and we believe that IPG is still relatively early in the adoption cycle. The leading analysts estimate that industrial fiber lasers can grow to $1.2 billion in 2015 and $1.5 billion if you include non-materials processing. So, there remain large opportunities for fiber lasers for the future and IPG intends to lead the way. I want to remark now on some of the progress we made in 2011 then I will comment on how we plan to move our technology forward for the future.

We are seeing that fiber lasers have become the laser of choice in the auto industry. It is an exciting time there for laser applications. They are making significant new investments in models and manufacturing lines. They are using new, exotic materials in car designs and they must lower their production costs. The trend toward lowering weight and improving the fuel economy results in increased use of lightweight, high strength steel and aluminum as well as welding together materials of different thicknesses and composition.

All of these developments favor laser cutting and welding over older technologies like tool dies, spot welding and others. We at IPG plan to take full advantage of this situation by offering innovative laser sources, specialized welding laser systems like steppers for remote scanning welders, and developing new applications with our lasers for automakers.

Last year, we also expanded the application for our fiber lasers. There are many examples, but I will give a few. In the oil and gas industry, our robust and efficient lasers allow for new applications. We have sold one customer three high power lasers to ate for oil and gas exploration. They believe our lasers can significantly reduce the cost of drilling oil and gas wells.

Also, our high power lasers in 2011 were used for fighting oil and gas well fires and for hardening steel in natural resource exploration. For example, the special laser cannon helped recently to remotely cut foundation in gas well station constructions in Siberia, saving a lot of time and money. This application uses very high power fiber lasers that only IPG can deliver, and the potential for this application is very significant.

Going forward, we plan to leverage our technology depth and culture of innovation, expanding the range of laser powers and wavelengths to address more applications and displace more existing laser and non-laser technologies. In particular, we believe the welding market represents a significant opportunity for fiber lasers to replace non-laser technologies like currently used spot welding, arc welding, wire based welding technologies. Fiber lasers are now used primarily on metals, but we are working hard to expand our product line so that we can process various non-metals.

One new innovative application is to use our high-power thulium lasers, 2-micron range to weld plastics. Also we are combining several of our laser product lines to do multiple tasks such as strip coating and weld specialty pairs of different metals. There are many new and interesting applications for fiber lasers, including our new mid-infrared lasers and high power green lasers. High power green lasers will enable us to expand to marking non-metals, amongst other applications.

IPG’s financial performance was strong in 2011 but we see more opportunities to build on the strong foundation we have established for fiber lasers over the last 20 years. Today, I am excited as I have ever been about the potential for our current and future products and fiber laser applications.

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

Timothy Mammen

Thank you, Valentin, and good morning, everyone. I’ll start with a review of our end markets, products and geographic regions. After that, I’ll follow with highlights from our income statement and balance sheet and close with our guidance.

Fourth quarter materials processing sales, which accounted for approximately 88% of total sales in 2011, increased 32% year-over-year to $111.1 million. Within the materials processing end market, we sell into automotive, shipbuilding, locomotive manufacturing, appliance manufacturing and heavy industry. We serve a broad array of applications, including marking and engraving, welding, cutting, drilling, cladding, prototyping, scribing, wafer processing, surface cleaning and hardening.

Fiber lasers are a dominant technology in the laser metal marking and engraving market. Fiber lasers’ presence in high power welding and cutting applications has also grown tremendously over the past few years. Just three years ago, the fiber laser market share of the high power materials processing was in the low single digits, and today it accounts for about 20% of sales in that market.

Our fiber lasers are currently being used to cut steel with thicknesses over 30 millimeters. This is an application that is dominated by CO2 lasers and, until now, traditional laser manufacturers have held on to the claim that this was a task that could not be completed with a fiber laser. However, right now, we understand that IPG fiber lasers are used to cut metal that is thicker than 30 millimeters and that the quality is equivalent to that of a CO2 laser, but for a lower capital equipment and operating cost.

As Valentin pointed out, changes in the manufacturing processes in automotive are stimulating demand for fiber lasers. We continue to see strong demand from the automotive market in the U.S., where we have placed units at each of the big three automakers, and in Germany, where we have numerous units at three major manufacturers. In Asia, our lasers are used by numerous major manufacturers for different body-in-white and other welding and cutting applications. Body-in-white applications generally involve welding materials of two different thicknesses or two different materials together to increase the strength-to-weight ratio. Lasers have significant advantages in these application areas.

Let’s turn now to smaller applications. Advanced applications sales were down 34% year-over-year to $6.2 million. Advanced applications sales tend to be uneven, and the year-over-year decline is a function of the strong Q4 we reported last year. Advanced applications were about 6% of our business in 2011. Sales for the telecommunications market decreased 18% year-over-year to $3.9 million. Much of the decline is related to lower sales volumes in Russia. In total, the telecom market represented 4% of sales in 2011.

Medical sales were up 3% year over year. Medical sales were about 2% of revenue in 2011. A majority of our medical sales continue to be related to a major OEM, but we are increasing sales for applications in medical device manufacturing and in the area of urological related surgery using a high power thulium laser. Advanced, telecommunications and medical applications accounted for 12% of total sales in 2011, which is a small portion of our total sales when compared to materials processing.

In future reporting periods, we will report these three applications in a group as other applications. While these applications have grown nicely over the recent years and we will continue to sell products into these applications as we have before, we will focus our reporting on materials processing which accounted for 88% of our 2011 revenues.

As Valentin mentioned, sales of high power lasers, our leading product line, increased 62% year-over-year to $64.7 million. This was driven primarily by sales of lasers for cutting and welding applications. Sales of medium power lasers increased to $7.8 million, or by about 1% year-over-year. We have recently seen increasing demand for medium power lasers for fine processing applications in markets such as consumer electronics. Other medium power applications include sintering and roto-gravure in the printing industry.

Pulsed laser sales decreased to $27.8 million, down 12% year-over-year. The decline was primarily related to lower demand from certain OEMs in Asia. Pulsed lasers sales are our most mature product category and are used for marking and engraving applications where fiber lasers already have significant sales in this market. As such, pulsed lasers sales can be most affected by general economic trends. Low power laser sales of $3.8 million were down 20% year-over-year as a result of reduced sales to our largest medical OEM.

Sales of QCW lasers, which are used for consumer and fine-processing applications, increased by more than 300% to $1.6 million, compared with last year. We recently began selling our new QCW medium power lasers for fine welding and cutting and drilling of thinner materials. We’re optimistic about the growth opportunities in this space. We plan to reduce the selling price of these devices as we reduce the manufacturing cost, which will make them even more competitive with lamp pump YAG lasers.

We believe that this will accelerate adoption of these products from Q2 2012. We have a unique new diode chip design that will increase power and reduce the cost per watt for these lasers. We are close to completing the development of this unique chip. Sales of other products, which include amplifiers, diode lasers, green lasers, mid-IR lasers and certain components, were $7.3 million, and service, parts, lease and other revenue totaled $10.5 million.

Now looking at our performance by geography. European sales increased to $54.8 million, or by 35% year-over-year. North American sales increased to $22.5 million, or by 28% on a year-over-year basis. We believe that the U.S. manufacturing is transitioning from using lasers predominantly in specialized processing to using lasers in a broader range of industrial materials processing. We expect this to translate into steady sales growth in North America.

Asian sales increased to $44.2 million, or by 4% year-over-year. We had a strong quarter in Japan, but it was largely offset by weakness in China and other Asian countries. China order flow improved at the end of Q4 2011 and has started reasonably well in Q1 given Chinese New Year at the end of January. As a side note, the flooding in Thailand did not have any significant impact on our sales, nor do we have any significant components sourced from Thailand. Rest of world sales increased significantly in Q4 to $2.0 million. The increase is the result of the sale of a 5-kilowatt laser to an industrial research institute in South Africa. We have been expanding into some geographies where we don’t already have a significant presence, including South America, Southeast Asia and South Africa.

Now, turning to the income statement. Total sales for Q4 increased 22% year-over-year to $123.5 million. Gross margins were slightly down to 53.8% from 55% in Q4 2010, primarily because of lower absorption of our manufacturing cost. Gross margin includes stock-based compensation charges of $428,000 and $145,000 in the fourth quarters of 2011 and 2010, respectively. We have made significant cost reductions to optical delivery systems, such as beam switches and optical heads, and the margins on those accessories and components are good. We expect to reduce manufacturing costs even further for our lasers, enhancing both our competitiveness and margin performance.

Sales and marketing expenses were $5.3 million and were 4.3% as a percentage of sales, which is down from 5.3% in the year-ago quarter. General and administrative expenses increased by 50% to $9.9 million, primarily related to legal costs associated with patent litigation. As we announced previously, a federal district court jury delivered a verdict that IPG did not infringe a patent asserted against IPG by IMRA America. The trial began in Q3 and ended in Q4. General and administrative expenses were 8% as a percentage of sales, which was up from 6.6% in the year-ago quarter.

R&D expenses increased year-over-year on a real-dollar basis by 24% to $6.6 million and as a percentage of sales were 5.3% of total revenues, which was flat with the fourth quarter of 2010. In total, operating expenses for the fourth quarter of 2011, excluding foreign exchange gains or losses, increased 27% to $21.8 million. Fourth-quarter operating income was $46.1 million, or 37% of sales, compared with $38.8 million, or 38% of sales, in the fourth quarter of last year.

Operating income includes stock-based compensation charges of $1,868,000 and $718,000 in the fourth quarters of 2011 and 2010, respectively. Net income attributable to IPG for the fourth quarter increased 15% to $31.1 million. On a per share diluted basis, we reported $0.64 in Q4 2011 compared with $0.56 a year ago. We estimate that if exchange rates had been the same as one year ago, sales in Q4 2011 would have been $1.3 million lower, gross profit would have been $0.2 million lower, and operating expenses would have been $0.1 million lower.

Now, turning to the balance sheet. Cash and cash equivalents, including short-term investments, increased by $9.1 million in the fourth quarter to $205.7 million. At December 31, 2011, inventory was $117 million, up 61% from year-end 2010, but down slightly from the sequential third quarter. Our current level of inventory on hand amounts to 186 days and is slightly higher than the top of our target range of less than 180 days. Accounts receivable was $75.8 million at the end of the fourth quarter, or 56 days sales outstanding, compared with $55.4 million at December 31, 2010, or 49 days sales outstanding.

Cash generated from operations in 2011 was $87.9 million. Capital expenditures for the year totaled $54 million, just above our target of $50 million. During the year, we made significant investments to build new manufacturing facilities, expand capacity in several high growth regions, add front-end diode capacity in the U.S., modernize and expand our facilities in Russia, and enhance our global sales and service infrastructure. We estimate that we will spend between $55 million and $60 million on capital expenditures in the U.S., Germany, and Russia in 2012.

Backlog, which we report annually, was $207 million at December 31, 2011, compared with $171.6 million a year ago. Our backlog includes $124.4 million of orders with firm shipment dates, and $82.9 million of frame agreements that we expect to ship within one year. In 2010, our backlog included $98.6 million of orders with firm shipment dates and $73 million of frame agreements. The book to bill ratio for Q4 and the full year 2011 was greater than 1.

The past year proved that significant opportunities exist for IPG, despite slow economic growth and economic uncertainties in our major geographic markets. Acceptance of our fiber laser technologies is growing and we are positioned to capitalize on this trend. The range of applications for our technologies is expanding and more potential customers are considering lasers instead of conventional, non-laser tools. As we move forward, we intend to expand our range of products and capabilities. One area that we will be directing much of our attention toward is developing specialized laser systems to meet customer needs.

Laser systems include the laser source, which we make, plus the motion control, software, enclosure and other elements. The total market for laser systems is estimated to be approximately $8 billion. We intend to enter select areas of this market where we can best leverage our technology and add the greatest value. In addition, our new lower cost QCW and thulium laser should expand our penetration into fine processing applications, a $400 million market, and also non-metal marking. New ultra fast and UV lasers will enable us to address part of the $800 million micro-processing market.

And now for our expectations for the upcoming quarter. Our guidance takes into consideration the uncertainty around the global economy. Despite the headlines, our European business continues to hold up well. We sell lasers mainly into Germany and Northern Europe, and our OEM customers in those regions are primarily exporting products to the rest of the world. So the European crisis has not had a direct effect thus far.

In addition, although China was up about 80% for the full year, we have seen some softness there in the just completed quarter. It is too early to tell what the impact would be or for how long will it last, but we’ll keep a watchful eye on the trends in that region. Q1 can be a seasonally weak quarter and the low to mid-point of our guidance reflects that potential seasonality.

With that as a context, IPG Photonics expects Q1 revenues in the range of $115 million to $125 million. The company anticipates Q1 earnings per diluted share in the range of $0.54 to $0.64. That is based on 48,685,000 diluted common shares, which includes 47,564,000 basic common shares outstanding and 1,121,000 potentially dilutive options as of December 31, 2011. This guidance is subject to the risks we outlined in our reports with the SEC, and assumes that the exchange rates remain at present levels. I reiterate that we do not attempt to forecast gains or losses related to exchange rates.

And with that, we’ll open the call up for your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question is from Zach Larkin with Stephens. Please proceed with your question.

Zach Larkin - Stephens, Inc.

Hey, good morning, gentlemen and congratulations on the quarter. First off, I wondered if you could talk a little bit about gross margins. You talked about absorption impacting them in the quarter. I wondered if you could give us a little color on mix and what that impact might have had on the gross margins. And then also with the seasonality going into 1Q, do you expect margins to be maybe slightly softer in line with what we saw this quarter?

Timothy Mammen

So in terms of mix, probably a little bit of an impact because the medium power sales were, as a proportion of sales, a little bit lower than they were in Q3 but there was nothing material related to mix there. In terms of absorption, we actually saw lower over time payments and total cash payments out for salaries and benefits a little bit lower in Q4, but that was offset by slightly lower utilization. So the combined effect of all of that was to lower margins year-on-year by about 1.2%. In Q1 we are factoring gross margins to be approximately the same in generating the guidance that we did. As we go through the year and revenues pick up and the utilization improves, we should be able to see some upside to gross margin number.

Zach Larkin - Stephens, Inc.

Okay. Thank you. Then I also wondered, kind of along the same line, if you could talk about pricing, are you seeing any different pressures than what you have experienced historically, and then anything new on the competitive front?

Timothy Mammen

On pricing, no. I mean we believe that we now really have a very good control over pricing in the market. Our products are lower than the cost of many of the competing legacy technologies. There are certain strategic areas we are evaluating reduction in prices. For example, I have talked about the QCW lasers. That really is to drive, we hope, tremendous increase in volume as that product becomes more directly competitive with some of the lamp pump YAG offerings. And then on the competitive front, clearly a lot of people are announcing products. We haven’t seen any significant traction of competitive wins against us. We’ve heard of a few high-power laser sales being sold in Asia.

I would say actually on the pulse laser product line, we’ve probably gained some market share despite many of the entrants, slightly older and some of them newer in the market. Basically because the cost effectiveness and the reliability of our product and the ability to deliver in volume so exceeds that of our competitors that it’s not just a technology that’s important anymore, it’s many of these other commercial attributes. In general, even people we think are announcing high power lasers, you know there’s a tremendous amount of technology here. It’s not all just about diodes and diode cost, it’s all the other components and fiber. And if you don’t get the reliability around those components correct, you’re going to have tremendous difficulty producing reliable lasers.

Valentin Gapontsev

In spite many new company claim, they now have started to sell fiber lasers last year. You see the total growth of fiber laser market, it’s accordingly to the analyst experience and publication, of about 48%. But IPG increased business more than 60%. So, IPG’s share in the market even increased, not decreased during the last year.

Zach Larkin - Stephens, Inc.

Thank you very much for that. And then one final question, if I may. Just wondered if you could talk about the mix of Greenfield versus retrofit orders that you saw in the Q, and what your expectations are as you look forward.

Timothy Mammen

So we don’t give any specific analysis on that. The general trend we’ve seen is some transition from predominantly Greenfield and new deployments to more and more retrofit. We’ve heard of instances of people not just retrofitting CO2 lasers, but also for example retrofitting plasma cutters. We have examples in the welding industry of people transitioning to retrofit lamp pump YAG lasers for welding, whether it be locomotive engines or in the automotive industry, for example, welding roof.

So we’re in a relatively early stage of the retrofit but it’s becoming a more important part of the business, and it represents fairly significant opportunities going forward. The best way to look at it I think is that people estimate that there are more than 40,000 lasers deployed for cutting applications around the world. Our total penetration into that installed base is probably less than 5%, even though we have 20% share, 20% plus on an annual basis. So there is significant retrofit opportunities that probably exist over the next five years or so.

Operator

Our next question comes from the line of Krish Sankar with Bank of America Merrill Lynch. Please proceed with your question.

Krish Sankar - Bank of America Merrill Lynch

Yeah, hi. Thanks for taking my questions. I have a few of them. Tim, what exactly was the sales to China in Q4 and can you also tell what the split was in China between low, medium and high power?

Timothy Mammen

We don’t disclose that split in China. The total sales in China was $18 million odd, I think. So it was down significantly quarter-on-quarter. It was weak on 2-kilowatt power lasers for cutting applications for 2D and also weak on pulsed. But we don’t break that out specifically.

Krish Sankar - Bank of America Merrill Lynch

Got it. All right. And then, when I look at your Q1 guidance, can you just help us understand what drives the spread? What gets you to the low-end and what is the opportunity to get to the upper end of the guidance range?

Timothy Mammen

We generate guidance using a methodology where we look at all the orders in hand at the moment. And then using assumptions and historical analysis drive the bottom and top-end of the guidance range, depending upon likely order flow that we can book and ship. There are also other factors we take into account. For example, if you happen to (inaudible) lasers that don’t get installed where you run into FOB destination shipping terms, we need to build some range in to accommodate those factors as well.

Krish Sankar - Bank of America Merrill Lynch

Got it. And then it looks like you guys are doing pretty well in China. I was just kind of curious, if you look at the next biggest market in Asia after China, which is Japan. Can you talk a little bit about how you’re progressing and what your market share expectations are for in Japan at this point?

Timothy Mammen

We are actually very optimistic about Japan in 2012. We’ve made significant gains in qualifying our lasers in different applications. So historically, we’ve been very strong in Japan on marking, engraving and welding applications. We’ve now qualified with a number of different OEMs for cutting applications. We see opportunities for entering more deeply into the fine processing market using our QCW lasers. And we’ve also qualified to a deeper degree in integration with some of the major automotive manufacturers there, that we think will start to purchase more lasers from Q2 2012. So, we are actually pretty optimistic about the traction we may be able to achieve in Japan over the next 18 months.

Krish Sankar - Bank of America Merrill Lynch

And then the final question is, if I look into your full -- into 2012, is it fair to assume that in the past you’ve said maybe 15% to 20% growth on the top line is doable. Given your Q1 guidance, is it fair to assume you could probably do better than that?

Timothy Mammen

We don’t give full year guidance. So, you can’t draw me entirely on that question. I’ll say that we’ve got a pretty tough budget that’s been approved by the board. And we want to make sure that we continue to penetrate this market and take full advantage of the -- advantages of our technology growing new applications, products, into different geographies. So we’re optimistic about the year but we can’t be drawn on the full year guidance.

Valentin Gapontsev

We’re not simply opportunistic. We are very opportunistic about 2012.

Operator

(Operator Instructions) Our next question comes from the line of Joe Maxa with Dougherty & Company. Please proceed with your question.

Joe Maxa - Dougherty & Company

Thank you. You’ve had some success in the cutting market over the last couple of years. Can you give us an indication where you’re seeing the most traction and then where you see the most opportunity?

Timothy Mammen

The most traction is basically entering into the very large 2D cutting market. That still represents the biggest opportunity ahead of the company. And then you also -- some of the multidimensional application for cutting different shaped parts, are also very significant. It’s basically 2D and multidimensional cutting of different thicknesses of materials, different types of material, where we have advantages in terms of speed and productivity. And then you combine that with the lower cost of running the laser and it drives higher ROIs for different companies. I think one of the bigger opportunities right now is going to start coming out of the job shop applications. There is significant additional cash flow that people can earn by implementing the fiber laser where we’ve been relatively lightly penetrated into job shop applications on cutting.

Valentin Gapontsev

In cutting, last year we still worked mainly with Europe and China. But this year we’ve opened door to Japan, to North America and so on. Most manufacturers of cutting systems in this region now, they start the work very seriously, when they have serious wins for this year with IPG.

Joe Maxa - Dougherty & Company

Okay. That’s helpful. Then on the -- back on the revenue. You do have the seasonal softness in Q1. At this point, would you suspect to see more of a normal Q2?

Timothy Mammen

I think the answer to the question is, I think we have seen good order flow in December and January. All the trends point towards a good Q2. The run rate of orders for those two months that I mentioned has been pretty reasonable after an anemic September and October. So, we’re optimistic for the year, Joe.

Joe Maxa - Dougherty & Company

Okay. Very good. Last thing I just want to touch base on is the backlog, the strong backlog you’ve given. And you have the $124 million, that’s firm to ship. What’s the kind of the turnover of that? Or you should (inaudible)

Timothy Mammen

Generally, if you average it out, it’s a four months of backlog in hand. There are orders that we have now that go out through Q3 and Q4 also. So, we don’t give a sort of forward aging of that completely, but on average, it turns sort of every 4.5 months or so.

Operator

Our next question comes from the line of Avinash Kant with D.A. Davidson. Please proceed with your question.

Avinash Kant - D.A. Davidson

Good morning, Valentin and Tim. First one, Tim, could you give us the number, what was the expense towards the litigation expense in Q4?

Timothy Mammen

Approximately $1.5 million.

Avinash Kant - D.A. Davidson

Okay. And could you talk a little bit about the automotive sector? Where do you think the automotive guys are in terms of the adoption and when do you think is the timing of the mass adoption?

Timothy Mammen

We’re still early stages in adoption. We have deployed lot of lasers in the last year, but in the context of transitioning from using lasers vary widely from welding as compared to traditional technologies, we’re still probably somewhere around the first base.

Avinash Kant - D.A. Davidson

So what’s been the hurdle there or what are they waiting for?

Timothy Mammen

To change from using technologies that have been used for almost 100 years to a new technology in production lines that are extremely complicated, where the technology, the amount of investment required to transition, it does take time. People tend to incorporate those transitions around technology changes. For example, we’re seeing, as we mentioned, as people have to go to reducing fuel consumption, reducing the weight of cars, looking at the ways to weld different materials together to achieve those targets, some of those technology changes are driving the laser change. It’s a complex process with long lead times to capital equipment decisions and technology change being made.

Avinash Kant - D.A. Davidson

So do you expect some of the players that are very close to making their transition?

Timothy Mammen

There have been a lot of people who claim that they’re close to making the transition. I don’t think it’s necessarily going to result in suddenly certainly a thousand unit order from anybody this year. I think we’ll even find that difficult to manage. But we expect that to grow significantly. We probably deployed -hundreds of lasers in 2011 in relation to that. One of the other barriers is that historically earlier in this decade people had poor results from using different types of lamp pump YAG lasers, for example, in mass deployment for welding applications, and they were turned off from using lasers. And we’ve had to overcome that barrier to prove the reliability and cost effectiveness of our devices.

Operator

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

James Ricchiuti - Needham & Company

Thank you, good morning. I wanted to follow-up on the comments you made about the new technology in QCW. To what extent would you expect to be in volume production in the second half of this year? And I wonder if you could just talk a little bit about how you see the market opportunity for this.

Timothy Mammen

I think we’re pretty close to getting into volume production in Q2 and ramping that in Q3. The opportunity here is.…

Valentin Gapontsev

Originally, we had started volume production last year, but problem was not in volume production, problem was in, still market acceptance of this technology. Of course, this technology is not comparable, much, much better than existing lamp pump YAG laser. (Customer wants) the cost price of this. The major, 90% of top manufacturers of the station system built on this technology. With lamp pump YAG, they produce own (inaudible) with pump YAG. For them very difficult to make decision to turn much better technology, but then because there margins in the case would be much less.

But we now are creating such conditions that we (inaudible) raising for our sales price for the much better laser would be cheaper than cost of these people including China manufacturing their sales with pump YAG. Only such conditions we created now such condition, open all doors. So we hope this year we’ll open the door. Last year, we produced 270 -- sold 270 QCV lasers. This year we went (inaudible) up to 5 to 10 times more to sales this year QCV. But total market, it’s like 5,000 to 10,000 QCV lasers per year.

James Ricchiuti - Needham & Company

And in terms of the newer version of this, can you give us a sense of what the ASPs, the prices might look like.

Valentin Gapontsev

I said to you, even now we now started to quote cheaper than manufacturing cost of major manufactures in China, so let’s compare. So the major manufacturers of these systems based on the gas pump YAG in China now starting to manufacture. They are looking -- claim that we’ve -- to buy our lasers. Well, now the other region like Europe, America and Japan, especially price is much higher. But to be in China where there is major market for such kinds of lasers. It will be in this market, so all other market would be no problem at all.

James Ricchiuti - Needham & Company

Got it. Tim, one quick question on the selling expenses. It’s been declining sequentially now since Q2, and that’s not going continue, but I am just wondering can you give a little color on that? And I would assume that even in Q1 you should see a lower level of selling expense depending on of course where you come in on revenues?

Timothy Mammen

We’d expect to see a pick-up in Q1 little bit, Jim. There are two things first of all, the effect of the exchange rates in Euro that benefits the translation. The second thing is through, you were right on this, the second and third quarters we’ve been pretty aggressive in accruing the bonuses for the sales people with slightly weaker Q4 that resulted in slightly lower accruals in Q4. And then on the selling side we’ve seen the depreciation on our demo units which were quite aggressive, have come down a bit. We expect to invest further in demo units and in our 2012 and in our application labs to make sure that we have new product to give out to customers to test. So, I know, we’re going to add some headcounts around the world on the selling side. So, there are different factors that have been effecting, that we had to let go of two salespeople in Q3 in the U.S. We found a couple of people to replace them, but haven’t managed to do that early on in Q4. So some timing stuff there as well.

Operator

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

Mark Douglass - Longbow Research

Hi, good morning, gentlemen. Tim, can you run down your expectations on the expenses again? So, you just said that there is going to be a roughly flat from 4Q to 1Q. Is that total op expenses?

Timothy Mammen

Yeah, total op expenses are probably going to be around $21 million in Q1.

Mark Douglass - Longbow Research

Okay.

Timothy Mammen

So, you get some benefits on lower legal expense.

Mark Douglass - Longbow Research

Right.

Timothy Mammen

Probably a little bit of a pickup on R&D and selling. And the bonus accrual level in Q4 is probably pretty representative of what it would be in Q1. And it was lower than it was in Q3 and Q4, that bonus accrual rate.

Mark Douglass - Longbow Research

Okay. What were the total bonus accrual in ’11?

Timothy Mammen

We’re not disclosing that.

Mark Douglass - Longbow Research

Okay. But is it fair to say though that, as you would expect sales to ramp, you can keep your expenses fairly stable through the year, or do you anticipate maybe you’d have -- aside from commissions?

Timothy Mammen

We’re going to add some expenses during the course of the year, but we’ll get leverage of this. And my budget model shows some pretty healthy operating margins coming into the end of the year. You should factor in some ramp, of course, on operations. Because we invest particularly in selling and R&D and a little bit on the G&A side. Getting to be a much bigger company with more complexity. So we’re going to invest in those areas. But if we grow like we hope to, we’ll see some leverage off that and we’ll see some pretty healthy operating margins coming into the end of the year despite that investment.

Mark Douglass - Longbow Research

Right. So we wouldn’t see op expenses grow on pace with sales?

Timothy Mammen

No. I mean not as fast as sales, no. So we get a little bit of leverage.

Mark Douglass - Longbow Research

Okay. And then on China you mentioned it was $18 million in the quarter. It’s a big sequential drop. So is that really indicative of how strong, say, automotive and cutting were outside of China. Can you kind of flush that out a little bit?

Timothy Mammen

So the Chinese number (we gave) is 19.1 million. My 18 was a little bit understated, but it was down sequentially, significantly. Most of that was marking and cutting. We installed a few units into automotive and we’re not heavily penetrated in that area. We’ve actually hired a couple of sales people who’ve got a lot of automotive experience. They only came on board in Q4. So actually optimistic about penetrating more of that market. In addition to that, some of the fine processing applications in consumer are starting to pick up. So we basically see the stabilization in China. We think we will see a little bit of a pickup in Q1 as compared to the Q4, both related to those new opportunities and the 2D cutting picking up a little bit. The low power marking should be relatively stable.

Mark Douglass - Longbow Research

Okay. Thank you.

Valentin Gapontsev

No major Chinese customers gave us -- forecasts for this year are extremely attractive.

Operator

(Operator Instructions) our next question comes from the line of Olga Levinzon with Barclays Capital. Please proceed with your question.

Olga Levinzon - Barclays Capital

Hi, thank you for taking my question. Just wanted to follow up regarding your comments for 1Q gross margins. You suggested that it would be likely flattish Q-over-Q. How do you think about inventory levels, given that they picked up over your target range? With sales probably flattish or slightly down and gross margins relatively consistent, should we expect inventories to pick up again? And how do you plan to work that down as we progress through the year?

Timothy Mammen

The first point is that I don’t think in order to get to just below our target range, there is a tremendous reduction in inventory relative to cost of sales required. Second thing is that we already factored it in Q4, reported in Q4 lower absorption related to lower activity within production. So, we feel comfortable targeting similar level and I expect inventories to be relatively flat Q4 to Q1.

Olga Levinzon - Barclays Capital

Okay. And then, following up on your comments for the laser system sales. You talked about that being an $8 billion addressable market, but you’re really going after a smaller niche of that market. What were laser systems sales in 2011 and what sort of TAM should we be factoring in that you’re actually pursuing?

Timothy Mammen

Well, laser system sales, we don’t disclose specifically. We only restarted that business last year. We’ve been selling some systems in India for a little bit. They were probably less than 2.5% of total sales, but we got some good traction with some very interesting applications in health. A number of different customers solved some very key problems that they were encountering. And some of the payback that they got on the systems that we helped them develop, has been less than a year. So, it’s actually been very successful, and we’re optimistic about it. Of course that whole available market is not necessarily either addressable by us at the moment, nor do want to necessarily address it.

So for example, are we going to start competing with all other people who sold marking and engraving systems which have relatively low value, the answer to that question is no. Are we going to compete with our major European OEMs on 2D cutting? The answer is no. A lot of it will come on welding application, some of the -- for example oil pipeline welding, we delivered $2.5 million system in Russia. Some of the cutting applications in geographies that are not well served by our customers. So for example again in Russia, selling complete cutting systems. And then on the higher value add stuff, it predominantly revolves around welding. Valentin mentioned remote welding and then using scanners to develop very high-speed welding systems.

Valentin Gapontsev

Yes. We are very successful for very short we introduced.. We can mention ten very big customers. We are happy when we see the demand now return again with new order for our system in America, in Europe, in some other locations. And we have very serious plan for some special system in especially such region like Russia, for example, India and so on.

Operator

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

Mark Miller - Noble Financial

Good morning. You’ve been able to significantly improve your margins, one of primary things has been component cost reduction. I am just wondering what lies ahead, is there still more coming here?

Timothy Mammen

I think we’ve articulated this quite well before. So there are certain specific areas where we think we’re going to get a lot of component cost reductions out. We talked a lot about the QCW size and we’ve talked about this unique diode chip. Even on the CW diodes, transitioning from new pack -- from old package designs to new, more simple package designs, will take, probably, diode costs down by 40% in 2012 as compared to 2011. Now, we’ve already taken so much diode costs on an absolute basis that’s not very significant, but it’s still very important. The costs that we’ve taken out of some of the optical delivery systems have been significant. We have ramped production of those, but we’ve probably still got opportunities ahead of us to build scale into the manufacturing of beam switches and optical heads.

There are other opportunities that exist in terms of developing internally which were very close to completion on, on different types of process heads as well. And then continual focus on reducing component costs. So, anything from the modulators that go into to pulse lasers, reducing the cost of those, reducing the cost of couplers, as we increase volume manufacturing. So, it’s a continuous focus within the business. I have said, one of the great strength of this company is that it’s not just a R&D and technically focused company. A lot of that R&D and technical development is focused on reducing cost.

Valentin Gapontsev

We installed our new automotive production line, very powerful. Also for mechanical parts we’d stop depend in from outsourcing, in price as well in lead time. We now opened also, now own production for automotive. Again for production line for PCBs and so on. So it will give us much more flexibility and save a lot of money and time.

Mark Miller - Noble Financial

Then we talked a little bit about the specialized laser systems, so that’s going to become a bigger part. Do you envision any acquisitions to help support you there?

Timothy Mammen

Yeah, I think that’s one of the ways you could really leverage that business is by identifying specific opportunities that could help to take your sales of certain products lines up significantly faster than waiting to qualify with other people. So, we have a lot of people approach us for, with different companies and interesting opportunities, and we evaluate those. But that’s exactly one area, Mark, we could be looking at over the next year.

Operator

Our next question comes from the line of Jiwon Lee with Sidoti & Company. Please proceed with your question.

Jiwon Lee - Sidoti & Company

Thanks, good morning. Couple of quick questions. So, the CapEx for this year, $55 million to $60 million, how much of that which is roughly set aside for investment in the system?

Timothy Mammen

A small part of it is on the systems side. A lot of it is -- you can’t really break it out. So, for example, we’re building a new state-of-the-art facility in Russia, part of that facility will be used to expand manufacturing of systems in Russia. And that facility in Russia really replaces some very old soviet style era buildings there. So, it’s not really possible to break it out specifically, Jiwon. A part of it could be used for expanding the systems business. We’ve got a new assembly area in the U.S. that will be shortly completed for the systems area. But they are not massive amounts of capital expenditure. I think the interesting thing on the systems side is that, the return on capital employed can actually be fairly significant and attained relatively quickly.

Jiwon Lee - Sidoti & Company

And that is in congruence to how you expect revenue to step up on that side? Your capital spending, I mean?

Timothy Mammen

Yeah, I think it’s still very early stages. It’s not a $50 million or $100 million business. But appropriate amounts of investments are being made so that we can leverage those sales.

Jiwon Lee - Sidoti & Company

Okay. And the second question, on the QCW laser, what end markets are you primarily focusing?

Timothy Mammen

It’s in the fine processing. So when you get into welding and cutting of very thin materials, very high speed drilling applications and consumer electronics. Any other specific applications there we do? Those are the main ones there.

Operator

Our next question comes from the line of Ajit Pai with Stifel Nicolaus. Please proceed with your question.

Ajit Pai - Stifel Nicolaus

Yeah. Good morning. Just looking at what you talked about in terms of expenses moderating and the gross margins staying relatively stable. You also have decelerating growth on the top line and in 2011 you generated about $88 million in cash from operations. So, this year, just given the decelerating growth and still continuing to expect operating leverage, can the cash generation from operations be materially more? Should we be thinking more like $100 million or so?

Timothy Mammen

I think that we will see some leverage on cash generated from operations this year.

Ajit Pai - Stifel Nicolaus

Right. And then you had $54 million in CapEx all of last year, and you had some pretty significant CapEx items there. So, can we see that -- that should also moderate this year?

Timothy Mammen

No, no. The CapEx number will still be about $55 million to $60 million. So, we’re in this phase of significant investment, part of which involves significant upgrade and modernization in Russia while the additions in the U.S. and Germany are more capacity additions and replacement. So, a lot of the major upgrades in Russia should be completed this year in 2013. Once we have state of the art manufacturing facilities there, as well as Germany and the U.S., I’d expect to see CapEx moderate.

Ajit Pai - Stifel Nicolaus

Got it. And then, looking at the newer set of system businesses you talked about. You had introduced the Seam Stepper and I assume that that’s a significant part of that business. But can you give us some color as to, are there any other applications outside of that, that are also material that you’d like to talk about?

Timothy Mammen

So, the Seam Stepper has generated reasonable amount of revenue, I think that acquisition was a successful one. Some of the other areas are being developing a micro-processing station using the QCW where customers want a one-stop shop for some of the cutting and welding.

Valentin Gapontsev

Not only QCW, also green laser tool. There are short wave pulse lasers and so, and mid-infrared lasers. So, all new kinds of lasers we introduced. Now in the market will allow us to go to the semiconductor, battery welding for the display, or the wafer processing and so on, where we still have a small position. With our position (inaudible) in the market would increase dramatically during next two, three years. Combining with new products, absolutely new, much high quality and industry grade sources not available now in the market, and also (mine) systems, special station which we’ll use this, our source to provide for new opportunities.

Timothy Mammen

And then finally the answer to this high-power welding which we’ve been successful in solving a number of different customers’ problems, giving them very rapid payback.

Ajit Pai - Stifel Nicolaus

Got it. And then the last question is, you talked about -- you have historically talked about the sort of diode wattage of the average diode. Could you give us some color as to what’s the bulk and what percentage comprises of the diode wattage right now?

Valentin Gapontsev

The wattage from our modules is based on single emitter diode chip. Our wattage will increase once we have (inaudible) with reduced (inaudible) module, now will be increased up to 200 watts, even more.

Ajit Pai - Stifel Nicolaus

Right, do you still produce 9 watts, is it completely gone? Or what is the bulk of your shipments? What wattage are the diodes?

Timothy Mammen

The chips are now at about 11 watts. And...

Valentin Gapontsev

No, no, the chips are up to (inaudible), even 20 watts, from chip.

Operator

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

Valentin Gapontsev

Okay, thank you very much for listening to our call and to your questions. We look forward to speaking with you again next quarter with better results.

Operator

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

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