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IPG Photonics Corporation (NASDAQ:IPGP)

Q1 2008 Earnings Call

May 6, 2008  10:00 am ET

Executives

Angelo Lopresti - Vice President, General Counsel and Secretary

Valentin Gapontsev - Chairman, Chief Executive Officer

Tim Mammen - Vice President, Chief Financial Officer

Analysts

John Lau - Jefferies & Co.

Unidentified Analyst - Thomas Weisel Partners

[Olga Evanson] - Lehman Brothers

Jiwon Lee - Sidoti & Company

Ian Fleischer - Friedman, Billians, Ramsey & Co.

Conor Irvine - Needham & Company

[Jenny Jones] - Schroder Investment Management

Operator

Good morning, everyone, and welcome to IPG Photonics first quarter 2008 conference call. (Operator Instructions)

At this time I'd like to turn the call over to Angelo Lopresti, IPG's Vice President, General Counsel and Secretary, for introductions.

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-Q for the year ended December 31, 2007 and other reports on file with the Securities and Exchange Commission. Copies of these filings may be obtained by visiting the Investor Relations section of IPG's website at www.IPGPhotonics.com or by contacting the company directly.

Any forward-looking statements made on this call are the expectations or predictions only as of today, May 6, 2008. 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 after the completion of the call. Please go to www.IPGPhotonics.com to view these remarks.

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

Valentin Gapontsev

Good morning and thank you for joining us today.

I'm pleased to report that once again IPG posted strong first quarter results [break in audio] of our product offerings across a variety of applications and our expanding presence in the world's major markets for industrial laser systems. In building IPG's business, we were quite conscious that not every market or every application area would perform consistently over time. But with the geographic and application diversity that we built, IPG has been able to generate superior results despite downturns or softness -

Operator

Excuse the interruption. This is the operator. Dr. Gapontsev, we are not able to hear you clearly at this time.

Valentin Gapontsev

Oh, sorry.

Angelo Lopresti

Can you speak up a little bit more?

Valentin Gapontsev

Okay. Can you start from beginning?

Angelo Lopresti

Can you hear him yet?

Operator

Just vaguely. Dr. Gapontsev?

Valentin Gapontsev

Yes?

Operator

Still not particularly clear at the moment.

Angelo Lopresti

Is that better?

Valentin Gapontsev

Now that's better?

Operator

Not quite yet, sir. Still a little difficult to hear you. Please stand by, everybody.

Valentin Gapontsev

And now?

Operator

I believe that's better.

Valentin Gapontsev

Hello? Can you start from beginning? Hello?

Operator

Still a little [inaudible]. Just one moment, sir.

Valentin Gapontsev

Okay. Hello?

Operator

Thank you for your patience, and we ask that you continue to stand by.

[break in audio]

Operator

Ladies and gentlemen, thanks for your patience. Dr. Gapontsev, please go ahead, sir.

Valentin Gapontsev

Okay. Good morning and thank you for joining us today.

I am played to report that once again IPG reported strong first quarter results despite a slowdown in the U.S. economy. This is a testament to the breadth of our product offerings across a variety of applications and our expanding presence in the world's major markets for industrial laser systems.

In building IPG's business, we were quite conscious that no every market or every application area would perform consistently over time. But with the geographic and application diversity that we built, IPG has been able to generate superior results despite downturns or softness in some geographic or application markets. This was true this quarter.

We continued to make good progress in growing our position in the overall laser market. The 27% increase in sales over last year was primarily due to the market expansion enabled by our product's breadth of laser performance, substantial energy savings, and lower cost of ownership and partially due to taking market share from makers of conventional lasers.

At the end of the third quarter, IPG was the fourth largest maker of commercial nondiode laser sources as measured by revenue. In 2006, we were the sixth largest. Many of our products, such as our kilowatt fiber lasers have competitors up to date. Also we were successful in targeting new application new applications for our products and expanding our product portfolio and our geographic reach.

We also dramatically expanded our intellectual property position in February with the purchase of more than 100 key U.S. photonics patents and their 340 foreign counterparts from British Telecom. These patents are relevant to both current and future photonics components and enhance our IP position.

Before I turn the call over to [inaudible] Tim Mammen, let me review some highlights. This quarter, revenue increased 27% to $52.9 million from the comparable quarter in the prior year, in line with our guidance. This was driven by strong sales of our lasers used for material processing applications. Earnings per diluted share of $0.18 for the first quarter were in the top end of our guidance range and our gross margin recovered to 46% again.

Now a better speaker, Tim Mammen, will provide you more details.

Tim Mammen

Thank you, Valentin. [inaudible] everyone. I will start with some [inaudible] and I will then review our financial highlights.

[inaudible] top and bottom line growth in our business. Our 27% revenue growth in the first quarter over the prior year -

Operator

Mr. Mammen, I'm sorry. This is the operator. But again, we're having the same problem we just had with Dr. Gapontsev. We're unable to hear you very clearly.

Tim Mammen

Is that better?

Operator

That's perfect. Thank you very much, sir.

Tim Mammen

I'll start again. Thank you, Valentin, and good morning, everyone. I will start with some operational remarks, and I will then review our financial highlights.

I want to reiterate Valentin's remarks on the top and bottom line growth in our business. Our 27% revenue growth in the first quarter over the prior year shows the traction that IPG's fiber lasers continue to experience. Our growth was driven by a 34% increase in sales for Materials Processing, which is our largest application. Growth has been driven by the broad diversity of uses for our products. With increasing global energy prices, we are experiencing additional interest in our fiber lasers because of the substantial energy savings from the high electrical efficiency.

During the first quarter, we saw continued strong growth in pulsed fiber lasers from a number of customers for solar or photovoltaic manufacturing, including scribing and isolation. This is a relatively new application for us and our lasers are well suited for this emerging industry, that has increased its capital spending for tools.

High power fiber lasers, an area where IPG's products stand alone, saw continued acceptance from automakers and suppliers throughout the world and for other heavy industry applications where our laser's power, beam quality and flexibility create meaningful gains in productivity. We will continue to leverage our core competencies for new sales opportunities.

It is important to note that IPG achieved 27% growth despite a significant drop in medical sales and flat materials processing sales in North America. IPG has built a business model that has application and geographic diversity that is enabling us to continue to grow revenue even when one or more of our end markets or geographies is experiencing some weakness or volatility. This is a testament to the strength of IPG's diversified business model.

We do estimate that exchange rates benefited revenue by approximately $3 million.

I want to point out that the sequential sales drop from our record Q4 to Q1 we experienced this year is fairly typical for IPG because of the buying patterns of our customers and was also influenced by the weak medical sales. This is driven by their budget cycles and geographic seasonality. In the last few years, Q4 to Q1 sales were either down or flat.

And finally, our gross margins improved in the first quarter sequentially over Q4. Gross margins sequentially gained nearly 3 percentage points from decline in the first quarter of 2007 because of better absorption of our fixed costs related to improved manufacturing yields and increased production, part of which contributed to the increase in inventory.

As you know, a key focus for IPG is the expansion of our manufacturing capacity in key technologies to take advantage of growth opportunities from our technological and brand position. The level of production in a period determines how efficiently we use our capacity. In general, gross margins improve as capacity utilization and production increase. Obviously, the goal is to match production to demand and capacity to production. As revenues grow, we would expect to be able to more consistently use our capacity to meet demand from sales and for our gross margins to stabilize and improve.

Currently, if production in a period is not sold it is placed in inventory in anticipation of future growth in sales. The current imbalance between capacity and demand could lead to some sequential volatility in gross margins as we vary production to either increase inventory in anticipation of future demand or consume items currently in inventory. Given the historically strong second half of prior years, we expect gross margin to improve in the second half of the year and into 2009 as we come to the end of the current phase of capital investment. As sales continue to grow, we should be able to more consistently balance production, capacity utilization and inventory levels.

Now I'll turn to the financial results. Let me start by providing you with some information about how we performed in the four markets that we target.

Materials Processing, which is IPG's largest market, contributed 84% or $44.2 million of the revenue we reported in Q1 and grew by 34% year-over-year. Sequentially, materials processing sales grew by 12%. The Materials Processing segment encompasses several end markets, such as general manufacturing, solar, automotive, aerospace, heavy industry, consumer, semiconductor and electronics. We have seen growth from each one of these applications in Q1. Let me give you a few examples.

As I mentioned, we saw increased interest for pulse lasers for solar panel processing, including a large order from a solar manufacturer in North America for a new application involving novel solar panels, and ongoing orders internationally. The international automotive market continues to be a strong one for us, for both automotive integrators and OEM manufacturers. During the first quarter we shipped a number of high power lasers to European and Asian automotive and components manufacturers, including several high power lasers for tailored blank welding.

We are making progress in penetrating cutting applications with our fiber lasers. Our largest customer this quarter was a cutting system OEM. We are pleased that our applications development work is starting to yield results with this customer and others, and proving that our lasers can effectively compete with CO2 lasers for cutting. Cutting has a larger installed base than laser welding currently.

Our lasers continue to win in head-to-head runoffs against conventional lasers and to replace CO2 units. Also during the quarter we placed several high power units into European research institutes for R&D on future industrial applications. These seed installations are invaluable in generating industry thought leader acceptance of our lasers for new and innovative applications. We continue to be encouraged by the growth prospects we see in the Materials Processing market.

Advanced Applications increased by 16% over the prior year, driven by sales of a variety of our products for scientific and government applications. The Advanced Applications segment represented 10% of total revenue during the first quarter. Coming off end of the year budget spends by institutions, the first quarter can typically be weak. Advanced Applications include test and measurement, instrumentation, sensing and defense applications as well as scientific research and development.

Revenues in Communications were up strongly by 29% over the first quarter of 2007. The Communications segment comprised 6% of our revenues in the first quarter. We believe that this segment has stabilized now. Sales in the Communications segment were again driven by demand from integrated DWDM systems and broadband access in Russia and, to a lesser extent, from increased shipments in North America.

Last year we were qualified by two North American Tier 1 integrators, which contributed to the growth in this hemisphere. Our products are well suited for long haul and ultra long haul applications, enabling service providers to extend network links beyond previously achievable distances. IPG continues to bid on new projects, both inside Russia and North America that leverage our product advantages.

Lasers for the Medical Applications segment comprised less than 1% of revenue in the first quarter. With a sharp drop off in orders from our main medical OEM, sales were down 77% from the first quarter of 2007. It continues to be our goal to diversify our customer base in this segment in order to reduce the reliance on this one customer. During the quarter we established a relationship with a new Medical Applications OEM in Europe, and we are in test with other medical OEMs. We do not expect sales in this segment to recover to prior year levels in the near term, but we remain optimistic that we can continue to develop this business.

Turning to the performance of our laser types in the first quarter, pulsed laser sales increased by 73% from the first quarter of 2007. As a percentage of revenue, pulse lasers represented approximately 39% of revenue or $20.7 million in Q1 '08. This is our oldest product line, but we continue to introduce new models with enhanced performance to increase the spectrum of applications for our pulsed fiber lasers.

Despite growing competition, our pulsed lasers have many competitive advantages. This line continues to be one of the best producers for us. As I mentioned earlier, we're seeing growing demand for our pulsed lasers used in solar panel manufacturing. Marking applications, including semiconductor marking, also continue to help drive sales of our pulsed lasers during the quarter, as well as other materials processing applications. We will continue to look for new materials processing applications for our pulsed fiber lasers.

High power fiber lasers used in materials processing and advanced applications continue to be a key growth driver. In the first quarter on a year-over-year basis sales of high power lasers increased by 21% and represented approximately 29% or $15 million of total revenue in Q1 2008. Overall, we expect high power laser sales to continue to be a key growth driver for us, although growth from high power lasers may fluctuate from quarter to quarter.

We're seeing strong interest in our YLR series of high power kilowatt class lasers for use in tailored blank welding, tube welding, steel cutting, nuclear demolition and railcar manufacturing. We have a growing number of OEMs of our fiber lasers for cutting applications. We believe that the buying trend we are seeing in cutting is similar to the passion we've seen in the past with the adoption of fiber laser technology for other applications. The early adopters are generally slow to move with fiber lasers; however, the success of the early adopters drives interest from other major OEMs.

Sales of medium power lasers grew 22% during the first quarter of 2008 over 2007 and represented 11% or $5.8 million of total revenue in Q1 '08. We see continued demand for centering and commercial printing applications.

Turning to our geographic performance during the quarter, we reported 37% of revenue from Asia and Australia, 46% from Europe, and 17% from North America. European sales increased 55% year-over-year, driven primarily by strong growth across the region. Sales in Asian markets increased 47% compared with the first quarter of 2007. Strong sales from our Chinese office and continued growth in India and South Korea contributed to this increase.

We are encouraged that sales in Japan, which had been weak for several quarters, appear to have stabilized and grew by 5%. Last quarter we strengthened our operations in Japan by hiring a new general manager with extensive materials processing laser experience, expanding our sales force there and opening a new sales and service center.

Sales in North America decreased 29% over Q1 '07. This was due to a steep drop in sales to our primary medical applications customer that I previously mentioned and lower sales in the often variable Advanced Applications market. Despite the declines in these markets and general economic weakness in the U.S., Materials Processing sales were flat in Q1.

In general, we have not experienced order cancellations in North America, but we have seen some delays in order placements in Q1. However, we are beginning to see some turnaround in the U.S. market, with improved order flow compared to the beginning of the year. While the order flow we're seeing should bring some benefit to Q2, we expect continued improvement to primarily benefit the second half of the year. We have added three highly experienced sales professionals during the quarter, each with a focus on a distinct aspect of the U.S. market.

As I discussed previously, gross margin for the first quarter was 46%, which is sequentially nearly 3 percentage points better than Q4 and compares with the 46% gross margin we reported in the first quarter of 2007.

Cost of sales includes approximately $733,000 related to inventory provisions and write downs.

SG&A was $9 million or 17% of sales compared with $6.2 million or 15% of sales in the first quarter of 2007. This is within the range of our SG&A target of 15% to 18% of sales in the short to mid term. We continue to invest in selling expenses with the expansion of our sales force, as I discussed earlier, as well as increases in the number of units we use for demonstration purposes.

Non-selling G&A expenses increased primarily due to expenses related to ongoing and recent litigation. Patent litigation defense fees were $1.3 million for Q1 2008 compared to $0.4 million in 2007. Litigation costs were higher in Q1 due to greater legal activity in the IMRA patent litigation. Recently, the IMRA case was stayed by the U.S. District Court until the U.S. Patent and Trademark Office concludes on a patent reexamination we requested earlier this year.

R&D expenses were $2.9 million or 5% of Q1 '08 revenues. This compares with $2.1 million or 5% of revenues in Q1 '07. We expect an increase in R&D expenses, but it would be within our target range for R&D of 5% to 7% of revenue. We have historically kept IPG's R&D expenditures low as a percentage of revenue due to efficiency and strategic focus of our R&D activity.

Operating income for Q1 '08 increased by 13% compared with the same period last year. IPG generated operating income of $12.5 million or 24% of revenue compared with operating income of $11.1 million or 26% of revenue in the first quarter of 2007. Operating income includes charges related to stock-based compensation of $387,000 and $213,000 in the first quarters of 2008 and 2007, respectively. In the first quarter of 2008, $22,000, $268,000 and $97,000 of stock-based compensation charges related to cost of sales, SG&A and R&D, respectively.

Our tax rate for the first quarter of 2008 was 32%, which is the overall effective tax rate we estimate for the year. The effective tax rate for 2007 was 32.6%.

Net income for the first quarter of 2008 was $8.1 million or $0.18 per diluted share compared with net income of $6.6 million or $0.15 per diluted share for the first quarter of 2007.

Let me turn now to our balance sheet, where cash and cash equivalents at March 31, 2008 stood at $38.7 million compared with $38 million on December 31, 2007. We also have $2.5 million in auction rate securities. We disposed of $4.5 million in auction rate securities in Q1.

For the first quarter of 2008, capital expenditures and investments in intangible assets totaled $13 million and were primarily related to facilities equipment in the U.S. and Germany and the portfolio of patents previously discussed.

Accounts receivable increased to $37.3 million at March 31, 2008 from $33.9 million at December 31, 2007, largely based on the timing of shipments and recognition of revenue in the quarter as well as the geographic distribution of sales as standard payment terms customarily vary between international territories. As a result of these factors, accounts receivable days outstanding increased to 63 days at the end of Q1 from 55 days at the end of Q4 2007. Historically our accounts receivable have been strong as measured both by low bad debt and AR aging, and they continue to maintain a high quality.

Inventory increased by $9.2 million to $69.6 million at March 31, 2008 from $60.4 million at December 31, 2007. Approximately $2 million of the increase in inventory was attributable to the continued appreciation of the euro against the dollar. The remaining increase in inventory was primarily due to an increase in work in progress related to the production of value-added components including packaged diodes and fiber modules as well as major subassemblies. We believe our overall level of inventory is comparable to some of the other companies in our industry given that we are much more vertically integrated and we are growing at a higher rate.

Additionally, IPG maintains significant levels of inventory for two strategic reasons - first, to ensure that if there was a disruption to the manufacturing capacity of any of our key technologies we would have components from which to continue to build finished products while those problems were resolved; second, it enables us to quote short delivery times to our customers and deliver product, particularly high power lasers, to them in a short period of time, providing what we currently believe is a competitive advantage. One example is a 15 kilowatt laser we were able to deliver to a customer in Europe in March for an order that we received in February. This is a very short lead time for a made-to-order high power laser.

Other factors that we take into account when we plan the level of inventory we should carry include future sales opportunities. For example, we are building high value fiber modules which will be used to build a 50 kilowatt laser that will be used for a defense demonstration trial in the second half of 2008. Also, historic distribution of sales  historically, our sales have always been stronger in the second half of the year, and to meet these anticipated sales we need to build inventory in the first half of the year.

During the first quarter of 2008 there was net cash flow from operations of $5.4 million. This compares with cash flow from operations of $600,000 for the first quarter of 2007. The increase in operating cash flow was primarily the result of higher net income and lower tax payments.

With regard to our line of credit facilities, at the end of the first quarter we had a total of $15.3 million drawn on our U.S., German and Japanese credit facilities. We will continue to use these facilities from time to time in order to finance our short-term working capital requirements.

I would like to provide you with our guidance for the second quarter of 2008.

For the second quarter, IPG Photonics expects revenues in the range of $52 million to $56 million.

The company anticipates earnings per diluted share in the range of $0.15 to $0.19. That is based on 46,041,000 diluted common shares, which includes 44,095,000 basic common shares outstanding and 1,946,000 potentially dilutive options.

This guidance is subject to the risks we outlined in our reports with the SEC and assumes that exchange rates remain at present levels.

Before we open the call to questions, I'd just like to sum up. IPG continues to see strong growth as a result of the market's acceptance and demand for fiber lasers and our products. IPG has application and geographic diversity that is enabling us to continue to grow revenue even when one or more of our end markets or geographies is experiencing some weakness or volatility. We are seeing improvements in our U.S. and Japanese markets and have taken proactive steps to ensure future growth in both locations, and we're focused on maximizing the infrastructure we have put into place to further improve our margins and profitability.

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

Questions-and-Answer Session

Operator

(Operator Instructions) Your first question comes from John Lau - Jefferies & Co.

John Lau - Jefferies & Co.

Tim, I wanted to follow up on your commentary with regard to bucking the normal economic downtrend with cost savings on the energy side. Can you quantify some of - the level of those savings, and not only on the electrical side but on the consumable gas side? In other words, are you saving 10% to the customer? Can you just give us a range?

Tim Mammen

I'd say it, in some instances, is much more than 10%. It depends upon whether a customer is able to replace a current laser technology with exactly the same power level. If they're able to do that, some of the feedback we're getting from people is that the electrical savings can be in the magnitude of 80%. If they're not able to do that, then the magnitude may come down to anything from 25% to 50%. I mean, Valentin, is that fair to say?

Valentin Gapontsev

Ten times savings compared to [inaudible], three times savings or four times savings compared to gas lasers, and twice savings when compared to disk lasers. It's only laser [inaudible]. But hopefully we provide a much better  much more savings, for example, for cutting systems in [total] because cutting systems [inaudible] only fiber laser. Help much with consumption because they're much more [inaudible] energy consumable with the linear models, for example, and so on. It's also an enormous saving in the design of cutting systems, for example, and many other applications.

John Lau - Jefferies & Co.

And as a follow up to that, Tim, when you, in terms of your business, if you come into a factory and you have these current existing bank of CO2 lasers, what is the process and how easy is that company able to replace just one of those CO2 lasers with yours, just as a comparison or design in activity, to start to immediately see the savings in energy or consumable gases?

Tim Mammen

I think I shall give Valentin that question. How easy is it to replace these lasers in some of the.

Valentin Gapontsev

It's very easy to replace because [inaudible] is the same. You just replace the laser source for our source. In some, it's only small update in the delivery. But laser [inaudible], that's all. It's immediate, where you have a result.

John Lau - Jefferies & Co.

Okay, so you don't need to replace the entire factory. You can start to replace those on an individual basis on the shop floor.

Valentin Gapontsev

[inaudible] to replace a CO2, a used CO2, for our fiber laser, not to replace - and with their old [inaudible] systems without any problem.

Tim Mammen

Here's an important point, John. It really is a question of just taking one laser, in many instances, out and replacing it with the fiber laser.

John Lau - Jefferies & Co.

The energy savings seems to be quite significant. In terms of the other area that I, as a follow up, in terms of consumable gases, you also mentioned that the consumables are down. What type of savings can you get from the consumables side on a typical cutting application?

Valentin Gapontsev

In our case, we can work without gelium gases so it's much cheaper. It's [inaudible] nitrogen or adjusted air, adjust air without any [inaudible] of gelium. Gelium is very expensive, gelium gas.

Operator

Your next question comes from Unidentified Analyst - Thomas Weisel Partners.

Unidentified Analyst - Thomas Weisel Partners

I have a couple of questions. The first one has to do with some of the manufacturing yield issues you guys faced in the last quarter. Have you guys achieved now your target yield levels?

Tim Mammen

Yes. We've dealt with all of those yield issues. The production of components across the diode line, whether it be the chips, the burn in or the transfer of production from producing PLD 9 packages to PLD 20s has really effectively been dealt with, and we are pleased with the results we're seeing now in each of those manufacturing processes.

Unidentified Analyst - Thomas Weisel Partners

And in terms of the gross margin for the coming quarter, how should we think about that?

Tim Mammen

For the coming quarter in Q2, first of all, it depends upon where we get to on the range of revenues. So we could be slightly below where we are today if revenue is at the bottom of the range.

The other balancing act that the company has at the moment is one that I tried to discuss more this quarter is depending upon the plan that we have for building inventory in anticipation of second quarter growth, that will affect gross margin a little bit.

So we would expect if we get to the top end of our range or the middle end of our range, we should see gross margins broadly flat. We do expect to see, with that, a less substantial increase in inventory, but a smaller rise up as we prepare WIP for the second half of the year.

Valentin Gapontsev

Second half of the year we expect very serious growth in gross margin.

Operator

Your next question comes from [Olga Evanson] - Lehman Brothers.

Olga Evanson - Lehman Brothers

Could you talk about how you see the litigation expenses trending throughout the year and as a result, what kind of SG&A we should expect?

Tim Mammen

In the second quarter - so this major litigation that we've had at the moment has been stayed by the judge. That is dependent upon the Patent Office determining whether they will review the patent. At the moment we expect litigation expenses in Q2 to be substantially lower than they were in Q1. If that patent goes into reexamination, we would expect them to stay relatively low. If the Patent Office decides not to reexamine, we will then be back on a higher litigation spend for Q3 and Q4, but it's not - right now, we don't know how long it's going to take them to decide whether they reexamine that patent or not.

Valentin Gapontsev

They don't give a report, Tim. It's two months after we apply [inaudible] so it's practical they accept [inaudible].

Olga Evanson - Lehman Brothers

And then in terms of -

Valentin Gapontsev

[inaudible] for some additional formal reason [inaudible] short time, two weeks, but two months passed and no reply to it [inaudible].

Olga Evanson - Lehman Brothers

And this is related to only one patent or several of them?

Tim Mammen

This is the IMRA litigation; one patent.

Olga Evanson - Lehman Brothers

And then in terms of the medical market, I think on the last call you had said that you had about five potential customers lined up. Can you talk about progress there and when you see those revenues beginning to trend up again?

Tim Mammen

On the medical business, we've already started working with one medical OEM in Europe and selling to them, so that business we expect to develop through the year. There are four or five, as you mentioned, other people that we're working with. Valentin, you can give an update on those.

Valentin Gapontsev

[inaudible] also medical companies in the U.S. We're selling and will get new orders. Getting orders from dental companies. We are watching also - in Russia we introduced in the medical market six different devices. [Finish] device service is growing. They're fully qualified by Russia, these inspections [inaudible] approved for use in medical - in clinics, so that the medical business, we expect, will grow very fast.

And also the competition of our current [inaudible] the competition now is - it's open door for competition, and now would make trials of our devices. So it's only in Korea, six companies making similar devices and all of them [inaudible].

Olga Evanson - Lehman Brothers

So it would be fair to assume that you could at least get to flat levels with '07 or potentially higher or would the fact that Reliant is slowing down sort of limit that a little bit?

Tim Mammen

Ultimately we would expect to get to, you know, growing medical sales, I don't think that will necessarily happen this year. We would hope to try and start to replace some of the reliant revenues that we've lost in the second half of the year, and we'd expect to see stronger medical performance next year now.

Olga Evanson - Lehman Brothers

And then in terms of the North American Materials Processing market, do you think that sales will probably be flattish in the second quarter and then trend up from there? Is that kind of the sense you're getting now?

Tim Mammen

No, we're definitely already seeing an improvement in North America. I think there are very strong indications on our order flow that we should see some pickup in Q2 and then really some significant increase in strength into the second half of the year.

Valentin Gapontsev

And how [inaudible] in America during all this, three months increase [inaudible] from the beginning of the year.

Operator

Your next question comes from Jiwon Lee - Sidoti & Company.

Jiwon Lee - Sidoti & Company

First, the cutting system OEM that was the biggest customer for the quarter, I think, Tim, you mentioned, where were they geographically located?

Tim Mammen

They're in Asia.

Jiwon Lee - Sidoti & Company

Were they ever a big customer over the last several quarters?

Tim Mammen

Yes. They were also focused on - they've moved their product line from just dealing with low power to now actually developing the cutting systems using the high power. So they have been a customer of the company for probably three or four years.

Jiwon Lee - Sidoti & Company

And then the IMRA lawsuit related expense, did you [inaudible] there was a $1.3 million for the quarter alone?

Tim Mammen

Yes.

Jiwon Lee - Sidoti & Company

And that compares to -

Tim Mammen

$400,000 a year ago.

Jiwon Lee - Sidoti & Company

I'm sorry.

Tim Mammen

It was $400,000 a year ago.

Jiwon Lee - Sidoti & Company

Okay, because last year the whole year you spent $1.5 million related to the patent, no?

Tim Mammen

Yes. There was a lot of activity in Q1 before the judge stayed the case related to preparing for the trial, so it really affected our G&A expenses in Q1.

Jiwon Lee - Sidoti & Company

Let me drill down a little bit on your selling G&A expenses. There were several sort of high profile hirings, especially targeting your North American growth. Going into the later part of '08, do you feel that you have enough infrastructure in place to drive that growth potentially into the beginning of '09 even?

Tim Mammen

It wasn't just North America where we've invested. I highlighted that. Japan as well, significant additional investments there. Obviously, the plan is to continue to invest in selling expenses. It's not just going to be a  we're not going to stop looking for good people in the different application markets that we address. I expect that we'll hire some sales people, both in North America and Europe and also in Asia throughout the rest of this year.

Jiwon Lee - Sidoti & Company

So how should we look at your selling expenses going forward?

Tim Mammen

We'll still maintain the SG&A within that guidance range that we've given, between 15% and 18%. They will ramp in absolute terms, but they're not going to jump out of line completely.

The other side of the selling expense that we'll continue to invest in is obviously in demonstration units, which will go into these facilities that we're building at the moment. And that really is a key driver to growth, and we see pretty quick payback on a lot of that.

Jiwon Lee - Sidoti & Company

And not a terrible sort of impact from the foreign exchange. You didn't make [a comment] on that this quarter?

Tim Mammen

FX did benefit revenue, I mentioned, by about $3 million. It actually impacted gross margin by about 1%. In absolute terms, gross margins would have been lower, but it actually affected the gross margin. And we estimate that the bottom line, it may have been - it's about between $0.01 and $0.02 impact on the bottom line.

So the business model continues to be overall hedged pretty well naturally, with the expenses in euros in Germany while you benefit from the euro sales over there.

Jiwon Lee - Sidoti & Company

And finally, can you sort of help us qualitatively or any way you can, the sequential capital expenditure on the fixed equipment and other organic expenditure, was this sort of similar in the first quarter sequentially?

Tim Mammen

The reason why we haven't gone into, like, splitting up the Capex that we spend on both equipment and facilities and intangibles is that we currently don't want to disclose exactly what this patent portfolio cost us for competitive and legal reasons, so I can't provide you any greater clarity on that.

Operator

Your next question comes from Ian Fleischer - Friedman, Billians, Ramsey & Co.

Ian Fleischer - Friedman, Billians, Ramsey & Co.

Can you comment or update us on your capacity expansion plans? Do you still plan to have those more or less completed this year in the third quarter, and how long do you think that capacity should last you if you continue to grow in the 20-ish percent area?

Tim Mammen

The answer is yes, that the plan is still to largely complete the facilities expansion in Germany and the U.S. in the third quarter. There'll be some smaller expansion in Russia, but it's, on a cash flow basis, going to be much smaller.

In terms of those facilities, in the U.S. and Germany we expect that they are sufficient for at least the next 18 to 24 months.

Valentin Gapontsev

We don't give [inaudible] Capex serious amount, up to 2010, 2011.

Tim Mammen

So they do provide for growing revenues very, very substantially. That will enable us to hopefully limit the increases in our fixed cost base and grow into that capacity based on - and Valentin mentioned that we do expect to see some nice increases in gross margin in the second half of this year. I concur with that. I think that we've done a lot of work on our business model and we can see that, based upon the sort of [inaudible] of our product, we should be able to get nicely to the top of our gross margin range, somewhere close to 49%. And with some really good management here, there is an ability to get even above that in 2009.

Ian Fleischer - Friedman, Billians, Ramsey & Co.

And in North America, you mentioned some pickup there with respect to orders. What end markets are you seeing the pickup in?

Tim Mammen

We're seeing it sort of across the range in materials processing. There's a lot of activity on some of the microelectronics in consumer. We've seen some activity even in the auto industry although it's less from that, but we're being covered in general manufacturing, microelectronics, some of the consumer area. The telecom orders in North America have also picked up in the first four weeks of this quarter.

The advanced applications should be stronger in the second half of the year. There are some pretty serious trials related to some defense applications which, if successful, should help us. But the advanced is a little bit more notoriously difficult to predict. But there definitely is a certain feeling within the company that we've seen a change compared to the first eight or 10 weeks of this year.

Valentin Gapontsev

We're seeing forward, also, in [inaudible].

Operator

Your next question comes from Conor Irvine - Needham & Company.

Conor Irvine - Needham & Company

A couple questions for you. My first is, are there any additional segments of the fiber laser market that you find attractive right now, such as in materials processing?

Tim Mammen

Are there any additional segments?

Conor Irvine - Needham & Company

Yes, additional attractive end markets?

Tim Mammen

Maybe, Valentin, you can talk about some of the new technological opportunities that - outside solar.

Valentin Gapontsev

Yes, it's - I would say the market that's now [inaudible] manufacturing growing very fast, and there's a lot of demand in that case for laser-based systems. We have found to be [inaudible] market, for example, and as we discussed, there's now a big project with such people.

It's also more biosystem for field material processing, field operation, [inaudible] enormous opportunities here. Pipe welding, watch [inaudible] pipe welding. It's now a going project; going very well in the field. The replacement of these [inaudible] welding for very thick metals. It's also very interesting and fast growing, the trials in these directions. So we see many applications, but [inaudible] would be very innovative use of the fiber lasers.

Conor Irvine - Needham & Company

And my second question, are you currently seeing any interest in your pump lasers in the merchant market?

Tim Mammen

Pump laser.

Valentin Gapontsev

We started to market this, but now the many companies from - a big interest for this was in laser pump application and also in medical, biomedical. And now that - we discussed now, many orders since people use our - start to test our products. And it will take some time, as usual, before we'll get much orders.

Operator

(Operator Instructions) Your next question comes from [Jenny Jones] - Schroder Investment Management.

Jenny Jones - Schroder Investment Management

I was just wondering, going back to addressing the working capital, in two years out, you know, when you feel like okay, you’ve gotten some more customer traction in certain end markets, do you still think that you have to be so ready that you have to service these customers with very timely deliveries? Because it would seem to me as long as you still have a competitive advantage in terms of, you know, your IP, you need not be such a wonderful supplier that you have to hold all this inventory. I'm saying maybe 18 months out. I mean, that's part of the problem, for is, the capital intensity from the working capital management. I understand now, but I guess I'm less understanding two years out. Can you address that, please?

Tim Mammen

Yes, hi, Jenny. Definitely at the moment we believe there are strategically important reasons to maintain this level of inventory. Just as an example, we talked about in Q4 when we had some problems with diode deals or moving production from one type of technology to another, there is a requirement, not just for satisfying the customer's needs but for maintaining some level of strategic inventory to ensure that we can - continuity of supply, if you like.

The target within the company is to try and bring the number of days inventory held down over, you know, I think probably the next 18 months is a good period to look at that. As we gain greater customer acceptance, we become more and more certain of the ability to use our capacity to generate product on a more reasonable timely basis rather than to have to hold buffer supplies of inventory.

So we look at inventory. We're reviewing it. We're reviewing the processes behind production planning, trying to match more closely demand.

The other thing I think that should be very clearly understood, though, is that some of these opportunities that we're pursuing out there are very significant, and we can't be in a position where we would have to sort of abdicate them because we wouldn't be able to fulfill those orders in time. It's very important that if someone is going to come to us and put a multiple unit order for kilowatt lasers - and some of these opportunities can run into tens of units  that we have to be able to supply those lasers very, very quickly.

And we're seeing that could happen in the next 12 months or so, if not sooner, so that's another very important reason.

From a management perspective, it is absolutely our intention to manage our working capital as best as we can do. I think the vertical integration within the business is important to understand, from buying a wafer and growing a chip and testing that diode and packaging it, putting it into a module, it does take the company three or four months to go through that whole process.

So there is some element of our business model that would require us to keep higher levels of inventory. And, you know, honestly, compared to some of the other people in the industry, we're not that far off. We're a little bit less efficient right now. We would obviously want to be viewed as being closer to the top of that pile.

Jenny Jones - Schroder Investment Management

Right, but I could expect to let - kind of what I already said was that, you know, once you've kind of built these different avenues of repeatable potential growth that you could be much more focused on how much inventory need be on hand.

Valentin Gapontsev

We're working where we [can] in this direction, to optimize inventory, but we have to add also - I care to add also  we have part of the ready products which delay shipments to work [inaudible] due to some expert [inaudible] for example, like China and Israel. But we will ship in May this.

But from the way the shipment - it's also - keep in mind its typical historic second half of the year, especially with quarter four and often quarter three, our shipments jump practically twice more than the first half of year, and we expect the same situation this year. But what we have to make, [inaudible] we'll get these orders in the end of the year, then we have to hire more people. But we produce now with existing people more inventory, which will help us without hiring new people to fulfill the program for second quarter, second half of year.

Jenny Jones - Schroder Investment Management

One more follow-up question. Now you may have said this, I came on a little late, but you gave kind of a backlog or a pipeline last quarter. Can you do that for us now?

Tim Mammen

No, we don't provide an update on a quarterly basis on backlog.

Jenny Jones - Schroder Investment Management

It's just on an annual year.

Tim Mammen

We just do it on an annual basis.

Valentin Gapontsev

I can say only that our backlog now is about 50% more than it was a year ago.

Operator

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

Valentin Gapontsev

Okay, so thank you everyone for joining us today. This has been an excellent start to the year. We reported solid financial results that were at the top end of our guidance. We're also continuing to execute well on our growth strategy, positioning IPG to leverage our superior technology to capitalize on significant growth opportunities across many diverse markets.

We'll look forward to speaking with you again in the second quarter.

Operator

With that, we will conclude our conference call. Thank you again for joining us today.

Valentin Gapontsev

And thank you, everyone. Bye.

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Source: IPG Photonics Corporation 1Q08 (Qtr End 3/31/08) Earnings Call Transcript
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