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IPG Photonics Corporation (NASDAQ:IPGP)

Q2 2008 Earnings Call

August 5, 2008 10:00 am ET

Executives

Dr. Valentin Gapontsev – Chairman and Chief Executive Officer

Timothy Mammen – Chief Financial Officer and Vice President

Angelo Lopresti – Vice President, General Counsel and Secretary

Analysts

Ian Fleischer - FBR Capital

Mark Miller - Brean Murray, Carret & Co

Ajit Pai - Thomas Weisel Partners

Unidentified Analyst – Lehman Brothers

Jiwon Lee - Sidoti & Co

John Harmon - Needham & Co

John Lau - Jefferies & Co

Operator

Good morning, and welcome to IPG Photonics’ second quarter 2008 conference call. Today’s call is being recorded and webcast. 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-K 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 company’s expectations or predictions only as of today, August 5, 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 review these remarks.

I will now turn the call over to Dr. Gapontsev.

Valentin Gapontsev

Good morning and thank you for joining us today. I am pleased to report that, once again, for the seventh consecutive quarter, since IPG has been public, IPG posted solid quarterly revenue growth over the prior year.

This is a testament to the breadth of our product offerings across a variety of applications and our expanding geographic presence. It also is a testament to the disruptive nature of our technology.

Throughout the world’s major markets for industrial laser systems, customers have recognized that IPG’s fiber lasers can transform the way they manufacture their products and provide cost savings. The performance of our fiber laser systems improve the quality of manufacturing items and lower electrical and other operating costs.

In many cases, the disruptive nature of our fiber lasers opens up new applications, where lasers have never been used before. As a result, we are making progress in growing our position in the overall laser market worldwide.

Before I turn the call over to Tim Mammen, let me review some accomplishments. This quarter, we grew top line revenue strongly, despite the challenging economic environment.

Pulsed lasers continued their strong growth because of solar and marking applications. Medium-power laser sales grew 96% from a new OEM win for microelectronics. We saw an improving demand in the U.S. and Japan in quarter two, which complemented to the strength we saw in Europe and other Asian markets in the first half of the year.

I will now turn the call over to our CFO, Tim Mammen.

Timothy Mammen

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

Our 27% revenue growth in the second quarter over the prior year shows the traction that IPG’s fiber lasers continue to experience. Our growth was driven by a 42% increase in sales for materials processing, which is our largest application and where we have a broad diversity of uses for our products. Their superior performance for a number of applications is being increasingly recognized.

Many customers have also reported to us that the energy savings from the electrical efficiency of our fiber lasers has been a major factor in selecting fiber lasers over other types of competing lasers and non-laser tools. The compact size of our lasers is also a competitive advantage in many space-constrained manufacturing operations.

During the second quarter, we achieved significant growth with our medium-power lasers. Sales grew by 96%, driven by their superior characteristics for microelectronics processing and light materials processing applications.

We also continued to see strong demand for our pulse lasers, which were up 66%. These laser types are in high demand for photovoltaic manufacturing, including scribing and isolation processes.

In this application area, we are adding OEM customers and broadening our customer base globally. Our pulsed fiber lasers continue to experience strong demand for marking applications, one of our oldest material processing applications.

High-power fiber lasers saw continued acceptance from automakers and suppliers throughout the world and for other heavy industry applications, where our lasers’ power, beam quality and flexibility create meaningful gains in productivity.

While order patterns can be volatile in this high average selling price/lower volume business, year-on-year sales for the quarter increased by 26%.

The automobile industry, in particular, has come to recognize the superiority of our solution, as evidenced by a recent multiunit order from BMW for high-power lasers used in a critical welding application.

Once again, it is important to point out that IPG achieved 27% growth, despite substantially reduced sales to our primary medical OEM customer and slightly lower year-over-year materials processing sales in Japan.

Again, this demonstrates that our business model enables us to grow revenue, even when one or more of our end markets is experiencing some weakness or volatility.

And finally, our gross margin continued to improve both year-over-year and sequentially. Gross margins gained 2 percentage points to 48% and improved by almost 2 percentage points over the second quarter last year.

Now, let me provide you with some information about how we performed in the four markets that we serve. Materials processing, which is IPG’s largest market, contributed 84%, or $46.9 million of the revenue we reported in Q2 and grew by 42% year-over-year. Sequentially, materials processing sales grew by 6%.

The materials processing segment encompasses several end markets, such as general manufacturing, solar, automotive, aerospace, heavy industry, consumer, semiconductor and electronics. Let me give you a few examples of strong areas of performance.

As I mentioned, microelectronics processing and light materials processing was a real highlight during the quarter. Applications include high-speed drilling, medical stent cutting, marking, engraving, digital printing and light steel welding.

We also continued to see strong interest for pulsed lasers for photovoltaic applications by manufacturers in North America, Germany and Japan.

The international automotive market continues to be a strong one for us, as automotive integrators, OEM manufacturers and Tier 1 parts suppliers deploy our high-power and medium-power lasers for tailored blank welding, 3D welding, and the welding of high performance batteries used in hybrid vehicles.

Our high-power lasers are also being used increasingly in sophisticated cutting applications, including high-precision, 5-axis laser cutting. This advanced technique can replace many drilling, milling and conventional cutting operations, while reducing costs and improving the fit and finish of the completed component.

Advanced applications increased by 12% 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 second quarter.

Advanced applications include test and measurement, instrumentation, sensing and defense applications, as well as scientific research and development. Sales during the quarter were driven by a few multi-kilowatt orders.

Revenues in communications were up by 28% over the second quarter of 2007. The communications segment comprised 5% of our revenues in the second quarter.

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 and Japan.

Our products are well suited for long-haul and ultra-long-haul applications, enabling service providers to extend network links beyond previously achievable distances.

Lasers for the medical applications segment comprised less than 2% of revenue in the second quarter. With a sharp drop-off in orders from our main medical OEM, sales were down 76% from the second quarter of 2007. However, sequential sales were up by more than a 100%.

It continues to be our goal to diversify our customer base in this segment in order to reduce the reliance on this one customer. We made some progress during the quarter, as we shipped product to a growing number of OEMs in the U.S. and Europe.

Turning to the performance of our laser types in the second quarter, pulsed laser sales increased by 66% from the second quarter of 2007. As a percentage of revenue, pulsed lasers represented approximately 39% of revenue, or $21.9 million, in Q2 2008. This is our oldest product line, and it continues to be one of the best producers for us.

As I mentioned earlier, we are seeing growing demand for our pulsed lasers used in photovoltaic manufacturing and marking applications, including semiconductor marking, which have also continued to help drive sales of our pulsed lasers during the quarter, as well as other materials processing applications.

High-power fiber lasers used in materials processing and advanced applications continued to be a key growth driver. In the second quarter, on a year-over-year basis, sales of high power lasers increased by 26% and represented approximately 24%, or $13.4 million, of total revenue in Q2 2008.

Overall, we expect high-power laser sales to continue to be an important growth driver for us, although growth from high-power lasers may fluctuate from quarter-to-quarter. We also have a growing number of OEMs employing our fiber lasers for cutting applications, and interest in this application continues to grow.

Sales of medium-power lasers grew 96% during the second quarter of 2008 over 2007 and represented 17%, or $9.3 million, of total revenue in Q2 08.

We see continued demand for sintering and commercial printing applications, but the primary growth driver in the second quarter for these products has been strong sales to a new integrator in the electronics industry.

Turning to our geographic performance during the quarter, we reported 34% of revenue from Asia and Australia, 40% from Europe, and 23% from North America. European sales increased 53% year-over-year, driven primarily by strong growth across the region.

Sales in Asian markets increased 14% compared with the second quarter of 2007. Strong sales from our Chinese office and continued growth in India and South Korea contributed to this increase.

In Japan, we are encouraged that sales have increased sequentially. While sales declined year-over-year by 13%, recent order patterns are improving and we look for a stronger contribution from Japan, going forward, as a result of the restructuring of our Japanese sales organization.

We also had a large order for a high-power laser from South Africa to be used in laser cladding. We see a similar pattern to our recent orders in North America, where sales increased 42% over the first quarter of 2008. Order flow in the U.S. remains firm.

During the quarter, we estimate that exchange rates benefited revenue by approximately $3 million. As I mentioned earlier, gross margin for the second quarter was 48%, which is 2 percentage points better than the 46% gross margin we reported in the second quarter of 2007 and a strong sequential increase from the first quarter of 2008.

The improvement in gross margin was driven by product mix benefits arising from the strong increase in sales of mid-power lasers, higher production – part of which was placed into inventories – and the recognition of approximately $450,000 of deferred revenue with no associated cost.

For the second quarter, inventory write-downs and reserves totaled $961,000. Given the historically strong second half, we expect to maintain gross margin in the second half of the year. It remains our longer-term goal to drive incremental gross margin into 2009 and achieve equilibrium in production, capacity utilization and inventory levels.

SG&A was $9.7 million, or 17% of sales, compared with $7.8 million, or 18% of sales, in the second 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.

Also, recently, the U.S. Patent and Trademark Office granted our petition to examine the patent involved in the IMRA litigation. The IMRA patent litigation case is stayed by the U.S. District Court, until the patent re-examination is concluded.

As a result, our litigation expenses related to this matter saw a significant drop in Q2 2008 sequentially over the prior quarter.

R&D expenses were $4.4 million, or 8% of Q2 2008 revenues. This compares with $2.4 million, or 5% of revenues, in Q2 2007. This is just outside of our target range for R&D of 5 to 7% of revenue and is due primarily to research into new and improved components and products.

In addition, we incurred substantial expenses related to development work on the CO2 laser project. We have historically kept IPG’s R&D expenditures low as a percentage of revenue due to the efficiency and strategic focus of our R&D activity, and we expect these expenditures to trend to more normal ranges in the coming quarters.

Operating income for Q2 2008 increased by 26% compared with the same period last year. IPG generated operating income of $12.8 million, or 23% of revenue, compared with operating income of $10.1 million, or 23% of revenue, in the second quarter of 2007.

Operating income includes charges related to stock-based compensation of $617,000 and $469,000 in the second quarters of 2008 and 2007, respectively.

In the second quarter of 2008, $97,000, $350,000 and $170,000 of stock-based compensation charges related to cost of sales, SG&A and R&D, respectively.

Our tax rate for the second quarter of 2008 was 31.0%. We estimate an overall effective tax rate of 31.5% for the year. The effective rate for 2007 was 32.6%.

Net income for the second quarter of 2008 increased by 34% and was $8.6 million, or $0.19 per diluted share, compared with net income of $6.4 million, or $0.14 per diluted share, for the second quarter of 2007.

Let me turn now to our balance sheet, where cash and cash equivalents at June 30, 2008 stood at $44.9 million compared with $38 million on December 31, 2007. We also have $1.4 million in auction rate securities. We disposed of $1 million in auction rate securities in Q2.

In the quarter, we repaid all of the unsecured subordinated promissory notes, due in December 2009, with the proceeds from a new secured term note. The current interest rate on the new term note is 4.9% and has been fixed using a swap.

This rate is 2.1 and 5.1 percentage points lower than the 2008 and 2009 interest rates, respectively, on the notes that we repaid.

The refinancing extended the maturity date of the debt to July 2013. The unsecured subordinated noteholders agreed to reduce the principal amount of their subordinated notes to $19.5 million from $20 million. As a result, we recognized an after-tax benefit of approximately $300,000 in the quarter.

For the second quarter of 2008, capital expenditures and investments in intangible assets totaled $7.4 million and were primarily related to facilities and equipment in the U.S., Russia and Germany.

We expect that the new facilities in Germany and Russia will be completed by the end of Q3 and that our new U.S. sales and demonstration facilities in Massachusetts and Michigan will be completed before the end of the year.

Accounts receivable increased to $37.7 million at June 30, 2008 from $33.9 million at December 31, 2007. Accounts receivable days outstanding, though, decreased to 61 days at the end of Q2 from 63 days at the end of Q1 2008.

Accounts receivable outstanding can be affected by the timing of shipments in the quarter as well as higher sales in certain geographic regions, where longer terms are standard business practice.

Historically, our accounts receivable have been strong as measured both by low bad debt and accounts receivable aging. We believe they continue to maintain a high quality.

Inventory increased by $16.2 million to $76.6 million at June 30, 2008 from $60.4 million at December the 31, 2007. Approximately, $2.6 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 keep inventory on hand for several reasons. First, we are vertically integrated, which means that the rate at which we turn inventory is low, as materials are turned into components and then ultimately finished products. Second, our high growth rate requires investment in inventories to support future sales.

Third, our inventories help 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 for a period of time.

Fourth, it enables us to quote short delivery times to our customers, providing what we currently believe is a competitive advantage.

During the second quarter of 2008, net cash flow provided by operations of $6.3 million compares to net cash used in operations of $1.4 million in the second 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 second quarter, we had a total of $19.9 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 third quarter of 2008. For the third quarter, IPG expects revenues in the range of $57 million to $61 million. The company anticipates earnings per diluted share in the range of $0.18 to $0.22.

That is based on 46,132,000 diluted common shares, which include 44,355,000 basic common shares outstanding and 1,777,000 potentially dilutive options. This guidance is subject to the risks we outline in our reports with the SEC and assumes that the exchange rates remain at present levels.

Today, we reported that IPG agreed to purchase the remaining minority interests in our Russian subsidiary from Dr. Gapontsev and Igor Samartsev, a member of our Board of Directors and Acting General Manager of our Russian subsidiary.

We presently own 58.6% of the company, and they own 31.6%. The purchase price for their ownership interests is $6.1 million in total and would be paid in unregistered shares of IPG common stock. The purchase price was based upon the net asset value of the Russian company at June 30, 2008.

We have reached prior agreements to purchase the remaining 9.8% owned by other unrelated minority shareholders. After giving effect to all of these purchases, IPG would own a 100% of our Russian subsidiary.

The purchase is expected to close in October 2008, subject to filing required government notices and receiving required government approvals.

IPG has previously reported strong growth in the Russian market. IPG believes that the transaction is good for IPG and its stockholders, because the transaction is expected to be accretive to IPG earnings, as IPG would no longer have to deduct the minority interests related to the Russian company.

Before we open the call to questions, I’d like to sum up. We continue to see strong growth as a result of the market’s recognition of the superiority of IPG’s products for a variety of traditional laser applications, as well as for novel and innovative uses of laser technology.

We believe IPG has the product, application and geographic diversity that enable us to grow our business, despite order volatility or any individual market weakness.

We are currently seeing continued strong sales into our European and Asian markets, and we are pleased to report meaningful improvements in our North American and Japanese markets, with brighter prospects for the remainder of the year.

Finally, we’re leveraging 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.

Question-and-Answer Session

Operator

We’ll take our first question from John Lau - Jefferies & Co.

John Lau - Jefferies & Co

Thank you very much, and great results. It seems like you’re continuing to gain traction and gaining market share in the laser market as a result of your technology, but you mentioned in your press release that just after the close of the quarter, you had a major order from the BMW group.

Can you give us a little bit more detail on that in that context and does that represent a major break into the automotive industry? Thank you.

Valentin Gapontsev

Perhaps it’s reformed for mass penetration of the automotive market. Before we won the good orders and introduced our laser for welding assembly lines in Shanghai, Korea, and now we’re working hard with Nissan and Toyota in Japan, and we want to have good results with PSA in France.

Our target was German carmakers where we have strong competition from the (inaudible). Now we’re practically winning this market segment and for us, it’s very critical and it will open door for mass penetration in car industries.

John Lau - Jefferies & Co

Great, and are you working with the other German manufacturers and other European manufacturers to continue that effort? And also, is this just the tip of the iceberg in terms of your market share in the automotive market?

Valentin Gapontsev

Yes, we’re working practically with most of carmakers in Europe and other countries, including United States and Asia. In our situation, it’s not very favorite for laser technology because former experience with couple of other kinds of legacy lasers provide negative results, and mainly the bought or sold cars, biggest car company afraid now to use laser technology.

But now we’re convinced that fiber laser is about to resolve the major problems with the use of laser technology and it’s now a real way we reach the new milestones with our main introduction of laser technology for the major assembly lines in a huge market for laser welding.

John Lau - Jefferies & Co

Thank you very much and congratulations.

Operator

We’ll take our next question from John Harmon - Needham & Co.

John Harmon - Needham & Co

A couple of questions please. First of all, I wonder if you could talk about your philosophy in going into the area and what some of the early response has been on your CO2 lasers, customer response?

Valentin Gapontsev

With CO2, we’re still in the stage of qualification of our own laser CO2 technology, and we now finishing internal qualification and soon will start to make qualifications with some of our potential customers.

As we reported before, we want to introduce our CO2 technology to the market in the first quarter of next year. We feel that we will support this schedule.

Timothy Mammen

And John, just in terms of the strategy there, we see fiber being adopted in particularly new cutting applications where a customer is not having to displace or replace an old piece of equipment.

Where customers have older equipment for cutting that has been preprogrammed into doing many different metals, the laser is often a lower part of that cost. So that’s the real market we’re targeting, and that should bring those customers into the IPG fold, and then when they upgrade their equipment, should see them migrate in some instances to fiber as well.

There’s a massive opportunity out there where people want to replace the light source and not necessarily all their cutting equipment.

Valentin Gapontsev

Yes, and during this last half of year, we found a new advantage of fiber technology again, of the CO2 technology in cutting applications. We have the perspective where you know better than with all the cars before.

But we never said that fiber laser cutting will replace in full CO2. It would be these two sources which will share this market in future. And we like to have all the share in the CO2 portion of this market.

John Harmon - Needham & Co

Thank you. You mentioned that the potential of an upgrade path with an IPG fiber laser and IPG CO2 laser use the same control software, for instance, so that a user wouldn’t have to reprogram his system to move from CO2 to fiber.

Valentin Gapontsev

It’s not a problem at all; it’s the same software. (inaudible) is the same interface system, and would match to the current situation. We don’t need any exchange in the machine.

John Harmon - Needham & Co

Okay, and just quick one please. Your CO2 laser, is it an all-in-one unit, or is it like typical CO2 lasers where there’s a power supply that’s connected by an electrical cable to the laser head?

Valentin Gapontsev

No, it’s two parts. One is the resonator, which is much more efficient and much smaller than existing laser and provides (inaudible) power. But we also introduce new power supply, but it is based on absolutely new technology of RF generator, much more efficient, much more compact and flexible than existing lamp-based or hybrid-based RF generator used by other people.

For example the efficiency of this new technology is electro-efficient more than 90% within distant power generator have efficiency 60, 65%. This is fully new solid-state technology first time introduced to this market.

John Harmon - Needham & Co

That’s great. Thank you very much.

Operator

Our next question comes from Jiwon Lee - Sidoti & Co.

Jiwon Lee - Sidoti & Co

Good morning. I wanted to talk a little bit more about your opportunities in tailored laser welding area. Roughly, what is the total opportunity for laser vendors, including yourself?

What is the sales related to this particular application? What can we expect for, let’s say, over the next couple of years?

Timothy Mammen

The total opportunities Jiwon, currently, I think lasers have probably got about only 10 to 15% of total laser sales going to welding. So if you try and quantify that opportunity, we’re making gains against the existing technologies, but more importantly against many of the non-laser welding technologies.

To try and put a dollar value on it at this point in time is practically impossible to do so. I think that fiber is particularly well suited to the welding applications. We think that it’s going to continue to be a key growth driver for us.

Then in response to your other question, we don’t break out at that granular level exactly what percentage of sales is going into tailor welded blank applications. But it continues to be a strong growth driver for us and will continue to be so going forward.

Valentin Gapontsev

Mass penetration to the welding market will depend only from the economics. Only if laser welding would be cheaper or similar in price for finished products as regular resistance welding and other kinds of welding, only this case it will be a really mass penetration for this market, practically the laser welding market is huge, but share of laser welding is very small today.

But fiber laser decreased weld costs; different people estimate five to ten times. And now in many applications especially and must say in the assembly lines, so on becoming cheaper and swift than spot welding. It’s really the threshold for them, the mass penetration (inaudible) go into the market.

And second question, what sort of time with such application is the (inaudible) laser machines, forensic experiments, which made the (inaudible) provide negative results; it’s too complicated, it’s too expensive and also not reliable, and the yield is not really good.

So it’s a result now the practical company, I don’t like to mention which car company which introduces, laser welding (inaudible). We play, anytime back to spot welded. Fiber laser first resolved this problem, yet now more and more car companies recognize this, so they start to change plan, again, to down to laser welding.

Jiwon Lee - Sidoti & Co

Okay. That’s helpful. And the second question is your traction in the microelectronics, would it be a simple way, the primary selling point of fiber laser?

Timothy Mammen

Cost effectiveness; the electrical efficiency; the quality of the processing; the speed of the processing; the quality of the beam.

Jiwon Lee - Sidoti & Co

The cost...

Valentin Gapontsev

(inaudible), high quality people, so now it’s the way the technology are able for people from the street where it was about, up to very small training. It’s also maintenance cost, practical in yield in many case, many power supply and start to claim publicly, they know first at time, no cost at all for maintenance.

Working by years without any salaries at all; for production people it’s a huge advantage. And also saving; for example now when customer selected technology in face of all this to make electrical power savings, it now cuts energy savings. It’s a dramatic improvement for China.

In Changsha and in other, they stop it all two or three days per week, they’re out of electrical energy, so they now are looking for energy saving, the major advantage of technology.

Jiwon Lee - Sidoti & Co

Okay. I get the gist of it. Thank you.

Operator

Our next question comes from C.J. Muse - Lehman Brothers.

Unidentified Analyst – Lehman Brothers

Hello, it’s Olga calling in for C.J. Just a couple of questions on the financial side. What are the gross margins assumptions that are driving your EPS guidance?

Timothy Mammen

We’re basically saying that for the remainder of this year, we may see a little bit of a benefit on gross margins, but certainly maintaining them, we’ve guided in the second half of the year to get into the upper 40s. I think we’ve got there a little bit earlier.

Unidentified Analyst – Lehman Brothers

Okay, so at the very least at the current levels.

Timothy Mammen

Yes. Particularly given that you see guided revenue taking at the top end of the range a nice step up, and at the bottom end it would be maintaining the current EPS levels. I think we’ve guided it in line with where we reported for Q2 in terms of the model.

Unidentified Analyst – Lehman Brothers

Okay, and then on the R&D side, you said you ventured outside of your targeted range a little bit. Do you see that maintaining through the second half of 2008, or do you see it coming back down within the 5 to 7% range?

Timothy Mammen

That should get back within the 5 to 7% range. Particular, there was about $600,000 related to the CO2 project that went through in Q2. So there is a pretty high level of activity there.

But as revenue steps up R&D, it will increase in the absolute terms continue to do so, but we’re confident we can get back to our 5 to 7%. And we’re only just over that at 8% at the moment. A little bit volatile quarter-on-quarter, but no real issues there.

Unidentified Analyst – Lehman Brothers

Okay, and then with the acquisition of the subsidiary, you basically have got minority interest expense is going to go away into December Q and beyond that?

Timothy Mammen

Probably about 80% of it. There’s still some minority interest in our Italian and Japanese companies. Obviously, those are smaller companies and only sales and distribution entities. So, it will decline substantially. We estimate in Q4, we should benefit EPS by about $0.01 from that.

Unidentified Analyst – Lehman Brothers

Okay. Then a quick question on the medical side. You said that you just began shipping to a couple of new customers. Given that traction, now that you’re no longer only shipping to one customer, how would those revenues trend in the second half of 2008 and then entering 2009?

Valentin Gapontsev

We supposedly done bad for the same volume, but we were okay the last year, and then in the future of the shelf medical revenue, we expect will increase in our total revenue.

Timothy Mammen

Probably more in 2009 than immediately.

Valentin Gapontsev

Yes.

Timothy Mammen

There’s a couple of other things we’re working on at the moment in Asia, and stuff like that, but probably won’t get much traction out of it until 2009.

Valentin Gapontsev

Before, we have some exclusivity with our first OEM. And so, other people would start to use the similar technology in updated way, tend to other potential suppliers. But now all of them will come back to us because we stopped the exclusivity condition with the first OEM.

Unidentified Analyst – Lehman Brothers

So now your exclusivity agreement is over?

Valentin Gapontsev

Yes.

Unidentified Analyst – Lehman Brothers

Okay. Got you. Thanks so much.

Operator

Our next question is from Ajit Pai - Thomas Weisel Partners.

Ajit Pai - Thomas Weisel Partners

A couple of quick questions. The first one is just about the initiative you took on providing laser diodes on a merchant basis to customers.

Can you give us some color as to how that is ramping right now, whether that did help contribute to the gross margin improvement in this quarter? And, how many customers you have over there, and what the forward trajectory of that looks like?

Timothy Mammen

In terms of Q2, the sales in Q2 are probably just under a couple of hundred thousand dollars, so that has not had any meaningful impact on the results of the company or gross margin.

Our backlog is growing a little bit in that. I won’t give a number on it, but it’s slightly higher than the sales we had. Actually, I just happened to be speaking to the sales guy there, and he’s very optimistic that he’s starting to get some traction, and over the next six to nine months should see diode bookings increase to more than seven figures and above.

I don’t want to give a number on that, but he’s optimistic; he’s starting to see some benefit coming from that business. Is that fair to say?

Valentin Gapontsev

Now, in terms of the potential OEM customer making qualification tests of our samples and they will promise the orders in large quantity orders.

Ajit Pai - Thomas Weisel Partners

And about maybe a year ago you provided some color as to you’re total volumes in laser diodes being a scale driven business, whereabouts four to five x that of the next player. Has that gap actually expanded, based on your research?

Valentin Gapontsev

Our total production capacity now can support five times more consumption than we have to be...

Timothy Mammen

...compared to the other people. Nobody has increased their production...

Valentin Gapontsev

Nobody increased production; we don’t see any competitions here, in quality and also in quantity.

Ajit Pai - Thomas Weisel Partners

Got it. So, you said that your current capacity that you’ve put in can support five times what your current production is? Did I hear that right?

Valentin Gapontsev

Yes, exactly.

Ajit Pai - Thomas Weisel Partners

Okay. And then just looking at the defense applications, and the defense market, I think at the end of last year you had some significant announcements over there. In this particular quarter, you didn’t call out anything specific over there.

Could you give us some idea as to how large you think that opportunity is, and any progress you’re making in addressing defense applications?

Timothy Mammen

It continues to be significant. We didn’t talk about it much, but there was a 10 kilowatt laser that went to a customer for that diode energy application in Q2, Ajit.

One 10 kilowatt laser is not that great for us at the moment; the 50 kilowatt laser has actually been completed a week and a half ago and is being tested internally and we’re still on schedule to run the demonstration trials with one of the U.S. customers, and hopefully if these trials work, we hope to get an order in the next few months.

If they don’t, we’ll have to upgrade the laser; it’s still open ended there. And the opportunities remain significant. We’ll know much more after this test has been done.

Ajit Pai - Thomas Weisel Partners

Got it. And then just lastly on the tax rate. I think from the 2007 tax rate of 32.5% you are indicating that you’ll probably get a tax rate of 31.5% in 2008. So that declining trend, it’s still higher than many players in the space. Do you think that will progress in 2009? Could you give us the drivers for the tax rate looking out further?

Timothy Mammen

In terms of that, we have seen tax rates in Germany come down, so they are at about 30%. The U.S., I’ve seen a lot of publicity about it now, has one of the highest corporate rates in the world. So we’re probably at a blended rate of almost 37% in the U.S.

We get some benefit out of increasing sales in Russia where corporate tax rates are 24% and then China where they are a bit lower. So it does just depend up on the forecast of mix of sales that we have worldwide.

As Russian sales increased, we should get a little bit of benefit of that. But I wouldn’t want to forecast the decline from the current 31.5%. For 2009, I think, to be conservative, we continue to model it at that. I don’t see any significant major benefits coming from the sales mix to drive that rate much lower.

Ajit Pai - Thomas Weisel Partners

Got it. Thank you so much.

Operator

We’ll now go to Mark Miller - Brean Murray, Carret & Co.

Mark Miller - Brean Murray, Carret & Co

I was just wondering if you could provide some comment about your backlog, either year-over-year or sequentially, what happened to that?

Valentin Gapontsev

We couldn’t say. We’ve not opened our backlog, because (inaudible) numbers can make some confusion; only once per year we claim our backlog. But we can say only it’s much higher than it was a year ago and growing very fast, not only in absolute number but also ratio of the backlog to our revenue grow in fact.

Timothy Mammen

...improved to the end of Q2 relative to Q1.

Mark Miller - Brean Murray, Carret & Co

And are you seeing a better product mix in your backlog now, or is it about the same?

Timothy Mammen

If you look at the backlog, there’s some improvement in even the amplifier, telecom orders. In the second half of the year, the high-power backlog is strong coming into the second half.

The medium power backlog continues to be equally as strong as it was at the beginning of March, so that the win on the medium power area that we’ve got is not just a one-off. We’re seeing continued orders there; increasing orders on the cindering applications.

The backlog mix, I’d say, is actually improved and particularly good if you see the medium power, where we put some sales effort into that increasing. Then the low power, excluding medical, continues to grow a bit, as well. We don’t see a main driver.

Mark Miller - Brean Murray, Carret & Co

A couple quarters ago you had some yield issues with some of your diodes, and you thought there was some margin improvement. Have you come up to now where you’re happy with your diode yields, or can we expect some more coming there in terms of better margins?

Valentin Gapontsev

It wasn’t probably with diode yields, it’s not correct. It was probably switch to new products, and, as usual, if you introduce new products, you haven’t beginning of high yield, and with full installation, optimization, product line, yields become the target of (inaudible).

In beginning, any new product yield is less. But it’s not problem with quality of product, just change of one product for much more powerful. We introduce in quarter four and quarter one of this year, instead of the 10 watts product, we introduce in mass production 20 watts, and now it’s reaching to 30 watts from one diode module.

So it’s again, new product is much more efficient, with lower price per watt, so we’re improving the quality of our diodes.

Timothy Mammen

Mark, I’ll give you some more color on that. The average cost on the diodes on this year has been stable, though no issues either on the chip side and, in fact, as the PLD 20 production has ramped up, we’ve brought the average cost a little bit down on that.

We continue to work on improving the cost of that product, and as we get to higher volumes, we should be able to do so. We’ll get some benefits, and there’s no detriment to that at all.

Mark Miller - Brean Murray, Carret & Co

Can you give me any estimate over your competitors who would have to buy these diodes, what type of advantage that gives you by having this low-cost ability to produce diodes? And how significant is that, in terms of keeping people out of your space?

Valentin Gapontsev

Mr. Miller, the diodes doesn’t have any competition. However, diode sits higher for one module in the same price, and so, brightness much more than available from any other source and, of course, also we provide cheaper price, not big different because we don’t like to destroy the market at all, but it’s cheaper to any competition.

Timothy Mammen

We estimate that our cost per (inaudible) is still about 15% of the market price.

Mark Miller - Brean Murray, Carret & Co

Only 15%? That’s very low. Okay, thank you.

Operator

Our final question comes from Ian Fleischer - FBR Capital.

Ian Fleischer - FBR Capital

Just to touch on your welding once again. Is auto really the primary end market where you’re addressing that welding opportunity right now, or are there other end markets that you are also starting to penetrate there?

Timothy Mammen

There are many different end markets; just a couple of the big ones is heavy manufacturing, manufacturing of railroad cars where we’ve already got lasers deployed in Japan on that, and then shipbuilding is another main target; battery welding, pipeline welding, and general manufacturing, and shipbuilding.

Valentin Gapontsev

Yes, shipbuilding going very well and we introduced first here with the laser welding and in the shipbuilding materials and shipbuilding; also we’re now starting program to introduce major building and construction field.

It also provides a lot of advantage in the high building and bridge, big bridges and so on, much better quality of much more strong weld. Now is the best time as possible to use materials in the future in this application; many other specialty, new (inaudible) competition with composite materials and many other things.

Ian Fleischer - FBR Capital

Okay, great. Thanks.

Operator

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

Valentin Gapontsev

Thank you for joining us today. We continue to make progress in our operation, our financial goals, during the first half of 2008. The quarter’s solid financial results were at the top end of our guidance, indicating that we are executing well on our growth strategy.

Moreover, the strategic investments that we have made should help ensure that IPG capitalize on growth opportunities across the globe in the future.

We look forward for speaking with you again in Q3. Thank you.

Operator

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

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Source: IPG Photonics Corporation Q2 2008 Earnings Call Transcript

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