IPG Photonics (NASDAQ:IPGP) Bank of America Merrill Lynch Conference June 6, 2012 2:20 PM ET
Tim Mammen - CFO & VP
Krish Sankar - Bank of America/Merrill Lynch
Krish Sankar - Bank of America/Merrill Lynch
Hello everyone, I am Krish Sankar of BOF/ Merrill Lynch, I am the analyst who covers IPG Photonics which is the next company presenting. IPG is one of the leading providers of fiber lasers and we are fortunate enough to have Tim Mammen, the CFO here. He is going to give a short presentation and then we will open up it for Q&A after that, Tim.
Okay. Thank you Krish. Just before I start I want to draw your attention to our Safe Harbor statement, fact that we will be maybe making a forward-looking statement during the course of this presentation. These forward-looking statements involve risks and uncertainties and I also want to draw your attention to the risk factors that are outlined in the quarterly reports we file with the Securities and Exchange Commission.
As Krish mentioned IPG is the company that has been credited with commercializing fiber laser technology. This is a unique new laser technology that is rapidly gaining share against traditional technologies like gas lasers predominately CO2 and solid state lasers that use crystals for example ND:YAG lamp-pumped lasers.
We sell our product all around the world, primarily to own equipment manufactures as well as end users. There is a tremendous amount of leverage in our business model, which drive some of our profitability and we really are a global company with operations all around the world and now over 2000 employees as well.
In terms of the investment highlights about the company there are a couple of things that I want to draw your attention to. The first is that the market for laser sources itself is fairly significant, it's estimated to be about $3.8 billion and it's also growing at a nice rate. So between 7% to 9% average growth predicted through 2015 I should characterize that as being two times GDP and the reason for that is whether if you look at fiber technology or some of the older technologies lasers are being deployed more and more widely either to displace the existing machine tools or a near applications particularly in the microelectronics industry in the laser diode industry. LED diodes for commercial and residential applications, growth in semi-conductor businesses and solar some of the main areas that we are seeing growth in to for example displacing traditional welding technologies that have been around for about a 100 years.
Within that total market and I will it down for you into different categories and demonstrate how far and well accepted fiber is in each of those areas, fiber is displacing the existing technologies and our growth rate is actually significantly above that of the market. Through 2011, the average growth rate was about 27% but actually is recently accelerated closer to 60% in 2010 and 2011 really is the price points of fiber has come down to be equivalent to some of those legacy technologies. We believe we have significant competitive advantages which I will talk about in more detail as I go through this presentation and clearly we are the first mover in the industry.
We also have some of the lowest cost product out there and a very deeply, vertically integrated business operation. That integration does drive stellar margins and I will show you how those change and have changed over time later on in the presentation. I will also talk as we go through this about the diversity of the company in terms of the end markets both geographically and applications that we address. Talk a little bit about the growth of fiber laser, a few years ago this was a very small market, it was not a widely deployed technology we really used in niche applications.
The largest application back in 2007 was simple marking and engraving where we displaced some traditional technologies as well as CO2. So when you mark with a laser it's non-contact it's permanent, you don’t require inks, you don’t use environmentally unfriendly chemicals but actually engraving application. As you can see here the total market in 2011 has grown about $600 million and average growth rate of about 31%.
We started to penetrate much more deeply into macro processing applications primarily cutting and welding as well as cladding, saw some growth in micro processing. But those areas also represent significant potential growth in the future, so in early stage.
And that’s why most of the market analysis is done and the internal analysis we do at IPG expects the fiber market to continue to grow robustly, expectation is more than 20% through 2015 and for the total markets were increased from just under $600 million to about $1.4 billion and for fiber penetration to go from about 15% to about 29%.
Now this analysis is interesting because it excludes certain new products and areas that we think we can already get in but when the market analysis was done halfway through last year we didn’t really have commercial devices. Those areas that we think we can get into the future and expand further into first of all the micro processing which is the third column here.
We have a new laser that is more directly competitive with lamped pump YAG lasers that means that from the 24% market share in micro-processing we can replace these lamp pump YAG lasers and probably grow to about 60% there.
The other two main markets that we see is future opportunities are non-metal processing so for example welding and marking of plastics particularly clear plastics which are one micron laser has historically not done well. We have developed a new laser that is of a different wave length, small similar to CO2 the absorption in clear plastic is a lot better. The initial process and application work is going on and been done around welding plastics has been extremely well received.
So the non-metal processing represents a $200 million market we have really hit to not address. In fine processing you again got lasers at different wave length primarily green and UV, the main applications there include semiconductor, many of the newer applications in terms of annealing crystals and flat-panel display and also light emitting diodes for commercial and residential lightening.
The issue that you have got there is again the wave length of fiber is traditionally operated at is not been good for those fine processing applications. We have recently introduced a laser that operates at the green wave length which is halfway between the existing one micron on UV.
We have a UV laser that is development in a very low power device actually in our laboratories, we expect to increase the power and improve the reliability of that opening up further the fine processing market.
Those represent some of the newer opportunities that we don’t think are really factored into the $1.4 billion total fiber laser market. In terms of the existing markets if you look on the left hand side here, the high power is the immediate largest opportunity that exists. This is primarily cutting applications would make up about 75% of that market and existing welding applications that is serviced by lasers. The cutting market is about 750 million, welding is probably about 250 million of it and then much smaller niche applications include things like cladding, deposition technology.
Fiber is extremely well suited to welding of different types of materials whether it be standard steels, high strength steels, aluminum. It's also extremely good at cutting different types of metals. The initial penetration into the metal cutting market was with thinner materials where the cutting speeds we achieve were dramatically higher, the electrical consumption of our devices are a lot lower and I will talk about the benefits of the laser specifically in another slide.
So we have seen market share grow from the low single digits to about 20% of that high power market, the work that’s been done in the last 6 to 9 month includes significant developments of welding processes to display traditional spot welding, make, take electron beam welding which requires a vacuum when you weld with a laser of thick metals you can achieve very high quality welds without the vacuum so the cost of the welding is dramatically reduced.
On the cutting side, the most significant advantage has been to increase the thickness of the metal we can cut. We have customers who are cutting up to 35 millimeter thick metal so it's over an inch and a quarter in thicknesses. That continues to be a debate in the market about the effectiveness of fiber to cut thick metals. I would say that the technical solutions are proven but fiber now needs to do a lot of work in gaining that acceptance in the market and to overcome the final claim of CO2 that it has in the advantage of over fiber and CO2 would say that if you need to cut metal that is up to an inch and thickness you have to use CO2 and you can’t use fiber.
That advantage I think is technically proven to be wrong and commercially has to be proven, the benefits over the next year or so is people introduce equipment into the thick metal cutting market. Having removed that barrier it really removes a critical decision point that people who run for example job shops have to make, they don’t necessarily want to buy two different types of laser technology and run one CO2 machine, the thick metal cutting and the fiber machine for doing all the thin metal cutting and processing a reflected materials.
That barrier we think will down very dramatically in the next 12 months enable much further penetration into the cutting market given all the other performance benefits of the laser.
This just breaks down a little bit how the fiber market itself is made up, the largest single part of it is the materials processing that’s the blue columns here but there are other applications out there, they are more nascent, advanced applications include esoteric, things like topographic mapping, using the laser to destroy an incoming motor or artillery or a missile.
So use very high power lasers, the unique attribute is some of our lasers is the beam does not diverge so that even if you try and focus it on a point that is 3 kilometers or 4 kilometers away it retains enough power density to actually destroy an incoming missile or motor.
So there are an interesting applications on the advance side, they are not really commercialized yet. We generate a significant amount of revenue from those areas about 16% comes from our advanced medical and telecom business. So they are growing opportunities, some of the more interesting applications on advance include for example the use of the laser to drill an oil and gas well.
And some of the key advances in technology have really been made in that area in the last year with partners that we have been working with. One of whom has proven the concept of delivering the laser beam several kilometers down and optical fiber and minimized the losses of energy so the resulting beam that is transmitted with the drill bit can soften the rock dramatically reducing the pressure required on the drill bit and reducing the amount of down time this required when you have to replace the drill bit and substantially reducing the cost of drilling wells and potentially making wells that are being so far uneconomic, much more economically viable.
So there are really esoteric type applications that even 2 or 3 years ago people were not thinking about but they do have tremendous commercial potential if they continued to be developed in the near future.
The other part of the market that I haven’t really talked about is the fact that the laser itself generally goes into a system, 2010, the later stage or half of the laser system business that market was about $8 billion. The materials processing light source that we currently sell was about $2.6 billion, in 2011 the material prices was about $2.8 billion. So the ratio of the value of the light source to the complete system is approximately 1/3rds to 2/3rds.
IPG intends to selectively enter the laser systems business and I was very clear though by selectively we do not intend to compete with our existing OEM customers who are experts in materials handling and cutting applications at very wide distribution around the world. We do not intend to compete with our 100 marking and engraving customers to produce low value add market and graving system.
Our focus to-date has been on really looking at new value added applications like welding and cladding, the microelectronics processes, ablation technologies for the solar industry and a lot of you work around those applications and processes actually happens internally at IPG. The other benefits of the company is that as you develop the processes in the systems, you actually develop a much closer relationship with the customer, keeping in-house a lot of the development work you have done and enabling user help the customer solve their problem.
So we believe this is an actually an important strategic path that we should pursue and is the one that we should not abdicate. Many of the systems that we saw to-date the gross margin of them has been close to our corporate average. So within these real value adding systems we do not expect to see a significant erosion of gross margin but the margin should not be the simple story about entering the system is you also have to look at the total return on capital and if you can provide a complete solution instead of selling for example five lasers into an application a year because you are completely against someone else who provides the complete solution but using a different laser technology you might be able to sell 10 or 20 of your lasers into that application leveraging the whole business.
I have mentioned the diversity of our company, 84% of the businesses is materials processing but within materials processing there are many different applications. I have mentioned a couple cutting, welding, cladding, drilling, and then the end industries that they serve range from the automotive industry to general manufacturing and heavy industry we are annealing and hardening pipes for the nuclear industry in Japan, in aerospace, recladding of turbine blades and fans to repair them, drilling of holes in turbine engines to improve their cooling efficiency that in turn drives fuel efficiency and reduces noise.
Semi-conductors, electronics, welding of batteries, photolithography applications widely used for lasers dicing and scribing of wafers as well. And then even basic consumer processes, one we like to call attention to is the welding of razor blades if you look at razor blades. If you look at razor blades they have microdots on them each of those is done with a laser and then a huge business for IPG on the consumer side is the marking and engraving of promotional items everything from pens to key rings, there are billions of these items that are produced every year and most of them are marked and engraved with the laser.
There is a very nice aspect of the model as well and it's the leverage that we have three or four main distribution channels. We do so directly to end users so for example in the automotive industry most of the welding applications are direct but once you qualify with the manufacturer it results in a relationship that can last for many years. There are automotive customers that we have to whom we have sold 80 plus lasers over the last three years.
And that’s the result of the work that we did with them initially qualifying for a very specific application. As they started to appreciate the value of the laser they have broadened the application that they have started to address. The other part of the business is selling into own equipment manufacturers and you should do distinguish this from a pure distributor relationship because these people take the laser and the engine and they add a tremendous, surround the technology around it and integrate it into their systems. The typical example is that 2 or 3D cutting systems with automated materials handling, take off and delivery procedures.
The marking and engraving, integration of the laser with software and scanning head, topographic mapping system. The great thing about that business is it is even more leveraged so that every single time that customer or those customers sell one of their systems we sell a laser, so effectively their sales force is working on behalf of IPG Photonics.
To a lesser degree we sell lasers integrator, and the difference between an integrator and an OEM in our mind is that the end user actually determines the specification of the equipment that they are going to use and then they just stop contracting and integrate to build that equipment, we have relationships with many integrators and then a very small part of our business is sort of the more traditional representative so for example in Brazil where we do not have an office we use a rep there and for small parts of our telecommunications business in Japan we have reps as well.
Having said that we do have global capability and sales and service manufacturing around the world. Our main manufacturing operations are in Germany, the U.S. and Russia. Sales and distribution as you can see here spread through North America, Europe and the Far East.
We have invested heavily, in personnel and sales and marketing over the last four years doubling our head count to more than 80 people. It's about 95 I think at the moment and we have also invested heavily in application centers, I have mentioned that one of the things IPG likes to do is get close to the customer help the customer solve their problem.
A very key part of their sales process, is working with the customer they will send materials into our laboratories. We will prove that they can weld or cut them at a certain speed to a certain quality. They will stress test the welds that we produce for them, so the sales people work close to the application people; they work close with the product development people if they are key technical uses that have to be solved. And we have built a lot of that out over the last three or four years as I said.
We deal with customers all around the world, the great diversity of them we really think we have a blue chip customer base I won't go through these names in detail but just a representation of the different companies that we have sold lasers into in the recent past. Some of them will be buying the largest OEMs by over $30 million of product from us a year, some of them of sort of $10 million to $15 million, the smallest OEMs if they are buying 10 lasers might purchase $200,000 or $300,000 but there is tremendous leverage in each of those areas.
What’s unique really about IPG’s technology is its simplicity. There is a tremendous amount that goes into making it simple so whether it's our laser diodes which are very efficient converting electricity into an optical output, the electrical efficiency of our lasers approach is 30%, traditional technologies range between 2% and 15%. We take the relatively poor quality output from the diodes which on the left hand side here and coupled out into our own active fibers. The active fibers convert a poor quality, relatively poor quality light source into an extremely bright non-divergent optical beam.
That optical beam enables you to process faster, cut thicker materials as we have explained earlier, welds the thicker depths, welds the higher quality, reduce the amount of metal that might be required during the welding process.
The unique aspect of this technology goes and IPG’s position is we actually produce all of the optical components that are used to build the base laser. The other unique aspect of it compared to other technologies is very scalable. If you want more power out of your laser you simply add more diodes and you combine more modules together. The average module power that we use at the moment is about 750 watts. If we are building a 4 kilowatt laser we will use eight of those modules in there.
If you are building a 10 kilowatt laser you use 12 or 14 of those modules. And that’s literally how we increase the power of our lasers. It's difficult to scale for example CO2 power nearly as easily as that. We can produce the laser that has 5 watts of output power, and the largest laser we ever sold with 50,000 watts of output power and that was several years ago and it's not even particularly leading edge for us anymore.
The benefits of the laser are immense and scalability of output power. People talk about beam quality and the brightness of the beam, so the less divergent the beam is, the more bright it is and the more power is retained on the workplace that you operate. A non-divergent beam, an example of it is a flash light, quickly losses its density. Electrical efficiency of our lasers is 30% compared to 2 to 15 for other technologies. We can produce laser of different wavelength. That's for example enabling us get into processing plastic. The footprint is a lot smaller. So factory space usage is reduced and the laser is low to no maintenance. So we've had lasers that have been used in the field and are run for thousands of hours without the service intervention as compared to a CO2 laser that has constant requirement to align optical mirrors, replace gases, replace parts and a amp-pumped YAG laser, the lamps which generate electricity are constantly having to be replaced. As soon as you put a lamp into the production line, it starts to degrade. So the power output of the laser starts to degrade and you have to adjust the running speed of the production light to match the laser. With a fiber laser you can run the production line at its optimal rate, rather than matching it to the laser itself.
So those are all the advantages that drive the reasons why people chose the fiber technology over the incumbent technologies. They can get to greater productivity, they can work on a wider variety of materials, they can save floor space, the can reduce their electrical consumption. This is a unique retrofit that IPG made last year, one of the automotive manufacturers in the United States, where they were using three lamp-pumped YAG lasers at multiple kilowatts were the roof of the vehicle. We retrofit the three lamp-pumped YAGs with two fiber lasers in July of last year. The payback in terms of reduced electrical consumption, maintenance and consumables we've been told was less than a year. The single biggest advantage though that they got from deploying the fiber laser technology was the throughput of vehicles per hour on the line with increase from 30 vehicles per hour to 60 vehicles per hour. The older laser technology was the limiting factor on the production line and when that was factored in; the payback was in a matter of months. That whole project has been elevated up to corporate level within that company and we're hoping that that will be an example and drives further adoption of our lasers and more wide adoption of the technology and different applications that they have.
I mentioned vertical integration, there are some key benefits that this has for the company has well and we've built tremendous scale within our manufacturing without outsourcing. How do we outsource that scale, we would be enabling the supplier to supply the equipment components to any of our competitors, allowing them to catch up much more quickly with us. The scale that we have is internal to IPG. We do not sell our optical components in the market in the commercial merchant market. We use them all internally. So scale is a very key barrier to entry. We think that it is really developers of the last two, three years, particularly as the high powered market has grown. Again, by not outsourcing a lot of these technologies, the people thought we should outsource 10 years ago. We've limit the spread of many of our trade secrets, we've developed manufacturing know-how, we've limited the spread of any process knowledge that we have, critically by holding a manufacturing, a lot of the components stock internally, we're able to shorten our lead times on the delivery responding to customer needs very rapidly and we've also dramatically reduced costs using the vertical integration strategy and I've got a great slide to demonstrate that.
So the vertical integration is a key part of our defensive position. We also have a very strong IP portfolio, many hundreds of patents to cover many different aspects of the technology; we continue to file many patents around the diode technology, around the fiber technology. We've defended successfully three or four present or one patent litigation that went to jury trial last year, we were led to infringe on someone's fiber technology that we won. Three or four other instances where people have alleged that we're infringing on their technology, we also successfully defended those without any material effects to the company. So we've proved the strength of our IP portfolio. Then I have also mentioned the manufacturing scale which we think is a very important part of the motor (ph) around the company and the barrier we have to people catching up to us. This is the probably most graphic example of the benefits of having vertical integration within the company and it looks that the cost of our diode power per watt.
In 2003, in the blue column was when we used to source the diodes from outside and it used to cost us $80 per watt. To produce a 1 watt kilowatt laser, you need 1.5 watts of diode power. So it would cost $120,000 is diode power to produce a 1 watt kilowatt laser. At that point in time, we could sell that laser for $150,000, would make no gross margin on it, you couldn’t really commercialize the device despite all of its advantages mainly because the cost of the CO2 laser was less than half of that $150,000. As soon as we insource the diode production, the cost per watt came down about $30. You'll see the IPG's gross margin actually went from negative to about 30% and overtime was dramatically run ramped up the manufactured outputs of diode chips, last year producing about 1.2 million chips and reduce the cost per watt on the diodes, exiting 2011, it was $3 per watt. Certain elements of the diode technology used in different products was as low as $2 per watt at this point in time. So it's gone for a point at which the diode cost has been 80% of the selling price, the laser is less than 10% of the selling price of laser and the selling price of the laser has come down from $150,000 per watt to an average of $50,000 per watt removing barrier that existed in the minds of many of the users that they didn’t want to deploy the fiber technology because it was initially too expensive to do so. That's also at the same time despite their rapid decrease in price driven tremendous improvements in IPG's profitability.
Slide just giving some photographic evidence of the production facilities that we have. I'll talk a little bit about on the CapEx, we continuing to invest and expanding capacity around the world, both in the US, Germany and Russia this year we'll spend about between $55 and $60 million both on core technologies and assembly and one of the great things I think the company has done is keep up with the demand for our laser and actually maintain lead times at a short level, satisfying the demands of the market.
Quickly on the financial overview, I won't spend much time on this but 2010, 2011 revenue growth average about 60%. It was a great return on capital; return on equity is in excess of 20%. Return on invested capital is about 46% last year. A lot of operating leverage in our model, both gross margin and operating leverage. So really, we priced our products in a cost plus basis, if you look at the billing material; we have a standard methodology for pricing products. So historically as we've reduced component costs, we've reduced selling price into market to gain that traction.
And then the other part of the profitability really depends upon how efficiently we're using our manufacturing process.
In 2007 and 2008 we had invested heavily in capacity after going public due to the capital that we raised then for those purposes. Our average utilization was probably around 70%. In 2009 with the financial crisis, utilization came down to about 50%| reducing gross margins to just about 35% and then as we ramp back up in 2010 and 2011 with tremendous growth we've seen, utilization is actually close to 90% is average about 85 to 90% over the last two years driving gross margins up to about 54%. That's pretty much the target top line on the gross margins. It's very difficult given the growth rates that we're going through and the continuous needs to add capacity to really drive utilization much further up and there's also to end to markets and continue to bring the cost of the components down. There's not merely so much pressures on reducing prices but there is a certain elasticity of demand that can be driven, that you can gain significant market share by reducing the selling price and displacing other technologies, whether they be laser or non-laser technology. So the overall statue of the company is to continue to marry selling price reductions as component cost reduction. Unless the company has a history of really delivering that gross margin improvement down to the operating line, operating margins were about 37% last year and just under 37% in the first quarter of this year.
90% of our sales comes through selling fiber lasers; we're specialist in this technology. Everybody else who's tried to get into this business is not a specialist there. We'll spend much more time on that slide.
And these slides just sort of breakout where the real growth of the business has been in terms of product line. (Inaudible) we've burned into well the incasing applications was a significant driver. The (inaudible) is on the left that used in marking engraving. Can be a little bit more susceptible to the macroeconomic climate because you've already penetrated to about 60% of that business.
Slide to show you great manufacturing scale; I won't spend much time on that, use 20,000 devices last year. Rock solid balance sheet, just under $400 million in cash. Very little debt outstanding. We generate positive operating and free cash flow. As I said, we expect to spend between $55 and $60 million on CapEx this year. We do intend to deploy some of the cash on strategic acquisition, either that leverage the existing product lines faster into end markets or potentially accelerate our penetration into the fine processing where we do not have a lot of experience at the moment. We do not intend to go out and acquire one of our customers in the cutting arena and end up competing with the 24 other customers that we sell to in that area. And with that I have taken a little bit of time to get through this presentation. We've got a few minutes for questions. I'll open the floor up to questions.
Krish Sankar - Bank of America/Merrill Lynch
First, can you give us some update on how the business is trending especially in China and Europe given all the macro uncertainties there? Has there been any change in doing from a customer since your earnings call a month or so ago. And then a follow-up on the margin.
Kris you're asking the $6 million question that everybody is asking. The general out of the business continues to be very positive. China is going along very well. We've put a lot of investment into China in diversifying the business there both in terms of the end users that well sell into and the applications. So we've actually started to get into some very high value add marketing engraving applications. The number of OEM customers who are purchasing lasers, the cutting applications is more diverse than it was last year. Growth into the microelectronics business, so a lot of the consumer electronic devices, both the well the end marking application continues to drives growth there and we've actually started to develop more meaningful relationship with the automotive supply chain and end users in China.
So continue to remain optimistic about that part of the world. Japan is expected to track more strongly in the second half of the year. And North America, I think a lot of the stuff in the press is about how much investment is going into North America and manufacturing that's benefiting us. The one part of the world that is not surprisingly a little bit soft is Europe. And it's particularly on the materials processing side. There was some benefit in the first quarter from advanced applications in Europe. We don't think that's the end of the advanced applications business in Europe. We think we're expecting some more fairly significant orders that hopefully would offset some of the weakness in Europe that we've experienced today. So the general the general tone continues to be very positive. I do say to everybody, you can tell me where the Chinese economy will be in Q4, I'll tell you where our business will be and in Europe really the concern is and if the euro falls part and there's a massive credit crunch, how does it affect us and it will affect everybody, that's the issue there. The general tone of the business remains (inaudible).
Krish Sankar - Bank of America/Merrill Lynch
And then a follow up on the growth margin side and clearly has a very enviable gross margin well above 50% compared to all your comps. Just to get a sense of over the next two years and you look at it, what other puts and takes in the gross margin side, I understand utilization has to be pretty high. What happens when you get more QCW into mix and what happens when there is more laser systems in the mix or what happens when there is more laser systems in the mix or what happens in a competitive situation. What do you think drives the gross margins and here given the upside or the downside.
On the QCW there isn't any negative gross margin impact once you ramp the production of those devices. I made the statement that we priced our product, we look at the variable cost of materials and labor that goes into it. We price it on a cost plus basis to that. When we introduced the QCW, the component cost that went in there when we were pricing those lasers at an average of $45,000 to $50,000, the desire and decision to come down to between $20,000 and $25,000 is because a lot of the cost has come out of the component base primarily with new diode design. Now there may be a brief period of transition where you have a fully baked in all of the priced benefits but it’s a very short period of time. The ultimate aim on the QCW is to have the same corporate average that we've got on the high power and the pulse lasers. In terms of systems, first of all, a lot of the system stuff that we're looking at the moment, some of the welding applications that the laser is the enabling part of the welding technology. You take the laser in the welding head and software that integrates this together.
A lot of the margins that we have on the welding head and the software and the integration and the motion and controls is actually equal to if not slightly higher than the margin on the laser and we're not buying in the robot that's being integrated into the end user will buy their own robots and then will integrate the system on to that. So if you were buying in the robot you'd have only a very small parts through margin on that. But there are other systems businesses where they for example in the fine processing business, the total margin profile may be slightly lower than ours. It maybe just 45 to 50% range. The critical thing there is that can you buy into the company that leverage using our distribution and channel grow the total size of the business and look at the total return on capital that's been invested and if you're reaching your return on capital hurdles and IPGs return is being consistently in terms of equity and other projects more than 20%. Just because you have a lightly lower gross margin, it does not mean you should abdicate entering into those business. So we look at it both from the margin point of view and also the total return on capital and particularly how quickly you can leverage your existing technologies or distribution network by buying into those systems or applications.
Krish Sankar - Bank of America/Merrill Lynch
And then in terms of (inaudible) long term, the cost of average gross margin is somewhere like 50 plus sort of mid-50s, is kind of the target down the road.
Yes I think we've given a range of 53% to 55% in the near, if you look at the relatively near term, what could impact that on a temporary basis is if you chose to free some working capital from inventory, we have not made any decision to do that but you might utilize the factory a little less, then in Q4 last year, in margins were just about 54%, maybe a little bit the low 54%, but we took inventory down by $3 or $4 million then you saw utilization and some product mix benefits in Q1 which took it about $0.55 (ph). We're pretty comfortable in that range assuming utilization is 85 to 90%, the quarter where utilization is a bit less you'll have gross margin potentially a little bit less for a period of time there. If the caveat to that is in say three years or four years' time, or even is there going to be some fundamental price dislocation in the market that we're not aware of is not apparent at the moment and that's the only thing that really affects gross margin. It's not anything integral to IPG, in terms of our component costs or utilization. It would just be if there is some real price dislocation in the market.
Krish Sankar - Bank of America/Merrill Lynch
Obviously from a competition standpoint you guys are doing really well, I think people have a pretty good understanding on where your public lucrative comps are, want to get a sense on how competition is progressing, especially in China given that that's one of your emerging geographies, you also have like these small companies called (inaudible) and they'll be starting making a lot of noise on fiber lasers.
A lot of the completion has first started to come into the lower power and pulse lasers. So people like (inaudible) and SPI lasers in the UK, they've been producing pulse lasers for over a decade. One of Roffin subsidiary has been around producing pulse lasers for a very, very long time. Actually think in terms of that lower power pulse business, we've actually gained market share. The market is growing a lot, but we've actually gained market share in the last couple of years. Probably the couple of main reasons, one, we're able to deliver short lead times reliable product in real scale, so we've got customers who buy 3.5 thousand pulse lasers from us. Nobody else can really match that kind of production capability and capacity.
And then as the cost of our components has come down, because the high power business is growing, the price point you can get to on some of the lower power devices actually is even more compelling for the end user and it's not really matchable by anybody else. So there is a lot of people making noise about the high power devices as well now. Clearly it looks become a lot more aggressive on price where they compete to us, that we believe that the electrical efficiency in a lot of these devices is substantially less than ours because their diode efficiency is lower and many of them are not using single emitted diodes, they are using diode bars. The beam quality are probably similar because they are one micron. But the key there is the depth of technology, how they resolve. The fiber is very important. The fiber darkens. The performance of the laser will start to degrade almost immediately and you only really realize the quality of fiber if you had lasers running for a couple of 1,000 hours in the field and a couple of 1,000 in less than a year. You don't want the laser degrading in that length of time. So it remains to be seen how close they can get to us.
Krish Sankar - Bank of America/Merrill Lynch
All right, thanks a lot and understand, I appreciate your time. Thank you.
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