Good afternoon, everyone. I'm Brian Gesuale, Senior Analyst covering IPG Photonics. Really happy to have the company here to take us through their story. A lot of macro currents, a lot of transformation at the micro level within the company as well. So it's a good time to listen up to the story. We have the company's Chief Executive Officer, Mark Gitin, here, who's going to take us through the story, as well as the CFO, Tim Mammen. Mark, Tim, welcome.
Thanks.
I'm going to not get blinded by the lasers there. Mark, why don't you level set the audience here? Give everyone a flavor for what it is IPG does, maybe a little bit of the history and what you've seen since you took over the business, coming up on a year and a few months from now, and really just give us an overview of where you see IPG in the future.
Thanks very much. Well, many of you, I think, know IPG was really a pioneer in the fiber laser area, really driving the adoption of lasers in a number of industrial applications, including sheet metal cutting, welding, additive manufacturing. These are key areas that the company has driven over the years. In the last two, three years, the company has faced some headwinds. And those have been in the industrial markets. With everybody else, the industrial markets have put downward pressure. We've also had issues with pricing that has been quite competitive in China. So overall, since then, the company, though, has done a tremendous job of really executing through some difficult periods. Still, even with the headwinds, also seeing still very good cash flows, very good financials as the cash flows run through the business. So all very strong.
In addition to that, now they were able to also get out of Russia. This was an issue also that the company needed to exit Russia, did that successfully. Again, strong, strong business, strong in the industrial markets. It's had an issue in the last couple of years, but has still performed very well. Then since coming in now, over the last six or eight months, I've had a chance to really look into the company technologies, extremely strong technology, very excited about what's there and the potential for growth in the company. We have done a very good job now driving execution in the business. Over the last couple of quarters, in Q3 and Q4, we've executed well.
We have come in at the top end of the guidance in both quarters, despite, again, these headwinds in the industrial markets that have been quite challenging, where we're really bouncing along the bottom. In these cases, we've still been generating good cash. The business model is very strong, and we have taken the chance now, over the last six months, to really delve into the technologies, the markets, the customers, and we have a great opportunity for growth. We have a great business plan and a great model strategy to grow the company over the next three years in a number of key areas where we have strong differentiation, and there's opportunities with large TAMs that we're going after to grow the company over the next three or so years.
Great. Appreciate the color with that. One question I get a lot as I interface with investors is, how much of this is macro related in terms of the demand slowdown versus some structural challenges to the market longer term? Would you maybe take us through your perspective on that, how you think of the total addressable market, and maybe align that to where IPG plays in the various growth rates and regional growth rates?
Absolutely. Thanks. So if we look at the core business for IPG in the industrial market, so this is areas of cutting, welding, cleaning, and additive manufacturing, for example. The total market there for the laser sources is about a $3 billion market. And in terms of growth rates of that, they kind of vary from the mid single digits up to low double digits. And those growth rates really depend on the driving adoption. So if you think about it, we've grown significantly faster than that in some periods because we're driving adoption in these markets. As far as, yes, yes.
OK. Fantastic. I want to talk, you mentioned you've executed really well, a lot of different balls in the air over the course of the last couple of years where demand has been structurally challenged. I want to talk about gross margins. A lot of people remember kind of IPG peak gross margins in the 58% range. You've laid out a course for 45%-50% over time. Can you maybe remind people of the escalator down and then how you take the escalator back up towards those levels?
Sure. Yeah, I can cover that. Yeah, we peaked at about 57%-58% in probably 2018, Brian. We had a couple of years after that when pricing started to become much more competitive around the cutting market in particular. Initially, we responded to those headwinds by trying to compete on price, particularly in China within that business. Pricing over the next two years actually came down on a per kilowatt basis by about 50%. Our gross margins ended up at about 47% after that. I'd say 500 to 600 basis points of that was the pricing and structural shift related to the cutting market primarily. And then there's a couple of hundred basis points because we bought a systems company. And we also started to invest more heavily in complete solutions. And they drove another couple of hundred basis points headwind.
Since then, you know the biggest impact since then is really the underabsorption related to the demand environment headwinds. Our product gross margin has continued to remain pretty stable, so pricing has also been a lot more stable. But we've also taken some cost out of product. We're actually launching a new generation of high power lasers where we're targeting taking 20%-30% out of that cost. So long as your underlying gross margin on the product remains the same, the business model in terms of getting back into the 40% gross margin range and back towards 45% remains intact, and what it requires is really a recovery in demand that drives utilization of manufacturing capacity and starts to offset the underabsorption, which we've quantified over the last couple of quarters, 700 basis points. In Q4, it came down a little bit. It was 600 basis points.
The other benefit is that we've also got inventory a lot more under control. There was a huge buildup in inventory post-COVID with the electronic supply chain. Inventory days are now much more where we want them. But during the course of the last couple of years, we've suffered inventory provisions that have been, on average, maybe 500 basis points a quarter. We think we can get those below 200. And I'd like to get them normalized at 100% to 150 basis points a quarter. So that would be another benefit to the overall reported gross margin.
Fantastic. Really helpful. Maybe just to double click a little bit on that. You've done a lot with your supply chain, relocating out of Russia and putting capacity in other regions. How is your footprint today when you think of optimization for IPG going forward?
Today, we've got, as I mentioned, we got out of Russia. And we've optimized our footprint in North America as well as in Europe. And today, that works very well. We have opportunity to further optimize that. Since when we got out of Russia, we'd had to do that quite quickly. And so we were able to move into Germany and Poland and Italy and some into the U.S. So I would say that it's not completely optimized yet. But we're making good progress on doing that. And that's something that we'll continue to optimize as we go forward in the future.
Great. One of the key themes, and I think one of the most tantalizing investment theses for the story, is the incremental margins that the business can bear when revenue comes back. Can you talk maybe about those incremental margins and what just $200 million or $500 million of revenue would mean to the business over time?
Yeah, I like the word tantalizing that you're using there. Unfortunately, we haven't seen them recently, but as I said, with the fundamental business model intact and product gross margins continuing to be very strong, incremental revenue starts to drive an improvement in absorption, first of all, so initially, the drop through on margins probably meaningfully about 50%. And then would normalize at about 50%, so incremental revenue of $300 million, you're going to see $150+ million of that drop through to operating income and to cash flow. So the model's still got a lot of cash generative and income generative ability attached to it. You referenced that we had a great year last year on generating operating free cash flow. Some of that came out of the reduction in investment and working capital.
But it was also a reflection of the underlying cash generative ability of the business, even at these depressed revenue levels.
Yep. Let's maybe shift a little bit to the demand picture. I think you've defined it as stable, maybe even a little bit of optimism embedded in here. Let's talk about China. It's still a meaningful part of the business. Maybe size that for folks and talk about your outlook maybe this year, but longer term as well.
Yeah, sure. Yeah, China is still a sizable piece of our business, as you said. And yes, there has been competition in that part of the business. As I mentioned, specifically in the area of flatbed sheet metal cutting, today, that's less than 5% of the business. In the other areas of China, the other market areas like cutting, sorry, like welding, additive manufacturing, cleaning, those are areas where we have significant differentiation. We're delivering, in many cases, processes. In the case of things like battery welding, we're supplying not only a specialized laser, but also quality control mechanism, what we call our LDD, our Laser Depth Dynamics, that actually will measure the weld in situ, as well as some process control around that and optics. So again, very significant moats in those areas.
Outside of China, the cutting is a small part of the business, less than 15% or so of the business.
Let's maybe sneak in, since we're on kind of Tariff Tuesday here. How do you think about overall demand as people relocate out of China, and really kind of what that would mean to your business if supply chains are just disrupted a little bit as people look to mitigate any type of tariffs longer term?
Yeah, no, thanks. So what I can tell you is that as a company, we have a footprint, as we talked about. We have a strong footprint in Europe. We have a strong footprint in North America. We don't manufacture anything in China. So we believe, as we look at that, that first of all, from that standpoint, our ability to mitigate tariffs should be quite helpful because we can move things around. In fact, we supply China, for example, today out of Europe. Also, if there are onshoring opportunities, if this push is onshoring, that's likely to be based upon automation. And we have a very strong play on automation with automated welding and other tools where we can even supply the robotics.
Makes a lot of sense. I want to maybe discuss a few other regions. In the last print, I thought Germany and Japan were really nice bright spots for the company. Wondering what drove that, how durable it is. And then I'd also like you to kind of talk about North America after that.
Yeah, sure. So yes, we've seen some bright spots. And I would say Japan, we had some bright spots in a number of markets, including some design wins. And we saw some growth, actually, in cutting recently as inventories have normalized. And then when we think about, you asked about Germany, we really think about that not as one country. But we think about really the Eurozone. And that's been a difficult area in terms of PMIs and such. But we have seen some uptick there with some design wins that we've had in areas including, for example, in automotive. And we've actually seen a little bit of uptick there in cutting too as there's been some normalization. Hard to say in terms of long-term durability. But it's great to see some positive signs and some uptick.
Absolutely, especially when we see these PMIs year after year that have been a real challenge.
Absolutely. And then North America, you asked about as well. We've actually seen a little bit of uptick there in some of the areas as well.
OK. A vertical market that's probably been emblematic of what investors have looked to for you is on the battery side, particularly EVs. That's a business that doubled in each of the years from 2021 through 2023, became 20% of sales. My model last year had it down over 35%. We've all read the headlines. Adoption outside of China has been very lethargic on the EV side of things. Can you talk about where you think your customer capacity is? And if there's some new plants that are kind of going up that offer some opportunities for that business to rebound?
Yeah, sure. So first, I just wanted to say, again, we're well embedded in that area because we have very strong moats around the technology, around the business. In terms of capacity, as I mentioned, we've seen a little bit of uptick there. We've heard CATL, for example, in China talking about the fact that they're reaching the edge of capacity and would need to start to turn some things on. And they're both in China. And they have some legs outside of China as well. And overall, again, it's not just EV. So I just want to point out that while EV has kind of been bouncing along, we have to see when that really sees an uptick. Battery storage has another component, for example, which is stationary storage. Stationary storage today is kind of 20%-25% of the world capacity. And that's doubled year over year.
It's grown 100%. Significant growth there. We also have plays in other areas of electrification, other battery technologies as well. Each of those areas has seen some growth. Some good things for batteries in the future.
Right, right. As you've come out with more complete systems and you've understood the solution sets and the pulse points of your customers, your share is stable, growing, shrinking when you think of those customer sets?
In the area specifically in batteries and EVs, we have a very strong position. I mentioned it before. We bring not just a laser, but we bring a very specialized laser to batteries that really solves some fundamental problems early on, and also the quality control tool, our LDD, Laser Depth Dynamics, which again measures the weld quality in situ, and then put that together with, as you said, being able to develop and deliver some solutions. Our moats are quite high, and our share is significant and has stayed that way.
Do you think the market for stationary storage is equivalent over time, long time horizon? Obviously, your mix is probably 90%, 10% EV to stationary storage. Over time, do they normalize? Or how do you think about that?
So I think a lot of that's going to depend on how EV ultimately grows. But EV in China has continued to grow. Stationary storage will continue to be a bigger issue as you end up having things like solar plants at the end of the line and such. You really need more and more battery storage. And again, we saw growth 100% year over year in that area. I'm not sure how that will play out long term. But it appears that that will continue to grow.
You've long had the reputation of being an innovator in the space and kind of driving adoption in substantial markets and disrupting those markets. I want to give you a few moments to talk about some of the emerging products out there that you're excited about, whether that's LightWELD, CleanLASER acquisition, or really any other of the markets that you're excited about product-wise.
Yeah, absolutely. So very excited in areas like welding, again, where we've really driven the adoption, as I mentioned before. If you look at LightWELD, that's an area where if you handed somebody a laser and said, go weld with it, that's not going to happen very quickly. It's very difficult to go and develop the process. So we have very deep process knowledge capability within IPG. We develop the processes around how to weld copper on copper, copper on aluminum, steel on aluminum, et cetera. And we built that into our LightWELD tool. So now you have something that you can essentially turn the dial and able to weld with that. And that's really helped to drive the adoption. And that's a good example. And in laser cleaning, that's an area also that's very important.
As I mentioned, industrial cleaning is a tens of billions of dollars market. It's really about turning that TAM into SAM and driving the adoption. We made the acquisition of CleanLASER in December, bring a lot of that process knowledge into the company, and again, drive adoption. We see very good opportunities for growth in that area as well.
Appreciate the color there. I want to talk about the balance sheet and capital deployment. Your balance sheet's loaded. Even with a subdued demand environment, you've been able to generate a lot of free cash flow every year, which has been really impressive to me. You've been in the market doing substantial buybacks over the course of the past 18 months or two years. It seems like you're signaling to do a little bit less of that going forward. Maybe just kind of weave your thought process behind all of that.
Yeah, let me step back and weave another piece into that, which is we have a very strong core strategy for growth now, and those are in a number of markets, including medical, including micromachining, including some of the advanced markets. These are areas that we're investing in, and first place for capital deployment is to invest in our technologies and our growth because we have really fantastic trajectories in those areas. So that's first and foremost, and along with that, of course, looking at tuck-in acquisitions that can speed us to market, give us access to adjacent markets like we did with CleanLASER in December. These are really good opportunities for us to accelerate the growth, and that's another piece to it, and then Tim, maybe you want to talk about when we have excess.
Yeah, no, I think then it comes down to, I mean, first of all, we've still got $50 million outstanding under current authorization, right? So I think people maybe on our last earnings call walked away thinking we weren't going to be doing buybacks at all, right? That's not the case. I think it's a question of depending upon whether you can identify tuck-in acquisitions, the amount of capital that you deploy on these growth initiatives, how much then do you have as excess capital available that you would return to shareholders, and we've demonstrated a commitment to do that over the last three years with over $1 billion returned and the share count reduced by 20%. So if we feel we're in that position to do it, we intend to do it.
But the priorities perhaps are a little bit reordered, I'd say, with looking at some of these tuck-in acquisitions and driving some growth for the newer and core applications out of those.
That's great. Maybe you've always run a fairly conservative balance sheet. Your cash position obviously speaks for itself. Is there some sort of target leverage that you're comfortable with as a CFO? If you saw a deal plus you thought your stock was attractive, how might we think about the upper limits of what you would consider?
Yeah, we've never really talked about that. I mean, I think we all know what a conservative amount of leverage is. And it's pretty well known out there. I would just say we have got available borrowing capacity to execute around tuck-in acquisitions. I mean, if you're doing tuck-in acquisitions, you're not necessarily going to need to use that borrowing capacity. But we've certainly got a rainy day fund out there. And we want to keep that available. And potentially, we'll use it going forward, but not in an inconsiderate or in an overly risky way.
No, no, of course not. Mark, I want to give you kind of what I traditionally like to do, the drop the mic moment. I want you to take a little bit of time and speak directly to the investors on why they should consider investing in IPG. And the good news is there's no follow-up from me. So I'll turn it over to you.
All right. What I'd just like to say is that IPG is a fantastic company. I'm really happy to be here. As I mentioned before, very strong positions in a number of industrial markets like welding, like cutting, like cleaning, like additive manufacturing. Again, there's been a set of headwinds that's affected the company. But we're well positioned in those areas. So as the markets come back in the industrial space, we're going to see very good drop-through in the financial model. And then we're taking and we have very good areas for growth. We have a fantastic strategy among medical, micromachining, and advanced markets where we can really grow significantly over the next two to three years. And so I would say that's the key piece. We've got very good opportunities for growth as a company.
Great. We're going to end it there. We're going to go down to the breakout room downstairs to double-click on these end markets and where we're going to get that tantalizing incremental market demand from. So with that, thanks so much for joining us, Mark and Tim. Appreciate it, everybody.
Thank you.