Good day, and welcome to the nLIGHT second quarter 2022 earnings conference call. All participants will be in a listen-only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press star then one on a touch-tone phone. To withdraw your question, please press star then two. Please note this event is being recorded. I would now like to turn the conference over to Joe Corso, Chief Financial Officer. Please go ahead, sir.
Thank you, and good afternoon, everyone. I'm Joe Corso, nLIGHT's Chief Financial Officer. With me today is Scott Keeney, nLIGHT's Chairman and CEO. Today's discussion will contain forward-looking statements, including financial projections and plans for our business. Forward-looking statements are subject to risks and uncertainties, many of which are beyond our control, including the risks and uncertainties described from time to time in our SEC filings. Our results may differ materially from those projected on today's call, and we undertake no obligation to update publicly any forward-looking statement except as required by law. During the call, we will be discussing certain non-GAAP financial measures. We have provided reconciliations of these non-GAAP financial measures to the most directly comparable GAAP financial measures in our earnings release, which can be found on the investor relations section of our website. I will now turn the call over to Scott.
Thank you, Joe. Starting on slide three. Q2 was a solid quarter for nLIGHT. Despite the significant operational challenges and uncertainties we faced due to the prolonged COVID-related lockdown in Shanghai, we delivered revenue that was within our guidance range. Favorable product mix and solid execution of our strategic growth objectives helped drive gross margins above the high end of our guidance, which resulted in positive adjusted EBITDA for the quarter. Turning to slide four. Growth in revenue from strategic areas enabled us to generate $60.8 million of revenue in Q2. Our second quarter revenue reflects the continued geographic and strategic transformation of our business. In Q2, revenue from customers outside of China grew 12% year-over-year to $56.2 million, or approximately 92% of revenue, compared to $50.3 million or 73% in Q2 2021.
Our focus on strategic growth areas outside of China have resulted in eight consecutive quarters with year-over-year growth in our non-China industrial and microfabrication business. Our global manufacturing team did an outstanding job during a quarter in which our key assembly facility was either closed or running at sub-optimal capacity for two months. A small percentage of our total workforce was able to gradually reenter our facility during the Shanghai lockdown, which began on March twenty-eighth. Much of our productive capacity was completely idle until June fourth, when we officially reopened our facility. Although the COVID-related lockdown in Shanghai lasted longer than we could have predicted, our team rapidly resumed normal multi-shift production, enabling us to meet nearly all demand from our key customers. Despite the reopening of Shanghai, we continue to see challenges in the broader global supply chain.
Lead times for many of our critical components continued to extend, and the cost of materials, labor, freight, and logistics continue to rise. Our recent experience with the COVID-related lockdowns in Shanghai have reinforced our decision to continue to invest in our manufacturing capabilities in the United States. Last quarter, we reported that we had installed the initial equipment required for the first phase of automation. In Q2, we began to increase the productive capacity out of our installed equipment, and in the coming quarters, we expect to increase output yields and add additional equipment to meet our automation targets. Finally, I'm pleased to announce that Chris Schechter has joined our team as Chief Operating Officer. Chris most recently was VP of Operations, Aerospace, and Defense at Celestica and brings a strong manufacturing background to support our continued growth.
Turning to slides five through six, where I will discuss revenue by end market. In microfabrication, we had another solid quarter. We generated $16.4 million of revenue, which represented approximately 27% of total revenue. Lower sales from microfabrication customers in China resulted in a 19% year-over-year decline compared to the record microfabrication revenue we generated in Q2 of 2021. We believe the current softness in our China microfabrication business is largely macro-driven, and we continue to maintain a market leadership position, which we believe will enable us to grow as the macro environment in China improves. Outside of China, Q2 revenue increased year-over-year and overall demand signals remain positive. We remain well-positioned to continue our global leadership position by introducing innovative high power, high brightness semiconductor lasers for existing and new markets.
In the second quarter, we developed a novel semiconductor laser with record peak power by leveraging our semiconductor device design and manufacturing capabilities. This technology has a wide range of applications, including LIDAR and other short-pulse imaging and sensing applications. We also continue to make excellent progress in the medical market, particularly for our newly released two-micron wavelength laser. We believe that this laser addresses a broad range of urological and other applications and offers nLIGHT yet another long-term growth opportunity. In aerospace and defense, second quarter revenue declined 6% year-over-year to $22.5 million, representing 37% of sales. Excluding advanced development revenue, Q2 aerospace and defense revenue increased approximately 18% to $9.7 million.
Overall sales in our aerospace and defense business was driven primarily by delays in receiving material required for certain directed energy development programs and fewer advanced technology development projects during the quarter. We view these delays as temporary as we continue to receive material required for our key directed energy programs and have signed several new advanced development contracts during the quarter. In the directed energy market, we had two major milestones during the quarter. First, we continue to demonstrate the ability to scale the power of our high-energy lasers, which we believe is critical for future defense systems. Second, we have expanded and deepened our engagement with potential customers, both in the United States and abroad. Our vertical integration, combined with U.S. manufacturing, enables us to take a system-level view of our customer's requirements and engage across multiple product levels, including diodes, fiber amplifiers, and beam-combined lasers.
During the second quarter, we generated product revenue from the sale of laser products to multiple U.S. defense contractors and foreign allies, and have engaged in many additional design-in opportunities with foreign allies seeking to deploy land, sea, and air-based lasers. As a result, we believe we have both expanded our served market and increased our near-term revenue opportunities. Finally, turning to the industrial end market, revenue declined 12% year-over-year in the second quarter to $21.9 million, representing 36% of total sales. However, industrial revenue from customers outside of China increased 43% year-over-year to $20.2 million. On a percentage of revenue basis, Q2 industrial revenue from customers outside of China increased to 92% versus 57% in the same period in 2021.
Industrial growth outside of China continues to come from strategic customers as we continue to deliver innovative solutions that enable our customers to increase their market share and at the same time increase their spend with nLIGHT. One of our key differentiators in the industrial market is the programmability of our lasers. We first introduced our programmable lasers to the cutting market in 2018, where they were quickly adopted as they addressed the long-standing trade-off between high speed for cutting of thin metal and outstanding edge quality for cutting of thick, mild steel.
We have continued to expand our line of beam control technology, and recently we extended the dynamic range of the beam area by 4x, thus allowing a 5 kW nLIGHT fiber laser to have the same cutting speed as an 8 kW conventional laser for thin metal cutting while maintaining outstanding edge quality for thick metal. For laser additive manufacturing, we are enabling our customers to continue to dramatically improve productivity in this growing market by offering lasers that provide benefits along two key dimensions. First, our highly reliable and stable lasers enable new multi-laser tools which improve productivity and reduce cost per part. Second, our programmable lasers can increase the build rate for additive manufacturing by 2x-8x with excellent material quality.
In addition, our lasers allow the microstructure to be engineered locally, thus optimizing the material properties such as ductility, strength, and hardness, introducing an entirely new capability for additive manufactured parts. For example, recently our programmable lasers were used to print turbo machinery components with spatially optimized mechanical properties that would not otherwise be possible without the use of our lasers. Finally, our programmable lasers are also being employed in welding applications to increase productivity and part quality. We are also deploying integrated process monitoring technology, which will further expand our market opportunity. I will now turn the call over to Joe to discuss nLIGHT's second quarter financial results.
Thank you, Scott, and good afternoon, everyone. Beginning on slide eight. Total revenue for the second quarter of 2022 was $60.8 million, a decrease of $8.3 million or 12% compared to the second quarter of the prior year and was within our guidance range. Product revenue for the second quarter of 2022 was $48.2 million, a decrease of $5.4 million or 10% compared to the second quarter of the prior year. The decrease in product revenue year-over-year was driven by lower sales to industrial and microfabrication customers in China, partially offset by higher sales to strategic customers outside of China.
Development revenue for the second quarter of 2022 was $12.6 million, a decrease of $2.9 million or 19% compared to the second quarter of the prior year. The decrease in development revenue year-over-year is attributable to the timing of project-based work we perform in the defense market. Turning to slide nine. Overall gross margin for the second quarter of 2022 was 25.3% compared to 29.4% for the second quarter of the prior year. Better than expected product mix enabled us to generate gross margins that were above the top end of our guidance range. Products gross margin for the second quarter of 2022 was 30.1% compared to 36.1% for the second quarter of the prior year.
The year-over-year decrease in products gross margin was driven by sales mix, decreased capacity utilization of our Shanghai manufacturing facility, increased investments in U.S. manufacturing, and continued increases in production and freight costs. Turning to slide 10. non-GAAP operating expenses for the second quarter of 2022 were $19.3 million or 32% of revenue, compared to $17.6 million, 25% of revenue for the second quarter of the prior year. The majority of the year-over-year increase is related to increases in salary costs, headcount, professional service fees, and investment in R&D projects to support our product roadmap and long-term growth opportunity. Turning to slide 11.
non-GAAP net loss for the second quarter of 2022 was $3.3 million or $0.07 per diluted share compared to non-GAAP net income of $4.4 million or $0.09 per diluted share for the second quarter of the prior year. The year-over-year decrease in non-GAAP profitability was driven by a combination of the decrease in product gross profit and increase in OpEx spending. On a GAAP basis, net loss for the second quarter of 2022 was $10.3 million or $0.23 per diluted share, compared to $7.9 million or $0.19 per diluted share for the second quarter of the prior year. Adjusted EBITDA for the second quarter of 2022 was approximately $200,000 compared with $6 million for the second quarter of the prior year.
Net cash used by operating activities was $4.8 million for the second quarter of 2022, compared to $1 million for the second quarter of 2021. The increased operating cash usage is the result of lower profitability, as previously discussed, and changes in working capital. Capital expenditures for the second quarter of 2022 were $7.9 million, compared to $4.8 million for the second quarter of the prior year. We continue to invest in directed energy for the defense market and automation of our U.S. facilities to serve our customers outside of China. Turning to slide 12. We ended the second quarter with cash equivalents, and marketable securities of approximately $121 million, and we had no debt. DSO for the second quarter of 2022 was 61 days, and we had 157 days in inventory.
DSO in the second quarter of 2022 was negatively impacted by the timing of shipments compared to prior periods, and the increase in inventory was driven primarily by material purchases for the defense and directed energy markets. Turning to slide 13 for our outlook for the third quarter. Based on the information available today, we expect third quarter revenue to be in the range of $60-$66 million. The midpoint of $63 million includes approximately $49 million of product sales and approximately $14 million of development sales. Turning to gross margin. Third quarter product gross margin is expected to be in the range of 26%-30% and development gross margin to be approximately 6.5%, resulting in an overall gross margin range of 21%-25%.
For the third quarter, we expect adjusted EBITDA to be between -$1 million and +$2 million. We expect third quarter average basic shares to be approximately 44.6 million and non-GAAP diluted shares to be approximately 47.1 million. With that, I will turn the call back over to the operator for questions.
Thank you. We will now begin the question and answer session. To ask a question, you may press star then one on your touch-tone phone. If you are using a speakerphone, please pick up your handset before pressing the keys. If at any time your question has been addressed and you would like to withdraw your question, please press star then two. At this time, we will pause momentarily to assemble our roster. Our first question will come from Greg Palm with Craig-Hallum. Please go ahead.
Yeah, good afternoon. Thanks for taking the question. I guess starting with China, you know, what makes you confident that what is going on over there is macro-driven and not maybe share loss from increased competition? Do you have any visibility into that? And then can you let us know, you know, if or how much revenue that you've, you know, maybe actively walked away from over in that region?
Yeah. Good, Greg. Thanks for the question. You know, I think as we've talked about previously, you know, in China, where we see our strength is in the microfabrication market, and there, you know, best of our abilities, we continue to see, you know, strong engagement with design wins based upon the leading technology that we have. But the macro environment there was you know very challenging in Q2. With respect to the fiber laser industrial fiber laser business, yeah, as we've discussed, certainly, we're not engaging with unprofitable business there. You know, we're not breaking out you know how much of that we're walking away from. I don't know anything else.
No, I think that's it, Scott.
Yeah.
Okay. Fair enough. As it relates to the lockdowns, can you help us understand what the impact of those prolonged lockdowns were in Q2? Is there any assumption of continued impacts in the Q3 guide?
Yeah. Greg. The lockdown lasted for longer than we had expected when we provided guidance in May. At the same time, when the facility reopened, we were able to ramp quite quickly. Kudos to the team operationally for being able to get back to multiple shifts as quickly as they have. You know, we left $2 million on the table during the quarter, but it, you know, had we been open the entire quarter, I don't think it would meaningfully change your perspective or how we really did during the quarter, frankly.
Okay. Makes sense.
From a revenue perspective.
Yeah. Okay. Just in terms of the Q3 guide, any assumptions of you know, whatever, continued impacts or challenges, or at this point, are you more or less back to normal?
Our operations are back to normal in Shanghai. You know, there are still some minor lingering effects. I mean, there was you know turnover in getting new folks into the facility, so that always takes a little bit of time to get back to the exact level of efficiency at which we were operating prior to the lockdown. There's nothing that we see right now that looks like it will affect us the way we were affected in the prior quarter. Of course, we're concerned with the you know overall environment and the potential for COVID and other related lockdowns to happen in Shanghai. Our guide this quarter assumes that it's business as usual in our Shanghai facility.
Okay, good. I'll leave it there. Thanks.
Our next question will come from Jim Ricchiuti with Needham & Company. Please go ahead.
Hi, good afternoon. I just wanted to get an update on the automation activities in the U.S. At what point do you think that becomes less of a headwind? Sounds like you're satisfied with the pace of the progress you're making in this area. I wonder if you can give us a little better handle on or maybe update us on the timeline.
Yeah. Good, Jim. Thanks for the question. This is a very important strategic topic for us. You know, we continue to ramp up automation in the U.S., and we're currently seeing benefits of that ramp. We have more work to do, but we're certainly continuing to focus on, you know, the majority of our business in the fiber laser market outside of China, having that automated for 2023. We're continuing to, you know, make progress on that ramp and, you know, continues to be a top priority.
Turning to the industrial, the growth outside of China was pretty healthy. You've highlighted a couple of the areas, and in your deck, you talk about welding and additive. I wonder if you can give us any more granularity in terms of the magnitude of those drivers and that 43% growth that you registered in. If I could just slip one in on the medical opportunity. Is there a way for you to frame that opportunity for us as we think about possibly 2023 and beyond?
Good. Jim, let me just make sure I've got the question. The first one is on the 43% year-over-year industrial growth outside of China and, you know, what are the key drivers there. The second one was going back to automation again. Is that right, Jim?
No. On the industrial growth, maybe we'll take one at a time. I apologize. You highlighted some of the progress you're making in metals additive manufacturing.
Right.
If we could drill down further into that 43% growth, what were the major catalysts for that growth that you saw? To what extent could you anticipate that continuing in Q3 and Q4?
Good. Yeah, I think the short answer, Jim, is the reason we talked about what we're doing in additive, that is a key driver of our growth. I think it's been, you know, it's an application area that has, you know, grown nicely, but it still has a lot of promise. For laser additive manufacturing to be truly viable, you know, we as an industry need to continue to drive productivity up significantly. To do that, you know, a couple of the key levers are more lasers per tool that gets you more parts at lower cost and more effective lasers. We are demonstrating continued, you know, progress not only in the technology but also the adoption in that market. We do see opportunities for continued growth there.
You know, how they play out quarter- over- quarter, that's harder to predict. I do see laser additive manufacturing becoming a more important, you know, theme that will continue to drive growth.
How many customers are you working with, can you say, Scott?
Yeah, we don't break out the details, but it is. It's more than 10 that are-
Okay
... are good customers. There's quite a long tail there, Jim, of companies in this space that are doing some really interesting work that are, you know, sometimes below the radar. It's a dynamic space that has the opportunity for continued growth.
Okay. Just quickly, just on the medical opportunity, which you seem excited by, I wonder if you could talk a little bit about how we might think about that contributing to revenues.
Good. Yeah. I think it is worth noting that we're making good progress there with a new product. Urology is the first application which is driving demand, and we're seeing, you know, significant growth from small numbers this year. But it is a market that certainly has the opportunity to be, you know, tens of millions of dollars of revenue for us. And over time, medical can be a more important part of our business. We don't break it out today. We put it into the micro space, but we do wanna highlight that that is one of the drivers of what's going on in the micro segment for us.
Yeah, thanks. I'll jump back in the queue.
Our next question will come from Patrick Ho with Stifel. Please go ahead.
Thank you very much. Scott, maybe first off on the products and the market opportunities. I think you highlighted in your prepared remarks the two-micron series of lasers. Where are you seeing I guess the earliest or the greatest adoption? Because if I recall, it was targeting several markets. Which markets are you seeing the greatest traction for that product initially?
Yeah. Good, Patrick. Yeah. The initial traction is in medical and in urology. But you're right, we have highlighted the fact that two micron does apply to a broader range of markets. There are defense applications, there are industrial applications, but for the current products that we're shipping, medical is what's driving that. Over time, we do see it as yet another example of, you know, a laser which enables a broad range of different end vertical markets.
Great. That's very helpful. Maybe Joe, for you, on the cost side and the supply chain, didn't hear much of it on this call. Have you seen improvements on the supply chain front? How do you look at the situation on a going forward basis?
Yeah, Patrick, I think the good news is that we haven't seen the supply chain deteriorate further during the quarter. In some areas, you know, it's been relatively flat. I will tell you that flat in terms of you know what we're seeing in terms of the health of our suppliers. The lead times have continued to extend. There are certain parts that are not as challenging for us to get, but costs are definitely up. Costs of materials are up, freight and logistics are up, cost of labor are up. We think that they are going to remain at this level for some time.
Would you wanna put any quantification on that? Like, is it 100-200 basis point impact or, you know, what's your thought on that?
Yeah, sure. Happy to do that. As we look kinda quarter-over-quarter, it was 200 basis points that we saw of incremental costs between, you know, freight, logistics and materials.
Great. Thanks a lot, guys.
Thanks, Patrick.
Thank you.
Our next question will come from Han Chung with D.A. Davidson. Please go ahead.
Hi. Thank you for taking my question. Just wanted to follow up on the gross margin. For third quarter, we have a revenue coming up a little bit from sequential basis. As product gross margin kind of dipped a little bit. I guess there are definitely factors, I mean, including the product mix or the cost premium you just mentioned due to the supply chain. Any color, I mean, just regarding the prudent take in gross margin for the third quarter and how should we think about the gross margin, let's say, into 2023?
Yeah, sure. Thanks for the question, Han. You hit the nail on the head. There are two big impacts as we look at the margin in Q3 of 2022. The first of which is the mix of business. In Q2, we had a pretty favorable mix. It doesn't take much with our level of product revenue, you know, to sort of improve the product gross margin. In the second quarter, we obviously saw lower revenue from China, both in industrial and in our microfabrication business. We also saw a more favorable mix of business inside of our fiber laser business. Obviously offsetting that were, you know, freight, logistics, consumables, all of those costs that we've talked about.
As we sit here, right, our best view of Q3 is that the mix of business will moderate to something that is, you know, more in line with our expectations, and we won't get exactly the same mix benefits that we got in the prior quarter. But at the same time, we're gonna see, you know, better absorption as Shanghai is not shut down for two quarters. You look at that and you say that from a supply chain perspective, right, labor materials, things like that are gonna remain relatively flat, is how we got to our gross margin guide for Q3, Hans.
Got it. That's very helpful. If I look at the revenue mix by product type, and then it seems like the low power mix, I mean, going up and then.
Mm-hmm.
Medium-power going down, does that reflect the weakness in microfabrication? Then, just any comment on that dynamic?
No, what you're seeing there is this quarter in Q2, 41% of our business were below the 2 kW and below. That is largely driven by continued growth in the additive manufacturing business, where power is not the figure of merit like it was historically in the cutting market, particularly in China. When you're looking at mix based on power, and you can see if you go back four or five quarters, you'll see that the low power percentage of total fiber laser revenue has continued to increase. That's largely a function of the growth in our additive manufacturing business.
Got it. Okay. If I look at the inventory level, it continue to go up.
Mm-hmm.
I know you kind of explained that it's related to some purchases for the directed energy program, but is it also kind of strategic investment in just in inventory overall because the supply chain constraint? And then how should we think about the inventory, the management strategy going forward?
Yeah, great question, Han. You're right, inventory has gone up, and you've identified a couple pieces of it. The first is that as the lead times for the material that we need have increased, we've strategically used our balance sheet to make sure that we are able to support our customers. As we've said in the past, organic growth is the primary thrust of what we are doing at nLIGHT, and we wanna be in a position to be reactive to our customers' demands. Many of the customers that we are serving today, they are growing, but we are growing our share of wallet inside of those customers. We've made a strategic decision that today, with the supply chain, where it is, to invest more heavily than typical in our inventory levels.
As we mentioned in our prepared remarks, there have been a couple of areas in which we've invested in inventory, right? Directed energy is one of those areas. This quarter we talked about, you know, initial volume sales of laser products to customers, right? In order to support what we see over, you know, the coming quarters and years, we need to be in a position to, you know, turn that inventory into revenue. The third piece of it, Han, is that, you know, costs have continued to rise, right? Part of the inventory growth is that, what we are buying and putting on the balance sheet is more costly today than it was, you know, a quarter ago or a year ago. That's kind of the current situation.
As we look in the future, we're taking a really hard look at where to continue to strategically invest in inventory or not strategically invest in inventory. There will be some period of time where you'll see it around these levels as we continue to transition some of our manufacturing from Shanghai to the U.S. as we build buffer stock and the like. It's something that, you know, we are managing. Today we're, you know, in a strong position from a balance sheet perspective to be able to do that to support our growth going forward.
Got it. Thank you.
You're welcome.
Our next question will come from Paretosh Misra with Berenberg Capital Markets. Please go ahead.
Thanks for taking my question. Can you talk about your order book, you know, given the seasonality and whatnot, is it slightly weaker for this time of the year, or you think it's kind of in line versus last year or so?
Yeah, Paretosh. You know, I think short answer I'd say is in line. I think you know, what we're seeing as we noted in the prepared remarks is you know, very good traction in the strategic growth opportunities in directed energy, in additive manufacturing, in medical, and you know, continued traction in our core markets. From an order book standpoint, I think in line with you know, where we typically are.
Got it. Thanks. Can you give us some sense of pricing also in your laser product? Sorry to be oversimplifying, but maybe on some sort of a dollar per kilowatt price metric, are prices still falling versus, say, last year? Given the very high inflation that we have seen, perhaps you're seeing prices stabilize or maybe even go up?
Yeah, I think the short answer is stability in general. There's some areas where we've seen price increases. In general, stability, I think would be the answer, especially as we're not engaged in the very low price business in cutting in China.
Understood. Maybe last one. What's the best way to think about the dollar, US dollar sensitivity or impact on your business, on your revenue as well as your operating income?
Yeah. Thanks, Paretosh. The impact that we have from currency is relatively insignificant today. Most of the revenue that we generate outside of China anyway is in US dollars. We have a little bit in euro, and then when you look to the China business, we've got a natural hedge because we both sell in RMB, and we satisfy expenses in RMB. We don't have you know a big exposure from a currency perspective today given the geographic composition of our business.
Thanks, guys. That's all I had.
Thank you.
Thanks again. If you have a question, please press star then one. Our next question will come from Mark Miller with The Benchmark Company. Please go ahead.
Thank you for the question. What % of fiber laser sales were for over 6 kilowatts?
Over 6 kilowatts this quarter was 40%, Mark.
Can you just remind me again on the margin comparison between the high power versus the low power in terms of margin contribution?
I think you've got to look at it by market. Certainly when you look at the cutting market, the higher power lasers carry much better gross margins than the lower power lasers. You know, there's also for our business, all of the high power lasers are not made equally either, particularly when you start talking about certain configurations, whether they're programmable or not. I said market because it's important to make the distinction between the cutting market and the additive manufacturing market. When you look at the additive manufacturing market, the product margins in additive manufacturing lasers, which we report as low power, tend to be, you know, higher than cutting lasers today.
You indicated you're getting some traction in the welding application area. Can you just give a little more color on that? Because that's been a dominant part of sales for one of your competitors.
Yeah, I think, you know, it's an area that we do see traction. I think we've highlighted other markets where we see more material growth for us. It is a market that is an important market, especially with the expansion of EV. Will continue to be, you know, a market that we address.
Thank you.
Thanks, Mark.
This concludes our question and answer session. I would like to turn the conference back over to Joseph Corso for any closing remarks.
Thank you everyone for joining this afternoon and for your continued interest in nLIGHT. We look forward to speaking with you during the quarter. Have a great afternoon.
The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.