IPG Photonics Still Looking To Find Its Footing As Markets Shift

Phuchit I was too early in thinking that the value I saw in IPG Photonics (NASDAQ:IPGP) in January of 2023 on relatively modest growth assumptions was worth taking on the cyclical risk I saw in many short-cycle industrial markets, not to mention the ongoing shifts in IPGP’s competitive situation. Though the shares did head as much as 30% higher from that article, those gains vanished as cyclical and competitive issues bit down hard and drove weaker-than-expected financial results. Now IPG Photonics shares sit about 20% lower, having underperformed the industrial sector and names like Lincoln Electric (LECO) by a significant amount. For what comfort it may bring, the shares of key Chinese fiber laser rivals Wuhan Raycus and Han’s Laser have done about the same over that time, perhaps underscoring some of the end-market challenges for the sector. As I was too bullish in January ahead of a multi-market downturn, I worry I may be at least a little too conservative now at what should be a cyclical low in the business. I do think drivers like electric vehicles (fiber lasers are very useful in battery assembly), 3D manufacturing, and industrial cleaning can drive better results (to say nothing of an eventual recovery in industrial capex), and I think the company’s hard times have pushed management to reevaluate the cost structure going forward. I do worry about the long-term growth potential of the business as fiber lasers have become more commoditized, but this is a name to watch as a short-cycle capex recovery play. EVs Have Gone Into Safe Mode The electric vehicle market, and EV batteries in particular, have grown to about 20% of IPGP’s business over the last few years, with the growth in this end-market offsetting some of the weakness in other areas of the business. IPGP’s fiber lasers are particularly useful in the welding and assembly of EV batteries, as fiber lasers can quickly make very precise welds between different materials and do so in a way that minimizes the heating of the surrounding materials. Fiber lasers are also fast and don’t require contact with the materials, reducing the risks of contamination. With that, fiber lasers have seen use in cutting foils, housing, and covers, as well as welding of electrodes, tabs, busbars, and so on. Unfortunately, while IPGP benefitted from a surge in EV-driven capex spending in 2021 and 2022, the business has slowed considerably as EV sales outside of China have disappointed and companies look to digest the capacity they’ve already added. Chinese battery manufacturer CATL has said it is running at around 70% capacity, while IPGP management has estimated that the industry as a whole is running at around 50% to 60% capacity (and generally speaking, you don’t see capex investment cycles until capacity utilization gets to around 70%-80%). As I am a believer in EVs, I do think this business can once again become a driver for the company. How long the company can garner good growth at attractive margins is a tougher question to answer; the consistent story with IPGP has been that they are the first to enter a market (they are quite good at product development and product quality), but then lower-cost competitors inevitably arrive, and that has been particularly true with Chinese end-markets. Still, I do see considerably more spending on EV battery capacity in the coming years, to say nothing of spending on related electrical components that will be necessary for the electrification super-cycle. Industrial Demand Is Down, But Should Be Bottoming While the businesses are very different, IPGP does find itself in the same sort of predicament as other industrial capex players like Lincoln Electric (LECO) and Hurco (HURC) (which I recently discussed here), as companies across a wide range of industries hit the brakes on capex spending in the face of higher interest rates, weaker macro indicators, and growing uncertainty about the health and direction of the U.S. economy. PMIs remain weak by and large across the world, with key markets like the U.S. and Germany still well below 50. The Caixin China General Manufacturing PMI has been above 50 for several months now, but many Western companies have reported soft capex demand, so the real “on the ground” experience is harder to work out. Further complicating the China situation, IPGP has seen this business decline at a faster rate as the company has been moving away from applications like cutting where there is just too much price competition. Calling bottoms in any economic cycle is more a matter of luck than prescience, but I do think that industrial capex demand is likely bottoming out. It may take a few more quarters before there’s clearer evidence of improvement, but spending now looks below what is necessary to maintain production capacity, let alone expand it, and I believe demand will recover later in 2024 and/or in 2025. The Outlook Barring a pretty dramatic turnaround in the business, IPGP will see its third straight year of year-over-year revenue decline in 2024 and that is something that has never happened before at this company. Coupled with underlying shifts in its traditional markets (like being priced out of the Chinese cutting market) and the disruptions caused by having to reconfigure manufacturing and logistics due to the sanctions against Russia, the last few years have been stressful and challenging for management. It is possible, though, that IPGP can come out of this a stronger company. The company recently named a new CEO (Mark Gitin) from outside the company (Gitin was previously at MKS Instruments (MKSI) and Coherent), as one of the company’s two co-founders (Eugene Scherbakov) steps aside. This means that IPGP will be run by someone other than one of the co-founders for the first time in its history, and that fresh perspective may be invaluable. The company has likewise been making some structural changes to the business. The company has been reducing costs to support gross margin, as well as reprioritizing some of its operating spending. Management believes they can get back to mid-40%’s gross margins on $1.2B-plus revenue, though there’s still some work to do in reducing inventories. One area worth watching is R&D – this has fallen in absolute dollar terms from $140M in 2021 to $100M in 2023. While Q1’24 spending annualizes out to $116M/year, long-term cuts in R&D investment could limit revenue growth, as one of the key drivers for IPGP has long been being first to market with new systems and capabilities, something its more cost-based Chinese competitors can’t manage. I’m at the low end (if not a little below) of the Street with my FY’24 and FY’25 estimates, but that’s largely out of an abundance of caution, as I believe IPGP is not only dealing with a cyclical downturn in industrial capex spending but also a more long-term structural change in its business (with low-price rivals pushing it out of some markets and newer markets still in their early adoption phases). I’m still looking for long-term revenue growth of around 5% which is around twice the growth I expect in industrial production. On the margin side, I don’t think IPGP is ever going to see mid-50%’s gross margins, mid-to-high-30%’s operating margins, and low-to-mid-40%’s EBITDA margins again, or at least not on a year-after-year basis. Mid-to-high-20%’s is doable, though, and maybe even into the 30%’s at the tops of cycles. Likewise, while I think free cash flow generation will be below average for a couple more years, I think mid-teens FCF margins are still achievable and can support good FCF growth in a recovery. I do think IPGP is a little undervalued today through both discounted free cash flow and a margin/return-driven EV/EBITDA approach (using a nearly 12x multiple on FY’25 EBITDA). The Bottom Line It’s easy to underestimate what a cyclical company can do as its business recovers from a trough, and I may certainly be too conservative with my numbers on IPGP today. Coupled with what I think are real opportunities in growth markets like battery assembly, advanced electronics manufacturing, 3D manufacturing, industrial cleaning, and so on I do lean positive on this stock, but I would like to see an end to double-digit revenue declines and “miss and lower” quarterly reports before sticking my neck out again.

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