# IPG Photonics Corp: Form 10-Q for the period ended Mar 31, 2011

- Company: [IPG Photonics Corp](/companies/ipgp.md) (CIK 1111928)
- Form: 10-Q
- Filed: 2011-05-09
- Accepted by EDGAR: May 9, 2011, 20:05 ET
- Period: 2011-03-31
- Accession: 0000950123-11-047378
- Inline XBRL: no
- Main document: https://www.sec.gov/Archives/edgar/data/1111928/000095012311047378/b86110e10vq.htm
- All documents and exhibits: https://www.sec.gov/Archives/edgar/data/1111928/000095012311047378/

## Management's discussion and analysis

As filed, 27,497 characters.

*You should read the following discussion in conjunction with our consolidated financial statements and related notes included elsewhere in this Quarterly Report on Form 10-Q. This discussion contains forward looking statements that are based on management’s current expectations, estimates and projections about our business and operations. Our actual results may differ materially from those currently anticipated and expressed in such forward-looking statements. See “Cautionary Statement Regarding Forward-Looking Statements.”*

### Overview

We develop and manufacture a broad line of high-performance fiber lasers, fiber amplifiers and diode lasers for diverse applications in numerous markets. Our diverse lines of low, mid and high-power lasers and amplifiers are used in materials processing, advanced, communications and medical applications. We sell our products globally to original equipment manufacturers, or OEMs, system integrators and end users. We market our products internationally primarily through our direct sales force and also through agreements with independent sales representatives and distributors.

We are vertically integrated such that we design and manufacture most of our key components used in our finished products, from semiconductor diodes to optical fiber preforms, finished fiber lasers and amplifiers. Since our formation in 1990, we have been focused on developing and manufacturing high-power fiber lasers and amplifiers.

### Factors and Trends That Affect Our Operations and Financial Results

In reading our financial statements, you should be aware of the following factors and trends that our management believes are important in understanding our financial performance.

*Net sales.* Our net sales have historically fluctuated from quarter to quarter. The increase or decrease in sales from a prior quarter can be affected by the timing of orders received from customers, the shipment, installation and acceptance of products at our customers’ facilities, the mix of OEM orders and one-time orders for products with large purchase prices, and seasonal factors such as the purchasing patterns and levels of activity throughout the year in the regions where we operate. Historically, our net sales have been higher in the second half of the year than in the first half of the year. Furthermore, net sales can be affected by the time taken to qualify our products for use in new applications in the end markets that we serve. The adoption of our products by a new customer or qualification of a new application can lead to an increase in net sales for a period, which may then slow until we further penetrate new markets or obtain new customers. Our net sales can also be affected from quarter to quarter by the general level of worldwide economic activity, including economic expansion or contraction, and expenditures on capital equipment. In general, increases in worldwide economic activity have a positive effect on our sales and decreases in economic activity have a negative effect our sales.

*Gross margin.* Our total gross margin in any period can be affected by total net sales in any period, product mix, that is, the percentage of our revenue in that period that is attributable to higher or lower-power products, production volumes, changes to the sales prices of our products in response to the competitive environment and other factors, some of which are not under our control. Our product mix affects our margins because the selling price per watt is higher for low-power and mid-power devices than for high-power devices. The overall cost of high-power lasers may be partially offset by improved absorption of fixed overhead costs associated with sales of larger volumes of higher-power products.

A high proportion of our costs is fixed so they are generally difficult or slow to adjust in response to changes in demand. In addition, our fixed costs increase as we expand our capacity. Gross margins generally decline if production volumes are lower as a result of a decrease in sales or inventory because the absorption of fixed manufacturing costs will be reduced. Gross margins generally improve when the opposite occurs. In addition, absorption of fixed costs can benefit gross margins due to an increase in production that is not sold and placed into inventory. If both sales and inventory decrease in the same period, the decline in gross margin may be greater if we cannot reduce fixed costs or choose not to reduce fixed costs to match the decrease in the level of production. We also regularly review our inventory for items that are slow-moving, have been rendered obsolete or determined to be excess. If we experience a decline in sales that reduces absorption of our fixed costs, or if we have production issues or inventory write-downs, our gross margins will be negatively affected.

*Sales and marketing expense.* We expect to continue to expand our worldwide direct sales organization, build and expand applications centers, hire additional personnel involved in marketing in our existing and new geographic locations, increase the number of units used for demonstration purposes and otherwise increase expenditures on sales and marketing activities in order to support the growth in our net sales. As such, we expect that our sales and marketing expenses will increase in the aggregate.

*Research and development expense.* We plan to continue to invest in research and development to improve our existing components and products and develop new components and products. We plan to increase the personnel involved in research and development and expect to increase other research and development expenses. As such, we expect that our research and development expenses will increase in the aggregate.

*General and administrative expense.* We expect our general and administrative expenses to increase moderately as we continue to invest in systems and resources to support our worldwide operations. Legal expenses vary from quarter to quarter based upon the stage of litigation, including patent re-examinations and termination of litigation stays, but could increase in response to any future litigation or due to a change in status of current intellectual property matters. The timing and amount of legal expenses may vary substantially from quarter to quarter.

*Major customers.* While we have historically depended on a few customers for a large percentage of our annual net sales, the composition of this group can change from year to year. Net sales derived from our five largest customers as a percentage of our net sales were 15% for the three months ended March 31, 2011, 19% during 2010, 12% in 2009 and 17% in 2008. We seek to add new customers and to expand our relationships with existing customers. We anticipate that the composition of our significant customers will continue to change. If any of our significant customers were to substantially reduce their purchases from us, our results would be adversely affected.

### Results of Operations for the three months ended March 31, 2011 compared to the three months ended March 31, 2010

*Net sales.* Net sales increased by $48.8 million, or 95.2%, to $100.0 million for the three months ended March 31, 2010 from $51.2 million for the three months ended March 31, 2010.

|  | Three Months Ended March 31, 2011 | % of Total | 2010 | % of Total | Change |  |
| --- | ---: | ---: | ---: | ---: | ---: | ---: |
| Materials processing | $86,397 | 86.4% | $42,740 | 83.5% | $43,657 | 102.1% |
| Advanced applications | 8,232 | 8.2% | 4,684 | 9.1% | 3,548 | 75.7% |
| Communications | 3,202 | 3.2% | 1,854 | 3.6% | 1,348 | 72.7% |
| Medical | 2,127 | 2.1% | 1,926 | 3.8% | 200 | 10.4% |
| Total | $99,958 | 100.0% | $51,204 | 100.0% | $48,753 | 95.2% |

Sales for materials processing applications increased due to substantially increased sales of high power lasers used in cutting and welding applications and pulsed lasers used in marking and engraving applications both due to the continued economic recovery and increased acceptance of the advantages of fiber laser technology. An increasing number of OEM customers have developed cutting systems that use our high power lasers and sales of these systems are gaining market share from gas laser systems because fiber laser systems cut a more diverse number of metals faster and at a lower cost. In addition, new welding processes using fiber lasers have been developed increasing sales of lasers for this application which are replacing traditional laser and non-laser welding technologies due to the faster welding speeds and improved weld quality. The increase in sales of advanced applications was due to increased sales for optical pumping and research and development applications and higher sales of high-power lasers used in government applications. Sales for communications applications increased due to increased sales of amplifiers in Russia. Sales for medical applications increased due to increased demand from our established customer in the United States and sales to new customers in Europe and Asia.

*Cost of sales and gross margin.* Cost of sales increased by $15.6 million, or 51.0%, to $46.3 million for the three months ended March 31, 2011 from $30.7 million for the three months ended March 31, 2010. Our gross margin increased to 53.7% for the three months ended March 31, 2011 from 40.1% for the three months ended March 30, 2010. Gross margin increased due to an improvement in manufacturing efficiency because the increase in manufacturing expenses was less than the increase in net sales. Absorption of our fixed manufacturing costs was also more favorable due to an increase in production volume part of which was sold and part of which was placed in inventory. In addition, cost of sales benefited from a reduction in the cost per watt of our diodes and a decrease in the cost of internally manufactured optical components and accessories. Expenses related to inventory reserves and other valuation adjustments increased by $0.4 million to $1.0 million, or 1.0% of sales for the three months ended March 31, 2011, as compared to $0.6 million, or 1.2% of sales for the three months ended March 31, 2010.

*Sales and marketing expense.* Sales and marketing expense increased by $0.6 million, or 14.1%, to $4.9 million for the three months ended March 31, 2011 from $4.3 million for the three months ended March 31, 2010, primarily as a result of an increase in personnel costs due to an increase in headcount, stock based compensation and bonus accruals, partially offset by a decrease in amortization of units used for demonstration purposes. Bonus accruals increased due to an increase in net sales. Stock based compensation increased in part due to changes in assumptions made during the quarter regarding how expense is recognized over the service period. As a percentage of sales, sales and marketing expense decreased to 5.0% for the three months ended March 31, 2011 from 8.5% for the three months ended March 31, 2010.

*Research and development expense.* Research and development expense increased $1.5 million, or 37.8%, to $5.7 million for the three months ended March 31, 2011, compared to $4.2 million for the three months ended March 31, 2010, primarily as a result of an increase in personnel costs. Research and development activity continues to focus on enhancing the performance of our internally manufactured components, refining production processes to improve manufacturing yields, the development of new products operating at different wavelengths and higher output powers and new complementary accessories to be used with our products. As a percentage of sales, research and development expense decreased to 5.7% for the three months ended March 31, 2011 from 8.1% for the three months ended March 31, 2010.

*General and administrative expense.* General and administrative expense increased by $1.4 million, or 19.6%, to $8.2 million for the three months ended March 31, 2011 from $6.8 million for the three months ended March 31, 2010, primarily due to an increase in personnel costs resulting from an increase in headcount, stock based compensation and accruals for bonuses, partially offset by a decrease in legal fees related to a patent infringement action brought against us and lower bad debt expense. We will continue to incur significant legal expenses as we prepare for the trial which is scheduled for September 2011.

Bonus compensation increased due to an improvement in our financial results. Stock based compensation increased in part due to changes in assumptions made during the quarter regarding how expense is recognized over the service period. As a percentage of sales, general and administrative expense decreased to 8.2% for the three months ended March 31, 2011 from 13.3% for the three months ended March 31, 2010.

*Effect of exchange rates on net sales, gross profit and operating expenses.* We estimate that if exchange rates had been the same as one year ago, net sales for the three months ended March 31, 2011 would have been $1.2 million lower, gross profit would have been $0.1 million higher and total operating expenses would have been $0.1million lower.

*Loss (gain) on foreign exchange.* We incurred a foreign exchange loss of $0.7 million for the three months ended March 31, 2011 as compared to an exchange gain of $0.1 million for the three months ended March 31, 2010. At the end of the first quarter our primary exposure to foreign exchange risk was due to our net dollar denominated assets held by subsidiaries with a Euro functional currency.

*Interest expense, net.* Interest expense, net remained consistent at $0.2 million for the three months ended March 31, 2011 and for the three months ended March 31, 2010.

*Provision for income taxes.* Provision for income taxes was $10.5 million for the three months ended March 31, 2011 compared to $1.6 million for the three months ended March 31, 2010, representing an effective tax rate of 31.0% and 32.3% for the three months ended March 31, 2011 and 2010, respectively. The increase in the provision for income taxes was primarily the result of increased income before provision for income taxes. The decrease in effective rate was due primarily to the mix of income earned in various tax jurisdictions and because we provided additional amounts for uncertain tax positions in the first quarter of 2010.

*Net income attributable to IPG Photonics Corporation.* Net income attributable to IPG Photonics Corporation increased by $19.7 million to $23.1 million for the three months ended March 31, 2011 compared to $3.4 million for the three months ended March 31, 2010. Net income attributable to IPG Photonics Corporation as a percentage of our net sales increased by 16.5 percentage points to 23.1% for the three months ended March 31, 2011 from 6.6% for the three months ended March 31, 2010 due to the factors described above.

### Liquidity and Capital Resources

Our principal sources of liquidity as of March 31, 2011 consisted of cash and cash equivalents of $160.6 million, unused credit lines and overdraft facilities of $53.2 million and working capital (excluding cash) of $92.8 million. This compares to cash and cash equivalents of $147.9 million, unused credit lines and overdraft facilities of $51.5 million and working capital (excluding cash) of $70.2 million as of December 31, 2010. The increase in cash and cash equivalents of $12.7 million from December 31, 2010 relates primarily to cash provided by operating activities in the three months ended March 31, 2011 of $13.3 million and financing activities in the three months ended March 31, 2011 of $9.9 million, partially offset by cash outflows related to capital expenditures of $9.6 million.

Our long-term debt consists primarily of a $16.3 million secured variable-rate note, of which $1.3 million is the current portion. During the second quarter of 2010 we renegotiated the terms of this note, extending its maturity from August 2013 to June 2015, at which time the outstanding debt balance would be $10.7 million. The variable interest rate was fixed by means of an interest rate swap through the original maturity date and that swap is still in place. In October 2010, we fixed the interest rate on this debt for the period from the original maturity date to the extended maturity date by means of a forward starting interest rate swap. The note is secured by a mortgage on real estate and buildings that we own in Massachusetts. In January 2011 we entered into a 10 year Euro 1.4 million ($2.0 million) mortgage obligation to fund the purchase of a new building in Italy, of which $0.2 million is the current portion. The interest on this mortgage obligation is fixed at 4.96% and it amortizes in full over the term of the obligation. The remaining long term debt consists of Euro 0.2 million ($0.3 million) seller provided financing relating to the purchase of Cosytronic, KG in 2010.

We expect that our existing cash and marketable securities, our cash flows from operations and our existing lines of credit will be sufficient to meet our liquidity and capital needs for the foreseeable future. Our future long-term capital requirements will depend on many factors including our level of sales, the impact of economic environment on our sales levels, the timing and extent of spending to support development efforts, the expansion of the global sales and marketing activities, the timing and introductions of new products, the need to ensure access to adequate manufacturing capacity and the continuing market acceptance of our products. We have made no arrangements to obtain additional financing, and there is no assurance that such additional financing, if required or desired, will be available in amounts or on terms acceptable to us, if at all.

The following table details our line-of-credit facilities as of March 31, 2011:

| Description | Available Principal | Interest Rate | Maturity | Security |
| --- | --- | --- | --- | --- |
| U.S. Revolving Line of Credit (1) | Up to $35 million | LIBOR plus 0.125% to 1.625%, depending on our performance | July 2015 | Unsecured |
| Euro Credit Facility (Germany)(2) | Euro 15.0 million ($21.1 million) | Euribor + 0.85% or EONIA 1.2% | June 2012 | Unsecured, guaranteed by parent company |
| Euro Overdraft Facilities | Euro 2.6 million ($3.7 million) | 2.0%-6.5% | Between July 2011 and February 2012 | Common pool of assets of German and Italian subsidiaries |

(1) $15.0 million of this credit facility is available to our foreign subsidiaries in their respective local currencies, including India, Italy, China, Japan and South Korea. Total drawings at March 31, 2011 were $4.0 million with a weighted average interest rate of 1.3%.

(2) $4.4 million of this credit facility is available to our Russian subsidiary and $4.4 million is available to our Italian subsidiary. Total drawing at March 31, 2011 was $1.4 million with an interest rate of 2.0%.

Our largest committed credit lines are with Bank of America and Deutsche Bank in the amounts of $35.0 million and $21.1 million, respectively, and neither of them is syndicated.

We are required to meet certain financial covenants associated with our U.S. revolving line of credit and long-term debt facilities. These covenants, tested quarterly, include a debt service coverage ratio and a funded debt to earnings before interest, taxes, depreciation and amortization (“EBITDA”) ratio. The debt service coverage covenant requires that we maintain a trailing twelve month ratio of cash flow to debt service that is greater than 1.5:1. Debt service is defined as required principal and interest payments during the period. Cash flow is defined as EBITDA less unfunded capital expenditures. For trailing twelve month periods until March 2011, up to $15.0 million of our capital expenditures are treated as funded from the proceeds of our initial public offering. The funded debt to EBITDA covenant requires that the sum of all indebtedness for borrowed money on a consolidated basis shall be less than two times our trailing twelve months EBITDA. We were in compliance with all such financial covenants as of and for the three months ended March 31, 2011.

The financial covenants in our loan documents may cause us to not take or to delay investments and actions that we might otherwise undertake because of limits on capital expenditures and amounts that we can borrow or lease. In the event that we do not comply with any one of these covenants, we would be in default under the loan agreement or loan agreements, which may result in acceleration of the debt, cross-defaults on other debt or a reduction in available liquidity, any of which could harm our results of operations and financial condition.

*Operating activities.* Net cash provided by operating activities increased by $5.4 million to $13.3 million for the three months ended March 31, 2011 from $7.9 million for the three months ended March 31, 2010, primarily resulting from:

- An increase in cash provided by net income after adding back non-cash charges of $32.5 million in the three months ended March 31, 2011 as compared to the same period in 2010; partially offset by
- An increase in inventory of $13.7 million in the three months ended March 31, 2011 compared to an increase of inventory of $3.3 million in the three months ended March 31, 2010;
- A decrease in accrued expenses and other liabilities of $6.0 million in the three months ended March 31, 2010 compared to an increase of $3.6 million in the three months ended March 31, 2010.

Given our vertical integration, rigorous and time-consuming testing procedures for both internally manufactured and externally purchased components and the lead time required to manufacture components used in our finished products, the rate at which we turn inventory has historically been comparatively low when compared to our cost of sales. Also, our historic growth rates required investment in inventories to support future sales and enable us to quote short delivery times to our customers, providing what we believe is a competitive advantage. Furthermore, if there was a disruption to the manufacturing capacity of any of our key technologies, our inventories of components should enable us to continue to build finished products for a period of time. We believe that we will continue to maintain a relatively high level of inventory compared to our cost of sales. As a result, we expect to have a significant amount of working capital invested in inventory. A reduction in our level of net sales or the rate of growth of our net sales from their current levels would mean that the rate at which we are able to convert our inventory into cash would decrease.

*Investing activities.* Net cash used in investing activities was $9.9 million and $5.5 million in the three months ended March 31, 2011 and 2010, respectively. The cash used in investing activities in 2011 related to the purchase of new buildings in Germany and Japan and start of the construction of a new building in Russia. In the three months ended March 31, 2010, cash used in investing activities was related to the purchase of a new building in South Korea to house a new laser application center, the acquisitions of Photonics Innovations Inc. and Cosytronic, KG and purchases of equipment primarily in the United States and Germany.

We expect to incur approximately $50 million in capital expenditures, including acquisitions, in 2011. The timing and extent of any capital expenditures in and between periods can have a significant effect on our cash flow. Many of the capital expenditure projects that we undertake have long lead times and are difficult to cancel or defer to a later period.

*Financing activities.* Net cash provided by financing activities was $4.1 million in the three months ended March 31, 2011 as compared to net cash used in financing activities of $1.0 million in the three months ended March 31, 2010. The cash provided by financing activities in 2011 was primarily related to cash provided by the exercise of stock options. The cash provided by financing activities in 2010 was primarily related to net drawings on line-of-credit facilities.

### Cautionary Statement Regarding Forward-Looking Statements

This Quarterly Report on Form 10-Q contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, and we intend that such forward-looking statements be subject to the safe harbors created thereby. For this purpose, any statements contained in this Quarterly Report on Form 10-Q except for historical information are forward-looking statements. Without limiting the generality of the foregoing, words such as “may,” “will,” “expect,” “believe,” “anticipate,” “intend,” “could,” “estimate,” or “continue” or the negative or other variations thereof or comparable terminology are intended to identify forward-looking statements. In addition, any statements that refer to projections of our future financial performance, trends in our businesses, or other characterizations of future events or circumstances are forward-looking statements.

The forward-looking statements included herein are based on current expectations of our management based on available information and involve a number of risks and uncertainties, all of which are difficult or impossible to accurately predict and many of which are beyond our control. As such, our actual results may differ significantly from those expressed in any forward-looking statements. Factors that may cause or contribute to such differences include, but are not limited to, those discussed in more detail in Item 1, “Business” and Item 1A, “Risk Factors” of Part I of our Annual Report on Form 10-K for the year ended December 31, 2010. Readers should carefully review these risks, as well as the additional risks described in other documents we file from time to time with the Securities and Exchange Commission. In light of the significant risks and uncertainties inherent in the forward-looking information included herein, the inclusion of such information should not be regarded as a representation by us or any other person that such results will be achieved, and readers are cautioned not to rely on such forward-looking information. We undertake no obligation to revise the forward-looking statements contained herein to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.

### Recent Accounting Pronouncements

In October 2009, the Financial Accounting Standards Board issued new accounting guidance for revenue recognition related to multiple element arrangements. This guidance established a selling price hierarchy, which allows the use of estimated selling prices to allocate arrangement consideration to deliverables in cases where neither vendor-specific objective evidence nor third-party evidence is available. The new guidance is effective for the Company prospectively for revenue arrangements entered into or materially modified beginning in the first quarter of fiscal 2011. The adoption of this accounting guidance did not have a material impact on the Company’s consolidated financial statements and is not expected to have a material effect on the Company’s consolidated financial statements in subsequent periods.

## Market risk

As filed, 2,448 characters.

We are exposed to market risk in the ordinary course of business, which consists primarily of interest rate risk associated with our cash and cash equivalents and our debt and foreign exchange rate risk.

*Interest rate risk*. Our investments have limited exposure to market risk. To minimize this risk, we maintain a portfolio of cash, cash equivalents and short-term investments, consisting primarily of bank deposits, money market funds and short-term government funds. The interest rates are variable and fluctuate with current market conditions. Because of the short-term nature of these instruments, a sudden change in market interest rates would not be expected to have a material impact on our financial condition or results of operations.

We are also exposed to market risk as a result of increases or decreases in the amount of interest expense we must pay on our bank debt and borrowings on our bank credit facilities. Our interest obligations on our long-term debt are fixed by means of interest rate swap agreements. Although our U.S. revolving line of credit and our Euro credit facility have variable rates, we do not believe that a 10% change in market interest rates would have a material impact on our financial position or results of operations.

*Exchange rates*. Due to our international operations, a significant portion of our net sales, cost of sales and operating expenses are denominated in currencies other than the U.S. dollar, principally the Euro, the Japanese Yen, the Russian Ruble, and Chinese Yuan. As a result, our international operations give rise to transactional market risk associated with exchange rate movements of the U.S. dollar, the Euro, the Japanese Yen and the Russian Ruble. Gains and losses on foreign exchange transactions totaled $0.7 million loss and $0.1 million gain for the three months ended March 31, 2011 and 2010, respectively. Management believes that the use of foreign currency hedging instruments reduces the risks of certain foreign currency transactions; however, these instruments provide only limited protection. We have foreign currency hedges as of March 31, 2011, however, we will continue to analyze our exposure to currency exchange rate fluctuations and may engage in additional financial hedging techniques in the future to attempt to minimize the effect of these potential fluctuations. Exchange rate fluctuations may adversely affect our financial results in the future.

## Controls and procedures

As filed, 1,030 characters.

### Evaluation of Disclosure Controls and Procedures

Under the supervision of our chief executive officer and our chief financial officer, our management has evaluated the effectiveness of the design and operation of our “disclosure controls and procedures” (as defined in Rules 13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)), as of the end of the period covered by this Quarterly Report on Form 10-Q (the “Evaluation Date”). Based upon that evaluation, our chief executive officer and our chief financial officer have concluded that, as of the Evaluation Date, our disclosure controls and procedures are effective.

### Changes in Internal Controls

There was no change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) promulgated under the Exchange Act) that occurred during the last fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

Filed May 9, 2011.
Source: SEC EDGAR, the filing index for accession 0000950123-11-047378. Last ingested by Listed: Nov 4, 2026, 17:26 ET. No prices; not investment advice.