IPG Photonics Corp (IPGP) 2010 Q1 法說會逐字稿

Good morning and welcome to IPG Photonics' first quarter 2010 conference call. Today's call is being recorded and webcast. At this time I would like to turn the call over to Angelo Lopresti, IPG's Vice President, General Counsel and Secretary, for introductions. Please go ahead, sir.

Thank you and good morning, everyone. With us today is IPG Photonics' Chairman and Chief Executive Officer, Dr. Valentin Gapontsev, and Vice President and Chief Financial Officer Tim Mammen. Statements made during the course of this conference call that discuss management's or the Company's intentions, expectations or predictions of the future are forward-looking statements. These forward-looking statements are subject to known and unknown risks and certainties that could cause the Company's actual results to differ materially from those projected in such forward-looking statements. These risks and uncertainties include those detailed in IPG Photonics' Form 10-K for the year ended December 31, 2009, and other reports on file with the Securities and Exchange Commission. Copies of these filings may be obtained by visiting the investor section of IPG's website at investor.IPGPhotonics.com/SEC.cfm or by contacting the company directly. You may also find copies on the SEC's website at www.SEC.gov.

Any forward-looking statements made on this call are the Company's expectations or predictions only as of today, May 3, 2010. The Company assumes no obligation to publicly release any updates or revisions to such statements. We will post these prepared remarks on our website following the completion of the call. Please go to www.IPGPhotonics.com and select investors to review these remarks.

I will now turn the call over to a Dr. Gapontsev.

Good morning and thank you for joining us today. We are pleased to report that earnings per share are at the high end of our guidance range on revenue, that was in line with guidance for the first quarter of 2010. IPG executed well on its business plan and improved sales and gross margins. We were also pleased that our book to bill ratio was in excess of 1, and this is reflected in our guidance for the second quarter. In addition, we generated $7.9 million in cash flow from operations.

Now I would like to touch on some recent highlights before turning the call over to Jim. The macroeconomic recovery appears to be underway, as we saw improvements in most major geographic markets across the globe. Much of IPG's first quarter year-over-year growth was driven by increased sales of IPG's pulse lasers for material processing applications and low-powered lasers for medical applications.

In fact, the materials processing market grew by 23% year-over-year and the medical applications market delivered its second-consecutive quarter of triple-digit year-over-year growth.

On the market front, I am pleased to inform you that the '09 fiber laser market results from the firm Optech Consulting are in, with associated positive conclusions for fiber lasers and IPG. According to Optech the global fiber laser market decreased last year by 24% from $317 million in '08 to $242 million in '09 compared to the total global laser market that decreased by 31% from $7.5 billion in '08 to $5.5 billion in '09. These results demonstrate increased momentum for fiber laser solutions versus traditional CO2, YAG and diode lasers in material processing, medical and advanced applications.

For our largest market, materials processing, the most recent market data also shows that fiber lasers represented nearly 10% in the material processing laser market in '09 up from 7% fiber laser penetration in '08. According to Optech estimates, the overall material processing laser market is predicted to grow by 15% in 2010.

We continue to believe that fiber lasers should grow even faster by playing an increasing role in many key applications and continuing to displace traditional lasers. In terms of new technology, we recently announced two acquisitions that expand our product portfolio and provide us with an entry into complementary markets. During the first quarter we acquired Photonics Innovations, an Alabama-based maker of active and passive laser materials and tunable lasers. The technology we acquired with Photonics Innovations enables IPG to expand our portfolio to the middle-infrared spectral range by combining it with our fiber laser technology to build new hybrid laser sources for various applications. These applications include scientific, biomedical, material processing, and eye-safe range-finding. The middle-infrared market is an exciting and emerging space, which we believe represents an attractive opportunity for us to increase market share. The immediate benefit of this acquisition is reflected in the level of inquiries we are receiving from prospective customers for new (inaudible) Zinc Sellenide Single Frequency Tunable Lasers.

Subsequent to quarter end, we also acquired a Germany-based Cosytronic KG, or COSY. COSY is a specialist in joining technology with an emphasis on engineering know-how in automated welding turnkey solutions. Through this acquisition, we expect to expand our products offerings to include an innovative welding tool laser-seam-stepper that integrates seamlessly with our fiber lasers. We believe this is a promising complementary market for IPG targeting the automotive industry, sheet metal production and other material processing applications.

Finally on new product introductions, our new quasi-pulsed CW lasers have been well received in the market and the first customer recently placed a multiple unit order for these devices. We are optimistic that they will start to contribute meaningfully in the second half of the year. After a rigorous testing process, we have now started to sell green pulsed lasers to customers covering a broad range of microelectronics and solar cell applications. Our high-power cladding lasers are gaining good momentum with customers and we are hopeful that cladding will become a meaningful material processing application going forward.

With that, I'll turn the call over to Tim.

Thank you, Valentin, and good morning everyone.

It was nice to see the year-on-year improvement in sales in Q1 2010 as Valentin has mentioned. Also significant was that the sales increase drove an improvement in our gross margins, evidencing the leverage in our business model that continues to exist.

First, I'll begin by taking you through our various markets, products and applications, and then review our income statement and balance sheet. Materials processing recovered nicely during the quarter, increasing 22.9% on a year-over-year basis and 4.0% on a sequential basis. In total, materials processing, which is IPG's largest market, contributed 83.5%, or $42.7 million, to the consolidated revenue we reported in Q1. Much of the growth for the materials processing market can be attributed to a substantial improvement in demand for pulsed lasers used in marking and engraving and high-power lasers used in cutting.

The advanced application market, which includes test & measurement, instrumentation, sensing and defense applications, as well as scientific research & development, represented 9.1% of total revenue, or $4.7 million, in the first quarter. This was a 34.3% decrease year-over-year and a 31.1% sequential decrease. This is a timing issue as order flow and shipments have been historically less predictable in this market. For example, we have orders in place for several sophisticated 10 kilowatt single mode lasers which will benefit sales when they are shipped later this year. The first quarter of 2009 in addition benefited from the sale of a high value 20 kilowatt laser which makes for a year-over-year comparison that is more difficult.

For the first quarter of 2010, medical sales comprised 3.8% of total revenue, or $1.9 million. Sales for the medical application grew by 133.1% on a year-over-year basis, but were down 36.1% from an unusually strong Q4. The year-over-year increase was due to demand from OEMs worldwide, particularly in the U.S., Korea and Germany, for both cosmetic and surgical applications. During the past few quarters, we have had some success diversifying our customer base and increasing unit sales of low-power lasers for medical applications.

The communications market, which decreased 30.5% year-over-year and 45.3% on a sequential basis, comprised 3.6%, or $1.9 million, on our total revenues in the first quarter. We had a weak quarter in Russia due to the timing of orders for long haul, broadband access and cable TV and due to the planned merger between long-distance provider Rostelecom with seven regional telecom operators. The merger is delaying orders that we expect to receive in the first quarter. We do expect our Russian telecommunication sales to improve in the second half of the year.

Now, let's look at the business in terms of product lines. Sales for high power fiber lasers were $17.5 million, down approximately 3% compared with the same quarter last year and a sequential decrease of approximately 15% from the fourth quarter of 2009. The year-over-year comparison was skewed by a large order for high power lasers for advanced applications, which was delivered in Q1 2009. The sequential decline was due to order timing and seasonality as Q1 is typically our slowest quarter for high-power lasers. We had a particularly strong quarter for pulsed lasers with sales of $17 million. Driven by the improving demand for materials processing applications, particularly marking and engraving, pulsed laser sales grew 30% sequentially and 51% on a year-over-year basis. Our OEM customers in this product line are returning to healthy, pre-crisis levels.

Our low power lasers, which are primarily used for medical applications and micro materials processing, were up 56% year-over-year to $4.5 million, yet decreased 14% on a sequential basis due to a strong Q4. We expect low power laser sales growth to continue to be strong on a year-over-year basis but sequential sales volumes could vary. Also note that rates of change are calculated from a relatively small base.

Sales of medium power lasers at $4 million for the quarter were down 24% compared with the first quarter of 2009, and decreased 8% from the sequential fourth quarter. Even though sales in total dollars decreased on a sequential basis, we believe the sales in this product line have stabilized. This is evidenced by a recovery in sales for microelectronics, printing and sintering applications.

From a geographic perspective, our revenue benefitted from an improved macroeconomic environment across the globe. Asia and Australia made up 39% of our total revenue. The region's revenues increased on both a year-over-year and sequential basis by 40.6% and 1.6%, respectively. We had particularly strong quarters in China and Korea, mostly related to electronics and also general manufacturing OEMs. In Europe, including Russia and CIS, we reported an increase of 10.8% on a year-over-year basis, or 34.7% of total revenues. On a sequential basis, Europe was down 16.1%, mostly related to a soft quarter in Russia. As I mentioned earlier, the softness in the Russian telecom market is primarily related to order timing and restructuring of the Russian telecom sector. On the other hand, Italy continues to perform well, especially because of its development of several cutting OEMs.

Our North American market grew by 3.8% on a year-over-year basis, amounting to 26.0% of total revenues for the quarter. Sequentially, North American sales were up 9.5%. The year-over-year growth in the U.S. benefited from increasing sales of low power lasers for medical applications and the sequential improvement was driven by an increase in sales of high power lasers.

The rest of the world made up 0.2% of total sales.

Now turning to the income statement. Total sales were up 12.8% year-over-year to $51.2 million, within our guidance for the quarter of $48 million to $53 million, but down slightly by 5.7% on a sequential basis. The fourth quarter is typically our strongest quarter and this was true in 2009. We typically experience a seasonal downward demand trend in the first quarter as compared to the fourth quarter due to budget and spending patterns in some of our major countries, such as Russia, China and Japan. We estimate that if exchange rates had been approximately the same as one year ago, our reported sales would have been $1.2 million lower in the quarter.

Gross margins were 40.1% in the first quarter, compared with 34.9% in Q1 2009. Benefiting gross margins were, one, the impact of providing for inventory reserves that was lower this quarter in the same quarter of 2009; two, we benefited from somewhat better absorption of manufacturing costs and product mix; and, three, a recovery in demand and unit elasticity catching-up with the pricing strategy we started implementing in Q1 2009, as a response to the competitive environment.

For the first quarter of 2010, inventory was $52.1 million, $0.7 million lower than the year end 2009. If you exclude FX, inventory increased slightly, which will tend to improve absorption of manufacturing costs because we build more product over the same amount of fixed costs. If exchange rates had been approximately the same as one year ago, our Q1 gross profit of $20.5 million would have been $0.3 million lower.

SG&A expenses in Q1 were $11.2 million, or 21.8% of sales, compared with $8.2 million, or 18% of sales, in Q1 2009. G&A was higher in the quarter as a result of legal expenses related to the increase in activity in the IMRA patent litigation, as well as higher salaries and benefits. In addition, our selling expenses rose due to increases in salaries and benefits and demo unit depreciation. The increase in salaries and benefits for both G&A and selling is largely due to the accrual of bonuses in 2010 because of an improvement in the Company's financial performance, whereas no bonuses were accrued in 2009. We estimate that if exchange rates had been approximately the same as one year ago, our Q1 2010 SG&A expenses would have been $0.4 million lower.

As we indicated during our previous calls, the IMRA litigation has recommenced. Fact discovery and depositions are complete, but there has yet to be any court action on any substantive matter to date. Due to a recent change in the trial judge, the Markman hearing has been moved to June 2010. The trial is still on track to begin in August 2010. We continue to expect to incur significantly higher legal expenses this year related to this case as we vigorously defend IPG against the claims in this lawsuit.

With respect to the CardioFocus litigation, the district court last week lifted the stay of the litigation. As a result of the patent re-examinations filed, the plaintiff abandoned one patent entirely and the patent office rejected many claims from the two other patents. As we have mentioned in the past, these patents have expired. Consequently, the number of products alleged to infringe has been significantly reduced and is immaterial in our opinion. Activity in this case will increase for the remainder of the year starting in Q2 2010.

R&D expenses were flat for the first quarter of 2009 at $4.2 million, or 8.1% of total revenues. If exchange rates had been approximately the same as one year ago we estimate that R&D expenses would have been $0.1 million lower. Total operating expenses for the first quarter of 2010 were approximately $15.2 million. We continue to expect quarterly operating expenses to be approximately $15 million going forward. In Q1 2010, we had exchange rate gains of $108,000 compared to losses of $1.5 million in Q1 '09. IPG's operating income in the first quarter was $5.3 million compared with operating income of $2 million in Q1 of last year. Operating income includes stock based compensation charges of $770,000 and $635,000 in the first quarters of 2010 and 2009, respectively. In the first quarter of 2010, $160,000, $503,000 and $107,000 of stock-based compensation charges related to cost of sales, SG&A and R&D, respectively. Our tax rate for the first quarter of 2010 was 32.3%.

Finally, our bottom-line results were at the high end of our guidance range of $0.02 to $0.07 per diluted share. We reported first quarter net income of $3.4 million, or $0.07 per diluted share, compared with net income of $1.3 million, or $0.03 per diluted share, for the first quarter a year ago.

Now, turning to the balance sheet, our cash and cash equivalents increased by $1.5 million to $84.4 million at quarter end. We drew down our credit line by $1.2 million in the quarter, so cash net of the change in credit line was up slightly. Cash generated from operations was $7.9 million. Capital expenditures were $5.5 million for the first quarter, in line with our expectations. During the quarter, we acquired a building in Korea that will be used for sales and service and expanding our applications center in Korea to add high power fiber laser applications. The purpose of the new application center is to advance our penetration of the Asian automotive, electronics, medical manufacturing and heavy-industry markets. Looking ahead, we are targeting CapEx for the year to be approximately $25 million which includes some budget spending for future acquisitions.

Accounts receivable were $30.1 million at March 31, 2010 compared to $30.4 million at December 31, 2009. Days' sales outstanding were 53 days at the end of Q1 2010 compared to 50 days at December 31, 2009.

This leads us to our expectations going forward. We started the year off with a solid quarter during which we executed quite well on our strategy, and we are encouraged by our prospects for the remainder of 2010. Our global sales force is reporting growing activity in customer inquiries and requests for quotations in almost all geographic areas. We continue to see the rate of adoption of fiber lasers in line with our expectations and some stability in pricing. This, coupled with our positive book to bill ratio in the quarter and signs of a general economic recovery provide reason for some optimism for us in the coming quarters. We are also taking actions to position IPG for longer-term growth and ahead of the competition. We are broadening IPG's suite of innovative fiber laser products through our aggressive product development program and acquisitions such as Photonics Innovation. We are also beginning to expand into complementary markets such as those provided by the acquisition of COSY. As always, we will continue to identify new profitable opportunities to expand our customer base and displace existing laser and other non-laser technologies in a wide range of applications.

Now, let me now provide you with our guidance for Q2. For the second quarter, IPG Photonics expects revenues in the range of $57 million to $62 million. The Company anticipates earnings per diluted share in the range of $0.10 to $0.15. That is based on 47,191,000 diluted common shares, which include 46,098,000 basic common shares outstanding and 1,093,000 potentially dilutive options. This guidance is subject to the risks we outline in our reports with the SEC, and assumes that the exchange rates remain at present levels. I want to reiterate that we do not attempt to forecast gains or losses related to exchange rates.

And with that, we will open the call for your questions.

(Operator instructions) Avinash Kant, D.A. Davidson & Co.

In the guidance that you are giving for Q2, what is your gross margin assumption, and what kind of operating expenses should we assume?

As far as gross margin, I think the business model continues to track as we expected. At the top end of the range with the drop through in total gross margin I would expect to get to above 43%, depending a little bit on product mix, maybe a little bit higher than that. On operating expenses we continue to believe that operating expenses will be about $15 million during the quarter.

And that's what you would add in the current quarter, so with higher revenues you don't see much change in your OpEx; right?

No; that also factored in the legal expenses that we incurred in the first quarter. We're not planning a lot of headcount additions right now. We have also moved a few people back out of R&D into manufacturing in the first quarter. So we are targeting, particularly in the short term, to be stable on operating expenses.

On acquisitions, both acquisitions that you have made at this point, it looked like more for the technology side. What should we expect from these? Would they contribute much to '10, or there will be more new products coming based on what they have?

I think meaningful contribution from them will probably start in 2011. We're optimistic, I think, that they will not be dilutive to earnings. They don't have a huge cost structure, either of them, so they shouldn't be diluted to earnings this year. They are -- both acquisitions represent significant opportunities in different areas. Technically, Valentin can maybe talk about the infrared spectrum in some of the areas and applications that we are targeting there.

In second half of this year we have introduced certain lines of mid-infrared devices, [based on] new materials which are the Photonics Innovations company that we (inaudible) before. It's -- where we (inaudible) for us would be (inaudible) quarter three, quarter four, and also next year will bring us, we hope, [$10 million].

Regarding the Cosytronic, we introduced now and we'll start ship to customers, one of the big automotive companies' first products, first machines, this year. We are getting the order for this machine with really big prospective in next year, couple years in automotive. So we expect to sell many countries (inaudible) machines for automotive industry, not only for automotive.

Jim Ricchiuti, Needham & Company.

I was wondering if you could talk a little bit about the bookings thus far in Q2. It sounds like you're seeing pretty good activity, but I wonder how you would characterize the bookings.

They have continued through April to remain very resilient and strong. In terms of, perhaps, geographic perspectives, Asia continues to be strong. Europe is also tracking along very nicely, particularly with both northern and southern Europe. We're optimistic about a little pickup in Russia. I would say the one area where things continue -- not continue, but a little bit weak in the quarter is, there has been a start to order flow in the US. There is a lot of stuff in the pipeline here that -- April was a little bit down in the US. The rest of the world continues to be extremely strong.

I can add, so they are working in March and April, practical (inaudible).

You mentioned the US. Is there any particular area where it's been a little softer? And conversely, you think the pipeline is strong. Where do you see that coming back?

It's not any particular area. I think it's probably more due to timing of orders. We have been qualified and we've got quite a lot of orders for the auto industry in the first quarter. If two areas are a little bit weak, one is order flow on the microelectronics, where we have a good customer on the West Coast; they are actually qualifying some of the new longer pulsed lasers. But we haven't seen anything meaningful out of that customer for quite a long time.

And then on the advanced applications side, the view of the head of sales there is this year is probably likely to be more of a year of consolidation. He has attended recent conferences where he was mobbed by many different people looking to buy the lasers, but I think there are funding issues that people still have to resolve before we see order flow out of that. So that's a bit of color on two of the areas in the US. The medical market should continue to perform well this year here.

And would you be able to break out legal in the G&A line for us for Q1?

The only guidance we'll provide on legal is that it tracked a little bit higher than our budget number in Q1. Our overall target for the year remains the same. For reasons of confidentiality we don't want to break it out specifically.

Okay, but you're not changing -- I think you were saying, was it 3.4 or so for the year?

For that year about 3.6 was the number we put out there. We're not changing that at this time.

Paul Thomas, Banc of America.

On the cost side, looking at gross margins, last quarter you had said that we hadn't really seen any benefit yet from the higher-power pump laser diodes. So, looking at the Q2 guide in reference to the gross margins, are we seeing any benefit from that yet, or is that still to come in the second half?

No; that's started to come through. We've transitioned to using some of the higher-power packages with the new chips. The older chips are basically being used on the pulsed lasers, and we've almost consumed that older supply. So there is some benefit coming through from that. We've also seen an increase in chip production coming into the end of the first quarter, and we are forecasting a substantial increase in chip production for the rest of the year. And that does help to improve the absorption in that area, which is really a process-driven one with high fixed costs, whether you are producing 200,000 chips or 500,000 ships a year.

On the revenue side you've said that obviously this was seasonally your low quarter. At this point, do you think you're going to see sequential growth going forward? You mentioned there are some timing issues also. After the June quarter, could we see some flattening out? Or do you still think there will be sequential growth after that?

It should be very substantial sequential growth. We will hope we have now all confirmations from the market. It will be very substantial sequential growth.

C.J. Muse, Barclays Capital.

I guess first question, was book to bill tracking above 1? And I guess you talk here about positive order momentum through April. And the last comment there, growth sequentially into Q3 -- can you talk where lead times are today and how far your visibility extends to?

Lead times have not really changed at all on the high-powered laser. We continue to quote eight to 12 weeks on pulse lasers. We're still at a lower level than that, probably built a little bit of and continue to build a little bit of pulse laser inventory. Our unit volume on pulse lasers was up to 1400 lasers in the first quarter and could climb as high as -- I think we're going to get up to 2000 lasers at some point in time this year. So no real change on lead times, C.J.

The disruption related to the volcano was temporary for us. We don't think that's going to impact this quarter. We did have some delays in shipments of product that had been produced and some delays in shipping components from Germany to the US, but those have all been resolved, and we don't think they are going to impact stuff.

We feel like -- I (inaudible) [to correct a little] with Tim -- lead time is six to eight weeks (inaudible) including high-powered lasers. But after, we will receive the license because, more and more, power laser require licenses and the license is unpredictable. So from a question of whether (inaudible) a shipment of many high-powered lasers, especially to China and Mexico and now Brazil and so on, they delay much more than six to eight weeks.

But now, the process to which they are licensing going much faster and so with (inaudible) a lot of licenses for the order plate to us in the quarter four of last year, and we start to ship large quantity of high-powered lasers to our customers.

As a follow-up on your outlook for potential sequential growth in Q3, can you comment on what areas you see driving that as well as geographically where you have higher levels of optimism?

It's really across the board. We're going to, clearly, expect a pickup in the high power lasers from what is traditionally a weaker start to the quarter. I just mentioned that pulse lasers -- we sold about 1400 units in the first quarter, and that coming into the second half of the year we want to probably be shipping closer to 2000. In terms of geographies, Asia, China and Korea -- we've seen some improvement in India. The German laser business has recovered very well. The sales of cutting lasers to companies in Italy, in China, in the US and other parts of Europe has continued to track very well. We've seen an improvement in some of the medium powered lasers in Europe that are going to the printing business; that's come back quite nicely, as well as an improvement in the centering applications.

The key question will be to see whether we can get an improvement in the US sales. I think this quarter we're just going to track that a little bit.

Could you talk a little bit about gross margins? I guess, first off, is the excess inventory write-downs behind us? And then I guess from here, can you talk about what kind of incremental gross margins we should assume? I know mix plays a heavy role there, but trying to understand where we are today and as we add revenues to the top line, what kind of incremental dollars can flow through?

First one -- on the inventory write-downs I believe that to a greater extent we are behind, we've put that behind us. We have continued to consume our [g-mount diodes] and we've brought those inventory levels down to a much lower level so there's a lot less risk around that. And inventory reserves this quarter were about $600,000; they were the lowest they've been for almost eight quarters. So that was a positive trend. They are a little bit higher than we'd still like to see them, but there is an element of that that's just part of our business model, given the vertical integration and the number of components we make internally.

In terms of gross margin improvement, I did do some analysis on the drop-through, comparing the first quarter of 2010 to Q1 2009 after adjusting for items like industry reserves and other valuation adjustments that we booked a year ago, and then I also adjusted the [Q-9] manufacturing expenses to a more normalized level because they were a lot lower due to the short work week programs.

And my estimate on the benefit was that about 65% of revenue dropped down to gross margin, and that's, I think, at the bottom end of the range that we've said we'd see in leverage. So 65% and a little bit above, hopefully, as we get to really utilizing capacity.

Mark Douglass, Longbow Research.

Tim, can we go back to the gross profit? Obviously, that's a big deal for a lot of us. You mentioned that obviously mix has a lot to do with the gross margin improvement. With high-power lasers picking up likely through fiscal '10, do you think they are neutral to the gross margin drop-through that you're expecting, or is there better absorption with pulse versus some of the other laser sources? Is there a way to think about it that way?

It's very difficult to split it out for a modeling purpose to such a granular level. I wouldn't get so hung up that it was just product mix in Q1 that benefited. It was also the fact that absorption had improved as well as the total scale of the business compared to a year ago. The statement I made about gross margin as well was that, if you tend towards the top end of the guidance range, we would hope that gross margins would be tending from 43% and above. That's irrespective -- we've factored in the different product mix in relation to that. So we are on target as we get the business back into a decent level of scale, I think, to get ourselves back up to closer to 45% gross margins. And as you get to higher than $62 million in revenue, our operating expenses should come down below 25%. So we can see path to operating margins improving from up above 15% to closer to 20%.

I can add that, this year our prices stabilized, so we don't plan to go down with prices this year. Last year, as you know, it was this correction of prices. And we are working again and it was very successful to cut the manufacturing cost of many of our products. So with -- I would target to even much higher with gross margin continues this year, the same as total revenue, instead of over -- (inaudible) now, we would be very successful with this reaction. New prices which we install now, our products now are extremely competitive. So we believe nobody from our competition can compete now with our prices a long time. So the situation for us now is very hopeful.

The final part of that is that some of the new product offerings, where we're bringing additional and new technologies, we would hope that those benefit the model for the second half of the year.

I was also thinking that, despite a sequential revenue decline, the gross margins improved nicely.

That's mainly related to the fact that in Q4, you remember, inventories were down by $6 million. And this quarter inventories, if you strip out the FX, were a little bit up. You can actually see that on the cash flow statement, where there's a net amount of cash outflow related to inventory. So, as we build inventory or we keep inventory stable at given revenue levels, you absorb your fixed costs better, and that benefits gross margins.

Switching to the cutting markets and opportunity there, any regions that you are seeing right now picking up faster than others? Or, right now are your OEM opportunities still more focused in Italy and China, or do you see significant opportunity to expand that at this point?

I think it's all around the world. As Valentin mentioned, we've got inquiries and orders coming out of Brazil. A lot of that is cutting equipment. Even though some of those customers are based in Italy, we know, for example, that one of them has sold lasers in Australasia. It's China, definitely. I think we had an order as well from one of the major cutting companies in Japan who historically uses CO2 lasers. They are being forced to transition to fiber because their customers want it. So it's a pretty broad swath of customers and end-users around the world.

The most now (inaudible) our laser cutter makers, in the world the biggest. They now, turning to fiber laser in spite of -- for them it's this situation; it's a very danger because all of them produce own CO2 lasers, but now the situation is very fast change such way that, all of them, have to use fiber lasers. This trend is growing very fast. Fiber, [with the coming winter], [even catching applications], [traditionally] is the place for CO2 lasers.

A couple others that have reported have noted that solar is starting to pick up for them. Are you seeing improved order rates or sales in your solar applications?

We have seen some pickup in that area -- say we had two meaningful orders, but they are still relatively small. They weren't a key driver of year-on-year growth, but there is some improved activity there.

Is this still more of a long-term a market for you to go after, then?

We are working (inaudible) but the schedule depends from not IPG, from integrators. We also develop (inaudible) some new, very attractive processes for solar application. And we are now developing own complete solution, so machines for some processes. It takes some time, but we will get serious position to this market segment.

Joe Maxa, Dougherty & Company.

I believe you indicated you had several orders in your multi-kilowatt lasers that hadn't shipped yet. Do you have any visibility or time when you expect to see some of these start to go through the order book?

So I mentioned some orders for some very sophisticated 10-kilowatt single-mode lasers which almost have a perfect non-divergent beam. We' are hoping -- I would think we are hoping to ship one of those towards the end of this quarter and then the remainder during the rest of the year.

Last year we claimed that the -- (inaudible) would reach such level of power single mode and what's (inaudible) was that people expect to overcome the threshold for the people need for directed energy applications. And during this year or last year, end of last year, this year, we made for this test characterization and now practical [continue] this process and final design. [End of the call], we have three orders today, and we hope to fulfill these orders in this quarter, quarter two. And I'm going to -- people standing in line waiting when we open door for new orders.

If I understood right, you said you had three orders for Q2?

Yes, we have three orders, which we received end of last year. We already delivered it due to characterization, and it's finishing all this product. Now we are practically (inaudible) in end of May and June to fulfill all these three orders.

(Operator instructions) Ajit Pai, Thomas Weisel Partners.

Just looking at the auto industry in the US, I think in the first half of '08 one of the themes that you talked about as well as some of the largest steel manufacturers like Arcelor Mittal were talking about is high-strength steel and retooling of the US auto industry for high-strength steel and fiber lasers benefiting from that. So a large number of the US auto manufacturers are talking about retooling their factories right now more on the engine side than the body side. But are you seeing any trends, if they are improving for your business over there and a transition towards high-strength steel accelerating?

Yes, I think that's a clear trend we're seeing. The one area where the high power laser business picked up in Q1 from Q4 was in the US, and a lot of that was driven from increased order flow from the auto sector. I think we are qualified now with both two of the largest three auto manufacturers, domestic manufacturers here as well as numerous manufacturers overseas. So I'd say that trend continues to help us.

And are we fairly early in that trend right now; right? So we could expect revenue to ramp quite materially if that trend -- like levels of penetration are still fairly low? Is that fair to say?

Yes. The levels of penetration are very low. It's difficult to predict how quickly people will adopt. We still haven't had someone buy 100 lasers to fit out a completely new line. We've had people by tens of lasers to adapt existing lines. So it's just very difficult to predict when the real traction starts to gain hold in that sector.

In Germany, we've had another repeat order, significant volume, from one of the major manufacturers and we've been qualified, as well, by one of the other Japanese major manufacturers as well very recently. And COSY has been working with a different -- a German manufacturer for a number of months with this new joining technology and processes. So there's a huge amount of work that continues to go on, and there continues to be some decent order flow from around the world in the auto sector.

Just going back to the directed energy commentary from Valentin a few years ago, he talked about three orders late last year. Were all three orders from different agencies, and were all of them for defense applications? And then, the Navy, I think about three years ago now, had taken a very large order of one of your I think highest-powered lasers that you have delivered. Can you give us some color as to whether the Navy was one of these three orders, and do we expect to see any great attraction over here? And Valentin also mentioned that he had closed his books because he said he's opening the books for orders right now. In the interim, why did he close the book? Was it just the characterization and some of the other qualification issues, or was it something else that prevented you from keeping your books open for orders?

It's our policy -- as you know, we have mentioned many times, very short lead time -- not six months, not one year, but only six to eight weeks. So when we are not sure we are able to ship so short time, we know the (inaudible) the book. Is the case, we agreed because they insist for three customers, three different [agency] (inaudible). It's not for experiment, it's still (inaudible) the people making experiments, it's not (inaudible) making the real products.

So we agreed with three orders, for all others said wait when we will finish qualification. And now we practically finish qualification and upgrade design and so would be ready to open again the book for other customers.

And if you are opening the books, do you expect the orders to come flooding in? Do you already have high levels of interest? And the average order -- is it going to be still in the multimillion dollar range because these are high-powered applications, directed energy?

It's not -- we don't expect -- it's slow process. We don't expect complete units. But we think 10 units order, it's realistic to get during this year.

10 units of what kilowattage, approximately?

Between 5 and 10 kilowatt single. Just to be clear (multiple speakers) this is single mode laser.

10 kilowatt (inaudible) other products (inaudible) [consumer] application.

Got it. Then, just revisiting the business model in terms of the operating -- of the income statement and operating in gross margins, so in mid-'08 you had high 40s gross margins and you had mid-to high 20s operating margin on a pro forma basis. Since then, of course, you've had pricing declines, have also added on more cost structure and you've made acquisitions. At some level you are still having a 65% float through to the gross margin line from incremental sales. So at what point do you think you can reach back to those metrics? Is it like a $70 million quarterly level or a $75 million? Do you think it's possible to get back to a high 40s gross margin and mid-to high 20s operating margin?

I think that you've got to be cautious about talking potentially where this business model could be in a year's time, when revenues get to $70 million. I think our initial target is to get them back up into the mid-40s and improve the manufacturing efficiency and leverage that we are generating, introduce some of these new products and then see where we can go from there.

In terms of operating margin I provided, I think, a pretty clear feeling that we can get back to like 20%. Getting back to the mid-20s is an absolutely stellar operating margin. Of course, if you run a business model right now and you put $70 million of revenue in there, it's going to flush out operating margins at 25% plus. But you've got to factor in we've got potential geographic areas we want to expand into, maybe starting a bigger service and sales offices in Brazil, where we use a distributor, working more closely with that distributor, some investments in the manufacturing capacity that will need to be made in Russia.

So there's a lot of different variables that, rather than just sitting here and smugly saying they're going to climb above 45% when we hit $70 million in revenue. I prefer to be a bit more cautious about that right now. I think that we'd be very happy with 20% in operating margin, and you will see a very healthy net income and positive momentum in the business model. Of course, we'd like to target to getting to higher levels. Valentin will be very much more optimistic.

Yes, Tim, [you are a] financial (multiple speakers) director, more conservative. But I believe we are able this year to reach high 40s numbers in gross margin.

And the driver of that -- just to clarify, you've managed to shift your production towards a higher [diode], but can you give us some color as to additional CapEx? Like your fabs; is your fab utilization fairly high? Is it closer to 50%? Is there no CapEx required on that side? I know your manufacturing overhead, you've got tremendous capability for assembly, etc., that's much greater than what you're using right now. But what about on the fab side?

The fab doesn't require a huge amount of CapEx. We're talking a couple of million dollars on the fab side. The major investment on the fab as we ramp, ship and packaging production will be to add assemblers and technicians, so direct labor. And that's not a huge cost, and we do that as we ramp up. There's no $20 million investment required in the diode area at the moment.

No, only a few million, including (inaudible) total this year (inaudible) a couple million.

Got it. And then, the M&A environment -- you've talked about M&A, a couple of transactions they've done recently. And it seems like you are integrating vertically as well as getting some interesting technologies. When you look at the telecom side, your relative scale relative to many players has actually been falling quite rapidly. Is that an area that is of strategic interest to you folks longer-term? Is that not of interest to you anymore? Business over there has been fairly challenged. You are watching your customer base consolidate. So why is that still a part of IPG, and do you expect to be more active in that area?

We are not looking to become a [global] player in telecom. But in some geographical regions like in Russia, we have big opportunities, and we believe we can multiple the business in this region. And this year we finish introduction of whole complete system in the market, and we passed with a successful certification of these new systems in 40-G solution in Rostelecom, biggest Russian player, operator here, who control up to 80% of all long-haul in Russia, is officially [35], recommended by Ministry of Communication Russia to use in all Russian systems.

I believe we agree with for us good to compete with Huawei, who is now a major player in this market. It's Russia; we have now very serious talks about new orders in Brazil with power company long distance. We have some advantage our system because, to compare it to other systems, and we also develop serious product in India. If we (inaudible) it's [$100 million] revenue.

But you are not looking at any M&A in this area?

We're not looking to acquire any -- we're not looking at any M&A in this area.

No, no, no; we are not looking.

-- internally development product.

Fully internally developed product.

Jiwon Lee, Sidoti & Company.

Taking on Valentin's comments on pricing trends, I wonder whether there was an area where you saw more stable or perhaps a little more favorable pricing during the quarter?

Compared to a year ago, prices have come down, but compared to Q3 and Q4 of '09 we have seen them stabilize. There was nothing in particular on any of the product lines that was vastly different. So they were stable, really, across the spectrum of products.

Was there any 10% customer during the quarter?

No.

(Operator instructions). Ladies and gentlemen, there are no further questions at this time. I will now turn the conference back over to Mr. Gapontsev for any closing or additional remarks.

Thank you all for joining us today. We plan to continue to make progress in executing on our operational and financial goals during the second quarter of 2010, and we look forward to speaking with you again this summer with much better results. Thank you.

And that concludes our conference call. Thank you for joining us today.