IPG Photonics Corp (IPGP) 2011 Q1 法說會逐字稿

Good morning and welcome to IPG Photonics' first quarter 2011 financial results conference call. Today's call is being recorded and webcast. There will be an opportunity for questions at the end of the call. (Operator instructions). At this time I would like to turn the conference over to Mr. 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 Chief Financial Officer, Tim Mammen.

Statements made during the course of this conference call that discuss management's for 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 uncertainties 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, 2010, and other reports on file with the Securities and Exchange Commission. Copies of these filings may be obtained by visiting the investors 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, 2011. The Company assumes no obligation to publicly release any statements or revisions to any such statements. We will post these prepared remarks on our website following the completion of the call. Please go to www.IPCPhotonics.com and select investors to review these remarks.

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

Good morning and thank you for joining us again.

We continue to ride the momentum that began to build in the second half of last year and the delivered another successful quarter in Q1 2011. Sales of approximately $100 million represented an increase of 95% from one year ago. We experienced growth across all of our applications, geographies and product lines. While Q1 is typically a seasonally slow quarter for IPG, our sales were less than 1 percentage point lower than the sequential fourth quarter, which was a record quarter for us. The strong leverage in our business model resulted in strong gross margins of 53.7% and operating margin of 34.1%. This led to earnings per share for the quarter of $0.47, a more than six fold increase from $0.07 we reported in the first quarter of year ago.

Materials processing was again our strongest end market, growing 102% year-over-year and comprising 86% of our total revenues. All our geographies delivered impressive growth for the quarter. China was the top performer, recording 234% growth. Japan and Germany also ordered strong year-over-year sales increases at 94% and 80%, respectively. The US also performed well, growing at 29% year-over-year.

High power and pulsed lasers continue to be our top-selling product lines, growing 161% and 59%, respectively. It is now clear that we have reached a point where there is a broad-based market acceptance of fiber laser technology for many different materials processing and other applications. Any remaining resistance to fiber lasers technology is shrinking, and the use of fiber lasers compared to the legacy technology is increasing in many applications, especially in cutting, marking, engraving and cladding.

As we have expected, more and more OEMs and end users are realizing the full potential of the technology and the cost and time savings it provides them. In the past few quarters we have seen a growing number of customers ordering our lasers in greater quantities, and this has led to our excellent sales growth.

While we are proud and financial results thus far, IPG continues to walk in new directions. I want to report that we achieved impressive results in the designs of many different types of complete laser systems. I want to mention a few. Our laser seam stepper system is under qualification for serial production with a major European automaker. Our laser seam stepper is a welding system that combines our fiber laser with the welding apparatus resulting in a robust welds on body in white at half the electrical cost replacing two conventional welders and providing a lot of other advantages and savings.

Also, we recently shipped a complete 15-kilowatt welding system to a large US locomotive maker for welding thick steel, replacing 20-kilowatt CO2 system. This system, which is awaiting installation, shows how we are leveraging our high power lasers and adding additional value to provide unique solutions to customers.

Also, we developed and shipped a patented battery laser welding to a well-known consumer battery maker.

With that I will turn the call over to Tim Mammen.

Thank you, Valentin, and good morning, everyone. I will start with the review of our end markets, products and geographic regions. After that I will follow with a summary of our income statement and balance sheet and close with our guidance.

Materials processing, which accounts for approximately 86% of total sales, continued to deliver impressive growth in Q1. Materials processing sales increased 102% to $86.4 million from Q1 a year ago and increased 2% from the sequential fourth quarter. Keep in mind that, as previously discussed, Q1 is typically seasonally slow.

Much of the sales were generated by high power laser sales for cutting and welding applications and pulsed lasers sales for marking and engraving. Advanced application sales increased to $8.2 million or by 76% year-over-year but were down sequentially by 13%. A highlight of the quarter was that we shipped another 10-kilowatt single-mode laser. As we have discussed, sales to this end market can be rather lumpy.

The telecommunications market increased to $3.2 million or by 73% year over year but down 34% sequentially from Q4. While Russian telecommunications sales increased year on year, they declined sequentially. We continue to see significant opportunity in Russia to sell fiber-optic equipment for long-haul, broadband access and cable TV. We are penetrating that market with new products that we specifically developed for this geography.

During the quarter geographic diversification and broadening of the application scope outside of Russia contributed to the telecom growth including amplification sales to Japan, Portugal, Austria and China. Medical sales increased 10% year-over-year and declined 5% sequentially to $2.1 million.

Turning to our performance by product line, high power laser sales increased 161% year-over-year and 11% sequentially to $44.4 million. High power lasers continue to be used increasingly in cutting and welding applications. At the recent EuroBLECH show in Hanover, Germany, in March, in addition to numerous OEMs demonstrating cutting systems using IPG's lasers, there were four cutting OEMs that were demonstrating systems that were not using IPG fiber lasers.

Since that time, three of the four OEMs have switched over to IPG. We have also had an escalation in demand in China from cutting OEMs and systems integrators. Sales of high power lasers for welding, which was really the standout performer of the quarter in terms of applications, is primarily being driven by the worldwide auto industry, although our high power laser sales are also being used to weld locomotive parts and in shipbuilding. We expect that trend to continue.

Pulsed lasers sales increased to $28.6 million or by 69% year-over-year and were down 9% on a sequential basis. Much of the year-over-year growth in pulsed lasers sales reflects increased demand in the general manufacturing market as well as sales to industrial and consumer electronics manufacturers seeking pulsed lasers for marking alphanumeric, graphic or bar code indications directly onto their manufactured components. The sequential decline reflects the effect of seasonality we previously referenced.

Sales of medium power lasers increased to $7.5 million or by 83% year-over-year and declined only 3% sequentially, primarily due to increased sales for thin sheet metal cutting, micro welding, printing and sintering. Low power laser sales increased to $4.7 million or by 5% year-over-year but down 1% sequentially. Growth in the medical end market helped to drive the year-over-year sales increase. Other low power applications include welding, marking and printing.

Sales of QCW lasers increased by more than 100% sequentially. There were no sales of QCW lasers in Q1 2010, as the product was launched at the end of the quarter. This new product line is starting to gain traction and interest from a number of OEMs and end users in the consumer electronics and micro processing industries. The QCW competes with high-powered flash lamp pump YAG lasers. Sales of other products, which include amplifiers, diode lasers and certain components, increased to $6.4 million or by 59% year-over-year and declined by 25% sequentially. Service, parts, lease and other revenue totaled $7.5 million.

I will now review our major geographic regions. As Valentin mentioned, we had strong year-over-year growth across all major geographic regions during the first quarter with particular strength in China, Japan and Germany. European sales increased to $39.2 million or by 120.1% year-over-year but were down 3.7% on a sequential basis. North American sales increased to $17.2 million or by 29.3% on a year-over-your basis but decreased by 2.4% on a sequential basis. Asian sales increased to $43.4 million or by 117.4% year-over-year and 2% sequentially. China performed exceptionally well on a year-over-year basis, up 234% but down 14% sequentially.

Japan also continued to perform well despite the natural disasters in that region. Sales were up 94% year-over-year and 75% on a sequential basis. We expect a slight slowdown in Japan in Q2, but we plan to use any available capacity to fill orders in other regions. We do not expect that the natural disasters in Japan will have a material effect on our Japanese sales.

The rest of the world, which represents less than a percent of our business, increased 33% year-over-year and 43% sequentially to $0.2 million.

Now turning to the income statement, as Valentin reported, total sales for Q1 increased 95.2% year-over-year but were down 1% sequentially to $100 million, exceeding our original guidance for the quarter of $89 million to $95 million. As I mentioned earlier, Q1 historically had been a seasonally slower quarter, so the 1% sequential decline was actually a positive.

Gross margins improved 13.6 percentage points to 53.7% from 40.1% in Q1 2010 and were slightly down from 55% in Q4 2010. Our gross margin performance was the result of an increase in sales and better absorption of fixed costs as a result of increased volume. As a result, while cost of sales increased by $15.6 million or by 51% year-over-year, the rate of increase was substantially less than the increase in sales. Production not sold and placed into inventory also benefited absorption of manufacturing expenses and gross margin in the quarter.

We continue to focus on vertically integrating more of our manufacturing by developing lower-cost, internally produced optical components used in our products, particularly in high power lasers. As a result, we are driving down manufacturing costs. We also have reduced costs by making greater use of internally produced, high power laser accessories and components including beam splitters, couplers, chillers and optical heads, which we previously sourced from outside vendors.

SG&A expenses in Q1 were $13.1 million or 13.1% of sales compared with $11.2 million or 21.8% of sales in the first quarter of last year. SG&A expenses include legal expenses related to the IMRA litigation.

As we reported in our Form 10-K filed in March 2011, the District Court granted our motion for summary judgment of no marking, precluding IMRA from seeking damages for any alleged infringing products sold prior to mid to late 2006. The District Court denied our motions for summary judgment on noninfringement, invalidity, no willful infringement and laches and granted IMRA's motions for summary judgment on no invalidity for derivation and no equitable misconduct.

The trial is now set to begin on September 26, 2011. We look forward to the opportunity to present our several defenses in this lawsuit.

R&D expenses increased year-over-year on a real dollar basis by 37.8% to $5.7 million but were down as a percentage of sales to 5.7% of total revenues versus 8.1% for the first quarter of 2010. We remain focused on manufacturing efficiencies as well as increasing power levels, improving beam quality and electrical efficiency, shrinking the footprint and lowering the cost per watt of our lasers.

Operating expenses include a $0.7 million net foreign exchange loss during the quarter compared with a $0.1 million net foreign exchange gain during the same period last year. Total operating expenses for the first quarter of 2011 excluding the effect of foreign exchange gains and losses were $18.8 million compared with $15.3 million for the same period last year.

First quarter operating income was $34.1 million or 34.1% of sales compared with $5.3 million or 10.4% of sales in the first quarter of last year. Operating income includes stock-based compensation charges of $2,607,000 and $770,000 in the first quarters of 2011 and 2010, respectively. Stock-based compensation increased in part due to changes in assumptions made during the quarter regarding how expense is recognized over the service period and in part because of the higher cost of options issued in the first quarter of 2011.

In the first quarter of 2011 $521,000, $1,806,000 and $280,000 of stock-based compensation charges related to cost of sales, SG&A and R&D, respectively. Going forward, we would expect quarterly stock-based compensation to be approximately $1.4 million per quarter for the remainder of 2011.

Our tax rate for the first quarter of 2011 was 31%. Net income increased to $23.1 million from $3.4 million a year ago. On a per diluted share basis, we reported $0.47 in Q1 2011 compared with $0.07 per share in the first quarter of 2010. We estimate that if exchange rates had been the same as one year ago, sales in Q1 2011 would have been $1.2 million lower, gross profit would have been $0.1 million higher and operating expenses would have been $0.1 million lower.

Now turning to the balance sheet, our cash and cash equivalents increased by $12.7 million sequentially to $160.6 million at the end of the first quarter of 2011. At March 31, inventory was $88.7 million, up 22.4% from year end 2010 including the translation effect of foreign exchange. Our current level of inventory represents slightly less than six months on hand, which is within our target range.

Accounts receivable were $58 million at the end of the first quarter or 52 days sales outstanding compared to $55.4 million at December 31, 2010, or 49 days sales outstanding.

Cash generated from operations in the first quarter was $13.8 million. Capital expenditures and acquisitions of businesses totaled $11.3 million for the quarter, which is on track with -- which is on track for our target of $50 million for the year. During the quarter we purchased a new building in Italy, completed a building in Japan and acquired a building in Germany. We plan to build a new fiber facility in Russia as well as add front-end die capacity in the US at the beginning of 2012.

The goal for the year is to expand capacity in Germany, Russia and the US and to enhance our sales and service infrastructure with new facilities in China, India, Italy and Japan.

That leads us to our expectations going forward. As Valentin mentioned at the outset of the call, the acceptance of fiber lasers has reached a tipping point in a few of our end markets. Our goals now are to ensure that we have the ability to keep up with demand, to maintain IPG's technological superiority and to develop new applications for fiber lasers. To do that, we are building capacity to meet future growth in demand, and we are investing in R&D.

As our sales continue to grow, we expect to generate sustainable long-term profitability.

Now let me provide you with our guidance for the upcoming quarter. For the second quarter of 2011, IPG Photonics expects revenues in the range of $102 million $110 million. The Company anticipates earnings per diluted share in the range of $0.50 to $0.59. That is based on 48,690,000 diluted common shares, which includes 47,099,000 basic common shares outstanding and 1,591,000 potentially dilutive options at March 31, 2011.

This guidance is subject to the risks we outlined in our reports with the SEC and assumes that exchange rates remain at present levels. I want to reiterate that we do not attempt to forecast gains or losses related to change rates. And with that, we'll open the call up for your questions.

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

So you have given us guidance about revenues, which seem to be growing. And of course, it looks like the seasonality did not impact too much in the March quarter. Could you talk a little bit about the bookings pattern? Was the book to bill closer to 1 this quarter, and how do you anticipate this in the June quarter?

The book to bill ratio was actually nicely above 1 in Q1. Some of the orders that we did take in in the first quarter are for deliveries in Q3 and Q4, but we had a very nice quarter in terms of bookings and then we've just run the reports for the whole of April, and the order trend in April continues to look good.

And did you talk about -- in the guidance that you have given for June, what kind of gross margin assumptions do you have embedded in that?

We are not forecasting any significant change in gross margins, so relatively constant. We don't provide that guidance specifically.

In terms of competition, though, as this market grows and you see better opportunities, we have talked about competition in the past being some players, several players trying to get into this market. If at all, where and which applications have you started to see your competition?

I wouldn't say there has really been a significant change. I think there's a lot of talk about people introducing fiber lasers. As we mentioned in the script, there were even a few companies demonstrating systems with other people's fiber lasers at recent shows. What we've actually seen is those people, when they've completed their evaluations, come back to IPG and actually sign frame agreements and longer-term agreements with us. So, particularly on the high power laser level, there really isn't a great deal of competition that we are experiencing or any sales that we are losing there. There may be a little bit of competition increasing in terms of potential suppliers of pulsed lasers; but as I said on previous calls, I think that the real benefit IPG has now is the ability to produce in very high volumes significant quantities of pulsed lasers with short delivery dates at an extremely competitive price and very, very reliable devices.

So those other non-technological and commercial competitive launches are really starting to shine through.

And you can see, for example, for last year result and this year forecast from the (inaudible) laser solution and also laser (inaudible) they use numbers for all fiber lasers sales last year and forecast for the year less than IPG only produced last year, and we are now (inaudible) next year. So the share of other people altogether is [negligible] compared to IPG sales.

And a final question, of course. Do you feel that your vertical integration strategy is actually working in your favor right now, given all these disruptions from Japan? And also any impact on pricing?

I think that the vertical integration strategy has been working very well for many years. The only time it doesn't work particularly well is when there's a decrease in sales. But we have control over our internal supply of components, the quality of those components, the development time of the components and the ability to bring down the cost of them. And we really have not seen any disruption from the Japanese natural disaster. So from that perspective, yes, it provides some maybe additional insurance to us, but overall I think that strategy has numerous benefits that arise from different areas.

And pricing-wise, have you seen any pressure?

From our suppliers of -- you mean raw components and raw materials?

No; in your pricing to your customers.

No; I think pricing remains relatively stable at the moment. There isn't -- the market is seeing such tremendous growth in demand that we are not seeing pricing pressure. We do provide discounts for volume orders, and we are hoping to see significant increases in volume orders from different customers.

C.J. Muse, Barclays Capital.

Hi, it's Olga (inaudible). Thanks for taking the question. This question is off of the gross margin side. As you add the capacity that you outlined on the call, can you talk about what sort of gross margins we should anticipate in the second half, assuming relatively constant quarterly growth in revenues?

Well, we don't get into providing gross margin guidance. I would say that we are not forecasting any significant decline in gross margins this year. We did add some capacity in Q1 in terms of labor and other costs that we were able to absorb those additions. You did see a slight decline in gross margins from Q4 to Q1, which reflected some of those increases in the cost. But what we have feel is that at the moment, as revenue continues to track up, we should be able to absorb those relatively well. So there's no change in our gross margin assumptions.

And then as you look into the rest of the year and given the backlog that you already to have, what sort of seasonality are you anticipating? And are there any changes in seasonality versus previous years?

There are no changes I would expect this year. I think we have continued to see the strengthening as it normally does. It was interesting to see that in Q1 we did actually start to collect orders even for the second half of the year, some of which we are actually seeing pulled into Q2 now. So there is no indication that this year will be any different from previous years.

And with growing backlog and now we have record numbers at (inaudible) very fast growing backlog, we can say.

Mark Miller, Noble Capital.

Congratulations on another strong quarter. In terms of the growing backlog, is the mix staying the same? Are you mixing it to a higher backlog? It appears from your margin guidance it looks like the mix is staying about the same.

I think what we saw in Q4 and Q1 was definitely real traction in the high power business. So you have seen high power sales as a percentage of total sales increase. I think that is also reflected -- well, it's clearly reflected if you look at our backlog in an increasing share of high power. And then our internal analysis in terms of production planning continues to see high power ramp. And probably more moderate growth from pulsed lasers sales this year. And hopefully coming into the second half of the year some good growth on the medium power and QCW lasers.

So we expect, because the market is dominated by high power, high power as a percentage of total sales to increase.

This quarter we [predict we will have reached] 50% of the [share] of high-power lasers. It's (inaudible) included in advanced lasers for advanced [specification] of about 50%. We expect the high power share will increase above 60% shortly.

You also noted that this quarter saw an increasing number of new internal components that were sourced, were made internally. And I'm just wondering, do you see that trend continuing? And what impact did that have on margins this quarter?

I think we've started to introduce a lot of those accessories throughout last year. So the full benefit of them is really starting to come through in the model. We were looking at other cost reduction initiatives that revolve -- you know, packaging of diodes, expanding actually the internal manufacturing of some metal components as well.

So it's very difficult; there are so many different components that you can't really quantify specifically by item. It's not really a valuable exercise to do. But there is an overall benefit coming from all of those different optical and mechanical components, redesign and products as well, to simplify the architecture and the electronics to (technical difficulty) --

Hello?

Yes?

I'm sorry. Just final question, again on competition -- there was an announcement by JDSU and Amada about a high linear cutting speed system using fiber lasers. I'm just wondering your thoughts or comments on that.

We've had a lot of questions about that. We don't know a lot about that laser. What we have heard in the market, that is, the beam quality is poor, the size of the device is significantly larger than ours and the reliability is questionable. But there's no real concrete evidence that we can point to on that. We haven't seen them start to generate any fiber laser sales for cutting systems from Amada. And interestingly, Amada is using our fiber laser; their welding division is using a number of our fiber lasers for welding applications.

It is very clear that with the use of external supply of core fiber, of core optics for high-power laser from our side for Amada, it would be we will grow, we are very essential with the (inaudible) cost of (inaudible) laser. So there is not once -- never on our evaluation, never would be able to compete with that [commercial].

Jim Ricchiuti, Needham & Company.

Congratulations on the quarter. As you continue to see the kind of strength and demand in your backlog grows, I'm trying to get a sense as to capacity and whether you see any constraints in the second half of the year. I realize you are bringing on some additional capacity. But maybe you can maybe comment on that.

At the moment I don't think -- clearly, there's a lot of planning and detail management that goes into this, to anticipate increases in demand. But there's a lot of investment that's being put into increasing diode packaging, modules, manufacturing, fiber block manufacturing and other optical component manufacturing in all three of our manufacturing locations, so in the US, in Germany and in Russia. I think the evidence that we can keep up with the increase in demand is borne out by the fact that we did manage to build a fair amount of inventory in Q1 in anticipation of increasing demand through the second half of the year. It's something we have to manage very closely, and there's a lot of planning involved in it. So we're not uncomfortable with the situation as it stands.

And then I wanted to also follow up on a comment I believe you made regarding some volume orders from new customers. Can you talk a little bit about the markets, the type of customer that you anticipate seeing some of these volume orders?

I think it's across different applications, so we continue to see a lot of strength in the cutting business, which has obviously grown very well over the last three years now. The standout performer in the first quarter of this year was for an application which we called out over the last year as being very, very well suited to fiber lasers; that's the welding business. And that welding business is not just the auto industry, although there is expected to be significant demand in the second half of the year from major automotive manufacturers. It's also in, for example, a system that we delivered to -- for welding locomotive engines, so that was a deep penetration welding application. In the shipbuilding industry in China, and then -- so there has been actually a press release issued by GE recently looking at hybrid welding applications where they talked about very significant improvements in welding productivity, quality and also very significant cost savings in terms of reduction in the materials that they are using to make the welds. So I think welding will be a strong driver of growth. I think cladding; there are some new cladding processes and technologies, and we're working with partners on that. That could be a good area of growth is well coming into the second half of this year and in 2012.

And in China, what percent of your revenue is now in China? You are clearly showing very strong growth there.

About 20%.

Okay, thank you.

Tom Hayes, Piper Jaffray.

I think, in the prepared remarks, you had mentioned that you are approaching a tipping point in several of your end markets. I was just wondering if perhaps you would provide a little bit of color on the thoughts of those markets. And are you taking the share from non-laser applications, or are you taking some of that share from older laser technology?

I think the first part of the question really was very similar to Jim's and the strength we have seen in cutting, welding, new cladding applications. I think that the one thing I could add to that is that the huge growth in consumer electronic devices is well recognized as playing into the laser industry as a whole, whether it be for flat-panel displays or basic applications like marking and engraving.

In terms of displacing technologies, it's both displacing existing laser technologies, so with cutting, it's definitely displacing CO2 because we have very significant advantages there. But when you get into welding and cladding applications, you are often displacing non-laser welding processes. And even in marketing and engraving, you could be displacing, for example, etching using chemicals or marking using ink. So that would be a non-laser application, so it's really a mixture of the two.

And then two quick questions on the expense line -- on the general and administrative it was up to about almost $8.2 million for the quarter. Is that a kind of run rate we should be able to think about for the balance of the year?

Yes; I think a reasonable level on all operating expense -- I think we are at about $19.3 million for the quarter. I think $19 million is a reasonable rate right now, and SG&A at about $8 million or G&A at about $8 million is reasonable as well. I think it's 8% of revenue.

And just lastly, it was a small piece this time on the net income attributable to noncontrolling interest. Do you have any thoughts for what we should use for a full-year number?

That's really related to the RUSNANO investment, so that reflected the fact that they owned 12.5% of that. The Russian quarter was relatively slow on third-party sales, and we would expect to see that increase fairly strongly. So I would model increasing that to probably $500,000 in Q2 and then they are likely to conclude another tranche of the investments in the second quarter as well, so their ownership interest will probably go up to 22.5%, but I would model increasing the noncontrolling interest to somewhere around $750,000 Q3 and Q4. I think, as we get further into the year, I will be able to give you more specific estimates on that. It is a difficult number to factoring. I agree with you.

[Mack Muirhead], Longbow Research.

You spoke about the sales mix, what you expect in the end markets in China -- the shipbuilding, for instance. Can you comment on what it was this past quarter? I think Europe and China, both very strong what the applications were? Was Europe auto driven? And what was the breakdown of the lasers -- high power, low power, pulsed? Could you go into that, please?

I think we're getting a bit too granular on analyzing sales there. We do have data on which kind of applications are going into geographic regions, but there's a number of assumptions we make in trying to determine that, and we do not disclose that information because we do not often know exactly which industry -- for example, OEMs -- are selling lasers into. So trend-wise those numbers are useful, but outside of that, to get more specific, we just wouldn't do that.

As I mentioned before, I think it's -- the trend in China is similar to everywhere else. Cutting is growing very strongly, welding is growing very strongly, the marking and engraving business continues to be strong. The end markets are general manufacturing, automotive, shipbuilding, heavy industry -- for example, in building locomotives and trains -- and then the consumer electronic device business continues to be a strong growth driver for many different types of laser applications.

Could you talk a little bit about inventories? I notice that they went up pretty significantly sequentially. Could you just comment on that?

Yes; again, I think I alluded where Jim asked his question about that. We're trying to balance here meeting demand from our customers and capacity expansion. So we do target holding less than six months inventory on hand, and we are at that level. Nonetheless, since December we have continued to invest in inventory. So we've built inventory of raw diodes, package diodes, fiber blocks modules. We are also seeing a longer lead times for certain components, a little bit longer lead times for certain components. So we have built some raw material inventory around that.

You have to bear in mind that when you go from making a diode chip to producing the package diodes and then putting that package diodes, splicing it to a fiber block and building a module, it does take a considerable period of time before that can be built into a finished product.

It's minimum three-month cycle.

We view our vertical integration and our inventories being our internal supply chain and one that's very important for us to invest in. As I said, we target six months or less inventory on hand. As growth rates ramp up we expect to be at about that six-month level.

Okay, great, thank you for taking the question.

Paul Thomas, Bank of America/Merrill Lynch.

Could you talk a little bit about factory utilization and just where you guys think you are in terms of revenue capacity, either in the current quarter or where you might be at the end of the year? I know it's not an exact number, but it sounds like you had some spare capacity and you were able to build a little bit of inventory. Where do you think you are in terms of that?

Overall capacity utilization is probably about 80% at the moment. That is including some of the inventory builds. We are not uncomfortable in terms of where we stand today to meeting our guidance number for Q2. We factor that in when we are trying to determine the Q2 guidance. And then we're seeing these investments take place in direct manufacturing labor. So for example, we actually had a job fair in Oxford, Massachusetts, with over 400 people attending that fair. We have an ability now to fill open requisitions for employees, and that should be done over the next quarter. So we factor that into headcount increases in Germany and Russia. We don't expect to have any problems with meeting increases in demand in the second half of the year.

It is, obviously, a difficult process to manage this kind of growth and then keep up with it, but I think we're doing a pretty good job so far.

Okay, thanks, very helpful

Joe Maxa, Dougherty & Co.

Tim, what was the headcount at the end of the quarter?

1700 people.

1700, approximately? Okay. I was curious if you could give us a breakout on your welding and cutting mix. I know you give specifics, but maybe as a third or a fourth? You know, of that combined would be welding, or how should we look at that, 3-to-1?

We don't get into that kind of specificity. Predominantly, if you look at the high power business at $44 million, (inaudible) --

(inaudible) (technical difficulty)

Approximately, yes. So 80% of that is really going into cutting and welding applications at the moment.

Right, of your high power --

We just don't get into giving what the exact split is on welding and cutting. As I've said before, it's very difficult sometimes for us to identify specific end users.

Okay, so on the welding side, it obviously was a standout performer, and that's obviously gaining, the way it sounds. And you would expect that to continue?

Absolutely. Both of them are gaining pretty quickly. Q1 was very strong on welding, and I think that's a trend that we've called out and we expect to continue and we think is actually at an early stage.

Okay, and then on the OpEx side, how should we think about or can you give us any thoughts on what your expenses may be related to this trial coming up in September?

In Q3, it's very difficult to say exactly what they would be, I think. But we are budgeting in total similar levels of total legal expenses as we had last year, which was about $2.6 million.

For the full year?

Yes.

Okay, and I think all my questions have been answered. Thank you.

Ajit Pai, Stifel Nicolaus.

Good morning, and congratulations on a great quarter. A couple of quick questions -- I think the first is just looking at the welding applications. You talked about locomotives and also shipbuilding. Can you give us an idea what the wattage for the type of laser for those applications are, and also an approximate ASP?

(inaudible) it's above 10 kilowatts, 15 to 20 kilowatts on those, and that 20-kilowatt laser is coming under $1 million at the moment.

And would it be fair to say that that's a completely new application for lasers, so that's expanding the addressable market for lasers?

It would probably be developed over the last year by our partners, so relatively new applications there, yes.

And, I mean, there haven't been CO2 lasers being used in some of these really heavy-duty applications, or even if they have it's a tiny percentage of the market, would you say?

Well, one of the lasers that we sold actually replaced a CO2 laser. The problem the customer had was with that CO2 laser was that it was so inefficient they were only allowed to run it for a certain number of hours per day, and the quality of the welds was not particularly good. So there were very limited quantities of CO2 lasers used in these ultrahigh power applications.

Laser welding (inaudible) for sheet metal was very bad (inaudible) up to now, very limited. Before they did not have good quality on laser (inaudible). Now the fiber laser provides them such opportunities, so the sheet metal welding will start to grow very fast to only now will open door for these applications. We signed recently an agreement to Lincoln that's (inaudible) for sheet metal welding at the company. And so this project is going now, it's very fast, and also it's [GE] and many others, the very big guys. So we believe that (inaudible) welding we use in the 10 to 20 or 30-kilowatt laser during our next couple years will be -- (inaudible) extremely well.

There's also other applications (inaudible) where we generate, for example, (inaudible) for automotive. Before, they tried to use some of the (inaudible) not successful with those. Now we have started (inaudible) replacement of the YAG (inaudible) pump (inaudible) the production line by fiber laser. In parallel with, we developed new what we mentioned stepper system, stepper laser system, which open absolutely new opportunity for (inaudible) wide welding, and since the March introduction very large quantity our system for such applications. That's now the biggest or one of the biggest in the world's automakers (inaudible) use in their preparation.

And other people also, very interested in this. It could be a very serious market for such kinds of these welding system.

And the automaker -- what is the wattage of the system they are going to be doing in the one that's in qualification?

Wattage from 2 to 4 kilowatts.

2 to 4 kilowatts -- and then you described the inefficiencies of the CO2 laser and the heavy-duty application. Could you quantify what the plug efficiency of that CO2 likely was and what the plug efficiency of your 15 to 20 kilowatt lasers is?

The plug efficiency in CO2 was included in (inaudible) 7% to 8%. People talking 10%, but it's [practical] not true. Our efficiency now, more than 30%. We introduce efficiency during the last year from typical 28% towards 51%-52%.

And this is even for the 15 to 20-kilowatt lasers?

Yes; more power, more efficiency.

Got it. And then the second question is just looking at your gross margins, you're talking about gross margin staying in the current range because of adding manufacturing capacity. A large part of the capacity you are adding is actually on all these additional components that you're designing in and vertically integrating. So why shouldn't your gross margins, as you keep growing your revenue, continue to expand from the 55% you saw in the December quarter to maybe 65% over the next two to three years?

We're really conservative in forecast; of course, our target is to increase gross margin. We have good chance (inaudible) speaking to make this. But we are very careful here not to promise your investors more [than that].

I think the other think you have to factor in, Ajit, is that our whole philosophy and strategy is to grow the addressable market and to find new applications into displaced non-laser technologies. So you do have to factor in, over time, whilst we improve capacity utilization and bring the cost of components down, that actually affords us the opportunity to reduce the cost of the laser and hopefully grow the Company at a much faster rate than might otherwise happen.

And then uses of cash -- now that you have so much cash and you've already made an investment in the Russian venture, what -- and the cash flows are going to be accelerating at some of the growth rates is some of the growth rates at some point begin to decelerate, can you tell us what the uses of cash are, whether you have any acquisitions in mind or how you plan to use it?

We haven't identified any specific applications -- sorry, acquisitions at this time. Clearly, that would be one source of it. I think this year we'll generate a little bit of surplus cash through a significant amount of investment that's happening. So right at this point in time we have not determined anything specific to do with the cash. It's very nice to be in the position we are; and I'll tell you it makes a difference from 2003 and 2004, when we had virtually no cash.

Jiwon Lee, Sidoti & Company.

I may have missed a comment on your segment growth expectation, especially in the first quarter. I wonder what specifically drove the high-power lasers sales and what are your growth expectations this year between the high power and pump lasers?

The high power laser sales were driven by very strong growth in welding and cutting applications and also some of the newer applications that are coming on like cladding. It was lasers in the range of power of 2 to 15 and 20 kilowatt, so really across the board. And then in terms of high powers, I think we already articulated this. As a percentage of sales high power has now moved up from probably less than 25% 18 months ago to closer to 50% and that we expect that trend to continue probably up to about 60% of total revenues, which would reflect the split more accurately, to reflect the total split of the market.

And then on the welding side again, I wonder what percentage of your last year's revenues address that market and how do you expect that to grow as a percentage of sales this year?

No matter how many times people ask that question, I'm not going to give a specific answer on exactly what percentage of our sales was welding and cutting. And I think we've articulated all the different areas of strengths that we see for fiber lasers in welding applications, both high power for deep penetration welding and also welding [better] metals, Valentin just talked at length about that.

And then lastly, for me, on the seam steppers, you are obviously penetrating OEMs a little more meaningfully on that front. Is there a revenue expectation level this year on that product alone?

Again, we don't provide specific revenue forecast by new product line. We have delivered several of those systems, and they have been used to do multiple welds on several hundred thousand bodies -- I'm sorry, more than 100,000 car bodies to date as part of the qualification process. So we are very optimistic about that line, but we will not provide a specific revenue forecast for seam steppers this year.

But the average selling price on those products are pretty high, aren't they?

The interesting thing about this system is that the value is added by the laser, so the seam stepper provides a very strong enhancement to the weld process, but it actually removes the need for all of the enclosures. So the whole benefit of the seam stepper is it reduces the up-front cost of getting into welding applications. We haven't talked about what specifically the average selling price is on that -- it's not a $1 million system because otherwise you wouldn't be able to break into that market very quickly.

And typical automaker is extremely conservative. For them to change technology for new ones, it's a very long process. It should be enormous maturation to make this. But in the case, it's so big advantages, so they run in very fast.

And let me just jam in one last question -- the growth expectations from China -- are you already seeing some pickup in welding, or is that going to come later in the year?

There has been some pickup in welding in China for different industries -- auto, general manufacturing and in the shipbuilding area. I think we're also seeing more of the licenses [issues] for end users at the higher power levels in addition to be able to ship the tropical version of our laser at 2 kilowatt without a license at the moment. So that process has improved a bit.

Yes, (inaudible) in China (inaudible) back in the business. Before, we are (inaudible) in China and marking only, in high power laser it was huge limitation for us do to the export license for this in the United States, in Europe and so on. Now we are only -- now we are only resolved the most of these programs, and so open door, even fleet only, now to go to Chinese large market. So I believe the market in China now, the sales in China, will grow many hundred percent (inaudible).

That's very good, thank you very much.

At this time we have reached the end of the Q&A session. I will now turn the conference back over to Dr. Gapontsev for any additional or closing remarks.

Thank you for joining us today. I look forward for speaking with you when we report our second-quarter results in the summer. We believe the results will be much better because the second quarter typically a very good quarter in our history.

That's the end of the call. Thank you very much, everyone.

Ladies and gentlemen, this concludes our conference call. Thank you for joining us today. You may disconnect your lines at this time.