IPG Photonics: A Turn In Short-Cycle Demand Only Adds To Challenges

IPG Photonics (NASDAQ:IPGP) has continued to have a difficult time of it. Russia’s invasion of Ukraine, and the sanctions that followed, were always going to make 2022 more challenging for the company, but IPG Photonics has also had to deal with interruptions in China’s economy from its COVID-19 policies, as well as emerging weakness in many short-cycle industrial markets.

I thought IPG Photonics had some high-risk contrarian attributes roughly a year ago, but the shares have lost another quarter of their value, lagging the broader industrial space, but performing more in line with nLIGHT (LASR) and Chinese laser rivals Han’s Laser (002008.SZ) and Raycus (300747.SZ). At this point, I do see elevated risks to short-cycle demand, but I also think the share price discounts a lot of that. I’m reluctant to double-down on a “buy” call that has failed, but mid-single-digit growth can support a double-digit return from here, and I don’t think that’s an overly demanding outlook.

The Macro Isn’t Getting Easier

My biggest concern about IPG at this point is simply the macro environment. ISM Manufacturing is below 50 in all of IPG’s major markets (the U.S., EU, and China), and that’s usually a sign of tougher times to come for companies that cater to shorter-cycle industrial customers – the typical rule of thumb is to sell when the ISM number starts to roll off its peak, avoid through the decline through 50, and then consider buying when ISM seems to be bottoming.

Cutting and welding activity are typically cycle-driven, and the outlook for 2023 demand isn’t particularly strong at this point. The auto sector should hold up relatively better, but with EV launch timelines getting pushed out, it remains to be seen how much new capex companies will be devoting to areas like EV/battery assembly. Likewise, heavy machinery is likely to start rolling over in 2023, and it seems unlikely that companies will be as eager to spend on capex expansion into significantly weaker orders.

There are a few areas of relative strength. First, I’m not expecting a severe recession. Second, relative to “general manufacturing”, the auto sector should hold up relatively better, and there should still be healthy demand in areas like aerospace and energy for cutting/welding systems, and more specialized systems like QCW lasers used to drilling cooling holes for jet engine turbines.

I also see growing adoption of additive manufacturing (particularly in areas like healthcare), which should help demand for IPG’s medium-power lasers. I also expect fairly healthy demand for renewable energy, which should support demand for green lasers used to produce solar panels.

Outside of industrial markets, the outlook remains look mixed. Weak personal electronics demand is going to limit demand for QCW lasers, but the company does seem to be making progress with its efforts to grow its medical business – a business that should be around 5% of total sales in 2022 and shouldn’t see cyclical weakness in 2023.

Another concern heading into 2023 is lower demand for IPG’s highest-power offerings (6kW and above). While marine, energy, and defense markets should be healthy (all of which are users of heavier plate steels that require higher-power lasers), I expect weaker demand in areas like non-residential construction and heavy machinery, and this is likely to create some unwanted gross margin headwinds, as higher-power lasers tend to be more profitable.

New Applications Can Drive Credible Growth

While the near-term macro is not favorable to the company, there are still some positive drivers beyond the next year or two.

Electric vehicles now make up about 20% of the company’s served addressable market, roughly doubling from the year-ago period. In addition to typical cutting/welding tasks, IPG is seeing their lasers adopted for more demanding tasks, including battery assembly (including foil cutting and microwelding) and motor production. Given the low penetration of EVs today and the need for considerably more battery and motor production capacity in the future, I do see a significant addressable market for IPG, and this is an area where performance demands are more exacting and where the company should have a more durable competitive advantage.

Likewise with additive manufacturing and healthcare. There are still engineering and throughput challenges that make additive manufacturing non-viable in many applications, but the list of industrial applications were additive manufacturing can be used continues to grow (3D-printed implants are not uncommon in healthcare now), driving a market for IPG’s medium-power lasers. Likewise with the healthcare market, where IPG has opportunities in a range of markets including ophthalmology, dermatology, and urology.

I do think it’s important not to go too far with expectations for contributions from new markets. I do see significant addressable opportunities in EVs, solar energy, additive manufacturing, and healthcare, but IPG’s track record is not flawless. Opportunities like OLED production and film projection never really panned out for the company, and it’s important for the company to successfully develop products for new markets, as its Chinese rivals continue to close the gap with many of the company’s products.

The Outlook

In addition to the input cost inflation and supply challenges that most industrials saw in 2022, IPG has also faced additional challenges due to sanctions on Russia. With those sanctions in place, it is far more difficult for the company to import/export components to and from Russia for use in its European facilities, and the company has had to turn to more expensive manufacturing and sourcing in the U.S. and EU. At the same time, the company has seen an adverse mix shift in China, as well as more challenging overall economic conditions, as the Chinese government’s pandemic policies impacted the economy.

I do see a risk of a miss-and-lower quarter when the company reports fourth quarter results in February. Simply put, the macro environment appears to be getting worse, not better, and while the easing of COVID-19 restrictions in China should help, the overall downturn in short-cycle demand will be challenging to overcome.

I’m basically in line with the Street for Q4/2022 numbers, but my 2023 revenue estimate is about 5% lower and my 2024 estimate is about 8% lower. The revisions since my last update drop my long-term revenue growth to about 4%, which is more in line with what I expect from more conventional high-quality metalworking companies like Lincoln Electric (LECO) (a customer of IPG for some automated welding systems).

My margin and EBITDA estimates are also below-average through 2024, as I believe the company is going to see higher manufacturing and fulfilment costs and higher inefficiencies due to the sanctions-driven dislocations. Long term, this could be an opportunity for the company to innovate and restructure, but it remains to be seen if they can execute. While I expect low-20%’s operating margin in FY’23 and FY’24, I think the company could get back to 30% operating margin over time (but I think mid-to-high 30%’s is unlikely on a sustained basis). At the cash flow level, I expect long-term FCF margins in the low-to-mid-20%’s, with some near-term uncertainty tied to net working capital.

Discounted back, those cash flows support a double-digit annualized long-term total return that is pretty good relative to what most industrials offer. Likewise, using my ’23 margin and return (ROIC, et al) estimates, I get a fair forward EBITDA multiple estimate of 11.75x; on my FY’23 EBITDA estimate that supports a fair value of around $114 today.

The Bottom Line

My contrarian call last February was definitely wrong, and I certainly don’t feel as confident with a bullish call on a company with meaningful short-cycle exposure at a time when ISM manufacturing numbers have cracked 50 and are heading lower. Likewise, I see miss-and-lower risk going into the fourth quarter.

All of that said, factoring that into my model, mid-single-digit revenue and FCF growth on the order of 4% to 6% over the next 10-plus years can support a good return from here. I think there’s definitely the risk of reaching for a falling knife today, but I also think a lot of negativity is built into the shares.