IPG Photonics Corporation: Showing Signs Of Underlying Strength (NASDAQ:IPGP)

The latest report from IPG Photonics Corporation (NASDAQ:IPGP) came in mixed at best. IPGP managed to surpass expectations in some areas, but it also fell short in other areas. IPGP continues to be confronted by headwinds that look to stick around for the foreseeable future. However, there is also reason to believe the worst may have passed for the stock, even if a full recovery is not likely to come anytime soon. Why will be covered next.

A noisy Q3 report

IPGP came up short in terms of the top line, but it also far exceeded expectations for the bottom line. Q3 revenue declined by 8% YoY to $349M, which is less than the $350-380M guidance had called for. In contrast, EPS increased by 5% YoY to $1.47, which is way above the $1.00-1.30 guidance had called for. Sales in North America increased by 1%, but this was more than offset by a 13% decline in Europe, a 14% decline in China, and a 21% decline in Japan, all YoY.

However, there’s more to it. If not for forex, Q3 revenue could have been $26M higher. On the other hand, the sale of the telecom transmission business to Lumentum Holdings (LITE) lowered operating expenses and boosted operating income by $21.7M, raising EPS by $0.32. Furthermore, IPGP lowered operating expenses by spending 25.8% or $8.8M less YoY on R&D in Q3, similar to Q2.

IPGP also spent $71M on stock buybacks in Q3, bringing the amount spent in the last three quarters to $383M. As a result, the weighted-average of shares outstanding declined from 53.8M in Q3 FY2021 to 51.7M in Q3 FY2022, a decline of almost 4%. Keep in mind that the bottom line in Q2 FY2022 was negatively affected by an $18M loss due to forex, skewing the QoQ comparisons.

Gross margin fell to 43.1%. This decline was due to the increased cost of goods sold, higher inventory reserves, higher shipping costs and tariffs. Cash, cash equivalents and short-term investments on the balance sheet totaled $1.2B at the end of Q3. The table below shows the numbers for Q3 FY2022.

(GAAP)	Q3 FY2022	Q2 FY2022	Q3 FY2021	QoQ	YoY
Revenue	$349.006M	$377.023M	$379.150M	(7.43%)	(7.95%)
Gross margin	43.1%	45.7%	49.0%	(260bps)	(590bps)
Operating margin	26.7%	19.0%	26.9%	770bps	(20bps)
Operating expenses	$57.262M	$100.669M	$83.888M	(43.12%)	(31.74%)
Operating income	$93.162M	$71.675M	$101.986M	29.98%	(8.65%)
Net income (attributable to IPGP)	$76.264M	$56.968M	$75.402M	33.87%	1.14%
EPS	$1.47	$1.10	$1.40	33.64%	5.00%

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Source: IPGP Form 8-K

Guidance calls for Q4 FY2022 revenue of $300-330M, a decline of 9.7% QoQ and 13.6% YoY at the midpoint. The forecast expects GAAP EPS of $0.70-1.00, a decline of 42.2% QoQ, and 29.8% YoY at the midpoint. In comparison, consensus estimates expected revenue of $365M and GAAP EPS of $1.14, a fairly large difference. IPGP is projected to earn $4.58-4.88 in terms of GAAP in FY2022, which is actually not that far from the $5.16 it earned in FY2021.

(GAAP)	Q4 FY2022 (guidance)	Q4 FY2021	YoY (midpoint)
Revenue	$300-330M	$364.5M	(13.58%)
Gross margin	42-44%	45.5%	(250bps)
Operating expenses	$77-79M	$81.2M	(3.94%)
EPS	$0.70-1.00	$1.21	(29.75%)

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IPGP did have some encouraging news elsewhere. For instance, the medical business grew by 70% YoY and is on track to reach $70M in FY2022, up from $43M in FY2021. In general, new products are doing well, especially when it comes to applications like batteries for electrical vehicles. Nevertheless, IPGP is dealing with a number of headwinds, including a weakening global economy. From the Q3 earnings call:

“We continue to see upward momentum in our emerging growth products in the third quarter. We saw the strong results in welding, cleaning, solar cell manufacturing, medical and 3D printer applications. These were offset by several headwinds and including unfavorable currency translations, weaker economic conditions in Europe and core-related lockdowns in China.

Softness in general industrial demand in Europe and China negatively impacted sales in high-power cutting applications. At the same time, we saw modest growth in North America, and we are pleased it is continued to increase e-mobility sales driven by new investment in electric battery capacity across all geographies. Emerging growth product sales were 43% of our total revenue in the third quarter.”

A transcript of the Q3 FY2022 earnings call can be found here.

Realistically, the headwinds are unlikely to go away anytime soon. Whether it’s China, the U.S. dollar or geopolitical conflict in Europe, they are all likely to remain with IPGP for the foreseeable future. For instance, a big reason why gross margin is going down is because the cost of goods is going up with IPGP forced to move away from Russia, a country where it has a large manufacturing presence and costs are relatively low, to other places where costs are higher.

These negative trends are unlikely to go away in the near future. In other words, earnings have been under pressure and, while the future is not set in stone, they are most likely to get worse and not better in the near future. With this in mind, one could make an argument that long IPGP is not worth pursuing while the aforementioned conditions persist.

Why the worst may be over for IPGP

However, one could make an argument that most if not all the bad news has been priced in. The stock’s price action suggests the worst is over. The stock has gone flat despite the continued presence of headwinds. While the stock did drop as much as 7% after the Q3 report on November 1, the stock recovered to finish the day at $85.48, which is just several pennies below where it traded before the report.

The stock is up since then, although it has still lost 50% YTD. Note also how the stock was able to gain almost 3% on November 2, which was a pretty bad day for tech stocks with the Nasdaq losing more than 3%. In other words, the stock has outperformed even though the latest earnings updates were worse than expected as shown in the chart below.

While the stock did reach a new intraday low of $79.88 on November 1, the stock has not fallen in recent months like it did last year and the early part of 2022. It’s been sideways for the most part. All this suggests that while IPGP continues to face off against headwinds, the market has priced it in as the presence of these headwinds were known beforehand and IPGP has not mentioned any new issues the market was not already aware of.

Valuations are appealing, but they may not tell the whole story

There seems to be buying interest out there given the recent price action. Valuations are likely a big reason why. Multiples for IPGP are much lower than they have been in recent years, which means that if people were looking at IPGP, but were turned off by the multiples, then now may be a good time to get in with multiples much lower.

For instance, IPGP trades at 18 times forward earnings with a trailing P/E of 17. In comparison, the 5-year averages are 33x and 40x respectively. The stock is also currently valued at 1.68 times book value, whereas in the past it was more like double at 3.71x. The table below shows some of the multiples IPGP trades at.

	IPGP
Market cap	$4.16B
Enterprise value	$2.95B
Revenue (“ttm”)	$1,460.5M
EBITDA	$420.2M
Trailing GAAP P/E	17.11
Forward GAAP P/E	18.47
PEG	0.79
P/S	3.12
P/B	1.68
EV/sales	2.02
Trailing EV/EBITDA	7.01
Forward EV/EBITDA	7.17

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Source: Seeking Alpha

However, it’s worth mentioning that expectations may be too optimistic. IPGP has posted GAAP EPS of $5.09 in the past 12 months and the forward estimates suggest only a small decline in the next 12 months, but this may be too optimistic. Earnings estimates could be too high for IPGP, although one could argue that is true for the entire stock market as a whole.

It’s possible earnings could decline more steeply in the coming quarters than they have recently, especially since large parts of the world could be in or close to a recession in 2023. If this happens, multiples will be revised accordingly. IPGP looks like a bargain, but that could be because the real slowdown and its impact on earnings has yet to arrive at IPGP. But just because something has yet to arrive does not mean it is not coming.

Investor takeaways

There are a number of arguments to be made as to why now is the time to go long IPGP. The stock seems to have found support. As pointed out in a previous article, there seems to be support for the stock around $80. The fact that the stock bounced when it got to $79.88 after the Q3 report supports this contention.

IPGP is seeing falling demand overall, but some segments continue to do very well. The outperformance of products like LightWELD is reason to be optimistic about the long-term prospects for IPGP. While a global recession will hurt industrial demand, it should pass given enough time. The same cannot be said of the need for fiber lasers. Their importance is unlikely to change, in contrast to the temporary nature of recessions.

The stock has outperformed lately despite the negativity hanging over IPGP, suggesting that the headwinds that have given IPGP problems like Europe and China are priced into the stock. The stock has overtaken the 20-day moving average and it is very close to overtaking the 50-day moving average, a bullish sign.

The fact that the stock has gone flat should be encouraging to the bulls. The bottom may be in if a fair amount of bad news was unable to bring down the stock, even though the stock market sold off. If the stock drops further, it will be because of new headwinds or a bigger drop in earnings than expected. Multiples are lower than they have been, something some may want to take advantage of.

IPGP presents an intriguing option, but I remain neutral on IPGP. The stock is unlikely to do well in the short term due to the many headwinds, temporary rallies notwithstanding, although a stronger case can be made for the long term. IPGP should eventually recover from the current bout of weakness, but it will take time to do it. The stock is most likely to go sideways with support in or around the $77.50-82.50 region and resistance in the $100-110 region.

While the stock may not have been able to break support despite the many headwinds, provided of course new ones don’t show up, it is also unlikely to break through resistance with earnings almost certain to go down in the coming quarters, probably more than expected. Rallies will be hard to sustain if earnings keep going down, which is almost certain with the way the cards are laid out right now. IPGP, for instance, has to move away from Russia and that alone will push up costs and lower earnings.

Bottom line, long IPGP could be worth it if one is in it for the long haul and can wait while IPGP moves towards resolving the issues that are giving it problems. In the more immediate future, the stock could go on temporary rallies, but it’s unlikely to hold them as long as the many headwinds are out there. So if someone is looking for more productive uses from capital than one is to get from sideways action, then IPGP is probably not it, at least for now.