IPG Photonics Corporation: More Downside Is Possible (NASDAQ:IPGP)

IPG Photonics Corporation (NASDAQ:IPGP) has released its latest report. Earnings fell as expected with IPGP facing several headwinds, but the report also included enough positives to counter the negatives. The first reaction to the report was positive with the stock jumping higher. However, the initial momentum could not be sustained and the stock turned south. There are still a number of roadblocks standing in the way of IPGP, making long IPGP a more questionable proposition than it otherwise would be. Why will be covered next.

Earnings are under pressure at IPGP

The top line was better than expected in the latest report with IPGP surpassing consensus estimates and the midpoint of its own guidance. On the other hand, IPGP missed consensus estimates for the bottom line. Q2 revenue increased by 1.4% YoY to $377M and EPS declined by 14.7% YoY to $1.10. Book-to-bill was below one. The table below shows the numbers for Q2 FY2022.

Gross margin declined with costs of goods going up, including as a result of the need for higher inventories to guard against supply chain disruptions, less absorption of manufacturing costs and increased shipping costs and tariffs. However, the earnings decline was mostly due to a drop in operating margins, which was powered by an increase in operating expenses.

The increase in opex was mostly the result of a $18M loss due to foreign exchange rates. Forex reduced operating income by $18M, operating margin by 470 basis points and EPS by $0.23 in Q2. The impact was partially offset by a lower-than-expected tax rate of 22% instead of the expected 26% and a 13% or $4.6M reduction in spending on research and development or R&D.

In addition, EPS got a boost from share buybacks. The weighted-average share count was 51.8M in Q2 FY2022, down from 54M in Q2 FY2021. IPGP spent $233M on buybacks in Q2 after spending $79M in Q1. Buybacks are expected to continue with IPGP authorizing a new $300M program.

Buybacks had a negative impact on the balance sheet with cash and equivalent falling to $1,234.7M at the end of Q2, down from $1,514.4M at the start of FY2022. Another notable change on the balance sheet was the increase in inventories to $557M in Q2, up from $461M at the start of the year.

All in all, the Q2 report was a mix of some good and some not so good. On the one hand, earnings were better than the headline number suggest it was once forex is accounted for. On the other hand, while stock buybacks and reduced R&D spending helped prop up earnings, some may feel buybacks and decreased R&D spending is not really beneficial to IPGP in the long run.

(GAAP)	Q2 FY2022	Q1 FY2022	Q2 FY2021	QoQ	YoY
Revenue	$377.023M	$369.979M	$371.658M	1.90%	1.44%
Gross margin	45.7%	46.4%	48.6%	(70bps)	(290bps)
Operating margin	19.0%	25.2%	24.8%	(620bps)	(580bps)
Operating expenses	$100.669M	$78.678M	$88.276M	27.95%	14.04%
Operating income	$71.675M	$93.143M	$92.252M	(23.05%)	(22.31%)
Net income (attributable to IPGP)	$56.968M	$69.572M	$69.800M	(18.12%)	(18.38%)
EPS	$1.10	$1.31	$1.29	16.03%	(14.73%)

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Source: IPGP Form 8-K

The report contained several positive developments worth noting. Sales of emerging growth products continued to outperform, particularly those related to electrical vehicles. If IPGP is to turn it around, new growth drivers will be needed to take the place of old ones. If new products from IPGP get a positive reaction, that’s a good sign for the future.

IPGP is also having success in reducing its exposure to China. China used to be IPGP’s main growth driver, but recent struggles have negatively affected IPGP. IPGP is seeking to reduce its reliance and there seems to be progress. Non-China sales accounting for 64% of the total in Q2 FY2022, up from 57% a year ago. Sales declined by 14% YoY in China, but it was partially offset by an increase of 33% in North America and 43% in Japan. Europe grew by 2% in Q2, but that’s down from 27% in Q1.

Guidance calls for Q3 revenue of $350-380M, a decline of 3.2% QoQ and 3.7% YoY at the midpoint. The forecast expects EPS of $1.00-1.30, a decline of 17.9% YoY at the midpoint. It’s also expected to increase by $0.05 QoQ, but that’s with a $14-16M sequential decrease in operating expenses. Keep in mind that IPGP is expected to be busy with share buybacks in Q3.

(GAAP)	Q3 FY2022 (guidance)	Q3 FY2021	YoY (midpoint)
Revenue	$350-380M	$379.2M	(3.74%)
Gross margin	44-46%	49%	(400bps)
Operating expenses	$85-87M	$83.9M	2.50%
EPS	$1.00-1.30	$1.40	(17.86%)

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Earnings are likely to remain under pressure with IPGP needing to make internal changes in the coming quarters, especially as it relates to Russia due to recent events. From the Q2 earnings call:

“IPG stopped all new investments in Russia and prepared plans to increase manufacturing of critical components in the United States and Western Europe in order to reduce our reliance on manufacturing capacity in Russia. We continue to make progress with hiring additional employees, allocating workspace for increased production and running second and even third shifts in certain locations.

Our inventories of critical components increased and further lowered our risks of supply chain disruptions. We qualified some third-party suppliers and are now placing orders for some of these components. In the second quarter, we started setting up infrastructure for production increases in Germany, Italy and United States.”

A transcript of the Q2 FY2022 earnings call can be found here.

IPGP will seek various mitigation efforts, but the spillover effect is that margins are likely to decline with IPGP transitioning from Russia with its lower costs to places like Europe and the U.S. with their higher costs. IPGP’s large exposure to Europe could be a problem with local manufacturing set to become more expensive, especially due to the higher cost of energy in Europe.

IPGP is trading at a discount

IPGP earned $2.41 in H1 and estimates expect IPGP to finish with EPS of $4.49-4.91 in FY2022, less than the $5.16 in FY2021. IPGP trades at 22 times forward earnings with a trailing P/E of 21. In comparison, the 5-year averages are 34x and 41x respectively. IPGP is cheaper than it has been in the past, which some might see as a buying opportunity. On the other hand, lower multiples are justified with IPGP not growing as it did before. The table below shows the multiples for IPGP.

Keep in mind that share buybacks are propping up earnings at the moment, but the current pace of share buybacks is unlikely to continue. IPGP already used up $312M of its cash reserves in the first half, leaving it with a cash balance of $1.2B. Enterprise value at $4B is still way lower than market cap at $5.2B, but the gap is shrinking along with the cash balance. Forward multiples are higher than trailing ones with earnings projected to decline.

	IPGP
Market cap	$5.19B
Enterprise value	$3.99B
Revenue (“ttm”)	$1,490.6M
EBITDA	$448.1M
Trailing P/E	20.59
Forward P/E	21.63
PEG	0.95
P/S	3.66
P/B	1.87
EV/sales	2.68
Trailing EV/EBITDA	8.91
Forward EV/EBITDA	9.22

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Source: Seeking Alpha

The stock is up against resistance

The stock rose after the Q2 report, but ended the day down. The stock was in the process of moving past resistance in the $105 region, but the response to the Q2 report pushed the stock below resistance. The chart below shows how the stock was able to find support in the $105 region when it was trading above it earlier in the year.

The stock is now below the $105 region and resistance here has kept the stock in check in recent months. Note how the stock has difficulties moving past the $105 region, a sign of resistance. The stock was able to get above $105 on a few occasions, only to be forced back below $105. Resistance has held its ground for months, forcing the stock into sideways action, except in June when the stock briefly collapsed to get close to the $80 region, which happens to be a past pivot point for support and resistance.

A previous article speculated this was likely to happen. The stock needed to bounce in the $100 region or the stock would be heading for the next support level and what was support was likely to become resistance. As it turned out, the stock moved lower and the $105 region appears to have become solid resistance. At the same time, there does seem to be support in the $80 region as suggested earlier.

Investor takeaways

The Q2 report was arguably better than expected, especially once forex is stripped out, which explains why the stock jumped initially. However, a closer look suggests IPGP has yet to feel the full impact of recent developments, especially those related to geopolitics. While stock buybacks and cuts to R&D will help with earnings, they are merely a band-aid solution and not really a cure to the problem.

IPGP has enough cash to keep funding stock buybacks, but it will come at the expense of the balance sheet. Some may welcome the intervention from IPGP, although others might feel it is better to reserve the cash if things get worse. At the same time, there is reason to believe IPGP will need to keep propping up earnings because they are likely to face downward pressure for various reasons.

The move out of Russia pretty much guarantees the cost of goods will go up, which will pressure earnings. IPGP is counting on Europe and the U.S. to soften the blow of falling sales in China, but the former could be following in the footsteps of the latter with the way their economies are going, Europe in particular. A range of macro-economic indicators suggest a worsening economy in the U.S. and Europe. To not expect at least some fallout for IPGP could be too much to ask for.

IPGP at the end of the day depends on the health of industrial demand. Some segments like those related to EVs may hold up better than others, but generally speaking, as the economy goes, so too does industry. The global economy is more likely to get worse than better. IPGP is unlikely to do well under these circumstances.

I am neutral on IPGP. If people are able to handle short-term setbacks and are willing and able to stick with IPGP, then long IPGP could be worth it. But those looking for a more immediate payoff should most likely look elsewhere. Europe alone should give people second thoughts. Earnings at IPGP are declining and there is reason to believe they could continue to fall with major economies heading for a recession, if they aren’t there already.

IPGP could be heading for stormy weather if sales in Europe and the U.S. start to decline like it has in China. Odds are the balance sheet and the income statement at IPGP are more likely to get worse than better. If record-setting stock buybacks only resulted in sideways action, then it’s worth asking what the stock will do with reduced buying, something that will have to happen eventually.

The stock is currently positioned in such a way that the way up is blocked by resistance, while potential support is much further down below. Lower stock prices are more likely than higher ones with the way the charts are laid out. There may come a time for long IPGP, but, with the way things stand, now does not look to be that time.