IPG Photonics Corporation: Anticipating Lower Stock Prices

The last six weeks have been tough on IPG Photonics Corporation (NASDAQ:IPGP). IPGP was on the move with the stock hitting a new 2023 high of $141.85 as recently as July 13, only to fall to $96.09 in the following month before recovering somewhat. The collapse was powered by a forecast that suggests demand is getting weaker, which could pressure the stock. More importantly, there is reason to suspect IPGP itself believes the stock is heading lower. However, some may see the recent drop as a buying opportunity with a view towards the long run. Why will be covered next.

The stock rallies and then drops

The stock might have lost 17.5% immediately after the Q2 FY2023 report, but the weak outlook did not come out of the blue. IPGP is facing a number of potential headwinds that are potent enough to pressure earnings in the near term. For instance, a previous article from June noted several issues of concern, including increasing competition in its top market, which has contributed to stagnant growth at IPGP, and increased cost of production and hence margin pressure.

The above and other issues are why the article questioned the reasoning behind an upgrade from Raymond James Financial, an investment bank, days earlier. The upgrade had sent the stock soaring, but the article’s statement of “the stock is hot right now, but I would not be a buyer” turned out to be the right move after the collapse in the stock as shown below.

The chart above shows how the stock has gained 11.6% YTD. That might not sound so bad, but YTD gains stood at 49.8% as recently as mid-July, before the recent drop in the stock. If not for a strong rally early in the year, IPGP would now be under water. Note that the big jump in the stock in June was due to the untimely upgrade from Raymond James. If not for this, the stock can be said to have been sliding since February by slowly ceding the gains from earlier in the year.

Why IPGP has sold off

Most of the blame for the recent collapse in the stock can be assigned to the most recent quarterly report from IPGP. The outlook suggests demand is getting weaker, which implies lower earnings, starting as soon as Q3 FY2023. The Q2 FY2023 results itself were okay as EPS actually surpassed consensus estimates by $0.06 with an increase of 19% YoY to $1.31, offsetting the fact that sales declined QoQ and YoY to $340M. The table below shows the numbers for Q2 FY2023.

Note that China was the main reason why Q2 FY2023 revenue declined YoY. China contributed $98.6M out of $340M in revenue in Q2, but that's less than the $137.4M China contributed the year before. China revenue fell by $38.4M YoY in Q2, more than the $37M YoY decline in total revenue. Except for North America and China, all other regions grew.

There are a few other things worth mentioning about the Q2 results. Q2 FY2022 EPS was adversely impacted by a $17.6M loss due to foreign exchange, which increased operating expenses in Q2 FY2022. R&D spending in Q2 FY2023 declined from $30.6M to $23.5M YoY, which helped lower operating expenses in Q2 FY2023. Q2 FY2023 net income received an additional boost from much higher interest income that increased from $1.2M to $9.3M YoY. If not for all these, the YoY increase in EPS would in all likelihood not have happened.

Source: IPGP Form 8-K

Is IPGP anticipating lower stock prices?

There is another thing worth noting in the table above. IPGP did not buy back shares in Q2 FY2023 like it did in past quarters, including the roughly $113M spent in Q1 FY2023, which is why the weighted-average share count did not change much QoQ. Stock buybacks are the chief reason why the cash balance has dropped in recent quarters from around $1.5B before the buybacks started. Around $600M has been spent on buybacks since IPGP started buying back shares in early FY2022.

But in Q2 FY2023 no shares were bought and cash, cash equivalents and short-term investments increased from $1,069.6M to $1,096.4M QoQ. Note that the halt is not due to having run out of cash authorized under the existing buyback program. IPGP is allowed to buy shares because it authorized another $200M for stock buybacks after Q1 FY2023.

Keep in mind that IPGP reserves the right to determine when and when not to buy back shares and it is under no obligation to buy back shares. Still, the fact that IPGP decided to not buy back shares should raise some eyebrows. IPGP has the means to buy back shares, but it chooses not to. This raises the question of what the motive is behind all of this, assuming there is one.

I think one could surmise that the reason why IPGP decided to halt the buying back of shares for the time being is because it anticipates lower stock prices, which is basically what happened with the stock selling off after the Q2 report was released. Keep in mind IPGP would have lost out if it had bought back shares before the recent collapse in the stock when prices were much higher.

I believe IPGP might have anticipated the market’s reaction to the report’s weak guidance as shown below. Guidance calls for Q3 FY2023 revenue of $300-330M, a decline of 7.4% QoQ and 9.7% YoY at the midpoint. The forecast calls for GAAP EPS of $0.85-1.15, a drop of $0.31 QoQ and $0.47 YoY at the midpoint. Keep in mind IPGP has a history of beating EPS estimates.

IPGP added some color to the weak guidance. Book-to-bill fell below one in Q2 FY2023 with soft demand in all the major manufacturing regions, which includes North America, Europe and China. From the Q2 FY2023 earnings call:

“Second quarter book-to-bill was below 1. We continue to see uncertain macroeconomic condition and soft orders in all major manufacturing regions. Leading indicators in North America and Europe point to contraction in the industrial markets, while the timing of demand recovery in China remains uncertain.”

A transcript of the Q2 FY2023 earnings call can be found here.

In addition, IPGP is forecasting about 47.5M shares outstanding in Q3. This number suggests IPGP will not be buying back shares in Q3, which could be interpreted as IPGP anticipating further weakness that is likely to pressure the stock and possibly drive it lower. In other words, I believe the reason why IPGP has stopped buying back shares is because it expects the see the stock price at lower levels in the near future.

Why some may still go long IPGP

If we read between the lines, IPGP seems to be preparing for some lean times and it remains to be seen how long it will last. Still, if IPGP earns $1 in Q3 FY2023 and GAAP earnings slowly increase from then on, then IPGP is estimated to earn anywhere from $4-5 in the next 12 months. Note that this is assuming that earnings do not fall below $1, something that has not happened since Q4 FY2020.

This implies a forward GAAP P/E ratio of 26.4 at the low end and 21.1 at the high end of estimates with the stock priced at $105.65 as of August 28. This compares well with the 5-year average of 32x. In comparison, IPGP has posted GAAP EPS of $2.13 in the last 12 months, which implies a trailing P/E ratio of 47.9. Remember this includes a loss of $1.91 in Q4 FY2022, which was due to various charges related to the restructuring of assets in Russia.

It’s also worth mentioning that while headline growth has been hard to come by with quarterly revenue stuck in the $300-400M region since mid-2017, IPGP has been able to achieve success with the introduction of new products, even if they have yet to completely offset the impact of soft demand elsewhere. For instance, handheld welding solutions like LightWELD are growing. As are e-mobility solutions for the automotive market, especially with production of EV batteries being scaled up around the globe.

Assuming this continues, it is reasonable to assume that the growth in emerging products may one day allow it to overtake the market for more traditional applications. It won’t happen anytime soon, but it is something that some may be betting on, assuming they can stomach the short-term pressure that IPGP is likely to experience, which could cause others to abandon ship.

Investor takeaways

The recent developments have shown that staying neutral was the right call when it comes to IPGP. The stock soared higher, only to collapse shortly thereafter. Anyone who got caught on the wrong side of the trade, short when the stock rallied and long when the stock sold off, is now nursing big losses due to the magnitude of the moves in a compressed timeframe.

The recent drop brought the stock back below the $100 level, which has shown to be a good entry point in recent years. IPGP has tended to stay below $100 for only a short while and this is why buying the stock when it is below $100 can be worthwhile, especially to those who are convinced of IPGP’s long-term potential, are in it for the long term and can deal with short-term fluctuations.

However, while IPGP has a shot at overcoming its present challenges like the lack of sustained growth in the long run, the reality is that IPGP continues to face a number of headwinds that have not gone away and could even intensify. For instance, gross margin is facing downward pressure because the cost of production is going up. The cost of production is going up due to various reasons, including the need on the part of IPGP to make changes to its supply chain as a result of geopolitical reasons. This is an ongoing process that will not end anytime soon.

Similarly, China remains IPGP biggest market by sales, which means China could remain a drag on IPGP if the market struggles. China’s share stood at 29% of total revenue as of Q2 FY2023, but that number is down big from where it used to be. Falling sales in China are driven by a number of factors.

A weakening in economic conditions is a factor, but so too is growing competition from local companies, who are increasingly able to deliver products that are increasingly competitive versus those from IPGP. China could continue to serve as a headwind for the foreseeable future due to its size. Once could even argue the challenges facing IPGP in China are structural in nature.

Pressure in the two other regions, Europe and North America, is not as intense, but here too there are worrying signs, Europe in particular. Major parts of Europe are in a recession or close to it, including Germany. Germany is the engine that drives Europe as it is a manufacturing powerhouse, reason why it is an important market for IGPG as a supplier of fiber lasers for industrial applications.

Unfortunately, Germany’s manufacturing sector is struggling with the rising cost of energy, which is affecting its competitive position in the world. It’s unlikely this will change anytime soon as there is no easy fix for expensive energy, which suggests that more bad news is to be expected from Germany, and likely Europe as a whole.

Bottom line, there are many headwinds facing IPGP, which have yet to find a solution. The short-term outlook is leaning bearish for IPGP. IPGP itself seems to be suggesting that people should strap themselves in by not buying its own stock. Just ask yourself, why would someone buy the stock of a company when the company itself has refrained from buying its own stock? Just something to ponder about.