You should read the following discussion in conjunction with our condensed consolidated financial statements and related notes included elsewhere in this Quarterly Report on Form 10-Q. This discussion contains forward looking statements that are based on management's current expectations, estimates and projections about our business and operations. Our actual results may differ materially from those currently anticipated and expressed in such forward-looking statements. See "Cautionary Statement Regarding Forward-Looking Statements." Overview We develop, manufacture and sell high-performance fiber lasers, fiber amplifiers and diode lasers that are used for diverse applications, primarily in materials processing. We also manufacture and sell complementary products used with our lasers including optical delivery cables, fiber couplers, beam switches, optical processing heads, in-line sensors and chillers. In addition, we offer laser-based and non-laser based systems for certain markets and applications. Our portfolio of laser solutions are used in materials processing, communications, medical and advanced applications. We sell our products globally to original equipment manufacturers ("OEMs"), system integrators and end users. We market our products internationally, primarily through our direct sales force. Our major manufacturing facilities are located inthe United States ,Germany andRussia . We have sales service offices and applications laboratories worldwide. We are vertically integrated such that we design and manufacture most of the key components used in our finished products, from semiconductor diodes to optical fiber preforms, finished fiber lasers, amplifiers and complementary products. Our vertically integrated operations allow us to reduce manufacturing costs, control quality, rapidly develop and integrate advanced products and protect our proprietary technology. Factors and Trends That Affect Our Operations and Financial Results In reading our financial statements, you should be aware of the following factors and trends that our management believes are important in understanding our financial performance. COVID-19 Update. Global demand trends have been impacted adversely by the COVID-19 pandemic and therefore remain uncertain at this time. While we have seen a rebound in demand inChina in the second quarter, this was partially offset by weakness in bothEurope andNorth America . We believe demand trends will continue to be impacted by how significantly COVID-19 is affecting various regions of the world. This uncertainty continues to make forecasting our business challenging in the near to medium-term. Currently, our three major production facilities inUnited States ,Germany , andRussia remain open. We have implemented employee safety and sanitization protocols that have impacted productivity and efficiency. We have vertically integrated manufacturing, and many of the components one facility supplies to another facility are single sourced internally and not available from third party suppliers, for example our semiconductor diodes manufactured inOxford, Massachusetts . While we have attempted to build safety stock of critical components at our various locations, if government restrictions to address the COVID-19 outbreak become more severe than we have experienced to date or if there was significant absenteeism as a result of a COVID-19 outbreak or resurgencein the places where we operate, it could impact our internal supply chain. We have implemented certain payroll and sick time policies to help support our employees impacted by COVID-19. These measures have and will continue to increase the cost of our operations but the magnitude and length of time of this impact is difficult to quantify at this time and may continue to be difficult to estimate in the future. If our revenues are reduced for an extended period or if our production output falls because of government restrictions or absenteeism, we may be required to reduce payroll-related costs and other expenses in the future through layoffs, furloughs or reduced hours, even though we have not done so to date. We have not experienced significant supply disruption from third party component suppliers; however, we face some supply chain restraints primarily related to logistics, including available air cargo space and higher freights rates. Available cargo space on flights between theU.S. andEurope andEurope andAsia is limited as a result of COVID-19, increasing shipping time and cost. We may experience delays in the future if resurgences are experienced and governments implement new restrictions. We believe we have the ability to meet the near-term demand for our products, but the situation is fluid and subject to change. We continue to monitor the rapidly evolving conditions and circumstances as well as guidance from international and domestic authorities, including public health authorities, and we may need to take additional actions based on their recommendations. The measures implemented by various authorities related to the COVID-19 outbreak have caused us to change our business practices including those related to where employees work, the distance between employees in our 16 -------------------------------------------------------------------------------- Table of Contents facilities, limitations on in person meetings between employees and with customers, suppliers, service providers, and stakeholders as well as restrictions on business travel to domestic and international locations or to attend trade shows, investor conferences and other events. To date, we have been able to accommodate these changes to our business operations and continue to meet customer demand. If the guidance from relevant authorities becomes more restrictive in the future due to a resurgence of COVID-19 in a particular region, the effect on our operations could be more significant. The COVID-19 pandemic has increased economic uncertainty and decreased demand for our products in many markets we serve and could continue for an unknown period of time. In these circumstances, there may be developments outside of our control, including the length and extent of the COVID-19 outbreak and government-imposed measures that may require us to adjust our operating plans. As such, given the dynamic nature of this situation, we cannot reasonably estimate the future impacts of COVID-19 on our financial condition, results of operations or cash flows. However, we do expect that it will have an adverse impact on our revenue as well as our overall profitability and may lead to an increase in inventory provisions, allowances for credit losses, and a volatile effective tax rate driven by changes in the mix of earnings across the Company's markets. Additionally, if the business impacts of COVID-19 carry on for an extended period, it could cause us to recognize impairments for goodwill and certain long-lived assets including amortizable intangible assets or right-of-use assets. In particular, the outbreak of COVID-19 has negatively affected new order flow inNorth America for our custom systems business. We are monitoring this business and if order flow does not improve in the near term, it may become a triggering event which causes us to evaluate the carrying value of goodwill related to that business. Net sales. Our net sales have historically fluctuated from quarter to quarter. The increase or decrease in sales from a prior quarter can be affected by the timing of orders received from customers, the shipment, installation and acceptance of products at our customers' facilities, the mix of OEM orders and one-time orders for products with large purchase prices, competitive pressures, acquisitions, economic and political conditions in a certain country or region and seasonal factors such as the purchasing patterns and levels of activity throughout the year in the regions where we operate. Net sales can be affected by the time taken to qualify our products for use in new applications in the end markets that we serve. Our sales cycle varies substantially, ranging from a period of a few weeks to as long as one year or more, but is typically several months. The adoption of our products by a new customer or qualification in a new application can lead to an increase in net sales for a period, which may then slow until we penetrate new markets or obtain new customers. Our business depends substantially upon capital expenditures by end users, particularly by manufacturers using our products for materials processing, which includes general manufacturing, automotive, other transportation, aerospace, heavy industry, consumer, semiconductor and electronics. Approximately 90% of our revenues for the first half of 2020 and 94% of our revenues for the full 2019 fiscal year were from customers using our products for materials processing. Although applications within materials processing are broad, the capital equipment market in general is cyclical and historically has experienced sudden and severe downturns. For the foreseeable future, our operations will continue to depend upon capital expenditures by end users of materials processing equipment and will be subject to the broader fluctuations of capital equipment spending. In recent years, our net sales have been negatively impacted by tariffs and trade policy. New tariffs and other changes inU.S. trade policy could trigger retaliatory actions by affected countries, and certain foreign governments. The Chinese government has imposed retaliatory tariffs on a range ofU.S. goods including certain optical and electronic products and components, which has impacted demand for our products, particularly for materials processing. The average selling prices of our products generally decrease as the products mature. These decreases result from factors such as increased competition, decreased manufacturing costs and increases in unit volumes. We may also reduce selling prices in order to penetrate new markets and applications. Furthermore, we may negotiate discounted selling prices from time to time with certain customers that place high unit-volume orders. The secular shift to fiber laser technology in large materials processing applications, such as cutting applications, had a positive effect on our sales trends in the past such that our sales trends were often better than other capital equipment manufacturers in both positive and negative economic cycles. As the secular shift to fiber laser technology matures in such applications, our sales trends are more susceptible to economic cycles which affect other capital equipment manufacturers. Gross margin. Our total gross margin in any period can be significantly affected by total net sales in any period, by competitive factors, by product mix, and by other factors such as changes in foreign exchange rates relative to theU.S. Dollar, some of which are not under our control. For instance, •As our products mature, we have experienced an increase in competition which has decreased average selling prices and reduced gross margin; 17 -------------------------------------------------------------------------------- Table of Contents •Our gross margin can be significantly affected by product mix. Within each of our product categories, the gross margin is generally higher for devices with greater average power. These higher power products often have better performance, more difficult specifications to attain and fewer competing products in the marketplace; •Higher power lasers also use a greater number of optical components, improving absorption of fixed overhead costs and enabling economies of scale in manufacturing; •The gross margin for certain specialty products may be higher because there are fewer or sometimes no equivalent competing products; •Customers that purchase devices in greater unit volumes generally are provided a lower price per device than customers that purchase fewer units. In general, lower selling prices to high unit volume customers reduce gross margin although this may be partially offset by improved absorption of fixed overhead costs associated with larger product volumes, which drive economies of scale in manufacturing; and •Gross margin on systems and communication components can be lower than the gross margin for our laser and amplifier sources, depending on the configuration, volume and competitive forces, among other factors. We expect that some new technologies, products and systems will have returns above our cost of capital but may have gross margins below our corporate average. If we are able to develop opportunities that are significant in size, competitively advantageous or leverage our existing technology base and leadership, our current gross margin levels may not be maintained. Instead, we aim to deliver industry-leading gross margin by growing sales by taking market share in existing markets or by developing new applications and markets we address, by reducing the cost of our products and by optimizing the efficiency of our manufacturing operations A high proportion of our costs is fixed so costs are generally difficult to adjust or may take time to adjust in response to changes in demand. In addition, our fixed costs increase as we expand our capacity. If we expand capacity faster than is required by sales growth, gross margins could be negatively affected. Gross margins generally decline if production volumes are lower as a result of a decrease in sales or a reduction in inventory because the absorption of fixed manufacturing costs will be reduced. Gross margins generally improve when the opposite occurs. If both sales and inventory decrease in the same period, the decline in gross margin may be greater if we cannot reduce fixed costs or choose not to reduce fixed costs to match the decrease in the level of production. If we experience a decline in sales that reduces absorption of our fixed costs, as experienced during the three and six months endedJune 30, 2020 , or if we have production issues, our gross margins will be negatively affected. We also regularly review our inventory for items that are slow-moving, have been rendered obsolete or determined to be excess. Any provision for such slow-moving, obsolete or excess inventory affects our gross margins. For example, we recorded provisions for slow-moving, obsolete or excess inventory totaling$6.0 million and$7.9 million for the three months endedJune 30, 2020 and 2019, respectively, and$14.4 million and$12.6 million for the six months endedJune 30, 2020 and 2019, respectively. Selling and general and administrative expenses. In the past, we have invested in selling and general and administrative costs in order to support continued growth in the Company. As the secular shift to fiber laser technology matures, our sales growth becomes more susceptible to the cyclical trends typical of capital equipment manufacturers. Accordingly, our future management of and investments in selling and general and administrative expenses will also be influenced by these trends, although we may still invest in selling or general and administrative functions to support certain initiatives even in economic down cycles. Certain general and administrative expenses are not related to the level of sales and may vary quarter to quarter based primarily upon the level of acquisitions and litigation. Research and development expenses. We plan to continue to invest in research and development to improve our existing components and products and develop new components, products, systems and applications technology. We believe that these investments will sustain our position as a leader in the fiber laser industry and will support development of new products that can address new markets and growth opportunities. The amount of research and development expense we incur may vary from period to period.Goodwill and long-lived assets impairments. We review our intangible assets and property, plant and equipment for impairment when events or changes in circumstances indicate the carrying value may not be recoverable.Goodwill is required to be tested for impairment at least annually. Negative industry or economic trends, including reduced estimates of future cash flows, disruptions to our business, slower growth rates, lack of growth in our relevant business units or differences in the estimated product acceptance rates could lead to impairment charges against our long-lived assets, including goodwill and other intangible assets. 18 -------------------------------------------------------------------------------- Table of Contents Our valuation methodology for assessing impairment requires management to make significant judgments and assumptions based on historical experience and to rely heavily on projections of future operating performance at many points during the analysis. Also, the process of evaluating the potential impairment of goodwill is subjective. We operate in a highly competitive environment and projections of future operating results and cash flows may vary significantly from actual results. As discussed above, we are also monitoring the effect of the COVID-19 pandemic on our business and the potential affect it may have on the recoverability of our long-lived assets. In particular, COVID-19 has negatively affected order flow for our custom systems business. If order flows continue to be negatively impacted going forward, the cumulative effect of this reduced demand on backlog and the future outlook for revenue could be a triggering event which causes us to evaluate the recoverability of goodwill for this reporting unit. The effects of COVID-19 may also affect the recoverability of other long-lived assets including our amortizable long-lived assets or right-of-use assets. If our analysis indicates potential impairment to goodwill, amortizable intangibles or right-of-use assets in one or more of our reporting units, we may be required to record charges to earnings in our financial statements, which would negatively affect our results of operations. Foreign exchange. Because we are aU.S. based company doing business globally, we have both translational and transactional exposure to fluctuations in foreign currency exchange rates. Changes in the relative exchange rate between theU.S. dollar and the foreign currencies in which our subsidiaries operate directly affects our sales, costs and earnings. Differences in the relative exchange rates between where we sell our products and where we incur manufacturing and other operating costs (primarily in theU.S. ,Germany andRussia ) also affects our costs and earnings. Certain currencies experiencing significant exchange rate fluctuations like the Euro, the Russian Ruble, the Japanese Yen and Chinese Yuan have had and could have an additional significant impact on our sales, costs and earnings. The appreciation of the Russian Ruble due to stabilizing oil prices created a foreign exchange loss in the quarter endedJune 30, 2020 , because our Russian subsidiary has certain net assets denominated inU.S. Dollars. Additionally, the appreciation of the Russian Ruble was the primary driver of a charge to other comprehensive income during the quarter based on the translation of Ruble denominated assets and liabilities intoU.S. dollars. Ongoing volatility of foreign exchange rates relative to theU.S. Dollar could continue to result in significant foreign exchange gains and losses related to transactions and charges or benefits to other comprehensive income. Our ability to adjust the foreign currency selling prices of products in response to changes in exchange rates is limited and may not offset the impact of the changes in exchange rates on the translated value of sales or costs. In addition, if we increase the selling price of our products in local currencies, this could have a negative impact on the demand for our products. Major customers. While we have historically depended on a few customers for a large percentage of our annual net sales, the composition of this group can change from year to year. Net sales derived from our five largest customers as a percentage of our net sales was 22% for the six months endedJune 30, 2020 and 21%, 26% and 28% for the full years 2019, 2018 and 2017, respectively. One of our customers accounted for 8% and 12% of our net sales for the six months endedJune 30, 2020 and 2019, respectively. The same customer accounted for 26% and 24% of our net accounts receivable as ofJune 30, 2020 andDecember 31, 2019 , respectively. We seek to add new customers and to expand our relationships with existing customers. We anticipate that the composition of our significant customers will continue to change. If any of our significant customers substantially reduced their purchases from us, our results would be adversely affected. Results of Operations for the Three Months EndedJune 30, 2020 Compared to the Three Months EndedJune 30, 2019 Net sales. Net sales decreased by$67.4 million , or 18.5%, to$296.4 million for the three months endedJune 30, 2020 from$363.8 million for the three months endedJune 30, 2019 . COVID-19 was a primary cause of the decline in revenue in the quarter with reduced sales inEurope ,North America and other countries inAsia , most notablyJapan , theRepublic of Korea andTurkey . In addition to reduced demand due to COVID-19, declines in average selling prices for materials processing products also contributed to the decline in revenue. The table below sets forth sales by application: Three Months Ended June 30, 2020 2019 Change (In thousands, except for percentages) Sales by Application % of Total % of Total Materials processing$ 271,708 91.7 %$ 345,591 95.0 %$ (73,883) (21.4) % Other applications 24,703 8.3 % 18,178 5.0 % 6,525 35.9 % Total$ 296,411 100.0 %$ 363,769 100.0 %$ (67,358) (18.5) % 19 -------------------------------------------------------------------------------- Table of Contents The table below sets forth sales by type of product and other revenue:
Three Months Ended
2020 2019 Change (In thousands, except for percentages) Sales by Product % of Total % of Total High Power Continuous Wave ("CW") Lasers$ 157,478 53.1 %$ 213,411 58.7 %$ (55,933) (26.2) % Medium Power CW Lasers 10,692 3.6 % 15,415 4.2 % (4,723) (30.6) % Pulsed Lasers 42,577 14.4 % 40,813 11.2 % 1,764 4.3 % Quasi-Continuous Wave ("QCW") Lasers 13,708 4.6 % 15,967 4.4 % (2,259) (14.1) % Laser and Non-Laser Systems 24,942 8.4 % 39,383 10.8 % (14,441) (36.7) % Other Revenue including Amplifiers, Service, Parts, Accessories and Change in Deferred Revenue 47,014 15.9 % 38,780 10.7 % 8,234 21.2 % Total$ 296,411 100.0 %$ 363,769 100.0 %$ (67,358) (18.5) % Materials processing Sales for materials processing applications decreased due to lower sales from high power lasers, medium power lasers, QCW lasers, laser and non-laser systems, and other laser products and service, offset by increased revenue from pulsed lasers. Sales for material processing applications were generally negatively affected by the COVID-19 pandemic. Although we benefited from sequential improvement in ourChina -based business, the effect of COVID-19 reduced sales inEurope ,North America and other countries inAsia , most notablyJapan , theRepublic of Korea andTurkey during the quarter endedJune 30, 2020 . Although we believe that COVID-19 was a primary cause of the decline in revenue in the quarter, we also continue to experience declines in average selling prices due to competition, particularly for high power laser products inChina . •The decline in high power lasers related to the decrease in sales of lasers used for metal cutting and welding. Within cutting applications, decreased sales were attributable to a weaker global demand environment primarily inN. America andEurope and continued competition affecting average selling prices. Part of the decline in average selling prices for high power lasers is due to the adoption of more compact or rack mounted "YLR" series lasers, which are displacing 1 to 3 kilowatt "YLS" series lasers that are larger and cannot be rack mounted. These more compact YLR lasers are less expensive to manufacture and are sold at prices lower than the YLS series lasers they are displacing. The decrease in sales of high power lasers used in welding applications was driven by lower sales into general manufacturing industries. •The decrease in medium power sales related to ongoing transition to kilowatt scale cutting lasers and decreased demand in laser sintering for metal-based additive manufacturing. •The increase in pulsed laser sales was due to growth in sales of high power pulsed lasers used for ablative and battery processing applications, partially offset by decreased demand of pulsed lasers used for marking and engraving applications. •QCW laser sales decreased due to lower demand for fine processing and consumer electronics applications. •The decrease in laser and non-laser systems sales was due to lower demand of non-laser systems in the transportation and aerospace sectors. •Other Revenue for materials processing decreased due to lower demand of parts and service. Other applications Sales from other applications increased due to higher demand for lasers used for medical procedures, government applications, and semiconductor applications. Cost of sales and gross margin. Cost of sales decreased by$23.5 million , or 12.8%, to$160.0 million for the three months endedJune 30, 2020 from$183.5 million for the three months endedJune 30, 2019 . Our gross margin decreased to 46.0% for the three months endedJune 30, 2020 from 49.5% for the three months endedJune 30, 2019 . Gross margin decreased mainly due an increase in unabsorbed manufacturing expense as a percentage of revenue in the second quarter of 2020 versus the year ago period. 20 -------------------------------------------------------------------------------- Table of Contents Sales and marketing expense. Sales and marketing expense decreased by$3.4 million , or 16.4%, to$17.3 million for the three months endedJune 30, 2020 compared with$20.7 million for the three months endedJune 30, 2019 . This change was primarily a result of decreases in personnel, travel, trade fair and exhibits and demo unit depreciation. As a percentage of sales, sales and marketing expense increased to 5.8% for the three months endedJune 30, 2020 from 5.7% for the three months endedJune 30, 2019 . Research and development expense. Research and development expense decreased by$3.3 million , or 9.5%, to$31.6 million for the three months endedJune 30, 2020 , compared to$34.9 million for the three months endedJune 30, 2019 . This change was primarily a result of decreases in R&D materials, personnel and travel. Research and development continues to focus on developing new products, enhancing performance of existing components, improving production processes and developing manufacturing of new components such as crystals and refining production processes to improve manufacturing yields and productivity. New products include lasers that operate at different wavelengths such as UV, visible and mid-IR, lasers with ultrafast pulses, laser based systems for material processing, projection, display and medical as well as accessories such as welding and cutting heads. In addition to new products, research and development is focused on enhancing the performance of our existing products by improving their electrical efficiency, increasing their average power and making them more compact. As a percentage of sales, research and development expense increased to 10.7% for the three months endedJune 30, 2020 from 9.6% for the three months endedJune 30, 2019 , mainly due to the decrease in sales. General and administrative expense. General and administrative expense decreased by$2.1 million , or 7.4%, to$26.4 million for the three months endedJune 30, 2020 from$28.5 million for the three months endedJune 30, 2019 . This change was primarily a result of decreases in personnel, bad debt expense, travel, legal and recruitment, partially offset by increases in insurance and information systems. As a percentage of sales, general and administrative expense increased to 8.9% for the three months endedJune 30, 2020 from 7.8% for the three months endedJune 30, 2019 , mainly due to the decrease in sales. Impairment of long-lived assets and other restructuring charges. We incurred impairment of long-lived assets and other restructuring charges of$1.2 million in total for the three months endedJune 30, 2020 , of which$0.4 million related to severance and$0.1 million related to lease termination costs as part of restructuring of our submarine network division. We also incurred$0.7 million of non-cash long-lived impairments related to machinery and equipment. Effect of exchange rates on net sales, gross profit and operating expenses. We estimate that, if exchange rates relative to theU.S. Dollar had been the same as one year ago, which were on averageEuro 0.89 ,Russian Ruble 65 ,Japanese Yen 110 and ChineseYuan 6.82 , respectively, we would have expected net sales to be$8.0 million higher, gross profit to be$4.1 million higher and total operating expenses to be$1.7 million higher. Loss (gain) on foreign exchange. We incurred a foreign exchange loss of$12.8 million for the three months endedJune 30, 2020 as compared to a$5.1 million loss for the three months endedJune 30, 2019 . The foreign exchange loss for the three months endedJune 30, 2020 was primarily attributable to the appreciation of the Russian Ruble and Euro as compared to theU.S. Dollar. The foreign exchange loss for the three months endedJune 30, 2019 was primarily attributable to the depreciation of the Chinese Yuan, partially offset by gains attributed to the appreciation of the Russian Ruble and Euro as compared to theU.S. Dollar. Interest income (expense), net. Interest income (expense), net decreased to$1.9 million of income for the three months endedJune 30, 2020 as compared to$4.1 million of income for the three months endedJune 30, 2019 . The reduction in interest income, net, is due to holding shorter duration investments to increase liquidity as well as a decrease in yields on shorter duration investments that resulted in lower market interest rates as compared to rates last year. Provision for income taxes. Provision for income taxes was$11.1 million (22.5% of pre-tax income) for the three months endedJune 30, 2020 compared to$23.3 million (24.3% of pre-tax income) for the three months endedJune 30, 2019 . There were net discrete tax benefits of$3.1 million and$0.6 million for the three months endedJune 30, 2020 and 2019, respectively, primarily related to the tax deductions for equity-based compensation that exceeded compensation expense recognized and an investment credit inRussia related to prior years for which an amended return was filed. Net income attributable toIPG Photonics Corporation . Net income attributable toIPG Photonics Corporation decreased by$34.1 million to$38.2 million for the three months endedJune 30, 2020 compared to$72.3 million for the three months endedJune 30, 2019 . Net income attributable toIPG Photonics Corporation as a percentage of our net sales decreased by 7.0 percentage points to 12.9% for the three months endedJune 30, 2020 from 19.9% for the three months endedJune 30, 2019 due to the factors described above. 21 -------------------------------------------------------------------------------- Table of Contents Results of Operations for the Six Months EndedJune 30, 2020 Compared to the Six Months EndedJune 30, 2019 Net sales. Net sales decreased by$133.1 million , or 19.6%, to$545.7 million for the six months endedJune 30, 2020 from$678.8 million for the six months endedJune 30, 2019 . COVID-19 was a primary cause of the decline in revenue in the period with reduced sales inChina particularly in the first quarter and reduced sales inEurope ,North America and other countries inAsia , most notablyJapan , theRepublic of Korea andTurkey particularly in the second quarter. In addition to reduced demand due to COVID-19, declines in average selling prices for materials processing products also contributed to the decline in revenue. The table below sets forth sales by application: Six Months Ended June 30, 2020 2019 Change (In thousands, except for percentages) Sales by Application % of Total % of Total Materials processing$ 489,782 89.8 %$ 646,676 95.3 %$ (156,894) (24.3) % Other applications 55,871 10.2 % 32,140 4.7 % 23,731 73.8 % Total$ 545,653 100.0 %$ 678,816 100.0 %$ (133,163) (19.6) %
The table below sets forth sales by type of product and other revenue:
Six Months Ended June 30, 2020 2019 Change (In thousands, except for percentages) Sales by Product % of Total % of Total High Power Continuous Wave ("CW") Lasers$ 276,794 50.7 %$ 392,430 57.8 %$ (115,636) (29.5) % Medium Power CW Lasers 21,945 4.0 % 31,013 4.6 % (9,068) (29.2) % Pulsed Lasers 74,416 13.6 % 72,250 10.6 % 2,166 3.0 % Quasi-Continuous Wave ("QCW") Lasers 23,581 4.3 % 30,133 4.4 % (6,552) (21.7) % Laser and Non-Laser Systems 43,576 8.0 % 72,014 10.6 % (28,438) (39.5) % Other Revenue including Amplifiers, Service, Parts, Accessories and Change in Deferred Revenue 105,341 19.4 % 80,976 12.0 % 24,365 30.1 % Total$ 545,653 100.0 %$ 678,816 100.0 %$ (133,163) (19.6) % Materials processing Sales for materials processing applications decreased due to lower sales of high power lasers, laser and non-laser systems, medium power lasers, QCW lasers, and other laser products and services, partially offset by increased sales in pulsed lasers. •The decline in high power lasers related to the decrease in sales of lasers used for metal cutting and welding. Within cutting applications, decreased sales were attributable to a weaker global demand and continued competition affecting average selling prices. Part of the decline in average selling prices for high power lasers is due to the adoption of more compact or rack mounted "YLR" series lasers which are displacing 1 to 3 kilowatt "YLS" series lasers which are larger and cannot be rack mounted. These more compact YLR lasers are less expensive to manufacture and are sold at prices lower than the YLS series lasers they are displacing. The decrease in sales of high power lasers used in welding applications was driven by lower sales into general manufacturing industries. •The decrease in medium power sales related to ongoing transition to kilowatt scale cutting lasers and decreased demand in laser sintering for metal-based additive manufacturing. •The increase in pulsed laser sales was due to growth in sales of high power pulsed lasers used for ablative and battery processing applications, partially offset by decreased demand of pulsed lasers used for marking and engraving applications. •QCW laser sales decreased due to lower demand for fine processing and consumer electronics applications. 22 -------------------------------------------------------------------------------- Table of Contents •The decrease in laser and non-laser systems sales was due to lower demand of both laser and non-laser systems. The reduction of revenue in laser systems was attributable to lower demand for laser systems used for cutting and welding applications. The reduction of revenue in non-laser systems was attributable to lower demand in the transportation and aerospace sectors. •Other Revenue for materials processing decreased due to lower demand of parts and service. Other Applications Sales from other applications increased due to increased demand for lasers used for medical procedures, government applications, and semiconductor applications, partially offset by lower sales of telecom products. Cost of sales and gross margin. Cost of sales decreased by$43.4 million , or 12.4%, to$306.3 million for the six months endedJune 30, 2020 from$349.7 million for the six months endedJune 30, 2019 . Our gross margin decreased to 43.9% for the six months endedJune 30, 2020 from 48.5% for the six months endedJune 30, 2019 . Gross margin decreased mainly due an increase in unabsorbed manufacturing costs and a decrease in average selling prices compared to the six months endedJune 30, 2019 . Sales and marketing expense. Sales and marketing expense decreased by$3.9 million , or 9.8%, to$36.0 million for the six months endedJune 30, 2020 from$39.9 million for the six months endedJune 30, 2019 , primarily as a result of decreases in expenses related to personnel, travel, trade fairs and exhibits and marketing. As a percentage of sales, sales and marketing expense increased to 6.6% of sales for the six months endedJune 30, 2020 from 5.9% for the six months endedJune 30, 2019 , mainly due to the decrease in sales. Research and development expense. Research and development expense decreased by$4.0 million , or 5.9%, to$63.4 million for the six months endedJune 30, 2020 , compared to$67.4 million for the six months endedJune 30, 2019 , primarily as a result of a decrease in expenses related to materials used for research and development projects, personnel, consultants, travel and training. Research and development continues to focus on developing new products, enhancing performance of existing components, improving production processes and developing manufacturing of new components such as crystals and refining production processes to improve manufacturing yields and productivity. New products include lasers that operate at different wavelengths such as UV, visible and mid-IR, lasers with ultrafast pulses, laser based systems for material processing, projection, display and medical as well as accessories such as welding and cutting heads. In addition to new products, research and development is focused on enhancing the performance of our existing products by improving their electrical efficiency and increasing their average power. As a percentage of sales, research and development expense increased to 11.6% for the six months endedJune 30, 2020 from 9.9% for the six months endedJune 30, 2019 , mainly due to the decrease in sales. General and administrative expense. General and administrative expense decreased by$2.3 million , or 4.1%, to$53.5 million for the six months endedJune 30, 2020 from$55.8 million for the six months endedJune 30, 2019 , primarily as a result of decreases in expenses for bad debt, travel, legal, personnel, recruitment and consultants, partially offset by increases in insurance, depreciation, and information systems. As a percentage of sales, general and administrative expense increased to 9.8% for the six months endedJune 30, 2020 from 8.2% for the six months endedJune 30, 2019 , mainly due to the decrease in sales. Impairment of long-lived assets and other restructuring charges. We incurred impairment of long-lived assets and other restructuring charges of$1.2 million in total for the six months endedJune 30, 2020 , of which$0.4 million related to severance and$0.1 million related to lease termination costs as part of restructuring of our submarine network division. We also incurred$0.7 million of non-cash long-lived impairments related to machinery and equipment. Effect of exchange rates on net sales, gross profit and operating expenses. We estimate that, if exchange rates relative to theU.S. Dollar had been the same as one year ago, which were on averageEuro 0.89 ,Russian Ruble 65 ,Japanese Yen 110 and ChineseYuan 6.79 , respectively, we would have expected net sales for the six months endedJune 30, 2020 to be$13.4 million higher, gross profit to be$6.7 million higher and total operating expenses would have been$2.5 million higher. (Gain) loss on foreign exchange. We incurred a foreign exchange gain of$6.8 million for the six months endedJune 30, 2020 as compared to a loss of$6.7 million for the six months endedJune 30, 2019 . The gain for the six months endedJune 30, 2020 was primarily attributable to depreciation of the Russian Ruble, partially offset by the depreciation of the Chinese Yuan as compared to theU.S. Dollar. The loss for the six months endedJune 30, 2019 was primarily attributable to the appreciation of the Russian Ruble and depreciation of the Chinese Yuan as compared to theU.S. Dollar. Interest income (expense), net. Interest income (expense), net, decreased to$4.9 million of income for the six months endedJune 30, 2020 as compared to$8.0 million of income for the six months endedJune 30, 2019 . The reduction in interest 23 -------------------------------------------------------------------------------- Table of Contents income, net, is due to holding shorter duration investments to increase liquidity as well as a decrease in yields on shorter duration investments that resulted in lower market interest rates as compared to rates last year. Provision for income taxes. Provision for income taxes was$22.4 million for the six months endedJune 30, 2020 compared to$40.6 million for the six months endedJune 30, 2019 , representing an effective tax rate of 23.0% and 24.2% for the six months endedJune 30, 2020 and 2019, respectively. For the six months endedJune 30, 2020 and 2019, the net discrete tax benefits were$5.9 million and$2.9 million , respectively, primarily related to the tax deductions for equity-based compensation that exceeded compensation expense recognized and for an investment credit inRussia related to prior years for which an amended return was filed during the six months endedJune 30, 2020 . Net income attributable toIPG Photonics Corporation . Net income attributable toIPG Photonics Corporation decreased by$52.8 million to$74.6 million for the six months endedJune 30, 2020 compared to$127.4 million for the six months endedJune 30, 2019 . Net income attributable toIPG Photonics Corporation as a percentage of our net sales decreased by 5.1 percentage points to 13.7% for the six months endedJune 30, 2020 from 18.8% for the six months endedJune 30, 2019 due to the factors described above. Liquidity and Capital Resources The following table presents our principal sources of liquidity: June 30, December 31, 2020 2019 (In thousands) Cash and cash equivalents$ 747,859 $ 680,070 Short-term investments 501,040 502,546 Unused credit lines and overdraft facilities 129,909 105,469
Working capital (excluding cash, cash equivalents, restricted cash and short-term investments)
506,341 522,114 Short-term investments atJune 30, 2020 , consist of liquid investments including corporate notes, commercial paper and certificates of deposit with original maturities of greater than three months but less than one year. We also hold long-term investments, included in other assets on the condensed consolidated balance sheets, which consist of auction rate securities totaling$0.6 million . See Note 5, "Fair Value Measurements" in the notes to the condensed consolidated financial statements for further information about our short and long-term investments. The COVID-19 pandemic is likely to reduce cash generated from operations as compared to previous levels due to a decrease in net income and because we may choose not to or be able to reduce working capital. Investment in working capital might need to be maintained or increased due to a need to maintain a higher level of inventory because of supply chain disruptions and an increase in accounts receivable days if customers delay payments. In addition, cash from operations could be affected by various risks and uncertainties, including, but not limited to, the effects of the COVID-19 pandemic and other risks detailed in Item 8.01 of the Current Report on Form 8-K filed with theSEC onMay 5, 2020 and "Management's Discussion and Analysis - Factors and Trends that Affect our Operations and Financial Results" in this Quarterly Report on Form 10-Q. Although we expect the COVID pandemic to adversely affect our cash flow from operations, we believe that our existing cash, cash equivalents and investment balances, anticipated cash flows from operations and available credit facilities will be sufficient to meet our working capital and operating resource expenditure requirements for the next twelve months. We also expect to continue investments in capital expenditures, to assess acquisition opportunities and to repurchase shares of our stock in accordance with our repurchase program, although the extent and timing of such expenditures may be adjusted in response to the impact of COVID-19 on our operations, cash flow and other factors. Our future long-term capital requirements will depend on many factors including our level of sales, the impact of the economic environment on our growth, global or regional recessions, the timing and extent of spending to support development efforts, expansion of the global sales and marketing activities, government regulation including trade sanctions, the timing and introductions of new products, the need to ensure access to adequate manufacturing capacity and the continuing market acceptance of our products. 24 -------------------------------------------------------------------------------- Table of Contents The following table details our line-of-credit facilities and long-term notes as ofJune 30, 2020 : Description Total Facility/ Note Interest Rate Maturity Security U.S. Revolving Line of Credit$75.0 million LIBOR plus 0.80% to April 2025 Unsecured (1) 1.20%, depending on our performance Euro Credit FacilityEuro 50.0 million Euribor plus 0.75% or July 2023 Unsecured, (Germany) (2) ($56.1 million ) EONIA plus 1.00% guaranteed by parent company and German subsidiary Other Euro Facility (3)Euro 2.0 million Euribor plus 0.89% to September 2020 Common pool of ($2.2 million ) 1.78% assets of Italian subsidiary Long-term Secured Note (4)$20.8 million Fixed at 2.74% July 2022 Secured by the corporate aircraft Long-term Unsecured Note (5)$19.0 million 1.20%
above LIBOR, May 2023 Unsecured fixed using an interest rate swap at 2.85% per annum (1) This facility is available to certain foreign subsidiaries in their respective local currencies. AtJune 30, 2020 , there were no amounts drawn on this line; however, there were$1.2 million of guarantees issued against the line which reduces total availability. (2) This facility is also available to certain foreign subsidiaries in their respective local currencies. AtJune 30, 2020 , there were no drawings on this facility; however, there were$2.3 million of guarantees issued against the line which reduces total availability. (3) AtJune 30, 2020 , there were no drawings. This facility renews annually. (4) At maturity, the outstanding note balance will be$15.4 million . (5) At maturity, the outstanding note balance will be$15.4 million . Our largest committed credit lines are withBank of America N.A . and Deutsche Bank AG in the amounts of$75.0 million and$56.1 million (or50.0 million Euro as described above), respectively, and neither of them is syndicated. OnApril 22, 2020 , we amended the Euro credit facility with Deutsche Bank AG, extending its maturity throughJuly 31, 2023 . We plan to seek amendments of our credit agreements and notes to modify LIBOR and Euribor reference rates as these rates are phased out as borrowing rates. We are required to meet certain financial covenants associated with ourU.S. revolving line of credit and long-term debt facility. These covenants, tested quarterly, include an interest coverage ratio and a funded debt to earnings before interest, taxes, depreciation and amortization ("EBITDA") ratio. The interest coverage covenant requires that we maintain a trailing twelve-month ratio of EBITDA to interest on all obligations that is at least 3.0:1.0. The funded debt to EBITDA covenant requires that the sum of all indebtedness for borrowed money on a consolidated basis be less than three times our trailing twelve months EBITDA. Funded debt is decreased by our cash and available marketable securities not classified as long-term investments in theU.S.A. in excess of$50 million up to a maximum of$500 million . We were in compliance with all such financial covenants as of and for the three months endedJune 30, 2020 . The financial covenants in our loan documents may cause us to not make or to delay investments and actions that we might otherwise undertake because of limits on capital expenditures and amounts that we can borrow or lease. In the event that we do not comply with any one of these covenants, we would be in default under the loan agreement or loan agreements, which may result in acceleration of the debt, cross-defaults on other debt or a reduction in available liquidity, any of which could harm our results of operations and financial condition. See Note 10, "Financing Arrangements" in the notes to the condensed consolidated financial statements for further information about our facilities and term debt. 25 -------------------------------------------------------------------------------- Table of Contents The following table presents cash flow activities: Six Months Ended June 30, 2020 2019 (In thousands) Cash provided by operating activities$ 130,256 $
101,779
Cash used by investing activities (35,204)
(106,258)
Cash used by financing activities (23,471)
(4,143)
Operating activities. Net cash provided by operating activities increased by$28.5 million to$130.3 million for the six months endedJune 30, 2020 from$101.8 million for the six months endedJune 30, 2019 . In 2020, net sales and net income decreased by 20% and 41%, respectively. As there were decreases in net sales and net income, cash provided by net income after adding back non-cash charges decreased. This decrease has been offset by a decrease in the amount invested in working capital. Our largest working capital items typically are inventory and accounts receivable. Items such as accounts payable to third parties, prepaid expenses and other current assets and accrued expenses and other liabilities are not as significant as our working capital investment in accounts receivable and inventory because of our vertically integrated structure. Accruals and payables for personnel costs including bonuses and income and other taxes payable are largely dependent on the timing of payments for those items. The increase in cash flow from operating activities in 2020 primarily resulted from an increase in cash provided by accounts receivable, a decrease in cash used by inventory and a decrease in cash used by income and other taxes payable; partially offset by a decrease in cash provided by net income after adding back non-cash charges. Investing activities. Net cash used in investing activities was$35.2 million for the six months endedJune 30, 2020 as compared to cash used in investing activities of$106.3 million in 2019. The cash used in investing activities in 2020 related to$37.4 million of capital expenditures, partially offset by$1.6 million of net proceeds of short-term investments. The cash used in investing activities in 2019 related to$86.5 million of capital expenditures,$15.1 million for acquisition of business and$5.1 million of net purchases of short-term investments. We expect to incur approximately$100 million in capital expenditures, excluding acquisitions, in 2020. Capital expenditures include investments in facilities and equipment to add capacity in selected countries, add redundancy in specialized manufacturing and support our research and development efforts. The timing and extent of any capital expenditures in and between periods can have a significant effect on our cash flow. If we obtain financing for certain projects, our cash expenditures would be reduced in the year of expenditure. Many of the capital expenditure projects that we undertake have long lead times and are difficult to cancel or defer to a later period. Financing activities. Net cash used in financing activities was$23.5 million for the six months endedJune 30, 2020 as compared to net cash used of$4.1 million in 2019. The cash used in financing activities in 2020 was related to the purchase of treasury stock of$28.2 million ,$1.9 million of principal payments on our long-term borrowings and$1.7 million of payment of a purchase price holdback from a business combination, partially offset by$8.3 million from the exercise of stock options net of amounts disbursed in relation to shares withheld to cover employee income taxes due upon the vesting and release of restricted stock units. The cash used in financing activities in 2019 was related to the purchase of treasury stock of$2.3 million and$1.8 million of principal payments on our long-term borrowings. Cautionary Statement Regarding Forward-Looking Statements This Quarterly Report on Form 10-Q contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, and we intend that such forward-looking statements be subject to the safe harbors created thereby. For this purpose, any statements contained in this Quarterly Report on Form 10-Q except for historical information are forward-looking statements. Without limiting the generality of the foregoing, words such as "may," "will," "expect," "believe," "anticipate," "intend," "could," "estimate," or "continue" or the negative or other variations thereof or comparable terminology are intended to identify forward-looking statements. In addition, any statements that refer to projections of our future financial performance, trends in our businesses, or other characterizations of future events or circumstances are forward-looking statements. The forward-looking statements included herein are based on current expectations of our management based on available information and involve a number of risks and uncertainties, all of which are difficult or impossible to accurately predict and many of which are beyond our control. As such, our actual results may differ significantly from those expressed in any forward-looking statements. Factors that may cause or contribute to such differences include, but are not limited to, those discussed in more detail in Item 1, "Business" of Part I of the Form 10-K for the year endedDecember 31, 2019 (the "Annual Report") and in the Current Report on Form 8-K, filed onMay 5, 2020 , with theSEC (the "May 5 Current Report"). Readers should carefully review these risks, as well as the additional risks described in other documents we file from time to time with the Securities and 26
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Table of ContentsExchange Commission . In light of the significant risks and uncertainties inherent in the forward-looking information included herein, the inclusion of such information should not be regarded as a representation by us or any other person that such results will be achieved, and readers are cautioned not to rely on such forward-looking information. We undertake no obligation to revise the forward-looking statements contained herein to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. Recent Accounting Pronouncements See Note 2 in the Notes to Condensed Consolidated Financial Statements for a full description of recent accounting pronouncements, including the respective dates of adoption or expected adoption and effects on our condensed consolidated financial statements contained in Item 1 of this Quarterly Report.
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