Phuchit/iStock via Getty Images

Phuchit/iStock via Getty Images

The year 2020 was a good year for IPG Photonics Corporation (NASDAQ:IPGP ) as the stock gained 54% that year. The year 2021, on the other hand, is unlikely to follow in its footsteps with the stock down 26% YTD with less than two months to go in 2021. The stock started out well, but it's now 36% off the high set in early 2021. However, this also raises the question as to whether IPGP is worth buying at this point. Some may see IPGP as a bargain since the stock has fallen by so much. Why some may be willing to take a shot, others may want to hold off. Why will be covered next.

IPGP had a very strong start to 2021 with the stock gaining as much as 16% in the first couple of weeks of 2021, following a gain of 54% in 2020. However, this momentum could not be sustained. The stock has gradually declined for most of 2021, which includes a drop of 18% after a disappointing Q2 report as covered in a previous article.

The chart above shows how the stock has been trending lower. Lows are going lower and highs are also going lower. Note that the trend was already in force before the Q2 report was released. The stock did buck the trend recently when it jumped 9% following the release of the Q3 report, helping it close above the 50-day moving average. But this was not to last. The stock has given back most of the gains post earnings release.

The market reacted well initially to the Q3 numbers, but it seems to have changed its mind on second thought. It appears the headline numbers somewhat overstate how well IPGP is doing, even if there were a number of encouraging signs in the report, especially the strong rebound in the U.S. and Europe. Still, some of the headline numbers do look quite appetizing.

Q3 revenue increased by 19.1% YoY to $379.2M, the sixth consecutive sequential increase in quarterly revenue. EPS increased by an impressive-looking 112.1% YoY to $1.40, the fourth consecutive quarterly increase, but YoY comparisons were skewed by the fact that Q3 FY2020 earnings were weighed down by a goodwill impairment charge of $44.6M.

It's also worth mentioning the role fluctuations in foreign currency exchange rates had on boosting the Q3 numbers. For instance, EPS benefited from a foreign exchange gain of $2M or $0.04 per share. The top line benefited from forex as well. If not for forex, revenue and gross profit would be $9M and $6M less, respectively. In other words, if not for forex, quarterly revenue would have declined sequentially instead of increasing for the sixth consecutive time. The table below shows the numbers for Q3 FY2021.

Guidance calls for Q4 FY2021 revenue of $330-360M, an increase of 2.5% YoY at the midpoint. At the same time, it's also a decline of 9% QoQ, which means IPGP's streak of sequential increases in quarterly revenue is expected to end at six. The forecast expects EPS of $1.00-1.30, an increase of 25% YoY at the midpoint, but a decrease of 17.9% QoQ.

While it may be too early to tell, there seems to be a topping out of growth at IPGP. Both the top and bottom line are expected to decline QoQ after increasing in the prior quarters. The chart below depicts revenue growth in recent quarters. IPGP has yet to get back to the highs in 2017/2018 and growth may be flattening out. The question is whether the expected decline in Q4 will just be a temporary blip or the start of an extended decline, similar to what happened to IPGP in the not too distant past.

While management would not provide any hard numbers, it did reiterate its optimism for the coming year. IPGP is banking on demand getting a lift from new products and other growth drivers like increased adoption of electrical vehicles. From the Q3 earnings call:

"Overall though, we remain really quite optimistic about next year. You got major growth drivers that we talked about. The macro trends out there with EV battery manufacturing, EV motor manufacturing, Body-in-White applications, new product introductions in the other parts of the welding market with LightWELD, growth in medical applications. High-power cutting market transitioning to much higher power levels globally, as well as in China."

A transcript of the Q3 FY2021 earnings call can be found here.

Still, if IPGP does encounter difficulties in 2022, China is likely to play a key role. Recall how China was an important factor as to why IPGP went through a stretch of nine consecutive quarters with declining revenue, starting in Q3 FY2018 and ending in Q3 FY2020. The downturn coincided with the start of the U.S.-China trade war as noted in an earlier article.

IPGP has left this episode behind and recent quarters have benefited from much better contributions from China. The table above shows how sales in China surged forward after the economy recovered from COVID-19 in early 2020. IPGP returned to positive growth in Q4 FY2020 with China playing a key role in the turnaround. China accounted for 41.8% of revenue in FY2020 and was actually the only sales region not to contract in FY2020.

However, demand in China seems to be weakening again, a development that came up in the Q2 FY2021 report, which in turn was a big reason for the subsequent selloff. Revenue from China increased by just 9.5% YoY in Q2, much slower than before. China still accounted for 36% of total revenue in Q3, but revenue declined by 7.3% YoY. All other regions grew as shown in the table below.

It's worth noting that what's happening now in China may be a preview of what could happen in other regions. Unlike other regions, China did not have the benefit of comps. The economy in China had pretty much recovered in Q3 FY2020 after an earlier COVID-19 outbreak. Europe and North America, on the other hand, were only beginning to recover after the lockdowns in the first half. Unlike China, the base was still low in the rest of the world. The YoY comparisons are reflective of this. What remains to be seen is whether other regions will follow China's example by also slowing down once they return to pre-pandemic levels.

IPGP has fallen in 2021, but that also means valuations are down. IPGP derives most of its revenue from materials processing and the table below shows how IPGP compares against some of the companies it considers competitors in its most recent Form 10-K. Included are Coherent (COHR), Lumentum (LITE) and nLIGHT (LASR). Note that II-VI's (IIVI) proposed acquisition of COHR caused multiples for the latter to spike, even with a net loss.

IPGP trades at a premium or a discount to the sector median, depending on which metric is used. For instance, EV/EBITDA and P/B look better, but P/E and P/S are worse off. All in all, IPGP is not what you would call a bargain, even though the stock has dropped by a lot. IPGP looks better in terms of the balance sheet with a cash balance of $1.5B, which is why its enterprise value is so much lower than its market cap.

The Q3 FY2021 quarterly report was unique in one way. It was the first that did not include the founder due to his passing on October 22. His contributions to the fiber laser industry will forever be remembered. If it wasn't for him, IPGP would not be what it is. Its products are arguably the best in class. With demand expected to grow as new use cases for lasers pop up, the future looks bright for IPGP in the long run. IPGP does have its strong points.

However, in the short term, things may be different. While the sky is still mostly clear, clouds seem to be gathering on the horizon. The headline numbers looked good with EPS more than doubling in Q3, but they look less so under the hood. Forex and comps skewed the numbers in favor of IPGP. While revenue and earnings continue to increase, growth seems to be topping out. The low end of Q4 guidance calls for revenue to shrink YoY for the first time since Q3 FY2020. Revenue and EPS have grown sequentially for some time, but they are expected to shrink in Q4 and it would have happened even sooner if not for forex boosting the Q3 numbers.

China seems to be the canary in the coal mine for IPGP. China gave IPGP a lift in previous quarters, but it now seems to be doing the opposite. The U.S. and Europe have done better, but that may only be due to China having a head start on everyone else. The market seems to believe IPGP is peaking, which could explain the stock's poor performance in 2021 after a very good 2020.

I am neutral on IPGP. IPGP is doing what it can to reduce its exposure to China, but those efforts will take time. China is still its biggest market and, as such, China is able to sway the quarterly numbers like no one else can. The numbers from China are going down, which may be a preview of what awaits other regions like the U.S. and Europe. If China goes down, there will be even more pressure on the U.S. market to make up for the loss with increased infrastructure spending.

The quarterly numbers itself are heading the wrong way, even though the headlines still look fine. The stock is trending down, a sign the market believes IPGP is heading for a bumpy ride ahead. There's room for the stock to move up within a descending channel, but that does not mean the direction of the channel is not pointing down. There may come a time for long IPGP, but with the way the cards are laid out, right now is most likely not the time.

This article was written by

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.