Phuchit/iStock via Getty Images

Phuchit/iStock via Getty Images

Going positive on IPG Photonics (NASDAQ:IPGP ) back in August has turned out to be a bad call. Not only has geopolitical tension with Russia created worries about how IPG Photonics could be impacted by potential sanctions against Russia, but the company appears to be losing even more share in China, and management is now talking about 2022 as a "reset" year for the business at a time when short-cycle industrial companies are doing rather well from a revenue perspective.

IPG shares are definitely beaten down, falling almost 20% from the time of that last article and trading at a forward multiple that the shares haven't seen in approximately six years. I think there's still some appeal here for patient contrarian investors, but one of my long-time concerns about the company - growing competition from Chinese fiber laser companies - is still very much in play and I think investors need to be aware of the risks around this business.

IPG reported 9% year-over-year constant currency revenue growth in the quarter, beating expectations by more than 3%. Looking at a liberally-defined peer group including Kennametal (KMT), Lincoln Electric (LECO), and Sandvik (OTCPK:SDVKY) - all of which are major players in metalworking, a key market for IPG - IPG's numbers compare unfavorably to the 11% to 19% growth seen in those other names. A more direct comp, nLIGHT (LASR), will report after the close on Thursday, February 17.

IPG saw notable weakness in its high-power laser business, with sales down 19% on significant weakness in China. Growth was far stronger in other categories, including medium-power, pulsed, and QCW lasers, all growing 28% to 32%.

Despite significant internal manufacturing capabilities, IPG is not immune to the global supply pressures of today, and while gross margin improved almost two points from the year-ago period (to 45.5%), it declined 350bp sequentially and missed expectations by more than three points. More efficient operations clawed some of that back, and operating income grew 30% year over year, but operating margin (up almost four points to 23.3%) still missed by about a point.

IPG's revenue from China declined 20% in the quarter, to about 30% of total revenue. While growth outside of China was strong (North America up 26%, Europe up 37%), the weakness in China seems beyond what can be explained just by weaker end-markets.

While IPG's management seemed to try to contextualize the weak results in China as a market issue, I don't believe that's the case, or at least not wholly the case. Neither Han's Laser nor Raycus has reported fourth quarter results, but preliminary Q4 results from Han's Laser made no mention of meaningful weakness in the high-power laser market, and both Han's Laser and Raycus have been outgrowing IPG in China for some time now and by meaningful amounts.

Moreover, I think there are other signs that the Chinese market isn't so badly off. Fanuc (OTCPK:FANUY) (a manufacturer of machine tool components, machine tools, and robots) posted 18% growth in China in the December quarter and called demand "astonishingly high". Yaskawa (OTCPK:YASKY) posted 24% growth in China in the same quarter.

That said, Lincoln Electric did note weakness in China in the quarter, so I won't argue that there are no challenges in the Chinese market at present, and Lincoln is definitely a closer comp to IPG than either Fanuc or Yaskawa.

In any case, management at IPG is reprioritizing its business to focus on opportunities outside of China, and I think that's the right move. There are still growing markets for high-power cutting and welding lasers outside of China, and Chinese vendors have yet to make meaningful inroads into North America or Europe so far. Likewise, companies like Han's Laser and Raycus aren't really addressing growth opportunities like medical and telecom, and they don't have the R&D capabilities that IPG possesses. That said, with Han's Laser and Materialise (MTLS) announcing a partnership last year to develop lasers for 3D printing, IPG can't afford to rest on its laurels outside of China either.

IPG's long-term outlook depends critically upon the company's ability to stay at the forefront of technology and find applications for high-end offerings that its Chinese rivals can't offer. This includes lasers above 10kW, QCW lasers, green pulsed lasers, and ultraviolet lasers, many of which are useful in applications where very precise connections have to be made between thin layers of different metals (like in batteries or solar panels).

While IPG has always managed to maintain leadership on the leading edge of fiber laser capabilities, market development has been more erratic - opportunities like OLED manufacturing never really panned out and markets like medical and additive manufacturing have been erratic.

On top of this, geopolitical turbulence is also roiling the outlook. Nearly 30% of IPG's workforce is in Russia, including substantial manufacturing, R&D, and management personnel, and Russia supplies components for the U.S. and Germany operations, as well as finished lasers for China. While the sanctions tied to Russia's prior involvement in Ukraine in 2014 didn't really impact the business, it's impossible to say where the current situation between Russia, Ukraine, and Western countries will lead.

Although management believes they'll return to double-digit growth after a "reset" year in 2022, I'm not modeling that. Instead, I expect around 5% revenue growth in 2022, followed by high single-digit growth for a few years thereafter and long-term annualized growth of around 6%.

I also don't expect IPG to ever return to the mid-50%s gross margins of the past. I think mid-to-high 40%s is probably about the best investors can expect on a sustained basis, along with operating margins in the mid-20%s to low-30%s. Given the impact Chinese competitors have already had on the business, I do see risk to those margin estimates, as IPG may be forced to increasingly compete on price in the future.

Discounting my revised cash flow estimates, I believe IPG shares are priced for a very high single-digit total annualized long-term return, provided those margins hold up. Looking at EV/EBTIDA, IPGP's margins and prospective returns would normally support a forward multiple around 16.5% to 17%, leading to a fair value of around $184 or so. At present, though, the multiple is back to around 12x forward EBITDA - a level the shares haven't seen in six years (when the stock used to typically trade between 10x and 12x forward EBITDA).

It's possible that IPG's competitive environment has changed so thoroughly (and permanently) that 30%-plus operating margins and mid-to-high teens EBITDA multiples are no longer reasonable or accurate inputs. Certainly, the arrow is pointing "down" right now, and this is a company that has struggled for years with intensifying competition from China. Although I can see value here and a path forward to market-beating returns, this is a very risky name that has to rebuild its credibility with the Street and faith in the long-term growth story.

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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.