Once upon a time, fiber laser manufacturer IPG Photonics (IPGP -0.04%) saw nothing but blue skies ahead. The global economy was booming for years, driving a strong demand for laser-based manufacturing systems. The upcoming debut of 5G wireless systems promised to unlock equally fantastic growth in communication systems lasers.
Heading into the second-quarter earnings report of 2018, sales were expected to increase more than 10% year over year alongside 15% higher earnings. IPG's stock had quadrupled in five years, returning 1,230% in 10 years.
However, IPG missed analyst expectations across the board in that game-changing report, and management's guidance set a low bar for the upcoming quarter. The company missed those below-expectations targets, as well, and IPG has continued to fall short of both management's guidance and analysts' estimates ever since. The stock is trading 40% below the price it held just before that gruesome second-quarter report, two summers ago.
I think that this disappointing streak of six straight earnings misses will end in 2020. Here's why.
The reasons behind IPG's cyclical swings
IPG's business fortunes are tightly tied to the ups and downs of the global economy. When times are good, manufacturing-grade lasers are in high demand and orders supporting the worldwide network of communications infrastructure are booming. Anybody who tells you that the global economy is just fine at the end of 2019 is trying to sell you something.
The trade war between Washington and Beijing only added force to IPG's macroeconomic headwinds. In the recently reported third quarter of 2019, sales to Chinese customers fell 24%, to $121 million. It's important to note that China still constitutes IPG's largest geographical market, at 37% of total third-quarter sales. That's down from 45% in the year-ago period but still a very significant order flow.
More detail on the Chinese situation
It's true that the trade-war tariffs are slowing down IPG's business, but perhaps not as directly as you thought.
IPG's vertically integrated manufacturing model allows the company to draw on internal resources, where others might need to buy components and services from other companies, triggering border-crossing tariffs along the way. This company makes its own light-emitting diodes along with other components and the automated testing and manufacturing tools required to make a complete fiber laser module.
The production lines are split between the U.S., Germany, and Russia, which allows IPG to deliver its products from facilities that aren't subject to trade-hampering limitations such as tariffs. American customers can get their lasers straight from an American factory, while Chinese clients are more likely to rely on IPG's Russian and German production lines.
So tariffs don't really affect IPG's sales or its manufacturing costs. The pressure on the company's Chinese sales stems from its customers reducing their own manufacturing capacity due to the difficulty of exporting their products to America.
The Chinese market is actually more volatile than weak for IGP, despite the big revenue drop in the third quarter. In IPG's second-quarter earnings call, CFO Time Mammen said:
There is some underlying demand that exists in China. It gets switched off when business uncertainty [causes] declines and it comes back when there is some confidence in the business environment. So I wouldn't say there is no demand for lasers in China, it's just volatile at the moment and that's the challenge that we're dealing with.
China doesn't have any domestically produced alternatives to some of IPG's most important products. IPG commands a 70% market share in the global market for fiber lasers with outputs of at least 5 kilowatts, and the only real competition in that sector comes from fellow American company Coherent. Chinese laser builders simply can't compete here.
What IPG's investors should look for
I'm not saying that IPG Photonics is going to smash analyst targets to smithereens in January's fourth-quarter report, but the company will absolutely come back swinging once the Chinese-American trade wars come to an end. Buying shares of IPG amounts to a bet on improving international relations in our lifetime. That might not happen in 2020, but I wouldn't be surprised to see the Trump administration bend over backward to get there faster. It's an election year, after all. Putting a stop to this artificial crisis could help the sitting president stay in power.
I expect the trade wars to end in 2020 due to a combination of financial fallout from the tariff slinging and pure political pandering. Call me a cynic or call me an optimist, but that would allow IPG to stun Wall Street with a strong rebound. The company will continue to deliver solid but unimpressive profits in the meantime, amid weaker top-line revenues, but the big bounce will be triggered in a hurry when the trade conflict goes away.