Summary of IPG PHOTONICS CORP

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
You should read the following discussion in conjunction with our 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 and manufacture a broad line of high-performance fiber lasers, fiber amplifiers and diode lasers for diverse applications in numerous markets. Our diverse lines of low, mid and high-power lasers and amplifiers are used in materials processing, advanced, communications and medical applications. We sell our products globally to original equipment manufacturers, or OEMs, system integrators and end users. We market our products internationally primarily through our direct sales force and also through agreements with independent sales representatives and distributors.
We are vertically integrated such that we design and manufacture all key components used in our finished products, from semiconductor diodes to optical fiber preforms, finished fiber lasers and amplifiers. Since our formation in 1990, we have been focused on developing and manufacturing high-power fiber lasers and amplifiers.
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.
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, and seasonal factors such as the purchasing patterns and levels of activity throughout the year in the regions where we operate. Historically, our net sales have been higher in the second half of the year than in the first half of the year. Furthermore, 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. 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 further penetrate new markets or obtain new customers. Our net sales can also be affected from quarter to quarter by the general level of worldwide economic activity, including economic expansion or contraction, and expenditures on capital equipment. In general, increases in worldwide economic activity have a positive effect on our sales and decreases in economic activity have a negative effect our sales.
Gross margin. Our total gross margin in any period can be affected by total net sales in any period, product mix, that is, the percentage of our revenue in that period that is attributable to higher or lower-power products, production volumes, changes to the sales prices of our products in response to the competitive environment and by other factors, some of which are not under our control. Our product mix affects our margins because the selling price per watt is higher for low-power and mid-power devices than for high-power devices. The overall cost of high-power lasers may be partially offset by improved absorption of fixed overhead costs associated with sales of larger volumes of higher-power products.
Due to the fact that we have high fixed costs, our costs are generally difficult or slow to adjust in response to changes in demand. In addition, our fixed costs increase as we expand our capacity. Gross margins generally decline if production volumes are lower as a result of a decrease in sales or inventory because the absorption of fixed manufacturing costs will be reduced. Gross margins generally improve when the opposite occurs. In addition, absorption of fixed costs can benefit gross margins due to an increase in production that is not sold and placed into inventory. If both sales and inventory decrease in the same period, the decline in gross margin may be magnified if we cannot reduce fixed costs or chose not to reduce fixed costs to match the decrease in the level of production. We also regularly review our inventory for items that are slow-moving, have been rendered obsolete or determined to be excess. If we experience a decline in sales that reduces absorption of our fixed costs, or if we have production issues or inventory write-downs, our gross margins will be negatively affected.
Sales and marketing expense. We expect to continue to expand our worldwide direct sales organization, build and expand applications centers, hire additional personnel involved in marketing in our existing and new geographic locations, increase the number of units used for demonstration purposes and otherwise increase expenditures on sales and marketing activities in order to support the growth in our net sales. As such, we expect that our sales and marketing expenses will increase in the aggregate.

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Research and development expense. We plan to continue to invest in research and development to improve our existing components and products and develop new components and products. We plan to increase the personnel involved in research and development and expect to increase other research and development expenses. As such, we expect that our research and development expenses will increase in the aggregate.
General and administrative expense. We expect our general and administrative expenses to increase moderately as we continue to invest in systems and resources to support our worldwide operations. Legal expenses vary from quarter to quarter based upon the stage of litigation, including patent re-examinations and termination of litigation stays but could increase in response to any future litigation or due to a change in status of current intellectual property matters. The timing and amount of legal expenses may vary substantially from quarter to quarter.
Major customers. 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 annual net sales were 29% in 2006, 20% in 2007, 17% in 2008, and 12% for the nine months ended September 30, 2009. We seek to add new customers and to expand our relationships with existing customers. We anticipate that the composition of our net sales to our significant customers will continue to change. If any of our significant customers were to substantially reduce their purchases from us, our results would be adversely affected. Our sales have been affected recently by a substantial reduction in purchases of pulsed lasers from several customers, including one that was formerly our largest customer for several years.
Results of Operations for the three months ended September 30, 2009 compared to the three months ended September 30, 2008 Overview. The worldwide economic downturn continued to negatively affect our results of operations for the three months ended September 30, 2009 as we experience continued weakness across many of our end markets, especially in materials processing. We continue to have limited longer term visibility to end market demand. Until end market demand becomes clearer, we will continue to focus on controlling costs and capital expenditures and reducing inventories in order to maximize cash flow. At the same time, we plan to continue to build on our technology by investing in new sales and application personnel and R&D for new products.
Net sales. Net sales decreased by $16.2 million, or 26.1%, to $45.8 million for the three months ended September 30, 2009 from $62.0 million for the three months ended September 30, 2008. This decrease was attributable to lower sales of fiber lasers in materials processing applications, where net sales decreased by $16.0 million or 31.4% and communications applications, where net sales decreased by $2.3 million or 53.6%. These decreases were partially offset by the increases in advanced applications, where net sales increased by $1.7 million, or 33.4%, and medical applications, where net sales increased by $0.4 million or 24.0%. The decrease in materials processing sales resulted from lower sales of high and medium power lasers and pulsed lasers used in welding, marking, engraving and drilling applications. The decrease in communications applications sales resulted primarily from decreased sales of amplifiers, particularly in Russia. The increase in sales of advanced applications was due to higher sales of high power lasers used in government and defense research and pulsed and low power lasers used for sensing and optical pumping applications. The increase in medical is due to the increased demand from our established customer in the US and new OEM customers.
Cost of sales and gross margin. Cost of sales decreased by $3.5 million, or 10.8%, to $29.1 million for the three months ended September 30, 2009 from $32.6 million for the three months ended September 30, 2008. Our gross margin decreased to 36.5% for the three months ended September 30, 2009 from 47.4% for the three months ended September 30, 2008. The decrease in gross margin was the result of less favorable absorption of our fixed manufacturing costs due to a decline in sales volume, less favorable product mix due to lower sales of medium power lasers and reduction of inventory as well as lower sales prices due to pricing pressure caused by the industry-wide reduction in demand. These cost of sales increases were partially offset by a reduction in manufacturing expenses in the period primarily related to reduced salaries and benefits expense and other manufacturing overhead. Expenses related to inventory reserves and other valuation adjustments decreased by $0.4 million to $1.3 million or 2.8% of sales for the three months ended September 30, 2009 as compared to $1.7 million or 2.7% of sales for the three months ended September 30, 2008.
Sales and marketing expense. Sales and marketing expense increased by $0.1 million, or 1.4%, to $3.8 million for the three months ended September 30, 2009 from $3.7 million for the three months ended September 30, 2008, primarily as a result of an increase in selling expenses related to depreciation of units used for demonstration purposes. As a percentage of sales, sales and marketing expense increased to 8.3% for the three months ended September 30, 2009 from 6.0% for the three months ended September 30, 2008. As we continue to expand our worldwide sales organization, we expect expenditures on sales and marketing to continue to increase in the aggregate although the near term increases may be more moderate.
Research and development expense. Research and development expense increased by $0.5 million, or 10.6%, to $4.6 million for the three months ended September 30, 2009 from $4.1 million for the three months ended September 30, 2008. This increase was primarily due to an increase of $0.2 million in material costs. Research and development activity continues to focus on enhancing the performance of our internally manufactured components, refining production processes to improve manufacturing yields, the development of new products operating at different wavelengths and higher output powers and new complimentary accessories used with our products. As a percentage of sales, research and development expense increased to 10.0% for the three months ended September 30, 2009 from 6.7% for the three months ended September 30, 2008.
General and administrative expense. General and administrative expense decreased by $1.3 million, or 21.5%, to $4.8 million for the three months ended September 30, 2009 from $6.1 million for the three months ended September 30, 2008, primarily due to a

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decrease of $0.9 million in bad debt, accounting, legal and contractor expenses. As a percentage of sales, general and administrative expense increased to 10.4% for the three months ended September 30, 2009 from 9.8% for the three months ended September 30, 2008. We expect that legal expenses will increase in future quarters in connection with defending two patent infringement actions against the Company.
Effect of exchange rates on Sales, Gross Margin and Operating Expenses. We estimate that if exchange rates had been the same as one year ago, our third quarter 2009 sales would have been $0.2 million higher, gross margin would have been $0.6 million higher and operating expenses in total would have been $0.2 million higher.
Gain on foreign exchange. Gain on foreign exchange decreased by $1.6 million to almost no gain or loss for the three months ended September 30, 2009 from a gain of $1.6 million for the three months ended September 30, 2008 and was primarily attributable to the stabilization of the Russian Ruble and appreciation of Japanese Yen and Korean Won against the U.S. Dollar off-set by the depreciation of the U.S. Dollar against the Euro.
Interest expense. Interest expense, net was $0.3 million for the three months ended September 30, 2009 compared to $0.2 million for the three months ended September 30, 2008. The change in interest expense resulted from increased utilization of credit lines.
Provision for income taxes. Provision for income taxes was $1.0 million for the three months ended September 30, 2009 compared to $5.3 million for the three months ended September 30, 2008, representing an effective tax rate of 31.5% for both the three months ended September 30, 2009 and 31.6% for the three months ended September 30, 2008.
Net income attributable to IPG Photonics Corporation. Net income attributable to IPG Photonics Corporation decreased by $8.6 million to $2.3 million for the three months ended September 30, 2009 from $10.9 million in income for the three months ended September 30, 2008. Net income attributable to IPG Photonics Corporation as a percentage of our net sales decreased by 12.7 percentage points to 4.9% for the three months ended September 30, 2009 from 17.6% for the three months ended September 30, 2008 due to the factors described above. Results of Operations for the nine months ended September 30, 2009 compared to the nine months ended September 30, 2008 Overview. The worldwide economic downturn continued to negatively affect our results of operations for the nine months ended September 30, 2009 as we experience continued weakness across many of our end markets, especially in materials processing. We continue to have limited longer term visibility to end market demand. Until end market demand becomes clearer, we will continue to focus on controlling costs and capital expenditures and reducing inventories in order to maximize cash flow. At the same time, we plan to continue to build on our technology by investing in new sales and application personnel and R&D for new products.
Net sales. Net sales decreased by $39.3 million, or 23.0%, to $131.6 million for the nine months ended September 30, 2009 from $170.9 million for the nine months ended September 30, 2008. This decrease was attributable to lower sales of fiber lasers in materials processing applications, where net sales decreased by $42.3 million or 29.8% and a decrease in communications applications, where net sales decreased by $2.3 million or 23.6%. These decreases were partially offset by the increases sales of advanced applications, where net sales increased by $3.7 million or 23.0% and in medical applications, where net sales increased by $1.7 million, or 57.0%. The decrease in materials processing applications resulted from substantially decreased sales of pulsed lasers and medium-power lasers used in marking, engraving and drilling applications. The decrease in communications applications sales resulted primarily from decreased sales of amplifiers, particularly in Russia. The increase in sales of advanced applications was due to higher sales of high power lasers used in government and defense research and pulsed and low power lasers used for sensing and optical pumping applications. The increase in medical is due to the increased demand from our established customer in the US and new OEM customers.
Cost of sales and gross margin. Cost of sales decreased by $2.9 million, or 3.2%, to $87.2 million for the nine months ended September 30, 2009 from $90.1 million for the nine months ended September 30, 2008. Our gross margin decreased to 33.7% for the nine months ended September 30, 2009 from 47.3% for the nine months ended September 30, 2008. The decrease in gross margin was the result of less favorable absorption of our fixed manufacturing costs due to a decline in sales volume, less favorable product mix due to lower sales of medium power lasers, a reduction in inventory, increases in charges related to inventory write-downs and lower prices due to pricing pressure caused by the industry-wide reduction in demand. These cost of sales increases were offset partially by a reduction in manufacturing expenses in the period, primarily, related to reduced salaries and benefits expense and other manufacturing supplies. Expenses related to inventory reserves and other valuation adjustments increased by $2.3 million to $5.6 million, or 4.3%, of sales for the nine months ended September 30, 2009 as compared to $3.3 million, or 1.9%, of sales for the nine months ended September 30, 2008.
Sales and marketing expense. Sales and marketing expense increased by $0.3 million, or 2.6%, to $10.9 million for the nine months ended September 30, 2009 from $10.6 million for the nine months ended September 30, 2008, primarily as a result of an increase in selling and depreciation expenses. As a percentage of sales, sales and marketing expense increased to 8.2% for the nine months ended September 30, 2009 from 6.2% for the nine months ended September 30, 2008. As we continue to expand our worldwide sales organization, we expect expenditures on sales and marketing to continue to increase in the aggregate although the near term increases may be more moderate.
Research and development expense. Research and development expense increased by $1.9 million, or 17.4%, to $13.4 million for the nine months ended September 30, 2009 from $11.5 million for the nine months ended September 30, 2008. This increase was

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primarily due to an increase of $1.2 million in material costs. Research and development activity continues to focus on enhancing the performance of our internally manufactured components, refining production processes to improve manufacturing yields, the development of new products operating at different wavelengths and higher output powers and new complimentary accessories used with our products. As a percentage of sales, research and development expense increased to 10.2% for the nine months ended September 30, 2009 from 6.7% for the nine months ended September 30, 2008.
General and administrative expense. General and administrative expense decreased by $3.5 million, or 19.5%, to $14.7 million for the nine months ended September 30, 2009 from $18.2 million for the nine months ended September 30, 2008, primarily due to a decrease of $1.6 million decrease in accounting and legal defense fees and a $1.8 million decrease in personnel and contractor expenses. We expect that legal expenses will increase in future quarters in connection with defending two patent infringement actions against the Company. As a percentage of sales, general and administrative expense increased to 11.2% for the nine months ended September 30, 2009 from 10.7% for the nine months ended September 30, 2008.
Effect of exchange rates on Sales, Gross Margin and Operating Expenses. We estimate that if exchange rates had been the same as one year ago, sales for the nine months ended September 30, 2009 would have been $4.2 million higher, gross margin would have been $2.5 million higher and operating expenses in total would have been $1.5 million higher.
Loss (gain) on foreign exchange. Loss (gain) on foreign exchange increased by $2.9 million to a loss of $1.0 million for the nine months ended September 30, 2009 from a gain of $1.9 million for the nine months ended September 30, 2008 and was primarily attributable to the depreciation of the Russian Ruble and Euro against the U.S. Dollar.
Interest expense. Interest expense, net was $1.0 million for the nine months ended September 30, 2009 compared to $0.5 million for the nine months ended September 30, 2008. The change in interest expense resulted from higher interest expense due to increased utilization of credit lines.
Provision for income taxes. Provision for income taxes was $1.0 million for the nine months ended September 30, 2009 compared to $13.4 million for the nine months ended September 30, 2008, representing an effective tax rate of 31.5% for both the nine months ended September 30, 2009 and for the nine months ended September 30, 2008.
Net income attributable to IPG Photonics Corporation. Net income attributable to IPG Photonics Corporation decreased by $25.3 million to $2.3 million for the nine months ended September 30, 2009 from $27.6 million for the nine months ended September 30, 2008. Net income attributable to IPG Photonics Corporation as a percentage of our net sales decreased by 14.4 percentage points to 1.7% for the nine months ended September 30, 2009 from 16.1% for the nine months ended September 30, 2008 due to the factors described above. Liquidity and Capital Resources
Our principal sources of liquidity as of September 30, 2009 consisted of cash and cash equivalents of $76.3 million, unused credit lines and overdraft facilities of $47.6 million and working capital (excluding cash) of $61.5 million. This compares to cash and cash equivalents of $51.3 million, unused overdraft facilities of $40.9 million and working capital (excluding cash) of $80.7 million as of December 31, 2008. The increase in cash and cash equivalents of $25.0 million from December 31, 2008 relates primarily to cash provided by operating activities during the nine months ended September 30, 2009 of $37.7 million, partially offset by capital expenditures of $9.6 million, net repayments of our credit lines of $4.4 million and the acquisition of non-controlling interests totaling $0.5 million.
We held approximately $1.3 million in auction-rate securities (ARSs) at September 30, 2009, all of which is included in other long-term assets. Our investments in ARSs at September 30, 2009 consisted solely of taxable municipal debt securities which are classified as long-term available for sale securities due to continued auction failures.
Our long-term debt consists of an $18.3 million secured variable-rate note which matures in July 2013. The note is secured by a mortgage on real estate and buildings in Massachusetts. We expect that the existing cash and marketable securities, our cash flows from operations and our existing lines of credit will be sufficient to meet our liquidity and capital needs for the foreseeable future. Our future long-term capital requirements will depend on many factors including our rate of net sales growth, the timing and extent of spending to support development efforts, the expansion of our sales and marketing activities, the timing and introductions of new products, the need to ensure access to adequate manufacturing capacity and the continuing market acceptance of our products. We have made no arrangements to obtain additional financing, and there is no assurance that such additional financing, if required or desired, will be available in amounts or on terms acceptable to us, if at all.

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The following table details our line of credit facilities as of September 30, 2009:

Description         Total Facility       Interest Rate          Maturity             Security
U.S. Revolving      $35 million        LIBOR plus 0.8% to    July 2011         Unsecured
Line of Credit                         1.2%, depending on
                                       the Company's
                                       performance

Euro Credit         Euro               Euribor + 1.0% or     September 2010    Unsecured,
Facility            15.0 million       EONIA + 1.5%                            guaranteed by
(Germany) (1)       ($21.9 million)                                            parent company

Euro Overdraft      Euro               2.82%-6.95%           Between           Common pool of
Facilities          3.2 million                              September 2009    assets of German and
                    ($4.6 million)                           and March 2010    Italian subsidiaries

(1) $4.0 million of this credit facility is available to our Russian subsidiary and $1.3 million is available to our Italian subsidiary

The Company is required to meet certain financial covenants associated with its U.S. revolving line of credit and long term debt facilities. These covenants, tested quarterly, include a debt service coverage ratio and a funded debt to earnings before interest, taxes, depreciation and amortization ("EBITDA") ratio. The debt service coverage covenant requires that we maintain a trailing twelve month ratio of cash flow to debt service that is greater than 1.5:1. Debt service is defined as required principal and interest payments during the period. Cash flow is defined as EBITDA less unfunded capital expenditures. For trailing twelve month periods until September 2010, up to $15.0 million of our capital expenditures are treated as being funded from the proceeds of our initial public offering. The funded debt to EBITDA covenant requires that the sum of all indebtedness for borrowed money on a consolidated basis be less than two times our trailing twelve months EBITDA. We were in compliance with all such financial covenants as of September 30, 2009.
The financial covenants in our loan documents may cause us to not take 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.
Operating activities. Net cash provided by operating activities in the nine months ended September 30, 2009 increased by $12.7 million to $37.7 million from $25.0 million in the nine months ended September 30, 2008 and primarily resulted from:
� A decrease in inventory of $2.8 million in 2009 compared to an increase of inventory of $21.8 million in 2008;

� A decrease in accounts receivable of $10.7 million in 2009 compared to an increase of $6.2 million in 2008; partially offset by

� A decrease in cash provided by net income after adding back non-cash charges of $23.9 million in 2009 as compared to 2008.

Given our vertical integration, rigorous and time-consuming testing procedures for both internally manufactured and externally purchased components and the lead time required to manufacture components used in our finished product, the rate at which we turn inventory has historically been low when compared to our cost of sales. We do not expect this to change significantly in the future and believe that we will have to maintain a relatively high level of inventory compared to our cost of sales. As a result, we continue to expect to have a significant amount of working capital invested in inventory.
Investing activities. Net cash used in investing activities was $9.5 million and $23.8 million in the nine months ended September 30, 2009 and 2008, respectively. The cash used in investing activities in the first nine months of . . .