Mar 10, 2008
Executives
Angelo Lopresti - Vice President, General Counsel and Secretary Valentin Gapontsev - Chairman and CEO Tim Mammen - VP and CFO
Analysts
Antonio Antezano - Bear Stearns C.J. Muse - Lehman Brothers John Harmon - Needham & Company Ian Fleischer - FBR Capital Markets Tom Diffely - Merrill Lynch Ajit Pai - Thomas Weisel Partners Jiwon Lee - Sidoti & Company
Operator
Good morning and welcome to IPG Photonics Fourth Quarter 2007 Conference Call. Today’s call is being recorded and webcast.
At this time, I would like to turn the call over to Angelo Lopresti, IPG’s Vice President, General Counsel and Secretary for introduction.
Angelo Lopresti
Thank you, and good morning everyone. With us today is IPG Photonics’ Chairman and Chief Executive Officer, Dr.
Valentin Gapontsev; and Vice President and Chief Financial Officer, Tim Mammen. Statements made during the course of this conference call that discuss management’s or the company’s intentions, expectations or predictions of the future or forward-looking statements.
These forward-looking statements are subject to known and unknown risks and uncertainties that could cause the company’s actual result to differ materially from those projected in such forward-looking statements. These risks and uncertainties include those detailed in IPG Photonics Form 10-K for the year-ended December 31, 2006 and other reports on file with the Securities and Exchange Commission.
Copies of these filings may be obtained by visiting the Investor Relations section of IPG’s website at www.ipgphotonics.com or by contacting the company directly. Any forward-looking statements made on this call are the company’s expectations of predictions only as of today February 28, 2008.
The company assumes no obligation to publicly release any updates or revisions to any such statements. We will post prepared remarks on our website after the completion of the call.
Please go to www.ipgphotonics.com to review these remarks. I will turn the call over to Dr.
Gapontsev now.
Valentin Gapontsev
Good morning. First of all, I would like to claim in spite of the complicated bond market situation and growing recession on American segment, 2007 was a terrific year for IPG.
We again reported a record revenue and net income. During the year, we continued to make good progress in growing our position in high performance fiber lasers and amplifiers.
Also, we were successful in targeting new application for our products, expanding our products portfolio, and trying to optimizing our manufacturing infrastructure. This strengthens our advantage as the industry’s only fully vertical integrated manufacturer of fiber laser.
We also made progress in expanding our geographical capabilities given us the ability to sell and support our products in major markets, especially in growing economies like Russia, India, and China. Before I turn the call over to Tim Mammen, let me review some highlights.
Fourth quarter revenues increased 31% to 55 million, which exceeded the high end of our guidance range. For the full year, revenues increased 32% to 189 million.
The revenues were driven by strong sales of our lasers used for material processing application. Earnings per diluted share of $0.18 for the fourth quarter was within our guidance range and we reported $0.65 for the full year.
As we look our performance last year, I want to note that IPG continues to grow strongly. Despite industry publication that estimated that fiber lasers sales would grow 25% in 2007, IPG’s overall sales increased by 32% and fiber laser sales from materials processing grew 43% in 2007.
This data show the growing penetration of fiber laser and IPG’s ability to compete with growing field of fiber laser makers. I will now turn the call over to Tim Mammen.
Tim Mammen
Thank you ,Valentin, and good morning everyone. I will start with some operational remarks and then -- and I will then review our financial highlights.
First, I want to reiterate Valentin’s remarks on the top-line growth in our business. Our 31% revenue growth in the fourth quarter driven by a 37% increase in sales for material processing applications, our largest application, shows the traction that IPG’s fiber lasers continue to experience.
Although the growth is driven by many uses for our products in the quarter we saw growing demand for pulsed fiber lasers from numerous solar customers and flat panel displays, for high-power fiber lasers from automakers and suppliers throughout the world, and for shipbuilding, and for the new kilowatt single mode lasers we introduced in 2007. With the introduction of additional products including the recently announced sale of diodes to the merchant market, we continue to use our core competencies for new sales opportunities.
Second, IPG saw 30% plus growth despite weakness in communications and medical applications, and concerns about the economy in the US and Japan. IPG has built a business model that has application and the geographic diversity, and that is enabling us to continue to grow revenue even when one or more of our end markets or geographies is experiencing some weakness or volatility.
This is a testament to the strength of IPG’s diversified model. Thirdly, we managed to improve our cash position in the fourth quarter.
During the quarter, we generated operating cash flow of $11.2 million and free cash flow of 2.9 million as a result of improved profits and lower cash tax payments. Lastly, we’ll continue to work to improve gross margins in 2008 despite the slight drop in the fourth quarter of 2007.
There were several factors that combined to affect our gross margins in the last quarter that I will discuss in further detail later. A key focus of IPG in 2007 was the expansion of our manufacturing capacity and sales reach.
In Q4, we took delivery and began production with the last of our three new multi-wafer MBE machines. We expanded and improved manufacturing facilities for optical components in Germany, and opened our new sales and service center in Beijing, China.
We also made progress in developing our new sales and service center in Yokohama, Japan. We completed the expansion of our burn-in facilities for testing diode chips to an industry leading 60,000 test channels, and added significant capacity for packaging our new high power diodes.
Burn-in and packaging were two areas where, at the beginning of the year, we were approaching capacity limits. Now, I will turn to the financial results.
Let me start by providing you with some information about how we performed in the four markets that we target. Materials Processing, which is IPG’s largest market, contributed 72% or 39.4 million of the revenue we reported in Q4, and grew by 37% year-over-year.
Sequentially, materials processing sales grew by 14%. The Materials Processing segment encompasses several end markets such as general manufacturing, solar, automotive, aerospace, heavy industry, consumer, semiconductor, and electronics.
We have seen growth from each one of these applications in Q4, and let me give you few of those examples. We saw increased interest for pulse lasers for solar panel and flat panel display processing including an order of several hundred units from a solar manufacturer in North America and other smaller orders for solar applications around the world.
The international automotive market continues to be a strong one for us for both automotive integrators and OEM manufacturers. During the fourth quarter, we shipped a number of high-power lasers to European and Asian automotive and component manufacturers including a third laser to a major German research center for the auto sector.
Also we saw our lasers winning head to head runoffs against conventional lasers and replacing CO2 units, as well as the integration of one of our lasers into a competitor’s laser system. We are encouraged by the growth prospects we see in the materials processing market.
We are also seeing strong growth from advanced applications for our fiber laser technology. Advanced applications include test and measurement, instrumentation, sensing, and defense applications, as well as scientific research and development.
The Advanced Applications segment represented 17% of total revenue during the fourth quarter. The fourth quarter was seasonally strong due to end of the year budget spends by institutions and agencies as well.
Advanced Applications revenue increase by 55% in the fourth quarter 2007 over the prior year, driven by sales of kilowatt lasers used in destructive testing, high-power amplifiers for government applications and continued growth of low-power lasers used in sensing and mapping applications. We have had a number of successful uses of our standard products in extremely high-power applications for the government and defense industries.
There are many indications that laser users in the government have determined that the fiber laser is the preferred laser for certain applications, and we believe the momentum we have established in this segment will continue to build. Lasers for the Medical Application segment comprised 4% of revenue in the fourth quarter.
Due to softer demand from our main medical OEM, sales were down 29% or by $846,000 from the fourth quarter of 2006. Our sales in this segment continue to be concentrated with one OEM and our goal is to diversify our customer base in this segment in order to reduce the reliance on this one customer.
Sales in this segment are expected to be soft in the near term. The Communications segment comprised 7% of our revenues in the fourth quarter.
Revenues were essentially flat with the prior year. However, we believe that this segment is stabilizing, because sales in the last two quarters of 2007 was stronger than the first half of the year.
Sales in this segment were driven by demand from integrated DWDM systems in Russia and several other telecom providers in North America, taking advantage of our lasers capabilities for long haul and ultra long haul applications. IPG’s fiber laser technology allows service providers to extend network links beyond previously achievable distances up to 350 kilometers without the need for amplifiers or repeaters within the link.
We are starting to see indications that our communications sales in the Americas and other parts of the world may experience some recovery in 2008. Turning to the performance of our laser types in the fourth quarter, high-power fiber lasers used in materials processing and advanced applications continued to be a key growth driver during the quarter.
In the fourth quarter, on a year-over-year basis, sales of high-power lasers increased by nearly 43% and represented approximately 34% or $19 million of total revenue in Q4 2007. Sequentially, high-power lasers sales were up 42%.
Although sequential growth will fluctuate, overall we expect high-power laser sales to continue to be a significant growth driver for us. Sales of medium-power lasers grew 19% during the fourth quarter of 2007 over 2006, and represented 9% or 5.2 million of total revenue in Q4 ‘07.
With the recent easing of expo regulations, we believe we are now in a better position to grow this line faster than previously. Pulsed laser sales increased by 76% from the fourth quarter 2006.
As a percentage of revenue, pulsed lasers represented approximately 32% of revenue or 17.7 million in Q4 ‘07. This is our oldest product line and it continues to be one of the best producers for us.
As I mentioned earlier, we are seeing growing demand for our pulsed lasers for the solar panel processing and flat panel processing industries. Marking applications also continued to help drive sales of our pulsed lasers in Q4 ‘07.
Turning to our geographic performance during the quarter, we reported 32% of revenue from Asia and Australia, 42% from Europe, and 26% from North America. Sales to Europe increased 42% year-over-year, driven primarily by strong growth from Eastern Europe and CIS countries, where we are experiencing growth in materials processing as well as stronger telecom sales.
Sales in Asian and Australasian markets increased 31% compared with the fourth quarter 2006. Strong sales from our new Chinese office and growth in South Korea contributed to this increase as well as sales into India and Thailand.
However, overall growth in Asia and Australia was offset by a decrease in Japanese sales. We have taken action to strengthen our operations in Japan, which included hiring a new General Manager with extensive materials processing laser experience, expanding our sales force and opening an expanded sales and service center.
Sales in North America increased 16% over Q4 ‘06. It should be noted that the 60% growth in materials processing in North America over the fourth quarter 2006 was offset by declines in communications and medical sales.
Gross margin for the fourth quarter was 43%, which is below our short to medium term target range and is lower than we would like to see. This compares with 48% gross margin we reported in the fourth quarter of 2006.
This decline was due primarily to the expansion of capacity, which we made during the year to prepare the future growth, a temporary decrease in yields related to the qualification of chips and packaging of laser diodes, flow through of certain purchased sub components for Russian system sales on which we made no profit, and higher than expected inventory provisions. These items limited our operating leverage and absorption of fixed costs during the quarter.
We are working to improve the manufacturing yields. In the short-term, we believe that this could affect our gross margin in Q1.
However, once these issues are resolved, we continue to target a gross margin range of 45 to 49%. The inventory write-downs previously mentioned totaled $904,000 in the quarter.
G&A -- SG&A rather was 8.6 million or 16% of sales compared with 7.3 million or 17% of sales in the fourth quarter of 2006. This is within the range of our SG&A target of 15 to 18% of sales in the short to mid-term.
Sequentially SG&A increased due to a decrease benefit on exchange rates of $500,000 and higher professional fees of $600,000. Patent litigation defense fees were $1.5 million for the calendar year 2007, compared to $400,000 in 2006.
R&D expenses were 2.7 million or 5% of Q4 ‘07, revenues. This compares with 2.2 million or 5% of revenues in Q4 ‘06.
This is within our target range for R&D of five to 7% of revenue in the short to medium-term. A continued focus on targeted R&D objectives combined with rapid development cycles and our results driven culture have kept IPG’s R&D expenditures low as a percentage of revenue.
Operating income for Q4 ‘07 increased by 16% compared with the same period last year. IPG generated operating income of $12.4 million, or 22% of revenue compared with operating income of 10.6 million or 25% of revenue in the fourth quarter of 2006.
Operating income includes charges related to stock-based compensation of $419,000 and $215,000 in the fourth quarter of 2007 and 2006 respectively. In the fourth quarter of 2007, $81,000, $247,000, and $91,000 of stock-based compensation charges related to cost of sales, SG&A and R&D respectively.
Our tax rate for the fourth quarter of 2007 was 31%. The effective rate for the full year 2007 was 32.6%.
For 2008, we have estimated that our overall effective tax rate will be approximately 32%. Net income for the fourth quarter of 2007 was $8.3 million or $0.18 per diluted share, compared with net income of 16.6 million or $0.11 per diluted share loss for the fourth quarter of 2006.
Results for the fourth quarter of 2006 included $3.1 million charge related to the change in the fair value of the company’s previously outstanding Series B warrants, $13.1 million benefit related to the release of the deferred tax valuation allowance and a one-time deemed dividend of $18.3 million related to the beneficial conversion of preferred stock in our IPO in December 2006. Let me turn now to our balance sheet, which continues to be strong.
Cash and cash equivalents at December the 31st, 2007 stood at $38 million compared with $75.7 million on December the 31st, 2006. We also have $7 million in marketable securities.
As we mentioned on previous calls in January 2007, we repaid 18.2 million of the remaining bank term debt in the US and Germany, leaving a balance of $20 million related to subordinated notes outstanding. For 2007, capital expenditures totaled 34.3 million and were primarily related to completing expanded facilities for diode, fiber, and another production, expansion of foreign sales and service offices, as well as the acquisition of equipment.
During 2007, for the full year, there was net cash flow from operations of $10.7 million. This compares with cash flow from operations of $19.2 million for 2006.
The decrease primarily resulted from an increase in several working capital items including inventory, prepaid expenses and taxes. We believe that the increase in working capital items such as inventory is consistent with present and expected sales growth.
We also continue to maintain strategic stock levels of certain critical inventory components such as diodes. We paid $16.8 million in taxes in 2007, compared with $2 million in 2006.
With regard to our line of credit facilities, at the end of the year, we had a total of $40 million available on our US German and Japanese credit facilities. Included in this amount is the new €15 million or $22 million unsecured revolving credit facility that we entered into in the fourth quarter.
We will continue to use these facilities from time-to-time in order to finance our short-term working capital requirements. Backlog at December the 31st, 2007 was approximately $72.6 million as compared to 51.8 million a year ago.
This represents 40% increase in our opening backlog. We provide backlog information annually.
I would like to provide you with our guidance for the first quarter 2008. For the first quarter, IPG Photonics expects revenues in the range of 50 to $54 million.
The company anticipates earnings per diluted share in the range of 14 to $0.18. That is based on 46,021,000 diluted common shares, which includes 43,820,000 basic common shares outstanding and 2,201,000 potentially dilutive options, compared to a share count of 55,602,000 diluted common shares used to calculate earnings per share for the first quarter of 2007.
Before I let Valentin comment on a few recent developments, I want to summarize. IPG continues to see growth as a result of the growing market acceptance and demand for fiber lasers and our products.
IPG has application, geographic -- has application and geographic diversity that is enabling us to continue to grow revenue even when one or more of our end markets or geographies is experiencing some weakness or volatility. In the fourth quarter, our cash position has improved slightly, and we continue to monitor closely as we invest in our capacity and sales reach.
We are also focused on dealing with the operating issues that have impacted gross margins. I will now turn over to Valentin for a few additional comments before questions and answers.
Valentin Gapontsev
Thank you, Tim. In order to take advantages -- advantage of our technical and production capabilities, as well as a growing market demand for high-power diodes we initiated a program intended to 2008 to sell the industry’s most powerful and highest brightness fiber-coupled laser diodes on a merchant basis to OEM customers in a variety of industries.
We hired salesmen for this product line and we have received a higher level of interest now, this natural extension of our product line. Last week IPG purchased 100 key photonics patent by acquiring a photonic patent portfolio from British Telecom.
This large portfolio includes patents for semiconductor devices, optical fibers, fiber-based amplifiers, and amplifiers gratings integrated optics, high-speed systems, and the optical networking. The patents cover British Telecom’s pioneering the research in the field of photonics dating back to the mid ‘90s.
IPG believes that this portfolio, which includes more than 314 counterparts strengthens our IP position in our markets and contributes to our growing number of patent applications. Finally, I am pleased to report a new fantastic result that we received in the Quarter Four.
We have developed the first 5-kilowatt power single mode fiber laser, and found the technical -- new technical solution to raise the power above 10 kilowatt. It is a big progress in the ways of a practical destructive means.
As a result also has opened the door for new applications such for example as a remote destruction first. We are working to reach higher power levels for this unique product.
Now, we will open the call for your questions.
Operator
Thank you. (Operator Instructions).
And, we will take our first question from Antonio Antezano of Bear Stearns.
Antonio Antezano - Bear Stearns
Good morning.
Tim Mammen
Hi Antonio.
Antonio Antezano - Bear Stearns
Hi. A follow-up on the gross margin, I don’t know if you said this; but in your guidance, what is the assumption for gross margin?
Tim Mammen
In Q1, we have not given a specific guidance rate. I think that we could be around -- we hope to be a little bit up on Q4, but we could be flat until we resolve the key issues.
We were pretty close I think to deal with some of these yield issues internally. So, we do thing that we are going to have some potential impact on gross margin in Q1 and then we would hope to see things improve through the rest of the year.
Antonio Antezano - Bear Stearns
Right, now looking at the gross margin, you mentioned four factors, but primarily you said it was expansion of capacity. Have you been able to kind of quantify each of these four factor, what has been the impact of gross margin?
Tim Mammen
To a degree, yes; I mean on the capacity expansion, the absorption of fixed cost was basically flat to down by maybe 1% on a year ago even though sales were very substantially up. I think the yield inefficiencies have impacted gross margin by between 1.5% to 2%.
And then our inventory reserves -- we forecast was slightly lower when we are looking at gross margin guidance than the ones we reported at 900,000. So, they may have had another impact of about 0.5%.
Antonio Antezano - Bear Stearns
Right. Just one final question before I go back to the queue, is that when you provide a guidance for the quarter was between 45 and 49%, and what is the, let’s say, the element of surprise or what is not under your control that would impact the gross margins and because it came below your guidance, so there must be some parameter maybe is not under your control.
So, what would be these surprise factors for you?
Tim Mammen
Definitely, the yield inefficiencies around chip qualification. And also one of the things on the production side on the packages was slowing down production of the lower power diodes and transferring production to high-power diodes.
And we decided, I think, to accelerate that during the quarter towards the end of the quarter. So that was kind of an impact that we hadn’t really foresaw and right -- foreseen right at the beginning of the quarter.
Antonio Antezano - Bear Stearns
Right. So, you mentioned that you are taking some actions to improve that, what are those actions?
Tim Mammen
I think first of all on chip qualification, Valentin can speak more technically to this. But already this year on chip qualifications, we’ve seen an improvement in yields.
It was really related to qualifying new chips that were coming out of our new MBEs, and some more stringent procedures around that. I think that already in January, we are seeing some improvements in that area.
Just one other point on Q1, Antonio, we are sort of forecasting guidance as 50 to 54 million. So, one of the reasons the gross margin in Q1 could potentially be a little bit impacted is depending on where revenue comes into that -- in that mix relative to the 55 million we reported.
Antonio Antezano - Bear Stearns
All right.
Valentin Gapontsev
It’s temporary. We have problem with transfer the production from low power to high-power diode modules and this transfer typical people should be retrained, productivity is going down, but temporary now, practical with the device.
The process that now we reach the targeted productivity gain. So, in January, February, we practically will fix this temporary drop of efficiency, and now it’s with the time to get highest yield and the highest efficiency of the productivity with new diode line.
Antonio Antezano - Bear Stearns
All right. Thank you, I’ll go back to the queue.
Thank you.
Operator
And our next question comes from C.J. Muse with Lehman Brothers.
C.J. Muse - Lehman Brothers
Yeah, good morning. Thank you for taking my question.
I guess I was hoping to focus on the yield issue again. Is this entirely chip qualification or is it a mix shift that’s going on, or is it the new capacity coming online?
I guess -- could you frame it for me as to how many isolated points are on the line are driving these yield weakness and then what the timeframe is to get it back up to par?
Tim Mammen
Hi C.J., its Tim here. More specificity on the yield – the specific points, where its current, I think, are in burn-in and qualification of new chips coming out of our MBE machines and also related to transferring production from PLD 9s to PLD 25s in Germany, and then bringing up production capacity of PLD 20s in the US.
So, those combined things really have had an effect of about between – about 1.5%, maybe a little bit more.
C.J. Muse - Lehman Brothers
Okay. And what’s the timeframe of rectifying these three things?
I mean, in terms of what you can control -- not in terms of, I guess, any sort of big shifts in mix that you can’t control?
Tim Mammen
I think we made already through the first six weeks of this quarter some progress on that. So that we’d hope by coming into the second quarter, we would have these issues -- the controllable issues sorted out, particularly related to operation of -- operating efficiencies.
So, the yields already on burn-in in January have improved substantially. And production of the higher power diode, which we are starting to consume more of, is already up.
C.J. Muse - Lehman Brothers
Got you. So, you think you can get back to your target operating margin model by 2Q?
Tim Mammen
I tell you it’d be at the bottom end of the range in 2Q and then getting up again in the third and fourth quarter towards the middle and hopefully to the top of the range. The other side that I would like to say we are looking at is that obviously as we built our capacity, we’ve hired a lot of people.
We are also focused on now ensuring that we are matching the capacity on the diode production and chip production to actual requirements this year. So, we hope to build that into and gain some benefit and leverage just -- with regard to that during the year.
So, these are issues I think that we are very closely focused on.
C.J. Muse - Lehman Brothers
Okay, and two last questions from me; can you tell me what percentage of your overall business was merchant laser? And then secondly, what was the stock based comp in the quarter?
Tim Mammen
By merchant related, you mean diode or --
C.J. Muse - Lehman Brothers
Where you are supplying to your competitors.
Tim Mammen
Sure. Not sure we understand the question.
You mean diode -- supplying diode to our competitors or selling?
C.J. Muse - Lehman Brothers
Exactly.
Tim Mammen
We didn’t -- in the fourth quarter, we didn’t have any merchant diode business. We’re only sort of starting that now.
We don’t have any orders from any competitors at the moment.
C.J. Muse - Lehman Brothers
What about low power lasers to like Rowfen?
Tim Mammen
In terms of that, there is -- we have a substantial order that is going to Rowfen onto one of the solar manufacturers. So, we haven’t disclosed what that is specifically.
C.J. Muse - Lehman Brothers
Okay, but that’s a small part of the business in terms of that merchant supply?
Tim Mammen
No, it’s growing to be a fairly -- it’s growing to be a nice volume of business for us from which we are getting a lot of benefit.
C.J. Muse - Lehman Brothers
Great, thank you.
Operator
We'll take a question from Needham & Company’s John Harmon.
John Harmon - Needham & Company
Hi, good morning.
Valentin Gapontsev
Good morning.
John Harmon - Needham & Company
Just a couple of questions, please. I guess first of all, I just want to confirm that your Q1 guidance being sequentially down, that’s just normal seasonality or are there any particular product categories or geographies where you are anticipating softness?
Tim Mammen
Part of it is the seasonality, where we see obviously weaker sales in Russia; we’ve talked about Japan can be a little bit light in Q1. I think that the issues that, on any weakness are in North America on these two end markets continuing to be weak, telecom and medical.
I think everyone is obviously worried about how the economic situation in the North American market is going to play out. We try to draw attention to that by saying that our materials processing is growing strongly in this market.
We just don’t have any support from the other applications there. So, telecom will be low in Q1 again in the US and it’s seasonally weak in Russia, and the medical has lent some weakness as well to that.
John Harmon - Needham & Company
Okay. Thank you.
Valentin Gapontsev
If you have a situation, so you can check our story for last five years each time, third quarter was the weakest.
John Harmon - Needham & Company
Right, thank you. And I believe that I saw the results of some -- on experiments that IPGP did in sheet metal cutting with positive results.
I am just wondering when that type of work could make its way to commercial product, whether it requires a change in design or some kind of change and when that might be able to start shipping?
Tim Mammen
Are you referencing the very high speed cutting of the thin sheet with the 100 holes,. Valentin can comment on that.
John Harmon - Needham & Company
Yeah.
Valentin Gapontsev
Yes, is it – our development the high-power single mode lasers, very high-power opened door for new technology of cutting before it’s send that technology, which traditional laser provides in other. But it’s only melting of the metal and then with high flow of gas, to remove this melt.
But with new technology allowed to make preparation of metal with cutting -- high speed cutting. It’s absolutely new technology for cutting.
Before it was used only for marking and engraving with powerful lasers but considerable way that actually providing the same big power, the same power density as in before was achievable only in the pulsed mode. And as a result, it’s open door especially within nano for high speed to increase speed of cutting in tens -- minimum tens time, so productivity were much higher.
CO2 lasers are not able to provide such result at all. So, it’s only the way for fiber lasers -- IPG fiber lasers.
John Harmon - Needham & Company
Is this how we --
Valentin Gapontsev
Special machine, which we will introduce for such application.
Tim Mammen
So, to John’s question was what is it basically commercially ready now, or is it --
Valentin Gapontsev
No, it is -- cutting machine this year, we will introduce in market -- different kind of cutting machine including this with new technology.
John Harmon - Needham & Company
Okay, thank you. And finally, you were talking about softness in the medical segment residing with one customer.
Is that customer seeing weakness in demand due to -- is it something that is related to the technology or is it really related to the customers?
Valentin Gapontsev
You know that we have concluded evaluations only with one customer as it did not allow us to sell to competition, but now in this application, competition growing very fast, now for about 10 companies compete the market in position of our customer. It’s only -- now we are changing the situation, and so open door for other customers.
So, we believe we will now turn it back to the good fast growing. It’s only one aesthetic application, but we developed it for the surgical and other applications, these lasers and customer reliance.
So, we believe market – medical market will grow much faster this year.
Tim Mammen
John, the other thing, I think, to add to that is that definitely discretionary medical spending, which I think the aesthetic spending is classified as that, I think is one of the first things that does get affected by economic weakness.
John Harmon - Needham & Company
Sometimes it’s the last thing to go. Thank you very much.
Operator
And our next question comes from Ian Fleischer of FBR Capital Markets.
Ian Fleischer - FBR Capital Markets
Hi, good morning.
Tim Mammen
Hi, Ian.
Ian Fleischer - FBR Capital Markets
Would you -- if you could, would you please touch on the capacity expansion? Are you -- when do you expect to have that fully up and what areas are you still ramping up capacity?
Tim Mammen
Which areas are we still ramping, increasing capacity?
Valentin Gapontsev
Capacity, we now during the last three year -- last year, after IPO, we practically use this investment from market to build the capacity. And now this year we’ve finished this, this phase and during next year, 2009, 2010 we do not quite see this investment in increased capacity.
Tim Mammen
So, the key areas that we’ve put it into are fiber chip production, chip qualification packaging.
Valentin Gapontsev
Some other components?
Tim Mammen
Some other components, and then the remaining investment is optical coating and --
Valentin Gapontsev
Also components.
Ian Fleischer - FBR Capital Markets
And do you expect to -- does that expect to continue through the year? Do you complete that in the third quarter, how should I look at that?
Tim Mammen
Most of that is primarily done. I think the remaining expenditures relate to the new building in the US that’s coming on for the demonstration, the state-of-the-art demo center here and expanded general manufacturing.
And the building in Germany, which is the --
Valentin Gapontsev
The progress in building in Germany. And most of this project should be completed into the quarter two, beginning three, so the second half of the year, the investment for new capacity will drop essentially.
Ian Fleischer - FBR Capital Markets
Okay. And on another or issue or topic; you mentioned some strength in the auto sector.
Could you just provide a little bit of color on what’s going on in that market?
Tim Mammen
Strength in the auto sector? Strength, so, I mean like talk about Hyundai’s reports, other German manufacturers who....
Valentin Gapontsev
Auto sector?
Tim Mammen
Yes, the cost...
Valentin Gapontsev
Yes, Hyundai has started in mass production to use our lasers in mass production in main line for assembly. And when you change this motor with executive model that using our laser in mainline.
So, we also have good progress with some other automakers and especially in Japan. So, and two major automakers have been practical, make decision to start in mainly production application with IPG.
And also we have good progress also in the United States in spite the crisis in Detroit. And in Europe also for PF, in August they started with us, they increased use of our lasers in production line.
Tim Mammen
Yes, it’s Peugeot, yes.
Ian Fleischer - FBR Capital Markets
And finally, maybe just touch on the logic behind the patent acquisitions that you made -- that you announced earlier this week?
Valentin Gapontsev
You are seeing first phase about -- the history of our company, you know, we were a small company without any investment. That would be in the based on or on the process and some credits from banks.
We did not have enough people, we did not have enough time to build our IP portfolio. And also with the -- from point that the company you saw way, how it related to the results.
People can reach it all, but much way the other big company, who uses our development and so on. Now when we became serious company, we have the investment; now we improve patent portfolio.
We place by now fast growing quantity of own patents -- new patent application. In Paraguay, we made decision from formal this development that yield and we agreed to be with the -- BT has very good quality in portfolio and they don’t need this.
And they made decision to sell. And we for a reasonable price we bought this portfolio to help us to protect our -- us against all the people.
Now when you are becoming the strong company and profitable company, a lot of people looking to get piece of pie from you. And so, some patent litigation we have in our product, we won the process.
Now it’s very serious counterpart like this Cisco, Scientific-Atlanta and Newport, we are still in process with -- litigation with IMRA, but we have -- we are extremely strong positions against. So, we can expect others now.
Other people, who will try to judge us and this patent portfolio from BT will help us extremely essential to predict our intuitive offer to eliminate position of the new people for going to fiber laser market, because some of the patents were created powerful.
Ian Fleischer - FBR Capital Markets
That’s helpful, thank you.
Operator
And our next question comes from Tom Diffely of Merrill Lynch.
Tom Diffely - Merrill Lynch
Yes, good morning. Maybe just couple of more questions on the capital spending.
With your expected ramp in ‘08, what is your projected CapEx level in ‘08, and then what is the maintenance level in ‘09 and 2010 when you’re not going to be ramping?
Tim Mammen
Projected CapEx in ‘08 continues to be at a pretty high level of about $33 million.
Tom Diffely - Merrill Lynch
Okay.
Tim Mammen
Primarily on buildings for two mainly what we talked about some expansion in Russia and equipment. The maintenance level after that is difficult to gauge exactly what it would be, but I would think it would come down to being, I would hope at that stage between seven to -- maybe 7%,seven to 10% of revenue.
It’s a bit difficult to give a specific number on that.
Tom Diffely - Merrill Lynch
Okay. And then based on that, what is your current depreciation level and how do you think that ramps over the next few quarters?
Tim Mammen
I think we are predicting overall in ‘08 about a 25% increase in depreciation. I don’t have the number specifically, Tom to --
Tom Diffely - Merrill Lynch
Do you know what it was in the fourth quarter offhand?
Tim Mammen
Hang on.
Valentin Gapontsev
Basically, Germany and US very seriously where we augment, so we’ll frozen development here for next two or three years, so it’s minimum and only the target for further development as such as the Russian company maybe someone inertia. But it would be much with development than we -- and investment was spent.
This year it’s -- last year with the -- especially too much for investments for development.
Tim Mammen
So, the total -- I see, the total last year, Tom, was $12 million. So, factoring something like 20% increase or 25% increase on that.
Tom Diffely - Merrill Lynch
Okay. All right, and then you talked --
Tim Mammen
The other thing -- the only other thing to note on amortization is related to the patents we have estimated that it’s about a penny out of earnings for the amortization related to the patent acquisition, a year, not a quarter.
Tom Diffely - Merrill Lynch
Okay, all right. And you talked about diversified a bit in the medical field.
What is the sales cycle like in that field right now, and how long would it take to diversify from the one customer today?
Tim Mammen
How long will it take to diversify medical?
Valentin Gapontsev
You see -- we open doors for our customers. And so, we now have foreign commitment from minimum five customers.
They raise in order very shortly if we are able to essentially increase our sales. And we develop more than 15 other customers in different application in medical, but some again time still for certification of FIG, and other certification in different countries.
But process is going very well.
Tom Diffely - Merrill Lynch
Okay, so it sounds like over the next few quarters, you could see some meaningful change there?
Valentin Gapontsev
Yeah, we have some partnership in Russia would develop this now full major device our sales for Russian in the Asian market. But not only on this for such devices that full significant devices for different application in these countries.
Tom Diffely - Merrill Lynch
Okay, great. And then finally you talked about little weakness in Japan; is that share losses or just slowing end market there?
Can you talk a little bit more about that?
Valentin Gapontsev
Tom, of course it’s in part slowing. It’s now the -- this Japanese market is not very active, but I can say, also it was a some severity -- serious mistake for my management.
Now we changed management for new one, it’s much more strong management. It was some --
Tim Mammen
Weakness on the experience on the sales side, I think that.
Valentin Gapontsev
Yes.
Tim Mammen
So, we strengthened that by bringing in -- someone has got a lot of material processing experience, and they started with us in January.
Tom Diffely - Merrill Lynch
Okay. All right, thank you.
Operator
Our next question comes from Ajit Pai of Thomas Weisel Partners.
Ajit Pai - Thomas Weisel Partners
Hi, good morning.
Tim Mammen
Hi Ajit.
Valentin Gapontsev
Good morning.
Ajit Pai - Thomas Weisel Partners
Couple of quick questions; I think the first is on the gross margin. I think almost all the reason that you attributed in the call were related to the cost side of things.
Could you give us some color as to what’s happening in terms of pricing for you folks?
Tim Mammen
The other side that may have impacted things relative to a year ago, which is a little less prevalent because you do see the volume increases, but the lower power, higher volume pulsed laser line has probably seen seven to 10% price decrease. I think on high-power lasers, the average selling price per kilowatt, it does fluctuate a little bit quarter-on-quarter, but is’ being relatively constant.
We may be seeing a slight degradation on the light source there as we’re supplying more lasers with bean switches and other accessories. So, there is a little bit -- we don’t see a significant impact on the medium power, on the low power.
Low power, probably again 7% declined, but medium power I think pretty stable still.
Ajit Pai - Thomas Weisel Partners
Got it. And then when you’re looking at your gross margins on the perspective of your merchant manufacturing of diodes as that business begin to ramp?
And once you’re at the yield that you consider to be healthy yields, are the gross margins of that particular business going to be above or below your corporate average?
Tim Mammen
The gross margins on that should be equal to or above the corporate average on diodes.
Ajit Pai - Thomas Weisel Partners
Got it. And then when you’re looking at the, I think you’ve talked to maybe about four or five months ago, when you want to large order with the navy that you are planning to ship almost everything before the end of 2007 and recognize the revenue for that.
Has that been fully recognized or there is still a portion of that to be recognized in the first quarter or in early ‘08?
Tim Mammen
It was fully recognized.
Ajit Pai - Thomas Weisel Partners
Okay, it was fully recognized, okay. And then your commentary on Japan, I think in a lot of you that you have attributed to sort of weakness in your sales force or leadership over there.
How much of that is the weakness in Japan is just the end market? Things in Japan have been fairly challenged right now in terms of manufacturing economy there, the industrial economy now for almost three to four quarters.
So, why would we expect things to reaccelerate over there and not stay as sluggish as the sort of macro indicators from Japan indicate?
Tim Mammen
I think part of the experience last year was due to the weaker economic situation. And I think that maybe you would like to call the low hanging fruit to more inexperienced sales for us, we are able to initially generate good traction on that level.
It was clear after that that in order to continue to develop the relationships in Japan with this major industrial companies that -- basically looking to shift from using one type of laser production to new lasers. If we can actually get that shift to happen despite potential weakness in the macro economic client, we may be able to get some good traction out of that country again.
Ajit Pai - Thomas Weisel Partners
Okay, got it. And then when you are looking at the military, I think there is potential for further orders of there once you have demonstrated the success of your fiber lasers and some of the remote destruction applications and other applications that you have talked about including the order that you shipped to the navy.
How soon do you expect some of those orders to start coming in?
Tim Mammen
In terms of sort of the smaller orders -- not in terms, but unit orders for initial qualification, we are expecting hopefully to get some stuff in the second quarter of the delivery, in the second half of the year. Again that business was stronger in the second half of last year.
We expect to get some nice orders we hope this year to help revenue along. In terms of the development cycle, it’s still a long way out before you get into potentially 30 or 40 unit orders.
If we are lucky something may come through in 2009 after qualification. But it’s not likely that significant jump will happen this year, but we should have some accretive revenue this year.
Ajit Pai - Thomas Weisel Partners
Got it, thank you so much.
Valentin Gapontsev
Some application, it was publicly claimed for example a Buoyant claim was our point of view that now that systems. And they have very serious intention.
It’s developed and qualified. Today it’s both published recently.
So, it’s our model. It’s about some more application in much more longer qualification.
But now the total lease the lot of developers direction came from solid state and chemical lasers to fiber lasers, main future the most potential for future development.
Ajit Pai - Thomas Weisel Partners
Got it. One last question, which is about the competitive dynamics.
Are you seeing any of your competitors come out with much more competitive offerings? And are you seeing any particular competitor that is -- that you are seeing much more frequently in the market?
Valentin Gapontsev
What was the market during IPO, around so and so into that -- what we expect growing competition if you would did not raise the goal. But we had in the performance, we had in the -- for the product line.
And we have decreases and we must have hit better economics cost advantage and so on. So, we don’t see still serious impact on our business from competition.
Ajit Pai - Thomas Weisel Partners
Got it, thank you.
Tim Mammen
Particularly, Ajit, like high-power there is still nobody there on fiber. And even like if you look at the pulsed laser line, I think that we believe that in terms of performance and cost.
Even though there are lot of people producing pulsed lasers, we are still getting tremendous traction in our sales in that market.
Valentin Gapontsev
You see our growth is much faster than growth all the fiber laser market, it’s also -- we practically -- twice higher growth than any competitor.
Ajit Pai - Thomas Weisel Partners
Got it. Thank you so much.
Operator
Take your question from Sidoti & Company’s Jiwon Lee.
Jiwon Lee - Sidoti & Company
Good morning.
Tim Mammen
Good morning, Jiwon.
Jiwon Lee - Sidoti & Company
Most of my questions were answered. But just going back to your ‘07 legal expense was $1.5 million, the total for ‘07, Tim?
Tim Mammen
For litigation defense, yeah.
Jiwon Lee - Sidoti & Company
Okay, and did you sort of dollar value on the CT hasn’t yielded?
Tim Mammen
No, we have not. What we have said is that we think it will be diluted to earnings by about a penny a year.
Jiwon Lee - Sidoti & Company
On an annualized basis?
Tim Mammen
Yes.
Jiwon Lee - Sidoti & Company
Okay, fair enough. And going back to your merchant diode sales, I am not sure if I heard, since January, was there any sales traction in the first quarter, and how should we look at that business on an annualized business, what are your sort of expectations for the year?
Tim Mammen
We haven’t had any significant diode orders in the first quarter. Historically, we have sold some small quantities of diodes for some medical applications.
We’ve obviously sold out diode lasers, which are effectively displacing diodes together. We have not yet had a solid order just simply on the merchant business.
There are indications and enquiries from several customers. I think that it may contribute it for a -- as we ramp it this year, something like 2% of revenue, 1.5% to 2% revenue this year.
Jiwon Lee - Sidoti & Company
I mean the focus there is, you don’t care what type of diode you sell essentially, the new ones or the old ones. Or is there sort of a targeted focus in your mind as to how you want to grow this business?
Tim Mammen
I’ll let Valentin to answer that. What type of we’re selling our standard diode?
Valentin Gapontsev
We sell -- our targeted sale diodes for first of all publication, which do not compete with us. But if it would be serious order for the competition, so we are also ready to discuss.
We are discussing with receivable on request. And we are discussing conditions and so on.
But it’s included old diodes and also new diodes also. And also not only diodes, but diodes-based modules with high-power up to 1 kilowatt power to it, always assembly diodes.
Jiwon Lee - Sidoti & Company
Okay, fair enough. And finally, we are aware that you may have brought in a couple of engineers sometime in the middle of last year.
And I think you may have acquired a product related to the particular organization or the patent. Is there any comments that you could make on that front, and how that relates to your sort of growth strategy going forward?
Tim Mammen
No, I’m sure, we don’t have any comment. We haven’t made any announcement about anything like that, I think.
That’s all we have to say on that.
Jiwon Lee - Sidoti & Company
Okay, fair enough. Thank you.
Operator
Take a follow-up question from Antonio Antezano with Bear Stearns.
Antonio Antezano - Bear Stearns
Yeah, just a follow-up on competition. I think during the prepared remarks, you mentioned that there was one instance, where you displaced the CO2 laser.
Could you expand a bit on that?
Tim Mammen
I think the reference that we got the lasers, but fiber laser was put into a laser system that’s actually built by one of our competitors. We don’t want to get into discussing that in too much detail.
Antonio Antezano - Bear Stearns
Right. But it was for high power, might be out processing or welding or cutting applications.
Tim Mammen
Yes.
Antonio Antezano - Bear Stearns
Okay. And then you also on mentioned on your balance sheet that you will probably pay down the existing debt this year.
Is that still the plan?
Tim Mammen
We haven’t made any determination on that, but the $20 million subordinated note is only due in December 2009. So, whether we decide to pay that down would depend upon available cash and resources that we have.
The issue on that note is that at the end of this year, the interest rate increases from 7% to 10%, so probably be worth a while if we don’t pay it down to at least look to -- we will pay it down by refinancing it.
Antonio Antezano - Bear Stearns
Right, all right. Thank you.
Operator
At this time, we have reached the end of the Q&A session. I will now turn the conference back over to Mr.
Valentin Gapontsev for any closing or additional remarks.
Valentin Gapontsev
Thank you. Through 2007, we have profit, strong financial results and have further position in IPG.
It’s a rival, the leader in high performance fiber laser for advanced application. We look forward for success to execute in on our growth strategy, and setting the foundation for an even better 2008.
Thank you for joining us today.
Operator
And that concludes our conference call. Thank you for joining us today.