Good day, and welcome to the nLIGHT Third Quarter 2021 Earnings Conference Call. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Joseph Corso, Vice President, Corporate Development and Investor Relations. Please go ahead.

Thank you, and good afternoon, everyone. With us today are Scott Keeney, nLIGHT's Chairman and CEO; and Ran Bareket, Chief Financial Officer. Today's discussion will contain forward-looking statements, including financial projections and plans for our business. Forward-looking statements are subject to risks and uncertainties, many of which are beyond our control, including the risks and uncertainties described from time to time in our SEC filings. Our results may differ materially from those projected on today's call, and we undertake no obligation to update publicly any forward-looking statements, except as required by law. During the call, we will be discussing certain non-GAAP financial measures. We have provided reconciliations of these non-GAAP financial measures to the most directly comparable GAAP financial measures in our earnings release, which can be found on the Investor Relations section of our website. I will now turn the call over to Scott.

Thank you, Joe. Starting on Slide 3. Q3 was a strong quarter for nLIGHT. We generated a record $72 million of revenue, which was a 17% increase year-over-year. Overall, revenue growth this quarter was driven by growth in each of our end markets, which highlights the diversity in our business model. We continue to focus on serving customers in multiple attractive markets and geographies with a diverse portfolio of high-powered laser solutions. In the third quarter, more than 80% of our total revenue was from outside of China, and we achieved another record revenue quarter from industrial customers outside of China. As a result, we generated 37% products gross margin, the highest in our history as a public company. In microfabrication, our high-power, high-brightness semiconductor lasers continue to lead the industry. In this market, our products serve as the energy source for many of the world's leading pulse laser manufacturers, which are used to manufacture products in a wide range of industries from consumer electronics to semiconductor manufacturing to electric vehicles. We continue to design and develop next-generation semiconductor lasers that will enable our customers to meet the secular demand of the industries that they address. In the industrial market, we continue to sharpen our focus on our business outside of China where our innovative products enable our customers to create a strong competitive advantage for their end systems. Our focus on developing market-specific solutions like programmable lasers for cutting and welding and single-mode programmable lasers for additive manufacturing have led to deeper customer engagement and have enabled us to secure new design wins and increase our share with multiple strategic customers. For example, nLIGHT lasers are uniquely suited for the next generation of series production additive manufacturing equipment where high-speed control and extremely stable output are critical. In defense,…

Thank you, Scott, and good afternoon, everyone. Beginning on Slide 7. Third quarter record revenue of $72.2 million was above the midpoint of our guidance range and was up 17% year-over-year. Third quarter products revenue was $54.4 million, an increase of 6% above the third quarter of 2020. Our products revenue growth was driven by higher sales to both our semiconductor and fiber laser to customers outside of China. This growth in Rest of the World product revenue was mainly offset by a decline in revenue to customers in China. Third quarter development revenue was $17.8 million, an increase of 68% above Q3 2020. The increase in development revenue in the third quarter of 2021 was mainly driven by higher development revenue related to direct energy project work that we performed for the U.S. government. Turning to Slide 8 to provide more detail into our gross margins. Overall gross margin was 29.6% in the third quarter versus 27.8% in the comparable period of 2020. Product gross margin was 37.1% in the third quarter compared to 32.2% in the third quarter of 2020, an improvement of approximately 490 basis points. Our year-over-year margin improvement was a direct result of the implementation of our strategy to increase sales to the rest of the world industrial and A&D customers, additional leverage on our fixed cost manufacturing and further cost reduction efforts. Turning to Slide 9. Non-GAAP operating expenses were $18.1 million during the third quarter compared with $14.3 million in Q3 2020. The majority of the year-over-year increase was related to higher R&D investment to support our product road map and long-term growth opportunity. As a percentage of revenue, our total Q3 non-GAAP OpEx was 25%, consistent with the prior quarter and with Q3 2020. Turning to Slide 10. Non-GAAP net income in…

Thank you. As a reminder, a copy of today's slide presentation can be found on the Investor Relations section of nLIGHT's website. We will now begin the question-and-answer session. [Operator Instructions] The first question comes from Greg Palm with Craig-Hallum Capital Group. Please go ahead.

Yes, good afternoon everybody. Thanks for taking the questions here, I guess, just starting off on supply chains. If I heard you right, I think you had mentioned something along the lines of constraints or supply chain challenges, and I was curious if that inhibited your ability to fulfill some demand specifically in Q3? And as we think about Q4, is there also some added impact inherent in the guidance as well, whether that's capacity-constrained supply challenges, et cetera?

Yes, Greg. It's a good question. Certainly, like everybody, we are facing numerous different supply chain issues and logistics issues. We've been able to manage those with minimal impact to our business. Certainly, our customers also see that. And so certainly some of the demand that we'd hope for our customers have been affected. But I think in Q3, it wasn't a material impact in the quarter as we look ahead. We see those issues continuing and we're continuing to manage them, and we don't see anything that is material that we want to highlight, but it is an ongoing challenge to continue to manage that in terms of our supply chain, in terms of our customer supply chain and in terms of cost, too. So those are all factors that are key topics that we're managing.

Okay. Fair enough. And looking at Q3 specifically from a geographic standpoint, Rest of world really stood out, not just on a year-over-year basis, but it was up quite a bit sequentially. So what type of regions are you seeing the most growth? And is it across the board? Or is it contained in new specific segment like industrial? What are you seeing exactly?

Yes. We are seeing growth across the board, but industrial grew 40% quarter-over-quarter in Q3. So some very strong growth there. And you're exactly right. Certainly, one of the topics we want to highlight that is a -- as part of our strategy, and Q3 certainly reinforces what we're doing to focus on growth in the rest of the world.

Any specific region you want to call out or don't you want to get that specific?

I don't believe there's any region that merits specific calling out. We certainly see strength in U.S., Japan, Korea and some good growth in Europe also.

Okay, good. All right, I'll leave it there. Thanks.

Thanks, Greg.

The next question comes from Patrick Ho with Stifel. Please go ahead.

Thank you very much. And congrats on a nice quarter in a challenging environment. Scott, in your prepared remarks, you talked about the diversification into new regions and things of that nature where power isn't the only criteria your customers are looking at. You mentioned service, reliability and performance. If you could give a little more color in terms of the performance attributes that are more and more important for customers outside of China, which I believe have become more commoditized. What are some of the performance characteristics that are differentiating what you offer?

Yes. Very good point, Patrick, that in the past, it was easier to describe the increases in power as a key theme, and that still is a theme that we will see. But I believe that increases in performance may be even more important. And there are a number of different dimensions of performance from very specific topics of the stability of our lasers for things like additive manufacturing to the programmability of our lasers that are unique in many of these different verticals. And I think those themes will continue to be important, and we'll be talking about more of those products as we release them. In the additive manufacturing trade show, Formnext, will be week after next, and we'll continue to be releasing new products in that market. Welding continues to be an important market. And even in cutting, while there is some more standard lasers that are used, I think the use of the programmable lasers will continue to be even more important there.

Great. That's really helpful. And maybe as my follow-up question, in the aerospace and defense market, it's always a little bit lumpy depending on the timing of projects and things of that nature. Directed energy is obviously a long-term opportunity for you guys. But I guess in just some more traditional aerospace and defense projects, how do you see the pipeline in that area over the next few years? Is that something that's also potentially growing? Or is all the growth is going to be coming from directed energy?

Yes, I'm glad you asked that question. I think we are seeing growth in other markets beyond direct energy and more than we have seen perhaps in previous quarters, what three meetings this week on new interesting opportunities outside of directed energy space is certainly one area where we're very proud of our space qualified lasers. In fact, we just learned today that our laser that's on the NASA ICESat-2 satellite just reached trillion shops and is exceeding its lifetime goals and providing data for changes in the environment and very proud of the work there, and we see a number of new opportunities in other applications in both aerospace and defense. So I hope to be talking more about those as they become public. But yes, it goes beyond directed energy.

Great, thank you very much.

The next question comes from Tom Diffely with D.A. Davidson. Please go ahead.

Yes, good afternoon and thanks for the question. Scott, first a question on China. So obviously, there's weakness there, and fiber laser pricing is pretty weak. But how is the market for the components for the semiconductor lasers, the diodes?

Yes, very good question, Tom. While the industrial market is less attractive, the market for our high-performance semiconductor lasers that go into notably pulse lasers that continues to be strong. That's a market that does require higher performance. And it's one that we are more differentiated, and we have a 20-year history of leading that industry. So that part of the market is an attractive part of the market.

Okay. That's good to hear. And we haven't heard you mention tariffs much lately. Is that the thing in the past or are those ongoing?

We haven't, have we? No, it's not a first-order issue for us at the present time and don't anticipate direct tariffs to be an issue. I think certainly, there's a wide range of non-tariff barriers that are out there. But no, we don't see tariffs as a first-order issue.

Okay. Good to hear. And then, Ran, when you look at the gross margin guidance, I would have thought that with China coming down as a percentage of business again, but at least the high end of that margin range would have been up a little bit.

Sure, so keep in mind, when we are talking about quarter-over-quarter, there are other mix between the different markets, different products that can impact the margin, not to mention that product revenue, at least based on our guidance, predict to go down. All of that would influence -- would impact our margin in Q4. But again, if you will see the trends over the last few good quarters on product margin, you can see a significant improvement, which we anticipate to continue next year as well.

Okay, great, well thank you both for your time today.

Sure, thank you.

The next question comes from Paretosh Misra with Berenberg Capital Markets. Please go ahead.

Thanks, and good afternoon, Scott, given the widespread inflation in the industry -- across many industries actually, can you discuss how the cost structure of the industry is evolving? What I'm trying to get at is that could you be better placed than maybe some other competitors because maybe you're more insulated due to vertical integration, whereas the high-cost guys, they are seeing a faster inflation, so there could be -- long-term, that could be good for pricing?

Yes, interesting. Let me think. We are vertically integrated. So there is some insulation there. We are seeing inflationary pressures from the components, especially electrical electronic components that we buy. But that's a relatively, to your point, relatively small part of our BOM. So yes, there is some insulation there. But I think those inflationary concerns are concerns that every business is going through right now.

Got it. And any sense you could provide as to where pricing is in the industry? I don't know if you could care a dollar per watt price, but maybe just how it is versus last year, like how far it has gone down maybe for the commodity grades?

Well, I'll say this. Look in China and others have reported this. Even the companies in China have reported that pricing in China for the standard more commoditized kind of lasers, that pricing remains very difficult and continues to be declining. That is just one market, and that is a market for a specific type of laser with certain set of specifications. As you go to other markets even in China, but elsewhere, you're really talking about very different performance, different lasers, and now we're not seeing that kind of price pressure in those other markets. We certainly expect in our core thesis for the company, we started 20 years ago is that we're going to continue to drive the technology, improve performance and bring down price so that we can displace other legacy technologies. So we certainly believe there's a secular long-term trend to displace other technologies. But kind of from a quarter-over-quarter basis, most of the markets, we don't see a dramatic change, but certainly in China, unattractive in general for those commodity markets.

Thanks Scott, I'll get back in the queue.

Thank you.

[Operator Instructions] The next question comes from Mark Miller with The Benchmark Company. Please go ahead.

Congratulations on your record revenues. You mentioned some design wins, and I was just wondering if you can give a little more color was one in additive manufacturing?

Indeed, yes. Yes, we've made -- Mark, we've made great progress in additive. I think we've seen a number of the new players coming out with next-generation products that are enabled by our next-generation fiber lasers. And it will be interesting to see the announcements in two weeks at Formnext, which is the big trade show. And there should be more public information over time as to who's doing these next-generation systems. But -- and the thing that I think is very interesting in this space is that we're seeing the economics really change for series production and innovations coming from some of the newer players in that space. So standby, there will be more information, it's released publicly.

Can you break out the laser sales by power like over six kilowatts in the medium power?

I can, yes, we continue to disclose those data. However, as I mentioned earlier, it's a little less meaningful as power is one dimension, performance is another dimension. So actually in Q3, our less than two kilowatt laser sales were 27% of the overall mix and higher power above six kilowatt was 50% and the remainder 23%. But that low power below two kilowatt at 27% was the highest it's been, oh boy, for like three years, which reflects that higher performance segment that is enabling welding and additive markets.

And finally, what do you contribute the malaise in the Chinese cutting market to? Is it overcompetition or macro conditions?

A bit of both, I think. It's always a little hard to tell. But certainly, there are macroeconomic factors going on in China that you've read about, everything from power shortages to all kinds of macro econ effects. And then the very aggressive playbook of companies that are SOEs that are driving prices even to the levels that they are publicly saying are less attractive. So it's a playbook that we've seen in other sectors. But as we've said for a long time, we're focused on growth in other markets.

Thank you.

This concludes our question-and-answer session. I would like to turn the conference back over to Joseph Corso for any closing remarks.

Thank you, everyone, for joining this afternoon and for your continued interest in nLIGHT. We experienced some technical difficulties during a portion of today's webcast. So if anyone has any challenges accessing the slides for any portions of our call, please feel free to reach out to me, Joe Corso at joe.corso@nlight.net. We look forward to speaking with you during the quarter, and have a great evening.

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.