In this uncertain world when investors are scared to touch anything with a whiff of cyclicality, some incredible bargains are being thrown out there. I believe that LED technology supplier Veeco (NASDAQ:VECO) is one of these. VECO makes capital equipment for one of the most compelling secular growth markets in technology, LEDs. The company trades at a low valuation (3.6x 2010E EBITDA, 7.8x forward earnings), generates a ton of cash and recently announced a $200M buyback. Against all this about 25% of shares are sold short, providing potential fuel for a rally. While there is a short case out there that I will address, I would argue that the shorts (especially those that shorted in the mid to high $40’s) have already made money when it is still unclear if they are right or not and face a poor risk/reward tradeoff going forward.
VECO’s primary business is designing and manufacturing metal organic chemical vapor deposition ("MOCVD") systems that are used to make LEDs or solar cells made of III-V compound semiconductors. MOCVD systems are the key process equipment used to fabricate LEDs on sapphire or silicon carbide wafers, and this is by far the most important product line for Veeco at about 80% of sales in 2H 2010, almost entirely from the LED market. MOCVD systems go for about $2.4M apiece and the market for them has been exploding this year as LEDs rapidly replace CCFLs for backlighting in LCD TVs and notebook computers. Veeco is essentially in an industry duopoly with Aixtron (NASDAQ:AIXG), a German company. MOCVD tool shipments have grown from 45 tools in Q1 to 81 in Q2 and are expected to be in excess of 100 in Q3 and 120 in Q4. VECO is basically selling tools as fast as they can make them and last quarter they received approximately $260M in orders (106 MOCVD tools) vs. shipments of $186M (81 tools). The company is currently carrying $490M in MOCVD tool backlog, representing over 200 tools and nearly 100% of production capacity for Q3 and Q4 of 2010. Any tool orders made today essentially go into backlog for 2011, and on its most recent call the company indicated it had purchase orders not included in the backlog numbers. In the Q2 conference call and a recent investment conference the company indicated orders remain strong.
The LED industry has been growing rapidly, primarily due to the proliferation of LEDs in backlighting for TVs and notebook displays. The customer base (largely Korean, Taiwanese and Japanese) essentially stopped investing in new capacity during the downturn and has been playing catch up ever since. Wafer substrates and MOCVD tools have been in short supply. Industry leader CREE grew sales over 50% for their fiscal year ended June 2010 and that is with limited participation in the fastest growing TV/notebook backlighting market. According to my channel sources industry capacity is expected to expand by 33% in 2010 (about $2B in LED fab spending) and a further 42-44% in 2011. A key question for the industry is how sustainable the recent growth is, and whether LED replacement in general lighting can pick up the growth baton from TV/notebook backlighting once this market is largely penetrated (some estimate that 80% of LCD TVs will use LED backlighting by 2012). The Chinese government in particular is subsidizing 50% the purchase price of MOCVD tools in an effort to grow its domestic LED industry. The Chinese government is also stimulating demand by changing local building codes to mandate LEDs in street lights and commercial buildings in certain cities.
The Short Case and Recent Events
VECO stock traded over $45 in July after its most recent earnings report. Since then, shares have declined by over 20% while the following news hit:
- Chinese LED startup Elec-Tech announced that Veeco would be its process tool of record for its new LED factories, representing eventual orders of 130 systems (more than a quarter’s MOCVD tool capacity).
- VECO announced the sale of its Metrology business to Bruker for $229M, which will be $160M after taxes and fees or about $3.75 in cash per share.
- VECO announced a share buyback authorization for $200M worth of stock, about 13% of the shares outstanding at current prices.
Why would a stock decline by 20% after reporting stellar earnings and reporting these positive developments? Well, there is a story about why VECO is a short going around. I originally looked at VECO as a short because of the heavy insider selling in the mid $40’s, but came away thinking the fundamentals were too strong. VECO’s stock declined after Cree’s most recent earnings report- when Cree gave forward revenue guidance slightly below analyst estimates but continued to guide for strong revenue growth overall. Note that Cree actually guided to a capex increase in fiscal 2011 over fiscal 2010 along with 64% Y-on-Y revenue growth in their first fiscal quarter. More or less the short case rests on the following points:
- The recent strength in orders is unsustainable, LED capacity is going up faster than demand and orders have to come crashing back down to earth.
- LED materials such as a wafer substrates (listen to RBCN’s recent call) are in too short a supply for this level of capacity ramp, so MOCVD tool demand is being stolen from the future.
- The Chinese MOCVD tool subsidies are distorting the market, capacity still soon outstrip demand and orders will fall off a cliff for 2012.
- New competition is arising from Applied Materials, the industry leader in traditional semiconductor capital equipment.
There is more than a grain of truth to the short case- demand has been growing for MOCVD tools at an unsustainable pace. No one expects it to keep growing like this, and at some point in the future (maybe even in 2011) it will decline. However, all the research I can do and channel sources I can find tell me that orders are continuing to come in strong and are expected to at least continue at a healthy clip in 2011 as well. The company is already taking orders for 2011 and has a large backlog to work through when orders decline. While there is certainly an element of catch-up in current orders, 30% industry capacity expansion is not far off total industry revenue growth. 42-44% capacity growth in 2011 will also not be much above industry growth if at all. According to LED industry research organization Strategies Unlimited (via VECO’s 10-K), the market for HB LEDs will grow from $4.2 billion in 2007 to over $14.0 billion in 2013, a compound annual growth rate of 32%. As for competition from Applied Materials, testing for their tools has apparently gone on for years with no commercial release. When Applied finally releases their tools they will face a tough uphill climb to convince customers to move from their proven success with Veeco and Aixtron equipment.
VECO will have $13.00 per share in cash by the end of the year (before any buybacks) and is expected to do anywhere from $4.00 to $6.00 in EPS in 2011, depending on how MOCVD tool demand holds up. Cash flow actually runs equal or better to earnings because the company has limited capex and takes 30% deposits on firm tool orders, so the company should between $17.00 and $19.00 per share in cash by the end of 2011. That would represent 47% to 53% of the market cap at current prices. The company had positive cash flow at less than $400M of revenue in 2009, so it would take a greater than 66% decline in revenue from 2010 for the company to become unprofitable and eat into its balance sheet cash.
Let’s say the shorts are right, and orders are about to fall off a cliff. I actually received a note from a Wall St. research analyst a while back hypothesizing that in a worse case scenario VECO’s MOCVD tool shipments in 2011 could go from an expected 460 tools to 277 tools (about 70 tools/quarter, compared to 120 expected in this year’s Q4), bringing his estimated $5.35 EPS down to $2.13. I estimate this would also be about$140M in EBITDA and $100M in free cash flow (bringing cash per share to over $15.00). By the end of 2010 the enterprise value will be down to $996M at current prices, so the company would trade at 7x EBITDA and a 10% FCF yield in this scenario. Not bad a for a successful company in a hot sector, especially in light of the fact that orders could be set up to increase in 2012. In my opinion this scenario has largely been priced into the stock while it is still unlikely. If I was short this stock and had seen this kind of decline in front of an actual turn in the fundamentals I would be thinking hard about covering. The downside is maybe to $25 (and this would be a rock-bottom valuation of only $10 in enterprise value per share, 5x ex-cash EPS and 3.6x EBITDA) while I believe the upside if fundamentals hold up is compelling.
Valuation and Return Potential
Right now VECO trades at 3.3x this year’s EBITDA and a 22% FCF yield on enterprise value. I estimate a current enterprise value around $1B pro forma for the sale of the metrology business, and the EV should be $900M after the roughly $100M of expected free cash flow in the back half of the year. If my current expectations for 2011 hold (basically that the business stays flat with the September quarter for the next five quarters), the company should do $230M in FCF next year, bringing the enterprise value down to roughly $800M after some share creep. This would put the company at 2.6x trailing EBITDA at the end of 2011 with a FCF yield of 29%. I don’t expect these numbers to persist and they will either be rectified by share price appreciation or a decline in fundamentals.
What kind of appreciation can we expect if the fundamentals hold up? For starters, the stock has declined from a high of $51 in May and $45 in early August. Valuing cyclical companies is always tricky but $51 would be less than 5x trailing EBITDA and a FCF yield of 16% by the end of 2011- this is still a discounted valuation in my opinion. A $70 price would represent a 2011 FCF yield of 10%- not unreasonable if it looks like business is going to hold up into 2012 on the back of strong LED market growth for general lighting. I also think that Applied Materials or Novellus may decide that they need to be in this market and acquire VECO. A price of $70 (9x 2011E EPS ex-cash) would be easy to justify even given the semi cap equipment sector’s depressed multiples.
Note that none of my estimates take into account the company’s $200M buyback, which will be highly EPS accretive at current prices. If God forbid VECO should trade at the same 16x forward earnings multiple as RBCN, another cyclical LED company, we are looking at over $80. In summation, I have a hard time seeing why this stock is so heavily shorted as the risk/reward seems poor. To be short I think you have to believe that orders will decline over 50% in 2011, and even then the downside seems protected by the large amount of cash VECO has and is building up.
Disclosure: Long VECO, Short RBCN