Veeco Instruments' Upside? Depends What Uncle Sam Does

| About: Veeco Instruments (VECO)

Veeco Instruments (NASDAQ:VECO) has had many incarnations since its founding in 1945 by two Manhattan Project scientists as the Vacuum Electric Equipment Company. In its current form, Veeco Instruments' main source of revenue is its leading position in the marketing and manufacturing of LED (light emitting diode) and solar process equipment, along with a smaller percentage of their business dedicated to data storage.

According to CFO David Glass in the 2010 Q4 Conference Call, 2010 was the best year in Veeco's history. [See previous conference calls for the company here.] The 13 analysts that cover Veeco seem to believe that growth is in its future with an average estimate of 13.33% CAGR for the next five years as reported on Yahoo Finance. With a modest P/E Ratio of 10 and its core business segments positioned for robust growth, is this the kind of stock you want to own? On the surface, it seems like a no brainer, but let's examine the situation more closely.

With its main stream of income stemming from the solar and LED divisions, Veeco primarily resides in the semiconductor industry, which is highly cyclical. Renown value investor Peter Lynch has a counter-intuitive rule of thumb when investing in cyclical securities: You buy when the P/E Ratio is high and sell when the P/E Ratio is low. Lynch's theory is that you buy when the P/E Ratio is high and the stock price is low because Wall Street has caught on to these equities, and many times has begun accumulating them before the market makes a big run and takes the stock along with it. When a cyclical security has a very low P/E Ratio with record profits, the street is anticipating a downturn and may be ready to bail on it. A good example of when looking at a high P/E, low priced stock is Veeco, back in 2008.

In 2008, Veeco hit a low of $3.50 a share and had an annual average P/E Ratio of 28 with decelerating earnings and sales growth, according to ValueLine. When the market began recovering in 2009, Veeco's share price had a parabolic rise, increasing ten fold to $35, then jumped again in the first few months of 2010 to $54/share. This was probably in anticipation of earnings/share increasing from $.20 in 2009 to $4.58 in 2010. It is difficult to buy at the bottom, but if you did, a ten or twenty bagger would have been a tidy profit. Even purchasing Veeco at $10, you would have made a lot of money if you would have sold at the top. This begs the questions: Is this the top and is this the right time to sell? That depends not so much on what Peter Lynch would advise, but on what Uncle Sam has to say.

The solar industry is less sensitive to the economy than other cyclical sectors because it is driven predominantly by government spending. In President Obama's State of the Union address to Congress in late January, he referred to his administration's push into renewable energy as 'our Sputnik moment'. However, any excess spending by Congress is a bit of a political football; the days of federal and state backing of the renewable energy industry may be numbered.

The Senate recently agreed to extend cash grants to solar and wind power companies through 2011, but there is no guarantee that the gravy train will go on indefinitely. In fact, earlier this month Veeco was the recipient of a $4.8 million grant by the Department of Energy to help beef up its R&D efforts. This may have contributed to the stock's run up back to $52 just a few trading sessions ago. This past week Veeco came back to the ground a bit, but that may have just been profit taking.

At its current valuation of $45/share, Veeco has a forward P/E Ratio of 9 and a PEG Ratio of .7, if you use an earnings growth rate of 13% as the analysts that cover it are predicting. That's a compelling appraisal for a value investor. If the government doesn't take away the punch bowl and continues to subsidise the renewable energy industry, then Veeco will probably continue to climb higher. How much higher? Who knows, but 13% CAGR is what you want in a growth company and that's not to say that the earnings rate won't go higher. Of Veeco's business, 68% goes overseas and that's in its favor. However, the industry is subsidised in foreign countries too, and we're not the only government running up deficits. I believe that government spending on a worldwide basis is going to curtail, but that's my two cents.

If Peter Lynch were making the decisions, he probably would have sold the stock long ago, but that's only my speculation and you can't turn back the clock. The main premise for this stock is deciding what the governments will do. If you think they will keep doling out money, then by all means, stick with a solid company like Veeco. If you believe that there will be some belt tightening in the near future, then all bets are off and everybody out of the pool.

Disclosure: I am short the market with inverse ETFs.