by Daniel Holland
The emergence of cost-competitive light emitting diode (LED) lighting solutions has taken the lighting industry by storm, creating meaningful growth opportunities in an otherwise static industry. While new revenue opportunities are helping to energize the business, in this case we think the shift to LED may be the end of a cash cow that a number of conglomerates have milked for decades.
A Field of Three Shrinks to One
In 2008, General Electric (GE) put its appliances business up for sale, a decision we thought made sense considering the low-margin unit didn't necessarily fit into chairman and CEO Jeff Immelt's vision of a pure infrastructure franchise. To the extent that housing was going to suffer a bit of a downturn, management thought it was better to move out then as opposed to selling at the bottom of the market. Curiously, though, GE opted to throw its lighting business into the deal as well. For several years prior to 2008, we were told about the growth potential of the LED markets, how cost-competitive the new products were, and how they would help energy consumers cut electricity bills by meaningful amounts. With the LED industry still in its infancy, this decision didn't seem to make sense, but our sources within the company told us that the two businesses, while solid, didn't really make sense in the longer-term strategy for the company.
General Electric was unable to sell those businesses as buyers were reluctant to commit significant capital to acquisitions with so much uncertainty in the macroeconomic environment. Since then, GE has continued to invest in both businesses, though management remains very noncommittal, in our opinion, to the longer-term prospects of the segment. Immelt noted at that Philips (PHG) has a much different opinion of lighting and LED than General Electric, indicating GE still would love to exit lighting at the first chance.
In February, Siemens (SI) announced that it would spin off its lighting unit Osram later this year. Siemens, already flush with cash, has no immediate need to exit Osram, aside from refocusing its efforts on building its cities and municipalities sector. We initially suspected that having a lighting business in place and a strong product portfolio to offer municipalities would be beneficial, so it is curious to see Siemens step back from lighting. While Siemens expects to maintain an equity interest in Osram post-divestiture, the onus for investment is now clearly in the hands of the leaders of lighting and not the corporate parent.
Fight or Flight
LED technology has been around for some time, most recently making inroads in televisions and hand-held devices. The lighting industry has been waiting several years for the cost curve to come down on the technology before releasing products to the end market. And the cost per lumen hour has come down dramatically, presenting the ideal opportunity for manufacturers to pitch the product. However, we see a couple of issues that should alert investors as the industry adopts these technologies.
First, LED bulbs last a lot longer than all other relevant lighting peers. By extending the replacement cycle, manufacturers push out further repurchases, decreasing unit volumes significantly. Naturally as an adjustment, a firm would ramp up pricing wherever possible to compensate for the lost revenue opportunity, but pressure from a variety of external sources may limit pricing power for manufacturers - our second and most damaging concern. In spite of an extended replacement cycle, consumer adoption is weak since the actual price per bulb is still above $25.00, on average; incandescent bulbs are less than $0.50 each. The sluggish consumer adoption is of particular concern when considering that the cost per lumen for an incandescent bulb is nearly 3 times more than LEDs. Sticker shock, as well as the fact that a product may last longer than a homeowner remains in his/her house, deters potential buyers. As a result, even flat pricing, let alone increases, would be difficult to overcome.
Environmentally conscious governments are eager to tout energy efficiency, and now can point to LED lighting as a solution that has a reasonable payback period. Again, tinkering with the sticker price affects a fundamental growth driver for the industry. Lastly, we fear there are many firms not necessarily interested in achieving reasonable returns on invested capital while operating in the space. While Asia offers the most growth potential for LEDs, it also provides the most competitors in the field. With ample demand and capital flowing into lighting projects, there is an opportunity for many players to exist and manufacturing expertise isn't necessarily required for building a presence in the marketplace. Under these conditions, the basis for a moat in the lighting industry quickly erodes.
The competitive response has been to flee - to the niches. While the major lighting incumbents have released some branded LED solutions for mass consumption, they have in reality focused most of their efforts on high-performance lighting - starting with special event and theatrical lighting and morphing to street-level lighting. Consumers of these products appreciate the shade flexibility and longer life cycle. Moreover, with regard to street lighting, the longer life cycle of the product means fewer labor hours committed to replacing light bulbs, which for larger consumers can be material.
For the first time, we have seen lighting equipment manufacturers switch from simply making the bulbs to creating the fixtures as well. Since LEDs can be arranged in a variety of ways and the lumen output and direction of the bulb is affected by the fixture, it makes sense for manufacturers to evolve this way. Philips has been the most aggressive in the vertical push through acquisition, but Siemens is also slowly catching on as well.
One area that also makes sense, particularly in Siemens' case, is lighting controls. Dimming switches, day-light capture, and other control mechanisms reduce energy consumption and are agnostic to existing bulb technologies. The payback period on industrial lighting projects is now around 18 months in many cases, a horizon that is palatable to most building managers. We expect firms like Hubbell (HUB.B), Cooper Industries (CBE), and Honeywell (HON) to benefit in the coming years from growing demand for quick and easy energy-efficient retrofits for buildings.
The Winner's Curse?
Philips appears to have won the war of attrition among the giants, with Siemens pushing Osram to be independent and GE's laissez faire approach making it less of a player than before. While the conglomerates typically have strong manufacturing expertise and lower manufacturing costs, they prefer to compete in the market on technology and value added to the consumer, not simply on price. In order to continue pursuing that path in LED lighting, we think the incumbents will need to materially step up research and development, acquisitions, and capital spending in this area to have capable products in an increasingly competitive field. Given that General Electric and Siemens both have more compelling investment opportunities within their broader portfolios, we think their decision to step back from lighting makes sense and is prudent for shareholders.
Philips' commitment to lighting has chipped away at asset turns, reducing the ratio to roughly 1.0 from 1.5 times, while returns on assets have dropped 5 full percentage points. Given the aforementioned difficulties that we see in recouping investments in LED lighting, we don't see the last few years as an aberration but rather as a harbinger of further financial weakness. If investors are interested in profiting from the growing demand for energy-efficient products and solutions, we encourage them to look at the firms focusing not on bulbs, but on switches and controls. The payback is much more palatable, and the opportunity for revenue after the initial equipment purchase increases the likelihood that the company can earn a decent return on investment in those sectors.