I have been bullish on the semiconductor industry for the last couple of months, as the sector has been hammered in 2011, resulting in solid valuations for a number of companies across the sector. Once again, Wall Street analysts seem shocked -- shocked -- to discover that semiconductor manufacturing is a cyclical industry. After bidding up names across the sector in 2010 -- particularly those who supply growing industries such as smart phones and consumer electronics -- the Street has downgraded company after company that misses quarterly earnings and complains about short-term "visibility." Companies such as Entropic (ENTR), Novellus Systems (NVLS), Microchip Technology (MCHP), FSI International (FSII), and LTX-Credence (LTXC) have seen drops of 11-38% based solely on missing earnings estimates and/or providing weak quarterly guidance. In most of the cases, the long-term story has remained the same; yet short-term worries have crushed the stocks.
The story has been a bit different for semiconductor companies that produce light emitting diode (LED) chips, which are used in everything from high-definition televisions to mobile phones to highway signs and traffic lights. Projected growth in the industry led to strong 2010 results for four of the industry's publicly traded players: Cree (CREE), Veeco Industries (VECO), SemiLEDs (LEDS), and Germany's Aixtron SE (AIXG). But earnings misses and analyst downgrades have resulted in a painful year-to-date performance in 2011.
2011 year-to-date chart; CREE in blue, LEDS in green, AIXG in brown, VECO in red. Chart courtesy Yahoo! Finance
While some may argue that price drops of 40-80% are a bit overdone, there are worries in the sector. Capacity built in 2009 and 2010 has resulted in a glut of chips, which combined with lower-than-expected spending on LED TV's and lighting to eat away at profit margins.
There is still promise in the long-term for the industry. IMS Research projects that total LED spending will surpass $12 billion by 2015, a 40% increase of 2011's estimated total of $8.7 billion. The continued transition away from incandescent lighting and the growth of LED televisions bode well for expansion in the industry;
In the meantime, the carnage in the stock prices of CREE, AIXG, LEDS, and VECO has resulted in valuations one might not expect from a growing industry:
Fundamentals For LED Stocks, 9/21/11
|Stock||Closing Price 9/26||Earnings (ttm)||P/E|
* -- non-GAAP (GAAP earnings of $1.33)
** -- includes midpoint of company's 4Q guidance for loss of .23-.25 per share
*** -- from company's non-GAAP full-year guidance of "at least" $5.25/share
The question is: are short-term fears resulting in unnecessarily depressed valuations? Or is the market rationally pricing in the possibility of future struggles? The answer depends on the company -- and the fundamental chart above gives a big hint.
SemiLEDs I would definitely classify as a value trap. At $4.03 per share, the company offers $3.08 per share in net cash, and a tangible book value of $6.20 per share. Yet, since its IPO in December, the Taiwanese company has missed earnings badly in all three quarters, and lost over 75% of its initial market capitalization. The most damning quote for a potential LEDS investor comes from Avian Securities' Andrew Abrams, courtesy of thestreet.com:
I looked at the filing when the company was first going public and my thought was "It's so insignificant, why is it going public?" I asked guys in the LED sector who said, "We never come up against them. They don't exist."
The Taiwanese company has already burned $17 million in the first three quarters, and the burn rate should increase in the fourth quarter, as the company expects gross margin to be negative, according to guidance given along with third quarter earnings. The silver lining of the negative margin is that SemiLEDs doesn't sell all that much product, which should limit its fourth quarter loss. The tiny company -- market cap is just $118 million -- still trades for over two and half times sales (which perhaps explains its lack of relevance in the sector.) With fourth quarter earnings due in early October, traders may look to short the stock, hoping the company's history of disappointing investors continues for one more quarter.
Cree is the largest of the four stocks covered here, and perhaps the most difficult to value. Even analysts can't decide; last week Sterne Agee's Shaw Wu listed it as a "beat-up gem" and Deutsche Bank initiated coverage on September 16th with a price target of $40. Four days earlier, Wunderlich had cut the stock to "sell," with a target of $25, on weakening worldwide consumer demand.
There is little doubt that the slowdown in demand will hit the company in fiscal year 2012 (ending in June 2012). Analysts are expecting earnings of $1.39 per share for the year (non-GAAP), an 18% drop from the current year. (The estimates range from 87 cents to $1.92, further showing the divergence of analyst opinion on the stock.) This gives the stock a forward P/E of 20.7 -- and there may be reason to discount the consensus estimate as optimistic. First quarter guidance from the company is for non-GAAP earnings of 25 cents, less than half of the 60 cents the company earned in the first quarter of 2011. Notably, the 35-cent per share dropoff is greater than the difference in annual earnings between the 2011 results and the 2012 estimates. Thus, the $1.39 consensus estimate requires the company to outpace its 2011 results for the following three quarters. Granted, the company's acquisition of Ruud Lighting (which slightly lowered first quarter guidance) is expected to aid earnings later in the year. However, further weakness in the sector could impact FY12 earnings significantly, leading to further cuts in a stock that is already off 60% from its December highs.
The bigger issue for Cree lies beyond its earnings, in its cash flow. Free cash flow for 2011 was just $14 million, with another $12.5 million earmarked for patent purchases and licensing fees. Increased capital expenditures -- up to $238 million last fiscal year from $55 million in FY 2009 -- were certainly a culprit, but operating cash flow was flat year-over-year, at around $250 million. This is strong on a revenue basis (26% of sales), but compared to the company's $3.3 billion market capitalization, it leaves much to be desired. Cash generation has been a weak spot for the company for some time; according to the company's 10-K, free cash flow for the last three years has totaled just $219 million, less than 7% of the company's current market capitalization.
Cree does offer a strong balance sheet -- the company offers about $630 million in cash, over $5 per share, after accounting for the Ruud acquisition, with no debt. But the limited visibility and lack of cash generated from operations should make value investors nervous. With many companies in the sector trading at single-digit P/E ratios, Cree's forward P/E over 20 doesn't seem justified by its growth prospects, and seems rather expensive on a relative basis. On the bearish side, the already large short float -- 16.7% of shares outstanding -- and the company's steep price drop so far would seem to make shorting the stock a risky gamble as well. The stock has bounced off a bottom around $27 repeatedly over the last six weeks, and another bounce could lead to a short squeeze. The lack of conviction on either side explains why the stock has been range-bound for the two months, movement that should continue until investors have more information to make their move.
Those investors willing to take a chance on a rebound can look at selling a cash-secured March 25 put. Bid at $3.75, the investor will either make a profit (a maximum of over 15%) or receive the stock at a net cost of $21.25, just above the company's book value. This hedged bull play provides some downside cushion and, in the worst-case scenario, allows for purchase of CREE stock at a valuation that seems more reasonable than that currently given by the market. But right now it's simply difficult to construct a compelling case for Cree -- on either side.
Aixtron SE is another difficult study. The company's current fundamentals -- nearly 30% of market cap in cash, a dividend yield above 5%, and a P/E below 6 -- look outstanding. But as is the case in many chip stocks, there are a variety of reasons for the depressed valuation. The company slashed revenue guidance earlier this month, from 800-900MM Euros to 600-650MM Euros, based again on softening worldwide demand. Margin projections were also diminished, and the stock fell nearly 14%, tacking on another 12% over the following days toward a 52-week low.
The stock rebounded last week on rumors that Samsung was considering a bid for the company, and closed Monday at $16.21, 63% off its 52-week high. Analyst estimates for 2011 and 2012 now average $1.50, and $1.23 per share respectively. Again, the numbers look solid -- enterprise value-to-earnings ratios of 8 and 10, respectively -- but the tremendous slump in revenues and the pressure on margins have to give investors pause. Its 5% yield -- based on a May payout of 83.8 cents -- is unsustainable given current events, and it seems likely that next year's annual payout will be closer to 2010's 20.4 cents. Finally, continued weakness in the Euro will negatively impact the value of Aixtron ADR's, adding another layer of risk for American investors. Like Cree, AIXG looks to lack a compelling reason for bullish or bearish plays. Unlike Cree, its option market lacks liquidity -- and offers large spreads -- limiting the effectiveness of a hedged bull play.
Veeco Instruments has had the strongest year-to-date performance, though that is likely of little comfort to VECO investors who have endured a one-third haircut since the beginning of the year. Veeco also appears to have the strongest position in the industry. The stock has been hit hard over the last few weeks, not by its own struggles, but by fears linked to reports from its competitors and suppliers. Aixtron's reduced guidance (accompanied by at least three downgrades of VECO stock to neutral) knocked down the stock, as did a similarly weak outlook from LED supplier Rudolph Technologies.
Yet the company's own second quarter earnings were strong, meeting previously announced guidance and affirming Veeco's full-year outlook of over $5.25 per share in non-GAAP earnings and over $1 billion in revenue (giving the stock a P/S ratio close to 1). Granted, the earnings were released on July 28th for the June quarter, and investors have reason to be fearful about conditions in the third quarter. But the company also announced the discontinuation of an unprofitable solar business, and the repurchase of $170 million in stock and convertible debt.
And on a valuation basis, VECO seems a far stronger buy than its competitors. P/E is 5.4, and price-to-sales, as noted previously, should be a touch above 1 (compared to over 3 at CREE and 1.5 at Aixtron). Veeco has not had the cash flow difficulties faced by Cree, either; 2010 free cash flow was $184 million, nearly one-sixth of market capitalization, and in the first half of 2011 the company generated another $44 million despite a large negative change in working capital. (Higher inventories and higher prepaid expenses, both of which will be converted to cash in the near future, were the main culprits.)
The fundamental numbers are all the more astounding when one considers that Veeco has $630 million in net cash, or $14.65 per share, over half of its market capitalization. Accepting analyst consensus for a 2012 slowdown in earnings to $3.57 per share, VECO trades at a forward enterprise value-to-earnings ratio below 4. (Take the most pessimistic estimate of 21 analysts, at $1.80 per share, and the EV/E ratio is still below 8!). The company has generated nearly half of its enterprise value in cash in the last six quarters alone; with guidance for second half earnings nearly equal to those of the first half, and changes in working capital expected to be positive, that trend should continue for the next two quarters.
The question for VECO -- as it is for the entire sector -- is whether the company can continue to produce earnings against a macro downturn. Those worries are real, but seem more than priced in, given the drop in the company's stock price. The company successfully navigated the 2008-09 recession -- growing cash flow each year -- and its exposure to the Chinese and Korean markets should provide some cushion against difficulties in the Western economy. Much of its Asian growth as of late has been in the lighting segment, projected to be the fastest-growing LED market, giving the company growth opportunities despite recession fears here in the West.
Indeed, at Monday's close of $28.55, VECO appears to have substantial downside protection. The 50% cash balance, the exposure to emerging markets, and the company's 66-year history should provide comfort to investors in these trying times. Investors looking to add to their downside protection can look to the options market, using cash-secured puts to hedge against short-term disruption from a weak third quarter earnings report (which should be out in late October) or additional volatility from competitors or suppliers. The April 25 put, bid at $3.50, offers 16.3% return (about 30% annualized), with a break-even at $21.50, just above the company's book value of $20.67. Ultra-conservative investors can look to the April 15, bid at 75 cents, which offers investors either a 5.3% profit (just under 10% annualized) or assignment at a net price of $14.25, below the company's current cash balance. No matter how you play it, Veeco looks to be the strongest stock in the sector.