Veeco Instruments (VECO) - Brighter Days Behind This LED Equipment Vendor?

Shares of MOCVD equipment maker Veeco Instruments (VECO) approached a new 52 week intraday high yesterday even though concerns over the ability of China to deploy already ordered systems mounts. With that in mind, I am recommending risk tolerant investors take a short position in Veeco Instruments and risk adverse shareholders that already own VECO use the shares as a source of funds, given the run up in the shares over the last 8 months – from a low near $31 to the current $52.46 – even though backlog and bookings for the core LED & Solar business have weakened over the last few quarters.

Currently Veeco shares are trade at 9.8 times and 12.6 times respective Street consensus expectations for 2011 and 2012. Similar to my analysis on Motorola Mobility Holdings (MMI), we need to adjust both the share price and EPS figures to account for VECO’s substantial net cash per share position ($14.23 per share). Backing out the net cash per share position roughly $0.20 per share in aftertax interest income per share, VECO shares are trading at 7.5 times and 9.7 times

While many will look at those P/E ratios and think “sounds cheap,” we have to consider that cyclical stocks - remember VECO is a cyclical growth stock - tend to look cheap on a P/E basis as earnings near and eventually reach their cyclical peak. As an investor that has looked at numerous cyclical companies over the years, we have to remember to buy cyclical stocks when they look expensive because their earnings are depressed and sell them when they look cheap because earnings are at or near the cyclical peak. This holds true for industrial cyclical as well as technology and growth cyclicals, such as Applied Materials (AMAT) and others.

In terms of downside, VECO shares bottomed in February near $42 a share or 5.5 times adjusted 2011 earnings. As confirming signs emerge that MOCVD demand is weakening the resulting decline in backlog levels and negative EPS revisions will pressure VECO shares past that $42 level. Keep in that VECO share have a beta of 2.47, which means its price swings are greater than the overall market and therefore should be considered volatile and higher risk in nature.

Given the nature of this thesis, those initiating a short position should be prepared to:
1. Be patient as this thesis will unfold over the next few quarters
2. Slowly build their short positions and capitalize on near term strength in VECO shares to build their position.


Background

A few months ago, I added Cree Inc. (CREE) to The Thematic Investor portfolio as part of my Replacement Demand/Technology theme. For those who might have missed it, the thesis was that Cree, semiconductor and light emitting diode (LED) company, would benefit as more traditional forms of lighting are steadily replaced with more energy efficient LED lighting, including high brightness LEDs (HB LEDs).

As I noted in my initial viewpoint, like most semiconductor companies, Cree tends to be what I call a cyclical growth company in that a long-term perspective shows a favorable growth curve as the addressable market expands. In 2009 and 2010 the LED industry experienced significant growth as LEDs penetrated laptop and television backlighting applications. In June 2010, Strategies Unlimited forecasted that growth in those applications will continue, resulting in a compound annual growth rate (OTC:CAGR) exceeding 80% from 2009 through 2014. LEDs are also starting to experience increased adoption for general lighting, with Strategies Unlimited forecasting a CAGR of 39% over the 2010-2015 period. Overall, the market for HB LEDs is expected to grow from $5.5 billion in 2009 to $18.9 billion in 2015, for a CAGR of 11.8%.

From time to time, however, that growth curve can get bumpy, if not disrupted. Such bumps tend to happen when LED industry capacity expands too quickly and eclipses demand. The result is a capacity glut that results in pricing and margin pressures.

Currently Cree and other LED companies in the industry are in the midst of such an environment and are burning off excess inventories as the overall LED industry digests excess manufacturing capacity. That excess manufacturing capacity resulted from a record number of shipments of capital equipment used to manufacture LEDs. In 2010, 786 such tools were sold, up from 228
in 2009. Part of that growth is attributed to China, which introduced a stimulus plan that is expected to result in $1.6 billion in spending on MOCVD capital equipment from 2010 to 2012.

There are a number of MOCVD equipment vendors - Aixtron, Applied Materials, Jusung, Taiyo Nippon Sanso and Veeco - however, two of these companies account for roughly 97 percent of industry MOCVD shipments. One is Aixtron AG (AIXG) and the other is Veeco Instruments (VECO) and in 2010 it is estimated that those two companies accounted for 97 percent of LED capital equipment tool shipments in 2010. Of the 798 tools shipped in 2010, Veeco’s share rose to 43 percent from 31 percent in 2009 as Aixtron’s share fell from 62% to 55%. In 2009, it’s estimated that 228 MOCVD tools were shipped industry wide.

That surge in MOCD tool shipment reflects an increasing number of players entering the LED market in general, and more specifically an increasingly aggressive effort by China to build- out its solid state lighting industry and the introduction of a MOCVD stimulus program that is expected to result in $1.6 billion in spending on MOCVD tools from 2010 to 2012. In addition to subsidies worth up to $1.8M per tool, local Chinese governments are also offering lower tax rates, accelerated depreciation and free land. This program has encouraged existing Chinese LED manufacturers to expand capacity, resulted in many new entrants, and caused existing players in Taiwan and Korea to form joint ventures and add capacity in China. In total, 25 new LED manufacturers have entered and nearly all of the approximately 75 LED manufacturers are adding capacity between 2009 and 2011. In aggregate, China led in MOCVD installations for the first time in Q3’10 and in 4Q 2010 China accounted for 64% of the market, up from 31 percent , while Korea’s share fell from 27% to just 5%.

One of the reasons for Veeco’s share gains in 2010 reflects the industry transition to larger wafer sizes. In 3Q 2010, 4” wafer capacity accounted for over a third of total wafer capacity according to IMS Research and LED companies have begun installing 6” wafer capacity tools over the last few quarters. While wafer yields tend to be relatively low as companies add incremental manufacturing capacity and during initial transition to larger wafer sizes, over time utilization levels should rise. In effect, this leads to a one-two punch in incremental LED capacity that is likely to lead to an eventual capacity glut. In my view, this is likely to be similar the last time there was a significant pick up in MOCVD equipment demand in 1999-2000 in anticipation of strong RF semiconductor growth owing to aggressive mobile phone expectations that turned out to be far less than expected in 2000 and 2001. For example, in 1999, the mobile phone industry delivered 283.6 million units and at one point Gartner DataQuest forecasted 500 million units to be shipped; the industry shipped 400 million units in 2001. As a result of that capacity glut, MOCVD equipment demand peaked in 2001 and orders weakened in 2002. In 2002, Aixtron recorded orders totaling EUR 94.1 million compared to 163.4 million in 2001 and its order backlog at the end of 2002 amounted to EUR 85.0 million compared to 133 million in 2001.

Already, there is chatter in the industry of equipment push-outs in Japan due to the earthquake, installation delays from a variety of smaller Chinese players as well as revised installation plans from more aggressive Chinese players including GCL Sola, Lextar Electronics, and Dalian Suzhou. With more than 75 companies serving the LED market, there is bound to be eventual industry consolidation and capacity rationalization as the surviving companies target profitable growth. Again, very similar to what happened in the RF semiconductor industry in 2001-2005.
Despite that chatter and potential risks to MOCVD equipment forecasts over the next several quarters, shares of both Aixtron and Veeco are at, or approaching their respective 52 week highs. While Aixtron has yet to report its March quarter results, Veeco recently reported its results, which on its face seemed better than expected. But in digging deeper into the results, there are reasons to be concerned. While Veeco’s reported EPS was better than expected, the company’s LED & Solar segment saw a 17 percent sequential drop in revenue to $215 million and that segment’s bookings fell 22 percent compared to those posted in the December 2010 quarter.

What raises my concern even more is that such declines have not been limited to one quarter. Rather, over the last several quarters Veeco’s LED & Solar bookings have continued to decline from a peak in 2Q 2010, the same quarter in which the company’s backlog peaked and it has since ticked down quarter after quarter. Exiting the March 2011 quarter, Veeco’s total backlog was $530 million, which equates to less than two full quarters of revenue given current Street expectations. To be fair, Veeco has operated on close to two quarters of revenue in its backlog for several quarters; however, I also need to point out that that was during improving Solar & LED bookings, which has not been the case for several quarters. Veeco’s Solar & LED book to bill levels well below year ago levels and below 1.0 for the last two quarters.

By comparison, Aixtron’s overall backlog level continued to improve during 2010. The company’s backlog levels rose from EUR 229 million at the end of 1Q 2010 to EUR 279 million at the end of 3Q 2010 and then again to EUR 302.2 million exiting 2010.

Getting back to the respective shares of Veeco and Aixtron, the shares of both companies are trading at or near their respective 52 week highs. Given the risk of weakening MOCVD orders and subsequently backlog declines over the next several quarters, I see greater risk than reward at current levels for both companies. Even though the valuation on AIXG is far richer than that for VECO shares, VECO shares have far more liquidity than AIXG shares as measured by average trading volume and as I commented earlier Veeco’s LED & Solar backlog has been declining over the last several quarters. As such, if I had to choose one or the other to focus on, it would be VECO over AIXG.



Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.