How would you like to own a stock with leading market share exposed to one of the best long term secular trends in technology and that is trading at a reasonable valuation on current year earnings which is likely to be a cyclical trough?
VECO is a manufacturer of process equipment technology. It has leading market share in equipment used to make Light Emitting Diodes (LEDs) and is the leader in process equipment for making hard disk drives. It also has a relatively small business exposed to Solar panels. In q4, LED’s represented 78% of sales, data storage represented 17% and solar was 5%. Similar to most capital equipment businesses, the company’s earnings are highly cyclical. Quarterly Earnings peaked in q4 2010 at $1.62 and is the Street is expecting q1 2012 EPS to be about 20c (the mid-point of company guidance is 24c). Annual earnings peaked at $4.73 in 2011 and the street is currently expecting slightly over $1 of EPS in 2012.
Investment highlights include:
1) Great secular growth. Less than 5% of lighting is currently LED and many countries are incentivizing its adoption. The incandescent light bulb is also being phased out over the next few years. Rapidly declining LED bulb prices have resulted in less than a 1 year payback period for commercial applications in most countries including the US. For residential applications, the payback period of an LED bulb is now less than 2 years in most of the countries of Western Europe. According to IEEE Spectrum, “The passing of Edison’s bulb has already been decreed and which of the two alternatives will replace it is at last becoming clear. It will be the LED.”
2) Company will likely go from significantly lowering estimates to at least making estimates in the short term. Because of continued overcapacity in the LED market, the company guided down significantly for 2012 vs street expectations. However, street estimates at this point seem achievable, if not beatable. Given how much LED orders dropped y/y, it is difficult to imagine the LED industry to be much worse than it was in q4 2011 and yet that is what the guidance effectively implies. Furthermore, Street estimates are currently below guidance. VECO is guiding for data storage growth of 25% this year (disk drive customers are rebuilding after the floods in Thailand). If you take this into account and the fact that the company already had $205m in LED equipment backlog as of the 2011, the company needs about $95m of LED bookings to beat the mid-point of its revenue guidance. Assuming a 6 month lead time, the company will need to get these orders over the first half of 2012. This implies that LED orders actually get worse than what they were in q4 ($59m) in q1 and q2 of 2012. The Deutsche Bank analyst recently came back from a trip to China where he met many VECO customers. He believes “greenshoots are emerging.” While he is not yet seeing strong order activity, he noticed that utilization rates at several customers had increased significantly from last Q. Customer utilization is the leading indicator. When utilization gets to a high enough level, they will start ordering equipment again. Even CLSA’s Mark Heller, who recently downgraded the stock, stated in his note that “q1 12 might mark the absolute bottom for orders.” He also admitted that utilizations rates at VECO’s customers are “off their lows.” As long as utilization rates do not get worse than where it was in q4 2011, VECO’s business is also not likely to get worse, which is what guidance implies. Therefore, VECO should meet or beat estimates going forward as opposed to guiding down significantly vs street estimates in previous quarters.
3) High short interest. As of the end of February, about 27% of the float was short. The short interest actually increased by 1m shares from the prior month despite some evidence (even from bearish sellside analysts) that the business environment does not seem to be at least getting any worse. With net cash at over 40% of the market cap and the business not likely to much get worse, I think this is a stale short idea. Furthermore, note that the stock actually went up after guiding down significantly last quarter. If last quarter didn’t make the stock go down, I am not sure what will.
4) Great balance sheet. The company had $489m of net cash as of last quarter. This is over 40% of the current market cap. The company opportunistically bought back stock last year when the stock hit a low point in the low to mid 20s.
5) Company making money in the trough. Because the company outsources most of its manufacturing, it continues to make money even at the bottom of the cycle.
6) Oligopoly and gaining market share. Potential winner take all type of business. VECO and Aixtron are currently the only two major players in the LED equipment industry. AMAT also recently entered the market but despite this, VECO’s share has actually been increasing and the average selling price of tools has been relatively consistent. Credit Suisse estimates that VECO’s LED unit share increased from 42% in 2010 to 51% in 2011. AMAT has not been successful in other new business areas they have tried to expand into like Solar and their tools do not seem to be differentiated. Finally, this industry has the potential to be a winner take all type of business as the company that has the leading share can afford to invest the most in R&D.
7) Reasonable valuation. Excluding net cash, the company trades at a reasonable mid-teens p/e on current year earnings, which is very likely the trough. Based on the previous peak earnings, the company trades at less than 4x p/e after excluding net cash.
8) Many LED tools coming off warranty. The company expects services revenue to be about 25% of sales this year and will be growing at 40%. Services revenue is currently mostly associated with data storage but the LED business should be a big driver of services revenue growth in the years to come as LED tools previously sold come off warranty. Furthermore, older LED tools are much less efficient than current tools so customers may start to upgrade their tools even when their overall utilization is low and they do not need much incremental capacity.
1) There could be cancellations from the backlog. My premise that guidance seems achievable assumes that there are not much cancellations from VECO’s backlog. Cancellations have been surprisingly low so far despite terrible industry conditions in this downturn. This is partially because VECO has a built in cushion since it requires a 30% deposit from customers before it recognizes an order in backlog.
2) Pricing could get more competitive. Pricing has been relatively stable. Because VECO is the industry leader and because it has an outsourced manufacturing model, it has very little incentive to price aggressively. The competitive dynamic could change, but I take some comfort in the fact that Aixtron and AMAT have also not been very aggressive with pricing even though industry orders are down over 80% from the peak.
3) The company may use some of its cash balance for M&A. The company has historically been disciplined about M&A so I have some faith that they do not stupidly deploy cash. VEO actually got into the LED equipment business through M&A several years ago. Furthermore, the company has publicly stated that it is not looking for a very large acquisition.
4) The trough could last longer than expected. If the current trough lasts into 2013, EPS could go slightly lower since data storage may also decline after comp-ing the rebuilding due to the thai floods this year. While this is a risk, I think that the worse the downturn is the better the upturn will eventually be. If the LED market stays very bad this year, LED pricing will likely go down significantly stimulating higher than expected unit demand from general lighting applications.
company will go from guiding down significantly recently to meeting/slighlty beating estimates. increasing utilization rates at VECO's customers will eventually translate into an industry upturn. There is also likely to be increased government regulation that incentivizes LEDs for general lighting.