Tuesday, July 31, 2012

Is the LED Market Turning?


There are a number of interesting and, at times, conflicting trends running through the LED marketplace at the moment. Increasingly, a consensus amongst market participants is being created towards the idea that a point of inflection has been passed. However, longer term, there seems to be significant variance in the outlook from both a geographic and industry perspective. Investors really need to be discerning about the best way to play the sector.

A good example can be seen in LED equipment manufacturer Veeco Instruments Inc $VECO recent results. Earnings and orders, fell off a cliff on a yearly basis, yet sequentially, they were both up significantly. Moreover, Veeco gave better than expected guidance which pleased the market. Similarly, the World’s leading provider of MOCVD equipment, Germany’s Aixtron $AIXG, recently reported a 90% fall in gross profit with gross margins now down to 25% from 51% last year. But investors were cheered by a more positive outlook and, the announcement that, key customer Osram, will build new capacity in China.


I Started Something I Couldn’t Finish

Essentially, what we are seeing here is an industry that is on a long term uptrend, but is also experiencing severe peaks and troughs within that uptrend. Interestingly, the spikes are being driven by technological changes and rapidly accelerating consumer adoption. For example, prior to the great recession of 2008, LED demand was driven by backlighting for notebooks. Following the severe recession, it was picked up by a surge in demand for LED tv’s and smart phones by the likes of Samsung.

Indeed, it is noticeable how much quicker, consumers are adopting new technologies. For example, it took the US less than ten years for smart phones to achieve 50% penetration. Similarly, LED tv sales have accelerated quickly. For companies like Aixtron and Veeco, this quicker rate of adoption, is creating a new market dynamic. It creates less earnings visibility and, encourages more unpredictable and variable capital investment. Investors need to be prepared for a wild ride.

And there is no greater uncertainty than that created by politicians!

In fact, the last spike in investment in the trend, was created by China making strategic investments in order to support and grow their own LED industry. To see how this is affecting the LED market, here is what Aixtron said recently.
“step forward to 2010, national and regional subsidies and strategic investments in China, supported by a Government five year strategic plan to create a sustainable Chinese LED industry, extended the backlighting investment cycle for another year and a half, peaking, for us at a record order intake level of €222 million in Q2, 2011, about 30% higher still than that high Q2, 2010 figure.”
Similarly, the uncertainty over the timing of China’s subsidies for street lighting investment goes on. It's something that Veeco blamed poor performance on last year.

For backlighting, Aixtron believes that the vast majority of LED capacity has already been installed.  And, investors cannot really rely on Solar to save the day either. Solar power is a heavily subsidized industry and, countries like Spain and Germany have notably scaled back investment in this sector, in response to dealing with their debt problems. In a sense, this is good news because it will encourage investment into making solar a truly economically viable option, rather than as an attempt to capture public subsidy. However, it will create short term headwinds for the LED industry.
So where is the growth going to come from?


Remain in Light

Both Aixtron and Veeco are pinning their hopes on future lighting demand and, for good reason. The industry does look set for growth. I discussed Cree’s $CREE recent results in an article linked here. Cree’s gross margins look like they have bottomed and ,any weakness in the lighting end market was seen as being the result of agent realignments rather than a tailing off of end demand.

There is definitely a market ‘buzz’ around LED lighting. Leading US lighting producer Acuity Brands gave positive pronouncements on the future of LED lighting and, companies like Philips, GE and Osram are aggressively expanding their offerings.

LED lamps and lights are now available at more reasonable prices in places like Home Depot and Lowes. Everyone knows they are more cost effective in the long run, but the problem was always that the initial extra outlay created customer inertia. Especially, when you consider that for a commercial application, a user will want uniformity in his lighting and, be committed to replacing with like-for-like in future.

Those issues are being addressed now and, it was interesting to hear Cree talking about LED light pricing starting to approach incumbent lighting. As for the adoption issue, let’s recall that many commercial builders already use LED lights!  Previously, the major demand for LED lighting in commercial and Governmental demand was for uses in lighting fixtures which were difficult to reach, because LED lights last longer and are brighter, so they don’t require as much cleaning or maintenance. The commercial building industry knows the product and, I believe, is waiting for the correct pricing environment before adopting it.

In this regard, investors can look to GE to take leadership. CEO Jeffrey Inmelt has always been keen to push GE’s environmental agenda and, the company has the kind of marketing and political clout to create awareness and support, for LED lamps and street lighting.


How to Invest?

In terms of investing, I think Acuity could be the best way forward. LED lighting sales are still a small part of its overall sales, but new adoption will be spur growth. Acuity is also heavily focused on North America and less exposed to the vagaries of China’s state expenditure plans. In fact, if LED demand in other areas is curtailed in other areas, than lighting companies could benefit from cost savings in the supply chain.  Furthermore, I think the outlook for US commercial and residential investment is, on a relative basis, looking brighter than it is in China.

As for, Veeco and Aixtron, they are exposed to a whole range of end demand drivers, none of which are giving great visibility right now. Furthermore, there are still over capacity issues which need to be resolved. Both companies are seeing a better outlook for 2013, principally being driven by lighting demand.

In conclusion, we are seeing an inflection point and things are starting to look better, but the end market focus is critical and, investors need to be circumspect.