Saturday, June 2, 2012

SemiLEDS Disappoints Again

Beleaguered investors in SemiLEDS $LEDS must have felt they were due a break with the latest set of results, but true to form, SemiLEDS disappointed and guided the next quarter below the market consensus. This is the latest development in an industry that has been suffering with overcapacity and uncertainty relating to the timing and/or viability of Chinese LED subsidies. This is definitely an industry wide issue and SemiLEDS should not be looked at in isolation.

Earnings Forecasts are being Reduced

In fact, across the board, there have been significant reductions in earnings forecasts over the last year or so. This is usually an early sign that a cyclical industry is about to enter into a downturn. For example, SemiLEDS competitor Cree $CREE has also seen its earnings guided lower after a series of misses. In the following table, I’ve included two of the capital equipment manufacturers, namely Veeco $VECO and Germany’s Aixtron $AIXG They are useful because they give an early indication of how their LED customers are feeling.

Year EPS EstimatesSemiLEDS  to Aug 12Cree to Jun 12Veeco to Dec 12Aixtron to Dec 12
7 Days Ago-.9.981.10.35
30 Days Ago-.87.971.16.51
60 Days Ago-.87.991.72.62
90 Days Ago-.831.181.83.64

Clearly the industry is suffering.
Earlier in 2011, Veeco had blamed poor results on longer order-to-revenue cycle times primarily coming from China and there can be little doubt that this where the weakness lies. The industry had geared up capacity for expansive Chinese expenditure on street lighting. Unfortunately, it hasn’t arrived yet.  This has left the industry dealing with the usual concomitant problems of overcapacity. In other words, inventory corrections, pricing wars, margin erosion and ultimately unhappy investors!
However, it is not only about China. Cree also complained about lower than expected growth in LED bulb applications.

So What Went Wrong with LEDs?

The short answer is... ...Nothing!
LEDs still represent a strong long-term growth area. They are more energy efficient, higher quality than conventional lighting, cheaper in the long term, and more "intelligent" than other forms of lighting. The long-term prospects look good for growing applications within commercial and industrial lighting. Moreover, wide scale adoption in the automotive and street lighting industries is a given. However, all industries suffer growth pangs and, right now, there is overcapacity.

Theoretically, a bit of overcapacity in an industry (due to some random shortfall) shouldn't worry long-term investors because they are in the stock for its long-term growth prospects. The idea is that end demand returns to normal after the blip, inventory's correct in time and, the industry goes back to its long-term growth path.

Unfortunately, the reality is that most investors don't see it this way. I think they tend to overreact to short and mid-term events. That said, it's hardly surprising that the market has discounted the sector over the last year or so.

So What’s in Store for the Industry?

The answer to this question probably lies in your viewpoint on what China will do with subsidies. Moreover, with property prices falling in China and growth in fixed asset investment slowing, private sector demand isn’t likely to strengthen. On the other hand, China works by its own rules and the central government certainly has the resources to spend heavily on supporting energy efficient industries.

Western observers frequently underestimate China’s determination to be energy efficient. So, you could make a good case either way. My concern would be that even if China steps up subsidies, will it be directed in a way to support their own industries and, ultimately employment?  Is it really so unfeasible to expect a Communist government to (ahem) try its hand at Communism?

If you share this skepticism then the only game left to play would be to try and analyze when an inflexion point will be reached in the industry. I always think that the key is to look at when gross margins stabilize. This is usually a sign that the glut is disappearing and pricing power is coming back.
The bad news is that with Cree and SemiLEDS, the gross margin declined in the last quarter’s results.  Similarly, investors could look at capital equipment suppliers Aixtron and Veeco to see if they are talking about any pick up in ordering patterns. So far, so bad.  I think there will be plenty of time to pick these names up, should we get more clarity on what China will do with LED subsidies. In particular, Cree is an exciting stock, but timing is everything and risk averse investors might want to be a little patient here.

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