The Best Stocks to Play the LED Lighting Boom

Shareholders in lighting company Acuity Brands were given a rude reminder of the risk of holding a highly rated stock recently. The company's third quarter results missed estimates and the stock plunged more than 15%. But it might not all be so bad. Acuity's management doesn't give earnings guidance, so Fools should expect some volatility around the results. In addition, the company is attractive for a host of reasons, many of which also apply to Cree  and Hubbell . Is this a good buying opportunity in Acuity Brands?



Acuity Brands, Cree, and Hubbell: cyclical and secular growth prospects
Acuity Brands is attractive because it has cyclical growth prospects via an upturn in spending in the commercial and industrial construction sector. In addition, it also has a secular growth story from the growth in utilization of LED lighting. Given the company's P/E ratio of 33 times current earnings, it's reasonable to conclude that Acuity needs both these growth drivers to perform in order to take the stock higher.



The good news is that the indications from Cree's LED lighting results is that the secular story is very much intact. Cree manufactures LED products, lighting (LED based), and power and radio frequency products. In its latest set of results, LED products (which service a range of industries) only grew 3%, but Cree's LED lighting solutions grew 35% and now make up 44% of its total sales from just 37% last year. Moreover, Cree's management expects "double digit growth in lighting in both LED fixtures and LED bulb" -- good news for Acuity because LED lighting sales now make up a third of its overall sales.


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Commercial Construction Is Looking Hot For 2014

If history is a useful guide, the housing recovery should lead into a pickup in commercial construction. With this in mind, well-known companies like building materials specialist CRH  or water heater manufacturer AO Smith  should be obvious beneficiaries. 

Why commercial construction will be strong in 2014
While a lag between an increase in residential activity and commercial construction is only to be expected, it's fair to say that the recovery in the latter has been somewhat disappointing in 2013. However, industry surveys and construction data are suggesting that commercial construction could be about to turn.

This chart compares U.S. new housing starts to how many months' supply of new houses the U.S. has. The lines should mirror each other, because if the housing market is seeing strengthening demand, then the months supply of housing available (blue line) should be falling. Consequently, home builders should be induced to build new housing (orange line) so that line should be going up. With around five months supply at present, history suggests that housing starts should be a lot higher going forward.

U.S. Months Supply of New Single Family Houses data by YCharts

And while residential housing is recovering, commercial construction appears to be finally kicking in. For example, here is the Architectural Billings Index, or ABI, from the American Institute of Architects. It's the most closely followed construction index. Fortunately, its indicating that commercial activity has finally picked up after a weather-affected spring.

source: American Institute of Architects

In addition, the banks are starting to report increased commercial real estate loan demand.

The following chart represents the net percentage of domestic banks that are reporting increased demand for loans.

Source: Federal Reserve

Note that commercial real estate demand has been strong, and outweighed Commercial and Industrial, or C & I, loans this year. This is unusual, and it could be a negative sign. But it could also owe to the strong state of U.S. corporate balance sheets, plus some reticence to invest thanks to political uncertainties.  

Which stocks to look at, and what they are sayingCRH is one of the world's leading building-materials companies, and its recent results perfectly matched the ABI data above. Its first-half U.S. sales were down 1%, mainly due to poor construction weather, but it recorded a 4% like-for-like increase in the third quarter, and it's expecting "a continuation of an improving trend in the U.S.". In an added plus,  it even discussed some stabilization in Europe.

While CRH is focused on building frameworks, Armstrong World Industries  is a leading flooring and ceiling company. In its third quarter, Armstrong saw its wood flooring rise 20.9% on the back of increased new residential construction. Meanwhile, its ceilings business (which is more affected by commercial office construction and represented 46% of sales in the quarter) saw sales up only 2.9%. If the commercial market improves next year then it's reasonable to expect better conditions for Armstrong.

AO Smith's water heating solutions are seeing strong demand. Its sales were up 16% in the third quarter, causing it to raise its full-year guidance for a third time this year. Moreover, its commercial unit sales surprised on the upside. From its recent conference call:

we've continually raised our estimates on commercial, and we just have much more difficulty kind of estimating that. I think last quarter, we set 154,000 units compared to last year's 147,000. And now, because of a very strong third quarter in commercial, we're going back to the drawing board and we've raised it to 157,000 units.

Heating, ventilation and air conditioning, or HVAC, is another vital component of any commercial building, and Foolish investors might be interested to look at stocks like Lennox International    or Regal Beloit. Lennox recently reported 13% constant currency growth in its residential business, and 8% in its commercial. Moreover, on its conference call, its management spoke of an "acceleration in in our commercial business in the third quarter". 

Lighting is another area that Foolish investors should look toward. Stocks like LED play Cree or North America's leading lighting company, Acuity Brands     look set to benefit from the secular move toward LED lighting, as well as a pickup in commercial building. Acuity has been doing very well this year; largely from the residential market. But its true strength is in the commercial and industrial sector. Analysts already have it on nearly 10% revenue growth to Aug. 2014, but those estimates could easily be taken higher if my thesis right.

The bottom line
In conclusion, anecdotal evidence from companies exposed to the sector as well as industry data are suggesting that commercial construction is likely to improve in 2014. Of the stocks discussed above, Armstrong World Industries looks the best value.

AOS P/E Ratio (Forward 1y) data by YCharts

Its also the stock with the strongest gearing toward the commercial construction sector. Its wood flooring margins will suffer with if lumber costs go up, so keep an eye on that. However, should end demand pick up as expected -especially with its commercial ceilings- then the stock has good upside in 2014.

Acuity Brands Lights Up The Markets

North America's leading lighting company, Acuity Brands (NYSE: AYI  ) , released its quarterly results recently, cheering the market with its positive outlook. The company offers good long-term growth prospects from both the increase in demand for LED lighting and a recovery in commercial and industrial construction. The market seems to have fully woken up to this story, however, and the company needs to deliver in order to justify the current evaluation. Is now the time to be chasing the stock?

An LED playThe growing acceptance of LED lighting is good for Acuity for two main reasons. First, it is seeing replacement demand coming from customers wanting to use LED lighting. Second, this type of lighting usually comes with control systems, so Acuity can generate add-on sales for the systems. Moreover, these demand sources don't rely on the economy or overall construction activity. In reality, it's more of an opportunity to grow sales (rather than margins), because its LED lighting solutions tend to have similar margins to conventional lighting.

Unfortunately, management didn't disclose the exact share of revenues coming from LEDs, but they outlined that it was at least above 21%. Consider that the last three quarters' numbers have been 13%, 15%, and 20%, respectively, which represents very good growth.

More than an LED playAcuity also offers earnings upside from an improving economy, and this time there are margin growth opportunities as well. Construction activity appears to be picking up, as seen in the Architectural Billings Index from the American Institute of Architects:

Source: American Institute of Architects.

The hope is that growing residential activity will ultimately translate into commercial and industrial construction. Increased housing construction implies the build-out of commercial buildings around the new communities. In addition, a resurgent housing market tends to grow household net worth, which in turn leads to increased consumer spending. Ultimately, this feeds into commercial and industrial construction investments in line with an improving economy.  

All of this positively affects Acuity in two ways. First, its strongest market has traditionally been the commercial and industrial sector, and any increase in activity will aid its top line. Second, new construction work is likely to create a higher margin mix than Acuity has now. For the second quarter in a row, Acuity saw its volumes rise 14%, though net sales increased by only 11% last quarter and 13% this time around. On the conference call, Acuity explained the discrepancy as being primarily due to changes in the channel mix, as well as the mix of products sold, and, to a lesser degree, lower pricing on like-kind LED luminaires.

Acuity's renovation work tends to be lower-margin activity, as does its sales through the home improvement stores like Home Depot and Lowe's. Clearly Acuity has a margin expansion opportunity provided that the new construction market improves next year.

Wal-Mart lights up the wayOne catalyst for growth could come from Wal-Mart (NYSE: WMT  ) , as it recently launched an LED light bulb selling for under $10. Analysts are mixed over the potential outcomes, with some seeing future margin pressure to come for Home Depot's LED bulbs (an important retailer for Acuity), and downward pressure on Cree's LED lighting margins. 

On the other hand, Wal-Mart's move is highly likely to spark wide-scale interest in LED lighting. This could turn out to be a net positive for the industry. Cree is also a large scale LED manufacturer, and an increase in end demand should help it to lower its prices. Meanwhile, Cree and Acuity could find it easier to convince customers to buy their lighting solutions if Wal-Mart's move creates mass awareness of the benefits of LEDs.

The bottom lineThere is a lot to like about Acuity, but at a price of $92.80 per share as I write, the company's stock is at 23 times its earnings forecast to August 2014, and around 20 times to August 2015. It looks priced for perfection, and any hiccup with short-term pricing due to Wal-Mart's move will hurt the stock. If you think the commercial construction market is going come back strongly next year, Acuity Brands stands to reap the benefits, but there are probably cheaper ways to play the idea.

The Key Earnings to Look out for this Week

There are some interesting earnings being released this week that should offer up a few investment ideas and shed some light on which sectors are set to outperform in the fourth quarter. Investors need to be selective, because the market has gone up significantly this year, while global GDP growth forecasts have been reduced. Consequently, valuations are likely to be high at precisely the point when some earnings might disappoint due to slower growth.

Monday

This morning saw shell egg producer Cal-Maine Foods (NASDAQ: CALM  ) deliver quarterly results. The company's earnings of $0.36 per share fell $0.13 short of analyst estimates. However, revenue of $319.5 million was up 17% from the year-ago quarter and well ahead of estimates of $272.9 million. This owed partly to the company's rising sales of cage-free, organic, and nutritionally enhanced eggs, which are growing ever more popular among consumers.

 

Cal-Maine is attractive for long-term investors, because it has the potential to grow irrespective of the economy. In other words, it gives you good diversification in your portfolio. Egg demand tends to be price-inelastic (i.e., demand doesn't change much in response to price movements), so when feed costs, rise Cal-Maine can usually pass on prices, albeit with some loss of margin.

 

Source: Company accounts.

 

However, the key to its prospects is what happens with industry egg supply. Note that its gross margins were extremely high in 2008, thanks to the financial crisis (and high feed costs in the first half of 2008), making it difficult for less efficient egg-producers to obtain credit.

 

Cal-Maine directly benefited because it's the largest independent egg-producer in the U.S. In the longer term, Cal-Maine can profit from consolidating the industry via acquisitions and expanding its higher-margin specialty egg sales.

 

Small-business service-provider Paychex (NASDAQ: PAYX  ) , due to report after today's market close, has long been a favored stock among dividend hunters, but it's also a great barometer of the state of the small and medium-sized business market.The key metric to follow is its checks-per-payroll number. Last quarter, its checks per payroll rose a miserly 0.9%, and it was even suggested that this growth would "moderate" in the quarter.

 

Furthermore, Paychex forecast that payroll services revenue growth would be 3% to 4% this year, but this is mainly due to price increases to customers rather than gains in checks per payroll. Look to see whether the price increases are sticking and the checks-per-payroll metric has improved. In addition, any update on its plans to develop an integrated management tool (so customers can use all of its separate services on one application) would be useful, too.

 

Tuesday

Lighting distributor Acuity Brands (NYSE: AYI  ) is one to watch because it is a direct play on a pick-up in construction activity in the U.S., as well as a backdoor way to play the increasing use of LED lighting solutions. Although management claims that its margins on LED lighting aren't any higher than on conventional lighting, it still has good growth opportunities. LED lighting will drive new demand, and Acuity is also able to sell LED lighting controls as an add-on solution.

 

The stock looks a bit rich going into these results, and Acuity tends to be volatile over earnings, so you need to be on your toes. One thing to look out for is its commentary on the state of the commercial and industrial lighting market. Architectural Billings Index data has perked up a bit lately, so the "favorable trend in June order rates" discussed previously might continue through the quarter for Acuity. We shall see.

 

Source: The American Institute of Architects.

 

Pharmacy giant Walgreen (NYSE: WAG  ) missed earnings last go-round, and the key thing to look out for in the upcoming results is whether its plan to revive store traffic and same-store sales growth is working. Last time, same-store sales came in at just 0.4%, with store traffic down 3.9%. In response, Walgreen initiated a renewed focus on pricing and promotions in mid-May, and since then conditions have improved. For example, comparable-store sales increased 4.8% in August, and its basket size, or average transaction value, increased 3.7%. On a more negative note, customer traffic was down 1.5% in August.

 

Watch to see whether the increased sales came at the expense of margins. Another thing to look out for is Walgreen's commentary on its balanced reward card program. Walgreen is trying to gather data from the cards so it can better target sales promotions.

Acuity Brands Looks Fully Valued

North America's leading lighting company, Acuity Brands (NYSE: AYI), delivered another good set of results for its recent third quarter, and spoke about its markets picking up.The stock offers a ‘back door’ way to play the increasing usage of LEDs in lighting solutions.If you like the construction industry and energy-efficient lighting, then Acuity could be a stock for you. Its prospects look positive, but is that enough to justify its lofty valuation?

Acuity Brands' secular growth drivers

The decreasing cost (per lumen) of LEDs means that Acuity can generate growth from LED lighting replacing conventional lighting. Margins on LED lighting are similar to conventional bulbs, but Acuity argues that it sells controls with virtually all its LED lights. Lighting controls are an essential part of the value proposition because, they help to increase the efficiency of lighting solutions.

The good news is that this is driving sales growth. Its net sales were up 11% in the third quarter, as opposed to the ‘low single digit growth rates’ that it claims its markets are growing at. The ‘bad’ news is that volumes grew by 14%. The discrepancy is due to lower prices of LED components and an unfavorable product mix. Essentially, Acuity is providing relatively more solutions to lower margin renovation work because large scale new construction hasn’t kicked in yet thanks to the slow economy.

Acuity's LED-based revenue is now at 20% of its total, from 15% and 13% in the previous two quarters. This is a powerful trend.

For example, a company like Cree (NASDAQ: CREE) is more of a pure LED play than Acuity. It offers a vertically integrated way to play growth in LEDs. Lighting looks set to be the primary driver of the next upswing in the LED cycle. Cree’s own lighting division managed to increase sales by 6% in the last quarter, even with unseasonal weather negatively affecting outdoor lighting sales.

Cree’s lighting products gross margins are at 30.6%, while Acuity’s numbers are at a more impressive 40.8%. Acuity has a more mature sales operation, while Cree uses sales agents. Nevertheless, Cree appears to have the opportunity to improve its lighting products margins going forward. Cree’s lighting product revenues currently represent nearly 38% of its total, so the opportunity is significant.

Cyclical growth drivers

Acuity can see cyclical growth in two ways. The first is from a general pickup in construction activity, and the second is through margin expansion, as more profitable activity like large-scale new construction takes place. Historically speaking, the former usually entails the latter.

In addition, investors need to appreciate that lighting is one of last phases of construction, so a natural time lag exists between general activity and orders coming in for lighting.


All eyes will be fixed on construction indicators such as the Architectural Billings Index (ABI) from the American Institute of Architects. It has been unusually volatile lately.

One explanation for this is the late spring this year, plus delays over worries with issues like the sequester and payroll taxes.

Moreover there are some peculiar recent dynamics which can be seen in the ABI data.

The recent weakness in the commercial/industrial (C & I) sector is concerning because it’s Acuity’s strongest end market. The hope is that new residential construction will feed into new C & I construction as infrastructure is built up around the new housing.Unfortunately, it hasn't happened yet.

Other companies have talked of weakness. Regal Beloit (NYSE: RBC) revealed a shocker of an earnings announcement at the end of April. The company makes the kinds of motors used in heating, ventilation and air conditioning systems.

Regal lost a major contract when a customer decided to source components from a third party (rather than buy from Regal Beloit and manufacture themselves) and, overall its commentary on its C & I markets was poor. Guidance was lowered and, the strength that it had seen in January fell away through the quarter. The ABI data has weakened since then so it's anybody’s guess what it will say in its next set of results. On the other hand, it's cheap on a cash flow basis and, this could be a decent entry point.

The bottom line

In conclusion, you need to believe in both these drivers to want to buy Acuity at this level. While secular growth looks assured, it is far from clear that the cyclical growth is. On a trailing PE ratio of nearly 32, compared to its smaller rival Hubbell at 20, the stock is not cheap. I share some of the optimism over this company, but a strong and sustained recovery in the C & I market is not a "done deal."  That makes Acuity one for the monitor list.