Is the Sell-Off Overdone in LED Stocks?

Cree Inc. (NASDAQ: CREE) and Veeco Instruments (NASDAQ: VECO) have been two of the market’s darling stocks since the March 2009 bottom.  Each has returned over 100% gains to investors.  However, in recent weeks, even as markets have bounced mightily off of the July 1st lows, these stocks have continued to exhibit weakness.   The speed with which these two went from breakout bonanzas trading with growth multiples to smacked-down has beens is rather astonishing.  Let’s take a closer look.

Why the Decline?

It certainly didn’t help that the newsflow turned negative in the sector right as markets were topping.  Cree peaked out on April 15th at a high of $83.38, and Veeco topped off on April 27th at $54.50.  As of yesterday’s close, Cree had shed 40% and Veeco 35% from those highs.  Veeco had made its new 52-week highs on their own earnings release; however, the stock proceeded to sell off mildly over the next few days.  After the bell on August 10th, Cree reported strong earnings, but issued tame guidance.  This turned a relatively tame sell-off into an aggressive flight to the exits.

Following Cree’s earnings report came a spate of downgrades on the LED sector due to a backlog in demand for HDTVs.  LCDs, and more recently LEDs, are key components in HDTV production, and as such, a backlog in end demand for TVs has a negative impact on all elements of the supply chain.  While Cree is engaged in the actual production of LED lighting, Veeco produces the instruments with which LEDs are designed and produced.

The Bull Case:

When Corning (NYSE: GLW) issued weak screen guidance on their recent earnings report, the LED sector rallied mightily.  That was just the first sign that at this point, the selling in relation to a backlog in TV and PC demand had been priced in to the related stocks.   No one is anticipating demand to drop in TV markets, rather they are preparing for a slow-down in the growth rate.

There are two secular trends that will continue to benefit these companies.  While it’s clear that LCD demand growth is slowing, neither Veeco nor Cree are seriously exposed to that market directly.  An element of the backlog in LCD demand can certainly be due to the fact that companies are only recently marketing LED TVs.  These LED TVs have much more vivid pictures, and they represent the next wave of technological advancement in HD.

Most importantly is the trend towards LED lighting more generally speaking.  LED lights can now be used anywhere from home lighting to street lamps.  Not only do these emit clear lighting, so too are they more energy efficient.  With energy rates continuing to soar, and many looking for a coherent long-term energy efficiency vision, LED lighting is uniquely qualified as both a practical and inexpensive solution to the problem.  In Cree’s recent earnings report, LED lighting showed 100% year-over-year revenue growth, while the company’s earnings grew by 53% over the same period.  Growth is projected to remain strong in component lighting and at present, LED accounts for a very small percentage of a much larger market.  The true secular story remains very much in tact.

Veeco in particular is an intriguing valuation story.  They produce metal organic chemical vapor deposition systems (MOCVDs) which are used to make LEDs and solar cells.  The company has outstanding exposure to two growth sectors, and enjoys limited competition at what they do.  The company now boasts a P/E of 14, and holds 29% of its market cap in cash.  Management isn’t sitting idle on that cash, as many other tech stocks are at this time.  Recently, the company announced and initiated a $200 million share buyback, which will see 13% of the market cap bought back.  Add that to the 26% short interest and you have a stream of players sitting on the bid in this stock.  (for a deeper dig into Veeco in particular check out this solid writeup at Seeking Alpha).

In initiating the buyback, Veeco’s CEO, John Peeler, had the following to say:

“This authorization reflects our continued confidence in and positive outlook for our business.  Our strong cash position and cash flow from operations will allow us to execute share repurchases while retaining the flexibility to continue to invest in other opportunities to grow our business. Our Board of Directors strongly believes that Veeco’s stock currently presents an attractive investment for the Company and its stockholders.”

That is a true vote of confidence from management.

With Tech merger mania in full force, there are few more attractive options than companies in growing secular businesses, loaded with cash and little debt, trading at fairly modest multiples.  While it takes time for charts to repair themselves after such dramatic sell-offs, the longer these companies remain depressed in price, the more attractive they will be to the bigger players in the Tech sector.  Many have speculated that Applied Materials (NASDAQ: AMAT) wants to increase its presence in the market, and the easiest such way would be to buy a competitor for a discount, rather than to jump head first into the business themselves.

Disclosure: Long CREE and VECO