Veeco Instruments Inc. (VECO) – Faraz Farzam, CFA
The investment case for Veeco is centered on a dramatic shift in the global lighting industry. Veeco is currently our largest investment in the Information Technology sector.
“After the electric light goes into general use, none but the extravagant will burn tallow candles.”
I was struck by one of Thomas Edison’s least well known but rather clairvoyant quotes as I came across a Pomegranate Noir Luxury Candle by Jo Malone London on Bloomingdale’s website priced at $470. One of the luxuries of modern civilization is the availability, abundance, and ubiquity of lighting. None of us think much about it until an incandescent bulb inevitably and inconveniently burns out.
Edison patented the incandescent bulb in 1879, revolutionizing industry and, indeed, everyday life. It was not until 1939 that the next great innovation in lighting appeared at the New York World’s Fair, the fluorescent lightbulb. These lamps lasted longer and were three times more efficient than the incandescent bulb. According to the Department of Energy (“DOE”), by 1951, more light was produced by linear fluorescent lamps than by incandescent bulbs. It wasn’t until the 1980s that compact fluorescent lights (CFL) were available for residential applications. Which brings us to the LED or Light Emitting Diode. Invented in 1962, LEDs are essentially semiconductor-based technology that turn heated diodes into light. The first LEDs emitted Red light followed by pale yellow and green diodes.
Initially, LEDs were used in calculator displays and other small electronic goods in the 1970s. To make LEDs an option for general lighting, researchers had to first develop white LEDs and then drive down cost and efficiency. According to the DOE, since 2008, the cost of LED bulbs has dropped more than 85%. Today, LED bulbs are six-to-seven times more energy efficient than incandescents and cut energy use by more than 80%, lasting 25-times longer in the process.
LED chips used to be relegated to such things as traffic signals, car tail lights, videogames and refrigerator case displays. Now there are nearly 500 billion LED chips produced annually. We believe LED chip demand today is driven by LED lighting applications, which consume roughly 40% of total LED chip demand. Another 40% of demand is driven by display and backlight applications for devices such as LCD TVs and mobile phones. The other 20% of demand comes from applications such as signage and automotive lighting. We estimate the global lighting market today is roughly $80 billion to $100 billion, with LED lighting representing roughly 22% of the market.
We expect LED chip demand to grow at low-double digit pace for the next five years, driven primarily from LEDs used for lighting applications. We believe robust demand for LED lighting units will offset LED applications that have already reached almost 100% penetration rate in display applications for cell phones, smart phones, PCs, notebooks and LCD televisions.
We believe LED lighting will become more widely adopted as prices decline, efficiency improves, and smart lighting helps improve the long-term payback. In turn, we believe the LED lighting market will be driven by the speed of converting the existing installed base to LED lights and new construction opportunities that support demand for LED lighting. We believe LED lighting demand will come from applications for indoor locations such as offices, schools, and hospitals, and outdoor locations such as street lights and parking garages. In 2012 alone, more than 49 million LEDs were installed in the U.S., saving about $675 million in annual energy costs. As prices continue to drop, LEDs are expected to become a common feature in homes across the country.
LEDs have rapidly commoditized. The price declines required for large scale adoption of LEDs in new builds and replacement in the sizeable installed base of CFL and incandescent bulbs places the industry at odds with our first two investment pillars (Strong Business Traits and Defendable Market Niche). However, the investment case for the equipment makers is vastly more interesting. The last major equipment vendor is Long Island, New York based Veeco Instruments.
Veeco makes Molecular Oxide Chemical Vapor Deposition (“MOCVD”) reactors. Although a mouthful, an MOCVD reactor is the essential capital equipment, or tool, in the complex process of making LEDs. We could “get into the weeds” of this process, but we will spare our readers. What is critical to understand is that Veeco is soon to be the dominant player in the industry. In December 2015, Veeco’s main competitor, German conglomerate Aixtron SE, received an unprecedented order cancellation for 50 of its MOCVD systems from Chinese LED equipment maker San’an Optoelectronics due to the system’s failure to meet qualification requirements. Shortly after this cancellation, Aixtron put itself up for sale in the wake of financial distress.
Although Chinese investor Grand Chip Investment Fund LP was able to acquire the company in May 2016, as of our writing this piece, it appears the German government may not allow the sale for national security reasons. In either case, we expect Veeco’s market share to grow from an already dominant 65% to as high as 85%! This is Intel-like market dominance. We also believe, based on the preliminary fourth quarter results, that the long depressed market for MOCVD reactors is about to begin a new cycle. Furthermore, Veeco is well into a cost cutting and manufacturing rationalization initiative that should drive profitability as revenues recover.
In our opinion, the company has a solid balance sheet with nearly $400 million in net cash and we believe substantially higher earnings power than Wall Street expects. At the peak of the last industry cycle in 2011, with Veeco at 40% market share, the company earned over $5.00 per share. We conservatively estimate earnings power to be roughly $2.00 per share in this cycle. With no competition to speak of, this estimate may prove to be overly conservative. Even assuming $2.00 however, we believe that places the private market value for the company in a takeover at roughly $40 per share. The stock currently trades around $27.
1 “Vanguard Group’s Passively Managed Mutual Funds Dominate Net Inflows for 2016”, Lipper Alpha Insight, 1/20/2017, Patrick Keon. “Morningstar Direct Asset Flows Commentary: United States”, 8/12/2016, Alina Lamy
2 Wall Street Journal analysis of data from Morningstar (fund and stock ownership)
3 Morningstar database, small blend category vs the Russell 2000
4 “Winning the Losers Game”, Charles Ellis, 2013, p. 126
5 Fortune Magazine, May 17th, 2016, Geoff Colvin, “Take This Market and Shove It”