It's a stretch to say that LEDs are everywhere, but maybe not by much. LEDs are still generally too expensive for residential, commercial or municipal lighting, but pretty much every smartphone, tablet or notebook PC owner has an LED screen on their device, and likewise for many TV owners.
Given the considerable economic advantages, LED lighting is likely a "when, not if" proposition, and that should spur demand for the critical LED-making equipment that Aixtron (Nasdaq:AIXG) sells. The key question for investors, however, is whether the stock of a very volatile equipment maker like Aixtron is really the way to play the next run in LEDs.
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Capturing 50% of the Capex Is a Mixed Blessing
Aixtron is largely built around selling metal organic vapor deposition (MOCVD) systems to the LED manufacturing industry. These systems are critical to the LED/OLED chip manufacturing process, and make up about 50% of LED capital expenditures. It's also a pretty cozy duopoly, as Aixtron and Veeco Instruments (Nasdaq:VECO) have more than 90% of the market to themselves.
Aixtron has a lot to offer LED/OLED chipmakers. Right now, the LED industry has basically saturated the market for phones, notebooks, PCs and TVs, and badly needs the greater adoption of LEDs in lighting to drive a new leg of growth. Unfortunately, while LED lights use about one-tenth the power of incandescent bulbs and last about 50 times longer, they cost 40 times as much and it's tough to convince consumers (and businesses) that it's worth spending so much upfront on an LED light to capture those long-term benefits.
Part of the problem is that while chip costs are maybe 20 to 30% of the cost of established LED products (like TVs and notebooks), they're more than 50% of the cost of the light bulb. Aixtron intends to do something about this by offering systems that allow LED companies to use larger wafers and obtain better yields. While Aixtron cannot influence the entire LED light cost food chain, it is proposing that its systems could cut certain costs by as much as 70% by 2016. That in turn could drive LED lighting prices to a point where adoption becomes widespread, spiking LED plant utilization rates and leading to another major wave of MOCVD equipment purchases.
In the meantime, however, Aixtron's heavy reliance on the LED business is a major weakness. When the LED TV boom started in 2009, companies rushed to add capacity and now there are simply too many LED makers with too much capacity. While the LED industry is starting to finally see consolidation, Aixtron's orders plunged in 2012 (down 80% through the first nine months) and Aixtron has also lost some share to Veeco.
More Than One Way to Play
Investors certainly should ask themselves whether equipment manufacturers like Aixtron and Veeco are even really the preferred way to play an eventual boom in LED lighting. For instance, the smartphone and tablet boom has done very little for semiconductor capital equipment vendors like Applied Materials (Nasdaq:AMAT). There have definitely been some chip winners (like Qualcomm (Nasdaq:QCOM), but frankly nobody has benefit as much as Apple (Nasdaq:AAPL).
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That cycle could well repeat in LED/OLED lighting. There really aren't many LED chip/product companies for investors to look at (most are Taiwanese, Korean or Chinese companies with no U.S. listings) outside of Cree (Nasdaq:CREE), Philips (NYSE:PHG) and Siemens (NYSE:SI) Osram unit. And just as Apple captures a large percentage of the value-added in the smartphone and tablet businesses, so too will Cree and Philips likely capture a lot of the value-added in LED lighting. That said, Cree certainly doesn't enjoy the duopoly that Aixtron and Veeco enjoy, so the range of potential outcomes is arguably greater for the component and end-product manufacturers like Cree and Philips.
Will the Turn Come in 2013?
In looking at both Veeco and Aixtron over the past year, "bumping along the bottom" seems like the best description. In both cases, investors had high(er) hopes in mid-2012 that a big recovery was on the way for MOCVD orders, but those orders have yet to materialize.
It's tough to say whether things will change significantly in 2013. TV-makers like Samsung and Sharp aren't seeing much growth anymore, and likewise much of the growth in the notebook PC and mobile phone sectors is relatively neutral for the LED industry, as it's not leading to substantial LED screen sales growth. There has been talk of countries like China launching subsidies to encourage businesses and individuals to switch to LED lighting, but a sluggish global economy likely has leaders more concerned with more pressing near-term economic issues.
Odds are good then that 2013 is not going to be substantially better for Aixtron or Veeco. By the end of 2013, however, investors should start seeing order improvements. What's more, the difference in customers could work in Aixtron's favor. Aixtron has been stronger with Chinese customers than Veeco, and that has likely fueled the recent share movements in Veeco's favor.
As consolidation leads to better utilization among Chinese companies, however, Aixtron could start regaining some momentum. There's the risk that consolidation sends a wave of secondhand equipment into the market and limits near-term demand for equipment. That said, it is going to be increasingly difficult for these companies to compete with older, less efficient equipment in what is likely to be a ferociously competitive market, so I believe Aixtron will eventually get those orders.
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Diversification Helps, But Not Much
While I've largely focused on Aixtron's LED-related business, the company does have some ongoing non-LED businesses. Aixtron has been trying to sell atom layer deposition (ALD) equipment to DRAM makers, and most analysts believe the company has had some success with Samsung (one of the largest DRAM players). Likewise, the company has been working with the makers of power semiconductors in an attempt to sell MOCVD tools into this segment.
For better or worse, though, Aixtron's fortunes remain tied to capital equipment demand in the LED industry, and that is unlikely to change in the near term. While the company has the financial resources to acquire its way into other market segments, management seems committed to navigating the ups and downs of its core business.
The Bottom Line
Over the last 15 years or so, the LED industry has moved in cycles spaced roughly four years apart. That suggests that LED lighting will start driving substantial equipment order growth around 2014. Given the sheer size of the global lighting market, this next cycle in LED equipment orders/sales could be quite a bit longer and higher than the last, but investors need to be careful of "it's different this time" arguments when approaching deeply cyclical industries.
Projecting revenue and free cash flow in highly cyclical businesses is generally a fool's errand, as the best you can really hope for is to be approximately right. Accordingly, while I think Aixtron can see low teens compound annual revenue growth over the next decade, the timing and magnitude are major unknowns. Likewise, I have no problem believing that the company will regain free cash flow margins in the high teens and 20% range as that cycle plays out, but I have less confidence on the length of the cycle and the depth of the next dip.
I think fair value for Aixtron is probably in the $10 to $12 range today, but I freely admit that there is a very large band of uncertainty around those numbers. Moreover, I've seen the cyclical dramas play out enough times that I know it's very likely that the upswing in orders will lead investors to forget that this is a highly cyclical business and encourage significant multiple expansion.
Consequently, I think Aixtron is a relatively binary play on the LED cycle - if LED demand picks up, the company will do well, if it doesn't, they won't. Given that the company has controlled its cash flow reasonably well in the downturn and has a clean balance sheet, more aggressive investors may see this as a turnaround/recovery story with relatively limited downside.
At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.