NEW YORK ( TheStreet) -- The downgrades of Veeco ( VECO) and Aixtron ( AIXG) on Tuesday put the brakes on the recent rally in LED stocks, but it was the Veeco downgrade to a hold by Citigroup that really exacted the biggest toll on shares.

Veeco shares were down 16% on Tuesday, whereas Aixtron shares were down 4%.

For two stocks that are in the same exact business and typically trade as a basket trade on the outlook in the LED sector, it's a little confusing to see such a disparity in the trading on Tuesday. Sure, it was negative sentiment for both Veeco and Aixtron, but the 12% additional decline in Veeco shares didn't seem warranted. Veeco had the biggest loss on the market in Tuesday trading. So was the Veeco selling overdone?

All the LED stocks were down and trading volume was elevated for the entire sector.

All it takes -- especially after a rally, which has been going on for over a month -- is for a major Street firm to step up and renew everyone's worst fear of something going wrong for the volatile LED sector, and the LED stocks will be under the gun once more. LED stocks have been on a run since a late summer/early fall selloff, led by Cree ( CREE). Over the past three months, the rise of LED stocks far surpasses the gains in the Nasdaq and S&P 500, up 16% and 11% respectively.

Citigroup is stoking renewed debate about China slowing its subsidy support for the purchase of the MOCVD equipment sold by Veeco and Aixtron. Yet the debate about China's role in supporting to continued growth of the LED market through subsidies has been raging throughout the past year.

Indeed, at the open on Wednesday Veeco shares were back up by 4% and the LED stock hit its average daily volume within an hour of the open. It's hard to imagine a stock not getting a little trading pop a day after a 16% decline, though. Aixtron shares slipped slightly at the open.

In light of all this, here are 7 factors to consider in making call on whether the Veeco selloff went a little too far....

No. 1 Reason the Veeco Selloff Might be Overdone:

Investors in the volatile LED space didn't really learn anything new on Tuesday from the Citigroup report, as far as potential reasons for a pullback in the LED sector. It was more anecdotal evidence of a potential hard stop on LED subsidies, but this type of anecdotal report has been out there in the market for months. Citigroup said itself that there is "no smoking gun" and that there is "no official confirmation" from the Chinese government that anything is going to be done.

Citi argues that "concern is mounting" and provides some anecdotal evidence for the alleged concern on the part of the Chinese government.

One industry observer said that when SemiLEDS ( LEDS) went public last week, its officials were playing up the idea of Chinese companies beginning to manufacture the same equipment as Veeco and Aixtron. The industry observer said that the call from Citi to downgrade shares isn't surprising since this anecdotal evidence has been making its way around the market in the past few weeks. Yet, again, the idea that Chinese equipment manufacturers will come to compete with Veeco and Aixtron is nothing new, and Veeco officials more or less assume that it's ultimately going to happen.

No. 2 Reason the Veeco Selloff Might be Overdone:

Even for investors selling on the Citi downgrade, consider the analyst's new price target for Veeco: $50 as opposed to the previous target of $52.

Veeco shares ended the day at $42.19, losing close to $8. So by Citi's own investment logic, Veeco is a buy immediately when the market's open tomorrow.

Citi reduced its 2011 earnings outlook for Veeco by a huge amount, cutting Veeco 2011 earnings from $5.72 to $3.88, way below the Street consensus of $4.93. However, Citi kept 2012 earnings per share for Veeco at $5, saying that an order slowdown in 2011 would lead to better conditions in 2012. It might just be that investors don't want to wait that long.

And this type of thinking leads directly to the most likely reason for the size of the Veeco selloff...

No. 3 Reason the Veeco Selloff Might be Overdone:

Fear and greed rules in the LED stock sector. If there's ever an easy call for an analyst to make in the LED space, it's to wait for the sector to go through a major downturn or a major rally and then call for investors to take profits before it is too late.

Given the recent performance in LED stocks -- after the woeful late summer/early fall performance -- all it takes is one analyst to step up and say it's time to cut and run and the damage will surely be done.

It can be argued that since Citi couldn't present a "smoking gun" about the Chinese subsidy situation, but was merely stoking the existing fire, the Citi call was more or less playing on the fears of the market and presenting a convenient time for investors to book profits.

No. 4 Reason the Veeco Selloff Might be Overdone

The Citi analyst downgraded Veeco to a hold with a price target of $50, reduced from $52. After the 16% selloff on Tuesday, Veeco shares were near the $42 mark, so that means that by Citi's own logic, the stock is a buy again.

No. 5 Reason the Veeco Selloff Might be Overdone

Since Veeco and Aixtron typically are a paired trade on sentiment in the LED sector, it's hard to understand the level of disconnect in trading on Tuesday. Sure, it's a well known fact that Veeco is more exposed to Chinese orders -- and reliant on growth coming from mainland China -- than Aixtron, but it's not as if Veeco is a Chinese supplier while Aixtron is not.

In fact, several analysts said that their model has a split of the Chinese equipment market at 60%-40% in favor of Veeco. That's a significant difference, but if the subsidies in China are to be yanked, it's not a difference that should lead to Veeco being down by 12% more than Aixtron.

It's true that some Street models have more of Veeco growth in 2011 coming from China than Aixtron models show -- so from that standpoint, the larger decline in Veeco makes some sense.

A curious footnote in the Citi downgrade was that it noted an order that China's GCL Group, a polysilicon giant, is reportedly planning to make from Aixtron of 500 tools. Yet Citi pointed to this order as one of the pieces of anecdotal evidence supporting the claim that the Chinese government would be looking to rein in subsidies.

Some LED market watchers speculated after Tuesday's divergence in trading between Veeco and Aixtron that the 500-tool order being rumored about limited the damage to Veeco, but if it's an alleged order that's being used by Citi as a primary factor in China pulling back on subsidies, it's hard to make a compelling case for it being a positive for the LED equipment players by and large.

It's true that GCL Group is not the type of "mom and pop" shop in China that would be reliant on the subsidies, and there has always been the claim that a pulling back of subsidies would really only hurt the bit players on the mainland.

Also, a 500-tool order from one customer in China would equate to most of Aixtron's annual tool production.

No. 6 Reason the Veeco Selloff Might be Overdone:

In alluding to the one particular larger order of 500 tools being pursued by GCL Group that has concerned the government, Citi made the statement that while the government LED program is building up a manufacturing base in China, "much of the money, at this point, has gone right out of the country and into the hands of VECO and AIXG -- something that troubles some officials."

Let's at least consider the total level of subsidies going to the LED players, versus, for example, the $30 billion or so just in loan commitments that China has offered to its solar industry this year -- which doesn't even take into account "hidden" subsidies in the form of land grants and cheap utility rates.

Adding up the annual revenue of Aixtron and Veeco comes to less than $2 billion a year, and China may represent 40% of revenue, or roughly $800 million. The Chinese government subsidy of half of that amount, to the tune of $400 million, is not something that the Chinese government may worry about in terms of a sheer price tag. Consider that once all the LED companies are up and running, they can export tens of billions of dollars in product for an $800-million-a-year upfront check from the government. That's also a lot less than the Chinese government would have to spend to build the power plants they remain worried will be needed if they don't become more energy efficient, through projects like LED street lamps.

No. 7 Reason the Veeco Selloff Might be Overdone

The basis for Veeco's stock value relative to Aixtron is also worth considering after the massive divergence in trading on Tuesday.

At the end of the day, Veeco has been trading at a 40% discount to Aixtron, and really has no significantly greater risk than Aixtron if the LED market slows, yet it's more likely to get bought out by a larger technology equipment market player.

Analysts note that $14 of Veeco's market value is in cash, and that makes it a more attractive takeout candidate than Aixtron.

In fact, even in downgrading Veeco, Citi alluded the M&A talk. The Citi analyst wrote: "With respect to acquisition risk, if VECO's equity value were to fall significantly below our target we could see a scenario where a larger tool company would acquire VECO. This is supported by our recent M&A analysis showing that the top six semicaps we cover will have ~$11B in cash and generate ~$5B in FCF -- both the highest the industry has seen - by YE2011."

Veeco certainly fell below Citi's target on Tuesday.

-- Written by Eric Rosenbaum from New York.

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