NEW YORK ( TheStreet) - The big equities rally and shift in macroeconomic sentiment hasn't catapulted LED stocks out of their doldrums. In fact, shares of two of the main LED lighting sector plays, Cree ( CREE) and Rubicon Technology ( RBCN), remain tethered near their 52-week lows, even as green energy stocks, by and large, and technology stocks have moved higher this week. Both stocks are dominant forces at opposite ends of the LED spectrum. Cree is the bellwether in the LED lighting market, and is vertically integrated, makings its own LED chips and components. Rubicon manufactures the sapphire substrate used as the raw material by many LED manufacturers, with one notable exception being Cree. The analyst ranks are showing the usual divide on these two LED stocks. Within a week, KeyBanc launched coverage of Cree with a buy rating, only to be followed by a Morgan Stanley note that said things will get worse for Cree before they get better in the second half of the year because of pricing and margin concerns. Cree headed south after the Morgan Stanley note, even though the note included more bullish commentary on overall LED market demand. Rubicon, meanwhile, continues to be a favorite of short investors who see nowhere for its high margins to go but down as competition increases in its niche. Cree shares have lost more than 20% in June, while Rubicon's stock is off about 25% for the month. Cree was up 3% to $33.41 in recent trades but it scraped a 52-week low of $32.40 earlier in the week. Rubicon is back above $17 in Thursday's session, enjoying a modest bounce since hitting a 52-week low of $15.51 on June 17. Are both of these LED stocks oversold and due for a rally? Is either Cree or Rubicon more likely to turn the corner and gain back investors before the other? Here are some keys to the outlook of both LED stocks as they struggle to break out of troughs in share price.
The Cree Case When it comes to supply and demand, visibility remains low in the LED sector. Investors have lost confidence in Cree over the past year in terms of its ability to provide visibility on the sector. Every time a bull steps up to say that the demand scenario is improving, the truth turns out to be different. For example, last November, when Cree was also at a trough point, Morgan Keegan launched coverage of the LED stock with a conviction buy rating and said that the demand scenario was improving in Asia. But things got much worse for Cree before they got better, with a rally in December 2010 petering out quickly, and Cree shares are down 50% year-to-date.
Ben Schuman, an analyst at Pacific Crest Securities, recently alluded to this dilemma, saying: "It's difficult to get conviction right now because end market visibility remains low. We've seen optimism in the channel before over the last three or four quarters that turned out to be supply chain optimism, rather than end markets taking off." Schuman added, "The recent track record of Cree earnings hasn't been good. With lead times still really short on orders in the LED sector, it's not a knock on Cree management to say they have no visibility. Timing is the issue for Cree." A slowdown in the Chinese market for LED street lamps was a major culprit in Cree's decline, and Andrew Huang, an analyst at Stifel Nicolaus, is willing to stick his neck out by saying Cree will pop before Rubicon. Huang notes that China is 40% of Cree's business, and concerns have been driven largely by China, yet other markets are showing improved demand, including Europe and the United States. "If I had to pick one LED stock to bounce on upcoming earnings, I'd pick Cree," he said. It's not just the Chinese street lamp market, or LED market visibility, where Cree has disappointed. Ramesh Misra, analyst at Brigantine Advisors, cautions investors that the LED market remains driven by backlighting applications for consumer electronics. It's not a general illumination market yet, even if the long-term opportunity is in general lighting as the incandescent bulb is eliminated. Consumer electronics devices from cell phones to flat panels TVs and computer monitors have been rapacious buyers of LEDs in the past, but have also forced the LED makers into periods of boom and bust as the Asian technology manufacturers manipulate the production gas pedal. Brigantine's Misra says that the LED market is headed into the slowest period of the year consumer electronics-wise, the summer doldrums. Cree has made the case quarter after quarter that the backlighting market for consumer electronics becomes an ever-smaller part of its business, and that's true - though Cree won't quantify it (the market estimate is 5% for Cree). In any event, the Brigantine analyst says that a decreasing focus on backlighting doesn't mean Cree is immune to the LED market pricing pressure caused by a slump in the consumer electronics market. "What happens in the consumer electronics market impacts pricing everywhere. The summer is a weak period for consumer devices and that will be impinging on pricing in the near-term and I expect it to keep the pressure on," Misra said. Last August, Avian Securities analyst Andy Abrams downgraded the two main equipment vendors in the LED space, Aixtron ( AIXG) and Veeco ( VECO), based on the supply/demand glut and the backlighting market weakness. Abrams is more optimistic this summer, though, and with Cree earnings not too far off. "Part of the problem for Cree was overstuffing the channel and hopefully Cree management has learned its lesson and avoids making that mistake again," Abrams said. Yet he added, "No one expects anything good to happen for LED stocks for the rest of the year." There's a positive side to this comment and the trough point for Cree. The Avian analyst said that Cree is selling at a level that it hasn't traded near since 2009, when there was no demand at all. "That's where Cree is now. Any positive outcome could get shorts to cover," Abrams said.
The Rubicon Technology Case There have been two recent drivers of downward pressure on Rubicon. First, solar equipment vendor GT Solar ( SOLR) entered the sapphire substrate equipment market, taking direct aim at Rubicon's domain. GT Solar is supplying the companies in Asia that want to challenge Rubicon. It's worked for GT Solar, as much as it has hurt Rubicon. GT Solar has released a series of announcements about deals for the sapphire market, and its shares continue to hit new 52-week highs, including another on Thursday at $16.40. Second, Rubicon recently had to revise its second-quarter guidance to a range of 53 to 55 cents a share, down from 82 to 86 cents, because of a tax change. The company exhausted its net operating loss carry forwards. Jeff Bencik, analyst at Kaufman Brothers explained that previously Rubicon did not accrue for federal taxes. As a result of increased profitability, the company will now commence paying federal tax payments and realize an effective tax rate of 40% versus roughly 7% previously.
The Kaufman analyst said that his $33 price target on Rubicon shares is based on fully taxed earnings. "There is no change to our operational forecasts and this was widely expected (we modeled in both the NOL impacted benefit and fully taxed rate previously). "If the company had the same 40% tax rate in 2010-2012, earnings would have grown from $0.05 per share to $2.15 per share to an expected $2.62 per share, respectively. However, because of the expected change in the tax treatment, it erroneously appears that RBCN is experiencing a slowdown in its business." Bencik believes that at least half of the decline in Rubicon shares over the past month is due to an overreaction to the tax issue and a spillover into lower Street estimates. Yet the shorts certainly aren't running scared from short positions in Rubicon based on any tax issue, and they aren't sticking to their short guns, either, simply because of GT Solar. "Even with every hundred millions of dollars coming across the tape in GT Solar orders and press releases, it's irrelevant to the guys shorting Rubicon. They see the writing on the wall and it comes down to the competitive barriers being broken down," said Pacific Crest's Schuman. Rubicon's latest quarterly results marked the first time the company talked about pricing pressure in the market, even though it still outperformed estimates. In fact, Rubicon traded down after the earnings, even after beating and raising. Stifel's Huang says conversations with competitors and customers in Asia indicate that pricing will be much worse than Rubicon's guide. The company had said pricing might be slightly down. The Stifel analyst says customers talk about pricing being down as much as 10%. "It's not the pre-announcement. It's the outlook," Huang says. The pricing pressure is in the two-inch wafer market where Rubicon has built its market lead. Rubicon is making the case that a switch to the larger 6-inch wafer will insulate it from the pricing declines in the commoditized 2-inch wafer space, but the shorts aren't convinced, and it's not a new story. "It's simply harder for this stock to work as margins come in," said Huang. He argues that GT Solar has sapphire customers in Asia willing to take a 15% gross margin on their business, while Rubicon has achieves gross margin above 60%. Kaufman's Bencik takes all the Rubicon negativity in stride, though. He has a sell on Cree and a buy on Rubicon. And here's why: The GT Solar risk is real, but could be overstated. "GT Solar bought their way into this business and they don't know the equipment. What kind of throughput do they get? Can they ramp to the larger wafers like Rubicon?" Bencik asks. Margins can drop for Rubicon and not be the end of the world. Kaufman Brothers has Rubicon margins dropping from 63% last quarter to 43% by the end of 2012 , but still predicts significant earnings growth or the premium it commands in the market. "End of the day this is the largest manufacturer or sapphire in the world. GT Solar can keep the pressure on, but can Rubicon decline from here, from, a 52-week low area?" Bencik says there is no proof of operational issues or pricing declines larger than expected that would merit a move down in the stock from here. Why pay 20 times for Cree when you can pay 8 times for Rubicon," the Kaufman analyst asks. "Rubicon will have competition, but it's not going away." Rubicon is a hard stock to borrow because it is so heavily shorted, and shorts aren't letting go. For the shorts, Rubicon's whole market is eventually going to unravel. Near-term Rubicon could move up, and from a valuation perspective it is not overpriced. It still should report good margins and possibly at the high end of revised guidance. "I think Rubicon bounces first," said Avian Securities Abrams. Cree has more to prove in the near-term, in Abrams opinion, related to end market demand for LEDs and its ability to effectively manage the distribution channel. One thing is certain, both LED stocks have room to move up. --Written by Eric Rosenbaum from New York. >To contact the writer of this article, click here: Eric Rosenbaum.