Best in Class: Veeco Instruments

China's ordering of LED lighting equipment remains on fire, and Veeco Instruments is the main beneficiary of the emerging giant's major ramp of its LED industry.
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(Veeco, LED sector story updated for impact of unit sale on quarterly bookings decline, analyst comment on market share gains)



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Veeco Instruments

(VECO) - Get Report

just announced record revenue and earnings per share in the third quarter. The reaction from investors: Veeco shares fell by more than 7% in trading in the after-hours session on Monday and were down another 5.5% on Tuesday on heavy trading volume.

So it goes in the fast-growing LED lighting sector, where any sign of weakness portends sudden doom, at least for some investors.

One day,

General Electric

(GE) - Get Report

says that LED lighting will comprise 75% of its general illumination sales within 10 years time, and all the LED stocks rally, led by


(CREE) - Get Report

. In fact, that event happened a few weeks before the Veeco earnings. Then come the record Veeco earnings, in which backlog dropped from 1.3 times bookings-to-backlog, to 1 times bookings-to-backlog, and it's all over for the LED equipment maker.

It's not easy to catch a break from the shorts that target the LED lighting sector in which Veeco is one of the two main equipment plays, along with Germany's



. It's also quintessential of a fast-growing sector tied to the semiconductor market that any sign of a huge growth cycle slowing will lead to investor panic.

The GE comments about the 10-year time horizon at one end, and the slight decline in Veeco bookings as a sign to sell out of the LED equipment company at the other end, are the book-ends of the bull and bear shelf of investment arguments about the LED space.

A skeptic could also note that just because Veeco is a favorite of the Street -- Veeco bulls outnumber Veeco bears by a ratio of 5 to 1 -- the Street shouldn't be trusted.

Nevertheless, the Veeco earnings were far from a sign that the LED equipment making world is collapsing around the Plainview, New York-based company, and an investor doesn't have to necessarily trust the Street to take a long-term bullish view of the LED equipment maker's chances.

In October, hedge fund

Caxton Associates

announced a 5.3% stake in Veeco Instruments, a new holding for the hedge fund. Caxton Associates is run by Bruce Kovner, the 69th-richest American, with a net worth estimated at $4.1 billion, according to the


400 ranking. It can't hurt to have a hedge fund manager who reportedly hasn't had a losing year since founding his firm in 1983 making a bet on your company.

It's important to note that Caxton Associates made its bet on Veeco at a time when shares had been pummeled. All the LED stocks, including Veeco, Aixtron and Cree took a beating in August as signs started to pour in from the LCD television market that a glut had formed. LED backlighting has grown to be used in 25% of the LCD TV market, and the news of a slowdown hit the stocks hard. A few weeks before Caxton Associates announced its strategic holding in Veeco, shares had come very close to a year-to-date low of $30.42, last seen in early February.

The earnings numbers reflect the Veeco growth story, even if the growth has slowed in the most recent quarter. Veeco bookings were $347 million in the second quarter, and fell to $278 million in the third quarter. LED orders, in particular, fell from $260 million to $243 million, down 7% sequentially, but up 36% year over year. Revenue was up 31% over the previous quarter.

One important caveat to the bookings decline is the impact of Veeco's sale of its metrology unit, which accounted for $37 million in bookings. Taking into account the sale of the unit, Veeco bookings were at $315 million, a smaller decline than the printed number -- or roughly a 5% decline in MOCVD equipment and 5% decline in data storage.

The much-debated backlog that fell to 1 times bookings to-backlog stood at $569 million at the end of the quarter.

Gross margin improved another 4% to 49% in the quarter -- the company expects gross margin will surpass 50% in the fourth quarter -- and EBITA profit reached a record of 35% of revenue.

Yet when a company has a rise as rapid as Veeco's has been -- revenue in the third quarter last year was $74.7 million as compared to this quarter's $278 million, a 270% increase year over year -- investors are going to walk the company on a short leash.

Veeco's guidance for the fourth quarter also exceeded the Street consensus at the top end by a wide margin. Veeco is guiding to $285 million to $320 million in revenue, whereas the Street is at $310 million. Veeco is guiding to earnings per share of $1.46 to $1.74, while the Street is expecting earnings of $1.47.

A detractor could say Veeco is a best-in-class play by virtue of the fact that so few companies target Veeco's bread-and-butter of selling equipment to the LED lighting component makers. If an investor can name the publicly traded companies that operate in the LED equipment space on less than half of one hand, it's not hard to reach best-in-class status.

Furthermore, imagine all the private companies in China just starting up and aiming at producing the same equipment as Veeco at a lower cost.

Veeco CEO John Peeler didn't seem concerned about the competition from China, which is Veeco's key market, when asked about pricing pressure on the earnings conference call.

"We've been doing well in the Chinese market and average sales prices (ASPs) have held up well. I believe we are booking well over half of our business in China. It's a little too early to quantify it, but we think we've got the best product for that market and there is no negative ASP impact," Peeler said.

China remains the growth engine for Veeco. It's both a blessing and a curse, as much of the LED market in China has been spurred by government subsidies for the purchase of LED equipment. While there is no actual sign that China is pulling back on subsidies for LED equipment, the press has been rife with anonymous speculation about a government subsidy decline predicated on fears of an overheated LED market.

Peeler conceded that China is a market where government subsidies are an important factor, but trying to predict what bookings will go to if the subsidies are eliminated is impossible. "China is clearly our largest growth market at this stage, so subsidies are an important factor," said Peeler.

Yet the Veeco CEO also made clear that at this point all systems are go in China. "We have seen no slowdown in China," Peeler said. The Veeco CEO strived to separate the Veeco story from the Cree story, especially as it related to a slowdown in China reported by Cree last week.

"We are a very different company than Cree. We are selling equipment into the Chinese market, helping them to build an industry, not competing against Chinese companies selling LEDs. Comparing the slowdown of LED component shipments into China and equipment sales is apples to oranges," Peeler said.

>>Cree Stock: Buy or Sell

What remains unclear -- and what analysts were planning to ask Veeco in follow-up calls to the earnings -- is to what extent its customers in China would go out of business if the government subsidies were pulled. There are plenty of Veeco bulls who believe that while government subsidies would force start-ups out of business, larger-sized Veeco customers would not be significantly impacted by subsidy reductions. After all, every single company that is offered a subsidy by the Chinese government will take the money and run, but that doesn't mean without subsidies the companies wouldn't be able to run at all.

Avian Securities analyst Andrew Abrams was in agreement with Peeler that fourth quarter order activity will be flat, with Chinese order activity continuing to close the gap.

"It looks like China is moving up fast enough to offset the decline from Taiwan and Korea, so Veeco has just come down from a record high order rate," the analyst said. On the other hand, "If China starts to slow down, Veeco will start working through the backlog and there will be a good quarter or two, but then a declining revenue base," the analyst cautioned.

The issue for Veeco is whether any weakness in the outlook and in the order backlog is a short-term hurdle before growth accelerates again, or indicative of a peak.

"The type of ramp Veeco has had in its business can't go on forever, and the question is from a peak, how far down does it go," Mark Miller, analyst at Noble Financial Group said. "It looks like Veeco's business will stay at high levels in the first half of next year, and then general lighting should come on stronger," he added.

It's possible that bookings have peaked for Veeco, according to several Street analysts. The peak earnings quarter, on the other hand, will be a function of how many tools Veeco can "push out the door" quarter to quarter, and orders are always a moving target. This is why even though Veeco conceded that revenue from orders to Taiwan and Korea, and possibly even from China, might be pushed out beyond the fourth quarter and into 2011, analysts believe it would be overstating concern to harp on these comments in particular.

"Backlighting will come back, but there won't be the desperate need, the 'we've got to have it tomorrow' from the Taiwanese and Koreans that we were seeing 12 months ago," Avian Securities Abrams said.

Coming off a record quarter, Veeco isn't bowing to the bears grumbling, either. "We are happy about our performance and expect to do it again next quarter," Peeler said in wrapping up the earnings conference call.

Time will tell, and time is always the issue for the LED lighting stocks and the shifts in investor sentiment about the sector outlook.

LED stocks may remain range-bound until the situation regarding LCD backlighting becomes more certain, and short of the broad adoption of LED lighting in the general illumination market.

"We're at a middle ground point with Veeco. The shorts can't get tremendously more out of it. The order rate coming down is of concern, but it's not as if anyone would not have expected it," said Avian Securities' Abrams, who went to a hold on Veeco in August. The analyst said he moved to neutral on Veeco on the expectation of an order decline, but there will be a point at which the LED backlighting penetration rate starts increasing again and that will burn through capacity and the current supply/demand issue.

Veeco is "best-in-class" coming off its record earnings and record revenue in the third quarter, but in a fast-growing tech sector prone to gluts, "best in class" could become a less important designation for an LED stock than "timed best" for an investment growth opportunity. There will likely be another leg up for Veeco shares, but when that opportunity presents itself, and whether the competitive landscape is the same by then, are unresolved questions.

"The chance of the backlighting business coming back and the general lighting business ramping up at the same time are pretty small, so there has to be a point where things drop off," said Avian Securities' Abrams. The analyst thought the second quarter 2011 would be that inflection point, but based on the Veeco results, the drop off could be a little sooner than that.

Noble Financial's Miller says that his model has Veeco revenue peaking in the December quarter at $320 million, and then falling for the next two quarters by 10%. Yet it's just as important that Veeco continues to gain market share. When a market slows down a company needs to gain market share to make up the difference, and Miller says Veeco is proving that it's gaining share versus competitors.

Part of Veeco market share gains are a function of more orders shifting to China, where it has had more success than Aixtron, especially as the sales slowdown in the LCD space has hit other Asian markets like Korea and Taiwan. Nevertheless, earlier this year fears were stoked that the introduction of Aixtron's G5 technology would hurt Veeco's sales efforts, but that doesn't seem to have happened yet. Veeco announced concurrent with its earnings a multi-tool sale to Taiwan's Epistar. Epistar officials had been quoted earlier this year on the Aixtron G5 tool when it was still in testing, and on their excitement about bringing the Aixtron tool into production.

Avian Securities Abrams said that Veeco was ramping up faster than Aixtron, but that's the nature of the beast in the new tool order cycle for technology. "Aixtron was behind, and Veeco caught them off guard and captured share in Taiwan. Aixtron was taking longer at a time when everyone was desperate for capacity and Veeco took advantage smartly," Abrams said.

The market share split between Aixtron and Veeco used to be close to 65% to 35% in favor of Aixtron, and that's not the case any longer, but another market share shift back in favor of Aixtron would be common for an industry dominated by two players. "I think Veeco will lose back a little share that they've gained," Abrams said.

Regardless of the back and forth in market share between Veeco and Aixtron, Noble Financial's Miller says the choice for investors is obvious: "If your perspective is more than a month or two, buy Veeco on any order pause paranoia," Miller said.

-- Written by Eric Rosenbaum from New York.

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Eric Rosenbaum


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>>Veeco Earnings: Revenue Delay, Backlog Dip Pressure Shares

>>Cree Stock: Buy or Sell

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