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LEDs: Bright Future, but a Burnout on the Way?

LED-focused firms have terrific growth prospects, but also face long-term risks.

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Light-emitting diodes, which are more energy-efficient than many other types of lighting solutions, appear to be the wave of the future. LEDs are already featured in notebook PCs and handsets, and are coming soon to a TV, office building, or home near you. This popular method of "going green" had also made lots of green for investors, especially in  Cree (CREE) and  Veeco (VECO), two LED-centric firms that, at their peaks, were up about 300% and 400% in the past year, respectively. While we're hoping for healthy LED adoption and global energy conservation (as well as anything that saves the planet in general), we fear that the industry could be prone to a sharp cyclical downturn down the line. While these two stocks in particular have pulled back in recent weeks, we think that prices at current levels are only just beginning to reflect some of the long-term risks surrounding LED stocks.

LED Industry Background
LEDs come in all shapes and sizes, are used in a wide variety of applications, and involve several steps of processing along the way. Firms involved in the production of LEDs can specialize in one of three areas: LED chips, which are made in a similar manner to semiconductors, the packaging of such chips into LED components, and the final step of integrating these components into LED bulbs and fixtures. Outside of the LED industry, many semiconductor firms have designed LED driver chips, which are used to control the functionality of LED chips. Also, high-tech manufacturing equipment makers, such as Veeco and Aixtron (AIXG), profit from the LED craze by supplying LED firms with specialized manufacturing tools.

There are four prominent players today that, in total, make up about half of the LED market: Nichia, a privately held Japanese firm,  Philips (PHG), Osram, a division of  Siemens (SI), and U.S.-based Cree. These firms manufacture both LED chips and components internally. The rest of the market is fragmented between many smaller firms that focus on specific steps in the LED supply chain, such as chip production or packaging.

Today, LEDs are most commonly found in consumer electronics, as LED chips are used to backlight mobile phones and other hand-held devices. LED components and fixtures are also commonly used in automobile displays, traffic lights and other display signs. However, the two areas for future LED growth should come from the liquid crystal display TV and general purpose lighting markets. Leading TV makers, such as Samsung, are increasingly turning to LED chips to backlight their latest TVs, because of improved picture quality, as well as the ability to sell slimmer products. Meanwhile, in the lighting market, Cree estimates that LED fixtures make up about 1% of the $60 billion general illumination market today, but Philips predicts that LEDs will make up 80% of the industry by 2020.

 

LEDs: A Glowing Outlook
Quite simply, the LED space is poised for tremendous growth in the coming years. Despite the credit crisis, many LED makers saw revenue growth in 2009, and 2010 should be a banner year for the industry. Recent growth has come from the exponential growth of LED-backlit LCD TVs, and industry experts expect the percentage of LED-backlit TVs to expand from 3% in 2009 to 30% in 2010 and 60%-80% by 2013. Based on this booming market, LED demand far exceeds supply at the moment, and industry insiders expect this supply shortage to continue into 2011.

Meanwhile, the general lighting market probably shows the most promise for the industry. Osram estimates that LED light bulbs last 25,000 hours, versus 10,000 for fluorescent bulbs and 1,000 for incandescent bulbs. Over this timeframe, LEDs also require less energy to produce the same amount of light. The downside, however, is that LED lights have significantly higher up-front costs.

Perhaps the biggest push for LEDs could come from public policy and broad consumer awareness surrounding "green" products. The first big step has come from several governmental bans of incandescent bulbs in Europe, Australia, and the U.S. over the next decade. LEDs should emerge as the most practical lighting alternative, especially for those that recognize that swallowing the high up-front costs for LEDs will be rewarded in the long-run in the form of longer bulb lives and lower energy costs. Commercial LED adoption in office and retail lighting should come first; Philips estimates that these segments make up about 40% of the total lighting market. However, residential LED adoption could take some time. Beyond the high cost of the bulbs, LED marketers will have to find a way to navigate around the hundred-plus years of consumer behavior where people are ingrained to buy cheap light bulbs and toss them away once they burn out.

LED Industry Dynamics
Although the growth prospects of the LED industry couldn't be brighter, we're not as confident that a single firm will emerge to dominate the space or that investors will make extraordinary profits from investing in certain names today. We see relatively few barriers to entry in the LED space. Samsung and LG, for example, have been huge buyers of LED chips in recent months as they shift their product mix toward LED-backlit TVs. However, both firms will make heavy investments in LED chip production, not by acquiring a firm with LED technical know-how, but by simply expanding their capacity and R&D in this area. Although these two firms have the high-tech manufacturing know-how and financial war chests to succeed with these investments, their entry into the space highlights the commoditylike nature of the LED business, in our opinion.

Although we recognize that the current LED supply shortage, combined with healthy demand, will lead to thriving industry conditions in 2010 and probably 2011, we are concerned about the rapid expansion plans from Samsung, LG, and a host of others. We fear that these new investments could flood the LED market with production capacity in excess of demand, regardless of whether LED demand continues to grow at a rapid pace. If overcapacity occurs, LED makers may have to cut prices and face lower profitability over time, and firms with significant LED exposure, like Cree and Veeco, may feel the brunt of a cyclical downturn down the line.

The Players
At Morningstar, Cree and Veeco are the two firms with significant LED exposure in our coverage universe and are the most direct way to invest in LEDs in the U.S., as LED sales don't move the needle at Philips, Siemens, or  General Electric (GE) just yet. Additionally, foreign investors may want to take a look at the Taiwanese market for LED chipmakers such as Epistar (TPE: 2448), Everlight Electronics (TPE: 2393), or Formosa Epitaxy (TPE: 3061).

Cree (CREE)
Cree produces all types of LED products for a wide array of markets, but the firm's primary focus is LED components aimed at the general lighting market. The firm is widely regarded as a technological leader in the space, and Cree claims that its trade secrets allow the company to produce more-efficient, higher-quality light. Financially, Cree is profiting from both the shift toward LEDs in lighting solutions, and robust demand for LED chips in TVs. While the company is seeing both exceptional sales growth and high profitability today, we expect the negative characteristics of the industry (few barriers to entry, many substitutes, rapid capacity expansion) to weigh on Cree in the long term. Down the road, Cree may have to choose between accomplishing stellar growth by cutting prices and earning lower gross margins or carving out a niche as a high-end, high-margin LED maker and leaving some lower-margin sales opportunities on the table.

Veeco (VECO)
Veeco is one of the two main suppliers of LED manufacturing equipment. Although the firm has several other equipment businesses, the company's LED segment has seen terrific revenue growth in recent quarters. Veeco is benefiting from a rush of orders for new LED equipment and tools, as LED makers are frantically trying to expand in order to meet their end-market demand today, as well as install the necessary capacity to be leaders in the LED space tomorrow. However, once these LED players get their manufacturing capacity in place, and LED chip supply finally catches up with demand, we'd expect orders for new LED equipment to dry up. Although Veeco's business conditions are terrific today, the LED equipment industry is deeply cyclical and a downturn could lie ahead.

Brian Colello does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.