Tuesday, December 14, 2010

MOCVD Space: VECO & AIXG downgraded

The MOCVD space is getting two downgrades this morning:

- Citigroup is downgrading Veeco Instruments (NASDAQ:VECO) to Hold from Buy with a $50 price target (prev. $52) as they now see heightened risk of 1H:11 policy change in China regarding MOCVD subsidies. In part due to fear around a change, checks indicate big China follow-on orders pulling in – helping CQ4 and maybe CQ1 orders – but creating what is likely a big falloff in orders moving through 2011. They are cutting C2011 EPS from $5.72 to $3.88 (Street ~$4.93), but this pushes into 2012 so EPS there remains ~$5.00. Cut target from $52 to $50 (still on SOP valuation), no longer justifying a Buy.

Reading the tea leaves — While their discussions w/key sources in China reveal no “official” change, they think concern is mounting around three factors: 1) the program is well on its way to a key goal of establishing 3-4 emerging Chinese LED companies (e.g. Sanan, Elec-tech, Epilight, Silan); 2) program mis-use and overheating (for example, checks indicate a unit of GCL Group is bidding a very large order (~500 tools) mostly w/AIXG, including many older generation tools); and 3) all of the money is going to foreign MOCVD suppliers (VECO/AIXG) and is becoming counterproductive to the ancillary goal of establishing some domestic MOCVD suppliers. As evidence, Citi thinks one city – Yangzhou – has already stopped any future subsidies. With change potentially coming in CQ1, customers like Sanan and Elec-tech are both trying to pull-in big follow-ons to beat a change.

2011 worse, but 2012 should be strong — Excluding China, improving LED fab utilization has provided a better backdrop of newsflow but they are also concerned about an extended “pause” in 2011 MOCVD demand from Taiwan/Korea until high costs (esp. larger diameter sapphire wafers) and low yields are resolved.

Where can the stock go? — Zeroing all Tier 2 China demand + adjusting for some Taiwan share gains, they see shipment downside to ~40-50 tools/Q w/EPS ~$0.40-0.50/Q. At 10x this annualized EPS plus ~$12/share net cash, we could see downside to ~$32 (~35%) at which point the firm is again Buyer, all things equal.

- Kaufman Bro's is downgrading another major MOCVD player Aixtron AG (NASDAQ:AIXG) to Hold from Buy with a $37 price target (prev. $34).

Aixtron's stock price has increased from roughly $24 per ADR to its current level of more than $37 per share. This represents over 55% appreciation over the last three months and above their original price target of $34 and our revised price target of $37. Additionally, consensus forecasts have moved higher, toward their estimates, reducing the potential for upside surprise. Finally, they believe that a potential shortage of sapphire wafers could delay some demand for new MOCVD tools in 2011. With all of these factors in mind, we believe the stock is now fairly valued for its near-term prospects.

Revising Forecasts: Going forward, KBRO has changed their assumptions to reflect a more conservative view on deliveries in 2011. They have made no changes to 4Q10 forecasts. They have lowered their MOCVD tool assumptions from 460 units in 2011 to 410 units. Firm's expectation is that the sapphire shortage is likely to become more acute in mid to late 2011 and that this shortage could slow order rates for Aixtron (AIXG). They believe the company will likely ship 419 tools in 2010, thus they are mostly flat for 2011. KBRO has maintained their ASP assumptions with a blended rate of $2.54 million per tool in 2011, up from $2.22 million per tool in 2010. They are forecasting gross margins for the first half of 2011 to remain at 55% given a flat order assumption going forward. This equates to 2011 EPS of €2.06 versus firm's prior estimate of €2.30. They are still 4% above consensus, but not enough to warrant a BUY rating.

There is potential upside to their forecasts if the Japanese or Korean customers return to their historical order patterns. However, they believe these customers will likely delay their orders until the G5 and Crius II products have been fully vetted. Importantly, China is the fastest growing market for MOCVD tools and AIXG was a little slower penetrating this market versus its nearest competitor, Veeco Instruments ($49.97, VECO, BUY).

Notablecalls: Both stocks should get hit on this. AIXG is up 8 pts in 10 days and VECO is up 15 pts from its September lows.

Short interest is high (VECO 32%; AIXG N/A, but probably in the 20%s) so these are not easy shorts. Shorting the sharp bounces is probably the best way to go.

This is all too similar to the Solar space. Incentives are running out & LED manufacturers have been scrambling to take advantage of the last remaining bits. Once the music stops.. it stops.

I'm somewhat surprised to see KBRO's comments regarding the sapphire wafer shortage. This could benefit Rubicon (NASDAQ:RBCN). Be sure to check out the short interest in this one.

You're probably best served not shorting VECO in the hole in the pre market but rather waiting for the open.

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