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Solid State Lighting has been a steady attractor of venture capital financing over the last two years, with 17 deals worth over $329 million categorized here on VCA Stocks since January of 2006. Almost half of that money ($147 million) was invested in the last three months.

The VCs are aiming to capitalize on a big shift occurring now in the $90 billion global lighting industry, as incandescent bulbs are being replaced by HB LEDs (High Brightness Light Emitting Diodes). Lighting industry participants see this shift occurring at an accelerating pace over the next five years. Here is a forecast from Robert Steele at the Strategies in Light Conference in February 2008:

• “Conference Chair Robert Steele of Strategies Unlimited kicked off the conference with his annual overview and forecast of the HB LED market, noting that the market grew by 9.5% to $4.6 billion in 2007, a significant uptick from the 6% growth rate that characterized the market in 2005 and 2006. He pointed out that the mobile phone application has declined in importance, accounting for just 43% of the market in 2007, compared to 57% in 2004. All other applications (e.g. signs, automotive, signals, illumination) together grew at a very healthy rate of 20% in 2007, with illumination applications having the highest growth rate. The overall HB LED market is forecast to grow at a CAGR of 20%, reaching $11.4 billion in 2012.”

The transition from incandescent bulbs to LEDs is not a new idea. Presenting a report for the US Department of Energy back in 2003, David Garman pointed out that 1) lighting takes up 20% of US electricity usage and 2) moving to solid state lighting solutions would cut annual energy consumption for lighting in the US by 33%. Mr. Garman presented these projections as both an environmental imperative and as an opportunity for US ingenuity to lead a global lighting revolution.

Perhaps Mr. Garman got it half right, as Netherlands-based Philips Electronics (PHG) seems to be the company that has most taken Mr. Garman’s presentation to heart. Philips’ acquisitions in 2007 of US companies Color Kinetics and Genlyte, along with their previous acquisitions of European companies Lumileds and PLI have positioned Philips as the global leader in solid state lighting and traditional lighting fixtures.

The acceleration in VC investments tracked here on VCA Stocks during the last three months gives me confidence that industry participants are correct and the transition to solid state lighting will accelerate over the next five years.

Price Targets for Philips, Cree and Rubicon

The three highest quality options for investing in this trend are Philips Electronics (PHG), Cree Inc. (CREE), and Rubicon Technology (RBCN).

As the table below summarizes, my pick would be Philips Electronics. I would buy Philips Electronics up to $41, 9% above the current price of $38. Cree Inc. is not attractive to me at more than $22, -27% from the current price of $30, and Rubicon Technology is not attractive at more than $17, -31% below the current price of $24.

View the spreadsheet used for creating these price targets.

Calculating a Target Price for Philips Electronics

Philips is a conglomerate whose major operating segments are Healthcare, Lighting and Consumer Lifestyles. With the Genlyte acquisition, completed in December of 2007, Lighting now represents 25% of Philips’ revenues and 38% of their income from operations. Not all of the Lighting division revenues are tied to solid state lighting — Philips classifies 36% of their Lighting revenues as Lamps, for example. This diversified operating profile is a negative for investors trying to invest in the solid state lighting theme.

You have to step back, however, and see how much bigger and cheaper Philips is than Cree or Rubicon. Philip’s Lighting division generated $10.7 billion in 2007 revenues, as compared to Cree’s 2007 annual revenues of $433 million and Rubicon’s $34 million. Philips’ Lighting division is 25 times bigger than CREE and 350 times bigger than Rubicon.

Philips is also a lot cheaper than Cree or Rubicon. Philips’ overall price-to-sales using 2007 revenues is 0.93, while Cree is 5.56. If Philip’s Lighting revenues excluding Lamps were priced at Cree’s 5.56 times sales, investors would get the rest of Philips for free. Plus they’d get $8 billion in cash.

Rubicon is 14 times 2007 sales, several times more expensive than Cree, much less Philips. You can compare valuation and technical data for companies in this theme by clicking on the VCA Stocks screening section.

This value comparison of Philips versus Cree is not part of my $41 current buy price or $65 five year target price for Philips, however. Those price targets are based on looking five years forward to develop sales, earnings and dividend values, applying what I feel are appropriate multiples on those five year projections to arrive at a five year target price, and then discounting that five year target back at my required internal rate of return. Here are the assumptions I made in this process for Philips:

• Top line revenues for Philips are forecast to increase at 5.5% per year over the next five years. This growth is in line with consensus estimates and management guidance of 5%-6%.
• I project operating margin increases over the next five years, with operating margins moving from 6.9% in 2007 to 9.3% in 2012. Management is guiding this operating margin increase to be completed by 2010, which would be even better.
• Share count is expected to drop to 800 million by 2012 from 1,097 million in 2007. Management is guiding to an 800 million share count by 2010.
• The combination of increasing operating margins and diminished share count drives Philips’ earnings per share growth at a 19% annual rate over the next five years.
• Earnings are therefore expected to more than double over the next five years. Management is guiding for this earnings increase to be completed by 2010, which would be even better.
• I have placed a 15 multiple on projected five year earnings and a 2.5% dividend yield on the projected dividend rate.
• I have discounted the five year target price of $65 back at a 10% internal rate of return to arrive at my current Buy price of $41.

The wild card in Philips’ $65 five year price target is the Euro/Dollar exchange rate looking out five years. I have used a projected 1.56 Euro/Dollar conversion rate (flat with today’s exchange rate). If the dollar drops to 2.00 euros, Philip’s target price rises to $83. If dollar rises to 1.25 euros, Philip’s target price drops to $52. Purchasing Philips gives US investors a dollar hedge.

Calculating a Target Price for Cree Inc.

Cree is tempting for a couple reasons. First, the company is now emerging into a stronger growth environment after a tough couple of years. Second, there is a uniqueness value attached to being the only mid-sized pure play in the solid state lighting industry. As a result, Cree is repeatedly rumoured as a takeover target, most recently for General Electric.

I try to include these story elements in developing a long term valuation model. Even with aggressive assumptions, I come to a long term price target of $39 and a current Buy limit of $22. Cree is therefore not attractive to me at the current price of $30. Here are the assumptions I make in developing my five year target:

• Revenues are projected to grow at 17.6% annually over the next five years, in line with consensus estimates.
• Gross margins are expected to rebound from 34% in 2007 to 43% by 2012.
• Non-operating expenses (R&D and SG&A) are expected to decrease from 28% of revenues to 24% over the next five years.
• Accordingly, operating margins are expected to rise steadily from 4% to 19% over the next five years. Operating margins peaked at 36% three years ago. These 19% projected margins are similar to 2003’s operating margins.
• Tax rates are projected at 25%, in line with historical experience.
• Share count is projected to grow at only 1.6% per year, a modest dilution.

The upside risk to these projections is probably on the revenue side. I am forecasting Cree’s revenues as increasing from $394 million in 2007 to $925 million in 2012. If Cree developed a hot product for some portion of this massive lighting industry, they could see their revenues surge through the billion dollar mark over the next five years.

The downside risks to these projections are in both the revenues and margins. In an industry dominated by giants such as Philips, a smaller player such as Cree is operationally at risk. The high level of downside risk to my long term projection is why I want a 15% internal rate of return for purchasing Cree stock, while I ask for only a 10% internal rate of return in discounting Philips’ long term target price.

Calculating a Target Price for Rubicon Technology

Rubicon Technology is a new, pure play in the solid state lighting market. Rubicon makes wafers out of sapphire. These wafers are used by LED chipmakers as the substrate upon which to grow layers of gallium nitride in the next step to making an actual LED chip. Rubicon’s superior wafer making technology allows the company to make larger wafers with fewer defects — increasing yields and opening up new product possibilities for the LED chip makers.

Plugging in aggressive revenue numbers for the next five years, assuming continued high margins, and granting a high terminal valuation does not support Rubicon’s current price. Here are the specific assumptions I made in developing a five year target of $32 for Rubicon, along with a current Buy limit of $17:

• Revenues are projected to grow at a 35% annualized growth rate over the next five years, from $34 million in 2007 to $155 million in 2012.
• Gross margins are expected to remain stable at 37% of revenues.
• R&D and SG&A are expected to grow at less than the pace of revenues over the next five years. This is consistent with the idea of Rubicon moving from a development company to a production company.
• Accordingly, operating margins are expected to rise steadily from 13% to 25% over the next five years.
• Tax rates are projected at 30%.
• Share count is projected to grow at 3% per year. Rubicon’s employee option plan is 7.5% of outstanding shares, so a 3% annual share dilution is a reasonable projection.

I have placed a high multiple on my 2012 projections — 30 times earnings and 5 times revenues — to arrive at a December 2012 target price of $32. I discount that back at a 15% internal rate of return to arrive at a current Buy limit of $17, -31% below the current stock price of $24.

The risk to my projection on the upside is if Rubicon manages to dramatically increase their capacity over the next five years. They recently opened a new sapphire wafer factory which they expect to double their wafer capacity over the next two years. My projections have them increasing that doubled capacity by a factor of 2.3 times over the three years following, which I think is an agressive but reachable goal. For Rubicon to be attractive at this price, I believe they would have to significantly increase their pace of expansion. Its actually not a bad bet that Rubicon will be able to expand more rapidly — I would however only make that bet from a lower price point.