DisplaySearch Blog

Is the Worst Behind Us?

By David Barnes, VP of Strategic Analysis

Several equity analysts made the headlines recently when they revised their expectations for LG.Philips LCD (LPL) stock upwards ahead of Q1’07 results. The analysts based their “buy” recommendations on two perceptions. They thought the market had already punished the stock for losses in 2006, and they heard that some panel prices were either stabilizing or rising in March-April. Management comments and Q1’07 results seemed to justify this view. A few days later, Samsung Electronics (SEC) also reported Q1’07 LCD results that were weaker than Q4’06 results and provided optimistic guidance for the remainder of 2007.

So where are we; is the worst really behind us? I would have to say yes and no. The TFT LCD industry is going through a transition. Producers increased their TFT area capacity about 50% a year for ten years. Now they are slowing the pace of expansion. Overall, that is positive for prices and profits but the benefit will not accrue to all markets simultaneously. Very little capacity will come on line for notebook and monitor panels in the next few years. LPL executives say they are still unsure about investing in their proposed Gen-5.5 fab. We see systemic oversupply in small-medium panel capacity. With falling prices and margins for even LTPS panels, there is little incentive for producers to reinvest in this sector. TV panel capacity is a different story, however. Producers are still piling in. Besides TFT LCD producer rivalry for branded customers, producers also face resurging competition from full-HD PDP like those offered by Panasonic. It looks like prices for panels in the 40” and 50” regime must continue declining faster than 32” panel prices have been in order to hit relative sweet spots in consumer pricing. We now see prices for 32” panels rising as much as 2% from Q1’07 to Q4’07 but falling 30% from 2006; the annual trend of decline remains 30% since Q1’04. The rate of price decay for 40” to 50” panels has been closer to 37% a year and we expect a 10% price decline from Q1’07 to Q4’07.

Producers will probably benefit from slowing expansion depending on how fast they expand. Companies that make many panels for PC applications and a few panels for TV in the 20” to 30” regime will probably see more price stability than will companies competing for share of the 40″+ LCD TV market. Leading producers will therefore gain from price strength in PC markets but lose from weakness in TV markets.

Will the gain offset the loss? Looking at LPL results, the gain seems to offset the loss somewhat. The question of future profit seems to hinge on making areal cost fall faster than areal price. In prior business cycles, producers like LPL made money when demand became “super elastic.” The following chart shows three periods when the LPL elasticity curve moved up and to the right. These positive slopes indicate boom times in the crystal cycle when buyers, PC brands primarily, paid more to get more. Prices went up and demand went up. Producers like LPL reported healthy margins in early 2002, early 2004 and late 2005. Subsequent to such cycle peaks, capacity expansions increased the negotiating power of buyers and demand became inelastic for a quarter or two. The chart shows the reaction in Q3’04, Q1’06 and Q1’07. During those reactions, buyers paid less to take less display area; revenues declined and losses ensued. In my mind, the story is told by the slow recovery of Q2’06 to Q4’06. The chart shows no super-elastic surge as seen in prior cycle recoveries. Elasticity merely returned to the long-term trend. I believe this comes from the increasing weight of large TV panel market dynamics on LPL and other leading producers. It is much more difficult to keep larger TV panel prices level, let alone raise them, than it is to raise PC panel prices. The PC supply chain is shorter and leaner. It carries less inventory risk. If LPL and its key competitors cannot raise their average price because of the weight of TV panels in their product mix, they cannot enjoy the super-elastic profit surge. Q4’06 was unprofitable for LPL and I assume it would be unprofitable for AU Optronics (AUO) on a US GAAP basis, also.

Demand Elasticity Relative to Price for LPL, Q1’02–Q1’07

Sources: Q1’02–Q4’03 numbers come from DisplaySearch estimates; Q1’04–Q1’07 numbers come from LG.Philips LCD disclosures.

In summary, Q1’07 looks like the low point for a business cycle but up-cycle profits are deteriorating. The worst may be over for this business cycle but the best may be over, overall. This may have little effect on stock movements, however, because smart speculators can profit from any business cycle.

In the final analysis, it comes down to moving costs down… relentlessly. Leading producers have done well recently but material savings through design are one-time things. Once implemented in production, further material cost reductions depend on purchasing power and new designs. This is why it important for panel makers to become material innovators, not just fab operators. CRT producers took control of their primary material inputs decades ago. The leaders made their own plates, funnels and grids. They did not buy them from suppliers with proprietary advantage. If panel makers can learn from CRT makers and take control of their material supply, their long-term success would be easier to forecast.

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