Listener Question: What Is the Future of OLED?

Smartphones are big business, but it's usually Apple (AAPL -1.22%) and Samsung that soak up the headlines in the space.

In this week's episode of Industry Focus: Tech, host Dylan Lewis and Motley Fool contributor Evan Niu dive into the smaller and more volatile world of smartphone parts manufacturing -- specifically Universal Display (OLED -2.06%), which produces and licenses IP for OLED displays. Things seem to be looking up for the company, but prospective investors will definitely want to know the risks before buying in. Also, find out how Apple's interest in OLED tech has shifted over the years, why a sharp 60%-plus drop in Universal Display's stock isn't as awful as it sounds, how TVs factor into materials sales, and more.

A full transcript follows the video.

This video was recorded on May 25, 2018.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, June 1st. We're talking about OLED. I'm your host, Dylan Lewis, and I'm joined on Skype by senior tech specialist, Evan Niu. Evan, what's going on?

Evan Niu: It's going well. Ready for the weekend.

Lewis: Ready for the weekend. A quick note, I guess, before we get too far into the discussion -- we're ready for a different weekend than is actually coming for people that are listening to this show, because we're pre-taping this episode. It's actually May 25th. We're pre-taping because I'm going to be on vacation in early June. I don't know what Evan's going to be doing, but I guess he'll have the day off from a podcast taping.

Niu: Nothing new for me.

Lewis: On today's show, we're going to cover a listener question. It comes from the form that we have pinned to the top of our Twitter feed -- hint, hint, listeners that might want to drop us a Q. This question is, "I'm interested in the company Universal Display. It grew enormously last year and then crashed over 60% because of Apple MicroLED plans. But I see OLED as being a big player in the display business over the next five years or so. What does its future look like?" 

Evan, I think this is a fun one because Universal Display is a company that operates in a space that we talk about a lot, but we haven't really talked about this business before. It's something that I think feeds into an industry that a lot of people know about, but maybe don't quite understand the guts of this company itself. They develop OLED technology, which is organic light-emitting diode technology. You want to walk through exactly what that means for them, and what their business looks like?

Niu: Universal Display create intellectual property around OLED displays, and they license this IP out to major manufacturers. On top of that, they sell the materials that go into the displays. They have two main revenue streams. Licensing makes up about 40% of total revenue. Of course, licensing is very R&D intensive, but once you have it out there, it's highly profitable and very nice margins there. On the materials side, UDC relies on PPG as its primary supplier for materials. The company's biggest customers are companies like Samsung and LG, two of the largest OLED panel makers in the world. These are companies that, when you think about phones that have OLED displays, those are usually some of the names that come to mind right off the top of your head.

Lewis: This is a company that you have owned and sold shares of at different points in the past. Where exactly do you stand with them now?

Niu: I actually first invested in them almost ten years ago, actually, at around $10-15, actually also just before I joined The Motley Fool. I recognized the potential of the technology, and I thought it was really promising, with a lot of benefits over traditional LCD screens, as well as LED displays. They're more energy efficient, you can have really innovative form factors because they don't have to be flat displays, you can have flexible displays, a lot of really cool stuff there.

But OLED adoption has been so slow. I actually got out for a few years because I was getting a little impatient. I got a nice gain. Part of my thesis was always that Apple would eventually adopt OLED technology, which would then catalyze more mainstream adoption from other companies. It turns out that other companies adopted it first. But, once it became clear that Apple was finally getting on board, after years of waiting and rumors to that effect, I finally got back in about a year or two ago.

Lewis: What exactly flipped the switch there? Why did Apple decide to get into OLED?

Niu: They saw a lot of technical shortfalls with the technology, which I think kept them away from it for a while. Things like color saturation, brightness, color accuracy. CEO Tim Cook had criticized OLED for those reasons a few years ago, back before they adopted it. And those are very valid concerns with OLED technology. For example, Samsung phones have a reputation of being oversaturated in particular. They have a very blue tint to them, particularly the older models. But the technology has improved quite a bit, to the point where OLED can meet Apple's really high quality standards. Many investors probably already know this, but I should point out really quick that Apple sources its OLED displays for the iPhone X from Samsung. They have very specific requirements in terms of calibration and such, which is why they do look a little bit different than what you'd find on a Samsung phone, even though Samsung is making all of the displays.

Lewis: It seems, like increasingly, Apple is getting interested in this market. I think, you go back to 2017, there was one model with an OLED display. Rumors are that we'll see two in 2018. Again, you have to discount it a little bit because it's an Apple product rumor. We get plenty of those all the time. But the thought here is that this is becoming an increasingly important technology for Apple. Universal Display is obviously very pleased with that. That was part of the huge rush of revenue that they saw in 2017. But they are not the only game in town when it comes to being an Apple supplier here.

Niu: Right. Apple has been trying to diversify its supplier base from Samsung adding on LG, but LG has hit these manufacturing hurdles and they're having a hard time meeting its requirements. Ultimately, all of it is good news for Universal Display, because all of these companies are all customers and they all feed into its business. It has a very unique role in the value chain, supplying all of these companies. It's really all good news for Universal Display.

Lewis: What that wound up turning into, looking at the financial statements for them, is, I think revenue was up something like 70% year over year in 2017. And this was after years and years of flat growth. They saw barely any sequential growth in 2015, 2016, 2017 leading up to it. There's this, wow, this just happened, and all of the sudden shares have sold off, I think, about 50% from the highs that they hit in 2017. What exactly is the market sentiment around this stock right now? It seems like so many things are going in the right direction for them.

Niu: A lot of it does tie into these fears of MicroLED, which is another competing display technology that is a threat in the long-term that could displace OLED eventually. Apple had acquired this small company called LuxView back in 2014, a small start-up that was exploring and developing MicroLED display technology. But that was four years ago, and investors didn't really hear much about that in the years since. But in March, Bloomberg reported some fresh details about Apple's MicroLED plans, which reminded everyone that they had this thing going. To be clear, MicroLED isn't anywhere near close to mainstream commercialization, and Apple is still very much in the early stages. But the fact that Apple's working on it scared investors.

It's also worth remembering that Universal Display's valuation was getting pretty crazy. It was trading at 30X sales in January. I think a pullback was kind of inevitable, because people were getting so excited about having Apple as customer that I think the shares probably got a little bit ahead of themselves. Then, when these fears around MicroLED come out, that's a catalyst that's going to trigger a lot of selling. 

All technologies face threats like this. To add another one into the mix, there's always been talk for the past few years, as well, about quantum dot displacing OLED. That also hasn't panned out, either. Not to say that it won't or can't. These are all just technological threats. I think that they're still a little ways off.

Lewis: My read in trying to figure out where this market is going is that MicroLED might be where we wind up going with things down the road, but we are still years and years away from that technology becoming a mainstay, particularly in the smartphone market. Is that kind of how you're feeling about things, too?

Niu: Yeah. I think it's one of those threats on the horizon. But, in the meantime, I do think that Universal Display has a lot going for it. They've been making all sorts of these licensing agreements with display manufacturers in Asia. Japan Display, Ever Display, BOE, Sharp, and many others. Remember that the initial licensing agreement is really just the start of the relationship. For Universal Display, that means ongoing royalty revenue as well as materials sales. China has been aggressively investing, as well, to ramp OLED manufacturing capacity. Once that capacity's in place, you know those companies are going to need to maximize capacity to try to sell as many as they can. For example, BOE, a Chinese manufacturer, is expected to start mass production this year at its first OLED plant, and they're going to start constructing their second plant here pretty soon, too. So, again, a lot of runway.

Lewis: A lot of our focus here has been on how this technology and the technology that Universal Display makes plays into the smartphone market. I think that's something that we need to take a step back from and remember that this goes into a ton of different consumer electronics devices. You have tablets, you have TVs, there are a lot of applications here. And while there may be some concerns about what's going on specifically in smartphones, there are a lot of other really viable markets for this business right now. 

Niu: Right. OLED TVs are starting to gain a lot of traction. Right now, they're still quite a bit more expensive than LCD TVs. But like all technology, costs come down over time. Once costs come down enough to the point where you can really get mainstream adoption, then you see unit volumes really jumping. I think that OLED adoption in TVs is still pretty early. But, same thing. Samsung is pushing a lot of OLED TVs, 4K TVs, a lot of stuff going on in that space, as well. Also, TVs are humongous, just in terms of the sheer display size. If you think about the amount of materials that have to go into a TV vs. into a smartphone, that's all coming from Universal Display.

Lewis: Yeah. I think I saw a management estimate where they were looking at the OLED TV market, and they're expecting it to quadruple between 2017 and 2022 on an annual basis. In that time, the smartphone market will likely 1.5X where it is now. That speaks to the display differences on working on the scale of a TV display. 

Looking at everything that's going on here, Evan, it seems like you're not super worried about this recent downturn. It might be something that's more reflective of a little bit of an overblown valuation than issues with the fundamental business.

Niu: Right. I think, when shares were in the neighborhood of $200, that was a little crazy. I'm not too worried about it coming down. It did come down like 50%, and that's always hard to watch, particularly if you're holding shares. But I'm still pretty confident in their prospects over the next three to five years, medium-term. I plan on holding my shares through then. I think investors should expect the shares to be volatile. They've always been super volatile because there's a lot of uncertainty regarding OLED adoption. And management has always been clear that OLED adoption is so hard to predict when it will happen. But everything is still going in the right direction. It is being adopted in the market. I don't think it's as much of a question of if, but more of just the timing of it that's really hard to predict, and it's really bumpy. 

Fundamentally, Universal Display has a lot of potential to enjoy this once adoption continues to rise before, maybe, some other technology comes along. And, yeah, that'll probably happen eventually. But these adoption curves take so long that there will be a lot of signs. You'll be able to see if some other competing technology starts to displace OLED. I think investors will have plenty of visibility, in terms of when they want to plan their next move.

Lewis: Yeah. To me, it sounds like a business where, if you're a shareholder, you might not be able to set it and forget it for the next decade, but for the next couple of years, you're probably going to be in pretty decent shape, unless there's a massive shift in the display technology that people are using for these devices.

Niu: Yeah, that's how I think of it.

Lewis: Well, thanks for hopping on and talking about it with me, Evan. Listeners, if you ever have something you want us to hit, shoot us an email at [email protected], or, like I mentioned, go to our Twitter feed. We have the form in there. Evan, I hope you enjoy whatever it is you're doing this weekend, or the weekend of six to one, since that's technically when people are going to be listening to this show. Thanks for joining me today!

Niu: Thanks for having me!

Lewis: Listeners, as always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocked mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Austin Morgan for his work behind the glass. I hope he, too, enjoys a couple of Fridays off. For Evan Niu, I'm Dylan Lewis. Thanks for listening and Fool on!