Cree (NASDAQ:CREE), a market-leading innovator and manufacturer of semiconductors, posted its Q3 2012 result on Tuesday. The share price declined as the results failed to meet Wall Street estimates. Cree competes with other large LED manufacturers such as Nichia, OSRAM Opto Semiconductor, Toyoda Gosei (OTC US:TGOSY), and Epistar Corporation (LI:EPIS). We analyze some of the factors that affected the current result, as well as certain trends that are likely to impact the future performance of the company.
Agent Transition Took a Toll on the Lighting Segment
At $285 million, Cree’s revenue was slightly below the company target of $290-$310 million. The LEDs & Power and RF segment revenue were in line with the targets, however the company saw a lower than expected result in the lighting product line. There was a $9 million decrease in lighting sales as it lost short-term momentum due to the agent transition. The indoor sales were most affected, due to shorter project cycles and the availability of traditional alternatives. The company blames the 80% agent transition that occurred in January 2012, during the integration with Ruud Lighting (which it acquired in mid 2011). As per the company, the transitions caused more disruption to the project pipeline than the company had anticipated.
The transition mainly affected the region of North America, so if we look at international and other direct business that Cree sells through other channels, the business was pretty much on line with the company’s target. Cree does not believe that the decrease in lighting sales was an indication of lower end user demand and claims that its sees the momentum come back and the backlog rebuild.
Widening Surplus in the LED Market
The increase in LED surplus to 45% in 2011 that resulted in significant pricing pressure, was responsible for the lower revenue targets in Q3. The $13 million decline in LED sales was well within the company’s expectation. The LED surplus was primarily due to an increased supply by Chinese manufacturers which led to a huge demand supply gap. However, the company claims that the LED component sales improved post-Chinese New Year and Cree targets an improved market demand.
Slight Increase in Gross Margins
At 34.9%, the gross margins were well within the target range and saw a slight increase compared to last quarter, despite lower revenues. Cree has seen eroding margins since 2010, mainly on account of increasing LED supply. The company attributes the slight gain to the combined effect of increased factory utilization, cost reduction, productivity and yield improvement which offset the pricing declines. The company targets a margin of 35% for Q2, as its new products gain traction in the market and increased factory efficiency puts the company in a better position to support higher revenue targets for Q4.
Future Outlook – Lead the Market & Drive Adoption of LED lighting
All three product lines of the company – LED, Lighting and Power & RF saw an improved order rate in March, and thus the company expects solid growth in Q4 with revenues in the range of $295 – $315 million – which will be comprised of double-digit growth in lighting, driven by strong growth in indoor and outdoor sales, single-digit growth in LED product sales for both direct and distribution customers, and incrementally higher Power and RF sales.
Over the last few weeks, Cree announced a series of new lighting products which lead the market, and believe will open up the applications to LED lighting. The company reached another performance platform milestone with the development of a prototype LED, which produce 254 lumens per watt. It produces more LEDs per wafer cost and at a similar utilization levels as Q2. The innovations in LED segment will help its customers deliver a more competitive payback versus traditional lighting. Cree’s share in the LED market will play a major role in determining its share price as it contributes close to 79% to its current stock price.
With increased R&D and introduction of new products, the company’s focus remains on driving adoption through innovation, and we believe they are well positioned to continue leading the transition to LED lighting and drive growth in business.
We maintain a $26.36 price estimate for Cree, which is at a discount of 11% to the current market price.