Cree (NASDAQ:CREE), a market leading manufacturer of LED products, with rivals such as SemiLEDS (NASDAQ:LEDS) and LED capital equipment manufacturers – Veeco (NASDAQ:VECO) and Aixtron (NASDAQ:AIXG), posted weak Q4 results after showing growth for three consecutive quarters. A widening surplus in the LED market and consequent pricing pressure were responsible for the temporary lull in an otherwise promising market. The demand-supply mismatch combined with the setback from agent transitions has led to a slowdown in Cree’s growth rate in the past year. As Cree begins to overcome the challenges faced in 2011, we see the company performing well in 2012 and have have consequently revised our price estimate from $26.36 to $27.50, still about 10% below the market price.
Stability in Gross Margins
After eight quarters of consecutive decline in gross margin, Q3 offered little respite at 34.9%, with a marginal increase of 30 basis points. The company’s gross margin saw a significant increase from around 32% in 2007 to a high of 48% in 2010. However, owing to depressed prices the gross margin witnessed a downward pressure and came down to 37% in 2011.
With a shift in product mix towards lower margin fixtures and a potential increase in competition, as LEDs gain ground with the traditional incandescent light bulbs and CFL technology users, the margins are expected to be more or less around the same levels. We believe, that as the current demand-supply shortage improves, the gross margins could witness a slight increase in the coming year, but will remain constant thereon till the end of our forecast period.
Growing Order Backlog
Cree witnessed consistent short term weakness due to heavy competition and low inventory levels at customers. However, the company claims that LED component sales improved post-Chinese New Year and it has a strong order backlog. It further expects to continue seeing improvement in orders.
Cree Q3 results were primarily pulled down by a decline in LED lighting sales. With the agent transition more or less complete, the situation is not expected to cause further disruption to the project pipeline. The company expects 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.
The acquisition of Ruud Lighting gives Cree a broader presence in the lighting systems market, which combined with recent developments such as – new R&D record of white-light LED with luminous efficacy of 254 lumens per watt and introduction of the new XSP Series LED Street Light, the most affordable and efficient Cree LED street light designed to last over three times longer than traditional street lighting, is likely to increase Cree’s share in the LED market. We believe that Cree has the capacity and the expertise to increase its market share to 13% by the end of our forecast period.
LEDs are approaching cost parity with traditional lighting, offer greater long term economy, require less maintenance and therefore offer increased payback. It is seeing increased acceptance amongst people accustomed to the traditional incandescent light bulbs and CFL technology. As LED products become more affordable, their penetration in the lighting market is expected to rise. Cree, one of the leaders in this high growth industry faces potential threat from players like General Electrics (GE) and Siemens. However, with a focus on achieving high performance benchmarks primarily steered by innovation, we feel that Cree is well geared to be able to satiate growth in end demand.
Though the company could see double digit growth in the coming year, we are of the view that its fair value is below what the market perceives it to be.