Cree (NASDAQ:CREE) is a leading innovator of light emitting diodes (LEDs), LED lighting and semiconductor solutions for wireless and power applications. Its products are used in applications for general illumination, video displays, automotive, electronic signs and signals, variable-speed motors and wireless systems. It competes with large LED manufacturers such as Nichia, Opto Semiconctor Toyoda Gosei (OTC US:TGOSY), and Epistar Corporation (LI:EPIS), among others. Cree derives close to three-fourth of its value from LED chips, components and lighting. Hence, any significant change in the drivers affecting this division could lead to an upside/downside to our current price estimate of $27.50.
1. Global LED Market Size: The LED market size almost doubled from $5 billion in 2007 to around $10 billion in 2011, a cumulative growth rate of close to 17%.
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2. Cree’s LED Market Share: Cree’s market share stood at 10% in 2011, an increase of around 2% from 2007.
3. Cree’s LED Products Gross Margin: Cree’s gross margin for 2011 was 37%, a y-o-y decline of 11%.
27% Upside Scenario | $35 Price Estimate
1. Increase in Global LED Market (+9%):
We forecast the LED market to grow at an annualized rate of 25% till 2016 and 13% thereon till the end of our forecast period. Last few years have seen a tremendous growth in the LED market, mainly on account of significant demand for LED in backlighting LCD TVs, notebooks and desktops. The LED share in backlighting market was around 50% in 2010, led by aggressive investments by Korean and Taiwanese panel makers.
With a growing shift from LCD to OLED TVs (that does not use backlighting), we see the backlighting market saturating by 2016. However, we think the decline in backlighting will be more than compensated by the increase in lighting, which, with an estimated 1% unit share and 10% revenue share of the lighting market in 2011, leaves significant potential for growth.
Considering a scenario where the saturation in backlight market occurs later than 2016 and/or, owing to the significant price cuts and bans on incandescent lighting in various countries, there is higher-than-expected penetration of LEDs in general lighting market, we could see an upside to our price estimate. If the LED market reaches $18 billion by the end of our forecast period, there will be a 9% upside to our price estimate.
2. Increase in Cree’s LED Market Share (+10%):
Except 2010, which was marked by a slight decrease, Cree has witnessed a year-on-year increase in market share since 2007 and currently accounts for 10% of the LED market. As the global market accelerates, we believe the recent expansion of its manufacturing facilities and the broadening of LED portfolio with the acquisition of Ruud Lighting, will help the company leverage the growing demand for LEDs. Therefore, we estimate its market size to go up to 13% by the end of our forecast period.
However, given the new R&D records set by the company with the launch of some innovative products, there is a possibility that we have underestimated the company’s potential. If Cree’s market share goes up to 15% by the end of our forecast period, we can see a 10% increase in our price estimate.
3. Higher Gross Margins (+6%):
We believe the gross margins will remain range bound between 37% and 40% throughout our forecast period. However, with manufacturing facilities moving closer to the distributors and raw material providers, combined with cost synergies by leveraging Ruud’s manufacturing capabilities, there could be a net positive effect on the margins. An improvement in factory utilization and higher yield could pull the margin up to 43%, an increase of 6% to our price estimate.
17% Downside Scenario | $23 Price Estimate
1. Slower Growth in the LED Market (-9%):
We do believe that as LED becomes a broadly affordable technology and incandescent bans take effect worldwide, the overall market is bound to see an increase in coming years, and we have adequately captured this growth in our model. However, in the event of our estimates being too optimistic, we face the chances of a downside to our estimate. In the likelihood of the demand-supply mismatch (that plagued the industry in 2011) reoccurring, there could be a downside to our estimate. If the LED market grows to only $14 billion rather than $16 billion that we forecast, we can see a downside of 9% to our price estimate.
2. Less than Expected Market Share (-6%):
During the integration with Rudd Lighting, Cree changed almost 80% of its agents which did not go as smoothly as expected and negatively impacted its Q3 2012 results. If the numerous synergies that are expected from the partnership do not come about, Cree might not be able to adequately leverage R&D across products and applications and thus its market share might turn out to be less than expected. For a 1% decrease in our forecast, there will be a 6% downside to our price estimate.
3. Falling Gross Margins (-3%):
The primary reason for the slow acceptance of LEDs in the lighting market is higher cost compared to traditional lighting options. The industry is witnessing heavy investments by manufacturers to reduce LED prices and increase its acceptance. As innovations are aimed to improve technologies and make them available at affordable prices, this means there is lesser scope for price increases. Nonetheless, if cost efficiencies do not pan out as expected, Cree could continue to see a downward pressure on margins. If the margins go down to 38%, our price estimate will decrease by 3%.