Cree Positive On Lighting Growth Though Margins Remain A Concern

Despite the current roadblocks, Cree (NASDAQ:CREE), one of the leading developers and manufacturers of LED lights, is making the  most of the tough LED market as is evident from its Q4 2012 earnings. Posting record revenue of $307 million and net income of $10 million, the company finished its fiscal year with a strong fourth quarter, demonstrating its industry leadership in the LED market. (Read: Cree’s Growth May Not Hold As Sluggish Macro Leads To Slowdown)

All the three divisions – LED components, lighting and power & RF – registered increases this quarter, though lighting sales delivered the strongest growth backed by growing LED lighting adoption and regained agent momentum.

As the strength in new product development continues to be offset by macro headwinds, Cree does not expect the growth momentum continuing in the next quarter. However, while its outlook for Q1 2012 remains more or less flat, the company firmly believes that it could witness solid growth in lighting driven by indoor and outdoor product sales.

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Growth in LED Lighting

Cree remains committed to drive LED adoption by optimizing performance and lowering costs to close the gap with conventional lighting. It is working on shortening the payback for LED lighting and, as it gains momentum, it expects the strong growth to continue in 2013 as well. Additionally, the recent acquisition of Rudd Lighting, one of the pioneers in LED lighting and a market-leading innovator for outdoor lighting applications, gives Cree a broader presence in the lighting market.

The accelerating adoption of LED lighting and increasing sales of indoor and outdoor lighting products are some of the priorities for Cree. We believe that since the industry is still in the early stages of opening up the markets for LED lighting, there is tremendous opportunity for growth. Cree is a leading player in the LED lighting market, and we believe that the continued investment in new product development will help it leverage the potential growth in this segment. Despite the extremely competitive LED market in fiscal 2012, Cree continued to win new designs and open new lighting applications that contributed to solid growth this quarter.

Stability In Gross Margins

Cree’s gross margin have seen a significant increase from 32% in 2007 to a high of 48% in 2010. However, owing to depressed prices and higher operating expenses, gross margin witnessed downward pressure and came down to 37% in 2011. After eight quarters of consecutive declines in gross margin, Q3 2012 offered little respite at 34.9% with a marginal increase of 30 basis points. At 34.8%, margins remained constant in Q4 2012 though they marked a 3.3% y-o-y decline.

The slight improvement in margins over the last two quarters was on account of improved factory utilization. However, as Cree continues to drive innovation at product and process design levels, the margins could remain under pressure in the coming quarters as well.

Cree registered a substantial increase in R&D and SG&A expenses during 2010-11 as it stepped up efforts for new product development and increased its sales and marketing initiatives to drive up product sales. Going forward, Cree expects factory cost reduction, process improvements and new products coming online to be the key drivers for improving gross margins.

We expect the company to clamp down on its operating expenses in 2012, but if the expenses keep increasing at a similar pace, the cost burden could weigh on its cash flows and impact its value significantly.

Our current price estimate of $26.20 is at a slight discount to the current market price.

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