Though most believe that LED lighting is the technology of the future, the industry is still in its nascent stage as LEDs account for only 10% of the total lighting market at present.  As one of the leading manufacturer of LEDs, Cree (NASDAQ:CREE) remains committed to increasing LED adoption and close the gap with conventional lighting by optimizing LED performance and lowering costs.
However, while the demand-supply mismatch in the LED market has put pressure on Cree’s top-line, the high R&D cost and operating expenses is shrinking its bottom line. We believe that the slowdown in Cree’s revenue growth is more on account of macro headwinds and estimate the growth rate to rebound this year onward. However, we feel that the increasing operating expenses is something that the company will have to clamp down on to maintain its growth trajectory.
While Cree’s gross margins increased significantly in 2010, they declined close to the historical level of around 37% in 2011. The downward pressure resulted from a combination of decreasing selling prices and high operating expenses as Cree stepped up R&D efforts to close down the LED gap with traditional lighting. However, after eight quarters of consecutive declines in gross margin, Q3 2011 offered some respite with a slight increase in margins. While margins remained flat in Q4 2012, they rebounded to 37.5% in Q1 2013.
But will Cree be able to sustain the current increase in gross margins? In this article we discuss the trends that impact gross margins and the factors that could stabilize or increase the same in the long run.
High R&D Expenditure To Increase LED Adoption
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. Cree is a leading player in the rapidly growing LED industry so it is imperative for the company to continue investing in building its technology to drive up LED adoption.
A focus on innovation has helped Cree execute big projects in the past, such as China’s largest municipal lighting control project and New York City’s central park. Cree continues to provide higher productivity at a lower lumen per dollar cost, which we believe would be the prime factor in closing down the gap with traditional lighting technologies.
However, 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.
Decline In Factory Costs & Higher Yields To Improve Margins
The slight improvement in margins over the last few quarters was on account of improved factory utilization. While Cree continues to make incremental investments each quarter, a decline in factory costs, higher yield improvement and the introduction of new low cost products, both in LEDs and lighting, have somewhat eased the pressure on margins. Though there continues to be a lack of visibility on future demand, Cree expects factory cost reduction, process improvements and new products coming online to be the key drivers for improving gross margins.
Additionally, the cost synergies gained by leveraging Ruud’s manufacturing capabilities could help ease the pressure off gross margins in the long run.
Higher Future Revenue For A Similar Cost Base
While LEDs currently account for only 10% of the total lighting market, it is estimated to increase to as high as 60% by 2020.  Apart from its environmental benefits, the use of LEDs help significantly reduce energy costs and lower maintenance charges. Many economies, especially in emerging markets, are witnessing rapid urbanization, which is leading to greater opportunities for economic and social development. We believe this gives the global LED market tremendous scope for growth. (Read Growth Potential In LED: Factors Driving Cree’s Valuation)
We expect that as the adverse macro conditions subside and demand picks up, higher revenues for a similar cost base would lead to a slight increase in margins. With an increase in LED demand, Cree’s high investment would pay off in the long run by driving a wider uptake of its technology.
However, with the shift in product mix toward lower margin fixtures and a potential increase in competition as LEDs gain ground with the traditional incandescent light bulbs and CFL technology users, we expect margins to remain more or less around the same level.
If gross margins decline to 35% by the end of our forecast period, our price estimate would decline by 10%. On the other hand, if margins reach near the pre-historic level of around 48%, it would lead to 11% upside to our price estimate.
Our price estimate of $28.62 is at a discount of around 10% to the current market price.Notes: