As one of the leading players in the LED domain, along with Nichia, Opto Semiconductor Toyoda Gosei (OTC US:TGOSY) and Epistar Corporation (LI:EPIS), Cree (NASDAQ:CREE) continues to introduce innovative products in the market to increase LED adoption and close down the gap with conventional lighting. Many believe that LED lighting is the technology of the future, and the industry is still in its nascent stage, which we feel leaves immense growth opportunities for the existing players in the LED market.
While we believe that Cree is well equipped to tap the potential growth in the LED market, we feel that we have adequately accounted for the factors driving LED growth in our price estimate of $28.62, which is at a discount of over 10% to the current market price. (Read Our Article: Growth Potential In LED: Factors Driving Cree’s Valuation)
Cree’s stock has fluctuated significantly in the last one year, hitting a bottom of $20.50 in December 2011 and marking a 52-week high at $33.60 in December 2012. While the growing LED adoption, acquisition of Ruud Lighting and the closing price gap with traditional lighting are factors favorable for Cree’s valuation – the demand-supply mismatch, decline in selling price and the high operating expenses could weigh down the company’s valuation.
Gross Margins Would Stay Under Pressure
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 factors, namely the decreasing selling prices and the high operating expenses as Cree stepped up R&D efforts to close down LED gap with traditional lighting. However, after eight quarters of consecutive declines in gross margins, Q3 2012 offered some respite with a slight increase in margins. While margins remained flat in Q4 2012, they rebounded to 37.5% in Q1 2013.
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 looks optimistic of further increasing its factory efficiency and improving margins.
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. However, with the shift in product mix toward lower margin fixtures and a potential increase in competition, we expect margins to remain range bound for the rest of our review period. (Read: Will Cree Be Able To Sustain Current Growth In Margins ?)
Potential Growth In The LED Market – Rapid Adoption Is Not Easy
Providing significant reduction in energy costs and lower maintenance charges, the global LED adoption is bound to increase as economies around the world aim for greater economic and social development. However, while the benefits of LEDs are apparent, rapid adoption is not an easy task. LEDs have high up-front costs, which acts as a deterrent for many users, especially in the emerging markets. LED’s currently account for only 10% of the total lighting market. ((Lighting the Way: Perspective of the global lighting market, McKinsey Report))
With the demand from the backlight market nearing saturation and the general lighting market yet to take off, the growth in LED demand has been slow, resulting in a huge demand-supply gap that has put downward pressure on the average LED selling price. The increase in LED supply led by Chinese manufacturers has resulted in the LED surplus rising from a relatively low 7% in 2010 to 45% in 2011.
However, Cree claims that the demand-supply gap in the global LED market is closing down and it has witnessed a steady increase in orders for the lighting as well as other LED segments. In the recently reported Q1 2013, Cree marked an improvement from both the agent and direct sale channel, and as a result its lighting sales grew by 7% q-o-q and the LED sales increased by $2 million from the previous quarter.
We estimate the global LED market to reach close to $24 billion in revenue by 2019, almost double the LED market size in 2011.
Increase In Capacity Could Lead To Market Share Gains
Cree remains one of the leading players in the global LED market. It is committed to drive LED adoption by optimizing performance and shrinking the gap between LED lighting and conventional technology. With a focus on investing in new product development and initiatives to drive product sales, we think that Cree is in a good position to leverage future growth in LEDs. 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.
With the introduction of a number of innovative products, Cree’s LED adoption continued to gain momentum in Q1 2013. We feel that its acquisition of Ruud Lighting, a leader in outdoor lighting, in mid-2011, allows Cree to extend its leadership in indoor as well as outdoor lighting. Lighting is estimated to be the fastest growing segment in the LED industry.
Apart from its acquisition of Rudd Lighting, we feel the expansion of Cree’s manufacturing facilities, in China and North Carolina, make it well equipped to capitalize on the growth in LED adoption.