Cree (NASDAQ:CREE), a leading LED manufacturer, has seen its stock price jump by more than 50% since its last quarter update. New product innovation across its portfolio enabled Cree to report a solid Q2 2013, despite the slow macro environment. Though the LED prices continued to decline, Cree witnessed a 14% and 69% annual increase in its revenue and net income last quarter, respectively. Additionally, the company registered close to 4% annual increase in gross margins on account of improved production mix, as well as higher productivity yields. As a result of the strong quarter earnings, Cree’s stock price increased by more than 20%.
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Cree’s stock saw another surge in its price last week (stock price increased by 17% between March 4 and March 7), after it announced new game-changing series of LED bulbs and revised its Q3 2013 revenue target. Available for as low as $10, Cree’s new LED bulbs consumes 84% less energy and provide similar level of brightness compared to traditional bulbs.
In January this year, Cree anticipated some softness in demand in Q3 2012, due to the Chinese new year holiday and the slowdown in outdoor lighting sales in cold-weather regions. While it expects the seasonal factors to impact earnings, it has revised its Q2 2013 revenue estimate from $325-$345 million to $335-$350 million.
Our price estimate of $35 for Cree marks our valuation at a premium of over 30% over the current market price. While we believe in the long term growth potential of the LED market and consequently Cree, we feel we have adequately accounted for the growth factors in our forecast.
Rapid LED Adoption Is Not An Easy Task
A surplus in the LED market and a consequent decline in prices are key trends currently plaguing the LED industry. However, witnessing an increase in orders for all its business divisions, Cree claims that the LED market dynamics are improving. LEDs provide significantly lower energy and maintenance costs. In major market segments – such as commercial, industrial and outdoor lighting – LEDs have only 10% market penetration, whereas in the residential sector (perhaps the most promising) the penetration stands at a mere 1%.  This gives the global LED market tremendous scope for growth, as economies, especially emerging markets, around the world aim for greater economic and social development.
However, despite its apparent benefits, the rapid adoption of LED’s is not an easy task. LEDs have high upfront costs, which acts as a deterrent for many users, especially in the emerging markets. If macroeconomic headwinds continue for a longer time, it can slow down the rate of adoption. Additionally, increasing awareness about the economic as well as environmental benefits of LEDs remain a challenge, as the technology changes rapidly and policy changes are met with bureaucratic red tape.
We estimate the global LED market to reach approximately $26 billion in revenue by 2019, almost double the LED market size in 2012. While we expect the growth rate to accelerate this year, we estimate the same to stabilize to around 7%-8% over our review period.
Cree Remains Well Equipped To Leverage LED Growth
Though there still remains some excess capacity in the LED market, Cree saw 12% increase in its LED revenue last quarter. While the LED components registered a 4% y-o-y increase, the lighting products business segment grew at a robust 28% (y-o-y). Cree is one of the leading players in the global LED market and remains committed to drive LED adoption by optimizing performance as well as closing the gap between LED lighting and conventional technology.
Cree has a fully integrated vertical lighting model and intends to continue working on building new lighting systems to reduce the cost of LED lighting and improve payback. 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 potential growth in LEDs.
Gross Margins Will Increase But Remain Below The Historical High
While Cree’s gross margins increased significantly in 2010, they declined close to historical levels 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, Cree marked a continuous improvement in its gross margins in 2012, on account of factory cost reduction, improved production yields, lower cost of new products and higher factory utilization owing to increased demand.
Cree continues to make incremental investments each quarter, which might offset any increase in operating margins due to improving factory efficiency. Last week, the company increased its operating expense target for Q3 2013, by approximately $2 million as it anticipates higher R&D and marketing costs to support the new product launch.
We expect that as adverse macro conditions subside and demand picks up, higher revenues for a similar cost base would lead to an increase in margins over the years. However, with the shift in product mix toward lower margin fixtures and a potential increase in competition, we expect gross margin to remain below the historical high of 48%.Notes:
- Lighting The Clean Revolution, The Climate Group – LED Report, 2012 [↩]