Seasonal Factors To Slow Cree’s Growth This Quarter

Cree (NASDAQ:CREE), a leading LED manufacturer, is set to announce it Q3 2013 results Tuesday, April 23, and owing to seasonal factors we anticipate the growth to slow down. Though the company expects the Chinese new year holiday and the slowdown in outdoor lighting sales in cold weather regions to negatively impact LED demand, it recently revised its Q2 2013 revenue estimate from $325-$345 million to $335-$350 million.

New product innovation across its portfolio enabled Cree to report a solid Q2 2013, despite the slow macro environment. Though LED prices continued to decline, Cree witnessed a 14% and 69% annual increase in its revenue and net income in Q2 2013, 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. The company’s stock price has jumped by over 50% since its last quarter update.

With improving LED market dynamics and Cree’s commitment to drive LED adoption and close down the gap with conventional lighting via increased innovation, we believe its top line will continue to grow at a rapid pace for years to come. However, we think that we have adequately accounted for the upside in our model, and thus, our price estimate of $35 for Cree is at a significant discount to the current market price.

See Our Complete Analysis for Cree Here

Accelerated Adoption of LED Lighting To Drive Sales

A surplus in the LED market, a consequent decline in prices and pressure on margins are some of the key trends currently plaguing the LED industry. Though there still remains some excess capacity in the LED market, Cree claims that the LED market dynamics are improving, which is evident from the 12% increase in its LED revenue in Q2 2013.

Many economies, especially in the emerging markets, are witnessing rapid urbanization, which is leading to greater opportunities for economic and social development. However, the same creates resource scarcity and raises environmental concerns. Countries are starting to recognize the opportunity LEDs provide to help them significantly reduce their energy costs and lower maintenance charges. With energy savings of 50%-60% leading to lower greenhouse gas emissions and a much higher lifespan compared to conventional technologies, LEDs offer a cost effective option to lower global electricity consumption.

As LED demand from the backlight market nears saturation, potential growth in the LED lighting market is estimated to fuel future growth in the LED industry. As per LED Inside, the LED lighting segment is estimated to increase from around $1.5 billion in 2012 to approximately $8 billion by 2015, a CAGR of over 70%.

With new product offerings, Cree’s indoor and outdoor lighting industry witnessed stronger than expected growth in Q2 2013. Cree remains focused on driving LED adoption and growing sales of its indoor and outdoor products. We think that its acquisition of Ruud Lighting, a leader in outdoor lighting, in mid-2011 allows it to extend its leadership in indoor as well as outdoor lighting. LED lighting products currently account for 35% of Cree’s total revenue, a substantial increase from 19% a year ago.

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. (Read: Why Cree Will Continue Growing Its LED Market Share)

Rapid LED Adoption Is Not An Easy Task

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.

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 month, it 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%.

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