Factors That Can Lower Our Valuation For Cree By 30%

Cree’s (NASDAQ:CREE) stock price has declined by more than 20% year-to-date. The company reported a strong Q2 2014 and Q3 2014, with a 19% and 16% annual increase in revenues, respectively. However, Cree saw its gross margin decline to 37% in Q3 2014, compared to 37.5% in Q2 2014 and 38.1% in Q3 2013. We believe the decline in gross margin led to the negative sentiment around the stock.

The rising proportion of lighting sales puts pressure on Cree’s overall gross margin as lighting products offer lower profit margins compared to LED devices. A higher proportion of revenue from the fast growing LED lighting market is expected to put additional pressure on Cree’s gross margin growth in the future.

Our price estimate of $63 for Cree is now at an approximate 30% premium to the current market price. LED penetration is expected to increase in the future and, being one of the leading global LED manufacturers, Cree will benefit from the trend, in our view. With $1.1 billion in cash and no debt, the company has a strong balance sheet, which gives it the ability to invest in growing its business and respond to new market opportunities.

In this article, we explore possible scenarios which can lead to an approximate 30% decline in our stock price.

See Our Complete Analysis for Cree Here

Gross Margin Remains Constant (>10% Downside)

In our current model, we forecast Cree’s gross margin to increase to 44% over our review period, compared to 38% at present. Though we expect Cree to derive an increasing percentage of its revenue from the lighting segment, we believe the company can manage to further increase its gross margin in the future. Higher LED volumes combined with lower new cost products, cost reductions and higher factory utilization will help increase Cree’s overall gross margin.

With many players vying to leverage the long-term growth opportunity, there is intense competition in the LED market. Cree competes with some big players, which can limit its growth potential in the future. Osram, Philips and GE (NYSE:GE) are some of Cree’s key competitors in the LED market. In terms of revenue, all these players are considerably larger than Cree. With $11 billion in lighting sales, Philips is the largest manufacturer of lighting products in the world. ^[1]

Increasing competition can limit Cree’s revenue growth, which by reducing factory utilization can negatively impact margins. If Cree’s margin remains at the current level for the rest of our review period, there will be more than 10% downside to our price estimate.

Cree’s LED Market Share Remains Constant (~15% Downside)

We currently forecast Cree’s market share to increase from 9% in 2013 to 11% over our review period. Cree is one of the leading LED players committed to driving global LED adoption and closing down the price gap with conventional lighting through innovation. Product innovation in the last few quarters has opened new applications and improved LED returns, in turn driving demand for Cree’s products. The company has a fully integrated vertical business model and is the market leader in both LEDs and LED lighting products.

Cree hit a milestone in driving LED adoption a year back by launching a LED bulb for as low as $10. The LED bulb is considered as one of the biggest industry innovations in years and has been seeing tremendous success at Home Depot stores. In November 2013, the Cree LED bulb earned the ENERGY STAR label, which means these bulbs qualify for incentive rebates through certain local utilities. With the rebate, the Cree LED bulbs is available for under $5. Driven by a full lighting season, utility rebate, new products and increased marketing activities, Cree’s LED bulb sales to consumers doubled sequentially in Q2 2014. The company claims that the Cree LED bulb gained additional momentum and brand recognition in Q3 2014. It is reinvesting most of its profits to fund additional marketing investments and generate more awareness for its LED bulb.

Weeks after Cree introduced its less than $10 LED bulb, Osram launched its LED replacement of the 40 watt incandescent bulb for 9.95 Euros. Soon Philips followed suit with its $10 LED bulb. These companies can outpace Cree’s products in the future, challenging its competitiveness in the LED market. If Cree’s market share remains constant, our valuation will decline by 15%.

Capital Expenditure Remains High (~5%)

We forecast Cree’s capital expenditure as a % of its gross profit to decline from 22.5% in 2013 to 11.5% over our review period. Cree has made some significant investments in the last few years, and thus we expect the capital expenditures to remain low. If Cree’s capital expenditure as a % of its gross profit remains at the current level, then it will have a 5% negative impact on our valuation.

As always, with any of these drivers, we invite readers to test their own assumptions with the accompanying visuals.

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1. Philips targets office maker with new LED light, Yahoo News, April 11, 2013 [↩]