Factors Responsible For The 20% Decline In Our Valuation For Cree

-22.09%
Downside
80.07
Market
62.38
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CREE
Cree

We recently downgraded our valuation for Cree (NASDAQ:CREE) by more than 20%, from $51.96 to $40.96. The LED manufacturer reported disappointing earnings for the first quarter of fiscal 2015. (Fiscal years end with June.)  While Cree’s lighting business continues to grow at a strong pace, the lower LED demand and declining gross margins are impacting the company’s near-term growth prospects. (Read: Cree’s Q1’15 Results Hit By Weak LED Demand Though Lighting Continues To Grow Strongly)

Our updated price estimate of $41 for Cree is still at a significant premium (~25%) to the current market price. Despite short-term weakness, we continue to believe in Cree’s long-term growth potential. The continued growth momentum, combined with a strong balance sheet, gives Cree the flexibility to respond to new market opportunities. 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.

Listed below are key factors that led to a more than 20% decline in our valuation for Cree.

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See Our Complete Analysis for Cree Here

1. Higher Effective Tax Rate (~8% Downside)

We had expected Cree’s tax rate to remain at the 2013 level (15.3%) over our review period. However, we now forecast an effective tax rate that increases to 18.3% and 22.5% in 2014 and 2015. We arrived at our revised 2014 estimate keeping in mind the average tax rate for the company so far this year. Our 2015 estimate is in line with the guidance provided by Cree in its Q1 2015 conference call. The company anticipates its effective tax rate will increase to 22.5% in fiscal 2015. We assume that the tax rate to remain at the same rate for the rest of our review period.

2. Increased Operating Expense Forecast For 2014 (~7% Downside)

We increased our R&D and SG&A expense forecast (as % of gross profit) from 26.4% and 32.8% to 31.4% and 34.3%, respectively. Adding up the actual R&D expense incurred in the first three quarters of calendar 2014 and assuming that R&D costs will remain around the same level in Q2 2015 (ending December) as in Q1 2015, we arrived at a figure that was out of line with our initial R&D forecast for 2014. With respect to the SG&A expenses, we have only marginally increased our 2014 forecast. Cree anticipates its GAAP operating expense will increase approximately $2 million in the current quarter due to incremental sales expense associated with higher fixtures revenue and incremental legal spending.

3. Higher Capital Expenditure (~3% Downside)

We have revised our capital expenditure (capex) forecast for calendar year 2014 and 2015 from $139 million and $160 million to $220 million and $153 million, respectively. In its Q1’15 earnings call, Cree mentioned that it expects capex of around $200 million in fiscal 2015 (ended June 2015). Its capex so far for calendar year 2014 adds up to $159 million. We estimate capex as a percentage of gross profit to remain at 22.5% 2015 onward.

4. Revised Forecast For Cree’s Market Share In 2014 (~3% Downside)

Initially, we expected  Cree to gain some (0.5%) market share in 2014 driven by the launch of new products and the rising sales of its LED bulb. Based on the above assumption, we estimated that Cree’s 2014 LED revenue (LED components plus lighting) would reach $1.67 billion. In our updated model, we do not forecast any change in Cree’s market share this year, and consequently assume that LED revenues will reach $1.58 billion by year end (We have not changed our forecast for global LED market size).  Our total revenue forecast for Cree for 2014 now stands at $1.68 billion, which is slightly above the market consensus of $1.66 billion (as per Reuters).

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