Cree (NASDAQ:CREE) is a leading manufacturer of light emitting diodes (LEDs), LED lighting and semiconductor solutions for wireless and power applications. It competes with other large LED manufacturers such as Nichia, Opto Semiconctor Toyoda Gosei (OTC US:TGOSY), and Epistar Corporation (LI:EPIS), among others. The stock has seen a significant reduction in worth from a high of $80 in 2010 to $40 in April 2011. In the face of a tough LED market, the stock saw a further decline by almost 21% in 2011.
We have a Trefis price estimate of $27.50, which is slightly ahead of the current market price. Here’s why we feel that despite growing LED demand, the stock’s outlook is not compelling.
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- A Look Into Cree’s Past
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Limited Scope for Margin Improvement
After eight consecutive quarters of declining margins, Cree saw a slight increase in its last quarter margin figures. We believe that the margins will improve slightly owing to cost synergies by leveraging Ruud’s manufacturing facilities, lower costs as a result of moving its manufacturing base to China, and improving yields on account of better factory utilization.
However, with manufacturers focusing on innovation and high performance benchmarks for LEDs to achieve cost parity with traditional lighting, there is not much scope to increase prices. On the contrary, with major countries promoting LED lighting, LED lumen efficiency has been improving and the prices for LED lighting are estimated to drop 20%-30% each year. Hence, we expect the margins to remain more or less range-bound through our forecast period.
Even if we account for an increase in margins on account of lower costs to say 42% instead of our estimate of 40%, this has a small impact on the stock valuation.
As LED lighting become an affordable option for everyone, the lighting market would witness a shift from traditional (incandescent and fluorescent) to LEDs, leading to significant growth opportunities. However, we feel that we have adequately captured the growth in our model.
Growing LED Market
In 2010 the industry witnessed a widening surplus primarily due to increased supply by Chinese manufacturers, which in turn resulted in pricing pressure as the industry witnessed a huge demand-supply gap. However, with growing stability on the supply side and a push in demand by an accelerating lighting market, we hope to see a revival in the current year. As manufacturers develop and improve LED technology and the market continues to focus on energy efficiency, the potential market for LED lighting will continue to expand. We estimate the market to reach $16 billion (in terms of revenue) by the end of our forecast period.
We can test scenarios in the included chart on to see how changes in the market size will impact Cree’s valuation.
Increase in Cree’s LED Market Share
As one of the prominent players in the LED market, Cree enjoys a market share of 10% currently. We believe that, going forward, Cree will witness a y-o-y growth in its market share mainly on account of the following factors:
Expansion in Capacity
Cree purchased a 565,000 sq. ft. facility in Huizhou, Guangdong Province, China, to support LED chip and LED component production in 2009, and is targeting to expand LED wafer production at its previous facility in North Carolina. This expansion is expected to increase the production and also place Cree near its distributors and other manufacturers in China, offering it a cost-competitive edge and higher market share.
Acquisition of Rudd Lighting
The recent acquisition of Rudd Lighting, one of the pioneers in LED lighting and a market-leading innovator for outdoor lighting applications, gives Cree a broader presence in the lighting market. Combined with some other recent developments — the new R&D record of white-light LED with luminous efficacy of 254 lumens per watt and the introduction of the new XSP Series LED street lights designed to last over three times more than traditional street lighting — it is likely to further increase Cree’s share in the LED market.
With a 73% contribution to our price estimate, the growth in LED market is the major contributor to Cree’s valuation. However, we have adequately accounted for the factors driving LED growth in our model and are of the view that there is still some scope left for correction in its market price.