Despite macro headwinds and the slow adoption of LEDs, Cree (NASDAQ:CREE), a leading LED manufacturer, witnessed strong growth in its 2012 revenues. It reported its Q2 2013 earnings on January 22. Rapid innovation across its product portfolio and an increase in orders for all its business divisions helped Cree post a 14% annual increase in revenues. Additionally, despite declining LED selling prices, Cree registered close to 4% annual increase in gross margins on account of an improved product mix as well as higher productivity yields.
We recently updated our price estimate for Cree to $35, which marks our valuation at a discount of over 20% to the current market price. While we believe in the long-term growth potential of the company, we feel we have adequately accounted for the growth factors in our forecast.
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- A Look Into Cree’s Past
LED Market Is Still At A Nascent Stage
LEDs presently account for only 10% of the total lighting market.  However, by providing significant reduction in energy costs and lower maintenance charges, the global LED adoption is bound to increase as economies around the world aim for greater economic and social development. While the benefits of LEDs are apparent, rapid adoption is not an easy task. LEDs have high up-front costs, which acts as a deterrent for many users, especially in the emerging markets.
With the demand from the backlight market nearing saturation and the general lighting market yet to take off, the growth in LED demand has been slow. 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.
However, Cree claims that the demand-supply gap in the global LED market is closing down and that it has witnessed a steady increase in orders for the lighting as well as other LED segments. We estimate the global LED market to reach approximately $26 billion in revenue by 2019, almost double the LED market size in 2012.
Cree’s Market Share Can Increase With Rudd’s Acquisition
Though there still remains some excess capacity in the LED market, Cree saw a 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 and shrinking 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.
Improving Gross Margins
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.
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.
While Cree continues to make incremental investments each quarter, improved factory efficiency have eased pressure off margins. We expect that as adverse macro conditions subside and demand picks up, higher revenues for a similar cost base would lead to a slight increase in margins this year. However, with the shift in product mix toward lower margin fixtures and a potential increase in competition, we expect margins to remain below the historical high of 48%.Notes:
- Lighting the Way: Perspective of the global lighting market, McKinsey Report [↩]