Wednesday, June 20, 2012

Cree and the LED Market

LED manufacturer Cree $CREE gave results recently, and disappointed the market by not only missing estimates but also issuing guidance which was below market estimates. Essentially, Cree is in a high growth industry but it has failed to hit market estimates for the last four quarters in a row. There can be a certain amount of sympathy for the management because this is an industry with short lead times and low visibility. However, Cree has been up against some easier comparables and the recent results plus guidance were not great.

Investors can be excused for being puzzled by the investment proposition here. On the one hand, Cree’s long term end market drivers are excellent. LEDs are approaching cost parity with traditional lighting, offer greater long term economy, require less maintenance and therefore offer increased payback. They are the future. And, everyone knows it.

On the other hand, the company is seeing consistent short term weakness due to heavy competition and low inventory levels at customers. Of course, customers do not want to carry inventory when their end markets are weak.

All of which leads to the classic conundrum of what to do with a long term growth stock that is stumbling in the short to mid term?

Cree’s Stock

Turning to the numbers
  • Q3 Revenues of $284.5m vs. estimates of $300m
  • Q3 EPS of 20c vs. estimates of 21c
  • Q4 Revenue guidance of $295-315m vs. estimates of $322m
  • Q4 EPS guidance of 20-26c vs. 28c estimates
It’s not hard to see why the stock fell after results. Moreover, in order to see how revenues are trending, here is a graph of sequential revenue growth.

Note that if Cree hits the midpoint of its internal guidance for Q4, it will be a sequential increase of 7.2% which looks low given that last years numbers were relatively weak. Let’s put it this way, $305m for Q4 would mean a seemingly impressive increase of 25.6% on the year. However, it would only be 15.2% ahead of 2010.

See what I mean about a conundrum?

Cree and the LED Market

Cree argued that whilst the LED, Power and RF results were in line with internal guidance, the revenue weakness was due to lighting. Moreover, it was ‘almost exclusively’ due to the shifting of agents caused by the integration of the Ruud acquisition last year.

Around 80% of Cree’s agents were shifted in terms of the product they were selling. All of which, caused a short term disruption in sales for BetaLED and Cree product lines in lighting. Indeed, Cree’s management went onto claim that they ‘do not believe that the decrease in lighting sales was due to lower end demand’.

This sounds entirely plausible, but if so, why is the guidance weaker than anticipated? As you can see from the graph above, there should be a sharp snapback in revenue following a theoretically short term sequential disruption. Analysts were quick to enquire why.The guidance implied that they would only do similar metrics in Q4 to what they should have done in the current quarter.

In reality, I suspect a number of forces have to come to play here. Cree is not alone in issuing weak guidance. Across the board companies like its rival SemiLEDS $LEDS and LED capital equipment manufacturers like Veeco $VECO and Aixtron $AIXG have also previously given weak guidance. However, that should be in the price, the key is weather an inflection point has been passed or not. Aixtron and Veeco could give advance notice of this, but SemiLEDS is increasingly looking like a small player in the marketplace.

Cree Potential

I think that gross margin trends are usually a good way to see if pricing power is coming back. With that in mind here are Cree’s.

Interestingly, this was the first quarter in the last eight where gross margins improved. This is a good sign, but frankly, I wouldn’t get too excited here. However, if the commentary from other companies in the sector gets better (and some are talking of a pick up) then we could see a return to the good times for the industry.

In particular, Cree is geared up to be able to satiate growth in end demand, and technology in the industry has moved on in the last year. Cree predicted margins would improve in the next quarter and that utilization would be flat. Cree has the capacity to deal with growth.

Thinking strategically, creating the appropriate ‘buzz’ in order to convince customers to forget their inertia and adopt LED based solutions, will take time. It also takes sound demonstrations of cost efficiency. All of which Cree is doing aggressively with things like new developments in street lighting technology.

Investing in Cree?

Investors following Warren Buffet’s famous fearful/greedy dictum would not have been a stock holder going into these results. Even with the initial sell off, Cree is still up over 30% in 2012. Investors were definitely not fearful. But they might be now. Which is why, Cree is starting to look interesting for the ‘nouveau greedy’.

Improving gross margins are a good sign as is the reduced expectations. Throw in some snapback in sales due to Cree’s lighting agents being settled within their new roles and there is upside potential here. However, risk averse investors may want to wait for a bit more of a sell off and monitor what Veeco and Aixtron say in the reporting season. Any positive guidance will benefit Cree. As a result, Cree is becoming attractive.