Monday, September 24, 2012

Cree and the LED Industry Outlook

Cree $CREE recently gave a mixed bag of results although the market sent the stock sharply higher. This is probably due to the fact that -- for the first time in five quarters -- Cree beat market estimates and because the stock went into relief rally mode.  In summary, whilst the results were mixed for Cree, I think there is enough "color" in the numbers and in the surrounding commentary to produce some useful takeaways for the industry at large.

The "relief rally" argument carries more weight if you recall that LED demand has low visibility and is subject to short lead times. Throw in the weaker macro economic environment in the quarter and there would have been a high degree of variability in investor expectations for the quarter. No matter. Cree delivered and in doing so it demonstrated that it had largely cleared up the agency issues that dogged lighting sales for the company in the previous quarter.

On the other hand, the guidance for the next quarter was weaker than market estimates, LED prices continue to fall, markets remain extremely competitive, the uncertainty of China’s stimulus spending remains (not to say Cree’s opportunity to benefit from it) and industry capacity remains under utilized. 

Agency Issues, Lighting Sales and Gross margins

Returning to the previous quarter Cree suffered some weakness in lighting revenue due to major changes in agency sales operations. Essentially around 80% of Cree’s agents shifted around the types of products they were selling and this caused disruption. This was a disappointment because lighting appears to have the best prospects within the industry.

LED prices are falling and quality is improving so LED based lighting products are approaching initial cost parity with traditional forms of lighting. This is important because many customers have ignored the fact that LED lights offer higher quality lighting require less maintenance and offer quicker payback in favor of buying traditional lighting because the upfront cost is less. With regards the agency issue, lighting sales came back strongly and it seems that the issues are largely resolved.

Cree stated that it was targeting ‘pretty significant’ growth in lighting and if we look at what competitors (within the lighting segment) Acuity Brands $AYI and Hubbell Inc $HUB-A are reporting, this part of the industry looks set for strong growth. Acuity reported a 6.4% increase in sales in the last quarter and Hubbell reported a 10% increase. In my opinion, Acuity remains the best play in the overall sector. With Acuity you get exposure to the North American residential, commercial and industrial lighting sectors and I like the outlook for construction in the US. Hubbell is also attractive but this company is more cyclically exposed to industry.

One area where Acuity and Hubbell have an edge over Cree is that they have been selling traditional lighting products so shifting customers into LED based solutions will be relatively easier for them. For example, many developers already use LEDs for difficult to reach areas which are expensive to maintain. Now these same developers can look at LED solutions as being cost effective all over a development. And Acuity and Hubbell are there to tell the story.

General Electric $GE is also going to help spur demand and awareness via their LED bulbs which are available in outlets like Home Depot $HD. Indeed, its new LED bulbs are priced at a comparable cost to traditional lighting. This is only a small part of GE’s operations but there is no doubt that with its muscle behind LED adoption, the penetration rates will increase markedly.

Turning to gross margins, I always think this is the key to decoding when an inflection point has passed. Here are the reported numbers for Cree.

It looks like we are bouncing along the bottom, but Cree’s management did spend an inordinate amount of time on the conference call outlining how on an adjusted basis they were improving. That said the stated reason for the adjusted uptick was that it was due to factory cost reductions, new products and process improvements. In other words, it wasn’t really about the kind of supply/demand imbalance which will lead to a sustained increase in the future.

The key to longer term growth will come from a sustained pick up in demand and a new wave of adoption of LED technology in the way that flat screens or solar power drove previous booms. The other imponderable is China and its stimulus spending.

China to Spur Demand?

Cree did have a big street lighting win in the quarter and there is no doubting China’s commitment to utilizing energy efficient technologies like LEDs in a wide range of applications. However, there is also no doubt that the timing and willingness of China to invest is subject to uncertainty. A lot of projects tried to use domestic LEDS and they failed, whilst this implies that Cree –as a higher quality manufacturer- should see great benefits going forward, we need to consider a few things. China is not the US. It is not ruled by a democratic and liberal free market consensus handed down from generation to generation. They are Communists.

It strikes me that maintaining employment, developing export industries and supporting their own companies are the Government’s main focuses. So when it comes to street lighting it is entirely feasible that they will wait until they feel domestic producers can supply them with the quality they want and then the spending will start. Unfortunately, that scenario is not ideal for Cree.

One company that may fair better out of this is Veeco Instruments Inc $VECO which provides capital machinery to manufacturers. In the end, it doesn’t really care where or who is making the LEDS just as long as they are doing it with Veeco’s manufacturing solutions. Veeco’s key end driver is capacity utilization by its end customers and the company recently talked of a gradual order recovery in the second half of 2012.

Where Next For Cree?

A quick look at the sequential movement in revenues suggests that this was a decent quarter for Cree but if we take the midpoint of next quarter guidance for $305-320 million in revenues, it is only a 1.9% increase. This is low by Q1 standards and doesn’t inspire a lot of confidence.

Longer term, the LED industry is very attractive and in particular lighting looks set for strong growth. Cree’s stock is certainly not expensive on a cash flow basis and a strong case could be made for some upside potential but I would exercise a bit of patience before chasing the stock higher.

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