Here's What Matters For Cree's $29 Valuation

| About: Cree, Inc. (CREE)

Cree (NASDAQ:CREE) is a leading innovator of light emitting diode (LED). Its products, which include LED chips, LED components, LED lighting and power and RF products, are used in applications such as general illumination, video displays, automotive, electronic signs and signals, variable-speed motors and wireless systems.

Cree’s stock has fluctuated significantly in the last year, hitting a bottom of $20.50 in December 2011 and marking a 52-week high at $34.45 in December 2012.

Here we provide a quick snapshot of the important segments that contribute to Cree’s business and the key factors that impact its current valuation.

Important Segments Driving Cree’s Business

Cree made a little over $1 billion in revenue in 2011 and earned 37.4% gross profit on the same, which is constant across its business segments. Around 93% of the revenue comes from LED products, with the remaining (7%) derived from the power and RF products portfolio. With over 35% revenue contribution, China remains the most important market for Cree followed, by the U.S. with close to 25% revenue contribution.

LED products generated $963 million in revenue for Cree in 2011. Keeping in mind the growth potential in the global LED market and Cree’s focus on introducing innovative products to increase LED adoption, we believe that Cree’s LED revenue will continue to increase at a rapid pace for the rest of our forecast period.

Though the power and RF products revenue was only $72 million in 2011, we expect it to increase at a steady rate in the future.

The decreasing selling prices and high operating expenses have put a downward pressure on Cree’s gross margins in the last two years. However, we forecast a marginal increase in margins in the future and estimate gross margins to remain range bound for the rest of our review period.

Factors That Could Restrict Cree’s Growth In The Short Term

Our price estimate of $28.62 for Cree is at a discount of over 10% to its current market price. While we believe that Cree is well-equipped to tap potential growth in the LED market, we feel that we have adequately accounted for the factors driving LED growth in our valuation. While the growing LED adoption, the acquisition of Ruud Lighting and the closing price gap with traditional lighting are factors favorable for Cree’s valuation, the demand-supply mismatch, decline in LED selling price and high operating expenses could weigh down the company’s valuation.

1. Gross margins would stay under pressure

While Cree’s gross margins increased significantly in 2010, they declined close to the historical level of around 37% in 2011. The downward pressure resulted from a combination of factors: decreasing selling prices and high operating expenses as Cree stepped up R&D efforts to close down LED gap with traditional lighting. However, after eight quarters of consecutive declines in gross margins, Q3 2012 offered some respite with a slight increase in margins. While margins remained flat in Q4 2012, they rebounded to 37.5% in Q1 2013.

While Cree continues to make incremental investments each quarter, a decline in factory costs, higher yield improvement and the introduction of new low cost products, both in LEDs and lighting, have somewhat eased the pressure on margins. Though there continues to be a lack of visibility on future demand, Cree looks optimistic about further increasing its factory efficiency and improving margins.

We expect that as the adverse macro conditions subside and demand picks up, higher revenues for a similar cost base would lead to a slight increase in margins. However, with the shift in product mix toward lower margin fixtures and a potential increase in competition, we expect margins to remain range bound for the rest of our review period.

2. Potential growth in the LED market – rapid adoption is not easy

By providing a 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. However, 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 emerging markets. LEDs currently account for only 10% of the total lighting market. ((Lighting the Way: Perspective of the global lighting market, McKinsey Report))

With the demand from the backlight market nearing saturation and the general lighting market yet to take off completely, growth in LED demand has been slow, resulting in a huge demand-supply gap that has put downward pressure on average LED selling price. The increase in LED supply led by Chinese manufacturers has resulted in LED surplus rising from a relatively low 7% in 2010 to 45% in 2011.

However, Cree claims that the demand-supply gap in the global LED market is closing down, and it has witnessed a steady increase in orders for the lighting as well as other LED segments. In Q1 2013, Cree marked an improvement from both the agent and direct sale channels, and as a result, its lighting sales grew by 7% q-o-q and LED sales increased by $2 million from the previous quarter.

We estimate the global LED market to reach close to $24 billion in revenue by 2019, almost double the LED market size in 2011.

See Our Complete Analysis for Cree Here

Disclosure: No positions