Improving LED market dynamics and increasing LED adoption driven by the launch of new innovative products has enabled Cree (NASDAQ:CREE) to witness top-line growth despite the slow macro environment. The company witnessed a 23% y-o-y increase in revenues last quarter and showed significant year-on-year improvement in its gross margins.
With widespread awareness about the economic and environmental benefits of LEDs, its global adoption is bound to increase in the future. As one of the leading players, we believe Cree is in a strong position to benefit from this growth in the LED market. The company claims to have a strong order backlog, which should help drive revenue growth in the future.
Cree witnessed a significant decline in gross margins in 2011 due to decreasing LED selling prices and higher expenses. However, despite a very competitive market environment, gross margins in 2012 improved due to better factory utilization, process improvements and new lower-cost product designs. Despite rising global LED demand, declining prices and intense competition place pressure on margins. Additionally, in order to compete against other players, Cree will have to continuously invest in its R&D capability and incur higher marketing expenses which can shrink its bottom line.
While we believe that Cree will manage to further increase its gross margins in the future, it’s important to keep in mind the factors that can hinder margin expansion.
Factors That Can Increase Gross Margins
If Cree manages to increase its gross margins to the 2010 level of over 48%, there will be around 10% upside to our price estimate for the company. Here are certain factors that can help improve margins in the future.
1. Improving LED Adoption
The LED market has more than doubled in size in the last five years from $5 billion in 2006 to around $12.5 billion in 2011. LEDs offer energy savings of 50%-60% leading to lower greenhouse gas emissions and a much higher lifespan compared to conventional technologies. LEDs offer a cost effective option to lower global electricity consumption and as economies around the world aim for greater economic and social development, LED adoption is expected to increase in the future.
With the demand from the backlight market nearing saturation, the expanding general lighting market is slated to drive LED sales in the future. As per LED Inside, the LED lighting segment is estimated to increase from around $1.5 billion in 2012 to approximately $8 billion by 2015, a CAGR of over 70%. While LEDs currently account for only 10% of the total lighting market, the percentage contribution is estimated to increase to as high as 60% by 2020. 
Cree claims to be witnessing a steady increase in orders for both its lighting and LED component products. With the acquisition of Ruud Lightings, it has become one of the leading players in LED components and lighting products. Driving global LED adoption and closing the gap with conventional lighting by optimizing LED performance and lowering costs remains key long-term goals for Cree. We forecast its market share to rise from 8.4% in 2012 to over 12% over our review period.
2. Higher Revenues To Improve Factory Efficiency
The increase in gross margins over the last few quarters was on account of improved factory utilization led by improving LED demand-supply dynamics. 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.
With rising global LED demand, we expect higher volumes to improve factory utilization in the future. Cree claims to be witnessing cost reduction across its product lines and believes that lower cost new product designs will help it improve margins in the future. Additionally, the cost synergies gained by leveraging Ruud’s manufacturing capabilities could help ease the pressure off gross margins in the long run.
Though macro headwinds might limit short-term growth in demand, Cree expects factory cost reduction and process improvements to help increase its gross margins in the long term.
3. New Facilities In China To Lower Costs
Realizing the growth potential of the Chinese economy, Cree has significantly expanded its manufacturing facilities in the country over the years. While only 14% of its property and equipment were concentrated in China in 2008, the percentage increased to 22% in 2011. Cree currently derives approximately 32% of its revenues from China and remains focused on expanding its presence in that market in the future.
New facilities in China can help Cree lower its manufacturing and distribution costs as its manufacturing facilities move closer to distributors and raw material providers. Estimated to grow at an annual compound rate of 49%, China is expected to have the largest LED lighting industry in the world for years to come. 
Factors That Can Limit Growth In Margins
If Cree’s gross margins remain constant at the current level for the rest of our review period, there will be an over 10% downside to our current price estimate for the company. Here are certain factors that can limit the growth in gross margins.
1. Intense Competition In The LED Market
With many players vying to leverage the long-term growth opportunity, there is intense competition in the LED market. The increase in LED supply led by Chinese manufacturers resulted in the LED surplus rising from 7% in 2010 to 45% in 2011. However, many manufacturers have cut down supply which combined with the increasing LED adoption has narrowed the supply-demand gap in the industry. Nevertheless, Cree competes with some big players in the market, which can limit its growth potential in the future.
Osram, Philips and GE (NYSE:GE) are some of Cree’s key competitors in the LED market. In terms of revenue, all these players are considerably larger than Cree. With $11 billion in lighting sales in 2012, Philips is the largest manufacturer of lighting in the world. 
With its focus on innovation and lower per lumen cost Cree has managed to not only survive, but grow in the global LED market thus far. Its lights are being used across the globe in street lighting, from New York City’s central park to China’s largest municipal lighting control project.
Nevertheless, competition in the LED market remains intense. Weeks after Cree introduced its less than $10 LED bulb, Osram launched its LED replacement of the 40 watt incandescent bulb for 9.95 Euros.  Philips also plans to introduce a new $10 LED bulb by the end of this year.
Increasing competition can limit Cree’s revenue growth, which by reducing factory utilization can negatively impact margins.
2. Shift Towards Lower Margins Products
Though rising competition in the market drives innovation it also leads to a decline in prices of energy-saving LED products. An increasing shift in product mix toward lower margin LED fixtures, especially in emerging markets, and pricing pressure in LED chips and components restrict growth in margins. LEDs have high up-front costs, which acts as a deterrent for rapid adoption. Thus, manufacturers are increasingly investing in R&D to drive down the cost of LED products. Though Cree has witnessed cost reduction across its product lines in the last few quarters, a drastic decline in selling prices can limit gross margins expansion.
Our price estimate of $41.73 is at a discount of approximately 30% to the current market price.
Disclosure: No positions.