Cree - Analysts Are Pushing Up First Quarter Earnings Expectations

| About: Cree, Inc. (CREE)

Shares of Cree (NASDAQ:CREE) jumped up in Tuesday's trading session after the LED producer received two upgrades in Tuesday's trading session. The upgrades came after shares have witnessed a sell-off on the back of its fourth quarter results in the middle of August.

On the back of the upgrades, shares have risen some 15% in Tuesday's training session, adding a little over a billion to the current market capitalization.

As analysts are confident that Cree can positively surprise when reporting its first quarter results later this month, shares might have even more upside potential from current levels.

I will wait for the first quarter earnings report, scheduled to be released on the 22nd of October, to learn more about the success of the company's new 60 Watt LEDs, before initiating any position.

Analysts Upgrades

Both Goldman Sachs (NYSE:GS) and Canaccord Equity issued positive research notes on the company, both issuing a "buy" rating on the stock. Canaccord actually attached a $80 price target to the research note, while Goldman Sachs' Brian Lee set a $72 price target.

Canaccord's analyst Jonathan Dorsheimer notes that it seems that Cree managed to lower the cost of the second-generation 60 watt light bulbs, available at Home Depot (NYSE:HD), which should boost gross margins. Dorsheimer believes that Cree could work on another third-generation bulb which could even further reduce costs of manufacturing.

Cree should be "leading the pack" in lighting LEDs, despite formidable competition. Gross margins should be able come in somewhere in the mid-teens, up from current levels in the mid to high-single digits, boosting the performance of the Lighting Systems division.


Cree ended its fiscal 2013 with $1.02 billion in cash, equivalents and short term investments. The company operates without the assumption of debt, for a solid net cash position.

Revenues for the fiscal year of 2013 came in at $1.39 billion, up 19.0% on the year before. Gross margins rose by 260 basis points to 37.8% of total sales as net income nearly doubled to $86.9 million.

Factoring in gains of 15% on Tuesday, with shares exchanging hands at $69 per share, the market values Cree at $8.3 billion, or operating assets at $7.3 billion.

This values operating assets of the firm at 5.3 times annual revenues and nearly 100 times GAAP earnings.

Cree does not pay a dividend at the moment.

Some Historical Perspective

Shareholders in Cree have seen nice returns in recent years, accompanied by great volatility. Shares rose from merely $13 in 2008 to peaks around $80 in 2010. Shares fell back all the way to $20 in 2011, and have recovered to highs of $75 prior to the release of its fourth quarter results at the start of August.

The sell-off on the back of those results has pushed shares downwards to $55 per share by mid-August.

Between the fiscal year of 2010 and 2013, Cree has increased its annual revenues by a cumulative 60% to $1.39 billion. Net earnings fell from $152 million to $87 million in the meantime.

Investment Thesis

So shares of Cree have seen a 30% sell-off ever since the release of its fourth quarter results halfway through August, which slightly missed consensus estimates. On the back of the analysts' upgrades, shares have nearly recouped all those losses, trading around $70 at the moment. At this level, shares have already doubled again so far this year.

Note that fourth quarter revenues came in at $375 million, implying an annual run rate of $1.5 billion. Revenues were up by 22.2% on the year before, an acceleration compared to the reported annual growth rate of 19.0%. Operating margins expanded to 8.2% of total revenues, compared to 7.0% for the entire year, as annual earnings are surpassing the $100 million mark again.

At the time, Cree guided for first quarter revenues of $380 to $400 million, implying that growth rates will accelerate to 23.5% at the midpoint of the range. Yet the real acceleration of growth is still to come and should be supported by the Lighting Products business. This unit reported a 33% increase in sales over the past quarter, as revenues totaled $133.6 million.

Cree's new LED bulbs were introduced in March of this year. The 60-watt light bulb is available for $12.97 at Home Depot, resulting in energy savings of 84% according to Cree itself. The lights are furthermore backed by a 10 year limited warranty, and replacing the 5 most frequently used light bulbs could save a US household some $61 per year, according to Cree's calculation example.

This makes the economics of a decision to buy these lights easy. Yet the real success of the LED bulbs depends on effective marketing and strong partners, like Home Depot, to make it a success. Note that an investors should really focus on these sales in the first quarter results to be released later this month.

As the US market for light bulbs is enormous, especially when it makes sense for consumers and businesses to replace still working light bulbs, Cree is well positioned. Its lights are technically superior and an effective marketing campaign, combined with a strong market position, could fence of low-cost competition going forwards.

That being said, what does all this imply for the valuation? If Cree can maintain current growth rates, or slightly increase them, revenues could easily double to $3 billion by 2016. Operating margins should be able to increase as well towards mid-teen percentages, as gross margins and operating leverage might result in solid margin expansion.

Operating earnings of $500 million should be among the possibilities in such a scenario. This would value operating assets at 2.4 times annual revenue and 15 times operating earnings, which seems reasonably fair.

Note that these valuation multiples would only apply to Cree in three year's time, assuming it could continue to grow revenues and successfully boost margins. Let's see at the presentation of the first quarter results, whether the partnership with Home Depot could result in an early surprise to the upside.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.