Cree's (CREE) stock price has declined by approximately 25% since the company announced its fiscal Q1 2014 earnings on October 22 (fiscal years ends with June). While it reported a 4% sequential and 24% annual increase in revenues, in line with expectations, its guidance for the next quarter was below analysts' consensus. That the shortfall contributed to a lower stock price, despite the company's strong growth, is no surprise. The stock is still up almost 100% over the prior-year level. The company is doing well.
Our price estimate of $61 for Cree stock is just above where it now trades. We believe in the company's long-term growth potential and model current rates of growth through the first third of our forecast. LED penetration is expected to increase in the future and, being one of the leading global LED manufacturers, Cree should benefit from the trend, in our view. With $1.1 billion in cash and no debt, the company has a strong balance sheet which gives it the ability to invest in growing its business and to respond to new market opportunities.
In this article we discuss key factors that contribute to our belief in Cree's long-term growth potential.
Global Shift To LED Lighting
With awareness widespread about their economic and environmental benefits, LEDs are rapidly being adopted. LEDs offer energy savings of 50%-60% over incandescent alternatives, 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, especially as economies of scale allow for lower average selling prices. As countries around the world aim for greater economic and social development, LED adoption should accelerate in coming years.
The general lighting market is expected to be the primary growth driver for the LED industry, as demand from the backlight market nears saturation. LED lighting accounts for 15%-20% of the global lighting market at present and the LED market share is expected to rise at a rapid pace over the next decade.  Improving economic conditions, innovative new products (such as the LED bulb available for $10) and the narrowing price gap between LEDs and conventional technologies are all key factors driving LED adoption.
Cree's Leadership In Lighting Products To Increase Its Market Share
Cree has a fully integrated vertical business model and is the market leader in both LEDs and LED lighting products. This places the company in a strong position to leverage growth in LED adoption. Product innovation in the last few quarters has opened new applications and improved LED returns, in turn driving demand for Cree's products. Cree's primary goal is to take market share from traditional technologies by driving LED demand through new product innovation.
Because LED lighting accounts for only 1% of all U.S. lighting sockets at present, LEDs remain a largely untapped opportunity.  In the long run, Cree aims to drive mass LED adoption and achieve the near 100% upgrade to LED lighting by its customers.
Below are some recent product launches and developments that support our belief that Cree's market share will rise over time. These include:
- Cree's low-cost LED Bulb: Cree hit a milestone in driving LED adoption earlier this year by launching a LED bulb for as low as $10. Cree's new LED bulb consumes 84% less energy and provides similar levels of brightness compared to traditional incandescent bulbs. The company claims that its LED bulb is the biggest industry innovation in years and it is seeing tremendous success at Home Depot stores.
- Energy Star Label: Last month, the Cree LED bulb earned the ENERGY STAR label, which means these bulbs now qualify for incentive rebates through certain local utilities. With the rebate, Cree LED bulbs will be available for under $5. Cree expects these rebates to contribute to higher LED bulb sales in the current quarter.
- True White Series: Cree became the first company to comply with the recent voluntary standard set by California regulators to make bulbs more closely resemble the warm white light from traditional incandescent bulbs. The company launched a new LED bulb, the TrueWhite series, which comes close to the quality of light from a 60-watt incandescent. Available in the range of $18-$20, the Cree LED bulb has a color rendering index (CRI) of 93 and a score of 100 is the closest to natural light that a bulb can get. The True Light bulb uses 78% less energy and lasts 25 times longer compared to traditional incandescent light bulbs.
- $99 Street Light: Cree's XSPR Series Street light is the first $99 LED streetlight that is designed to compete head-on with low-cost, high-pressure sodium streetlights in residential applications while delivering 65% energy savings and a significant upgrade in light quality.
Higher LED Adoption And Operational Efficiency To Improve Gross Margins
Despite a very competitive market environment, Cree's gross margins in 2013 improved due to better factory utilization on account of higher LED volumes, process improvements and new lower-cost product designs. Backed by higher lighting demand, benefits from LED bulb cost reductions and higher fixture sales, the company experienced a gross margin improvement of one percentage point quarter over quarter and and a 1.8 percentage points year over year in the most recent quarter.
However, Cree continues to make incremental R&D investment each quarter, incurring higher operating expenses and pressuring margins. 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 weigh on its bottom line.
We expect Cree's marketing expense to decline in the future. Additionally, the company indicates that the gross margin earned on LED bulbs is improving. Higher LED volumes and lower cost from new product designs can help improve gross margins, helping to offset the pressure from higher R&D.
Disclosure: No positions.