Cree (NASDAQ:CREE), a leading innovator of LEDs, will report its Q2 2014 earnings on January 21. Fiscal years end with June.) In 2012, A surplus in the LED market, the consequent decline in prices and downward pressure on margins were the key trends that plagued the LED industry in 2012. The LED market dynamics improved considerably in 2013, primarily driven by the launch of new innovative products and the closing price gap with traditional lighting.
Led by strong lighting demand, Cree provided guidance for revenue to grow to $400-$420 million, with a gross margins of around 38% in Q2 2014. Backed by strengthening demand across business segments - LEDs, Lighting and Power and RF - the company reported a 24% annual increase in its revenue base last quarter. Additionally, backed by higher lighting demand, benefits from LED bulb cost reductions, and higher fixture sales, Cree's gross margins improved by 1.8 percentage points year-to-year.
We believe in Cree's long-term growth potential. LED penetration is expected to increase in the future and being one of the leading global LED manufacturers, Cree will benefit from the trend, in our view. Ending Q1 2014 with $1.1 billion in cash, no debt, the company has a strong balance sheet which gives it the ability to invest in growing its business and respond to new market opportunities.
Our price estimate of $61 for Cree stock is almost in line with the current market price. We will update our valuation after the Q2 2014 earnings release.
Cree's Leadership In Lighting Products To Increase Its Market Share
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 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 the 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. In the long run, Cree aims to drive mass LED adoption and achieve the near 100% upgrade to LED lighting by its customers.
Cree's low-cost LED Bulb, the ENERGY STAR label, means these bulbs now qualify for incentive rebates through certain local utilities, the TrueWhite series and $99 LED streetlight designed to compete head-on with low-cost, high-pressure sodium streetlights in residential applications are recent product launches that reiterate our belief about Cree's market share increasing in the future.
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 1 percentage point quarter over quarter and and a 1.8 percentage points year over year in the fiscal first 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.