Keep Buying Cree

| About: Cree, Inc. (CREE)

After the bell on Tuesday, Cree (NASDAQ:CREE) reported eagerly anticipated earnings. Last quarter, investors were deeply disappointed with the results, which sent shares down 10%, so it was important for the company to deliver strong results. Fortunately, management did execute and reported excellent numbers that affirmed my optimism about the company's future (press release available here). In the quarter, Cree earned $0.46, which easily beat the analyst consensus of $0.39 and was up 54% from a year ago. At the same time, Cree grew sales by 20% year over year to $415 million ahead of expectations by about $3 million. Simply put, Cree delivered.

Many investors had been worrying about gross margins, and Cree helped to alleviate these concerns. Cree is moving increasingly into the retail light bulb space with an exclusive distribution deal with Home Depot (NYSE:HD). Cree's retail products represent a strategic shift for the company as it had previously focused on providing LED substrate to other firms. Cree has since decided to roll out Cree branded lights and be a virtually integrated fixture provider, and bulbs tend to have lower margins than substrate sales. As the company ramps up production and better utilizes its capacity, costs should fall, which will be accretive to margins.

In the immediate term, there should be some margin contraction, but it is not nearly as dramatic as feared. In the quarter, non-GAAP gross margins were 38.2%, which were down sequentially from 38.6%. However, operating margins were robust and actually higher year over year at 14% from 13.7% last year. After all, investors panicked last quarter when Cree forecasted earnings of $0.36-$0.41 compared to consensus of $0.44. In fact, Cree ended up beating the original consensus by $0.02.

This beat came even as Cree ramped up its advertising for the Cree bulb, which is a testament to how popular its bulbs are because of their longer life (twenty five times longer) and energy savings (upwards of 90%) despite the higher selling price (between $10 and $25). As a consequence, the lifetime cost of a bulb is significantly lower for consumers despite the higher selling price. In fact, management said bulb sales have doubled since the March Home Depot launch. Lighting fixture revenue was up a fantastic 42% in the quarter.

Cree also has regulatory tailwinds as it is now illegal to produce 60 watt incandescent bulbs, though existing inventory can continue to be sold. The government is pushing consumers towards more efficient 21st century technology, which will help LED continue to gain share in the fixture market. Cree has expanded its offerings beyond the original 34 watt-equivalent bulb up to a 75 watt-equivalent offering. Management plans on increasing its offerings beyond this range with lower-priced offerings to push reluctant consumers off the fence and to LED lighting.

With superior energy efficiency, lifespans, and now government support, I believe the LED revolution is an enduring investing trend and not a short-term fad. With a significant technological edge, robust patent portfolio, proven manufacturing process, and expanding retail distribution, Cree is poised to be a leader in this sector for years. Clearly, consumers are moving to Cree as bulb sales have doubled, which is leading to stronger revenue and earnings. I expect Cree to continue growing sales by roughly 20% in calendar 2014 on the back of retail adoption.

Management also offered pretty strong guidance for this quarter with sales of $390-$420 million and earnings of $0.34-$0.41 with gross margins improving sequentially to 38.5%. Now, analysts had been looking for $0.40 and $413 million in revenue, so Cree's midpoint would suggest a slight miss. However, as this quarter showed, Cree's management has a tendency of under-promising and over-delivering. In this quarter, Cree proceeded to blow through analyst consensus that it lowered last quarter. I expect the company to deliver near the high end of its range yet again.

Importantly, the company can afford to grow. In the quarter, Cree added $95 million to its cash hoard, which now totals $1.2 billion. Cash now accounts for 15.8% of Cree's market capitalization. This cash balance gives Cree the capacity to fund growth projects, R&D, and eventually return cash to shareholders in the form of buybacks and dividends. Cree is in the forefront of a major technological revolution. As incandescent lighting gets phased out, I expect LED to account for 75% of lighting sales by 2020, which would lead to $120 billion in sales. Even if Cree only maintained 4% market share, it would generate $4.8 billion in sales and at least $6 in EPS, which would translate to an annual return of 10%. If it can hold higher market share, potential returns could be appreciably higher.

Overall, Cree delivered a strong quarter that should alleviate many of the concerns that arose last quarter. The company continues to grow its retail presence thanks to a successful partnership with Home Depot. With lower priced options in the pipeline and an incandescent phase-out, Cree should continue to gain share and grow sales by 20%. Below $65, Cree is extremely attractive. Cree remains my favorite long-term stock, thanks to its strong position in a fantastic industry. Five years from now, investors will be thrilled to have bought CREE in the $60's.

Disclosure: I am long CREE, . 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.

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