Cree: Staying On The Right Path

| About: Cree, Inc. (CREE)

Investors in Cree (NASDAQ:CREE) are happy with the company's second quarter results and the outlook for the current third quarter, revealing that gross margins pressure is coming to an end, at least for now.

Cree's focus on excellent products and adoption over short term gains should be applauded as the company remains a leader in a long term rapidly growing industry.

Second Quarter Highlights

Cree generated second quarter revenues of $415.1 million, up 19.9% on the year before and slightly beating consensus estimates at $412.5 million.

The company reported a sharp 74.9% increase in net earnings, totaling $35.7 million.

As a result of a little dilution, earnings per share rose by 61.1% to $0.29 per share. Non-GAAP earnings rose by 44% to $0.46 per share, coming in comfortably ahead of consensus estimates at $0.39 per share.

Looking Into The Results

Top line revenue growth was healthy and rose by a solid 6.2% on a sequential basis as well. While revenue growth has been strong, there has been a little pressure on gross margins which fell by a full percent point to 37.5% of total revenues.

LED product sales rose by 7% to $215.0 million, still making up slightly more than 50% of total revenues. The promising lighting business reported 42% revenue growth to $173.7 million, while power and RF revenues rose by 17% to $26.4 million.

The margin picture was quite mixed. LED margins rose by 350 basis points to 45.4% of total sales, while lighting margins fell again by some580 basis points to just 27.9% of total sales. Power margins were very strong, inching up another 140 basis points to 58.0% of total revenues.

On the back of strong operating leverage, Cree managed to boost operating margins despite the compression in gross margins. R&D as well as selling, general and administrative expenses grew much slower compared to topline revenue growth, boosting operating income by 130 basis points to 8.5% of total sales.

Note that reported GAAP earnings growth might be inflated to some extent. Cree's effective tax rate dropped from 26.0% to just 8.0% over the past quarter.

Looking Ahead

For the current third quarter of the fiscal 2014, Cree sees revenues of $390 to $420 million. This implies that revenue growth is expected to slow down to 13.2% on an annual rate at the midpoint of the guidance, while seen down 4.8% sequentially.

GAAP margins are seen around 37.7%, which is up 20 basis points compared to the second quarter. Operating expense are seen at similar levels to the second quarter, while tax rates are seen around 21%.

This results in lower net income, targeted at $24 to $32 million, or between $0.19 to $0.26 per share. Non-GAAP earnings are seen between $0.34 and $0.41 per share.

The first quarter guidance is a bit soft compared to consensus estimates standing at $412.9 million and earnings of $0.41 per share on a non-GAAP basis.

Valuation Check

Cree's growth story continues, as the company could post revenues north of $1.6 billion for 2014, while posting earnings of around $120 million.

Trading at $67 per share, the equity in the business is valued just north of $8 billion, yet note that the company trades with a sizable $1.2 billion net cash position, valuing operating assets just short of $7 billion.

This values operating assets at 4.4 times annual revenues and nearly 60 times GAAP earnings, which is not very cheap on today's multiple. Of course, Cree's valuation is based on growth and margin expansion.

Growth Prospects Remain

During the quarter Cree released the LEDway street light for multi-lane freeways and express ways. The company expended its product line further, focusing on consumers as well through its sales alliance with Home Depot (NYSE:HD).

Analysts at Goldman Sachs (NYSE:GS) remain optimistic as well, maintaining a little inspiring price target of $72 on the shares. The bank has three reasons to be optimistic about the company.

42% year-on-year growth in LED lighting shows the adoption curve remains in the early stages according to analysts at Goldman. The margin forecast for the third quarter assumes 30% + gross margins in the fast growing lighting business after seeing compression for quite some time. Finally, market shares with LED bulbs remains high thanks to the alliance with Home Depot.

Takeaway For Investors

In October of last year, I checked out the prospects for Cree. A sell-off pushed shares towards $60 per share after the company reported its first quarter results.

It now shows that while LED growth is slowing down, growth in the lighting products business is actually accelerating, creating enthusiasm among investors.

I concluded that the sell-off offered a fair entry point after the market exaggerated in a quality name. I noted that Cree is focusing on adoption of the products and company recognition, sacrificing margins to achieve that goal. Current earnings are not of the most importance given the strong state of its financials.

The simple economics of offering bulbs costing $12.97 at a retail price, while lasting 25 times longer and saving $12 per bulb in annual energy costs, are too beautiful to ignore. As such I am happy if the company focuses on adoption and innovation over earnings for quite some time to come. Operating margins gains are more important later in the game.

Realize that the company posted operating margins of 20% in the not too distant past. Shares are still fairly attractive in the long run. If all goes well, $5 billion in revenues by 2020 and operating earnings of $1.5-$2 billion could be within reach, and I am sure the market would not attach a $7 billion valuation to such a company at the time.

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.