Cree Should Launch A $700-Million Buyback

| About: Cree, Inc. (CREE)

Cree (NASDAQ:CREE) has spent much of the past few months trading around $60 even as the company continues to perform well. In the most recent quarter (financial data available here), Cree grew revenue by 20% to $415 million, and earnings jumped by 54%. Cree has successfully transitioned into a consumer company with its Cree light bulb gaining traction thanks to the energy-saving power of LED lighting. Before launching the Cree bulb, the company was focused on providing LED substrate to other firms. Now, it does this while also selling a Cree branded bulb to consumers, mainly through its distribution deal with the Home Depot (NYSE:HD).

(Image from Google Finance)

In the most recent quarter, fixture revenue jumped 42%, which suggests consumers are increasingly gravitating towards LED lighting. While Cree bulbs retail between $10 and $25, they can last 25x longer and cut energy usage by 90%, making them very cost-effective over their lifespan. Further, the federal government is supportive of the industry with the long term goal of phasing out incandescent light bulbs, though it did recently permit the continued manufacturing of 60 watt bulbs. Importantly, Cree does not expect its growth to slow down with revenue of about $405 million this quarter and robust gross margins of 38.5%. By 2020, I expect LED lighting to account for 75% of lighting sales, which will make it a $120 billion annual business. Even if Cree only held a 4% market share, it should be generating over $6 in EPS with a growth rate still in the double-digits. Given the long growth runway of LED lighting, shares are very attractive at current levels.

The real issue for a company like Cree is whether it will be able to fund this growth. Cree has already major investments in factories to grow its production capacity to meet the growing demand of its bulbs. In the past twelve months, it has spent $151 million in cap-ex, though that is below its 2011 level of $250 million (past financial statements available here). Importantly, Cree has been free cash flow positive in each of the past five years. While Cree has invested several hundred million in its business, its operations generate even more cash. In other words, Cree's operations provide enough cash to fully fund any investments need to further grow the business.

In fact, Cree is generating far more cash than it needs with $124 million in free cash flow over the past twelve months. Thanks to its strong cash flow, Cree now has $1.18 billion in cash and cash equivalents. It also carries no debt. Its cash hoard now accounts for 15.8% of its market capitalization. Frankly, Cree is now carrying far more cash than it needs. The business is free cash flow positive, and there are no debts coming due. Given the massive growth potential of LED lighting, I respect that Cree will want to maintain a somewhat outsized cash balance in case it has an opportunity to start a large cap-ex project. However, its current cash hoard exceeds any potential use.

In the past five years, capital-expenditures have not exceeded $250 million, so its current cash hoard is 4.7x peak cap-ex needs while the business will generate $300 million in operating cash flow this year. Even under extremely conservative parameters, I cannot justify carrying over $500 million in cash or 2x peak cap-ex. Cree is currently carrying excess cash of at least $680 million, and it is time for the firm to return that cash to shareholders.

With shares stuck in the low $60's, the best use of this cash would be a share repurchase. A share repurchase would also help to offset recent dilution from employee stock options; the diluted share count is now 123 million shares compared to 116 million a year ago. With a buyback in the $600-$700 million range, Cree can cancel out further dilution and begin to cut the share count. Like many tech companies, Cree is now carrying too much cash. While the future market is large, Cree is generating enough cash to make future investments and does not need to carry over $1 billion in cash. Management should aim to bring the cash balance back to $500 million by repurchasing stock. By cutting the share count, EPS growth will be even faster, which will get shares pushing up towards $70 again. Cree is an attractive buy for investors right now, and the company should take advantage of recent softness by repurchasing shares.

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.