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. Cree (NASDAQ:CREE), a leading innovator of LEDs, witnessed a 22% year-over-year growth in revenue in the first half of fiscal 2014 primarily driven by strong LED lighting demand.
The company is scheduled to report its fiscal Q3 2014 earnings on April 22 and expects its revenue to either decline marginally or remain flat in the quarter. (Fiscal years end with June.) Cree's stock price has declined by more than 20% since the company reported its Q2 2014 earnings on January 22. The expected slowdown in Q3 2014 is more on account of seasonal trends, primarily the expected decline in LED demand due to the Chinese New Year holiday. Cree derives over 35% of its revenue from China.
Our price estimate of $63 for Cree is at an approximate 15% premium to the current market price. (We will update our valuation after the Q3 2014 earnings release.) We continue to 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. 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 respond to new market opportunities.
With Rapid Innovation, CREE Remains One Of The Leading LED Manufacturers
Cree is one of the leading LED players committed to driving global LED adoption and closing down the price gap with conventional lighting through innovation. Product innovation in the last few quarters has opened new applications and improved LED returns, in turn driving demand for Cree's products. The company has a fully integrated vertical business model and is the market leader in both LEDs and LED lighting products. This places it in a strong position to leverage the growth in LED adoption.
Below are some recent product launches and developments that affirm Cree's competitiveness in the LED market:
Cree's Low Cost LED Bulb: Cree hit a milestone in driving LED adoption a year back by launching a LED bulb for as low as $10. The LED bulb is considered one of the biggest industry innovations in years and has been seeing tremendous success at Home Depot (NYSE:HD) stores. In November 2013, the Cree LED bulb earned the ENERGY STAR label, which means these bulbs qualify for incentive rebates through certain local utilities. With the rebate, where they are available, the Cree LED bulbs is available for under $5. Driven by a full lighting season, utility rebate, new products and increased marketing activities, Cree's LED bulb sales to consumers doubled sequentially in Q2 2014.
Cree has expanded its LED bulb portfolio with a 75-watt (consumes 84% less energy and provides similar levels of brightness compared to traditional incandescent bulbs) as well as a 100-watt replacement bulb, which at $19.97 is the lowest-priced 100-watt LED replacement bulb. The company has also lowered the prices of the Cree LED Bulb product line by as much as 23%, which we believe will further accelerate sales in coming months. 
True White Series: Cree became the first company to comply with the 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 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.
In the long run, Cree aims to drive mass LED adoption and achieve 100% upgrade to LED lighting by its customers.
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. However, the rising proportion of lighting sales puts pressure on Cree's overall gross margin as lighting products offer lower profit margins compared to LED components.
In Q2 2014, Cree earned 27.9% gross margin on lighting products as compared to 45.4% gross margin on LED components. However, the company claims that the gross margin earned on LED bulbs is improving. The company saw its lighting gross margin improve from 26.9% in Q1 2013 to 27.9% in Q2 2013.
We believe that higher LED volumes combined with lower new cost products, cost reductions and higher factory utilization will help increase Cree's overall gross margin in the future.
Disclosure: No positions.