Buy Cree On The Drop

Apr.23.14 | About: Cree, Inc. (CREE)


Cree shares dropped 8% as investors were disappointed with quarterly results.

While EPS beat, guidance disappointed and gross margins were lower than hoped.

Lower gross margins are not problematic because Cree is seeing outsized growth in its bulb business, which is a lower margin business.

LED lighting is a major growth market, and Cree will generate substantial growth for years to come. Shares are cheap at current levels.

Cree (NASDAQ:CREE) reported quarterly results after the bell on Wednesday, and Wall Street was unimpressed. During the after-hours session, shares were trading lower by about 8% in the low $50's. As someone who bought Cree about six months ago at $62, it has been a tough ride. However, Cree's long term growth is on track, and shares are still an attractive value. While imperfect, this quarter was not all bad news. If anything, I am inclined to buy more shares at current levels.

In the quarter, Cree earned $0.39, which beat estimates of $0.38. Revenue of $405 million missed by $2 million, but it was up a robust 16% year over year (all financial and operating details available here). Cree is in the process in shifting to be a consumer company as it is now selling LED light bulbs directly to consumers, mainly through its distribution deal with Home Depot (NYSE:HD). Some investors are concerned this shift will result in lower gross margins. LEDs currently command a significant premium to incandescent light bulbs because they consume less energy and last many more years. Some fear that if big players like General Electric (NYSE:GE) and Phillips enter the LED space aggressively margins could face serious problems.

So far, margins have eroded a bit but certainly not collapsed. Gross margins were 37.8% in the quarter on a non-GAAP basis. This figure was down 100bp from a year ago. It was also a bit lower than the 38.5% the company had previously guided to. Margins have fallen a bit and weaker than anticipated, though this is driven in part by strong adoption of Cree's light bulb. Simply put, the light bulb business generates lower gross margins than LED products. Light bulb revenue is growing much faster, so the product mix is shifting towards the lower margin business.

A shift to lower margin business is not problematic, so long as both business show growth. Investors need to focus on margin deterioration within each business unit rather than headline gross margins. Thus far, we are not seeing this type of margin deterioration, which suggests Cree is maintaining solid pricing power in its various business units. During the quarter, its lighting products division (which sells the light bulbs) increased revenue by 21%, which is faster than the total company's 16.1% growth. Its legacy LED product increased sales a more modest 3%. The revenue blend is simply shifting towards a lower margin but higher growing business. Lighting products now account for nearly 44% of Cree's sales. With solid double digit growth, the success of this unit is great news for Cree shareholders even if consolidated gross margins appear weaker.

Finally, Cree's guidance disappointed some investors. The company is expecting non-GAAP EPS of $0.38-$0.44. Analysts were looking for $0.44. This certainly seems like a disappointment. Personally, I was looking for guidance of $0.40-$0.48. The company will be increasing operating expenses by $7 million in the quarter, likely as it ramps up advertising for the Cree bulb. This expenditure will account for about $0.06, which would explain why guidance a bit on the weak side. Cree is investing in its future, not working on gaming each quarterly release. This is a better strategy for a company to succeed in the long run. Gross margins should remain relatively stable in the quarter at around 37.5%.

Investors should also be aware that Cree currently has $1.2 billion in cash and investments. This is nearly $10 per share. Cree has a fortress balance sheet, and it can continue to invest in the business and someday even launch a share buyback or dividend. This cash position makes the stock a lot cheaper than it would appear otherwise. . 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 10-12% for shareholders. If it can hold higher market share, potential returns could be appreciably higher.

Overall, Cree delivered a mixed quarter. Cree's bulbs continue to show dynamite growth, which does push gross margins lower. Still, commoditization of bulbs has yet to materialize. Guidance was a bit weak, but Cree continues to invest in the future and has many years of growth remaining. 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 occurring in the developed economies, Cree should continue to gain share and grow bulb sales by 20%. Below $55, Cree is very attractive. Cree remains one 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. While I wish I bought Cree at a lower price, shares are very cheap and I may add more here.

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.

Additional disclosure: I am long Cree, and I may increase my position over the next 72 hours.