Lighting Sales Drive Cree's Growth, But Lower Gross Margins

| About: Cree, Inc. (CREE)

Generating $405 million in revenue (16% year-over-year growth) and net income of $28 million (27% year-over-year growth), Cree’s (NASDAQ:CREE) Q3 2014 earnings were well within its target range. Top-line growth in the quarter was mainly driven by a 35% year-over-year increase in lighting sales. However, lighting gross margin came in lower than expected, as the LED bulb price reduction offset a more favorable lighting mix. This led to a marginal decline in Cree’s overall gross margin in Q3 2014 (37%).

Having witnessed slow growth in 2012 (calendar year), the LED market dynamics improved considerably in 2013 (calendar year) primarily driven by the launch of new innovative products and the closing price gap with traditional lighting. 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.

For the first three quarters of fiscal 2014, Cree’s revenues are up 20% and non-GAAP operating profit up 32% compared to the same period last year. The company believes it is well positioned to grow in the current quarter as well. Its net cash balance increased by $39 million in Q3 2014, taking the total to $1.22 billion, which gives it the ability to invest in growing its business and respond to new market opportunities. In its earnings call, Cree announced that it is in the process of working at potential strategic opportunities to expand its product portfolio and gain access to new customers.

Our price estimate of $63 for Cree is at a slight premium to the current market price. We are in the process of updating our valuation for the company.

Strong LED Lighting Sales To Drive Growth

The general lighting market is expected to be the primary growth driver for the LED industry, as demand from the backlight market nears saturation. Cree’s lighting product revenue grew by 35% year over year to $177 million in Q3 2014 as the company continued to make significant progress in indoor and outdoor fixtures as well as LED bulbs, despite an extremely cold winter in the Central and North Eastern U.S.

Cree has a fully integrated vertical business model and is the market leader in both LEDs and LED lighting products. This places the company in a strong position to leverage the global shift to LED lighting. LED lighting accounts for 15%-20% of the global lighting market at present and the LED market share is expected to rise at a rapid pace over the next decade.

Rapid 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 established a completely new efficiency benchmark for lighting systems with the first 200 lumen per watt LED concept luminaire that is more than twice the efficiency of the best linear fluorescent luminaires. Recently, it also reinvented the concept of lighting controls with its self-programming one button SmartCast technology, which reduces energy consumption by more than 70%. Cree’s products continue to raise the bar in LED price performance.

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 as one of the biggest industry innovation in years and has seen 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 bulb is available for under $5. Cree recently 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.

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. The company claims that the Cree LED bulb gained additional momentum and brand recognition in Q3 2014. It is reinvesting most of its profits to fund additional marketing investments and generate more awareness for its LED bulb.

Rising Lighting Sales Negatively Impacts Gross Margins

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. Cree’s overall gross margin declined from 38.1% in Q3 2013 to 37% in Q3 2014 as the proportion of lighting sales increased from 37.4% to 43.6% during the same period. In Q3 2014, Cree earned 27.4% gross margin on lighting products as compared to 45.6% gross margin on LED components.

In Q3 2014, Cree’s LED lighting gross profit and margin growth was slower than revenue growth due to the full quarter of LED bulb sales this year compared to Q3 2013. The LED bulb price reductions offset a more favorable lighting mix. The company has lowered the prices of the Cree LED Bulb product line by as much as 23%. However, the company claims that the gross margin earned on LED bulbs will improve as it focuses on reducing the LED bulb cost.

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.

Q4 2014 Outlook

  • Revenue in the range of $430 million to $460 million, with double digit growth in lighting sales, single digit growth in LED sales and Power and RF sales slightly higher.
  • Non-GAAP gross margin and GAAP gross margin at 37.5% and 36.8% respectively.
  • Operating expenses to increase by approximately $7 million sequentially due to higher sales cost associated with higher targeted revenue.
  • Tax rate of 21%.
  • GAAP net income to be between $28 million to $36 million.
  • GAAP EPS target is between $0.23 to $0.29 per diluted share and non-GAAP EPS at $0.38 to $0.44 per diluted share.

Disclosure: No positions