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Back in early June, we wrote an article titled "It's a Matter of Economics, Cree is Overpriced." The purpose of that article was not to urge investors to short Cree (NASDAQ:CREE) or the market but to observe what would happen to a company that was using overly optimistic expectations in their guidance. We felt that Cree was a perfect case in point. So where are we with CREE right now?

On Tuesday, Cree reported earnings that exceeded expectations, but revenue guidance missed the consensus view. As a result, UBS took the target price down to $64 from $83. The target price of $83 was reached in April and since then the stock has been trading in the $60 to $75 range.

Fundamental View

Overall, the data looked good for Cree. Revenue rose 79% year-over-year while earnings per share exploded 348%. Operating margin expanded to 25.9% from 19.7% mentioned in our last article. These are amazing figures, but how is it possible that after such a great quarter the shares could be down more than 10%? One possible explanation is that all the good news has been discounted into the stock as suggested by Dow Theory.

Another piece of interesting data to support our argument was from the equipment side of the LED market. We mentioned that Kulicke & Soffa (NASDAQ:KLIC) had a tremendous amount of booking (equipment orders) from the LED side of the market. Prior to that, they didn't have any business in that segment. Additional data points came from another research firm, Displaybank, which claimed that the Blue LED capacity is to double. The equipment mentioned are the Metal-Organic Chemical Vapor Deposition ((MOCVD)) systems which is the primary method of depositing film on to wafers in the LED making process. The front-end of the market (depositing films) has now confirmed with the back-end (assembly).

Technical Picture

The up-trend was established back in December 2008. As the market (Dow Jones Industrial Average) made a lower-low in March of 2009, Cree held above their December 2008 low pointing to a sustained rally. Throughout 2009 and the most of 2010, it held above the 50 days moving average and 200 days moving average. The collapse in price yesterday established an opening price below the 200 days moving average which we use as a long-term trend of the stock.

(Click to enlarge)

Summary

Yesterday's decline of Cree could simply be just another pullback in a longer term rally. We're not quite so sure just yet. However, at the current rate, we wouldn't touch CREE with a 10-foot poll. Once again, we're not encouraging shorting CREE. After all, the shares of Cree could easily move back to $80, as it retraces the old high. The purpose of this article is to point out the obvious fact that when things are rosy and analysts are upping their forecast of inflated P/E, then investors should be looking for the exit sign. The macro view of margin contraction and entrance of competition is the nature of business which affects the micro view in the long run.

The short run performance of the stock market could be go anywhere. However, the long run is often determined by values. After the drop in price yesterday, Cree's trailing P/E will be around 35, much lower than the 60 we observed in June. Even if earnings exploded, multiple (P/E) contraction will be the key to the share price going forward.

Sources:
It's a Matter of Economics, Cree is Overpriced
Report: Blue LED capacity set to double
Cree Swoons On Disappointing Guidance; UBS Cuts Rating
Cree Reports Record Revenue and Net Income for the Fourth Quarter and Fiscal Year 2010

Disclosure: No positions

Source: Cree: Multiple Contraction Is the Key