Cree's (NASDAQ:CREE) stock price has declined by 20% since the company reported its Q3 2014 earnings, even though the results were well within its target range. It reported revenue of $405 million (16% year-over-year growth) and net income of $28 million (27% year-over-year growth). However, Cree's gross margin declined from 38.1% in Q3 2013 to 37% in Q3 2014 as the LED bulb price reduction offset a more favorable lighting mix and lighting gross margin came in lower than expected. We believe the decline in gross margin led to the negative sentiment around the stock.
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. A higher proportion of revenue from the fast growing lighting LED market is expected to put additional pressure on Cree's gross margin growth in the future. Though we expect Cree to derive an increasing percentage of its revenue from the lighting segment, we believe the company can manage to further increase its gross margins in the future. Higher LED volumes combined with lower new cost products, cost reductions and higher factory utilization will help increase Cree's overall gross margin.
Our price estimate of $63 for Cree is now at a more than 30% premium to the current market price. 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.
Rising Lighting Sales Negatively Impact Gross Margins
Cree's overall gross margin declined from 38.1% in Q3 2013 to 37.0% 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. 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.
Higher Revenue To Improve Factory Utilization
Cree has managed to increase its overall gross margin from 36.4% in 2012 to 37.9% in 2013 (calendar year). While Cree continues to make incremental investments each quarter, a decline in factory costs, higher yield improvement and the introduction of new low cost products, both in LEDs and lighting, eased pressure off margins.
With rising global LED demand, we expect higher volumes to improve factory utilization in the future. 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.  LEDs offer energy savings of 50%-60% leading to lower greenhouse gas emissions and a much higher lifespan compared to conventional technologies. LEDs offer a cost effective option to lower global electricity consumption and as economies around the world aim for greater economic and social development, LED adoption is expected to increase in the future.
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. It is reinvesting most of its profits to fund additional marketing investments and generate more awareness for its products. Cree claims to be witnessing cost reduction across its product lines and believes that lower cost new products designs will help it improve margins in the future. It expects factory cost reduction and process improvements to help increase its gross margins in the long term.
Downside: Intense Competition In The LED Market Can Impact Margins
With many players vying to leverage the long-term growth opportunity, there is intense competition in the LED market. Cree competes with some big players, which can limit its growth potential in the future. Osram, Philips and GE (NYSE:GE) are some of Cree's key competitors in the LED market. In terms of revenue, all these players are considerably larger than Cree. With $11 billion in lighting sales, Philips is the largest manufacturer of lighting in the world. 
Weeks after Cree introduced its less than $10 LED bulb, Osram launched its LED replacement of the 40 watt incandescent bulb for 9.95 Euros.  Soon Philips followed suit with its $10 LED bulb. Increasing competition can limit Cree's revenue growth, which by reducing factory utilization can negatively impact margins.
If Cree's margin remains at the current level for the rest of our review period, there will be 15% downside to our price estimate, which still leaves our valuation at a significant premium to the current market price.
Disclosure: No positions.