- Cree's shares are recovering lately from a very weak start to 2014.
- Philips' decision to spin off its lighting business and an analyst upgrade fuel momentum.
- Shares might be appealing for true long-term investors, I hope for a re-test of the $45 lows.
Shares of Cree (NASDAQ:CREE) have seen a good week. Part of the sentiment is aided by Philips' (NYSE:PHG) intentions to spin off its lighting business, while analysts of Oppenheimer added to the momentum by raising the company to outperform.
Analysts at Oppenheimer raised their rating on Cree from market perform to outperform which has been accompanied by a $59 price target. Analyst Andrew Uerkwitz believes that Cree is well positioned to benefit from the strong trends in LED lighting.
Uerkwitz furthermore anticipates market share gains for Cree as the company expands into sales channels, thereby becoming ¨less fragmented.¨
Near-term margin concerns and disappointing commercial growth left shares undervalued according to Oppenheimer. Uerkwitz furthermore notes that disciplined operational spending should be able to offset and alleviate margin concerns.
Solid Top-line Growth
Cree has been demonstrating very solid and consistent revenue growth. It was 2007 when the company last reported a decline in annual sales. Ever since it has increased sales from roughly $400 million to nearly $1.6 billion on a trailing basis, resulting in very impressive growth rates.
This implies that revenues have grown at a percentage in their low twenties at a compounded growth rate. With Cree growing in size, replicating these growth numbers is hard to do, yet year-over-year growth of 16% over the past quarter is still quite impressive.
But What About Margin Pressure?
While top-line growth has been very impressive and quite steady, Cree's margins been quite low compared to historical standards. Operating margins came in at roughly 30% in 2005 to nearly evaporate during the difficult period of 2007-2009. This was followed by a strong comeback in 2010 with margins expanding again to 23%. Ever since, pressure from competition and lower prices in general have put pressure on margins which have fallen to 9% on an operating basis.
The very volatile margins have been the driver behind historical stock price volatility. Shares rose from $20 in 2009 to a peak of $80 in 2010 on the back of the margin expansion and promising future of LED.
Shares have fallen back to $25 again in 2012 amidst renewed margins concerns but rose to highs of $75 last summer on the anticipation of a potential acquisition. A recent correction send shares to lows of $45 in recent months, with shares trading in their low fifties now on the back of the news from Philips and Oppenheimer's upgrade.
What About The Valuation?
With shares advancing to $53 per share, Cree is now valued at roughly $6.4 billion. Note that the company holds large cash balances of $1.2 billion while it has no debt, resulting in operating assets being valued around $5.2 billion.
On a trailing basis, Cree reported revenues of $1.59 billion on which it net earned $123 million. This values operating assets at 3.3 times sales and little over 40 times earnings.
Despite the very strong financial position Cree does not pay a dividend. Disappointing is the 65% increase in it's outstanding share base as well over the past decade, resulting in dilution which averaged 5% per year.
To offset some of the dilution and take advantage of the stock correction over the past year, Cree announced a new stock repurchase program in May. Under the expanded $300 million plan it has already repurchased 2.1 million shares for a sum of nearly $100 million.
Cree appears to be moving along just fine as third-quarter revenues are anticipated to come in between $430 and $460 million, which implies a nearly 19% year-on-year growth rate at the midpoint of the guidance.
The problem therefore is not top-line revenue growth but rather margin pressure which results from competition, falling prices and a very unfavorable change in the mix. Being a top supplier to Home Depot (NYSE:HD) is arguably good for sales, but probably less good for margins. Interesting is of course the big divergence between LED sales and lighting product sales in the second quarter.
LED sales were up just 3%, while lighting sales rose by 35%, on track to nearly overtake LED revenues in the not too distant future. This results in severe margin pressure as LED sales generate high margins of 45.6% which compares to gross margins of just 27.4% for the lighting division.
As should be clear by now, Cree is an excellent growing business, but unfortunately margins are quite volatile and historically low at the moment. Yet if the company can boost operating margins to 10-20% again, and can demonstrate sustainable revenue growth, these are still very interesting long-term entry levels despise a recent 15-20% jump.
I personally believe the company might need a bit more time before it can demonstrate this recovery, but keep the stock on my watchlist if shares would re-test their recent lows of $45 per share. I would be willing to make a ¨gamble¨ at 35 times earnings given the strong growth, solid balance sheet and low margins at this point in the cycle.