Investors in Cree (NASDAQ:CREE) have been very disappointed with the company's fourth-quarter results and soft guidance for the upcoming first quarter.
Given the continued long-term growth track record, the future growth prospects and strong financial position, shares offer appeal. While the valuation based on current earnings is elevated, a margin recovery to levels more consistent with the past could spark enthusiasm for the shares.
Final Quarter Headlines
Cree posted fourth-quarter revenues of $436.3 million, a 16.3% increase compared to the final quarter of last year. Despite the impressive reported growth, analysts were expecting even more growth as they anticipated sales of $444.1 million on average.
Net earnings came in at $29.9 million, a 5.7% increase compared to the year before, as the company suffered a bit from margin compression. Reported GAAP earnings were up by just a penny to $0.23 per share.
Non-GAAP earnings were up by four cents to $0.42 per share, thereby beating consensus estimates by a penny.
Looking Into The Numbers
As has been the case recently, Cree's growth is very much tied to the lighting products business, and the power and RF products business to a smaller extent. While LED products sales have been growing over the last year, momentum has faded towards the end of the fiscal year. In the last quarter, the company reported a decline in year-on-year sales for this segment.
Unfortunately, the LED products business remains very profitable, so the shift to lighting products is dilutive to company-wide margins given the lower gross margins on those products.
LED products sales were down by 8% on an annual basis for the quarter, coming in at $199.5 million. Even as gross margins were down by 60 basis points, the reported margins of 45.1% remain impressive.
Lighting product sales rose by 56% on an annual basis to $208.2 million, now being the biggest revenue contributor of the overall business. Fortunately, gross margins improved by a full four percentage points to 29.1% of sales. Despite the margin gains, the gap between the margins reported by the LED business is substantial with the shift in revenue growth continuing to put pressure on Cree's earnings potential.
Sales of power and RF products rose by 16% to just $28.6 million. Gross margins improved by another 320 basis points, resulting in very lucrative margins of 56.9% of sales.
As a result of the continued headwinds in the gross margin mix, overall margins were down by 30 basis points to 37.2% of sales. This, combined with an increase in operating expenses, hurt operating margins which compressed by 90 basis points to 7.3% of sales. It should be noted that elevated operating expenses largely related to one-time items this quarter.
Looking Into The First Quarter For 2015
For the current first quarter, Cree sees revenues between $440 and $465 million. This guidance fell short compared to consensus estimates at $467.4 million. Despite the shortfall in the guidance for revenues, the midpoint of the guidance still implies year-on-year revenue growth of nearly 16% per annum.
GAAP gross margins are anticipated to show a little more compression due to the sales trends as discussed before. Gross margins are expected to fall by another 30 basis points on a sequential basis to 36.9% of sales.
With revenue growth offsetting gross margin compression, GAAP earnings are projected to come in between $30 and $37 million. This results in earnings per share anticipated to come in between $0.25 and $0.30 per share.
The non-GAAP earnings guidance of $0.40-$0.45 per share looks a bit soft compared to consensus estimates at $0.45 per share.
At the end of the quarter, Cree held roughly $1.16 billion in cash, equivalents and short term investments. The company has no debt, which gives the company a very strong financial position.
With 122 million shares outstanding at the end of the quarter, and shares trading at $45 per share, Cree's equity is valued around $5.5 billion. This values operating assets at $4.33 billion.
Given the reported revenues of $1.65 billion for the past year, operating assets trade at just 2.6 times annual earnings. With earnings coming in at ¨just¨ $126 million, this implies a valuation of about 35 times annual earnings.
History Of Growth
Cree has rapidly grown its operations over the past decade. Revenues have roughly grown five-folds from roughly $300 million back in 2004 to $1.65 billion for the past fiscal year.
Earnings have risen over this time period as well, just not as quick as topline sales growth. After-tax net margins of 10-20% as reported in many of the years over the past decade have fallen to about 5-10% at the moment. Worse, the cumulative dilution of roughly two-thirds of the outstanding share base have limited the progress being made on a per-share basis.
It should be noted that the company has amassed a comfortable net cash position of over a billion in the meantime. Cash holdings amount to roughly $10 per share at the moment.
Takeaway For (Potential) Investors
Cree has three major segments in which it operates. The LED products business has for a long time been the growth driver and leading unit of the company. At the moment, it is facing some real pressure with downwards momentum creating a fall in sales amidst harsh Chinese competition.
The problem is that the shift to lighting products is actually impacting company-wide margins given the much lower gross margins of the lighting products business. This is even amidst solid margin improvements being made at the lighting products business. Fortunately, the growth pace of this business is very impressive and more than offsets the actual fall in LED sales, thereby allowing earnings to continue to grow on an actual dollar basis even as margins are down.
Despite the strong revenue growth alleviating the impact of the margin pressure, Cree is not out of ¨trouble¨ yet. For the current first quarter of the new fiscal year, another 30 basis points in gross margin compression is anticipated. This results in earnings growth continuing to underperform compared to the topline sales gains.
Cree has some headwinds, and despite shares trading down nearly 30% year to date, the valuation on traditional metrics remains high at 35 times past earnings. This is amidst solid growth prospects and a rock-solid balance sheet. The problem has not been growth, however, but rather multi-year margin compression.
If the company can return to post margins of around 15% after taxes, this could result in earnings of $250-$300 million per annum making the current valuation a lot more appealing given the cash holdings and double-digit revenue growth rates.
Yet it seems that for now more pain in gross margin compression is ahead, at least in the short term. This is creating pressure on shares at the moment. That being said, these headwinds will end at some point in time given the margin improvements in lighting products and the fact that LED is rapidly becoming less important at the moment. The modest contribution from the high margin RF products business is also a help in this process.
I am a buyer in the $42-$44 region if share might see a further drop in the coming days. This position is based on prospects for further revenue growth and an anticipated margin recovery at some point in time.
Disclosure: The author has no positions in any stocks mentioned, but may initiate a long position in CREE over the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.