Cree Misses but Is a Solid Buy Around $50

Jan.19.11 | About: Cree, Inc. (CREE)

Cree’s (NASDAQ:CREE) earnings disappointed for the second quarter in a row, leading the stock to drop some 15% in afterhours trading. Revenues came in at $257m, below guidance of $270 - $280m and actually down 4% from the previous quarter (although still up 29% on a year-on-year basis). Earnings per share on a non-GAAP basis (excluding one-time items) came in at 55 cents, below expectations of 58 cents. Moreover, the company sought fit to guide down for Q3 ’11 – reducing earnings per share guidance on an equivalent basis to 38 cents. These numbers are clearly disappointing.

Cree’s conference call was particularly illuminating and covered a range of issues. However, from a trading perspective there really is only one key issue to focus on – and that is that Cree undershot its earnings guidance specifically as a result of a sudden freeze in the Chinese LED street-lighting market. China has seen a major push to convert its street-lighting to LED-based product in an effort to support a long-term energy conservation program. Cree has in the past benefited greatly from this source of demand. Indeed, CEO Chuck Swobada indicates that some 39% of demand for Cree product comes from China (a hefty portion of this is street-lighting but it also includes LED input for bulb manufacture).

However, China’s push on conversion to LED lighting hit a major road block late last year as it became clear that many suppliers were providing sub-standard product – with subsequent safety issues related to inadequately lit streets. In the medium-term, this is obviously good for quality LED lighting suppliers such as Cree. However, in the short-term in meant that the entire country more or less experienced a freeze on new LED street-lighting conversion projects as new regulations were formulated aimed at controlling quality specifications etc.

As a result, Cree has seen customers in China push orders into Q3 – with the end result that Cree actually experienced a decline in total revenues in the quarter from this sector. As much of the related production was already complete, it also led to a significant $19.86m increase in inventories. Moreover, as Cree expects their Chinese customers to spend much of Q3 working through their own inventory backlogs that have resulted from this block in the system, the company does not see a rebound in terms of its own new orders until Q4 – hence the need for a downward adjustment to earnings guidance for Q3.

None of this was either expected or welcome. However, these developments in China should undoubtedly be seen as a temporary bump in the road – and one that may well lead to significant pay-back further along. There should be no doubt that China is committed to its energy efficiency program. Even the Chinese military, with its concern about the country’s reliance on foreign oil, is a major supporter of this part of the domestic policy framework.

Meanwhile, the indications are that the new regulations on quality control are already in place and that the first of the new lighting conversion programs are out to bid. The rebound for foreign suppliers such as Cree will not be immediate. Initial orders will be met from the inventory backlog that has built up amongst local players – such as Cree’s own Chinese customer base. Secondly, a major new thrust is probably unlikely before Chinese New Year – Feb 3rd (year of the rabbit, my personal favorite). The recovery from the bottleneck is therefore likely to occur in Cree’s Q4 (calendar Q2).

Importantly, the political system in China does not reward error. Local officials will have taken note of a significant lesson. As a result, there is little chance that many of the upcoming projects will fail to meet the new quality specifications. That means increased demand for quality product during the catch-up period. Given Cree’s already significant exposure to the Chinese market place one would think that this has to bode well. And with 39% of Cree’s earnings coming from China, it seems reasonable to expect solid potential for a significant bounce-back in Q4 earnings.

There are many other issues facing Cree – and other areas of support including the progress being made in producing increasingly efficient retail and commercial lighting product. However, the key issue facing Cree is really the reality and timing of the bounce back in Chinese street-lighting demand.

In my opinion, investors should look forward to a solid Q4 rebound in earnings which will put Cree back on track with its earnings performance – a performance that has seen Cree increase earnings by an average of 22% per annum over the past five years – and one which justifies analyst expectations of an average increase in earnings of 26% per annum over the next 5 years.

Of course, a combination of the market’s inevitable short-termism and embedded herding instinct will ensure significant downside for Cree following these numbers. The point is that this should be seen as a solid opportunity for the medium-term strategic investor. Cree is a market leader in a market facing transformational growth opportunities. The company’s latest earnings results will in hindsight be seen to be reflective of little more than a short-term bottle-neck.

The issue is one of finding a price level that looks like offering a solid valuation floor worth betting on. In the aftermarket following the earnings disappointment, Cree traded in the low $50s. Meanwhile, a reasonable rule of thumb suggests that anything around $50 looks very interesting. During the worst of the pessimism on the LED sector last year Cree traded to a low of $48.74 on October 21st – down 41% from its April 15th high of $82.85. However, this proved to be a reasonable base – and in its subsequent rally Cree traded above $70. My own opinion is that the long-term outlook remains the same and that we will see a similar recovery over time.

On the day prior to the latest earnings numbers, Cree closed at $62.71 - implying a P/E ratio on forward-looking earnings of 26 (given full-year forward earnings of $2.36). This compares to 5-year growth expectations also at 26%.

The market will now have to price in a lower level of expectations for Q3 of only 38 cents. And of course it may be slow to price in the bounce back in earnings discussed above. To be conservative, let’s take forward-looking earnings encompassing Q2 2011 through to Q1 2012. If we take Q2 ’11 as given at 55 cents, Q3 ’11 in line with guidance at 38 cents and add the previously expected numbers for the following two quarters at 61 and 63 cents respectively (ie without factoring in any give-back from the Q2-Q3 bottleneck) we get 4-quarter earnings of a lowly $2.13. However, on $50 a share this still gives a PE ratio of 23 – which seems reasonable for a company facing 26% annual earnings growth in an industry expected to face a transformational few years ahead.

Earnings Per Share

Expectations

Conservative Adjustment

Before Announcement

Post-Announcement

Q2 '11

0.58

0.55

Q3 '11

0.58

0.38

Q4 '11

0.61

0.61

Q1 '12

0.63

0.63

Total

2.40

2.17

PE ratio on $62.71 Share Price

26.13

28.90

PE ratio on $50 Share Price

20.83

23.04

Click to enlarge

In October of last year, I recommended buying Cree on a long-term basis at prices just below current levels. In the run-up towards the end of the year I took profits on half of my position. Following this latest earnings disappointment I have just bought of reasonable portion of that position back in the aftermarket at precisely $53 and intend to buy back the rest of the position if we dip below $50.

Towards the end of Cree’s conference call CEO Chuck Swododa said “disrupting markets is messy but we are on the right track’. That is a sentiment with which I wholeheartedly concur. And the incandescent lighting market is one which needs to be disrupted.

Disclosure: I am long CREE.