Cree: A Strong Rebound Candidate

| About: Cree, Inc. (CREE)

By David Sterman

Companies in the high-technology industry must innovate constantly in order to stay competitive. Right now, a predictable turn of events is unfolding: an industry pioneer has posted very impressive growth. Heavy competition ensued, crimping growth and profit margins, forcing the company to refocus its game plan to remain on the leading edge. And now that things are turning around, it spells real opportunity for investors.

This is precisely what's happening with Cree Research (Nasdaq: CREE). Cree grew hordes of fans when sales of its light-emitting diode (LED) lighting products began to surge in mid 2007. But growth and profit in recent quarters has slumped and the company is now saddled with many detractors. The good news is clear catalysts are in place to win back the hearts of currently dubious investors.

An impressive stretch of sales growth has come to an end

Cree has poured massive sums into research and development (R&D) efforts to establish a leading position in LED lighting, which is more energy-efficient than standard forms of lighting. These lights used to be too dim for many industrial applications, but with recent technology, they can now be used in virtually any industry.

Cree also focuses its R&D efforts on durability. Its lights can last for several decades without wearing out, something the competition (mostly Chinese) hasn't delivered. In fact, these competitors have been selling LEDs that burn out far sooner than promised. The Chinese government, which has been an active consumer of LEDs, has even started to replace many of the low-cost, short-life LEDs that had been installed in street lights with Cree LEDs.

Still, even shoddy competitive goods can take market share and pressure pricing. So even as Cree is expected to keep boosting sales at a solid clip in fiscal 2011 and 2012, per-share profits will barely budge as gross margins slump. This is why Cree's per-share profits are expected to be flat in fiscal 2011 (results will be released Aug. 9), even with a projected 13% hike in sales. Few analysts expect profits to do any better in the fiscal year that just began either.

Cree has also lost a good deal of credibility simply for failing to see how quickly the competition was building. The company kept producing more LED chips, lights and fixtures in anticipation of a strong future growth that never materialized. This has pushed inventories up to alarming levels. The stock has suffered as a result...

But if you dig deeper, you'll see that Cree still has levers to pull in order to move gross margins higher and take back some of its lost market share. For starters, the company is changing the wafer size used to make LED chips from 4 inches to 6 inches. This effort, which is expected to begin this fall, is intended to lower costs by up to $30 million. Second, Cree is expanding its product line to serve the semiconductor, fixture manufacturing, telecom and military industries in order to capitalize on the strength of LED technology (a move which Chinese rivals aren't expected to follow). Third, the company is pouring its $80 million annual R&D budget (said to be as much as the rest of the industry combined) into advancing LED technology for even greater luminosity and durability, along with a wider range of applications.

It's important to remember this is an industry still in its infancy. LEDs account for less than 5% of all lighting, though analysts expect this figure to rise to 15% or 20% in the next five to seven years. This is only expected to happen when U.S. and European construction starts to rebound, since LEDs are better suited for new installations rather than retro-fits.

In the near-term, management needs to take several steps to win back investor confidence. First, inventories need to start coming down. Cree is very vulnerable to pricing on the spot market right now and will only get firmer pricing when customers need to order well in advance (i.e. lead times move back up to the historical six to eight week mark).

Rising Inventories

Second, management will need to establish a realistic set of expectations -- and exceed them. Analysts have had to serially lower estimates in the past nine months, while management had to come to grips with the damaging effects of rising competition. I expect the Aug. 9 conference call to be used to "reset the bar." Although Cree's forward guidance is likely to be uninspiring for near-term expectations, analysts are likely to begin to note the long decline in margins and the steady build in inventory has ended. With shares far off of their highs, these analysts are likely to cite a still-robust long-term outlook.

Cree is sitting on more than $1 billion in cash. Back this out of the balance sheet, and shares trade for around 13 times projected profits. With a pole position in the bumpy yet promising LED-lighting field, this may prove to be a very attractive entry point. There's no need to rush to buy shares before the Aug. 9 conference call. Right now is the time to do your homework on this promising stock. But be prepared to move in if inventory levels start to recede, because this should set the stage for firmer gross margins and higher earnings per share in the years to come. And this, of course, can only mean good things for the stock.

Disclosure: Neither David Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.

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