By David Sterman
Investing in an undervalued high-growth play brings an inherent challenge. Shares are usually undervalued because the near-term growth prospects aren't as bright as the long-term prospects. This was the biggest risk factor I laid out when I added Cree Inc. (Nasdaq: CREE) to my $100,000 Real-Money Portfolio.
"Cree isn't a stock to own for near-term results. It may look quite cheap at just 12 times consensus fiscal (June) 2013 forecasts of around $1.80 a share. But I want to take a much more cautious stance, anticipating per-share profits of just $1.50," I noted when I recommended this stock last month. In fact, subsequent tepid quarterly results led analysts to lower their view, so the consensus fiscal 2013 profit forecast now stands at $1.47 a share. Nevertheless, shares have staged an impressive rally and are now up more than 30% in the past two months.
This creates a real conundrum, because I still think quarterly conditions remain challenging. Indeed, analysts at Credit Agricole downgraded shares to "underperform" on Monday, Feb. 13, lowering their price target from $30 to $26 and pushing the stock down by roughly a dollar to $27 per share in an otherwise rising market. The firm's analysts say the recent rally may be overdone in relation to still-challenging industry conditions as prices for LED lighting continue to fall. My concern: shares can slip back into the lower $20s when Cree releases fiscal third-quarter results in mid-April.
I want investors to be prepared for this possibility so they can preserve profits if they so choose. Yet for those who look at this as a one or two-year holding, this is really just noise. Sure, shares may consolidate in coming weeks, but they have considerable upside in the quarters ahead.
I retain this view after digesting events at the just-completed Strategies in Light 2012 conference held in Santa Clara, Calif., last week. (There are four of these conferences held around the world each year: the next one takes place in May in Shenzen, China, and is the industry's most important annual event, thanks to China's huge investments in LED lighting).
Perusing the various reports of analysts who attended the conference, some clear themes have emerged. The LED-lighting industry is undergoing a shakeout as commodity LED-chip providers struggle with the deepest price cuts, while makers of advanced LED-lighting designs such as Cree are attracting better order flow and (relatively) firmer margins.
This means Cree should soon start to post more stable results as pricing for its products decline at a much lower pace. Industry conditions remain challenging due to industry overcapacity. (Factory utilization rates hover in the 45% area, and would need to move toward 60% before pricing pressures truly abate). Analysts seem to understand the current dynamics: The consensus forecast for Cree's fiscal third-quarter earnings per share (EPS) was recently lowered from $0.30 to $0.21. Did the analysts go far enough? I don't know, but upside to that lowered forecast is extremely unlikely.
Taking the longer view, Cree's sales and profits should mark steady gains in 2013 and beyond, as I laid out in my initial focus on this stock. But for the rest of 2012... well, two potential catalysts lay on the horizon.
First, Cree is increasingly the subject of buyout rumors. I hate that. These rumors rarely come to pass, and as it becomes apparent that no suitor is waiting in the wings, shares could give up recent gains when the merger and acquisition (M&A) traders step away.
Second, the China Solid State Lighting Alliance (CSA) is expected to issue updated spending plans later this year. China has wisely understood the long-term payback associated with LED lighting in terms of longevity and low power consumption, and has been spending heavily on the technology in recent years. It's crucial that China remains supportive with its future plans and that Cree continues to play a key role in the Chinese market. What the CSA has to say is the biggest risk and opportunity for Cree in 2012. Unfortunately, the timing of any moves is unclear.
Risks to Consider: Cree remains a great investment but is not as appealing as a trade. Indeed, the downside support I noted last month is no longer in place. I was convinced this stock always had ready support from new buyers when it was hovering near $20, but that isn't the case with the stock in the high $20s.
I encourage you to take the long view. If my concerns come to pass and Cree's shares see further profit-taking, then far-sighted investors should see those windows as entry points. I committed roughly $7,000 on this pick a month ago, and would be glad to add to the position in the face of fresh share-price weakness.
Disclosure: David Sterman does not personally hold positions in any securities mentioned in this article. StreetAuthority LLC owns shares of CREE in one or more if its “real money” portfolios.