Cree, Inc.: 24M Short Shares Likely to Reassess

As of December, the short interest in Cree, Inc. (CREE) was 24 million shares – almost 33% of the free float. A quick analysis of the return potential from such a bet raises serious questions about the thought process of anyone holding or advocating the position. Let’s assume that an investor hoping to profit from shorting CREE went to the prime broker to borrow shares to short. And assuming he could find shares to borrow (quite a stretch), he would have to pay the prime broker about 35% annualized to borrow the shares on cash terms calculated daily (i.e. pay as you go).

With the stock now at $30 following a strong December quarter, if you had a price target of $20 (one of the most vocal bears on the street, Jed Dorsheimer at Canaccord Adams, has a price target of $19, a sell rating on the stock and has been advocating shorting the shares) for Cree and were shorting it to achieve this target towards the end of this year (we outline below why we feel this is the correct time-frame over which to analyze the position), your expected return from this investment would be approximately ZERO (borrowing costs of $30x35%=$10.5 vs a stock price decline of $10).

The point is, even if you were able to anticipate the fundamentals and call the decline accurately, you would be taking an extraordinary amount of risk in shorting the shares for what looks like almost no return potential. The primary reason that we feel that one year is the correct time-frame over which to analyze the investment is that Cree’s largest competitor, Phillip’s Lumileds division, has recently experienced a manufacturing problem which will significantly reduce their capacity until the second quarter of 2008, at the earliest. So if Cree has a misstep, it is likely a long time from now. Phillips’ recent problems with their HB power chips provide CREE incremental opportunity for a minimum of the next two quarters.

With visibility very clear and numbers much more secure with the likelihood of winning at least some former Lumileds business, an investor is likely to be waiting until at a minimum the September or December quarters of 2008 for a chance to see CREE make a mistake and the shares to fall. By that time, momentum with LEDs is likely to accelerate substantially making the short bet on CREE that much more of a poor financial bet.

In addition to having almost no upside from shorting the stock, there is significant downside. Cree very clearly has the potential to be valued as high-multiple momentum stock as evidence of the adoption of LEDs for general lighting begins to be recognized. There is also the risk that GE (GE) will make a bid for CREE at a much higher level to induce Cree shareholders to tender their shares. GE is completely behind the curve on LEDs and looks like it is about to miss an enormous opportunity. Even if they spent absurd sums pursuing R&D to try and close the gap, they could never catch up with industry leaders. Their only chance if they intend to have any presence in the future of lighting, which is clearly LEDs, is to buy CREE.

Cree is the only LED manufacturer that is independent that can make lighting quality power LED chips. So, GE should buy Cree or acknowledge that their lighting division is irrelevant. This has been a subject of frequent rumors, but worse still, all the recent media attention surround LEDs and the strength of Cree’s position makes the likelihood of a bid that much more realistic. So, for those of you waiting to buy CREE, the likelihood that holders of 24 million shares of short positions in CREE are likely to cover when they do the math make it just that much more attractive as a long.

Disclosure: Author holds a long position in CREE

Comments

[calvino:]

GE should buy CYBL, much cheaper and organic LED is better tech than CREE's silicon semi based stuff - the basis of the short on CREE. Hard to believe, but true nonetheless.

2008 Feb 01 03:01 AM

[floppy:]

35% interest from prime broker? never heard!

You can short the naked call without paying any interest (maybe earning interest) as long as you get approval from brokerage.

2008 Mar 02 12:11 PM

[keanemd:]

This is great analysis into this stock. I didn't know the short level was so high.

2008 Mar 02 04:37 PM