Much is being said about Cree’s (CREE) foray into the Silicon Carbide space. There’s no doubt that this up and coming business vertical has the potential to become a major growth driver for the overall company. However, I just wanted to discuss the opportunities and risks ahead of Cree’s SiC sub-segment to temper expectations and to set realistic expectations among readers and investors, so that nobody gets caught off-guard. Let’s take a closer look.
(Source: Bigstockphoto, Image license purchased by author)
Let me start by saying that Cree doesn’t report standalone revenue figures for its Silicon Carbide sales and includes the sales contribution within its Wolfspeed operating segment. Per the company’s recent 10-Q, the segment’s products consist “silicon carbide (SIC) and gallium nitride (GAN) materials, power devices and RF devices based on silicon (SI) and wide bandgap semiconductor materials.”.The chart attached below should provide further clarity on how big of a revenue driver its Wolfspeed segment really is.
But that just highlights the revenue side of the story. The chart attached below highlights that Cree's Wolfspeed segment is a high-margin business vertical. So, the sales growth of this particular business vertical stands to meaningfully bolster the overall company's margin and profitability profile as well.
Also, Silicon Carbide is being evaluated and adopted as a replacement for traditional Silicon in certain electrical and electronics applications. There have been several research papers on the same, and discussing the technical differences between them is out of the scope of this report but the crux of it all is that SiC offers far better switching efficiency and power density than traditional silicon as highlighted in the comparison chart below.
(Source: Cree’s Investor Presentation)
Cree’s management noted during their Q2 earnings call that these benefits are generating a lot of interest from manufacturers and OEMs operating in and around the EV market. Here’s the relevant excerpt for your reference:
Within the EV market, the interest in silicon carbide is extremely high because the value proposition is so strong. Utilizing silicon carbide saves space, reduces cooling requirements, and allows for a smaller, lower-cost battery. These benefits far outweigh the incremental cost...And with this becoming better understood, the conversation is shifting from the merits of utilizing silicon carbide to ensuring that an adequate supply will be available as EV production ramps.
So, the facts that we’ve established by now are that SiC offers performance and cost advantages and that it’s en vogue. But how does this impact Cree as a business, from an investors’ standpoint at least?
Well, for starters, Cree is one of the early entrants in the SiC wafer foundry business which gives it a first mover advantage. To put it in simpler terms, it positions Cree as one of the prominent go-to names in the industry when it comes to sourcing SiC wafers and I believe it must also give the company access to some large-scale procurement discussions with some of the world’s largest manufacturers for the same.
Besides, Cree has already signed three major wafer supply agreements with Infineon, STMicroelectronics, and an undisclosed customer over the last year which had a combined disclosed value of $450 million. This is a sizable figure, considering that Cree did about $1.49 billion in revenue in FY18.
Secondly, Cree’s management claimed during their Q2 call that they command about 50% share of the market. This suggests manufacturers who want to source SiC wafers in volume quantities would consider going with Cree as its one of the largest players in the business. Cree might just have to reallocate its production lines, expand production, or readjust delivery schedules to make room for SiC volume supplies.
This scale of operations and dominance partly ensures that Cree gets first consideration for the big orders while its smaller competitors continue to compete for the scraps. This market positioning also suggests that if the demand for SiC applications ramps up going forward, Cree would ideally be one of the prime beneficiaries.
Third, the revenue by segment chart attached above would highlight that Cree’s Lighting products and LED products segments have been more or less stagnating in terms of sales. In fact, it’s the Wolfspeed division that’s actually still posting healthy growth on a sequential as well as on a year-on-year basis. So, the rapid uptake of SiC is vitally important for the continued sales growth and the diversification of the overall company.
Also, the market for SiC components is fairly small right now but Cree’s management expects it to become a sizable industry over the next decade. The chart attached below should put things in perspective, and highlight the long-term growth opportunity that’s in front of the company as a whole.
(Source: Cree's investor deck)
With that said, the industry isn’t exactly closed to new entrants, as it’s a basic material play after all. Cree’s management noted during the earnings call that competitors won’t be able to creep in overnight because they would have to make sizable investments in manpower and equipment over time to be able to compete with them in the SiC wafer foundry space. However, they also acknowledged during their Q2 earnings call that competitors can creep in:
...we believe that we have a substantial amount of know-how, intellectual property, and experience that is going to allow us to continue to have a really unique position in this marketplace. That all being said, we worry every single day about competitors coming in.
So, investors should understand that Cree’s market share is penetrable. If the industry becomes a major revenue driver for Cree over the next few years, then expect competition to intensify as other players in the industry would want to capitalize on the growth opportunity. Sure, Cree may have a leading market share for now, but that number won’t stand for long if competitors start making sizable investments to meaningfully grow their market shares.
Secondly, the SiC foundry industry may not ramp linearly over the next couple of years. Chances are that Cree wins most of the orders but there are also chances that the industry becomes lumpy and most of the orders go to a bunch of other smaller firms who are willing to sacrifice their margins to grow market share or to achieve economies of scale. So, investors shouldn’t take Cree’s market positioning and dominance for granted.
Third, I doubt that Cree would start being valued at vastly higher multiples because of the growth of its SiC business. The company is fairly diversified, operating different businesses, some of which, by the way, have stagnated in terms of sales. So, I would expect Cree to be valued only marginally higher, at best, should its SiC wafer business grow to become a substantial revenue driver for the overall company, but that’s about it. For example, its shares are currently trading at 3.4x its trailing twelve-month sales, so maybe they can go up to 5-6x but investors shouldn’t expect an exponential rise to about 40-50x.
The takeaway here is that Cree’s Silicon Carbide business is showing encouraging signs for long-side investments but investors should temper their expectations and not go overboard when modeling its growth. For now, I reiterate my call that Cree is a buying opportunity for long-side investors at the current levels but I absolutely dismiss the premise that its shares will double or triple in 2019. Good luck!
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.