Cree: Goodbye Lighting Products, What Does The Future Hold?

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About: Cree, Inc. (CREE)
by: The Value Investor
Summary

Cree is finally getting rid of its underperforming lighting business.

The declining business was creating a drag, and investors' reaction shows that they have attached no value to it.

I like the move, as Cree is very well positioned (accidentally), as CFIUS prevented the sale of its current crown jewel not too long ago.

Sales multiples look reasonable given the growth, but this growth and promise still have to translate to the bottom line.

Cree (CREE) has sold its former core business which now was just a drag on the company. The positive reaction from investors shows that they would be happy with almost any price for this underperforming segment, as Cree becomes a more focused business with a real promise following this deal, and one to watch with great interest.

Goodbye Lighting

Cree has reached a deal with Ideal Industries to sell its Lighting Products business, thereby getting rid of its LED lighting fixtures, lamps and corporate lighting solutions.

The reported deal tag comes in at $310 million, but involves an initial upfront cash payment of $225 million, as earn-outs of a maximum of $85 million can be achieved depending on the EBITDA performance in two years' time from now.

With the deal, Cree will become a more focused semiconductor company, as the cash will be used to fund the growth of Wolfspeed, the core Power and RF business, and other semiconductor activities. This reconsideration of the strategy resulted in Wolfspeed seeing strong growth in recent times and Cree acquiring the RF business of Infineon (OTCQX:IFNNF) of course last year.

With the transformation, Cree will be greatly positioned to benefit from the trends towards zero emissions in the automotive market, transition to 5G networks in telecom, and continued growth in LED applications in various forms and applications.

Implications Of The Deal

If we look at the results reported for fiscal-year 2018, which ended in June of last year, we can see how important the lighting unit still was in terms of sales contribution. The segment generated $569 million in sales in 2018, making up 38% of total sales which totaled $1.49 billion at that time period. Full-year sales for the segment fell by 19%, yet the 7% fall in the final quarter of the year was much more limited.

Based on the reported deal price of $310 million, the sales price amounts to just little over half a times annual sales, even requiring that full earn-outs will be achieved upon. The business unit was not that profitable as it reported $109 million in segment gross profits, equal to 19% of sales.

With R&D and SG&A costs not being split out across segments, it is impossible to "measure" how much the unit contributed to Cree and its bottom line.

How Does The Pro-Forma Business Look Like?

With the sale of this underperforming business, Cree has transformed itself into a rapid growth company again, although it is much smaller by now. The main driver is the Wolfspeed segment, which is growing rapidly and generating revenues just north of half a billion a year. LED products business is now actually a stagnant business with roughly $600 million in sales.

While the divested Lighting Products business is seeing continued sales declines, with the sales run-rate just surpassing the half a billion mark, gross margins have improved quite a bit in recent quarters. These margins gains and growth at the high-margin segments resulted in Cree, at large, posting flattish to small positive operating earnings in the first two quarters of fiscal-year 2019.

The deal will add significantly to the solid financial position of the business. With cash and equivalents amounting to $772 million at the end of the second quarter, pro-forma cash amounts to a billion, even if I exclude the earn-out.

The company has convertible notes outstanding with a nominal value of $458 million, which at the current share price levels mean they are not converted, but they are close to their conversion level. Assuming debt is paid off in cash, I am working with a net cash position of around $550 million. That is still equivalent to nearly $5.50 per share with 103 million shares outstanding.

The Market Likes It

Shares of Cree rose by 5% to $56 and change in a move which adds about $300 million to the market value of the firm, suggesting that this is a good move as the company becomes more focused and investors essentially attached zero value to the divested activities.

With 103 million shares outstanding and operating assets valued at around $50 per share, the enterprise value of the firm amounts to $5.1 billion. With the remaining core business doing about $1.1 billion in sales, the assets are valued at little less than 5 times sales, yet the margin profile of those growth areas is a bit mixed.

Excluding the divested activities, Cree sees third-quarter sales at $271-277 million, which confirms the $1.1 billion annual revenue run rate as indicated above. The company sees GAAP losses from continued operations at $9-14 million, with adjusted earnings seen at $14-18 million. The $27 million discrepancy results from stock-based compensation expenses, amortisation charges and interest accruing on the convertible bonds, among others.

We known that stock-based compensation runs at a pace of $12-13 million a quarter, and this is a real expense for investors. Amortisation charges can be excluded, as interest accrues at a rate of about a million a quarter. Adjusted for all of this, the remaining core business is close to breaking even, or might post some small profits.

Hence investors really see this as a strategic play which trades at around 4.6 times sales, yet is really only breaking even, and is showing resilient growth thanks to its Wolfspeed segment.

What Now?

The last time I checked on Cree was the summer of 2016 as the company actually announced the sale of Wolfspeed to Infineon in a $850 million deal, as the unit reported $173 million in annual sales at the time. The disappointing move behind this deal was the net proceeds amounted to just $585 million.

The good news is that CFIUS blocked the deal in early 2017, resulting in a break-up of the deal which is now the value driver of Cree and would have been detrimental to the outlook for investors if the deal went through. Last year, Cree actually bought assets from Infineon. For EUR 345 million, the company acquired the Radio Frequency Power Business in a deal, adding about $115 million in sales, and adding key expertise which is beneficial to the business currently.

Reality is that while current sales multiples look reasonable given the gross margin profile and the solid growth notably of Wolfspeed, as well as the long-term opportunity in the segment, Cree is not be able to report real profits. The real promise is however in the Wolfspeed segment, and that is SiC (Silicone Carbide), which is crucial in the multi-billion-dollar plans already announced around electrical vehicles. Furthermore the company will be much more focused now and has even greater financial resources to make bolt-on deals to reinforce its strong position in its rapidly growing segment.

This makes Cree a potential takeover target itself, but how profitable and large the business could become on its own remains to be seen. While I see the promise, I recognise that no earnings are really being delivered on for now, as has been the case for a while, which makes Cree a show-me story, but a story which I will watch with great interest going forwards.

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.