It seems like a major transformation is underway for Cree (CREE). The company is selling its Lighting Products segment which has been stagnating in terms of sales growth for quite some time now. Additionally, the company is ramping up the production capacity of Silicon Carbide (SiC) and Gallium Nitride (GaN) wafers which comes under its rapidly-growing Wolfspeed division. I believe Cree and its shareholders stand to benefit greatly as a result of these restructuring and expansion efforts. Let’s take a closer look.
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The Big Deal
The big news for Cree investors is that the company is selling its Lighting Products segment to Ideal Industries for $310 million before tax impacts. The chart attached below would highlight that the segment accounts for a significant portion of Cree’s overall revenues, and also that the division has been stagnating in terms of sales growth for several quarters now.
This sale has basically four repercussions for Cree:
- Selling the lighting products division obviously would shrink Cree’s revenue figure by about 33% as the segment has historically represented a sizable portion of its overall revenues.
- The sale would reduce the drag on Cree’s overall sales growth figure. Its lighting products division has been posting declining sales figures after all.
- Now that Cree would be a leaner and a fast-growing company, excluding the sales contribution of its lighting products division, we can expect it to be rerated to higher valuation multiples.
- The sale will free up capital for capacity expansion and growth acceleration of its Wolfspeed division, which has in reality been the only growth driver for the company of late.
The sale protects Cree from further commoditization of products listed under its lighting products division (LED lighting systems and lamps etc.) that could’ve brought further decline in its sales. Therefore, I view this sale as a positive move by Cree’s management and the board.
With that said, investing in Cree isn’t just about unlocking value by way of asset divestments. Its Wolfspeed division has been growing at an impressive pace for many quarters straight and it may continue to do so going forward as well. I say this because certain managements tend to become complacent and develop a lax attitude towards shareholder returns after tasting a bit of success. However, Cree’s management continues to be proactive and they seem to have a very ambitious plan to grow the Wolfspeed division in terms of product offerings and actual sales by a substantial degree over the coming years.
For anyone new to tracking Cree, their Wolfspeed segment includes materials such as Silicon Carbide and Gallium Nitride which are starting to replace conventional Silicon in multiple electrical and electronics applications due to their better switching efficiency and power density. There’s also GaN on SiC, which the company claims is gaining particularly good traction amongst networking hardware providers.
But with that said, things are looking good for Cree’s Wolfspeed division. I discussed in my last article that the company has already signed three SiC wafer supply agreements, worth over $450 million in value, with prominent industry names such as STMicroelectronics and Infineon Technologies over the last year alone. My guess is that Cree would be able to sign more such agreements going forward as it expands its production lines, to basically assure their customers that they’d get uninterrupted quality supplies. (Read Cree: Don't Go Overboard With Expectations).
This capacity expansion isn’t a far-fetched dream by any means. Cree’s management mentioned during their Q4 FY18 earnings call that they were planning to quadruple Wolfspeed revenues to $850 million in a few years by way of expanding materials (SiC and GaN) production capacity as these market segments were undersupplied. Fast forward to their recent Q2 FY19 conference call and the management was still sounding upbeat:
The outlook is very promising and we are in the process of adding GaN production capacity to meet the increasing demand that we're seeing...We're expanding the materials capacity. That's rolling out very, very nicely. We're also expanding the wafer fab capability for our own chip business.
There are two things to note here. First, if the company was facing ramp issues then its Wolfspeed revenues wouldn’t have grown considerably since Q4 FY18 and their management would have rather tempered their expectations when they hosted their conference call back in January. Second, the sale of their lighting products division is expected to fetch about $225 million in an initial cash payment right away, which should allow the company to meet any unplanned expenditures in their ambitious expansion plan. There’s also the possibility that they use this fresh cash to further accelerate their expansion plan, but that’s just conjecture and investors should wait for the official word.
With that said, expect Cree’s margin profile to evolve over the course of 2019. First of all, the chart attached below would highlight that its lighting products division is a low-margin business, so selling it off should, in theory, bolster Cree’s overall margin profile.
However, we also know that Cree is looking to aggressively ramp the production capacity of its Wolfspeed division. The company could be faced with lower factory utilization rates, redundant inventory, increased depreciation rates and maybe even yield issues; these items can drag its margins lower. Besides there’s also the possibility that with Cree ramping up SiC wafer output, the industry is no longer undersupplied and ASPs eventually soften as we head towards the end of the year.
It’s too early to tell how the company’s margin profile would evolve over the coming year, as there are too many variables here, but I would expect some dramatic changes in its overall profitability in FY19.
The takeaway here is that Cree is positioning itself nicely to accelerate its growth momentum over the years to come. It’s divesting a stagnating business vertical and investing into the expansion of a business vertical that is already showing promise. Therefore, I would expect Cree to be re-rated to a higher valuation multiple on the back of its evolved growth profile.
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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.