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Cree: Misunderstood With Upside Ahead - 9277 views
The following commentary comes from an independent investor or market observer as part of TheStreet’s guest contributor program, which is separate from the company’s news coverage. The opinions expressed are those of the author and do not represent the views of TheStreet or its management.
WINSTON-SALEM, N.C. (Magnum Opus Financial) -- I continue to believe that the key to understanding an investment is to get as much of your information from the company’s management as you can. Many individual investors do little to no homework, and the analysts may just be doing too much homework.
While the analysts have been looking at Cree (CREE) with a microscope, many investors haven’t looked closely enough. Part of the misunderstanding in the CREE story has been by people who think the company is trying to be something it’s not. Cree isn’t a consumer products company, and it doesn’t want to be. It isn’t interested in selling things to people as it is in facilitating the LED revolution.
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The idea of “Lighting the LED Revolution” seemed to be about convincing people to buy Cree light bulbs (as I thought after I saw the company's social media campaign by the same name). But when I asked
Raiford Garrabrant, Cree's director of investor relations, about bringing that campaign “offline” into traditional media like television, that’s when “it” happened. Garrabrant told me that Cree doesn't want to sell its light bulbs to people (the Home Depot (HD) deal not withstanding). I asked him if Cree was concerned about Phillips and GE’s foray into LED lighting and the fact that they beat CREE into the production of a “60-whatt” equivalent. That’s when he told me that the GE (GE) LED light has Cree lighting components in the bulb. The Philips (PHG) bulb also has Cree parts in it. Philips both buys LED components from Cree and competes with Cree in the LED chip space (Philips has its own fabrication plants). That is an interesting fact (that Philips is vertically integrated). I asked Cree if it made sense for GE to buy the company, and they politely informed me that since Cree is a publicly traded company, it is for sale every day.
We then moved on to what Cree is capable of. I asked Garrabrant if Cree saw itself providing outdoor stadiums with its lighting since it can produce a rather large amount of lumens for an incredible cost. (While its lighting is not the “cheapest” alternative to traditional lighting, what they can produce in terms of lumens for the cost is very impressive.) He said the technology to light a stadium with LEDs doesn’t exist yet. But the television in the Dallas Mavericks indoor arena is lit by Cree LEDs.
The bottom line: Cree will continually move forward what is available to be done with LEDs, and then those who use LEDs will find ways to integrate them and vice versa. Much of Cree’s business comes from companies that have a need and ask Cree to design the system to fit their use. By constantly pushing the envelope of what can be done with LEDs, Cree makes its ultimate service attractive to more companies. So its goal in driving the adoption of the LED light isn’t about selling more lightbulbs to people -- it’s about growing its backlog with design and implementation projects. This is how Cree will protect its margins since irreplaceable expertise always demands higher margins than the commodity chip business.
Speaking of Cree's chip business, it has declined as a percent of revenue consistently quarter over quarter for about a year. On its conference call, Cree said there are two important points to its chip business: 1) The business gives Cree great insight into its end markets to be able to see just what its LEDs are being used for and where supply and demand is at, and 2) Cree is perfectly content to serve the chip sector as long as it can operate the business for a profit, but it has no intension to grow the businesses because it means lower margins on account of pricing pressure because ultimately chips are a commodity business.
As Cree's chip business declines as a percent of revenues, it makes it easier to defend its margins of 40%. This was a key number that many were looking for when Cree reported last week. The 40% number is being used to gauge the success or failure of Cree as a company. If it can maintain 40% margins, then analysts think it has a fighting chance. If margins slip to under 40%, then there are some who think Cree can’t make it. Cree guided to the 40% number exactly, and an analyst challenged the company on being able to maintain it. I initially didn’t have a context for its response but have been perturbed by management’s continued confidence despite a stock price that’s been cut in half. Management has been confident on the conference calls because it understands that it doesn't want to be Nokia (NOK) or Samsung or Dell (DELL) or even Apple (AAPL) -- it wants to be like Qualcomm (QCOM). The beauty of being Qualcomm is that it’s irrelevant who ultimately wins the “smartphone war”; as long as your chips are in most of the devices, then Qualcomm will surf the wave of success despite who the winner is.
Cree doesn’t want to fight against low-cost Chinese competitors. It doesn’t want to compete against GE or Philips in the “high end” of the consumer market in the U.S. Cree wants to make it possible for these companies to compete with each other. Cree pointed out to me that GE already has a distribution channels, consumer brand loyalty, established end market relationships and so on. Why would Cree want to put all those in place when it can just sell GE (or Philips, for that matter) the lighting components needed (and the chips, LEDs and such) to make a bulb that does what GE wants it to? Qualcomm doesn’t care whether Nokia, Apple or any other smartphone maker wins the war -- it just wants to supply it with the guns (or chips) to fight it. This, we believe, is why Cree has been misunderstood.
When you put Cree against either the low-cost Chinese makers of LED bulbs or the more-established American “competitors,” it looks like Cree doesn’t have an edge in either fight. But when you look at Cree in the vein of Qualcomm, in which it will simply sell parts that go to the competitors, it’s easier to see how Cree can drive what is possible in LED lighting. As Cree brings on more capacity (which it is doing) and brings greater and greater innovation to the LED market, it creates its own future -- one that should be quite bright.
When I asked Garrabrant why Cree's free cash flow was negative on the quarter despite a net EPS number that was positive, he informed me that it is still spending on capital expenditure (CapEx) to increase capacity to meet demand that they are seeing. Garrabrant said Cree is starting to see more rushed orders in the most recent quarter. While it is not seeing end markets stock more inventory, the fact that more and more orders are being rushed to market means that the demand it is seeing is “more real” than in an inventory build. If demand increases any more significantly, then the days of accumulating inventory may end up having to come back in order for the end markets to meet their demand. Garrabrant also told me that Cree will pull back on that CapEx if it feels that the market supply/demand fundamentals dictate that excess supply capacity would end up being derogatory to the company or the LED market.
Despite concern and critique from analysts, Cree has not wavered in its goal to drive adoption of the LEDs in its end markets. That confidence seemed unfounded based on the last two quarters, but now that we understand that Cree is more like Qualcomm and less like Apple (although it is also like HP (HPQ) in that it is driving the percentage of consulting work higher and letting the lower-margin chip business atrophy), it’s easier to understand the Cree story.
And, to a certain extent, it's easier to understand how Cree plans on driving the LED market. When Cree tells a GE that it can now do X with its LEDs, then GE says to them: “I bet we can do Y with that capability.” Cree is creating demand for its products by driving innovation.
In the U.S., our idea of “green energy” or “green technology” is to engineer efficiency into our current processes, rather than to try to invent new technologies (hence the lack of adoption of solar, wind and hydro, yet Cummins (CMI) and Honeywell (HON) have made traditional gas engines tremendously more efficient than they were 10 years ago). While the LED is certainly different than traditional filament that lights most bulbs, it’s still a light bulb, and if a light bulb has GE's or Philips' name on it or even that of a low-cost Chinese competitor, Cree's OK with it, as long as the components on the inside came from either the factories or the ingenuity of Cree.
Cree’s new production capability that it's bringing online is in China, so it is only so “hurt” by Chinese competitors because it can source from the same markets. Cree simply doesn’t want to play in the “low end” of the market, and it made that quite clear on the conference call.
Now that valuations have come down, and the P/E is in a more stomachable number (about 24), the stock will become more attractive to value investors (especially with the stock only a couple of points off its 52-week low and about $40 from the highs of only a year ago). The PEG ratio is reasonable at 1.05 (should be worried about that number until it hits 2). And if we back out Cree’s $9.85 a share in cash, the stock trades with a P/E of only 18.44 (hardly nosebleed territory).
At some point, having over $1 billion in cash on your balance sheet and no debt means something. While the stock has been sold endlessly (short interest is now at 24% as of March 31), it can’t do that forever if management executes on its vision for the company.
Cree is at the very beginning of the LED revolution with adoption of LEDs for everything it could replace at only 4% or 5%. Just think about the market share opportunity Apple has in front of it with iMac and MacBook adoption only in the teens compared with its inferior PC rivals on the Windows platform. Apple’s products may be expensive, but people who want a good device buy them anyway.
While the stock seems to say that the Cree story is over, if Cree’s management is correct, it’s only just beginning -- unless, of course, Cree gets bought by a GE or Philips. Either way, there should be more upside than downside for Cree investors, and the risk/reward favors the buyer of the stock.
Brad Kelly is president, founder and portfolio manager for Magnum Opus Financial, a Registered Investment Advisory firm based in North Carolina that serves clients in 10 states. Kelly has been trading for 10 years and managing money professionally for clients for five years. He is president of the Piedmont Club Men's Investment Group and frequently is a guest lecturer at University of North Carolina Greensboro, in the finance department.