When it comes to successful investing, the key is not how you
perceive an issue, but how you think the crowd will perceive it.
Your analysis may be more accurate, but you can't buck the
That was a key concern
I raised six months ago
in my negative view of LED company
At the time, I thought analysts and fund managers were off the
mark when it came to this company's gross margin profile:
"Analysts have been continually forecasting margin gains as Cree
more fully utilizes its manufacturing capacity, but so far,
that's just not happening." And analysts' eventual move to lower
their gross margin forecast stood as a key negative catalyst for
That fear has come home to roost. Cree recently reported
fiscal third-quarter results highlighting a further decline in
gross margins, and shares are now paying the price.
#-ad_banner-#To be clear, the concern isn't the gross margins
themselves, but instead the market's perception and anticipation
of higher gross margins. Those perceptions have evaporated, and
it's time to look at this stock from a different perspective. Now
that's it is clear to investors that this company's move into the
mass market of LED lighting will yield weaker gross margins, what
kind of total profits can this company still make? Simply put,
Cree will be making it up on volume.
Demand for LED lights is exploding, and though Cree sees ample
competition, there are enough sales for all parties to benefit.
The LED lighting market is anticipated to grow to $42 billion by
2019, which works out to be a 45% annual growth rate,
according to Wintergreen Research
. Cree is on track to deliver 30% more units to customers in
fiscal (June) 2014 then a year ago, though actual revenues are
growing around 20%, thanks to falling unit prices. Analysts
target a similar revenue growth rate for fiscal 2015, by which
time Cree's sales will likely approach $2 billion.
The LED lighting market is anticipated to grow to
$42 billion by 2019, which works out to be a 45% annual
growth rate, according to Wintergreen Research.
And that top-line trend should eventually garner more focus.
"Although the gross margin story will cloud Cree in the
near-term, we believe a more normal decline in LED pricing and
constant cost improvement initiatives should begin to stabilize
gross margins and shift focus toward top-line growth," note
analysts at DA Davidson, who have a $70 price target on the
To be sure, such price targets are more art than science.
Davidson's analysts suggest a $70 target as it equates to 25
times their (calendar) 2015 earnings per share (
) estimate of $2.40 a share (plus Cree's $10 a share in cash).
But nobody really knows what a perfect multiple is. When this
stock was trading at $70 seven months ago, that was the target
multiple (presumably) being utilized. Now, Cree is subject to
lower target multiples.
Here's a different way to think about stocks like Cree and
their target prices and target multiples. You want to own good
companies when investors are focusing on the negative aspects of
the business model. And you want to avoid such stocks when
investors are seemingly ignoring such a potential negative.
With shares now down in the mid $40s, it's the top-line growth
that should dictate your outlook -- assuming that higher
operating profits will be the end result. With that in mind,
let's again look at the company's recent annual results.
Despite falling gross margins, earnings before interest, taxes,
depreciation, and amortization (EBITDA) margins have rebounded as
the company makes better use of its overhead, and free cash flow
is growing at an especially fast rate, thanks to a major upgrade
of the company's manufacturing platform a few years ago. "Bears
also continue to underappreciate the potential leverage in Cree's
model, which we note has posted six straight quarters of
year-over-year growth in operating margins," write analysts at
Goldman Sachs (NYSE:
, who rate shares a "buy" with a $68 price target.
What about the years to come? Analysts at Canaccord Genuity
retain their "buy" rating and $77 price target for one simple
reason: "We continue to believe in the long-term story that Cree
can deliver strong operating leverage." These analysts note that
"Cree continues to invest in the business, be it branding,
capacity, inventory... It is doing all the right things to build
a stronger sustainable lighting company and is not paying much
attention to near-term quarterly noise."
Goldman's analysts appear to agree. They see EBITDA surging
from $305 million in the current fiscal year, to $430 million in
fiscal 2015, to $570 million by fiscal 2016.
When Wall Street loved this stock a few quarters ago and
expectations were in place for rising gross margins, it had
nowhere to go but down. Now, with the wind out of the sails and
gross margin expectations back in check, the pivot toward
operating leverage and operating profits brings this struggling
stock fresh appeal.
Risks to Consider:
The main risk to this business model is too much industry
capacity that leads to price wars. Price declines have been
orderly thus far, and need to stay at a predictable level if Cree
is to gain the margin leverage investors need to see.
Action to Take -->
Cree shows why it's crucial to track stocks that represent good
companies but unsustainable valuations. As you continue to watch
them, their shares may come down to a price that makes a lot more
sense. Now that Cree is broadly reviled for its weak gross
margins, the decks are cleared for more positive catalysts in the
form of operating leverage and sales growth to re-emerge.