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 tide.
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 this stock.
#-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.
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 stock.
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 ( EPS ) 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: GS ) , 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.
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