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Great Products, Terrible Investments

One trap investors sometimes fall into is buying the stock of a company because they like the company's product. A good product and a good investment are two very different things, and ignoring the bias created by customer loyalty can be difficult. Stocks like this tend to become dramatically overpriced, with loyalty and blind optimism driving up the stock price. These stock almost always crash back to earth at some point

The future is...light bulbs?
The incandescent light bulb was the standard up until recently, but the hot yellow bulbs are being phased out as compact fluorescent lamps become more popular. Incandescent bulbs are highly inefficient, emitting about 90% of energy into heat instead of light. CFLs improve upon this, but they still leave much to be desired. The future is clearly light-emitting diodes, or LEDs, which convert almost all energy to light.

LEDs are not new, but using them to create light suitable for home use is a fairly recent development. One company that sells such bulbs is Cree (NASDAQ: CREE  ) , and up until recently the stock has been unstoppable.

CREE data by YCharts.

However, a recent weak earnings report caused a massive 20% decline in the stock the next day. Even with revenue growing 22% year over year, analysts were expecting more, and guidance suggested that margins would likely decline.

Most articles I read about Cree focus on the energy savings a consumer could achieve by buying one of the company's LED bulbs. Not only do the bulbs last longer than traditional bulbs, but they also use less energy, leading to significant cost savings over the bulb's lifetime, even though the retail price is quite a bit higher. That's all well and good, but Cree is a light bulb company. Light bulbs -- even advanced ones -- are a commodity, therefore Cree's margins are declining. As LED lighting becomes more popular, competition will grow and prices will come down.

I don't doubt that LEDs eventually will be the dominant form of lighting, but it won't be a high-margin business. Before the post-earnings crash, Cree had a market capitalization of almost $9 billion. That's about nine times sales. Even now, the market cap is a little greater than $7 billion, which is nearly 50 times the best net-income figure from the past three years.

Revenue will grow, margins will decline, and those who bought Cree at such high prices will be disappointed. It's as simple as that.

Irrational exuberance
Electric-car company Tesla Motors (NASDAQ: TSLA  ) has seen its stock rocket higher in 2013. So far this year, the stock is up more than 300%, as the company's first real profit delighted investors. The Tesla Model S has received overwhelmingly positive reviews and taken a legitimate chunk of the luxury car market. Tesla sold 5,150 Model S vehicles in the second quarter of this year.

Tesla's market cap is now about $20 billion. Trailing-12-month revenue is $1.3 billion, and while net income was positive, it was small enough to be insignificant.

The auto industry involves constant and substantial capital investments. Expanding production is expensive, and profit margins are typically small. Tesla is aiming to eventually make a mass-market vehicle, and if it succeeds, margins will be extremely low. Ford, for example, had a net income margin of just 4.2% in 2012. More than 60% of its operating cash flow went to capital expenditures. As Tesla grows, profitability will be constrained by the nature of the industry.

Tesla does have a real chance at becoming a major car company, but the stock price has gotten so out of line with reality that even the best-case scenario doesn't lead to exceptional results for investors. Ford has a market cap four times that of Tesla, with about 100 times the sales. If it takes Tesla 15 years to grow its market capitalization to match Ford's, investors will achieve an annualized return of 9.7% -- that's the best-case scenario. This is unlikely, as Tesla will probably become a niche player instead, in which case the return will be far lower or even negative. If everything goes right, buying Tesla today will give you decent returns. Incredible risk, modest returns -- that's what Tesla offers today.

No barrier to entry
A lot of people use Pandora (NYSE: P  ) , an Internet music-streaming service, and it's a great product. Pandora pays out royalties each time it plays a song and generates advertising revenue from its free members and subscription revenue from its paying members. The problem is that there are a tremendous number of rivals, each offering essentially the same thing, and this will keep Pandora's profitability low or negative for the foreseeable future.

Spotify has become extremely popular, Apple is set to launch its own service, Google has an offering, and Windows 8 has a built-in music-streaming app. There are plenty of smaller competitors as well. There's almost no barrier to entry in this business.

I don't think that Pandora makes sense as a stand-alone company. If it ever becomes consistently profitable, those profits will be low -- far too low to justify the $3.6 billion market capitalization. There's nothing truly unique about Pandora to make it stand out from other services, and I've found most of them to be perfectly fine for my music-streaming needs. The owners of the content will always be the ones holding the cards, and the streaming services will always be at their mercy.

The bottom line
It's not a bad idea to research companies that make your favorite products, but basing an investment decision solely on that product is a recipe for disaster. The three companies above have had their stocks bid up to elevated levels, likely by investors focused on the product instead of the business model, and eventually reality will catch up with them. A great product alone doesn't make a great company, and too often this point is forgotten.

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Read/Post Comments (11) | Recommend This Article (5)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 11, 2013, at 12:12 PM, pwright99 wrote:

    Here we go again with the gratuitous Pandora bashing... this is becoming a habit for Mr. Green. Don't forget to use pejoratives in your headlines, Timothy - why do you write articles for Motley Fool when MF recommends Pandora as a stock?

  • Report this Comment On September 11, 2013, at 3:13 PM, highgrowthcarson wrote:

    Hmmm. Lets say battery costs come down significantly. Not certain. But not impossible. To, say 200/kwh. Then tsla can make a camry equivalent car for under 20k -- 8k for the 40kwh battery. 12k for the rest of the ultra simple car with almost no moving parts. Sell the car for 30-35k. Faster, better handling and more luxurious than any camry. How many might they sell? How much money might they make?

    Competition? Maybe. Maybe the majors wise up as battery costs come down. Or maybe they are so invested in their ICE's by the time they see the blur passing them by they will be so much roadkill on the technological highway.

    Both things could happen. Maybe. But if they do, tsla might be worth more than apple. Think about it. Auto market 2-3x larger than entire computer device market. Old-line auto companies far weaker than, say Sony in 2003, or HP, or Dell or Nokia or Rim -- all of which were trashed by apple tech.

    Plus Tsla has the smartest business guy on the planet running it.

    Seems like a good bet to me.

  • Report this Comment On September 11, 2013, at 3:18 PM, StanO6 wrote:

    What @highgrowthcarson said.

  • Report this Comment On September 11, 2013, at 3:25 PM, Carfan79 wrote:

    Your argument on Tesla is a straw man, you are attacking Tesla on the basis that Tesla, if it succeeds, will be a company like Ford. But it won't. Tesla is an Auto Tech company because it of its technology which is good enough for everyone else to want it, and expensive enough for everyone else not to pursue developing it, so instead they will take the cheaper alternative and lease from Tesla. This is a huge revenue potential. Ford makes crappy cars compared to Tesla, and they rarely innovate new technology, and are rarely leased from.

  • Report this Comment On September 11, 2013, at 3:51 PM, Borg1977 wrote:

    Why is expanding production expensive? You simply put a different top on the same bottom. And you buy some land and copy the existing technology.

    The sky is the limit. Every baby born today on the planet is a potential customer.

  • Report this Comment On September 11, 2013, at 4:11 PM, AjitC wrote:

    Tesla is a Gorilla. It has proprietary architecture, technology with a supercharger network that adds significant value. What kind of value? $7-8/fillup versus $70-80 for a tank of gas. Free use of SCs. BEV competition with 60-90 mile range and LAME performance.

    Tesla will achieve Porsche like margins in the 30-50% range for Model S/X and ASP of $90+K, once worldwide volumes reach and exceed Porsche's 140K/year. How? Economies of scale with simple design, economies of scale, falling battery prices. Yes, range of battery will increase 500 miles. Within 3-4 years. Do the math.

    Just a matter of time.

  • Report this Comment On September 11, 2013, at 6:47 PM, plange01 wrote:

    great products equal a super stock price! cree has had a fabulous year just took a drop but with even better products just coming out now this one will be close to $100 in six monrhs

  • Report this Comment On September 11, 2013, at 7:14 PM, highgrowthcarson wrote:

    You know, if you actually look at the market, it seems that great products usually make investors who are in fairly early gobs of money.

    Iphones, ipods, ipads, imacs. aapl.

    Massive on-line store. amzn

    Healthy good mex food. cmg

    Great workout clothes. lulu.

    cloud biz software. crm.

    convenient coffee. gmcr.

    on-line video store. nflx.

    A coffee place to hang out. sbx.

    Biz social network. lnkd.

    Great athletic shoes. nke.

    Best car in the world. tsla.

    And the beat goes on.

  • Report this Comment On September 16, 2013, at 8:16 AM, Stillers11 wrote:

    This analyst needs to do a bit more research. Cree is not a light bulb company. The majority of its revenue comes from industrial lighting.

  • Report this Comment On September 17, 2013, at 2:26 PM, marcojlm wrote:

    Ditto stillers11. This analyst needs to do a lot more research. Cree might add some volume from replacement bulbs, but their commercial/ industrial products drive their company and their margins.

    They are the industry leader ( by far ) in LED street lighting.

  • Report this Comment On September 24, 2013, at 12:53 PM, POGJYHValme wrote:

    Green is just another blogger who shorts stocks and tries to use fear tactics to negatively influence stock price. Of course he can claim he does not "own" shares, because he hasn't actually "purchased" shares to cover a short yet. With Tesla, he is using false analogies between companies with completely different business models and choosing only those statistics that support his claims.

    As with any new product, market adoption takes time as manufacturing and support infrastructure is built. The Model S is not the only thing Tesla has going, as anyone who has been following company developments knows. Don't let this article be the last word.

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