An Upsetting Story About Dimming Profitability at CREE, Inc.

North Carolina-based CREE (NASDAQ: CREE  ) is a leader in the manufacture of light-emitting diodes, commonly known as LEDs. Founded in 1987, CREE focuses on two major product lines: LED components and lighting products. The recent worldwide push for energy savings has compelled people and businesses everywhere to start the slow march toward replacing fluorescent and incandescent light bulbs with LEDs. 

As can be seen in the image below, the LED bulb is as much as five times more efficient than a traditional incandescent bulb and lasts over 20 years. These figures are only expected to rise -- the semiconductor aspect of LED technology will potentially lead to even greater differences in energy efficiencies with each passing year.


Photo: General Electric

Given its early investment in LED technology, CREE led its competitors due to the efficiency of its chips, which drove early adoption of its products. The company enjoyed significant revenue growth in 2010 with the adoption of LED TVs and lighting fixtures. Not only did CREE enjoy record revenues at the time, but gross margins also hit an all-time high of 48%. 

Unfortunately for CREE, its success would ultimately lead to the growth of Asian competitors such as LG Innotek, Samsung LED, and Epistar who were willing to compete on price versus technology. As LED TVs became a commodity, CREE focused its energy on the general lighting space, hoping the fragmented nature of general lighting would allow the company to sustain its margins for a longer period of time. To accelerate this effort, CREE acquired a company called Ruud Lighting in 2011, a move that would take CREE from being a supplier just of LED chips and components to also providing the end products -- fixtures such as street lights, down lights, etc. While this sounded like a great idea at the time, it was fraught with difficulties. Instead of competing with smaller competitors like Epistar, CREE now competed with more established players such as Acuity and Phillips. While it was able to beat competitors due to better technology in its LED components, selling fixtures was a whole different ballgame, one more about having the right product portfolio and distribution network. It was no surprise then that CREE would be again met with not only lower gross margins, but lower operating margins in the ensuing two years.  

Where is CREE today?
CREE recently announced its fiscal-third-quarter earnings, 2014 earnings, and guidance (Q4 revenues expected to be a company record in the range of $430 million-$460 million. Per CREE management, this revenue beat was driven by the lighting segment (acquired in 2011). Despite this revenue beat, the stock is down over 10% since earnings were announced. By dissecting CREE's earnings further, we can see why investors are cautious about its prospects.

Revenue is projected to hit record highs in the June quarter; CREE estimates its non-GAAP EPS to be between $0.38 and $0.44, compared to analyst estimates of $0.44. On the earnings call, CREE blamed the margin shortfall on two major factors: pricing discounts the company had to give Home Depot on their light bulbs, and increased marketing costs in CREE’s efforts to create a brand. You might recall CREE ran a commercial during the Super Bowl this year. 

While on the surface this seems like a positive undertaking for CREE, the real reasons underlying this move are more defensive in nature. As LED technology has continued to mature, Asian competitors have finally started to make headway into the American and European general lighting market, a market that was once reserved only for CREE and its western competitors. Brands such as FEIT, Phillips, and Acuity have started to adopt Asian brands such as Epistar for significantly lower price. To put this in context, Epistar has a 22% gross margin in their LED chip business compared to CREE's over 40%. 

Most sell-side analysts are calling for a bottom on CREE, but I would remain cautious of its future earnings growth. The company will have admirably grown revenues from $860 million in 2010 to an expected $1.6 billion upon exiting 2014, but its EPS has remained flat during this period. The CFO has promised operating leverage going forward, but I believe this will be hard to achieve. While the LED market and its revenue might shine brightly, its profit and margins seem dim at best. 

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