Are Acuity Brands and Cree the Best LED Lighting Plays?

Shareholders in lighting company Acuity Brands (NYSE: AYI  ) were given a rude reminder of the risk of holding a highly rated stock recently. The company's third quarter results missed estimates and the stock plunged more than 15%. But it might not all be so bad. Acuity's management doesn't give earnings guidance, so Fools should expect some volatility around the results. In addition, the company is attractive for a host of reasons, many of which also apply to Cree (NASDAQ: CREE  ) and Hubbell  (NYSE: HUB-B  ) . Is this a good buying opportunity in Acuity Brands?

Acuity Brands, Cree, and Hubbell: cyclical and secular growth prospects
Acuity Brands is attractive because it has cyclical growth prospects via an upturn in spending in the commercial and industrial construction sector. In addition, it also has a secular growth story from the growth in utilization of LED lighting. Given the company's P/E ratio of 33 times current earnings, it's reasonable to conclude that Acuity needs both these growth drivers to perform in order to take the stock higher.

The good news is that the indications from Cree's LED lighting results is that the secular story is very much intact. Cree manufactures LED products, lighting (LED based), and power and radio frequency products. In its latest set of results, LED products (which service a range of industries) only grew 3%, but Cree's LED lighting solutions grew 35% and now make up 44% of its total sales from just 37% last year. Moreover, Cree's management expects "double digit growth in lighting in both LED fixtures and LED bulb" -- good news for Acuity because LED lighting sales now make up a third of its overall sales.

As for the expectation of a cyclical pickup in lighting demand, investors need to appreciate that construction activity was held back in the winter due to severe weather. But Fools already know that anecdotal and industry data is pointing to a stronger second half for commercial construction. Hubbell, a rival company to Acuity, manufactures electrical systems, power systems, and lighting products for the residential and nonresidential markets. In line with the industry, its first quarter performance was hampered by the severe weather, but in a Q1 2014 earnings call Hubbell's management added, albeit tentatively, to the chorus of companies suggesting an uptick in construction activity: "[B]ut certainly we see some dynamics within the markets that may end up resulting in some upside going forward on the nonresidential construction." 

Moreover, Hubbell is interesting because its management commented that residential lighting was the strong area in the quarter, rather than weather-affected commercial and industrial lighting. In other words, commercial and industrial lighting was held back by the weather. Given that Acuity's core strength is in nonresidential lighting, it's reasonable to expect that Acuity's lighting results will improve with better weather in 2014.

Acuity and Cree display uneven growth
While the outlook for LED lighting looks assured, it's also likely to follow a variable growth pattern. There are a few special factors that Fools need to consider about the market.

One of the biggest deciding factors in making the switch from conventional to LED lighting is the cost efficiency of using a LED light. Simply put, there is pressure on LED manufacturers and lighting companies to spur adoption by lowering prices or investing in increasing LED efficacy. For example, in Cree latest quarter its management disclosed that its lighting margins were below expectations (lighting gross margins fell 320 basis points to 27.4% in the quarter to April) due to LED bulb price reductions.

Moreover, the mix of lighting products sold in the quarter will also affect margins for Cree and Acuity. On an adjusted basis, Acuity's gross margins fell by 70 basis points to 40.3% even while net sales increased by 11.5%. The reasons behind the fall were due to negative foreign exchange effects, a warranty issue due to a design defect in an older product, and a negative product mix shift. Acuity's management described the latter as a "temporary activity" that is "impossible to predict". Therefore, Fools shouldn't get too wrapped up in any one quarter's results, especially coming from a company that doesn't give earnings guidance.

Moreover, growth industries require growth products, and Acuity's investment in ramping up its electronic component capabilities reduced gross margins by 20 basis points in the quarter. Furthermore, management expects further investment to constrain gross margins "over the next few quarters." Acuity needs to make these investments because selling lighting controls (alongside LED lighting) is a key component of its growth plan.

Clearly, LED lighting is a growth industry, but it won't come without some bumps along the way.

The bottom line
The long-term outlook for Acuity is good. Cree is generating strong growth with LED lighting, and Hubbell is also seeing relative strength with its lighting solutions. Indeed, analysts have Acuity's EPS rising by 19% and 25% in the next two years. Good growth looks assured, but for the reasons discussed above, Fools can expect some volatility along the way. On a forward P/E of more than 23 times earnings to August 2015, the stock doesn't look great value right now, but it's well worth following for a future entry point.

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