Hello Fools! Today we take a closer look at one of the companies we're considering in our high-growth study, Cree, Inc. (Nasdaq: CREE). Because I own shares of Cree and follow it closely, Jeff asked me to drop by and explain a little bit about the company.

First, we can broadly classify Cree as a semiconductor company. That industry encompasses a wide range of products and services, however, so that's really not much help. Specifically, Cree makes products based on silicon carbide (SiC).

There are two things that you need to know about SiC. One, it has very desirable properties that make it better suited than other compounds, such as silicon, for a variety of products. Two, it's extremely difficult to produce efficiently in commercial quantities. In fact, only Cree has really been able to do so. The reason: Cree simply had enough of a head start over other companies, and has been able to patent many of its methods along the way.

This, therefore, places a nice, deep moat around the business. Any other company that decides it wants to get into the SiC business will find that Cree not only has a big head start, but also most of the top talent in the field, and patents on all the methods and processes it uses. Most companies that wish they could produce SiC for themselves instead just give up and purchase what they need from Cree. One estimate floating around out there (and unverified by me) is that Cree produces 95% of the monocrystalline SiC that's on the market.

The bulk of Cree's revenue comes from its light-emitting diode, or LED, product line. But these aren't your father's clock radio red LEDs. Cree specializes in blue and green high-brightness LEDs for automobile dashboards, cell phone displays, indoor and outdoor full-color signs, traffic signals, miniature white lights, etc. Right now, Cree -- like most LED companies -- is racing to develop products that will replace the incandescent bulb.

Cree sells more nitride-based LEDs than anyone in the world (it's the only company to use SiC as a substrate). The key to grabbing more of that market share is the continued decrease in average selling prices (ASPs). Through increased yield efficiency, Cree has been able to lower ASPs by about 25% a year while maintaining or even raising its margins. CEO Neal Hunter rightly feels that as the prices go lower, Cree's LEDs will find their way into more and more products.

Cree also derives a significant portion of revenue from selling SiC wafers for use in research for other semiconductor applications. Again, the difficulty of the material plays in Cree's favor, as no other company is able to produce such high-quality wafers in sufficient quantities.

As exciting as the LED and wafer opportunities are, however, most believe that Cree's greatest revenue potential lies in products that have yet to hit the production line. Cree is racing to be the first to market with a blue laser product, for instance. Because of its shorter wavelength, a blue laser can read information that is more highly compressed than a red laser can. This means that CDs, DVDs, and similar products will be able to hold up to several times more information on one disc.

Cree is also developing radio frequency (RF) and microwave transistors, devices that are critical components in power amplifiers for wireless infrastructure. Another area with a potentially big payoff is the development of "power chips" for power-switching devices.

I want to emphasize that it's possible Cree may never derive significant revenue from some of these areas. None of this stuff is easy, and it all requires top-notch R&D and execution, and even that may not be enough in some cases. For instance, whoever's first to market with the blue laser product may set a de facto standard that others won't be able to overcome. So, the waters are treacherous, but the hidden treasure may well be worth the risk.

Now let's take a look at some of the financials:                 

               1998    1999     2000
Sales growth:  52%      42%     74%
EPS growth:    60%      90%     112%
Flow Ratio*:   2.32    2.15     1.17
Gross margin: 33.5%   45.3%    51.8%
Net margin:   14.2%   19.9%    28.1%
CK margin*:  -8.6%   -34.1%    -14.6%

Cash and equivalents: $258 million
Debt: none
*For more on Flow Ratio and 
Cash King Margin, see the Rule Maker.

I think Cree meets all the high-growth criteria except one: Cash King Margin of 20% or more. There is a reasonable explanation why it's falling short in this area, however. The company is in the process of building  new manufacturing capacity to meet future demand, and its capital expenditures have increased as a result. Once the new factories are up and running, Cree's CKM should roll back into positive territory.

Now, one of the big questions we're looking at with these high-growth companies is where will they be in 15 years? For Cree, it all boils down to execution. Will its scientists be able to turn the promise of these SiC products into revenue-producing reality? The very issue that gives Cree such a sustainable competitive advantage over potential competitors is also the one that could keep it from being a first-class, word-class company: The difficulty in working with SiC. For instance, it has fallen behind its own timetable for transitioning from a 2" wafer to a 3" wafer, something that, when complete, will greatly increase product yield and lower ASPs. (Intel (Nasdaq: INTC) has recently been slower than desired in upgrading to newer technologies, too.)

So, when considering Cree, it's important to realize there will be bumps and potholes along the way. Should this turn out to be a great 15-year investment, you may have to ride out some rough times, as this two-year chart demonstrates.

If you have any thoughts or questions about Cree's validity as a Drip Port candidate, be sure to post them on the Drip Companies board!