Uber Bull Passing

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By Imshaken
February 20, 2002

Posts selected for this feature rarely stand alone. They are usually a part of an ongoing thread, and are out of context when presented here. The material should be read in that light. How are these posts selected? Click here to find out and nominate a post yourself!

As many of you are painfully aware, at one point the value of Cree stock lost almost 2/3 its value in the month after the FY 2002, Q2 CC. The fact I sold my business almost a year ago to buy more Cree stock, and now work at a trade I don't particularly care for, has caused me to re-evaluate my position and decision. My current occupation is part of the price I pay for owning Cree. (Unless I decide to move out of the region then I can go back into vibration and other predictive technologies. But I digress) Currently things don't look so hot when reviewing several components of the overall decision. Did I make a mistake? The results of my decision aren't currently profitable, or much fun on a daily basis (when I'm at work. :o)) ) However, I'm not complaining. I made my decisions with my eyes open, and was well aware of risks and ramifications.

I'm not a diversified investor. The fact that this increases my downside risk doesn't frequently trouble me. In the FAQ for Berkshire Hathaway it basically states that Coca-Cola was a GREAT investment. Then goes on to say, they would gladly invest in fifty "Coca Cola's" but fifty Coca Cola's don't exist. (paraphrased). Great companies are hard to find. Evidently Buffet doesn't really worry about diversification for diversification's sake. He's interested in locating investments that fit his criteria, that make sense for him. I obviously don't follow Buffet's valuation guidelines about investing, or I wouldn't hold a single share of Cree rather than the 8 shares I have tucked away somewhere. My point is that I'm primarily interested in investing in the best company I can find. So, what's "the best"? Ideally the company with the best business model would have some of the following characteristics; unlimited markets, a monopoly, no possible competition, 1000% margins, no debt, huge growth forever, generous dividends, and of course great management. It seems doubtful such a company legally exists. If it does, would someone please share the symbol with me?

I'm currently so invested in Cree because over time, as I learned more about the company, I began to realize that it seemed to fit my "ideal model" better than any other company I've learned about. The possible exception being MSFT. However, I personally don't like MSFT and can't bring myself to invest. (It's amazing my reaction to a set of Excel install disks that contains grossly excessive installation copyright warnings. I've had several computers and now the disks warn me about multiple installations, and I have to press the "enter" button every single time a file is installed. There are many hundreds of files! I swore I would never freely purchase another MSFT product. But again, I digress.) In any event, I "realized" about investing and growth too late in the game to take advantage of MSFT's growth even if they didn't irritate me.

Anyway, the fact that I've recently been referred to by some posters as perma-bull, and uber bull regarding Cree is primae facie evidence I may no longer have a balanced perspective when it comes to Cree. I realize one of my personal strengths, and ironically, weaknesses, is that when I'm convinced, (which is not an easy thing) I can become very convinced. Years ago I became convinced about Cree's future, and I was ahead of the curve for a change. However, Perma Bull /Uber Bull guy thinks perhaps it's time to revisit the subject of due diligence on Cree, warts, beauty marks and all that lies between, hopefully it will facilitate acquisition of a balanced perspective.

Earnings warts.

Not only has the rate of growth of Cree's earnings have been slowing, in the last two quarters it appears earnings began to accelerate in the wrong direction. In the Pro Forma world Cree's earnings are suddenly bleak. In Fiscal Year;

1997 - 1998 - 1999 - 2000 - 2001 - 2002 (1st half) - 2002 (estimate assumes .10 eps in the last two qtrs.)
.06 --- .11 --- .20 --- .43 --- .37 --- (.15) ---------- .05

Jeepers Creepers! It looks like Cree is headed back to 1997 earnings levels. This from a growth company with no debt, free cash flow, and hundreds of millions in cash?

While we ultimately have to look at Cree for the results of Cree's earnings, Cree isn't operating in a vacuum. Earnings evidence indicates the economy is integral to Cree's success, (along with most other companies). Therefore, being somewhat forgiving when viewing the above doesn't seem too unreasonable. However, since Cree is acting like Campbell's (Campbell's isn't doing so hot these days.) I think it might make sense to look at the overall economy as part of Cree's DD.

Economic warts

The economy has been in trouble for over a year now. My gut feeling is the recovery will not be particularly robust, and won't be long winded (unlike this post). Consumers and companies have not significantly reduced debt levels yet, and are in fact being induced to go further into debt with record low rates. I think this debt will mute the recovery unless productivity gains are great enough that they can compensate. I don't have the latest consumer debt information but here's an article that gives an idea.

Not included in the article was the fact that in 2001 there were 1.3 million bankruptcies, and in 2002 they expect another 1.35 million so consumers aren't getting any brighter. Recall that after the 9/11 attacks even the President was suggesting that everyone do their patriotic duty and go out act normally and go shopping. (Some more info.)

Additionally, Japan appears to be in a position to dampen the global economy as a result of not dealing with corruption in its banking industry extends its recession to 11 years. Reflecting the economy, the stock market has been bearish for a couple years now. While the market in the recent past has technically become a bull market again, I wouldn't characterize the market as currently being either strong or bullish. It seems the bull has a long wall of worry ahead to climb.

All this said... If the global economy is flat, or slightly expanding in the next two years how reasonable is it to expect Cree to grow at 30%? After a conversation with Mybestshot recently I learned that globally, the high brightness LED market, Cree's bread and butter, has been flat. Thus for Cree's HB LED market share to grow they have to displace Nichia and Toyoda Gosei (TG). While I have no illusions that Cree is a formidable supplier of the worlds brightest and lowest-cost LED die, ultimately Cree's chips have to provide a profit for at least two business entities. First, Cree has to make a profit, then the packager, then the purchaser of the packaged LEDs if they're installing the LED as a component in another product, whereas Nichia, and TG only have to make themselves and perhaps the end manufacturer a profit. As nitride based LED manufacturing capacity expands, downward pricing pressure for nitride based LEDs will increase. Since there are numerous new entries into the nitride LED arena it would seem capacity is expanding. Thus, Cree can maintain in CC's that it doesn't see any effect of the new competitors, but I suspect the fact that Cree's business model of increasing margins to lower prices and open new applications would tend to mask the overall effect of pricing pressure on the nitride LED market in general from Cree's perspective. To the best of my knowledge Cree's largest customer, Osram, currently uses standard brightness product for VW dashboard lighting, and who knows what other applications. I'm guessing these would likely be the deferred product. The standard brightness chips are probably going to have the most competition, as that level of brightness can be achieved by others. (I would think ESD requirements protect Cree's auto sales applications, unless Osram can start making their own inexpensive LEDS, or if they're willing to take a loss in the near term.) However, it seems clear that if the economy is slow, LED revenue growth won't be great despite the breakthrough and promise of XBright LEDS, and power chips.

In any event, it seems unlikely that Cree will displace large percentages of Nichia's and TG's sales since Cree hasn't done so to date. Nichia / TG displacement may become more likely once the XBright is packaged in full force. However, we know this is several months away yet since packagers have to specifically setup for the XBright during a scheduled shutdown.

Competition and Customer Warts

The semiconductor industry certainly appears to be a global den of cut-throats. With 35% of the GDP there's a great deal of money at stake and so it's extremely competitive. It seems that several of Cree's customers would like very much to get into Cree's business. (At 50% margins I can't bring myself to blame them.) Siemens would like to produce its own SiC and Osram would like to produce it's own LEDs for sale to VW, Audi, BMW, Daimler, etc. These companies are taking steps to achieve that goal. What would Cree's balance sheet look like sans Osram? In addition to Siemens, it seems like there are companies who are trying to enter some part of the SiC business popping up every day. Currently Libra, (AKA SEA99, and PermaSleuth :o)) ) has a list of 30 competitors. ABB had a contract with Cree supplying Cree wafers about three years ago. Evidently ABB decided to go it alone to develop SiC and devices. It didn't work out so well for ABB and they quit the effort. This is somewhat bittersweet however because they might have quit trying to develop SiC devices as well, which isn't a positive thing for the emerging SiC sector.

So if one presumes the economy will stay anemic, and Cree's LED revenue growth will be muted for some time to come, where will GROWTH come from? New devices? Let's briefly examine the prospects for new devices.

RF Device Warts.

Cree's new devices. Well.... We really don't hear much on the SiC RF device front these days. This despite the Hunter (then CEO) statement several CC's ago "The CRF 2010 is about ready to go." This after explaining they had achieved yield improvements on the device in the neighborhood on an order of magnitude. OK. So this is old news, the reason it's worth mention IMHO is because we all thought it was here and bet, and bragged accordingly. Now apparently SiC RF devices can't be price competitive with Si LDMOS for 3G, and so are now targeted for 4G. (in eight to ten years?) My personally opinion is that GaN on Si devices will be the norm for 4G by the time 4G is developed and SiC RF devices will probably never prevail unless SiC substrate pricing is significantly reduced. Cree seems reasonably positioned in the 3G arena with the UltraRF purchase. However, I bought stock in a SiC monopoly not a Si LDMOS chip maker with lower margins.

SiC power devices, Laser diode, and white LED device Warts

Cree announced it's first SiC schottky offering in July 2001. Cree doesn't expect significant revenues from the schottky device line until next year, and there have been no announcements of design wins to date. Also curious (to me at least) is the fact that Infineon came out with SiC schottky's before Cree could. Why? Is Infineon better than Cree at device epitaxy? Did they get lucky? Did they just throw a ton more money at the device in R&D? Now IXYS introduced SiC schottky's. We don't know if they make their own or package others (Infineon or Cree's). Cree acknowledges that IXYS probably uses Cree's SiC. (Since Cree claims 90% of the SiC market we may have guessed that anyway.) Additionally, Libra has found threads from British and French researchers who've demonstrated SiC schottky's and intend to transfer that technology to industry.

On the Fool thread, Libra (PermaSleuth) recently dug up some information that subsequently and ultimately brought to light the fact that stacking fault problems in SiC material dashed the near term hopes of ABB to get into the SiC power device business. Now the as yet unanswered question is; will Cree's, Infineon's, and IXYS' SiC power devices suffer from shortened life expectancies too? If not, will the knowledge of the potential problem delay implementation of SiC schottky power devices into product design wins?

Technically, the laser hasn't even been announced as a commercially viable device yet. (Although I personally believe Cree is sandbagging for some unknown reason.) Also, even if the laser were announced tomorrow with no market currently in existence for the device it could be a year or longer before Cree would recognize significant revenues.

White LED's. Cree indicates in it's 2001 annual report that general illumination market penetration isn't expected for several years. (paraphrased). Although I expect that Xbright will initiate niche general illumination penetration, the grand daddy of all potential LED markets... General lighting must wait for brighter chips and lower costs. Cree will in all probability get there, but almost certainly not in the next few quarters.

To answer the question of where is Cree's revenue growth going to come from in the next six months? One gets the feeling Swoboda's guidance of 0 - 6% for the next six months was realistic. Did Cree factor an anemic global economy into the equation?

Legal Warts.

Cree's legal costs have been rising as a result of increasing litigation with Nichia. If Cree loses any of these suits LED sales to Asian customers have the potential to plummet. Sumitomo is a large customer, I would hate to see Cree lose Sumitomo because of legal issues. I believe we can expect lawsuits against Nitronex in the future, and Sterling (if they survive, and thrive). So it would seem elevated legal bills will be part and parcel of increased SG&A expenses for years to come. In fact, maybe current expenditures should be considered ground level reference from now on.

Accounting Warts.

At this point I'm convinced Tinker's recent argument has some merit. That is, some portion of Cree's price decline is due to confidence deflation created by related party deals (some aggressive accounting). These issues left Cree open to attacks from hedge funds. Cree/MVIS, Cree/CTHR, and Cree purchasing sales with SPCT flags were all raised by short sellers and the subsequent resulting orchestrated negative media blitz. The fact that Cree was acting in all cases in Cree's best interest was ignored and perception became more important. These doubts coupled with slowing earnings, and a bursting market bubble resulted in a dramatic stock price decline.

IMHO confidence issues have been exacerbated recently by "Enronitis" which nobody at Cree could have seen coming. IMHO the fact that Cree's CEO wasn't plainly candid about Osram's deferral in the Q2 2002 CC initially created the perception that Cree wasn't completely forthcoming about a material development. The fact that Cree's stock dropped on high volume the day the 10Q came out is a reflection of how aware Cree investors weren't of the Osram deferral. That communications breakdown IMHO was a direct result of Mr. Swoboda's not wanting to communicate bad news clearly with investors during the conference call. How much confidence can I have that in the future will Mr. Swoboda be completely candid regarding business' hiccups? I don't believe for an instant Cree is concealing anything in SEC filings much less anything on an "Enron" scale. However, Enron has sensitized investors and like it or not, Cree has, in the past, had some needless flags waving in the breeze. Hopefully Cree's management will learn to avoid situations that create these kinds of problems.

I'm not aware of any other significant issues facing Cree, aside from normal issues such as marketing strategies, to package or not, R&D decisions, etc. Actually, upon consideration Cree has many issues to deal with besides having to create recipes from scratch with some of the worlds most difficult cooking ingredients. Swoboda's going to earn his money. :o))

Cree's beauty marks. Now that I've almost talked myself into selling my eight shares let's look at why I invested so heavily (for me) to begin with. (If anyone is still reading I promise this will be shorter and sweeter).

Economic beauty marks...

When the economy was expanding and the Nitride LED device demand was expanding such that Cree was literally doing everything it could to get as much product out the door as possible. Profits grew. However, since there was great pressure on Cree to get product out, there would be pressure to reduce equipment resources available to R&D. R&D is the future lifeblood for Cree. Additionally, Cree probably wasn't able to effectively implement process improvements to improve yields and efficiencies. The economic slowdown has allowed Cree to ramp-up R&D and implement process improvements. In the last two quarters we've observed several new devices, and Cree's margins have improved as well. Cree has taken advantage of the economic slowdown and continued to invest in infrastructure development. When the economy turns around Cree is superbly positioned to take advantage. With LED production that can migrate to 3" when Cree requires that level of production, hundreds of trained personnel available, and a hundred thousand square feet of extra plant space available Cree will improve margins even further when production ramps up as economy of scale improves.

Material beauty.

Despite increasing competition in SiC Cree retains a commanding lead in SiC material characterization. Even if competitors do happen to gain a foothold in the SiC material market, the increasing need for electronics to operate in environments consisting of: radiation, high temperature levels, current and/or voltage densities exceeding the capabilities of Si, or switching frequencies higher than Si devices can achieve, market should develop into a massive market. Increasing competitors simply validate the market and improve the odds of Cree's ultimate success. Even though SiC is by all accounts a difficult material to work with, the promise of improved devices means the material is too good to be ignored. Indeed, characterization of the material is improving and micropipe free material is expected within a few years by It will be interesting to see if Cree's SiC someday ends up in Tanks as armor. Half the weight and twice the strength.

Beautiful Devices.

Those lovely LEDs.

Regarding Cree's LEDs I think it's all been said many times so I'll just hit the broad strokes. In the last year Cree's made great improvements in LED brightness. Cree now sports a wide range of nitride LED products, the lowest cost, the brightest chips, the smallest chips, the only vertical structure, the only ESD rating, etc. Prototypes of Cree's new Power Chip were displayed at the annual meeting. If the pricing is competitive, flashlights are an immediate market for this device. An automobile market application for headlights doesn't seem out of the question either. (Or perhaps several XBrights since they're more efficient). Cree's increasing brightness levels and decreasing price per mw will ultimately open new applications whether or not the economy turns around. This won't happen overnight. I think the migration of lighting to LEDs is as inexorable as the movement of the tide. It's just that the migration to LEDs won't be quite as predictable. :o))

The Nitride LED market is expected to grow at a long term rate of around 20%. (Once the economy turns. eh?). If Cree's devices maintain only Cree's current position in that market Cree's growth rate will be quite respectable. However, I believe Cree will increasingly penetrate new applications and increase its share of the market. Add in Cree's increasing margins as scale of economy factors improve and we could see greater than 50% margins.

SiC power devices.

Cree hasn't even announced a design win for it's SiC schottky's yet and already there are three other companies competing with Cree to sell the devices. (Well... technically just two since MSCC doesn't sell the same amp rated models as Cree). I think the important thing is that it's clear to multiple companies that SiC schottky diodes have a profitable role to fill in industry. There are other potential competitors as well. IRF indicates they will have devices in the next year or two, and the aforementioned British and French research efforts. Rather than being alarmed by the already stiff competition I'm encouraged. Cree thrives in competition. Additionally, I suspect the stacking fault issues that created life expectancy problems for ABB have probably been solved or these companies wouldn't all be in the game. The market for these devices is potentially in the billions of dollars a year. Whereas LEDs are in the pennies apiece, SiC schottky's should be in the dollars apiece. When design wins are finally achieved revenues will ramp in an exponential manner for some time. If margins can be maintained in the 50% range EPS increases will be exponential as well.

As with nitride LED sales inevitably increasing, I believe that in the years to come SiC power devices will inevitably take away a large market from Si devices. It won't happen overnight but it WILL happen.

Beautiful Blue Laser

In the next year Cree's going to be one of three or four companies that can produce a commercially viable blue laser. I believe Cree will hookup with Rohm and should command a sizeable share of whatever market develops for the blue laser. As with power devices, blue laser diodes will be in the dollars per device and when significant revenues do finally begin, Cree's EPS growth will again accelerate in the right direction.

Cree's management:

Despite the fact that I've hammered on Swoboda regarding the Osram issue in the last CC, I think Cree's done pretty well with him in a difficult economic climate. Cree's management is making some tough decisions and doing what it should do. Increasing R&D, expanding infrastructure, holding the line on expenses when they can, and strongly protecting Cree's IP. Even Cree's secretiveness, which has been extremely frustrating to me at times, is really to Cree's benefit most of the time. The less Cree's competition knows the better. I believe Cree's management is honest, and ethical and I'm not concerned about Enron type issues. I believe Swoboda will learn something from this last CC.

Considering the above do I stay invested in Cree? Or should I sell?

Initially I invested in Cree for the long haul, because they have, and maintain a near monopoly in SiC, have great margins, diffuse competition, ethical management, several potential markets for diverse type devices that will ultimately be in the billions of dollars each. None of the opportunities have changed except, I believe, SiC RF devices. Which will be great if it happens but I'm not holding my breath.

Cree will have their fair share of these markets. The economy improving will solve many of Cree's current problems. When this happens Cree's stock price will rise. When each of Cree's device lines 'hit" Cree's stock price will rise. I think Cree's management has done a commendable job to date in guiding the company. I believe with current leadership keeping their eye on the ball, Cree will ultimately meet the numerous challenges it faces and be successful. So I've decided my eight shares are staying in the drawer where they belong!


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