What's the Price of CREE?
Cree is a semiconductor manufacturer headquartered in the Raleigh-Durham Metro region of North Carolina. They are primarily known for producing light-emitting diodes or “LEDs” as most people probably know them. Cree also makes power and radio frequency (RF) products, but most of their sales and most of their potential comes from the LED sphere.
LEDs have many advantages over incandescent bulbs (what you might call our “traditional electric lighting source”) and even over fluorescent bulbs that are rapidly gaining acceptance in with consumers. For starters, they are more energy-efficient than both requiring a lesser amount of watts to produce the same amount of light. They also have a longer useful life at an estimated 35,000 to 50,000 hours. Fluorescent lights are comparable on lifespan at 30,000 hours, but incandescent lag far behind at roughly 1,000 to 2,000 hours. LEDs are also more difficult to damage than fluorescents and incandescent bulbs due to their solid state. Finally, one of the major advantages for LEDs over fluorescents is that LEDs do not contain mercury.
On the downside, LEDs have higher up-front capital costs associated with them. This is partially offset by the fact that over their life cycle, they can be cheaper than incandescent bulbs and halogen sources and have similar costs to fluorescents. There are also some health concerns that might potentially be associated with blue-light LEDs. However most of this seems to be limited to certain poorly designed LEDs and it does not appear to be much of an issue at the moment.
The reason for much of the investor interest in LEDs is that many believe they could eventually become the predominant form of lighting; at the very least, many believe they’ll gain in popularity significantly over the next decade or so. Indeed, Cree is doing a lot of work to try to promote LEDs as a general lighting solution. They’ve started the “LED City” initiative, which promotes the deployment of LED lighting in municipal infrastructure. There’s also the similar “LED Workplace” initiative which promotes LED lighting for businesses. I mention these because they give insight into the end-goal: to make LEDs a mainstream lighting product.
The major obstacle to Cree and other LED makers is cost. LEDs still have a way to go before they will definitively beat out fluorescent lighting and the “sticker shock” from the up-front costs will have to be lessened before general consumers ever begin considering it. But the potential is definitely there for LEDs to transform the lighting industry and Cree is one of the companies at the forefront.
If Cree is an interesting company to consider owning stock in, it’s also a difficult company to value. For one, no one really knows how much the LED lighting industry will grow, how profitably it will eventually be, or how long it will take for it to reach any goals. Then there’s also the fact that it’s a semiconductor stock and as with most semiconductor companies, there is constant margin pressure due to competition. Cree is certainly not exempt as their margins have continually been squeezed over the last few years. Just to make matters more confusing, you can get radically different results when trying to evaluate Cree’s financials using different approaches. But we shall give it a shot all the same. I’ve analyzed Cree a few different ways: Earnings and P/Es
Let’s start with the simplest method of evaluation and examine Cree’s earnings so we can get a trailing price-to-earnings (P/E) ratio. Only, as it turns out, using the trailing P/E as a guide isn’t all that simple with Cree. I always use Diluted Earnings Per Share (DEPS) rather than the more traditional Earnings Per Share (EPS) under the rationale that if you are buying a stock, you are doing so because you believe it will perform well --- and if it performs well, people who hold various forms of options will probably exercise them. I also tend to ignore Discontinued Operations since it will not have any predictable effect on future profitability. With these rules in mind, we’ll first examine DEPS from Continuing Operations (after-tax) for Cree. This yields the following results per share:
2008 – $0.36
2007 – 0.63
2006 – 1.02
2005 – 1.18
The trend clearly seems to be that the earnings are moving downward over time. Based on 2005 earnings, the stock might’ve looked like quite a bargain at $27, which would give it a P/E ratio of 22.9 (low for a high-growth company). However, based on 2008, it looks to be quite the opposite and the stock has a whopping P/E of 75!
Looking over the Income Statement, one thing that sticks out to me is that a substantial portion of Cree’s earnings are coming from “financial income”, which is not a very good indicator of future prospects. So let’s look at DEPS only from Operations --- I want to see post-tax results but in order to do that, I need to come up with an imaginary tax rate --- looking at Cree’s past and having some knowledge of their business, I think something between 25-30% would be reasonable for a good year. I take the low-end and go with 26%. With that measurement, earnings drop considerably in the prior two fiscal years:
2008 – $0.10
2007 – 0.15
2006 – 0.90
2005 – 1.10
Based on that, the stock looks like a horrible deal at $27! That’s a trailing P/E of 270! While this seems like a more accurate way to look at Cree’s profits and future prospects, there is one big issue. Looking at Cree’s Cash Flow Statement, I notice that while they aren’t exactly raking in huge profits on the Income Statement, their Cash Flows from Operations are substantially higher. The major culprit is the Deprecation charge, which in the most recent Fiscal Year (2008), is roughly 20% of revenues! This makes sense due to the fact that Cree probably planned to make major up-front investments and earn their profits later on; however, the depreciation charges will be spread out over the life of the property on their Income Statement, causing some distortion.
I came up with two quickie methods to attack this problem. I didn’t want to go through an entire Discounted Cash Flows valuation, but I did calculate DEPS based on the Free Cash Flows (“Cash Flows from Operations” minus “adjustments for Capital Expenditures”). Based on this, I get the following DEPS figures:
2008 - $0.55
2007 – 0.36
2006 – 0.96
2005 – 0.45
Suddenly things don’t look quite as bad. It would appear that the Income Statement distorts things a bit. Still, using FY ’08, that yields a P/E of 49. Much less scary, but not necessarily a blinking light telling me to BUY, BUY, BUY!
We’ll make one last evaluation using trailing P/E. I look at EBITDA (Earnings Before Income Taxes, Depreciation, and Amortization) but then add back Income Taxes based on our imaginary tax rate from before (26%). This yields the following DEPS:
2008 – $0.89
2007 – 0.84
2006 – 0.76
2005 – 0.03
And now things don’t look so bad. We end up with a trailing P/E of 30 which isn’t too shabby for a company that may very well be on a high-growth track. Also, while evaluating this company using trailing P/E seems to be difficult, we do learn that their fundamentals appear to be much stronger than a shallow look at their earnings might indicate and the dips in earnings appear to be very misleading.
Trailing P/E often ends up being a bad method to evaluate high-growth companies and companies with inconsistent earnings as is evidence by our wildly varying results. The next thing we’ll do is use what I call the “Future P/E method” where we try to forecast forward to more of a steady state and try to gage a reasonable P/E at the end of the forecast horizon. From this, I’ll try to come up with a trading range.
I decide to use three forecasts. Forecast #1 strictly goes by margins, growth rates, and other figures I calculated while trying to spot trends. I make virtually no assumptions about their future growth prospects in that forecast --- I simply mechanically forecast forward with the current norms. Forecast #2 assumes an increasing level of revenue growth --- this seems to be the trend and it’s reasonable to assume they will continue to grow faster as LEDs catch on more. However, aside from that, I change little from the first forecast. Forecast #3 assumes the stronger revenue growth as well, but also assumes that Cree will increase their margins in the future, which isn’t necessarily supported by the current trends.
We look at DEPS from Continuing Operations again and get the following results --- Forecast #1: No Changes in Market
2009 - $0.21
2010 – 0.25
2011 – 0.30
Assuming the stock trades at a P/E ratio around 25-35 at the end of 2011, that would give us a trading range of $7.50 to 10.50. However, while this forecast is a little bit useful, it does seem particularly unlikely to me. Forecast #2: Stronger Revenue Growth
For this forecast, I assume 5.5% revenue growth for 2009, 7.0% for ’10, and 9.0% for ’11:
2009 - $0.22
2010 – 0.29
2011 – 0.45
Using our established P/E ratio, we have a trading range around $11.25 to 15.75 at the end of ’11. Forecast #3: Stronger Revenue Growth plus Better Margins
2009 – $0.28
2010 – 0.50
2011 – 0.92
Using our P/E ratio again, we end up with a trading range of $23.00 – 32.20.
With a current price of $27, only Scenario #3 makes this stock look moderately appealing and even that only yields a 19.3% return over a 3 year period. Not that much for a stock that many consider “speculative” in nature.
However, using these forecasts alone probably undervalues the stock due to the high growth prospects well into the future. But it is difficult to account for those, except by taking a guess as to how much the “potential” is worth. Other Important Information
Cree is considered a “speculative stock” by many. Tom Konrad, a blogger from Alternative Energy Stocks even included it on his “Top 10 Speculative Stock" picks at the beginning of this year. Cree is a bit different from most companies in the “speculative stock” category, however, in that they are already making fairly healthy profits. There’s not much of a fear of waking up and seeing Cree stock drop to 0!
All the same, it’s difficult to come up with a realistic valuation of them because it’s anyone’s guess as to when, where, and if LEDs will start to experience explosive growth. Maybe it takes 5 years. Maybe it takes 10 years. Maybe it takes 15 years. Certainly, there’s reason to be impressed by Cree’s efforts but until prices come down, LEDs aren’t going to break through. And if a competitors prices go down more quickly than Cree’s do, margins could get destroyed regardless.
Since the expectations for growth seem to be built into the price, the stock is somewhat of a risk. Simply take a look at our first forecast to see what might occur in the future! At the same time, my growth scenario did not assume much dramatic growth into the future. The main problem is that it’s difficult to forecast 8 years into the future and pretend that those forecasts provide any meaningful data. Using our higher growth scenarios, however, we could easily see how Cree could grow to $40 or $50 range in 5 years. The main point here is that you’re basically taking a stab in the dark as to whether LEDs will take off soon if you’re buying into Cree.
In good news, however, Cree’s lower earnings look to be somewhat deceptive. The company’s cash flows are in very strong shape in actuality. When you ignore depreciation and amortization, this company looks as if it’s raking in a considerably larger amount of dough than many might believe. These cash flows can be a good predictor for the future, but we still don’t want to buy an overpriced stock burdened with too many expectations. The Case for Cree
The case in favor of Cree is that LEDs are the most energy-efficient lighting solution and will gain in popularity in an age where the environment and energy savings are becoming issues of colossal importance! We’re already seeing GE’s fluorescent energy-saving bulbs making major in-roads with consumers. Maybe LEDs are next. In fact, LEDs could change the way we think about lighting. Given their life span, it seems possible that they’ll simply be installed upon construction and a home owner will only rarely have to worry about replacement.
Cree is a leader in this field and has one of the best reputations in the industry. The company seems well-run enough and there’s constant chatter about larger companies trying to buy them out, which could drive up the stock price much higher, as well. Couple all that with the strong cash flows Cree is bringing in and you can make the argument that this stock is underpriced and could take off in the next half-decade or so. Don’t expect this thing to go through the roof and make five-fold earnings in the next decade, but one could make a pretty good return on CREE all the same. The Case against Cree
Despite strong cash flows, Cree’s margins are getting squeezed, an indication of tougher competition. Moreover, despite the great growth prospects for LEDs and their potential ability to transform lighting, take a look at some other semiconductor stocks to see what can happen in this industry. Spansion (SPSN) sold at $18 a few years ago and now trades at $1.60. Micron (MU) traded at $70 and now trades just above $4. Qimonda AG (QI) sold at $18 around the time of its IPO and now is below $2 with the prospects of having to sell off to Micron being discussed.
None of this is to suggest that LEDs will ever be as commoditized as DRAM or NAND Flash memory, but it is a reminder of the fact that simply having a cutting-edge technology isn’t necessarily enough to thrive in the semiconductor sector. Even with explosive revenue growth, Cree might simply trade sideways due to tightening margins. Plus, in the $25-27 price range, it looks like there might be a lot of room to go down. As a downside risk, there’s no reason this thing can’t drop to the $8-10 range at some point in time. Concluding Analysis
CREE is a tempting stock to look at, but given the risk level, I’d wait for a lower price than the market is currently offering. I briefly bought in during the middle of the year, before taking a nominal profit on it in order to buy into something with bigger upside. Given my analysis of Cree’s financials and going on my gut instincts, I’d suggest that this becomes a “Buy” target under $20 and a “Hold” till maybe $25. At the current price range ($25-28), there simply does not seem to be enough upside to offset the risk in my own mind. However, I would love to hear a dissenting opinion who thinks it’s justified even at $27. As somewhat of an educated stab in the dark, I’d go with a 3-year target price in the $28-32 range.