It's pretty rare for a company at the leading edge of an emerging technology to have a smooth growth trajectory, and LED leader Cree (Nasdaq:CREE) has certainly had a few wobbles over the years. That said, Cree has established itself as one of the “Big Five” LED chip companies, one of the three major integrated LED lighting companies, and a leader in patents and technologies. Couple that with a greater than 10-year run of positive free cash flow and it's not hard to see why Cree is a go-to name for growth investors.
 
That popularity comes with a cost, though. It's exceedingly rare to see a company's stock rise more than 150% in 12 months and still have modest expectations and/or an undemanding valuation attached. Given that margins are a pressing concern with Cree and the company's guidance for the next quarter looked light, it's not too surprising to see the shares indicated down in pre-market trading.

SEE: Measuring Company Efficiency
 
Lighting Ramping Up
For a company still looking forward to the big adoption of LED lighting, Cree continues to report strong growth. Revenue rose 22% this quarter (up 7% sequentially), just slightly below the average of sell-side estimates. LED product revenue rose almost 18%, with lighting product revenue up 33%. Power and RF product revenue rose 14%.
 
Margins also continue to benefit from increasing volume. Gross margin rose almost three points from the year-ago quarter, though a shift towards bulbs and fixtures hurt the sequential comparison (down more than half a point). Operating income more than tripled from the year-ago level and rose sequentially by a third.
 
Reactions To Guidance Seem A Bit Extreme
Cree committed a cardinal sin of growth stocks – management lowered sequential guidance – and the Street is poised to punish the stock harshly. Although I think the valuation and expectations for Cree have climbed into the nose-bleed zone, this reaction still seems a little extreme.
 
On the top line, the new guidance is less than 2% below the prior average. Management guided to a sequential improvement in gross margin (about one point on a GAAP and non-GAAP basis). While the bottom-line number is about 10% lower than the prior estimate, it looks like a higher tax rate is going to be playing a part in that and the Street is often willing to ignore estimate changes tied to taxes.
 
Long Term Outlook A Balancing Act Between Technology, Integration, And Competition
It's hard not to respect the technology and the degree of vertical integration Cree has achieved in the LED space. The issue that concerns me, though, is how that will translate into long-term market share and profitability.
 
In a relatively short period of time, I expect to see a host of Asian suppliers (including Nichia and Epistar) ramp up their production of LED chips for the lighting market, and my concern is that the same flood of supply that rocked the solar market will reoccur here. If that happens, and chip prices erode quickly, it will certainly help consumer adoption, but I worry that it will leave companies like Eaton (NYSE:ETN), Acuity (NYSE:AYI), and GE (NYSE:GE) in a better position in compete in the lighting and fixture end market and take out at least some of Cree's integration-based competitive advantages.
 
On the other hand, Cree has done a good job of lowering its own chip costs (including the newer SC-squared chip) and the lighting market is large enough to support several players. What's more, Philips (NYSE:PHG) and Osram are in the less enviable position of trying to maintain their historical position in a lighting business that is shifting under their feet while Cree is looking to carve out share with its own proprietary technology and products.
 
The Bottom Line
As a go-to stock for investors looking to play the LED lighting trend, it's no surprise that Cree appears overvalued relative to its likely growth prospects. Just to get to the indicated pre-market price, you have to be willing to project more than a 17% free cash flow CAGR for a decade, and while that may not be an outlandish target, it really doesn't leave much room for any stumbles or disappointment.
 
Disclosure – At the time of writing, the author did not own shares of any company mentioned in this article.
 

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