Category Archives: LED

We wrote an article titled "It's a Matter of Economics, Cree is Overpriced" back in early June. The purpose of that article was not urging investors to short Cree or the market but to observe what happen to company with overly optimistic expectations. We felt that Cree (CREE) was a perfect case in point. So where are we with CREE?

Yesterday Cree reported earnings that exceeded expectations but revenue guidance missed the consensus view. As a result, UBS analyst took the target price down to $64 from $83. The target price of $83 was reached in April and since the stock has been trading in $60 and $75 range.

The data looks good for Cree. Revenue rose 79% year-over-year while earnings per share exploded 348%! Operating margin expanded to 25.9% from 19.7% mentioned in the last article. These are amazing figures but how is it possible that such a great quarter shares could be down more than 10%?  Possible explanation is that all the good news have been discounted into the stock as suggested by Dow Theory.

Another piece of interesting data to support our argument was from the equipment side of the LED market. We mentioned that Kulicke & Soffa (KLIC) had a tremendous amount of booking (equipment orders) from the LED side of the market. Prior to that, they didn't have any business in that segment. Additional data point came another research firm, Displaybank, which claimed that the Blue LED capacity is to double. The equipments mentioned are the Metal-Organic Chemical Vapor Deposition (MOCVD) systems which is the primary method of depositing film onto wafers in the LED making process. The front-end of the market (depositing films) has now confirmed with back-end (assembly).

The up-trend was established beginning December 2008. As the market (Dow Jones Industrial Average) made a lower-low in March of 2009, Cree held above their December 2008 low pointing to a sustained rally. Through out 2009 and the most of 2010, it held above the 50 days moving average and 200 days moving average. The collapse in price today established an opening price below the 200 days moving average which we use as a long-term trend of the stock.

Today's fallout of Cree could simply be just another pull back then resume the rally. We're not quite so sure. At this rate, we wouldn't touch it with a 10-foot pole. Once again, we don't encourage shorting. Shares of Cree could easily move back to $80 as it retraces the old high. The purpose is to point out the obvious fact that when things are rosy and analyst are upping their forecasts inflating the P/E, investors should be looking for the exit sign. The macro view of margin contraction and entrance of competition are nature of business which affect the micro view in the long run. The short run of the stock market could be anything but the long run are often determined by value. After the fall of today, Cree trailing P/E will be around 35, much lower than 60 we observed in June. Even if earning exploded, multiple (P/E) contraction will be the key to share price going forward.

A stock that we’ve been watching closely is Cree Incorporated (CREE) which is a U.S. based developer and manufacturer of light emitting diode [LED] products and other types of compound semiconductors. We've been following this stock since the price was in the mid-$40 range and the P/E was in excess of 50.

CREE recently touched a high of $83 and has pulled back to the $70 range. The P/E ratio has expanded to 60 with the expectation that earning will rise 154% in 2010 (from average estimates on 6/3/10 by $0.66 to $1.68) and followed by a rise of 37% that is expected in 2011 (from $1.68 to $2.30). On a forward earnings basis, stock looks reasonably price at 30 times next year earnings. The caveat here is that it is based on next year earnings.

Competitors
Today’s article from The Wall Street Journal titled "LED's Bright Prospects Could Dim", reaffirmed our thinking of what was the hot company / market in 2009 could become the cold one in the not too distant future. Currently, CREE has a healthy operating margin of 19.7% while the industry's margin sits at around 8.22%. The key is question is, will CREE be able to protect its competitor from creeping into its margins? Our answer to that is, it is only a matter of time before competitors start crowding into the market in pursuit of the healthy margins. Some of competitors are Lumileds (Philips), Sharp, Nichia, Toyoda Gosei, Taiwan Semiconductor  (TSM), and many smaller companies in China.

The talk of competition is where things get pretty interesting. Seeing the fat margins that are ripe for the picking, Kulicke & Soffa (KLIC) ), a $500 million market cap company that sells assembly equipment seems to be getting in the game. KLIC is one of the largest companies in their market. What's important is KLIC serves as a leading indicator for the chip industry, LED included. KLIC’s most recent earnings report provided great insight into the state of their backlog. Increasing backlog is an important indicator because it typically leads to excess inventory. Increased inventory leads to a possible contraction of profit margins.

Below is the breakdown of the current and historical backlog for KLIC:

• 2010 - $132,000
• 2009 - $15,000
• 2008 - $73,000
• 2007 - $59,000
• 2006 - $60,000
• 2005 - $62,000

If you take the average of the last six years, the backlog is $66,833. Taking the average of 2005 - 2008 (excluding the extremes), we get $63,500. In both cases, the recent surge to $132,000 is extraordinary. This is caused by KLIC trying to rebuild inventory after depleting it during the credit crisis. Adjusting for the extreme situation, our calculations show that the backlog in 2010 is up by 97.5% from the average of the last 6 years and 108% above the average excluding the extremes.

Additionally, Kulike & Soffa isn't your typical LED equipment supplier as noted by the CEO:

The other point I guess I'd make is that in the 2007-2008 peak we had no LED business. So the LED business is all incremental to that.

This tells us that LED makers are going the last mile to make LEDs. Kulicke & Soffa is also expanding their product offerings so we could be completely wrong in that respect. Regardless, the capacity build up is real. Here's another statement from the CEO from the conference call:

When I look at how we've got bonders allocated in the current quarter and into the future, we're seeing a big spike in LED bonders above those levels. So there is a lot of good things happening in terms of stories. And the other thing about the LED again is that that seems more like a secular story than a cyclical story; it should have longer legs to it.

The bullish tone is great for Kulicke & Soffa but doesn't bode well for CREE.

Technical Picture

The important part is that earnings haven't improved materially over the intervening period. Current earnings of $1 is still below the 2005 mark but the price has moved well out of proportion to the historical norm. If the stock can get above $105 with good support from earnings, then the stock is off to the race on the upside. Although we can't imagine anymore upside without calling it a bubble based on the chart.

Bottom Line
We think CREE is overpriced and we point it out not as a short selling opportunity but as an observation. CREE has the tone of a growth stock with expanding multiples (P/E) coming to an end. Some of what we have explained above may be more complicated than it needs to be. If so, a simple way to look at it is that CREE trades at more than 60 times its current earnings, very expensive by any standard. They will probably face more competition in the coming years if not months. As a result, profit margins should diminish. This will eventually lead to lower earnings that will likely lead to (all things being equal) a drastic decline in the stock price.