Former Tech Highflyer Looks Like a Screaming Bargain

I’ll bet Charles Swoboda would like Wall Street to make up its mind. Over the past few years, the investment community has repeatedly shifted its view of his company, Cree (NASDAQ: CREE). 

Four years ago, many were convinced that Cree was on the cusp of explosive growth thanks to its strong position in the LED market. Shares briefly moved above $70 in December 2010. Yet, investors soon soured on the stock after realizing that, while the LED business would indeed be huge, it was not necessarily very profitable. Within a year, shares plunged to just above $20. 

Then, a string of good quarters pushed CREE right back up to its prior highs by summer 2013. But once again, shares are in freefall, recently touching a 20-month low.

CREE Stock Chart

To be sure, it was never clear that this stock deserved to trade above $70. As I noted roughly a year ago on our sister site, StreetAuthority.com, “Analysts have been continually forecasting margin gains as Cree more fully utilizes its manufacturing capacity, but so far, that’s just not happening.”

A look at the company’s gross margins reveals a business that is feeling the heat of competition and tough pricing.

CREE Profit Margins

While gross margins are unlikely to rebound, analysts’ earnings models now reflect such a reality. This should mean shares are no longer vulnerable to false hopes that Cree’s results will improve through economies scale. They won’t, at least regarding gross margins.

There’s another side to the margin performance. Cree isn’t making as much money on each LED product as it once hoped, but it sure is selling a lot of them. Back in fiscal (June) 2011, Cree had yet to generate $1 billion in annual sales. In the current fiscal year (which began in July), sales are expected to exceed $1.8 billion and rise another 15% in fiscal 2016 to around $2.1 billion.

#-ad_banner-#

To be sure, management’s decision to lower fiscal first-quarter sales guidance last week sets the stage for a stagnant fiscal year. Per-share profits are likely to be flat, thanks in large part to a lull in global demand for LED lighting and other products. 

With a veil of pessimism hanging over this stock, it’s worth noting that the encroachment of LEDs into all kinds of markets is just getting started. 

Automakers, for example, have begun to replace traditional bulbs with LEDs thanks to their longevity and energy efficiency. Architects are using LEDs in their designs to open up a wide range of new lighting schemes to mimic the effect of ambient daylight (i.e., bulbs can be programmed to change hue at various times). Municipalities around the world are saving loads of money by swapping out old street lights for new LED lights. 

Sure, Cree has gross margin challenges, but it can make it up on volume.

Analysts at Merrill Lynch, even as they model for ongoing weakness in gross margins, think sales leverage will boost operating margins from around 8% in fiscal 2014 to 11% by fiscal 2016. By then, they estimate Cree should be throwing off $300 million in annual free cash flow. 

Let’s put that figure in the context of Cree’s current market value. After a multi-quarter pullback, Cree sports a market value of about $3.9 billion and around $2.8 billion on an enterprise value basis (thanks to the company’s $1.15 billion net cash position). 

That means that CREE trades for less than 10 times projected fiscal 2016 free cash flow, which is often the kind of multiple you see on a stock that has zero growth prospects. Cree, on the other hand, is a proven grower, even if the current fiscal year is proving a bit challenging. 

Investors may also be overlooking the fact that Cree possesses a vast trove of intellectual property. It has spent over $500 million on research and development over the past three years. The company licenses its patents and also pursues any rival that infringes on its intellectual property. Cree’s patent base ensures it will stay on the industry’s leading edge.

Make no mistake, it was hard to justify a $70 share price a year ago, as that led to lofty forward multiples that couldn’t be sustained. Yet investors appear to have overshot the mark again, and the recent sell-off puts CREE back into the bargain bin. 

The key for this stock is for management to give a sense that recently lowered guidance has created a floor for expectations. Another clear catalyst: Management may look to sharply bolster the current $300 million share buyback program, which has been in place since spring. 

Cree is scheduled to announce fiscal first-quarter results on Oct. 21. As long as investors expect a resumption in sales and profit growth later in the fiscal year (and in fiscal 2016), then bottom fishers will likely start to build positions. 

I look for shares to trade back up to around 25 times projected fiscal 2016 EPS of $1.90, translating into a share price of $47.

Recommended Trade Setup:

— Buy CREE at the market price
— Set stop-loss at $28
— Set initial price target at $47 for a potential 48% gain in six months