(Cree earnings, LED market outlook story, updated for Monday trading)

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NEW YORK ( TheStreet) -- The New York Times ran a piece last Friday about a brand new market for LED lights: the teeth of hip Japanese teenagers. Apparently, a few high-tech lab rats in Japan saw an LED light bulb go off above their heads when metal toys known as LED Throwies debuted last year, leading them in a straight line to the latest Japanese fashion accessory craze: the LED Smile. Affix the LED Smile to any set of teenage teeth, and your ordinary youthful grin can be made to glow in a variety of bright colors. Japanese school kids now gather in street parties to show off their glowing LED smiles to the world, as a photo in the New York Times glowingly proves.

In the bread-and-butter world of LED chip and component sales, on the other hand, it was anything but smiles last week, with an earnings disappointment from industry bellwether Cree ( CREE - Get Report) that still has the sector in the doldrums, and has left investors asking when it's going to be safe to come out from hiding.

It's an irony that there's a brand new market inside the mouths of Japanese teenagers for LED lights, since with the way things went for Cree in the last quarter, they may soon be having their direct sales and distribution partners de-camping on the exits of Japanese high schools as a market of last resort for inventory that amassed to its highest level in a decade at the end of the last quarter.

The Cree miss was viewed by many analysts as more significant that other recent disappointments because it was tied to an inventory correction in Cree's core LED component market, and less so tied to conditions in the LED backlighting flat panel display niche, which had been a problem in the previous quarter but represents a much smaller portion of Cree's overall revenue profile.

Cree shares were down 23% last week, and if there is a silver lining, it's that Cree shares still haven't even touched down at their lowest 52-week level. During the Fall of 2010, when the short-term weakness in the LED backlighting market dragged down all the LED stocks, Cree shares fell below the $48 mark. Even after its freefall last week, Cree was still trading above the $51 mark at week's end; however, Cree shares opened lower again on Monday and dipped below the $51 level.

Yet the question -- or really a set of questions -- remain about the inventory correction that caused Cree's big miss and whether a rock-bottoming of Cree shares could still take them lower than the previous low mark.

It's also a gut check time for the entire LED sector, with reports still due out from the LED equipment makers, Veeco Instruments ( VECO - Get Report) and Aixtron ( AIXG, and from the volatile companies like Rubicon Technology ( RBCN - Get Report) in the sapphire substrate space, one of the core raw materials for LED production.

All the LED stocks had been rallying into the Cree earnings, and not surprisingly for the volatile basket-trade friendly LED space, all the LED stocks sold off this week, though nowhere near the level of Cree's decline.

On Monday morning, Aixtron and Veeco were both down between 2% and 3% on relatively heavy morning volume for the stocks.

There were some signs even before the Cree earnings that all was not well in the LED space. In an earnings call last week that was a classic "lost in translation" commentary from a Chinese CEO, SemiLEDs ( LEDS mentioned pricing weakness that led it to disappoint the Street, and after its shares sold off by more than 32%, a guessing game ensued to try and figure out where the LED problems lay. Some contended it was weakness in a niche in which SemiLEDs was reliant for "scrap" LED market revenues, the cell phone LED camera flash segment.

SemiLEDs bulls contend that the CEO comments were misinterpreted, and it was one and the same general weakness in the LED market that would rear its ugly head in the Cree results. Still others, spooked by the Cree miss, speculated that maybe the pricing weakness in the cell phone LED camera flash market was caused by Cree, desperate to move overstocked inventory, looking for any and all outlets for its LED product, except the teeth of Japanese teenagers, which at least as far as we know remains an untapped market for the LED bellwether.

Confusion about end markets and supply/demand dynamics in the LED space remain a short-term trader's best friend and a long-term investor's short-term nightmare. In light of the darkness in the LED space, and the sentiment shift this week, it's time to take a look at the questions embedded in the Cree disappointment that are still open for debate...

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Question 1: Is the street-lamp market in China going to recover as quickly as Cree suggests?

The Cree miss was primarily about the street-lamp market in China not rebounding as quickly as investors and the Street, or Cree, had been modeling.

Last fall, the Chinese government implemented new specifications for the LED street-lamp program and it was seen as a boon to Cree, for no other reason than the new requirements were designed to weed out the worst product, and Cree is inarguably a premium product vendor in the LED space.

Around Thanksgiving, the bullish Street reports on Cree started citing the street-lamp program in China again kicking into high gear. Morgan Keegan, for one, raised Cree to a buy -- after having been bearish on the company for a long while -- and added Cree to its target list of buys. Several analysts cited anecdotal evidence from China that the street lamp buyers were signing contracts again.

Yet what investors learned from Cree in the last week is that if new street-lamp contracts were being signed, the Chinese weren't yet forking over the dollars, and there was an inventory buildup at Cree's distribution partners in China and within its own direct sales inventory. It didn't help that the LED backlighting business remains far from moving at full throttle, but the lack of follow-through on the supposed resurgence of the street-lamp market was the big Cree surprise.

Indeed, since Cree, the Street and investors mostly got it wrong about what was going on in China's street-lamp market in the past quarter, why should Cree be trusted when they say the inventory correction is short-term and the balance will be back to normal by the fourth quarter?

Volatile sectors linked to the semiconductor market like the LED space don't always do the best job of predicting the supply/demand balance at any given time, and the Cree miss was just one more example; the LED space is even more sensitive to supply/demand surprises since it is still in its nascent stage.

Jeff Bencik, analyst at Kaufman Brothers, said that Cree and its distributors are in the inventory destocking process now, and that inherent in that process is the risk that inventory destocking continues for a longer period of time than Cree forecasts. Yet the analyst said that he is willing to give Cree the benefit of the doubt in terms of a true rebound in the street-lamp sales by the fourth quarter, and said a recent meeting he had with a local LED player in China, China Intelligent Lighting & Electronics ( CIL - Get Report) makes him mostly comfortable that the government is continuing to support the LED market.

Even if no one can ever know the exact timing of these things, presumably Cree has a better idea than most, since they are selling into the market and have 40% of their revenue there. True enough, yet Cree didn't exactly know better than most in the past quarter, or else they would not have missed their own revenue guidance low-end by $14 million. "Typically inventory de-stocking is not a one quarter event," the analyst added.

Bill Ong, analyst at Merriman Curhan Ford, noted that this miss was the most disconcerting miss for Cree, from his perspective, and it's troublesome for the LED stocks that the steep slope expected for growth in China isn't happening. "The demand is not happening right now and that's worrisome, and if it takes longer than expected, it's not a patient group of investors in these stocks," Ong said. "When do the Chinese really start to commit the dollars that everyone already thought was happening? We need to at least adjust models for this near-term issue before we move on," the analyst added.

Kaufman Brothers' Bencik also noted that while the Chinese government wants to support the LED market, it doesn't necessarily want to support Cree versus local players -- and that even though Cree is "best of breed," there is increasingly more LED product coming online that meets the new street-lamp specifications. Bencik added, "One question a skeptic would ask right now is, 'Is the slower than expected ramp in the Chinese street-lamp market a delaying tactic by the Chinese government to allow the local competition to get their manufacturing standards up to a competitive level?'"

Mark Heller, analyst at Credit Agricole thinks the street-lighting market should rebound in the next few quarters, but there are no guarantees, and with inventory in the channel already, to say Cree is well represented among suppliers in the market doesn't mean they are going to get all of it. "Obviously, with the Chinese subsidizing LED tool purchases in China, at some point the government pushes to use more local domestic suppliers, but I still think that's more of an intermediate to longer-term threat, whereas the inventory correction is a near term issue," Heller said.

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Question 2: Are the bears now proven right that Cree is no more than a semiconductor commodity stock, and ever more will be?

Curiously -- or maybe not -- there were few major downgrades of Cree after its big miss and with its inventory backup reaching the highest level in a decade. If the Cree bulls were drinking too much of the Cree management Kool-Aid in the past quarter as the company talked about the opportunities in China, the Cree bulls are far from capitulating.

Hans Mosesmann, the Raymond James analyst, has long held a bearish view of Cree based on the thesis that ultimately its premium technology advantage is erased and Cree becomes just another vendor in a market dominated by low-cost Asian manufacturers, the LED version of the solar sector's SunPower.

With another delay in the Chinese street lamp market, the question has to be raised, Could the inventory de-stocking last long enough to overlap with the onslaught of low-cost LED supply and Cree, as a result, be hit by a double whammy? In other words, by the time the general adoption of LED lighting in China is really taking off, its competitors have narrowed the gap enough to alter the competitive equation.

Hans Mosesmann told TheStreet after the Cree miss, "Our view is that even when spending returns in China or elsewhere, there is massive oversupply of LEDs from global players and Asian players as well. The Chinese government will favor local players all things being equal, and in most cases their quality is good enough. If it's not good enough today in some applications, it will in the next several quarters."

The long-time Cree bear added, "The street will struggle with what this all means, with the bulls simplistically throwing up big general lighting numbers as is typical without much mention about supply. In this industry, after the massive subsidies of equipment in the past 15months, we should start looking at this market perhaps in terms of traditional oversupply we see in DRAMs. Not good."

Most analysts, though, even those concerned about how long it takes for the inventory de-stocking to work itself out, don't believe that these two trends will overlap.

Merriman Curhan Ford's Ong said that the next big negative it the pricing learning curve of those closing in on Cree, but that's still at least a 12-month to 18-month timeline. The inventory issue and the pricing war are still two distinct issues.

Kaufman Brothers' Bencik agreed that long-term LED chips are a commodity business, and Cree sees increasing pressure, but he doesn't think Cree's technology advantage in terms of lumens per watt is going away anytime soon. Rather, it's narrowed over a period of years. "Eventually, Cree does become a semiconductor stock, but in near term it still has a two- to three-year significant advantage in technology over competitors," the analyst argued. He added that while pricing is down across the board in the LED space, Cree is bringing down pricing in reaction to that, but it's not yet a compression of its technology premium. "It's not the double whammy yet," Bencik said.

Credit Agricole's Heller noted that the general pricing trend is down and that's good for the LED space: lower pricing means more demand in the classic demand elasticity theory, and Cree has to follow this general pricing curve.

"I don't think the bulls on Cree are giving up yet. They see the secular growth opportunity in LED lighting, and Cree is one of the few ways to play it in the U.S. My view longer term is that this is largely a commoditized market and that longer-term multiples will compress. Ultimately the competitors catch up to Cree."

Yet Heller agrees that Cree still has a year or two lead on the low-cost Asian competition before it is good enough from a technology standpoint to compress Cree's premium beyond the existing pricing-curve pressure.

-- Written by Eric Rosenbaum from New York.


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