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Cree Selloff Is the Beginning, Not the End, of the Debate

Cree shares dive on its earnings, but even Cree bears say debate about the future of the LED market leader won't be decided today.



) -- The huge sell-off in shares of


(CREE) - Get Cree, Inc. Report

on Wednesday -- a decline of more than 13% at midday -- isn't the beginning of the end for the LED market leader. The selloff is simply another day in the battle that for years has divided the Cree bulls from the bears. In fact, even some of Cree's biggest naysayers think that a final verdict on the future direction of Cree shares can't be gauged from the big beating the market is handing to Cree on Wednesday.

It's not that nothing has changed as a result of the Cree after-market earnings report from Tuesday. Cree beat the Street in its earnings per share -- 55 cents versus a Street call of 50 cents -- but reported in-line revenue. Most notably, the LED player provided revenue guidance for the coming quarter that was lower than the Street's by $4 million. It might not seem like much, but Cree has been known, and its valuation justified, as a "beat and raise" company.

"It just doesn't cut it," said Merriman Curhan Ford analyst Bill Ong. The Merriman analyst noted that when Cree provided guidance for the quarter, it expected a high-end revenue range of $265 million. It reached that revenue bogey, but it's a bogey that Cree usually beats. "When you see the revenue in line and the miss on guidance, from a company that is supposed to be dominating, it creates uncertainty," Ong said. The uncertainty leads to the question, "Is this as good as it gets for Cree?"

Cree's outperformance, even Cree bears concede, has been rewarded by the Street with some hefty multiples -- the 2010 consensus price to earnings ratio is 47.5 times earnings. The Street sets the bar so high for Cree, in fact, that any sign of weakness can send investors to hit the sell button.

No doubt, some of the Wednesday selling can be attributed to short-term profit taking. Cree had been trading as low as $60 at the beginning of July, before reaching above $70 ahead of its earnings. Therefore, the 13% decline on Wednesday includes some investors who made the decision to book gains, instead of hanging around for a final verdict on Cree shares.

Cree improved revenue sequentially, even as it guided to revenue in the coming quarter that disappointed the Street. Cree had gross margin of 49.5% in the quarter, and guided to gross margin of 48% to 49% again. Nevertheless, the question raised by the in-line Cree revenue in the past quarter, and revenue guidance miss, is if the canary in the LED mine is finally singing for Cree.

"Overdone," is how Wunderlich Securities analyst Theodore O'Neill, a long-time Cree bull, described the big sell-off.

The larger Cree debate dividing the bulls and bear has been, and will continue to be, whether the LED company is on its way to becoming the next poster-child for the commoditization of a once-hot technology market -- and, as such, is an unjustly overvalued company about to be devoured by cheap Asian competition and oversupply. Think

First Solar

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, the U.S. solar market bellwether once valued at over $300, which saw what many judged to be an insurmountable market share and cost advantage steadily eaten into by low cost Chinese solar vendors.

Some Cree bears read the latest results as proof of the challenges ahead for Cree, and a steadily eroding margin profile. Merriman Curhan's Ford, for his part, seized on the weakness in the consumer backlighting business as the canary in the coal mine for Cree.

Cree Stock Rating Report (CREE) Rating and Financial Analysis

Cree said that weakness in the commodity LED backlighting consumer market caused the revenue guidance miss, but that it's a smaller part of Cree's overall business. Yet, Cree bears note that the LED company's management won't break out its revenue profile showing how much of its business is dependent on the consumer backlighting business, versus the illumination business where the threat of commoditization is not as acute, and where Cree sells to lighting players like

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Cree bulls argue that the consumer backlighting business that feeds into consumer electronics display products has already been commoditized, but that trend doesn't impact Cree negatively because of its focus on illumination. There is oversupply in this market, and that's why Cree has pulled back, bringing its factory utilization down to 90% in the current quarter.

There is no reason to flood an oversupplied consumer market with product, the Cree bull arguments runs, when it won't generate the profit margins that Cree is used to generating. This dynamic is the cause for the revenue guidance miss. Still, it's a short-term oversupply situation, and in a market that is not the most important to Cree. Additionally, Wunderlich's O'Neil notes that Cree continues to increase revenue sequentially.

The Cree bears, on the other hand, aren't so sure that the oversupply situation is a one-quarter event, and that the consumer market is as unimportant to Cree as its management -- and the Cree bulls -- would like investors to believe. Hans Mosesmann, Raymond James analyst and a long-time Cree bear, who has covered the company for more than 10 years, noted that the consumer market represents 80% of LED sales. Cree won't break out its revenue profile is because it wouldn't look good for the company.

"Cree is exposed to the consumer market. It may not be 80% of sales, but it is a significant part, and the notion that the oversupply only lasts one quarter, and that Cree is more or less immune, is naïve, and this earnings is the first indication," Mosesmann argues.

Additionally, Cree bears say the focus on the consumer market commoditization obscures the truth of an illumination market that also faces steep competition, even if Cree is the undisputed leader. There are hundreds of players in Asia with Cree in the crosshairs and even if Cree continues to own the high-end of the market, other players will make inroads and there is a ton of capacity coming online. The Chinese, Taiwanese, and Korean players are ramping up and cutting prices. Cree bulls say that this argument is now three years old and Cree has continued to outperform.

>>Cree Shares Tank, Now What?

Even Cree bears believe the market is a long-term growth story, but in the near-term, the increased supply, a slowdown in Cree sales, and an unsure margin profile make Cree the most vulnerable of the LED stocks, specifically because of its outperformance. "How much higher can you go from 50% gross margin? This this as good as it gets for Cree," is the judgment of analyst Bill Ong of Merriman Curhan.

Mosesmann is a Cree bear who concedes a lot to the LED company. "Over the past two years I've been a Cree naysayer and it's been to my regret, so I would not underestimate these guys. Cree will survive this better than most, but if I'm wrong, it's only by a matter of degree. We're going to see multiple compression here," the Raymond James analyst said.

The Raymond James analyst thinks it's reasonable for long-term Cree bears to sit tight, even given the big Wednesday sell-off. "People committed to this story won't even blink," the analyst said. In fact, Mosesmann says that while he believes Cree multiples will continue to depress, those skeptical should hold the stock for a few quarters. In fact, the next few quarters from Cree will be more important than the just-passed quarter, in the opinion of the Raymond James analyst.

"Today is just the ongoing, reasonable debate. Is it a one-off vent or the crack in an area where there could be further weakness for Cree?" the Raymond James analyst asked.

It's not even a question of whether Cree deserves a premium stock price, but how much of a premium. Cree 2011 price-to-earnings ratio consensus is 31 times, versus the 2010 P/E ratio of 47.5 times. At some point, the growth rate has to level off. It's an argument that led investors to back up the truck on Wednesday, and others, like Wunderlich's O'Neill, to pound the table and instruct investors to get in while the getting is good in oversold Cree shares.

-- Written by Eric Rosenbaum from New York.


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