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disappointed on the top line, and disappointed with its revenue outlook for the next quarter, but some analysts are focusing in on the LED lighting leader's decision to pull back on spending as the unexamined wrinkle worth exploring among the Cree earnings details.
In the technology sector, capital spending is always monitored as a sign of management bullishness about demand. The intensity of capital spending in tech can signal when a market is overheated and due for a demand slowdown. Analysts who have long covered the chip sector will reference times during the 1990s when capital spending was out of hand. There have also been times when a tech giant like Intel has beaten on the top line, guided higher, yet also scaled back its capital expenditure plans. In the case of Cree, it accomplished an unholy trinity: reining in spending, on top of printing the disappointing revenue numbers.
Is the Cree pull back in spending a tell from the LED leader's management that demand is weaker than expected, and weaker in its core general illumination market? Cree was cagey, or in the least a little vague, in its explanation on the earnings conference call. Cree said that it was not reducing its "strategic cap ex," which would remain at $150 million. The company is only reducing its "variable cap ex." To be specific, Cree had previously projected cap ex for 2011 of $300 million, and is now saying cap ex will be in the range of $250 million to $260 million.
Specifically, Cree said on the earnings conference call, "As we look out for the whole year, we have strategic cap ex at $150 million, but as we look right now at where we are in terms of total revenue in the short-term and the slowdown in chips, we realized we can back off a little bit. We have lots of flexibility, although we've taken down cap ex a bit. It's recognition of being further ahead than we thought, and it's an opportunity to go slower."
Cree was asked on the call if it will still reach its capacity target for its XLamp with the cap ex decrease. Cree's answer was, at best, vague: "We still have the ability to do it if we want to. We were probably trying to get further ahead of curve than was obvious to outsiders."
Much of the debate in the past few months that led to a selloff in the LED stocks was predicated on the slowdown in the consumer electronics backlighting market. Cree noted in its earnings that the percentage of its revenue coming from backlighting went down yet again in the quarter, in the range of 6% to 7% of sales. If backlighting has become even less of what was already considered a minor part of the Cree revenue equation, and the opportunity in general lighting is an even larger part of the Cree pie, then why the reversal on capex?
The answer to that question isn't a simple one, and it's the latest in the tug of war between Cree bulls and bears over the immediate future business opportunities. Ask a bear -- and
asked more than one -- and the decision by Cree to drop spending by roughly 15% is a big issue. Ask a Cree bull -- and
did that too -- and the argument from the bears about the Cree capital spending plans is, well, we can't print the words that the Cree bulls used to describe the latest bear argument.
Cree shares are down near 10% since its second earnings disappointment in a row, but there have been a few subpar days for the markets in there also.
In any event, it's worth taking a look at both sides of the capital spending issue as one more way to penetrate the thinking going on inside the management mind of often-evasive, if not outright secretive, LED leader Cree. What follows are the opinions of several analysts covering Cree on both sides of the capital spending debate....
The Bear Case: Hans Mosesmann, Raymond James:
"General lighting over time is a fantastic opportunity, and until recently Cree had been beating and raising, but anyone who covers semis knows that there are cycles that rule this industry. LEDs are a commodity just like memory and will go through oversupply and undersupply. Cree has very good technology, maybe the best in the world, but if no one else can touch their market, why are they reducing cap ex?
"It's because if they see a disaster coming, why add to the glut? Why add to the problem? The issue, though, is that this implies the growth opportunity is not as big in general illumination as Cree believed. It can't be reduced to the old debate about the glut in the television backlighting market, because that should not have been a significant part of Cree capex anyway. Cree LED use in the display market was less than 10% and down again in the quarter and presumably will be insignificant a year from now.
"Cree is bringing down cap ex because there are issues with the lighting market, and that's a tough admission for Cree. The Street is still too high on revenue and Cree says something slightly different each time, but at the end of the day from the perspective of the semiconductor industry, when you bring cap ex down it's a bearish signal about the demand perspective. That's what spooks investors. It's not the kiss of death, but from a company as bullish as Cree, it tells the analysts that the company has been shaken by what's happening.
"Nobody, bear or bull, would have predicted Cree cutting cap ex. Cree can argue, and provide compelling reasons, why early next year things will recover, but when you cut spending it means that you are less optimistic over the mid- to longer-term, possibly over two to three years. Something happened and they don't need as much production. There's more bad news to come rather than better news, and when things do come back it will be tougher for Cree, with a lot more capacity flooding the general illumination market.
"For me, to bring down cap ex is the proof. Cree blinked. You can't cut spending and say with a straight face you have the same bullish vision as you had a quarter ago."
The Bull Case: Andrew Huang, Sterne Agee:
"Cree is the most vertically integrated LED company in the world. No one outside of Cree knows where they are adding capacity. Is it in silicon carbide or LED MOCVD equipment? No one has an idea where it's being added by Cree. Directionally, it doesn't look good that Cree is cutting back on spending plans, but if you look back to 2007, every year Cree is doubling or tripling XLamp capacity, every year going off a higher base level.
"Yes, that one line from the conference call sounds very iffy, when Cree responded to my question about meeting XLamp capacity goals this year even with the spending decrease. 'If we want to do it,' Cree said. But remember, Cree is aware that competitors are listening in to their earnings calls, so they don't want to be too specific. I don't think the iffy answer was a sign that Cree won't meet the XLamp target.
"If you look back to 2010, Cree spending was $169 million, and now they are still spending $250 million to $260 million in 2011. The bears will say there's not enough demand, but I see it as Cree planning prudently. It's a lot easier for them to maintain gross margin and operating margin targets with less capacity than more.
"Let's look at chip capacity. When Cree adds chip capacity, they can make more to sell on the open market, or they can use more chips to put into XLamps. So I think the implication of lower cap ex is that Cree plans to sell less chips into the open market. It sounds like a big deal, but on an average sales price (ASP) basis, chips sell for dimes to a dollar, whereas the XLamp is north of a dollar. The lower cap ex reflects less need for merchant chip capacity. It's not a reflection that LED component demand slowing.
"This earnings was an incremental negative, but with all the sell side guys downgrading and cutting estimates, the bar is lowered for Cree. I went from a price target of $112 to $82. The reset is not surprising. The question is what happens going forward.
"I think Cree was intentionally vague because they still believe backlighting demand will return in late 2011 and they want to keep their options open."
The Bear Case: Bill Ong, Merriman Curhan Ford:
"I don't think the negative market reaction to Cree earnings was related to the capex decrease, but if demand is that good, why is capex down? To put capex into perspective, look at traditional tech companies in the 90s, when Intel kept saying business was strong and they were spending, spending, spending, and then they slowed down. It's an indicator and a response to weakened end markets and the revenue coming down. If revenue is strong and margins solid, why would Cree need to dial back on spending?
"With a company as difficult to get inside as Cree, from their point of view they can make the argument that the capex decline is within 'internal' noise levels that outsiders can't understand, but these guys threw a number out there, going up from $150 million to $300 million and now they are scaling back, so they had the expectation of doing $300 million and now it's $250 million.
"Some change has taken place. If it was simply internal noise -- that's fine -- but giving capex guidance is no different from giving earnings or revenue guidance. If you're Cree, you can't say the capex target is within the 'noise range.' They could have come out with another number a year ago, and said 'let us give you a wide number that hasn't been fine-tuned,' but they came out with number and there is inherent meaning in it. That said, I still rank the capex decline as third or fourth on the list in terms of incremental negatives in the Cree earnings.
"To play devil's advocate, it could be that they are doing a better job of efficiency with their equipment, but then why didn't they have stronger revenue and stronger demand offsetting the lower capex? I remember with Intel back in the 90s times when they cut capex but top line growth was still strong. They just got more efficient. That's a better stance, but at the end of day, we don't know what's going on inside Cree. If the top line is slowing and they are seeing inventory issues, it has to influence a decision on the spending rate.
"They are doing the right thing, gearing down on capex. Why have supply run ahead? They made a number of macro comments that were incrementally negative. What's not clear on China is if it is slowing on a macro level, or is pricing competition slowing top line growth for Cree, representing a potential loss of market share and a tougher fight ahead. Companies may not be able to compete with Cree on a lumens per watt basis in general lighting, but they can compete on pricing."
The Bull Case: Dale Pfau, Cantor Fitzgerald:
"This issue is a canard and amounts to no more than noise generated by timing of when equipment is received, and Cree's fiscal year being different from the calendar year. That affects when they allocate spending. Cree allocated almost $200 million in spending last year."
"The major factor here is that Cree has been tremendously successful increasing yield, and as they move forward all the capital equipment they purchase can be converted and utilized more efficiently. Investors seemed to miss in the earnings that Cree margins are holding up well, and a reason is that Cree has been tremendously successful at improving yields. I think the yield improvements are better than they themselves anticipated.
"It's simple. If you are improving yield percentage you don't need to bring on as much equipment. Add up timing issues, yield improvements, and conversion of existing equipment, and a $50 million decrease in spending is not a big deal. I wouldn't read anything into it.
"With Cree, look over the past five quarters at the sequential growth rates. What we can say for sure is that Cree no longer has accelerating revenue growth. So there's a breather here. It's not one homogeneous market out there for general illumination. Each niche will grow in fits and starts, and it's such an early stage of growth you can't quite predict what's going on in any one quarter.
"There aren't any cracks in the bull thesis, but there are near-term issues that provide fuel to those counting street lights in China or talking to Cree competitors."
-- Written by Eric Rosenbaum from New York.
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