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Will the Bleeding End for Cree, LED Stocks?

Cree leads LED lighting stocks lower again on Wednesday, and it's not at all clear that the bleeding for the sector is done yet.

(Cree, LED lighting stocks story updated for bearish Cree options trading)



) -- The outlook for LED lighting sector stocks, including industry bellwethers


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dimmed a bit this week.

There were a spate of negative reports on the inventory build-up in the LCD flat-panel television sector on Wednesday, sparking a new negative read-through for companies linked to the LED supply chain for flat panel TV backlighting.

Industry consultant iSuppli was out with a report showing high inventory levels in the LCD market. The iSuppli data was one data point among a raft of negative numbers in a

Wall Street Journal

report on Wednesday detailing the bleak conditions among LCD TV makers, with utilization cuts coming from companies in the market. Weak demand in Europe and the U.S., a much-anticipated (but never to occur) surge in World Cup television buying, and an inventory backlog of six to nine weeks in July, were all mentioned in the



Boston-based securities firm Avian Securities downgraded Veeco and Aixtron to neutral, citing the same higher inventory in the LCD space and weak consumer spending.

If it seems like the sudden flood of negative news for the LED lighting stocks that sell into the LCD TV market came out of nowhere on Wednesday, it didn't. In fact, reports about the LCD inventory build-up and a looming rationalization of supply of LEDs for the TV market have been bandied about for months already. Veeco and CREE slumped by near double-digit percentage margins on Wednesday, and Aixtron declined as well, but it's just the latest selling pressure on these shares.

Since August 9, Cree shares are down by more than $22. In the case of Cree, its recent lowering of revenue guidance for the September-end quarter exerted specific pressure on shares.

Veeco shares are down $12 since early August.

Of course, August was a tough month for the markets in general, but more concerning for these LED stocks is that they've been on a downward trend since reaching year-to-date highs in April.

Bill Ong, an analyst at Merriman Curhan Ford said that the Wednesday selling action was pretty late in the game for those in-the-know about the LED sector. This doesn't mean Ong thinks stocks like Cree and Veeco won't fall any lower before the cyclical slide is over -- indeed, he thinks they will sink more -- but the analyst thinks that the unraveling in the LED sector has to be seen as beginning earlier, and lasting longer.

Ong noted that Cree hasn't tried to hide the fact that the LCD market is a trouble spot. In fact, Cree management acknowledged at a Citigroup conference on Tuesday weakness in the backlighting market, and cited the factor as a headwind in its earnings and revenue guidance.

>>Cree Selloff is the Beginning, not end of Debate

For Ong, the continued slide in shares of the LED stocks, most notably Cree, shouldn't send the message to investors that it is finally time to buy up the depressed shares, at least not yet anyway.

For Cree bulls, like analyst Theodore O'Neill of Wunderlich Securities, the Cree bears are once again trotting out the same old tired arguments about the LED company, focusing on the 10% of its business tied to the flat-screen TV market, and not its growth prospects in the general lighting market as energy efficiency efforts increase.

Wunderlich's O'Neill noted that at less than 10% of Cree earnings, even if the LCD backlighting market went to zero overnight, that's at most 10% of Cree earnings.

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O'Neill argues that focusing on the much smaller portion of the Cree story tied to the TV market leads investors astray. "A fraction of these TVs are backlit with LEDs, and a smaller fraction of these are CREE, but people put two and two together. I think it's entirely misguided and it's an out-of-date view of Cree, linking it to a commodity product, as opposed to energy efficiency and lighting," the Wunderlich analyst said.

O'Neill is far from alone among Cree bulls. There are at least three analysts with price targets on Cree of $100 or more. On Wednesday, Cree was nearing the $50 mark. Whether Cree is a buy or sell may come down to an investor's time horizon.

Merriman's Ong, who is at a hold on Cree, says Cree can in fact reach $100 a share, but whether that happens one year or five years from now is anybody's guess, and the pressure on the shares will continue in the near-term.

The Merriman analyst says that the LED shares are still coming down from nosebleed levels of growth achieved in the sudden surge of LCD backlit TVs at the beginning of the year, and that process may bottom with the upcoming earnings, or sometime next year. In particular, with Cree missing the Street expectation for revenue guidance in the September-end quarter, there's a good chance that its upcoming earnings will exert additional pressure on Cree shares.

Some numbers provided by Merriman Curhan Ford suggest that, at least in the immediate future, the LED market could have some growing pains. Cree's market cap reached as high as $8 billion this year, whereas Merriman Curhan Ford projects a total LED global sales level of $7.4 billion this year.

Revenue growth for Aixtron reached 150%, while Cree's revenue growth reached 66%. These are the type of nosebleed numbers that Merriman's Ong says can't be sustained for a group of stocks that trade together and that are being hit by an inventory-triggered cyclical downturn.

In the case of Cree, investors remain concerned that as the LCD TV market dries up, more and more competition from LED companies will flood the general lighting market, putting greater pressure on Cree. Currently, only 10% of Cree's earnings power is competing with these players, but the other 90% of Cree earnings could be threatened if more and more LED players abandon the LCD glut. "That level of uncertainty would weigh on Cree shares," Ong says. It already has, before the latest news on Wednesday.

On a longer-term basis, the migration to LED general lighting should in fact be a positive for Cree, but for investors playing growth stocks in a cyclical downturn, the longer-term stories are not necessarily entry points to buy stocks. For these investors, Cree may have to get through the near-term issues, and provide some confidence on how the general lighting market is playing out, before investors feel that the cloud has lifted.

With the slide in the value of all shares in recent months, the basic question for investors can be boiled down to whether the data points are likely to be positive or negative for the next three months. When the cycle hits right, like in any technology space, the group of LED stocks all trade higher as a basket. With the current oversupply, margin pressure and valuations that, at least in the immediate future, could dip even lower based on the huge run up earlier this year, the time may not yet be right to bet on these stocks again charging ahead.

Hans Mosesmann, an analyst at Raymond James who has covered Cree for years, says that the question for investors regarding the "relatively richly valued CREE" is related to the following question: is the current inventory adjustment in LED TVs a single quarter adjustment (as implied by management in the most recent earnings call) or multi-quarter in nature?

Mosesmann wrote in a research note on Wednesday, "We tend to view the current LED TV dynamic as multi-quarter from a supply chain perspective given the massive amounts of equipment capacity being added in China."

The Raymond James analyst thinks Cree won't have problems with its September quarter guidance. However, Mosesman wrote that it is "increasingly difficult to believe that Cree will be able to meet the 7% consensus sales growth for the December quarter and 4% consensus sales growth for the March quarter. Expectations are still too high, in our opinion, and with the prospects of potential downward revisions, the shares appear vulnerable to us."

"I can see getting more positive on Cree next year, but I can't say whether it will be in January or June," said Ong. "Cree won't be heading south indefinitely, but my guess is that after its upcoming earnings call it resets, and investors start to view these cyclical names in a more positive light in 2011," the analyst added.

Wunderlich's O'Neill says that thinking of Cree in terms of the LCD TV backlighting market isn't the full extent of the outdated thinking about the LED stock. In fact, the analyst argues that thinking of Cree as being tied to the cyclical ups and downs in the semiconductor sector is a theory that is running out of support. It may be correct for right now, but it's a trading dynamic set to change sooner rather than later.

The Wunderlich analyst conceded that in the next six to 12 months, there is a fair chance of a traditional cyclical slowdown in semiconductors. What's more, O'Neill says that analysis of Cree trading patterns show that the stock has moved in line with the sentiment in the semiconductor space.

Wunderlich Securities' analysis of Cree's quarterly revenue data from 2006 to 2010 shows what the analyst described as a remarkably high correlation between Cree revenue and semiconductor sales. Still, Wunderlich estimates the percentage of LED-backlit LCD monitors and televisions as 12% of the market, and if the business were to disappear, it would impact Cree's EPS by less than a dime.

The larger argument for Cree bulls is that beginning in 2012 incandescentlight bulbs will no longer be sold in the U.S., and LED lights are poised to become the standard replacement. For all the bearish talk that the future for Cree is uncertain, the Wunderlich analyst says that this sea change in lighting is just 15 months away. Home Depot (HD-NR) is already carrying Cree lighting products and Cree-equipped lighting. In this scenario, Cree is no longer a semi-linked stock -- rather, Cree revenue will become more closely correlated with consumer staples.

If that's to the reason for Cree's rise in the long-term, the consumer staples argument for Cree wasn't holding sway on Thursday and Friday, as Cree shares kept heading lower, slipping below the $50 mark. Cree wasn't just down on Thursday; it's trading volume was also twice its daily average.

Options trading analysis also indicated that the bleeding in Cree shares might not immediately end. An analysis by


showed Thursday's Cree option volume at more than three times the average and almost 2:1 in favor of the puts. In one October put trade referenced, the net cost of $1.14 is the maximum risk in the trade and would be lost if Cree is above $45 at expiration. If shares are below $40, the maximum gain of $3.86 would be realized. The only other time this year Cree saw the $40 level was on the way up to its high of $83.

The options web site wrote it's possible that some of the action was a protective trade on a long stock position, but that would seem to be a very limited hedge, leading to the conclusion that the Cree action on Thursday was a straight bearish bet.

>>Cree Draws Bearish Options Trade

-- Written by Eric Rosenbaum from New York.


>>Cree Selloff is the Beginning, not end of Debate

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