Cree shares fall on analyst downgrade (new version)
Cree's share price fell more than 10% on October 3 after an analyst downgraded the shares from hold to sell.
Jed Dorsheimer of Canaccord Adams also said that rumors of a buyout by GE (see news) were false.
LEDs Magazine spoke with Jed Dorsheimer to understand the reasons behind his actions.
LEDs Magazine: Why downgrade Cree at this time?
JD: I knew that Cree's decision to vertically integrate through the Cotco acquisition would come with some market challenges, as Cree overnight became competitive with the majority of its LED customer base. However, what we did not fully appreciate was the timing and magnitude of the potential impact. Based on my extensive meetings over the past two weeks here in Asia, we now disagree with Cree management's ability to achieve its goal of maintaining flat LED chip sales over the coming quarters.
LM: But aren't power LED lamps the growth engine for Cree?
JD: Yes. In fact given our scenario of declining LED chip sales for Cree, the company will have to ramp these sales to achieve expectations. This caused us to turn towards the company's more strategic packaged power LED business to better understand the growth prospects. If Cree is able to ramp these sales beyond the potential pressures imposed by chip customers moving to second sourcing agreements, then from an external perspective, Cree may be able to successfully grow its business overall .
LM: What are the growth prospects?
JD: We estimate this business to be less than 15% of total sales. Yet, it is perhaps the area that is focused on the most, as it appears as if it will become the strategic growth engine for Cree longer term. These are the half watt and 1W devices, termed XLamp, that are used primarily for specialty and general lighting applications.
Our detailed analysis of Cree's cost structure suggests problems though, which is why we do not feel they will see enough growth to offset the issues in the chip business. Specifically, due to its proprietary SiC substrate technology -- versus traditional methods by Osram, Nichia, and Lumileds that are more acceptable to laser ablated lift-off technology -- confirm Cree's cost structure is currently not as competitive.
LM: Where is the cost issue?
JD: Due to certain processing techniques, specifically the removal of the silicon carbide substrate to increase light output (SiC absorbs light), we believe Cree is experiencing 30-50% lower yields than its peers. In my opinion, this results in XLamp pricing that is 30 to 40% above its competition assuming similar margins. This creates a challenge for Cree to grow both sales and margins in this strategic business in the near term (defined at 6 months to 1 year).
LM: So what does this mean in terms of numbers?
JD: Well, the collective issues facing Cree, in my opinion, will make it difficult for the company to meet the Street's aggressive expectations. Specifically, we see an increased risk to the December quarter (2nd fiscal quarter 2008) and are expecting a miss, which is why we lowered our estimates well below consensus. Our new December expectations are at $108.8M and $0.07 pro-forma EPS versus consensus of $119.6M and $0.10.
LM: Is this a long-term, systemic problem for Cree?
JD: No, I don't think so, and I recognize that my caution is near to medium term (defined as 1 to 2 years). Cree has some of the best scientists in this industry, resulting in solid technology. This is precisely why I set my $18 price target off of tangible book value versus a multiple of earnings - we derive our price target by applying a 2x multiple of tangible book value of roughly $9. However, if we see a 15% performance benefit at a 2x to 3x higher cost, Cree will need to fix this issue to be competitive.
I fully expect that over the long term, Cree will find a way to solve these issues and become more competitive - the question is one of timing. Timing is key, with companies in Asia moving so fast to enter the market. Maintaining market share is valuable for incumbents - these issues may hurt Cree but time will tell. Beyond these transitional and technical issues, I think the greater question Cree will need to reconcile is its high cost center in North Carolina compared to other companies in Asia. Cotco could help this issue longer term.
Jed Dorsheimer made the following disclosures: "I do not own any of Cree shares nor does any family member, My firm has not received any banking revenues or non-banking revenues from Cree in the past 12 months. My firm does make a market in the shares. I serve on the Industry Advisory Boards of two small private companies, Lamina Ceramics and Quanlight."