News Analysis date published New: 
Friday, September 21, 2012 - 13:00
New Date created: 
Thursday, September 27, 2012 - 06:59
New Date last updated: 
Friday, September 21, 2012 - 13:00

This High-Growth Stock Still Has Plenty of Upside

Friday, September 21, 2012 1:00 PM

As we head into earnings season, this $100,000 Real-Money Portfolio holding, also one of my first picks, is due for an update. The stock has already risen by 19% since I bought it in January, and could have a lot more upside -- if a key investment metric stands up.

I'm taking about LED-lighting manufacturer Cree Inc. (Nasdaq: CREE), which I first profiled here. Back then, I wrote that "though management has laid out plans to get gross margins back above 40% by boosting manufacturing yields and entering niches with firmer pricing, I think it's better to assume this never happens and that gross margins remain stuck below 40%. (They had been above 40% in six of the last eight years.) "

It's simply the nature of this company's growth trajectory.

As Cree pursues more customers, it must compete with an expanding pool of competitors, many of which offer inferior technology and therefore price their products very aggressively. For Cree, the goal is to figure out just how much it can charge -- to reflect the higher quality of its products -- before it starts losing orders to rivals. And lost orders are deadly for a stock like this. After all, Cree has boosted sales at least 14% each of the past five years, and analysts are expecting sales to rise at least that much in fiscal (June) 2013 and again in fiscal 2014.

Yet even as Cree works to meet top-line forecasts, many investors want to see that the company isn't getting too aggressive on pricing, sacrificing gross margins for the sake of the top line. Well, how has Cree fared on that count? Let's look at Cree's gross margins since the prior three quarters before I bought this stock.

Gross margins fell in the company's fiscal second quarter of 2012 to just 34.6%. Yet in the past two quarters, they appear to have firmed up slightly. And that's crucial. As long as gross margins are no longer sliding lower, investors will have reason to trust that management isn't pursuing growth in an unsustainable manner. Instead, management is striking a balance between sales growth and bottom-line results.

Well, almost...

Cree's management understands the need to deliver solid bottom-line results, but the company is still making heavy investments in its infrastructure to handle projected growth in the years to come. For example, Cree spent $143 million on research and development (R&D) efforts in fiscal 2012, and it isn't stepping off the gas now.

As a result, analysts have had to tamp down their profit forecasts to account for high levels of spending. Roughly three months ago, analysts expected Cree to earn around $1.35 a share in fiscal (June) 2013 and around $1.90 a share in fiscal 2014. These forecasts have been trimmed by 10 cents and 20 cents, respectively, during the past three months.

Make no mistake, the next few quarters are crucial for this stock. That's because analysts say Cree's rising sales base -- coupled with stabilized gross margins -- should finally enable earnings per share to start growing at a solid pace. Take a look at Cree's recent earnings per share performance and expectations for the next few quarters.

Cree is expected to announce 2013 fiscal first-quarter results in mid-October. Analysts are currently looking for earnings of 26 cents per share, a 4% increase from the year-ago quarter. More important will be what management has to say about the rest of the fiscal year. Will Cree be on a path for ever-rising earnings per share, as the chart above indicates?

A quick view of Cree's stock chart implies that investors anticipate solid quarterly reports to come. Although the long-term "story" around LED lighting is impressive, Cree is no longer so beaten down that it can afford to deliver sub-par quarters in the near-term.

Risks to Consider: Though Cree has excellent long-term positioning, investors need to brace for any near-term hiccups in this high-growth business model. Shares were hit by profit-taking this summer on just such concerns, before a recent rebound, so investors need to brace for a possible repeat performance.

Action to Take --> If you have a long-term focus, then much of this is noise -- unless Cree's gross margins weaken anew. If you see margins weakening, then it may be wise to lock in profits in this stock, as it will be a sure sign that the commoditization of LED lighting will blunt any secular sales growth Cree may experience.

Yet as along as margins remain stable, this still has the makings of a top-performing stock into mid-decade, by which time adoption of LED lighting should be extremely robust. There are a number of players in the space, but Cree appears to be the technology leader by a considerable margin. How the company parlays its massive levels of R&D into leading-edge product lines will ultimately determine how high this stock can go. Recall that this was a $70 stock less than two years ago. I think it will be quite some time before we ever see that mark again, but if you've got a multi-year time-frame, then this is an upside opportunity to be considered.

The near-term wildcard for Cree is China. The Chinese government is looking to keep rolling out LED lighting, recently awarding contracts to three local suppliers that will be using Cree's technology. That's likely to be the dominant topic of the upcoming conference call. And it's likely to keep this stock in the mid to upper $20s or perhaps bump it into the low $30s during the next three to six months.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC owns shares of CREE in one or more of its “real money” portfolios.