Tuesday, January 10 2012

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Looking for stocks with big upside potential and limited downside risk? David Sterman delivers.

Two decades as an investment expert, including a Senior Analyst position at Smith Barney and Director of Research for Individual Investor. Appearances on CNBC and Bloomberg TV. Hundreds of thousands of readers each month. StreetAuthority.com's most popular analyst identifies attractively valued companies with the potential to jump 50% or more.

I'm Spending $7,000 on my Latest Stock Idea

(** Please note that this is a premium service, but it is currently free for a limited time.  For more info on this, please read the note in yellow at the bottom of this newsletter.)

I like to strike while the iron is hot. That's why I've wasted no time committing cash from my $100,000 real-money portfolio in short order.

To recap...

I bought $12,500 worth of Ford Motor (NYSE: F), which I think is poised for great things in 2012, thanks to fresh car designs, a burgeoning cash balance and rebounding demand for automobiles.

I committed a smaller stake to my second pick, Alcoa (NYSE: AA), just before the aluminum maker released year-end results and issued an outlook for 2012. [You can read my take here.]

But sometimes, it pays to wait.

I wanted to parse Alcoa's results and confirm my opinion that investors would begin to look forward to the company's brightening prospects after digesting the earnings release. It looks like they're doing just that, which is why I plan to buy an additional 700 shares on Thursday, Jan. 12.

My third pick, Zoltek (Nasdaq: ZOLT), is also off to a strong start, bringing readers a quick gain so fast that it ran up roughly 10% before I was able to take my stake. (Remember, I give you at least two days' notice before I make a buy for my portfolio.) So I'm waiting to build my position on pullbacks in the stock.

It's been a fun ride so far, and I expect a lot more excitement to come. If you haven't already, I encourage you to sign up for these portfolio ideas to be delivered to your inbox as soon as they're published.

Now for my latest idea...

There's been a great deal of anger over an Obama administration decision to phase out the use of incandescent light bulbs. Some see it as a needless exercise in government intrusion into our lives, limiting our choices. Yet these same people also want to see us cut our dependence on foreign oil, especially from countries that we would rather not have to cozy up to.

Though government-mandated changes can be annoying when it involves items we have been using all of our lives, this policy change should be a welcome one.

Why's that?

Because one of the best ways to cut out energy use is to get rid of those incandescent bulbs, which date back to Thomas Edison's heyday. The fact that these bulbs are too hot to touch when lit tells you that much of their energy is being wasted in the form of heat. In contrast, LED bulbs make so much sense. They're very energy-efficient and can last years. The upfront cost, at roughly five times the price, is a bit hard to swallow. But consumers see a payback in terms of energy savings within just a few months. Eliminating the need to frequently buy replacement bulbs only heightens the Return on Investment (R.O.I.).

I have been focusing readers' attention on Cree Research (Nasdaq: CREE), the undisputed leader in the global field of LED lighting. The stock garnered a great deal of buzz as 2011 began, trading above $65. Six months later, the stock had fallen by half, for reasons I'll explain in a moment, and I predicted better days ahead as the company's long-term outlook remains really promising.

Well, investors continued to focus on an admittedly challenging short-term picture, and in these uncertain times, they decided that the long-term upside would have to wait. Shares now trade even lower, 70% off their 52-week high.

With such pessimism built in to this stock, I think a contrarian take is essential.

The greatest headwind for Cree has been industry. Rivals flooded the market, leading to falling prices and profit margins, and rising inventories.

Take a look at Cree's numbers over the last four quarters.

Sales got off to a slow start last year, falling 15% sequentially in the first quarter, and they've rebounded at a slower pace than management expected. As a result, inventories surged, which led to price cuts that crushed margins. The problem is still being resolved. At the end of the most recent quarter, Cree had more than 100 days' worth of inventory on hand, which is far too much for a just-in-time business.

In my view, the future direction of this stock will hinge on how these numbers trend.

More recent signs are promising. For example, based on current sales run rates, gross margins should flatten in the quarter that just ended and rise roughly 0.5% during each of the next two quarters. That's not due to an expected firming in pricing but rather a lowered cost of manufacturing. Equally important, output has been throttled back. And though inventory may not drop sharply in the December 2011 quarter, it should steadily trend down in coming quarters, thanks to rising demand and flat production.

The reversal of these metrics are a key reason to focus on this stock now.

Perhaps the most promising data point is that China, which accounts for 40% of Cree's revenue, apparently embarked on a year-end budget flush, placing fairly large orders for LED lights in December. That removes a key risk for this stock, as December quarter results are now likely to meet or exceed current forecasts. (Cree has slightly trailed forecasts in three of the last four quarters.)

With an eye toward capital preservation, I didn't want to own this stock on the cusp of earnings season if I thought a subpar quarter was imminent. Cree will release fiscal second-quarter results on Tuesday, Jan.17.

Make no mistake, this will always be an industry marked by price declines, as rising volume sparks greater competition. One industry study, conducted by analysts at Needham, predicts demand for LED lights will grow 90% a year for the next five years. But industry sales will only rise 38% annually as price cuts take a bite out of revenue.

The question for us is how much of that growth is captured by Cree? And what kind of profit margins can the company garner?

On the first question, Cree should surely benefit from an expanding pie. Analysts expect the company to boost sales roughly 25% in each of the next two fiscal years, culminating in a sales base of $1.55 billion by fiscal (June) 2013. I think 20% growth would be a prudent expectation, just because the company hasn't lived up recent expectations (though it surely did for a number of years before 2011).

And 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.)

I may be too bearish here. Cree is working on a raft of technology tweaks that will extend its lead against many other LED lighting makers. That's the payoff of an R&D effort that by some estimates has been as large as the rest of the industry -- combined.

Bearish or not, I expect results to be good -- not great -- in coming quarters. Yet I think this is stock is vastly oversold.

To be sure, Cree isn't a stock to own for near-term results. It may look quite cheap at just 12 times consensus fiscal (June) 2013 forecasts of around $1.80 a share. But I want to take a much more cautious stance, anticipating per share profits of just $1.50. That puts the forward multiple at around 14. Still, not bad...

The downside protection --> This company was valued at $8 billion a year ago and is now valued at just $2.5 billion. Back out the company's $600 million in net cash, and the enterprise value slips under $2 billion, roughly half of what the sales base may look like by 2014 or 2015.

The upside triggers --> As noted above, a reversal of deteriorating quarterly trends on the income statement and balance sheet is the most solid catalyst. Once that happens, investors can again focus on the bright long-term view. Note that sales came in under $500 million in fiscal (June) 2008, almost hit $1 billion in fiscal 2011, and could approach $2 billion by the middle of the decade.

Assuming gross margins in the low 30s, earnings could hit $4 a share by then. That's the way this stock was once viewed back in early 2011 when it hit almost $70, and that's the way it should again be viewed. It may take some time for sentiment to reverse, but the powerful macro trends underpinning demand for LED lighting will eventually determine this stock's fate. At a recent $21, the upside looks too good to pass up.

Action to Take --> As a solid core holding, I am allotting 300 shares (or roughly $7,000) to this stock. I'll make the trade on Thursday, Jan. 12 and will adjust the position after glimpsing at the next quarter's gross margin and inventory figures.


$100,000 Portfolio

This is a portfolio for investors seeking upside without a huge degree of risk. I actually buy and sell each pick in a real brokerage account, funded with $100,000 cash. And I'll always give you 48 hours advance notice before buying or selling any security, giving you plenty of time to beat me to the punch.

Previous $100,000 Portfolio Issues:

Why I'm Spending $12,500 on this American Powerhouse
I'm Adding Another Holding to my $100,000 Real-Money Portfolio
A Third Pick for my $100,000 Real-Money Portfolio
Portfolio Update: Too Much, Too Soon

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In the meantime, please enjoy "David Sterman's $100,000 Portfolio."  This newsletter will remain 100% free for the next few months, and we'll give you plenty of advance notice before we make any changes to this service.

Good Investing,

David Sterman
Chief Strategist -- $100,000 Portfolio

Disclosure: StreetAuthority owns shares of Ford in one of its "real money" portfolios. In accordance with company policies, StreetAuthority always provides readers with at least 48 hours advance notice before buying or selling any securities in any "real money" model portfolio.

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