Cree's Light Is Shining

With a strong market for its high-brightness LEDs, the company will continue growing, despite competition from Asia, says S&P

In Standard & Poor's view, advanced semiconductor company Cree (CREE ; recent price, $25) will benefit from technological improvements in product and manufacturing-process technology that will allow it to address multiple new markets, each of which has the potential to grow significantly larger than the markets it currently serves.

We believe Cree will succeed in increasing revenues, earnings, and free cash flow at rates substantially above the rate of growth in the global economy, the semiconductor industry, and the markets that use its products. Cree can accomplish this via further penetration of existing markets and entry into new ones, which will be made possible by the product and manufacturing advancements we expect the company to achieve over the coming years.

MANY APPLICATIONS. In addition, its debt-free balance sheet and significant cash and investments provide a measure of safety, in our opinion, that the company can carry out an aggressive planned expansion program to tap these market opportunities. Given our view of promising growth potential and attractive valuation, we have a 5-STARS (strong buy) recommendation on the shares.

Cree develops and manufactures semiconductor materials and devices composed of silicon carbide, gallium nitride, and other related compounds. These materials have physical and electrical properties superior to those of silicon chips, which enable them to operate at higher temperatures, voltages, and power levels.

In fiscal 2005, ended June, product sales derived primarily from the sale of light-emitting diode (LED) chips and packaged LEDs for use in a wide variety of lighting applications, such as in automobiles, wireless handheld devices, and consumer appliances and electronics. LEDs accounted for 83% of revenues in fiscal 2005, and unit shipments rose 53% over fiscal 2003.

COLORWAVE OF THE FUTURE. LED chips come in three brightness ranges: standard, mid-brightness, and high brightness. High-brightness LED chips, made in green and blue -- and convertible into white light if combined with phosphors -- are suitable for a greater number of applications than mid- and standard-brightness LEDs. Such applications include backlighting for full-color liquid-crystal displays and camera flashes.

High-brightness LEDs have provided most of the growth in LED shipments in recent years, increasing to 59% of LED revenue in fiscal 2005, from 49% in fiscal 2004 and 35% in fiscal 2003. The majority of the remainder of LED revenues is now derived from mid-brightness products, with standard products used for very low-cost applications such as indicator lights on appliances.

Development of high-brightness LEDs continued in fiscal 2005. Cree has pursued an initiative to develop a backlighting solution, branded Colorwave, for large-size LCDs used in flat-screen computer monitors and TVs. The new backlighting solution would consume less power than other LED and traditional compact fluorescent backlighting. As the reduction in power consumption would eliminate the need for a cooling system, it would allow manufacturers to build thinner monitors and reduce costs.

DIAMOND-LIKE We think this would represent a substantial market opportunity for Cree, and expect significant progress in calendar 2006, with likely initial revenue contributions from sales of Colorwave chips in the first half of fiscal 2007.

Cree has also made substantial progress in the development of high-power packaged LEDs intended as a substitute for general and incandescent lighting. Sales of high-power packaged LEDs constituted less than 1% of revenue in fiscal 2005, as the company seeks the right combination of reliability, performance, and cost. Development also continues on near-ultraviolet lasers for use in next-generation optical disk drives and data-storage applications.

In addition, Cree makes power devices and transistors for radio frequency and microwave applications made from SiC, as well as from silicon. SiC wafers and bulk materials are sold to other electronics manufacturers and for gemstone applications, due to SiC's properties similar to diamonds.

KEEPING IT CONFIDENTIAL. Together, these products accounted for about 10% of fiscal 2005 revenue. Cree also receives revenue (6%) from research and development contracts with various U.S. government agencies to modify, enhance, or otherwise build upon, its intellectual-property base.

Cree's intellectual-property portfolio as of July, 2005, consisted of 284 owned or licensed patents, as well as significant trade secrets and manufacturing know-how in the making of advanced SiC materials. Its North Carolina facilities closely guard this know-how.

The company competes with numerous other businesses, primarily Asian, which make LED chips and alternative lighting solutions. We believe Cree's chip design and manufacturing process know-how are enabling it to successfully compete on both quality and price against these competitors.

BRANCHING OUT. The diverse customer base to which Cree sells includes a number of key distributors and customers. Among them are Sumitomo (SMTOY ) in Japan (41% of fiscal 2005 revenue), which represents sales to about 20 leading Japanese companies, and OSRAM Opto Semiconductors (11%).

Cree is preparing for substantial growth at its North Carolina base, with the construction of an additional 150,000-square-foot facility on its 48-acre Durham site, and the early 2005 purchase of a 228,650-square-foot facility in Research Triangle Park. Operations have not yet commenced at this site. Capital expenditures were $142 million in fiscal 2005, and are targeted at $90 million to $100 million in fiscal 2006.

Operations of the Cree microwave segment, centered in Sunnyvale, Calif., are winding down, with plans to cease manufacturing silicon-based products there by December, 2005. We think the elimination of substantial losses from this unit will provide a boost to financial results beginning in the second half of fiscal 2006.

SLOWER THAN USUAL. We belief the market opportunities cited here are potentially significantly larger than Cree's current scale of operations. In recent years, growth has largely stemmed from market penetration of the keypad and small LCD-display backlighting market, primarily in wireless device handsets.

As is often the case with a company undergoing a transition from one growth phase to the next, financial results during the transition do not always remain as steady as before. The process can unnerve investors accustomed to consistent growth, which we believe is now the case with Cree.

For fiscal 2006, we expect revenues to increase 20%, to $467 million, the slowest rate of growth in four years. We expect the LED product mix to continue shifting to higher brightness products.

CUTTING COSTS. We expect gross margin to approximate 50%, with the first half of the year lower due to inclusion of costs for the windup of the microwave segment, and the second half somewhat higher than 50%.

Average selling price will likely drop a typical 15% to 25%, in our view. We believe reductions in production costs of a similar amount are likely, with more production of chips using larger wafers and higher production yields accounting for significant cost gains.

We are projecting a 21% increase in company-funded research and development (exclusive of contract services costs) to support ongoing product development. Selling, general, and administrative (SG&A) expense is expected to rise 7.5%.

ORDERS GALORE. Beginning this fiscal year, Cree has included the costs of equity-based compensation in its financial statements. We estimate such costs (allocated to the appropriate expense category -- cost of goods sold, R&D, SG&A) will total about $11.5 million.

In fiscal 2007, outlook is for 25% revenue growth, steady gross margins, and some overhead savings from shutting down the microwave segment. Our EPS estimate is $1.65.

Cree entered fiscal 2006 with an order backlog of $303 million, including $74 million of long-term government contracts, of which $245 million was expected to be recognized in fiscal 2006.

RETIREMENT-PLAN FACTOR. In recent quarters, the company has turned over its inventory about every 50 to 60 days; although inventory has turned over faster in the past, lower levels of inventory may have resulted in lost sales, in our view.

Receivables, as of Sept. 30, 2005, represented 39 days sales outstanding, a level we view as satisfactory. Cash, investments and marketable securities totaled $322 million as of Sept. 30, and the company had no outstanding debt.

Cree expenses equity-based compensation and does not sponsor a defined benefit retirement plan. Hence, S&P Core Earnings in fiscal 2006 are identical to as-reported earnings. We estimate equity-based compensation will total $11.5 million, or about $0.10 a share, in fiscal 2006.

NOT WITHOUT RISK. Outstanding stock options as of June, 2005, equaled 15% of outstanding common shares, which we view as toward the high end for all public companies, but average for technology concerns. Stock-option grants in fiscal 2005 of 1.9 million amounted to 2.6% of outstanding shares. The company currently has a share-repurchase authorization for up to 5.5 million shares to partly offset potential dilution from stock-option exercises.

Our 12-month target price is $35. We use discounted cash-flow analysis as our primary valuation methodology for Cree. In our analysis, we have incorporated our view that Cree has superior growth potential over a multiyear period, but we have also assumed a fairly high risk premium to arrive at a net present value of the cash flows implied by that growth. This suggests the high-reward potential we see in the shares carries high risk.

Our target price values the stock at 22 times our calendar 2006 EPS estimate of $1.58 and at 6.7 times revenues, which we believe is reflective of Cree's strong fundamentals relative to its peer group. At our target price, the p-e ratios based on our estimated EPS for fiscal 2006 and fiscal 2007 are 27 times and 21 times, respectively, which we view as similar to the peer group.

CFO'S DEPARTURE. We regard Cree's governance practices as similar to other companies its size -- and substantially better than a peer group of semiconductor companies. Two notable drawbacks, in our view, are that the CEO and chairman positions are currently combined, and that a poison-pill anti-takeover provision with a trigger of less than 20% is in place.

Cree's CFO, Cynthia Merrell, has announced her intention to leave the company for personal reasons. The selection of a new CFO entails a small amount of uncertainty for investors.

In addition to general macroeconomic and systemic market risks, we see risks to our recommendation and target price from more intense pricing competition from Asian-based LED manufacturers; higher-than-expected legal costs to enforce patent rights against competitors who may infringe on Cree's intellectual property; disruptions in production and higher-than-expected costs from changes and expansion of manufacturing capacity; and an inability to achieve adequate production yields in the manufacture of products based on new technology and processes.

READER COMMENTS

Analyst Basham follows shares of emerging growth companies for Standard & Poor's Equity Research Services

All of the views expressed in this research report accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is or will be, directly or indirectly related to the specific recommendations or views expressed in this research report.
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