Markets & Finance

A Green Light for Cree


By Mark Basham We at Standard & Poor's expect semiconductor maker Cree Inc. (CREE

; recent price, $18) to post superior gains over the next 12 months, as its light-emitting diodes (LED) find their way into a greater number of products. Another reason for our optimism: The primary issues in a lawsuit that had clouded the stock have been dropped or dismissed. Cree carries S&P's highest investment ranking of 5 STARS, or buy.

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

Most of Cree's sales come from its blue, green, and near-ultraviolet (UV) LEDs, used in a wide variety of lighting applications, such as in automobiles, wireless handheld devices, and consumer appliances and electronics. LEDs accounted for 75% of Cree's revenues in fiscal 2003 (ended June).

VALUABLE KNOWHOW. In addition, Cree makes SiC- and silicon-based power devices and transistors for radio and microwave applications. SiC wafers and bulk materials are sold to other electronics manufacturers and for gemstone applications, due to SiC having similar properties to diamonds. Cree also receives revenue from research and development contracts with various U.S. government agencies to modify, enhance, or otherwise build upon its intellectual property (IP) base.

Cree's IP portfolio consists of 207 owned or licensed patents, as well as significant trade secrets and manufacturing knowhow in the making of advanced SiC materials. This knowledge is closely guarded, and visitors are generally not allowed inside Cree's North Carolina facility.

Of note, Cree's toughest competitors are located in Asia, where patent enforcement has met with mixed success. However, recently, a key Asian licensee won a patent-infringement decision against a Taiwanese competitor that had been pressuring prices for Cree LEDs. Our view of this decision is that it's a first, and important, win.

LEDs IN YOUR LAMP? Cree's growth strategy entails increasing penetration in existing markets, improving key product characteristics (such as brighter LEDs) for new markets, and a zealous ongoing drive to lower production costs. We think these points go hand-in-hand, in that lower production costs enable Cree to offer customers better performance compared to price than competing technologies.

Also, successive generations of chips enable Cree to pursue new markets. For example, the majority of LED applications so far have been for display or backlighting. Future generations may enable Cree to enter the potentially much larger market for ambient lighting, now dominated by incandescent lights.

S&P's expectation of a sustained economic recovery into 2004 bodes well for demand for many of the products that use Cree's chips, in our opinion. We expect new generations of Cree LEDs -- Xbright and Xlamp product lines -- to open new markets and increase penetration in existing ones. Consistent reductions in manufacturing costs and increases in yield are likely to allow Cree to follow a "push" strategy into these markets i.e., keeping prices low to tempt customers to switch to its LEDs. Generally, once a customer converts from an older technology to SiC-based Cree products, the decision is very costly to reverse.

NEW OPPORTUNITIES. We believe Cree has made inroads in another market: Power devices. Investors have overlooked its presence here in the past due to its recent entry and relatively low sales level. We believe that Cree has been maintaining and developing this product line while it has operated at a loss. We think sales will reach a level over the next several quarters that could significantly boost profitability. And it represents an important effort by Cree to diversify its product line.

Over several years, we believe the largest new product opportunity for Cree is for near-UV lasers. The primary target markets for these devices (sometimes referred to as blue lasers) are optical disk drives for next-generation DVD and data-storage applications.

LOWER RISK. Over the summer of 2003, issues other than financial performance dominated the news about Cree and were likely a key hindrance for the stock price. These issues involved a lawsuit with company co-founder Eric Hunter, in which he accused Cree of securities fraud and unfair trade practices, among other charges. In early October, a special committee of independent directors reported the results of an investigation in which it failed to find evidence to support any of the allegations. Simultaneously, Hunter dropped the most serious charges of securities fraud and unfair trade practices.

We think concerns about the litigation should be laid to rest and that the stock should be valued on its fundamental merits with no discount for potential litigation risk.

S&P estimates that Cree's revenues will increase 30% in fiscal 2004, with earnings of 62 cents a share, a 35% gain over fiscal 2003. Higher projected revenues result from growth and further penetration of existing markets, as well as sales in new markets. We expect gross margins to widen by approximately 100 basis points, as manufacturing yields improve, more than offsetting declines in average selling prices. We also expect litigation costs to decline significantly. Due to a change in the geographic sales mix, we project the tax rate to increase to 31% from 26%.

FINANCIALLY STRONG. In fiscal 2005, our revenue growth projection is 28%, with another 100-basis-point improvement in gross margins. Margins are likely to also benefit from the absence of litigation costs in the first quarter, particularly compared to fiscal 2004. We expect these margin gains to result in a 42% increase in EPS, to 88 cents.

Standard & Poor's Core Earnings for Cree, which primarily take into account previously unexpensed stock-based compensation, are estimated at 9 cents a share in fiscal 2004 and 31 cents a share in fiscal 2005.

We believe Cree's financial position is strong. As of Sept. 30, it had cash and investments of $195 million and no long-term debt. We expect past investments in additional manufacturing capacity as well as ongoing yield improvement will enable it to reduce capital spending this fiscal year and next, as compared to fiscal 2003. Free cash flow is therefore expected to increase substantially, in our view. Cree is likely to retain earnings for finance future capital expenditures, and it may opportunistically repurchase its shares.

Based on our intrinsic value estimate of $21.69 (derived from our

discounted cash-flow model), we have a 12-month target price of $23, implying the potential for approximately 30% capital appreciation from the current share price. Furthermore, at 26 times our fiscal 2005 EPS estimate (using our target price), Cree would be valued in the middle of the range for its peer group of semiconductor companies. At this multiple, the p-e-to-estimated growth (PEG) rate, which we project at 20%, is 1.3, relatively low compared with Cree's peer group. Analyst Basham follows emerging growth stocks for Standard & Poor's


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