We have done enough work to get to a point that we think CREE is going to be a great stock, so we are moving it to Best Ideas. We recognize, however, that part of the rally is already behind us, as the stock is up ~50% since the new CEO was appointed on September 25th and ~30% since we added it to the Long Bench. We are not immune to the common analyst desire to buy a favorite name lower. In fact, we wouldn't dispute intelligent investors who argue for a n-t pullback to something like ~$30, restoring a sub-20x EV/FCF (LTM) multiple and deflating expectations for major non-linear changes to fundamentals in the short term. But, if that is the view, we would recommend buying the pullback with two fists, and here is why:
- SiC is a breakthrough power conversion technology that is in the process of being adopted by more mainstream applications. Cree's position in that market, including substrate, epi, and devices, amounts to a ~$140-150m annualized run-rate in a $325m+ market that will grow 2-3x in the coming years. Over time, SiC applicability will continue to broaden. We recognize there is some excess hype in the category, and we don't see $500 worth of SiC adopted into a car, more like $50 at real volumes. However, the breadth of adoption is widening, CREE's competitive position is strong, and there is a CEO in place who will also care about the bottom line and FCF.
- The LED market is a tough place for CREE to operate but headwinds in the market have partially receded and the new CEO will have opportunity to better monetize the IP in this category as the industry shifts to intelligent lighting (IoT). Furthermore, while we realize we are in a minority on this view, after several horrible years, there is finally a demand catalyst on the horizon for the overall LED industry (micro LED) that can help improve unit fundamentals starting likely in 2019. While that sounds like a long way off, it is the first time in years that there is a new long term demand driver for the industry.
- The Lighting division's troubles are mostly from being locked out of the most lucrative channels, which is not set to change in the near term. But industry executives believe there would be potential suitors for the division, and management sees a path to margin improvement as they solve for some of the self inflicted wounds from the past few quarters. We think margin upside in Lighting is not priced into buyside expectations at this time.
The bearish side of the equation would argue: a) linear fundamentals points to risks of disappointment on the current quarter, b) with many good long term fixes but no s-t fixes, CEO Lowe will not produce some magic plan that will rescue the stock from itself, c) incremental buyers have already bought a position. We think some of this has merit, but we see these elements forcing a short term buying opportunity, rather than a call for Shorting the stock.
Your Pushback
Since we added CREE on the Long side back in early October, we heard from intelligent investors on the Short side. Here is an accumulated thesis from those conversations:
- Cree can’t compete with Acuity and major brands in key lighting segments, and is stuck competing with the Chinese in the low end bulb replacement markets. Thus GM% will continue to move lower.
- LED components are massively oversupplied and 2017 MOCVD orders indicate more oversupply ahead.
- CREE uses higher cost SiC for LED and is therefore uncompetitive with Chinese Sapphire based LED.
- Wolfspeed is the only good asset and the Chinese are coming into SiC as well.
the answers we found in our work
- Revenue for the lighting business grew for many years. Yet, management under-estimated the difficulty of penetrating the key commercial channel and they are still stuck on the outside of much of that business. There is no immediate path forward that can help them penetrate the channel. However, in our work we found enough evidence to imply that there are natural potential suitors for the lighting division, should Cree decide to sell it, which - to us - supports a basic value for the business. In addition, management believes they have a plan for GM% improvement in lighting and a path forward for revenue. If they were to succeed it would create upside pressure on estimates.
- In the LED chip category in which CREE mainly participates, there is already some (anecdotal) evidence that LED chip pricing is stabilizing, which even if that is second or third derivative, would imply a fairly large directional change in profits. In mainstream LED components, TV area growth continues to absorb much of the excess and most of the MOCVD equipment demand in 2017 is for replacement tools, as last generation’s tools are no longer cost effective for today’s manufacturing environment. New tools are more productive, and so there will naturally be supply growth in 2018, but the net new capacity additions may be less than many anticipate.
- The Sapphire versus SiC case is now a de-minimus portion of costs and less relevant to figuring out future profitability.
- The list of technology companies with capabilities in SiC today is narrow. Manufacturers use proprietary equipment to grow substrate and epi, and unlike the LED chip industry, there are no off-the-shelf merchant equipment tools (that we have found) which can basically rapidly commoditize the category. The Chinese may make an effort to join the high voltage power conversion devices market using SiC, but it may take a long time.
Net, we are excited about what (new CEO) Gregg Lowe can do with CREE. We admit the stock has had a good run, pushing the LTM EV/FCF calculation to less compelling levels with FCF set to go lower in the near term to fund SiC capex. Still, if we were on the buyside, we’d be buyers on red, looking to own this one for ~18 months duration to benefit from a 2x in SiC revenue, LED industry improvement, Lighting GM% changes, and the new CEO’s strategic direction.
