Morgan Stanley is out making a significant LED lighting call this morning downgrading the sector leader Cree Inc (NASDAQ:CREE) to Underweight from Equal-Weight with a $36 price target (prev.NA).
Firm is cutting their estimates way below consensus noting they cannot recommend the stock today as a way to play the secular growth theme.
The stock is down 40% since July 2010, following four successive disappointments in earnings or guidance. At 25x 2011 earnings, valuation is nearly twice the market multiple, but Morgan Stanley forecasts only 4% EPS growth in 2011 and –5% in 2012. They believe lower ASPs, lower gross margins, and lower market share will offset strong industry volume growth in LED lighting. They are lowering their F2012 estimate by 29% and are 17% below consensus. Firm’s $36 target implies 21% downside.
Four reasons for Underweight rating:
1) Competition and pricing pressure. More companies have the technology and IP to produce and sell lighting-class LEDs and are pricing aggressively,especially for higher-volume products.
Channel checks indicate that at least one top tier producer plans to sell lighting class LEDs at $7/klm by the end of calendar 2011. Epistar has targeted even lower pricing of $4/klm. Although Epistar has not been in the top tier of manufacturer for lighting class LEDs, a recent joint venture with Toyoda Gosei provides access to patents that will help it address the lighting market. Cree’s ASPs vary widely across products, but Morgan Stanley believes they currently average over $12/klm.
Even if Cree maintains a 15% price premium to the competitor at $7/klm, that would imply a 33% price drop from our current estimate of $12/klm. If Cree cannot maintain a price premium, $7/klm would imply a 43% price drop.
2) Share loss is a headwind. LED adoption is happening: Firm forecasts penetration rising from <4% today to 35% by 2015. Cree is the share leader at 30+%, but they expect its share to fall to 15% by 2015.
3) Morgan Stanley sees negative earnings growth in F2012 on lower ASPs (down 23% p.a., they expect) and lower gross margins (42.5% in 2012e vs. 45.8% in 2011e and L/T guidance of mid-to-high 40s).
Cree management believes long-term gross margins will be 45-48%; Morgan Stanley sees downside to that estimate and forecast 42.5% in F2012 and F2013. Over the last 10 years, Cree’s margins have averaged 44.7%, with a high of 55% in 2005 and a low of 34% in 2008. Firm’s basis for a lower margin forecast is increasing competition, especially from Asian companies who are willing to operate at lower margin structures, and more price competition as we move into the lighting adoption phase of LEDs.
4) Unfavorable risk-reward. While Morgan Stanley’s bull case offers 65% upside (Bear case -56% downside to $20), it requires margin assumptions that the firm views as low probability.
Significant forecast uncertainty. With growth rates over 50% and rapid evolution, there is significant uncertainty in LED industry forecasts.
They believe in LED lighting. Cree has excellent products, a history of execution, and over $1 billion in cash, but the firm cannot recommend the stock today as a way to play this secular growth theme.
Notablecalls: The call is a must read for every LED sector investor (42 pages long). Morgan Stanley paints a fairly bright picture for the sector as a whole but not so pretty for Cree (CREE).
Cree’s market share appear to be unsustainable & with declining ASP’s raising volumes aren’t going to help that much.
I would call it a big change of heart by Morgan Stanley’s team. They used to be so bullish. Now their price target is the new Street low.
To make things worse, take a look at what Semileds (NASDAQ:LEDS) had to say this morning. Cree’s Chinese kid brother literally shit the bed. They almost halved their guidance blaming competitive pricing environment and their decision to preserve their market share. This does not read well for the industry. Remember, it was Semileds that acted as the canary in the coal mine in January. Looks like things may have worsened from there.
I wonder if CREE breaks the $43 level today?