Shedding Some Light on Cree’s Valuation

Cree, Inc (CREE), maker of energy efficient lighting products, has been on an absolute tear for more than a year now. It’s hard to believe that in December of 2008 the stock fell to as low as $13 and change, but in the ensuing year and a half the stock has appreciated 600%. Clearly, they are a large part of a hot industry, and Cree’s LED lighting products are likely to continue to show robust growth as more households and businesses switch over from more energy intensive incandescent bulbs. At last check, the company holds well over 300 US patents and a quick click over to Cree’s investor relations page shows they are furiously using their patents to drive innovation (7 product related press releases already this week).

As a value investing shop, our historical valuation chart is exactly as we would hope it would be. We had two different Undervalued periods when the stock was below $20 per share, and then we shifted to Fairly Valued for the majority of 2009. Then our valuation methodology began to see reason for concern early in 2010 with the stock trading above $60 per share, and we placed our Overvalued rating on CREE. However, last week’s sell-off in addition to continued strengthening fundamentals has allowed us to moderate our stance back to Fairly Valued in an upgrade this week.

With our ratings history in mind, if we had to pick a side of the trade on CREE we would recommend selling over buying because the stock is not priced attractively compared to historical norms. For example, based on current earnings expectations for this fiscal year CREE is trading for nearly 50x cash earnings per share. That may sound excessive, but compared to the historical norms for CREE of 33.7x to 71x, it is not all that troubling. However, our analysis of price-to-sales shows CREE’s current valuation in a less flattering light. Historically speaking, the market has been willing to pay 3.3x to 7.5x times sales per share, but at current levels it trades at a price-to-sales level of 9.6x. This incorporates the 52% estimate sales growth in fiscal 2010 (ends June).

In the case of a rapidly growing company like CREE, we believe that some premium is deserved in the stock price, but that doesn’t mean that we abandon disciplined investing principles. For years, growth has been an attractive part of Cree stock, and as you can see the market has historically awarded them high fundamental valuations as a result. Some current valuation metrics such as price-to-sales are even higher than in the company’s past. Trading for close to 10x sales per share means that the market has already priced-in a substantial growth factor. Furthermore, this stock is an analysts’ darling with Wall St issuing 2 upgrades and 1 initiation at “buy” in just the last few weeks, yet its price is approaching the mean target price of $84.47 of 15 analysts.

We are reaffirming our Fairly Valued stance even after the stock advanced more than 7% on Wednesday morning. However, we may consider downgrading in the coming weeks as the valuation leaves an unfavorable risk/reward for allocating fresh capital. Does the company have strong growth? Certainly. But as we tried to demonstrate with price-to-sales per share, the market has already baked in quite a growth premium. Although we see plenty of opportunity to continue to expand, we are concerned that gross margin will soon slip as light bulbs can become commoditized and more competition enters the field. This is undoubtedly a great company, but at this valuation you have to absolutely love it to dive in.

About Ockham Research 645 Articles

Ockham Research is an independent equity research provider based in Atlanta, Georgia. Security analysis at Ockham Research is based upon the principle known as Ockham's Razor, named for the 14th- century Franciscan friar, William of Ockham. The principle states that a useful theory should utilize as few elements as possible, because efficiency is valuable. In this spirit, our goal is to make the investing environment as simple and understandable as possible, yet no simpler than is necessary.

We utilize this straightforward approach to value over 5500 securities, with key emphasis given to the study of individual securities' price-to-sales, price-to-cash earnings and other historical valuation ranges. Our long term value investing methodology is powered by the teachings of Ben Graham and it has proven to be very adept at identifying stock prices that are out of line with fundamental factors.

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