Description

We are recommending a short position in Cree Inc. (CREE).  CREE’s primary business is producing light emitting diodes (LEDs).  LEDs are used in electronic displays, automotive interior lighting, commercial lighting, home and office lighting, cell phones, and a variety of other applications.  CREE sells into many of these markets, but cell phones which make up approximately 40% of revenue is their largest end market.   We believe the LED market is growing, but unfortunately for CREE, as a result of competition, prices are falling faster than volume is growing.  In addition, we have seen multiple examples of questionable accounting practices by CREE over the past few quarters, and believe that they have been manufacturing earnings to make estimates.

 

Over the past few years y/y revenue growth has declined from 28% in FY ’05 to 10% in FY ’06 to 1% last quarter.  Sequential revenue growth has been negative the past two quarters, and last week, the company announced lowered revenue guidance for the December quarter which should result in a third negative quarter.  The lowered guidance of $90MM - $92MM will also result in the first negative y/y comparison in years.  (Apologies for not getting this posted earlier).  This represents a 14% decline.  The primary reason for the revenue decline has been pricing.  Gross margin was 55.7% for FY ’05 and 48.9% for FY ’06.  The company reported a 41.3% gross margin in the 9/06 quarter vs 51.5% a year earlier.  As CREE has not been experiencing any significant production issues, it is apparent that competition is making the business much less profitable.  We believe this trend is not about to reverse.

 

Just as interesting to us are the multiple ways CREE management stretched to make estimates.  CREE appears to be manipulating their sales reserves.  At the end of FY ’05, the company’s sales reserves were 2.5% of revenue.  At the end of FY ’06, that ratio had fallen to 1.3%.  The company recorded $7.7MM of returns in ’06 and only added $3.6MM of new reserves, and they were not over-reserved to start.  To keep the reserve level as a percentage of revenue consistent, CREE would have had to reserve an additional $5.1MM which would have hit EPS by approximately $.05, and would have caused them to miss estimates.  In 1Q ’07 (Sept. ’06 quarter), CREE’s sales reserve was only 1.0% vs 2.3% a year earlier.  CREE would have had to reserve less than $2MM to keep the reserve levels constant with year-earlier levels and in line with their recent return experience, but it would have been enough to cause them to miss both revenue and EPS estimates.

 

To us, the most significant method CREE used to manipulate earnings last quarter was building inventory.  Despite only growing revenue by 1% y/y in the September quarter, inventory was up 37%.  On the conference call, the company claimed that they intentionally grew inventory so that they could be more responsive to customers.  Given the stiff competition in the LED business, and rapidly falling gross margins, it seems clear that the additional inventory which now totals 60 days of sales is not going to go up in value over the next couple of months.  We believe the company built inventory to allow them to spread out their fixed costs over a larger number of items.  This benefited gross margin by 1.4% and without the inventory build, CREE would have fallen short of the earnings estimates.  Despite these accounting games, CREE still needed a lower-than-expected loss from discontinued business to make the September quarter.

 

Last week, CREE reduced December quarter guidance from revenue of $105MM - $109MM to $90MM - $92MM, and EPS guidance from $.14 - $.17 to $.03 - $.05 (excluding extraordinary items).  They are facing lower demand combined with lower gross margins which we believe is related to the high inventory levels and greater competition discussed above.  As a result of this lowered guidance, analysts have cut their FY ’07 estimates to approximately $.40 on revenue of approximately $390MM representing a decline of 8%.  The fact is that while accurately projecting LED demand and pricing over the next year is a challenge, the situation at CREE would need to improve (or more accurately, start to decline at a slower rate) for revenue to be down only 8%.

 

In conclusion, we see revenue declining at an increasing rate, gross margins plummeting as a result of competition (a non-temporary variable), large increases in inventory, and accounting and business practices which indicate management has been stretching to make recent estimates.  While the stock is down recently, our experience is that situations like this do not turn around quickly, and while we would never short a stock based on valuation alone, even if all of the bad news is properly reflected in the current guidance and analyst estimates, we are comfortable shorting a company with the above characteristics at 44x declining earnings.

 

Full disclosure:  Last week, we did hear low-quality rumors CREE was being looked at as a takeover candidate.  We think that an acquisition at a substantial premium to the current stock price is unlikely, but thought it was important to mention the risk.

Catalyst

- Increased competition leading to continued price declines, and lower revenue and margins.
- Possible downward guidance revisions related to fundamentals. In particular, we are skeptical of the FY ’07 revenue estimates.
- Negative impact on EPS due to reserve reductions to unsustainable levels.