Cree's Lighting Business Glows, But Should You Buy the Stock?

For all the promise of green technologies, investing in them can require a lot of patience and nerves. Unlike many Web start-ups, many greentech companies require significant capital investments and years of nurturing before they can deliver on their promise.

But that hasn't stopped investors from aggressively buying shares of Cree (CREE) the Durham, N.C.-based company that is at the forefront of the green revolution. Shares of Cree, which sold at just $13 in December 2008, now sell for about $66 -- an increase of more than 400%. Behind the rise: Steady revenue growth and profits that often beat analyst expectations as well as the belief among investors that LED technology (light emitting diodes) will soon replace today's lights.

Perhaps the euphoria has outpaced the technology's development. Over the past six weeks, CREE has given up 20% of its market value, which hovers around $7 billion. The fall is probably a reflection not only of the broader stock market, but also the hurdles the company faces.

Soon to Replace Incandescent Bulbs

LEDs are, to put it very simply, semiconductors that emit light. They have been around for decades, in the tiny colored bulbs that pepper electronic appliances, in the glowing numbers on an alarm clock and in the illuminated signage that are making neon lights a relic of past eras.

But increasingly they are taking on a bigger role as LED displays are used in high profile, big events such as the 2008 Chinese Olympics. LEDs are also finding their way into homes and buildings as an appealing alternative to the energy-hog incandescent bulbs and the ashen-pallor of fluorescent lighting. They don't rely on a filament or gases. They lack the toxic mercury found in fluorescent bulbs. And they can last a long time while using much less energy than standard lighting.

There is a little doubt that in time, LED lighting will become the standard way we light up our homes and buildings. Lighting companies, big and small, are investing heavily on two fronts -- improving the semiconductor technology for LEDs and preparing for larger-scale production of LED bulbs. That means that over the next several years, we should see many more LED lights with lower prices.

According to Greentech Media, some large and well-capitalized lighting manufacturers are working on new bulbs: Osram Sylvania plans an LED bulb emitting as much light as a 60-watt bulb this year and a 75-watt bulb equivalent next year. Philips (PHG) will also announce a brighter LED bulb, retailing for about $60. Lighting Science, which sells bulbs through Home Depot, plans one in the $30 range.

Industry Undergoes Sea-Change

"The lighting industry, which until recently seemed more devoted to LED lip service than adoption, is undergoing a sea-change," Yair Reiner wrote in a recent report on Cree. "There is no longer a debate about whether LED lighting will happen or even when (it is happening now). The only question is how fast. And every company we spoke with thought the answer for them had to be, 'as fast as we possibly can', because the train has already left the station."

At Cree, the train is moving fast. The company reported record revenue of $234 million during the quarter which ended March 28, and said that net income increased more than tenfold year-over-year to $44.6 million. Looking ahead, things continue to look good. Analysts at Lazard Capital and Sidoti & Co. have increased their ratings on Cree, and Reiner at Oppenheimer sees "the likelihood of another strong beat and raise quarter."

But there is reason for investors to be cautious. From a technical perspective, there is still much to be accomplished. White-light LEDs, for instance, may last years, but poorly designed ones can flicker or change color pretty quickly. Most LED bulbs on the market don't emit as much light as consumers are accustomed to. Those that do can be dauntingly expensive. Right now, you can go to Home Depot (HD) and buy an LED light bulb between $20 and $70 that will emit as much light as, say, a 40 watt incandescent bulb. Or you can buy that incandescent bulb for less than a dollar.

The company could also face future margin pressure, as more players enter the market. While Cree's gross margins rose to 48% in the first quarter from 36% a year earlier, FBN Securities analyst Michael Burton, pointed out in a report that Cree's free cash flow was "anemic which is not a current investor concern but reflects the capital intensive nature of the business and is an indicator to us that margins will face pressure going forward."

On top of all that, the stock, which currently trades at 60 times recent earnings, isn't cheap -- despite its recent decline.

Mark Heller, at CLSA Asia-Pacific, warns that while Cree is well-positioned, there could be a supply glut in LED lighting in 2011. "It's not that we don't believe in the LED lighting story," he recently wrote." [Our concern] has more to do with the rate at which supply is being added to the market and the potential for over-supply."

That's something investors should keep in mind.