Cree, A Long-Term 'Hope Trade' With Near-Term Problems

The rating on the shares now goes from Neutral to Underweight, while the price target was bumped up from $23 to $28.

The Hope Trade

Analysts Paul Coster, Paul Chung and Mark Strouse think investors re-rated Cree's stock due to hopes that the recruitment of a quality CEO would result in the company successfully transitioning to a semi pure-play.

The analysts believe a successful transition eliminated conflicts with end-customers, reduces the need to invest in brand, removes the company from price-based consumer and contractor end-markets and reduces SG&A margin. The analysts see this to yield a stock, valued at $32 or higher by 2019 under one scenario, sooner if Gregg Lowe, the new CEO, can sell or spin the Wolfspeed and LED businesses to capture their value.

But Reality Hurts

JPMorgan is of the view the transition would likely take a couple of years, with Lowe starting from a position of weakness. The firm noted that the company has lost share in the LED and lighting markets, which are experiencing a slowdown in growth and face uncertainty in the second half of 2017.

"De-emphasizing the lighting products business might be strategically desirable, but unless it can (for instance) be sold quickly, declining volumes and revenues could lead to lower gross and segment operating margins over the next few quarters, which is what we now assume in our revised model," the firm said.

Adjusting Estimates

Despite leaving its estimates for the fiscal year first-quarter of 2018 unchanged, the firm thinks it is no longer business as usual at Cree. The firm expects Lowe will announce a strategic transformation very quickly.

Accordingly, the firm trimmed its revenue estimate for the Lighting products business and the associated gross margins by 100 basis points through 2020. However, the firm clarified that the impact will be offset, if SG&A is lowered by 100 basis points a year. The firm also trimmed its growth expectations for the LED product business slightly.

As such, the firm now expects 2018 pro forma earnings per share of 27 cents, lower than the consensus estimate of 30 cents. The firm's 2019 pro forma earnings per share estimate of 60 cents is in line. Meanwhile, the firm estimates calendar year 2019 pro forma earnings per share of 81 cents.

Previewing FQ1 Results

Cree is scheduled to report its fiscal year first-quarter results on Oct. 17. The firm expects pro forma earnings per share of 4 cents on revenues of $361 million. This is in line with the consensus estimates and the guidance.

The firm expects a 2.7-percent sales drop, with Lighting products sales declining 16 percent, while LED product and Wolfspeed sales are expected to rise 4 percent and 38 percent, respectively. The firm estimates an 843 basis-point decline in pro forma gross margins to 29 percent and pro forma operating profit of $3 million.

Additionally, the firm said it expects GAAP operating margin to remain pressured throughout 2018. For the fiscal year second quarter, the firm estimates pro forma earnings per share of 7 cents on revenues of $365 million, while the Street looks for pro forma earnings per share of 7 cents and revenues of $368 million.