LED lighting and manufacturing company Cree (NASDAQ: CREE) is starting to look like an attractive business again. Timing the entry and exit points into investing in the LED cycle is fraught with difficulty, but I think there is some evidence that the stock is beginning to look reasonably priced in relation to its upside potential. LED lighting is going to be the next driver of an upcycle in demand and I think Cree is doing all the right things operationally.

You can think of the LED industry as being highly cyclical but the underlying trend is positive. Waves of adoption across new industries typically sweep in and drive demand higher until a peak forms and then it inevitably falls.  Then we get the usual cycle issues of overcapacity and price cutting as demand troughs again.

Over the last few years the drivers have been LED backlighting for electronic devices, solar technology and now it is lighting. I’m a great believer in the LED lighting story and my preferred play on it would be lighting company Acuity Brands (NYSE: AYI) which is seeing its LED based revenues increasing as percentage of total sales. The company is doing well and I think recent improvements in the Architectural Billings Index bode well for it.

But I digress! Back to Cree.

Cree Restores Gross Margins

I’ve monitored Cree for a while and there is an article linked here which discusses the last set of results. Anyone new to the company should understand that Cree reshuffled its agency sales operations in LED lighting and the Q3 numbers were weak as a consequence. To the company’s credit it has dealt with the problem and the division is back on a secure growth track. I also suggested the non-GAAP gross margins are usually the key to whether pricing power is coming back. There is some good news here.

Moreover Cree forecast an increase to 38.5% in the next quarter. It looks good but it doesn’t give a clear underlying picture. To demonstrate that I need to break out the segmental revenues.

Lighting Strong, LED Products Stabilizing

Revenue growth is slowing at Cree but the mix of revenue generation is fascinating. The story is one of poorly trending LED Products growth (actually negative for four of the last five quarters) but strong increases within LED lighting products.

LED product growth has disappointed as the economic slowdown has hurt growth in solar, backlighting and delayed expenditures in things like LED street lighting. The industry has subsequently faced overcapacity and prices have fallen hard as a consequence. That much is known and I would argue it’s in the stock price now and the year on year comparables for the company.

There isn’t much that Cree can do about the macro-environment but what it can do is bread and butter management of the company in order to maximize profitability within the LED products segment. Meanwhile it can make initiatives to drive adoption in LED lighting.

I see gross margins rising as a sign that capacity utilization is increasing, which in turn demonstrates that at least some pricing power could be coming back to the industry.  The successful resolution of a patent dispute with SemiLEDS (NASDAQ: LEDS) is also likely to allow both companies to focus on their core business of LED manufacturing rather than lining lawyers’ pockets.

Another bright point is that the ‘vast majority’ of lighting revenues comes from North America. Europe only makes up around 15% of total revenues but roughly a third goes to China which is more of a concern. However lighting is favorably positioned in North America and every quarter I see Acuity increasing its percentage of LED lighting based sales.

Driving LED Lighting Adoption

The challenge for Cree is to increase adoption rates for LED lighting over traditional forms and the good news is that it is not alone. Home Depot (NYSE: HD) is aggressively promoting it as part of its drive to expand its product range to its customer and what investors need to appreciate is that consumers don’t just get better lighting they also get the opportunity to purchase lighting control systems which allow for a huge amount of interoperability within lighting solutions in the home. LED lighting is a lot smarter than traditional lighting.

Home Depot isn’t the only heavyweight behind it. Phillips now generates a substantial part of its revenues from LED lighting and General Electric (NYSE: GE) has been an aggressive early mover in getting products out to the consumer.  When these sorts of companies create a ‘market buzz’ around a product you can be sure it will accelerate awareness and adoption.  It is also fits in nicely with GE’s corporate message.

However as Cree’s management pointed out on the conference call the range of lighting solutions and applications makes it very hard to make a ‘one size fits all’ price comparison with traditional lighting.  In general LED lighting is still more expensive from an initial cost perspective, but in terms of life cycle costing- helped by things like extended warranties- it is now moving into range as a cost saving option in certain categories.

The Bottom Line

Cree is starting to improve its operating metrics in terms of gross margin and significant free cash flows. While this is a sign of a maturing industry it also indicates that -provided lighting can generated double digit growth and LED products demand remains stable- Cree is moving into a position where it can leverage a slower rate of growth into decent cash flows. This is no mean feat and suggests that Cree has relatively less downside risk than most people think and a significant amount of upside potential.

That said the economy is weakening and realistically in the near term Cree will be subject to investors beating up the stock on any disappointment with, say, Chinese demand. Longer term and for those who can stomach volatility, the stock is looking attractive.

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