After A 30%+ Gain In 3 Months, I'm Holding On To This Stock

Investors are often faced with a clear conundrum -- what to do with a stock that holds great long-term promise and stumbling near-term execution. That question has been vexing me ever since I added shares of Cree Inc. (Nasdaq: CREE) to my $100,000 Real-Money Portfolio in early January and then shares make a quick upward move.

At the time, I wrote that gross margins were unlikely to post a near-term rebound after slipping from the low 40s to the mid 30s. And I added that investors were concerned that results wouldn't improve until bloated inventories were worked down. My conclusion: "The future direction of this stock will hinge on how these numbers trend." Yet I also thought the stock had tangible downside protection trading in the low $20s.

I was wrong. Investors embraced this stock much more quickly than I expected, turning Cree into the strongest gainer in my portfolio. Kudos to the crowd for spotting the great long-term opportunities in front of this LED lighting supplier.

Just a few weeks later, investors again showed a newfound farsightedness, overlooking another challenging quarter, which I discussed here.

Well, this time around, investors aren't in such a forgiving mood. Shares of Cree slipped back below $30 in after hours trading on Tuesday, April 17, after the company delivered a subpar fiscal third quarter. The key culprits: you guessed it -- weak gross margins (34.9%) and a bloated inventory (worth 96 days of sales). Adding further pain, guidance for the fiscal fourth quarter is also uninspiring: The midpoint of the targeted sales range is $305 million, below the $324 million consensus. Non-GAAP earnings per share (EPS) are expected to be around $0.23, below the $0.28 consensus.

The bright side
This is still very much a growth story. Even that lowered sales guidance represents a company record and 30% growth from a year ago. Management has recently laid out key technology developments that should at least keep gross margins at current levels. Cree operates in an industry that is rapidly commoditizing, but the company's massive research and development effort should help keep it above the fray. Gross margins in the 35% range are disappointing in light of the company's history, but are still the most impressive in the industry -- by far.

Make no mistake. This stock is no longer being valued on the basis of current quarterly run rates. The post-earnings sell-off would have been far more dramatic if investors were viewing this stock in terms of near-term profits. Indeed, you can look for analysts to lower their fiscal 2013 EPS forecast, which currently stands at $1.50 (perhaps, as a rough guess, to around $1.25 a share).

Strangely enough, this is still one of the biggest potential winners in my portfolio -- despite the near-term doldrums. The broader investment community still underestimates just how powerful the LED lighting revolution will be. I have no doubt that Cree will see intense competition and will lose market share. But the pie will be so big that even a smaller slice of that pie will still be huge.

What I wrote in January still stands: Cree's revenue could approach $3 billion to $4 billion by mid-decade (from a current projection of $1.47 billion in the fiscal year that begins in July). And EPS in the $3 or $4 range by then is a real possibility -- if pricing and gross margins don't deteriorate further.

Despite  the modest sell-off in shares on Tuesday, analysts hold an increasingly positive view. Jefferies, for example, raised its price target from $31 to $35, adding that the upcoming Lightfair industry conference, to be held on May 9, could be a positive catalyst for the stock. Oppenheimer's price target was boosted from $34 to $38, noting that the company's recent challenges are now "in the rear-view mirror." Keybank lowered its price target from $37 to $35, noting the company's "recovery appears to be more muted than previously expected."  As I've noted, I see a lot more upside than these price targets by looking at several years and not several quarters, as these analysts tend to do.
 
That said, I'm simply standing tight right now and neither adding to or selling my current 300-share position. Clearly, I should have taken a bigger stake in January, but I didn't anticipate a quick upward move that we saw in the stock later in January. At this point, I'm tempted to wait for a deeper pullback, though if you don't yet own this high-growth company, this week's sell-off may create a fresh entry point for you.

by David Sterman