By Bob Faulkner May 25, 2010 9:30 am
Reposted from www.minyanville.com

Can you name one stock that you’d feel comfortable owning for at least the next five years? Given the obsolescence risk of any technology over an extended period of time, that list can’t be very long. But there’s a wave building out there and it’s one that will carry Cree (CREE) for quite a while.

Despite the continued embarrassment behind the good ship Global Warming, it’s never going to hurt any of us to be more efficient with the energy we use. If there’s been one villain second only to the internal combustion engine that’s been caught in the sites of green rangers, it’s been the lowly incandescent light bulb. To some, you’d think Tom Edison’s little invention was challenging the Black Plague in its ability to reap death and destruction.

I’m a market-based solutions guy. Left to our own devices, each of us tends to figure out what works best for us. Consequently, I find nothing more annoying and intrusive than Washington (or Brussels) pontificating about what’s in my best interests. More often than not, it has nothing to do with the common good and simply reflects the agenda and votes of special interest groups. Such is the case when it comes to lighting.

A number of states have passed bans on the future use of incandescent bulbs and the Energy Independence and Security Act of 2007 at the federal level will effectively ban them 2020. Virtually all of this legislation was based upon the presumed glories of using CFLs (compact fluorescent lights) as their replacement.

There’s no argument that CFLs are more energy efficient. But a funny thing happened on the way to nirvana. Consumers began to examine the fine print and discovered that CFLs contain mercury. The typical bulb contains about 4mg of the neurotoxin and, if it’s a bad idea to have it in your fish, it can’t be a good idea to have it in your rug. That’s what happens if you break one, and who among us has never broken a light bulb? You can find the recommended procedures in handling this calamity from the EPA here.

Aside from the potential danger of breakage there’s also the disposal issue. While a number of big-box home centers promote used CFL disposal services, far more of these products wind up in the trash with the risk of contaminating landfills and waste disposal workers. Great little “green” gadget!

CFLs also don’t work well in cold climates and can’t be used with a dimmer. You might insist on mood lighting but there’s usually a fire that comes along with it for no extra charge.

The last dirty little secret of this scam is that there’s an increasing amount of anecdotal evidence that CFLs don’t hold up that well in the real world. The claimed life expectancy may be great in a lab, but more than a few consumers have dumped them because they failed in the first inning.

Don’t you just love what all those benevolent politicians do for us?

Fortunately, there’s a far better solution coming to a lighting socket near you: LEDs (light-emitting diodes). And that’s where Cree comes in.

LEDs are simply a type of semiconductor that, when current is applied, gives off light (i.e. photons). They’ve been around since the 1960s for use as indicator lamps in thousand of products, but it’s only been within the last decade that they’ve started to make inroads in the general lighting market.

A quick look at the table below demonstrates that the efficiency of LEDs far surpasses that of incandescent lights as well as CFLs. LEDs output far more light per unit of energy and the last far longer as well. Given the fact that they’re solid-state, they’re far less likely to break and they emit substantially less heat than incandescents as well. Furthermore, the cost of running an LED light for 50,000 hours is one-fifth that of the current technology.

With 22% of our electricity demand going to lighting what’s not to love?

Given the obvious benefits, you would have thought there’d be lines at the home centers to buy them. Unfortunately, that’s not the case because of one little problem with the silver bullet: cost. It seems that a typical incandescent bulb will cost you $0.60-$0.70, while a CFL might be in the $12-$13 range. However, a typical LED goes for about $40-$50 per bulb. At that rate it’s only a couple of thousand dollars to change out your home. No problem, right?

With all that energy you’re going to save they may pay for themselves in about 10 years or so. While that may not be such a great deal for the typical homeowner, today there are certainly many commercial/industrial applications where they make perfect sense and provide a cost-effective solution. That’s been particularly true for applications where the labor cost associated with replacements is high.

One of the biggest providers and beneficiaries of LED lighting systems, Cree provides numerous examples of applications. The company has been a leader in working to standardize the LED lighting industry. As you can see in the graph below, the company’s top line has demonstrated fairly steady growth over the years with the exception of the very tough pricing environment in fiscal year 2007. Even the recession hasn’t stopped the migration to LED lighting.

Despite the company’s success thus far, the cost per bulb is a natural barrier preventing adoption from accelerating faster. Granted, as volumes increase so will economies, but there’s one problem that volume won’t erase.

Most LEDs are made using gallium nitride (GaN). However, unlike most semiconductors, most GaN LEDs are grown on silicon carbide or sapphire wafers not silicon oxide, the substrate of most common semiconductors. Those wafers are far more expensive than their silicon cousins and generally offer lower yields.

However, there’s been plenty of research being done over the last several years at migrating LEDs to silicon oxide or other less expensive alternatives. Lab work has been successful and now the hurdle is migrating those processes to real-world production. I can’t tell you exactly when this happens but when it does, the cost of LED lighting should drop a factor of 10. In the US alone, there are an estimated 3 billion light bulbs waiting to be changed. Consequently, the opportunity for a huge ramp in the total available market (TAM) is quite high.

Unfortunately, Cree isn’t exactly and undiscovered, inexpensive stock. We’re looking at 29-times forward P/E, a P/E-to-growth-rate of 1.8-times, and EV/S of 8.2-times. However, these numbers are all lower than what they were a couple of weeks ago. The market sell-off has created an opportunity to buy an expensive stock while it’s on sale for a while.

Every investor goes through this with successful, high-growth companies. If valuation were the sole criteria for buying a stock, you’d never have owned Google (GOOG), Cisco (CSCO), or Microsoft (MSFT) in their respective hay days. Sometimes you just have to pay up if you believe the longer-term fundamentals are positive and occasionally the market runs a sale on everything for you.

The market weakness was given a boost yesterday with a downgrade at one of the brokerage houses. The theory behind the action is capacity and new competition will compress prices as supply outstrips demand. I can’t say if this call is right or wrong, but what I do know is that industry models of supply and demand are built on towers of assumptions. How’d those housing industry models work out?

The direction of the lighting industry is clear, and Cree is a major beneficiary of that trend. Take a look and see if it’s the right type of name for your portfolio.