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WIKI ANALYSIS
Based in Durham, North Carolina, Cree, Inc. (CREE) develops ultra violet (UV) and high power-packaged light emitting diode (LED) chips. The company also manufactures SiC and GaN materials and high-power products that use its internally developed SiC and GaN materials. The company holds 333 US patents as well as several other foreign patents.
Only a handful of companies use Silicon Carbide (SiC) and Gallium Nitride (GaN) materials. Traditionally, semiconductors are made out of silicon substrates, as it is relatively easy to grow single crystals from silicon. However, Silicon carbide (SiC) has superior optical, mechanical and thermal electronic properties in that it is a more electrically stable and heat resistant material, with a higher saturation drift velocity and partial transparency in visible light. Its sensitivity to acid, alkali and moisture levels is also very low. This makes a SiC device particularly suitable for applications in high-temperature, high-power, high-frequency power and high-stress environments, as for example, in the automobile, aerospace and oil & gas industries. Although these properties were discovered in the early 1990s, technological difficulties hindered the commercial viability of SiC for use in semiconductor chips. Therefore, it was not until the late 1990s that the first SiC device became commercially available.
Several methods are used to grow single crystal SiCs. This is essentially the growth of mono/poly crystalline layers on a silicon substrate by using Metalorganic Chemical Vapor Deposition (MOCVD), gas-source Molecular Beam Epitaxy (MBE), electron cyclotron resonance (ECR), or plasma and liquid phase epitaxy techniques. Epitaxy is the growth of crystals of one mineral on the crystal base of another mineral, such that its crystalline orientation is the same as that of the substrate. The company grows the SiC crystals, manufactures the wafers, and fabricates and tests them. Most of the manufacturing and testing is done at its Durham facility in North Carolina, although some packaging of high-power products is outsourced to subcontractors. It also operates an R&D facility the Santa Barbara Technology Center in Goleta, California.
The LED business has always been the chief revenue earner, and Cree discontinued the silicon-based radio frequency (RF) and microwave business lines in the fourth quarter of fiscal 2005. LED products generated 78% of revenue in fiscal 2007, roughly 10% came from Materials products (i.e. SiC and GaN wafers and bulk materials for gemstones). Around 4% came from high power products. Funding from different agencies of the U.S. government for specific research projects accounted for the remaining 8%. The company had 21 such research projects in operation in fiscal 2006.
Cree manufactures blue and green LED chips, as well as high-power packaged LEDs such as the 7090 and 4550 series of XLamps. These LED chips have a single wire-bond connection, low forward voltage, exceptional thinness, low heat generation, high electrostatic discharge (ESD) tolerance and long life. LED chips are used in the backlighting of mobile handsets and other portables, automotive interior lighting, full color electronic displays, gaming equipment, digital camera flash, other consumer products, traffic signals and other electronic equipment. Some customers purchase blue LEDs and convert them to white (through combination with phosphor). These white LEDs are then used in specialized lighting applications. The company has also internally developed several white LEDs. A new backlighting solution code-named Colorwave is being developed from blue and green LEDs for large screen liquid crystal displays (LCDs) in TVs and PCs. The company's LED chips can be split into high-brightness and mid-brightness categories.
Wafer products (SiC or GaN) are available in three sizes two-, three-, and four-inch. These are used in optoelectronics and power switching products, as well as in corporate, government and university R&D projects for the development of optoelectronics, microwave and high-power devices. The company also produces a crystal SiC, the color, hardness and brightness of which are very similar to a diamond. The product has application in the gemstone industry. Cree's sole customer for the SiC crystals is Charles & Colvard Ltd. Cree also has a range of power products, including 300, 600 and 1,200-volt Schottky diodes. It is the leading producer of SiC diodes for power control and management. The smaller size, greater efficiency and higher frequency power devices find application in solar inverters, industrial motor drivers and output rectification devices. Its switching products are very fast, temperature-independent and are able to operate at very high frequencies. SiC-based power devices such as PIN diodes, bipolar junction transistors (BJTs), and power metal-oxide semiconductor field effect transistors (MOSFETs) are currently under development.
Cree has developed a near-UV laser (blue laser), and is in the process of commercializing it. This technology will help improve the storage capacity of optical drives that currently use red lasers.
The company has a distribution agreement with Sumitomo Corporation (which has sole distribution rights in Japan). Through this agreement, it is able to reach 20 Japanese LED manufacturers. In fiscal 2007, Sumitomo generated 24% of revenue, while Seoul Semiconductor Company generated 14%. The primary sales and marketing team operates from the Durham facility, although this effort is supplemented by sales offices in Vienna, Tokyo and Hong Kong and sales reps in Taiwan and Korea. The sales to Charles and Colvard are on the basis of an exclusive supply agreement.
Although SiC and GaN technologies are not used by most of Cree's peer companies, its products continue to face competition from the traditional manufacturers using silicon and GaA (gallium arsenide). The company is pitted against a number of small Asian manufacturers, which produce blue and green LED chips. Although not in direct competition with Cree, Nichia Corporation is a major player in the white LED market, with the largest market share in nitride-based LEDs. Phillips Lumileds, the market leader in high-power packaged LEDs, Avago, Edison Opto Corporation, Kingbright Corporation, OSRAM and Seoul provide most of the competition in packaged LEDs. Infineon is the chief competitor in the high-power products space.
Strong R&D focus that is essential for growth and survival
Cree has an experienced engineering team, which has enabled it to create a product line based on the latest technology. It is one of two companies (Infineon being the other) that first started using Silicon Carbide on Gallium Nitride substrates. Although Cree faces strong competition in the current market environment, most of the competing products are based on the older Silicon and Gallium Arsenide materials. The company is technologically ahead of the others, since it is already in the process of making competitive products from the new material/s.
The more advanced materials used by Cree necessitates that the company find higher-end applications, since the production complexities involved in the manufacture of these materials raise manufacturing costs. Also, the prime advantage of using these materials is that they remain stable at higher temperatures and when exposed to higher-frequency electric currents, and other environmental factors such as acidity, alkalinity and humidity. These extremes are more easily found in the automotive, avionics and military sectors. While CREE currently competes in mobile phones and PC and CE displays, the more stringent requirements of the automotive, avionics and military sectors, as well as the limited competition will enable it to reap greater profits, as market penetration improves. Management continues to look for new applications and new avenues of growth. Since some of the company's products are already being deployed in military operations in Iraq, we expect the government and military sector to be one of these "new" areas.
Significant growth opportunity in the high-end lighting and notebook markets
Cree's technology is being recognized in the lighting market, and management appears enthusiastic that near-term growth will be driven by lighting applications. Management expects to compete in three major lighting segments. The first is the incandescent lighting space, with application in emergency vehicles, personal lighting and so forth. The second is in the commercial lighting space, where high-pressure sodium and helium are currently being used. The third area is compact fluorescent lighting. The company's competitive strength in the commercial space comes from the lower maintenance costs and greater energy savings of its LED lighting solutions, when compared to sodium or helium lights. The compact fluorescent space, though growing, is also a future market, as the energy savings claimed by compact fluorescent manufacturers usually fall short of actual savings made. There have also been some rumblings about mercury emission and disposal, since these products use about 4 mg of mercury. It remains to be seen whether the company can leverage off these disadvantages to create a position for itself in the CFL space.
Another area of LED application is the TV, PC and notebook display market. Management expects notebooks to be the most important of the three, since the incremental cost of using LEDs in notebooks is substantially lower than in TVs and high-end monitors. This is mainly due to the color complexities that are of more importance in these displays as compared to notebook displays. Most of the top notebook makers in the U.S. are optimistic about using LEDs in notebooks. Both HP and Dell already have LED-based models, and Apple is expected to follow suit. Management expects the LED-based notebooks to gain traction as early as in the first half of fiscal 2008, followed by a broader acceptance in 2009 and beyond.
Lighting is already an important driver of Cree's growth
In March of 2006, Cree announced the EZBright LED chip platform. Products in this category are targeted at higher-end lighting and power applications. The series consists of the company's highest brightness chips, which although fabricated separately, allows easy attachment to other devices. They can, therefore, be packaged together with other industry-standard LED products. The XLamp 7090 power LED is the first product developed on the EZBright platform. Volume production of this white LED started in June last year, and the product has been growing very strongly since inception. The XLamp 7090 is targeted at general lighting applications such as street lamps, parking lamps and lighting at retail outlets. It can also enhance lighting quality of various consumer applications such as flashlights. The XLamp product line was up again in the last quarter, and management expects continued strong growth driven by infrastructure builds for the 2008 Olympics. Production ramp up of the EZ290 and EZR products for display and mobile light applications started in the September quarter. The new lighting and high-power components of LED continued to grow strongly in the last quarter. The company's power products for Schottky diodes continue to do well. The company had new design wins at some power supply and inverter applications, which enabled it to expand beyond the traditional server power supply applications. Management also intends to introduce the first MOSFET products this year.
The COTCO acquisition is expected to be the primary growth driver in 2008
Cree acquired COTCO's Luminant Device business on March 30, 2007 in exchange for 7.6 million Cree shares and $70 million in cash. The acquisition broadens the company's portfolio of LED components, which are expected to have a positive impact on its margins. The acquired product line is a perfect complement for the company's existing XLamp line. COTCO is based in China, which helps the company in two ways. China is one of the fastest growing markets for high-brightness LEDs, and management expects significant revenue synergies, as it sells its XLamp product line into COTCO's customer base, and sells COTCO products into Cree's customer base. Further, COTCO's Chinese factory is a low-cost manufacturing unit, which will help the company reduce costs. Since COTCO does not play in the handset space, the acquisition reduces Cree's dependence on this end market, furthering its diversification strategy.
Cost-reduction initiatives are on track
Management has outlined a specific cost reduction strategy. Currently, a lot of Cree's products are manufactured on 3-inch wafers, which raises the cost of manufacturing these products. The company has already started transitioning to 4-inch wafers, and intends to qualify the new products for 4-inch. Both the Schottky diode and LED chip transitions are on track, and the process is expected to be complete by the second half of the year. The INTRINSIC acquisition is expected to facilitate the development of these larger-diameter substrates. Additionally, management plans to shift a portion of the production process at the chip and packaging levels to low-cost regions in Asia. The COTCO facility is going to be used to manufacture some XLamp products, which will help increase shipments. Both these initiatives will lead to lower manufacturing costs, and help improve margins through fiscal 2007 and 2008. Cree follows an aggressive R&D strategy, which is currently focused on high-brightness products for the lighting market, high-power devices, as well as the development of larger wafers.
The market is characterized by commoditization
Cree's business is dependent on the success of its LED chips. However, while the demand for LEDs is likely to increase, prices are likely to weaken. LED prices have fallen in seven of the last eight quarters. The only reason for temporary increases in CREE s blended ASP is a mix shift to higher-ASP high brightness products. Management s R&D focus has been centered on the development of high-brightness chips for lighting applications. This, along with noticeable increase in demand for LED-based lighting applications, had a positive impact on ASPs in Q3. The flip side to the story is that the company is still in the early stages of the learning curve as far as high-brightness is concerned. This means that until it churns out significant volumes of the product, costs will continue to accelerate. Therefore, in the near-term, rising ASPs will be offset by increasing costs, so that gross margin expansion is marginal. Over the longer-term, costs will drop, volumes will ramp and ASPs will be on a decline. Management's long-term goal is to increase revenue by 60-70% over the next three years, with GAAP operating margins growing to the low-20% range. This could be a little too optimistic.
Competitive pressures continue to intensify
A large chunk of the company's LED business is generated in Japan. Competition in the Japanese market is heating up, with Nichia defending market share at the high-end, and Toyota Gosei making inroads into the low-end. Management expects the EZBright to provide some leverage at the high-end, and nearly half the LED chips are now manufactured on the EZBright platform.
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