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No. of Recommendations: 36
Valuation is a tricky subject. There are two ways of valuing this company. The first is to look at the metrics the second is to look at it's potential.


Metrics - Growth Duration

Growth duration is a way of getting a feel for a stock to see if its price is in line with its growth. Growth rates are not sustainable forever; otherwise Cree would be larger than the world economy (hurray)! Just how long would Cree have to grow at its projected rates to justify its stock price? And is the growth rate reasonable and sustainable? Growth duration helps to shed some light on those issues. (Paraphrased from TMFFuz)

This is the logic of the growth duration formula:

If you invest $100 in the S&P 500 today, you will see earnings of $2.87 the 1st year (100/34.8, the P/E ratio). These earnings grow at 21.2% a year. On the 5th year, the expected earnings amount to $7.47.

If instead you invest $100 in CREE Inc, your 1st year earnings will only be $0.75 (100/133 - because the P/E ratio would be higher), but the growth rate of 64.5% yields 5th year earnings of $9.03. In other words, you would have passed the S&P 500. In fact it would take 4 and 1/2 years to match the S&P 500. After that, you could be content growing at the same rate as the S&P 500 to justify today's valuation.

OK, so if we agree that this is the concept. The working is:

Growth Duration = Log (P/E Firm / P/E Market) / Log ( (1 + g Firm) / (1 + g Market) )

where P/E is the price/earnings ratio and g the growth rate in percentage.

Growth Duration = Log (133/34.2)/ Log (1.645/1.211) = 4.4 years

So, it would take 4.4 years to justify its stock price. Which is within it's tolerance.

(log in base 10 and natural log (a.k.a. ln) both work)


Potential

Another way to look at the prospects is to look at the potential of the company. You can say go hang. I reckon that the build up of revenues from lasers, RF equipment, Power transistors, and residual build out of LED's will more than beat the market over the next 5 years.


Valuation Conclusions

Although a high P/E I do not find it out of tilt with it's growth rate. In addition it has a number of upsides from the potential uses of SiC. If you are considering selling for the only reason that the stock has gone down then you are destined to make bad investing decisions.


Other Concerns

Patent Disputes

Cree Inc has a large and rich number of patents relating to SiC. It is an inherent risk in the technology business. However, we are the only mass producer SiC in the world and even if we gave all our patents away no company would be able to produce SiC to the same standards and costs as we do without a number of years of work. I would suggest that unless Siemens wants to try another business it is in both our interests to settle this matter and get on with business.


Euro

The effect of a weakening Euro is to make our product more expensive. Orders for the entire years production have already been taken. These are all paid in dollars. The devaluation of the currency has no immediate effect on Cree. It will have the effect in coming years to make our product more expensive. If this were a commodity business it would be important. However, it isn't it is a premium business with a net profit margin of 28%, way above the 19.5% found in other semiconductor companies. In addition we are capacity constrained, if we had more to sell we would. Of course Cree makes every effort to reduce the costs but for now companies will have to pay what Cree offers.

Insider Trading

Watching insider trades is usually a fruitless task. First off they are businessmen and not investors. Insider sales rarely give any insight. In general investors ignore insider trading with the exception of large insider buying.

Anyway for Cree. Insiders hold 8.45 million shares. Market guide reports that for the 6 months preceding 30th September 2000 there have been no insider purchases, and there have 11 insider sales for a total of 168 thousand shares or a massive 2% of all the shares. (Feel free to update this data).

Should you use tight stops?

There are a number of reasons to not use tight stops. As often as not kicking you out of a stock during an intraday low before closing at a higher level. Whatever, your choice it is an especially unusual decision for such a volatile stock. Volatility is measured in stocks by the beta coefficient. Described in the following link http://www.investopedia.com/terms/b/beta.asp

Cree has a beta of 1.7 or 70% more than the average stock, you certainly shouldn't use tight stop if you want to invest long term in this stock.


Investment Conclusions

There are more reasons not to buy a stock than to buy a stock. If you read the 10-K risks section you probably never invest in any stocks at all. Cree is a horse that knows many tricks and is learning a few more. Given the high valuation of course you should always consider all sides when making an investment decision. It is good advice to say that a 'long' that does not provide reasoning for his decisions and just unverifiable statements is just a zealot. However long or short, this is advice that cuts both ways.



A Long View
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