LED – Cree results highlight margin pressure :: Macquarie Research,

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LED – Cree results highlight margin
pressure
Event
 Following our MacqTech Express “LED – implications of SemiLEDs’ results on
Taiwanese names” on 6 April, Cree posted weak CY1Q11 results/2Q guidance
on 19 April, which will have negative implications for LED chip makers, in our
view. While we believe LED lighting (especially commercial) could see greater
adoption in 2011, our concern for Epistar and LG Innotek is over LED TV chip
commoditization amid higher exposure to backlight LED (50%+ of sales) in
2011E, while the potential risk of LED lighting margins facing pressure from
foreign suppliers such as Cree/SemiLED, who are being forced to price down to
defend market share, persists. We retain our non-consensus UP on Epistar and
stay negative on LG Innotek which is on our MarQuee Sell List.

Impact
 Cree – weak 1Q results. Cree posted weak 1Q results following its negative preannouncement
on 23rd March. 1Q sales fell 15% QoQ (-6% YoY) and GPM fell to
42% (47% in 4Q10) due to weakness in LED chip ASP ("significant double digit
ASP decline") and LED component (“low double digit ASP drop”). Inventory days
rose to 119 versus 96 days in prior quarter.
 2Q outlook is soft. Cree stated that the LED chip outlook has “gotten worse” and
it expects sales decline for LED chip (flat volume growth and further ASP drop),
while component should see improvement and lighting systems will see strong
growth. It guides 2Q11 sales to be +2% to +12% QoQ (slightly down from prior
guide of +10-12% QoQ) and -7% to -15% YoY falls. Management guides for
GPM in 40%+/- range, implying further drop QoQ but confidence levels seem
uncertain.
 LED lighting share battle heats up. Importantly, when asked about stability of
margins and its business model going forward, Cree noted that in the short term,
order visibility is still low and much softer than a year ago and the outlook remains
fluid; in the mid-term, Cree is focused on boosting LED adoption rates and thinks
the model will revert back to being more stable/healthy in the longer term. This
follows SemiLEDs public intention to defend its market share via aggressive
pricing. We believe such business model changes are likely to lead to greater
cost and margin pressure for the LED lighting segment and for Epistar/LGI, this
means 2010 peak margins would be difficult to achieve again, in our view.
 Product mix key in 2011. 2010 was a great year for LED chipmakers as LED
lighting enjoyed 50%+ GPM while LED TV saw no ASP pressure until 4Q10. For
Epistar, LED lighting is likely ~25-30% of the mix in 2011 (20-25% in 2010), while
LED backlight (which we see as increasingly commoditized) is >50% of mix.
While bulls hope lighting (enjoyed >50+% GPM in 3Q10) can help offset margin
shortfall from LED TV chips in 2011, Cree and SemiLED’s strategy to defend
market share could lead to more intensified pricing and margin compression for
the high-end lighting segment, in our view.
Outlook
 For Epistar, at 1.8x PBV/15x PE, we maintain our non-consensus Underperform
due to medium-term concerns over LED TV chip commoditization, overall higher
exposure to backlighting (50%+ of sales) in 2011E, and potential risk of lighting
margins being pressured by foreign vendors defending market share. We are
also underweight LG Innotek in Korea, which is on the MarQuee Sell List.