Color Kinetics: How to Play the LED Game

The allure of investing in such a powerful secular theme as Light-Emitting Diodes [LEDs] is high, but so are the risks. On the one hand, the rapid acceptance of this technology can be viewed quite broadly, whether we are crossing the street and looking at the traffic control, shopping, driving by a landmark at night, looking at illuminated pools or landscapes, watching the Jumbotron at a stadium or gambling in Vegas. Lower maintenance costs due to their longevity, energy savings due to their efficiency and quite compelling aesthetics all point to continued strong demand. In fact, the holy grail of the light industry, the screw-in-the-socket white LED bulb, is finally about to become a reality. So, the demand side seems pretty solid. What could prove problematic, however, is the supply side.

My observation of the industry over the past several years has shown it to be highly capital-intensive and laden with competition. The best example is Cree, Inc. (CREE), which, not surprising to me, has proven to be an investment disaster. They are the only publicly-traded LED maker, with a big emphasis on cellphones. While their unit growth has been stellar over the years (like flash makers or DRAM providers), their sales and profitability have greatly lagged due to significant price erosion and high manufacturing costs. I long ago concluded and continue to believe that they will be unlikely to profit from the growth of this industry. How, then, can one make money by the rapid adoption of this technology?

While it isn't the only public way of which I am aware, I believe that Color Kinetics (CLRK) (19.39, $367mm market cap) is likely to benefit greatly over the next several years. Though the company conducted its IPO in 2004, I didn't learn about it until I read about it in Investor's Business Daily almost a year ago. As a Mid-Cap focused investor, it had never hit my radar screens. I followed the stock for a while and used an earnings "miss" in July to finally buy the stock.

Unlike the suppliers of LEDs, this company benefits from the rapidly falling prices. CLRK uses the technology, as their products, which are the result of a very broad and deep patent portfolio, control the LED light. If you visit their website you will learn a great deal. (For an even more extensive explanation, I recommend that you contact the head of IR, Justine Alonzo for a copy of their Investor Day presentation last June.)

In a nutshell, as you examine their income statement, you will find that the company, despite its leadership position, spends a great deal on R&D and SG&A (they are investing in the business rather than maximizing short-term profits). Their balance sheet shows that their business, unlike those that manufacture the chips, isn't capital intensive at all.

The company has three different approaches, the largest of which is its own products. Two smaller segments are OEM (where it makes the controllers for others) and Licensing. They have won two patent infringement cases since their IPO. They are covered by 9 firms, none of which would be considered major.

So, where is CLRK the stock headed? While the PE has always been high, its strong revenue growth coupled with an extremely high R&D spend justifies it in my opinion. The closest peer, Daktronics (DAKT) (the maker of large scoreboards and displays), has a much lower GM (due to higher material costs), yet trades at a similar type of multiple. CLRK is expected to have EPS of .62 per share in 2008, an increase of over 25% on sales of $103mm (23% growth). While there is little evidence of operating leverage at this point, as the company continues to invest heavily, I believe that down the road the company will not have to spend so much on SG&A. Perhaps after the recent legal wins, their fees to protect their patent portfolio might decline! In any case, my target is for the company to achieve a 40 multiple on its 2008 EPS a year from now, or $24 per share. From a technical standpoint, I think that the chart looks very attractive.

While the stock endured its highest volume day in its public history on February 1st in a case of pre-EPS jitters apparently, despite some volatility, the stock has doubled since its 2004 IPO at 10 and has consolidated its recent secondary sale last year at 19. The 150-day moving average has lifted after a plateau. There is strong support in the 18.5-19.0 area, with resistance in the 21-22 area. The top three holders own over 22% of the company, and gorilla FMR still has some room to add. On the flip-side, though, the smart Royce guys started to sell last quarter, and PowerShares dumped their entire 1mm share position. I was encouraged last year to see Director John Abele (the founder of Boston Scientific) buy a big chunk on the open market at higher prices than when he initially joined the board in 2005 and made open market purchases. He has yet to sell a share. Maybe $1mm isn't so much to him, but I think that he is excited by this company.

So, with CLRK, we have a great secular growth story, a company with a pristine balance sheet that is investing heavily (and depressing near-term EPS) while it ramps up sales at a healthy pace, a strong patent portfolio that has stood up to court challenges, a reasonable valuation in terms of PE and P/S, no Tier-1 street coverage, and good risk/reward on a technical basis. While there might be some competitive issues from some of the larger lighting industry players, the patent portfolio should prove to be a large source of protection. In fact, the strength of their intellectual property position might serve as justification for their acquisition, though that isn't a part of my investment thesis.

Disclosure: Author is long CLRK.

Comments

[AlanBrochstein]

As a follow-up, there are some very exciting things going on here. The company's report today in and of itself wasn't spectacular in that it essentially was in line with expectations. Even the outlook for next quarter wasn't so great, especially on the EPS line. While people who look at just those numbers may be inclined to take profits after this nice run, I believe that would be very foolish.

The CEO did a good job of framing the extremely positive developments, including international regulations that could further stimulate demand, the incredible strength in licensing in Q1 (Trumpf and Ford stand out, but there were many others) and the increasing visibility of projects (like Deal or No Deal's set, the Hollywood Bowl, LAX and many big international installations). Further, the CFO set the tone for the strengthening long-term prospects, indicating that these licenses don't bear revenue initially (hence, no upside in the short-term). On the negative side, inventories were a little higher than expected. Also, the OEM portion, which is about 5%, was weak, with profitability further impacted by a one-time event. While it wasn't addressed until the Q&A, a very exciting prospect is the large potential installation at what is known as the Empire State Building. The NY Times detailed the competition between CLRK and PHG for this huge project.

I continue to believe that this stock has a long way to go in coming years and is the single best way to capture the theme of LED lighting. My position is quite large as a percentage of my holdings, so I may trim some around 24. One thing that could help the stock despite the ho-hum report of 28% organic sales growth and 100+% EPS growth is the upcoming tradeshow:

Lightfair International
May 8-10, 2007
Jacob Javits Convention Center
New York, NY
Booth 944
lightfair.com