If you want to be a thorough investor, then it’s absolutely crucial to keep track of once-loved growth stocks that have fallen out of favor. Many investors simply move on to other ideas, not fully understanding that lagging growth stocks may simply be suffering from some short-term growing pains. When the company’s growth trajectory comes back into focus, shares can subsequently post remarkable gains.#-ad_banner-#

That was the case with LED maker Cree Research Inc. (Nasdaq: CREE) in January 2012, when shares were on a downward spiral, falling from about $80 to just $23 in just a few years.

As a bit of background, during his first term, President Barack Obama announced efforts to phase out the use of incandescent light bulbs to reduce energy use and costs.

Needless to say, Cree and its energy-conscious LED lights quickly became a hot growth story.

But the “story” of this stock remained just in theory.

Investors started to grow frustrated that the LED-lighting industry was slow to develop. After all, sales growth decelerated from 53% in fiscal (June) 2010 to just 14% in fiscal 2011. Some investors mistakenly assumed this market had already matured, even though we’re only in the early innings of industry growth.

This view has now come back into force, as shares have been soaring in recent weeks.

I’ve written about Cree on several occasions in the past, but the recent gains for Cree are a result of a game-changing announcement. Whereas LED lights had previously been too expensive for mass market adoption, priced in the $20 to $30 range, Cree has plans to sell a new a line of LED 40-watt lights at retailers such as Home Depot (NYSE: HD) for just $10. That’s still a lot more expensive than traditional incandescent bulbs, but considering that LED lights use 80% less energy, the payback time in terms of saved energy is just a few years. And these light bulbs can last for more than 10 years, which coincidentally, is how long their warranty will last.

Cree paired this announcement with a bump in quarterly guidance as well. Sales for the 2013 fiscal third quarter ending this month will likely be about $342 million (using the mid-range of guidance), which is 2% above the consensus forecasts and roughly 20% higher than year-ago levels. Management also bumped up the earnings outlook, from a range of 30-35 cents a share to 31-36 cents a share.

This is a nice shift from recent quarters, when Cree had a habit of lowering guidance as the LED market faced myriad pricing pressures and order deferrals. Yet, even as Cree starts to fulfill its promise, a key issue remains in place: LED lights, as highlighted by the $10 bulb, may not be very profitable.

Indeed, even with higher-priced LEDs, Cree’s gross margins have been under severe pressure in the past few years and have rebounded only modestly in recent quarters.

Gross margins will likely never move meaningfully above 40% simply because the LED industry will be characterized by ever-fiercer pricing pressures. Cree’s $10 LED light bulb is great news for unit sales growth, but it’s simply unclear whether the company will be able to generate decent profit margins at that price.

To its credit, Cree’s heavy research and development investments have enabled it to steadily lower manufacturing costs. But rivals will likely catch up, eventually. Competition from established lighting firms such as GE (NYSE: GE) and Philips (NYSE: PHG) is growing (though they are also partners as they use some of Cree’s technology), but a number of Chinese manufacturers are also ramping up production. These manufacturers have thus far been unable to match the power output or long-term durability of Cree’s LEDs, but it’s unwise to think they won’t catch up over time.

Richly valued
One of the key factors behind this stock’s huge drop in 2011 was the realization that Cree may never deliver the robust cash flow to justify a market valuation that at one point, exceeded $9 billion. The market value has now stands at a more reasonable $6 billion, but still looks pretty rich in the context of projected cash flow.

D.A. Davidson pegs fiscal (June) 2014 cash flow at about $180 million, meaning that the company is trading at more than 30 times that figure. Looking another year out, to fiscal 2015, UBS sees that figure hitting $250 million, though by that time, this industry’s strong growth trajectory may have started to cool. The $6 billion market value more than accounts for the cash flow growth to come.

Risks to Consider: As an upside risk, Cree has long been rumored to be a buyout candidate, though the recent spike in market value may soon make this too big a fish to digest.

Action to Take –> As I’ve written about Cree on several occasions in the past, this is an excellent stock, but one that’s subject to bi-polar perspectives from investors. A few solid quarters, and investors bid up shares strongly. Conversely, a few weaker quarters, and this stock tends to fall out of bed. It’s unwise to chase this stock at this point, and if history is any guide, then a quarterly stumble later this year could put shares right back into value territory.