Many consumers are still ignoring the quickest way to lower their utility bills. 

Swapping out all of your older light bulbs for new light-emitting diode (LED) bulbs can save hundreds of dollars in power costs. And the fact that these bulbs can last up to 25,000 hours means you’re all set for the next decade.

This new technology has been a notable success story for Home Depot (NYSE: HD), and its key LED supplier, Cree (Nasdaq: CREE). You would think that Wal-Mart (NYSE: WMT) would also like to have been a major vendor of this cutting-edge, cost-saving lighting technology. But the LEDs it sold from many manufacturers have always been a bit too pricey for Wal-Mart’s rank-and-file shoppers. 

Yet Wal-Mart’s new house-brand line of LEDs changes everything.#-ad_banner-#

Wal-Mart’s Great Value LED lights, made by privately held TCP Inc., are priced under $10, which is crucial in two respects. It’s a price point that lures many more consumers to make the change, considering these bulbs can now pay for themselves in terms of power consumption in just two or three years. And it’s a nightmare price point for Cree, which appears hard-pressed to make profits at such a price. 

At least that’s the view of Piper Jaffray’s Jagadish Iyer: “At a $10 price point, we see a big squeeze on profitability at least initially for the OEMs, as we have highlighted in the case of Cree, where we think its light bulbs currently carry negative gross margins.”

For a bit of context, Wal-Mart is selling GE’s dimmable 60-watt LED bulb for just under $11 — roughly $2 less than Cree’s price at Home Depot. 

A Long Climb Back
Make no mistake, Cree deserves a huge amount of credit for stimulating demand in the LED market, which had been slow to take off in 2010 and 2011. The company pushed hard to hammer down its own costs, getting many of its bulbs below the $20 price point in recent years. That’s why I thought this stock was so appealing back when it traded for $20 in early 2012.

Yet as Cree’s shares have now rebounded sharply, investors may be ignoring the serious challenges ahead for the company. Simply put, industry production capacity is growing at a rapid pace, which will surely impact pricing and gross margins. 

	© 2013 Cree, Inc.
	Cree pushed hard to hammer down its own costs, getting many of its bulbs below the $20 price point in recent years.

Across the globe, companies such as China’s Yankon, Elec-Tech International, and San’an, Taiwan’s Epistar, and South Korea’s LG-Innotek and Seoul Semiconductor are ramping up production of “good enough” products that may not be quite as leading edge as Cree’s LED products, but good enough to be long-lasting and meet low price points. 

In effect, LED lighting is about to be hit by the “Wal-Mart effect,” where price trumps all, leading industry margins to remain wafer-thin.

Gross Margins At A Peak?
Cree’s fiscal fourth-quarter results (for the quarter ended June) were just shy of forecasts, and tepid fiscal 2014 guidance has led the EPS consensus to drop from $1.87 to $1.77 over the past 60 days. D.A. Davidson’s Avinash Kant used the quarterly results as the basis for a ratings downgrade to “neutral” (lowering his price target to $65), noting concerns that slower than expected margin expansion and revenue growth leaves very little room for upward earnings revisions. 

Analysts have been continually forecasting margin gains as Cree more fully utilizes its manufacturing capacity, but so far, that’s just not happening. 

Cree has been able to make major gains in terms of its manufacturing efficiency and overhead absorption, but ever-tougher industry pricing pressures keep the company from benefiting from lower costs.

Will margins ever rebound?

Despite those apparent challenges, many of which reappeared on the fourth-quarter conference call in early August when shares slumped below $60, they’ve rebounded once again to near the 52-week high of $76 as investors again focus on the positive traits of the LED lighting industry.

But at current prices, these shares are no bargain, trading for nearly 35 times projected fiscal 2015 profits. Yet it’s fair to wonder if the rapid fresh price declines for LED light bulbs (led by Wal-Mart and GE) will make it impossible for Cree to deliver the margin growth that the most bullish investors are anticipating. 

Risks to Consider: As an upside risk, Cree has long been seen as a buyout candidate, and some of the recent share price strength is attributable to buyout rumors. 

Action To Take –> When shares of Cree were widely reviled in early 2012, shares traded for little more than 10 times forward earnings. Less than two years later, investors are now according a much richer multiple to this stock. As a result, Cree now faces a much higher hurdle. Investors may be in for a rude surprise if the company’s profit margins remain stuck in neutral in coming quarters.

Editor’s note: In some previous versions of this article, the supplier of Wal-Mart’s Great Value LEDs was incorrectly identified as General Electric.

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