2 High-Tech Stocks with 50% Upside in 2012

David Sterman
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Posted: Dec 07, 2011 12:01 AM

Here at StreetAuthority, we're always looking for "game-changing" stocks. In fact, my colleague Andy Obermueller has an entire newsletter dedicated to the subject. These "game-changers" are usually smaller firms that are developing revolutionary new products. Yet we also have our eye on larger, more well-established companies that seek to push the envelope, developing technologies that can enhance the customer's experience in new and different ways.

These larger firms know heavy investments in research and development (R&D) are crucial. R&D efforts, which often yield a treasure trove of patents, can help them command firm pricing and generate impressive margins.

Right now, there is a pair of "game-changers" I have my eye on. They may be well-known, but they are not widely-loved by Wall Street, at least not yet anyway. Each trades for less than half of its 52-week high, and each looks poised for a solid rebound in 2012. It's just a coincidence that they cater to two of the five senses -- sound and sight.

Dolby Labs (NYSE: DLB)

This name has become synonymous with crisp sound, whether at a movie theatre, in your car or in your living room. A rising tide of consumer-electronics companies has licensed Dolby's technology, helping sales rise by at least 10% every year for the past decade. Just as impressive, its focus on patent licensing yielded remarkable profit margins: Operating margins typically exceed 40%, while net margins have been above 30% for four straight years. These margins helped Dolby generate more than $800 million in free cash flow in the past three years.

Still, even high-growth stocks sometimes need a pause before resuming their upward trajectory. Shares of Dolby Labs have fallen more than 50% from the 52-week high and are back at levels seen four years ago. Why the sell-off? Because the next version of Microsoft's (Nasdaq: MSFT) Windows operating system -- known as Windows 8 -- is due to ship in 2012, and it will not come pre-bundled with Dolby's audio software. (Dolby currently earns a tiny profit on every Windows PC shipped, thanks to a soon-to-expire licensing agreement.)

To be sure, the loss will likely negatively affect the company. PCs represent 30% of total sales and roughly 20% of operating income. But Dolby continues to make clear progress in other areas, especially in new mobile devices, set-top boxes, gaming platforms and in international markets. In the near-term, new licensees simply offset the Microsoft loss. As a result, sales and earnings per share (EPS) are likely to be stagnant in fiscal (September) 2012 and 2013 at about $950 million and $2.50 per share, respectively.

Analysts say these numbers could get a solid boost in subsequent years as recent new relationships will take devices that are just now being designed by many consumer electronics firms to hit the market within 18-24 months. "The combination of the global transition from analog to digital broadcasting and Dolby's significant presence in digital media will provide a basis of growth once the company gets through the Windows 8 transition," note analysts at Dougherty & Co.

Analysts at Barrington & Co. agree. They boosted their rating to "outperform" on Nov. 22 with a $43 price target. They cite video streaming, where Dolby works with Apple (Nasdaq: AAPL) and others as one of several growth drivers.

Meanwhile, strip out the $1 billion net cash balance, and shares trade for around 6.5 times projected 2012 profits. To support the stock, Dolby is in the midst of a $250 million buyback plan (another one may follow suit after the current plan is completed). More important, the company boosted R&D spending by about 25% in fiscal 2010 and again in fiscal 2011 (to a recent $124 million), which should keep the company ahead of the pack in terms of next-generation technology.

Cree Research (Nasdaq: CREE)
Back in June, I predicted this stock would post a strong second-half rally. Little did I know the market would go on to post a very challenging second half, taking this stock even lower. Still, the more I research this stock, the more I become convinced it is on the cusp of very robust growth during the next five years.

As a quick recap, Cree's light-emitting diode (LED) lights last far longer than traditional incandescent bulbs and consume a lot less power. To stay on the cutting edge, the company has been boosting R&D spending at a 20% annual clip to a recent $115 million in fiscal (June) 2010. The R&D effort means Cree's LEDs are generally considered to be the most durable in the industry. The company also offers the widest range of form factors for these lights to be used by architects and industrial designers.

Why the stock price plunge? China, the biggest market for LED lighting (37% global share in 2010),  had sought to focus more on domestic suppliers, But it ultimately found that the Chinese-made LEDs failed at alarming rates. Cree stands to pick up lost market share in China in 2012 and beyond, as it has been making the case that in terms of total cost of ownership, its lights are the cheapest. Still, the Chinese hiccup will lead EPS to drop from $1.70 in fiscal 2011 to roughly $1.20 in fiscal 2012, before an expected rebound to $1.70 in fiscal 2013.

Although Cree has been publicly traded since 1993, its most impressive growth may still lie ahead, according to Goldman Sachs. It predicts LED lighting will grow at a 30% annual pace through 2020, by which time more than half of all lights should be LEDs. Europe is probably going to lead the way. By the end of 2012, half of all newly-installed lights in Europe will need to be LEDs, according to EU mandates, with this figure rising to 100% by 2015. In the United States, around 15% of new buildings constructed in 2011 were made with LED ballasts. This figure is expected to steadily rise, even in the absence of any Washington mandates.

Goldman Sachs calls Cree a "top pick," with a $40 price target, which represents 60% upside. "We see the company's product portfolio optimally positioning the company to address the applications (outdoor, commercial), that will see the most significant pace of adoption over the next several years given the best returns and payback profiles."  The fact that this stock began the year above $60 and now hovers around $25 sharply discounts this bright outlook.

Risks to Consider: A slowing global economy in 2012 could lead to delays in adoption of Dolby and Cree's newest technologies.

Action to Take-- > These are stock picks for the long haul. It's unclear what the next quarter or two will look like for these in-transition firms, but their multi-year view remains quite bright as they reap a payoff from heavy R&D spending. These stocks may not rebound to their recent 52-week highs in 2012, but in each case, a 50% upward move appears reasonable.

From a current $25, Cree could move toward the $40 mark, which would still place the 2012 P/E multiple in the low 20s, below the projected 30% annual growth rate Goldman Sachs anticipates. A similar 50% upward move for Dolby Labs to about $50 also represents a reasonable 20 times forward earnings multiple for this high-margin business model that should see a resumption in profit growth in calendar 2013 (i.e. the later quarters of fiscal 2013).

Disclosure: Neither D. Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.

This article originally appeared at www.streetauthority.com.