This Just In: Upgrades and Downgrades


At The Motley Fool, we poke plenty of fun at Wall Street analysts and their endless cycle of upgrades, downgrades, and "initiating coverage at neutral." Today, we'll show you whether those bigwigs actually know what they're talking about. To help, we've enlisted Motley Fool CAPS to track the long-term performance of Wall Street's best and worst.

Is that a light at the end of Cree's tunnel?
It's been four months since Wall Street last lined up to take potshots at Cree (NAS: CREE) . In April, the leading light in LED lighting reported strong sales growth through retail partners Home Depot (NYS: HD) and Wal-Mart (NYS: WMT) , but it failed to produce anywhere near the level of profit from those sales that Wall Street had expected. In response, everyone from Caris to Kaufman to Wunderlich blasted the company, and even one of its fans, Barclays Capital, lamented the lack of "clear signs ... of a meaningful business turnaround, a ramp-up in general lighting, or a trough in pricing/margins ... "

Well, folks, the times they are a-changing. Yesterday, Cree stunned the skeptics with a fiscal Q4 report that showed much better results than anticipated. Now it's reaping its reward in the form of a big upgrade from ace analyst Canaccord Genuity.

The details
While acknowledging declining revenues and profits at Cree, Canaccord argued that management "has adequately reset expectations." At the same time, the analyst sees Cree taking concrete steps to improve its business -- working down "inventory levels relative to sales," adding "a few accretive margin points," and capitalizing on "a bifurcation in the LED market in which the low end [i.e., Cree] gets commoditized but the high-end market maintains a more robust profile."

Going forward, Canaccord expects Cree to, at the very least, exceed "bearish buy-side expectations." Result: The analyst argues that "shorts [will] begin covering and money on the sidelines [will] explore building positions again following the reset." The banker now sees Cree shares hitting $39 within a year. But is it right?

Buy these numbers?
On the surface, it seems an easy question. Cree today sells for just 22 times earnings, and is pegged for 22% long-term earnings growth. That looks like a fair price at worst. If you agree with General Electric (NYS: GE) that Cree is top dog in the LED industry -- GE just hitched up with Cree to help build its new line of LED lights -- and probably deserves a premium price to its competitors, then 22 times earnings might even be "cheap."

It might ... if not for one thing: The company's still not churning out cash the way it should.

Consider: Over the past 12 months, Cree says it earned more than $146 million in GAAP profits. That sounds pretty good until you discover that further up the LED supply chain, LED manufacturing equipment makers like Veeco (NAS: VECO) and Aixtron (NAS: AIXG) earned twice as much. What's more, buried within Cree's earnings report was the admission that whatever accounting profit GAAP says it earned, in actual fact the company only generated about $14 million worth of real free cash flow from its business -- an even smaller fraction of the free cash flow the manufacturing equipment makers are hauling in.

Foolish takeaway
When I look at Cree, I don't see a "22 P/E company" growing at 22%. I see a company valued at 270 times its annual free cash flow. A company that everyone says will grow at 22%, but that here and now is generating the least amount of free cash flow it's earned at any time in the past five years, including the very cash-poor year that was 2007.

To be crystal clear: No, I don't see this as an argument in favor of buying Cree.

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At the time thisarticle was published Fool contributorRich Smithowns shares of Veeco Instruments. You can find him on CAPS, publicly pontificating under the handleTMFDitty, where he's currently ranked No. 472 out of more than 180,000 members. The Motley Fool has adisclosure policy.The Motley Fool owns shares of Wal-Mart Stores.Motley Fool newsletter serviceshave recommended buying shares of Wal-Mart Stores and The Home Depot.Motley Fool newsletter serviceshave recommended creating a diagonal call position in Wal-Mart Stores.We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors.

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