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.

And speaking of the worst ...
Over the past year, LED lighting superstar Cree (NAS: CREE) has made its fans in the stock market look anything but brilliant. 52 weeks of trading have generated little more than the stock market's average historical annual 11% gain -- and actually underperformed the S&P 500 in the real world, lagging the market by about one full percentage point.

But according to one analyst, this is all about to change.

Looking at Cree in a new light
This morning, investment banker Wedbush announced it is initiating coverage of Cree. According to ratings aggregator, the analyst has given Cree an "outperform" rating and a modestly bullish $36 price target, promising 14% profit from today's prices -- a target that, believe it or not, looks achievable.

Why is that? What's there to like about Cree? Wedbush explains:

We see Cree as optimally positioned to benefit from broader growth in LED lighting fixtures, given the company's leadership in developing high-brightness LED components and vertical integration with fixtures production. Gross margins appear to have finally bottomed. ... The outlook for improving [fiscal] 2H13 profitability from the recently introduced C3 chip platform and the potential for increasing fab utilization ... suggest margins have good prospects for further expansion.

In fact, profit margins at Cree -- gross, operating, and net -- are all at the highest levels we've seen in about a year. But the story here is about more than just improving margins -- more than last year's news of the tie-up with General Electric (NYS: GE) to advance LED manufacturing or last week's news of Cree's helping Best Buy (NYS: BBY) to develop a line of private-label "Insignia" LED bulbs. The story here is value.

Valuation matters
Admittedly, Cree doesn't look like much of a value stock on the surface. The stock sells for a 76 P/E ratio for one thing, and there aren't many value investors who would gravitate to that number. But dig a little deeper into Cree, and what do we find?

  • A company with $800 million in cash and not a lick of debt to its name.

  • A company generating free cash flow at the rate of $212 million a year -- more than four times the clip suggested by its $48 million in "net income" reported under GAAP. That's a relationship directly opposite to what you see at other leading "LED plays" such as Veeco Instruments (NAS: VECO) , which reports more income than it actually produces as cash profit. It's a darned sight better than Aixtron (NAS: AIXG) , which is actually burning cash.

  • And finally, in Cree we have a company that even the skeptics on Wall Street admit is likely to achieve 13.5% annual profit growth over the next five years.

Add it all up, and what you have here is a stock selling for an enterprise value-to-free-cash-flow ratio of just 13.3 but growing at a higher number (again, 13.5% annualized growth). And that, Fools, suggests that Cree is at worst a fairly valued stock and perhaps even a bargain -- if Wedbush's thesis of improving factory utilization rates and expanding profit margins pans out.

Long story short, I'd rather be long this stock than short.

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Fool contributor Rich Smith does not own (or short) shares of any company named above. You can find him on CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 290 out of more than 180,000 members. The Motley Fool owns shares of Best Buy and General Electric Company. Motley Fool newsletter services recommend Best Buy. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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