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're going to try and 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.

Cree crumbles
It's not easy being Cree (Nasdaq: CREE  ) -- or being one of its stockholders. On Tuesday, the leading light in LED illumination reported a near-60% drop in quarterly earnings for fiscal third quarter. (Pretty rough for a mere 6% slowdown in revenues.) The news undershot analyst estimates. Worse, Cree guided for more of the same in the current, fiscal fourth quarter. Earnings are expected to come in around $0.28 per share, or nearly a quarter below the $0.36 analysts had been projecting.

Needless to say, Wall Street was not pleased. As of this writing, StreetInsider.com has at least three separate analysts (Caris, Kaufman, Wunderlich) already on record lodging downgrades against the stock. Other analysts, including Barclays, Canaccord Genuity, UBS, and Jefferies, left their various ratings intact but made negative noises about the stock. But who's right -- the folks selling Cree, or the ones who only talk like they wish they had sold?

Let's go to the tape
Call me a pessimist, but as I review Cree's results I cannot help side with the more pessimistic crowd. It's not just that Cree missed estimates, mind you. Nor does management's anemic guidance scare me. After all, the analysts still have Cree pegged for nearly 22% annual earnings growth over the next five years. No, what worries me is that that may not be enough to justify the stock price.

What also worries me is that the analysts seem to agree.

And these aren't just any old analysts we're talking about here, either. There's not a Capital One or "Auriga U.S.A." among 'em. Examine the records of these raters on Motley Fool CAPS, and you'll find that each of Caris and Kaufman, Wunderlich, Barclays, Canaccord, UBS, and Jefferies, belongs to the "All-Star" cadre of investors -- those who've proven over the years a consistent ability to outperform 90% or more of the investors we track on CAPS. And none of them like Cree much right now ...

Actions, not words
And for good reason. Cree may say its results "were in-line" with what it expected to achieve in Q3. It may boast of "continued success in LED lighting" and promise to "disrupt the market and lead the LED lighting revolution in the years ahead." But so far this year, the revolution looks in trouble.

Consider: There's certainly some truth to what Cree tells us. In its write-up, UBS noted that Cree's "LED lighting sales to resellers such as Home Depot (NYSE: HD  ) / Walmart (NYSE: WMT  ) rose 16%. But its sales success there notwithstanding, management isn't doing a great job of generating real profits for its shareholders. It's not churning out the cash.

In Q3, free cash flow plunged steeply, and put Cree deeply in the red as the company burned through $21.7 million of its cash. (For comparison, by this time last year, Cree had already banked $27.8 million.) Maybe I'm being overly critical when I say this, but to me, if a company valued in excess of $4 billion cannot generate even a dime's worth of cash profit ... then maybe the company's really not worth $4 billion.

Where's the cash?
Sure, at 21 times earnings, Cree may look like a bargain relative to its "22% growth" assumptions. But according to the analysts, Cree's facing a whole host of problems that are keeping it from translating growth into cash. Multiple analysts have noted the fact that the company is facing "pricing pressure" from competitors. And while Jefferies (one of the Cree-non-downgraders) muses hopefully about a possible "slowing rate of ASP decline", other analysts, such as Canaccord, insist there's still a lot of "aggressive pricing" going on out there, and adds "inventory" and "utilization" to the list of Cree concerns.

Meanwhile, a lot of Cree's competitors seem to be navigating the turbulent LED environment better than Cree -- and offer better bargains to boot. STMicroelectronics (NYSE: STM  ) and Philips (NYSE: PHG  ) , for example, are both expected to grow as fast as Cree over the next five years, but sell for much lower P/E ratios. Ultra-diversified General Electric (NYSE: GE  ) is growing slower, but costs less and has made a major commitment to its LED lighting business. Meanwhile, farther upstream, investors are practically giving away shares of LED manufacturing equipment maker Veeco Instruments (Nasdaq: VECO  ) , which cost less than six times earnings.

Foolish final thought
As for Cree itself, I'll sum up with a few choice words from Barclays (again, one of the more optimistic analysts, inasmuch as it has at least not downgraded the stock in response to earnings.) Says Barclays: "With no clear signs yet of a meaningful business turnaround, a ramp-up in general lighting, or a trough in pricing/margins, we continue to see downside risk for shares."

So do I.

Fool contributor Rich Smith owns shares of Veeco. You can find him on CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 602 out of more than 170,000 members. The Motley Fool has a disclosure policy.

Home Depot and Wal-Mart Stores are Motley Fool Inside Value picks. Wal-Mart Stores is a Motley Fool Global Gains recommendation. Wal-Mart Stores is a Motley Fool Income Investor recommendation. Motley Fool Options has recommended a diagonal call position on Wal-Mart Stores. The Fool owns shares of Wal-Mart Stores.

Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.


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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 21, 2011, at 3:41 PM, FoolSolo wrote:

    CREE has been over valued, which is why I have stayed away from it. Even after having their price cut in half, they are still at 61 times FCF. Add their dismal 10% ROE, and you have plenty to worry about.

    On the other hand, VECO is ridiculously cheap. I've been stating for a while that their Market Cap is half of AIXG, despite the fact VECO sales are $933M versus $1.14B for AIXG, and VECO Income is $260M versus AIXG's $279M. So, why is AIXG valued at $4.23B whereas VECO is valued at $1.98B?

    In my opinion, LED will continue to grow, and will eventually displace other forms of lighting. However, CREE is not the likely master to lead the way. I believe VECO will reward, and certainly has been rewarding since I took a position in them late last year in the low $40s. I'm sure if you do your own due diligence into their financials and their balance sheet you will wonder when, not if, will VECO break out.

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