This Just In: More 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." While the pinstripe-and-wingtip crowd is entitled to its opinions, we've got some pretty sharp stock pickers down here on Main Street, too. (And we're not always impressed with how Wall Street does its job.)

Given this, perhaps we shouldn't be giving virtual ink to "news" of analyst upgrades and downgrades. And we wouldn't -- if that were all we were doing. Fortunately, in "This Just In," we don't simply tell you what the analysts said. We also show you whether they know what they're talking about.

Turn it off? Or turn it up?
Here we go again, folks. Last week, I regaled you with the tale of two major megabankers dueling over the fate of LED star Cree (Nasdaq: CREE). To recap, Goldman Sachs was for it, calling Cree a near-term winner in the movement to replace incandescent light bulbs with LED lighting globally. Morgan Stanley, in contrast, thought Cree was unlikely to outperform the market. This analyst cited a growing overcapacity in the LED manufacturing industry as part of its reason for slashing Cree's growth estimate by more than a third, and downgrading the stock.

So it seems what we really need here is a tie-breaker -- and as luck would have it, that's just what we got yesterday, when the market watchers at Maxim Group announced they, too, were initiating coverage of Cree... with a buy rating.

Cree: Turn it up
Admittedly, Maxim's not the most reliable indicator of success in the alternative energy/energy-efficiency sphere. To the contrary, this analyst has quite a checkered past when it comes to such stocks. A few examples:

Source: Motley Fool CAPS.

And yet, contrasting Cree with fellow alt-energy play First Solar, which it says has been crushed by competition from low-cost solar panel-makers in China, Maxim Group says Cree's prospects look considerably brighter. Maxim argues that unlike solar panels, LEDs are not a commodity business. To the contrary, the analyst notes that one reason LEDs haven't taken off as quickly as many investors thought they would is that China -- which has initiated a very public campaign to convert to LEDs -- has had trouble getting high-quality product out of its domestic manufacturers. In contrast, Cree's LEDs are high-quality, and Maxim thinks this gives the company a leg up on the competition.

Maxim also likes the growth prospects here. While not hot on the upper end of the LED supply chain (Maxim assigned sell ratings to Veeco Instruments (Nasdaq: VECO) and Aixtron (Nasdaq: AIXG)), Maxim argues that the nonresidential (i.e., business customers) market will generate $50 billion in sales over the next three years, and that Cree can grab a lot of that business. (For context, the company sold less than $1 billion in LEDs to all markets in the past 12 months.)

The high price of high growth
Getting interested yet? You should be, because Maxim thinks growing into this market will allow Cree to expand its revenues at about 29% per year over the next three years. With profit margins "close to bottoming," this suggests that Cree may be undervalued at today's trailing P/E ratio of 24.

Unfortunately, I see two flaws in that argument -- flaws that I fear doom Maxim's buy rating on Cree to the same fates that it's met in past solar power picks (solar power is a semiconductor-chip-based technology, similar to LEDs). The first flaw is that if you're valuing Cree on P/E, you risk missing the fact that Cree's not currently generating much free cash flow at all to back up its reported GAAP earnings. (This, by the way, goes hand in hand with my own past arguments for selling the solar stocks before they got crushed.)

Second, even if Cree were generating enough cash to back up its claimed "profits," the company may not grow as fast as Maxim expects. Morgan Stanley, the banker that just finished downgrading Cree after being a fan for years, thinks 22% growth is more likely, while the consensus on Wall Street is actually a bit lower than that.

Foolish takeaway
Cree shareholders have had a rough time of things in 2011 -- but don't expect 2012 to be much better. Unless and until this company begins generating significant, sustainable free cash flow from its business, even 29% sales growth won't be enough to save its stock.

My advice therefore remains the same as it's always been: If you want to profit from the LED revolution, bet on a proven free cash flow generator, with real economies of scale already in place, and a dedication to dominate the market: General Electric (NYSE: GE).

I've publicly recommended GE stock above all other LED players on Motley Fool CAPS. I stand by that opinion still.

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