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.

Cree crumbles
Wednesday was not a fun day to be a Cree (Nasdaq: CREE  ) shareholder. And if you're an investor in Aixtron (Nasdaq: AIXG  ) , Veeco Instruments (Nasdaq: VECO  ) , or Rubicon Technology (Nasdaq: RBCN  ) -- look out. What happened to Cree could happen to you, too.

The best-known name in the LED lighting industry (probably not the biggest; that title would go to its partner in lighting, General Electric (NYSE: GE  ) ), Cree tends to set the tone for LED lighting bulls and bears alike. And it's looking like bears are ascendant this week. Not only did Cree "miss" Wall Street targets for both fiscal third-quarter earnings and revenues last quarter, but according to Tuesday's earnings report, the company's likely to miss both earnings and revenues again when fourth-quarter results roll around.

That news sparked an immediate downgrade from analysts at ThinkEquity, who were sufficiently miffed at the results that they withdrew their buy rating on the stock. And yet, for all the bad news, Cree still has its fans on Wall Street.

Who drank the Cree Kool-Aid?
Who's still backing Cree after its disappointment? Let me count the names. So far, no fewer than four analysts have doubled down on their endorsements of Cree.

According to StreetInsider.com, Oppenheimer wrote yesterday that whatever you think of Cree's earnings, the company's 30% growth in third-quarter revenue clearly shows that "the transition from incandescent and fluorescent lighting to LED [is] beginning to hit an inflection point." Canaccord Genuity insisted the "lighting macro is still well on track." Needham & Co. actually turned logic on its head and described Cree's failure to hit either earnings or revenue targets in Q3 as proof that "business troughed in the March quarter." And how did Needham react to seeing the stock crater 6% in Wednesday trading? It advised using "near-term weakness as a buying opportunity."

Chug! Chug! Chug!
Of course, one analyst went above and beyond the call of duty in backing Cree post-earnings. While almost everyone else on Wall Street was tying themselves in knots trying to explain why the bad news wasn't really as bad as it looked, analysts at Jefferies & Co. actually went so far as to raise their price target! According to Jefferies, what this week's news really shows is that "business fundamentals are improving and Cree's competitive positioning is ... strong."

Astounding. Do these folks really have any idea what they're talking about?

Facts are stubborn things
As a matter of fact, they do. Things may not be as bleak for the LED companies in general, or for Cree in particular, as the "earnings miss" implies. Because while most of the mainstream media was busy castigating Cree for missing earnings, if you actually look closely at the numbers, it turns out that Jefferies may be right. Business may indeed be improving.

You see, in anticipation of growing acceptance of, and demand for, LED lighting, Cree has spent a lot of money building out capacity in recent years -- more than $500 million over just the past three or four years alone. And while that expense is eating into reported earnings, and profit margins, it's starting to pay off in the form of actual cash profits.

Consider: Over the past nine months, Cree booked $34.4 million in profit (a 73% decline). But with sales growing 15% year over year -- including the sharp 30% spike in Q3-just-ended -- Cree is starting to throw off sizable free cash flows -- $95.4 million, versus negative free cash for the nine months ended March 27, 2011.

Annualized, this works out to perhaps $127 million in free cash that Cree can generate, and once you back out the firm's $685 million in net cash, what you wind up with is an enterprise value-to-free-cash-flow ratio of less than 22.

Foolish takeaway
Relative to Cree's 21% projected growth rate for profits, that's not quite enough to make the stock a bargain yet. But it's darn close to fair value -- and a much better value than Veeco, which is generating free cash at less than half the rate of reported income, or Aixtron or Rubicon, both of which are currently burning cash.

Personally, I still think that the best way to play the conversion to LEDs is via General Electric -- but that's just me. (What can I say? I'm a sucker for a dominant conglomerate with a generous, and growing, dividend payout.) But for Fools looking to take on a bit more risk, and potentially score a bigger payday, Cree's move back toward positive cash generation suggests this stock could indeed become "buyable" sooner than we thought.

Think I'm wrong? Follow along as I lay odds on Veeco and GE, Aixtron and Cree, on Motley Fool CAPS.

And if you're looking for more unconventional ways to invest in tech, read the Fool's new -- and free! -- report. Find out how you, too, can profit from The Next Trillion-Dollar Revolution.

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. 345 out of more than 180,000 members. The Motley Fool has a disclosure policy.

We 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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