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 loses a fan
For a while there, it looked like Cree (NASDAQ: CREE  ) could do no wrong. Across the industry and around the globe, major corporations were lining up to partner with the LED lighting specialist. General Electric (NYSE: GE  ) wanted to use Cree technology to build a better 60-watt light bulb. Home Depot (NYSE: HD  ) put its product in stock. Best Buy (NYSE: BBY  ) even asked Cree to develop a line of branded "Insignia" light bulbs to sell at its stores.

Result: Last year, Cree booked a 50% gain as the good news kept rolling in.

Prospects dim
But today, one analyst sees prospects dimming for Cree. In a research note issued Monday, analyst Canaccord Genuity announced it is downgrading Cree to hold, and setting a $32 price target on the stock, on the theory that gross margin "expansion" at Cree's components business has reached a top, and is already "reflected" in the company's share price. From here on out, Canaccord sees Cree needs to sell more actual lighting systems, not just components. And here, the analyst sees less chance of margin improvement.

Why? According to Canaccord, as Cree switches from being an LED components manufacturer, to a branded maker of lighting systems, it will need to make "investments ... to stimulate the market and capture share."

Mind you, Canaccord sees this as a good thing, and says it's optimistic about the company "over the medium to long term." It's the near term that is the problem. This quarter, Canaccord sees Cree beginning to ramp up spending on its operations and earning smaller profit margins as a result, even as it enters into a period of slowing seasonal sales. Canaccord warns that investors who've become accustomed to seeing Cree expand profit margins, as it has for the past three consecutive quarters, may be disappointed if this trend is abruptly cut short in Q4 (fiscal Q2).

The analyst's advice: Avoid the rush for the exits, and get out now.

Sound advice
I agree. Listen, Fools -- I'm not one of those pundits who gapes in awe at Cree's 78 times earnings valuation and exclaims instinctively that the stock costs too much. I recognize that Cree's GAAP earnings don't tell the whole tale. Fact is, this company generated $212 million in real free cash flow over the past 12 months -- more than four times the amount of "earnings" claimed on its income statement.

But the fact also is, that if you take this free cash flow number and compare it to Cree's $3.7 billion market cap, you still end up with a stock that costs more than 17 times annual cash profits. That's quite a lot to pay for a company that's projected to grow at only 14.4% per year over the next half-decade. If Canaccord's right, and that growth rate is overly optimistic because Cree's margins improvement will soon stall, then the stock's even more expensive than it already looks.

Foolish takeaway
Like Canaccord, I like Cree as a long-term play on the emergence of LED lighting as an alternative to wasteful incandescents -- but the plain truth is that I'd like it a lot more at a lower price. Today, we appear to be seeing Cree en route to a big stumble, as margins stagnate and growth slows. Assuming such a stumble causes momentum investors to think twice about buying a company with such an apparently high P/E ratio, this could create an opportunity for long-term value investors to buy a great free cash flow producer at a lower price than it costs today.

My advice: Patience, grasshopper. For now, the stock's too expensive to buy, but Cree will become a bargain yet.

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