Cree Stock Upgraded on Hopes for a Sale: What You Need to Know

By Rich Smith Markets Fool.com

Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

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Three months ago, analysts at JMP Securities downgraded shares of Cree (NASDAQ: CREE) on fears that a sale of its Wolfspeed power and radio frequency productsdivision was about to collapse. They were right to worry -- Cree stock is down 16% since.

Three months later, JMP is back on Wall Street -- and this time it's singing Cree's praises. Upgrading Cree stock and assigning it a $29 price target, JMP says it sees three ways forward for the LED lighting pioneer. Here's what you need to know.

Image source: Getty Images.

1. Whither Wolfspeed?

Last summer, LED lighting specialist Cree announced plans to first spin off its fast-growing (but capital-intensive) Wolfspeed business. Responding to other companies' interest in buying Wolfspeed however, Cree quickly pivoted to negotiate a sale of Wolfspeed to Infineon (NASDAQOTH: IFNNY) for $850 million in cash -- a valuation that I estimated worked out to "a price-to-sales ratio of 4.9 on Wolfspeed -- nearly three times the 1.7 P/S ratio that Cree gets on its own shares!"

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Sadly for Cree, the Committee on Foreign Investment in the United States (CFIUS) quickly stepped in and stomped on that sale, leaving Cree both without a buyer for Wolfspeed, and facing heavy capital investment needs to realize Wolfspeed's full growth potential. But now, JMP has issued a new report (covered on StreetInsider.com this morning) predicting there's about a 40% chance that Cree will find another buyer for Wolfspeed, and sell it for at least $800 million.

If JMP is right about that (or if Cree simply proceeds with its original plan of holding a Wolfspeed IPO), it could help to return Cree stock to where it was back when the Infineon deal was still on -- at a share price approaching $29.

2. What's behind door No. 2?

As I said, JMP sees a 40% likelihood of this scenario playing out for Cree, but what about the other 60% of possibilities?

Instead of investing a lot of money in Wolfspeed this year, then selling it to someone else to reap the benefits, Cree could sell off its LED products division (which makes chips for flatscreen TVs and mobile devices) instead. This wouldn't be as lucrative for Cree, because whereas Wolfspeed earns Cree about a 48% gross margin (according to data from S&P Global Market Intelligence), LED sales gross closer to 35%.

Still, JMP estimates that such a sale might bring about 1.2 times LED products' annual revenue, which have been declining but ran to $611 million last year. You can probably ballpark that sales price at $730 million. JMP views this outcome as also 40% likely.

3. Steady, as she goes

That leaves us with 20% of likelihood left, and JMP assigns this final percentage to the scenario whereby Cree does nothing, and continues to operate its "business as usual."

What it means for investors

Investors seem to like these odds overall, and are bidding up Cree stock 5% this morning.

Let's hope investors are right about that -- and that JMP is right about "business as usual" being the least likely outcome -- because so far that hasn't served Cree very well. Last quarter, for example, business-as-usual Cree turned in shrinking sales and negative profit. Three straight years of declining revenue have left Cree losing money at the rate of nearly $103 million a year.

And yet, not all hope's lost.

Although accounting profits are running negative, from a cash profits perspective, Cree generated free cash flow(FCF) of $150 million over the past 12 months. On a $2.2 billion market capitalization, that works out to a valuation of less than 15 times free cash flow -- and Cree could get even cheaper than that if it succeeds in selling Wolfspeed, for example.

Three months ago, I calculated that adding $850 million in cash from the sale of Wolfspeed ($585 million net of fees) would leave Cree with net cash of more than $1 billion on its balance sheet. The math would work similarly after a sale of Cree's LED business. At current cash production levels, either of these scenarios would value the stock at barely eight times FCF. (The stock would become even cheaper, if by unloading Wolfspeed, Cree lowers its capital spending requirements.)

Even if the sale of a division slowed Cree's anticipated sales growth somewhat (analysts are still estimating 16% annual growth under a "business as usual" scenario), I have to say that at just eight times cash profits, I like the odds of Cree stock outperforming the market.

JMP is right to upgrade this stock today.

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Rich Smith has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.