Is Cree Stock Doomed? 1 Analyst Thinks So

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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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It's been a rough year for owners of Cree (NASDAQ: CREE) stock.

Over the past year, Cree stock has slumped 4% while the S&P 500 has marched 12% higher -- 16% underperformance for the shares. This bad news got even worse on Wednesday, with Cree shares trading down 10% pre-market in response to the company's fourth-quarter loss, which was announced last night. And now, the downgrades have begun rolling in on Wall Street.

Here are three things you need to know about that.

1. What Cree said last night

Reporting earnings for its fourth and final quarter of fiscal 2017, Cree admitted last night that it lost $0.06 per share on sales of $358.9 million. Cree exceeded analyst expectations on revenue (Wall Street had predicted sales would be only $350 million), yet still managed to miss on earnings. Analysts wanted to see a $0.05 profit, but got a loss instead.

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For the year, Cree scored a loss of $1 per share, and this was nearly five times as bad as the $0.21-per-share loss the company had reported in fiscal 2016.

2. What Cree said about next quarter

Commenting on the results, CEO Chuck Swoboda said his company posted "good results in each business and non-GAAP earnings per share that were in the middle of our target range." So while the numbers were bad last night, they were apparently no worse than what management had hoped to achieve.

Swoboda himself is heading for the exits at Cree. But on his way out the door, he paused Tuesday to reassure investors that, as bad as the Q4 numbers look, Cree has "built a solid foundation for growth in all three businesses over the last year." (These "three businesses" would be LED lighting products for consumers and industry; LED chips used in video screens, car headlights, and other non-"lighting" products; and the company's "Wolfspeed" power and radio frequency products.)

Unfortunately for Cree shareholders, Cree's guidance for the current fiscal Q1 2018 undercuts these assurances somewhat. After reporting its loss for Q4, Cree went on to warn investors that revenue will be coming in between $353 million and $367 million (i.e., below Wall Street's expected $368.5 million) in Q1. Furthermore, Cree expects to report a loss of $0.20 to $0.25 in Q1 -- much worse than the breakeven profit Cree achieved in Q1 last year.

3. What Wall Street had to say about all this

So the news was not good, and the guidance wasn't, either. Unsurprisingly, Wall Street is displeased with all the above, and this morning it's making its wrath felt.

Analysts at Stephens, already unenthused with Cree stock before earnings came out, made their displeasure official this morning when they downgraded Cree stock from equal weight to underweight (i.e., sell). As explained in a note on TheFly.com morning, Stephens is of the opinion that profitability for Cree's core LED business "remains under pressure," and may have "plateau[ed]." Data from S&P Global Market Intelligence confirm that sales at Cree declined year over year in each of the past four quarters, which tends to support this view.

Given this lack of growth -- this actual shrinkage in the business -- Stephens believes that Cree's current valuation is "unsustainable" and the stock is likely to continue falling. Thus, in addition to tagging Cree stock with a sell rating, Stephens is assigning it a new price target of just $16.50 --28% below where Cree closed yesterday ahead of earnings.

Bonus thing: What "unsustainable" means to investors

How should investors react to this news? That's a bit tricky to answer. Unprofitable over the past year, Cree currently has no P/E, and that makes it difficult to gauge its valuation, and how "unsustainable" it might be.

Cree does have free cash flow, of course, which I would ordinarily consider a factor in the stock's favor. In last night's report, Cree confided that while its earnings were negative in Q4 (and for the year), the company did generate positive free cash flow of $116.6 million. Surprisingly, that was up 70% from last year's $68.8 million, and enough to value Cree stock at 19 times cash profits.

Problem is, because Cree was unable to sell Wolfspeed to Infineon as previously planned, it's now once again on the hook for significant capital investments needed by Wolfspeed. We don't yet know precisely how much money these investments will soak up, but we can anticipate that they will ding free cash flow somewhat, and push the company's price-to-free-cash-flow valuation even higher.

Given that 19 times free cash flow is probably too much to pay for a company that is not growing, and given that the valuation is only going to increase as Wolfspeed consumes more and more cash, I'm forced to agree with Stephens today: Cree's valuation is unsustainable, its stock is overpriced, and it's doomed to fall.

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