Cree, Inc. Beats on Earnings, and Is Immediately Downgraded

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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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Wednesday was a fabulous day for Cree (NASDAQ: CREE) investors, who saw shares soar as much as 20.9% after the company reported market-topping earnings results the previous evening. Cree stock is up again today, if by just a fraction -- and maybe even that gain won't last long.

Why not? You can blame the somewhat less-than-friendly analysts at Williams Capital for the risk Cree shareholders bear today. This morning, you see -- immediately after seeing Cree's earnings beat -- StreetInsider.com reported (requires subscription) that Williams is downgrading Cree stock from hold to sell and assigning the $34 stock a new price target of just $27.

Here are three things you need to know about that.

1. Why Williams downgraded

Let's begin with the good news. Williams says it's "encouraged" to see new CEO Gregg Lowe taking the helm at Cree. Furthermore, Williams believes Lowe will have "opportunities" to capitalize on Cree's Wolfspeed power and radio frequency electronics division (now that it's not going to be sold), and on the world's growing conversion from incandescent and CFL light bulbs to LEDs.

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That said, Williams also believes Cree is losing market share in the LED lighting business, and believes investors must "wait and see" if new CEO Lowe can right the ship.

2. But what about the earnings beat?

And yet, isn't that exactly what Lowe did when Cree reported its fiscal Q1 2018 earnings beat yesterday? Doesn't that beat prove that Cree is back? Well, yes, and no -- but mostly no.

As fellow Fool Travis Hoium reported, Cree beat estimates by reporting a $0.04 profit yesterday, when Wall Street was expecting to see a $0.03 loss. Still, Cree's revenue fell short of analyst estimates, with Q1 sales objectively down 3% year over year. What's more, even the earnings beat wasn't all it was cracked up to be.

As Travis explained, Cree's earnings were $0.04 "adjusted" for one-time items. The company's actual GAAP result for the quarter, however, was a loss of $0.20 per share -- much worse than last year's fiscal Q1 2017 profit of $0.01 per share.

3. What the future holds for Cree

It gets worse. Forecasting financial results for the current fiscal second quarter 2018, Cree told investors to expect revenue ranging between $340 million and $360 million, with a GAAP loss of between $0.25 and $0.31 per share. Sequentially, therefore, we're probably looking at Q2 numbers that will be worse than what Cree reported in Q1.

Part of the reason for this (as we learned earlier this year) is that the Wolfspeed electronics business that Williams sees as a plus for Cree is also a big cash drain on the company, reducing the company's annual free cash flow by about 20% due to needed capital investments.

Bonus thing: Valuing Cree stock

At last report, Cree had generated about $148 million in positive free cash flow from its business over the past 12 months. Weighed against the stock's $3.3 billion market capitalization, and adjusted for the company's $484 million in net cash (cash data provided courtesy of S&P Global Market Intelligence), that works out to an enterprise value-to-free-cash-flow ratio of about 19 on Cree stock.

For a company growing profits at 20%-plus, that would be a fine valuation. For Cree, however -- which is seeing its revenue decline as its losses grow -- it's probably too much to pay.

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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.