Analysts Offer 1 Laser Stock to Buy, and 1 Laser Stock to Sell

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...

Lasers are the hot new tech, but which stock should you buy if you want to invest in lasers? This morning, two Wall Street analysts offered up their opinions on two possibilities. But are either of these stocks actually good bargains right now?

Read on to find out. You may be surprised by my answer.

Time to buy II-VI?

We'll start with the happier of the two stories today. This morning, analysts at Deutsche Bank announced they're initiating coverage of laser components maker II-VI (NASDAQ: IIVI) with a buy recommendation and a price target of $58 per share. If Deutsche is right about that, then investors at II-VI's current share price below $50 stand to make a 17% profit on the stock over the next 12 months.

But is Deutsche right about that?

II-VI reported a somewhat successful fiscal fourth quarter earlier this month, with sales growth of 17% but a 17% decline in net profit.

Some analysts are calling the quarter a success despite the drop in profit, citing II-VI's 8% increase in adjusted earnings. (I count myself in that camp -- not because of the pro forma profits, though, but because there was a clear increase in the company's free cash flow in Q4, from just $0.8 million a year ago to $10.1 million in this year's Q4.)

Deutsche believes that II-VI can keep the growth going, as explained by a write-up on (subscription required). "[K]ey growth drivers" include silicon carbide, vertical-cavity surface-emitting lasers (VCSELs), and extreme ultraviolet (EUV) lithography tools. Deutsche expects these advances to help sustain a steady growth rate in the mid-teens for II-VI, and most analysts agree. According to data from S&P Global Market Intelligence, the consensus estimate for II-VI's growth rate over the next five years is 15%.

Time to sell nLIGHT?

The news for investors in laser-maker nLIGHT (NASDAQ: LASR) isn't quite so encouraging. On the one hand, nLIGHT stock has had a fantastic run, more than doubling at one point off its April $16 IPO price. Still priced at more than $30 today, nLIGHT remains close to a two-bagger for investors who got in on the ground floor.

The downside to this success story for existing shareholders, of course, is that nLIGHT stock now looks very expensive to potential new investors. Valued at just over $1 billion in market capitalization, nLIGHT stock sells for nearly 100 times trailing earnings, which would seem kind of pricey even if the company succeeds in growing earnings at the 30% annualized rate that Wall Street projects for it. In fact, in a report on StreetInsider, analysts at Benchmark argue that this is "an unreasonable price to pay for growth" -- and recommend selling the stock.

On top of that, nLIGHT has no free cash flow to speak of. To the contrary, last year nLIGHT burned through $2.1 million in negative free cash flow. Its burn rate is also increasing. Over the past 12 months, nLIGHT burned $9.7 million in cash -- a discouraging counterpoint to II-VI's generating positive free cash flow of $10.1 million last quarter.

The upshot for investors

So what does this all mean for investors? Should you take Wall Street's advice -- sell nLIGHT stock and buy II-VI instead?

Unfortunately, I don't think it's as simple as that. While I agree with Benchmark that nLIGHT stock looks overpriced for a company that's been unable to generate positive consistent free cash flow, and while I commend II-VI for growing its free cash flow last quarter, the fact remains that I think that II-VI stock is too expensive to invest in as well. Here's why:

According to S&P Global, II-VI earned $88 million over the past 12 months. Weighed against the company's $3 billion-plus market capitalization, that values II-VI at more than 34 times trailing earnings -- too expensive for a stock pegged for 15% long-term growth, in my view. Making matters worse, although II-VI succeeded in generating strong cash profits last quarter, free cash flow is a lumpy statistic, and one quarter's success may not be indicative of II-VI's ability to continue generating strong free cash flow over the long term. In that regard, I note that over the past year, II-VI actually generated less than $8 million in total free cash flow -- a number less than 10% of its reported net income.

Given that II-VI was already looking pretty expensive when valued on net income, I can't say that its FCF number makes the stock look any more attractive to me. The sad conclusion: I'm afraid I can't recommend either of these two laser companies at current valuations.

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