Wednesday's Top Upgrades (and Downgrades)

Motley Fool

This series, brought to you by Yahoo! Finance, looks at which upgrades and downgrades make sense, and which ones investors should act on. Today, our headlines include downgrades for defense contractors AeroVironment (AVAV) and Harris Corp (HRS). Meanwhile, though...

LCD specialist Cree lights up the scoreboards
Great news for Cree (CREE) shareholders this morning: Wall Street likes your stock again. In twin announcements Tuesday, Cree confirmed that it's going to begin selling a new LED lightbulb, exclusively through Home Depot, and for the low, low price of less than $10. Even better, Cree's so convinced this product will be a success that it's upped its revenue guidance for the fiscal third quarter (that's the one we're in now) to a new range of from $335 million to $350 million -- and on stable gross margins of perhaps 39.5%.

Wall Street loves the news, with Credit Agricole upping its rating from underperform to outperform in a Paris minute yesterday, and Goldman Sachs praising the company's new "price points as very competitive" and hiking its own price target for Cree stock to $48. This morning, a third analyst joined the Cree fan club, as UBS went a step further and projected Cree shares will hit $51 before a year is out.

Are they right? Well, let's see here. According to StreetInsider.com, Cree thinks it can earn between $0.16 and $0.21 per share this quarter ($0.31 to $0.36 pro forma). If it's right, that would work out to at least a double in GAAP profit over last year's Q3 levels, and perhaps an increase of 162%. Even pro forma, the growth rate would exceed 50%. Either way, that's a whole heck of a lot faster than the 37% earnings growth Wall Street has Cree pegged for this year, and suggests there's reason for the analysts' optimism.

Granted, at 108 times earnings, Cree shares don't look like much of a bargain on the surface. But if you value the company on its remarkably strong (four times GAAP earnings) free cash flow, and credit it for its strong cash reserves ($886 million, with no debt in evidence), the stock actually looks pretty fairly priced at 20% projected growth, and an enterprise value-to-free-cash-flow ratio of just 19.4. In short, I wouldn't short Cree on this rally. This stock's not nearly as expensive as it looks.

AeroVironment crashes and burns
If only I could say the same for small unmanned aerial vehicle specialist AeroVironment, which yesterday missed earnings badly, then compounded the fumble with a prediction hat fiscal 2013 earnings will come in at just $0.42 a share -- down from earlier projections of $1.43. The news prompted an immediate cut in price target by FBR Capital, which slashed expectations by nearly half, and said AV investors will be lucky if their shares are worth even $19 a year from now. BB&T Capital seconded the emotion, pulling its buy rating and downgrading AV to "hold."

But is the news really as bad as all that? Well... no, actually. It's not -- but it's certainly bad enough.

On the minus side, AV's new earnings guidance tells us that despite appearing to cost only "13 times earnings" today (according to Yahoo! Finance), the company's going to earn so little this year that its P/E ratio will soon soar as high as 44. The company's also reporting exceedingly weak free cash flow, even if the good news is that it's not as weak as it looked just a few quarters ago. FCF for the trailing 12 months now clocks in at $7.3 million, implying a price-to-free-cash-flow ratio of 56 for the company -- a valuation even worse than the forward P/E.

Result: There's little question that AV is no buy at today's depressed profits, and still too-high prices. The only question is whether AV's a sell. (And the answer, I fear, is "yes.")

When Harris met Sell-y
Similarly bleak news -- if slightly less so -- greeted Harris investors this morning, as analysts at Oppenheimer shrugged off news that Harris has just won a big Air Force meteorological satellite contract, and downgraded the shares to "underperform," regardless.

Is the downgrade deserved? It's hard to say. Although technically "unprofitable" as GAAP defines such things, Harris actually generated considerable cash profit last year, generating about $676 million in positive free cash flow. That's enough cash to give this stock a price-to-free-cash-flow ratio of 7.6, and an enterprise value-to-free-cash-flow only moderately less attractive at 10.3.

These aren't exactly high prices, folks -- especially not when set next to AeroVironment's sky-high valuations and compared side-by-side. Although analysts see faint hope of Harris growing earnings any time soon, with only 3% annualized growth projected over the next year, the simple fact is that with Harris still paying a 3.1% dividend yield, providing valuable services to the government, and selling for very low P/FCF and EV/FCF ratios, I simply don't agree that the stock must be sold.

Long story short: Harris may not be the world's best buy, but it's not so awfully expensive that you need to sell it, either. For my money, the stock's still worth a hold on the potential that earnings growth may turn out to be not as slow as the analysts fear.

Motley Fool contributor Rich Smith owns shares of AeroVironment. The Motley Fool recommends AeroVironment, Goldman Sachs, and Home Depot. The Motley Fool owns shares of AeroVironment.

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