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, Ask Friedrich (823 clicks)
Research analyst, registered investment advisor, value, contrarian
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The main thrust of this analysis is concentrated in three parts. The first two parts are based on free cash flow (current and historical) and the third is based on historical price action as a gauge of investor sentiment.

The three methods used in this analysis are:

1) Price to Owners Earnings [OE] = Current and future analysis

2) Cumulative Owners Earnings [COE] = Historical analysis of owners earnings

3) Statistical Indicator Analysis [SIA] = Historical price action

For those new to this analysis please link here for an introduction: OE and COE, SIA, CapFlow.

The main goal of my analysis is first to determine a sell price. With that in mind, we attempt to buy the stock at half its sell price and then hold it for 5 years (provided that no macro- economic negative catalysts force us to sell). Due to the fact that we bought it at par, we can potentially achieve an average annualized return of 15% per year. This may enable us to double our money every 5 years. Occasionally we do find a stock that is not selling at par, but is actually selling at a discount. When this happens, gains are usually higher.

Analysis of Cree (NASDAQ:CREE)

Wednesday morning I was reading the news on Seeking Alpha and came across the following:

Wednesday 7:33 AM Cree continues its fall premarket after yesterday's earnings miss. The company also reported weaker than expected guidance for the next quarter. Shares -14.5%.

So I went back to Tuesday’s news and found this:

Tuesday, January 18, 4:07 PM Cree: FQ2 EPS of $0.55 misses by $0.03. Revenue of $257M (+29% Y/Y) misses by $20M. Shares -10.2% AH.

With Cree's price falling so heavily Wednesday, I thought it would be interesting to test out the company using my Mycroft Research System (MR) and see how Cree stacked up to a free cash flow examination and determine if my system could have assisted the Cree investor/trader in avoiding such a loss.

The following is an Owners Earnings (OE) table of Cree from 1991-2010:

From the table above you will notice that Cree is definitely not a free cash flow generator and there are a lot of problems with it. It is true that revenues have risen sharply in the last twelve months, but those revenues mean very little if the result is zero growth in owners earnings. Investors are obviously focusing on Cree’s future potential cash flow generation, without factoring in the sharp rise in capital expenditures.

Since 1991 Cree has only had four positive Owners Earnings Years (OE) and from 1991-2006 they ran negative OEs per share. The chart below gives you a good long term view of their Cumulative Owners Earnings (COE):

Why is this happening if revenues are so good? The answer can be found by looking at the company’s CapFlow record. From 1991-2011 (including estimates) Cree generated $19.95 in Cash Flow, but unfortunately spent $15.82 in capital expenditures in order to do so. The net result is $4.13 in COE, which is hardly impressive. If you look at the CapFlow chart below you will see that management has not done a good job of managing costs, averaging a CapFlow of 145% over the period from 1991-2011:

For the first 12 years under analysis the management spent more each year in capital expenditures than they generated in cash flow. I like to own companies that have a CapFlow of 25% or less as that tells me that management is on top of its game. Cree looked like they were making progress in 2009 as they actually achieved a CapFlow of 36%, but unfortunately they are expected to double that in 2011 to 70%.

If you must invest in a company like Cree, then looking at it from a free cash flow point of view is not an option, because they do not generate much in OE. Obviously Cree is a trader's stock, so the best way to play it would be to use my Statistical Indicator Analysis (SIA), which measures investor sentiment over a long term period and shows both over enthusiasm as well as times of deep pessimism. Here is the SIA chart for Cree:

Cree hit its 3651st day of trading on August 28, 2007 (#1) and was trading for $24.06 and had an SIA of $16.61 on that day. It broke below its SIA (Red Line) on November 11, 2008 (#306) and would have given the trader a good three months to buy it at a discount to SIA, before it shot up and never looked back. The stock dropped to a low of $13.13 on December 5, 2008 (#313) and had an SIA of $18.65 at the time and was selling at a 30% discount to its SIA.

The following upside panic in investor sentiment that ensued took the stock up to $82.85 by April 15, 2010 (#663) when its SIA on that date was $22.01. At that point its Price to SIA (P/SIA) hit 3.76 times. So at (#313) it was at a P/SIA of .70 and then went to 3.76 P/SIA (#663) .

I personally like to sell at 2.0 and walk away with my profits as I don’t like roller coasters and thus my current sell price for Cree is 25.10 X 2 = $54.20, as its current SIA is $25.10. The farther you get away from a stock’s SIA, the more risk you take on as a trader. Here is a chart of Crude Oils SIA as an example of excess investor sentiment on the upside:

To read the article associated with the chart above please go here.

At its high, Crude Oil was trading at 4.10 times its SIA, so when Cree was trading at 3.76 times its SIA, it was trading at nosebleed territory.

Disclosure: My Clients at Mycroft Research LLC and Geasphere LLC. have no position in CREE