This Just In: Upgrades and Downgrades

At The Motley Fool, we poke plenty of fun at Wall Street analysts and their endless cycle of upgrades, downgrades, and "initiating coverage at neutral." So you might think we'd be the last people to give virtual ink to such "news." And we would be -- if that were all we were doing.

But in "This Just In," we don't simply tell you what the analysts said. We'll also show you whether they know what they're talking about. To help, we've enlisted Motley Fool CAPS, our tool for rating stocks and analysts alike. With CAPS, we track the long-term performance of Wall Street's best and brightest -- and its worst and sorriest, too.

Tech investors in a tizzy
There's a reason that Warren Buffett famously refuses to "invest in tech." Things move fast in the computing world, and change comes in a heartbeat. Just two years ago, investors were hailing the rise of the netbook -- the next new thing in computing, and a significant threat to the dominance of laptops. Yet already, netbooks are passe, and tablet PCs now rule the roost.

So pity the poor investors as we scramble to keep up with developments. On the one hand, we're told that the rise of the tablet ushers in the age of flash memory makers Micron (NYSE: MU  ) , SanDisk (Nasdaq: SNDK  ) , and STEC (Nasdaq: STEC  ) . On the other, we're told that hard disk drive makers Seagate and Western Digital have one collective foot in the grave. And they're not alone.

Last week, in one of the few moments when markets were actually open for business, investment banker Wedbush Morgan found time to dash off a rating revision. Alas, it was bad news for Smart Modular (Nasdaq: SMOD  ) investors, because their stock got Wedbush-whacked.

"DRAM ASP declines to likely be a near-term headwind muting [gross margins], earnings and revenue growth," warned Wedbush. While Smart Modular may have diversified its business into the production of solid state drives, specialty DRAM modules and NAND flash memory cards, Wedbush fears the "near-term challenging DRAM fundamentals" outweigh any hope for SSD profits. In anticipation of that development, Wedbush pulled its buy rating on the stock, downgraded to neutral, and sliced 26% from its projected target price (now set at $7.)

But did Smart-Mod deserve to get carved up like a Thanksgiving turkey?

Let's go to the tape
At first glance, you might think so. After all, when it comes to picking semiconductor stocks, there are few analysts out there who rival Wedbush's record for accuracy. Fully 80% of the analyst's active semi-recs are currently outperforming the market, including such name-brand winners as Intel (Nasdaq: INTC  ) and Texas Instruments (NYSE: TXN  ) -- both up 19 percentage points over the S&P -- and Advanced Micro Devices (NYSE: AMD  ) , which a whopping 34-point lead over Mr. Market.

How, an investor may wonder, can we compete with a record like that? Maybe Buffett's right. Maybe we should all leave investing in tech to the experts -- just do what Wedbush tells us, full stop.

And maybe not ...
But don't lose heart, good Fool. Because as it turns out, even Wedbush isn't right all the time. In fact, as I dug into the analyst's record on CAPS (where we've been tracking its performance for more than four years now), it became apparent that there's one glaring gap in this banker's portfolio: And Smart Modular just happens to sit right smack-dab in the middle of it:

Companies

Wedbush Says:

CAPS Rating 
(out of 5)

Wedbush's Picks Beating 
(Lagging) S&P By:

Seagate Outperform **** 7 points
Western Digital Outperform **** (4 points)
Micron Underperform *** (34 points) (picked twice)
SanDisk Underperform **** (41 points)
STEC Underperform *** (88 points) (picked twice)

Do you see what I see? Seems to me that, while Wedbush has a fine grasp of the basic building blocks of computers (semis), it's as lost as the rest of us on the question of which memory makers to buy. It began with a winning bet on Seagate, got burned by rival Western Digital, then leapt from frying pan to fire on Micron, SanDisk, and STEC in quick succession. It's mayhem all around.

So will SSDs replace HDDs? Will gaming console makers phase out DRAM in favor of flash RAM? Your guess is as good as theirs. And if Wedbush is feeling a little gunshy on Smart Modular today, and wants to refrain from picking a winner -- I can't blame it. Its analysts are obviously not very good at picking these kinds of stocks, and if you're no good at the game, it's best to take a cue from Buffett and just decline to play.

Valuation matters
But that's not to say you should avoid Smart Modular. Because while Wedbush may be unsure of the stock's prospects, what I see tells me they're actually pretty solid. Right now, S-Mod stock sells for a mere seven times earnings -- nearly as cheap as most of the memory market players named above, and cheaper than either SanDisk or STEC. Yet most analysts agree Smart Modular will grow these earnings at 16.5% per year over the next five years. To me, that looks like a bargain price.

Best of all, I've examined the company's earnings and found them to be of generally high quality. Over the past five years, reported GAAP earnings have almost exactly mirrored the amount of free cash flow the company generates. So while it's true the company isn't currently free cash flow-positive, if history is any guide, they soon will be -- and strongly so.

Even if Wedbush fears to tread here, Fools just might want to rush in and pick up some cheap stock.

Rich Smith owns shares of Western Digital. You can find him on CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 620 out of more than 170,000 members. The Motley Fool has a disclosure policy. Intel is a Motley Fool Inside Value selection. The Fool owns shares of and has bought calls on Intel. Motley Fool Options has recommended buying calls on Intel. The Fool owns shares of Texas Instruments.

Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.


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  • Report this Comment On November 30, 2010, at 10:08 PM, jrmart wrote:

    Yes sir, it's true, the horse and buggy still survives in Central Park, NYC.

    In the 80's, a 25 MB mini computer slow spinning hard drive cost $65,000. It was 2 feet wide by 2 feet high and shook like crazy. I know, because I sold a lot of them. Today you can buy a 16 GB solid state USB drive for $20.

    When it comes to fast data searches, you can buy 2 ZEUS solid state drives from STEC to replace 300 15,000 RPM hard drives from Seagate, thereby saving tons of money on power, air conditioning, maintenance and space costs.

    Seagate would be better off spending their billions either buying STEC or SanDisk and the rest of us should be investing in STEC and Sandisk.

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