This Just In: Upgrades and Downgrades

By Rich Smith | More Articles
December 13, 2011 | Comments (4)

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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." Today, we'll show you whether those bigwigs actually know what they're talking about. To help, we've enlisted Motley Fool CAPS to track the long-term performance of Wall Street's best and worst.

Wall Street catches Thai flu
The hits (to market cap) just keep coming. Yesterday, Intel (Nasdaq: INTC ) confirmed that the Thai flooding, which idled hard disk drive capacity at Western Digital (NYSE: WDC ) earlier this year, has indeed depressed demand for semiconductor chips. As result, Intel slashed $1 billion from this quarter's sales projections -- and 5% from its own market cap.

Surprised? You shouldn't have been. In fact, Wall Street's been warning for weeks about the dangers of a "Thai contagion" infecting the computer industry. The logic's simple: If a computer maker like Hewlett-Packard (NYSE: HPQ ) or Dell (Nasdaq: DELL ) can't get hard drives for its PCs, because Western-D and its peers can't supply them, then there's really no sense in building a hard drive-less PC, right? And if you're not building the PC, then it stands to reason you won't be buying chips to install in the PC-that-you're-not-building. (Note to Microsoft (Nasdaq: MSFT ) shareholders: You probably also don't need to license a copy of Microsoft Windows for the non-existent PC, either. Word to the wise ...)

As a result, supply chain troubles in hard drives infect demand for computer chips -- and the whole dang PC industry catches the flu.

Paging Dr. Morgan
Indeed, just last week we got confirmation of the epidemic, when Texas Instruments (NYSE: TXN ) warned shareholders to expect significantly lower sales and earnings in the current quarter, in part because of the situation in Thailand. But there's good news to report as well. Just days after the earnings warning appeared, the tech analysts at Morgan Stanley took a closer look at TI -- and its valuation -- and came to a startling conclusion: The news isn't really as bad as everyone seems to think. In fact, TI just might be cheap enough to buy.

Why? For one thing, Western Digital announced last week that it's already restarting production at one of its formerly flooded factories ahead of schedule -- so while the supply interruption is real, it's also history -- and new inventory is already en route to PC makers looking to get their factories humming again. For another, Morgan Stanley argues that investors fixated on today's headlines may be missing the bigger picture at TI. The analyst argues that:

TI is "well-positioned" broaden its revenue streams by as much as an additional "$6B+ in add'l revenue" as it steals market share from rivals,
Add further sales into the "smartphone and tablet" markets,
And generate "consistent and stable cash flows for investors."

But is Morgan Stanley right? Actually, the numbers seem to argue the opposite.

Valuation matters
Beginning at the beginning, Morgan Stanley argues that TI has the potential to grow its business by something on the order of $6 billion by capturing new revenue streams. This, however, implies about a 50% increase in the firm's trailing revenues. That seems quite a stretch, considering that most analysts on Wall Street think TI will be hard pressed to grow at even a 7.5% annual rate over the next five years.

Nor am I particularly impressed by Morgan's "consistent and stable cash flows" argument. The truth of the matter is that right now, TI's free cash flow lags reported net income by more than 11%. Valued at 12 times "earnings" today, TI's stock looks pricier when valued on its cash profits -- and pricier still when the firm's debt is figured into the calculation. All in, I get an enterprise value-to-free cash flow ratio of 14 on this one -- a number nearly twice as big as the consensus growth rate for TI.

Foolish takeaway
Long story short, the case for buying Texas Instruments looks less compelling than the case for shorting it. While I still like the firm, and agree with Morgan Stanley that it will recover from the Thai troubles eventually, I do not consider the stock a buy at this time.

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Fool contributor Rich Smith does not own shares of (or short) any company named above. You can find him on CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 333 out of more than 180,000 members. The Motley Fool owns shares of Western Digital, Microsoft, and Texas Instruments. The Fool owns shares of and has bought calls on Intel. Motley Fool newsletter services have recommended buying shares of Dell, Intel, and Microsoft; and creating bull call spread positions in Intel and Microsoft. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (4) | Recommend This Article (3)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment icon found on every comment.

Report this Comment On December 14, 2011, at 2:19 AM, Ironbob wrote:

Um, so every hard drive is built in Thailand? Really?
Report this Comment On December 14, 2011, at 3:52 AM, soiseesurfer wrote:

ironbob - 40% of them are
Report this Comment On December 14, 2011, at 4:50 AM, soiseesurfer wrote:

Hi Rich, thanks for your note.
In it you wrote: "Western Digital announced last week that it's already restarting production at one of its formerly flooded factories ahead of schedule -- so while the supply interruption is real, it's also history"
I believe that is an oversimplification. Current estimates are that the industry will ship 121m - 129m units this quarter against a total market demand of 175m. Important to note that that is with a starting inventory of 20m drives in finished goods (en route or in warehouse). In CQ1-2012 the industry is expected to ship 140m drives but again, total demand, even with a normal seasonality effects of a slight decline would likely have been 165- 168m units. The shortfall will continue to have ramifications throughout 2012, with special difficulties in the consumer channels and in retail.
One more thing to consider: Hitachi GST has been enduring a worker's strike at the Shenzhen China factory the last few days and sources tell me it will have a negative impact on volumes in CQ1-2012.
Finally, Lenovo has notified its custmers that they are out of certain models of HDD including the popular 7200 RPM mobile drives. Finally, we have to consider that aside from the choking effects of the flooding in Thailand, we also have an increasingly bleak picture of the forecast owing to economic malaise. The PC industry is directly called out for lowering of forecast and it is difficult to say how impact is which problem.
I think history is still being written. At least twenty-eight key parts manufactures and three primary HDD assy operations were flooded. Remediation is underway and initial news of progress is encouraging. However, the really good news is that we will see gross margins lifted in these companies. In the meantime, while Seagate may have a short term (6 months)advantage, we expect that Western Digital will emerge even stronger. The market wants & needs three vendors. Every possible initiative is being undertaken at the suppliers of parts and at WD & Toshiba, the two most directly affected HDD companies in Thailand. Just a couple of hours ago a story broke that Western Digital is lowering its warranty on certain internal drive models. This is most likely in a predetermined agreement with OEM/ODM buyers which may allow WD to loosen slightly their internal test specifications which could potentiallly lift yields and allow more product to be shipped. (Caution: This is speculative on my part. It may result in no more than a reduction in the warranty liability measurement.)
Report this Comment On December 15, 2011, at 8:12 PM, pokute wrote:

Wow. I am seriously disturbed by the mock authoritative tone of both the author and commenter.
Seagate, Samsung, Toshiba, Hitachi, and Western Digital have several markets: OEM, consumer, and enterprise. Suggesting that a company like WD, that has a rock-solid reputation in the consumer and enterprise markets will "loosen" their QC is more than speculation, it's fantasy, and mendacious fantasy at that. WD has stellar customer service compared to Seagate, and it costs them dearly to maintain it... Reducing warranty liability for their consumer drives during rough times is a no-brainer for WD.

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