Upgrades and Downgrades: Semiconductor Edition

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.

And speaking of the worst ...
It's hard times in the semiconductor industry these days. According to investment banker Piper Jaffray, Apple's "outsized influence" in the mobile computing realm is "squeezing" companies that build the chips that make computers work. Even the giant of the industry, Intel (Nasdaq: INTC  ) , has had trouble getting its products into Apple devices "because they could not agree on wafer pricing." Meanwhile, the runaway success of the iPad is hurting DRAM demand, because your average iPad carries only 1 gig worth of DRAM in its innards, "versus 4GB for a PC."

Result: Every time a consumer buys an iPad instead of a PC, DRAM demand drops 75%.

Brean enters the fray
A similar understanding of the "Apple dynamic" informs a series of new semiconductor ratings that just came out of Brean Murray, which on Friday picked four stocks to outperform the S&P 500, and three more (NVIDIA, Marvell, and TriQuint) to just pace it. According to Brean, "historically significant weakness in PCs in the 2H12" will weigh on NVIDIA's results, while Marvell could suffer from "negative ... PC inventory levels and consumption trends all the way into 2013." Meanwhile, TriqQuint is simply overvalued based on numbers that are expected to "underperform."

So which stocks does Brean expect to outperform the market? Here's a quick look at the recommendations, along with a summary of their valuations:

Stock

P/E Ratio

Price-to-Free-Cash-Flow

Growth Rate

Broadcom (Nasdaq: BRCM  ) 25.2 14.5 15.5%
Qualcomm (Nasdaq: QCOM  ) 21.0 29.0 14.6%
Skyworks Solutions (Nasdaq: SWKS  ) 22.0 16.1 15.1%
RF Micro Devices (Nasdaq: RFMD  ) N/A 12.8 11%

Source: finviz.com. N/A = not applicable; RF Micro has no trailing earnings.

Of these four, Brean seems to like Broadcom best, saying it has "favorable inventory and consumption dynamics" and arguing that Broadcom is well positioned "to benefit from the growth in Smartphones, Tablets, and the Connected Home."

At Qualcomm, the analyst sees "Snapdragon reaccelerating" as "higher-ASP smartphones tak[e] share from feature phones and lower-end smartphones." The analyst is similarly optimistic about Skyworks' role in mobile, praising the company's "excellent execution, diversification, and continued growth in both Wireless and Analog." And as for RF, the analyst seems to think this one is a turnaround play, pure and simple.

Let's go to the tape
Let's hope so, because if RF goes the way it's been going -- unprofitably -- investors who follow Brean's advice and buy into the stock today will be sorely disappointed. In fact, when you get right down to it, very few of the analyst's picks seem particularly sure things.

Broadcom ... yes, it has strong free cash flow to its credit, and if growth approaches the levels it's expected to, I agree with the analyst that of the four picks named, Broadcom probably has the best chance of success. That said, Qualcomm has high expectations baked into its share price, and a valuation too high for its growth prospects. Skyworks, overpriced on P/E, is also slightly overpriced based on its free cash flow. Similarly, RF Micro's free cash is its most attractive feature, while without GAAP earnings it has no P/E at all.

Foolish final thought
In short, there's little reason to follow Brean Murray's advice and buy these stocks at today's prices. The case for following the analyst's lead weakens even more when you examine Brean's record and discover that, on average, over the past six years that we've been tracking Brean's performance, only 44% of its recommendations have actually outperformed the market -- and only 25% of its semiconductor picks have done so!

Given this history of underperformance, maybe investors are better off using Brean Murray's "recommendations" as a contrarian indicator. Rather than hope for short-term pops at Broadcom, Qualcomm, and the like, focus instead on the long-term value at some of the companies Brean passed over. For example, I've long been a fan of the strong free cash flow and low stock price at NVIDIA. And I recently -- and publicly -- recommended Marvell as an outperformer based on the company's ultralow valuation of 4.5 times free cash flow, alongside its 14% growth rate. Either of these stocks, it seems to me, is better priced for long-term outperformance of the S&P, and long-term profits for their shareholders.

Want to learn more about how Apple is shaping the ecosystem in semiconductors, and reshaping it to its liking? Our analysts recently prepped a detailed report on Apple's prospects, and you can read it here today.

Fool contributor Rich Smith owns shares of NVIDIA. You can find him on CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 283 out of more than 180,000 members. The Motley Fool owns shares of Qualcomm, Intel, Apple, and TriQuint Semiconductor. Motley Fool newsletter services have recommended buying shares of Apple, Intel, and NVIDIA. Motley Fool newsletter services have also recommended creating a bull call spread position in Apple and writing puts on NVIDIA. We Fools don't 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.


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