This series, brought to you by Yahoo! Finance, looks at which upgrades and downgrades make sense, and which ones investors should act on. Today, we'll be looking at three new semiconductor stock picks from broker ISI Group, which recently advised investors to buy shares of Qualcomm (NASDAQ: QCOM ) and Micron Technology (NASDAQ: MU ) -- but not SanDisk (NASDAQ: SNDK ) . Let's dive right into the ratings.
Qualcomm -- strong buy
On another "red" day for stock markets, shares of Qualcomm are defying the downturn in early trading, gaining a small fraction of a percent in response to late-breaking news that ISI Group has endorsed the stock.
Assigning Qualcomm and "strong buy" rating and a $90 price target last night after market close, ISI predicts a 15% profit for investors who buy the shares today. Is the analyst right?
Priced at 20 times earnings, Qualcomm shares still look somewhat overvalued from a traditional PEG perspective (price-to-earnings ratio, divided by forward growth rate). And yet, ISI Group may still be onto something here. Qualcomm, you see, generates a whole lot more cash than its GAAP income statement gives it credit for -- $8.5 billion in positive free cash flow produced over the past year, versus only $6.8 billion in reported GAAP "earnings."
This powerful cash engine has also enabled Qualcomm to amass a warchest of just under $17.3 billion in cash, with negligible debt. As a result, a better picture of the stock's value may be gained by thinking of it not as a "20 P/E stock," but rather as a business selling for an enterprise value of just 13.6 times its annual free cash flow. With Qualcomm expected to grow its profits at about 15% a year over the next five years -- paying its shareholders a 1.8% dividend at the same time -- the stock looks every bit the "strong buy" that ISI says it is.
Micron Technology -- strong buy
Meanwhile, DRAM memory specialist Micron had an even worse time of things yesterday than Qualcomm did, losing more than 4% of its market cap in a day of frenzied tech trading. After the dust settled, ISI announced a "strong buy" rating on this stock as well, and assigned a $30 price target that suggests Micron holds even more potential for profit than Qualcomm does -- potentially as much as a 38% gain over the next 12 months.
Now, personally, I actually like Micron a bit less than I like Qualcomm as things stand today. But here, too, I believe the analyst has struck upon a good value.
Unlike Qualcomm, Micron pays no dividend. It's also generating somewhat less free cash flow than it reports as GAAP net income. Yet selling for less than 9 times earnings, Micron shares look like a nice bargain if the company can achieve a 10% long-term growth rate. Valued on free cash flow, the stock has an enterprise value a bit less than 10 -- which suggests fair valuation.
The wild card here is that Micron appears to be turning the corner on free cash flow. While its real cash profitability currently lags reported income, the gap between FCF and GAAP profits has been closing recently, and if this trend continues, we could soon see Micron in the same enviable position that Qualcomm occupies -- generating more cash profit than it reports as net income, and thus offering a better value than the stock's headline numbers suggest. While not an obvious bargain today (the stock looks only slightly undervalued), ISI is right: If this trend toward swelling free cash flow holds true, Micron could indeed hold the potential for even bigger profits than Qualcomm shares offer.
SanDisk -- neutral
Playing the part of odd man out in ISI's series of endorsements is rival flash memory maker SanDisk, which, according to StreetInsider.com, ISI has just tagged with a "neutral" rating this morning and an $87 price target.
And yet, SanDisk occupies a bit of a middle position between Qualcomm and Micron. Costing 17 times earnings and paying a 1.1% dividend, it's cheaper than Qualcomm, but less generous with its dividend checks. At a 12.5% projected growth rate, it's growing slower, too. This may explain the analyst's greater enthusiasm for the bigger stock.
What tips the balance in SanDisk's favor, in my view, is the fact that SanDisk also resembles Qualcomm in generating strong free cash flow from its business. Last year's $1.65 billion in cash profits exceeded reported GAAP income by more than half, and are enough to give the stock an enterprise value-to-free cash flow ratio of just over 10.
Long story short, ISI may think SanDisk stock less attractive than faster growing Qualcomm, and cheaper than Micron. But in my view, the projected 13.6% "total return" from earnings growth and dividend payments is enough to make SanDisk stock a bargain, too.