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Tuesday's Top Upgrades (and Downgrades)

This series, brought to you by Yahoo! Finance, looks at which upgrades and downgrades make sense, and which ones investors should act on. Today our headlines feature some optimistic thoughts from Jefferies on the Applied Materials (NASDAQ: AMAT  )  merger with Tokyo Electron. But before we get to that, let's take a quick look at the rapid implosion going on at Quiksilver (NYSE: ZQK  ) today.

Quicksilver going down quickly
Surf-and-skate apparel specialist Quiksilver shares are down roughly 40% in response to an after-hours earnings miss reported yesterday. While analysts had prepared for the prospect of Quiksilver showing a small loss on the quarter, the magnitude of the $0.15-per-share loss took investors by surprise, falling $0.13 beyond the consensus estimate and quickly sinking the stock.

In response, at least two analysts -- Stifel Nicolaus and Monness, Crespi, Hardt -- have already pulled their buy ratings on the stock. Piper Jaffray, which already had the stock rated only neutral, cut its price target to $4 a share, criticizing "the company's Q2 results in which revenue came in well below expectations compounded by reduced visibility in management's outlook." Specifically, Quiksilver warned investors not to expect it to turn a profit before 2017 at the earliest -- a walk-back from its previous target of profitability by 2016.

This news was guaranteed to torpedo the stock, and rightly so. After three straight years of burning cash, Quiksilver looks to be in perilous straits indeed. Nearly $800 million more debt than cash on its balance sheet, with little prospect for generating new cash internally, and now a potential three-year wait before profits begin flowing again? The risk is very real that Quiksilver will not survive to see those promised profits. And the Quiksilver bulls are right to pull in their horns.

Big changes in semiconductors
Now on to the day's good news, in which Jefferies announced new buy ratings on a pair of semiconductor stocks: Applied Materials and, as a corollary play, Lam Research (NASDAQ: LRCX  ) . Let's start with A-mat.

Applied Materials, as you've probably heard, is merging with Japan's Tokyo Electron to form a giant of the semiconductor manufacturing equipment industry. Quoted on today, Jefferies asserted that "the merger [will] complete in 2H14, and translate into increased pricing power and scale benefits." Jefferies said it expects both "higher margins and cash returns" to result, and to convince investors to price the new and improved Applied Materials at a higher multiple to earnings.

That would be a neat feat, though, given that the shares already sell at 30 times earnings -- pricey relative to the stock's projected 11.5% growth rate, if the merger doesn't come off. If the merger does happen, though, Applied Materials will emerge as a combined company generating $983 million of its own free cash flow, plus $324 million from Tokyo Electron (according to S&P Capital IQ data), for a grand total of at least $1.3 billion -- plus any additional cash the company can generate from growth and "synergies" after the merger. This all works out to a price-to-free cash flow ratio of about 18 post-merger, which looks significantly cheaper than the stock appears today. We'll get a better picture of the valuation after the merger closes and the dust settles. But for now, I'd say Jefferies is right to be optimistic.

Ready to go on the Lam?
Jefferies also sees Applied Materials rival Lam Research benefiting from the merger, even though it's not involved in it at all. The reason? As Jefferies explained, "We expect LAM to benefit from AMAT's merger with TEL through increased pricing power due to industry consolidation in deposition and etch equipment."

Increased pricing power could result in operating margin rising as much as "200 bps in FY15 after expanding by 700 bps in FY14." If Jefferies is correct, that would translate into about a 13% improvement in annual profit at Lam -- perhaps $0.38 more in earnings per share. But is Jefferies right?

It may not matter. The fact is, at a P/E ratio of just 22.5 and a projected long-term annual earnings growth rate of nearly 22.5% (according, again, to S&P Capital IQ), Lam shares look attractive right now. Free cash flow is strong, even stronger than reported net income of about $500 million per annum. So any improvement in profitability at the company will only make these shares an even better bargain. Kudos to Jefferies for pointing this out.


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Rich Smith

As a defense writer for The Motley Fool, I focus on defense and aerospace stocks. My job? Every day of the week, I'm monitoring the news, figuring out the winners and losers, and tracking down the promising companies for you to invest in. Follow me on Twitter or Facebook for the most important developments in defense & aerospace, and other great stories.

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