Tuesday's Top Upgrades (and Downgrades)

Analysts shift stance on Silicon Labs, Applied Materials, and 3M.

Jul 8, 2014 at 12:39PM

This series, brought to you by Yahoo! Finance, looks at which upgrades and downgrades make sense, and which ones investors should act on. Today, headlines feature new buy ratings for chip stocks Silicon Labs (NASDAQ:SLAB) and Applied Materials (NASDAQ:AMAT). But before we get to those two, let's take a quick look at why Goldman Sachs is...

Downgrading The Fresh Market
Natural foods grocery stocks have been pummeled on lack-of-growth growth fears this year, and there's more bad news in "store" for shareholders of The Fresh Market (NASDAQ:TFM) today, as Goldman cuts its rating on the chain to "sell."

As related on StreetInsider.com today, Goldman worries that "TFM is operating in a more competitive environment for specialty grocers that we expect will cap the top line and pressure margins long term." The analyst foresees "a combination of downward earnings revisions and valuation rerating to drive 18% downside to our price target" of $27, and warns that even if The Fresh Market succeeds in growing sales this year, profit margins are going to get squeezed so hard as to prevent the stock from hitting management's guidance of $1.56 to $1.66 in profits. Indeed, if Goldman is right, The Fresh Market could end up earning as little as $1.54 per share.

When you consider that the stock is already trading for nearly 34 times earnings, and therefore overvalued based on consensus growth targets of 17% annually, the prospect of slow or no growth in 2014 isn't one that's likely to sit well with gung-ho growth investors. (Value investors are almost certainly already avoiding the stock). Meanwhile, free cash flow at the firm remains anemic, with only $21 million in actual cash profits  having been produced over the past year -- less than half Fresh Market's claimed $45 million in GAAP "earnings."

Long story short, Goldman's right about this stock. At this price, I'd rather be short it than long.

Value in silicon?
 So what's a better bet than organic groceries? MKM Partners humbly suggests you try a bit of tasty silicon -- Silicon Labs. Initiating coverage of the semiconductor maker at "buy" today, and with a $60 price target, MKM argues that Silicon Labs will be a leader in the new industry of the "Internet of things" -- connected household devices.

On its own or as an acquisition target, MKM thinks Silicon Labs "remains attractive either as an organically growing IoT company or a potential asset of interest to larger companies looking to increase IoT exposure." Personally, though, I have my doubts.

Why? Depressed GAAP earnings have the stock trading for a 55 P/E ratio. And while it's true that Silicon Labs generates superior free cash flow -- $129 million over the past 12 months -- this still leaves it trading for about 16 times FCF, which seems a high price to pay for the stock's projected 12% long-term growth rate.

Independent and "organically growing," as MKM puts it, I think Silicon Labs is a better bet than the organic grocers, certainly. But it's still not cheap enough to buy on its own merits.

"Applied Materials" no more
 Last but not least, get ready for a big change at Applied Materials. The chipmaking equipment-maker announced recently that after completing its merger with Tokyo Electron, the combined company will adopt a new name -- "Eteris ." It's not as techy as the company's original moniker, but analysts seem to like it regardless.

This morning, Cowen & Co, announced they're doubling down on their "buy" rating on the stock, and keeping a $26 price target based on an expectation of "both more favorable spend mix and more sustained industry spend over next few yrs" by Eteris's customers.

Simultaneously, Piper Jaffray  announced they're picking up coverage of the stock with an equivalent "overweight" rating and a nearly identical $27 price target. Like Cowen, Piper highlighted a belief that "industry fundamentals remain positive for equipment suppliers and that AMAT is among the best positioned to benefit" as the basis for their optimism.

As for "Eteris" itself, in the person of Applied Materials, it most recently guided investors  to expect sales to be "flat to down 5 percent" sequentially in the current fiscal third quarter, but up 13% to 19% year over year. This suggests the company may be growing significantly faster than the 11.5% long-term growth rate that analysts forecast for it -- even before adding Tokyo Electron to the mix.

While on its own, the stock continues to look pricey at 32 times earnings, valuation calculations could change dramatically after the merger takes place.

My advice? Sit tight. Take the analysts' optimism as a hopeful sign, but don't make any drastic moves until the merger is finished. There will be plenty of time to buy after Applied Materials/Tokyo Electron/Eteris have released combined financial results -- and that's when you'll get the best picture of the stock's valuation, and whether it's really worth buying.

Rich Smith has no position in any stocks mentioned, and doesn't always agree with his fellow Fools. Cases in point: The Motley Fool recommends both Silicon Laboratories and The Fresh Market.

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