This Just In: Upgrades and Downgrades

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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.

And speaking of the worst...
If you're an investor in AdvancedMicroDevices (NYS: AMD) , I've got good news and bad news for you this week.

Good news first, you say? Sure thing. Yesterday, the analysts at Jefferies upgraded your stock, lifting their price target from $7 (below where AMD trades today) all the way up to $10.50 -- about 28% higher than where the shares are currently trading.

Now, a 28% potential profit sure sounds like good news -- but wait. I haven't told you the bad news part of this yet. The bad news is that Jefferies rarely has any clue which way a semiconductor stock is heading.

You see, here at CAPS, we've been tracking this analyst's stock picks since way back in 2006. That's a problem for Jefferies, because according to our records, over this time period the 45 positive buy/sell recommendations it's made on semiconductor stocks have actually underperformed the S&P 500 about 63% of the time. Worse, this underperformance has translated into a cumulative 470-point loss for investors who followed Jefferies' advice.

So Jefferies' performance has been pretty miserable so far. But the past is past. Could Jefferies be right this time? Is AMD the stock that breaks the losing streak?

Well, let's consider. According to Jefferies, AMD today "offers one of the best risk/reward ratios in semis." Argues the analyst: "AMD's [accelerated processing unit] delivers a unique [microprocessor] + high-end graphics product to the low end and mainstream mobile markets, driving share gains in both segments. We think share gains continue and improving manufacturing yields could translate to upside surprises."

So in a nutshell, Jefferies' buy thesis hinges on AMD capturing a large and growing share of the market for smartphones -- a market where archrival Intel (NAS: INTC) has been a notable laggard. AMD has been making noises lately about licensing popular IP from ARM (NAS: ARMH) and/or MIPS Technologies (NAS: MIPS) , for use in its own chips, as a means of capturing share in the mobile market. Even with the added cost of paying royalties, Jefferies believes AMD could earn as much as $0.68 per share this year, and $1.08 next year, if it goes this route.

Pros...
Viewed in that light, it's not hard to see how AMD could fulfill Jefferies' predictions -- and then some. $1.08 in 2013 earnings, and a $10.50 share price, would still leave the stock trading for less than 10 times earnings even as it comes off a year of 59% earnings growth.

...and cons
Of course, first AMD has to achieve the "improving manufacturing yields" that Jefferies foresees for it. To be blunt, AMD needs to boost the profit margin it earns on its sales.

You see, there's a reason that AMD currently sells for just 0.8 times sales. Rivals Intel and NVIDIA (NAS: NVDA) sport P/S ratios of 2.5 and 2.2, respectively. Both these firms simply do a better job of translating strong sales into stronger profits through robust profit margins. In contrast, AMD currently sells for 0.8 times sales because its profit margin is a meager 7.5% -- and even that may be too much.

Discussing the risks to its rating, Jefferies notes that AMD's P/S ratio (actually, they talk about the EV/S ratio, but it's a distinction without much difference) currently stands at 0.8 times annual sales. That's roughly the EV/S ratio AMD stock fetched back in 2008 -- a year in which the stock never touched $8 (much less $10.50), and actually traded down to below $2 a share. The reason AMD stock is getting such a good price out of the market is that a lot of people are betting it will succeed in boosting profit margin where it failed before. They're betting that this time is different.

Foolish takeaway
For AMD shareholders' sakes, and for the sake of Jefferies' reputation as a stockpicker, I hope they're right. But if history is any guide, they won't be. The sad truth of the matter is that AMD's poor profit margin means that NVIDIA and Intel can underprice it on chips -- accept prices that would drive AMD into a loss if it tried to match -- and still have money left over to invest in research and development and stay ahead of AMD technology-wise.

Given this state of affairs, I don't see how AMD can achieve the sales growth Jefferies expects for it and boost profit margins (as Jefferies also predicts) at the same time. AMD can have higher sales, or it can have higher profit margins. It can't have both -- and without both, Jefferies' upgrade fails the logic test.

And which stock succeeds in earning beaucoup profits, when AMD fails? Find out in our new Fool report: "The Next Trillion-Dollar Revolution." It's free for downloading today, but it won't be for long. So make sure to click quick.

At the time this article was published 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. 379 out of more than 180,000 members. The Motley Fool has a disclosure policy.The Motley Fool owns shares of Intel. Motley Fool newsletter services have recommended buying shares of Intel and NVIDIA, as well as writing puts on NVIDIA. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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