This Just In: Upgrades and Downgrades

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 ...
Did Apple (NAS: AAPL) go out of business when I wasn't looking? Have Silicon Valley's 80 varieties of tablet computer all suddenly become passe? That might explain the massive wave of downgrades that crashed over solid-state disk drive maker STEC (NAS: STEC) on Friday.

Oh, I know -- STEC is "enterprise" flash. Apple's iPads, -Pods, and -Phones are all "consumer" flash. But in investors' minds, STEC's popularity is indelibly tied to the rise of Apple's devices that use flash memory and solid state drives (SSDs), rather than the hard disk drives (HDDs) more common on most laptops and desktop computers. But in reality, these are two completely different animals. Apple's i-devices are still selling like hotcakes. STEC's not so lucky.

On Thursday, STEC reported earnings for fiscal Q2 that missed analyst targets "by a penny." That was bad enough, but STEC warned that increased competition from rival SSD makers like Intel (NAS: INTC) , Western Digital (NYS: WDC) and Micron (NYS: MU) -- and perhaps especially SanDisk (NAS: SNDK) , now that it owns Pliant -- will drive Q3 profits far lower than almost anyone expected.

Wall Street had been predicting STEC per-share profits in the low $0.30 range this quarter. STEC's prediction: $0.10 or less. Hearing this, Wall Street threw the predictable hissy fit.

Needham, Benchmark, JP Morgan, ThinkEquity, Northland Securities, and FBN Securities all either cut ratings, target prices, or both on STEC. Even Gleacher & Co., still a fan of STEC, warns that it sees "no material catalysts ... for the next 12 months" at least.

Is Gleacher right? Could its even more pessimistic peers be right? Should investors quietly shed STEC from their portfolios?

STEC: Buy the numbers?
On the surface, at least, STEC shares look almost unbelievably cheap. Valued on its "GAAP" earnings, STEC sells for just 10.6 times the amount of profit it earned over the last 12 months. That sounds reasonable for a company expected to grow 15% per year for the next five years.

But I'm not sure we can believe in this unbelievable bargain. Consider last quarter. At the end of fiscal Q1, STEC showed $48 million in trailing "profit." But it generated less than half that sum in actual free cash flow -- just $23 million.

STEC didn't see fit to share its cash flow information with its shareholders in last week's earnings release, so we're still not sure how its FCF looks today. But if the ratio of FCF to net income we saw three months ago holds true, STEC might now be at $26 million or so.

Foolish takeaway
On a $506 million market cap, this suggests STEC shares could still be selling for as much as 19.5 times FCF. Its earnings aren't growing at all -- they're shrinking. Yet even if we take analyst estimates at face value, and give STEC credit for its predicted 15% annual growth rate over the long term, 19.5 times FCF would seem like a high price to pay for that growth.

In short, I don't know that STEC is really as cheap as it looks. To the contrary, I think it's entirely possible that STEC remains overpriced -- even after losing 44% of its market cap last week.

And analysts like JP Morgan, who still tell you to sell STEC even after its near-half-off sale, just might be right.

At the time thisarticle was published The Motley Fool owns shares of Western Digital and Apple. The Fool owns shares of and has bought calls on Intel.Motley Fool newsletter serviceshave recommended buying shares of Intel and Apple, and creating a diagonal call position in Intel and a bull call spread position in Apple.Fool contributorRich Smithowns shares of Micron and SanDisk. You can find him on CAPS, publicly pontificating under the handleTMFDitty, where he's currently ranked No. 585 out of more than 170,000 members. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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