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.

Chips crumble
There's no two ways about it -- last week was a lousy time to own semiconductor stocks. In a one-two punch to the gut, first Advanced Micro Devices (NYS: AMD) and then Micron (NYS: MU) disappointed investors with their quarterly earnings reports. We covered the A-M-Disaster (and the downgrades it spawned) last week. Now let's take a look at the mess that is Micron.

As you've probably heard by now, Micron stunned the Street Thursday. Instead of reporting the small profit it was expected to deliver, the company announced a $0.14-per-share pro forma loss. Revenues were fine, sure. But somewhere between promise and delivery, the company misplaced a full third of its gross profit margin on these revenues. This news shocked investment banker Wedbush Morgan right out of the stock: "We are moving to the sidelines on Micron Technology ... following the company's unexpected shift into the red." While Wedbush hadn't exactly expected great things from Micron last quarter, it did hope the company could at least break even on DRAM production. It didn't.

With its buy thesis busted, Wedbush warns that Micron is set to report at least two more money-losing quarters before earnings turn positive again. With profits now postponed, the analyst advises against putting any "new money" into the stock -- counseling investors instead to wait for "a return to profitability in DRAM," better visibility on 2012 "NAND supply/demand," and/or a final decision in the Rambus (NAS: RMBS) litigation, before deciding whether to buy more shares.

I agree.

Let's go to the tape
But I don't say this lightly. Fools, it breaks my heart to have to advise against buying Micron today. I own the stock myself. I've argued in its favor in the past. But facts are facts, and the fact is that Wedbush Morgan is a very good semiconductor analyst. Of the 22 recommendations it currently has active in the chip sector, fully 65% are outperforming the market today. When Wedbush tells us that things are going to get worse for Micron before they get better -- that worries me.

What worries me even more are the numbers I'm seeing in Micron's latest report. Sure, in some respects the stock still looks cheap. At 0.6 times annual sales, it appears to be priced at half the value of the average stock on the Dow Jones Industrial Average (INDEX: ^DJI). Micron's price-to-book value ratio of 0.7 is less than a third the going rate on the Dow and is cheaper than chipmakers AMD, Intel (NAS: INTC) , and SanDisk (NAS: SNDK) , too. The problem, though, is with Micron's inability to make money from its assets.

In the blink of an eye, Micron's stock has jumped from 8 times earnings, based on pre-Thursday numbers, to 26 times earnings. More, the key metric on which I value most of my stocks -- free cash flow -- has turned from very attractive to decidedly ugly. Free cash flow that as recently as last quarter was strongly positive for Micron plunged into the red last week. At last report, the company is burning cash at the rate of $66 million a year.

Foolish takeaway
Admittedly, cash flow is a more volatile figure than GAAP earnings -- as Micron's switcheroo from strongly FCF-positive to barely negative in the space of one day just illustrated. And yes, this means that as quickly as things fell apart for Micron last week, they could improve again just as quickly once profit margins stabilize.

This could happen, but if you're like me in using free cash flow as an indicator of where "earnings" are heading, and if you agree that it's earnings that most other investors will focus on, then Micron's plunge into the red on free cash flow suggests there's more bad news ahead for its shareholders. My advice, therefore, is to not wait for the other shoe to drop before getting out. And to echo Wedbush's advice, no, you certainly should not buy on this price drop.

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At the time thisarticle was published Fool contributorRich Smithregrets to say thathe owns shares of Micron (for now), and SanDisk, too.You can find him on CAPS, publicly pontificating under the handleTMFDitty, where he's currently ranked No. 276 out of more than 180,000 members.The Fool owns shares of and has bought calls on Intel.Motley Fool newsletter serviceshave recommended buying shares of and creating a diagonal call position in Intel. We Fools don't 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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