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 best...
This won't come as news to veteran semiconductor investors, but this industry can be a bit volatile. Take the earnings warning that SanDisk (NAS: SNDK) issued last week, for example. Investors who thought they'd heard the worst of things when Micron (NYS: MU) disappointed investors the previous month were in for a shock when the more NAND-centric SanDisk announced that it, too, was running into some revenue headwinds. As a result, shareholders suffered mightily from SanDisk's one-day loss of 11% of its market cap.

My fellow Fool Anders Bylund argued this was an overreaction. The widespread adoption of solid-state drive tablets and smartphones, combined with a PC move toward similarly SSD-intensive ultrabooks, means that demand for SanDisk's products isn't going away anytime soon. As such, the stock's sell-off offered investors a chance to buy SanDisk on the cheap. And maybe not just SanDisk -- as Anders pointed out, bad news from this one company also took down the stocks of rivals STEC (NAS: STEC) and OCZ Technology (NAS: OCZ) , dropping the shares 3% and 6%, respectively.

Recently, a well-known voice on Wall Street echoed the sentiment, but said the real opportunity now doesn't lie in any of the obvious semiconductor names. Rather, the big money to be made is in semiconductor tester FormFactor (NAS: FORM) instead. You see, it doesn't matter how cheap you think SanDisk or its peers might (or might not) be. None of 'em are as cheap as FormFactor, which according to DA Davidson is worth at least twice what the market is charging for it right now.

One year, 100% profit
In a note issued Monday, Davidson argued FormFactor's new management team is making all the right moves to fix a history of "mismanagement ... [that] led to years of financial losses" at the semiconductor-wafer-probe-maker. Davidson believes FormFactor's ready for "a return to profitability as the industry recovers." And when you combine a return to profitability, with FormFactor's flush balance sheet -- currently boasting close to $300 million cash but without a lick of debt -- Davidson thinks FormFactor could more than double to $12 a share, within just a year.

They might be right.

Valuation matters
Valuing a still-unprofitable company like FormFactor is no easy task. P/E ratios don't work -- there's no "E" to compare the "P" to. FormFactor's also burning cash, which makes P/FCF calculations similarly tricky. (Although this, too, could soon change. With free cash flow of just $37 million over the past 12 months, the rate of cash burn has dropped markedly, and the company looks close to breaking even.)

Our best bet, I think, is to judge FormFactor against a comparable company. While there's little sizable competition in this space, the company that looks most like FormFactor is probably Tokyo's Advantest, a $2.6 billion behemoth, 10 times FormFactor's size in both market cap and revenue.

Like FormFactor, Advantest is currently losing money. Unlike FormFactor, though, Advantest has already reached (and passed) FCF-breakeven. As a result, Advantest today boasts a market cap of 1.9 times sales, and 1.8 times book value, versus FormFactor's 1.5 P/S ratio and its 0.7 P/B valuation.

Foolish takeaway
This suggests Davidson may be on to something. If FCF-positive Advantest deserves a market cap of anywhere from 130% to 250% of FormFactor's, then it seems likely that a FCF-positive FormFactor would deserve improved multiples -- or even more.

Consider: Advantest has strong cash reserves, but nothing like the more-cash-than-market-cap bank account that FormFactor possesses. A conservative valuation might begin by applying a 1.5 multiple to FormFactor's $169 million in annual sales, and add in the company's cash balance on top of that -- generating a potential market cap of $555 million, or well over twice what FormFactor costs today.

Incidentally, this just happens to work out to the same price Davidson is targeting, and explains why I think the analyst is right. (And yes, just as soon as FormFactor proves me right by producing the required free cash-flow-positive earnings quarter, I intend to make a Motley Fool CAPScall and rate this stock an "outperform." Not yet, mind you -- but hopefully soon.)

Don't want to wait for FormFactor to get its act together? Want to find a stock you can invest in today? As it just so happens, you're in luck. Read about out favorite stock idea for this year in the Fool's new report: "The Motley Fool's Top Stock for 2012." It's free for downloading today, but won't be for long -- so make sure toclick quick.

At the time this article was published Fool contributor Rich Smith owns shares of SanDisk. You can find him on CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 375 out of more than 180,000 members. The Motley Fool has a disclosure policy.The Motley Fool owns shares of FormFactor, Motley Fool newsletter services have recommended buying shares of FormFactor, and Motley Fool newsletter services have recommended creating a bull call spread position in FormFactor.We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

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