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.

Is this the end of smartphones?
On CNBC's Fast Money last night, analysts were all in a lather over a report just out of J.P. Morgan titled "Smartphone adoption peaking in 2013." A report that, among other things, convinced J.P. to downgrade Qualcomm to "hold."

If all you know about J.P.'s report is what you heard about it last night, you probably have to side with the analysts on this one. As AlphaOne Capital CIO Dan Niles noted, for example, 700 million smartphones were sold last year, out of 1.7 billion cell phones total -- suggesting there's still the potential for a good billion upgrades out there, annually, and not counting new sales.


Niles noted, too, that smartphone market "penetration" in developing nations is only 15% (suggesting there will be plenty of new sales). And his colleague Stephen Weiss, of Short Hills Capital, quickly chimed in: "Don't forget the tablet market," pointing out that Qualcomm has a chance to put chips in some 650 million tablet computers annually by 2016. All of which, Weiss, said, makes J.P. Morgan's assertion, that smartphone adoption has peaked, sound pretty "ludicrous," and all of which suggests there's still every reason in the world to own Qualcomm.

That being said, there's just one thing wrong with the analysts' attack on J.P.'s report:

That's not what J.P. said
J.P. Morgan never actually said what they say it said, you see. What J.P. did say was: "We see 2013 as another strong year for smartphones with 37% growth predicted ... However, our proprietary smartphone model continues to predict that 2014 will be the first year that new adoptions decline with unit growth slowing to 17%."

See the difference? According to CNBC, J.P. just baldly predicted the demise of smartphones within 12 months. But in fact, J.P. only predicted a slowing in the rate of smartphone sales increases. Sales will continue to happen. Indeed, smartphones sales will continue to grow and grow in 2014 and beyond. They just won't grow at faster and faster rates.

A distinction with a difference
That's important. It's important in particular because it means investors can't simply dismiss J.P.'s prediction as the ravings of a barking mad banker. Instead, they need to give J.P.'s warning serious consideration -- not just as it relates to Qualcomm, but as it relates to pretty much everyone involved in the making of smartphone components, and smartphones, period.

So what exactly did J.P. say, other than making the obvious point that sales can't accelerate to infinity and beyond? Three points stand out:

  • First, J.P. noted that "average selling prices must still come down."
  • Second, "lower cost smartphones and tablets" are key to maintaining sales growth rates.
  • Third, since falling average selling prices will crimp profit margins, and tend to cancel out earnings gains from growing sales, there is "limited upside to current earnings estimates."

What it means to you
Now what does this mean to Qualcomm shareholders? Let's start with where the stock stands today. At a P/E ratio of more than 17, but a projected growth rate of less than 15% (and a 1.5% dividend yield to make up the difference), Qualcomm shares today look appropriately priced. To justify a buy rating, we'd have to see Qualcomm's growth rate rise substantially from already strong levels -- something J.P. argues is not likely to happen.

As it turns out, though, J.P.'s warning about Qualcomm may actually have more significance for other players in the smartphone space. Let's take a quick look at three of the more popular names in smartphone components: Skyworks Solutions and TriQuint Semiconductor , for example, both of which supply power amplifiers and related chips used in smartphones, and OmniVision Technologies , which supplies a popular line of image sensors for cameras incorporated into phones.

Of the three, Skyworks looks best-positioned to weather a drop in smartphone ASPs, and resulting pressure on components makers to reduce prices in tandem with falling smartphone price tags. Skyworks is profitable, with a 22 P/E. It generates strong free cash flow -- 14% ahead of reported net income in 2012. And it's sitting on a big pile of cash -- $378 million already. All in all, a nice position to be in.

In contrast, TriQuint and OmniVision both have cash in their favor -- $139 million for TriQuint (and no debt); $95 million (net of debt) for OmniVision. But both companies are burning cash like mad, and neither boasts a P/E ratio that anyone sane could call attractive. OmniVision shares cost a steep 55 times earnings, while TriQuint has no earnings, and therefore no P/E at all. If J.P.'s right, neither of these stocks looks like a place you want to be when the other shoe drops, and we see predictions of falling ASPs turn into actual reports of falling ASPs -- and falling profits for component makers.

Finally, some good news for Nokia
One final thought: JP's prediction of a squeeze on average selling prices for smartphones may be bad news for component makers like TriQuint and OmniVision, and even for Qualcomm and Skyworks. It could be good news, however, for Nokia , whose Lumia is starting to grab a toehold in the market, and whose prices are looking very competitive indeed, both here in the U.S. and in Asia as well. Nokia just finished reporting its first quarterly profit since Q1 of 2011, and its best free cash flow quarter since Q4 of that year -- $550 million.

If manufacturers' scramble to bolster sales growth at the cost of profit margins turns the sale of smartphones turns into a race to the bottom on prices, well, Nokia's already halfway there already. And it's making a profit regardless.

Nokia's been struggling in a world of Apple and Android smartphone dominance. However, the company has banked its future on its next generation of Windows smartphones. Motley Fool analyst Charly Travers has created a new premium report that digs into both the opportunities and risks facing Nokia to help investors decide if the company is a buy or sell. To get started, simply click here now.

The article This Just In: Upgrades and Downgrades originally appeared on Fool.com.

Fool contributor   Rich Smith   has no positions in the stocks mentioned above.   You can find him on CAPS, publicly pontificating under the handle TMFDitty , where he's currently ranked No. 352 out of more than 180,000 members. The Motley Fool owns shares of Qualcomm and TriQuint Semiconductor. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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