Tuesday's Top Upgrades (and Downgrades)

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Stocks go up, stocks go down -- and so do analysts' opinions of them. This series, brought to you by Yahoo! Finance, looks at which upgrades and downgrades make sense and which ones investors should act on. Today, we look at why one analyst thinks it's game-over for Electronic Arts (NYS: EA) , while two others see good things ahead for L-3 Communications (NYS: LLL) and USG Corp. (NYS: USG) .

Bad news first
New York-based securities broker Monness, Crespi, Hardt announced this morning that it's giving up on Electronic Arts and downgrading the stock from neutral to sell. Details on the downgrade are hard to come by so far, but we do know that MCH has assigned an $11.25 price target to the stock.

So far, investors are shrugging off the news, and instead of selling EA are bidding it up right along with the rest of the market. This could be a mistake.


Priced at 63 times trailing earnings, EA shares look richly valued for the 17% long-term growth that Wall Street expects the company to produce. What's more, even if you give the company every benefit of the doubt -- value it on free cash flow instead of GAAP earnings and net out cash to give the company the benefit of its $3.4 billion lower enterprise value -- the result is a still-high enterprise-value-to-free-cash-flow ratio of 32. Still pretty pricey for a 17% grower.

Analysts do expect the company to earn more in the future, driving its forward P/E down to 13. But that assumes its games take hold, which isn't a foregone conclusion; witness the recent disaster over its Star Wars release. Add in the fact that gaming retailer GameStop (NYS: GME) just reported a 10% decline in Q1 profit, and that market tracker NPD Group last month warned of a 25% industrywide decline in March gaming sales, and buying EA in the face of today's downgrade looks like a very risky bet indeed.

In happier news
In contrast to gaming, there's one industry where investors not only acknowledge the risks, but have arguably over-reacted to them: defense. This is key to Oppenheimer's suggestion this morning that it's time to stop selling shares of defense contractor L-3 Communications. Priced at 7.3 times earnings, and an even deeper discount to free cash flow, Oppenheimer thinks "downside risk is now largely priced in" for this stock.

As Oppenheimer argues, a weak 2012 is likely to give rise to earnings growth in fiscal 2013, with earnings turning up by about 6% in comparison to this year. Even the analyst's below-consensus forecast of $8.69 in 2013 earnings would therefore price L-3 at about 7.8 times these forward earnings -- not bad for a 3% dividend payer growing in the low single digits. And if L-3 finds a way to grow faster than expected? In that case, the stock might even become buyable again.

Building a case for homebuilding
And speaking of stocks with brighter futures than their recent pasts... news this month that U.S. homebuilders' sentiment has hit its highest level in five years has many investors looking for a way to play a renewed housing boom (or at least an end to the bust). Problem is, stock prices at homebuilders like Toll Brothers (NYS: TOL) have already rebounded strongly. Toll shares now trade for twice what they fetched last fall. So where do we go to shop for bargains?

According to analysts at Longbow, you go to the suppliers. USG, for example, is likely to benefit from higher volumes of wallboard being shipped, and Longbow believes we will soon see "revenue acceleration" at this company, which in fact reported 13% better revenue last quarter than it saw in the previous year.

Burning cash, unprofitable today, and priced at 150 times next year's projected earnings, I think it's probably a bit early to be following Longbow's advice and diving back into USG today. Still, you have to admire the analyst's initiative. Even if USG is no bargain, surely there are some bargains, somewhere up or down the homebuilding supply chain.

Where do you think Longbow should be looking for them? Tell us what you think in the comments section below.

Fool contributorRich Smithholds no position in any company mentioned. The Motley Fool owns shares of L-3 Communications Holdings and GameStop.Motley Fool newsletter serviceshave recommended buying shares of L-3 Communications Holdings.Motley Fool newsletter serviceshave recommended writing covered calls on GameStop.

At the time this article was published

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

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