Friday's Top Upgrades (and Downgrades)

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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're looking at new downgrades at Staples (NAS: SPLS) and Merck (NYS: MRK) -- but for USG (NYS: USG) , an upgrade to "buy."

The Easy button is broken
Let's get the bad news out of the way first, beginning with Staples, where a recent earnings miss has left the analysts at Morgan Stanley feeling downbeat on the stock. This morning, Morgan Stanley pulled its "overweight" rating and downgraded Staples to "equalweight" instead. Is this justified?

There's no denying Staples had a rough second quarter, with sales down more than 5% and earnings falling 28%. But just as undeniable is the fact that post-sell-off, Staples has become a real bargain of a stock. 8.2 times earnings, for a projected 9.3% long-term grower paying a 3.3% annual dividend? Morgan Stanley might not like those odds, but value investors can take advantage of any weakness caused by today's downgrade to snap up some cheap shares.


Jot yourself a Post-it note. Don't forget.

Will the patient live?
So far, investors seem to be passing on the opportunity to own Staples, as the stock sits out today's market bounce. One company they're more eager to own -- Wall Street analysts notwithstanding -- is big pharma behemoth Merck.

This morning, Bank of America decided to close out the week with a close-out of its buy rating on Merck. The stock's up 34% over the past year, and B of A has decided that's more than enough profit to make it happy. The analyst is downgrading the stock to neutral, and it's right to do so.

Priced close to 20 times earnings, Merck's not actually as expensive as it looks. (Free cash flow at the firm is especially robust.) Yet even so, the drug giant's scrambling to keep from falling over the patent cliff, just like everyone else in big pharma these days. Sure, long-term, analysts think the company can keep itself steady and even grow earnings a few percent per year. Whether such anemic growth can support a 20-times-earnings valuation, however, is open to debate. Bank of America is probably right to be cautious and quit while it's ahead.

Sheetrock-solid?
Last but not least, as America's housing industry begins to climb back out of the hole dug for the McMansion's optional basement, lots of people are getting excited about homebuilder stocks.(PulteGroup, for example, is now selling for a heady 2.6 times book value!) Longbow Research, however, urges investors to find an alternate entryway, through drywall maker USG. The analyst upgraded the shares to "buy" this morning, arguing that $20 a share is too cheap, and that USG shares should fetch at least $26 apiece within a year's time.

There's just two things wrong with this argument: First, the shares have already more than doubled over the past year. Second, they may not be worth what they're selling for already today, much less be headed for $26 a year from now.

USG hasn't generated any free cash flow whatsoever since way back in 2009. It isn't currently profitable under GAAP, either. Sure, USG is expected to earn a small profit next year ($0.12 per share), and to grow this profit at about 3% per year on average over the next five years. But it's hard to argue that bare profitability a year from now, and anemic growth thereafter, justifies the stock's nosebleed 171 forward P/E ratio today.

So while Longbow may like the stock, maybe USG investors should take a cue from Bank of America (and its decision to back away from Merck) instead. Once you've made your profits, it's time to declare victory and go home.

Fool contributorRich Smithholds no position in any company mentioned. The Motley Fool owns shares of Staples.Motley Fool newsletter serviceshave recommended buying shares of Staples.

The article Friday's Top Upgrades (and Downgrades) originally appeared on Fool.com.

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