Wednesday'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, our headlines feature a pair of new buy ratings for and pending acquisition ExactTarget . But the news isn't all good, so before we address those two, let's check in on the housing industry real quick.

American Woodmark has termites
Cabinet maker American Woodmark -- a big source for cabinetry in both new homes and remodels -- beat analyst estimates  with a 2-by-4 yesterday, reporting $0.34 per share in Q4 income, or $0.13 more than had been expected. Revenues similarly thumped estimates.

And yet, today we hear that analysts at Griffin Securities are downgrading the stock to "hold." Is that fair?

Actually, yes, it just might be, for while there's no denying Woodmark turned in a terrific quarter, the valuation on this stock is getting just a wee bit pricey.

Based on trailing-12-month earnings, Woodmark shares now sell for a valuation north of 53 times earnings. Free cash flow at the company -- which is great, by the way, at $18.4 million, or nearly twice GAAP "profits" -- still leaves Woodmark shares selling for more than 28 times earnings. That seems a bit much to be paying for a firm expected to grow profits at only 8% per year over the next five years. Fact is, even if Woodmark were able to maintain the 26% pace of sales growth it reported in Q4, and keep it up quarter after quarter, for the next five years straight, I'd still think 28 times free cash flow is only fair valuation for the shares.

Given that almost no company ever manages to maintain that kind of growth pace for long, however, there's just one, inescapable conclusion: American Woodmark shares are overpriced.

Good news for ExactTarget shareholders
Somewhat better news greeted investors in online marketing firm ExactTarget Wednesday -- although not quite on the order of the 52% leap in share price that followed yesterday's news of its buyout by Salesforce.

Responding to news of the buyout, analysts at Deutsche Bank upped their rating on ExactTarget to "hold," suggesting a) the analyst was wrong about the stock having been overvalued before Salesforce decided to buy it, and also b) that Deutsche is pretty sure the sale will be consummated, and ExactTarget shares won't lose their buyout premium.

As for me... well personally, I still think Deutsche was right the first time around -- and that ExactTarget was overvalued then, and even more overvalued at a price within pennies of what Salesforce has agreed to pay for it. While I agree that the buyout is likely to happen, I don't see any reason to hold onto the stock any longer. My advice would be more along the lines of: Go ahead and sell today. Take the money and run.

...and for Salesforce as well? 
Given that this is my opinion of ExactTarget, you can probably guess my opinion of the company that's buying it, too. Simply put, I think Salesforce is a great business, but a bad stock to own -- and not only because of this purchase.

Of the three big database software firms, Salesforce currently sports the worst record for cash production, having generated only $622 million in real free cash flow over the past year. This gives Salesforce a current price-to-free-cash-flow ratio of 36, and while that's better than its current P/E ratio of infinity (because you can't easily divide negative earnings into a positive stock price), it's also a number likely to worsen as a result of the ExactTarget acquisition. That's because ExactTarget is currently free cash flow-negative -- and has been so every year but one over the past 10 years.

That being said, my opinion clearly isn't a popular one. Most notably, Goldman Sachs itself announced it was upgrading Salesforce today, adding the stock to its "conviction buy" list, and arguing that far from being overvalued, the stock's likely to rise as much as 59% in value over the course of the next year!

Quoted on today, Goldman explains that "CRM had 12% share of the $20bn total customer relationship management market in CY12." Goldman thinks that market share "will grow to 22% of the total $26.5bn market in CY16 (including sales, service and marketing pre-ET)." (So nearly twice the share of a bigger market.) Goldman further projects that salesforce will maintain its 12% share of the smaller, but faster-growing $3.5bn Platform-as-a-Service market, growing revenues there as well.

Combined, that's about $4.4 billion in revenue growth, on top of the $3.2 billion in business Salesforce already does -- and Goldman thinks Salesforce will capture this growth over just the next three years. That adds up to a $60 share price, says the analyst.

Me, I won't quibble about the revenue expectations -- but until Salesforce proves it can turn more of this revenue into real cash profits, instead of frittering it away buying overpriced, cash-burning subsidiaries, I'm not going to be a buyer, myself.

Motley Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool recommends Salesforce.


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