Thursday's Top Upgrades (and Downgrades)

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 headliners include a downgrade for Seattle Genetics (NAS: SGEN) , but an upgrade for Transocean (NYS: RIG) . Meanwhile, one analyst pulls the plug on AT&T's (NYS: T) too-high price target. Let's get started.

Bad news first
Beginning with the downgrade, cancer researcher Seattle Genetics reported losing less money than expected in yesterday's earnings report -- a $0.12 per share loss versus the anticipated $0.15 loss. Banker Cantor Fitzgerald attributed the happy result in part to "a very successful launch that saw rapid acceptance [of] ADCETRIS." Nevertheless, the company "has struggled to produce sequential quarterly growth." Consequently, the analyst sees the company's valuation "relative to the near-term prospects" as unattractive, and downgraded the shares to sell this morning.

I'm not sure that's the right call, though. On the one hand, sure, S-Gen is still losing money at the rate of about $70 million a year. But it's got a well-stocked warchest, flush with $330 million in cash and not a lick of debt. Cash-burn, while significant, moderated last quarter when S-Gen turned briefly free cash-flow-positive. Results for the current quarter won't be known until the company publishes its cash-flow statement, but if those numbers look good, it could be that S-Gen isn't in as dire straits as it appears.

Transocean spans the gap
Another company reporting better-than-expected numbers this week was Transocean, which on Monday announced Q3 earnings of $1.37 per share, or $0.60 better than the expected $0.77. Not bad, considering that revenue actually came in a bit lighter than hoped. Analysts at Argus responded to the news with an upgrade to buy today, and gave the stock a $62 price target, suggesting 29% upside from today's prices. And this time, Wall Street may be calling things right.

While technically "unprofitable" under GAAP, Transocean is in fact generating considerable cash from its business -- $1.3 billion in free cash flow over the past 12 months. On a $17.5 billion market cap, that works out to a P/FCF ratio of just 13.5, which looks cheap for the company's projected 20% annual long-term growth rate. The wild card here is debt; Transocean has a lot of it, about $8.1 billion net of cash on hand.

Still, even if you add the company's debt to its market cap, the resulting "enterprise value" only works out to about 19.5 times free cash flow. Assuming the company can hit its growth targets, that looks like a fair price to pay for Transocean. Maybe even a little bit cheap. In short, Argus is probably right to recommend the stock as a buy.

AT&T disconnects from value investors
Contrariwise, free cash flow is a bit of a problem for our third and final stock today: AT&T. Yesterday, Ma Bell announced a plan to accelerate capital spending in its wireline and wireless businesses, a move that will directly impact free cash flow over the three-year term that AT&T intends to keep spending.

If AT&T spent the same amount this year, as it plans to spend the next three years ($22 billion each), for example, trailing free cash flow at this firm would be $14.4 billion instead of $17.1 billion. That's still a fair sight more than the $4.4 billion in "net income" AT&T gets to claim under GAAP, but it's still about 16% less cash flowing into the kitty.

This being the case, Hudson Square Research's decision to cut its price target on AT&T by about 11% this morning (to $32 per share) may actually be cutting AT&T some slack, and anticipating an increase in revenues (and earnings) from all the new investment in infrastructure. Regardless, at an enterprise value-to-presumed-free-cash-flow ratio of 17.5 or thereabouts, the stock still looks overpriced to me based on consensus growth estimates of 6.8% for Ma Bell. Long story short, I still think Verizon is a better bet.

Motley Fool contributor Rich Smith has no positions in the stocks mentioned above. The Motley Fool owns shares of Transocean. Motley Fool newsletter services recommend AT&T.

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