Friday'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 headlines include a new buy rating for Zillow and a higher price target for Pandora . Unfortunately, it's not all good news, so let's start out by finding out why.

Skullcandy got smacked upside the head
Despite reporting revenues that exceeded analyst forecasts, audio earbuds maker Skullcandy failed to hit its earnings target yesterday. Earnings, which came in $0.01 short of consensus at $0.47, sparked a wave of sell recommendations on the Street. First, Northland Securities cut the stock to "market perform." Then in rapid succession, each of Piper Jaffray, Raymond James, and DA Davidson reduced their ratings to "underperform."

According to the most pessimistic of these analysts, Skullcandy shares that currently cost close to $6 a share could easily fall as low as $4 over the next 12 months. But is it really as bad as all that?

Sadly, yes, it is. Sure, at first glance it seems crazy to think a stock that can earn $0.47 a share in a single quarter might be worth only $4. But look at the facts: Despite reporting GAAP "earnings" of nearly $26 million last year, Skullcandy really only produced just $3 million in actual free cash flow. On Skullcandy's $185 million market cap (where it ended last night), that makes for a price-to-free cash flow ratio of more than 61. That's a hard price to justify even if Skullcandy achieves analysts' projected 16% long-term growth rate -- and as we saw yesterday, the stock's already having trouble living up to these lofty expectations.

Until Skullcandy figures out how to generate a bit more cash from its business, I'm forced to side with the analysts on this one, and to agree: Skullcandy's buy thesis has suffered a serious head wound.

Has Pandora peaked?
Now for the "good" news. Last night, as Skullcandy was suffering its after-hours post-earnings sell-off, shares of Internet radio star Pandora surged more than 21% in late evening trading. The company reported strong revenue growth in its fiscal fourth quarter, and promised investors more of the same in the current Q1 2013. This inspired analysts at Needham to increase their price target on Pandora stock, which they now say could be worth $16 a share before a year is out.

There's just one problem with that prediction: It's dead wrong.

Revenue growth notwithstanding, Pandora ended last year burning cash at a rate 38.5% greater than the rate at which it was burning greenbacks in 2011. GAAP "earnings" -- by which I mean GAAP losses -- more than doubled. Long story short, while Pandora may be doing a fine job of collecting revenues, it's doing a lousy job of generating enough revenues to offset the costs -- and continues losing money.

To me, that's not the kind of trend that justifies raising a target price on the stock. Just the opposite.

And speaking of overvalued tech stocks...
Finally, we come to, the go-to site on the Interwebs for voyeurs who want to peek through the windows at the neighbors and find out how much their house is worth. Historically low mortgage rates, combined with a near-17% plunge in homes for-sale on the market, have lamenting an "inventory shortage" in housing -- and boosted the fortunes of sites like Zillow that help home-shoppers identify what few houses are actually available for sale.

This trend caught the eye of analysts at The Benchmark Company this morning, prompting them to "reinitiate" coverage on Zillow at a buy rating, and with a $60 price target. The problem here is... Benchmark is coming late to the party. Up 66% in share price over the past year, Zillow already looks dreadfully overvalued at a market cap of $1.7 billion and a P/E ratio of... 275!

Granted, things aren't quite as bad as these numbers make them sound. With nearly $20 million in free cash flow generated over the past year, Zillow's churning out cash at a rate three times as fast as GAAP accounting standards lets it report "earnings." Still, that works out to a price-to-free cash flow ratio of more than 80 -- quite pricey, even for a company expected to grow its profits north of 30% per year over the next five years.

Long story short, despite the firm's strong cash production, I'd still rather be short this stock than long.

Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool recommends Zillow. The Motley Fool owns shares of Zillow.


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