Wednesday'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 upgrades for both J.C. Penney and Electronic Arts . But the news isn't all good, so before we get to those two, let's take a quick look at why...

ValueClick got toggled off
's mini-rival in the market for online ads, ValueClick , beat earnings by a couple of cents in yesterday's earnings report. Unfortunately, this good news isn't translating into good grades on Wall Street, as a whole series of analysts cut their ratings on the stock to various flavors of "hold." Stephens and Cantor Fitzgerald, Craig-Hallum and Raymond James -- one and all, the analysts are downgrading ValueClick today -- but why?

Well, let's see here. ValueClick reported $0.42 per share in profits for the first quarter. That's a good start, but the news gets worse from there. Earnings in the current fiscal second quarter are expected to range from $0.38 to $0.40 per share, versus $0.41 estimated. Revenues, which already fell a hair short of estimates in the first quarter, are now believed likely to miss second-quarter targets by more than 5%.

In short, it looks like things are slowing down for ValueClick, and for a stock that was already only expected to grow earnings at 13% per year -- despite carrying a P/E ratio of more than 19 -- that's not good. It is not, however, a reason to sell the stock, and I'll tell you why.

Whatever its GAAP earnings numbers may say, ValueClick is in fact a whole lot more profitable than it looks. Last year, the company generated $138 million in positive free cash flow -- 35% more than it reported as net earnings under GAAP. This trend accelerated in the first quarter of this year, with ValueClick generating $48.1 million in positive free cash flow -- 83% more than its reported earnings. By my calculations, the company's now generating real cash profit at the rate of nearly $140 million per annum, and ValueClick stock now costs only about 14.5 times that free cash flow.

That makes the stock, if not exactly cheap, then not nearly as expensive as it looks. So while I still wouldn't go out and buy it, I do think it's safe to hold.

J.C. Penney is doing it... wrong
Now let's move on to the more unabashedly "good" news... in a manner of speaking. Yesterday, J.C. Penney preannounced its sales for the fiscal first quarter, warning investors to expect about a 16% year-on-year decline from first-quarter 2012 levels.

On the face of it, that's not very good news at all. On the other hand, with the news out of the way, analysts may be thinking the stock has room to surprise us to the upside when its official results come out on May 16. Analysts at Maxim Group appear to be adhering to this line of thinking, and this morning, they upgraded Penney shares from sell to hold.

I couldn't disagree more. Unprofitable today, and expected to keep losing money for the foreseeable future, J.C. Penney is a company traveling the road to ruin. Even if this quarter's bad news is now out of the way, that still leaves next quarter's bad news to deal with. And the quarter after that, and the one after that, and -- well, you get the picture. Analysts polled on Yahoo! Finance see Penney's earnings actually declining, and by an average of 28% annually, for the next five straight years.

As a result, I see no good reason for Maxim deciding to remove its sell rating from the stock. If it were I making the ratings, I'd have let that one stand pat.

The Force is with Electronic Arts
Lastly, we come to Electronic Arts, which earlier this week announced a big deal to cooperate with Disney on designing Star Wars video games for the latter's new Lucasfilm subsidiary. At least one analyst likes the idea, because this morning, Monness, Crespi, Hardt announced it's removing its sell rating from EA, and upgrading the stock to neutral.

Why not "buy," you may ask? Well, to be blunt, the reason to not upgrade EA any further than Monness did is simple: The stock costs too much to justify a "buy."

Consider: Right now, EA shares cost 38 times annual earnings. True, the company generates strong free cash flow -- strong enough to drop its price-to-FCF ratio down to 29. But even so, both of these numbers are simply too high to justify, given that even after the announcement of the Disney deal, analysts still think EA is stuck at about a 14% annual growth rate.

Don't get me wrong: 14% growth is entirely respectable. It's just not fast enough to justify upper 20s and 30s multiples to free cash flow and earnings. It's not enough to win EA a "buy."

Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool recommends Google and Walt Disney. The Motley Fool owns shares of Google and Walt Disney.


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