Tuesday'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 focus on the health care sector, as analysts shift their stance on three big names -- upping expectations on both GlaxoSmithKline and Abbott Labs , but ...

Downgrading St. Jude Medical
Markets are rallying around the globe today, but shareholders of one stock -- St. Jude Medical -- are sitting out the rally.

Can you blame them, though? This morning, analysts at Canaccord Genuity sent a chill down investors' spines with a warning that St. Jude's product pipeline looks thin relative to its rivals. "Earnings quality" is also brought into question. Canaccord worries further that the company is losing market share -- and to top it all off, says the shares themselves cost too much. What it all adds up to is a new "sell" rating for St. Jude.

And yet... the more I look at St. Jude, the more that rating looks like an overreaction. Sure, on the surface I get why Canaccord might have misgivings. The stock -- selling for 18 times earnings but pegged for less than 10% annual profits growth over the next five years -- does look expensive on the surface.

On the other hand, though, earnings quality at St. Jude actually looks pretty good to me. It's good enough that I wonder if the stock might actually be a decent bargain at today's prices. Free cash flow at the firm exceeded $1 billion over the past 12 months -- far ahead of reported "GAAP" earnings of $763 million. That works out to a 12.7 times price-to-free cash flow ratio for the company, and with St. Jude paying a 2.2% dividend yield, and growing at nearly 10%, that looks only slightly overpriced to me.

Long story short, for a company of this quality, the shares look fairly priced in the low-to-mid-$40s, and don't deserve Canaccord's cut to a $35 price target -- or its "sell" rating, either.

Glaxo going up?
Turning now to the "good" news, international megabanker Deutsche Bank upgraded shares of GlaxoSmithKline to "buy" this morning. The analyst was quoted on StreetInsider.com pointing out that "GSK has underperformed a buoyant Pharma sector by [about] 20% in the past year as sales forecasts have been cut for the company's mature drugs portfolio."

That's not particularly good news, but Deutsche thinks that "consensus forecasts are now realistic and that the balance of risk/reward for regulatory decisions and pipeline news has swung to positive" -- opening the possibility for positive catalysts that could drive Glaxo's stock price higher.

Here, though, I'm decidedly less optimistic than the analysts. Why? Well, for a handful of reasons, actually.

First, upgraded Glaxo has a higher P/E ratio than St. Jude. It costs nearly 20 times earnings, or 10% more than today's downgrad-ee. Second, it's growing slower than St. Jude despite the higher valuation. Analysts on average have Glaxo pegged for a long-term growth rate that barely passes 3%. Third and finally, where St. Jude generates free cash flow superior to its reported earnings, Glaxo's FCF number is inferior to its GAAP profits. The company reported "earning" $6.4 billion last year, but in fact generated real cash profit of only $5.3 billion.

In short, the stock looks overpriced to me on first, second, and third glance, and unworthy of Deutsche's buy recommendation.

Always end on a bright note
And finally, we come to Abbott Labs, truly the highlight of today's recommendations. RBC Capital Markets opened up the trading week with a 10% price target hike for Abbott -- from $38 to $42. I think it's justified, and I'll tell you why.

Priced at less than 12 times earnings, net-debt-free, and paying a modest 1.5% dividend yield, Abbott Labs looks cheap relative to consensus expectations for 12% earnings growth over the next five years. Plus, Abbott is more like St. Jude than it is like Glaxo in that it generates cash profits superior to what it's allowed to report as GAAP earnings. Last year's free cash flow haul amounted to $5.9 billion, far ahead of reported of its reported "income" of $5.3 billion. As a result, the stock's trading for close to just 10 times free cash flow.

That valuation, on 12% growth, and with a 1.5% dividend, makes Abbott looks undervalued to me.

Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned.


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