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 feature a pair of downgrades for document storage company Iron Mountain and insulin treatments-equipment maker Insulet . But the headlines aren't all bad, so before we break the bad news to you, let's start off on a bright note about...

Ciena's banner quarter
Telecommunications equipment maker Ciena stunned the skeptics Thursday with a surprisingly profitable Q2 earnings report. Expected to lose a penny a share, Ciena instead reported a $0.02 profit -- and it beat on revenues, too.

Needless to say, Wall Street liked the report, and this morning, two analysts are hiking their expectations for the stock. Japan's Nomura Securities is positing a $23 share price a year from now, impressed that "revenues finally beat expectations - expectations that were already at the high end of guidance." Nomura's also pleased to see that "the mid-point of Q3 guidance is 4% ahead of prior expectations and the high end of guidance 7% ahead." Needham, meanwhile, points to calendar year 2013 guidance of $0.51 per share, and a potential double to $1 a share in profit in 2014, as justifying its own price target hike to $22.

If it hits that last target, we're looking here at a company trading for less than 20 times earnings on near-100% earnings growth -- at least in the short term. Longer-term, analysts expect to see Ciena slow down to a more sustainable 16.5% pace of annual earnings growth. That's certainly impressive, but to my mind... still not a good reason to buy the stock.

Why not? Well, consider this: 16.5% annual growth on $1 profits would be great, but right now analysts are only calling for 16.5% from currently negative profits. It's hard to figure out precisely what that means, in terms of positive numbers.

Similarly, Ciena turned in strongly positive free cash flow in Q2 -- but remains free cash flow negative for the past year as a whole. Put it all together, and while Ciena's news this week is certainly good, it's not quite as good as the headlines are suggesting.

All that is gold does not glitter -- and Iron's looking pretty dull, too
Turning now to the day's downgrades, Iron Mountain is going down like an avalanche on reports that the IRS is scrutinizing its plans to convert itself into a REIT, or real estate investment trust. (Seems IRS is skeptical of IRM's assertion that its mountains of server-filled warehouses constitute "real estate.")

The shares are down more than 15% as of this writing, and it's not helping matters much that analysts at Stifel Nicolaus just pulled their buy rating on the stock. But is this an overreaction?

No, I don't think so. Let's assume the worst-case scenario (in investors' view, apparently), that Iron Mountain gets stuck operating as an ordinary company and not a REIT. In that case, what we're looking at here is a stock selling for 37 times earnings, yet growing at only 13% -- hardly a value proposition.

On the plus side, now, Iron Mountain does generate a mountain of cash from its business -- about $184 million over the past year, or 35% more than its reported "GAAP" income. This, however, only gets the price-to-free cash flow ratio down to about 30, which still seems quite high for a projected 13% grower.

Result: I don't know if Iron Mountain would magically become a great investment if it were to convert itself into a REIT. I do know that as-is, as an ordinary profit-making venture, I wouldn't pay this price to own Iron Mountain.

A poor prognosis for Insulet
Our final rating, and second downgrade of the day, is an even easier call. Here, we see Wunderlich Securities pulling its "buy" rating on Insulet Corporation. Investors aren't responding much to the news -- the contrary, actually, because they're bidding the shares up even more than the rest of the Nasdaq is rising -- but to my Foolish eye, Wunderlich's still making the right call in downgrading.

Although growing smartly -- Yahoo! Finance has the stock increasing earnings at a 26% annualized rate over the next five years -- Insulet remains a deeply unprofitable operation, losing $48 million last year, and burning nearly $32 million in negative free cash flow.

According to Wunderlich, the stock's only worth $28, and that explains the downgrade. Personally, though, I have to wonder whether investors might not be better off just selling an unprofitable, cash-burning company -- no matter the growth rate.

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


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