Friday's Top Upgrades (and Downgrades)

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 new buy ratings for Eaton and FedEx . But the news isn't all good, so before we address those two, let's start with why one analyst thinks...

SodaStream has lost its fizz
As the trading week winds down, shares of SodaStream , are getting flattened in response to a downgrade from investment banker Oppenheimer. According to the analyst, SodaStream investors could be disappointed when the company issues its next earnings update in August. SodaStream began selling its at-home soda fountains at Wal-Mart last year -- and while that boosted numbers then, it may make current-day growth rates look the worse by comparison.

That said, Oppy remains optimistic about SodaStream in the long term, and doesn't exclude the possibility that the stock could surprise us to the upside as easily as to the down. As such, the worst it's prepared to say about the stock is that it might no longer "outperform" the market, but merely "perform."

I'll go a step further than that, though. I'll go so far as to say that, from where I sit, SodaStream's stock looks priced to underperform the market -- and rather massively so.

Why? With a projected earnings growth rate of more than 26%, SodaStream shares can't help but attract a growth investor's attention. The stock's 27.5 P/E ratio, meanwhile, suggests the stock may not even be overpriced. And yet, one look at SodaStream's cash flow statement is enough to alert you to the risk: These earnings are all fizz, little substance.

This company burned cash in two out of the three past years, is free cash flow negative over the three-year period as a whole, and is still burning cash today (negative free cash flow: $2.2 million). This contrasts starkly with the firm's claimed "earnings" of $45.8 million, and tells me that even as it remains optimistic about the company's future, Oppenheimer is right to pull back on urging investors to buy SodaStream at today's prices.

Good Eaton?
A somewhat better choice to buy -- but only somewhat, and only if you really like dividends -- may be Argus Research's recommendation today. This morning, Argus initiated coverage of industrial conglomerate Eaton with a buy rating and a $78 price target. With Eaton shares trading for $68 and change today, this suggests nearly 15% upside to the stock -- or even a bit more, counting the firm's 2.5% dividend yield.

Also arguing in the stock's favor, Eaton generates copious free cash flow of about 97.5% of reported earnings -- $1.25 billion over the past 12 months.

However, at 20.4 times earnings, and projected earnings growth of less than 12% per year, Eaton would look expensive to me even if it were generating a bit more cash than its reported earnings, much less a little bit less. Long story short, while Eaton is a better bet than SodaStream, it's not a good bet to outperform the market. I think Argus is going to lose its clients some money on this one.

When you absolutely, positively have to lose money overnight
But not as much money as investors in FedEx will lose. This morning, FedEx rival UPS preannounced earnings that fell short of analyst estimates, sending its stock down nearly 6%. FedEx shares are falling in sympathy -- down about 2.4%. That almost makes you feel sorry for the analysts at Wunderlich, who chose this unfortunate moment in time to recommend buying FedEx, just as the bad news about its peer broke loose.

The worst part, though, is that there was no reason for Wunderlich to ever have made this mistake. Because if Eaton's valuation looks iffy, FedEx's valuation is even worse.

Priced at 20.8 times earnings, FedEx costs more than Argus' pick, Eaton. Yet it pays a significantly worse dividend yield -- only 0.6%. Free cash flow is also worse (relative to reported earnings), at just $1.3 billion FCF versus nearly $1.6 billion in GAAP net income.

Really, the only advantage that FedEx has over Eaton, as a value proposition, is the fact that analysts are hoping to see the former grow earnings at 13.4%, versus the 11.8% estimate at Eaton. But that's still not fast-enough growth to justify paying nearly 21 times earnings, or 25 times free cash flow. And it's still not a good reason to buy FedEx.

Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool recommends FedEx, SodaStream, and United Parcel Service. The Motley Fool owns shares of SodaStream.

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Originally published