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, we're focusing on tech stocks, as analysts pull back on Facebook and Dolby Labs , but become more bullish on LogMeIn . Let's start with that last one.

LogMeIn signs up some more fans
Remote computer access software maker LogMeIn released its second-quarter numbers yesterday, reporting a $0.06-per-share loss despite growing revenue by 20% (to $40.7 million). Management promised to reverse the quarter's loss as the year progresses, however, predicting full-year net income will at least match analyst estimates of $0.49 per share, and could come in as high as $0.52 per share.

Investors are therefore shrugging off news of the loss, and focusing on brighter days to come. Shares today are up more than 4%, helped in no small part by a series of three price-target hikes on Wall Street, from Wunderlich, Dougherty, and Maxim Group -- who posit share prices ranging anywhere from $28 to $38 on LogMeIn.

Unfortunately, it looks like only one of those analysts is close to the mark: Wunderlich, which has a hold rating on the stock, and sees its shares declining in value over the course of the year.

Why do I say this? Well, consider: From a GAAP perspective, the best case for LogMeIn this year is that it might earn $0.52 per share. That works out to about 57 times earnings... assuming the earnings come in at the very tippity-top of LogMeIn's predictions. Meanwhile, from a free cash flow perspective, the $15.6 million LogMeIn has generated over the past 12 months works out to a price-to-free-cash-flow ratio of 46.

So the free cash flow picture on this one is better than GAAP makes it appear. Still, whether you see the stock's multiple as 46 or 57 -- either way, that's too high a price to pay for a stock that grew revenue 20% last quarter, and that analysts see growing profits at a similar 20% rate over the next five years. In short, the problem with LogMeIn isn't the lack of GAAP profits -- it's the too high price you're being asked to pay for the profits LogMeIn will earn in the future.

Turning away from Facebook...
Turning now to the downgrades, we begin with Facebook, the beneficiary of a huge 30% run-up in share price after Wednesday's earnings release showed a 53% jump in revenue on surprising strength in mobile advertising. One analyst, however -- Argus Research -- seems to think Facebook's run-up in share price moved too far, too fast.

Going against the grain of the multiple upgrades and price target hikes we saw yesterday, Argus is downgrading Facebook to "hold" today -- and I have to say that I think Argus is calling this one right.

Once again, we're faced with a stock whose P/E looks totally out of whack -- this one being valued at some 150 times earnings, on 30% profits' growth estimates. Once again, a deeper dive into the numbers reveals the stock to be not as overvalued as it looks, since free cash flow at Facebook ($2 billion), is about 3.6 times as strong as the company's $557 million in reported profits might suggest. But once again, the price is just a bit too high.

Valuing the company on its real free cash flow as opposed to its accounting earnings gets us to about a 42-times multiple. But that's still too much to pay for the 30% long-term growth that analysts predict for Facebook. Even if the stock's no longer as clearly overvalued as it was looking before Wednesday's earnings beat, it's still too expensive to buy.

...and tuning Dolby out
And finally, we come to Dolby. Like the other techs, Dolby surprised a lot of analysts yesterday with fiscal Q3 earnings of $0.47 per share -- more than half-again as good as the number Wall Street was expecting to see. Unfortunately, Dolby paired its "beat" with weaker-than-expected revenue, and a prediction that next quarter's profits will come in between $0.30 and $0.36 -- far short of the consensus number.

Analysts are reacting poorly to that prediction, with Dougherty & Co. downgrading to "neutral" this morning, and investors bidding Dolby down 3.5% in response. They're right to do so.

Priced at 17 times trailing earnings, Dolby looks to be on-its-face overvalued based on 10% long-term growth expectations. What's more, free cash flow at the firm is still lagging reported income badly, clocking in at less than $150 million, versus GAAP income of $195 million. That lifts the price-to-free cash flow ratio on this one north of 22 -- far too much to pay for 10% growth, if that's all Dolby will be able to produce.

As a former fan of the stock, and a former owner, I have to say... I'm glad I don't own this one anymore -- and I think that Dougherty is right to pull its buy rating as well.

Motley Fool contributor Rich Smith owns shares of LogMein and Dolby Laboratories. The Motley Fool recommends Dolby Laboratories and Facebook. The Motley Fool owns shares of Facebook.

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