Wednesday's Top Upgrades (and Downgrades)

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 feature downgrades for NYSE-listed McDermott and Fossil . The news isn't all bad, though, so let's start off on a bright note, with a few positive words about...

Activision Blizzard
Activision gained a new fan this morning, when analysts at The Benchmark Company initiated coverage with a buy rating and a very precise price target of $20.31 per share. Quoting from the upgrade note, has Benchmark lauding Activision's "compelling pipeline of anticipated core/casual games for fiscal '14." Benchmark suggests that investors look to buy Activision shares below $17 per share, and sees a bottom forming around $16 per share.

That sounds about right to me. Priced below 15 times earnings today, and selling for about 13.5 times free cash flow, Activision currently looks overpriced for sub-9% growth and a dividend yield of only 1.1%. However, crediting Activision for its sizable cash hoard, and its potential for faster growth by way of reclaiming shares from Viacom, I get a fair value on the stock of just under $16 per share.

Long story short, this stock isn't a bargain yet, but it's getting there. Benchmark is right to alert investors to the possibility that Activision will soon become a "buy."

Fossil gets buried
Now for the bad news. Shares of Fossil were falling today, despite the fact that yesterday the company reported second-quarter earnings of $1.10 per share pro forma, or $0.17 better than analysts had expected.

Fossil's 3% decline in share price this morning can probably be attributed to the fact that earnings guidance did not measure up to expectations. Predicting that third-quarter pro forma earnings will range between $1.38 and $1.45 per share, Fossil's guidance fell short of analysts' hoped-for $1.46 in third-quarter earnings. But it didn't help matters that Citigroup this morning lowered its rating on the stock.

According to Citigroup, Fossil lacks "positive catalysts" to drive the stock higher. I agree.

Priced at nearly 21 times earnings, expected to grow at less than 14% per year over the next five years, and lacking any dividend, Fossil shares look overpriced for their growth prospects. Free cash flow at the company has historically been strong, but not notably superior to GAAP earnings. Fossil did not provide an update on free cash flow, or even a cash flow statement with yesterday's earnings announcement. But if we presume that the company's free cash flow numbers were roughly as strong as its earnings numbers, this would still suggest that the stock is as overpriced and valued on FCF as it is on GAAP earnings. Citigroup is right to downgrade it.

McDermott dissed
Finally, we come to McDermott, which reported an "earnings miss" fully as large as Fossil's "earnings beat" earlier this week. On Monday, McDermott announced that it had transformed last year's second-quarter profit into a $0.63-per-share quarterly loss this past quarter. This morning, analysts at Stifel Nicolaus responded to the miss by downgrading McDermott to "hold," and criticizing the company for "poor execution over the past few years."

Stifel is right to be concerned. Although McDermott only technically became unprofitable earlier this year, and has reported strong GAAP profits for most of the past five years, its ability to generate positive free cash flow has markedly deteriorated over the past two years. Combined, fiscal years 2011 and 2012 saw McDermott burn through more than one-quarter billion dollars in negative free cash flow. As of today, the company's record of burning through $277 million in negative free cash flow over the past 12 months looks even worse than its reported GAAP loss of $38 million.

Fact is, while some shareholders may be upset to learn of Stifel's downgrade to "hold," I think the analyst is actually being too lenient. A company incapable of generating positive cash flow for its shareholders does not deserve to be even "held," much less "bought."

Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool recommends Activision Blizzard and Fossil. The Motley Fool owns shares of Activision Blizzard and Fossil.

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