Tuesday's Top Upgrades (and Downgrades)

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 feature upgrades for Facebook and Hologic -- for two entirely different reasons. Before we examine those two, though, let's take a quick look at a downgraded stock.

Cypress Semi is getting chopped
Cypress Semiconductor shareholders woke up to a double-bit axe's worth of bad news this morning. First, Cypress issued an earnings warning to the effect that "a customer push out of certain new handset programs to Q1, as well as order reductions at various end customers in China to balance inventory levels" will result in Q3 revenues of $187 million or less -- at least 9% below the Street consensus -- and that the company expects to book a loss of somewhere between $0.09 and $0.11 a share.

Compounding that disappointment, Topeka Capital reacted to the news by chopping $4 off its target price for Cypress (now $11) and removing its buy rating. Topeka still sees hopes for an "intermediate-term revenue recovery" at the company, and is downgrading only to "hold" -- but downgrading nonetheless. Is it right to do so?

Actually, probably, yes. Here's why. Cypress' earnings and free cash flow have been declining for a couple of years now already, and most analysts expect the company's profits to drop by 9% annually, on average, over the next five years. That's a bit farther out than most folks would ordinarily look for an "intermediate-term" recovery. As for today, the stock's paying a nice dividend yield -- 3.8% -- and remains free cash flow positive. Still, $84 million in trailing FCF isn't a lot with which to support a $1.5 billion market cap. With Cypress warning now that, at the very least, things will get worse before they get better, I see no great reason to rush in and buy this one -- even in an environment saturated with motivated sellers.

Facebook gets a lift
Turning now to happier news, Facebook investors opened their portfolios today to see their shares soaring more than 4% in response to an upgrade from Citigroup. Citi analysts says they see "sustainable" growth in advertising at the social networking site, with "several advertisers ... experiencing >15% seq. growth in [ad spending]," growth in spending on "mobile app downloads" as well, and "significant room to increase [ad sales] coming out of 2Q13."

The introduction of video ads, better "audience segmentation" and improved "campaign analytics" are other pluses, in Citi's view, which may help to grow the stock to $55 a share within a year.

Is Citi right? It had better be, because to be painfully blunt, the 223 P/E ratio -- and even the more reasonable-sounding 60 times price-to-free-cash-flow ratio -- at Facebook today appears to be taking megagrowth for granted. At present, the nicest thing I can say about Facebook stock is that if the company achieves the 30% annualized profits growth that Wall Street expects from it, then a 60x P/FCF ratio isn't a whole lot more fantastic than what tech investors have paid to own similar growth stories in the past.

It is, however, still a 2.0 price-to-free cash flow-to-growth ratio, and therefore about twice what any self-respecting value investor should be willing to pay for Facebook.

Whole lot of assumptions at Hologic
Last but not least, we come to medical device maker Hologic, which, like Facebook, scored a big upgrade this morning (to "strong buy," from analysts at ISI Group) -- but for an entirely different reason.

Unlike Facebook, Hologic is not currently experiencing megagrowth. Its projected 11% profits growth rate is more respectable than astounding. The stock's not currently profitable, but it is generating decent free cash flow -- about $403 million a year. And that's where our story begins.

$403 million on a $5.5 billion company works out to about 13.6x FCF, which I'll admit doesn't seem a terribly expensive price to pay for a leader in the radiology products market. On the other hand, Hologic also carries a lot of debt -- about $4 billion worth, net of cash. This lifts the company's enterprise value up toward $9.5 billion, giving it an EV/FCF ratio of 23.5, which actually is a pretty penny to be asked to pay to own a piece of its $403 million in annual cash profits.

And yet, ISI still decided to upgrade it. Why?

Well, as StreetInsider.com describes in reporting the upgrade this morning, even if traditional avenues for "growth" at Hologic seem limited, ISI thinks it sees two ways for Hologic shares to grow in value regardless. First, the company could restructure itself to cut costs, potentially boosting earnings per share "to $2 by 2015." If it's right about that, this would suggest a forward P/E multiple of just a little more than 10x to those projected earnings, and make the stock look something more like a "buy."

Alternatively, ISI argues that Hologic could make itself buyout bait. The stock trades for only 2.2 times sales, after all, which is low for the medical appliances and equipment industry, where valuations tend to circle 2.7x sales. Should a bigger player in the industry company -- Philips, say, or even GE -- be tempted by that valuation, they might bid a price that tends to close the gap between Hologic's price, and the average in the industry.

Of course, this begs the question of whether a Philips or a GE would want to pay a premium to Hologic's current price, given that the company currently seems unable to earn a profit. Personally, I have my doubts about that. I think Hologic's debt burden and lack of GAAP profits continue to argue against its shares being a "buy."

Motley Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool recommends Cypress Semiconductor and Facebook. The Motley Fool owns shares of Facebook and General Electric.

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