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 include an upgrade for Mattel (NASDAQ: MAT  ) , but downgrades for both Microsoft (NASDAQ: MSFT  ) and IPG Photonics (NASDAQ: IPGP  ) . Let's dive right in, beginning on a bright note as ...

Mattel plays on
Our first notable ratings move of the morning is Mattel, which just scored an upgrade from the friendly analysts at Needham. According to StreetInsider.com, which reported the rating this morning, Needham relies on a belief that "retail sales of MAT's products were better than the overall toy sector during the holiday season, and ... it enters 2013 with decent momentum." Needham is forecasting "solid revenue and EPS growth in 2013," with the potential for a dividend increase as well.

And yet, Needham strangely points out that when it predicts Mattel will hit $42 by year-end, it's basing this on the assumption the shares will sell for 13 times the profit it earns this year. Problem is, based on consensus estimates for what it will earn in 2013, Mattel shares already cost 13.2 times earnings. In other words, far from being undervalued today, and likely to rise to $42, there's a very real risk that Mattel shares are already overvalued at less than $37 a share!

This is especially true given the numbers we have to work with today. Selling for more than 15 times trailing earnings, Mattel shares are pegged for only 9% long-term earnings growth by most Street firms. Free cash flow  at the firm is anemic -- a mere $683 million over the past 12 months, or 19% less than the $840 million Mattel claims as its GAAP earnings for the period.

Long story short, don't take Needham's projections of a good year for Mattel as a given. Mattel's cash-production machine right now is looking like it should read: "Batteries not included."

Moving on, to Microsoft
Mr. Softy's shareholders got some bad news this morning, as Argus Research downgraded the stock to hold ahead of Microsoft's planned Q2 earnings release (due out Jan. 24). While caution ahead of earnings is understandable, though, Microsoft shares look so cheap today that you just might want to ignore Argus' advice and pick up a few shares ahead of earnings.

Consider: Selling for less than 15 times earnings today, Microsoft hardly looks expensive. In fact, if you value the company on its free cash flow (currently almost twice as big as reported "net income" at $29.1 billion), and give the company credit for its enormous cash hoard (a staggering $53.6 billion, net of debt), the company actually looks terrifically cheap at an enterprise-value-to-free-cash-flow ratio of just 6. Microsoft's 3.3% dividend yield justifies half that purchase price in and of itself. Meanwhile, the company's 9% projected growth rate, while not a barn-burning pace exactly, is more than enough to justify the stock's price.

Result: Microsoft remains, as ever, eminently buyable.

IPG's prospects dim
Last and least, we come to fiber laser-maker IPG Photonics. The stock just caught a downgrade to hold from Stifel Nicolaus, and for good reason: Priced at 23 times earnings, and as weak a producer of free cash flow as Microsoft is strong (IPG's $78 million in trailing free cash flow is barely half the $141 million in claims to be "earning" in GAAP profits), IPG looks dreadfully overpriced, even if the company does manage to hit the 20% annualized growth target Wall Street has set for it.

While profitable, cash-rich, and free cash flow positive, the stock simply costs far more than its earnings justify. Stifel was right to downgrade it. The only question is... did they downgrade it far enough?

Motley Fool contributor Rich Smith has no positions in the stocks mentioned above. The Motley Fool owns shares of IPG Photonics, Mattel, and Microsoft. Motley Fool newsletter services recommend IPG Photonics, Mattel, and Microsoft.

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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 04, 2013, at 2:37 PM, jordanwi wrote:

    PE of 15 on MSFT is a bit misleading because of a $6B write down, actually closer to trailing PE of 10-11 if I'm not mistaken. Doesn't help the case all that much though, since MSFT is seemingly ALWAYS cheap.

  • Report this Comment On January 05, 2013, at 8:49 AM, EquityBull wrote:

    Microsoft grows 25% as fast as apple and sports the same EV to cash flow multiple. Apples future also looks brighter as they have tablets and mobile while msft is missing there.

    So either msft is real expensive still or apple is insanely cheap. Can't have both

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