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Thursday's Top Upgrades (and Downgrades)

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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 biotech upgrades for Gilead Sciences (NASDAQ: GILD  ) and Celgene (NASDAQ: CELG  ) . But the news isn't all good, so before we get to those, let's find out first why one ...

Critic pans DreamWorks Animation
As a general rule, analysts on Wall Street don't downgrade stocks to anything sounding like "sell" unless given basically no choice. Because why upset a potential client you might want to woo for stock and bond business, right? So it was pretty surprising to see this morning that not only is ace analyst Sterne Agee recommending selling DreamWorks Animation (NASDAQ: DWA  ) -- but it's doing this sua sponte, initiating coverage of a stock it didn't even have to cover, and warning folks it is going to underperform the market.

Why? According to Sterne, it's really pretty simple: "The Street is likely assuming that future film releases will perform as well as The Croods, DreamWorks Animation's most recent title." Investors are pricing this assumption into the stock, but Sterne doesn't believe it's a given, and sees every likelihood that earnings will fall 35% at DreamWorks in the coming year.

Sterne comes to this conclusion based on "a run-rate estimate of domestic box office of $160 million and international box office of $280 million for an average original title" coming out of DreamWorks. In the case of the company's next title, Turbo, to be released next month, that works out to about 12% less revenue than everyone else on Wall Street is expecting.

So is Sterne right, and everyone else is wrong? I don't know. What I do know is that an unprofitable company that usually burns cash and generated all of $27 million in free cash flow over the past year is not worth the $1.9 billion price tag that's currently being hung on it. DreamWorks isn't worth 70 times FCF, full stop. For me, that's more than enough reason to sell the stock.

Turning now to happier news, shareholders of two biotech companies -- Gilead and Celgene -- received upgrades from the analysts at Argus Research this morning. Let's take them one at a time.

Gilead Sciences
Argus is switching from a "hold" to a "buy" rating on Gilead, and this is a recommendation I agree with. Gilead recently received Food and Drug Administration priority review status for its new sofosbuvir drug for the treatment of hepatitis C. It's put out positive news of test results of a drug to cut the risk of HIV transmission even more recently than that.

"Headline" momentum is clearly on the stock's side, and even better, the valuation looks right. Gilead shares cost 29 times earnings right now, and are even cheaper when valued on the company's free cash flow. Earnings growth over the next five years is expected to approximate 26% -- perhaps even more, given the recent positive news developments.

I think that, worst case, the stock's fairly priced at these valuations. Whether  it's a "buy," though, really depends on how much the latest news can move the needle on earnings growth.

Argus also shifted its stance on Celgene from "hold" to "buy." Here, the analyst also produced a price target of $140 on the stock, which currently costs about $120 a share.

But here's the thing: At 36.5 times earnings Celgene costs even more than Gilead, while at a 22% projected growth rate, it seems to be growing slower than Gilead. If you're counting along at home, that's two big strikes against the stock.

On the other hand, Celgene does generate a lot of cash. At $1.9 billion generated over the past year, it's actually about 34% more profitable than its "GAAP" earnings figure makes it look -- and it's also carrying less debt than Gilead is.

All that being said, 26 times free cash flow (which is what $1.9 billion in FCF on a $50 billion market cap works out to) still seems a bit much to pay for a projected 22% grower. While Celgene has some positive news developments of its own to boast about, I'm probably even more skeptical of this stock's valuation than I am of Gilead's.

Long story short, I'd hold off on buying either one of Argus's biotech picks today and wait for better prices. The one thing I'm sure of about today's ratings, though, is Sterne's warning about DreamWorks. That one definitely looks too pricey to be worth the risk.

Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool recommends Celgene, DreamWorks Animation, and Gilead Sciences.

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5/25/2016 4:00 PM
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