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 feature a downgrade for ITT Educational (NYSE: ESI  ) , an upgrade for Facebook (NASDAQ: FB  ) , and a much improved price target for tiny iRobot (NASDAQ: IRBT  ) . Let's dive right in, beginning with why one analyst just...

Flunked ITT Educational
Citing negative trends in enrollment, regulatory pressures, and reduced government funding for Pell Grants, analysts at Argus Research cut their recommendation on ITT Educational to "sell" this morning. The stock's already down some 4.8% in response to the downgrade, but what we really want to know is... will it fall further?

I think it will, and I'll tell you why.

Priced at just over five times earnings today, ITT stock sure looks cheap, but it's cheap for a reason. Several reasons, actually. Chief among them is the fact that while most investors like to buy companies that grow, ITT is expected to shrink, with its earnings declining nearly 6% per year, on average, over the next five years. Such shrinkage already looks to be in the cards given that ITT reported earning $110 million over the past year, but its actual cash profits for the period, its free cash flow, amounted to a mere $9.5 million -- just 8.6 cents on the dollar.

This doesn't bode well for the company's earnings trends going forward. It's part of the reason most analysts think next year's earnings will be bad enough to nearly double ITT's forward P/E ratio (to 9.5). And it's a good reason to play hooky from ITT stock.

Cut school, and hang out on Facebook instead? 
Happier news greeted Facebook shareholders today, as Swiss megabanker UBS weighed in with an upgrade to "buy," and an improved price target of $30.

UBS says it likes Facebook's idea of allowing users to post 15-second videos on its Instagram service, and especially likes the prospects for Facebook selling ad space on these video postings. UBS says video ads could generate something on the order of "sevenfigure" revenue for Facebook, and expects to see video ad placements begin sometime in the second half of this year. Brother banker RBC Capital, which also likes the stock, agreed that this form of advertising could prove "lucrative" for Facebook.

Shareholders had better hope the bankers are right about this one, though, and that ad spending will be considerably bigger than "sevenfigure." Because Facebook is going to need a whole lot more revenue, and high-margin revenue at that, if it's to justify the 526-times-earnings valuation that its stock is already lugging around.

Granted, from a free cash flow perspective, the stock's throwing off enough cash to give it a price-to-free cash flow ratio closer to 75. But even that valuation looks stretched in light of Facebook's 31% projected profits growth rate.

In short, faster profits growth from placement of lucrative video ads could help to justify the stock's sky high valuation. But "could" isn't the operative word here. That word is "must." Absent literal hypergrowth, there's simply no justifying a triple-digit P/E like the one Facebook sports. Absent literal hypergrowth... Facebook stock will continue to fall.

"Domo arigato," said Mr. Roboto
Last but not least, we come to what's no doubt the oddest ratings / stock performance pairing of the day. This morning, analysts at The Benchmark Company took a close look at Roomba-maker iRobot, a stock they've already recommended buying, and already had a $32 price target on. They looked at it and promptly hiked their price target by 40%, to $45 a share.

The question is, why? Sure, earlier this month, Cisco (NASDAQ: CSCO  ) announced it's collaborating with iRobot on the development of an Ava 500 video-conferencing robot. Last week, iRobot landed a $30 million Pentagon contract for itself. So the news flow is certainly in iRobot's favor of late. But does this make the stock a 40% better investment than Benchmark thought it was as recently as yesterday?

I don't think it does. At $36 and change, iRobot shares already cost nearly 42 times earnings, which is quite a lot for a stock that most analysts agree will only grow earnings at about 9% annually over the next five years. Meanwhile, free cash flow at the firm, while strong at $28 million, isn't all that much better than the company's GAAP earnings number of $25 million. It's enough to pull the price-to-free cash flow ratio down to just under 37 -- but no better than that.

On a 9% grower, that's still too much to pay.

Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool recommends Cisco Systems, Facebook, and iRobot. The Motley Fool owns shares of Facebook.

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