Monday'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 pair of upgrades for favorites Apple (NASDAQ: AAPL  ) and Pandora (NYSE: P  ) . But the news isn't all good for everyone.

3M gets dropped
The week opened on a bleak note for shareholders of industrial conglomerate 3M (NYSE: MMM  ) , as Morgan Stanley pulled its "overweight" endorsement and downgraded the shares to "neutral." And yet, 3M shares are up more than 0.8% in early trading, so it doesn't look like investors are too worried by the downgrade. Should they be?

Actually, yes. They should. After outperforming an ebullient stock market this past year, 3M shares now trade for a pretty pricey 17 times earnings. If that doesn't sound like much to you, though, consider: Most analysts who track 3M's progress doubt the company can grow its earnings even 9% per year over the next five years (it's averaged less than 7% earnings growth over the past five years).

Free cash flow at the firm shows that it's more expensive than it looks already, with cash profit for the past 12 months coming in about 12% below the company's reported "net income" of $4.4 billion. That means that this stock with the "17 P/E" actually sells for closer to 20 times its actual annual cash profits -- despite a projected percentage growth rate of less than half that.

True, 3M does pay a nice dividend, currently yielding 2.3%. But with 10-Year T-bills now paying even more interest than that, 3M's dividend has ceased to be as big of a draw as it once was. With the stock itself overvalued on both P/E and P/FCF measures, I see little reason left to want to buy it.

Time to play Pandora?
Happier news greeted investors in Pandora Monday, as a new upgrade from Morgan Stanley (yes, them again) helped to lift the stock more than 3%. According to the analyst, "Pandora is establishing itself as the 'Netflix (NASDAQ: NFLX  ) of Radio': a truly disruptive form of content consumption that offers investors the best pureplay exposure to the secular shift of broadcast radio dollars to online channels."

Morgan Stanley's particularly impressed with Pandora's move to integrate its service into automobiles, saying this was "the lone remaining hurdle to competing with broadcasters for meaningful share of radio dollars." With this hurdle now leapt, Morgan Stanley is ready to recommend buying the stock, and predicts Pandora will hit $24 within a year.

And maybe it will -- but it shouldn't. Automobiles notwithstanding, and comparisons to other overpriced media stocks likewise, there's little basis for thinking Pandora is worth anywhere near the $4.2 billion market cap that a move to $24-a-share would give it.

The company earns no profits, and only burns cash. Sure, Pandora is growing its revenue strongly. But with each passing year, as revenues rise, losses rise even faster. In 2011, for example, Pandora posted revenue growth of 98.5%, but losses increased nearly 800%. Last year's 56% slower revenue growth resulted in a 136% increase in the amount of money Pandora was losing.

In short, it's entirely possible Pandora will grow every bit as fast as Morgan Stanley says it will, that it will expand into new fields of broadcasting, and retain dominant market share. But all of this is for naught if the company can't earn a profit. And so far, it hasn't.

And speaking of profits...
One company scoring an upgrade this morning, and earning the kinds of profits that could justify it, is Apple. Right on the heels of news that Apple has filed a trademark in Japan for the term "iWatch," we hear that analysts at Raymond James are upgrading the stock to "strong buy" as the company enters "phase 2" of an expansion beyond smartphones and tablets, and into new kinds of smart devices.

In addition to the iWatch, Raymond James discusses the potential for mobile computing to expand throughout the automobile industry, televisions, appliances, and other devices -- and suggests Apple will continue its history of innovation as "mobile" moves into these new areas.

This expectation that Apple -- already a $169 billion-a-year business -- will find new ways to grow in the future explains why so many analysts still see the company growing earnings at a 20%-plus clip over the next five years. What it does not explain is why investors continue to think that growth rate is only worth paying less than 10 times earnings for.

Raymond James, with its strong buy recommendation, and its $600 price target, seems to think Apple is worth a lot more than its shares currently fetch on the market. I do, too.

Fool contributor Rich Smith owns shares of Apple. The Motley Fool recommends 3M, Apple, Netflix, and Pandora Media. The Motley Fool owns shares of Apple and Netflix.


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