Wednesday'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 run the gamut, with downgrades impacting kids-games-maker LeapFrog (NYSE: LF  ) and "Argentinean eBay" Mercadolibre (NASDAQ: MELI  ) alike. Meanwhile, one banker takes a stab at calling a bottom on defense. Let's start with that one, and find out why one analyst is...

Taking L-3 up a notch
The day started downright great for L-3 Communications (NYSE: LLL  ) investors, as investment banker Drexel Hamilton upgraded the shares from hold to buy and established a price target of $115 per share. This upgrade appears to accord with recent media commentary on L-3, praising the company for beating estimates in its most recent earnings release, and for expanding its profit margins in the face of diminished expectations. As Forbes recently noted, "L-3 has 11-figure support contracts with multiple international governments, including the U.S., South Korea and Canada" and appears "well positioned" to prosper even in an environment of constricted defense spending.

But does that make it worth buying?

Costing roughly 12 times earnings, L-3 undoubtedly looks cheaper than many of its rivals in the defense industry. And yet, last quarter's "earnings beat" notwithstanding, consensus thinking on Wall Street is still that L-3 will struggle to achieve earnings growth of more than 2% annually over the next five years.

The question, then, is whether you think that the stock's 2.2% dividend yield and valuation of 12 times earnings (or less than 10 times free cash flow) makes L-3 cheap enough to buy on the assumption of low-or-no growth for the foreseeable future? Personally, I'd be more inclined to go with a faster grower such as Lockheed Martin or, even better, Boeing -- but to each his own. Drexel's right about L-3 stock being cheap, period. The only question in my mind is whether its expected growth rate is so slow as to render the stock a value trap.

Time to take a "Leap" of faith?
Of course, if it's growth you seek, you need look no further than one of the stocks Wall Street is downgrading today to find it. Earlier this week, games maker LeapFrog enterprises beat earnings estimates soundly with a third-quarter report featuring $0.38 per share in profits -- $0.06 better than Wall Street had anticipated. Projections for the future likewise outpaced expectations, with LeapFrog predicting it will earn at least $0.36 per share this year, and perhaps as much as $0.46.

Regardless, analysts at Imperial Capital announced this morning that they are downgrading the stock to "in-line." Why?

According to Imperial, "an increasingly challenging consumer spending environment" and expected "highly promotional and competitive holiday season" all augur poorly for LeapFrog's profits in the current quarter. Although long-term, Imperial remains optimistic about the stock, the analyst is cutting $0.20 per share off its earnings estimates for both this year and next, reducing 2013 estimates to $0.44 per share, and 2014 estimates to $0.55.

If Imperial is right about that, then LeapFrog's current 5.6 "P/E ratio" may not be as big of a bargain as it looks. The $0.44 in earnings per share this year could soon have the stock valued at a P/E of 17.5 (if the stock price does not change), or a slightly less pricey 14 times forward earnings valuation.

And yet, even if Imperial is right about LeapFrog's earnings, I still think the stock's cheap enough to own. Moving from $0.44 to $0.55 in the space of a year implies 25% annualized earnings growth -- more than enough to justify a 17.5 P/E. Indeed, even the more conservative consensus projection for LeapFrog -- 17.5% long-term growth, according to Yahoo! Finance data -- should justify today's price.

Long story short, LeapFrog may not be as big of a bargain as it appears on the surface. But it's still a big enough bargain to buy.

What's Spanish for "sell"?
Last and -- to some investors, apparently -- least, we come to Mercadolibre, which yesterday reported earnings that fell short of consensus estimates by a good $0.07. Adding to shareholders' distress, Mercadolibre likewise missed estimates for revenues, reporting third-quarter sales of only $123.1 million where $125.5 million had been anticipated.

Investors are responding to the bad news by selling off Mercadolibre to the tune of 11% this morning, and a downgrade from Pacific Crest is not helping matters. But now here's the really bad news:

The sellers are right. Mercadolibre is a stock that should be abandoned posthaste.

Why? Well, just take a look at the numbers. Based on Mercadolibre's most recent report, the stock now sells for some 49 times earnings, and nearly 54 times free cash flow. Even if you think these valuations were justified by the company's projected 29% annual growth rate, it's now clear, after yesterday's report, that the analysts have overestimated how fast Mercadolibre will grow. It's not living up to expectations.

Result: While it would certainly have been preferable for Pacific Crest to warn investors away from the stock before yesterday's bad news broke, it's at least clear now that the analyst is making the right call. Overpriced for 29% growth yesterday, the stock's even more dangerously valued... for whatever lower growth rate we can expect Mercadolibre to produce today.

Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool recommends LeapFrog Enterprises and MercadoLibre. The Motley Fool owns shares of L-3 Communications Holdings, LeapFrog Enterprises, Lockheed Martin, and MercadoLibre. 


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