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 new upgrades for Big Board heavyweights Caterpillar (NYSE: CAT  ) and Alcoa (NYSE: AA  ) . On the flip side, though...

AOL runs out of free hours
Shares of Web pioneer AOL (NYSE: AOL  ) have gained more than 24% over the past 52 weeks. But according to one analyst, that's about as good as things are going to get. With AOL shares within just a few cents of its $46 price target, therefore, RBC Capital Markets pushed the eject button on its outperform rating this morning, and downgraded AOL to sector perform.

Now, it's worth noting that RBC left its price target intact, suggesting that today's downgrade decision was a valuation call, plain and simple. This also leaves open the possibility that RBC might again recommend the shares if AOL falls far enough. They're already down 3.3% in response to RBC's note. Will they fall further?

Well, let's see here. Based on trailing profits, AOL shares cost about 40 times earnings today. Analysts who follow the stock predict that earnings will only grow at about 9% annually over the next five years, though -- about half the industry average. If they're right about that, then this suggests the stock is pretty severely overvalued.

Granted, AOL does generate a ton of cash -- not all of which is reflected on its income statement. Free cash flow over the past 12 months came to $237 million, which when divided into the company's market capitalization results in a price to free cash flow of less than 15. Is that cheap enough?

It depends. If AOL is able to grow faster than analysts expects -- say, about as fast as the average expected growth rate in its industry -- then a 15-times multiple to free cash flow would suggest the stock is fairly priced, or even a bit cheap. If, on the other hand, analysts like RBC are right about the 9% growth rate... then RBC is also right to downgrade the stock.

Time to let Cat out of the bag?
Turning now to the day's "good" news, Caterpillar caught an upgrade from Merrill Lynch this morning, and its shares are climbing 2% in response. Merrill thinks the stock is a buy, and Cat's 16.1 P/E ratio certainly doesn't look too expensive. So is the analyst right to recommend it?

Perhaps. Like AOL, Cat is a company that doesn't get enough respect for the cash it produces. Trailing FCF at the company came to $4.9 billion over the past year -- 41% higher than reported net income. That's enough cash to drop Cat's price to free cash flow ratio down to just 11. And with the stock's growth rate estimated at 10% long term, and its generous 2.9% dividend yield, I actually think the analyst might be right about this one.

After underperforming the rest of the S&P 500 by 30 percentage points over the past year, I think the time has come for Cat to roar. Merrill is right to rate it a buy.

Alcoa an "A"-lister?
So what about Alcoa? Like Cat, the aluminum magnate has underperformed the S&P pretty significantly over the past year, posting only an 11% gain against the market's 28% surge. This morning, Goldman Sachs upgraded Alcoa shares to buy, and assigned an $11 price target to the stock -- but this time I think Wall Street is calling it wrong.

Goldman says "the market is not fully appreciating Alcoa's solid position in growing value added and high margin aluminum products for the aerospace and automotive industries," arguing that revenues and EBITDA are likely to grow strongly over the next three years.

Personally, though, I think the market is fully appreciating a few other facts -- like the fact that Alcoa carries a crushing $7.2 billion debt load (net of cash), that its free cash flow of $422 million, while superior to reported net income, is nowhere near the levels at which it was producing just a couple of years ago, and the fact that at a P/E ratio of 35, and a price to free cash flow ratio of 24, Alcoa's overpriced even if the company manages to achieve the 17% earnings growth rate that Wall Street expects of it. Factor debt into the valuation, meanwhile, and the company's enterprise value to free cash flow ratio rises to a staggering 40.9.

Given that analysts are already expecting strong growth at Alcoa, it's hard to argue that Goldman is seeing something positive in the company that other analysts are missing. At today's high prices, I think Alcoa's positives are all fully priced into the shares -- and Goldman is wrong to recommend it.

Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned.


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