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Tuesday'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 sell rating for go-go growth stock Mercadolibre (NASDAQ: MELI  ) , but upgrades for defense plays iRobot (NASDAQ: IRBT  ) and Huntington Ingalls (NYSE: HII  ) . Let's dive right in, beginning with...

How do you say "sell" in Spanish?
If you want to know the answer to that one, ask investment banker Goldman Sachs, which this morning sparked a sell-off in shares of Argentinian online marketplace Mercadolibre, when it initiated the stock with a sell rating.

Yes, you read that right. This morning, Goldman began covering Mercadolibre stock at "sell," predicting the $100-plus stock will soon trade for as low as $85 a share. And that's not even the worst part. If you take an objective look at Mercadolibre's business, it seems the stock may be worth even less than that.

Consider: Most analysts agree that Mercadolibre will grow its earnings at a good clip over the next five years. Revenue growth looks strong in Brazil, for one thing, and the consensus is that earnings will grow at about 29% annually. And yet, at a valuation of nearly 43 times earnings, Mercadolibre shares are already priced at a premium to this growth rate. Meanwhile, free cash flow at the firm lags reported net income -- $98 million FCF, versus $107 million in reported "income." So arguably, the shares are even more richly valued than they appear on the surface.

Personally, I prefer to buy stocks when the growth rate is more in line with P/E -- so I'd only begin to get interested in Mercadolibre at a valuation 30% below where it sits today. This suggests a decline in share price to $70, or roughly twice the sell-off that Goldman is predicting.

iRobot gets the Google bump
Speaking of overpriced stocks, have you noticed what's been happening at iRobot lately? Reports that Google bought robotics pioneer Boston Dynamics, a maker of bipedal and quadrupedal robots yesterday, sent interest in the maker of PackBot military robots surging. iRobot shares jumped nearly 7% in Monday trading -- and are up 22% today.

For this, you can thank not just "pin action" from the Google announcement, but also an upgrade from analyst Raymond James, which now rates iRobot a "strong buy." Interestingly, though, it's not iRobot's expertise in highly mobile PackBots that got Raymond James interested in the stock. In this analyst's opinion, it's upgraded versions of iRobot's domestic robots that will win the day. Specifically, Raymond James loves iRobot's new line of brushless Roomba 800 vacuum cleaners, and also its Swiffer-like Braava hardwood-cleaning robot.

According to Raymond James, iRobot shares are likely to hit $39 within a year. But here's the thing: Thanks to the immediate investor response to Raymond James' upgrade, shares of the Roomba maker are already trading for $38 a stub. So even if the analyst is right, this still leaves just a single buck, or 2.6% worth of upside, in the stock over the next 12 months.

Long story short, if you were long this stock before the upgrade -- congratulations. You hit the jackpot, and it's time to take your winnings. On the other hand, if you want to follow Raymond James' advice and buy the stock now, it's probably better to wait for the inevitable pullback. At a valuation of nearly 60 times earnings today, there's basically no upside left in iRobot.

Buy a better bargain
So what's left to buy? Deutsche Bank has one idea -- and at today's valuations, I think it's a better idea than either iRobot or Mercadolibre. This morning, Deutsche upgraded shares of military shipbuilder Huntington Ingalls (a recent spinoff from Northrop) to "buy." The analyst also gave Huntington a $100 price target, which suggests about 18% upside from today's price of $84 and change.

As relates, Deutsche thinks that "Huntington Ingalls has done pretty much everything they laid out in their initial strategy after spinning off from Northrop Grumman." Cash flow is improving, bad contracts expiring, and costs are being cut. Best of all, Deutsche now believes that Huntington could conceivably generate free cash flow as much as 10% to 25% ahead of reported net income over the next three years.

Why is this important? Already, Huntington Ingalls shares look attractively priced at a P/E ratio of 19, with an industry-leading estimated growth rate of 27% over the next five years. Free cash flow has not been the company's strong suit, however, with trailing FCF of just $162 million lagging reported net income by more than 26%. When you factor this FCF discount into the mix, therefore, the shares looks only fairly priced to me today.

But what happens if you reverse the relationship between free cash flow and reported income? Why, in that case, you've got a stock that looks cheap, but is actually fairly priced today... turning into a stock that looks cheap, but is actually even cheaper than it looks, tomorrow.

Long story short, I think Deutsche Bank is right to be long this stock. You should give it a close look too.

Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool recommends Goldman Sachs, Google, iRobot, and MercadoLibre. The Motley Fool owns shares of Google and MercadoLibre.

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 23, 2013, at 8:21 PM, DrGoldin wrote:

    So let me get this straight. HII is up 100.4% year-to-date, and Deutsche Bank decides to upgrade it NOW? Can you say "late to the party"?

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