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. In today's headlines, there's little holiday cheer for new downgrades BlackBerry (NASDAQ: BBRY  ) and Micron (NASDAQ: MU  ) . But it's not all bad news, so before we get to those two, let's consider the tale of...

Two aspirin for Skullcandy investors 
Investors in hard-hit headphones-maker Skullcandy (NASDAQ: SKUL  ) are getting a huge lift this morning -- 8% or better -- on news that analysts at Roth Capital have taken a liking to the firm. Calling Skullcandy "well positioned for trends back toward in-ear headphones," (according to a StreetInsider report this morning), Roth upgraded the shares from "neutral" to "buy."

The analyst also raised its target price by 36% to $7.50 per share, suggesting a potential 14% profit from today's prices. But will it happen?

At first glance, you might think Skullcandy shares are already fully priced -- or even overpriced -- at a valuation of 38.5 times earnings and a growth rate of 20% (according to S&P Capital IQ). This suggests that any further gains are unlikely. But before jumping to conclusions, consider that with $37.5 million in trailing free cash flow, you can just as easily argue that this company is "cheap" at less than five times free cash flow as you can call it "expensive" at 38 times earnings.

On the other hand, it's true that Skullcandy's FCF number has jumped around quite a bit over the past five years, ranging from a low of negative $5.3 million to today's high of $37.5 million in trailing FCF. This suggests that today's FCF performance may be an anomaly.

Perhaps the best way to look at the stock is to say that its average rate of FCF generation has been about $9 million annually. At 20% growth, and a valuation of just $183 million, I'd say that at worst, the stock looks fairly priced. If recent improvements in cash generation can be sustained in the future, though, Roth is probably right: The stock looks cheap enough to buy.

BlackBerry -- Sweet or sour?
Speaking of stocks that are tricky to value: BlackBerry. With no GAAP earnings to its name, and "earnings" projected to get worse, not better, over the next five years, the stock looks pretty hopeless at first glance. On the other hand, BlackBerry is still generating cash profits -- $286 million over the past 12 months. But on the third hand, free cash flow appears to be evaporating rapidly. Just a year ago, the company was raking in nearly $2 billion a year.

Crunching all these numbers, Hudson Square decided that discretion is the better part of value here, and downgraded the stock to "sell" this morning. Simultaneously, analysts at FBR Capital reiterated their "underperform" rating, but suggested that the company's decision to outsource its manufacturing makes it somewhat less unattractive than it used to be -- and upped its price target to $6.75 per share.

Investors seem to be focusing on FBR's higher price target, as they bid up BlackBerry shares by 5% today. But they're missing the bit about how even FBR agrees that BlackBerry will underperform the market from here, still thinks the stock is worth less than it's selling for, and predicts that even if the company can be saved, any improvement is still "two to four quarters" away. I fear those are the more important takeaways here.

Macro risk at Micron? 
Finally, we come to Merrill Lynch's decision to downgrade Micron Technology. Warning that oversupply in the DRAM market is depressing spot prices on memory, Merrill cut its price target to $19.50, and lowered its rating to "underperform." This is sparking a 4% slide in the stock's price today -- and investors are probably right to be selling.

Consider: Micron today trades for less than 19 times its $1.2 billion in trailing earnings. Earnings growth over the next five years is predicted to average 18% annually. These numbers suggest the shares are at best fairly valued. Meanwhile, free cash flow is improving, but continues to lag reported income by a pretty significant margin -- meaning that the valuation relative to free cash flow is even less attractive.

All things considered, the high valuation and low prospects of further share price growth, plus Merrill's warning about lower ASPs, suggest that now is a good time for investors to cash in some of the profits they've made off this stock's 12-month, 255% rise in price.

Motley 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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