Tuesday'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, here in the homestretch of 2013, analysts at FBR Capital have cranked out three final ratings tweaks before the year draws to a close. Read on, and we'll take one final look at why FBR has decided to boost its target prices for...

Honeywell (NYSE: HON  )
The day's first ratings tweak should bring a smile to the faces of Honeywell shareholders. Although only modestly optimistic about the stock's chances, rating it a market perform, FBR is upping its target price on Honeywell by nearly 10%, to $98 per share.

Now here's the bad news: It's not worth it.

Don't get me wrong. Honeywell is clearly a superior business, boasting strong profit margins, a nice rate of growth, and a debt balance that's modest at worst. The problem here is simply one of valuation. Honeywell shares cost 22.5 times trailing earnings today. With free cash flow backing up an impressive 98% of reported earnings, it's only slightly more expensive when valued on free cash flow.

However, 22.5 times earnings is just too much to pay for the 11% long-term-earnings growth that most analysts expect out of Honeywell over the next five years. Even with a 2% dividend yield to help bridge the difference, the stock costs too much relative to its growth rate, and is unlikely to reach the new valuation FBR has assigned it. (On the plus side, at least the analyst isn't recommending the stock to new buyers -- so FBR's right to that extent).

United Technologies (NYSE: UTX  )
At first glance, there would seem to be more promise in FBR's second target-price rise of the day: United Technologies. An industrial giant like Honeywell, United Technologies boasts both a lower P/E ratio and a higher price target than its rival -- and a slightly better dividend yield (2.1%) to boot. So even if Honeywell is not a buy at 22.5 times earnings, could United Technologies be a bargain at 16.4?

Answer: no.

The reason here isn't GAAP earnings (which are robust enough to give the stock that 16.4 P/E), or earnings growth, which analysts estimate at 13.2% per year. Rather, the problem with United Technologies is that it's simply not generating as much real cash profit as its GAAP earnings suggest. Free cash flow for the past 12 months amounted to only $4.6 billion -- or about $0.72 for every dollar of claimed GAAP "earnings."

As a result, United Technologies sports a Honeywell-like price to free cash flow ratio of 22.6. Factor the company's sizable debt load into the picture, and United Technologies' enterprise value to free cash flow ratio spikes to 26.1. That's too high a price for the stock's nearly 13% growth rate to support. It tells me that FBR's new price target of $128 on the stock is probably beyond reach.

Illinois Tool Works (NYSE: ITW  )
Saving the "best" for last, we now turn to FBR's third price-target hike of the day, and so far it's only actual recommendation: outperform-rated Illinois Tool Works.

FBR sees Illinois Tool shares rising to $97 over the course of the coming year, right in line with Honeywell's rise. But while I agree that Illinois has a better chance of booking some gains in the New Year, I'm not convinced that this stock, either, is a buy.

Here's why: Costing 17 times earnings, Illinois Tool is a better bargain than Honeywell. That much is clear. The stock is rated for 11.5% long-term growth by most of the analysts who follow it, and again, that's better than Honeywell's number. Meanwhile, its 2% dividend yield precisely equals Honeywell's.

Like both of its industrial peers discussed so far, however, Illinois Tool also suffers from free cash flow that lags reported income. Free cash generated over the past 12 months amounted to just $2.06 billion -- that's compared to $2.25 billion in reported income. The resulting 8.4% lag of free cash flow behind reported income means that the stock's slightly more expensive than it looks. And since 17 times earnings already looks like too much to pay for 11.5% growth, I have to conclude that even this stock -- FBR's favorite of the three industrial conglomerates mentioned today -- fails the value test.

Like the others, Illinois is a fine company... whose stock simply costs too much to be worth buying.

Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool recommends Illinois Tool Works.

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7/24/2014 1:37 PM
HON $96.27 Down -0.33 -0.34%
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ITW $85.48 Down -0.10 -0.12%
Illinois Tool Work… CAPS Rating: *****
UTX $109.29 Down -0.44 -0.40%
United Technologie… CAPS Rating: ****

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