Thursday'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 ratings out of JPMorgan for a pair of fast-growing tech stocks -- MercadoLibre (NASDAQ: MELI  ) and HomeAway (NASDAQ: AWAY  ) . But before we venture too far into tech land, let's take a quick look at one old-economy stock and find out why another analyst is warning investors that ...

... Hershey is melting
Markets are moving upward this morning, but one stock is sitting out the rally: candy king The Hershey Company (NYSE: HSY  ) . For this fact, you can thank the analysts at Argus Research, who chose today to downgrade Hershey shares to hold.

Argus believes Hershey may be worth a bit more than it's currently selling for (say, $100 within a year). Regardless, the analyst worries that shares of the chocolatier may have limited ability to grow more than that as "promotional pricing" erodes profit margins, but has little effect on improving sales. Suffice it to say, Argus feels that the prospect of only a 3.4% return on the stock, even bolstered by Hershey's 2% dividend yield, is not rich enough to justify buying Hershey.

In fact, though, Argus may not be pessimistic enough about Hershey. Priced at 26.4 times earnings, this stock looks expensive based on consensus projections that Hershey will grow profits at about 10% annually over the next five years. Worse, Hershey didn't even achieve that modest level of growth in its most recent quarter, growing earnings only 4.4% -- and sales just 2.4%.

Long story short, this summer is a great time to visit Hershey Park and put Hershey chocolate bars on s'mores for the kids -- but at today's prices, it's just not a good time to buy Hershey stock.

The eBay of Argentina
Turning now to tech, we see investment banker JPMorgan aiming low -- way low -- at South American online auctioneer MercadoLibre, which was tagged today with an overweight rating and a $104 price target. JP likes MercadoLibre's earnings growth potential (which most analysts agree will approach 25% over the next five years). JP also suggests that worries over devaluation risk on the continent are already priced into the stock -- which the banker now assigns a $104 price target, down $10 from its previous estimate.

Investors are jumping on the news, and MercadoLibre shares are rushing higher in response to it -- up nearly 7% as of this writing. But if you ask me, they're jumping the gun and giving too much credence to this ill-thought-out upgrade.

MercadoLibre may have growth potential in spades in the undeveloped Latin American market. And you might even think the stock's valuation at 30 times earnings isn't too high a price to pay for this potential. But the problem with MercadoLibre is that its earnings are of such low quality.

According to S&P Capital IQ figures, MercadoLibre reported earning $130 million in GAAP earnings over the past 12 months. The company's cash flow statements, however, show that MercadoLibre actually only generated $22 million in real free cash flow during this period -- about $0.17 on the dollar, relative to reported earnings. Valued on free cash flow, rather than "earnings," therefore, the stock sells for a sky-high multiple of 175 times FCF. This seems quite a lot to be asked to pay, even if the company is able to grow at 25%, as projected.

With a valuation ranging from slightly to vastly overvalued (depending on whether you value the stock on earnings of free cash flow), there's little reason to buy this stock today -- and certainly not just on JPMorgan's say-so.

HomeAway stock: Go ahead and leave home without it
JPMorgan strikes closer to the mark on its next big tech rating of the day: HomeAway.

At first glance (and second, also), HomeAway seems a pricey stock today, despite having lagged the S&P 500's performance over the past year. Valued on GAAP profits, the stock sells for a startlingly high P/E of 159. Valued on free cash flow (which is admittedly robust), HomeAway looks cheaper, but still expensive at a valuation of 32-times FCF. Growth estimates quoted on S&P Capital IQ, meanwhile, have most analysts positing 25% profits growth at the company over the next five years.

On its face, a valuation of 32x FCF seems expensive for a 25% grower. But according to JPMorgan, the situation could be even worse than it appears. JP warns investors to expect "greater marketing spend and downward guidance revision during the upcoming Q2 earnings conference call." This raises the possibility that the company could both miss on earnings (from reporting higher costs than most investors are counting on) and disappoint on guidance going forward.

For value investors, too, this would be bad news -- depressed earnings would raise the P/E and P/FCF ratios on the stock, while lowered guidance could slow down the projected growth rate. JP's take on all of this is that "visibility will be limited in the near-term and return on marketing spend could take some time." From an investor's perspective, though, the conclusion is even clearer:

As HomeAway shares look increasingly expensive, the stock price must fall.

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  • Report this Comment On May 31, 2014, at 1:18 AM, OnceDaisy wrote:

    You have to be careful, IMO, about giving too much weight to this type of public MF article – they are often canned and based on a formulaic look at certain numbers, without real analysis. For example, Seth Jayson (TMFBent) writes gazillions of canned articles that probably do not receive any real thought at all – just spitting out results of a few formulas and input of selected reported numbers. I do not know if Rich Smith does this, but the referenced article has that appearance.

    Let’s start with MELI – Smith criticizes JPM’s positive view on MELI because:

    “the problem with MercadoLibre is that its earnings are of such low quality. . . . MercadoLibre reported earning $130 million in GAAP earnings over the past 12 months. The company's cash flow statements, however, show that MercadoLibre actually only generated $22 million in real free cash flow during this period -- about $0.17 on the dollar, relative to reported earnings. Valued on free cash flow, rather than "earnings," therefore, the stock sells for a sky-high multiple of 175 times FCF. This seems quite a lot to be asked to pay, even if the company is able to grow at 25%, as projected.”

    Plausible, but let’s dig down just a bit – ten minutes will do it. A quick look at MELI’s reported cash flow shows that this problem happened only in FY 2013, and was *entirely* attributable to extraordinary capex that year (up from normal levels of $18 Million to $114 Million). And, cash flow figures have returned to normal levels, approximately, in Q1 of FY2014.

    A quick look at the Q4 FY13 conference call transcript (copy and paste into Word and then search for “cash flow” or “capex” or “capital expenditure”):

    tells us that:

    “Purchases of property equipment and intangible assets during the quarter total $37.9 million, driven by the purchase of commercial real estate, mainly in Venezuela as a strategy to preserve the value of our aspects today. Consequently, for the period ended December 2013, free cash flow was negative $18.7 million versus positive $51.1 million last year.”

    For 2013 as a whole:

    “In terms of the investments in commercial real-estate, just a very quick recap, Venezuela is as we said a profitable and strong business for us. It generates cash. It’s also a hyper inflationary country and one that has capital control. And so because we are unable to pursue our standard treasury policy, which is to remit cash generation from our Latin American operations into US dollars, into U.S. bank accounts in the case of Venezuela what we have to pursue is investment in alternative assets that best preserve value against inflation and also against devaluations. And the choice there that we have been pursuing in most U.S. companies that have operations in Venezuela have to an extent followed suit is to buy commercial estate. We bought roughly 450 million Bolivars worth of commercial real estate last year. So at the official exchange rate, that’s about $75 million of property, plant and equipment on our Venezuelan balance sheet.”

    So it is not really a cash flow issue – it is a Venezuela risk issue (which does not mean it is not important; it just means that Smith basically has no idea what he is talking about here, to put it bluntly). If MELI left the cash in a Venezuela bank account Smith would never have noticed a cash flow issue but the risk would actually be higher I.e., if you want to understand an investment, read the financials, listen to the conference call, and read the annual reports. Or, find an analyst who will do that before opining.

    And that is a risk of these “canned” MF articles, based on a quick fact or two without investigation. Did Smith really think all the analysts covering MELI missed what he perceived to be a glaring FCF issue? No, he just did not think very much at all, probably; just wrote a quick article and cashed the check.

    In fact, if Smith would just say this is an issue that should be investigated, it would be OK, but he concludes (again, without doing any work at all) that “there's little reason to buy this stock today.”



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Rich Smith

As a defense writer for The Motley Fool, I focus on defense and aerospace stocks. My job? Every day of the week, I'm monitoring the news, figuring out the winners and losers, and tracking down the promising companies for you to invest in. Follow me on Twitter or Facebook for the most important developments in defense & aerospace, and other great stories.

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8/28/2015 4:00 PM
AWAY $29.19 Up +0.19 +0.66%
HomeAway CAPS Rating: ***
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MELI $113.19 Up +1.22 +1.09%
MercadoLibre CAPS Rating: ****