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, Wall Street turns its focus to tech stocks, with new buy ratings for Microsoft (NASDAQ: MSFT  ) and Bankrate (NYSE: RATE  ) , but a downgrade on Zillow (NASDAQ: ZG  ) . Let's get the bad news out of the way first...

Zeroing in on Zillow
As most markets wobble around the zero-change mark, shares of online real-estate information provider Zillow are taking a dive this morning, down more than 1% on a negative report out of SunTrust Robinson Humphrey. But is the news really bad enough to justify the price decline?

Quoted on today, SunTrust informs: "We are lowering our rating today on Zillow to Neutral from Buy, based on the strong run the stock has had and its sustained surpassing of our $110 year end 2014 target." That being said, the analyst says it is still "very bullish on the long term prospects for the company." SunTrust simply thinks that whether you value the stock on "EV / Revenue / growth, EV / EBITDA / growth, [or] EV / EBITDA / rev growth," Zillow shares look a bit pricey. Now that doesn't sound so scary, does it?

Actually, yes, it does. Because "EV / Revenue, etc." doesn't begin to describe the true scope of the overvaluation at Zillow.

Unprofitable over the past year -- and unprofitable in three of the past five years as well -- Zillow shares currently trade for a P/E ratio of infinity. Valued on cash profits (free cash flow), the stock looks nearly as expensive at a price-to-FCF ratio of 240. So even assuming that analysts' phenomenal expectations of near-65% annualized profits growth (according to Yahoo! Finance figures) are accurate, the stock still looks expensive.

Indeed, some of SunTrust's own statements in its note on Zillow suggest the shares could be as much as 50% overvalued. The analyst notes that for the three metrics it lists above, most tech stocks sell for price multiples of "0.2x, 0.5x and 0.9x." But "for an investor to receive a 15% return from yesterday's close," Zillow shares would need to sell for "higher multiples of 0.3x, 0.7x, and 1.4x" -- half again as much as Zillow's peers cost. If that's not reason enough to downgrade the stock, I don't know what is.

Microsoft can't miss?
Moving on now to happier news, shareholders of Microsoft are enjoying a modest rise in stock price today in response to an upgrade to outperform from FBR Capital. FBR has kind words for new CEO Satya Nadella, and thinks he's guiding the software maker well toward "the transition to mobile." The analyst also expresses hope that Nadella will steer away from the expensive, ill-considered acquisitions of his predecessors, and finally begin to enjoy a "long-awaited growth in free cash flow ... representing a breath of fresh air for investors." But is that reason enough to buy the stock?

Sad to say, no it is not. Here's why: According to S&P Capital IQ figures, Microsoft generated $22.7 billion in positive free cash flow over the past 12 months. That sounds like a lot of money, but was in fact a decline from the $29.3 billion in FCF pumped out in 2012. Even if Nadella is able to turn this decline around, though, it still leaves the stock selling for more than 15 times earnings and nearly 15 times free cash flow.

Working off the 7% long-term growth in profits that most analysts foresee for Microsoft, or the more modest 5% growth that FBR envisions in 2015, and either way, you're still looking at a stock selling for a double-digit P/E, but showing only single-digit growth. That's not usually a winning proposition in stock investing -- and it's not a good reason to recommend Microsoft.

Can you bank on this upgrade?
I'm similarly pessimistic about our other tech upgrade of the day -- Bankrate -- albeit with a glimmer of hope. Citing a 30% decline in share price "from recent highs," but an improving outlook for the insurance and credit card markets, RBC Capital announced today that it's reentering shares of Bankrate with an upgrade to outperform.

The idea is not entirely without merit.

While unprofitable under GAAP accounting rules, Bankrate is actually a pretty prolific generator of free cash flow, producing nearly $89 million worth of cash profits over the past year. This works out to about an 18x multiple to FCF on the stock -- much more attractive than its current P/E ratio, which like Zillow's, is "infinity" due to the stock's lack of GAAP profits.

Most analysts expect that Bankrate will only grow earnings at about 12% to 13% annually over the next five years, however, which is probably too slow to justify the 18x FCF multiple on the stock. Bankrate's industry as a whole, however, is expected to grow profits at north of 16%. If you consider Bankrate a superior company to the average, as I do, then it seems at least possible that the company will match, or exceed, industrywide earnings growth. If that's the way things play out, then the stock may not be quite as overpriced as it now appears.

That being said, I'd still like to see a bit more of a margin of safety in this one. Bankrate may one day be the buy that RBC says it is, but until we start seeing more profits growth, I'm going to sit on the sidelines and consider this one a hold, myself.


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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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