Friday'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, we're sticking with NYSE stocks, which our headlines featuring upgrades for L-3 Communications (LLL) and Kansas City Southern (KSU). On the other hand, the news isn't so good for Western Union (WU 2.13%).

Western Union -- going south?
The week is ending on a weak note for money transfer shop Western Union. This morning, analysts at British investment banker Berenberg announced they were initiating coverage of the company with a sell rating and a $12.50 price target. With Western Union shares currently costing about $15.80 apiece, that implies close to 10% downside on the stock. But does Western Union deserve to take such a hit?

I'd argue it does not. Priced at just 11 times earnings today, the stock seems appropriately valued for its projected growth rate of nearly 11%. Plus, the stock pays its shareholders a generous 3.1% annual dividend yield. Plus, it's cheaper than it looks.

Between the growth rate and the dividend, Western Union shares already look pretty undervalued. But the key thing to focus on here is that Western Union is more profitable than it looks. The company reported "earning" only $789 million in profits last year, under GAAP accounting standards. But a glance at its cash flow statement will reveal that Western Union actually generated positive free cash flow of $967 million during that same time span -- 22% more than it reported earning.

Valued on free cash flow, the stock trades for a low multiple of just 8.8 times free cash, which seems very cheap indeed for a near-11% grower paying out more than 3% in dividends. Far from being the "sell" that Berenberg labels it, I'd say the stock looks very attractively priced indeed.

Does L-3 deserve an "A"?
Although operating in a different industry entirely -- defense -- the situation with L-3 Communications looks similar to that at Western Union, albeit somewhat less attractive. For one thing, L-3 pays a nice dividend yield -- 2.1%. For another, although it has a share price a bit less than 14 times earnings, the company boasts robust free cash flow that brings its price-to-free cash flow ratio down to just 11.6.

Upgrading the shares to outperform this morning, analysts at investment banker Credit Suisse highlighted the company's strong free cash flow as one reason to want to own the shares, and noted that the "end market" for defense products appears to be bottoming. In other words, if governments aren't buying as many weapons systems as they were during the height of the Iraq and Afghan wars, then at least the cuts aren't coming as fast and furious as they were last year.

All of which is true. The problem with L-3, however, is that if defense cuts may not be increasing in size, no upturn in spending seems in sight, either. Analysts who follow L-3 don't expect it to grow earnings at much more than 4% annually over the next five years. That makes the company's multiples to earnings and free cash flow a bit more problematic.

The stock looks overpriced at $116 per share today -- and Credit Suisse's promise of a $145 target price within a year unrealistic.

Will Kansas City Southern turn north?
The case of railroad operator Kansas City Southern is another matter entirely. Like L-3, it's received an upgrade today, from Merrill Lynch, which calls the stock a buy. But unlike the other stocks discussed so far, Kansas City Southern stock is reacting pretty swiftly to the change of sentiment on Wall Street.

The stock's up about 3% already in response to positive comments from Merrill Lynch, which sees Kansas City Southern as attractively priced for "sustained mid-teens EPS growth for the next 5-10 years" after falling 20% in price since the turn of the year.

The real question here, though, is not whether the stock is cheap-er than it cost back in January. It's whether you can argue the stock cheap is enough to buy when it costs 33 times earnings, but is growing at only 15% annually. That's the prediction from most analysts who follow Kansas City Southern. And even with the stock's modest 1.1% dividend yield, it looks expensive to me.

Now add in the fact that Kansas City Southern, in addition to showing weak GAAP profitability, is producing no free cash flow whatsoever on its cash flow statement. The company burned through more than $100 million in negative free cash flow over the past 12 months, was free cash flow negative in two of the past five years on an annual basis, and over the entire period, averaged positive free cash flow of only $84 million annualized. That's barely 32% of its reported $261 million in average annual GAAP "earnings." And what it tells me is that as expensive as the stock looks when valued on GAAP earnings, Kansas City Southern is vastly more expensive when valued on the free cash the company generates.

I think the stock quite simply costs too much, and Merrill Lynch is wrong to recommend it.

Rich Smith has no position in any stocks mentioned, and doesn't (always) agree with his fellow Fools. Case(s) in point: The Motley Fool recommends Western Union, and also owns shares of L-3 Communications Holdings.