Thursday's Top Upgrades (and Downgrades)

Motley Fool

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 downgrades for two of the biggest names in construction, mining, and agricultural equipment -- Caterpillar (CAT) and Deere (DE) . On the plus side, though...

HomeAway wins an away game
Online vacation rental company HomeAway (AWAY) blew away analyst estimates last night, reporting Q3 earnings of $0.19 per share, or $0.03 more than expected. Revenues for the quarter, $90.1 million, similarly stomped expectations of only $89 million and change. Meanwhile, management predicted that the current quarter's revenues will once again trounce estimates, with a potential revenue haul of as much as $86.5 million in the cold weather months.

Responding to the good news, analysts at Raymond James doubled down on their already optimistic outperform rating on the stock, upgrading HomeAway to strong buy. And perhaps more tellingly, Monness, Crespi, Hardt just threw in the towel on its sell rating, grudgingly upgrading HomeAway to neutral.

Personally, I'm inclined to agree.

Sure, on the surface HomeAway looks vastly overpriced at a price-to-earnings ratio of more than 120. But HomeAway's "GAAP" earnings don't give the company enough credit for its cash-generating potential. Over the past year, HomeAway generated more than $85 million in real cash profits, giving the stock a price to free cash flow ratio of only 34, and an enterprise value to free cash flow ratio of just 30. Based on the 27% annualized pace of earnings growth that analysts expect the company to produce, that does not seems like an unreasonable valuation to me. A bit pricey, perhaps, but not unreasonable.

While I'd certainly prefer to own the stock at the price it was selling for yesterday, rather than the price -- 17% higher -- that it costs today, on the whole I think HomeAway remains a fine investment for long-term shareholders, even at today's significantly higher price.

Mining equipment makers fall into a hole
Now for the bad news: Not everyone's doing as well as HomeAway is. Not by a long stretch.

Take Caterpillar and Deere for example. Last quarter, sales were up barely 4% at Deere, and down 18% at Cat. Analysts at ISI Group think things will get worse before they get better, too, and this morning announced that they're pulling their buy rating on Caterpillar, and cutting Deere from neutral to a more ominous rating of cautious.

That may sound overly pessimistic, of course, considering that right now, Caterpillar shares only cost a cheap-sounding 16 times earnings, while Deere shares can be had for less than 10 times earnings. But consider:

With the commodities boom looking likely to bust, neither of these companies is expected to produce much growth over the next five years. Analysts on average expect to see only 10% annualized earnings growth at Cat, and just 8% at Deere. So in neither case are the company's earning enough, relative to their growth rates, to give their stocks a PEG ratio of less than 1.0 -- the eternal target for value investors.

Of the two, ISI seems slightly more optimistic about Caterpillar's chances, and I agree with the analyst on that score. After what can only be described as a miserable year for cash production in 2012, Caterpillar crawled out of a hole recently, and is now again generating free cash flow superior ($4.9 billion) to what it reports as GAAP net income ($3.5 billion). Arguably, this makes Caterpillar stock somewhat less expensive than it looks -- although if you factor debt into the equation, I'd still argue that at an enterprise value to free cash flow ratio of 18, Caterpillar is not yet cheap.

Deere, meanwhile, generated a bare $461 million in free cash flow over the past 12 months, which was a far cry from the $3.4 billion in claimed to have earned under GAAP accounting. At 68 times annual free cash flow, or an astounding 132 times free cash flow with debt figured in, I think ISI is right to be "cautious" about Deere's valuation.

Cautious... to say the least.

Motley Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool recommends HomeAway.

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