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. For Thursday, our headlines feature an upgrade for Cree (CREE) , and a higher price target for Cummins (CMI) . Not all the news is good, however. Before we get to those two, let's take a quick look at why...

Merrill Lynch gives CNH an "F"
Investment banker Merrill Lynch resumed coverage of global agricultural and construction equipment manufacturer CNH Industrial (CNHI) this morning -- but shareholders would probably have been just as happy had Merrill stayed away. The banker is not particularly enthused about the stock, which it rated underperform, and predicted would fall to an $8 share price within a year -- more than a 20% drop from today's prices.

Merrill thinks there are better bargains out there than shares of CNH. Quoted on StreetInsider.com Thursday morning, Merrill warned that "the company's five year target is too optimistic and the 16x 2014 P/E is unappealing relative to Deere and AGCO , which trade at 10-11x despite superior FCF generation" -- and Merrill has a point.

Priced at 12.5 times earnings today, CNH shares may look attractive at first glance, given that analysts polled by S&P Capital IQ expect the firm to grow its profits at a brisk 20% annual pace over the next five years. Unfortunately, CNH generates only about $575 million a year in free cash flow -- barely half its reported net income. And as a result, the stock is arguably much more expensive than it looks, sporting a price-to-free cash flow ratio of 23 -- and an enterprise value to free cash flow ratio three times higher than that.

Long story short, at such extreme valuations, I'd rather be short on this stock than long.

Cummins coming along nicely?
Continuing the industrials theme for a bit, we come next to Cummins. Argus Research reiterated its endorsement of the diesel engine specialist Thursday, assigning the stock a $170 price target. Working off Thursday's share price of $156 and change, and adding a modest 1.6% dividend yield, this works out to a potential profit of about 10% for investors who follow Argus's advice, and buy the stock today -- which is nice, but I do wonder if it's a big enough opportunity to necessitate an out-and-out buy recommendation.

After all, at a P/E of 19, but a projected long-term growth rate of just 13%, Cummins isn't an obviously cheap stock. In fact, with free cash flow for the past 12 months ($1.26 billion) trailing reported net income ($1.5 billion) by more than 18%, Cummins shares sell for a price to free cash flow ratio of nearly 23 -- which actually looks pretty pricey for a 13% grower.

Although a fine company in many respects, and one with better than average growth prospects , I just don't see Cummins stock as cheap enough to buy.

Cree lights up
Lastly, Cree. The LED lighting specialist's shares got lit up this morning when analysts at Oppenheimer upgraded them to a buy rating, and assigned a $59 price target to the $52 shares. That works out to about a 12% profit opportunity, for investors who think Oppenheimer is right about the stock going up.

Unfortunately, Oppenheimer is not right. Like the other stocks already profiled, Cree, too, is overpriced.

Here's how the math works: Cree shares sell for 52.5 times earnings today, but are projected to grow at an annual percentage rate less than half that -- just 23%.

The valuation picture isn't quite as bad as that sounds. Free cash flow at the firm is strong with $148 million in cash profits generated over the past year. A strong producer of cash historically, Cree has also built up a sizable war chest, with $1.2 billion on its balance sheet, and no debt. Factor that cash into the valuation, and what you end up with is an enterprise value-to-free cash flow ratio of 35 on Cree shares.

But while not as bad as the 52.5 "P/E" that most investors will see on the stock, for 23% growth, 35 times FCF is still too high a price to pay for Cree shares -- and Oppenheimer is wrong to recommend it.

Rich Smith has no position in any stocks mentioned, and doesn't always agree with his fellow Fools. Case in point: The Motley Fool both recommends and owns shares of Cummins.