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, Wall Street sparkles with a new buy rating for Zale  (NYSE: ZLC  )  and an upgrade for Signet Jewelers (NYSE: SIG  ) . On the bad-news side, however, Disney (NYSE: DIS  ) just got hit with a downgrade. Let's start with that one, and find out why...

The House of Mouse just got condemned 
Disney got itself downgraded by Janney Capital this morning, in a report criticizing the House of Mouse for poor "advertising fundamentals (and ratings) combined with the reinvestment of Park profits" -- two trends that Janney sees weighing on profits growth in the near term. Until the ad market revives, or Disney begins seeing a payoff from improvements in its parks, the analyst worries that investors will balk at paying a "premium valuation" for Disney shares.

Are these worries justified?

At 16.6 times earnings, Disney shares do sell for a premium to shares of CBS (NYSE: CBS  ) . But this valuation is basically par for the course at Comcast (Nasdaq: CMCSA  ) , owner of the third major network (NBC). The problem, though, is that Janney appears to be right about growth. Pegged for only 12% long-term earnings growth, Disney lags both of its major rivals in this department. Meanwhile, neither its free cash flow nor its dividend yield look sufficiently attractive to make up the difference.

Given the stock's disadvantages relative to the competition, the neutral rating Janney now gives it is probably the most Disney deserves. Less charitable analysts might even call the stock a "sell."

Zale's: Shiny?
Making less sense this morning is Janney's brother banker Citigroup, which decided to initiate coverage of Zale this morning, ahead of the fiscal first-quarter 2013 earnings release due out Nov. 20. With Zale shares up 80% over the past year, Citi may think it's found itself a diamond in the rough here, and decided to follow the lead of investors who've been buying it. Me, I think the banker's done got itself a piece of cheap costume jewelry.

Why? Just look at Zale's numbers: $27 million in GAAP losses over the past year. $57 million in negative free cash flow. And of course, the company's also carting around a net debt load of $425 million -- nearly twice its own market cap. Why, even if you look out into next year and decide the company's 14 forward P/E ratio isn't too bad-looking a price, the consensus forecast for 8% long-term growth suggests that yes, in fact, 14 times earnings is a bad price.

Long story short, if Citi wants to buy Zale, let them. You can do better.

A better idea
But if not Zale's, who should you buy? In Bank of America's humble opinion, rival jewelry store Signet offers a cheaper alternative.

Why? The parent company of Kay Jewelers is profitable where Zale is not, for one thing. If Zale might earn enough to give it a 14 times forward P/E ratio today, then Signet is already there -- selling for less than 14 times trailing earnings. Next year, earnings are expected to grow enough to push the forward P/E down toward 11 times. And looking even further out, analysts on average see Signet posting nearly 12% annualized profits growth -- half again what Zale is expected to achieve. Topping it all off, Signet pays its shareholders a small dividend (0.9%).

Now... all this is not to say that I agree with B of A saying the stock's a "buy." Fact is, I'm leery of Signet's weak record on free cash flow. And honestly, I'm not entirely certain the stock is as cheap as it looks. It is, however, a debt-free, solidly profitable, cash-generating operation. Which is more than Citi can say about Zale.

Fool contributor Rich Smith has no positions in the stocks mentioned above. The Motley Fool owns shares of Walt Disney. Motley Fool newsletter services recommend Walt Disney.


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