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, our headlines include a new buy rating for SodaStream (NASDAQ: SODA  ) , but a downgrade for Pepco Holdings (NYSE: POM  )  and a lower price target for Aeropostale (NYSE: ARO  ) .

Good news first
Let's begin with the "good" news. This morning, Citigroup announced it was initiating coverage of at-home pop maker SodaStream with a buy rating and a $60 price target, suggesting there's more than 27% worth of upside to the stock. The analyst cites the fact that big-name retailers including Costco and Wal-Mart have signed on to distribute SodaStream's wares in the U.S., helping to diversify revenue streams away from Europe. Five years ago, 80% of the company's sales came from the Old Country. Today, that number's just 50%.

Citi sees SodaStream sales growth slowing a bit in future years, but continuing to fizz as household penetration continues. Near-term, Citi's looking for 20% growth in 2013. Profit margins on those sales are also expected to expand, resulting in strong profits growth -- maybe even as strong as the 30% rate of earnings growth the rest of Wall Street is expecting.

For a 24 P/E stock, that sounds pretty good. The question, though, is whether these "profits" numbers really mean anything, given that SodaStream currently generates no free cash flow whatsoever from its business and, to the contrary, is actually burning cash at the rate of $18 million a year.

Personally, I expect Citi's right, and SodaStream's share price will in fact rise, so long as investors believe its GAAP earnings numbers are on the up-and-up. It's what happens after investors lose that faith that worries me.

No cheers for POM
Now for the more obviously bad news. This morning also saw a downgrade in the form of electric utility Pepco, which got taken down a notch by Credit Suisse. The analyst pulled its outperform rating on the stock Friday, and downgraded to neutral, but why?

At 16.7 times earnings, and with a 5.4% dividend yield, Pepco should only have to grow earnings 12% a year or so -- less than half as fast as SodaStream -- in order to justify a buy rating. Problem is, analysts on Wall Street think Pepco will in fact only grow earnings at less than half the needed rate -- 5.2%.

Now, add in the fact that Pepco, like SodaStream, is a recidivist cash-burner, generating negative free cash flow in three of the past five years, and currently burning the stuff at a rate in excess of $600 million annually. Add, too, the fact that the company is deep in debt, with $5.3 billion more debt than cash, and there seems little reason for optimism about this one. Credit Suisse may have only downgraded Pepco to neutral so far. However, other analysts, who take an even closer and more critical look, may want to downgrade it further than that.

Not all bad news is bad
Last but not least, we come to Aeropostale, recipient of a cut in price target from Imperial Capital and -- this just in -- now also downgraded by Piper Jaffray. Aero just reported its holiday sales results, showing an 8% decline in same-store-sales for the nine-week period ending Dec. 29. Earnings guidance is down sharply, from about $0.38 a share to something more like $0.22 -- and adding insult to shareholders' injury, management says these estimates are only "pro forma." Add in charges taken for "store asset impairments" and the GAAP earnings number could be even worse.

So in short, it's no surprise analysts are nervous.

That said, the valuation on Aero continues to look attractive. Free cash flow at the clothier is an impressive $114 million for the past 12 months, or nearly twice reported GAAP earnings. Cash profits are so strong, in fact, that once you net out cash already on the balance sheet, the enterprise value-to-free cash flow ratio on debt-free Aeropostale drops below 7.0.

Near-term worries aside, that's a very attractive price if the company can live up to long-term earnings growth expectations of 11%. If it can't, of course, the analysts are probably right to be downgrading it. But investors willing to invest with a longer time horizon, and resist the urge to knee-jerk drop-kick the stock, should profit handsomely from these levels.

Rich Smith has no position in any stocks mentioned. The Motley Fool recommends Costco Wholesale and SodaStream. The Motley Fool owns shares of Aeropostale, Costco Wholesale, and SodaStream. 

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