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 an upgrade for Walgreen (NYSE: WAG ) , a downgrade for Cubic Corp (NYSE: CUB ) , and for Dawson Geophysical (NASDAQ: DWSN ) , a big bump in target price. Let's take 'em in order:
Walgreen can make you some green
First up is Walgreen, recipient today of an upgrade to "buy" from Mizuho Securities. Priced at $41 and change today, Mizuho is calling for a rise to $46 over the next 12 months, which makes for a 10% profit. Combined with Walgreen's generous 2.7% dividend yield, that makes for a tidy 12.7% return -- not bad for a year's "work." But how likely is it to happen?
Call me an optimist, but actually do think it might happen, and I'll tell you why: At first glance, Walgreen shares look pretty pricey. They cost nearly 19 times earnings, which is about a 12% premium to the average big drugstore chain and an apparent premium to the company's 13% growth rate as well.
But consider: Walgreen also generates a lot more free cash flow than it reports as net income -- $2.75 billion in FCF versus GAAP "earnings" of just $2 billion. When valued on the cash profit it's actually generating, therefore, rather than the earnings it is allowed to report, the company actually looks attractive at a price-to-free cash flow ratio of just 14.4. To my mind, 13% profit growth and the 2.7% dividend yield are more than enough to support Walgreen's share price -- and may even justify a small increase in that price.
Result: So long as Walgreen's profits grows as they're projected to, the stock price should follow.
Cubic gets cut
Worse news awaits Cubic Corp shareholders, however. Yesterday, the defense contractor reported a sizable "earnings miss," admitting that Q4 profits came to only $0.47 per share, versus the $0.70 that Wall Street had been counting on. Needless to say, analysts were not pleased.
Already this morning, Benchmark Capital has downgraded the stock to "hold." StreetInsider.com says the reason is Benchmark's fear that "lower growth in Transportation and deceleration in Defense" will compress profit margins, and make this a "transitional year" for Cubic. Expectations need to be reset before Cubic can begin growing again.
And how! With a P/E ratio that's risen to 14.2 after its deeply disappointing earnings quarter, Cubic looks significantly overpriced relative to single-digit earnings growth projections. The company's measly 0.5% dividend yield does little to tip the scales in its favor. Topping off the bad news, Cubic's now burning cash, with free cash flow for the past year running to negative $52.8 million.
Cubic no longer deserves a "buy" rating, and Benchmark is right to downgrade it. In fact, the analyst probably should consider going a step further, and downgrading all the way to "sell."
Dawson -- can you dig it?
Last but not least, we get to end today's column on a bright note -- and a hike in target price for oil diviner Dawson Geophysical. Dawson reported blowout earnings last week, sending the shares up 12% in a day. The rally continued on the other side of the weekend yesterday, and today... Dawson shares are on the march once again.
The catalyst this time is a big bump in Wunderlich's target for where Dawson shares will be trading over the next 12 months. The analysts says Dawson shares, currently sitting just shy of $32, could rise to $38 over the course of the year, adding another 20% profit onto all the profits shareholders have already reaped over the past few trading days.
If Wunderlich's right, that means there's still time to buy Dawson shares and get in on the profits. Problem is, though... Wunderlich is not right. Dawson's reaped some impressive gains, true, but as of this moment, the shares finally look appropriately priced.
Here's how we reach that conclusion: Dawson generated $22.1 million in free cash flow over the past year. Credit the company for its cash reserves, and that gives the stock an enterprise value-to-free cash flow ratio of almost exactly 10 -- which is in turn almost exactly the "right" number for a stock that Wall Street has pegged for 10% long-term earnings growth. So best case, the shares are fairly priced today, and unlikely to rise to Wunderlich's predicted $38 target.
Worst case, the stock's 23.4 "P/E" ratio suggests the shares are already over-valued... but we won't go there. Suffice it to say that the stock's not as undervalued as Wunderlich says it is, and therefore doesn't deserve the higher price target, and we'll leave it there for now.
Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool recommends Cubic and Dawson Geophysical Company. The Motley Fool owns shares of Dawson Geophysical Company.