Wednesday'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 new buy ratings for a pair of specialty retailers, Coach (NYSE: COH  ) and Aeropostale (NYSE: ARO  ) . Meanwhile in mining, Freeport-McMoRan (NYSE: FCX  ) suffers a downgrade. Let's dive right in, beginning with why...

Coach is fashionable again
The day dawned bright for Coach investors Wednesday, as analysts at CLSA upped their rating to "buy" in response to a strong earnings report featuring 7% first-quarter sales growth and a 10% bump in earnings per share.

In each case, these numbers beat estimates, and analysts were particularly enthused over Coach's 40% jump in sales in China. But does all this mean that you should now follow their advice, and rush out and buy yourself some Coach shares?

Possibly... yes. Priced at just under 15 times earnings based on its latest income figures, Coach shares don't look half bad relative to projected earnings growth of nearly 14% annually over the next five years. Factor in a 2.3% dividend yield, and the shares actually look to be a bit of a bargain. Granted, Coach hasn't yet revealed its free cash flow figures for the most recent quarter. But once it does, and assuming those figures mirror the growth shown in net income, I'd say the stock's a bargain.

Aeropostale is looking cool, too 
Aeropostale -- initiated this morning with a "positive" rating at Susquehanna -- is a bit iffier of a proposition. On one hand, the stock looks expensive at 30 times earnings. On the other hand, the stock boasts strong cash reserves that reduce its enterprise value and shrink the apparent overvaluation. Also, Aeropostale is a strong cash generator.

Fact is, if you give Aeropostale credit for its cash hoard, and value it on its $72.5 million in trailing free cash flow rather than its trailing "income" of just $35 million, the stock is selling for an enterprise value-to-free cash flow ratio of less than 11.

That's not a horrible price at Aeropostale's projected 9.5% earnings growth rate -- but it's not a huge bargain, either. Right now, my thinking on the stock is that it looks slightly overpriced if it can't grow faster than analysts project. And if Aeropostale surprises us -- if it grows as fast as the 12% rate projected for the rest of the specialty retail industry, say -- then the stock might even be cheap enough to buy. For now, though, I'm going to sit on the fence. Aeropostale doesn't look clearly overvalued to my Foolish eye, but it's not an obvious bargain, either.

Freeport-McMoRan's down in the dumps 
Finally, switching gears both from positive ratings to negative and from retail to another sector entirely, we turn to copper, gold -- and now oil, too! -- company Freeport-McMoRan.

Freeport reported first-quarter earnings last week, beating estimates despite experiencing a 15% slide in net earnings. After mulling the numbers for a few days, analysts at Argus Research finally came to a conclusion this morning, and downgraded the stock to "hold" -- but I think even this lower rating is overly generous.

Although priced at "only" 9.6 times earnings, Freeport's stock looks pricey relative to earnings growth that's expected to average only 3.5% annually over the next five years. A powerful 4.4% dividend yield should be enough to make up for the slow growth estimate, but it doesn't. And the reason it doesn't is that Freeport's earnings -- the number upon which its 9.6 P/E ratio is based -- don't hold up to close examination.

Only about 7% of Freeport's claimed "earnings," you see, are backed up by real free cash flow. Put another way, for every $1 Freeport claims to be earning, it actually collects only about $0.07 in real cash-money. This low quality of earnings has me thinking that Freeport looks a lot more like a sell than it does a buy -- or even than the "hold" that Argus now says it is. Personally, I think that discretion is the better part of value here, and I'd stay away from Freeport stock.

Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool recommends Coach. The Motley Fool owns shares of Coach and Freeport-McMoRan Copper & Gold.

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 24, 2013, at 1:26 PM, withOpenMind wrote:

    Curious what is your math behind your claim that only 7% of earning is 'real money'. So the other 93% is fake and out of thin air? Are you claiming they're doing accounting fraud or what?

  • Report this Comment On April 24, 2013, at 3:18 PM, TMFDitty wrote:

    Hardly. More often than not, GAAP accounting standards permit companies to report "profit" far in excess of the cash they're actually generating. It's entirely legal -- and something to watch out for.

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