Monday'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 downgrades for both NetApp (NASDAQ: NTAP  ) and Lowe's (NYSE: LOW  ) . But the news isn't all bad, so before we get to those two, let's take a quick look at why one analyst thinks that...

J.C. Penney is "doing it right"
Monday's starting off with a bang for investors in J.C. Penney (NYSE: JCP  ) -- and fans of George Soros -- as investment banker Maxim Group ups its rating on JCP to "buy," and posits a price target of $27, which is nearly 50% higher than where the stock traded as recently as Friday.

In a write-up on StreetInsider.com, we see Maxim lauding CEO Mike Ullman for reverting to JCP's historical practices of "couponing, promoting, and ... returning popular private brands to the stores." Maxim blames the absence of these initiatives directly for the "steep decline" in JCP's sales last year, and notes that it's already seeing a pickup in foot traffic at the stores now that the promotional initiatives are back in full force.

Of course, that's all well and good, but... even greater sales at JCP won't help the stock much when the company's currently losing $0.09 cents for every $1 in goods it sells. To the contrary, unless JCP's revenue revival is so great as to deliver serious economies of scale, simple math will tell you that a negative profit margin means the more stuff J.C. Penney sells, the more money it loses. And selling stuff with bigger coupons and steeper discounts on the sales prices isn't likely to change that.

Aside from that, Mrs. Lincoln, how was the play?
Okay, so if today's featured upgrade is as bad as just described, that probably sets the tone for how bad the downgrades are going to be, right?

Well, not necessarily. So let's start out with Lowe's, just downgraded to "perform" at Oppenheimer. These shares are up 67% over the past year already, and with Lowe's slated to report earnings on Wednesday, Oppy appears to be thinking that discretion is the better part of valor at this point. Rather than risk an earnings disappointment, and an evaporation of the gains the stock's reaped over the past year, the banker is pulling its buy rating. At the same time, though, Oppenheimer retains its $46 price target on Lowe's shares, which currently cost just $42 and change.

So what gives? Are these shares overvalued after their run-up, or do they still have room to rise?

Me, I think the latter. Although it's true that Lowe's shares look pretty pricey when valued on GAAP earnings (the stock has a 25 P/E ratio), if you value Lowe's instead on its real free cash flow, I'm not so sure its shares are as expensive as they look. I mean, Lowe's generated $2.55 billion in cash profits over the past year. At $46.25 billion in market cap, that works out to a price-to-free cash flow ratio of 18 -- not unreasonable for a projected 17% grower paying a 1.5% dividend yield.

Long story short, while the discount on this one isn't exactly huge, it is significant for a firm of Lowe's size and quality. I think the stock's still a winner, and undeserving of a downgrade.

NetApp: Shorting out?
A second stock getting dropkicked ahead of earnings is data storage solutions specialist NetApp, which reports tomorrow. Ahead of earnings, BMO Capital warned investors today to expect that NetApp will probably deliver a profits warning of its own. The banker sees downside as limited, however, and is therefore holding firm with a "market perform" rating. Not everyone's feeling so confident, however.

This morning, a second analyst -- R.W. Baird this time -- announced it's going to go ahead and downgrade the stock right away, before the bad news breaks. Baird is now rating NetApp "underperform" -- but here again, I think the analyst is mistaken.

Sure, on one hand NetApp looks even pricier than Lowe's on the surface, trading for nearly 27 times earnings. On the company's projected 12% long-term rate of profits growth, that looks pricey. But once again -- the cash flow statement tells a different tale.

Over the past 12 months, NetApp has generated a whopping $1.15 billion in real free cash flow from its business. That's more than twice reported "GAAP" earnings, and it's enough to push the firm's P/FCF ratio down to less than 12 -- and right in line with projected profits growth.

What's more, when you recall that NetApp's strong cash-generating capabilities currently have the company sitting on a $4.5 billion cash surplus (that's cash minus debt), the stock's arguably even cheaper, and sells for an enterprise value-to-free cash flow ratio of only 8.0.

I have to say, for 12% projected growth, that's a mighty fine-looking valuation to me. It's not deserving of Baird's sell rating. And it's cheap enough that I think even BMO's hold looks conservative. Whatever happens after tomorrow's earnings report in the short term, NetApp, to me, looks like a winning investment over the long term.

Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool recommends Lowe's.

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  • Report this Comment On May 20, 2013, at 7:03 PM, tomd728 wrote:

    NTAP was a pick by one of the "Options Brothers" on CNBC.

    As their recs turn out to be nothing more than a self-serving device, I personally would not touch it.

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