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 feature downgrades for both Alcoa (NYSE:AA) and Overstock.com (NASDAQ:OSTK). But the news isn't all bad, so before we get to those two, let's first check out why one analyst is...
Putting Chipotle on the menu
Markets are off a couple tenths of a percent in early Wednesday trading, but shareholders of at least one stock are still grinning: Chipotle (NYSE:CMG). The upscale burrito-meister is up 2.3% itself today on the back of an upgrade to "buy" from analysts at Argus Research. Citing expected same-store sales gains of 2.5% in 2013, Argus is taking its target price on Chipotle shares to $430. But is it right?
Unfortunately, probably not.
Priced in excess of 41 times earnings today, Chipotle is not quite as expensive as it looks. Free cash flow at the fast-casual restaurant chain is a beefy $324 million for the past 12 months, or 11% ahead of reported net income. Yet even so, this leaves the shares trading for 36 times free cash flow, or significantly more than you'd ordinarily want to pay for a company like Chipotle, which is expected to grow its profits at about 20% per year over the next five years.
In other words, with fast growth and good free cash flow, Chipotle is a terrific business, and one you should want to own at the right price. Unfortunately, today's price is not right.
Alcoa: No longer shiny
Switching gears now from aluminum-foil-wrapped food to aluminum foil manufacturing, we turn to Alcoa and its downgrade. Citing a predicted 5% cut in aluminum pricing for 2013, and an even steeper, 12% drop in 2014, JPMorgan removed its buy rating from Alcoa this morning, and downgraded to "neutral." JP notes that demand for aluminum remains "firm"; however, supply is even stronger, which makes it hard for companies like Alcoa to charge more for their metal.
Result: The banker is cutting its predicted earnings for Alcoa to $0.29 this year, and $0.55 next year -- reductions of 49% and 47%, respectively -- and cutting its price target to just $9 a share. Personally, I think the analyst is still being too generous.
Why? Consider: At 33 times earnings today, Alcoa clearly costs too much for the 6.5% long-term profits growth it's expected to produce. And just as was the case with Chipotle, even stronger-than-earnings free cash flow ($437 million) isn't strong enough to save the valuation case here. Based on trailing free cash flow, and even assuming this number doesn't deteriorate, I see the stock trading for nearly 19 times FCF -- too high for a 6.5% grower. Factor in Alcoa's mammoth debt load -- nearly $7.4 billion net of cash -- and the enterprise value-to-free cash flow on this behemoth looks even worse.
Long story short, in contrast to JPMorgan, which only sees Alcoa as less attractive than it once thought the stock to be, I think the stock's downright ugly. Its valuation shows no room for upside, and I'd expect it to fall.
Stock up on Overstock?
And finally, thankfully, we get to end on a "bright" note today, with Merrill Lynch's downgrade of Overstock.com. If that sounds strange, though, it's not really. Here's why:
According to Merrill, Overstock is showing weak and inconsistent customer growth. At 33 times earnings (about the same valuation as Alcoa), the banker sees Overstock shares as overvalued, and bound to "underperform." But Merrill Lynch is wrong.
Priced at 33 times earnings, Overstock shares do look expensive, I'll admit. But that "P/E" ratio doesn't take into account the fact that Overstock generates significantly more real cash profit (free cash flow) than it reports as GAAP net income. Indeed, FCF for the past 12 months came to $32.3 million, or 65% more than GAAP income. As a result, the stock that appears to sell for "33 times earnings" can just as easily be said to cost only 20 times free cash flow. And when you consider that most analysts who follow Overstock see it growing earnings at 34% per year over the next five years, 20 times FCF hardly seems too high a price to pay for such barn-burning growth.
Now... could that growth rate fail to appear in the future? Sure it could. Merrill Lynch itself notes that growth at the firm seems "inconsistent." But based on the numbers we see today, and the estimates analysts are on record supporting, the stock still looks cheap today.
Result: Despite more than quadrupling in share price over the past year, Overstock.com could still run higher.
Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool recommends Chipotle Mexican Grill. The Motley Fool owns shares of Chipotle Mexican Grill.