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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 new buy ratings for both Buffalo Wild Wings (NASDAQ: BWLD ) and Abercrombie & Fitch (NYSE: ANF ) . But the news isn't all good, so before we get to those two, let's find out why...
Mead Johnson curdles
Markets are moving broadly upward this morning after a strong jobs report, but not everyone's enjoying the green tickers. In particular, shareholders of Enfamil baby formula-brewer Mead Johnson Nutrition (NYSE: MJN ) are watching their stock flatline, after being downgraded by Morgan Stanley today. According to Morgan, "pricing" could be a problem for Mead going forward, as customers balk at paying any more for its already pretty expensive product. But what does this mean for the stock?
Costing 23 times earnings at last report, Mead Johnson already looked expensive based on analyst projections of an 11% long-term earnings growth rate. If Morgan is right, and hitting that target could turn out to be harder than analysts have assumed already, then that would give investors a second reason to sell the stock.
Granted, there are pluses as well as minuses affecting the basic valuation at Mead Johnson. On one hand, free cash flow at the firm is quite strong -- $710 million over the past 12 months, versus only $613 million in reported "GAAP" earnings. On the other hand, Mead Johnson is also lugging around about $500 million more long-term debt than it has cash in the bank, which tends to cancel out the positive effects of strong free cash flow on the stock's valuation.
In the end, I see the stock as not quite as expensive as it appears at first glance. But with an enterprise value-to-free cash flow ratio of 20, on 11% growth, the stock still looks overpriced. Morgan Stanley is right to downgrade it.
Wings get a lift
And speaking of overpriced: Buffalo Wild Wings. The purveyor of chicken wings 'n' things scored an upgrade to "buy" from analyst Miller Tabak Friday. Miller sees same-store sales growing at Buffalo Wild and, with the cost of chicken wings falling, expects this will lead to outsize profits growth. Investors are reacting to the upgrade with enthusiasm, bidding up the shares 1.5% in early trading -- but should they?
After all, at 34 times earnings, Buffalo Wild shares cost nearly 50% more than Mead Johnson -- a stock that's clearly overpriced already. True, Buffalo Wild is also growing faster than Mead Johnson, with most analysts agreeing 18% annual growth is achievable. On the other hand, B-Dub doesn't pay a dividend like Mead Johnson does. And in complete contrast to Mead Johnson's superb, better-than-reported-earnings free cash flow number, B-Dub is actually burning cash. Free cash flow at Buffalo Wild ran to more than negative $10 million over the past 12 months.
As a result, I see little reason to own the stock based on its P/E ratio -- and no reason whatsoever to buy Buffalo Wild Wings, based on its inability to produce real cash profits.
Abercrombie & Rich?
Now the good news today is that after all this bad news, we finally get to end on a bright note: with Standpoint Research's upgrade of Abercrombie & Fitch. At last report, A&F was doing about $4.4 billion in annual sales, earning a 5.7% net profit margin on those sales, and earning a bit more than $3 a share. According to Standpoint, however, the company's on a good growth track that could see it grow sales by 25%, improve its net margin by 14% (to 6.5%), and result in a 62% boost in per-share profits by 2015-2016.
Standpoint sees A&F earning $5 a share at some point within the next couple-to-three years, which would put the stock at a 10 P/E ratio at today's share price. But in fact, you don't even have to look out two to three years to see that this stock is already cheap today.
Abercrombie shares cost roughly 16 times earnings right now, yet it is expected to grow earnings at better than 16% per year over the next five years. That's a better-than-1.0 PEG ratio right there. Plus, the company generates 22% more free cash flow than it gets to report as GAAP profit. Plus, it's got nearly $350 million more cash than debt on its balance sheet. Plus, it pays its shareholders a 1.8% dividend yield.
That's three great reasons to think the stock is cheap enough to buy. With numbers like these, A&F shouldn't even need an upgrade to do well. (But it does deserve it.)
Fool contributor Rich Smith likes shares of Abercrombie & Fitch Co. so much, he bought them himself. Also, The Motley Fool recommends Buffalo Wild Wings, and The Motley Fool owns shares of Buffalo Wild Wings.