Friday'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 feature a lower price target for Dick's Sporting Goods (NYSE: DKS  ) , a higher one for GameStop (NYSE: GME  ) , and for Applied Materials (NASDAQ: AMAT  ) -- an honest to goodness upgrade. Let's tackle those in order, beginning with...

An unsporting downgrade for Dick's
Sporting-goods superstore Dick's is slated to release third-quarter earnings Tuesday morning, but one analyst, at least, isn't waiting around to get slapped upside the head with bad news. This morning, Canaccord Genuity announced that while it's still technically in favor of "buying" Dick's stock, it's going to hedge its bets going forward, and cut its price target to $58.

Given the raft of retailers reporting disappointing news lately, that's probably prudent. But given Dick's financials in particular, you have to wonder why Canaccord didn't go the extra step and officially downgrade its recommendation on the shares.

After all, while it's certainly possible that Dick's will surprise to the upside next week, its shares are looking especially vulnerable in the event an earnings disappointment should occur. Trading at 21 times earnings today, the shares cost more than their projected 15% growth rate would appear to warrant. Worse, the quality of Dick's earnings is also suspect. Trailing free cash flow at the retailer, which amounts to just $169 million, is barely half the $298 million the company has reported as GAAP "profits" for the past 12 months. As a result, Dick's shares now carry a price-to-free cash flow ratio in excess of 37 times.

At this high of a valuation, one stumble and Dick's shares could tumble.

Booting up for GameStop
A second specialty retailer poised to report next week -- GameStop -- is getting an opposite reaction on Wall Street today, as analysts at Telsey Advisory Group up their price target on the stock to $58. That's 26% more than Telsey used to think the stock was worth, but why?

Unlike Dick's, GameStop lacks a trailing P/E ratio to hang a valuation on, because... well, to be blunt, because GameStop hasn't been profitable in more than a year. But while the stock may lack GAAP profits, what GameStop does have is free cash flow. And it's got that in abundance.

Over the past 12 months, GameStop generated some $322 million in real cash profit from its business, belying the negative GAAP "earnings" number. That's a big pile of cash pouring through the door. Problem is, the stock's valuation is also quite high. GameStop shares flew up 165% over the past year, with the result being that the stock now sells for about 17.5 times free cash flow.

Now, that doesn't sound like an unreasonable number. But analysts only expect to see the company grow in profitability at about 13.6% per year over the next five years. Even with a generous 2.2% dividend yield, GameStop shares look overvalued today -- and unlikely to reach Telsey's $58 price target.

Applied rethink
And finally, Applied Materials. After initially slipping in after-hours trading, following news that the company had "missed earnings" and decided to switch CEOs mid-year, Applied shares are on the upswing again today. For this, you can probably thank the friendly analysts at D.A. Davidson -- who this morning upgraded Applied shares to "buy" and assigned an $18 price target.

At first glance, this upgrade looks a lot like Telsey's recommendation for GameStop. Like GameStop, Applied is afflicted by the stigma of negative GAAP profits at present. Also like GameStop, however, Applied has abundant free cash flow arguing in its favor.

Applied's latest report shows that cash profits at the company amounted to $834 million over the past year, giving the company a 23 times price-to-free cash flow ratio. That's probably too much to pay if analysts are right and Applied is only going to grow its profits at about 9% per year over the next five years. On the other hand, management advised yesterday that it sees "fab equipment investments ... up 10% to 20% relative to this year," which suggests the company could actually grow faster than the analysts are projecting. (On the other other hand, though, Applied also warned yesterday that it thinks its gross margins will probably keep falling for the next couple of quarters, blunting the effect of any projected sales gains.)

When you get right down to it, though, I think the upshot is this: 20% sales growth in the best-case scenario only suggests a fair valuation on Applied Materials shares today. Meanwhile, the potential for 10% sales growth, and even slower profits growth (due to the declining margins) suggests significant risk that profits won't grow fast enough to justify the valuation on Applied Materials shares. On balance, this looks like a stock that's too risky to buy, and investors are probably better advised to use this morning's price-spike as an occasion to exit the shares.

Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool owns shares of GameStop.


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