Tuesday'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 new buy rating for Bloomin' Brands (NASDAQ: BLMN  ) , and an upgrade for ANN (NYSE: ANN  ) . But the news isn't all good, so before we get to those two, let's take a look at why one analyst thinks that...

Arcelor Mittal is smelting down
The day opened on a sour note for shareholders of world's-largest steel maker ArcelorMittal (NYSE: MT  ) , which this morning got hit with a downgrade to "underweight" by investment banker Morgan Stanley. Although down 15% over the past year, Arcelor shares have gained 9% since their lows earlier this month. Morgan Stanley, however, believes these games are "unsustainable," and that the shares are due to fall again.

I agree.

Unprofitable, and trading for 35 times trailing free cash flow, Arcelor shares look richly valued today. Analyst expectations for future earnings growth vary widely, ranging from uber-optimistic predictions of 98% annual earnings growth, to declines averaging more than 13% per year, every year, for the next five years. The midpoint on these expectations, however, is a consensus expectation of approximately 20% average annual earnings growth over the long term. Impressive as that may be, it's probably not enough to justify a 35 times multiple to free cash flow.

Morgan Stanley is right to be nervous, and right to downgrade the shares.

Optimism blooms
Turning now to happier news, shareholders of Bloomin' Brands are seeing the shares turn green this morning, as Bloomin' leads the market up on the back of a new buy rating from British banker Barclays.

Barclays initiated the stock at "overweight" Tuesday, assigning Bloomin' a $29 price target. While perhaps a tad optimistic, I think Barclays is on the right track here.

Bloomin' shares cost about 24 times earnings today. They boast superior free cash flow -- about $181 million, or roughly 50% more than reported net income. This strong free cash flow is counterbalanced by a heavy debt load, however, resulting in an enterprise value-to-free cash flow ratio of 23 -- roughly equal to the stock's P/E. Both these numbers seem too high, given that Bloomin' brands pays no dividend, and is only expected to grow at approximately 17% per year over the long term.

The valuation's not completely out of whack, however. While I wouldn't buy Bloomin' Brands at today's price, I would keep an eye on the stock as a potential buy on a pullback.

How far can ANN run? 
Last but not least, we come to a stock I've mentioned positively in the past. ANN is benefiting from an upgrade to buy from investment banker Janney Montgomery Scott this morning. StreetInsider.com is quoting the analyst praising "improved product" and "attractive valuation" at ANN, and predicting the stock could rise 16% in price over the next year (to $38 a share).

"Product at the LOFT brand shows solid improvement," says Janney, while "at Ann Taylor, we believe the new fall product recently set in stores is trend- and target-right." With these two chains catering correctly to their consumers, Janney predicts we will see ANN capture market share from its rivals going forward.

Be that as it may, the question still remains: Is the valuation right? Should we invest in this stock?

Priced just under 17 times earnings, ANN actually looks a little bit expensive relative to consensus projections for 12% long-term earnings growth. But the company's real problem is free cash flow. According to its most recent financials, ANN generated only about $51 million in real cash profits over the past year. That's barely half $95 million in GAAP net profit that ANN reported earning in the period. It's such a small number as to push ANN's price-to-free cash flow ratio up close to 30 -- far too high for a 12% grower.

Long story short, I still like ANN the business, and quite a lot. But with the stock up more than 20% off its lows of February, I cannot recommend ANN the stock.

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


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