Thursday'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 upgrades for oceangoing shipper DryShips (NASDAQ: DRYS  ) , and also for motion-detecting electronics-parts maker InvenSense  (NYSE: INVN  ) alike. The news isn't all good, however, so before we get to those two, let's find out why...

Abercrombie & Fitch is going out of style

The day dawned dark for shareholders of clothier Abercrombie & Fitch (NYSE: ANF  ) , which opened today down nearly $10 a share after reporting second-quarter earnings. Why the sell-off? Take your pick of the reasons:

  • Earnings per share of $0.14 were just half of the $0.28 expected.
  • Sales of $946 million were $50 million shy of what analysts had been expecting.
  • Same-store sales fell 10%, with especial weakness in the U.S.

Topping it all off, Abercrombie warned that third-quarter earnings will range between $0.40 per share and $0.45 -- both numbers well short of the $1.06 that Wall Street had expected Abercrombie to earn.

About the only good news that Abercrombie had to report was the fact that gross margins on its merchandise grew 160 basis points in comparison to last year, ending at 63.9%. Not that this helped net profits one whit.

Little wonder, then, that this morning, analysts at Janney Capital announced they were downgrading Abercrombie shares to neutral, reducing their price target to $40, and blasting management on its "lack of visibility on the turnaround." According to StreetInsider.com, Janney says it "no longer [has] confidence that the cost savings initiatives are sufficient to bolster top-line and have lost faith in the turnaround."

I have to admit, although I own Abercrombie & Fitch shares, after seeing these numbers, I'm starting to lose faith myself. Taking next quarter's earnings estimate as a given, and adding it to the numbers from the past three quarters, I get "current earnings" of about $2.31 per share for Abercrombie, and a P/E ratio near 17 -- too high for the company's anticipated 15% growth rate, and much too high a price to pay if Abercrombie keeps shrinking.

DryShips floats this analyst's boat
Moving on now to happier tidings, dry bulk shipper DryShips reported a $0.05 per-share loss earlier this month. That sounds bad, but it was actually $0.02 better than what analysts had been expecting. This news, plus anticipation of "potentially significant price appreciation" at the company's Ocean Rig UDW (NASDAQ: ORIG  )  subsidiary, has analysts at Imperial Capital feeling optimistic about DryShips. Imperial initiated coverage of the company this morning with an outperform rating and a $2.75 per-share price target. But here I have to disagree.

Neither DryShips nor its UDW subsidiary are currently profitable. Both carry significant debt loads -- $2.6 million net of cash at UDW; nearly $4.2 billion at DryShips. DryShips looks particularly unseaworthy, inasmuch as it has been burning cash consistently for the past three years, burned more than $515 million in the past 12 months, and is experiencing declining levels of operating cash flow as well.

Despite trading for only a fraction of its book value, DryShips' heavy debt load and inability to generate cash for shareholders tells me this is a company best to be avoided.

Sensing value at InvenSense
Wrapping up, we now turn to InvenSense, a maker of tiny electronic widgets that, for example, tell your tablet computer which way is up. InvenSense shares received a new buy rating from Needham & Co. this morning, which initiated the company at a $20 price target. According to Needham, "InvenSense offers investors a unique opportunity to capitalize on the rapidly expanding motion sensor capabilities found in mobile handsets as well as numerous other electronics devices. InvenSense has a winning technology approach that we believe will remain ahead of competitive offerings and extend its customer penetration from Samsung and smaller mobile handset vendors such as HTC, into other major opportunities such as Apple." 

Many other analysts agree. On average, Wall Street estimates that InvenSense will grow its earnings at 18.5% annually over the next five years. That's not a half-bad growth rate, albeit probably a little expensive given that the stock trades for 28 times trailing earnings today. The bigger problem at InvenSense is that its cash profits don't measure up to the earnings it's reporting under GAAP.

Trailing free cash flow at the company amounts to only $35 million -- about $0.64 per $1 reported as GAAP profits. This means that the company is trading for approximately 43 times free cash flow today. So even if analysts are right about the growth rate -- even if Needham is right about InvenSense's opportunities -- the price is still so high as to make it unlikely that InvenSense will "grow into its valuation" anytime soon.

Long story short: I like the company, I like the business, but I just can't recommend buying InvenSense at this valuation.

Fool contributor Rich Smith owns shares of Apple and Abercrombie & Fitch. The Motley Fool recommends Apple. The Motley Fool owns shares of Apple and InvenSense. 


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