Wednesday'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 scatter to three of the four winds, with one analyst downgrading biotech ViroPharma (NASDAQ: VPHM  ) , another cutting its price target on educator K12 (NYSE: LRN  ) , but a third singing the praises of restaurateur Ruby Tuesday (NYSE: RT  ) . Let's start with the good news first.

Hello, Ruby Tuesday! 
The day dawned bright for shareholders of Ruby Tuesday, as analysts at B. Riley initiated coverage of the stock with a buy rating. As StreetInsider.com confirmed this morning, Riley is predicting the stock, currently at $7 and change, could reach $10 within a year.

Riley believes that sales declines at a restaurateur have "troughed" and are poised to grow as "the economy improves and the new menu/media platforms take hold." The analyst is placing a lot of faith in a "relatively new management team to deliver a consistent guest experience," however. Is it possible that Riley is jumping the gun?

Unprofitable at last report, and slightly free cash flow-negative to boot, Ruby Tuesday currently has no P/E ratio, and sells for nearly 40 times what analysts believe it will earn next year. To me, that hardly sounds like the kind of stock that investors should be rushing to buy. All that said, it bears mentioning that Riley has picked a curious time to recommend buying Ruby Tuesday -- just hours before the company reports earnings. Investors who choose to follow its advice now could find themselves quickly disappointed within just a few hours ... unless, that is, Riley knows something that the rest of us do not. Tune back in after the close to find out.

"Learn" from their mistakes
Turning now to the field of for-profit education, K-to-12 educator K12 shocked its shareholders last night with news that fiscal first-quarter 2014 average student enrollments increased only 5.7% in comparison to first-quarter 2013, which was considerably slower than management had been guiding previously. K12 now expects that full-year revenues will range between $905 million and $925 million, with operating profits ranging from $53 million to $57 million.

This news sparked a series of analyst downgrades this morning, as each of BMO Capital, R.W. Baird, and Merrill Lynch lowered their ratings to various flavors of "neutral." Cutting its price target nearly in half, to $22, BMO in particular noted that without any "near-term catalysts" visible, it's beginning to fear that the "short-seller thesis about slowing enrollment growth may be only beginning to play out" -- and things could get worse before they get any better at K12.

I fear they're right.

Priced at more than 23 times earnings even after this morning's sell-off, K12 shares depend greatly on the company's ability to achieve analyst targets of 23% annualized earnings growth to justify their valuation. Now that the company's ability to hit these targets has been called into question -- and called into question by the company itself -- the valuation really is starting to look problematic.

ViroPharma is looking sicker
Shares of biotech ViroPharma have been on a wild ride lately. Reports that larger pharmaceutical companies Sanofi and Shire may be interested in buying the company sent ViroPharma stock soaring 30% last month. Now, however, analysts at Mizuho Securities say it's "unclear" whether that buyout will ever happen -- and warn that the shares may be overvalued if it doesn't.

They're right to worry.

Even with ViroPharma pegged for a healthy 27% long-term earnings growth rate, the shares look expensive with no trailing P/E to speak of, and a forward P/E of more than 50. Free cash flow at the company, formerly one of ViroPharma's great advantages, has been declining for years, and now sits firmly in the red -- $24.5 million in FCF burnt over the past year.

While it's entirely possible that Sanofi or Shire will eventually ride to the rescue of ViroPharma investors, there's still a big risk of being stuck with an overvalued stock if they don't. I believe Mizuho is correct in advising caution, and downgrading shares to neutral. The only question in my mind is whether the analyst should have gone one extra step and told investors to sell.

Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool recommends K12. 


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