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 upgrades for Wet Seal (NASDAQOTH: WTSLQ  ) and Johnson & Johnson (NYSE: JNJ  ) , balanced out by a downgrade on Sonoco Products (NYSE: SON  ) . Let's dive right in.

Put on a happy face
 Leading off with the "good" news, analysts at Dougherty & Co. this morning announced it's upgrading shares of retailer Wet Seal to "buy." Arguing that the company "is winning mindshare with its core teen customers and is pulling the right promotional levers to consistently drive traffic into stores," Dougherty says it expects the company to continue turning in good numbers, and believes the stock could be worth $5 within a year.

As quoted on this morning, Dougherty is extrapolating from sales weakness among other retailers, and theorizing that Wet Seal is stealing market share, and will continue to do so "in the near term and into the holiday season." Management at Wet Seal also may be planning to capitalize on this year's success by opening new stores, carrying the sales gains into next year as well. But even if Dougherty is right, does this make Wet Seal a good "buy?"

I'm not so sure.

Sales growth is all well and good, of course, but what Wet Seal really needs is profits. Last year the company lost more than $113 million, and it's currently losing money at the rate of about $96 million a year . Free cash flow at the firm, which has usually averaged between $20 million and $30 million in years past, is currently a negative $41.6 million. Meanwhile, if it's true that the company is growing sales when others (Aeropostale, Abercrombie & Fitch) are flagging, Wet Seal's revenue growth in the most recent quarter was still only 1.5% -- hardly a number to crow about.

Long story short, while it's entirely possible that Dougherty is right about Wet Seal being well on its way toward a turnaround, the numbers don't yet support the thesis. I'd be cautious about taking the analyst's advice on this one.

A Goldman-plated seal of approval
 Further good-ish news arrived today for shareholders of consumer and medical products giant Johnson & Johnson, as megabanker Goldman Sachs announced it was removing its "sell" rating from the stock. As Goldman explains it, "JNJ's pharma business has performed well this year, driven by strong launches of Xarelto, Invokana, and Zytiga." The analyst sees new launches of drugs ibrutinib and simeprevir keeping the momentum going in the near term, and says that "longer term, we anticipate FDA filings of several biologics, including daratumumab (FDA breakthrough designation), sirukumab, and siltuximab." All of this suggests that the drought of new drug ideas in Big Pharma -- or at least at Johnson & Johnson in particular -- may soon be ending.

And yet, even Goldman Sachs isn't ready to recommend actually buying the shares, which it upgraded only to "neutral." And I don't blame Goldman for its hesitation.

Priced at nearly 20 times earnings, Johnson & Johnson stock is hardly bargain-priced for the 6% long-term earnings growth that most analysts expect it to produce. Meanwhile, free cash flow at the firm -- nothing to sneeze at, at $12.5 billion annually -- still lags reported net income. As expensive as it looks when valued on GAAP earnings, Johnson & Johnson is even more expensive when valued on real free cash flow. I say that makes it too pricey to buy.

The Sonoco also sets
 Where I begin to differ with Goldman, though, is on its next rating -- the sell-rating that the banker just assigned to boxmaker Sonoco Products.

According to Goldman, it's mainly downgrading Sonoco on how the company compares to its peers. Goldman notes that earnings growth at Sonoco is expected to average only 7% annually through 2015, versus a 15% projected growth rate at the company's peers. The banker also points out that at 15.4 times its estimates for Sonoco's earnings in 2014, the stock costs a bit more than the average boxmaker, where valuations average closer to 14.6x earnings.

But here's the thing: Sonoco may have a high-ish P/E ratio relative to its peers, but it's also generating tons of cash. Free cash flow at the firm for the past 12 months approached $300 million, or roughly 45% more than the company reported as its net income under GAAP. Thus, when valued on free cash flow, the company actually sells for only about a 13.1x multiple, rather than the 15.4x P/E multiple that Goldman highlights in its downgrade report

Granted, even this lower valuation won't be enough to save the shares if all Sonoco can do is grow at 7% annually. But Sonoco is a quality firm, generating superb free cash flows, and reporting gross and operating margins on par with peers Bemis and Rock-Tenn. That being the case, I see little reason to expect the company to grow at only half the average rate in its industry, as Goldman and other analysts expect. To my Foolish eye, low-teens growth should be achievable for Sonoco, and combined with the firm's generous 3.2% dividend yield, that makes the stock's valuation of 13.1x FCF look quite attractive -- and unworthy of Goldman's "sell" rating.


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5/26/2016 12:50 PM
JNJ $113.00 Down -0.35 -0.31%
Johnson & Johnson CAPS Rating: ****
SON $47.23 Up +0.07 +0.14%
Sonoco Products Co… CAPS Rating: ****
WTSLQ $0.00 Down +0.00 +0.00%
The Wet Seal CAPS Rating: **