This series, brought to you by Yahoo! Finance, looks at which upgrades and downgrades make sense, and which ones investors should act on. Today, in honor of the holiday shopping season, we'll be covering a pair of retailer recommendations -- Cabela's (NYSE: CAB ) and American Eagle Outfitters (NYSE: AEO ) -- both just upgraded to buy. But before we get to those two, there's a burning question we must address:
Who doesn't love Post-it Notes?
And 3M (NYSE: MMM ) makes Post-It notes, so it follows that everyone must love 3M, right? Well, apparently not -- because just this morning, Morgan Stanley downgraded 3M from "neutral" to "underweight."
Pointing out that 3M has had a great 2013 so far, and outgrown the S&P 500 by nearly 10 full percentage points over the past year, Morgan Stanley worries that the industrial conglomerate is heading for a period of "EPS underperformance and multiple compression through 2014," which will cause it to lag the other big Dow stocks. And Morgan Stanley could be at least half right about that.
I don't personally know what Morgan Stanley means when it says that earnings per share will "underperform" -- or whom or what they will be underperforming. But it seems to me that the thesis that 3M is due for "multiple compression" does hold water. Priced at 20 times earnings today, the stock is only expected to post earnings growth of about 10% annually over the next five years. That alone suggests that the stock's multiple to earnings should be lower than it is today.
Plus, 3M is currently generating only about $0.86 in real free cash flow for every $1 of earnings that it claims under GAAP -- so the "quality" of earnings here is no great shakes, either. This, too, would appear to warrant a lower multiple to earnings.
Long story short, while it's a fine business, 3M currently "suffers" from a stock price that's just too high to justify. That stock price is likely to fall, and Morgan Stanley is right to warn investors away from 3M stock before it's too late.
Can fast growth save Cabela's?
Moving on now to the retailers: The Wall Street Journal is reporting today that Black Friday was basically a bust, with post-Turkey Day retail sales falling 2.7% year over year -- the first time in seven years that sales have fallen over the shopping weekend. Given this news, it seems a strange time for analysts to be singing the praises of retailers. Yet that's just what we're seeing today.
Stifel Nicolaus, for example, just upgraded shares of fast-growing Cabela's to "buy," assigning an $86 price target in the process. They may regret the decision, however. While it's true that Cabela's is growing faster than many of its peer sporting goods retailers, this growth comes at a high price.
Cabela's shares cost precisely 22 times earnings today, according to Yahoo! Finance figures. Yet according to S&P Capital IQ, the company generates no free cash flow whatsoever. Rather, Cabela's burned through $76 million over the past 12 months as it continued to build out its store base. The company's also carrying nearly $3 billion in debt -- for the same reason.
Both these facts leave me wondering whether 17% projected "earnings" growth at the company is worth paying a premium for -- and I'm inclined to say no.
Will American Eagle soar?
Finally, over at Janney Capital, they just upgraded shares of American Eagle, rating the stock a "buy" and assigning a $20 price target on the theory that a "stabilizing promotional environment" will lead to improved profits in 2014. The analyst isn't looking for an immediate turnaround, mind you, cautioning that it could take a couple of quarters before AE's numbers start to reflect improvements in its operations. Still, Janney calls AE "best-positioned in fashion and value among the 'three As.'" Better than Abercrombie & Fitch. Better than Aeropostale. And best positioned to profit from its rivals calling a halt to the price wars.
And Janney might be right about that. With $262 million in trailing free cash flow , versus only $221 million in reported "GAAP" earnings, and $405 million in the bank (with no debt), AE looks less like a "15 P/E stock" to me, and more like a company trading for an enterprise value of just 10.2 times its annual cash profit. That's plenty cheap for the company's 9% projected growth rate, once you factor in a 3.1% dividend yield.
In contrast, Aeropostale at last report was running free cash flow negative. Abercrombie, while generating strong free cash flow according to its last four reported quarters, has not yet updated investors on its most recent quarter's cash flow figures -- so we cannot be certain that is still the case.
Result: We can't be sure that the valuation at Abercrombie is as cheap as it looks. We can be certain, though, that American Eagle is selling for a good price -- and that Janney is right to recommend it.
Fool contributor Rich Smith owns shares of Abercrombie & Fitch. The Motley Fool recommends 3M.