This series, brought to you by Yahoo! Finance, looks at which upgrades and downgrades make sense, and which ones investors should act on. Today, an ebullient stock market is giving way to worries about valuation, as analysts downgrade Twitter (NYSE: TWTR ) and The Pantry (NASDAQ: PTRY ) on concerns about their valuations. Elsewhere in the market, however, one analyst imagines it sees...
A bargain floating Westlake Chemical
Here in the waning days of 2013, most analysts are taking a break from their daily stock-picking ritual, and with stocks up 25% this year, maybe they deserve it. But over at Susquehanna Securities, they've decided to rush out one final upgrade of the year, and they gave it to Westlake Chemical (NYSE: WLK ) .
Priced north of $120 a share today, Westlake shares have already doubled the S&P 500's gains in 2013, rising more than 52% year to date. They've exceeded Susquehanna's expectations, too, surpassing the analyst's prior $118 price target. It's perhaps understandable, then, that Susquehanna is feeling "positive" about the stock, and thinks it may continue to outperform the market.
It's understandable -- but wrong.
According to Susquehanna, Westlake shares are primed to outperform, and will rise a further $27 over the next 12 months, to hit $145 per share. Yet the stock already costs more than 15 times earnings. Worse, most analysts agree that these earnings have just about peaked, and are only likely to expand at about 6% annually over the next five years.
Now, paying 15 times earnings for 6% growth is not a particularly attractive value proposition. It looks even less attractive when you consider that Westlake has very low quality of earnings. Free cash flow at this company has lagged reported net income in four of the past five years. Over the past 12 months, FCF amounted to a mere $30 million -- less than 6% of reported net income.
Susquehanna may think that all these numbers add up to a "positive" future for Westlake. I disagree.
Fortunately, not all analysts are as sanguine as Susquehanna seems to be about the market run-up. In isolated instances, at least, we're starting to see more and more bankers come to the realization that stocks can't go up forever -- and try to warn investors away before it's too late. The latest such warning: Twitter.
This morning, analysts at Macquarie highlighted the 182% post-IPO run-up in shares of microblog site Twitter as evidence of market frothiness, and changed its rating on the stock from "neutral" to "underperform." While impressed with Twitter as a business, and sure the company has a "bright future," Macquarie worries that the stock has gotten a bit ahead of itself. As StreetInsider.com reports today, Macquarie notes that since it began following the stock in December, literally nothing has happened "to justify the 40 percent surge" in Twitter's stock price. The analyst sees this unjustifiable run-up as a catalyst for a stock price decline even absent external events, and I agree.
This morning, The Wall Street Journal also ran a story on the Twitter run-up, attributing the stock's rise largely to momentum traders who buy the stock because "they think others will do the same." This self-reinforcing trend works both ways, however. If Twitter investors discover that the stock can go down as well as up, they may begin selling -- likewise because "they think others will do the same," and hope to beat the rush. In so doing, they may actually precipitate a rush to the exits.
As the Journal quoted an investor saying: "I have my hands on the sell button. If it goes down, I'm out of here."
I think that says it all.
Clearing out (of) The Pantry
Finally, in our last "too far, too fast" ratings-change story of the day, we find analysts at Benchmark shying away from convenience store operator and quick-serve restaurateur (or QSR) The Pantry. The stock's up 45% so far this year, and like the other stocks mentioned so far, running pretty far ahead of the market. Today, Benchmark declared that enough is enough, and cut its rating from buy to hold.
Explaining its move, Benchmark opined, "We believe consumer spending could be under pressure in 2014 due to increased healthcare costs." This plus a valuation that the analyst describes as "full" suggest there's little reason to expect further gains in the stock price.
That said, Benchmark seems reluctant to curb its enthusiasm too much. At the same time as it cut its rating, Benchmark increased its price target on the stock to $18, explaining that "merchandise comps continue to improve," while the expansion of the QSR business promises "to triple the amount of QSRs over the next couple years, driving traffic, revenue and margin."
So which is it? Is The Pantry a story of incredible growth and expanding margins, or is it a story of a too-expensive stock?
It really could be either. On one hand, I find it hard to recommend a stock like The Pantry, which carries an incredible amount of debt relative to its market cap, is currently unprofitable, and sells for nearly 20 times what it's supposed to earn next year. On the other hand, 20 times earnings may not be too much to pay for the supposed "48%" long-term earnings growth we're told by Yahoo! Finance to expect. And The Pantry is generating a sizable amount of free cash flow today -- $40 million over the past 12 months.
At a valuation of 10 times free cash flow, or even 30 times free cash flow once you factor its debt load into the equation, that supposed growth rate suggests that The Pantry remains cheap enough to buy. But only if that growth materializes. Given that the average stock in this industry is only expected to grow earnings at one-third the pace promised for The Pantry, though, I have to say I'm skeptical.
Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool recommends Twitter.