Monday'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 end-of-year upgrades for both Crocs (NASDAQ: CROX  ) and Walt Disney (NYSE: DIS  ) . But it's not all good news, so before we get to those two, let's take a quick look at why one analyst is...

Closing the book on Martha Stewart Living
 Shares of Martha Stewart Living Omnimedia (NYSE: MSO  ) have gained a clean 25% over the past two weeks, after new company CEO Daniel Dienst announced plans to lay off 75 employees and cut the company's annual costs by about $10 million. But according to analysts at National Alliance Securities, this is about as good as things are going to get. Accordingly, they've pulled their buy rating on the shares this morning, and downgraded to "hold." I think that's the right call.

Though the company is unprofitable today, analysts on average think Martha Stewart might earn perhaps a penny a share in 2014 -- giving the company what is in effect a forward P/E ratio of 425 at today's share price. Look two years down the road, and an anticipated per-share profit of $0.14 still has Martha Stewart trading for a 30 P/E, which seems pricey given long-term growth estimates of 15% annualized.

Free cash flow at the company is currently negative -- as it has been for the past five years running. On the plus side, if Dienst succeeds in cutting $10 million in costs, the company might turn FCF-positive. Based on current trends, however, a $10 million reduction in costs could just as easily leave the company still burning cash -- just less of it.

In short, while Dienst's promises sound encouraging, the easy money in response to these promises has already been made. But improving this business is easier said than done. Further gains will depend on execution, and a return to profitability and cash production at Martha Stewart -- and that's anything but certain.

A step up for Crocs 
Speaking of businesses that could use some improving: Crocs. The plastic-shoe maker scored an upgrade to "neutral" at Sterne Agee this morning after Blackstone (NYSE: BX  ) promised to invest $200 million in the company's convertible preferred stock, and CEO John McCarvel announced plans to retire in April.

Sterne thinks both events bode well for Crocs, and could spur cost-cutting as the company closes unprofitable stores and slows down spending on opening new ones. On the other hand, the analyst isn't particularly thrilled with Crocs' warning that fourth-quarter results will come in toward the low end of estimates -- as low as $200 million in sales, perhaps leading to a $0.25-per-share loss.

If that's how things play out, it will be a significant step down from the $0.04 per share that Crocs lost in last year's Q4. It will push trailing profits down to about $0.63 per share for the last 12 months, and push Crocs' P/E ratio up from 19 currentl, to more than 25. That's quite pricey for a firm that analysts doubt will be able to grow its profits at much more than 10% annually over the next five years. And with free cash flow closely tracking reported earnings at Crocs, the price-to-free cash flow equation won't look much prettier.

In short, the only way Crocs deserves even its new, lower rating of "neutral" is if you believe that Blackstone's influence on the corporation can result in both significant cost-cutting, and simultaneous stronger earnings growth. I think that an unlikely scenario. Sterne's downgrade to only "neutral" may not be going far enough.

Upgrading the House of Mouse
Finally, and in what may turn out to be the final upgrade of the Year 2013, we turn to Walt Disney and the upgrade it just received from Guggenheim.

As related on StreetInsider.com this morning, Guggenheim has upped its recommendation on Disney to "buy," and raised its price target. Citing "positive momentum" from Disney's Marvel, Pixar, and Star Wars brands, and strong performance already from the films Thor 2 and Frozen, Guggenheim argues that Disney shares, which currently cost only $76 apiece, could be worth $87 within a year.

I disagree.

While most analysts are of the same opinion as Guggenheim as far as Disney having strong prospects goes, the average guess at long term annual earnings growth still sits south of 15%. That's not fast enough to support Disney stock's 22.5 P/E ratio -- not even with free cash flow running 8% ahead  of reported GAAP earnings.

Given the stock's strong position in the entertainment space, Disney may be worth its premium 1.5 PEG ratio. Maybe. But the stock's still selling for a premium, and that's the direct opposite of the kind of bargain-basement valuation that Wall Street should be guiding investors toward. I wouldn't buy Disney until there's an argument to be made that the stock is actually "cheap" -- and we're simply not there yet.

Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool recommends Walt Disney. The Motley Fool owns shares of Crocs and Walt Disney.


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    Content is King. And who is the King of Content? It's going to keep going up. For good reason.

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