Wednesday's Top Upgrades (and Downgrades)

Analysts shift stance on Sturm, Ruger, Smith & Wesson, and Ambarella.

Jan 8, 2014 at 1:02PM

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 gun makers Sturm, Ruger (NYSE:RGR) and Smith & Wesson (NASDAQ:SWHC) -- both recipients of new buy ratings this morning. But the news isn't all good, everywhere. Before we get to those two, let's take a quick look at why ...

Ambarella just crashed
Following a report detailing insider selling at Ambarella (NASDAQ:AMBA) earlier this week, and a downgrade of the stock to hold by Needham & Co. earlier this morning, shares of the high-def "system-on-a-chip" semiconductor maker are plunging, down nearly 8% at last report. Should investors be worried?

Not necessarily -- but probably. On one hand, the fact that insiders at Ambarella are selling will certainly annoy investors, and maybe even shake them up a bit, suggesting as it does that insiders might "know something they don't." Keep in mind, though, that statutorily defined insiders still control 43% of the stock of this company. That's a heck of a lot of skin in the game, and the fact that this number got slightly smaller on Monday really shouldn't be too much cause for concern.

What is of more concern, to me at least, is the valuation on this stock. After rising some 40% in response to December's news that Ambarella has developed a new chip for use in wearable cameras, the shares are looking mighty pricey today at a valuation north of 40 times earnings, and nearly seven times sales. Free cash flow at the company is strong, but still lags reported earnings by a few percentage points. And with analysts projecting profits growth in the neighborhood of 22% annualized over the next three years, it's hard to see why a 40 times multiple to earnings, and an even higher multiple to FCF, would be justified.

Long story short, the stock's overpriced -- and Needham's right to downgrade it.

Have gun, will travel (up)
Moving on now to the day's happier news, shareholders of gunsmiths Sturm, Ruger, and Smith & Wesson are enjoying modest gains in their stocks in response to a pair of new "initiations at buy" from the analysts at CRT Capital.

According to CRT, shares of Smith & Wesson are bound to reach $16 by the end of this year, and Ruger could hit $85. If the analyst is right, that would work out to about a 14% gain for S&W shareholders, 7.5% for Ruger (plus a 3.4% dividend yield, so closer to 11% total). Personally, I think the analyst is likely right.

Valued at less than 11 times earnings today, Smith & Wesson shares look attractively priced for the 30% annualized profits growth that Yahoo! Finance is predicting. They're even cheap relative to the more modest 13% growth rate quoted on S&P Capital IQ.

Ruger, in contrast, costs a bit more than S&W at 14.5 times earnings -- and is growing either faster or slower than its rival depending on which analysts you choose to believe. (S&P Capital IQ, for example, projects 13.5% annualized earnings growth at Ruger. Yahoo! Finance doesn't hazard any guess at all.) Factor in the 3.4% dividend yield and Ruger also looks underpriced for its prospects.

Beware of misfires
Is there risk in the stocks? Of course there is. There always is. For one thing, free cash flow at both Ruger and S&W looks weak lately. Based on data from the firms' respective cash flow statements, Ruger is currently generating only about $0.68 in real free cash flow for every $1 in earnings it reports under GAAP. Smith & Wesson is likewise churning out $0.68 in cash profits for each $1 of net income it reports.

This fact suggests that neither stock is quite as profitable -- or as cheap -- as it looks, and bears careful watching to make sure that FCF catches up to reported earnings and not the other way around.

Also worth noting: Earlier this week, analysts at KeyBanc pointed out that NICS data on handgun background checks run by the FBI in December (indicative of handgun purchase activity in the U.S.) was down 32.5% year over year against December 2012. That means that as a whole, Q4 background checks were down about 19.4% year over year. Even worse, KeyBanc noted that it seems to be seeing "a heightened promotional environment (the likes of which have not been seen for several quarters now)" among gun sellers. This, in turn, suggests that profit margins on the few guns that were sold last quarter may not have been all that great.

While the KeyBanc warnings don't necessarily upset the buy case for S&W and Ruger stock, they do bear consideration. At the very least, investors considering putting money in these two stocks should make sure to be ultraconservative in deciding which analyst growth estimates to believe and base their buy/sell decisions upon. In other words, if given a 30% and a 13% growth rate for Smith & Wesson and then asked to choose one to believe in, err on the side of caution: Pick 13%.

Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool recommends Ambarella. The Motley Fool owns shares of Ambarella. 

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