Thursday's Top Upgrades (and Downgrades)

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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 a new buy rating for Williams-Sonoma (NYSE: WSM  ) and a price target improvement for Deckers Outdoor (NYSE: DECK  ) . On the other hand...

No one's envying NVIDIA
Thursday's dawning gray and cloudy for shareholders of graphic chip specialist NVIDIA (NASDAQ: NVDA  ) , as the shares get walloped by a 3% decline after being downgraded by Canaccord Genuity. Earlier this week, NVIDIA unveiled its new Tegra K1 mobile gaming chip at the Consumer Electronics Show in Vegas, trying to prove that its Tegra business has staying power -- but Canaccord isn't convinced.

Arguing that there's little chance of earnings exceeding estimates, and therefore little upside to the shares, Canaccord cut its rating on NVIDIA stock to "hold," while maintaining a $16 price target. But if you ask me, Canaccord is missing the point.

Sure, I have to agree with Canaccord that NVIDIA doesn't look attractive on the surface. Its current P/E ratio of 20.6 would be too high for the 11% long-term growth that analysts expect out of the stock... if that were the end of the story. But it isn't.

Dig a little deeper into NVIDIA, and you'll discover that this stock generates so much more cash than it reports as net income and boasts a balance sheet flush with so much more cash as to make the stock a real bargain. Trailing free cash flow at NVIDIA for the past 12 months approached $650 million, which, on the stock's current $9 billion market cap, works out to a price-to-free cash flow ratio of less than 14. So already, that looks like a fair price to pay for a stock with 11% growth prospects and a 2.2% dividend yield.

What's more, if you factor NVIDIA's $3 billion in cash (and next-to-zero debt) into the picture, NVIDIA's enterprise value-to-free cash flow ratio works out to an even cheaper 9.1 ratio -- an absolute steal if the company achieves 11% growth and maintains that 2.2% divvy. Long story short, I liked NVIDIA as a value stock before Canaccord's downgrade -- and I like it even more at the cheaper price the shares sell for after the downgrade.

How shiny is Sonoma? 
So much for the "bad" news of the day. Now let's turn to the "good," beginning with home furnishings store Williams-Sonoma. This morning, analysts at Argus Research upgraded shares of Williams-Sonoma from hold to buy, and assigned a $68 price target to the stock. I think they're wrong about that, and I'll tell you why.

Curiously, considering their divergent areas of business, Williams-Sonoma seems to bear a lot of resemblance to NVIDIA from a valuation perspective. Its 20.8 P/E ratio and 2.1% dividend yield are both remarkably similar to the valuations we find at NVIDIA. Meanwhile, Williams-Sonoma's 13.7% projected earnings growth rate actually outpaces the 11% expected of NVIDIA.

So far so good. But here's where the story takes a turn for the worse. With only $216 million in trailing free cash flow, Williams-Sonoma's cash profits lag its reported GAAP income of $279 million rather badly. For every $1 of "profit" that Williams-Sonoma says it's earning, the company's actually generating only about $0.77 in cash.

Viewed from this perspective, Williams-Sonoma actually appears to cost more than its P/E ratio implies, rather than less -- a whopping 25.8 times free cash flow. Even on a near-14% growth rate, that's too much to pay for Williams-Sonoma stock, and Argus is wrong to recommend that investors buy it.

Decking the halls
Finally, we come to Deckers Outdoor, maker of the popular UGG brand fleece-lined boots -- and by now, much more than boots. Few investors today would still argue that UGGs are a fad, and the company behind them doomed to fail. But that doesn't necessarily mean that today's ratings move, a $20 increase in price target from Canaccord Genuity (yes, them again) is right.

Let's take a quick look at the valuation here, and see if this pair of UGGs is really as good of a deal as Canaccord seems to think.

At nearly 30 times earnings, Deckers shares look overpriced based on analyst expectations that the company will only be able to grow earnings in the high single digits over the next five years. The good news is that Deckers isn't quite as overvalued as it looks, given that free cash flow at the firm ($116 million) exceeds reported net income ($103 million) by a good margin. The bad news, however, is that the shares are still overvalued enough to throw Canaccord's improved price target into question.

Even $116 million in positive free cash flow isn't enough to make these shares look attractive, you see -- $116 million in free cash flow only gets Deckers shares down to about a 26 times P/FCF valuation, and at 9.4% projected growth, that's too much to pay for the stock. Meanwhile, in its last earnings quarter, Deckers reported that its earnings actually declined 23% -- so the numbers here are getting worse, not better.

Long story short, with Deckers shares having more than doubled in 2013, I think now's a great time to start thinking about taking profits -- not hoping against hope that these overvalued shares will somehow become even more overpriced in the future. 

Fool contributor Rich Smith owns shares of NVIDIA. The Motley Fool recommends NVIDIA and Williams-Sonoma.

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Rich Smith

As a defense writer for The Motley Fool, I focus on defense and aerospace stocks. My job? Every day of the week, I'm monitoring the news, figuring out the winners and losers, and tracking down the promising companies for you to invest in. Follow me on Twitter or Facebook for the most important developments in defense & aerospace, and other great stories.

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Related Tickers

4/1/2015 12:46 PM
DECK $74.30 Up +1.43 +1.96%
Deckers Outdoor Co… CAPS Rating: ***
NVDA $20.91 Down -0.02 -0.07%
Nvidia CAPS Rating: ****
WSM $78.62 Down -1.09 -1.36%
Williams-Sonoma CAPS Rating: ***