Friday's Top Upgrades (and Downgrades)

Analysts shift stance on Alaska Air, Southwest Air, and Arctic Cat.

Jan 24, 2014 at 10:51AM

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 improved price targets for airlines Alaska Air (NYSE:ALK), and Southwest Airlines (NYSE:LUV) as well. But the news isn't all good. Before we get to those two, let's take a quick look at why one analyst is...

Putting Arctic Cat in a bag
Snowmobile and ATV manufacturer Arctic Cat (NASDAQ:ACAT) shocked the market yesterday, reporting fiscal Q3 2014 earnings of just $0.89 per share -- 32% below year-ago levels, and 33% short of the Wall Street consensus. Responding to the bad news, investors shaved 11% off of Cat's market cap -- and they're bidding the shares down once again this morning, with Arctic Cat off a further 5.5%.

It's not helping matters that analysts at Raymond James just cut their ratings on Arctic Cat by two notches -- from strong buy to market perform -- withdrawing their endorsement of the stock, and removing their price target as well. So how should shareholders react to this news?

It depends. Even factoring in yesterday's disappointing profits, Arctic Cat shares still cost only 17 times earnings, which seems cheap for a company expected to grow profits at 20% annually over the next five years. On the other hand, Arctic Cat did not deign to reveal its cash flow number to shareholders yesterday, with CEO Claude Jordan saying only that the company expects to generate at least some "positive cash flow this fiscal year." That vague promise is hardly encouraging, and the lack of a hard number on how the company has performed to-date makes it even less encouraging.

Granted, forward guidance now calls for Arctic Cat to earn at most $3 per diluted share this year -- down about 11% from the most optimistic previous guidance, but sufficient to imply a 15 times valuation on the stock if Arctic Cat can hit its target by year's end. If the company can hit that target, and then claw its way back into the 20% growth path that Wall Street has set for it, the stock could well be a buy after its sell-off. But unless and until Arctic Cat gives us some clarity on the quality of its earnings, and specifically, on its free cash flow, I can't recommend the stock. If you ask me, Raymond James is right to be cautious.

Better news greeted shareholders in airlines Alaska Air and Southwest this morning -- both of which "beat earnings" yesterday, and both of which are seeing their stock prices lifted this morning as a result. Let's take them in alphabetical order, beginning with Alaska Air.

Alaska Air has wings
Reporting $1.10 per share in fiscal Q4 profit yesterday, Alaska Air topped analyst estimates by $0.03, and beat on revenues as well. CEO Brad Tilden credited "award-winning customer service, industry-leading on-time performance, and solid execution by our outstanding people" for putting an exclamation point on Alaska Air's "best year ever."

The CEO's enthusiasm seems contagious, with both Cowen & Co. and Imperial Capital upping their target prices on the stock (which both rate it as outperform), to $95 and $90 per share, respectively. And judging from the stock's valuation, they're right to get excited.

With $7.16 per share in diluted earnings for the year (up 63% from 2012), Alaska Air shares now sell for just 11.4 times earnings -- a clear bargain price for the stock's projected 12.2% long-term-growth rate. And Alaska Air pays its shareholders a 1.3% dividend yield, to boot.

While it would be nice to see a cash flow statement on this one as well, for the time being, conditions look "green" for Alaska Air to fly higher.

And so does Southwest
The granddaddy of discount airlines, Southwest, reported a similar "beat" yesterday, earning $0.33 per share in the fourth quarter where only $0.29 had been expected. This sparked a second hike in price target from Cowen (no word yet from Imperial Capital), which now predicts Southwest shares will hit $26 per share by year end.

Cowen could well be right about that. At just under 20 times earnings, Southwest shares may not look as cheap as Alaska Air's, but looks can be deceiving. In contrast to its peer, Southwest has already released cash flow information for the year 2013. What this tells us is that Southwest is doing even better than its GAAP numbers suggest.

Despite reporting "net income" of only $754 million for the year, Southwest generated more than $1 billion in real free cash flow from its business. As a result, the stock's true valuation is probably better reflected by its 14.3 times free cash flow number, than by the more standard "P/E" ratio of 20 most investors will look at.

Meanwhile, analysts who follow the company are predicting long-term-growth rates of anywhere from 21.4% annually (S&P Capital IQ) to 39.9% (Yahoo! Finance). Which number is right? It hardly matters. Either of those numbers will do quite nicely to justify today's stock price. Either growth rate is quite fast enough to make Southwest Airlines stock a buy.

Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned.

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