Thursday'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, as the U.S. Commerce Department laments a seasonally adjusted 0.4% decline in retail sales in the U.S., we'll take a look at a few recommendations from Nomura Securities on how to play the news. Nomura is advising investors to buy Tiffany (NYSE: TIF  ) on the high end of retail and Wal-Mart (NYSE: WMT  ) on the low, but thinks that it's...

Probably time to sell J.C. Penney
"Bad" news first. Last week, department store chain J.C. Penney (NYSE: JCP  ) told investors to expect 2% same-store sales growth when it reports earnings later this month. Wall Street initially reacted poorly to the news, selling off Penney stock, but over the past week, a miracle happened. Despite no new good news appearing to support the stock, Penney shares soared 17% to a recent high near $6.

Crazy? No doubt. But according to Nomura, this remarkable rise in Penney shares is a gift horse whose teeth need no examining. Warning that "a sales and market share recovery will take much longer than many may anticipate," and that "the J.C. Penney customer has migrated to other department stores and off-price retailers" and won't soon return, Nomura is recommending that investors get while the getting is good, and "reduce" their positions in the stock before any more bad news surfaces.

I agree. Over the past 12 months, J.C. Penney has burned through $2.5 billion in free cash flow, and booked GAAP losses of $8.66 per share. The shares themselves are worth less than Penney lost last year! Meanwhile, Nomura expects nearly as poor results in the current year -- a $3-per-share loss on further revenue declines.

Simply put, this company is a hot mess, and more likely to go under than to go up -- and Nomura is right to downgrade it.

Tiffany is shiny
In contrast, way up at the far end of the retail chain, Nomura sees great things ahead for Tiffany investors. Initiating coverage of the high-end jeweler with a buy rating and a $100 price target, Nomura argues that "after its encouraging performance in 2013, Tiffany is well positioned for another year of solid momentum, achieving perhaps $3.76 per share when 2013 earnings come out, and then growing that a further 14% to $4.30 per share in 2014."

Quoted on StreetInsider.com today, Nomura praises Tiffany's decision to implement its "first price increases in more than a year," and predicts that the company will "slowly and methodically increase price points" going forward, growing profits in tandem.

But here's the thing: At a P/E ratio of 24.5, the "price point" on Tiffany's stock already seems to take this profits growth for granted. More than that, I'd argue that 24.5 times earnings is too much to pay for the 14% growth that Nomura sees happening this year, and much too much to pay for the 12% long-term growth that is the consensus among analysts who follow the company. The more so because, judging from the company's cash flow statements, Tiffany's quality of earnings is not especially high.

Over the past year, the company has generated barely $301 million in real free cash flow, despite reporting earnings of nearly $465 million. That's about $0.65 in cash profits for every $1 of claimed "earnings." And it's the key reason I'm ignoring Nomura's advice on Tiffany and avoiding this stock.

Time to roll back into Wal-Mart?
And finally, shifting back toward the low end of the retail spectrum, we end with Wal-Mart -- and a situation similar to what we see at Tiffany, but worse.

Priced at 14.5 times earnings, Wal-Mart looks at first glance a lot cheaper than Tiffany, I'll admit. But looks are deceiving here for a couple of reasons. Unlike Tiffany, Wal-Mart carries a boatload of debt on its books -- about $53 billion net of cash. Like Tiffany, it's having real trouble converting its GAAP earnings into the kind of cash it would need to pay down that debt. Earnings for the past year totaled $17.2 billion at Wal-Mart, but free cash flow came to just $9.5 billion -- about $0.55 on the earnings dollar.

Even if Wal-Mart's valuation didn't already look egregiously out of whack at 14.5 times earnings on a projected 8.5% growth rate (which it does), and even if the company were not wallowing in debt (which it is), that free cash flow number would be enough to scare me away from the stock.

And as for Nomura's suggestion that the stock's a buy and will hit $85 within a year thanks to "e-commerce business and an uptick in traffic in the U.S. stores?" Sorry. I don't buy it.

Motley Fool contributor Rich Smith has no position in any stocks mentioned, and neither does The Motley Fool.

 


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