Tuesday'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 retailers Big Lots (NYSE: BIG  ) and lululemon athletica (NASDAQ: LULU  ) . Not all the news is good, however, so before we get to those two, let's take a quick look at why...

Weight Watchers just shed 50% (of its target price)
Shares of weight-loss company Weight Watchers (NYSE: WTW  ) got hammered last week after last quarter's earnings numbers came in lighter than predicted. Weight Watchers earned $0.54 in the fourth quarter, $0.07 shy of estimates. On the plus side, revenues at Weight Watchers actually exceeded expectations.

So good news and bad news. What tipped the scales against Weight Watchers last week, though, was the company's forecast that it will earn only about $1.45 per share this current year -- barely half the $2.78 per share that Wall Street expected.

Weight Watchers shares shed 28% of their value in response to the bad news last week. They're down a further 4% today in response to a downgrade from Barclays Capital -- and that's the good news. The bad news is that, according to Barclays, Weight Watcher shares could fall another 30% over the course of the next year, en route to a new target price of $15 per share (half its prior target of $31). In anticipation of this sad fate, Barclays now rates the stock -- ironically -- underweight. But is that the right call?

It's hard to say. On one hand, Weight Watchers' profit number was certainly a disappointment. For the second year in a row, it fell, this time landing at $205 million, net. Free cash flow also appears to be down. Weight Watchers has not yet released a full cash flow statement, but it did admit to generating only $323 million in cash from operations (another decrease). Assuming capital expenditures similar to the $49 million the company spent in 2012, that would work out to $274 million in free cash flow.

On the other hand, though, valued on earnings, Weight Watchers now sells for less than six times trailing profits. Valued on free cash flow, it's even cheaper at a multiple of just 4.4 times FCF! Even taking the company's sizable debt load ($2.4 billion) into account, these are pretty cheap valuations. Considering how much the stock has fallen already, I'm almost tempted to think it can't fall much further than this.


Is Lulu a lemon?
In contrast, one stock I'm certain has further room to fall is yoga-wear maker Lululemon. Citing growth initiatives being undertaken by new management, analysts at Oppenheimer upgraded the stock to outperform this morning. Arguing that the company is set to grow both its top and bottom lines, Oppy calls the stock "compelling" with "premium positioning" and "intact" brand equity despite recent missteps -- and predicts the shares will hit $63 within a year.

If they're right about that, then Lululemon is a 21% profit opportunity. Now here's why I think they're wrong: Priced at 27.5 times earnings today, it needs to grow its profits at a percentage rate somewhere in the mid-20s to justify its current valuation. Most analysts agree, however, that the company will be lucky to achieve even 18% annualized earnings growth.

That's the good news. The bad news is that if you examine the company's cash flow statement, you'll notice that actual cash profits at Lululemon don't add up to the GAAP earnings the company reports -- not even close. In fact, while it was reporting $279 million in "profits" last year, it generated only $169 million in real free cash flow. As a result, even the 27.5 P/E you see on the stock may be giving Lululemon too much credit. I think it's more accurate to say that the stock is selling for more than 44 times free cash flow -- and thus still overpriced for 18% growth.

Accordingly, I believe Oppenheimer is wrong to recommend the stock.

Big Lots, bigger opportunity?
So what should you buy instead? If they may be so bold, Deutsche Bank would like to suggest you take a look at brick-and-mortar overstock retailer Big Lots. Citing the stock's steep 32% fall in share price over the last three months and 10% short interest, Deutsche paints the company as a potential candidate for a short squeeze -- if management can get the company back to earning "at least its historical earnings power of ~$3.00."

Deutsche could be right about that, but I wouldn't bet on it.

Already, Big Lots is earning about $2.79 per share. An improvement to $3, such as Deutsche is targeting, wouldn't be too much of a stretch. And yet, at today's valuation of nearly 10 times earnings, or 12 times free cash flow, Big Lots needs to grow at something close to the 12% annual average growth rate predicted for the retail industry in general, in order to justify even today's share price -- much less the $33 target that Deutsche is assigning the stock.

Instead, most analysts predict the company will average less than 4% earnings growth over the next five years. Plus, even Deutsche admits that Big Lots is likely to miss earnings at its next report -- so that expectation of 4% long-term growth could actually be optimistic, rather than conservative.

Long story short, the shorts may not be as wrong about this stock as Deutsche thinks.

Rich Smith has no position in any stocks mentioned. He sometimes, but not always, disagrees with his fellow Fools. Case(s) in point: The Motley Fool owns shares of Weight Watchers International, and it also recommends lululemon athletica. 



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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

8/28/2015 4:01 PM
BIG $48.58 Up +6.58 +15.67%
Big Lots CAPS Rating: ***
LULU $63.17 Up +0.53 +0.85%
Lululemon Athletic… CAPS Rating: ***
WTW $5.98 Up +0.16 +2.75%
Weight Watchers In… CAPS Rating: **