Wednesday's Top Upgrades (and Downgrades)

Analysts shift stance on Ericsson, Pandora, and Staples.

Mar 5, 2014 at 2:44PM

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 upgrades for each of telecom equipment maker Ericsson (NASDAQ:ERIC) and online radio station Pandora (NYSE:P), but for Staples (NASDAQ:SPLS), it's...

Time for a downgrade
We begin the day's news on a down note, as shares of Staples wobble between slight gains and slight losses in the wake of a downgrade to neutral from analysts at B. Riley.

Staples isn't expected to report earnings until tomorrow, but Riley isn't waiting around for the bad news to hit. The analyst warns that the retail market is "weak" right now, enticing retailers to discount their wares and imperiling profit margins in the process. Accordingly, Riley is both lowering its rating on Staples shares and cutting its price target to $15 per share.

I think that's a bad call for long-term investors, though, and here's why: Priced north of 18 times earnings but expected to grow these earnings at less than 4% per year over the next five years, Staples shares do not look cheap. But the stock has a couple of big factors in its favor. Free cash flow, for example, is nearly twice reported GAAP income at $849 million. The stock also pays a hefty 3.5% dividend yield, which, when combined with the low growth rate, helps to move its valuation back toward fair value.

A third wild-card factor in Staples' favor is the low growth rate itself. Never underestimate the value of low expectations. With investors expecting Staples to produce almost no growth over the next five years, it's going to be easier for Staples to exceed expectations with only moderately good results. If and when it does so, the high short interest in the stock could result in a "short squeeze" that drives share prices higher.

Long story short, this is not a stock I'd short. In fact, at today's prices I'm almost tempted to go long.

Ericsson the green?
A second stock worth taking a look at is Ericsson -- at least according to one analyst. RBC Capital Markets upgraded Ericsson shares to outperform this morning, assigning the stock a $16 price target on hopes for improvement in profit margins and greater sales of LTE equipment. But is RBC right?

Here, I'm afraid I must differ with the analyst. On one hand, I find a lot to like in Ericsson's business. The company churns out cash at the rate of $2 billion a year (a number bigger than its reported GAAP income). It pays a respectable dividend yield of 2.3%. And Ericsson boasts a strong balance sheet, plump with $11.6 billion in cash, against only $4.4 billion in debt.

However, with a P/E ratio of 23.4, but a growth rate of only 8.4%, Ericsson shares still look overpriced to me. Viewed in the most favorable light, the stock's $34.6 billion enterprise value is only about 17 times annual free cash flow. But the modest growth rate doesn't seem sufficiently speedy to justify even this lower-seeming valuation. While it's a fine company in many respects, I just don't see as much value in the shares as RBC apparently does.

Don't get tricked by Pandora
Last and least (attractive) of our three stocks on parade today, though, is Pandora. This morning, analysts at MKM Partners finally threw in the towel on their sell thesis against the stock, upgrading Pandora shares to neutral and assigning a $39 price target.

They couldn't have picked a worse time to change their minds.

Unprofitable from the day it was born, and still so today, Pandora is burning increasing amounts of cash as it attempts to keep revenue growth climbing. The attempt succeeded -- revenues grew 54% in 2013. But operating cash flow turned negative again, after briefly getting above water in 2012. Meanwhile, capital expenditures surged 79% to an all-time high of $23.1 million.

Result: Free cash flow at the company has descended to negative $26.4 million, even as shareholders rushed in to buy the stock, more than tripling its stock price over the past year.

To me, this looks like a great argument in favor of cashing out before the stock crashes. Instead, MKM is cashing out its short thesis at a sizable loss. 

Rich Smith has no position in any stocks mentioned. He sometimes, but not always, agrees with his fellow Fools  For example, The Motley Fool owns shares of Staples, but it also recommends and owns shares of Pandora Media. 


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