Friday's Top Upgrades (and Downgrades)

Analysts shift stance on Houghton Mifflin, Sirius, and Skullcandy.

Mar 7, 2014 at 2:40PM

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 new upgrades for both Sirius XM Holdings (NASDAQ:SIRI) and Skullcandy (NASDAQ:SKUL). But it's not all good news, so before we get to those two, let's take a quick look at why Goldman Sachs is...

Closing the book on Houghton Mifflin
The week is ending on a down note for shareholders of Houghton Mifflin (NASDAQ:HMHC). After reporting full-year 2013 earnings yesterday (sales up 7%, but a loss of $111 million for the year), the textbook publisher was hit by twin downgrades (to hold and neutral, respectively) from Stifel Nicolaus and Goldman Sachs.

Goldman, in particular, noted "strong adjusted EBITDA growth" at Mifflin, "driven by a rebound in U.S. K-12 spending and lower costs." In comments relayed by StreetInsider.com this morning, the banker also mused about the possibility that Mifflin might "begin returning cash next year" -- for example, by initiating a dividend. Regardless, with Mifflin shares up 11% since the start of this year already, Goldman thinks that the company's modest improvements in performance are already "largely reflected" in the stock's price, and sees little likelihood of further gains.

I'm afraid I have to agree with Goldman on this one. On the one hand, Mifflin's situation isn't quite as bad as its $111 million "loss" makes it look. The company did generate $97 million in free cash flow after all, and has been free cash flow positive for the last four years straight. However, that still leaves Mifflin selling for 27 times cash profits. And with most analysts in agreement that profits will only grow at about 10% annually over the next five years, the valuation on this stock already looks quite high. Seems to me, the analysts are right to be switching to downgrades today.

Sirius could fly higher
Speaking of highly valued stocks, Sirius XM Holdings shares are getting a lift this morning from analysts at Australian securities firm Macquarie. Upgrading to outperform and raising their price target to $4, Macquarie says Sirius is likely to grow its business well over the next three years. Meanwhile, the analyst thinks the company's negotiating position vis-a-vis Liberty Media (NASDAQ:LMCA) is getting stronger as well, potentially yielding a better buyout price for shareholders if the takeover plans succeed.

I agree. While it's hard to gauge the takeover battle, Sirius shares do not appear overvalued today, and are likely to rise in future months. For although the company trades at a seemingly steep P/E ratio of 59, the truth is that with $929 million in positive free cash flow to its credit (versus reported net income of only $377 million), Sirius is far cheaper than it looks.

I calculate a price-to-free cash flow ratio of 23.5 on the stock -- which is reasonable given its projected 22% annualized growth rate over the next five years. Assuming a strategic buyer is forced to pay a good-size premium to fair value to capture the company, Sirius shares could very well rise to the $4 that Macquarie is projecting.

Skullcandy comes out on top
And finally, we come to Skullcandy. The earbuds maker beat earnings expectations in its Q4 report yesterday, earning $0.13 per share where analysts had expected only $0.09. In so doing, Skullcandy also earned itself a pair of analyst upgrades, as first Northland Capital upgraded to outperform, then DA Davidson reluctantly agreed, giving the stock a belated neutral rating.

Northland is seeing "solid sell through at key accounts in 4Q and higher sales in several int'l mrkts" at Skullcandy, according to StreetInsider.com, and thinks this will translate into "mid-to-high single digits" sales growth in FY14. The analyst also thinks the stock could hit $12 within a year.

But here's the thing: with the $3.29 boost in stock price Skullcandy has already won in response to its earnings beat, more than half the gains Northland envisions have already been made. A further move from today's share price ($10 and change) to the $12 predicted by analysts will work out to only an additional 12% profit.

And maybe not even that. Based on yesterday's updated numbers, it appears Skullcandy still managed to lose money last year despite the Q4 "beat." Free cash flow looks better -- $19.4 million for the past year. But that still leaves the stock selling for more than 15 times FCF... and infinity times earnings.

Objectively speaking, of course, 15 times earnings isn't ordinarily what you'd consider an expensive valuation. But given that even the company's newfound fan, Northland, doesn't think growth will break into the double digits, 15 times earnings may in fact be too much to pay for Skullcandy stock.

My hunch: If you benefited from the 44% surge in Skullcandy's share price today, it may be best to take those profits now, rather than struggle to eke out the last few pennies Northland is promising over the course of the next 12 months.

Rich Smith has no position in any stocks mentioned. The Motley Fool owns shares of Liberty Media. and Sirius XM Radio. 

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