Monday's Top Upgrades (and Downgrades)

Analysts shift stance on Staples, Big Lots, and Skullcandy.

Mar 10, 2014 at 4:00PM

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 yet another downgrade for Staples (NASDAQ:SPLS) -- but even more upgradesfor the already increasingly popular Skullcandy (NASDAQ:SKUL) and Big Lots (NYSE:BIG). In fact, let's start with those two.

Skullcandy wins by a head
Last week, Skullcandy shareholders were rewarded with a double dose of good news when their company first beat earnings with a stick and then was promptly upgraded by two successive analysts in response to the beat -- resulting in a 10% gain for the week. This week, we're starting off optimistically again with two more endorsements. Imperial Capitalis raising its price target to $9. DA Davidson is upgrading to neutral and assigning a $10 price target.

And yet, investors can't fail to note that Skullcandy is already trading within a few cents of Davidson's new target, and actually costs more than Imperial says the shares are worth. While Imperial acknowledges "the Skullcandy brand remains compelling with a distinct brand image that resonates well within its core youth customer base, offering the opportunity for longer-term growth," at today's prices it's hard to say whether this growth will reward new investors in the stock.

I agree. Last week, I pointed out that with no trailing profits to its name, Skullcandy currently sells for "infinity times earnings," while its price to free cash flow ratio is still above 14x. The stock therefore needs to be growing earnings at least in the double digits to offer an attractive value proposition -- but in fact, analysts tracked by Yahoo! Finance predict earnings will resume falling in the years to come, shrinking by more than 10% annually over the next five years.

Long story short, the stock's simply too pricey to go long on at these prices.

Big Lots, big opportunity?
Big Lots was also the recipient of a recent upgrade, with Deutsche assigning the stock a $33 price target last month. Today, it's FBR Capital joining the Big Lots fan club, giving the stock an outperform rating and a $45 price target.

Quoted on this morning, FBR says: "Big Lots' management clearly has a handle on the business" and "the turnaround is clearly under way." Warning investors that if they don't buy Big Lots now, they risk taking a starring role in "a classic 'I missed it' story." FBR goes so far as to say, "[I]nvestors are OK to chase the shares from this point forward" -- no matter how expensive they get.

That's a brave stand, but not necessarily good advice.

Priced at 17 times earnings, and probably a bit more expensive valued on free cash flow --Big Lots has not released complete cash flow informationas of yet -- the company's shares are like Skullcandy's in that they appear to require modest double-digit earnings growth to justify their valuation. Despite all the recent upgrades, however, analysts on average appear to be still predicting no more than 4% earnings growth, on average, over the next five years.

If they're right about that, then we can make two predictions about Big Lots with some confidence. First, the 23% surge in share price that Big Lots enjoyed on Friday was a "short squeeze," plain and simple. Second, it's not the beginning of a trend. To keep these shares moving upward, growth is going to have to be a whole lot stronger than anyone out there currently thinks realistically achievable.

In short: FBR is wrong. You didn't "miss" Big Lots. If you owned it Friday, you've already won all there was to win. Now it's time to take your winnings and find the next big opportunity.

Staples gets jammed
And finally, we revisit Staples, the nation's second biggest e-tailer after, and a big loser last week after it reported a $0.06-per-share earnings miss on light revenues -- and a weak Q1 2014 forecast to boot. This morning, BB&T pulled its buy rating on Staples stock, downgrading to neutral. This followed similar downgrades from Argus Research, Janney Capital, and Edward Jones last week. Goldman Sachs also put out some depressing thoughts on Staples's future last week ("store closings [will fail to improve profit] margins ... skeptical of broadening assortments at retail and online propelling results," and so on.)

And yet, I can't help but think there's a lot still to like in this stock, which trades for just 12.4 times still-strong earnings, and only 10.3 times its even more robust free cash flow. Plus, Staples continues to earn more than enough profit to maintain its generous 4.2% dividend yield.

True, the company's projected earnings growth rate is now an anemic 2.7% -- even lower than Big Lots'. But is Staples really a worse retailer than Big Lots? Is it really likely to grow no faster than the rate of inflation? I don't think so. And if Staples finds a way to outgrow analysts' depressed view of its prospects, then its 10x FCF valuation could turn out to be very cheap indeed.

Upgrades and downgrades come and go....
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Rich Smith has no position in any stocks mentioned. The Motley Fool owns shares of Staples.

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