Monday'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, we'll be checking out a pair of new endorsements from Oppenheimer on shares of both Yelp (NYSE: YELP  ) and Netflix (NASDAQ: NFLX  ) . But outside the tech sphere, the news isn't quite as good...

Getting out of Olin
Recent months have seen diverging fortunes for two of America's bigger firearms companies, with Smith & Wesson shooting the lights out in its recent quarterly earnings report but Sturm, Ruger missing the mark. Mixed news of this sort can make investors nervous, and with FBI background checks for handgun purchases now on the wane, one analyst has decided that it's time to begin dialing back the enthusiasm for this sector -- and it's doing so a few weeks before Olin Corp. (NYSE: OLN  ) reports earnings.

Olin, as we know from Yahoo! Finance's earnings calendar, is expected to report first-quarter 2014 earnings on April 24. Before any bad news can surface, though, analysts at Monness, Crespi, Hardt have decided to pull their buy recommendation on the ammunition manufacturer, downshifting to a neutral recommendation.

Why? It's not hard to guess. By many measures, Olin's shares don't look expensive. The stock pays a tidy 2.8% dividend yield and sells for less than 13 times GAAP earnings, and is even cheaper when valued on free cash flow. Olin's "fatal" flaw, though, is that analysts expect both earnings and cash flow to evaporate in short order, as guns sales wane.

Consensus estimates for long-term growth at Olin average 5% on both Yahoo! Finance and on S&P Capital IQ. If you assume that a double-digit P/E requires at least a double-digit growth rate to support it, therefore, the fact that basically no one expects Olin to grow faster than single digits poses a problem -- and means Monness is probably right to adopt a cautious stance.

The opportunity here, though, lies in the fact that expectations for Olin's growth rate are so low. Five percent earnings growth isn't a high hurdle to clear for Olin. Indeed, with $216 million in positive free cash flowing into its coffers annually, the company could conceivably grow earnings at 10% annually just by diverting its free cash to buying back shares. Pair such a potential earnings surprise with the exceedingly high short interest in the stock -- 23% of its float, at last report -- and I think Olin could actually surprise us in the quarters and years to come. In short, while Monness' fears are not unfounded, I wouldn't be selling these shares just yet.

Some help for Yelp
I'm a bit less sanguine, however, about the prospects for two of the stocks now on Wall Street's buy list. Let's start with Yelp, which was just upgraded to outperform by Oppenheimer this morning.

According to Oppenheimer, the recent sell-off in high-beta Internet and technology stocks has created a buying opportunity in Yelp shares, which Oppy sees rising 19% over the course of the next year to a new target price of $78. The problem here, though, is that with no trailing profits to its credit, minimal free cash flow, and a forward P/E ratio of 185, Yelp stock already costs quite a pretty penny.

Growth expectations for the stock are superb, with most analysts projecting Yelp will grow earnings in excess of 43% annually over the next five years. However, with no trailing profits base to grow from, it's hard to say what a "43% growth rate" really means for Yelp. Free cash flow at the firm, $5.2 million for the past year, results in a P/FCF ratio of 919 -- incredibly expensive even if the growth rate were to be taken at face value. In short, while the business certainly has potential, I see no justification for the valuation.

Is Netflix's buy thesis full of holes?
Similar valuation concerns plague Oppenheimer's recommendation to buy Netflix, which the analyst says is worth $419 a share, and holds even more potential for profit than does Yelp. Once again, we're looking here at a stock for which pie-in-the-sky expectations -- 50% growth -- are driving valuation. But the justification for this valuation is both better- and worse-founded than what we find at Yelp.

Valued on earnings, Netflix at least has trailing earnings. But its trailing P/E ratio of 182 is hardly a bargain price, even taking 50% growth as a given. (Hint: Never take 50% growth as a given -- not even for a tech stock.)

Valued on free cash flow, meanwhile, Netflix may be selling for a higher multiple than its P/E ratio suggests (FCF as calculated from operating cash flow minus capital expenditures works out to only about $44 million, or less than half reported GAAP earnings), or it may be selling for a multiple so high as to be meaningless. Deduct the $66 million annually Netflix spends to maintain and build its DVD library for its still-extant DVDs-by-mail business from its "traditional" FCF number, and you must conclude that real free cash flow at the company is actually negative.

In short, the best-case scenario for Netflix is that its stock sells for a P/E too high for even an overoptimistic growth rate to justify. The worst-case scenarios are that it's either more expensive than it looks (traditional FCF valuation) or much, much, more expensive than it looks (taking the DVD costs into account). Any way I look at it, though, I don't see a good reason to follow Oppenheimer's recommendation to buy the stock.

Motley Fool contributor Rich Smith has no position in any stocks mentioned, and doesn't always agree with his fellow Fools. Case(s) in point: The Motley Fool recommends Netflix and Yelp and owns shares of Netflix. 

 


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