Friday's Top Upgrades (and Downgrades)

Analysts shift stance on Kate Spade, Michael Kors, and Natural Grocers.

May 2, 2014 at 12:37PM

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 a pair of new buy ratings for luxury consumer goods companies Kate Spade (NYSE:KATE) and Michael Kors (NYSE:KORS). The news isn't all good, however, so before we get to those two, let's take a quick look at why one analyst thinks...

Natural Grocers is going stale
Shares of Whole Foods wannabe Natural Grocers by Vitamin Cottage (NYSE:NGVC) are getting rocked today, down nearly 35% at last report despite the company having just reported Q2 earnings that showed it growing sales by 22%, achieving "daily average comparable store sales" growth of 5.7%, and growing earnings 28%. It seems that merely hitting earnings estimates isn't enough for Wall Street today, though, and this morning, analysts at William Blair pulled their outperform rating on the stock and downgraded Natural Grocers to market perform.

What's got Wall Street, and ordinary investors, so upset about Natural Grocers?

The answer can probably be found on the company's top line, where stellar sales growth nonetheless failed to match consensus estimates, much less exceed them. Apparently, 20% profits and sales growth aren't considered sufficient to justify paying the near-70 P/E ratio that Natural Grocer shares sported before the sell-off. Indeed, you could argue that even after the sell-off, the stock's 47 times earnings multiple looks pretty pricey -- especially given that the company hasn't generated a penny's worth of positive free cash flow since 2009 and remains FCF-negative today.

Blair is undoubtedly right to be downgrading the stock today. The real question is why they didn't cut their rating on this overpriced stock long ago.

Fallout from Coach
Turning now to happier news (for some), the disgruntlement with Coach's earnings results earlier this week is starting to work to the benefit of a couple of its competitors. This morning, analysts at Nomura Securities decided that weak sales at Coach might mean good things for rival handbag makers Kate Spade and Michael Kors, and initiated coverage on both these stocks with new buy ratings. Let's take them one at a time, beginning with Kate.

Kate Spade
Rating Kate Spade a buy and assigning a $41 price target to the shares, Nomura appears to be projecting 15.5% potential profits for buyers today. According to StreetInsider.com, the analyst justifies its new rating by pointing to Kate's "best-in-class top-line growth through ongoing share gains" in a market where "global luxury spending continues to grow."

Nomura foresees Kate earning $0.28 per share this fiscal year, then more than doubling that to $0.65 in 2015, before nearly doubling it again to $1.13 per share in 2016 -- 59% compounded annual earnings growth.

Crazy as it may seem, if Nomura is right about these numbers, this story might even be good enough to justify the sky-high valuation of 60 times earnings that investors are currently paying for Kate Spade shares. My major reservation about following the analyst's advice, however, is that this story probably is not as good as it seems. Accounting profits (such as Nomura projects) are all well and good, but the truth of the matter is that Kate Spade hasn't generated any positive free cash flow at all since 2011, and is currently burning cash at the rate of more than $100 million a year (according to S&P Capital IQ figures).

Given this, I'd be leery of following Nomura's advice and buying into the company until Kate Spade proves it can produce some actual cash from its business.

Michael Kors
The situation with Michael Kors, while similar, is still different enough to be worth a look. Here, too, Nomura is initiating coverage with a buy rating. Here, too, the analyst describes its stock pick as exhibiting "best-in-class top-line growth" and names global trends in higher spending on luxury as a driver behind the stock.

Nomura's projection of just $3.90 per share in fiscal 2015 profits, however, rising 22% to $4.75 in fiscal 2016, seems both more conservative, and more achievable -- and also generates a more realistic valuation argument -- for Kors than what we see at Kate Spade.

Priced at 32 times earnings today, hitting Nomura's earnings target would value Kors shares at under 20 times 2016 earnings -- not an unrealistic number for a projected 22% grower, albeit I'd rather see a 20 times multiple to trailing earnings than to what the stock might (or might not) earn three years from now. Plus, while Kate Spade is currently burning cash, Michael Kors is generating it. Free cash flow for the past 12 months approached $384 million, which, while not quite up to snuff with the company's claimed $602 million in GAAP earnings, is at least better than a negative number.

Long story short, at today's prices and based on today's numbers, I still think Michael Kors shares are overpriced. They're just not quite as overpriced as the riskier, cash-burning Kate Spade.

Rich Smith has no position in any stocks mentioned, but The Motley Fool both owns and recommends Coach, Michael Kors Holdings, and Whole Foods MarketJohn Mackey, co-CEO of Whole Foods Market, is a member of The Motley Fool’s board of directors.

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