Wednesday's Top Upgrades (and Downgrades)

Analysts shift stance on J.C. Penney, Office Depot, and Groupon.

May 7, 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 upgrades for retailers J.C. Penney (NYSE:JCP) and Office Depot (NASDAQ:ODP), but a downgrade for e-tailer Groupon (NASDAQ:GRPN). Let's dive right in.

Beginning with Groupon...
Online deals site Groupon beat estimates in its Q1 earnings release yesterday, but that isn't saving the stock from a real shellacking in early Wednesday trading. Shares are down more than 19% already in response to worries, voiced by analysts at Northland Capital today, that increasing sales of "Groupon Goods" may not be as good news as they seem.

Goods sales helped Groupon beat sales and earnings estimates yesterday, but StreetInsider.com reports that Northland is concerned about Groupon's increasing reliance on a "much lower-margin business" of selling stuff rather than services. It says: "Without meaningful progress on both Local growth and Goods margins[, earnings targets] may be challenging to achieve." What's more, "continued aggressive marketing will be needed to meaningfully" improve sales. And since such spending would increase costs, it might do little to improve profit margins.

Granted, it's not all bad news at Groupon. While the company lost money last year, it's losing a bit less money than analysts had worried it might lose. And free cash flow, pegged at $125.5 million over the past 12 months by S&P Capital IQ, is still positive.

The real problem, though, is that even this robust rate of cash production leaves Groupon stock selling for about 30 times free cash flow. That isn't exactly cheap if profits grow, as expected, at 26% annually over the next five years. It could even be expensive if free cash flow continues to contract, as it has done over the past two years. Long story short, Northland's decision to downgrade Groupon to "market perform" is probably the right one.

Bad Penney turning up?
If there's one nice thing we can say about Groupon, though, it's that at least the company is doing better than J.C. Penney. Burning cash, unprofitable, and expected by most analysts to experience deepening losses over the next five years, with no end in sight, Penney looks like a bit of a basket case. And yet, this morning, investment banker UBS announced it is upgrading the stock to neutral, while Piper Jaffray has just reiterated its rating of buy. Why?

Piper insists that Penney, priced at less than $9 today, is worth at least $11 a share. According to the analyst, J.C. Penney still has an "opportunity to improve their sales and margins, and ultimately, their cash flow over time."

Believe it or not, Piper could be right about that -- but still wrong about its rating. If J.C. Penney were to close down operations and liquidate its assets at book value (the stock currently trades for just 0% of book), that would result in a valuation 25% higher than today's -- and a share price of about the $11 Piper is projecting. And as for the "opportunity of improvement," well, with a profit margin of negative 11.7% and operating cash flow of negative $1.8 billion, there's certainly room for improvement at J.C. Penney. Were Penney to go out of business, at least its profit margins and cash burn would "improve" to zero.

The bad news is, the longer J.C. Penney remains in business, the less its assets seem to be worth. In my view, that's hardly an argument in favor of buying the stock.

Office Depot gets a beat and a raise
Finally, Office Depot. This retailer reported a nice earnings beat yesterday -- $0.07 per share when analysts were only looking for $0.03 in profit. Revenues, too, exceeded the consensus. Perhaps best of all, Office Depot offered optimistic guidance for the rest of the year, saying "adjusted" operating income will likely exceed $160 million this year, $20 million more than previously hoped for. "Synergies" -- cost savings -- from the merger with OfficeMax are also looking to be better than previously anticipated.

In response to all this good news, Credit Suisse announced this morning that it's upgrading Office Depot shares to outperform, while Jefferies & Co. raised its price target on the stock to $5.25 per share and forecast "a string of beats ahead."

Jefferies estimates that Office Depot could earn $0.21 this year, then $0.27 in 2015.Other analysts see the company earning even more in 2015 ($0.32 per share is the consensus), and with earnings growing to $0.67 by 2018, according to S&P Capital IQ data. If the analysts are right, the Office Depot of just a few years from now could be a firm eight times more profitable than the company we see here today.

My take? The future's uncertain, and the future of retailers in an age of e-tailers is especially so. That said, the supercharged earnings estimates we're hearing, and the growth rate they imply, suggest that Office Depot shares may not be as overpriced as they look today. Until the company actually starts earning positive profits, it has to be considered speculative, but my hunch is that this is one speculation that could reward Office Depot shareholders quite richly.

Rich Smith has no position in any stocks mentioned, and neither does The Motley Fool.

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