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 downgrades for Keurig Green Mountain (NASDAQ:GMCR) and Walgreen (NASDAQ:WBA). But the news isn't all bad. Before we get to those two, let's take a quick look at why...
Autodesk just got upgraded
On a "red" day for stock markets in general, shares of computer-aided design software maker Autodesk (NASDAQ:ADSK) are dodging the downturn and moving modestly higher. For this, you can thank the friendly analysts at Canaccord Genuity, who this morning upgraded Autodesk to buy.
Canaccord cites favorable trends in commercial construction as one reason that it thinks Autodesk shares, currently selling for $48 and change, could soon hit $60 a share. But for individual investors, this could be an expensive bet to make.
Priced at 48 times earnings today, Autodesk shares look expensive given that most analysts -- Canaccord obviously excepted -- think the company will struggle to grow earnings much faster than 10% per year over the next five years. Mitigating the risk (somewhat) are the facts that, one, Autodesk is flush with cash, with more than $1.5 billion net cash on its balance sheet, and two, that more cash is pouring into Autodesk's coffers by the day. Trailing free cash flow at the company is a whopping $499 million -- more than twice Autodesk's reported GAAP earnings.
Ordinarily, this might be enough to convince me that Canaccord is seeing something that other analysts are not. But as it turns out, even giving Autodesk full credit both for the cash in its bank account and the FCF on its cash flow statement, the company still sells for an enterprise value-to-free cash flow ratio of more than 18. I think that's still too expensive for a 10% grower. So for Canaccord to be proven right, Autodesk must prove it can grow its business faster than anyone thinks possible.
Green Mountain gets burnt
Speaking of cash-flush, cash-producing but expensive stocks: Green Mountain Coffee Roasters. That used to be the name of the stock that Northcoast Research just downgraded to sell, but Green Mountain has fully embraced its identity as the maker of Keurig single-serve coffeemakers and changed its name accordingly.
Problem is, Northcoast doesn't think a name change is enough to save the stock from increasing competition by other coffee companies. Northcoast is predicting a slowing in the rate of K-Cup sales as competition heats up, believes this will force Keurig Green Mountain to cut prices and accept lower profit margins, and accordingly, says the stock will soon be worth only $95 a share. If Northcoast is right about that, it will work out to a near-20% decline from today's stock price. But is Northcoast right?
Unfortunately, probably, yes. While Green Mountain benefits from all the advantages we described as accruing to Autodesk up above -- lots of cash, lots of free cash flow -- and has the additional advantage of growing at a projected 17% rate over the next five years, the stock's price still looks too high to buy. Green Mountain shares currently sell for 33 times earnings. Valuing the stock on free cash flow rather than GAAP earnings, and factoring cash levels into the mix, the stock's even cheaper at an enterprise value-to-free cash flow ratio of just 27.7.
But that's still too high a price to pay for 17% growth. Chances are, the stock would be a sell even if Northcoast turns out to be wrong about a slowing growth rate in K-Cup sales. And if Northcoast turns out to be right about that? Look out below.
Walgreen's on the sick list, too
Rounding out today's tale of woe is Walgreen, which just got hit with a downgrade of its own, this time from Cowen & Co. Cowen says its reason for removing its outperform rating from the stock is quite simply that Walgreen costs too much -- and I think the analyst is right about that.
Walgreen shares sell for 24 times earnings today -- and 24% more than the P/E at archrival CVS. Granted, Walgreen is expected to grow earnings at a faster pace than CVS' 14% projected growth rate -- but the difference is less than 1 percentage point and probably not big enough to justify the differing valuations.
For that matter, 24 times earnings would probably be too much to pay for Walgreen's 15% growth rate in any event. And given that Walgreen's quality of earnings are not particularly high, falling for the past two years straight, and with actual free cash flow now trailing reported earnings by nearly 8%, I see little reason to give the stock the benefit of the doubt. I think Cowen is right to downgrade it.
Motley Fool contributor Rich Smith has no position in any stocks mentioned, and doesn't always agree with his fellow Fools. Case in point: The Motley Fool recommends Keurig Green Mountain.