Tuesday's Top Upgrades (and Downgrades)

Analysts shift stance on General Dynamics, Ryanair, and Foot Locker.

May 20, 2014 at 3:38PM

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 look into why the stocks of both aerospace firm General Dynamics (NYSE:GD) and Irish discount flyer Ryanair Holdings (NASDAQ:RYAAY) got grounded with downgrades. But before we get to those two, let's start on a happier note -- from Foot Locker (NYSE:FL).

Wall Street lacing up
Yesterday, we looked at two separate recommendations of brand-name footwear manufacturers, as Citigroup assigned buy ratings to each of Deckers Outdoor and Skechers. Today, we continue the theme (for a bit) with a few words on Foot Locker -- courtesy of another analyst, Canaccord Genuity.

Echoing Citi's positive thoughts on the footwear industry yesterday, Canaccord argued today that shoes sales specialist Foot Locker is right "in the trend sweet spot" for accelerating sales of footwear. Canaccord announced this morning that it's raising its price target on the retailer to $55, up from $52 previously. And yet, just as Citigroup was wrong about Skechers yesterday (albeit right about Deckers), so too is Canaccord wrong to recommend Foot Locker.

Priced at 17 times earnings, but growing profits at barely 10% annually, and paying only a modest 1.8% dividend yield, Foot Locker shares already look priced pretty expensively -- and unlikely to rise the 14% they would need to in order to hit Canaccord's new price target. But the situation is actually even worse than it seems. This is true because Foot Locker's profits, while apparently robust at $429 million when calculated according to GAAP accounting standards, are actually of pretty low quality -- and not likely to deserve even the multiple to earnings that investors are already paying for them.

Actual free cash flow at the company for the past 12 months doesn't come close to matching Foot Locker's reported net income. Rather, FCF for the period amounted to only $324 million -- barely $0.75 in real cash profit for each $1 in claimed "earnings." This low quality of earnings combines with an already high valuation on the stock, to make Foot Locker an unattractive investment.

Canaccord Genuity is wrong to recommend it.

And speaking of unattractive investments... 
Argus Research thinks it's found another stock to avoid in shares of General Dynamics. With GD shares up 47% over the past 12 months, Argus pulled the plug on its buy recommendation of the stock this morning, saying the valuation is no longer attractive. I'm inclined to agree.

Priced at 17 times earnings, General Dynamics actually shares a valuation not unlike Foot Locker's, but for one thing: While Foot Locker's expected growth rate of just over 10% over the next five years is at least modest, General Dynamics' growth number of less than 8% is downright plodding. General D makes up some ground lost on growth, by paying a higher dividend than Foot Locker shares with its owners -- 2.2%. The defense-and-aerospace titan also boasts superior free cash flow of about $2.6 billion, 8% better than the $2.4 billion GD reports for trailing free cash flow.

But even so, the resulting price to free cash flow valuation we get for General Dynamics is 15.2, and that's a bit too much to pay (in my view) for a growth rate below 8%. Long story short, while a fine company in many respects, and one I suspect will weather the storm of defense budget cuts better than some investors may expect, the stock's simply not a good enough bargain to be worth buying at today's prices.

Argus is right to downgrade it.

Ryanair: coming in for a hard landing?
For our final stop on today's tour of Wall Street's ratings changes, we hop the pond to take a quick look at discount airline Ryanair, just downgraded by Imperial Capital to in line. As reported on StreetInsider.com today, Imperial took the axe to Ryanair primarily due to valuation concerns. "With shares trading toward valuation levels not seen since 2007, we view the earnings upside as fully valued in the share price," said the analyst.

Imperial notes that "passenger-friendly changes being implemented at Ryanair, including the addition of more mainstream airports such as Rome (FCO), Lisbon (LIS), and Brussels (BRU), should help drive 2015 earnings growth," which may allow the shares to rise as much as 10% more above today's price. But still, the analyst can't quite resist the temptation to cash in the 6.5%, two-day gain that Ryanair shares have enjoyed since the end of last week, when these shares cost only $51 apiece (they trade north of $54 already, today.)

Given that these shares will likely bob up and down over time, along with the market, and may permit a reentry at prices closer to Friday's close than what the shares cost today, I can't say as I blame Imperial for wanting to capture a quick two-day gain of such magnitude.

More than that, though, I'd be leery of owning Ryanair shares for the long term. Free cash flow at the firm is good -- better than we often see at many airlines, in fact, and even slightly superior to reported net income. But even so, analysts who follow the stock only expect Ryanair to grow earnings at 6% annually over the long term, and this seems insufficient to justify the stock's above-market multiple of 22 times earnings.

Long story short: So long as there are better prospects for buying discount airlines in the U.S. -- and there are, with Southwest Airlines, for example, boasting both a lower P/E ratio than Ryanair, and a faster projected growth rate -- I simply see no reason to travel overseas to own a more expensive, slower growing stock like Ryanair.

Rich Smith has no position in any stocks mentioned, and doesn't always agree with his fellow Fools. Case in point: The Motley Fool owns shares of General Dynamics and Citigroup.

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