Friday's Top Upgrades (and Downgrades)

Analysts shift stance on L Brands, Aeropostale, and Portfolio Recovery Associates.

May 23, 2014 at 5:45PM

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 L Brands (NYSE:LB) and Portfolio Recovery Associates (NASDAQ:PRAA). But the news isn't all good today -- actually, far from it. Before we get to those two stories, let's take a quick look at ...

The trainwreck that is Aeropostale
Teen clothier Aeropostale (NYSE:ARO) is a hot mess this morning. After reporting Q1 earnings  that were actually losses last night ($0.52 per share lost, which was better than analysts had feared, but only because the company sold a whole lot less merchandise than analysts had hoped), Aeropostale has just been downgraded to "sector perform" at RBC Capital . Price target cuts are coming fast and furious as well, with RBC positing a $6 share price for Aeropostale, and Piper Jaffray  saying it thinks the stock's worth perhaps $4.

With Aeropostale shares actually changing hands at just $3 and change this morning (down 24% since earnings were released), these price targets may actually make you think the analysts are optimistic about the brand's chances. They are not.

Piper in particular warns that "margin rate pressure and deleverage was severe," at Aeropostale last quarter, while "cash burn rates accelerated." What's more, even if Aeropostale lost less money than feared in Q1, management guided investors to expect worse numbers than were hoped for in Q2. Piper puts the case bluntly: "A timeline and rate of recovery is entirely uncertain."

Is the situation really as bad as that? It's hard to be certain. Aeropostale actually did not release complete information on its cash flow for Q1 yesterday, but the information it did admit to appears to have been enough to raise concerns among the analysts. What we know for sure is that Aeropostale burned cash all of last year (data from S&P Capital IQ confirms this ). If it's true that the situation improved not at all in Q1, and that Q2 could be even worse than investors have been led to believe, then there seems little reason to want to own the stock today.

Un-Limited potential
Turning now to happier news, shares of Victoria's Secret owner L Brands are reacting positively to an upgrade out of Stifel Nicolaus this morning. "L" reported earnings  late Wednesday -- $0.53 per share in profit, which exceeded analyst estimates, with revenues likewise beating expectations. On the downside, L says its full-year profits are unlikely to meet analyst expectations for $3.24 per share, somewhere in the range between $3 and $3.15 being more likely.

This lowered expectation isn't scaring off Stifel, however, which thinks the stock is a "buy," and could deliver as much as a 19% gain to investors who follow its advice today, as the shares soar to $68 apiece over the course of the next year. quotes the analyst calling L Brands "fundamentally... solid" and showing "strong" momentum, insulated from "fashion risk associated with apparel," and deserving of a premium multiple to earnings.

Speaking of earnings, Stifel expects a strong bounceback in profitability at L Brands heading into 2015, with the stock growing its profits as much as 20% from the low end of this year's guidance, to perhaps $3.60 next year. For context, that's nearly twice the rate of growth that most analysts believe L Brands is capable of producing over the long term.

And this could be the fatal flaw in Stifel's analysis. While paying L Brands' current 19x multiple to earnings, or 16x what it's expected to earn in 2015, might make sense for a stock growing profits at 20% over an extended period, most analysts seem to think L Brands' resurgence will be short-lived. Simply put, 19 times current earnings, or even 16 times forward, is too much to pay for an 11% grower. For L Brands to turn into a winning stock, Stifel must be right about both the growth rate in the very near term, and farther out as well. At today's prices, I think that's a risky bet to make.

A better bet on Recovery?
 What's a better bet? Take a look at debt collection specialist Portfolio Recovery Associates, just upgraded to "buy" this morning at Janney Montgomery Scott.

Janney believes Portfolio Recovery is worth $60 a share, about 10% more than what the shares cost today, and Janney could be right about that. Portfolio Recovery shares sell for only about 15.5 times earnings, which appears cheap in light of consensus expectations for 18% long-term earnings growth. Free cash flow at the firm is strong -- about $196 million over the past year, according to S&P Capital IQ  figures, which would coincidentally work out to about 10% more "cash profit" than the $178 million that Portfolio Recovery reported as its accounting "earnings" for the past year -- right in line with Janney's predicted rise in price for the stock.

I calculate about a 14-times multiple to free cash flow on the stock at today's prices, which at 18% growth, would make Portfolio Recovery stock an even more attractive candidate for investment. Long story short: Janney is right to recommend it.


Rich Smith has no position in any stocks mentioned, but The Motley Fool both recommends and owns shares of Portfolio Recovery Associates. 

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