Wednesday's Top Upgrades (and Downgrades)

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 both DreamWorks Animation (NASDAQ: DWA  ) and AutoZone (NYSE: AZO  ) . But not all stocks are so lucky. Before we get to the good news, let's address why one analyst foresees...

New lows for Lowe's
Shares of home improvement retailer Lowe's (NYSE: LOW  ) are tumbling this morning in response to a downgrade to sell from investment banker Canaccord Genuity.

Last week, as you may recall, Lowe's reported first-quarter earnings featuring a 2.4% rise in net sales and a 25% leap in earnings per diluted share (to $0.61). Adding to the good news, Lowe's matched its one-penny earnings "beat" by raising its full-year earnings outlook by $0.03 -- to $2.63 -- suggesting that the first-quarter profit was not borrowed from future quarters, and that earnings strength should continue growing throughout the year. So why isn't Canaccord buying that argument?

As it turns out, maybe it is. In the write-up on its downgrade, Canaccord acknowledged that Lowe's has benefited "from the flood of positive housing data" recently. The problem, as Canaccord sees it, is less a worry that the housing market will collapse, but that growth in housing might decelerate, and that this risk is not baked into Lowe's share price, which is up 88% dating to the beginning of 2012.

Admittedly, there is a risk here -- but if you ask me, it's not a big one. Priced just north of 20 times earnings, Lowe's looks slightly overpriced relative to consensus expectations for 17% annualized earnings growth over the next five years. But if you value the stock on its cash profits -- which at $3.2 billion for the past year are fully one-third higher than Lowe's reported net income, according to S&P Capital IQ -- I still see a lot of value in the stock.

Valued on free cash flow, Lowe's still sells for a modest multiple of less than 15, which is easily justified by the stock's projected growth rate. Add in the 1.5% dividend yield for a bonus, and I'd argue Lowe's shares remain cheap today -- and unworthy of the sell rating Canaccord has put forward.

Not so, AutoZone
I wish I could say the same about today's first big upgrade -- AutoZone -- but I cannot. The auto parts retail specialist reported strong earnings yesterday: $8.46 for its fiscal third quarter, $0.02 ahead of the consensus estimate, with same-store sales rising 4% year over year. This earnings beat prompted an upgrade to buy today from Gabelli, which said that AutoZone is doing so well, it deserves a premium multiple to peer retailers. But why?

Based on the company's latest numbers, AutoZone shares sell for nearly 17 times earnings. With only a 14.4% projected growth rate, and no dividend to sweeten the deal for investors, AutoZone shares already look pretty premium-priced. Factor in the fact that, unlike Lowe's, AutoZone actually generates a bit less free cash flow than it reports as net income on its income statement, along with the company's sizable debt load of more than $4.1 billion net of cash, and the stock actually starts looking pretty expensive.

Long story short, even if you think AutoZone deserves a premium multiple -- it's already got one. The chances of this stock going up even more, absent significantly higher growth than analysts are expecting it to produce, seem slight. Gabelli is wrong to recommend buying the stock.

Dream on
AutoZone isn't the only stock analysts are wrong in recommending today, of course. So let's wrap up today's column with a quick look at DreamWorks, which earned some kind words from Topeka Capital this morning.

Formerly a bear on DreamWorks, Topeka relented and upgraded the shares to hold today. According to StreetInsider.com, the analyst argued that with the damage from DreamWorks' writedown of its investment in Mr. Peabody & Sherman over and done with, the stock's "18.7% decline in the 5 sessions after the earnings call" last month is about as bad as things are likely to get.

I disagree. I think there's more pain ahead for DreamWorks shareholders.

Here's why: The $57 million charge to earnings that DreamWorks took last quarter was sizable, no doubt. But it was no aberration at this movie maker, which has taken more than $230 million in such writedowns over just the past six quarters. Even with these writedowns, DreamWorks says it still managed to earn $6.6 million in trailing earnings over the past year.

DreamWorks' cash flow statement, however, shows zero cash profit generated over this past year. To the contrary, cash burn at the company topped $64 million for the period -- meaning DreamWorks actually burned through nearly 10 times as much cash as it says it earned in profits. And while the company has historically generated some cash over time, its record over the past five years -- averaging about $17 million in annual free cash flow -- is no great shakes.

Simply put, DreamWorks isn't generating enough cash to justify the stock's $2.4 billion market capitalization, which values shares at nearly 140 times average annual cash production. I think the stock's worth far less than what investors are presently valuing it at, and that it's likely to continue to fall.


 

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