Friday's Top Upgrades (and Downgrades)

Analysts shift stance on Alaska Air, Annie's, and Dynamic Materials.

May 30, 2014 at 12:21PM

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 include a downgrade for Alaska Air Group (NYSE:ALK), and a cut to price target for Annie's (NYSE:BNNY). But the news isn't all bad. Before we get to those two, let's take a quick look at why one analyst is urging investors to...

Buy it! BOOM!
Investment banker Stifel Nicolaus initiated coverage of explosives specialist Dynamic Materials (NASDAQ:BOOM) this morning, assigning the stock a buy rating and a $29 price target. Why?

Dynamic Materials is coming off a banner Q1, in which the company reported only 4% revenue growth -- but a near-eightfold increase in profits. Yahoo! Finance data show analysts expecting Dynamic Materials to earn $0.89 per share this year, then grow these profits 55% in 2015, to $1.38 per share. And longer term, most analysts agree the company should be able to maintain a robust growth rate in excess of 15% annually for the next five years.

All of this suggests Dynamic Materials is performing well as a business. The problem here isn't the business, though. It's the price investors are asked to pay for it. This stock sells for 33 times earnings, after all, which seems quite expensive for a 15% grower. Strong cash production drops the company's price to free cash flow ratio down to just 21.5 times. But even so, this is a premium valuation for 15% growth. While it's certainly possible that the stock could surprise to the upside, I see significantly more risk than reward in the stock.

Alaska Air -- grounded! 
At the same time as it was singing Dynamic Materials' praises, Stifel Nicolaus was removing its endorsement from Alaska Air Group. Downgrading the shares to "hold," with a $95 price target, Stifel cited on single reason for its worry about the shares: Seattle.

You see, Delta Air Lines (NYSE:DAL) is expanding its operations in Seattle, Wash., and according to Stifel, this is bad news for Alaska Air, which also flies out of the airport. "We question whether valuation and expectations fully account for the downside risk should the competitive dynamics become more aggressive" in Seattle, warned the analyst. And in fact, that is a concern.

Based on Yahoo! Finance data, it appears Alaska Air is expected to maintain about 14% annualized earnings growth over the next half year -- a rate of growth nearly twice the industry average. If Alaska Air pulls it off, the stock appears appropriately priced at its current valuation of 12.3 times earnings -- maybe even a little bit cheap, once you factor the 1% dividend payment into the equation. But if Delta can compete effectively with Alaska Air, and erodes profit margins or steals market share (or both!) in the process, this would have a deleterious effect on Alaska Air's growth rate, and narrow the margin of safety in the stock significantly.

All that being said, I can't help but wonder if Stifel is blowing the risks here out of proportion. Certainly, Delta is a threat. But most surveys of customer satisfaction rate Alaska Air as superior to Delta in quality. This suggests the company may have some leeway in responding to price cuts by its rival, and may not suffer as badly as Stifel thinks. At today's prices, I see Alaska Air Group stock as appropriately priced, and with limited downside risk.

Can this bunny hop?
Finally, shares of packaged natural foods producer Annie's are tumbling this morning in response to fiscal Q4 results that showed the company "missing estimates" by $0.04 per share, and guided investors to expect no more than $0.95 in pro forma profits for the current fiscal year (2015). That's 16% less than Wall Street was looking for, and Annie's left open the possibility that it might earn even less than this.

Little wonder, therefore, that investors are dumping the stock (now down 8.5% on the day). Little wonder, too, that analysts at RBC Capital are cutting $8 off their price target on Annie's shares this morning. What is surprising here is that despite the awful earnings report, RBC still insists that Annie's stock will outperform the market, and still believes they'll reach $37 per share within a year.

I have no such hope.

Valued on its most recently reported GAAP earnings, Annie's shares sell for a premium multiple of 35.6 times earnings. Valued on free cash flow, the stock's nearly as expensive, with a P/FCF ratio of 34.9. Yet the stock pays no dividend, is expected to grow at only about 25% annually over the next five years -- and has entirely failed to live up to growth expectations so far this year. In fact, Annie's has missed analyst profits estimates in each of the past four quarters.

Long story short, while a fine business in many respects, and a profitable, cash-generating one, Annie's suffers from the single, fatal flaw of having a too-high stock price. I don't expect it to outperform the market from here on out, and believe RBC is making a mistake in recommending the stock.

Rich Smith has no position in any stocks mentioned, and doesn't always agree with his fellow Fools. Case(s) in point: The Motley Fool recommends Dynamic Materials, and The Motley Fool owns shares of Annie's.

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