Friday'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, we'll take a peek under the hood at some of the nation's biggest used car dealers, as two analysts roll out new ratings for CarMax (NYSE: KMX  ) , AutoNation (NYSE: AN  ) , and Sonic Auto (NYSE: SAH  ) . Without further ado...

Will Sonic go "boom"?
Our first rating today is a bad one, as Goldman Sachs downgrades to "sell" over concerns about profit margins and debt. Sonic's not expected to report earnings for another month, but Goldman already sees the new-and-used car retailer showing "slower earnings growth than peers." Goldman is projecting earnings per share of $2 this year, but just $2.13 next year and $2.36 the year after that.

Ordinarily, 18% earnings growth in two years wouldn't sound half bad. But last year, Sonic reported earnings of just $1.53. So what we're really looking at here, from Goldman's perspective, is a quick 31% jump to $2 this year -- followed by a much steeper falloff in growth going forward.

With Sonic shares costing 17.5 times earnings today, that slowing growth could be a problem. It averages out to about 9% annually, which is slower than the 15% long-term growth Wall Street had been expecting, and probably too low to support a 17.5-times multiple to earnings. Add in the fact that Sonic struggles under a sizable debt load, with $2 billion in debt, and almost no cash to its name, and the case for selling this stock only grows stronger.

Time to test-drive AutoNation?
Looking for a better buy? Goldman Sachs suggests you give rival car dealer AutoNation a spin. Quoted on today, Goldman praises AutoNation's "strong growth outlook, better core efficiency metrics, and best in class industry margins," arguing the stock is a buy, up to about $65.

AutoNation shares cost a bit more than Sonic's -- 18.4 times earnings. But analysts expect it to outgrow Sonic with a 16.4% long-term growth rate, and Goldman backs up that hypothesis, predicting that earnings will hit $3.45 this year, then rise to $3.99 in 2015, and $4.51 in 2016. At 31%, that's nearly twice the growth rate that most analysts foresee for Sonic, and three times the rate of growth Goldman projects for the AutoNation rival.

So why don't I agree that AutoNation is a buy? Well, there's the debt load, for one thing. At $4.6 billion net of cash, AutoNation is about twice as deeply in hock as Sonic. More important to me, though, is the fact that with trailing free cash flow of just $250 million, AutoNation is really only about 65% as profitable as its $387 million in reported GAAP earnings would suggest.

Valued on free cash flow, I see the stock trading for close to a 28-times multiple to real cash profits, and even if the analysts are right about the growth rate, that's too much to pay. Goldman may see the stock as a buy, but I do not.

Is CarMax king?
Last chance at finding a winner, and for it, we turn to analysts at William Blair and their upgrade of CarMax. CarMax beat earnings soundly this morning with a report featuring same-store sales growth of 3.4%, and $0.76 per share in profit, where analysts had been looking for only $0.67.

That's a big beat, and it's having the expected effect on CarMax shares, which are up more than 15% as of this writing. Problem is, CarMax's "new and improved" stock price now leaves the shares selling for 22.4 times earnings. The company is also free cash flow negative, and continuing to burn cash (as it has done every year since 2011, according to data from S&P Capital IQ).

Even if it were not burning cash, the fact that the stock sells for such a high P/E ratio but is only expected to produce earnings growth of about 14.5% annually over the next five years (slower growth than analysts expect to see at AutoNation, or even at Sonic) tells us that CarMax shares are probably overpriced as well.

Long story short, while arguably the best used-car dealer in the business, CarMax the stock just doesn't look likely to reward investors anymore.

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


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Rich Smith

As a defense writer for The Motley Fool, I focus on defense and aerospace stocks. My job? Every day of the week, I'm monitoring the news, figuring out the winners and losers, and tracking down the promising companies for you to invest in. Follow me on Twitter or Facebook for the most important developments in defense & aerospace, and other great stories.

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8/31/2015 3:45 PM
AN $60.05 Down -0.47 -0.78%
AutoNation, Inc. CAPS Rating: ****
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SAH $21.50 Down -0.23 -1.06%
Sonic Automotive,… CAPS Rating: *****