Monday'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 downgrades for Coach (NYSE: COH  ) and Kroger (NYSE: KR  )  but an upgrade for Express (NYSE: EXPR  ) . Without further ado...

Coach goes off the rails
Let's start off with Coach, which sold off hard last week after management confided in a recent "investor day" presentation that it's likely to see revenues decline by double digits (percentage-wise) this year. Shares are down 17% over just the past four days of trading and falling again today in response to a new downgrade from analysts at Wedbush.

As the analyst explained, Coach is closing stores and warning of operating profit margin declines. All told, "guidance for FY15 was much worse than we anticipated," says Wedbush, causing the analyst to cut its earnings estimate for the year to $1.95, and downgrade the shares to "underperform."

If correct, this will be a steep drop from the $3.61 (diluted) that Coach earned last year. It will mean that the shares, which currently read as valued at only "10.4 times earnings" on Yahoo! Finance, will soon cost more than 17 times earnings (unless the stock falls further).

Wedbush appears to believe that the stock price will fall -- and is probably correct. Seventeen times earnings is clearly too much to pay for a company like Coach, where analysts are forecasting long-term earnings growth of less than 2% per year. It's much, much too much to pay if earnings will be declining over these next five years. Wedbush worries this will lead to underperformance in the stock, and it's right to worry.

Is Kroger still cool?
A second stock getting tapped for downgrade this morning is supermarketeer Kroger, which was just cut to "neutral" at Hilliard Lyons. But unlike Coach, Kroger's recent news has been good, not bad.

Last week, Kroger beat earnings estimates with a Q2 report featuring $1.09 per share in profits, a good $0.04 better than expected. Revenues likewise topped estimates, and Kroger topped off the good news with a projection of 3% to 4% same-store sales growth for fiscal 2014. So what's not to like about that?

Actually, it's not Kroger's results that are worrisome, but its valuation. Selling for 17 times earnings, but generating weak free cash flow ($1.1 billion) that backs up only about 73% of reported net income (according to S&P Capital IQ data), Kroger seems overpriced for a stock expected to show only 11% annualized earnings growth over the next five years. The company is also struggling under a sizable debt load -- $11 billion net of cash on hand. This debt doesn't factor into the stock's P/E, making Kroger stock look cheaper than it is...

...and seeing as the stock doesn't look particularly cheap in the first place, I'm forced to conclude that Hilliard Lyons, too, is making the right call with its downgrade.

Express train to nowhere
Finally, I'd like to end this column on a bright note, with Janney Montgomery Scott's endorsement of Express. Unfortunately, I cannot. Janney says Express is a buy, you see. But it really isn't. And I'll tell you why not.

Priced at just 16 times earnings, nearly debt-free, and pegged for a 19% long-term growth rate on Wall Street, Express at first looks like it has all the earmarks of a successful investment. Quoted on StreetInsider.com today, Janney argues that the stock could be the target of a leveraged buyout at $22.33 per share or better.

But here's the thing: Express' 16 P/E ratio makes the stock look cheaper than it is. Real free cash flow at the company amounted to only $43 million over the past year -- less than half of reported earnings. Valued on real cash profits, the company sells for a multiple closer to 33 times free cash flow, and that's too much to pay for 19% growth.

Granted, if Janney's buyout thesis plays out as planned, it could result in a 33% profit for investors who buy shares of Express today. But it's hard to believe a would-be acquirer would want to pay even today's high asking price for Express shares -- much less pay the premium that Janney is predicting. And if a buyout doesn't happen, investors today will be stuck owning the same overpriced shares that the putative buyer-outer decided not to buy. 

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 Coach.

 


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