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's headlines feature new and improved price targets for hard-disk drive manufacturers Seagate Technology (NASDAQ: STX  ) and Western Digital (NASDAQ: WDC  ) . The news isn't all good, however. Before we move on to the tech stories, let's take a quick look at why one analyst thinks home-goods retailer Bed Bath is ...

Beyond expensive
Shares of Bed Bath & Beyond (NASDAQ: BBBY  ) are following the market down today, sliding a small fraction of a percent in early morning trading. But in one sense at least, that's actually good news. The damage could have been much worse.

Merrill Lynch today downgraded Bed Bath to underperform (a Wall Street equivalent of sell) on worries that earnings won't live up to guidance -- and once that become apparent, analysts will cut their estimates for Bed Bath's future earnings, spooking investors even further. As explained on StreetInsider.com this morning, Merrill thinks Bed Bath faces significant competition from online "e-tailers." While e-tailers won't steal all of the company's walk-in business, Merrill thinks Bed Bath will have to cut prices to match offerings from online competitors, hurting profit margins on the goods it does manage to sell.

Merrill sees operating profit margins contracting by about half a percentage point annually through at least 2016, by which time Bed Bath could be earning a margin of as little as 12.2% (down 1.5 percentage points from today's 13.8% margin). If Merrill is right, and assuming a corresponding drop in the company's net, that could equate to nearly 20% less profit per dollar of revenue collected two years from now -- wiping out all earnings growth implied by Wall Street's projected 8% long-term growth rate over that period.

That sure sounds like bad news. Bed Bath shares, trading for more than 12 times earnings, already looked expensive assuming 8% earnings growth. Take away that growth and Merrill Lynch could well be right in advising investors to sell today.

But let's turn now to happier news, where investors in the tech space are getting a confidence boost from analysts at Needham, which this morning raised its price targets on Seagate and Western Digital. We'll take these one at a time, beginning with...

Seagate Technology
Reiterating a buy rating on Seagate, and upping its price target to $67 a share, Needham asserted today that a "rational build and pricing discipline exhibited within the drive industry is now meeting slightly improving demand conditions." This implies stable-to-improving profit margins, along with less risk of product "flooding the market" than seen in past business cycles. Needham expects this to translate into "strong" earnings of $5.01 per share at Seagate this year, followed by even better earnings in fiscal 2015 -- perhaps as much as $5.57. If it's right, Seagate shares that currently cost only a little more than 13 times earnings could soon sell for barely 10 times earnings (absent a rise in share price).

Needham expects the share price to rise, however, perhaps as much as 13.5%. Combined with Seagate's generous dividend yield, that should yield a nice, fat profit for investors who buy the shares today. But is Needham right about all this?

It may well be. Between the dividend and the 8.8% long-term growth rate that analysts project for the stock, Seagate shares look close to fairly priced today. Free cash flow is strong -- about $1.8 billion over the past year, according to S&P Capital IQ figures, and 13% ahead of reported generally accepted accounting principles profits, which also suggests that earnings will soon swing up. While not screamingly cheap, the shares look like a decent bargain, and Needham is right to recommend them.

Western Digital
Shares of Western Digital could be an even better bargain, or maybe not. Boasting $2.2 billion in trailing free cash flow, the disconnect between this stock's apparent P/E (22) and its true worth when valued on cash profit (about 10 times free cash flow) is even bigger than what we see at Seagate.

The problem here is that Western Digital appears to be nearing an "earnings peak" from which further growth will be difficult. Overall, analysts who follow the stock see Western Digital growing earnings at just 2%-3% annually (depending on whom you listen to) over the next five years. That's an awfully slow pace of growth to sustain a 22 times earnings valuation, or even a 10 times free cash flow valuation.

Indeed, despite recommending that investors buy the shares, and upping its price target from $100 to $110 today, Needham warned that earnings at the company may slide back down to $7.80 per share in 2015, after nearly doubling (versus trailing results) to $8.01 per share in 2014. In other words, 2014 could be a terrific year for Western Digital -- but subsequent years won't.

Western Digital needs to figure out how to goose growth substantially. If it can simply match Seagate's 8.8% pace of projected growth, I'd say Western Digital shares look at least as attractive as its peer's. But if analysts who follow Western Digital are right and earnings growth is about to peter out -- well, in that case, I'd suggest this is a stock to avoid, no matter how cheap it may look today. 


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