Tuesday's Top Upgrades (and Downgrades)

Analysts shift stance on Kellogg, Campbell Soup, and The Fresh Market.

Jul 15, 2014 at 2:42PM

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 head to the grocery aisle, where we find Wall Street analysts singing the praises of "natural" foods grocer The Fresh Market (NASDAQ:TFM), but panning processed foods producers Kellogg (NYSE:K) and Campbell Soup (NYSE:CPB). Let's take these in order, beginning with...

Repackaging The Fresh Market as a buy
The Nasdaq's in a funk today, but one stock is avoiding the gloom, as shares of The Fresh Market eke out a small, fraction-of-a-percentage-point gain on the back of an upgrade to "buy" out of Northcoast Research. The question is, why?

Presumably, the stock attracted Northcoast's interest due to its astounding fall in share price -- down more than 40% over the past year, Fresh Market shares have underperformed the rest of the stock market by a good 60 percentage points. If "reversion to the mean" has any meaning at all, chances should be good for a rebound. That is to say... they might be good but for the fact that even down 40%, Fresh Market shares still look woefully overpriced.

Costing 34 times earnings, but expected to grow these earnings at less than 17% annually over the next five years, Fresh Market continues to carry a premium PEG ratio of 2.0, or about 20% higher than the average PEG in the supermarkets sector. Meanwhile, free cash flow at Fresh Market, just $21 million over the past 12 months, is less than half the $45 million that the company reported for "net income" over the past year, suggesting that the PEG ratio could actually be understating the amount of overvaluation in this stock.

In short, despite the decline in share price, this stock is not yet cheap. Northcoast is calling the bottom too soon.

Goldman weighs in
Coincidentally, Goldman Sachs made much the same point last week when, in contrast to Northcoast, it rated The Fresh Market not a buy, but a sell. And now, today, Goldman is back with two new sell ratings for your consideration: Kellogg and Campbell Soup.

Priced at just 12.6 times earnings, Kellogg isn't nearly as expensive a stock as The Fresh Market. But quoted on StreetInsider.com this morning, Goldman warned that efforts to reignite sales growth at Kellogg are "falling flat," and that the company's promise of improving sales and earnings this year and next will not be met. When you consider that analysts, on average, were only expecting 6% earnings growth before this news broke, it seems likely that any growth Kellogg does produce will be anemic in the extreme.

Again, free cash flow figures back up this assessment. According to S&P Capital IQ data, Kellogg produced a bare $1.1 billion in positive free cash flow over the past year -- far less than the $1.9 billion that shows up as "net profit" on the firm's income statement. So if you think 12 times earnings is too much to pay for 6% (or slower) earnings growth, the prospect of paying 21 times free cash flow for the same (or slower) growth should be downright frightening.

Goldman is right to downgrade the stock.

Soup is good food, but Campbell is not a good stock
It's right, too, to be leery of Campbell Soup. Priced at 27 times earnings, Campbell looks more expensive right on the surface than Kellogg becomes only after close examination. Plus, it sports a smaller projected growth rate (of less than 4%). And, like Fresh Market and Kellogg, Campbell generates less free cash flow than its reported net income figure (only in Campbell's case, the difference is minuscule).

Goldman Sachs says these high valuations put the stock at risk of a "valuation re-rating" -- meaning essentially that investors will eventually wise up and refuse to overpay for the stock. The analyst sees a likely "earnings shortfall" as the catalyst for this, and notes that the company could earn about 3% less than the $2.54-per-share consensus target for Campbell that's found among other Wall Street analysts.

Even if Goldman is wrong about the earnings miss, though, the numbers here are clear: A canned soup maker with low-single-digits growth rates simply isn't worth paying 27 times earnings for. The "valuation re-rating" that Goldman predicts is inevitable, and the analyst is right to downgrade Campbell Soup shares ahead of the pack.

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


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