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 new buy ratings for Western Digital (NASDAQ:WDC) and United Natural Foods (NASDAQ:UNFI). The news isn't all good, however. We'll also check in on Tractor Supply (NASDAQ:TSCO) and find out why that one's getting cut.
United Natural Foods -- fresh or spoiling?
Natural foods grocery stocks have been pummeled on lack-of-growth fears this year, with most of the big names in the sector suffering steep stock market declines. Theoretically, that shouldn't be good news for one of the sector's biggest suppliers of foodstuffs: United Natural Foods. And yet, this morning, analysts at Oppenheimer announced they're initiating coverage of United Natural Foods with a rating of outperform. Why?
In part, one suspects, Oppenheimer has picked United Natural Foods to outperform today for much the same reason seen in Northcoast's endorsement of The Fresh Market yesterday -- share price underperformance, and a hope that that will change. After all, over the past 12 months, United Natural Foods stock has gained less than 8% in share price, while the S&P 500 rocketed ahead twice as fast.
And yet, this still doesn't make United Natural Foods stock "cheap." Here's why:
Priced at more than 26 times earnings, and paying its shareholders a dividend yield of exactly zilch, United Natural Foods is expected to post annual earnings growth of less than 16% over the next five years. That 26 times earnings is quite a lot to pay for 16% growth. And in fact, it's an even more expensive price than it seems, once you realize that over the past 12 months -- the past 18 months, in fact -- United Natural Foods has generated not one red cent's worth of real free cash flow from its business. According to S&P Capital IQ data, the company was still burning cash at the rate of $80 million a year at last report, even as it reported earning $124 million in GAAP "profits."
Now, Oppenheimer may believe that such performance merits an outperform rating. I disagree.
Tractor Supply needs a tune-up
Shifting our focus a bit while remaining in the consumer sector, we turn next to Tractor Supply -- mecca for the suburban farmer set, but a stock that Oppenheimer is considerably less hot on. This morning, the same analyst that pegged United Natural Foods for an endorsement panned Tractor Supply with a reiterated perform rating and a $10 reduction in price target, to $60 per share.
Last week, as reported on StreetInsider.com, Tractor Supply warned investors that its Q2 earnings are going to come in a bit light at just $0.94 or $0.95 per share, versus consensus expectations of $1.02 per share. That news sparked a 5.5% sell-off in the stock, and now Tractor Supply's down another half a percent on Oppenheimer's reduction in target price. Are these sell-offs justified, though?
I think so. Like United Natural Foods, Tractor Supply is a stock targeting a subset of well-heeled consumers. Like United Natural Foods, it sells for about 26 times earnings. And like United Natural Foods, that's too high a price to pay for the stock's anticipated growth rate (which, like United Natural Foods, is also about 16%).
Mind you, Tractor Supply isn't quite as bad a deal as United Natural Foods. Whereas UNF is currently burning cash, the worst we can say about Tractor Supply is that it's not generating as much cash as you might think from its $333 million in reported income. (Actual free cash flow at the company is only $180 million over the past 12 months, or roughly half of reported income.)
Long story short, valued at 26 times earnings, Tractor Supply costs too much. Valued at 46 times free cash flow, Tractor Supply costs way too much. Oppenheimer is right to cut its target price.
Go West(ern Digital), young man?
And finally, we come to our one ratings change of the day not originating with Oppenheimer -- and the one that looks like it might have a chance of working out for investors: Western Digital.
This morning, Western D won an upgrade to outperform from R.W. Baird. According to the analyst, Western Digital's Hyperscale Cloud for big data and cloud computing has the potential to lift these shares, which cost just $100 and change today, as high as $120 a year from now. Here's why this prediction might work out for investors.
On the surface, our analysis of Western Digital stock is quite simple: The stock costs 23 times earnings, but generates massive free cash flow -- more than twice reported earnings. None of that matters, though, because analysts polled by Yahoo! Finance have the company pegged for no more than a 2% long-term growth rate. The growth rate is too slow to support almost any valuation on the stock, and so Western Digital is "too expensive" -- Q.E.D.
Now here's why this analysis might be wrong, and why Baird might be right to recommend Western Digital: Across the data storage device industry, growth rates are expected to average not 2%, but 15% annually over the next five years. Given that Western Digital is one of the better operators in this industry, it seems strange that the company would be pegged for a growth rate barely one-tenth the "average" among its peers. Should Western Digital manage to exceed expectations, therefore, and grow anywhere near the rate at which its peers are expected to grow, the stock could quickly move from looking overpriced to fairly priced to cheap.
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 The Fresh Market, and The Motley Fool owns shares of Western Digital.