This Just In: Upgrades and Downgrades

It was the kind of headline that investors love to read: "Bank of America / Merrill Lynch upgrades The Container Store (TCS -1.12%). Says concerns over negative traffic are overdone, and sentiment is beginning to turn."

Unfortunately, that was the headline we read on StreetInsider.com last November. This December, the big news is that Merrill Lynch once again hates The Container Store.

The news at 9
As the ratings aggregator informs us, Merrill Lynch's on-again, off-again sentiment toward the retailer is off again, and Merrill Lynch is downgrading the stock -- all the way from buy to sell. Formerly a fan of TCS, Merrill announced its decision (along with a reduction in price target all the way from $23 per share to just $9 price target).

What StreetInsider did not tell us, and what appears to be missing from all the mainstream media stories on this very un-Christmas-like downgrade this morning, is why Merrill has decided that it hates The Container Store. Indeed, none of our usual sources for details on these kinds of downgrades has any information on the rationale for Merrill's downgrade -- an incredibly frustrating experience for investors who are wondering how much stock to put in the banker's decision.

So let's help you out with that.

Let's go to the tape
While we may not know precisely what Merrill Lynch is thinking about The Container Store today, we do at least have a good idea of how well Merrill thinks about these sorts of things. This is because we've been tracking Merrill's performance for you for nearly a decade now, on Motley Fool CAPS, and have amassed a treasure trove of data on how well this banker's stock recommendations tend to work out for investors.

For example, within the specialty retail segment, Merrill has publicized 42 recommendations (that we're aware of) in 10 years, including winners such as:

Overall though, Merrill's record in specialty retail is pretty unimpressive. A handful of big winners notwithstanding, the banker by and large tends to get most of its picks wrong (33% accuracy) and to underperform the market on its retail recommendations.

On the other hand, Merrill Lynch does tend to do very well when it comes to ... containers, per se. It's scored highly on picks like:

And Merrill's record in the containers and packaging sector is much more impressive overall -- 71% accuracy on its picks, and a market-crushing 425 percentage points' worth of combined market outperformance in the sector.

What it means for investors
So what is an investor to do with all this information? We know that Merrill has a good grasp of containers in general. We know, too, that the analyst is occasionally good (but more often not) in evaluating the health of retailers who may or may not sell containers.

It's an apparent contradiction, so I think we need to let The Container Store itself cast our deciding vote -- by letting its numbers speak for themselves.

Valuing The Container Store
At first glance, The Container Store stock looks kind of attractive. Valued on price-to-earnings, the stock sells for a 25 times multiple. Analysts surveyed on Yahoo! Finance peg the store at a 23% long-term growth rate. Combined, these numbers add up to a PEG ratio of about 1.1 -- reasonable, but not quite cheap.

Where the story really begins to turn against The Container Store, though, is on the company's cash flow statement. Data from S&P Capital IQ clearly show that despite reporting GAAP profits of nearly $17 million over the past 12 months, The Container Store in fact generated no cash profits at all over this period. In fact, free cash flow for the past 12 months has run negative to the tune of $1 million.

Viewed thusly, and also in the context of The Container Store's recent weak sales growth and plunging profits, a stock that looked perhaps fairly priced (but not cheap) at first glance actually looks like a pretty poor value on further review. Although not all my colleagues may agree with me, I think Merrill Lynch is right to be downgrading the stock -- and even to suggest selling your stake in The Container Store altogether.