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 top trio of top headlines includes a downgrade for Darden
Let's tackle the restaurant ratings first, beginning with Darden. This morning, analyst R.W. Baird downgraded Darden to "neutral" ahead of next week's Orlando shareholders meeting. Investors are reacting with disappointment, as Darden sits out today's rally on the Dow but, in fact, they should probably be grateful Baird didn't drop their rating any further.
Priced at more than 15 times earnings, Darden shares don't look particularly appetizing at their projected sub-12% earnings growth rate. That's before you notice that the company is carrying $2.1 billion in net debt, and before you realize that the company generated a mere $122 million in free cash flow over the past year -- barely 25% of the reported "earnings" that give the stock its already pricey P/E ratio.
Result: Darden's one pricey eatery. Baird's right to downgrade it -- but it's wrong to stop at neutral. This one should go immediately to "sell."
Order up, at Chipotle
Meanwhile, Baird peer Miller Tabak put down its burrito long enough to post a quick upgrade in target price for Chipotle Mexican Grill. Miller thinks the $338-a-share stock is worth closer to $355 a share, and continues to recommend buying it. Investors, however, should pause before drinking the sangria on this rating.
While avoiding Darden's debt dilemma, Chipotle has problems of its own. Chief among them, a stock price that, at 41 times earnings, looks obviously expensive -- a fact compounded by Chipotle's inability to generate free cash flow equal to its net income. (Although better off than Darden, Chipotle's FCF number still lags reported income by a good 15%.)
True, Chipotle is growing faster than Darden, with a growth rate most analysts put around 21% annually. But even this number isn't big enough to justify today's stock price. Investors who follow Miller Tabak's advice, and buy the shares today in hopes of earning a mere 5% profit a year from now, may find the shares a bit spicier than they bargained for.
Too many Nuances
In contrast to today's restaurateur ratings, one problem Nuance Communications does not have is generating cash. Over the past 12 months, the maker of Dragon Naturally Speaking voice-to-text software packages generated a whopping $367 million in cash profits -- more than four times its reported annual "earnings." And yet, even at 21 times FCF, the stock may not be worthy of the "overweight" rating that Morgan Stanley assigned it this morning.
Nuance, you see, depends heavily on acquisitions of other companies and their cash streams to keep its own FCF numbers high, and its capital budget low. Over the past five years, the company's spent a good $1.7 billion acquiring other businesses -- but generated operating cash flow of only $1.2 billion itself. So it's not so much "creating value" as it's rolling up other companies into its financial statements, and reporting their value as its own.
Even then, the value doesn't look particularly compelling. Analysts expect Nuance will continue growing quickly through its roll-up strategy. But the 17% growth rate that they assign the stock isn't quite fast enough to justify the 21x FCF valuation on the stock -- even if Nuance deserved full credit for its free cash flow. Long story short, while this is a dangerous stock to short, I wouldn't want to go long Nuance, either.
Fool contributor Rich Smith holds no position in any company mentioned. The Motley Fool owns shares of Chipotle Mexican Grill and Darden Restaurants. Motley Fool newsletter services have recommended buying shares of Nuance Communications and Chipotle Mexican Grill.