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 include downgrades for Tractor Supply (TSCO 1.80%) and United Natural Foods (UNFI 0.41%), but a big hike in price target at Honeywell (HON 0.47%).
Good news first
Let's tackle that one first. Honeywell shares are surging this morning -- up more than 1%, or three times more than the Dow -- on reports that the company has just reaffirmed that it can hit its growth targets for this year. Management says it's on track to achieve 4% to 5% sales growth, and 6% to 11% profits growth in fiscal 2013, ending the year with per-share profits of as much as $4.95.
This prospect convinced analysts at Stifel Nicolaus to add $6 to their price target on the stock, which Stifel now thinks could hit $80 by year-end. There's just one problem with that analysis, though.
It's wrong.
Priced at 19.5 times trailing earnings, Honeywell shares already look richly priced for the 10%-plus earnings growth analysts expect it to produce over the next five years -- growth that already looks to be at the high range for what Honeywell's saying it can achieve. Free cash flow at the company, at $2.6 billion, lags reported net income by 10%, showing Honeywell to be even more expensive than it looks.
Indeed, even if all goes perfectly, and Honeywell maxes out its profits guidance this year, the stock would still cost more than 14.5 times earnings -- overpriced for 10% growth and a 2.4% dividend yield. And that's the best case scenario. Worse case, Honeywell falls short on its growth promises, and looks even more overpriced than it already does. To my Foolish eye, this argues in favor of a decline in stock price -- not a surge to $80 and beyond.
Tractor Supply stalls
Meanwhile, the news for stocks Wall Street does not like is even worse. Tractor Supply, for example, just got hit with a downgrade (to "hold") from Feltl & Co. This is strange, because according to StreetInsider.com, Feltl actually thinks the stock could rise to $112 a share over the course of the next 12 months.
It might. With 17% earnings growth projected for this year, and for each of the next five years, Tractor Supply looks likely to keep investors happy, and keep on keeping them happy, as earnings rise higher and higher. But what if the momentum stalls?
Already, Tractor Supply shares look overvalued at 27 times earnings. The dividend payout here is minimal, just 0.8%. Free cash flow is weak, with Tractor Supply generating only about $0.82 in real cash profit for every $1 it claims to be "earning" under GAAP. So long as the company maintains its growth pace, I suspect investors may be willing to ignore the obvious overvaluation. But if Tractor Supply misses the gas pedal just once, investors are going to slam on the brakes.
United Natural falls apart
Last and least, we come to organic food distributor United Natural Foods, falling alongside Tractor Supply this morning, and for the same reason: a downgrade to "hold." This time it's analyst Argus Research that is holding the knife, but once again, it's right to be cutting bait on an overpriced stock.
United Natural costs nearly 25 times earnings. It carries significantly more debt than cash, and generates paltry free cash flow of just $37 million per annum. That's as compared to GAAP "profits" of $98 million. (In fact, United Natural doesn't even generate as much operating cash flow as it claims to be earning, let alone positive free cash flow.)
So what's supporting the stock? Once again, it's an enviable projected growth rate. Analysts expect United Natural to grow earnings 12% this year, and then accelerate toward near-15% annual growth over the next five years. The problem is that even if it does exactly what Wall Street promises it will do, the company's weak free cash flow number, and unimpressive earnings, all mean the stock will still look vastly overvalued.
And what happens if United Natural fails to produce the growth expected of it -- as happened in last week's earnings report, for example? That'll be the time when United Natural's growth thesis truly falls apart.
Motley Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned.
