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Monday's Top Upgrades (and Downgrades)

By Rich Smith - Apr 8, 2013 at 1:58PM

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Analysts shift stance on G-III Apparel, Northrop Grumman, and Google.

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 a new buy rating for G-III Apparel (GIII -1.70%), and an upgrade for Northrop Grumman (NOC -1.40%). It's not all good news, however, so let's start off the day with a few words on why...

Google may not compute 
The week started off on a down note for Google (GOOGL -1.35%) investors, as analysts at Pivotal Research cut their rating on the stock from buy to hold on worries that Google's spending too much money building its own fiber-optic networks -- when it should be focused on milking its core paid search business for mondo cash.

As quoted on StreetInsider.com today, Pivotal argues that Google is "spending hundreds of millions (and eventually billions?) of dollars on Google Fiber," having just announced it is building out a network in Austin, Texas. While Pivotal hedges that the investment "may be justified because of the future-proofing aspects of the initiative," the analyst points out that even if you like the strategy, it's clearly "margin-eroding," and will hurt Google's ability to earn profits for its shareholders -- laying fiber being a lot more cost-intensive than selling clicks.

This is particularly worrisome given that Google already arguably costs too much even at its current level of profitability. Priced north of $770 a share, Google stock costs about 24 times earnings, which seems quite a lot to pay for the sub-15% growth rate analysts assign the stock. Slow down that growth rate by "eroding" profit margins at Google, and the stock could be even more expensive than it already looks.

Long story short, I see Google shares as fairly priced today assuming (1) the company is valued on free cash flow rather than GAAP earnings, (2) it gets credit for its more than $40 billion in net cash, and (3) it maintains its expected growth rate, and suffers no margin erosion whatsoever. Remove any of the three legs from this tripod, however, and the case for buying Google keels over.

Could G-III "go to 11"? 
On the other hand, the case for buying Google is still a whole lot stronger than the one that Brit banker Barclays just made for buying G-III Apparel this morning. Initiating coverage of the clothing manufacturer Monday, Barclays assigned G-III an overweight rating and a $46 price target, you see.

But G-III may not deserve either one.

Sure, on one hand, I see the appeal in G-III's "14 price-to-earnings ratio," which looks attractive enough in light of consensus expectations for 20% earnings growth at the company. But there are two problems with this buy thesis: The price and the earnings.

Price-wise, calling G-III a 14 P/E stock fails to take into account the more than $240 million in net debt being toted around on G-III's balance sheet. Factor that into the valuation, and the stock's "enterprise value" to earnings ratio is closer to 18 than to 14.

As regards earnings, G-III failed to include a cash flow statement with its recent fourth-quarter earnings release, so it's hard to say for certain whether the company generated real free cash flow in line with the $2.80 in earnings per share that it reported. What we do know for certain is that the company burned cash steadily in the first three quarters of last year (as it usually does), so going into the fourth quarter, at least, G-III was firmly free cash flow negative. The company's 10-K filing may show that all's well with the company -- or it may not. But until we see the numbers therein, it's too early to call G-III a buy.

Neutral on Northrop Grumman 
Last but not least, we come to defense contractor Northrop Grumman, recipient of an upgrade to "neutral" from investment banker JPMorgan.

Northrop, like most of its brethren in the military-industrial complex these days, is dogged by concerns that cuts to defense spending will curtail its ability to earn a profit. But while I'm not dismissing these concerns entirely, it does seem to me that the low valuation on Northrop shares more fully prices in the risk of defense cuts.

Northrop shares sell for only about two-thirds of annual sales, after all, which is one of the lower valuations you'll find among its peers. Northrop costs about nine times earnings, largely due to the fact that analysts aren't expecting the stock to grow these earnings at all -- but actually to shrink them a bit -- over the next five years.

Even so, though, this "bad" growth news means that if Northrop just holds the rudder steady and maintains its current level of profitability, its $2.3 billion in annual free cash flow will produce enough cash to buy back every single share of the company's stock -- or alternatively, to back up the firm's entire market cap with cash-in-the-bank -- in less than seven-and-a-half years. That prospect, it seems to me, is more than good enough to justify JP's neutral rating on the stock. It might even be good enough to justify a "buy."

Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool recommends Google. The Motley Fool owns shares of Google and Northrop Grumman.

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Stocks Mentioned

Alphabet Inc. Stock Quote
Alphabet Inc.
GOOGL
$2,207.68 (-1.35%) $-30.31
Northrop Grumman Corporation Stock Quote
Northrop Grumman Corporation
NOC
$448.50 (-1.40%) $-6.37
G-III Apparel Group, Ltd. Stock Quote
G-III Apparel Group, Ltd.
GIII
$23.14 (-1.70%) $0.40

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