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 Domino's Pizza (DPZ 2.72%) and Aeropostale (ARO +0.00%). But the news isn't all bad, so before we get to those two, let's take a quick look at why...
American Eagle could fly
The day starts out bright for owners of American Eagle Outfitters (AEO +0.24%) stock. After crunching the numbers on True Religion's (NASDAQ: TRLG) recent buyout, independent analyst Standpoint Research has concluded that there's value to be had in the shares of a rival teen retailer -- American Eagle.
Standpoint upgraded shares of AE to "buy" this morning, and it's not hard to see why. Priced at 17.3 times earnings, AE stock sells at a sizable discount to the more than 22 times earnings that TowerBrook Capital is paying for True Religion. Plus, at 11% projected earnings growth over the next five years, AE is growing nearly twice as fast as TR.
Adding to the attraction, AE generated $381 million in real free cash flow over the past year -- 64% more than the $232 million in GAAP earnings the company reported. By my calculations, this has AE shares selling for a very attractive 10 times FCF valuation, and selling at a discount based on 11% earnings growth. Throw in a tidy 2.2% dividend yield, and right there, folks, you have yourself a market-beating investment for the taking. Standpoint is absolutely right to upgrade it.
Aeropostale -- lost in the mail?
Now on the other hand, the news isn't quite as good for another of the "A-list" teen retailers. At the same time as Standpoint was urging investors to buy AE, you see, this same analyst was downgrading shares of Aeropostale to "hold."
Why? Again, the numbers tell the tale.
Priced at 38 times earnings, or even at the more attractive-sounding 17 times free cash flow, Aeropostale is pretty obviously more expensive than rival American Eagle. It's even arguably more expensive than True Religion, meaning that the buyout price paid for TR holds out little promise for Aeropostale owners.
The stock's also growing slower than AE (10%, projected), and to top it all off, Aeropostale pays no dividend. If you ask me, that makes the stock not just a worse prospect for buying than AE is -- it comes darn close to an argument for selling Aeropostale shares outright.
Domino's Pizza doesn't taste good
A second stock getting whacked by the Wall Street ugly stick today is Domino's Pizza -- although this time, it's not Standpoint doing the downgrading. Rather, Miller Tabak is blowing the whistle on Domino's 85% stock-price surge, and urging investors to take a time out... and take their winnings off the table.
Again, I agree that there's no time like the present to do this. Here at the apex of their run, Domino's shares cost a heady 27 times trailing earnings, which seems like a lot to pay for a projected 14% long-term grower like Domino's. The dividend yield, 1.4%, makes up some of the difference between P/E and growth rate. Also, Domino's is a strong free cash flow generator, bringing in 37% more cash profit over the past year than it reported as GAAP net income.
That's enough to get the stock's P/FCF ratio down to about 19 -- but to my Foolish eye, even with the dividend, and even with the robust free cash flows, this stock still looks significantly overpriced. I think Miller's advice to pare back your position is sound. And again, as with Aeropostale, I'd suggest that conservative, value-focused investors might want to go ahead and sell out -- maybe invest the proceeds in a bona fide value like American Eagle instead.
Because -- yes -- I think AE stock is just that good.
Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned.
