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 feature a pair of upgrades for home furnishings store Pier 1 (OTC:PIRRQ) and engine technologist BorgWarner (NYSE:BWA). Let's address those two real quick, before we get to the day's really big news (about American Tower (NYSE:AMT)).
Pier 1 won't sink
As housing sales boomed, Pier 1 Imports grew its sales 9%, and its earnings 14% in the most recent quarter. Arguing that Pier 1 is likely to continue growing sales in quarters to come, Argus Research announced this morning that it's upgrading the shares to "buy" and assigning them a $27 price target. With the shares currently trading for $23 and change, that works out to about a 13% potential profit on top of Pier 1's modest 0.8% dividend yield. An attractive proposition in an overvalued market, to be sure -- but will Pier 1 really rise to $27?
I don't think it will, and I'll tell you why.
Pier 1 shares sell for about 19 times earnings right now. That doesn't seem too unreasonable a valuation at first glance. After all, you get a small dividend for that price. And you also get 16% projected long-term earnings growth. The problem with Pier 1, though, is that the quality of those earnings is frightfully low.
According to Pier 1's cash flow statement, the company only generated about $86 million in real free cash flow over the past year. That's about 35% less than the $132 million its income statement says it "earned" during the same period -- $0.65 in cash profits per $1 of claimed earnings. It means a stock that Argus is reading as selling for a "19 P/E" is actually better thought of as a stock that costs 29 times the amount of cash that it can generate in a year. That's too high a price to pay, and Argus is wrong to recommend it.
Analyst assimilates BorgWarner
In contrast to Pier 1's respectable growth pace, growth was notably lacking at engine-parts-maker BorgWarner last quarter. Sales were down 3% at Borg, with profits dropping 10%. Regardless, analyst R.W. Baird sees a bright future for Borg, arguing that the outlook for auto sales in Europe is improving, Borg has plenty of cash flow to wait out the storm, and the stock is likely to "outperform" the market.
And, well, Baird is partly right. With $464 million in trailing free cash flow, Borg is generating a lot of cash. Problem is, as with Pier 1, the company's still not making as much money as its income statement suggests -- and not enough to justify its stock price.
Borg's share price -- 22 times earnings -- is already too much to pay for a company expected to grow profits at 15% per year annually. And the stock is even more expensive when you consider that $464 million is about $21 million less than what Borg reports for its trailing net income. Plus... Borg no longer pays a dividend.
Long story short, while BorgWarner remains a fine company, and Baird is right about the company's ability to survive till better times arrive, its stock remains too expensive today. Once again, this is an upgrade to "buy" that you should pass by.
American Tower is leaning the wrong way
And now for the rating you've all been waiting for: American Tower. This morning, noted short-seller Muddy Waters announced it was initiating coverage of the cellphone tower company -- announced it with a 21-gun broadside fired at the company's flank.
As reported on StreetInsider.com, Muddy Waters alleges dirty tricks are ongoing at American Tower, keying in on:
...an approximately US$250 million discrepancy between what AMT claims to have paid for the acquisition of towers in Brazil, and the actual selling price. AMT claimed to have paid US$585.4 million for the towers, but the real price was close to US$300 million. If AMT is aware of this discrepancy, it would amount to fraud. We have provided our research to the SEC.
Strong words -- but they're not the end of Muddy Waters' criticism, which also targets "consistent sales of approximately 90% of the shares" American Towers' CEO receives from the company, alleged revenue inflation, poor rates of return on capital, and more broadly against the business, a threat that cellphone towers may ultimately lose relevance as Wi-Fi hot spots begin taking over as the preferred method of Internet delivery.
Do Muddy's allegations hold water? Investors don't appear to think so, as they mostly shrug off today's "strong sell" initiation and bid American Tower shares down only a modest 1.1%. But really, it doesn't matter who's right in this debate over alleged fraud. At 50 times earnings, American Tower's shares are pretty obviously overpriced -- even for optimistic predictions of 27% annualized long-term growth.
In this case at least, Wall Street is right about its stock recommendation.
Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool recommends American Tower and BorgWarner. The Motley Fool owns shares of American Tower.