This series, brought to you by Yahoo! Finance, looks at which upgrades and downgrades make sense, and which ones investors should act on. Today, we'll be looking at a pair of downgrades for both Lear (NYSE:LEA) and Whole Foods (NASDAQ: WFM), followed by an improved price target at 3M (NYSE:MMM). Let's start with that one.
3M gets an A
3M gave Wall Street a mildly pleasant surprise last week, reporting $1.71 per share in earnings, a 3% improvement over last year and either matching or a penny ahead of analyst estimates -- depending on whose estimates you're referring to. This news has Swiss banker UBS upping its price target on the stock Monday morning, with UBS now saying the shares could hit $128 within a year, and recommending a buy rating on the stock.
Is that prudent? I don't think so, and I'll tell you why. Right off the bat, you can see that 3M is a pretty pricey stock at its 18-times-earnings valuation. Earnings growth over the next five years is estimated at less than 10%, and the company's 2.2% dividend yield, while nice, isn't quite big enough to make up the difference.
Adding to the case against 3M, its P/E ratio is about 50% higher than the average among industrial conglomerates (which as a whole sport a 12.1 P/E ratio according to data from Yahoo! Finance). Also, 3M's profits are of somewhat lower quality than we'd like to see. Although the company reported nearly $4.5 billion in GAAP "earnings" over the past 12 months, actual free cash flow generated by the business fell short of $4.2 billion. That discrepancy pushes the stock's price-to-free cash flow ratio up to nearly 19, while the addition of debt to the calculation gives the stock an enterprise value-to-free cash flow ratio of more than 19.
Long story short, the stock looks overpriced to me. I wouldn't recommend buying it at today's price, much less hoping to see 3M run up to $128.
Moving on now to the downgrades, we find UBS in the mix again, this time cutting its rating on auto parts maker Lear to "neutral." That's a bit counterintuitive, given that Lear, like 3M, beat earnings last week -- and by a much more decisive margin, reporting pro forma profits of $1.62 per share versus analyst expectations of $1.37. Lear also beat estimates on revenues, and increased its forecast to a prediction of $15.8 billion in revenues, and operating profits of between $750 million and $800 million.
And yet... with its shares up 90% already over the past year, there's an argument to be made that Lear shares already have all of this good news "priced in." With the stock now approaching UBS' $70 price target, the analyst is downshifting a bit -- leaving its price target intact, but curbing its enthusiasm about actually buying the stock. Is that the right call?
I think it is, but to be honest, I think this stock is quite a bit more attractive than 3M. Here's why: Lear's free cash flow isn't great. At just $331 million for the past year, it's a far cry from the $1 billion in net profits the company has claimed to have earned over the period. Still, $331 million is enough to give the stock a 17.5 price-to-free cash flow ratio. That's cheaper than 3M, and Lear offers the added benefit of a faster rate of estimated growth. Analysts peg it at better than 14% over the next five years, which, when added to the company's 1% dividend yield, gets Lear stock close to fair valuation.
Meanwhile, traditional P/E investors can't help but be attracted by the PEG ratio you get from dividing Lear's 5.1 P/E by its 14% growth rate.
All in all, I don't think the stock's quite as cheap as its inflated earnings make its P/E ratio appear. But it's far from a lost cause. If Lear can grow as expected, and maybe produce just a bit more cash from its business, the stock could reach UBS' $70 price target -- and then surpass it.
How healthy is Whole Foods?
Finally, we come to Whole Foods -- like Lear, downgraded to a variant of "neutral," but with no reduction in price target. (This time, it's Cantor Fitzgerald doing the downgrading, and retaining a $54 price target on the stock.)
I admit to being conflicted about this one, because Whole Foods is certainly a superior business. The problem is that its share price is similarly superior -- as in, too high to justify. The stock costs 40 times earnings today -- more, if you value it on free cash flow, which is currently flowing in at the rate of about $0.94 for every $1 in claimed "net income."
Maybe the stock can hold on to this premium valuation if Whole Foods can wow investors with its earnings report Wednesday. Longer-term, though, I just don't think the company's projected growth rate -- 18% annually according to the analysts -- is fast enough to justify a 40 times earnings valuation.
Long story short, I'd probably rather be short this one than long.
Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool recommends 3M and Whole Foods Market. The Motley Fool owns shares of Whole Foods Market.