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 better price target for Pandora (P +0.00%) shares, and an upgrade for Lumber Liquidators (LL +0.00%). But the news isn't all good, so before we get to those two, let's find out why one analyst is...
Pushing the eject button on Lockheed Martin
We begin the day's news on a down note, as analysts at UBS cut Lockheed Martin (LMT +2.36%) shares to "sell." Details on the reasoning for this downgrade aren't widely known just yet, but it may have something to do with a Reuters report out over the weekend, which suggests Lockheed's F-35 Joint Strike Fighter may be too expensive to win a multibillion-dollar Korean fighter jet contract it's been competing for.
Reuters is giving Boeing the edge in winning Korea's "F-X III" fighter contract competition, suggesting it will beat out both Eurofighter's Typhoon and Lockheed's F-35. Meanwhile, a shipment of Lockheed F-16s, destined for Egypt, is being held up by Pentagon officials worried about the implications of continuing to send arms to a government that's increasingly turning its guns on its own people.
These twin developments threaten to rob Lockheed of billions of dollars in expected revenue. And with Lockheed already expected to be facing a long-term growth rate in the single digits, but selling for a P/E in the double digits, it's arguable that Lockheed stock is already too expensive to buy. A shortfall in revenues -- and earnings -- could cause the stock's sub-14 trailing P/E to rocket sharply in future years, making a cheap-seeming stock look much more expensive.
UBS' decision to hedge against that risk today, before the overvaluation becomes apparent, may be the right move.
Good quality Lumber?
Moving on to happier tidings, shares of building supplies specialist Lumber Liquidators are getting a boost today from an upgrade to "buy" at Jefferies & Co. According to StreetInsider.com, Jefferies is predicting a "long runway" of profits growth at the flooring retailer, which is benefiting from "housing tailwinds."
Jefferies had better be right about that, though, and the runway had better be very long indeed, if it's to justify the valuation on these shares.
Priced at upwards of 43 times earnings today, and selling for more than 49 times its inferior free cash flow, Lumber Liquidators is only expected to grow its earnings at about 18% per year over the next five years. Don't get me wrong -- that's a respectable growth pace. But it's not nearly fast enough to support a 40-ish-times-earnings valuation on the stock. One huff, one puff from Mr. Market, and Lumber Liquidators shares could come tumbling down.
The trouble with Pandora
And speaking of overpriced stocks -- Pandora Media. Ever the optimist, banker Needham & Co. announced this morning that it's increasing its price target 25% on Pandora's already buy-rated shares, and predicting Pandora will hit $25 within a year.
Why all the bullishness? Needham thinks Pandora has passed the "breakeven" point in its business, and will collect $871 million in revenues in 2015, and earn operating income of $23 million that year.
That emphasis on operating income is important for two reasons. First, operating profits are not net profits. They're the "profits" a company gets before they reach the bottom line. The "profits" before all expenses have been deducted -- so not really "profits" at all. From a net profit, bottom-line perspective, Pandora is still losing money hand over fist ($46.5 million lost over the last 12 months).
Second, Needham admits that the upcoming fiscal second-quarter 2014 report will show that for now, at least, even Pandora's operating results remain in losing territory. True profitability may or may not arrive by 2015. But for now, it's not here -- which is why Pandora continues to be plagued by a negative P/E ratio. As a result, the fact that Pandora is said to be expecting 45% annualized profits growth (according to Wall Street analysts) doesn't mean much -- because growing a negative number doesn't mean much. (And of course, free cash flow at the company remains negative as well, with more than $13 million burnt over the past year).
Long story short, Needham may be right about Pandora, or it may be wrong. Until the company actually proves itself capable of earning a net profit, or at least of producing positive free cash flow, assigning any specific valuation to the shares remains pure speculation.
Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool recommends Lumber Liquidators and Pandora Media. The Motley Fool owns shares of Lockheed Martin and Lumber Liquidators.
