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 downgrades for Alcoa (AA) and Qualcomm (QCOM 1.62%), but a new buy rating for Garmin (GRMN 1.07%). Let's start with that good news first.
Dedicated GPS is dead...
Once upon a time, Garmin was the name in global positioning system technology for the everyday consumer -- but then, iPhones and Androids began offering free GPS, and kind of stole Garmin's thunder. You might think that this development made dedicated GPS device manufacturers like Garmin passe, but at least one analyst disagrees.
This morning, Atlantic Equities announced that despite all the negative sentiment surrounding Garmin's business model, it still believes the company is doing fine, and has a bright future. Ahead of Garmin's upcoming Q3 earnings report due out Oct. 30, Atlantic is initiating coverage of the stock with an "overweight" rating, and suggesting the shares could reach $59. Considering that the shares currently cost less than $47, that prospect sounds attractive.
But Atlantic Equities is wrong.
Garmin's problems extend beyond its broken business model. With shares priced at more than 17 times earnings, the 6% long-term earnings growth that analysts expect Garmin to eke out is simply too little to support its stock price.
Granted, Garmin has factors in its favor. The company boasts $1.2 billion in cash on its balance sheet, generates strong free cash flow on its cash flow statement, and uses all this cash to pay out a generous 3.8% dividend yield. Nonetheless, single-digit earnings growth can't justify a double-digit P/E ratio. The stock's overpriced, and Atlantic is wrong to recommend it.
...but smartphones aren't
Now let's contrast Atlantic's misplaced optimism over Garmin with Merrill Lynch's too-pessimistic view of fellow "tech stock" Qualcomm. On Monday, analysts at Merrill cut their rating on Qualcomm from buy to neutral, citing worries that global smartphone sales growth will decline from 32% this year, to as slow as 10% in 2015.
With Qualcomm being one of the bigger players in building smartphone components, this would appear to bode ill for the stock -- especially given that Merrill thinks that by 2015, most of the growth we do see with come in the form of third world phone-shoppers buying no-name devices that run on cheap, non-Qualcomm chips.
Yet when you look at Qualcomm's share price, it's hard to wonder whether these worries aren't already priced into the stock. Despite being one of the preeminent names in the space, Qualcomm shares sell for a rather modest P/E multiple -- less than 18 times earnings. Free cash flow at the firm is strong, roughly equivalent to reported GAAP income. Cash reserves are likewise strong, at nearly $11.5 billion net of debt.
Meanwhile, most analysts see Qualcomm growing earnings at close to 17% annually over the next five years (considerably faster than the overall smartphone sales growth rate that Merrill is warning of), and paying its shareholders a 2.1% dividend yield. Overall, I have to say that these numbers suggest a moderately discounted share price relative to the company's prospects. I think Qualcomm's still a buy, and Merrill Lynch is wrong to downgrade it.
Alcoa looks rusty
True, aluminum isn't supposed to rust. But chemistry notwithstanding, Alcoa's gotten downgraded to "equalweight" by Morgan Stanley. As StreetInsider.com reports, Morgan Stanley thinks global aluminum prices are heading lower, and will lead to Alcoa earning as little as half of what it was previously expected to earn in fiscal 2014/2015.
Based on this prediction, Morgan Stanley cut $1 off its price target for Alcoa stock (reducing it to $9), and cut its rating in tandem.
While this is certainly not good news, it seems a rather muted reaction to the worries. A 50% reduction in profits, but only a 10% reduction in stock value, seems like an underreaction to me. And when you consider that Alcoa stock already costs more than 66 times earnings today, and carries a crushing debt load of $7.2 billion (net of cash), even the consensus estimate of 17% long-term earnings growth seems too little to justify the stock's price.
Slash Alcoa's earnings as drastically as Morgan Stanley just estimated, though, and the logical conclusion is that Alcoa's even more overvalued than first meets the eye -- and perhaps deserves a rating even lower than the one Morgan Stanley just assigned it.
Motley Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool owns shares of Qualcomm.
