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 focusing on popular consumer brands Michael Kors (KORS 1.63%) and Netflix (NFLX +0.12%), both of which have suffered downgrades, and lululemon athletica (LULU 3.66%) -- which scored a rare upgrade this morning. In fact, let's start with that one.
LULU is no lemon
Shares of yoga-wear maker Lululemon are leading the market up this morning after receiving an upgrade to "buy" from analysts at D.A. Davidson Tuesday. Citing the potential for growth to reignite as the company gets past its see-through pants problems, combined with the company's inarguable market leadership and a more attractive valuation, Davidson says we could see Lululemon shares hit $73 within a year.
But is Davidson right?
With its stock down nearly 20% over the past year, against a 25% gain for the S&P 500, Lululemon is definitely cheaper than it has been. Yet the stock still sells for 31 times earnings, which appears expensive in light of expected 18% long-term earnings growth. Worse, free cash flow at the company ($169 million) continues to lag behind reported GAAP earnings ($279 million) -- resulting in an even less attractive price-to-free cash flow ratio of 50.
Result: While it would be nice to imagine that Lulu's troubles have made its stock a bargain that can be taken advantage of, the truth of the matter is that its shares were so vastly overvalued before the scandal struck that, even in its aftermath, the stock remains overpriced. Davidson is wrong to recommend buying Lululemon.
Of Kors, it's overpriced!
Keeping our focus on highly sought-after consumer goods for a bit, we turn now to fashion accessories manufacturer Michael Kors -- just downgraded to neutral by Citigroup. According to StreetInsider.com, which reported the rating this morning, Citi's worries center on Kors' watches business. Citi notes that retailer Macy's experienced weak sell-through in watches in Q3, while Fossil, which specializes in watches, says it's experiencing sluggish traffic and is having to cut prices (and profit) margins to move inventory.
These trends have Citi feeling cautious about Kors' valuation after the stock's 60% runup in 2013. And rightly so.
Priced at 32 times earnings, Kors shares carry a valuation similar to that found at Lululemon. Growth expectations at the company (25% over the next five years) haven't taken as much of a hit yet. But after examining the company's cash flow statement, I can't help but wonder if people shouldn't perhaps be more worried about Kors than they are about Lululemon.
After all, Kors generates barely half as much free cash flow as the company's GAAP income statement suggests -- just $272 million in cash profits generated over the past year, versus reported "income" of $502 million. As a result, the stock's price-to-free cash flow ratio sits north of 59, which is almost certainly overpriced even if the company does achieve 25% growth. Given this, Citi is right to be cautious about the stock, and right to downgrade it.
The granddaddy of overpriced momentum stocks
And speaking of overpriced stocks: Netflix. Popular though the company's services may be, at 287 times earnings, they sell for a very pretty penny indeed. Far more than even its projected 22.5% annualized earnings growth rate (which is 2.5 points behind Kors', by the way) could possibly justify. Far, far more than the stock is worth, given that Netflix currently generates no free cash flow whatsoever.
Viewed in the most favorable light, Netflix's free cash flow for the past year was negative $10 million -- negative $40 million, once you factor in the costs of keeping Netflix supplied with DVDs for its rent-by-mail service. Little wonder, then, that this morning analysts at Morgan Stanley cut the stock's rating to "underweight" (meaning "sell").
Morgan justifies its tardy downgrade of Netflix -- the shares have actually been overpriced for quite some time -- by saying that it's just now noticed that "viable alternatives" to Netflix's streaming service have emerged in the form of Amazon Prime Instant Video, HBO Go, and Hulu Plus. But, honestly, I don't think there's any need to strain for a justification here. Netflix's on-its-face overvaluation is more than reason enough to sell this stock.
Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool recommends Fossil, lululemon athletica, Michael Kors Holdings, and Netflix. The Motley Fool owns shares of Netflix.
