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 new buy ratings in the entertainment sphere as Wall Street analysts upgrade shares of Walt Disney (NYSE:DIS) and assign numerous new buy ratings to King Digital Entertainment (NYSE:KING) -- aka "that Candy Crush company." The news isn't all good, however, so before we get to those two, let's take a quick look at why a couple of analysts think...
Whole Foods is going stale
Last week, we looked at how a strong earnings report, paired with an analyst downgrade, crushed shares of Whole Foods (NASDAQ:WFM) wannabe Natural Grocers by Vitamin Cottage. Today, it's Whole Foods itself getting stabbed by Wall Street's analytical pencil as analysts at Oppenheimer cut their price target to $61 per share, while lesser-known analyst Wolfe Research goes a step further and downgrades Whole Foods shares to underperform. Should investors be worried?
StreetInsider.com, which reported on the Wolfe downgrade this morning, did not provide much detail on the whys and wherefores of the analyst's negative note. Fortunately, we got more detail on why Oppenheimer cut its price target -- and it appears to trace right back to Natural Grocers' report last week.
Oppenheimer worries that slowing growth in same-store sales at Whole Foods' peers ("daily average comparable store sales" at Natural Grocers were up only 5.7% last quarter) could foreshadow "softish" Q2 profits at Whole Foods. Indeed, Oppenheimer says it's possible we will see Whole Foods shares wilt down into the $40s in the near future -- before rebounding and growing straight up to Oppy's targeted $61 share price.
Investors today are responding more to Oppenheimer's short-term worries than to its long-term optimism, however, and selling off Whole Foods shares by more than 2% this morning -- and I can't blame them for it. Priced at 32 times earnings and at more than 40 times free cash flow, the shares look expensive in both the short and long terms.
Fact is, most analysts see little chance of Whole Foods posting more than mid-teens earnings growth over the next five years -- which is probably too-slow growth to support the prices Whole Foods shares fetch today. I see little chance of Oppenheimer's hoped-for $61 share price appearing anytime soon -- but every chance of the analyst being right about Whole Foods dropping lower into the $40s.
Next up, the House of Mouse.
Applause for Walt Disney
Disney shares, meanwhile, are dodging the downturn on markets today after Topeka Capital announced it's upgrading Disney stock to buy, and setting a $91 price target -- more than $10 above where Disney shares sit now. Quoting the analyst, StreetInsider.com notes that "the stock trades at 14.6x ... F2016 non-GAAP EPS estimate of $5.40/share, a 16.4% growth clip over F2015, and a reasonable multiple." Topeka goes on to point out that when valuing the stock on earnings two years out (and on pro forma earnings at that), Disney stock has pretty consistently averaged a "PE/G of 1" for the past two decades, and it sees any valuation in that neighborhood as a fair price to pay.
So... take $5.40 times 16.4 = $88.56, and, voila, you've got yourself Disney's new price target.
Now, granted, this is a bit of an unorthodox way to calculate a PEG ratio. Ordinarily, how you'd want to do this is to base your PEG on Disney's trailing earnings -- the ones we know for a fact and are not guessing at. And you'd want to use a five-year estimated growth rate, rather than just the growth expected over the next year or two (because growth rates tend to slow over time). Calculated this more traditional way, Disney's $3.64 in trailing earnings times its 16% estimated long-term growth rate results in a "fair" share price of only $58.24 per share -- plus a premium that you might be willing to pay for owning one of the best-quality entertainment stocks in the country.
But tomayto-tomahto. However Topeka wants to justify its buy rating is up to Topeka, and only time will tell whether the analyst is right about the premium it's telling investors to ante up. Personally, I see the stock as overvalued, and will not be following the analyst's advice to buy.
King gets crowned
Last and far from least, we wind up today's column with King Digital, the maker of the popular mobile devices game Candy Crush Saga. Now that the quiet period on this stock's IPO has expired, everybody who's anybody is taking the opportunity to give the stock a rating -- and so far, these ratings are almost unanimously positive, with 10 analysts saying it's time to buy King and only two coming out with neutral ratings.
Why all the enthusiasm? RBC Capital sums it up best: "KING has emerged as a leading Casual Gaming company. What separates it from many of its competitors is that it has expertly developed a Mobile-oriented, fremium-model, highly profitable platform. It has also demonstrated diversification away from its dominant Candy Crush franchise. Current valuation is highly undemanding."
Undemanding? I'll say!
Valuing this stock on trailing profits, King shares today sell for a measly 10.2 times earnings. Valued on free cash flow, the stock's an even cheaper 8.7 times free cash flow. That seems awfully cheap if King can post even mid-double-digit earnings growth going forward. It's almost worth paying if the company grows not at all, but just cruises on its Candy Crush success and maintains its current level of profitability.
But in fact, in an industry that analysts predict will grow at close to 19% annually on average over the next five years, RBC notes that King currently boasts "the sector's fastest growth rate" -- suggesting King could probably grow somewhere in the 20s, if not even faster than that.
It's not often I side with the Wall Street consensus, where all the bankers are rushing in one direction on a trade and everyone is shouting "buy." This time, however, the bankers appear to be right. King Digital is one very cheap stock indeed.
John Mackey, co-CEO of Whole Foods Market, is a member of The Motley Fool's board of directors. The Motley Fool recommends and owns shares of Walt Disney and Whole Foods Market. Motley Fool contributor Rich Smith has no position in any stocks mentioned, and doesn't always agree with his fellow Fools.
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