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 another new buy rating for King Digital Entertainment (NYSE:KING), but downgrades for both Target (NYSE:TGT) and InterContinental Hotels Group (NYSE:IHG). Let's get the bad news out of the way before proceeding with the good.
As you've probably heard by now, Target CEO Gregg Steinhafel is resigning his post. The news can't come as much of a surprise, after the fiasco that was this past Christmas' massive data breach at the retailer. But unexpected or not, the loss of a leader who's guided Target through 35 years of retail success -- six at its helm -- isn't going over very well on Wall Street.
This morning, analysts at MKM Partners warned that the CEO's departure adds "uncertainty" about the stock, while failing to improve MKM's opinion of Target's unprofitable Canada operation. Quoting from StreetInsider.com's write-up today: "Mr. Steinhafel may have made some miscalculations and missed some opportunities, but we think external factors played a greater role."
Translation: It wasn't all Steinhafel's fault, and getting rid of him doesn't solve the problem. With or without Steinhafel, MKM says, "We continue to hear concerns from consumers about the late-2013 data breach and believe it continues to hurt sales and RedCard usage/signups."
Until these problems are resolved, MKM is adopting a "neutral" position on the stock. But should it?
I mean, when you look closely at the stock, yes, Target has some problems. But the stock has gotten so cheap lately that you really have to wonder whether those problems are already baked into the stock. Apparently, priced at 19 times GAAP earnings, Target generates so much positive free cash flow from its business (S&P Capital IQ data puts trailing free cash flow at $3.1 billion -- more than half of what Target reports as GAAP profits) that its price-to-free cash flow ratio sinks below 12. For a projected 12% grower paying a 2.8% annual dividend yield, that's an awfully tempting price.
Maybe even tempting enough to entice an investor to buy Target stock, despite MKM's downgrade.
InterContinental Hotels Group condemned
Another stock losing Wall Street's favor this morning is InterContinental Hotels Group, downgraded to neutral at UBS today on concerns that, after running up 22% over the past year, the stock is now too expensive. They're probably right about that.
Much like Target, InterContinental Hotels is a superb cash generator. The hotel manager generated positive cash profits of $465 million last year -- 25% ahead of reported net income. Yet even so, this only gets the stock's valuation down to about 21 times FCF. Meanwhile, its price-to-earnings ratio is a heady 27 times. Either way you look at it, these are high prices to pay for a stock that few analysts expect to achieve even 10% profits growth over the next five years. Even the stock's modest 2.5% dividend yield isn't enough to make up the difference.
Long story short, this looks like a tale of "great company, lousy stock" to me. Robust profit margins, steady dividends, and respectable growth are all marks in the stock's favor -- but all of them combined fail to overcome the fact that this stock simply costs too much.
It's good to be the King
Last but not least, we return once again to King Digital, the maker of the popular mobile devices game Candy Crush Saga. Yesterday, as you may recall, nearly every stock shop on the Street responded to the expiry of the quiet period surrounding King's IPO by rushing out new buy ratings on the stock. One final straggler arrived just today, however: investment banker Wedbush. Let's see what they had to say.
Quoting again from StreetInsider.com:
King participates in a large and rapidly growing market for free-to-play games. We estimate that the market opportunity in 2013 was $12 billion in King's Western addressable markets, and expect the market to grow by $4 billion per year for the foreseeable future... Although we are far from certain that King will grow at the 25-30% compound annual rate we forecast for the free-to-play games industry, we believe that the company can grow its top line nicely...
The first thing that jumps out at us about Wedbush's write-up on King, then, is the fact that while trying to curb its enthusiasm, Wedbush is actually projecting more growth potential for King than everyone else did yesterday. Last we heard, projections for gaming industry growth were closer to 19% annualized, but now Wedbush is saying the potential could be 30% to 60% greater than that.
Again, the analyst can't guarantee that King will grow as fast as everyone else. After all, RBC noted yesterday that King already boasts "the sector's fastest growth rate," and such growth rates do tend to erode over time. But even so, Wedbush posits a litany of ways King could grow respectably -- through "expansion into China" and "by enhancing its existing games with tournament play, which we think will attract a different type of player than the company's core customer," to name just a couple.
Prospects like these make it much easier to see King growing at least as fast as the 10% annual growth rate it would take to justify the 10 times earnings valuation on its stock -- and very easy indeed to see why Wedbush thinks that King deserves an "outperform" rating.
Motley Fool contributor Rich Smith and The Motley Fool have no position in any stocks mentioned.