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 up-down movements in the shares of erstwhile merger partners Pfizer (NYSE:PFE) and AstraZeneca (NYSE:AZN). Later on, we'll open the door and see how Papa Murphy's (NASDAQ:FRSH) cooking. But first, the headlines:
Pfizer goes up
Confirmation this morning that Pfizer's bid to buy rival Big Pharma AstraZeneca has fallen through -- and cannot, under U.K. law, be renewed for at least six months -- sparked divergent views on Wall Street. Quoted on StreetInsider.com this morning, analysts at Goldman Sachs praised the development arguing that Pfizer shouldn't have been thinking about spending $120 billion to buy AstraZeneca in the first place.
Goldman expressed faith in Pfizer's CEO and his strategy "to unlock value" in his company, whether through "break-up, M&A or whatever drives the most value. Our long-held view has been that PFE's size is its enemy and that getting smaller could unlock substantial value." That being the case, the fact that Pfizer will not likely get $120 billion bigger has to be seen as a good thing. But why was Pfizer trying to buy AstraZeneca in the first place?
Basically, it boils down to growth, or the lack thereof. As blockbuster drugs come off-patent, and face increasing competition from cheaper generics, Pfizer's earnings growth rate is expected to just crawl along at 3% annually over the next five years. The purchase of AstraZeneca, with its existing and future revenue streams, was viewed as a way to juice that grow rate a bit.
Without growth, even Pfizer's currently cheap nine times P/E valuation may seem expensive. (The more so when you consider that free cash flow at the company -- just $17.1 billion over the past year, according to S&P Capital IQ figures -- lags reported net income by more than 20%, meaning Pfizer is actually more expensive than it looks.)
True, spinoffs could unlock value and reveal individual business units that are growing faster and might trade at higher multiples to earnings. True, too, Pfizer is paying its shareholders a generous 3.5% dividend yield while we await the results of such spinoffs. But unless the sum of those parts is significantly more profitable, and faster growing than is Pfizer as a whole, I still think the stock looks overvalued.
AstraZeneca goes down
And yet, the situation at AstraZeneca, which spurned Pfizer's takeover attempt, looks even more dire. Don't get me wrong: AstraZeneca has some things going for it, too. For example, the company's $5.6 billion in annual free cash flow is nearly triple reported earnings of just $2 billion for the past year.
But even so, valued at 44 times earnings today, or even at its more modest 16 times free cash flow valuation, the stock looks even more expensive than does Pfizer at a similar 3% projected growth rate. It's certainly too expensive to buy just for the superior dividend (3.8%, versus Pfizer's 3.5%), and AstraZeneca carries a heavier debt load than its rival, to boot.
At the same time as Goldman is upgrading shares of Pfizer, therefore, SteetInsider.com reveals that Societe General is downgrading shares of AstraZeneca to sell.
I think that's the right call. Sixteen times free cash flow is far too much to pay for 3% growth at AstraZeneca. While a fine business, the stock quite simply costs too much to buy. Societe General is right to downgrade it -- and incidentally, Pfizer is right to walk away from the deal.
A fresh idea
Turning now to a fresh opportunity for stockpickers, no fewer than four separate investment bankers announced buy ratings for new IPO -- and recent earnings reporter -- Papa Murphy's this morning. The take-and-bake pizza maker (which puts together pies for you to take home and finish cooking yourself) reported Q1 profits of $0.12 per share last week, nearly twice last year's $0.07 profit on a 28% increase in revenues.
CEO Ken Calwell pronounced himself "pleased" with the results, and he's not the only one. Jefferies & Co. says the company "offers a high-quality, differentiated product at a lower price vs. peers" and could grow strongly as it triples the number of restaurants it operates nationwide, growing earnings perhaps 20% annually. Investment banker Wells Fargo thinks the stock is heading to $11 or $12 a share as debt payments decline and free cash flow swells.
Actually, though, free cash flow at the company so far is not looking so hot. Cash profits at Papa Murphy's have declined for two years running, and hit a new low of just $2 million generated over the past 12 months, in the most recent quarter. GAAP profits -- which it has never earned -- are now running at negative $2.5 million for the past year.
While the company certainly has the potential to grow (with a market cap of only $165 million, it could hardly get much smaller), and while last quarter's results were encouraging, Papa Murphy's still remains a bit of an unknown quantity and its success is far from certain. While the analysts certainly seem enthusiastic, I'd suggest that ordinary investors leave this one in the oven a bit longer. There will be plenty of time to buy after -- or if -- Papa Murphy's puts together a few quarters of proof that it can generate sustained profits and free cash flow. Buy this one too soon, though, and you could get burnt.
Rich Smith has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.