Thursday's Top Upgrades (and Downgrades)

Analysts shift stance on Sprouts Farmers Market, Hewlett-Packard, and lululemon athletica.

Rich Smith
Rich Smith
Jun 12, 2014 at 2:10PM
Consumer Goods

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 upgrades for Sprouts Farmers Market (NASDAQ:SFM) and a more muted endorsement for Hewlett-Packard (NYSE:HPQ). Meanwhile, in the wake of earnings, one analyst has concluded that...

Lulu is a lemon
Don't say you weren't warned. On Monday, in the run-up to earnings at yogawear maker lululemon athletica (NASDAQ:LULU), I pointed to weak free cash flow as suggesting "Lululemon's business may be worse than anyone realizes." Now earnings are out -- and everybody realizes it.

Lululemon shares are plunging more than 15% so far today in response to an earnings report Wednesday night that showed the company edging out earnings expectations for Q1, with $0.02 more profit per share than analysts had expected. Problem is, Lululemon also told investors to expect as much as $0.08 less profit than analysts had been expecting in the current second fiscal quarter. Earnings for Q2, says Lululemon, will run anywhere from $0.28 to $0.30 per share, versus a consensus expectation of $0.36.

Also, their chief financial officer is retiring. Oops.

Following the bad news, both Stifel Nicolaus and William Blair have pulled their buy ratings from the stock, downgrading to various flavors of "hold." And yet, curiously enough, things actually appear to be improving a bit at Lululemon. (Not enough, but a bit.)

With $251 million in trailing earnings, down from $280 million last year, you might not think so. But S&P Capital IQ's up-to-date information shows that free cash flow at the company increased to $218 million for the past 12 months, and now backs up 87% of reported net income. Cash reserves are up, with no rise in long-term debt. And the stock now trades for 25 times free cash flow -- with an enterprise value-to-FCF ratio of less than 22. That's still not cheap enough for a stock with a projected earnings growth rate of less than 17%, much less one where the growth rate just got thrown into question by weak guidance. But by and large, I'd say the valuation picture here is improving.

The analysts are still right to downgrade the stock, mind you. It's not cheap enough to buy -- but it is getting cheaper.

"Outperform" rating planted at Sprouts
Turning now to the day's "good" news, analysts at Credit Suisse have just upgraded shares of Sprouts Farmers Market to "outperform," and the news is helping Sprouts dodge the downturn seen elsewhere on markets today. Sprouts shares are down nearly 40% since their highs of last October. CS says it's taking advantage of the big pullback to reenter the stock in hopes of seeing it rise to $34 over the course of the year.

Don't be fooled. It's not going to happen.

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Sprouts has been one of the better performers in the natural and organic foods supermarkets space lately. Out of "the three FMs" -- Whole Foods, The Fresh Market, and Sprouts -- it's currently the only one generating free cash flow superior to what it reports as net profits on its income statement. Sprouts is also growing strongly, with analysts projecting long-term profits growth of 25% annually over the next five years.

But even so, and even after its stock price has shrunk so much, Sprouts shares still cost nearly 65 times earnings, and a good 47 times free cash flow. 25% growth isn't fast enough to justify what these shares already cost, and Credit Suisse's belief that this overpriced stock will go up another 13% is a pipe dream.

"Hew" might do better than that?
If you ask Goldman Sachs, a better bet than either of these stocks might be Hewlett-Packard. Emphasis on "might" -- because as of Thursday, the most Goldman is willing to do for Hewlett-Packard is upgrade the stock to "neutral." (But the stock does have potential.)

HP shares sell for just 12 times earnings, and this company is such a prodigious producer of cash profits that its shares sell for only a little more than eight times free cash flow. Growth projections are low -- just 4.6% annual growth expected over the next five years. But HP pays a modest 1.9% dividend yield, and that will juice returns somewhat.

Quoted on today, Goldman Sachs notes that it's still feeling "cautious" about the stock, but admits that "HP management has executed far more effectively than we anticipated." As such, the analyst is relenting on its previous sell rating, and says it's particularly impressed with the company's "robust cash generation" -- as am I.

For now, 8 times free cash flow still seems a bit much to pay for a 6.5% "total return" on the stock. But if growth should improve, or stock markets take a tumble, Hewlett-Packard is certainly one company we'll want to take a good look at.

John Mackey, co-CEO of Whole Foods Market, is a member of The Motley Fool's board of directors. Rich Smith has no position in any stocks mentioned, and doesn't always agree with his fellow Fools. Case(s) in point: The Motley Fool recommends Lululemon Athletica, The Fresh Market, and Whole Foods Market. The Motley Fool also owns shares of Whole Foods Market.