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 look at a pair of new buy ratings in the retail clothing sector -- Lands' End (LE 0.17%) and Gap (GPS 0.51%). But first, some bad news for another "GPS" stock...
Analyst tells Garmin to get lost
It's shaping up to be a bad day for shareholders of GPS navigation company Garmin (GRMN 0.04%), with Morgan Stanley initiating coverage on the stock with an underweight (read: sell) rating.
Garmin's shares are up 73% over the past year, but at $60 and change today, Morgan Stanley thinks all the good news that the company has to announce is already priced into the stock, and that there's "little potential for upside" from here. In fact, if you ask Morgan Stanley what it really thinks, the analyst is pretty sure the stock is overpriced already, and probably worth only about $52.
Why? Well, there's the growth rate, for one thing. Most analysts who follow Garmin agree the company is unlikely to grow earnings any faster than 6% annually over the next five years; 18.5 times earnings is a lot to pay for single-digit growth. There's also the fact that despite reporting "net income" of $642 million over the past 12 years, Garmin's actual free cash flow level is 10% below that amount. This is a red flag warning us that the stock is more expensive than its P/E ratio suggests.
Long story short, Morgan Stanley believes investors buying Garmin today can expect to lose 14% of their investment as the share price falls over the coming year. Garmin's generous 3.2% dividend yield will take some of the sting out of that -- but only some.
Gap-ping up
Turning now to happier news, things may be looking up for Gap. Canaccord Genuity this morning upgraded its opinion on the stock to buy, raising the price target to $51. Quoted on StreetInsider.com today, Canaccord asserted that "the omni-channel and supply chain initiatives GPS is executing will drive greater long-term margin expansion than we had previously forecast." Costs are coming down, and the company is becoming more nimble and better at responding to changes in fashion trends.
Canaccord said it sees "leaner inventories and greater margin contributions" in Gap's future, and said that at today's price -- about 15.2 times earnings and 15.6 times slightly lagging free cash flow -- the stock is undervalued. The analyst could be right, too -- but only if it's right about the margins expanding.
Here's why: Gap shares currently cost 15.2 times earnings; for this price tag, investors can expect to see a total return of about 15.1% on the stock. (That's 13% from projected earnings growth, and another 2.1% from dividend yield.) This suggests the stock is fairly priced -- maybe just a wee bit overpriced, given that free cash flow is lagging reported net income.
But if Canaccord is right about Gap growing faster than most analysts expect, the stock would accordingly be somewhat underpriced, rather than just fairly priced. In short, whether the stock is a bargain depends largely on whether Canaccord is calling the growth trend right. Motley Fool CAPS, our investment banker report card, has this analyst pegged as performing just below the level of the top 10% of investors we track. So I'd say the odds are good that Canaccord is going to be proven right about this.
Worst case? You could do a lot worse than buying a quality retail operation at a fair price.
Lands' End, ho!
Final call of the day now, and this time it's Lands' End. Now free from its parent company Sears Holdings, the independent Lands' End just reported first-quarter earnings of $0.34 per share, with revenue climbing about 4% in comparison to last year's first quarter. These results appear to have been good enough to win approval from Craig-Hallum, which today announced it is initiating coverage of the stock with a buy rating and a $40 price target.
But should they be good enough for you?
Valued at $1.05 billion in market cap, Lands' End has reported earnings totaling $82 million over the past year. That works out to a P/E ratio of just 12.8. Meanwhile, S&P Capital IQ data shows Lands' End doing even better at the business of generating cash. Free cash flow for the past year reached $116 million -- yielding a price-to-free cash flow ratio of just 9.
As a recent spinoff, Lands' End hasn't attracted enough reliable analyst growth estimates to provide a very good picture of how quickly the business might grow independent of Sears. But with the retail clothing industry as a whole expected to boost earnings north of 13% annually over the next five years, according to Yahoo! Finance data, and with Lands' End being one of the better-respected brand names in the space, it's probably a safe bet that the retailer will perform at least that well.
At 9 times free cash flow, it's a bargain -- and Craig-Hallum is right to recommend it.
Rich Smith has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned.
