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 consumer favorites La-Z-Boy (NYSE:LZB) and Starbucks (NASDAQ:SBUX), but a downgrade for tech star NVIDIA (NASDAQ:NVDA). Let's find out why, starting with...
Bad news first
Starting off the day on a low note, we find analysts at Merrill Lynch cutting their rating on NVIDIA to "underperform" (that's analyst-speak for "sell"). As an NVIDIA shareholder myself, I find this advice discouraging but... quite possibly correct.
NVIDIA shares hit a new 52-week high earlier this week. But according to Merrill, the stock's gone about as high already as it can reasonably be expected to go. Gross margins are peaking at about 55%, says Merrill, with operating margins at 15%. Earnings are at risk from an Intel licensing agreement that may not be renewed past 2017. Meanwhile, continued weakness in the PC space is offsetting strengths in NVIDIA's videogaming business. So while Merrill admits "NVIDIA is doing well," on balance, the banker sees more negatives than positives -- and believes sales will grow only 3% to 4% annually over the next couple of years.
Why? Consider that at its current P/E ratio of 22, NVIDIA is hardly a cheap stock. Even if the other analysts who follow NVIDIA are right about the company's growth rate, and Merrill is wrong, the consensus is still that NVIDIA can still only grow earnings at about 7% annually over the long term -- at best. That's simply not fast enough growth to support a 22 P/E, not even with NVIDIA paying a 1.7% dividend yield to sweeten the deal.
Long story short, Merrill Lynch is right to worry about the valuation on this stock. Up 35% over the past year, and beating the S&P 500 over that period, it may be time for shareholders to sell out of NVIDIA, and invest their winnings in another stock.
Sell NVIDIA, buy Starbucks?
And which stock should be your next "buy"? UBS (wrongly) suggests you take a look at Starbucks.
Positing an $87 price target on the $77 stock, Swiss megabanker UBS upgraded shares of Starbucks to buy this morning -- sending the shares on a 2% romp upward. According to UBS, even if growth in the Americas region isn't looking exactly perky, the company has enough levers to pull to drive traffic to keep sales growing at 5% annually in the region.
In fact, Starbucks may do even better than that. Last week, the company told investors to expect "10% plus" sales growth this year, with 20% to 22% growth in profits. But here's the thing...
I have no doubt whatsoever that Starbucks is capable of growing earnings 20-odd percent this year. After all, the company only earned $153 million over the past 12 months. Such small profits (for a $58 billion company) shouldn't be at all hard to grow. The problem, though, is that Starbucks' anemic profits stream means that at today's prices, the stock is selling for close to 380 times earnings.
Even 20% growth won't be fast enough to justify that kind of earnings multiple. Even 22% won't suffice. For Starbucks to become a buy, it's going to have to get back to earning several times more profit than it currently does and then continue growing in the double digits from that higher level of earnings. Until it proves it can do so, UBS is wrong to recommend it.
Sleep it off
So is there any stock out there -- any stock at all -- still worth buying in today's overheated market? Well, maybe there is. Or rather, maybe there soon will be.
Over at BB&T Capital this morning, analysts have pointed to recliner-maker La-Z-Boy as a potential buy. La-Z-Boy shares, as you've probably heard, got hit big-time yesterday after reporting "in-line" earnings of $0.33 per share for Q4 2014 Tuesday evening. Revenues also came in light at $353 million.
And yet, after yesterday's 8% sell-off, La-Z-Boy shares sell for only 22 times earnings. Factor in the company's net cash, and value it on actual free cash flow rather than GAAP reported "earnings," and the stock's valuation sinks to an enterprise value-to-free cash flow ratio of just 19. For a stock expected to grow profits at about 16% annually according to analysts, and paying a modest 1% dividend yield, that's not a half-bad price.
I won't go out on a limb and actually recommend buying the shares just yet, mind you. But I do believe they're worth a good hard look -- after the enthusiasm from today's BB&T recommendation fades away, and the shares (hopefully) get just a little bit cheaper once again.
When should you start shopping? Once La-Z-Boy shares drop below 17 times FCF, I think that would be a fine time to sit up and start paying attention. For now, though, feel free to take a nap. La-Z-Boy shares, like so many others in this overheated summer market, remain just a bit too expensive to buy.
Rich Smith owns shares of NVIDIA. The Motley Fool recommends Intel, NVIDIA, and Starbucks. The Motley Fool owns shares of Intel and Starbucks.