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Thursday's Top Upgrades (and Downgrades)

By Rich Smith – Jul 17, 2014 at 3:11PM

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Analysts shift stance on Dollar Tree, PetSmart, and Textron.

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 begin with a pair of retail picks, as Street analysts take Dollar Tree (DLTR -2.29%) up one notch, while knocking PetSmart (PETM) down a peg. Then we'll wind up with a few words about Textron's (TXT -0.19%) surprising earnings beat -- and the higher price target that won for it.

Without further ado...

Dollar Tree could be worth a lot more
First up, shares of dollar store retailer Dollar Tree are dodging the downturn on markets today, enjoying a small fraction-of-a-percent lift in response to an upgrade from new (to this column at least) analyst Prime Executions.

Based out of New York (natch), Prime Executions is, according to S&P Capital IQ, an investment banker focusing on equities and "macro–economic strategy," with a special focus on the energy sector. So why is it picking a dollar-an-item retailer to upgrade today? The answer may be as simple as "because the stock is starting to look cheap."

Priced just under 20 times earnings, and pegged for nearly 17% annualized earnings growth over the next five years, Dollar Tree shares may not be a screaming bargain, but they're not terribly expensive, either. Free cash flow at the company is a respectable $563 million, or about 94% of GAAP earnings reported over the past 12 months. Debt levels are modest at just $370 million, net of cash.

Best of all, as the rest of the stock market has raced ahead 18% over the past year, Dollar Tree shares have relatively underperformed, rising less than 3% during the same time period. They're looking close to fairly valued today -- perhaps still a bit too expensive to rush into. But on balance, I'd say Prime Executions is on the right track. A bit more earnings growth, or a bit longer of a stock price slump, and these shares could turn into a real buy.

Is PetSmart just a dog?
Next up, rumors of a potential PetSmart/Petco merger (see for the full story) have sent shares of the former on a tear these past couple of weeks. But now, says analyst RBC Capital, it's time to take some winnings off the table -- whether the merger happens or not.

Shares of PetSmart recently topped RBC's intrinsic valuation of $66 per share, racing toward $70. But the analyst seems convinced that PetSmart's value hasn't changed -- just investors' opinion of it. Accordingly, while maintaining its price target, RBC this morning cut its rating on PetSmart stock to "sector perform."

While I personally like the stock, I also think that's the right call -- downgrading PetSmart after the run-up. Here's why: PetSmart shares sell for 17 times earnings today. The stock's actually cheaper than it looks, however, because PetSmart's free cash flow number -- $460 million generated over the past year -- is nearly 9% higher than the net profit it's permitted to report under GAAP accounting standards ($421 million). PetSmart also pays a modest dividend yield of 1.4%.

The key issue with the stock, however, is the growth rate. Most analysts who follow PetSmart agree that it's unlikely to grow earnings at much more than 10% annually over the next five years. That's a bit low to sustain a 17 P/E ratio. And accordingly, I think the stock price has gotten a bit ahead of itself on account of the merger speculation.

Long story short, the profits that were to be had from PetSmart have already been made. It's time to count your winnings and walk away.

Textron's a winner
Finally, a few words on Textron. This aerospace and defense stock is following the rest of the market down today, but Textron enjoyed a nice boost in share price on Wednesday following an earnings report that featured a nickel-a-share "earnings beat."

Priced today at 22 times earnings, with a 20% projected growth rate and only a minuscule dividend, Textron shares look just about correctly priced at $38 and change. But after reviewing the company's earnings, and its forecast for the rest of the year, RBC Capital has concluded that Textron shares could rise to as much as $44 over the course of the next year.

And RBC's right about that. Textron could be cheap enough to continue buying the shares, even after yesterday's price spike.

Why? Well, when you examine the company's cash flow statement, what you'll find is that the company's currently generating more than twice as much free cash flow as its income statement reflects as net income. Free cash flow for the past year, in fact, topped $1.2 billion, versus only $495 million in net income. Valued on FCF, therefore, Textron stock is selling for less than a 10 times multiple, which seems very cheap indeed for an expected 20% grower.

Caveat: Management is predicting more muted cash production over the course of this year, and if it's right about that -- if it's not lowballing the analysts and setting itself up for an earnings surprise to the upside -- then the steep discount to fair value we're seeing in Textron's FCF number will disappear six months from now. Personally, I think the discount is big enough to take the risk, and I think RBC's right to continue recommending Textron.

But there is a risk there. Be aware.

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 PetSmart, but The Motley Fool also owns shares of Textron. 


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