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 focus shifts to large caps as Wall Street analysts announce upgrades on shares of Verizon (NYSE:VZ) and PepsiCo (NASDAQ:PEP). Before we tackle those two, though, let's start off small with a few thoughts on ...
Angie's big miss
Shares of pay-to-play online contractor reviews site Angie's List (NASDAQ:ANGI) are down big this morning -- 22% big -- on news that the company has once again missed its earnings estimates. Reporting Q2 results last night, Angie admitted its Q2 2014 loss swelled to $0.24 per share, seven cents worse than Wall Street was expecting to see. Revenues also came in light at $79 million, and the company's latest forecast calls for no more than $82.5 million in revenues in Q3 -- setting the company up for yet another miss.
Needless to say, Wall Street is not pleased. At last report, at least seven analysts (that we know about) had already downgraded the stock. Few have taken Angie below hold or neutral ratings so far, but at least one, Northland Capital, is now recommending that investors sell the stock.
As for why, I think RBC puts the bear case on Angie's List best. Quoting from this morning's StreetInsider.com write-up: "[A]ccelerating declines in member monetization and uncertain member acquisition trends raise questions about the total addressable market for a paid membership model." That's disturbing news for long-term investors. Meanwhile, short-term traders may also have cause to worry: "[T]he company might enter a capital requirement air pocket given delayed profitability combined with ramped-up capex investments," warns RBC.
At first glance, this may not look like a problem. Angie's List still has ample cash reserves. And although it's still deeply unprofitable from a GAAP earnings perspective, Angie is at least treading water on free cash flow, no longer burning cash. (S&P Capital IQ data show that the company generated about $0.1 million in positive free cash flow over the past year). That said, a separate downgrade note from Merrill Lynch this morning pointed out that Angie had to "significantly reduce" spending on advertising to remain FCF-positive.
The upshot: Investors are counting on Angie's List achieving a barn-burning growth rate of 32% (according to Yahoo! Finance) to support its market cap. But if the only way the company can cut its losses is by cutting to the bone on marketing, then that growth rate is bound to suffer -- and Angie's List stock is bound to fall further.
Verizon a buy?
Turning now to happy news, Verizon beat earnings earlier this week, reporting $0.91 per share in Q2 profit on $31.5 billion in sales -- both numbers ahead of estimates. It got its reward today, when analysts at FBR Capital announced they were upgrading Verizon shares to outperform and setting a new and improved price target of $57 per share.
FBR sees "continued momentum in wireless" at Verizon, "moderating decline in wireline," and "increased adoption and penetration of FiOS and FiOS Quantum." And at the same time as Verizon is firing on all cylinders, FBR foresees a potential merger between Sprint (NYSE:S) and T-Mobile (NASDAQ:TMUS) taking pressure off the company, as those latter two companies are forced to focus more on integrating their networks, and less on stealing customers from Verizon.
So far, this all makes sense. But here's where I think FBR goes wrong on Verizon: The price is too high to justify a buy.
Currently, Verizon is pegged for a 5.2% forward growth rate, and pays a 4.3% dividend yield. That adds up to a total return of about 9.5%, which while respectable, isn't quite enough for the 13.6 P/E ratio that Verizon currently carries. The valuation on this one gets even worse when you notice that Verizon has racked up a simply immense debt load of more than $100 billion net of cash -- meaning the stock is about 50% more overvalued than it appears on the surface.
Long story short, until that debt load gets worked down substantially, or the share price falls even more, the stock's just too expensive to buy.
And what about PepsiCo?
Similar story with Pepsi. Like Verizon, PepsiCo beat earnings nicely this week, reporting $1.32 per share in profit, where Wall Street had expected only $1.23. Revenues likewise topped estimates. Stifel Nicolaus is rewarding the stock with an upgrade to buy on the news, predicting that such a big earnings beat is likely to shock analysts into a series of "positive earnings revisions," which could help to lift the stock price.
But me, I'm not so sure.
With "only" $22 billion in net debt, PepsiCo isn't as heavily leveraged as Verizon. But the company's share price is still more than 20-times earnings. That's quite a lot to pay for a company expected to post earnings growth of only 7.4% annually over the next five years. Even with the 2.9% dividend that Pepsi pays, investors are only getting about a 10.3% return on their investment here, resulting in a total return ratio of nearly two times. Meanwhile, the stock continues to underperform on cash profits, generating only $6.5 billion in real free cash flow over the past year, versus reported net income of more than $6.8 billion.
Between the low FCF number, the high level of debt, and the even higher valuation on the stock, Pepsi looks to me like one of those "great company, lousy stock price" situations that investors are best advised to avoid.