This Just In: More Upgrades and Downgrades

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At The Motley Fool, we poke plenty of fun at Wall Street analysts and their endless cycle of upgrades, downgrades, and "initiating coverage at neutral." The pinstripe-and-wingtip crowd is entitled to its opinions, but we have some pretty sharp stock pickers down here on Main Street, too. And we're not always impressed with how Wall Street does its job.

So perhaps we shouldn't be giving virtual ink to "news" of analyst upgrades and downgrades. And we wouldn't -- if that were all we were doing. Fortunately, in "This Just In," we don't simply tell you what the analysts said. We also show you whether they know what they're talking about.

Forget John Galt. Who is Janney Montgomery Scott?
All week long, the Internets have been buzzing with consumer outrage over lululemon athletica (NAS: LULU) and its Atlas Shrugged-inspired shopping bags. My advice: Get over it. Lulu has bigger things to worry about than just bad PR.

Case in point: yesterday the yoga clothier announced Q3 earnings that sparked an immediate 12% sell-off in the stock. Profits leapt 50% year over year, exceeding expectations. But investors were spooked when lulu failed to beat sales estimates -- even though it grew sales 31% and posted strong 16% same-store sales growth (no mean feat in an economy that's seen nothing of the sort at more plebeian clothiers such as Gap (NYS: GPS) or Kohl's (NYS: KSS) , for example).

Up-up for lulu?
So yes, this spooked investors. But only some of them. Already, two investment bankers have been sufficiently impressed by the results that they've upgraded lulu's stock. This morning, KeyBanc announced an upgrade to "buy," saying it likes the new, post-sell-off valuation and argues that "higher in-stock levels" of inventories will fuel growth in the coming year. This seconds the emotion expressed by Janney Montgomery Scott yesterday, which also upgraded to "buy," dismissing investor concerns over lulu's "significantly higher inventory."

Me, I wouldn't take those concerns so lightly.

Bloated yoga pants
How bad is the inventory situation at lulu? Q3 sales were up 31%, but piles of unsold yoga pants climbed twice as fast -- up 77% year over year, compared with just a 34% increase last quarter. Even worse, last quarter lulu was showing a healthy relationship between sales growth and inventory growth. Sales, climbing faster than inventories, suggested strong demand for the product and strong pricing power at lulu. It showed that there was good reason for why lululemon shares had outperformed the Dow Jones Industrial Average (INDEX: ^DJI) so handily this year and suggested that continued performance lay ahead.

But that trend is gone now. Also gone missing is the happy state of affairs in which lulu was generating more cash from its business than it reported as net income. Today, trailing-12-month results show lulu claiming $165 million in net income -- but generating only $115 million in actual free cash flow.

Foolish takeaway
Admittedly, this is a problem not unique to lulu. Elsewhere in the specialty "lifestyle" market, we find Nike (NYS: NKE) and Crocs (NAS: CROX) also generating significantly less free cash flow than they claim as net income. One rival that I'm particularly skeptical of, and which lies particularly close to lulu's market, Under Armour (NYS: UA) , is actually in even worse shape -- generating both negative free cash flow and actual negative operating cash flow.

But still, saying that lulu looks relatively strong in a weak industry looks to me like a pretty weak reason to be urging investors to buy the stock. Seems to me, it doesn't really matter if you value lulu on its reported earnings (and 48 P/E ratio), or on its more suspect free cash flow (P/FCF on this one works out to 62). Either way, I don't see these shares offering much value at analysts' projected 28% long-term growth rate.

My advice: Avoid them, unless you're looking to practice your "downward facing portfolio" stance.

Looking for a stronger beneficiary of this year's Black Friday boom to invest in? Read the Fool's new -- and free! -- report onThe Death of Wal-Mart: The Real Cash Kings Changing the Face of Retail.

At the time this article was published Fool contributorRich Smithdoes not own shares of (or short) any stock named above. You can find him on CAPS, publicly pontificating under the handleTMFDitty, where he's currently ranked No. 331 out of more than 180,000 members.Not all Fools say no-no to lulu. In fact, The Motley Fool owns shares of lululemon athletica, and also Under Armour, and Gap.Motley Fool newsletter serviceshave recommended buying shares of lululemon athletica, Nike, and Under Armour, as well as creating a diagonal call position in Nike.We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

Copyright © 1995 - 2011 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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