Did These Analysts Just Downgrade Your Stock?


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." While the pinstripe-and-wingtip crowd is entitled to its opinions, we've got some pretty sharp stock pickers down here on Main Street, too. (And we're not always impressed with how Wall Street does its job.)

Given this, 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 series, we don't simply tell you what the analysts said. We also show you whether they know what they're talking about.

Today, we're going to take a look at three big moves on Wall Street: upgrades for retail clothiers Abercrombie & Fitch (NYS: ANF) and American Eagle Outfitters (NYS: AEO) , balanced by downgrades for Costco (NAS: COST) and Plum Creek Timber (NYS: PCL) . Let's dive right in.

"Good" news first
Shareholders of Abercrombie & Fitch and American Eagle -- and in all likelihood, fans of the consumer-driven recovery thesis in general -- will be elated to learn that this morning their stocks received upgrades from two of Wall Street's best and brightest. But should they be?

Abercrombie, says UBS, offers a "favorable risk/reward assessment with better upside potential to EPS estimates in 2012 and beyond." UBS sees Abercrombie cutting back on its discounting practices, and seeking "higher margin int'l and [direct-to-consumer] sales. Meanwhile, Wedbush Morgan advocates an investment in Aber-rival American Eagle, whose "leaner inventory" levels should likewise reduce the need to discount wares, permitting an expansion of gross profit margins.

Both analysts now recommend buying their respective picks -- but me, I'm not so sure that's a good idea.

Consider: Analysts on average expect Abercrombie to grow earnings at 21% annually over the next five years, and UBS sees them growing even a bit faster than that. Even so, valued on its trailing profits, Abercrombie is one pricey stock at 37 times earnings. Plus, Abercrombie isn't exactly a powerhouse in the free cash flow department. (Actually, FCF for the past 12 months came to an anemic $47 million -- even worse than the $128 million Abercrombie claimed for "net income.") AE, in contrast, costs a bit less (24 times earnings) and is growing a bit slower (12%) -- but the resulting PEG ratio of 1.4 looks just as overpriced to me. (And yes, like Abercrombie, AE is generating less cash than its income statement would suggest.)

Long story short, I'd rather be short both names than long.

"Cost's" too much
Not everyone's a fan of overpriced retailers, however. Citing Costco's recent run-up to its $89 price target as a reason to take profits, Deutsche Bank this morning downgraded the warehouse wholesale chain to hold. Says Deutsche, it's a lack of "positive catalysts on the horizon" that has it most pessimistic about Costco. While the company "remains a best-in-class operator," its share price reflects that already, and there's little reason to expect it to go up any more.

I agree. Already, Costco shares look fully valued at 25.5 times earnings, versus long-term growth estimates of just 12.7% annualized. Costco outclasses Abercrombie and AE in that while they're not making even as much cash as their income statements claim, Costco is actually making more. It's not making enough cash, however, to justify a valuation nearly twice as high as its growth rate. Like Deutsche said -- it's time to count your winnings and move on to the next opportunity.

Might I interest you, perhaps, in a nice steady-eddy tree farm as a potential investment? No? Not even if it's paying a 4% dividend?

Good call, says D.A. Davidson, which downgraded Plum Creek Timber this morning for the same key reason that soured Deutsche on its Costco stock: "No near term catalysts" (according to the folks at StreetInsider.com, who reported on the downgrade this morning). But there are more reasons to avoid Plum Creek Timber than just that one. The company just "missed earnings," for one thing -- not just Davidson's estimate, but also Plum Creek's own guidance. And not to sound harsh or anything, but with a stock price nearly 34 times trailing earnings, that's a mistake Plum Creek really couldn't afford to make.

A 4% dividend yield is nice, sure. But I'm not sure it's nice enough to make investors forget that Plum Creek is pegged for only 2% long-term earnings growth. Or the fact that its stock sells for 5.1 times book value right now -- a price more than 20% more expensive than peer timberland operator Rayonier (NYS: RYN) . Which, incidentally, has a P/E 13 points lower than Plum Creek's, a dividend nearly as big, and a growth rate four times as fast. I don't know that this is enough reason to go out and buy Rayonier exactly -- but it's certainly a good argument for avoiding overpriced Plum Creek.

If you feel as if watching analysts' upgrades and downgrades is akin to chasing your tail, you should take a look at a great buy-and-hold stock like The Motley Fool's Top Stock for 2012. It's an emerging-market retailer that you can set and forget without worrying quarter to quarter. You can learn more by clicking here.

Whose advice should you take -- mine, or that of "professional" analysts like UBS, Deutsche Bank, and Davidson?Check out my track record on Motley Fool CAPS, andcompare it to theirs. Decide for yourself whom to believe.

At the time thisarticle was published Fool contributorRich Smithdoes not own shares of, nor is he short, any company mentioned above.He does, however, have public recommendations available on more than 50 separate companies. Check them out on Motley Fool CAPS, where he goes by the handle "TMFDitty" -- and iscurrently ranked No. 352 out of more than 180,000 CAPS members.Not everyone agrees with him, however. In fact, The Motley Fool owns shares of Costco Wholesale. The Fool owns shares of and has created a covered strangle position in Plum Creek Timber.Motley Fool newsletter serviceshave recommended buying shares of Costco Wholesale.The Motley Foolhas adisclosure policy.We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors.

Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.