Tuesday's Top Upgrades (and Downgrades)

Tuesday's Top Upgrades (and Downgrades)

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 a price target hike for Time Warner Cable , balanced by a pair of lowered price targets for American Eagle Outfitters and American Science & Engineering as well.

Let's tackle those two "American" stocks first.

AE gets its wings clipped American Eagle Outfitters lowered its guidance for second-quarter earnings yesterday. Earnings during the current quarter will likely approximate $0.10 per diluted share, or less than half of what American Eagle earned this quarter last year. AE says that its sales declined 2% in the second quarter. Same-store sales declined 7%. Profit margins are also likely to have declined.

AE CEO Robert Hanson pronounced himself: "Not at all happy with our second-quarter results." Wall Street seconded the motion this morning, with analysts at both Telsey Advisory Group and UBS cutting their price targets on the stock, to $19 and $18 per share, respectively.

I think that's an overreaction. Sure, American Eagle's new guidance is weak enough to raise its P/E ratio from 15 times trailing earnings (a clear bargain) to 17 times current earnings (a bit less so). American Eagle generates strong free cash flow, however. Strong enough that its price-to-free cash flow ratio is currently less than 11 times. That's pretty cheap if the company can return to the 12% annualized growth rates that analysts had projected for it. Throw in a 2.5% dividend yield, and I think that after today's 16% drop, American Eagle shares are once again priced to move higher.

American's Science experiment -- a failure or success?
Moving on now to the day's second "American" story, Backscatter X-ray maker American Science & Engineering reported earnings last night. AS&E beat estimates on earnings, reporting $0.62 per share in fiscal first-quarter 2014 profits, but missed on revenues, recording about $500,000 less than expected. Analysts at The Benchmark Company responded to the news by reducing their price target on the hold-rated stock by 10%, to $54 per share.

At first glance, this, too, seems an overreaction. A strong producer of free cash flow, AS&E currently trades for less than 14 times its trailing free cash flow. Throw in a generous 3.3% dividend yield and a 15% projected annual profits growth rate, and you might expect analyst estimates would be going up rather than down.

But here's the thing: Bookings at AS&E dropped significantly in the fiscal first quarter. Indeed, AS&E brought in new orders sufficient to replace only about 70% of the revenue the company recorded into the first quarter. This suggests that revenues will continue to fall in future quarters, and that analysts' projection of a 15% growth rate may prove overly optimistic.

While I admit to being tempted by the stock's low price-to-free cash flow valuation, I'm going to need to see an uptick in bookings before I can call this one a buy.

Time to tune in to Time Warner Cable?
Possibly the most interesting story in today's news, however, is the one going on over at Time Warner Cable --currently embroiled in a dispute with broadcaster CBS . Yesterday, we learned that Time Warner has offered to return CBS to its lineup if, for example, CBS would agree to permit Time Warner to market its channel a la carte. CBS isn't thrilled with the idea, characterizing it as a "sham" proposal -- but at least one analyst is impressed.

This morning, analysts at Argus Research announced they are raising their price target on Time Warner by more than 10%, to $130. Argus already rates the stock a "buy" -- the question is, why?

CBS wants pricing concessions from Time Warner, which would hurt the latter's profitability. But even in the best case -- a continuation of the status quo ante -- Time Warner's valuation just doesn't look that attractive. The stock costs about 15.6 times earnings. Its free cash flow, while strong, is not significantly greater than reported GAAP earnings. These prices are simply too high to justify for a stock that analysts doubt will grow faster than 11% annually over the next five years, and that pays a dividend yield of only 2.2%.

Long story short, I see Time Warner as overvalued if it wins this dispute with CBS, and significantly more overvalued if it loses. (Side note: At more than 20 times earnings, and with a growth rate barely reaching 12%, CBS is no great bargain either.)

Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned.

The article Tuesday's Top Upgrades (and Downgrades) originally appeared on Fool.com.

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