Friday'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 new buy ratings for Internet plays Shutterstock and RetailMeNot . But it's not all good news, so before we get to those two, let's take a quick look at why...

Apogee is losing altitude...
The week is ending on a down note for shareholders of industrial glassmaker Apogee Enterprises , which manufactures windows for the construction market, and glass fronts for picture framing. Earlier this week, Apogee reported Q3 earnings that missed analyst estimates by a couple cents. Sales, too, fell short of the mark. And while Apogee says it still expects to turn in "a strong performance in the fourth quarter, with our fiscal 2014 full-year earnings per share outlook narrowed to $0.95 to $1.00 on 10 to 11 percent revenue growth," analysts at Northland Capital aren't so sanguine.

This morning, Northland removed its outperform recommendation from Apogee. The analyst says that it's decided to take "a more conservative view on commercial construction growth," and as a result, worries that even if Q4 works out as planned, "Apogee's out-year estimates will be difficult to achieve." But in truth, even if Northland's worrying over nothing -- even if Apogee continues hitting its growth targets -- these shares still look overpriced.

Consider: Ordinarily, you'd expect Apogee's projected earnings growth rate of 10% to support maybe a low-teens price to earnings ratio. In fact, though, Apogee shares currently cost nearly 43 times earnings. Sure, free cash flow is strong at the firm -- $29.6 million generated over the past year. But even that number only gets the stock's price to free cash flow ratio down to about 35 times -- which is two or three times what the shares should probably sell for.

Personally, while I still like Apogee a lot as a business, there's just no defending the stock's valuation today. It's overpriced, plain and simple, and Northland is absolutely right to downgrade it.

...but could Shutterstock soar?
Moving on now to the stocks that Wall Street does like, we begin with online photo studio Shutterstock, the subject of an initiation at buy by Wunderlich Securities this morning. Priced at $82 and change today, Wunderlich thinks Shutterstock could hit $92 within a year, making for a respectable 11% profit. But is that good enough?

Consider that most market pundits consider 11%-or-so returns the annual "average" for a broad basket of stocks such as the S&P 500. To justify making an undiversified investment in a single stock like Shutterstock, therefore, you'd ordinarily want to see at least a chance of winning bigger-than-11% profits. But with Shutterstock, even 11% returns look questionable.

Why? I'll give you three good reasons. First, today's valuation on the stock -- 59 times earnings -- is quite a bit more than the average stock on the S&P 500 costs. Second, the "average stock" on the S&P 500 also pays a dividend, which Shutterstock does not. A third reason to be leery of Shutterstock: The company's free cash flow currently lags reported income by about 16%, which suggests that even the earnings Shutterstock already makes, are of less than first-rate quality.

Result: Even the expectation of 34% long-term earnings growth at Shutterstock (the average calculated for the firm by S&P Capital IQ) may not be fast enough to justify buying this stock at this valuation. And if something goes wrong, if Shutterstock stumbles and fails to grow as fast as it's expected to?

Look out below.

Buy not RetailMeNot, either
I wish I could tell you that Wunderlich's other recommendation today was better... and it is slightly better. It's just not good enough to justify the risk.

Continuing its investigation into Internet stocks today, Wunderlich moved on from Shutterstock to also recommend digital coupon-hawker RetailMeNot. Here, the analyst promises much more significant profits, as RetailMeNot moves from today's $28.75 share price toward a target of $38, delivering a 32% profit for investors.

Will it happen? Perhaps. Although apparently priced at 69 times earnings today, RetailMeNot is actually not quite as expensive as it looks. Superior free cash flow at the company ($38 million, versus reported income of only $25 million) gets the stock's price to free cash flow ratio down to 38 times. Meanwhile, analysts polled by S&P Capital IQ have the stock growing its profits at 26% annually over the next five years.

That goal looks nearly as ambitious as Shutterstock's projected 34% pace -- but it's probably still not fast enough to justify paying 38 times free cash flow for the stock. Long story short, I'd steer away from this recommendation as well.

Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool, however, does recommend RetailMeNot.

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