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 upgrades for retailers Pier 1 and New York & Co. . The news isn't all good, though, so before we get to those two, let's take a quick look at why.

PetSmart is in the doghouse
PetSmart  investors are being treated to a dog's breakfast today, as shares of the pet supplies superstore tumbled 3% this morning in response to a downgrade from Bank of America/Merrill Lynch. Last quarter, PetSmart reported a 4% decline in sales and a 2% decline in profits, and its stock price has been lagging the rest of the market this past year.

To some, this might be an argument in favor of buying PetSmart -- the lagging stock price. Selling for less than 17 times earnings and about 14 times free cash flow, PetSmart actually looks pretty fairly priced for its 13%-plus growth rate and 1.1% dividend yield. But according to Merrill, it's an increase in competition in the pet supplies sector that has it most worried about PetSmart.

The banker may be right. While publicly traded, direct competitors to PetSmart are hard to find (Petco's the most obvious, but it's now gone private), there's indirect evidence of the effect competition is having on the company in its declining revenues. While PetSmart may be a fair value at 13% growth, continued declines in sales and profits will make the stock much less attractive to investors.

While I won't run all the way out on a limb and agree with Merrill Lynch that the stock needs to be sold at this price, unless and until management proves it can turn the growth engine back on, Merrill's probably right to be cautious.

New York, New York?
Next up, New York & Co. Janney Montgomery Scott picked this one as a buy today, and the upgrade is having a marked effect on this low-dollar-priced stock (currently priced at less than $5 a share). New York & Co. stock is up nearly 5% as of this writing in response to Janney's assertion that the company's new lines of spring clothing are "trend-, target-, and price-right," that same-store sales are stable to up, and that there's a "margin expansion opportunity."

The stock's no obvious bargain, however. Trailing P/E on this one is a lofty 116 times earnings, while the price-to-free cash flow is a more palatable, but still pricey, 30 times ratio. Most analysts seem to agree that the best New York & Co. can expect to grow its profits over the next five years is about 15% annually -- which doesn't do much to make the 30 times P/FCF ratio look cheap. And New York & Co. pays no dividend to tide shareholders over while they wait for growth to pick up.

Best case, if Janney is right about New York & Co. earning $0.30 per share in 2015, the stock looks fairly priced for next year's earnings -- not this year's, when the company is only expected to earn perhaps $0.16 per share. That being the case, I see no urgent need to rush out and buy the stock just on Janney's say-so. The value case just isn't that compelling.

Take a long walk...
Finally, we wind up at Pier 1, which, according to StreetInsider.com, just scored an upgrade to overweight at Barclays -- and a big hike in target price to $23 per share. If Barclays is right about that, it should translate into about a 28% profit for buyers at today's prices.

Problem is, Barclays probably is not right about Pier 1.

Consider: Barclays' buy thesis on Pier 1 hinges on the company winning a big payoff from investments in capital expenditures that Pier 1 has made over the past three years. Most analysts agree, however, that the most Pier 1 can hope to grow earnings over the next five years is about 13% annually -- or right in line with the rest of the retail sector. That doesn't seem like the kind of outperformance that would justify paying 18 times earnings for Pier 1 stock right now. The more so when you consider that high capex has the company's free cash flow currently depressed to just $79 million annually -- or about 73% of reported net income.

Valued on free cash, I get a 23 times multiple on the stock, which suggests it's even more overvalued than it looks when valued on GAAP earnings. In short, Pier 1 is not the bargain that Barclays thinks it is.

Motley Fool contributor Rich Smith has no position in any stocks mentioned. Despite his personal reservations, The Motley Fool recommends PetSmart.


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

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