Friday's Top Upgrades (and Downgrades)

Motley Fool

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 two upscale food industry companies that are popular with consumers and analysts alike -- and one more that isn't.

Starbucks (SBUX)
Let's start with the good news first. With sales growth of 13% in its most recent quarter, Starbucks continues to bring the crowds into its aromatic restaurants. Meanwhile, the company's 34% growth in profits has analysts sniffing around.

This morning, investment banker RBC Capital Markets announced it is initiating coverage of Starbucks with an outperform rating and assigning the stock a $90 price target. That works out to a potential 11.4% gain from today's price of $80 and change, plus a 1.3% yield from Starbucks' modest dividend, which is a fair profit -- if you can get it.

The problem, of course, is that at today's price Starbucks shares look nearly as expensive as its coffee. Valued on GAAP earnings, the stock sells for a P/E ratio of nearly 36. Free cash flow, while strong, is only sufficient to bring the company's P/FCF ratio down to about 34. So even if Starbucks does achieve analyst estimates, and grow at its anticipated 20% annual rate -- which is nearly twice the industry average -- it's hard to see the shares as anything but overpriced today.

And as for the chance that these overpriced shares will rise a further 11% in value, as RBC predicts? Anything's possible, but I wouldn't bet on it.

Chipotle Mexican Grill (CMG)
The story's similar with Chipotle, another stock that RBC just added to its buy list. According to the analyst, this purveyor of freshly made Mexican food will "outperform" the stock market over the coming year, with its shares rising more than 16% to a new high of $620.

But after booking a more-than-100% gain over the past year, Chipotle's chances of fulfilling RBC's predictions for the coming year look anything but certain. Chipotle shares currently sell for more than 54 times earnings -- pricey even for the company's projected 21% long-term earnings growth rate. Again, free cash flow is strong at $318 million, or about 3% greater than reported net income. But that still works out to a price-to-free-cash-flow ratio of 52, and that's still too much to pay for 21% growth.

Factor in the fact that unlike Starbucks, Chipotle pays no dividend whatsoever, and I think this stock's an even worse bet than RBC's first choice.

Whole Foods Market (WFM)
Last and, in Wall Street's estimation, least, we come to upscale supermarketer Whole Foods. This one caught a downgrade Friday morning at the hands of Goldman Sachs, which according to StreetInsider.com is warning that "softer top-line trajectory relative to broader industry trends" plus a rich valuation adds up to at best a "neutral" recommendation on the stock.

Here, finally, I find myself in agreement with Wall Street -- partly.

Priced at 40 times trailing earnings today, Whole Foods is certainly in the same class of overpriced shares that Starbucks and Chipotle occupy. And it got here, of course, by virtue of being a company expected to grow roughly as fast as the upscale restaurateurs. Analysts predict Whole Foods will grow earnings in excess of 18% annually over the next five years, a rate right in line with what Starbucks and Chipotle are expected to achieve.

Goldman doesn't disagree with this assessment, by the way. To the contrary, despite downgrading the stock, Goldman says it still thinks Whole Foods will be a "secular winner" and will continue its trends of "store growth and margin expansion." Where Goldman differs with its brother analysts, though, is in the realization that sometimes, a great growth rate simply costs too much.

Paying 40 times earnings for 18% growth isn't generally a bright idea in investing. Paying that much when you know that Whole Foods' earnings are inflated is even less astute. With only $472 million in trailing free cash flow to its name, Whole Foods actually only generates about $0.86 in real cash profits for every $1 it reports in "GAAP" earnings -- and accordingly is even more overvalued than it looks at first glance.

Long story short, Goldman's right to downgrade Whole Foods. My only objection is that I think a downgrade to only "neutral" doesn't go far enough.

Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool recommends Chipotle Mexican Grill, Starbucks, and Whole Foods Market. The Motley Fool owns shares of Chipotle Mexican Grill, Starbucks, and Whole Foods Market.

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