Warning: Expect Huge Downside For These High-Fliers

StreetAuthority Network

Hedge fund managers, along with many financial writers on the Internet, have no qualm focusing their attention on sharply overvalued stocks.

To these folks, any stock that has entered into a bubble needs to be called to task. But Wall Street analysts rarely take a negative view on stocks. Even when they do dislike a stock (or its valuation), they'll simply rate it a "hold" or "neutral." In very rare instances, you'll see an "underperform" or "sell" rating, but even then, these analysts typically have target prices close to the current trading price.

Yet in recent days, I've noticed some unusually gutsy calls from the "it's always sunny" Wall Street analysts. They've been singling out certain stocks, citing severe levels of overvaluation. Even if you are long these stocks, it pays to listen to what these analysts have to say. And if you are looking for short sale ideas, then these stocks are a fine place to start.

1. Twitter (NYSE: TWTR)

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It's easy to see why some may think this stock is overvalued: The company is valued at 34 times projected 2014 sales. I can't recall ever seeing a figure that high before. Indeed, short sellers are now targeting 2013's hottest IPO in a big way.

John Blackledge, who follows Twitter at Cowen & Co., takes an extreme view, suggesting shares have nearly 50% downside to his target price. In a Jan. 8 report, he doesn't merely quibble with this stock's valuation, but with its growth prospects too. Blackledge thinks advertisers don't hold much interest in the company's site, which is the current focus for management as they begin to monetize this platform.

The analyst surveyed around 50 potential ad buyers and found that just 5% of them believed that Twitter's site would deliver solid returns on their investment. Fully 60% thought Facebook (Nasdaq: FB) was the best platform for advertisers, with another 25% citing a preference for LinkedIn (Nasdaq: LNKD). Part of the problem for Twitter stems from a policy that requires relatively high levels of spending to conduct ad campaigns on its platform.

According to Rutledge, it costs four times more to reach the same number is viewers on Twitter than it costs on Facebook. And this creates a real conundrum.

If Twitter sticks with its current pricing, then it won't be able to sign up enough customers to meet current expectations for 75% sales growth this year. But if it cuts prices, then it will need to sign up a lot more customers than analysts currently expect just to meet sales targets. Cowen's Rutledge sees Twitter's sales in 2014 and 2015 coming in 10% to 15% below consensus forecasts. If his logic is correct, then Twitter may need to aggressively tamp down forecasts when it delivers fourth-quarter results on Feb. 4.

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2. Netflix (Nasdaq: NFLX)

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This stock is like a freight train that can't be stopped, pushing through the $380 barrier this week for the first time ever. It's hard to believe this stock was trading at just $60 15 months ago. Credit goes to CEO Reed Hastings and his team, who have delivered absolutely terrific execution. The company now has more than 30 million subscribers in the U.S. (and 44 million worldwide) and continues to grow at a fast pace.

Most analysts have no desire to go against the grain of this very impressive growth story, though it's pretty clear that it's hard to make a case for further upside, based on the fundamentals. Analysts generally greeted the just-released fourth-quarter results with a nearly unanimous view: Growth is great, and shares look fully valued.

Analysts at Jefferies have no qualms about sticking their neck out. In its quarterly review, they ran through a host of positive financial metrics, raising their 2014 earnings per share (EPS) forecast to $4.24: "Our model gives NFLX plenty of credit for go-forward growth and margin expansion, our estimates are above the Street, yet we see 37% downside." They see shares collapsing to just $250. Their key takeaway: "NFLX now trades at 93 times our 2014 EPS estimate; we have difficulty justifying this valuation given the risks."

So what will it take for this momentum stock to reverse course? Investors will need to get a clearer sense of when growth has finally cooled. Analysts expect sales to grow roughly 25% this year and next, and around 20% in 2016. Already-high penetration rates argue for slower growth after that. That's not of imminent concern, but with shares now near $400, any quarterly hiccups in the company's growth this year would send this stock down to much lower levels.


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3. Cree (Nasdaq: CREE)

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I was once quite bullish on this maker of LEDs and LED lighting systems. Back in 2011, I wrote that I was "convinced it is on the cusp of very robust growth during the next five years." Indeed, sales rose around 18% to 19% in fiscal 2012 and 2013, and are expected to rise at the same pace in fiscal 2014 and 2015 as well.

Shares, which traded for around $20 just two years ago, now trade above $60. But all through Cree's rebound, a key concern has nagged at me. As I noted in October, profit margins have been disappointing, highlighting the severe price completion in this fast-growing niche. A company that once generated 47% gross margins seemed stuck with a margin profile these days in the upper 30s.

Analysts at Merrill Lynch cite that margin problem as a key reason why they think shares will fall by more than half to just $30. Their key takeaway: "Cree continues to be a well-run company with excellent products, but is facing margin compression in its fast growing lighting segment before meaningful competition has even ramped."

While many other analysts think Cree's margins will rise as the company generates higher factory utilization, Merrill sees no such margin ramp. The consensus fiscal 2016 EPS forecast for Cree is around $2.65, but Merrill expects EPS of just $2.15 by then. And don't be fooled by the fact that Cree just topped consensus EPS forecasts by a hefty 17%. That was entirely due to a lower-than-expected tax rate.

Risks to Consider: These stocks look like great short-sale candidates if the market is headed sideways or downward, but could be bid up yet higher in a short squeeze if the market moves to new heights.

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Action to Take --> It's not always worthwhile to pay attention to Wall Street research. Groupthink tends to lead these folks to reiterate nearly identical views -- so whenever you see the views of an outlier, it pays to heed their views. They often are doing outside-the-box thinking, which is the only way to get ahead in the market. Both Cree and Twitter do indeed appear ripe to disappoint consensus profit forecasts, while Netflix simply appears overvalued.

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