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Thursday's Top Upgrades (and Downgrades)

Rich Smith

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 include downgrades at both Bed, Bath & Beyond (BBBY) and Deckers Outdoor (DECK). But the news isn't entirely bleak, so before we get to those, let's find out why one analyst thinks...

General Dynamics has a fighting chance 
A funny thing happened on the way to President Obama's 2014 budget proposal. Somehow, someway, a budget that was supposed to cut $41 billion in defense spending under sequestation actually reduced requested spending by less than $4 billion from 2012 levels. This development has one analyst -- Drexel Hamilton -- thinking things might not turn out so badly for defense contractors like General Dynamics (GD) after all.

In a note released Thursday, Drexel relented on its "sell" position on General-D -- and also on Lockheed Martin (LMT) and Northrop Grumman (NOC), incidentally -- upgrading all three stocks to neutral. Now, of the three, the upgrade of General-D looks most curious. Both Lockheed and Northrop are GAAP-profitable operations. General Dynamics, in contrast, is reporting GAAP losses. So why upgrade it?

Here's why: Despite reporting "losses" under generally accepted accounting procedures, General Dynamics still generated more than $2.2 billion in free cash flow last year. This gives the stock a price-to-FCF ratio of only 11, which seems a fair price if GD continues paying out a 3.2% dividend, and growing profits at 7.1%, as it was projected to do under the sequester. On the other hand, if GD can grow faster than that -- if for example, defense spending doesn't get cut as much as it was expected to only a few days ago -- then the stock could be even cheaper than it looks. It might even deserve an upgrade to buy.

Now for the bad news
At the same time as Drexel was upping its opinion of GD, LockMart, and Northrop, independent analyst Standpoint Research was downgrading its opinion of a pair of retailers. On Wednesday, Standpoint cut its rating on each of Deckers Outdoor and Bed, Bath & Beyond, to hold. Here again, though, while I agree with the sentiment, I think the analyst isn't going far enough with its ratings moves.

Take Deckers for instance. Priced at 17 times earnings, the stock already looks expensive relative to consensus forecasts for 9% long-term earnings growth. In fact, though, Deckers' cash flow statement shows that the company's only generating about $0.79 in real cash profits (FCF) for every dollar it claims to be earning under GAAP. This means that a stock that that already looks pretty expensive under its GAAP valuation is actually about 25% more expensive than that, when valued on free cash flow. To me, it's reason to go a step beyond a hold rating, and downgrade Deckers all the way to sell.

Speaking of going beyond, Standpoint also cut its rating on Bed, Bath & Beyond this morning. And while the situation here isn't as bleak as what we see at Deckers, the valuation still looks bad.

Bed, Bath, you see, costs less than Deckers -- only 15 times earnings versus 17 times earnings at the Uggs-maker. It's also growing faster than Deckers -- with a 13% growth rate projected for it. At best, though, this suggests slight overvaluation risk in the shares.

Now here's where things get worse: Just like Deckers, Bed, Bath is a weak cash producer, generating only about $0.85 in free cash flow for every $1 it reports as net income. To my Foolish eye, that's enough to take Bed, Bath's valuation up a notch from slightly overvalued to pretty darn overvalued. While not as expensive as some other retail stocks I could name (I'm looking at you, lulu), the stock's pretty far from buy territory, and even Standpoint's grudging hold rating looks tenuous to me.

Here again, I think discretion is the better part of value: Absent a total absence of better stock ideas out there, I'd go ahead and sell Bed, Bath right now, rather than risk taking a bath on an overpriced stock.

Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool recommends Bed Bath & Beyond. The Motley Fool owns shares of General Dynamics, Lockheed Martin, and Northrop Grumman.