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 a downgrade for Arrow Electronics (ARW), balanced by price target hikes at Nike (NKE) and Hertz (HTZ). Let's dive right in.
Bad news first
Beginning with Arrow, French megabanker Credit Agricole reversed course on the commercial electronic components maker this morning. Citing "weaker component demand" and a too-high "valuation," CA cut the stock all the way from outperform to underperform -- a 180-degree reversal. But does Arrow really deserve the punishment?
After all, far from running away with the market, Arrow shares are up only 13% over the past year -- less than what we've seen elsewhere on the S&P 500. At 8.5 times earnings, the stock hardly looks expensive on the surface...
But here's the thing: Cheap as Arrow looks, most analysts agree the stock has hit a top, profits-wise. Earnings growth is expected to approximate 1% annually over the next five years, slower than the pace of inflation. That being the case, it's likely that all the gains that were to be had in Arrow have already been had. Credit Agricole is probably right about this one: It's time to return Arrow to its quiver.
Next up: Nike
Another stock that's lagged the market lately is Nike. The sportswear giant has gained a mere 3% over the past year, versus nearly a 16% gain for the S&P 500. But according to Stifel Nicolaus, this underperformance has just set up Nike for a new run higher. The analyst upped its price target on Nike stock Tuesday, to $110 from a prior forecast of $104.
Problem is, despite its recent underperformance, Nike remains a very expensive stock, and unlikely to fulfill Stifel's aspirations for it. Priced north of 21 times earnings, Nike's only expected to post mediocre 8% annual earnings growth over the next five years -- and paying double-digit P/Es for single-digit earnings growth is rarely a winning proposition.
Add in the fact that Nike currently generates only about $0.82 in actual free cash flow for every dollar it reports in GAAP net income, and the stock's arguably even more expensive than it looks -- and even less likely to outperform the market.
Hertz could motor
Breaking the trend of slow-growing stocks, we turn finally to Hertz Global, owner of the famed car-rental brand, and as of today, possessed of a sparkly new $26 price target -- courtesy of analysts at MKM Partners.
On one hand, at a 20.5 P/E ratio, Hertz looks almost as overvalued as Nike. But there's a crucial difference here: Whereas analysts predict only 8% long-term growth at Nike, at Hertz the consensus Street estimate calls for compounded annual earnings growth of 38%. Also, whereas Nike currently generates less free cash flow than it reports as net income, Hertz does the opposite. Over the past year, its free cash flow has amounted to $868 million, or 265% of reported net income. So... what could be wrong with this story?
One word: debt. That's Hertz's potential Achilles' heel. Atop its $6.7 billion market cap, you see, Hertz is hauling around a debt load of $12.2 billion (net of cash). Now personally, when I run the numbers and see that this still works out to an enterprise value-to-free cash flow ratio of less than 22, I think Hertz's rapid projected growth rate is still fast enough to justify the valuation -- and MKM's endorsement of same.
That said, the debt load's big enough that it may scare away some investors. Bear it in mind, and if you decide to buy this one, keep a close eye on trends in interest rates. They'll be a make-or-break issue for this stock going forward.