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 upgrades for clothiers American Apparel (APP) and lululemon athletica (LULU). But it's not all good news, so let's start the day off with a look at why...
Tuesday opened on a bleak note for shareholders of Archer Daniels Midland (ADM) when Canadian broker BMO Capital Markets announced it was pulling the stock's outperform rating and downgrading it to "market perform."
Why the downgrade? At $31.58 a share, and 15.2 times earnings, ADM doesn't look egregiously expensive. Indeed, with a 2.4% dividend yield and a 10% projected growth rate, the stock looks close to fairly priced... maybe just a wee bit pricey.
Problem is, $32 a share happens to be exactly the price target BMO had on the stock when it was recommending the stock as cheap. Now that the stock's approaching its target price, therefore, BMO sees most of the potential profits as having already been reaped -- and I agree.
ADM is already trading a bit ahead of where its dividend yield and earnings growth rate suggest it "should" be trading. What's more, the quality of ADM's earnings are a bit suspect. Free cash flow at the firm currently backs up less than $0.80 on every $1 worth of "profits" the firm says it's earning. Add in a debt load that exceeds cash-in-the-bank by about $7.2 billion, and I'd say there's considerably more risk left in this stock than reward. A downgrade seems appropriate here.
Time to "buy American"?
Better news greeted American Apparel shareholders this morning, as Brean Capital stepped up to support the domestic clothing manufacturer with a buy rating, a $2 price target, and the assertion that this brand is simply "unsinkable."
According to the analyst, AA boasts "a fiercely loyal following" for its "unique and enduring brand." Financially speaking, the firm is producing "strong top- and bottom-line results, with January 2013 same store sales of +10% marking the 20th consecutive month of YoY increases."
One thing AA has failed to produce, though, is profits. American Apparel lost $53.3 million over the course of the past 12 months, alongside negative free cash flow of $4.2 million. Debt at the company is a massive $180 million, against just $7 million cash. While Brean seems convinced that the company has turned the corner, and will produce "material operating gains in 2013 and beyond," the jury's still out -- and even if the company does succeed in producing an operating profit, it's going to be hard to achieve actual net profitability with that debt load dragging it down. For now, the stock remains a gamble -- high potential reward, but with high risk attached.
When all you've got is lululemons, make... profit
Apparently, though, Wall Street analysts have no problem with taking on a bit of risk -- or recommending you to -- in their recommendations today. Case in point: Even as Brean was recommending investors patriotically pile into American Apparel, Cowen & Co. was tapping another clothier for an outperform rating of its own: yoga-ware manufacturer lululemon athletica.
Unlike American Apparel, of course, Lululemon is already a profitable operation. It's also debt-free, and free-cash-flow positive. Just like American Apparel, though, Lululemon is overpriced. The $16.7 million in free cash flow it generated this past year is less than $0.30 on the dollar, compared to the $57.3 million it reported earning during the same period. But even if Lululemon's FCF backed up its reported income 100%, the stock would still look a bit pricey at 41 times earnings.
Long story short: Right now, investors are willing to forgive Lululemon's sins of valuation... as long as it lives up to expectations of near 28% annualized earnings growth. If that growth momentum should stumble, however, they'll quickly abandon the stock -- like a downward-facing dog, with fleas.
Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool recommends lululemon athletica.