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 both General Mills (GIS) and Buffalo Wild Wings (BWLD). But it's not all good news, so before we get to those stories, let's take a look at why...
Rackspace got shelved
Wednesday opened poorly for investors in cloud hosting company Rackspace (RAX), as analysts at Hong Kong-based CLSA began covering the stock with an underperform rating -- essentially a "sell." But does Rackspace deserve such a harsh rating?
On one hand, the company certainly looks too expensive to "buy." Shares cost 67 times earnings even after today's post-downgrade sell-off. That's a high price to pay, even if you agree with the consensus among analysts that Rackspace is likely to grow its earnings at close to 30% per year for the next five years. On the other hand, Rackspace does boast high-quality earnings, generating $129 million in positive free cash flow last year, or nearly 23% more cash profit than it's allowed to claim as its "net earnings" under GAAP accounting standards.
Still, even viewed under the best possible light, what we're left with here is a stock that costs more than 53 times the amount of cash it makes in a year. While growth prospects are bright, they'd have to be positively blinding in order to justify this kind of valuation on the stock. They're not. And CLSA is right to point that out.
General Mills: Now with fiber!
Another stock boasting similar superior free cash flow characteristics -- and one getting a boost from analysts, instead of a bash today -- is cereal maker General Mills. Argus Research just upped its recommendation on the stock to "buy," and again it's easy to see why.
Priced at 17 times earnings and 14 times free cash flow, General Mills hardly seems expensive. It pays a pretty generous 3.2% dividend yield, too. And yet... you shouldn't buy it.
Why not? Two reasons: First, analysts have General Mills pegged for a pretty anemic 8% pace of growth over the next five years, which is too low to justify the price. Second, the company's carrying about $7.2 billion in net debt, which isn't factored into its market cap. Looked at through the lens of enterprise value, though -- which does factor in debt and cash -- the stock is selling for a 21-times multiple to earnings, and a 17-times multiple to free cash flow. Which is again too pricey for the 8% growth rate.
Long story short, General Mills is a terrific company with a storied brand name, great quality of earnings, and tremendous staying power. And you still shouldn't buy it.
Could Buffalo Wild fly?
Hoping then that the "third time's the charm," we turn finally to restaurateur Buffalo Wild Wings, which caught an upgrade from Feltl & Co. this morning, and tacked on 1% in response. But does B-Dub deserve the improved market cap?
Sadly, no. Buffalo Wild boasts an impressive 19% projected growth rate, true. But its price-to-earnings ratio is a simply preposterous 28.8, and the company's generating so little real free cash flow from its business (less than $15 million in real cash profits, versus reported "earnings" of more than $57 million) as to lift its price-to-FCF ratio well above 100.
Feltl's rating change today only lifts the stock to "hold" from "sell," granted, so at least the analyst isn't getting totally carried away here. But even so, I don't believe Buffalo Wild deserved the upgrade at all. At these high prices, investors should simply choose to eat elsewhere.
Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool recommends Buffalo Wild Wings and Rackspace Hosting. The Motley Fool owns shares of Buffalo Wild Wings.