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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 a new buy rating for Zumiez (ZUMZ), a higher price target for Home Depot (HD), and a downgrade on Obagi Medical (OMPI). Let's dive right in.

Zumiez could zoom
The day started off with a bright note for "action sports" retailer Zumiez. Ascendiant Capital initiated coverage of the stock with a buy rating Thursday, sending Zumiez shares up a full percentage point in morning trading. But could they zoom even higher than that?

It depends. On one hand, I have to say that Zumiez shares look very attractively priced relative to reported GAAP income. The stock costs about 18 times earnings, and analysts have it pegged for 18% annualized earnings growth over the next five years. On the face of it, this price looks fair -- and gets fairer still when you notice that this valuation doesn't even factor in how the stock's $97 million in net cash makes it even cheaper.

But that's just the first hand. On the other hand, investors can't be thrilled about the job Zumiez is doing with generating cash. Free cash flow at the retailer came to just $25 million over the past year -- far short of the $42 million in "earnings" the company reported. Valued on free cash flow, and giving Zumiez credit for its cash in the bank, it gets an enterprise value-to-free cash flow ratio of about 25, which seems a bit steep for an 18% grower.

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My advice: Leave this one on the rack for now. All retailers eventually go on sale. Zumiez, too, will become worth buying... at the right price.

Home Depot: Leave home without it?
Speaking of overpriced retailers: Home Depot. Analysts at Canaccord Genuity upped their price target on the stock this morning, saying HD shares should be worth about $61 a year from now. There's just one problem with that, however. Home Depot shares currently cost $69! So while technically Canaccord is upping its price target on the stock, this sounds like mixed news at best for Home Depot shareholders.

So why didn't Canaccord come out with a better price target? Maybe a buy rating as well, to go with it, instead of the half-hearted "hold" Canaccord currently rates the stock? The answer, I fear, is simple: Home Depot isn't worth a buy rating. It might not even be worth $61, and certainly shouldn't cost the $69 a share investors are paying for it today.

Here's why: Home Depot shares cost 23 times earnings today, which is more than you'd ordinarily expect to pay for 14.5% annualized profits growth, even with Home Depot's generous 2.3% dividend yield to help bridge the gap in valuation. Or viewed under a most favorable light, Home Depot's superior ($5.7 billion) trailing free cash flow works out to a price-to-FCF ratio of 18... which is still a bit too much to pay for 14.5% growth and a 2.3% divvy.

Long story short, while Home Depot may be worth a hold rating (and that's what Canaccord gives it), the stock's clearly not worth buying... and probably isn't worth the $69 its shares cost today, either.

Obagi Medical: The patient will live
Finally, and on a "brighter" note, we turn to the one stock on today's list that actually got a downgrade today: Obagi Medical.

As you've probably heard by now, Valeant Pharmaceuticals (VRX) bid $19.75 a share for Obagi yesterday. Responding to this news, analysts at Cantor Fitzgerald pulled their buy rating on the stock, and downgraded to hold. That looks like the right call.

At today's buyout-inspired valuation of 22 times earnings, Obagi shares already sell for a premium to their 16% growth expectations. The only chance the shares have of rising higher, therefore, would be if someone else comes out and tries to trump Valeant's bid. Cantor doesn't see any such competing bids as being likely, and with investors currently paying less than Valeant's offer price for Obagi shares, it seems Mr. Market agrees with Cantor on this one.

So do I. With the shares up 58% in the past year, it's time to declare victory on Obagi, and count your winnings.

Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool recommends Home Depot.

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