This Just In: Upgrades and Downgrades

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At The Motley Fool, we poke plenty of fun at Wall Street analysts and their endless cycle of upgrades, downgrades, and "initiating coverage at neutral." Today, we'll show you whether those bigwigs actually know what they're talking about. To help, we've enlisted Motley Fool CAPS to track the long-term performance of Wall Street's best and worst.

And speaking of best and worst...
Over in analyst-land, Credit Agricole brokerage CLSA has just issued a series of reports on the big players in data storage. Specifically, the analyst is telling its clients to buy up shares of EMC (NYSE: EMC  ) and VMware (NYSE: VMW  ) , but to sell NetApp (NASDAQ: NTAP  ) . Why?

Valuation is probably part of it. Focusing first on NetApp, we note that Forbes just published a report worrying about the stock's P/E ratio, which the magazine describes as "much higher than its peers." On the one hand, NetApp may deserve the higher valuation, given that it just reported an "earnings beat" a couple weeks ago. Forbes sees this as evidence of the company's ability to "fend off competition from the likes of EMC, IBM (NYSE: IBM  ) , and Dell (UNKNOWN: DELL.DL  ) ."

On the other hand, investors can still lose money by buying a winning stock, if they overpay for it. So does NetApp's share price today make sense?

How pricey is it?
Well, let's consider: At 25 times earnings, NetApp shares costs about 25% more than a share of EMC will set you back. That right there seems to explain why CLSA is rating EMC an "outperform" while it rates NetApp an "underperform" -- the one's clearly less expensive than the other. What's more, with a projected five-year profits growth rate of less than 11%, NetApp isn't even outgrowing EMC so as to justify its higher P/E ratio. To the contrary, EMC's 14.4% long-term growth projections leave NetApp in the dust.

On the other hand, there's still VMware to consider. The EMC subsidiary, after all, carries a P/E ratio more than twice that of NetApp, which hardly jibes with Forbes' assertion that NetApp carries a higher P/E ratio than its peers. Even if EMC proper is a better bargain than NetApp, does VMware, too, deserve Wall Street's endorsement?

Survey says!
In a word, yes. Sure, VMware may cost more than NetApp on a GAAP basis. But if you value the company not on its GAAP "accounting earnings," but on the actual cash profit it produces, it becomes clear that VMware, too, is a pretty cheap stock.

Over the past 12 months, VMware has generated $1.76 billion in free cash flow which, when compared to its market cap, gives the stock a price-to-free-cash-flow ratio of 22.2. That's entirely reasonable, given that most analysts agree VMware is capable of growing its profits at better than 22% per year over the next five years.

So where does this leave us? Judging from the numbers, VMware is clearly priced low enough to justify a purchase at today's valuation. But here's the thing: NetApp is, too.

Far from being the "underperformer" that CLSA says it is, NetApp boasts a price-to-free-cash-flow ratio easily as attractive as VMware's. The $1.07 billion in positive free cash flow that NetApp generated over the last year is enough to give the stock a 10.8 P/FCF ratio. And if you think VMware is worth 22.2 times FCF based on its super-fast 22% growth rate, then you pretty much have to admit that NetApp's more modest growth rate of 10.7% is at least fast enough to justify that stock's 10.8 times FCF valuation as well.

Foolish final thought
Finally -- EMC. If I think that the valuations on VMware and NetApp are both entirely defensible, then I'm positively giddy about the bargain basement price that investors are being offered on EMC stock.

Priced at a low, low, 9.1 times free cash flow, there's simply no way EMC is not a bargain if the company manages to achieve the 14%-plus growth rate that Wall Street expects out of it. Plus, EMC boasts a balance sheet brimming with $3.7 billion in net cash -- meaning that its valuation is arguably even cheaper than it looks.

Long story short: Of the three big data stocks discussed so far, EMC is probably the one I like the best. That said, I see a lot to recommend all three of 'em -- EMC and VMware, which CLSA says it likes, and also NetApp, which CLSA says it hates. The analyst's biases notwithstanding, I think all three of these stocks are buyable.

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 30, 2012, at 9:52 AM, StorageInvestor wrote:

    It's a little strange to compare VMWare with NTAP - one is a software company and the other is a hardware company. Customers will view the two completely differently when making decisions about how to build their environments. They aren't even competitors, customers will choose VMWare, (or some other virtualization platform), and the underlying storage platform storage could be EMC, NTAP, HP, or any other myriad storage vendor. Also, VMWare is arguably the default decision relative to their competitors, while NTAP is in much more of a commodity market, fighting with other storage vendors for mind share with customers.

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