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 Netflix (NASDAQ:NFLX), but shifts to sell at both Harmony Gold (NYSE:HMY) and Freeport-McMoRan (NYSE:FCX).
Netflix could hit $250
The trading week dawned bright for Netflix shareholders, as institutional broker BTIG initiated coverage of the DVD's-by-mail-and-stream provider with a "buy" rating -- and a price target of $250.
Homing in on Netflix's streaming video business as key, BITG lauded the "improving Netflix price/value relationship, along with high-quality, proprietary original programming." The analyst predicted that by offering more content than the competition, and original content to boot, Netflix will earn "better than expected subscriber growth" and also "moderate churn." Going forward, BTIG sees "streaming leverage" accelerating, with Netflix's "domestic revenue growth outpacing content spend."
So in essence, BTIG is saying that Netflix has reached critical mass. It can stop spending down... and still grow its revenues. Let's hope BTIG is right about that -- because as things stand, Netflix's been spending so much more money than it takes in, that earning dropped to $17 million last year, while free c ash flow has gone negative.
With a triple digit P/E today, and a price-to-free cash flow of infinity, the stock still looks like a "sell" to me.
No happiness at Harmony
Moving on from that "good" news about Netflix, we now turn to Harmony Gold. Citigroup downgraded the South African goldminer to "sell" this morning. The plunge in gold prices to below $1400 probably had something to do with this rating. Goldman's prediction that gold will keep falling into the $1300s probably had a bit more to do it.
But are these short term price movements reason enough to sell Harmony? It depends.
If you value the stock on its P/E ratio, Harmony actually looks like a pretty nice bargain. It sells for 8 times earnings, is projected to grow these earnings at about 6% per year going forward, and it pays a modest 1.7% dividend. These numbers all suggest that the stock's, at worst, fairly priced.
The problem is that Harmony's earnings -- and hence its price-to-earnings ratio -- don't fully reflect the weakness of its cash flows. Last year, Harmony brought in $515 million in operating cash flow. It then spent $435 million of this on capital investments, leaving real cash profit -- free cash flow -- of only $80 million. That's only about 28.5% of what the company reported as its "net earnings" for the year, and leaves the stock trading for about 27 times annual FCF.
To my mind, that's too high a price to pay for a 6% grower, and the fact that Harmony's got a pretty P/E ratio doesn't sway me one whit.
Freeport isn't free. It's expensive
Speaking of free cash flow, that factor was the crux behind Citi's other big mining downgrade as well. Warning of falling copper prices, and predicting the company will generate "minimal" free cash flow over the next two years, Citi also slapped a "sell" rating on copper-and-gold miner, and oil producer, Freeport-McMoRan this morning.
As with Harmony, Freeport's downgrade looks strange at first glance -- but obvious on closer examination. The stock may seem to cost only 9.3 times earnings today, but with free cash flow of only $280 million for 2012, Freeport backs up a smaller proportion of reported "net income" with real free cash flow than even Harmony does. Quite literally, only $0.09 out of every $1 the company claims to be earning actually shows up as cash in the bank at Freeport. As a result, you can as easily pan Freeport for having a 100x price-to-free cash flow ratio, as praise it for its "9 P/E."
Result: Just like Harmony, Freeport offers a lesson in how commodity mining companies are often more expensive than they look. Today's downgrade -- and the 7% sell-off in stock price -- reminds us of what can happen when Wall Street wakes up and realizes the mistake it's made in focusing on "earnings," and forgetting about cash.
Motley Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool recommends Netflix. The Motley Fool owns shares of Freeport-McMoRan Copper & Gold and Netflix.