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 contain bad news for heavy-equipment manufacturers in the form of new sell ratings for both Deere (NYSE:DE) and Caterpillar (NYSE:CAT). But it isn't all bad news everywhere...
Strong signal for DIRECTV
Satellite television powerhouse DIRECTV (NASDAQ:DTV), for example, just received a new buy rating from investment banker Stifel Nicolaus. While panning rival Dish Network (NASDAQ:DISH) for having a too-high valuation (an opinion I share), Stifel says it likes DIRECTV, and says the stock could grow into a $65 valuation as it expands in Latin America, and buys back stock.
I agree on this one, as well... sort of.
Priced at just 12 times earnings, DIRECTV shares look attractively valued based on consensus long-term growth estimates of 17%. Valued on its free cash flow, too, the stock looks good -- not as good as it does when valued on GAAP "earnings," granted. But the price-to-free cash flow ratio on this one is still short of 14, and still comfortably below the 17% growth rate, suggesting there's value to be had in the stock.
What does worry me about DIRECTV is the company's debt load, which is sizable (about $15.6 billion net of cash). Fact is, if you factor debt into the picture, DIRECTV begins to look a bit overpriced, rather than undervalued. Granted, this may not worry everyone, and granted, too, DIRECTV appears to have plenty of cash flow with which to pay down its debt. But it is a concern, and bears watching.
Deere, and Cats, and Bears -- oh my!
Speaking of bears, one analyst down in Australia took a rather bearish stance on two of America's other heavy industrial animals -- Deere and Caterpillar -- today. The banker in question, Macquarie, downgraded both stocks to neutral this morning, assigning price targets of $95 to Deere, and $88 to Cat.
Why? According to Macquarie, lower crop prices could reduce farmers' demand for, and ability to buy, Deere's wares going forward, resulting in weaker sales of agricultural equipment. Simultaneously, StreetInsider quotes Macquarie knocking assumptions about Caterpillar's prospects, based on fears of tepid economic growth in China -- a trend Macquarie says could stretch out for some time to come.
Laying the companies side by side, the twin downgrades make sense. Both stocks cost about 10 times earnings today. Both pay 2.4% annual dividend yields. (So far, so good). On the other hand, both companies are reporting exceedingly weak free cash flow at this time. Caterpillar generated only $165 million in positive free cash flow last year, a far cry from the $5.7 billion it claimed to have earned under GAAP accounting standards.
Deere is actually worse off in this regard. According to data from S&P Capital IQ, Deere's operating cash flow of $1.1 billion, minus capital expenditures of $2.2 billion, results in negative free cash flow. For its part, Deere calculates free cash flow differently, separating out its manufacturing division from its financing division. Viewed from this perspective, the company notes it is free cash flow positive. Also, Deere’s projected growth rate is also slower -- 10% versus Caterpillar's expected 14.
As a result, I'm personally not particularly optimistic about either of the two firms, and agree with Macquarie's decision to downgrade. Whether or not the analyst is right about the big macroeconomic trends, the simple fact that these two firms aren't currently showing much success in generating cash from their businesses suggests investors should stay away.
Editor's Note: This article has been updated to describe the Macquarie report statements and John Deere's cash position in greater detail.