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 feature new buy ratings from Morgan Stanley on heavy equipment manufacturers Terex (NYSE: TEX ) and AGCO (NYSE: AGCO ) -- but not for Deere (NYSE: DE ) . Let's dig in and find out why not.
Terex is tops
Morgan Stanley named Terex its top pick in the machinery sector this morning, assigning the stock an overweight recommendation, and a $47 price target. According to StreetInsider.com, Morgan Stanley is labeling Terex a "self help" story, capable of growing sales and profits even if the non-residential construction industry should sputter.
I don't necessarily disagree. With a business balanced pretty evenly among aerial work platforms, materials handling and processing, and construction and cranes, Terex is clearly focused on non-residential construction -- and could well get punished if this sector sags further. That said, the company's stock looks so cheap today that this risk may already be priced into it.
Valued at a market cap of $3.3 billion, Terex carries a sky high P/E ratio of 84 -- but a much more modest price to free cash flow ratio of just 10.4. Analysts on average expect the company can grow its earnings in excess of 9% annually over the next five years. Assuming the right about that, the stock looks slightly overpriced to me, but not egregiously so. What's more, given that the consensus forecast for the rest of the construction industry is 13% growth, it would appear that analysts are already erring on the side of caution in respect to Terex. Should the company grow at a rate approaching that of its peers, rather than the more modest 9% rate at which it's expected to grow, Terex shares may even be undervalued.
Is AGCO a go?
The analyst is nearly as optimistic about agricultural equipment maker AGCO, which it also rates overweight. And in fact, AGCO's prospects may be even brighter than those of Terex.
Priced at precisely 10 times its $556 million in trailing free cash flow, AGCO looks cheaper than Terex when valued on FCF. In fact, AGCO may appeal to individual investors even more. This is because the company's P/E ratio -- the first thing many investors look at when they began to investigate a prospective investment -- is a much more appealing 10.7, and not nearly so frightening as the 84 P/E at Terex.
Add in the prospect of a 12.5% projected growth rate at AGCO, and a modest 0.7% dividend yield, and to be perfectly honest, I think AGCO is actually a better bet than Morgan Stanley's top pick (Terex).
Deere in the headlights
Now let's turn to the one machinery stock that Morgan Stanley really loves to hate: Deere & Company. Out of the six stocks that Morgan Stanley initiated coverage on Thursday, the others being Caterpillar, Joy Global, and Manitowoc, Deere was the only stock tagged with Morgan Stanley's underweight rating. Why?
According to StreetInsider.com, Morgan Stanley worries that "weakening ag demand" will sap Deere's strength. On the one hand, this argument doesn't seem to make much sense, given that Morgan Stanley gave high marks to a company literally named for the agricultural industry -- AGCO. On the other hand, however, Deere shares are not nearly as attractively priced as those of AGCO.
Deere stock may sell for only "9.5 times earnings," according to Yahoo! Finance. However, the fact that analysts only expect to see Deere grow its earnings at 8% per year over the next five years means that this 9.5-times-earnings price doesn't buy you nearly as much growth at Deere as does AGCO's 10.4-P/E.
What's more, with trailing free cash flow of only $461 million, according to S&P CapitalIQ, versus reported GAAP earnings of $3.4 billion, Deere shares may actually cost far more than they appear to cost. That's not a risk investors need to fear when buying into AGCO, which generates more free cash flow that reports as GAAP earnings.
Long story short, I'm broadly in agreement with Morgan Stanley's recommendations today, with the sole proviso that while I agree that Terex is attractive, and Deere unattractive, I still think that AGCO is the best buy of the three.
Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool owns shares of Terex.