Thursday's Top Upgrades (and Downgrades)

Analyst places bets on data storage companies EMC, Nimble Storage, and Violin Memory.

Mar 13, 2014 at 1:29PM

This series, brought to you by Yahoo! Finance, looks at which upgrades and downgrades make sense and which ones investors should act on. Today, we'll look at why one analyst has just recommended data storage specialist EMC (NYSE:EMC) and made a couple of other recommendations in the storage space -- neither of which you've ever heard of. Let's start off with the headline name, though:

EMC = cheap, squared
Shares of EMC are defying the downturn on stock markets today, up a good half a percentage point in response to a new buy rating from Wunderlich Securities. Citing EMC's strong position in four tech "megatrends," storage, virtualization, security, and analytics, and its robust market share, Wunderlich argues that "the stock is undervalued" and should be bought.

And Wunderlich is right. EMC is undervalued -- whether it looks that way or not.

I'll admit that, priced north of 20 times earnings but expected to grow these earnings at only about 12% annually over the next five years, EMC is not an obvious value candidate. But looks can be deceiving. The fact is that, with $6 billion in annual free cash flow, EMC actually earns about twice as much cash profit as it reports for its "net income" under GAAP accounting standards. Result: At a price-to-free cash flow ratio of just 9.2 (and an enterprise value-to-FCF ratio that's even lower), EMC actually is very cheap for its growth rate.

Add in a tidy 1.5% dividend yield for good measure, and Wunderlich is exactly right to recommend buying EMC. But what about the other two stocks that Wunderlich initiated coverage on today -- the stocks you've never heard of? What about...

Violin Memory (NYSE:VMEM)
Like EMC, a company in the data storage business, but unlike EMC in that it's been public less than a year and has a much smaller market capitalization, Violin Memory is volatile enough that it's reacting strongly to Wunderlich's endorsement today. Describing the company as a participant in the "large and growing market for enterprise solid state systems," and praising CEO Kevin DeNuccio as an executive with a "track record for transforming businesses," Wunderlich argues that Violin has been unfairly punished by investors for missing "revenue estimates" in its first couple of quarters as a public company.

Wunderlich thinks the shares, which currently trade for $4 and change, are worth closer to $6. But personally, I'm not so sure about that. Unprofitable for its entire history, and a perpetual cash burner, I think that "revenue estimates" are the least of Violin's problems. Its real problem is that it's not making money on the revenue it does have.

What's more, given that very profitable EMC shares can be bought for just 2.4 times annual sales, I see no reason why investors should pay 3.3 times Violin's unprofitable sales for its shares. Rather, I'd stick with quality -- and ignore Wunderlich's second recommendation.

Nimble Storage (NYSE:NMBL)
Last and least, we come to Nimble Storage, another recent IPO -- but one Wunderlich is less enthusiastic about. While bigger than Violin, Nimble shares are reacting just as violently to the analyst's negative note (Wunderlich rated this one only a hold, calling its valuation "lofty") as Violin reacted to the analyst's positive note.

As relayed by this morning, Wunderlich actually likes the fact that Nimble is "gaining traction" in the storage market on the strength of its "state-of-the-art technology," "strong channel distribution," and "solid product monitoring technology and customer support system." Wunderlich believes the company will gain market share going forward.

The problem with Nimble, quite simply, is the price, which Wunderlich puts at "10x calendar-year 2015 sales" and believes is too high for investors to safely buy.

As for me, I don't know what kind of sales numbers Nimble will produce two years from now (psst! Wunderlich doesn't, either). What I do know is that right now, today, Nimble is every bit as unprofitable as Violin; that it's burning cash like mad; and that it pays no dividend. It's also selling for 16.5 times the annual sales we know it can achieve (because it's already reported them), which makes the stock about seven times more expensive than EMC on that metric.

Long story short, I'm with Wunderlich on this one. As long as EMC is out there, profitable, growing, and paying a dividend, I see no need to invest in a second-class storage stock like Nimble.

Rich Smith has no position in any stocks mentioned. The Motley Fool owns shares of EMC.

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