Friday's Top Upgrades (and Downgrades)

RBC Capital rearranges its picks in the optical networking business.

Mar 28, 2014 at 2:36PM

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 be examining a trio of rating changes in the optical networking business as RBC Capital throws its support behind Finisar (NASDAQ:FNSR) and withdraws it from rivals Ciena (NYSE:CIEN) and JDS Uniphase (NASDAQ:VIAV). Let's dive right in, beginning with...

Finisar far from finished
Finisar shares are soaring, up more than 4% at last count, in response to an upgrade to outperform from RBC Capital. Arguing that the stock benefits from high fixed costs that dwindle in significance as sales race ahead, RBC expects Finisar to outperform its peers and hit a $30 share price target within a year.

I'm not sure RBC is right about that, though.

As far as Finisar's costs being "fixed" goes, the fact that the company's capital spending has grown nearly twice as fast as operating cash flow over the past three years (and several times faster than sales) suggests otherwise. Worse, over the past year, cash flow actually declined even as capital spending kept growing. And as a result, today Finisar is generating only $13 million in annual free cash flow, despite reporting GAAP "profits" of nearly $87 million.

Priced at 30 times these GAAP profits, the stock looks reasonably priced for the 26% annualized earnings growth it's expected to produce. But if you value Finisar on its free cash flow, the company sells for nearly a 200 times multiple to FCF -- very pricey indeed.

Long story short, after watching the shares nearly double in price over the past year, I'd be more inclined to go short this stock than long.

Ciena no longer shiny?
But what about RBC's other picks in the networking equipment space? Ciena, for example, has done pretty well over the past year -- not as well as Finisar but still up a good 41%. Yet it's seeing its stock sag in reaction to RBC pulling its buy rating this morning and downgrading to sector perform.

According to RBC, Ciena's made some impressive gains in revenue and market share over the past year (sales were up 18% last quarter, for example). But while Ciena's losses are shrinking, actual profits are still proving elusive. Ciena hasn't earned a GAAP profit since way back in 2008, and free cash flow, which had been quite strong just a couple of years ago, has now shrunk to a mere $6 million generated over the past 12 months.

Result: While expected to go GAAP positive next year and sell for a not-unreasonable 17 times forward earnings, the stock still looks risky. Ciena has no trailing P/E ratio to hang a valuation on, and free cash flow is too negligible to justify the stock's $2.3 billion market cap. A boom in telecom investment could still save Ciena, but anything like a recession would likely kill it.

JDS-U going up... or down?
Finally, we come to JDS Uniphase, which RBC is downgrading to sector perform as well today, a move the analyst describes as a valuation call, plain and simple. JDS shares haven't performed particularly well this past year, rising a mere 3% as the rest of the stock market tacked on 18%. Yet even so, the shares sell for a princely sum of 44 times earnings.

That seems a lot to pay for JDS's projected 19% growth rate. And yet, of the three stocks discussed so far here today, JDS is actually my favorite. The company boast a high quality of earnings and generates substantial free cash flow from its business -- more than $93 million over the past 12 months, or nearly 26% ahead of reported GAAP income.

Granted, at a market cap of 34 times free cash flow, the stock is still no bargain. But JDS' clean balance sheet and copious cash flows mean that should a broad market pullback arrive -- and bring a better price on JDS shares -- this is the first networking stock I'd look at with an eye to making a buy.

Rich Smith has no position in any stocks mentioned, and neither does The Motley Fool.

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