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 a pair of "system"-atic upgrades for shares of Pegasystems (NASDAQ:PEGA) and Quality Systems (NASDAQ:QSII), both now rated buy on the Street. But before we get to that good news, let's first take a quick look at why another analyst is...
Putting Potash(Corp) in a hole
Stock markets are broadly up this morning, but fertilizer giant PotashCorp (NYSE:POT) is sitting out the rally, dropping more than 1% in early trading. For this you can thank Raymond James, which this morning downgraded the stock from outperform to market perform.
Raymond named valuation as its primary concern about the stock. This is curious, given that PotashCorp shares are actually down 12% over the past year -- but it's not necessarily a wrong call (just late).
PotashCorp shares sell for more than 20 times earnings, after all. And while that's a cheaper valuation than the 50 times earnings multiple at archrival Mosaic (NYSE:MOS), it's still not exactly cheap, given that few analysts expect PotashCorp to grow earnings even as much as 7% annually over the next five years. (Mosaic is pegged for slightly greater growth of 8%).
S&P Capital IQ data lists PotashCorp's trailing free cash flow at $1.66 billion for the past 12 months, slightly better than the company's $1.57 billion in generally accepted accounting principles net income. But even so, that's only enough free cash to drop its price-to-free cash flow ratio to 18.7 -- still pricey for a sub-7% grower. With PotashCorp carrying $3.7 billion in net debt, I'd argue the stock's arguably even more expensive than it looks, whether valued on earnings or free cash flow.
Long story short, PotashCorp shares are overvalued, and Raymond James is right to downgrade them. The real question is, what took so long?
Will Pegasystems fly?
Turning from bad news on fertilizer stocks to good news on tech, we begin with business process management software provider Pegasystems, which Wedbush this morning upgraded to outperform. Wedbush sees Pegasystems hitting $27 within a year -- a 33% profit for buyers today of a stock at $20 and change.
Quoted on StreetInsider.com this morning, Wedbush stated: "PEGA's 2-year-old initiative to cultivate partnerships with large system integrators and grow its partner ecosystem is yielding positive results, helping PEGA to expand its market footprint, accelerate sales activity, shorten sales cycles, and close larger deals." The analyst sees revenue growing, and growing more predictably, lending more confidence to investors interested in buying the stock. But is Wedbush right?
At first glance, you'd have to be a real optimist to have confidence about this stock's potential to earn you a profit. Pegasystems shares sell for more than 41 times earnings, after all, a price that appears high even assuming the company can hit the 25% earnings growth rate that Wall Street projects. But looking a little closer, Pegasystems shares may not be quite as pricey as they seem.
S&P Capital IQ data shows that Pegasystems generated nearly $82 million in positive free cash flow over the past year -- more than twice the company's reported net income. Valued on this free cash flow, rather than on its GAAP income, the stock appears to trade for less than a 19 times multiple to cash profit. That's a very reasonable price to pay for 25% growth, if Pegasystems can deliver. Last quarter, earnings grew only 8%. But if the analysis is right, and brighter earnings days lie ahead, then this stock could well deserve the outperform rating just bestowed by Wedbush.
Another Quality investment?
The situation with electronic medical records company Quality Systems is similar to what we find at Pegasystems, but more so.
Priced at a seemingly sky-high valuation of 158 times earnings, Quality Systems churns out so much more cash profit than it is allowed to claim as "earnings" under GAAP -- $83.5 million in free cash flow over the past 12 months alone -- as to give the stock a much more reasonable-sounding price-to-free cash flow ratio of just 11.5. The company sports a debt-free balance sheet and, awash in cash itself, is not reluctant to share it with its shareholders. The annual dividend yield is a generous 4.6%.
Truly, the only "issue" with this stock seems to be its growth rate, which according to Yahoo! Finance numbers is set to just crawl along at 1% annually over the next five years -- in a software industry expected to grow north of 18%.
How likely is it that Quality Systems will underperform its peers by so much? RBC Capital seems to think it's not very likely at all, and this morning released a note rating Quality Systems at outperform, predicting that the shares will climb by roughly 19% over the next 12 months. I agree with that assessment. Judging by valuation alone, Quality Systems looks to be the cheapest stock on today's list -- and the best opportunity to consider buying.
Rich Smith has no position in any stocks mentioned, and doesn't always agree with all the stocks his fellow Fools like. Case(s) in point: The Motley Fool recommends Pegasystems and Quality Systems, but The Motley Fool also owns shares of PotashCorp.