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 two downgrades in the construction industry, as RBC Capital Markets takes both USG (NYSE:USG) and Vulcan Materials (NYSE:VMC) down one notch to sector perform. Before we address those two, though, let's take a quick peek at a relatively new issue -- Russian payments processor Qiwi plc (NASDAQ:QIWI).
Qiwi looks sweet
Despite the name, Qiwi has little to do with New Zealand, being focused rather on the electronic payments markets in Russia, Kazakhstan, Moldova, Belarus, Romania, and... the U.S. and U.A.E. With the exception of those last two, this make Qiwi a sort of Slavic PayPal. And Qiwi got a new pal of its own this morning, when analysts at Deutsche Bank initiated coverage of the stock with a buy rating.
Quoted on StreetInsider.com today, Deutsche says it sees "50% upside potential" in Qiwi stock, arguing that the company will "be a winner in the Russian epayment market, benefiting from the shift from offline retail sales and bank transactions to online payments and money transfers." Deutsche sees the company growing earnings at upwards of 30% annually over the next few years, and believes this justifies a $60 target price on the stock.
Deutsche may be right about that.
Priced at 32 times earnings today, Qiwi doesn't look like much of a bargain, even if Deutsche is right about the stocks' 31% growth rate. (Most analysts, meanwhile, see only 20% annualized growth in Qiwi's future). But here's the thing: Qiwi's light business model keeps capital spending levels down low, with the result that the company's currently generating free cash flow far in excess of its reported net income -- $133 million in FCF, according to S&P Capital IQ figures, versus net income of just $63 million. As a result, while Qiwi's most obvious valuation metric is its 32 P/E ratio, it may be more accurate to think of the stock as trading for just 17 times free cash flow -- which suggests Qiwi is undervalued at even the consensus target of 20% annual profits growth. And If Deutsche is right about the company being able to grow at 30%?
That would make Qiwi an even sweeter bargain.
Vulcan melting down?
Turning now to the day's bad news, we begin with rock miner Vulcan Materials, just downgraded by RBC Capital on fears of a slowdown in road construction in the U.S. This bad news is eclipsing today's happier announcement that Vulcan has just solved its succession problem by naming Chief Operating Officer J. Thomas Hill to replace outgoing Chief Executive Officer Donald James -- and rightly so.
While it's good to know that Vulcan has worked out its C-level issues, the fact remains that this stock looks expensive based on current expectations for earnings growth... and extremely expensive it RBC is right about road construction spending slowing down.
Vulcan shares currently cost 64 times earnings, despite consensus expectations that these earnings will grow at only 9% annually over the next five years. Free cash flow at the firm -- just $70 million -- lags reported net income of $133 million pretty badly, too, so there's no hope for a reprieve on the "overvaluation" thesis there. And in a final bit of bad news for investors, Vulcan pays only a minuscule 0.3% annual dividend, and is burdened with more than $1.7 billion in net debt.
Long story short? You might as well bury your money in a hole in the ground, as sink it into this overvalued rock digger. RBC is right to downgrade it.
USG gets a "D"
A second stock getting pilloried at RBC today is drywall manufacturer USG Corp, the subject of the analyst's second downgrade to sector perform. Once again, this looks like the right call to me.
Priced at 37 times earnings, the stock may not look expensive considering that analysts expect to see its earnings rocket nearly 35% annually over the next five years. But is such a growth rate really realistic?
Personally, I just don't see that kind of growth in drywall -- or housing -- as likely in the near future. Meanwhile, USG carries an even heavier debt load than does Vulcan ($2 billion-plus), and with no free cash flow to its name, has little ability to pay down that dead. The company pays no dividend whatsoever. And to top it all off, the "profits" that may or may not grow at 35% annually over the next five years, aren't worth much.
Again, while shareholders won't be pleased to hear the news, RBC is probably right about this one. USG deserves the downgrade. This stock is no buy.
Rich Smith has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned.