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 include a new buy rating for Oracle (NYSE:ORCL), balanced out by twin downgrades for Southwest Airlines (NYSE:LUV) and Ethan Allen (NYSE:ETH).
Good news first
Let's end the week on a bright note, and do the buy rating first. This morning, analysts at Janney Montgomery Scott initiated coverage of database superstar Oracle at a rating of "buy" and a price target of $40. With the shares currently selling for under $32, this promises better than 25% upside in the stock -- but is Oracle really worth $40 a share?
At first glance, you might not think so. While Oracle doesn't look particularly expensive at a P/E ratio of less than 16, the fact that analysts are only expecting 12%-or-so annual earnings growth at the company over the next five years suggests the stock is already fairly priced today. But here's the thing: GAAP earnings don't tell the whole tale at Oracle. In fact, this company is a whole lot more profitable than it looks.
For example, the company's cash flow statement reveals that over the past year, Oracle has generated some $13.4 billion in real, cash profits from its business. That's about 31% more than the $10.2 billion in "earnings" it reported. Also, Oracle's balance sheet shows the company has $16.8 billion in net cash. Combine these two bits of data, and it becomes apparent that what we're really looking at here is a company selling for an enterprise value-to-free cash flow ratio of just 10.1.
For a 12% grower, that's a cheap price to pay, made even cheaper by Oracle's modest 0.8% dividend yield. In short, Janney's calling this one right: Oracle is a bargain.
Do you LUV it?
Curiously, one of the stocks getting downgraded today may be an even bigger bargain: Southwest Airlines.
The stock's encountering little turbulence despite Standpoint Research knocking it down to neutral this morning, and if you ask me, investors are right to be unconcerned. Priced at less than 16 times earnings, and carrying essentially no net debt on its balance sheet, Southwest looks every inch the bargain at projected growth rates averaging nearly 20% over the next five years.
Like Oracle, Southwest pays its shareholders a small dividend (0.4%). Like Oracle, it generates considerably more free cash flow than its income statement lets on -- $864 million in trailing FCF, versus just $495 million in reported earnings. So again -- this is a stock that's significantly cheaper than it looks.
Given that even looking at GAAP numbers alone, Southwest is a bargain, I'd say the company's net-debt-free balance sheet and strong free cash flow make this one a solid bet as well.
Short the housing optimists?
If only I could say the same for today's other big downgrade. Priced at 13.5 times earnings, and growing at 19%, Ethan Allen is hardly the kind of stock you'd expect to find Wall Street hating. Nonetheless, ace investor Stifel Nicolaus knocked Ethan Allen down to a hold rating as well this morning. Why?
Actually, there are two reasons to be skeptical of Ethan Allen's outperformance this past year. First, despite strong reported earnings, the company's generating little in the way of free cash flow these days -- barely $10 million over the last 12 months, despite claiming to have "earned" $53 million. Second, with so little cash coming in the door, Ethan Allen is hard-pressed to make much of a dent in its massive, $150 million debt load (nearly twice cash on hand).
Result: Debt-heavy and free cash flow-light, Ethan Allen shares currently sell for an EV/FCF ratio of more than 80 -- which is quite pricey even if the company manages to hit Street targets of 19% annualized profits growth over the next five years.
At this price, Stifel's right to put Ethan Allen back on the shelf, and walk out the door. You should, too.