This series, brought to you by Yahoo! Finance, looks at which upgrades and downgrades make sense, as well as which ones investors should act on. Today, it's "good" news all around as analysts upgrade shares of Avon Products (NYSE:AVP) and VMware (NYSE:VMW), while even downgraded Progressive (NYSE:PGR) gets a higher price target.
Let's go ahead and tackle that last one right away, because it's a bit of a puzzler. This morning, analysts at RBC Capital Markets cut their rating on Progressive by one notch, dropping the property and casualty insurer to a "sector perform" rating. However, RBC also raised its price target on the stock, predicting the shares will hit $25 within a year. What's up with that?
Actually, the answer is pretty simple. Previously, RBC had a $24 price target on Progressive and was encouraging investors to buy the stock. But Progressive shares crossed the $24 line back in mid-February and haven't looked back since. With Progressive having achieved its target price, it's only logical that RBC would now cool its enthusiasm on the stock -- hence the downgrade. However, with the stock trading north of $25, Progressive had to at least raise its target price to match -- or else consider making a sell recommendation. So what to do?
Personally, I probably would have gone ahead and recommended selling the stock. Priced at 17 times earnings yet having a growth rate of less than 9%, the stock looks expensive. Progressive costs more than its peers: The average property and casualty insurer today sells for a P/E of eight. And although Progressive pays a dividend, its 1.1% yield is hardly big enough to make it worth sticking around and owning an overpriced stock.
But after selling Progressive, where do you put the cash? Stifel Nicolaus this morning put a "buy" rating on Avon Products -- but honestly, I disagree with this call as well.
Don't get me wrong; despite being unprofitable today, Avon isn't quite as bad as it looks. Free cash flow at the firm was a respectable $327 million last year, and Avon's a pretty consistent cash-producer. The problem is that Avon doesn't generate enough cash to be worth the $8.9 billion market cap it currently costs (or the whopping $10.5 billion enterprise value it carries, once you factor in debt).
At the more generous price-to-free-cash-flow ratio (let alone the less generous EV/FCF ratio) of 27, Avon's 20% long-term growth rate fails to measure up. The firm's dividend, at 1.2% today following a recent cut, isn't enough to make up the difference. Long story short, the stock is almost as overpriced as Progressive -- and unworthy of a buy rating.
A smarter choice: VMware
Fortunately, an investor today has better options, and as it turns out, one of them got recommended this morning by none other than RBC Capital. At the same time RBC was downgrading Progressive, you see, it was upping its rating on virtual data storage specialist VMware, which RBC now predicts will "outperform" the market.
Although VMware looks pricey on the surface with a P/E ratio of 49, the firm generates robust free cash flow of $1.66 billion annually -- more than twice its reported "GAAP" income. This results in a P/FCF ratio of 21.5 on the stock, which is right in line with VMware's 21% projected long-term growth rate.
Now, what takes this stock from "fairly priced" to "undervalued" is the fact that with VMware generating so much cash, the greenbacks tend to stack up in its bank account. VMware's balance sheet shows about $4.1 billion more cash than debt to the company's credit, meaning that its stock is actually even cheaper than the P/FCF ratio makes it look. At an enterprise-value-to-free-cash-flow ratio of less than 17 and a growth rate of more than 20%, I think VMware is a great stock selling for a good price.
It may not hit the exact $110 price target RBC has set for it, but so long as the company achieves the growth it's projected to, VMware shares are definitely destined to go up.