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 read like a Kindergarten review of the alphabet: upgrades for CSX (NASDAQ:CSX) and AOL (UNKNOWN:AOL.DL), but...
A downgrade for EMC
Let's get the "bad" news out of the way first. This morning, analysts at Monness Crespi & Hardt announced they have pulled their buy rating from EMC Corporation (NYSE:EMC).
EMC's full-year 2013 earnings aren't due out for another two weeks (January 29), but with the stock lagging the S&P 500 by a good 15 percentage points over the past year already, Monness isn't waiting around to risk any further bad news. Cutting and running in advance of the report, they downgraded the data storage specialist to neutral today. But were they right to do so?
I don't think so, and here's why: Personally, I don't know what kind of results EMC is going to report at the end of this month -- I probably no more know this than does Monness does itself. What I do know, though, is that based on the numbers EMC has put up in the past, this stock offers a pretty incredible bargain to less risk-averse investors.
While the stock's 21 P/E ratio doesn't look particularly cheap, the truth is that EMC is a lot more profitable than it looks. Free cash flow for the past 12 months exceeded $5.6 billion -- more than twice reported income under GAAP. That means that when valued on its actual cash profit, this stock is selling for less than a 10 times multiple. To me, EMC's projected long-term growth rate of 12% more than justifies that valuation -- and that's before you give the company credit for its $3.4 billion worth of net cash and before you give it credit for its generous 1.7% dividend yield.
Long story short, in a market like this one, good values come few and far between. But EMC is one of the good 'uns, and Monness is dead wrong to downgrade it.
CSX: Are we there yet?
Our next bit of news is of the (ironically) "good" variety. Earlier this week, I told you about FBR's (now clearly ill-fated) decision to increase its price target on train operator CSX to $35. At the time, I panned the call, pointing out how CSX generates too little real free cash flow and is growing its business too slowly to justify FBR's optimism.
Two days later, CSX proved me right with a Q4 earnings report that fell well short of Wall Street estimates. With costs rising 7% in the quarter, but revenues from coal shipments declining, CSX reported $0.42 in Q4 earnings -- two cents less than it earned a year ago and a penny below consensus estimates. Regardless, the stock is getting another vote of confidence from analysts at Argus Research this morning, as they upgrade CSX to buy after the stock's near-7% post-earnings price decline.
Now here's the bad news about this one: Argus is just as wrong today, as FBR was on Monday.
While CSX is undeniably cheap-er today than it was three days ago, the stock still costs nearly 15 times earnings, still carries an $8.3 billion debt load, and still isn't generating nearly enough free cash flow to call it "cheap." True, trailing free cash flow improved a bit in the final quarter of the year, and now reads about $954 million -- versus the $943 million we were seeing three months ago. But that's just not enough cash being generated to justify the stock's $28 billion market cap. Not with $8.3 billion in debt still looming, certainly.
While slightly less egregiously overvalued today than it was on Monday, CSX stock is still no buy -- no matter how many analysts say it is.
AOL: Do you want to open this mail?
And last but not least, we come to mini-media titan AOL, recipient of our other featured upgrade to buy.
Yesterday, AOL announced it has partnered with Zillow (NASDAQ:ZG) to have that company power its real estate website -- and is having private equity firm Hale Global help it run the Patch local news site as well. These announcements appear to have been enough to swing CRT Capital from a neutral opinion on the stock to buy, as CRT rated the stock such, and assigned AOL a $57 price target this morning.
Here, finally, I think may have found an analyst who's calling it right. Priced at 46 times earnings, it's true that AOL looks like no great bargain. But as we saw with EMC above, P/E-based looks can be deceiving. And much like with EMC, at AOL we find a company generating so much more free cash flow than it reports as earnings as to make its stock look (potentially) attractive.
Over the past 12 months, AOL generated $237 million in real cash profits -- more than twice its reported $92 million GAAP profit. With plenty of cash in the bank and less debt than it has cash, I calculate AOL's enterprise value-to-free cash flow ratio at just 14.7 -- barely a third of its apparent "P/E." Meanwhile, S&P Capital IQ calculates AOL's likely profits growth rate at 15% over the next five years. If it's right about that, then AOL's growth rate is more than enough to justify its modest market cap.
Caveat: As of this moment, Yahoo! Finance is showing only a 9% projected growth rate for AOL. If it turns out that this is the more accurate growth rate, then AOL shares could still take a tumble. While I personally like AOL's chances, beware. Forewarned is forearmed.