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 three new tech ratings out of international megabanker Deutsche Bank, which advised investors today to buy shares of EMC (NYSE:EMC) and Hewlett-Packard (NYSE:HPQ) -- but not IBM (NYSE:IBM). Let's dive right into the ratings.
EMC -- buy
Noting that "EMC continues to outgrow the overall storage market and take share" from its rivals, Deutsche endorsed shares of EMC this morning, predicting the company's stock will hit $32 (a 16% gain) within a year.
Quoted on StreetInsider.com today, Deutsche argues that "EMC remains one of the few names in IT hardware that is seeing above-market growth, and we expect this to continue. With shares trading below historical multiples despite attractive growth drivers, we see upside to the shares and rate EMC a Buy." Despite the data storage market as a whole showing 2% revenue slippage last year, EMC's revenues rose 7% -- demonstrating that the company continues to steal market share from its rivals. The company's "emerging storage" products, which include Isilon, ViPR, Atmos and XtremIO, are growing even stronger, with revenues up 54% year over year in 2013.
Granted, at a market capitalization more than 20 times earnings, the stock doesn't look like an obvious bargain relative to analyst projections of 11%-ish long-term earnings growth. But when you consider that EMC generates significantly more free cash flow ($6 billion in 2013) than shows up on its income statement ($3 billion), the company's actual valuation is probably better thought of as "9.3 times free cash flow" -- or with cash factored in, as an even cheaper-sounding enterprise value of 8.7 times free cash flow.
Relative to EMC's strong 11%-plus growth rate, those numbers look a lot more attractive -- and argue strongly in favor of Deutsche Bank being right to recommend the stock.
Hewlett-Packard -- buy
Deutsche's second pick in Big Tech is personal computer producer Hewlett-Packard. Like EMC, HP is a deceptively strong cash producer, generating free cash flow of nearly $8.5 billion last year, against a reported GAAP net income of only $5.3 billion. This works out to a price-to-free cash flow ratio of just 7.6 -- even cheaper than HP's P/E ratio of 12.3 already looks.
Granted, with a growth rate of only 4.5%, even 7.6 times free cash flow may turn out to be too high a price to pay for the stock. But Deutsche argues that HP "is mid-way through a 5-year turnaround," and so far has been successful in its efforts. Deutsche believes that the company's "IT hardware portfolio is well positioned for the next phase of IT, with strength in converged infrastructure and Big Data," and that HP deserves a valuation "in line with peer IBM."
Personally, I'm not sure how Deutsche gets from this hopeful observation (IBM's own P/E ratio is only about 13.3 after all, or about 8% higher than H-P's), to its conclusion that H-P shares should sell for $40 a pop -- 19% more than they cost today. As a result, I find the analyst's recommendation of EMC much more convincing than its argument that H-P is a buy simply because it's undervalued relative to IBM.
IBM -- don't buy
Speaking of IBM... Deutsche doesn't have very much nice to say about the tech giant, which at a market cap of $206 billion costs more than EMC and Hewlett-Packard combined.
Pointing out that "from 2010 to 2013, IBM's revenue has been essentially flat at $100B," and that "sales have declined for the past 7 quarters, with declines seen in all of the company's segments except for software," Deutsche declines to recommend IBM despite initiating coverage of the stock, rating the stock only a "hold." The analyst warns investors that, in its view, IBM is "growth ... challenged ... given its size and limited exposure to growth segments." Indeed, Deutsche's view is significantly more pessimistic than average on Wall Street, where most analysts are predicting that IBM will grow earnings at a pretty respectable 9% annually over the next five years -- but Deutsche is expecting something closer to "the 1-2% range."
Needless to say, investors who are paying more than 13 times earnings for a share of IBM today are probably hoping to see a lot more than just 1% earnings growth at the company. If Deutsche's warning proves prescient and all IBM can manage is 1% or 2% growth, they're bound to be disappointed -- and could punish IBM shares harshly for the disappointment.
Given that of the three tech stocks we've discussed so far IBM is the only one currently generating less free cash flow than it claims to be earning, and less by a pretty significant margin -- $13.9 billion FCF versus reported GAAP income of $16.5 billion, or a 15% difference -- I fear Deutsche is more likely right than wrong. IBM's earnings quality looks weak, and its prospects for growing as fast as investors hope and expect it will are slim.
Rich Smith has no position in any stocks mentioned, and doesn't always agree with his fellow Fools. For example, The Motley Fool owns shares of both EMC and IBM.