At The Motley Fool, we poke plenty of fun at Wall Street analysts and their endless cycle of upgrades, downgrades, and "initiating coverage at neutral." Today, we'll show you whether those bigwigs actually know what they're talking about. To help, we've enlisted Motley Fool CAPS to track the long-term performance of Wall Street's best and worst.
FBN? Who dat?
Today, we're going to talk about neither the best nor worst, however. In fact, we're going to discuss a series of new ratings published by New York broker FBN Securities, which does not provide ratings data to Briefing.com for analysis, and so is unrated on CAPS. Said ratings come along with a poached analyst from Capstone Investments -- also unrated on CAPS. So a double mystery, and doubly worth our viewing with a critical eye.
Yesterday, FBN issued a whole host of new ratings across the enterprise data storage industry. EMC
Summarizing the report, FBN tells its customers that Western Digital and Seagate are both pretty appropriately priced today, with high-single-digit P/Es reflecting all the benefits of recent consolidation in the hard disk drive sector. FBN thinks there's still some value to be had, however, in storage specialist NetApp and EMC -- and it's the EMC analysis that catches my eye today.
FBN describes EMC as the best "external controller-based storage company" in the business, and possessed of the best "storage software" to boot. Yet despite its being best of breed, FBN thinks investors continue to undervalue EMC's shares. I agree.
Now I admit, selling for 30 times trailing earnings but expected to grow those earnings at only 15% per year over the next five years, EMC isn't obviously cheap. And yet, EMC's GAAP financials don't give the company full credit for all the cash it produces. According to the firm's cash flow statement, EMC actually generates free cash flow at a rate nearly 80% greater than shows up on the income statement -- $3.6 billion over the past year alone.
If you net out the firm's sizeable cash stash, what this works out to is an enterprise value-to-free cash flow ratio of 15 for EMC. While that's not a huge bargain given the growth rate, it does give investors the chance to buy a great storage business in the industry at a fair price.
Why so shy, EMC investors?
The question is why we're being offered the chance to make such a good buy in the first place -- and FBN thinks it knows the answer: VMware
But here's the thing: Just like its parent company (EMC owns 80% of VMware), there's more to VMware's profitability than meets the eye. Once again, we turn to the cash flow statement, and this time we find not an 80% disparity in earnings versus free cash flow, but a FCF number that outpaces reported earnings by nearly three times. Over the past 12 months, VMware reported "earnings" of a mere $404 million, but generated a whopping $1.2 billion in free cash flow. As a result, this company that many investors are thinking of as having a "98 P/E" is actually not quite so expensive, selling for an EV/FCF ratio closer to 30.
So … after seeing all the above, you may ask why I'm not buying EMC myself -- or VMware either, for that matter? The answer is simple: I'm not interested in owning fairly priced stocks (as EMC is.) I'm certainly not interested in owning moderately overvalued stocks (as VMware appears to be, based on its 24% projected growth rate.)
Call me crazy, call me a Fool, but, I prefer to buy screamingly undervalued bargains -- a strategy that has served me well in the past. Since recommending that investors buy EMC back in December of '08, I've racked up 112 points worth of market outperformance on the stock at Motley Fool CAPS. But revisiting EMC today, I'm pretty sure that I've made most of the profits that were there to be made, and I intend to close out my "buy" recommendation today.
My advice if you own EMC today? Take a bow -- then go forth in search for your next big winner.
Fool contributor Rich Smith does not own (nor is he short) shares of any company named above. You can find him on CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 521 out of more than 170,000 members. VMware is a Motley Fool Rule Breakers recommendation. The Fool owns shares of EMC and Western Digital. Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.