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This Just In: Upgrades and Downgrades

By Rich Smith - Updated Apr 6, 2017 at 9:56PM

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FBN says EMC = buy.

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 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 (NYSE: EMC) and NetApp (Nasdaq: NTAP), along with QLogic, Dot Hill, Datalink, Network Engines, and Silicon Graphics (NYSE: SGI) all received new "outperform" ratings. Meanwhile, hard drive specialists Western Digital (NYSE: WDC) and Seagate (NYSE: STX), plus Emulex, Xyratex, Quantum, and Brocade (Nasdaq: BRCD) all got tagged as "sector performers."

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.

VMware inside
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 (NYSE: VMW). According to the analyst, this EMC subsidiary is "pricey" at "50 times forward earnings."

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.

Foolish takeaway
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.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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Stocks Mentioned

Dell EMC Stock Quote
Dell EMC
Western Digital Corporation Stock Quote
Western Digital Corporation
$59.17 (3.70%) $2.11
Brocade Communications Systems, Inc. Stock Quote
Brocade Communications Systems, Inc.
VMware, Inc. Stock Quote
VMware, Inc.
$116.65 (0.93%) $1.07
NetApp, Inc. Stock Quote
NetApp, Inc.
$90.67 (2.80%) $2.47

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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