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 are biased to the downside, as Riverbed Technology (RVBD) scores an upgrade, but both CSX (CSX) and Emerson Electric (EMR) get knocked down. Let's find out why, and whether it matters, beginning with...
Riverbed could run through IT
Ever since Riverbed Technology announced it was spending $1 billion to acquire rival OPNET (OPNT) last month, the acquirer's shares have been under pressure. But according to one analyst, all this selling may have been overdone.
Analyst Northland Securities was quoted on StreetInsider.com this morning opining that "recent checks with [value-added resellers and corporate chief information officers] suggest a favorable response to the acquisition." Northland is of the opinion that far from being a strategic mistake, the OPNET purchase "is a good strategic fit for Riverbed." Accordingly, the analyst is upgrading Riverbed shares to "outperform" and raising its price target to $23.
This seems like a fair call. Over the past 12 months, Riverbed and OPNET combined to generate $244 million in free cash flow. Riverbed, at its now-discounted share price, costs only $2.6 billion en toto. Assuming the acquisition goes through, the company coming out of it should be selling for just under 11 times free cash flow -- but growing its earnings at close to 20% per year, per analyst estimates. That looks like a bargain price, and Riverbed looks like a "buy."
Does CSX mark the spot?
Not so CSX, the recipient of a downgrade to "market perform" from Avondale Partners this morning. Although priced at an apparent bargain basement 10.9 P/E, and growing strongly, CSX has a dirty little secret. Namely, its cash flow statement shows that this railroad operator actually only produces about $0.28 in cash profits for every dollar it claims to be "earning" under GAAP.
What that means, quite simply, is that while many investors are looking at CSX as an "11 P/E stock," they should instead be thinking of it as a company whose stock costs 39 times the amount of cash it generates in a year. The company's even more steeply overvalued when you factor debt into the equation, as its $9 billion debt load dwarfs CSX's mere $728 million cash balance.
Long story short, shareholders should probably be sending Avondale thank-you cards today, for only downgrading the stock to "market perform." With numbers this bad, the analyst could just as easily have downgraded to "sell." Come to think of it, it probably should have.
Emerson: not particularly electric
A second stock getting beat by the Wall Street ugly stick this morning is Emerson Electric, downgraded to "perform" by analysts at Oppenheimer on worries over pension costs and stock compensation plans potentially hurting earnings growth going forward. Oppenheimer also worries that capital spending is on the upswing, limiting cash production at Emerson.
That's significant because, in fact, cash production has been a strong point at Emerson in recent quarters. Free cash flow at the industrial equipment manufacturer ran at $2.4 billion over the past 12 months, about 20% ahead of GAAP-reported income of $2 billion. With a price-to-free cash flow ratio of less than 15, therefore, Emerson didn't look like such a bad bet. Its dividend yield of 3.4%, and growth rate of nearly 10%, combined to just about justify the stock price.
The worry now, though, is that if free cash flow starts to approximate net income more closely going forward, then Emerson, at an 18 P/E ratio, is going to start looking more expensive. For now, the stock appears fairly priced, and so Oppenheimer's "hold"-equivalent rating looks appropriate. But unless Emerson can produce a faster growth rate than it expected to produce going forward (a growth rate that, remember, Oppenheimer says will be hampered by employee compensation costs and higher capex), the stock could begin to look overpriced in future quarters.
Fool contributor Rich Smith has no positions in the stocks mentioned above. The Motley Fool owns shares of Riverbed Technology. Motley Fool newsletter services recommend Emerson Electric Co. and Riverbed Technology.