This Just In: Upgrades and Downgrades
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.
Who's hot, who's not -- in Internet stocks
"Woe unto you! The end is nigh, declareth FBR Capital!" That's basically the headline from Thursday's twin downgrades of Juniper Networks and Cisco Systems , courtesy of Arlington, Va.-based investment banker FBR. So what does FBR have against two of the best-known and best-respected names in Internet backbone-building? Simply put, their business models are about to get upended.
StreetInsider.com gives us the lowdown on FBR's thinking: "We believe Cisco will become increasingly more challenged to offset weaker-than-expected routing and switching demand as ... technological trends ... significantly blur the lines between routers, switches, and servers."
According to the analyst, telecom providers will more and more cut the number of routers and switches they buy. (Hint: Cisco and Juniper sell routers and switches). Meanwhile, sales of what routers and switches they do buy will increasingly get eaten up by "new competitive products and vendors" selling "white box, lower-margin product." ("White box" is basically a tech industry term for generic, non-brand-name equipment).
And why is this bad?
Assuming FBR's right in its analysis, this is bad news for two reasons. First, lower sales of routers and switches means, almost by definition, lower revenues for Cisco and Juniper. Second, if FBR's right about telecoms being willing to buy product from non-brand-name manufacturers, then increased competition is likely to hinder pricing power and squeeze profit margins at the two tech giants. This is why FBR is recommending that you sell both stocks.
Yet in this world of ours, there are stocks you might want to consider selling, and stocks you must sell now. Cisco might be the former. Juniper is definitely the latter. Here's why.
The risky play
Priced at 54 times earnings, Juniper shares are wildly overpriced for the mere 15% long-term growth that most analysts think the company is capable of producing. Indeed, valued even on its more robust free cash flow, the company sells for a 32 multiple and is probably overpriced by a factor of two -- that's if FBR is wrong about the "white box" threat. If it's right, then things are even worse than they look.
The defensive play
The situation with Cisco is a bit better. Priced at only 12 times earnings today, and with a price-to-free cash flow ratio that's even lower, this stock already has a lot of the white-box-threat priced into it. Cisco also pays a tidy 2.6% dividend yield -- Juniper yields zilch -- and has modest growth expectations to fulfill -- only 8.4%.
The out-and-out disasters
Another thing to keep in mind when deciding how to play this trend is staying power. If there's a price war afoot in high-tech routers and switches, Cisco, with its beefy 22.7% operating margin, is much better positioned to depressed profit margin losses and survive, than is Juniper and its modest 9.4% margin.
Rivals farther down the profitability ladder could be in for an even worse ride. Here you need to keep your eye on Alcatel-Lucent , which currently ekes out a living on a 0.9% operating margin (and even that may be overstating the case, because Alcatel is currently free cash flow-negative), and on Ciena as well. In addition to burning cash, Ciena also sports negative operating margins.
When you get right down to it, I kind of suspect that FBR's fears about Cisco are overblown. With strong free cash flow and a deep cash cushion -- $30 billion net of debt -- Cisco is a corporate fortress, and probably able to handle whatever troubles Mr. Market sends at it. Juniper, Alcatel, and Ciena, on the other hand ... well, let's just say I'm less confident in their chances, and leave it at that.
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The article This Just In: Upgrades and Downgrades originally appeared on Fool.com.Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool recommends Cisco Systems. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.