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 feature new buy-ratings for both American Electric Power and Corning . But it's not all good news on the NYSE today, so before we get to those two, let's find out why ...
FedEx just got grounded
Last week, I responded to an upbeat earnings report out of FedEx by pointing out a few downbeat notes in the company's report -- a failure to raise guidance in response to better-than-expected Q1 earnings, and reduced expectations for economic growth in the U.S. and abroad. Today, we see Wall Street echoing my skepticism.
On Monday, ace analyst Stifel Nicolaus (ranked in the top 5% of investors we track on Motley Fool CAPS) announced it's cutting its rating on FedEx stock from "buy" to "hold." Why might that be?
Well, for one thing, the valuation of FedEx stock really doesn't look all that attractive right now. This stock costs 23 times its earnings, which is significantly more than the company's average P/E ratio in most years over the past decade . A nice uptick in free cash flow recently worked to lower the company's P/FCF ratio, which is good -- however, FedEx noted in its earnings release that it expects to spend significantly more on capital investments this year than last (about $4 billion total), with the result that free cash flow at the firm is likely to be cut by more than half before the year is out.
Add in the risks of a slowing economy, which FedEx cited as one reason why it did not raise full-year guidance, and growth estimates that analysts already see restricting the company to low-teens earnings growth over the next five years, and suddenly 23 times earnings just isn't an attractive price to pay for FedEx today. Stifel is right to downgrade it.
Time to turn to American Electric Power?
One stock Wall Street seems -- rightly or wrongly -- to like more than FedEx today is American Electric Power. This morning, AEP caught an upgrade to "outperform" from the analysts at Wells Fargo, which used to think the stock was worth $44 to $45 a share and now values it at roughly $50.
According to Wells, AEP's recent underperformance of the S&P 500 Utilities index has the stock trading at a significant discount to its peers. In a note this morning, StreetInsider.com quoted Wells arguing that AEP's "core regulated operations can more than justify the current share price and that the Genco business has positive value of $1-3/share. As such, we believe the current risk/reward proposition tilts heavily toward investors' favor."
Unfortunately, I'm not so sure they're right about that. Like most utilities, AEP is a stock rather short on growth potential, and long on dividend payout. The stock's only expected to grow earnings at about 4% per year over the next five years. Its dividend yield, however, is four-point-five percent.
If you're a retiree on a fixed income, that's certainly a better return than you'll get from a passbook account, and may argue in favor of owning the stock. But only if the stock itself doesn't lose value at the same time as it pays out its dividends. Sadly, that's exactly what's happened over the past year, as AEP shares lost more than 1% of their market cap even as the rest of the S&P 500 roared ahead 17%.
Here's why I think this trend will continue: Priced at 18 times earnings, and carrying a boatload of debt (about $19 billion more than it has cash on hand), AEP shares cost far more than its growth prospects can justify -- even with the dividend payouts. Moreover, free cash flow at the firm is positively abysmal, with AEP generating a meager $306 million in positive free cash flow over the past year, far less than its reported GAAP income of more than $1.2 billion.
This suggests to me exceedingly low quality of earnings, and a stock that's even more overpriced than first meets the eye -- in short, not a stock I'd buy.
Corning could shine
Happier news greeted Corning shareholders this morning, as analysts at Gilford Securities chose to initiate coverage of the stock with a "buy" rating, and set a $20 price target on it. This time, that estimate could prove to be conservative.
On the face of it, Corning looks like a bargain-priced stock. The company costs less than 11.5 times earnings, yet is expected to grow these earnings at 12% annually over the next five years -- and Corning even pays a tidy 2.7% dividend yield.
Is the company generating too little cash to fully back up its reported earnings? Well, yes, it is. It usually does . But even so, the $1.5 billion in cash profits that Corning produced over the past 12 months suffice to give the company an enterprise value-to-free cash flow ratio of 12.6.
Result: Compared to the stock's total return ratio (that's the growth rate, plus the dividend yield, divided by the P/E or P/FCF), I see Corning stock as roughly 14% undervalued at today's price. While a move all the way up to $20, as Gilford predicts, seems a bit overoptimistic, I could easily see Corning going back to its 52-week high price, and maybe even a bit higher than that -- call it $17 and change.
Either way, whether you think the stock goes to $17 or to $20, Gilford is right in calling it a "buy" at today's sub-$15-a-share price.
Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool recommends Corning and FedEx. The Motley Fool owns shares of Corning.
The article Monday's Top Upgrades (and Downgrades) originally appeared on Fool.com.
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