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 a pair of downgrades from R.W. Baird, on mining equipment makers Joy Global Inc. (NYSE:JOY) and Caterpillar Inc. (NYSE:CAT). But the news isn’t all bad. Let’s find out why one analyst thinks that …
Nokia could go higher
Just two weeks after Microsoft Corporation (NASDAQ:MSFT)‘s offer to buy Nokia Corporation (ADR) (NYSE:NOK)‘s cell phone business sparked a surge in the latter’s stock price, Nokia Corporation (ADR) (NYSE:NOK) shares are climbing again today … on the prospect the company will sell off additional parts.
Specifically, analyst Credit Suisse thinks it’s entirely possible that Nokia Corporation (ADR) (NYSE:NOK), which licensed certain patents to Microsoft Corporation (NASDAQ:MSFT) when it sold its cell phone business, will now go a step farther and actually sell the patents — perhaps to Microsoft Corporation (NASDAQ:MSFT), perhaps to someone else.
Credit Suisse names a whole series of potential buyers for Nokia’s patent portfolio, which the analyst says is worth $14.7 billion, or roughly $4 per share. Add that to the $7.2 billion ($2 a share, give or take) that Microsoft Corporation (NASDAQ:MSFT) is already anteing up, and you’ve got $6 worth of value in the parts Nokia is, or may soon be, selling off.
As for the rest of Nokia, Credit Suisse seems to be assigning about $2 worth of value to each share of rump Nokia, arriving in the end at an $8-per-share target price. Is it right about that?
Well, Credit Suisse is certainly right about the first $2 that Microsoft Corporation (NASDAQ:MSFT) is paying. The infrastructure business that will become rump-Nokia had $18.2 billion in sales last year. If you value that at, say, the 0.4 times sales valuation of infrastructure rival Alcatel Lucent SA (ADR) (NYSE:ALU), then that works out to a further $7.2 billion — $2 per share more. So right now, you’ve got about two-thirds of Nokia’s present value accounted for. The only remaining question is whether Nokia’s intellectual property alone is worth $4 — equal to the value of every tangible piece of property in the entire company.
Personally, I think that’s probably a bit of a stretch. We’ll probably have to wait and see if a bidder for the patent portfolio emerges, though, to know if Credit Suisse is right about that one … and whether it’s right about Nokia still being a “buy.”
No joy for Joy … or for Caterpillar, either
Turning now to the day’s bad news, analysts at Robert W. Baird decided this morning that the commodity prices seems to be at an end, and so pulled in its horns on two of its former-favorite mining equipment stocks — Joy Global Inc. (NYSE:JOY) and Caterpillar Inc. (NYSE:CAT). Both stocks got downgraded to “neutral” this morning, with Baird positing a $55 target price for Joy Global Inc. (NYSE:JOY), and $90 for Caterpillar Inc. (NYSE:CAT).
But is Baird cutting bait too soon? After all, the analyst’s new price targets suggest there’s still at least a few dollars’ worth of upside left in both stocks. Nor do either Joy Global Inc. (NYSE:JOY) or Caterpillar Inc. (NYSE:CAT) look particularly expensive — at least on the surface. Joy shares cost only 7.8 times trailing earnings, while Cat shares fetch 13.6 times earnings. With estimates for earnings growth in the mining industry still averaging 13.6% annually over the next five years, this would appear to suggest that Caterpillar Inc. (NYSE:CAT) is at worst fairly priced, and Joy Global Inc. (NYSE:JOY), potentially a bargain.
Don’t believe it.
Both of these stocks’ purported GAAP “earnings” are actually of extremely low quality, raising the risk they could decline in short order. Financial data provider S&P Capital IQ reports that actual free cash flow at Joy Global Inc. (NYSE:JOY) is only $457 million for the past 12 months — just 64% of reported net income. Caterpillar Inc. (NYSE:CAT) did a little better than that, but only just barely. It generated only $2.9 billion in free cash flow over the past year — 68% of reported net income.
What this suggests to me, as a value investor, is that both stocks are roughly half-again more expensive than their P/E ratios make them look, and correspondingly, 50% less attractive to invest in.
Long story short, Baird is correct to be cautious, and right to downgrade the stocks.
The article Wednesday’s Top Upgrades (and Downgrades) originally appeared on Fool.com and is written by Rich Smith.
Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool owns shares of Microsoft.
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