This Just In: Upgrades and Downgrades

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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.

How long will Embraer remain grounded?
The month of August is looking more like the month of "arrrgh and disgust" to shareholders of Embraer (NYS: ERJ) . On Tuesday, the Brazilian plane maker reported a 25% decline in Q2 profit despite delivering more planes than it had in last year's Q2. Worse, the company admitted that its order backlog was at a six-year low, news that has helped push the shares down since earnings came out. But was this reaction overdone?

Analysts at UBS think so. In a note related on StreetInsider.com yesterday, UBS said that current share prices seem to assume continued earnings declines at Embraer. However, the analyst argues that, to the contrary, even if you assume "much lower regional jet production," Embraer still has every chance of turning in "double-digit EPS growth over the coming years," alongside strong cash generation "driven by higher customer deposits and lower cash R&D spend." Indeed, the consensus on Wall Street is that Embraer investors can expect to see 18% annualized profits growth over the next five years.


Embraer seems to agree. At the same time as it fessed up to the earnings decline, management promised to maintain production levels and improve profit margins as the year progresses.

"Hey, it's an improvement!"
In one respect at least, Embraer is outperforming rivals such as Boeing (NYS: BA) and Lockheed Martin (NYS: LMT) , and also the Hawker Beechcraft business that Goldman Sachs is attempting to sell to China. (As you may recall, Hawker is Embraer's chief rival for a Pentagon contract to build fighter-bombers for the Afghan air force). Whereas Boeing and Lockheed both report earning more GAAP profits than they currently bring in as free cash flow (and whereas Goldman's Hawker subsidiary is free cash flow negative), Embraer is positive for free cash, and cash-profitable where its GAAP earnings show a loss over the last 12 months partly due to a non-operating expense taken in 2011's fourth quarter.

So that's a factor in Embraer's favor. Unfortunately, the numbers suggest it's still not enough to justify UBS' advice to buy the stock. Profitable on a cash basis Embraer may be, but it's generating so little cash that the company's price-to-free cash flow ratio is still a rather pricey 31.2.

Three strikes is all you get
So to sum up: Lacking profits, the stock has no P/E to value it on. Free cash flow, while present, isn't robust enough to justify the stock price. What about price-to-sales, perhaps? Could this metric give us an excuse to follow UBS' advice and buy Embraer?

Unfortunately not, because here, once again, Embraer fails the valuation test. At a price-to-sales ratio of 0.84, Embraer doesn't look expensive in isolation, but relative to the other options available to aerospace investors, it's still pricier than the alternatives. From top to bottom, we find Lockheed trading at 0.6 times sales, Northrop Grumman at 0.64, and Boeing at 0.71 -- in all three cases, cheaper than Embraer.

Long story short, I see little reason to go long Embraer at today's prices. The shares may be down 3% over the past year, but they're still not cheap enough to buy. (But we've found one defense stock that might be. Check out our new report, "Stocks That Could Skyrocket After the 2012 Presidential Election," and we'll tell you all about it.)

The article This Just In: Upgrades and Downgrades originally appeared on Fool.com.

Fool contributorRich Smithdoes not own shares of, nor is he short, any company named above.You can find him on CAPS, publicly pontificating under the handleTMFDitty, where he's currently ranked No. 306 out of more than 180,000 members. The Motley Foolhas adisclosure policy.The Motley Fool owns shares of Lockheed Martin and Northrop Grumman.Motley Fool newsletter serviceshave recommended buying shares of Goldman Sachs and Embraer.We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors.

Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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