Monday's Top Upgrades (and Downgrades)


This series, brought to you by Yahoo! Finance, looks at which upgrades and downgrades make sense, and which ones investors should act on. Today, we're looking at one analyst in particular -- RBC Capital Markets -- and a series of upgrades and downgrades it's just issued in the aerospace sector. Without further ado, let's dive right in, beginning with the...

Good news first
RBC starts out the week on a bright note, with an upgrade for military manufacturer Textron . With the fiscal cliff avoided, and defense sequestration postponed at least till March, RBC is taking the opportunity to slap an "outperform" rating on Textron, and upping its price target to $30. The shares aren't exactly reacting as you might expect, falling 0.2% on the upgrade. Why?

In a world where many defense contractors are trading at bargain basement levels, shares of Textron don't look like much of a bargain. Sure, the company boasts a big number for estimated growth, with analysts projecting near 30% annualized profit increases over the next five years. Problem is, Textron also carries a big P/E ratio -- more than 18. It's got a big debt number, too -- $2.8 billion, net of cash on hand. Meanwhile, the company's dividend yield is surprisingly weak at just 0.3%, and its free cash flow rate lags badly behind reported net income, with Textron generating only about $0.79 in real cash profit for every $1 it reports in "earnings."

In short, there's really not a lot to recommend the stock based on today's numbers. Why RBC is recommending it, therefore, remains a mystery.

Could Northrop fly?
RBC's other upgrade of the day may hold more promise -- even if it doesn't look all that promising. On the one hand, most analysts have Northrop Grumman pegged for slow or no growth over the next half-decade. On the other hand, though, the company's share price appears to incorporate these pessimistic projections.

At less than nine times earnings, acquiring a share of Northrop will only set you back about half as much as will Textron. And Northrop brings with it both a stronger balance sheet (only $410 million net debt) and a better dividend yield (3.2%).

Free cash flow at the firm is also surprisingly strong, with Northrop generating more than $2.5 billion in positive cash profits over the past year, versus the less than $2 billion reflected on its income statement. In other words, the company's generating so much cash that even if it grows not at all, just maintaining the current rate of cash generation would load up the company with enough money to buy back every share it has on hand in less than seven years.

For now, this prospect is only enough to win a grudging "sector perform" rating from RBC, equivalent to a hold recommendation. But it won't take much good news to transform a stock this cheap from a hold into an outright buy.

And finally, we come to the stock RBC is least optimistic about: SpiritAeroSystems , a major parts supplier for airplane builders around the world, and a key supplier to Boeing's vaunted 787 program in particular.

Historically, RBC has been a fan of the stock, but this morning, it downgraded Spirit to "sector perform." Truthfully, though, the stock may not merit even that much. Priced north of 70 times earnings, Spirit was just starting to get some wind beneath its wings as Boeing's 787 and 737 production ramped up, when news of a possible labor strike at the plane maker struck. Now, even the 12% long-term earnings growth rate that analysts had been projecting for Spirit looks to be at risk.

Viewed in the most positive light, Spirit today is a company generating $108 million a year in positive free cash flow. Ignoring the firm's depressed GAAP earnings and its hefty debt load (about $1 billion net of cash on hand) alike, that still works out to a price to free cash flow ratio of nearly 23 -- far too high for a 12% grower. If Boeing's labor strike comes to pass, as it appears destined to, and Spirit's growth rate nosedives, it could be a long way down for this stock.

No wonder RBC is reaching for the parachutes already.

Rich Smith has no position in any stocks mentioned. The Motley Fool recommends Spirit AeroSystems Holdings. The Motley Fool owns shares of Northrop Grumman Corp and Textron.

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