Thursday'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, our headlines feature a pair of hikes to price target at aerospace parts suppliers B/E Aerospace and Precision Castparts . But the news isn't all good, so before we address those two, let's start with why one analyst thinks...
Cliffs could dive
In direct contradiction to the bullish note struck by analysts at BB&T Capital earlier this week (where analysts upgraded Cliffs Natural Resources stock on news of its CEO's departure) a different banker announced this morning that it's not nearly so hot on the company's chances. Disagreeing with BB&T's analysis (but agreeing with my own), analysts at CIBC cut their rating on Cliffs from sector perform to underperform.
Why might this be the right all, and BB&T's endorsement of the stock the right one?
For the same reasons I outlined earlier in the week: Cliffs Natural Resources is not a profitable company. It might turn profitable next year (or it might not). But even if it does, the 4% consensus earnings growth projections of the analysts simply aren't strong enough to support the 10 times forward earnings valuation the share now carry. Not with Cliffs burning through cash at the rate of $500 million a year. Not while it's laden with $3.4 billion in net debt.
Based on these facts, CIBC is right to turn to be pessimistic.
Now for the good news
Turning now from iron to aluminum, titanium and carbon composites... in contrast to CIBC's bearish note on Cliffs, one analyst is taking a decidedly bullish note on the aerospace sector, and on the companies that supply parts to it in particular. In a note released to investors this morning, investment banker Sterne Agee argued that "pure-play aerospace companies should continue to benefit from production rate increases" in the current quarter.
Reviewing seven companies operating in the sector, Sterne highlighted five that it likes -- and two that it likes a lot. Those two, from which the analyst says it expects to see "the most upside to our estimates," are metal aircraft components manufacturer Precision Castparts, and aircraft interiors specialist B/E Aerospace. For each of these firms, Sterne sees "still plenty of runway left in cycle." Let's take them one at a time.
Sterne notes that Precision Castparts now has "a full quarter" revenues from its Timet acquisition now under its belt, and on its books. "Momentum is just commencing on the $30-$40 million of synergies expected over the next 12+ months," says the analyst, as this has Sterne predicting the shares will hit $281 within 12 months.
Is such an 18.5% profit on the stock likely? I don't think so, and I'll tell you why.
With Timet firmly in hand, most analysts agree that Precision Castparts will grow strongly over the next few years, averaging 14% increases in earnings annually. But while certainly a respectable pace of growth, I don't think that's strong enough to justify paying more than 24 times earnings for the stock.
Free cash flow at the firm -- rarely anywhere near as good as the "GAAP" earnings it reports, today lags reported income by 20%. As a result, if you're skeptical (like I am) of this stock's 24.4 P/E ratio, you're going to positively hate its price to free cash flow ratio of 31.5.
I'm a bit more optimistic about Sterne's other aerospace parts play of the day -- but only a bit. Here, we're looking at a stock that costs nearly 28 times earnings. On the other hand, with a 24% projected growth rate, that higher P/E ratio at least has more justification to it. Free cash flow at B/E, as at Precision Castparts, is unimpressive -- just $227 million over the past 12 months, versus reported net income of $255 million. As a result, the stock sells for almost precisely the same price to free cash flow ratio as we find at Precision Castparts: 31.7.
The plus side here, of course, is the faster projected growth rate at B/E.
Sterne Agee sees "modest aftermarket growth coupled with integration gains tied to previous acquisitions" boosting the company's results, and thinks B/E is "well positioned to trade higher from current levels" -- perhaps as high as $80.
Me, I disagree. I think a run to $80 is unlikely (or if likely, unjustified). But on the plus side, at least this stock isn't quite as obviously overvalued as Sterne's other pick.
The article Thursday's Top Upgrades (and Downgrades) originally appeared on Fool.com.
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