This series, brought to you by Yahoo! Finance, looks at which upgrades and downgrades make sense, and which ones investors should act on. Today, Wall Street continues to be down on defense stocks, as each of Northrop Grumman (NOC) and Raytheon (RTN) catch downgrades. On the other hand, good news out of the courtroom has analysts feeling happier about Bank of America (BAC). Let's begin with that one.
Bad news is good news
Yesterday, Bank of America announced a series of charges to earnings that will be taken as it tries to put liability for its role in the national mortgage crisis to bed once and for all. The bank's paying Fannie Mae $3.9 billion to settle various disputes with the government sponsored enterprise, buying back $6.75 billion worth of bad residential mortgage loans, selling the rights to service 2 million residential mortgage loans held by the three big GSEs (Fannie, Freddie Mac, and Ginnie Mae), and taking a $3.2 billion hit for everything from the cost of litigating mortgage matters to something called "negative debit valuation adjustments and fair value option adjustments related to the continued improvement in the company's credit spreads."
In all, it works out to about a $10.4 billion hit B of A's taking. So naturally, Wall Street is thrilled. This morning, both FBR Capital and RBC Capital Markets announced they were upping their target prices on B of A, to $11.50 and $14 a share, respectively...
Why all the happy talk over a B of A admitting to a multibillion dollar loss? Because really, everyone knew the losses were out there. They're just happy that B of A has finally fessed up to them, bitten the bullet, taken the hit, and is now -- with any luck -- ready to get on with its life.
The reaction's understandable, but investors shouldn't jump in necessarily, based solely on Wall Street's knee-jerk optimism. Remember that B of A is still a stock that costs 32 times earnings, and only expected to grow these earnings at about 9% per year over the next five years. That's anything but a bargain price.
And good news that is bad news
Meanwhile, over on the flip side, Congress delayed the "sequester" of defense spending last week, postponing the day of reckoning for defense contractors into March. Rather than rejoice at this good news, however, Wall Street is taking it as an excuse to head for the exits, hopefully pocketing some gains on the way out.
This morning, analysts at JPMorgan announced they were downgrading each of Raytheon, Northrop Grumman, and Harris Corp (HRS) "following a year in which the group as a whole performed surprisingly well."
Northrop and Harris are taking the biggest hits here, as JP cuts each from "neutral" to "underweight." That's not terribly surprising, given that most analysts think Northrop will show slightly negative earnings growth over the next five years, while Harris will do little better, growing only about 3% per year. Valuation-wise, both stocks sell for reasonable multiples to 2013 earnings -- 9.7 times and 9.4 times, respectively. But Wall Street's always been more a fan of growth than of value, and so long as prospects for earnings growth appear limited, so too will the analysts' interest.
That probably explains why Raytheon, while likewise downgraded by JP, escaped an out-and-out sell rating. Although slightly more expensive than its rivals at 10.1 times trailing, and 10.7 times forward earnings, Raytheon has the redeeming quality of being pegged for at least modest forward earnings growth of 7.8% annually.
Factor in a strong 3.4% dividend yield, modest net debt, and free cash flow that backs up 98.9% of reported net income, and the stock looks almost cheap enough to own -- JP's downgrade notwithstanding.
Rich Smith has no position in any stocks mentioned. The Motley Fool owns shares of Bank of America Corp, Northrop Grumman Corp, and Raytheon Company.