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 analyst RBC Capital Markets hogged all the headlines as it issued downgrades on defense contractors SAIC (SAI) and L-3 Communications (LLL). On the plus side, the analyst does like one company having nothing to do with defense, though, so let's check out why one analyst is ...
Devising a better future for Analog
Semiconductor maker Analog Devices (ADI) disappointed some investors yesterday, when it reported a fiscal Q1 2013 profit that fell a penny short of estimates (at $0.44 per share). But not everyone's upset. In fact, after taking a good, hard look at Analog's results, RBC Capital announced this morning that far from being discouraged by the results, it's actually raising its price target on the stock to $46.
Why? Well, for one thing, if Analog missed estimates by a penny yesterday, it promised to earn back that penny in the current quarter. According to the company, Q2 profits could be anywhere from $0.49 to $0.55 a share. The midpoint of that range would therefore be $0.52 -- or a penny above consensus.
RBC says it's encouraged by "restocking" and improved capex trends in the company's industrial market, which accounts for 45% of sales. Nevertheless, the analyst is reluctant to make an actual "buy" call on the stock, noting that "it is too early to measure the magnitude and speed of the recovery in the current cycle."
Most analysts agree that over the long term, Analog's probably only going to grow earnings at about 3% per year going forward. That number justifies RBC's caution. Although Analog has a lot going for it -- strong free cash flow that backs up 98% of accounting earnings for one thing, and a $3.2 billion net-cash hoard for another -- 3% growth probably won't be good enough to move the needle on a stock that already costs 22 times trailing earnings. Long story short, I'd still rather be short this stock than long.
SAIC spells "sell"
Meanwhile, if RBC has reservations about Analog Devices, the analyst is downright pessimistic about the chances for defense contractor SAIC. This morning, RBC cut its rating on the stock from "sector perform" to "underperform," and cut its price target to $11 a share.
Here, too, the analyst is right, and this time, we'll give RBC kudos for taking the plunge, and actually advising investors to dump an overpriced stock. At an Analog-like P/E ratio of 22 times earnings, SAIC looks overpriced for the 10% annualized growth it's expected to produce over the next five years. SAIC's beefy 3.9% dividend yield provides some downside cushion on the stock, and the company's strong free cash flow -- fully 25% better than the $178 million in trailing GAAP earnings it reports -- means that stock's actually a bit cheaper than it looks.
Still, it's nowhere near cheap enough to be worth buying. It's not as bad a bargain as Analog, granted, but it's still a sell.
How low can L-3 go?
RBC's second defense downgrade of the day, L-3 Communications, is a bit trickier. On one hand, at a P/E ratio of 9.3, the stock doesn't look all that expensive. On the other hand, the fact that most analysts think L-3 will show no earnings growth at all over the next five years -- and will actually post earnings declines -- certainly doesn't argue in L-3's favor. Plus, when you factor the company's $3.3 billion net-debt load into the equation, the company's actually trading for an enterprise value closer to 13.4 times earnings.
Even with a 2.8% dividend yield, that seems a steep price to pay for zero growth.
All that being said, I'm more optimistic about L-3's chances than I am about SAIC. Why? Because if SAIC generates strong free cash flow, L-3 is simply a cash-producing powerhouse. Over the past year, L-3's generated nearly $1.1 billion in real cash profits -- 35% better than reported earnings.
Now, I won't say the stock's a "buy." For that, I'd need to see some actual growth prospects in L-3's future. But still, valued on its free cash flow, and even factoring debt into the picture, L-3 sells for a multiple of less than 10. That's probably cheap enough to justify holding the stock, collecting the dividend checks, and waiting for better days in the defense industry.