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." So you might think we'd be the last people to give virtual ink to such "news." And we would be -- if that were all we were doing.
But in "This Just In," we don't simply tell you what the analysts said. We'll also show you whether they know what they're talking about. To help, we've enlisted Motley Fool CAPS, our tool for rating stocks and analysts alike. With CAPS, we'll be tracking the long-term performance of Wall Street's best and brightest -- and its worst and sorriest, too.
And speaking of the best...
"Best" may not be quite the word to describe our featured analyst today. After all, Cowen & Co. only calls about 45% of its stock picks correct. Still, that's been good enough to outperform 75% of the investors tracked by CAPS -- so perhaps we should pay at least some attention to what Cowen had to say yesterday.
Which was...?
Oh, right: Cowen downgraded Northrop Grumman (NYSE: NOC ) from "outperform" to "neutral". As for why, that's a bit complicated -- but basically we can sum up the bear thesis here in one word: "Pensions."
Cowen cited three factors in making its downgrade: "FAS/CAS exposure, deferral of the tanker bid, & residual execution risk." Now, the tanker bid -- you know all about that one already. Execution risk? Pretty self-explanatory. Any company can screw up -- if you know anyone invested in Lehman Brothers or Merrill Lynch (NYSE: MER ) , I'm sure they can tell you all about execution risk.
No, the key here is the pensions. You see, in the process of downgrading Northrop, Cowen based its valuation on an arcane financial metric that goes by the acronym: "EBITDAP", short for Earnings Before Interest, Taxes, Depreciation, Amortization, and -- you guessed it -- Pension Income. According to Cowen, Northrop actually looks pretty good under this light, sporting a "modest 6.8x '09 TEV/EBITDAP (vs. peer avg. of 7.6x)." Regardless, Cowen argues that "there's better potential" in General Dynamics (NYSE: GD ) and L-3 Communications (NYSE: LLL ) . Cowen rates both as outperform, saying they "offer 1) likely strong Q3, 2) modest '09 FAS/CAS risk, & 3) above-consensus '09 EPS with upside."
Hold up a sec. "FAS/CAS?"
Yep. There's another clue for you. Not content with using just one cryptic acronym in its analysis, Cowen tossed us another puzzler to ponder: FAS/CAS, which as near as I can figure refers to "Financial Accounting Standards/Cost Accounting Standards." Actually, the FAS part refers to a specific Statement of Financial Accounting Standards, No. 87 to be precise, the "Employers' Accounting for Pensions."
The issue here seems to break down as follows: Defense contractors like Northrop have to account for pension costs in calculating their profits and losses under GAAP. The problem is, not all pension costs can be recovered when calculating payment owed by the government under the Cost Accounting Standards. So in essence, what we're looking at here is the potential for margins getting squeezed by the difference between FAS and CAS. Savvy?
OK, now my head hurts
Mine too. So let's make this real simple. Pension calculation intricacies are all pretty theoretical until either: (a) disputes over contractual obligations cause a fracas with the union (a la Boeing (NYSE: BA ) , Ford (NYSE: F ) , GM (NYSE: GM ) , or, um, Bethlehem Steel), or (b) the pensions actually have to get paid out. Ask somebody who used to work for Beth Steel how certain that last one is.
Meanwhile, investing in the here and now, individual investors may want to leave the EBITDAP arcana to the accountants who (think that they) understand them, and focus instead on something a bit more solid, like the price-to-free cash flow ratio.
Foolish takeaway
From that perspective, I think you'll find that Northrop looks fairly priced today. The stock currently sells for 12 times the free cash flow it generated last year, which seems entirely reasonable in light of the 12% annual growth rate that most analysts project for the company. For comparison, that's roughly the same valuation you'll find attached to General D's stock (which Cowen likes) and L-3 (which Cowen also likes).
But if all three stocks sell for roughly the same valuation, why is Cowen panning Northrop while praising the other two? Apparently it's the pension thing. Is that enough? Dunno, folks. What I do know is that Cowen's more often wrong than right on these things -- draw your own conclusions.
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