This Just In: Upgrades and Downgrades

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 track the long-term performance of Wall Street's best and brightest -- and its worst and sorriest, too.

And speaking of the best ...
Investors generally were a happy lot yesterday, as tickers turned "green" across the boards. But happier than most were the shareholders of Northrop Grumman (NYSE: NOC  ) . Their stock booked a good 3% gain because of: (1) confirmation that the long-awaited sale of its TASC unit has been inked, and (2) an upgrade from Jefferies & Co., inspired by said sale.

Let's go to the tape
Why get excited over an upgrade from Jefferies, you ask? You say the analyst doesn't make the cut as a CAPS All-Star, and has historically gotten more of its ratings wrong than right?

True, all true. But while Jefferies is a mediocre stock picker in general, there is one segment of the market where this banker knows its stuff: Aerospace & Defense. It's here we've seen Jefferies pick such winners as:

Stock

Jefferies Says:

CAPS Says:

Jefferies' Picks
Beating the S&P by:

General Dynamics (Nasdaq: GD  )

Outperform

****

25 points

BE Aerospace

Outperform

****

21 points

United Technologies (NYSE: UTX  )

Outperform

****

9 points

Has Jefferies made its share of gaffes in this sector? Sure it has. It's blundered on Boeing (NYSE: BA  ) , been shocked by TASER (Nasdaq: TASR  ) , and had its profits Spirit-ed away on several occasions:

Stock

Jefferies Says:

CAPS Says:

Jefferies' Picks
Lagging the S&P by:

Boeing

Outperform

***

5 points

Spirit AeroSystems

Outperform

*****

24 points

Taser

Outperform

****

43 points

But generally speaking, and over the course of three years' history picking defense stocks, Jefferies has proven itself capable of beating the market fully 53% of the time in this sector -- no mean feat.

No grumbling at Northrop    
And I Fool-y expect the same thing to happen with this week's Northrop endorsement. It all comes down to valuation, you see.

When Jefferies looks at the TASC deal, it notes that Northrop really had no choice in the matter. Federal regulations are changing to limit defense contractors' ability to both advise the government on which weapons systems to buy, and then sell those same systems to the government. As a result, according to Jefferies: "Changes in procurement law almost required this sale." Yet despite playing the role of motivated seller in this deal, Northrop managed to secure for itself a very "reasonable" price for its TASC consulting unit -- $1.65 billion for a business that will book $1.6 billion in revenue this year.

Jefferies likes the fact that Northrop knows how to find value for shareholders. It will plow the entire after-tax proceeds of the deal into stock buybacks, with the result that despite losing the ability to profit from TASC's revenues, Northrop's profits per share should remain stable going forward. Me, I like that aspect of the deal, too -- but there's another factor that really gets me excited about this transaction.

Don't give up yet
For months, Foolish readers of my "6 Stocks that Never Surrender" column have watched with me as I detailed the steady decline of the American defense sector. Bleeding from a "thousand cuts" inflicted by the Pentagon procurement office, and generally expected to underperform under a dovish Democratic administration, defense stocks have lagged the rest of the market badly this year.

Foolish takeaway
This week's TASC deal reaffirms that there's still value to be found inside these companies. Northrop's ability to sell TASC for more than one times annual sales in what essentially amounted to a forced spinoff tells us that when the market values the rest of Northrop at less than 0.5 times sales -- that's far too low a price. It also suggests that, with Textron (NYSE: TXT  ) selling for only 0.47 times sales, Boeing at 0.59, and yes, even Lockheed Martin (NYSE: LMT  ) at 0.65, these stocks are cheap

Does it mean we're now poised to see each of these stocks rise on the order of 100%, to achieve a 1 times sales valuation? I don't think that they will, but I do believe that in any reasonable market, they should move closer to that figure.

Want to find more undervalued defense prospects for your portfolio? Check out Motley Fool Rule Breakers, where we're looking into options in everything from UAVs to missile defense, from bombproof trucks to bulletproof soldiers. Thirty-day free trials are available on-demand.

Fool contributor Rich Smith owns shares of Boeing. You can find him on CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 647 out of more than 140,000 members. General Dynamics is a Motley Fool Inside Value selection. Spirit AeroSystems Holdings is a Motley Fool Hidden Gems recommendation. The Motley Fool has a disclosure policy.


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