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." Today, we'll show you whether those bigwigs actually know what they're talking about. To help, we've enlisted Motley Fool CAPS to track the long-term performance of Wall Street's best and worst.

Wedbush gets "Hexed"
In honor of National Poetry Month, we're going to start with a few lines from Mr. Screamin' Jay Hawkins:

"I put a spell on you
'cause you're mine
You better stop the things you do
I ain't lyin'."

Of course, if you ask the analysts at Wedbush Morgan, the last thing they want aerospace materials maker Hexcel (NYSE: HXL  ) to do is stop anything. In truth, the reason Wedbush upgraded Hexcel to outperform yesterday is because it hopes -- and expects -- Hexcel will keep doing exactly what it said it did last quarter. Growing revenues 21% year over year. Growing profits 50%. Issuing profits and revenue forecasts far above what Wall Street was expecting to see... and then beating those expectations with a stick.

If Hexcel can accomplish all this, Wedbush sees the stock rising to its new target price of $32 a share within a year. But can Hexcel keep it up?

That's the question
Key to Hexcel's magical performance in Q1 was a bumper crop of aircraft sales at Boeing (NYSE: BA  ) and Airbus, both major customers of Hexcel's portfolio of honeycomb, adhesives, and other advanced aerospace composite materials. As Wedbush pointed out in its upgrade, Hexcel's defense and space industry sales were lackluster at just 6.5% revenue growth last quarter. What saved the quarter were commercial aerospace sales, up 24%, as the major plane makers not only expanded production of new aircraft like the A380, A350, 747-8 and 787, but also increased production of "legacy commercial aircraft" (Boeing's uber-successful 737 program) at a 20% annualized pace.

Taking its cue from Hexcel's new and improved guidance, Wedbush argues that $1.55 in 2012 per-share earnings, followed by a bump to $1.65 in 2013, should be enough to justify the shares' $32 target price. But me, I'm not so sure.

Valuation matters
Consider: Right now, Hexcel shares fetch a premium 19 times valuation on trailing earnings. Up those earnings to $1.55 a share, and yes, a sustained 19 times multiple would seem to justify $32 a share on the stock. But really, that valuation's only realistic if Hexcel can grow fast enough to sustain it -- say, 20% a year.

The problem here is that most analysts think Hexcel can only maintain about 12% annual earnings growth over the long term. Even this year's optimistic forecast suggests only about a 15% growth pace in 2011-2012, followed by a reversion to 6% growth in 2012-2013. That hardly seems fast enough to explain why investors would keep paying 20 times earnings for this stock.

A better idea
But here's the good news: There are other ways to play the surge in commercial aircraft construction that's giving Hexcel wings this week -- ways other than investing in overpriced Hexcel. Honeywell (NYSE: HON  ) , for example, services the same companies that patronize Hexcel. It costs a little more than Hexcel (22 times earnings), true, but it's growing faster (14% annualized) and it pays a nice 2.5% dividend, which Hexcel does not. United Technologies (NYSE: UTX  ) , another major player in aerospace, is growing close to Hexcel's pace, but costs quite a bit less at 14.5 times earnings. And it pays a dividend, too.

Most obviously, airplane engine-builder General Electric (NYSE: GE  ) offers a third possibility. GE produced strong earnings last quarter. It's growing at about 12% a year, like Hexcel. But at 16 times earnings it's 20% cheaper. And GE pays a generous 3.5% dividend, too. Hexcel doesn't. (Or did I mention that already?)

Long story short, Wedbush Morgan did us all a favor by highlighting Hexcel's superb results. But at its current premium price, Hexcel stock looks most useful as an example that spurs us to seek better bargains elsewhere.

Where are the smartest investors finding their own bargains? Find out in the Fool's new (and appropriately titled) report: "The Stocks Only the Smartest Investors Are Buying." It's free for download today, but won't be for long -- so make sure to click quick.

Fool contributor Rich Smith does not own (or short) shares of any company named above. You can find him on CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 350 out of more than 180,000 members. The Motley Fool has a disclosure policy.

We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.


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