Thursday's Top Upgrades (and Downgrades)

This series, brought to you by Yahoo! Finance, looks at which upgrades and downgrades make sense, and which ones investors should act on. Today, with earnings season in full swing, we're seeing mainly analyst reactions to earnings news. Specifically, today we'll be looking at a pair of price target hikes in the defense sector -- General Dynamics  (NYSE: GD  )  and Northrop Grumman  (NYSE: NOC  )  -- then move on to a downgrade in the neighboring air parts business: Spirit AeroSystems  (NYSE: SPR  ) .

"General-ly" good news
First up, investment banker RBC Capital Markets is lifting price targets in the defense sector, raising its estimate for the value of General Dynamics shares to $102, and for Northrop Grumman to $92. Both companies reported earnings this week. Let's take them one at a time.

General Dynamics reported $1.81 per share in profit yesterday, topping analyst estimates of $1.62 by 12%. Revenues also exceeded expectations, yet all these profits still leave General Dynamics with a trailing-12-month profit of... nothing. Actually, less than nothing -- $319 million in net losses. So why does RBC think this one is worth owning?

Perhaps it's because no matter what the "net profits" numbers say, General Dynamics really is making money. Real free cash flow at the company amounted to more than $2.1 billion over the past year, which gives the stock a price to free cash flow ratio of 14.3.

That being said, I still don't think General D is making enough money to justify the buy rating RBC has on it, or the increased price target either. Fourteen times free cash flow isn't an obviously expensive price, but with General Dynamics currently pegged for about 6% annualized profits growth, and paying a dividend yield of less than 3%, it's simply not growing fast enough, or paying out enough money, to justify its current valuation.

So... how about RBC's other price-target hike? How do the numbers at Northrop Grumman look?

Here, we saw another "earnings beat" yesterday, with Northrop reporting $2.05 per share in profits, and exceeding expectations by 19%. Again, revenues came in stronger than expected, and with Northrop shares costing a bit less than 11 times GAAP profits (and the price to free cash flow ratio not much worse), this is a stock that looks quite a bit cheaper than General Dynamics. But is it cheap enough?

That, I fear, is very hard to say. On the one hand, Northrop boasts the lower valuation just mentioned. On the other, it pays a higher dividend than does General D. On the third (?!) hand, however, if General Dynamics has been pegged on Wall Street for an anemic 6% growth rate, analysts think Northrop is in considerably direr straits -- and that its earnings will actually shrink over the next five years, falling at an annualized rate of 1.4%.

Given that, as investors, we prefer to invest in growing businesses rather than shrinkers, I therefore cannot endorse RBC's recommendation of Northrop, either. Much as I'd love to go "contrarian" and recommend a defense play today, the numbers just don't justify it.

And speaking of numbers...
A better idea than buying these companies may be selling them, selectively. Take Standpoint Research's recommendation to take profits on Spirit AeroSystems today, for example.

According to Standpoint, this stock is up 55% since the analyst last recommended it. Spirit's enjoying a particularly sharp spike this morning, on rumors that British engineering firm GKN is contemplating a buyout offer for Spirit at $35 a share. (The shares currently cost a bit less than $26).

Standpoint says that it tends to discount takeover rumors, and warns that if no buyout materializes, and Spirit perhaps reports poor earnings news "as it did in Q42012 and the stock collapses", well, that's a future shareholders would not particularly enjoy sticking around to see. Then again, if you "play it safe" and sell the shares today, you're locking in a clean 7% profit, minimum, if you bought the shares yesterday, and a 55% profit if you bought back when Standpoint told you to.

Result: A $26 bird in the hand being worth a $35 turkey in the bush, Standpoint is pointing investors toward the easy money today, and I agree with that advice.

Spirit's not a horrible business; in fact, analysts see the company growing earnings at 13% over the next five years, which is faster than either of the defense stock plays discussed up above. That being said, Spirit's 87-times-earnings valuation is still more than a little rich for such growth prospects, and with no dividend checks in the offing, there's really very little reason to stick around.

Personally, I'd take the money and run, and let someone else worry about whether the buyout rumors are right or not.

Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool recommends Spirit AeroSystems Holdings. The Motley Fool owns shares of General Dynamics and Northrop Grumman.

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