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 ...
Shares of Motley Fool Rule Breakers recommendation AeroVironment (NYSE:AVAV) caught an updraft yesterday, lifted by an upgrade to "buy" from Wall Street analyst Broadpoint.AmTech.

Taking a good hard look at the likely trend in unmanned aerial vehicle (UAV) deliveries over the next few months, Broadpoint concludes: "We anticipate 2Q10 to be weak as managers have put off UAS [unmanned aerial systems] purchases in anticipation of the Digital Data Link (DDL) upgrade. However, the DDL production upgrade cycle actually began in late 2Q10 (October) with the significant ramp expected throughout 2H10."

More simply put, Broadpoint expects bad news when AeroVironment reports earnings next month. But if its future earnings you're looking for, AV should produce 'em in droves. Given "the critical need of the Raven UAS" in the Afghan theater, "coupled with DoD funding" that seems to favor unmanned systems such as AV's Raven, "the outlook looks favorable for 2H10 and FY11 results."

Not so with the valuation, unfortunately. After reporting a surprise loss last quarter, AV's lackluster trailing profits now have this stock priced at 42 times earnings -- quite a pretty penny. It behooves investors to ask: Just how confident can we be that Broadpoint's calling this one right?

Let's go to the tape
Pretty confident, actually. Historically, Broadpoint has been best known for its expertise in tech stocks. Its 2006-era recommendation of Research In Motion (NASDAQ:RIMM) produced a clean double, while its circa-2007 endorsements of Oracle (NASDAQ:ORCL) and salesforce.com (NYSE:CRM) are up 34% and 61%, respectively.

But this analyst is no slouch in the cockpit, either. Within the Aerospace and Defense sector, Broadpoint regularly achieves 53% accuracy on its picks, and has beat the market by 100 percentage points over the last three years, helped by such winners as:

Crucially, regular readers of my Hey, Who's Flying This Thing? column will recognize all three of the companies named above as being leaders of the nascent UAV industry.

But what about the price?
Admittedly, price is an object in this discussion. But remember that AeroVironment's P/E ratio right now is based on the $0.73 per share it earned over the past year. In contrast, as this progresses, Broadpoint sees AV selling or upgrading some 1,000 Raven systems, and earning anywhere from $1.04 to $1.25 per share in profits.

At the top end of that forecast, the stock could be selling for as little as 25 times this year's earnings. For a projected 23% five-year grower like AV, that doesn't seem an unreasonable valuation -- and it's entirely possible that AeroVironment is even cheaper than that. Consider three "force multipliers" at work: 

• Measuring "price" and "earnings" doesn't tell you the whole story about AV. The company also has more than $6.50 per share in cash. Subtract that from the stock price, and AV's current P/E ratio could drop as low as 19.
• Just a few weeks ago, AeroVironment secured favorable certification for the Dutch military to operate its Ravens within the borders of the Netherlands -- clearing the way for additional international sales to that country. The more such certificates AV secures, the greater the opportunities outside our own borders.
• Last point: You may recall that last month, Broadpoint rival Boenning & Scattergood came out with an upgrade of its own for AV, predicting an imminent Pentagon contract to purchase the company's new Switchblade UAV.

In contrast to a small UAV like the Raven, which shows you "where to put the bullet," or a UAV like the Predator, which is armed with its own bullets, the Switchblade actually is the bullet. It not only carries a camera to let you scope targets out, but also packs a small explosive charge that allows an operator to -- what's the appropriate military parlance? -- "neutralize" targets of opportunity. An invaluable tool to the military, this UAV's one-off nature means that every Switchblade fired in combat equals an additional recurring sale for AeroVironment (and on, ad infinitum).

Foolish takeaway
Now, Boenning & Scattergood may have been wrong about the timing last month, but I suspect that's all they were wrong about. Somewhere, wandering the maze of Pentagon corridors, a Switchblade contract probably is in the works. When it arrives, expect another pleasant surprise.

Whether or not Switchblade was part of the reason Broadpoint upgraded AeroVironment yesterday, I actually think this contract could be the best news yet for AV investors. All we have to do now ... is wait for it to be announced.