Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...
It's been nearly two weeks since Orbital ATK (NYSE: OA) reported its fiscal Q2 2017 earnings, surprising analysts with a better-than-expected pro forma number. Today, at long last, Orbital ATK received its reward, when analysts from Argus Research announced they were upgrading the stock to buy.
Here are three things you need to know about that.
1. What Orbital ATK said
Orbital ATK reported Q2 2017 earnings on Aug. 3. Sales for the quarter were $1.12 billion, slightly ahead of analyst estimates of $1.11 billion, and up 3% in comparison to Q2 2016. Profits, however, were more of a mixed bag.
On the plus side, and from a pro forma perspective, Orbital reported adjusted earnings of $1.56 per share, which was $0.13 more than Wall Street had expected. On the minus side, actual GAAP profits were down 3% at $1.51 per share, despite the revenue rise.
Operating margins are to blame for the decline. Despite management's saying that it achieved "strong profit margin performance," Orbital's operating profit margin in Q2 actually fell 140 basis points year over year, to 12.2%. Orbital struggled to make up the difference farther down the income statement -- and succeeded in part, cutting its net profit decline to only 4% with the help of a lower tax rate, and using share buybacks to pare the per-share decline in profits to just 3%. But even so, profits declined.
In other bad news, free cash flow evaporated during the quarter. Whereas one year ago, Orbital ATK generated positive cash profits of $107.2 million, in Q2 2017 the company burned through $55.8 million in negative free cash flow.
2. What Orbital ATK said about the future
All that being said, Orbital ATK management remains optimistic about the balance of this year. CFO Garrett Pierce argued that Orbital "is performing well both financially and operationally and is meeting or exceeding our annual plan." Furthermore, Pierce promised that Orbital will "accelerate" revenue and earnings growth in H2 2017, and "trigger significant free cash flow."
Helping fuel this optimism was a wave of new bookings that is swelling backlog at Orbital ATK. During the quarter, Orbital landed $1.4 billion in "new firm and option orders," and a further $220 million worth of "option exercises under existing contracts." Compared to the company's $1.12 billion in sales, this works out to a book-to-bill ratio of about 1.45 for Orbital -- very strong, and indicative of revenue growth on the horizon. Orbital says its firm backlog of work now waiting to be done has climbed 10% over the past year -- about three times faster than revenue had been growing.
With all this new work in hand, Orbital raised its guidance for full-year sales and earnings (but curiously, not free cash flow). Orbital now expects to see sales range between $4.6 billion and $4.65 billion this year (up about $25 million from previous expectations). Profits will be a minimum of $5.95 per share ($0.15 more than previously expected), and could go as high as $6.25 per share ($0.05 higher than the previous ceiling). Free cash flow will still range between $250 million and $300 million.
3. What Argus said about Orbital ATK
Responding to Orbital's guidance revision, Argus Research announced that it is upping its rating on the stock from hold to buy and assigning a new price target of $120. This implies that Argus is looking for Orbital stock to grow about 12.5% from its present price.
As explained in a note on TheFly.com this morning, even though Orbital left its free cash flow projection unchanged, Argus believes that the stock can grow its cash flow by hitting "milestones" in the second half of the year. The analyst is also looking for Orbital to benefit from increased defense spending in the second half of the year, and into 2018.
Argus finds the stock's valuation compelling enough to justify the new buy rating. But should you agree?
The most important thing: Valuing Orbital ATK stock
I have to admit that I've been a fan of Orbital ATK for some time myself -- but I'm a fan of the company, and not necessarily of the stock. Over the past 12 months, you see, Orbital ATK stock has rocketed 44% in price, but that success now leaves the valuation looking somewhat stretched.
Currently valued at $6.1 billion in market capitalization, Orbital ATK stock costs 22 times trailing earnings, and 17 times the tippety-top of management's projections for 2017 earnings. Valued on its $189 million in trailing free cash flow, Orbital stock is even more richly priced.
Weighed against the company's $7.6 billion in enterprise value, with net debt included, the stock sells for an enterprise value-to-free-cash-flow ratio of more than 40. Even assuming management succeeds in maxing out its free cash flow target of $300 million this year, the EV/FCF drops only down to 25. With analysts on S&P Global Market Intelligence broadly in agreement that Orbital ATK will grow its profits no faster than 10% annually over the next five years, these valuations all look too expensive to me.
Result: I know a lot of Fools will disagree with me on this one, and given the stock's remarkable performance over the past 12 months, they've been right to do so -- but at today's prices, and with today's expectations, I find Orbital ATK stock simply too expensive to justify a buy rating.