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Monday's Top Upgrades (and Downgrades)

By Rich Smith - Apr 22, 2013 at 3:29PM

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Analysts shift stance on Cliffs Natural Resources, Hexcel, and EADS.

This series, brought to you by Yahoo! Finance, looks at which upgrades and downgrades make sense, and which ones investors should act on. Today, our headlines include a pair of aerospace upgrades for European Aeronautic Defence and Space Company (EADSY 3.58%) and Hexcel (HXL 0.99%). But it's not all good news, so let's start off by finding out why.

This analyst doesn't dig Cliffs Natural Resources
Investors in coal and iron miner Cliffs Natural Resources (CLF 2.54%) are off to a rocky start this week, as analysts at FBR Capital cut their price target on the stock 15% to $28 a share.

Now admittedly, FBR isn't recommending you sell Cliffs. To the contrary, the banker reiterated its overall feeling that the stock's more of a market performer than an actual sell. The big question, though, is why FBR didn't come out and give Cliffs a big ol' buy rating -- seeing as it thinks the stock is worth $28, and Cliffs only costs $17 and change today.

After all, Cliffs does appear pretty attractive on the surface. The stock pays a nice, fat 3.4% dividend. It's not growing fast, but it is growing, with most analysts suggesting Cliffs can increase profits by about 6% per year over the next five years. So really, why not just dive right into Cliffs and buy?

The way I see it, there are at least three reasons to hesitate before taking the plunge -- and three reasons that FBR is still too optimistic even with its reduced target price. First and foremost is the fact that, at 6% projected growth, Cliffs shares appear to have too high a PEG ratio for their 7.8 forward P/E (not to mention their negative trailing P/E).

Second, the company's total lack of free cash flow to back up its reported GAAP earnings suggests that next year's hoped-for earnings, even if they arrive, may not be worth much.

Third and finally, until Cliffs returns to generating cash profits instead of burning cash (the company burned more than $600 million last year), it will have a hard time paying down its $2.1 billion debt load -- which itself is a factor arguing that the stock is more expensive than it appears. Long story short, there are a lot of negatives to consider here, and any one of them could trip up Cliffs before it reaches FBR's new price target.

Next up: Hexcel
Flipping over from bad news to good news, analysts at RBC Capital Markets upped their rating on airplane parts supplier Hexcel this morning, rating the stock outperform and raising their price target to $33 a share. Hexcel costs $28 and change currently, so we're looking at about a 16% gain if RBC is right. But is it right?

I have to admit: I have my doubts.

Priced at nearly 18 times earnings, and paying no dividend, Hexcel shares look overpriced to me based on analyst estimates of 12% long-term earnings growth. The company's burdened by a bit of debt, too, weighing down its valuation, and its trailing free cash flow number is... negative. Rather than generating cash at the same rate at which it reports earnings ($164 million last year, supposedly), Hexcel actually burned through more than $31 million in negative free cash flow last year.

Long story short, RBC may think this one's a buy, but I'm leaning more toward sell.

Does EADS spell B-U-Y?
A second stock winning high marks from RBC today is European aerospace "champion" and Boeing (BA 2.28%) archrival European Aeronautic Defence and Space Company. Like Hexcel, RBC is slapping a buy rating (actually, outperform) on EADS today. But to be honest, I'm even more leery of this one than I am of RBC's other recommendation.

Valued at $42.4 billion, EADS is at nearly two-thirds Boeing's market cap. But with only $1.6 billion in annual net income, the company pulls down less than half the $3.9 billion in annual profit of its American rival. Worse, EADS generated only about $752 million in real cash profit last year -- less than half its own net income. In contrast, Boeing's $5.8 billion in trailing free cash flow vastly exceeds the $3.9 billion that GAAP accounting standards permitted the company to report as net income.

Simply put, Boeing's a cash monster, and EADS is not. At a valuation of 26.5 times earnings, and an even more altitudinous price to free cash flow, EADS shares are priced to crash and burn. For this stock, at least, investors' fear of flying seems well-founded.

Motley Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned.

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Stocks Mentioned

The Boeing Company Stock Quote
The Boeing Company
BA
$139.84 (2.28%) $3.12
Cliffs Natural Resources Inc. Stock Quote
Cliffs Natural Resources Inc.
CLF
$15.76 (2.54%) $0.39
Hexcel Stock Quote
Hexcel
HXL
$52.83 (0.99%) $0.52
Airbus Stock Quote
Airbus
EADSY
$25.16 (3.58%) $0.87

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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