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 feature downgrades for aerospace and defense firms B/E Aerospace (NASDAQ:BEAV) and Huntington Ingalls (NYSE:HII). But the news isn't all bad. Before we get to those two, let's take a quick look at why one analyst in particular is...
"Targeting" a better price for Cherokee
After a brief, earnings-fueled surge in stock price following the release of Q4 results last month, shares of clothing brands licensor Cherokee (NASDAQ:CHKE) have entered a slump of late. The reasons aren't too hard to guess. On May 5, we learned that Gregg Steinhafel, CEO of Target (NYSE:TGT), was stepping down as head of that corporation after Target's move into Canada stumbled operationally, and its stores in the U.S. were hit with a massive data breach. Investors are leery of Target these days -- and according to Cherokee's own 10-K filings, Target remains its single largest customer, accounting for more than half of Cherokee's revenues in each of the past three years.
But focusing on the positives of last month's earnings report -- sales up 8% for the year, profits down but still strong at $0.72 per share -- analysts at B. Riley decided today to ignore the negative Target news for now and double down with a buy rating on the stock. Are they right to do so?
Maybe yes, but maybe no. Priced at nearly 19 times earnings, Cherokee shares look expensive at first glance. Analysts polled by S&P Capital IQ give the company a 14% annualized growth rate going forward, and 19 times earnings may be too much to pay for such a modest pace of growth. On the other hand, Cherokee does generate significant free cash flow -- about $8 million a year. That's about a third better than it reports for GAAP earnings, but still only enough to push the price-to-free cash flow down to 14.
At best, I'd say this makes the stock fairly valued at today's price, and possibly overvalued for a couple of reasons: For one, Yahoo! Finance estimates have Cherokee growing at only 2%, not 14%. For another, the company carries a lot of debt on its books, which doesn't factor into either a price to earnings or price to free cash flow based valuation. When you get right down to it, therefore, while not a horrible company, on balance, I suspect you can find better stocks to buy than Cherokee.
B/E Aerospace coming back down to earth...
So what about the two stocks that Wall Street does not like today? We'll start with B/E Aerospace, whose stock recently went on a tear after the company revealed on May 4 that it's seeking a partner to buy, or merge with, the company (or some part thereof).
At the time, the company did warn investors that: "No decision has been made and there can be no assurance that the board's exploration of the company's strategic alternatives will result in any transaction being entered into or consummated" and that it "has not set a timetable for completion of this process." Investors may not have paid much attention to these caveats at the time, but now UBS is reminding them, as it downgrades the stock from buy to neutral.
According to UBS, B/E shares have gone up too high, too fast, based solely on the hope for a merger emerging at a premium price. Earlier this month, Reuters reported that at least one potential buyer, Airbus (NASDAQOTH:EADSY), is in fact not interested in B/E at all, dashing some cold water on the hopes of merger enthusiasts.
Other potential buyers may exist out there, sure. But you have to wonder how many of them would willingly ante up the 26 times earnings that B/E shares now cost, especially in light of the facts that B/E comes with substantial debt attached to it -- about $1.6 billion net of cash -- and generates pretty weak free cash flow to boot. At $202 million, B/E's cash profits are barely half as much as it reports for GAAP "net income."
Long story short, I think the stock's worth perhaps half what investors are paying for it today, and unlikely to fetch any more in a buyout. UBS is right to be cashing in its chips and calling it a day.
...and Huntington Ingalls gets sunk, too
Our final rating that we'll be reviewing today, that of Huntington Ingalls, is a bit trickier. Merrill Lynch cut its rating on Huntington to neutral this morning, arguing that while the defense spending picture has improved, and Huntington is earning better margins than it once was, this good news has already been incorporated into the stock price -- and so there's little left to be gained by buying it today.
With the stock up more than 80% over the past 12 months, it's hard to argue with that logic. And yet, Huntington Ingalls is actually one of the very few defense stocks out there that I see as still potentially undervalued. Why?
It's not the valuation, necessarily. At less than 16 times earnings, Huntington looks cheapish, sure. But the company only generated $251 million in positive free cash flow over the past year. That's 18% lower than reported GAAP earnings, and pushes the stock's price to free cash flow ratio up to nearly 19 -- and its enterprise value to free cash flow ratio up to nearly 24.
The key is the growth rate -- and the key question is whether Merrill Lynch is underestimating it. S&P Capital IQ estimates have Huntington growing earnings at about 25% annually over the next five years. If they're right, then between the valuation, the growth rate, and the modest 0.8% in dividends that Huntington pays its shareholders, the stock is arguably still slightly undervalued.
The undervaluation is not huge, however. Indeed, if the analysts are wrong about 25% growth -- and that's a very aggressive figure, make no mistake -- the stock could easily turn out to be even more expensive than it looks. On balance, I suspect Merrill Lynch is right to be cautious on this one -- 80% profits are nothing to sneeze at. Better to take them off the table now than risk losing them if Huntington's race to grow earnings gets hung up at low tide.
Rich Smith has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned.