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PACCAR Stock Upgraded: What You Need to Know

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...

PACCAR (NASDAQ: PCAR) stock crashed 8% after the company reported earnings last month, and hasn't really recovered much since. This morning, however, some good news arrived.

So far since earnings, two analysts -- Evercore ISI and Seaport Global Securities -- have used PACCAR's earnings report as an excuse to downgrade the stock. But breaking with that sentiment, this morning Argus Research announced it is upgrading PACCAR stock and assigning it a price target of $82 per share.

Here are three things you need to know about that.

Truck sales are zooming, and one analyst thinks Paccar stock will zoom along with them. Image source: Getty Images.

1. What PACCAR said

Despite what you might have heard (and despite Wall Street's reaction to it), PACCAR's Q3 earnings report was actually quite good. Management itself called the results "excellent."

Sales for the quarter rose 19% in comparison to Q3 last year, while PACCAR's profits were up 16%. Both numbers exceeded Wall Street's estimates. The company raised its forecast for Class 8 truck sales through the end of this year by about 10%, and said truck demand is accelerating, with the number of Class 8 trucks sold in Europe holding steady and growing in the U.S. and Canada.

2. What Wall Street said then

And yet, investors sold off the stock. Reviewing the news, my fellow Fool Jason Hall speculated that analysts were spooked by a comment from management that it didn't expect to grow profit margin much at all -- holding it steady at between 14% and 15% -- despite the additional sales.

As Jason explained, capital-intensive industrial companies like PACCAR are supposed to enjoy "leverage" in their operations, such that when sales (and revenue) go up, fixed costs are supposed to be spread out across more production, enabling the company to earn higher profit margins on additional trucks sold.

PACCAR is saying it doesn't expect that to happen next year. And Wall Street isn't happy to hear that.

3. What Argus is saying now

So why is Argus optimistic when the rest of its Wall Street kin are not? As explained in a write-up on TheFly.com this morning, Argus believes that sales of heavy-duty trucks in the U.S. are "at an inflection point," while the European market for heavy trucks is also "showing strength." Argus sees PACCAR capitalizing on the strong demand for big trucks by grabbing market share from rivals such as Navistar, and thus growing faster than the market at large.

The most important thing: Is Argus right and everyone else wrong?

But here's the thing: Even if sales do grow, if PACCAR can't capitalize on them by expanding its profits dramatically, PACCAR stock could still be overvalued -- and unworthy of Argus's buy rating.

Consider: The consensus among analysts following PACCAR stock is for earnings to nearly triple over 2016 levels this year, with PACCAR earning as much as $4.19 per share in 2017. But longer-term growth estimates (provided by S&P Global Market Intelligence) show PACCAR's profits expanding at only about a 6% annualized rate over the next three years.

That growth rate doesn't compare well to PACCAR's trailing P/E ratio of 19.1. In fact, even crediting PACCAR with all $4.19 in profits that Wall Street expects it to earn this year (trailing earnings are still just $3.74), PACCAR stock would look pricey at a current-year P/E ratio of 16.9.

And it gets even worse. PACCAR's P/E ratio doesn't take into account the company's hefty debt load, currently about $5.6 billion net of cash. Factor that into the valuation, and PACCAR's stock becomes about 20% more expensive than meets the eye. The company also isn't generating a whole lot of cash with which to pay down its debt. Trailing free cash flow at the company is only $769 million -- meaning PACCAR is really generating only about $0.56 in real cash profit for every $1 it claims to be earning under GAAP.

PACCAR isn't as cheap as it seems -- and it didn't seem all that cheap to begin with. I know not all Fools will agree with me on this one, but personally, I think Argus is wrong to recommend PACCAR stock.

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Rich Smith has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends PACCAR. The Motley Fool has a disclosure policy.