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Burned by a Bad Downgrade, Merrill Lynch Changes Its Tune on Oshkosh Stock

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...

One month ago, Merrill Lynch downgraded Oshkosh (NYSE: OSK) stock ahead of earnings -- and ahead of a big contract win by the Wisconsin truck maker. Merrill made a bad call (as we saw in Oshkosh's earnings yesterday). But today, Merrill Lynch is admitting its mistake, claiming a mulligan, and upgrading Oshkosh stock right back up again.

Here are three things you need to know about that.

Image source: Getty Images.

1. What Merrill Lynch (used to) think about Oshkosh

Last month, Merrill Lynch slashed its target price on Oshkosh shares to $60, and cut its rating on Oshkosh stock to underperform (i.e., sell). Citing a perceived "lack of new M-ATV orders for FY18 delivery," the banker warned that Oshkosh would be unlikely to hit the top range of its sales plan next year, disappointing investors.

Rather than wait around for this bad news to be confirmed -- or even to hear what Oshkosh had to say about its fiscal Q3 earnings -- Merrill proceeded to pan the stock, advising investors to sell.

2. What happened next

It didn't take long for Merrill Lynch's pessimism to be proven misplaced. Within just a few days of the company's downgrade coming out, Oshkosh reported a big sale of armored vehicles -- admittedly, not the M-ATV armored vehicles that Merrill had worried about, and not sales to the U.S. military, either, but rather sales of Joint Light Tactical Vehicle armored trucks to the British military. The deal promised to add $1 billion worth of high-margin revenue to Oshkosh's most profitable business segment, and undercut Merrill Lynch's sell argument entirely.

And then, the news got even better.

On Wednesday, Oshkosh released its financial report for fiscal Q3 2017. Sales for the quarter surged past $2 billion, up nearly 17% over fiscal Q3 2016 levels. Profits jumped 50%, to $1.69 per share. And while Oshkosh "increased sales in all four segments," CEO Wilson R. Jones gave the bulk of the credit for this big earnings beat to -- you guessed it -- Oshkosh's defense unit.

Specifically, Jones noted that "a large international order" of M-ATV armored trucks boosted its Q3 results, a sale that will continue producing results for Oshkosh "into the first quarter of fiscal 2018." On top of that, Oshkosh is "on track delivering JLTVs to the U.S. Department of Defense." And that's not even mentioning the big British JLTV order.

3. What Merrill Lynch is saying today

Result: Oshkosh today predicts that it will earn anywhere from $3.33 to $3.43 per share in 2017. Allaying Merrill's previous worries, Oshkosh further noted that with "strong backlogs" and "positive sentiment in our markets," the company is "well positioned for fiscal 2018" as well.

Hearing this, Merrill Lynch was quick to respond. As reported today on StreetInsider.com (requires subscription), the banker says it is "taking a mulligan" on its previous downgrade of Oshkosh stock, and returning the stock to a neutral rating -- and raising its price target to a level even above where it had been before: $78.

The most important thing: Valuing Oshkosh

The question now facing investors is: Merrill Lynch was clearly wrong about Oshkosh last time around (and to the banker's credit, it's admitted it), but is Merrill also wrong -- and late -- in upgrading Oshkosh again after the good news has arrived? And do investors who choose to follow Merrill's advice risk being wrong along with the banker -- twice?

Let's take a quick look at the valuation and find out.

Judging from the midpoint of Oshkosh's latest earnings guidance, the company is on track to earn about $3.38 per share this year. What's more, Oshkosh is now midway through its fiscal fourth and final quarter of the year -- so its estimates for how much it will earn this year are likely to be pretty accurate.

Now, if Oshkosh earns $3.38 this year, then its present stock price of $72.39 per share this leaves the stock valued at 21.4 times current-year earnings -- which seems kind of expensive given that most analysts who follow the stock see Oshkosh growing earnings at only 14% annually over the next five years. In fact, if that was the only way of valuing Oshkosh, I'd be inclined to argue that stock is now overpriced, and that Merrill Lynch should stick with its sell rating.

But here's the thing: Valued on free cash flow, Oshkosh isn't quite as expensive as it looks. Over the past year, Oshkosh has generated positive free cash flow of $432 million -- 70% more than the $254 million in "net profit" reflected on Oshkosh's income statement. Weighed against the company's $5.9 billion enterprise value, Oshkosh stock costs just under 14 times cash profit. And between that valuation and Oshkosh's modest 1.2% dividend yield, the stock actually looks fairly priced to me.

Long story short? This time around, Merrill Lynch is getting Oshkosh right. Oshkosh stock may not be the screaming bargain it once was, but it's not as expensive as it looks on the surface, either. If you ask me, I'd say Oshkosh probably has just a little bit more room to run before it reaches fair value.

A neutral rating is appropriate.

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Rich Smith has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.