This Just In: Upgrades and Downgrades

At The Motley Fool, we poke plenty of fun at Wall Street analysts and their endless cycle of upgrades, downgrades, and "initiating coverage at neutral." So you might think we'd be the last people to give virtual ink to such "news." And we would be -- if that were all we were doing.

But in "This Just In," we don't simply tell you what the analysts said. We'll also show you whether they know what they're talking about. To help, we've enlisted Motley Fool CAPS, our tool for rating stocks and analysts alike. With CAPS, we track the long-term performance of Wall Street's best and brightest -- and its worst and sorriest, too.

And speaking of the best ...
Tech investors were all aflutter at the ahead-of-expectations results Alcatel-Lucent (NYSE: ALU) posted last week, and Deutsche Bank was doing its level best to keep the enthusiasm running today. Posting 17% growth in sales compared with the first quarter, Alcatel blew past Wall Street's revenue projections Friday. Then the telecom giant promised "a strong second half" as "sales trends continue to improve" and the "leverage effect at the operating profit level will be significant."

Upgrading the shares to "buy" in response, Deutsche declared that "painful share losses and margin declines post merger" are things of the past. Going forward, a "combination of revenue stabilization and cost cuts should drive improving visibility toward ALU generating mid-single digit margins in the mid-term." So ... the worst is behind us. The shares are destined to grow, and all is right with the world, right?

Not quite
There are at least two things wrong with this morning's upgrade, from where I sit. First, the company being upgraded, and second, the analyst doing the upgrading. Let's take them in reverse order, beginning with a brief review of Deutsche and how it became one of the worst investors in the history of telecom. At least as tracked by CAPS:

As you can see, Deutsche isn't exactly tearing up the track in telecom. Fact is, while a pretty successful banker overall (52% of its total recommendations manage to beat the market, and the analyst outperforms about 90% of the investors we track), Deutsche drops an inordinate amount of calls in the field of communications equipment stocks. Historically, fewer than 40% of its recommendations here beat the market, with Motorola being only the beginning of its troubles.

And speaking of troubles ...
Let's consider a few of the faulty assumptions that got Deutsche into this fix and will doom this latest Alcatel upgrade as well. First and foremost, the improving sales trends, and consequent affirmation of fiscal year revenue growth and operating margins that Alcatel boasted of last week.

Is it just me, or did nobody else notice that Alcatel produced better revenue numbers than predicted for Q2 ... yet left its full-year projections intact? I mean, sure, this sounds good. But if Q2 was such a boffo quarter, shouldn't the guidance for the rest of the year have been (at least) increased in proportion to how well Alcatel exceeded expectations in Q2? Because if Q2 was ahead of expectations, but the full-year projections remain constant, that suggests to me that things are going to slow down later this year -- not increase as "sales trends continue to improve."

And for that matter: Forget about sales. Where are the profits? Revenue may have exceeded expectations in Q2, but Alcatel managed to lose more money than analysts had warned about -- $0.10 per American depositary share, versus a projected $0.06.

Sure, the company tells people it's going to get this fixed, and earn an "adjusted " (read, "imaginary") operating profit margin of 1% to 5% this year. But not only is that number nothing to write home about (Juniper (Nasdaq: JNPR) regularly reports real operating margins in the high teens, while Cisco (Nasdaq: CSCO) boasts margins in the low 20s). As Credit Suisse recently pointed out, it's not even terribly realistic as a goal.

To hit the midpoint of that margins range, Credit Suisse says, Alcatel's going to have to post 10% operating margins by Q4 -- just six months after reporting a loss. And that's unlikely. As Gartner recently pointed out, Alcatel faces pricing pressure from low-cost Chinese rival Huawei on the one hand, even as companies with greater efficiencies of scale -- Ericsson and the joint venture between Nokia and Siemens -- loom on the other. That's hardly a competitive environment geared to rapidly ramping profit margins.

Foolish takeaway
Ever optimistic in its projections for growth in the telecom sector (and ever wrong in those projections), Deutsche has once again fallen prey to its optimism gene, I fear. It hears Alcatel-Lucent promise great things for the future (even as it keeps losing money in the present), and it believes 'em.

Don't you make the same mistake.