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 worst ...
Goldman Sachs may well be the king of commodities analysts -- not always right, but always influential. When Goldman declared in 2006 that oil would hit $200, it very nearly made the statement fact, just by saying it. And when in September of this year, Goldman dissed steelmakers U.S. Steel (NYSE: X) and Nucor (NYSE: NUE) and threw its support behind copper magnate Freeport-McMoRan (NYSE: FCX), well, that moved those markets, too.

This week, Goldman's back with another round of metals picks, panning AK Steel (NYSE: AKS) even as it upgrades Reliance Steel & Aluminum (NYSE: RS). But it's why it's doing this that is most interesting.

Is that a spot of rust I see?
According to Goldman, raw materials prices are on the rise in the steel sector, crimping margins on the input side at AK Steel, even as demand among AK Steel's automaker and construction industry customers looks to be weak in Q4. Adding price wars to insult, Goldman warns that "the addition of new capacity should create challenges for the industry," with the result that any recovery in 2011 "will be very slow with prices moving mostly in response to cost pressure."

And while you might think that trends hurting AK Steel would hurt Reliance Steel as well, Goldman begs to differ. Citing the company's greater exposure to "aerospace and energy markets," Goldman actually thinks Reliance Steel is a buy at these levels, in contrast to the "neutral" rating it just hung on AK Steel. But is Goldman right?

Let's go to the tape
Not if its past performance is any indication. Fact is, Goldman has been picking and choosing among steel concerns all year long now, but with decidedly mixed results:

Overall, Goldman's success rate in steel this year has been stuck at a sub-50% level (43%, to be precise). Of the 14 picks it has made, the average is underperforming the S&P 500 by nearly two percentage points (and the year isn't even over yet).

So you'll understand if I take this week's ratings with a couple grains of salt and prefer to check Goldman's math before taking Goldman's advice as gospel.

Danger: Hard-hat zone
Actually, it doesn't take a whole lot of math to figure out why Goldman's wrong on these recommendations. Fact is, neither Reliance Steel nor AK Steel is anywhere near cheap enough to own. I mean, yes, on the surface Reliance Steel looks like a better bet than AK Steel, if for no other reason than the fact that its 14 P/E ratio is more than 10 times cheaper than AK Steel's 146 P/E. The mere fact that AK Steel is expected to grow a bit faster than Reliance Steel (10% per year over the next five years, versus Reliance Steel's 4% annual growth pace) is not enough to change the fact that at today's prices, both stocks look quite expensive.

Worse, they're even more expensive than they look. Neither Reliance Steel nor AK Steel is generating nearly as much free cash flow as the companies report for their GAAP "profits." At $247 million for the past year, Reliance Steel's GAAP number overstates its actual free cash flow by a factor of three times. And even that's a number that AK Steel would envy -- because AK Steel is actually burning cash today.

Foolish takeaway
Mind you, both companies have performed better than this historically. Over the past five years, AK Steel has generated average annual free cash flow of $98 million, which is better than its reported GAAP profit for the period. But even if AK Steel can return to its historical performance, the stock still looks expensive to me at nearly $1.9 billion in enterprise value.

As for Reliance Steel, the company's superior free cash flow production ($440 million on average, over the past half-decade) has me slightly more optimistic here. But not enough so that I'm prepared to endorse a projected 4% grower with a sub-1% dividend. It's a good company, yes, but not cheap enough by half.