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." Today, we'll show you whether those bigwigs actually know what they're talking about. To help, we've enlisted Motley Fool CAPS to track the long-term performance of Wall Street's best and worst.

In through the out door
A few weeks back, I told you about the big upgrade UBS gave Alcatel-Lucent (NYSE: ALU  ) -- and the stock rally that resulted. Unfortunately, what the market gaveth, the market just tooketh away. Today, the news is all about another big Euro banker, Deutsche Bank, and its downgrade of Alcatel.

Citing Alcatel's strong price performance post-UBS upgrade, and the stock's 83% rally year-to-date, Deutsche now warns us that Alcatel's run is done: "After significant outperformance, we believe ALU's share price now largely reflects an anticipated margin recovery to 6+% by 2012." Worse, there's now downside risk in the stock because "revenue and margin momentum" will "slow" as we head into 2012.

Who's right?
What's an investor to make of these arguments? Within the space of less than two weeks, two major investment banks have given us diametrically opposed opinions on the stock's future. UBS cites a mini-selloff as reason to upgrade the stock to "buy," while Deutsche points to the longer-term rally at Alcatel as reason to pull its buy rating and downgrade to "hold."

So who's right? It depends on the trends -- and how you read them.

UBS: uber-bull
From UBS's perspective, Deutsche has a point that Alcatel's "high-margin CDMA business" is headed into a long, slow decline. But the analyst there sees "improving margins and robust growth trends" in Alcatel's other businesses that will carry it through the tunnel and back out into the light.

There's merit to that argument. As I pointed out two weeks ago:

  • … while still burning cash, Alcatel is at least burning less cash than it did in 2010 and 2009. There's an upward trend in its business, and if UBS turns out to be right about the stock, I suspect that it will be because free cash flow turns the corner.
  • … contributing to the better FCF picture, Alcatel generated significant cash from operating in Q4 of last year -- even better than it did in Q4 2009, the last quarter in which operating cash flow was positive. So long as capex remains more or less stable, as it appears to be in most years, rising cash from ops will slowly but surely move Alcatel in the right direction.

Deutsche: Dismal economist
Yet at the same time UBS was upgrading Alcatel, it admitted there are risks to its analysis. Juniper (Nasdaq: JNPR  ) , Finisar (Nasdaq: FNSR  ) , and Ciena (Nasdaq: CIEN  ) have all been making cautious comments about future revenue growth. Cisco's (Nasdaq: CSCO  ) troubles in telecom, too, are well known.

Comments like these have Deutsche wondering whether the trend that's been friend to Alcatel shareholders for so long is about to end. And yes, there's merit to that argument as well. Remember -- there's a difference between my saying Alcatel is moving in the right direction and my (hopefully, eventually) declaring that it's arrived. Because for now, Alcatel still has a way to go before it will meet my criteria for investment.

Free cash flow at the company remains stubbornly absent, with Alcatel burning more than $470 million in cash over the past 12 months. This company hasn't generated a euro-cent's worth of positive free cash flow on an annual basis since 2006. And even if it were to repeat the feat it accomplished in that year, today, the company would be valued at 41 times free cash. On a stock that's seen earnings decline by an average of 18% per year for the past five years running and that's expected to grow going forward at only 10%, that's a pretty high multiple to profits that Alcatel still isn't earning.

Foolish takeaway
When you get right down to it, investing in Alcatel's stock remains an exercise in guesswork. I guess UBS could be right that things will continue to get better at Alcatel. But I don't know for certain, and I won't know until Alcatel generates numbers that prove the thesis.

And until I do see those numbers, I won't be investing in Alcatel-Lucent.

Fool contributor Rich Smith does not own shares of (or short) any company named above, but  The Fool owns shares of and has created a bull call spread position on Cisco Systems. Motley Fool newsletter services have recommended buying shares of Cisco Systems and shorting Juniper Networks.

You can find Rich on CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 555 out of more than 170,000 members.

We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.The Motley Fool has a disclosure policy.


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  • Report this Comment On July 14, 2011, at 12:32 PM, DanTheMan1984 wrote:

    Rich you sure are follwing ALU closely lately....Good to see my friend. Will see how ALU numebrs are when they report second quarter earnings on July 28th.

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