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.

And speaking of the worst...
"If at first you don't succeed, fail, fail again." This must be the motto at beleaguered Swiss banker UBS.

Two months ago, I took UBS to task for recommending that investors dive into the steel sector and buy AK Steel (NYSE: AKS  ) and U.S. Steel (NYSE: X  ) ahead of earnings. Two months later (last week, to be precise) both AK and U.S. Steel reported earnings. Long story short, the stocks are down 7% and 18%, respectively. (In contrast, free-cash-flow-positive Steel Dynamics (Nasdaq: STLD  ) managed to hold up fairly well, while my favorite company in the industry, Nucor (NYSE: NUE  ) actually gained 12%. Which just goes to show you why I believe cash is still king.)

Be that as it may, UBS seems undeterred by its disastrous record to date. To the contrary -- after betting big and losing bigger on AK and U.S. Steel, UBS is doubling down on its industrywide bet. Yesterday, the Swiss megabanker initiated coverage on the world's biggest steelmaker, Arcelor Mittal (NYSE: MT  ) with a buy rating.

Doubling down on a loser
What has UBS feeling so sure it can pick a winner -- especially after the last time it recommended the stock, UBS underperformed the market by a whopping 60 points on the pick? Perhaps it's the self-published report that Arcelor put out yesterday, which the company coyly disclaimed as "the Q311 EBITDA sell-side analyst consensus" (emphasis added).

According to this report, Arcelor is on track to earn $2.5 billion in Q3 2011, before interest, taxes, depreciation, and amortization are subtracted. If correct, that would work out to about a 10% improvement in gross profit for the company, year over year. It would also suggest the company's doing a whole lot better than its predicted 43% decline in net profit would suggest. And it would help explain why so many analysts on Wall Street are predicting that over the long term, Arcelor will outperform the rest of the steel industry, growing earnings 25% per year over the next five years, while other steelmakers struggle to achieve even 4% annual growth.

Arcelor Mittal: Buy the numbers?
Over the past year, Arcelor stock has underperformed the Dow Jones Industrial Average (INDEX: ^DJI) and the S&P 500 badly (lagging the latter by more than 40 percentage points, for example). But if UBS is right, this weak performance sets up Arcelor for strong outperformance in the years to come.

Consider: At 8.7 times trailing earnings today, and with 25% long-term growth projected for it, Arcelor shares currently sell for a PEG ratio of only 0.37. That's a remarkably cheap price, if true, and helps explain UBS' enthusiasm for the stock. But is it true?

I'm not so sure it is. Or rather, I'm not so sure the "headline" numbers at Arcelor mean what they seem to mean. While Arcelor is incredibly profitable on a GAAP basis, its free cash flow statement shows the company to be lagging badly in the cash-generation business. At the same time as the company was reporting $3.2 billion in net earnings for the past 12 months, Arcelor's cash flow statement showed the company actually burned through $1.8 billion in negative free cash flow.

Foolish takeaway                                               
UBS may be right that Arcelor is on the cusp of recovery, will soon reverse its cash-burning ways, and proceed to deliver barn-burning growth in the years to come as global economies recover. For the time being, however, I'm more comfortable investing in companies that have proven themselves able to generate cash in good times and bad. Companies like Nucor in the steelmaking sector. Or like iron ore miner Cliffs Natural Resources (NYSE: CLF  ) farther upstream.

Call me old-fashioned, call me a Fool: I think generating cash profits is better business than burning it.

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Fool contributor Rich Smith does not own (or short) shares of any company named above. You can find him on CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 320 out of more than 170,000 members. The Motley Fool has a disclosure policy. Motley Fool newsletter services have recommended buying shares of Nucor.

We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.


Read/Post Comments (5) | Recommend This Article (1)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 02, 2011, at 10:49 AM, alphawise wrote:

    I don't know what cash flow statements you are looking at, but their SEC filings for the year 2010 shows they generated $4.0 BILLION in positive cash flow from operations. What am I missing??

  • Report this Comment On November 02, 2011, at 6:04 PM, depletemycapital wrote:

    My goodness, Mr. Smith,

    Have we been looking at short term views, while Mr. Fool recommends long term to the point of a company breakdown before selling?

    Was it ok for the UBS to recommend it around $19 a share? Why that would mean MT was selling @ less than 50% of it's book value. Oh yeah!, it depends on what you mean by book value!

    Next, did you know that MT is an iron-ore producer & they started doing this to combat rise in ore prices, which all major competitors have to pay premium for? Bad Arcelor, bad! Planning to reduce costs by mining your own iron-ore!

    Gee, I wonder what the value of all those fully operational mines are? Could that add value to MT, as no one has placed the mines value to overall bookvalue, yet!

    Lastly, I don't know what's up with you MF guys. Your paid services constantly preach long-term, while those of you who are not part of that tend to be just like analysts who '"initiate...., upgrade, downgrade"' etc. Wish you guys would get with the program & not look at short term & think about 10 years plus. After all, how else are we going to keep buying great stocks like Netflix?

  • Report this Comment On November 03, 2011, at 12:20 AM, TMFDitty wrote:

    @alphawise: Keep reading. You've got the cash flow right, but now take a look at the capex. Once you subtract that out, 2010 FCF was roughly 25% of reported GAAP earnings. (And yes, it has turned negative in 2011.)

    @depletemycapital: It's a free country. I focus on free cash. But you are more than welcome to focus on book value. In which case, I can recommend some fine banks for you, all selling for much less than book.

    TMFDitty

  • Report this Comment On November 03, 2011, at 11:09 AM, alphawise wrote:

    @TMFDitty: Yes, I understand cap-ex, but I believe in the case of MT that these are discretionary expenditures intended to increase production capacity and future earnings streams, are they not? It would be entirely different if these were non-discretionary expenditures required to maintain existing production capacity. Am I making sense?

  • Report this Comment On November 03, 2011, at 1:31 PM, TMFDitty wrote:

    Absolutely -- and if you can segregate the expansion capex from the maintenance capex, that's a fine strategy. Just remember, though, that if you try to value a company on ... let's call it "maintenance FCF," then you need to also reduce the projected growth rate to get a decent ratio.

    Otherwise, you're (a) removing the penalty for expansion capex, while (b) still giving the company credit for all the growth it will get from spending that expansion capex. When in doubt, use the most conservative numbers you can find.

    TMFDitty

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