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 best ...
On a generally green day for Wall Street Thursday, shareholders of a certain fertilizer producer were having their own private party yesterday. PotashCorp (NYSE: POT  ) posted a 6% increase in value, or roughly 12 times the rise on the Dow.

For this you can thank the friendly analysts at RBC Capital Markets. Praising the quality of PotashCorp's assets, RBC pointed out that the company "has almost completed the major spending for its massive brownfield expansion program." The analyst further predicted that PotashCorp is poised to take strong global fertilizer demand (which gives it pricing power), combine this with expanding sales volumes, and transform itself into a veritable cash cow of a business.

But is RBC right about that?

Let's go to the tape
I wish I could give you an unqualified "yes" to that question, but in fact, RBC's record on past recommendations of chemical stocks like PotashCorp is mixed. The banker's done pretty well on PotashCorp itself, outperforming the market handily on its last recommendation, made back in 2007. But across the broader chemicals industry, and over longer periods, RBC's gotten more picks wrong than right -- underperforming the market on 56% of its recommendations to date. I'm not sure this week's recommendation will fare any better.

To see why, it may help to look at a few numbers:

Company

P/E

Growth Rate

Free Cash Flow as a % of Net Income

Intrepid Potash (NYSE: IPI  ) 17.3 7% 43%
PotashCorp 12.9 11% 42%
Mosaic (NYSE: MOS  ) 8.4 8% 39%
Agrium (NYSE: AGU  ) 8.2 4% NM
CF Industries (NYSE: CF  ) 7.8 17% 175%
Terra Nitrogen (NYSE: TNH  ) 6.6 NM 98%

P/E and growth rate data courtesy of Yahoo! Finance; free cash flow from S&P Capital IQ. NM -- not measurable, or no data available.

None of these stocks looks frighteningly expensive. Indeed, it seems the same worries about the drying up of global commerce, which sank the shares of dry bulk shippers such as DryShips (Nasdaq: DRYS  ) in 2011 (dry bulk is how fertilizer gets shipped internationally), are also weighing on the fertilizer-producing companies. Regardless, in recommending that investors buy PotashCorp, RBC is telling us to buy the second-most expensive (by P/E) fertilizer producer in the industry. (It's already recommended the most expensive, Intrepid Potash, twice in the past three years -- and been proved wrong both times.) And of course, RBC is recommending you buy a company that generates considerably less cash profit than it reports as GAAP net income -- rarely sound advice.

On the other hand, RBC may be right that PotashCorp will be able to improve cash production. For several years now, PotashCorp has been spending heavily on capital investment. If it ratchets this spending back to the rates more common in 2007, for instance, it could lift PotashCorp's free cash flow number considerably. Best guess -- I estimate that a return to 2007 levels of capex would give the company a price-to-free cash flow ratio of about 14.

A few better ideas
Of course, this would still leave us with a stock expected to grow at 11% per year and selling for a 14 multiple -- hardly a bargain. I think investors may be better off ignoring RBC's advice on this one and taking a look at Terra Nitrogen or CF Industries instead.

Terra sports the lowest P/E ratio of the group. And while PotashCorp may or may not begin generating free cash flow in line with reported earnings, Terra already is. Its free cash flow backs up 98% of reported net income. (Terra's also debt-free versus Potash's $4.2 billion in net debt -- never a bad thing.)

An even better option, it seems to me, is CF Industries. Here we have the second cheapest stock (by P/E), which is also the fastest grower in the group. That sounds attractive already, but CF is also the only stock on the list generating significantly better free cash flow than it reports as net income.

Of the two, I'd say I'm inclined to think CF offers the better value -- but both Terra Nitrogen and CF Industries look like better ideas than PotashCorp.

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Fool contributor Rich Smith owns no shares of any company named above. You can find him on CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 342 out of more than 180,000 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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