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.

Level 3: Going up?
As you've probably heard by now, bandwidth wholesaler Level 3 Communications (Nasdaq: LVLT  ) reported earnings Wednesday. The numbers were good, not great. The company missed on revenue but beat on earnings by losing less money than expected. Nonetheless, Wall Street seemed pretty pleased with the results, bidding Level 3 shares up 9% -- and playing cheerleader to the buyers was Wall Street investment banker Cowen & Co., which has upped its rating on Level 3 to "outperform."

What has everyone so enthusiastic about Level 3 lately? First, key customer Netflix (Nasdaq: NFLX  ) is back on track and growing its streaming numbers again. Nearly as important, the rivals for Netflix's L3 bandwidth are growing. Amazon.com (Nasdaq: AMZN  ) is venturing ever deeper into the movie-streaming business, and earlier this week we learned that another of L3's biggest customers, Verizon (NYSE: VZ  ) , has partnered with Redbox operator Coinstar to offer a similar video streaming-service.

So bandwidth demand looks like it's only going to grow, and after Wednesday's results, Cowen says it has "better visibility of net synergies/integration costs tied to its acquisition of Global Crossing," too.

"I can see clearly now ..."
But what do we see here with this newfound "visibility"? Well, I took a look and I'm not quite as impressed as Cowen seems to be with Level 3. The revenues and earnings you already know about, so let's skip merrily past those and move on two other numbers that may be more telling: earnings before interest, taxes, depreciation, and amortization (EBITDA) and free cash flow.

Cowen says it's focused on the effect the company's merger with Global Crossing will "have on EBITDA." Coincidentally, that's the same number that rival analyst shop Davidson looked at back in September and that convinced DA Davidson to downgrade the stock. As Davidson wrote at the time, Level 3's "7.7-times EBITDA" seemed too high to justify based on the company's prospects. Davidson thought a 5.6 EBITDA ratio would be more appropriate. But what ratio does Level 3 sport now, post-merger with Global Crossing?

I'll give you a hint: It's not 5.6 times EBITDA. It's not even 7.7. Based on the company's most recent financials, Level 3 trades for an astounding 13.9 times EV/EBITDA. Hmm.

Free cash flow
I've never been a fan of EBITDA -- sometimes referred to as EBBS ("Earnings Before the Bad Stuff") or even EBE ("Earnings Before Everything"). Instead, I focus on free cash flow -- the actual cash a company generates from its business. But even here, the situation at Level 3 looks grim. According to the company's earnings release, Level 3 burned through some $74 million in FCF last year. Its new acquisition, Global Crossing, burned $128 million more, for a combined $202 million in negative free cash flow.

Granted, Level 3 asks us to ignore $104 million of this cash burn because it was "acquisition-related" and therefore presumably one-time in nature. But still -- that's $98 million in crispy cash to account for. Not good.

Foolish final thought
Call me a pessimist, but the more I look at Level 3's tie-up with Global-C, the more it reminds me of another ill-fated merger of a few years ago -- when Sears married Kmart to form Sears Holdings (Nasdaq: SHLD  ) . Envisioned as a way to create a rival to Wal-Mart, the merger turned out more as review question for a (really easy) pop quiz in math class:

1 bad business 1 other bad business = 1 really bad business

And of course you know how that one worked out: Over the past five years, Sears Holdings shares have shed some 75% of their market cap. And that's really the moral of this story. Even with arms linked, two free cash flow-negative companies are always going to have a hard time competing with a rival that sports negative free cash flow. Sears couldn't beat Wal-Mart. I don't expect to see Level 3 beat its archrival Akamai, either.

In fact, while I'm not a huge fan of Akamai, I'm so sure Level 3's stock is a dog that I'm going to head right over to Motley Fool CAPS right now and publicly predict that the stock will underperform the S&P 500 for the foreseeable future. Feel free to follow along -- and jeer loudly if it turns out I'm wrong.

Looking for a few companies with a better chance of making it big than Level 3 can offer? Read the Fool's new -- and free! -- report: "3 Stocks That Will Help You Retire Rich."

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. 371 out of more than 180,000 members.

The Motley Fool owns shares of Amazon.com and Wal-Mart Stores. Motley Fool newsletter services have recommended buying shares of Wal-Mart Stores, Amazon.com, and Netflix and creating a diagonal call position in Wal-Mart Stores. 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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