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.

Steel melts
Here we go again. It's been about a month since bullish banker Deutsche Bank removed its endorsement from favored stock AK Steel (NYSE: AKS  ) -- a month in which steel stocks first rallied, then sank right back to where they started. And now that the rally has fizzled, it seems other steel bulls are starting to lose heart as well.

Case in point: Yesterday, ace investor Longbow Research announced that it, too, was calling time-out on the industry. In a series of downgrades, Longbow cut each of AK rivals Nucor (NYSE: NUE  ) , Steel Dynamics (Nasdaq: STLD  ) , and U.S. Steel (NYSE: X  ) to "neutral."

Why? So far, the mainstream media outlets covering the downgrades are mum on the rationale behind Longbow's move. It is curious to see, though, that in making its downgrades, Longbow has left its price targets on all three stocks intact (for the time being.) For now, Longbow still sees Nucor hitting $48 within 12 months' time, Steel Dynamics reaching $18, and U.S. Steel rising to $36 a share. So in theory, at least, it would appear that the analyst is telling investors: These stocks are poised to deliver profits of anywhere from 10% to 30% apiece, so... definitely don't buy them.

Huh?
I know. Doesn't make much sense, does it? Unless, of course, this is only the first shoe that Longbow intends to drop on investors -- a downgrade preparatory to dropping the price target as well. But how likely is that to happen?

Actually, pretty likely.

As I've argued before, there's a pretty serious gap between the prices investors are paying for steel companies these days, and profits the firms are earning... and the rates at which these profits are expected to grow. Unprofitable AK and U.S. Steel are the most obvious examples. But even Nucor -- a stock I've recommended buying at better prices -- looks pretty pricey today at a P/E ratio of 18, but only 10% long-term growth expected for it.

Steel Dynamics? Sure, it looks cheaper at 12 times earnings and 15% growth. The problem with Steel-D is that it's an even worse producer of free cash flow than Nucor is. Nucor generates free cash equal to only 76% of its reported net profit, but Steel-D's free cash is less than half of reported profits. On the other hand, neither AK nor U.S. Steel generates any free cash flow at all. So I guess everything's relative.

Foolish final thought
Now, could the steelmakers surprise us, turn suddenly profitable, and grow faster than anyone expects?

It's possible. After all, Deutsche Bank -- the folks who started the stampede into steel in the first place back in June 2011 -- have been saying steel prices were "nearing a floor" for close to a year now. (Turned out, it was the sub-basement floor they were talking about, when we all thought it was the ground floor.) My worry, though, is that even if we ever do reach this long-awaited "floor" price, China will jump out and cut it right out from under us.

Just this week, iron mining magnate Vale (NYSE: VALE  ) warned that supplies of iron ore are getting "tight." Bloomberg says one reason may be that China has amassed a huge stockpile of iron ore -- up 32% from year-ago levels -- ore that's just waiting to get smelted down into steel.

On the one hand, by locking up so much supply for the key raw material, the Chinese have likely raised the cost of making new steel for everybody else (virgin steel producers like AK and U.S. Steel, in particular). On the other hand, with so much iron in hand, Chinese producers are in a position to undercut their rivals on price, if and when prices start to show signs of strength.

Longbow is right to be cautious here. The tough times for U.S. steelmakers are far from over.

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Fool contributor Rich Smith does not own shares of any company named above. You can find him on CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 400 out of more than 180,000 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.


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