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." The pinstripe-and-wingtip crowd is entitled to its opinions, but we have some pretty sharp stock pickers down here on Main Street, too. And we're not always impressed with how Wall Street does its job.
So perhaps we shouldn't be giving virtual ink to "news" of analyst upgrades and downgrades. And we wouldn't -- if that were all we were doing. Fortunately, in "This Just In," we don't simply tell you what the analysts said. We also show you whether they know what they're talking about.
We begin in Britain, and with HSBC's upgrade of Luxembourg-based steelmaker ArcelorMittal to "overweight." The upgrade flies in the face of recent downbeat reports on both Europe's economy, and the broader steel industry alike, as alarm bells clang wildly around the globe. Earlier this month, iron ore mine BHP Billiton (NYSE: BHP ) warned of weakening demand for its signature product, even as The Wall Street Journal was reporting of dangerous oversupply in the Chinese steelmaking sector. Yet despite these danger signals, HSBC looks at the forward P/E ratio on Arcelor (posited at less than 5 times earnings based on expected fiscal 2013 profits) and sees an opportunity.
HSBC should get its vision checked.
Future profits predictions are all well and good, but based on the facts as we know them, Arcelor is anything but a "buy." The stock costs nearly 28 times trailing earnings, and while that may not look like too much of a premium for a company that's expected to post 25% compound annual earnings growth over the next five years, the quality of Arcelor's earnings remains suspect. The company burned through $1.5 billion in negative free cash flow last year, even as it claimed to be "earning" $1.2 billion.
Arcelor's also hip-deep in debt -- about $23.5 billion, net of cash on hand -- and ill-positioned to weather a slowdown. Investors following HSBC's advice had better hope the analysts there read tea leaves better than the WSJ does. Otherwise, there could be a lot of pain in store for them.
Mighty, mighty Molycorp?
A somewhat stronger case can be made for Molycorp, a U.S.-based producer of the rare-earth metals that China's been hoarding these past few years, and the recipient of a price target increase (to $55) from Dahlman Rose this morning.
Focusing on the company's recent acquisition of Neo Material Technologies, Dahlman argues Molycorp will pick up $0.50 in annual "earnings power" once it brings the rare-earths processor in-house, plus additional savings in "synergies." Crunching the numbers, Dahlman predicts this will all add up to about $1.70 in earnings for Molycorp this year, followed by a quick doubling of profits in fiscal 2013, to $3.50.
That's a pretty aggressive target and yields a forward P/E ratio of less than 6 on the stock -- more than one full point cheaper than the consensus on Wall Street. But it could actually prove conservative if Molycorp succeeds in hitting the 32% annualized earnings growth Wall Street forecasts for it over the next five years. Indeed, you could argue that at that growth rate, and the mere 16 multiple to 2013 earnings that Dahlman's price target implies, Molycorp is worth even more than the analyst in predicting.
There is, of course, the nagging detail that like Arcelor, Molycorp is currently free cash flow-negative. Then again, with more than $600 million in its war chest, against just $200 million in debt, Molycorp -- unlike Arcelor -- has a lot more room to maneuver as it gets its production machine on track.
A logical conclusion
Last but not least, we come to semiconductor manufacturer LSI, recipient of not one, but two separate cuts to price target this morning. Barclays sliced $2 off its price target, dropping LSI to $10. Maxim Group's verdict was even harsher, as it cut price expectations for LSI by a full third, to $8 a share.
Interestingly, both analysts still believe the stock is a "buy." So why all the pessimism about the share price? Barclays explains in its note that "end-demand remains soft in the PC and distribution channels." This suggests that the 17% long-term earnings growth that Wall Street has heretofore forecast for LSI may take a while in materializing -- with the implication being that the stock's 10.2 P/E ratio isn't quite as cheap as it seems, and the further implication being that patient investors might want to buy this one on the dip, secure in the knowledge that things will turn around eventually.
That would be a mistake.
You see, the truth of the matter is that LSI already isn't as cheap as it looks. While technically, GAAP accounting rules permit the company to claim that it "earned" nearly $400 million last year, in fact, actual free cash flow at the company was a much more modest $85 million. At a market cap currently 45 times these cash earnings, therefore, even if LSI does achieve the growth rate it's pegged for, the stock's still too expensive to own.
In short, the problem with Barclays' and Maxim's ratings isn't that they're being too harsh on LSI. It's that they're not harsh enough.
Whose advice should you take -- Rich's, or that of "professional" analysts such as HSBC and Dahlman, Barclays and Maxim? Check out Rich's track record on Motley Fool CAPS, and compare it with theirs. Decide for yourself whom to believe.