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." While the pinstripe-and-wingtip crowd is entitled to its opinions, we've got some pretty sharp stock pickers down here on Main Street, too. (And we're not always impressed with how Wall Street does its job.)

Given this, 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.

Macquarie makes a mess
Last week, a lot of people were talking about telecommunications stocks. Clearwire (Nasdaq: CLWR  ) in particular got a lot of attention, as investor opinion seesawed back and forth all day Friday. Early in the morning, a downgrade from Macquarie Capital sent Clearwire shares tumbling -- down as much as 9% on worries that the company had "significant liquidity risk" and little access to the funds needed to keep the doors open.

 Soon after, however, word began filtering out about a new $1.5 billion bond offering at Sprint Nextel (NYSE: S  ) -- and Sprint's suggestion that it might use the funds to help keep Clearwire afloat. When all was said and done, Clearwire shares ended up right back where they started, at $1.62 a share.

Can you hear Goldman now?
Meanwhile, farther up the supply chain, analysts at Goldman Sachs were raising a ruckus as they reinitiated coverage on four telecom equipment stocks. In quick succession, Goldman assigned neutral ratings to Ciena and Finisar (Nasdaq: FNSR  ) , but told investors to go ahead and buy JDS Uniphase (Nasdaq: JDSU  ) and Level 3 Communications (Nasdaq: LVLT  ) .

Investors reacted positively to Goldman's renewed interest, bidding up all four stocks -- in particular Level 3, which rose a whopping 8.7%! But did Goldman give good advice? Let's dispose of the easy calls first:

Ciena
Ciena shareholders are doubtless disappointed that Goldman didn't put their stock in the same winners circle as JDS and Level 3. And yet -- unprofitable under GAAP and selling for 30 times annual free cash flow -- it's hard to see why Ciena would deserve a rating any better than "neutral." In fact, Goldman's actually probably being charitable here. As the analyst notes, Ciena stock is already "up 47% ytd." Best not get greedy -- there's only one direction left for Ciena, and "up" isn't it.

Finisar
Similarly, Goldman argues that although "well-positioned to capitalize on the current inventory up-cycle," Finisar's share price more than adequately rewards the company for its growth prospects and fundamentals. With a very generous P/E ratio of nearly 32 and essentially no free cash flow to back it up, Finisar stock, too, shows little potential for profit.

Now see if you can spot the differences in the stocks Goldman likes. First up...

JDS Uniphase
Ciena shareholders should be practically up in arms about this one. Like Ciena, JDS is currently unprofitable by GAAP accounting standards. Like Ciena, it generates free cash flow... but so little that JDS' price-to-free cash flow ratio is actually 50 -- versus Ciena's 30x ratio. So, why does JDS get the nod while Ciena doesn't?

Excellent question -- but there doesn't appear to be any good answer. According to StreetInsider.com, Goldman likes JDS as a play on "a snap-back in North American carrier capex." But really, you can say the same about Ciena -- which Needham & Co. recently pegged as a company with the potential to grab "85% of U.S. equipment orders in the switch to 100G." On the one hand, JDS certainly has a better balance sheet than Ciena, which is loaded down with some $800 million in debt. On the other hand, it's still hard to imagine why Goldman thinks this fact alone would make JDS worth 50 times free cash flow -- or worth buying at all.

Level 3
As for Level 3 -- well, if you were looking for one company to encapsulate everything that's wrong with all the other companies Goldman was recommending, and that could add a near-stall growth rate for good measure, then Level 3 is clearly the winner:

  • Unprofitable like Ciena and JDS
  • Burning cash faster than Finisar
  • Growing at a measly 3.5% per year (according to consensus estimates)
  • And carrying more debt than all three of the other companies that Goldman looked at combined

Level 3 is easily Goldman Sachs' worst stock idea yet. Goldman says Level 3's merger with Global Crossing last year was a game changer that will put the combined company "on a path to sustainable FCF for the first time in its history." Personally, I'll believe it when I see it. For now, the company's still burning $214 million a year, which will only add to its near-$8 billion net debt load -- and anything but a "buy."

In fact, I'm so sure that buying Level 3 is a bad idea that I'm going to do something incredibly Foolish: I'm going to go head-to-head with the mighty Goldman Sachs and vote for Level 3 to underperform the market even as the smart money says it will outperform. Want to see how the pick works out? (To be honest, I'm kind of curious myself.)

Follow along right here.

(Meanwhile, if you're looking for a tech idea that will actually make you money, rather than losing it as Goldman's pick promises to do -- read our new tech report. Discover the only stock you need to profit from the new technology revolution.)

Fool contributor Rich Smith holds no position in any company mentioned, neither short nor long. You can find Rich on CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 276 out of more than 180,000 members. The Fool has a disclosure policy

We Fools may not 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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