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...
Yesterday, my fellow Fool Dan Caplinger laid out the case for why the third quarter could be an ugly one for many investors, highlighting the troubles faced by a series of Wall Street's favorite stocks. This morning, one analyst up on the Street nodded in agreement, and downgraded one of the companies Dan had pinpointed for failure: Alcoa (NYSE: AA  ) .

Blasting Alcoa as a company incapable of generating value for shareholders "in the company's current form," investment banker Dahlman Rose argued forcefully for breaking up the company, so that investors could better benefit from strength at the "Global Rolled Products and Engineered Products and Solutions segments [which are doing] quite well" -- and get quit of the firm's downstream operations, which aren't.

Warning that a weak global economy, combined with continued overproduction of aluminum in China, will pressure prices and keep them range-bound between "$0.85 and $1.05/lb over the next 12 months," Dahlman downgraded Alcoa to "hold" while it waits to see if management takes the hint and sheds its less desirable operations.

A plethora of problems
And while I don't necessarily disagree with the downgrade per se, I honestly doubt Alcoa deserves even the new "hold" rating that Dahlman graces it with. Seems to me, Alcoa has so many problems, that anyone stopping short of a "sell" rating is in real danger of over-optimism. Let's start with the theory that "Alcoa's future lies" in global rolled and engineered products, as Dahlman argues.

Read through Alcoa's numbers, and what you'll find is that there really isn't a whole lot to be optimistic about in any of Alcoa's operations. Sure, in engineered products the company boasts a respectable 10.1% after-tax operating profit margin. But that's not appreciably better than the 9.8% operating margin it scores in the alumina division. Similarly, Alcoa's 3.4% profit margin in rolled products lags the 4.2% margin it gets from primary metals. In short, if the divisions Dahlman likes are doing "quite well," then the other divisions are doing just as "well" (or just as poorly, depending on your perspective).

It's all a matter of perspective
Personally, I lean toward the "poorly" side of the argument. Because really, any way you look at Alcoa today, the stock comes out looking like dead money. Starting with GAAP profit, it's hard to justify an investment in a stock selling for 129 times earnings. But, even valuing the company on its more attractive free cash flow numbers, Alcoa's P/FCF ratio of 17 times looks pretty pricey on a 12% projected growth rate. The valuation gets even more expensive when you factor in Alcoa's debt load, which swells the company's enterprise value to free cash flow ratio all the way up to 31 times.

And relative to its peers, yes, Alcoa costs less than unprofitable Aluminum Corp of China (NYSE: ACH  ) -- but the very fact that Aluminum Corp is willing and able to operate at a loss tends to put a check on Alcoa's ability to turn a profit from its products. Meanwhile, Rio Tinto (NYSE: RIO  ) , which costs a bit more than Alcoa at 22 times earnings, also pays a stronger dividend and a much faster growth rate. So if Aluminium Corp undermines the pro-Alcoa business thesis, Rio hurts any argument in favor of choosing Alcoa as the better stock valuation.

The future's uncertain
Meanwhile, elsewhere in the world the tide continues to turn against Alcoa and its aluminum-manufacturing peers. Boeing (NYSE: BA  ) and Airbus have elected to start building airplanes from plastic composites, hurting Alcoa's ability to profit from the boom in plane-buying. Meanwhile, Tesla's (Nasdaq: TSLA  ) efforts to turn on Americans to all-aluminum, battery-operated supercars appears in danger of stalling as well.

In short, sources of new demand are coming few and far between. Meanwhile, aluminum supply is all too plentiful, as China works to keep its factories humming, and exports the excess production that its slowing economy no longer needs. So, sure, if Alcoa's price was objectively cheap, and factored in all these challenges, then hope for a positive catalyst might make the stock worth holding onto.

But it isn't, it doesn't... and it isn't.

Oh, and for anyone out there investing in Alcoa for the dividend -- a word to the wise: Yes, Alcoa pays a modest 1.5% yield. Unfortunately, it also pays out 150% more in dividends than it actually earns as profit -- a trend that's logically unsustainable. If you want a real deal on dividends, therefore, skip Alcoa, and instead read our new free report on the three Dow Stocks Dividend Investors Need.

Fool contributor Rich Smith does not own shares of, nor is he short, any company named above. You can find him on CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 285 out of more than 180,000 members.

The Motley Fool owns shares of Tesla Motors and Motley Fool newsletter services have recommended buying shares of Tesla Motors. 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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