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.

Big trouble in big steel
Things are starting to look really ugly in the steel sector. Earlier this week, as you may have heard, an analyst at Citigroup downgraded shares of U.S. Steel (NYSE: X  ) to "neutral." The analyst had even harsher words for USX rival AK Steel (NYSE: AKS  ) , blasting it for producing "negative cash flow," warning of further troubles as steel prices "deteriorate," and slapping a "sell" rating on the stock.

And it's only going to get worse.

Already, Nucor (NYSE: NUE  ) has warned investors that its Q3 earnings could come in close to half what the company earned last year. Jefferies cut fellow steel mini-mill operator Steel Dynamics to a "neutral" rating earlier this month as well, while slashing its price target by 10% (to $13.50 a share). And now, we're hearing from StreetInsider.com that two analysts have cut their ratings on the world's biggest steelmaker, ArcelorMittal (NYSE: MT  ) -- Macquarie downgraded it to neutral, and Goldman Sachs pointed to the expiration of hedge contracts, and wage inflation at factories in the former Soviet Union, and downgraded it all the way down to "sell."

It gets a Fool to wondering: Is there any hope left for investors in any of these steelmakers?

Abandon hope, all ye who invest here
Probably not. I've laid out the arguments against the steelmakers already (read the gory details here), and I won't belabor the point. Suffice it to say that with P/E ratios and price to free cash flow ratios all far above the companies' pre-downgrade growth targets, there's not a bargain to be found anywhere among the name-brand steelmakers. And if growth slows even more than forecast... beware: More downgrades could be coming down the pike.

And yet, it's not all doom and gloom. Searching through the SEC filings for a diamond in the rough, I have come upon one "steel company" that appears to hold some promise.

Invest in a blast from the past
It's been several years since I last pointed to steel scrap recycler Schnitzer Steel (Nasdaq: SCHN  ) as perhaps the best leading indicator I know of, for forecasting trends in steel pricing. Lately, though, Schnitzer has started to earn my respect in another respect as well: as an investment.

Consider: At a P/E ratio of just 12, Schnitzer shares cost considerably less than pretty much any name-brand steelmaker you can name. They're a third cheaper than Steel Dynamics. Nearly half the cost of Nucor. But Schnitzer may be even cheaper than it looks.

Schnitzer, you see, generates a whole lot more free cash flow than it gets to report as "net income" under the rules established by GAAP accounting standards. It churned out $180 million in positive free cash flow over the past five years, for example, or nearly three times its reported income.

That's enough to push the price to free cash flow ratio on this stock down to just 4.3. And with analysts estimating Schnitzer will grow its profits at nearly 10% over the next five years. This price offers a pretty big margin of safety if growth rates falter. On the other hand, if analysts turn out to be right about Schnitzer's growth trends, the stock's a huge bargain at today's prices.

Foolish final thought
It could be a few more months before we start to get a solid read on where steel prices are heading, but with Schnitzer shares trading for prices that range from cheap, to very cheap, depending on the growth rate, I think this one's worth waiting around for. And the best news of all? With a generous 2.7% dividend yield, Schnitzer pays you while you wait.

(And if it's dividend stocks you're looking for, here are three more Dow stocks dividend investors need. Check 'em out!)

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. 281 out of more than 180,000 members. The Motley Fool owns shares of ArcelorMittal, and Motley Fool newsletter services have recommended buying shares of Nucor. The Motley 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.


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