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 worst...
When investment banker UBS downgraded Alcatel-Lucent (NYSE: ALU  ) to sell last month, and warned that the $1.06 stock was heading down to $0.78, shareholders probably imagined things could get no worse. Then Alcatel reported earnings, and all of a sudden, things did get worse.

A lot worse. Sales in fiscal Q3 dropped 9.5% at Alcatel, and with profit margins declining across the board, Alcatel ended Q3 with an $0.08-per-share net loss, a reversal from last year's $0.10 per share profit.

The news was so bad, in fact, that it prompted one analyst to throw in the towel on Alcatel. Yesterday, analysts at Bernstein announce they were trading in their market perform rating for an underperform, and setting a new target price of... better sit down for this... $0.60 per share.

Why so harsh, Bernstein?
What was it that prompted Bernstein to take a look at UBS' recommendation, and then undercut it by a further 23%? According to the analyst, the key factors in its downgrade were:

  • Alcatel's lack of "market traction," as illustrated by its total failure to exhibit the kinds of gains recently seen in Nokia's (NYSE: NOK  ) report on its joint venture with Siemens (NYSE: SI  ) .
  • The total deterioration of profit margins. Alcatel now sports a gross margin of just 30.9% , nearly 10 whole percentage points worse than Ciena (Nasdaq: CIEN  ) , and barely half the profit margin at Cisco Systems (Nasdaq: CSCO  ) .
  • Topping it all off, Bernstein says it sees little evidence of "meaningful restructuring" at Alcatel, the company's ballyhooed "streamlining" program notwithstanding.

And to be perfectly blunt, Bernstein's right. (So is UBS). Alcatel-Lucent is in dire straits.

Crunching the numbers
Nearly a month into its latest plan to save itself by firing 5,000 workers, reshuffling its management team, and shaving $1.6 billion off its annual costs, Alcatel just reported losing $187.5 million in its fiscal third quarter. Operating cash flow is deeply in the red, and free cash flow for the quarter came to a staggering negative $462 million -- basically wiping out all the improvements in free cash flow we've seen over the past year.

The company's now officially operating cash-flow-negative for the past 12 months, and with capital spending levels still high, it burned through nearly $470 million during the period. Most troubling of all, the company's continued inability to generate strong, sustainable cash from its business has put Alcatel in the position of having more long- and short-term debt than it has cash on hand to counterbalance this debt. Add in the firm's near-$8 billion in pension obligations, and the company's ability to keep itself afloat -- much less provide security for its workers -- is now in real doubt.

What's next?
I see three possible outcomes to this situation. First and most obviously, Alcatel can continue down the path it's heading, hit UBS' $0.78 price target, then Bernstein's $0.60... then continuing plummeting into bankruptcy. If that's a view you share, then the company makes an attractive short candidate.

Alternatively, Alcatel could turn it around. If management succeeds in cutting $1.6 billion from its annual butcher's bill, that would be enough to turn Alcatel into a solidly profitable operation, and one that, presumably generating more than $1 billion a year in positive free cash flow, is a screaming bargain at today's $2.3 billion market cap.

The third option -- and the one I'm going with -- is the middle road. Alcatel's promised turnaround, like other best-laid-plans, doesn't work as well or as quickly as promised. But it does make some headway, and Alcatel postpones its day of reckoning by issuing shares and warrants to raise additional capital and buy itself time to survive. Shareholders thereby avoid the disaster scenario of their shares "going to zero." They are, however, badly diluted in the process.

Diluted enough to drive this $1 stock down to $0.60 a share? Yes. It's entirely possible this is the way it works out.

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