This Just In: More 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.

Who's hot and who's not in steel stocks
Wading into the steel sector Wednesday, Longbow Research announced a series of four new stock initiations -- three buys, and one hold. Now, there's nothing unusual about that on its face. After all, across the length and breadth of Wall Street, multiple analysts make dozens of picks (and pans) every day of the trading week.

What's significant about Longbow, though is that it's actually good at this stock picking thing. (Well, usually. As you'll see in a moment, even good stock pickers sometimes make boneheaded calls). Ranked in the top 5% of investors we track on CAPS, Longbow gets the majority of its stock picks right, and tends to outperform the market by about 11.9 percentage points per pick. That seems like statistically significant outperformance, folks. So today, let's take its picks one at a time, beginning with...

Nucor (NYSE: NUE  )
According to Longbow, one of the better steel buys out there today is mini-mill specialist, and maxi-market-cap operator Nucor. According to Longbow, checks on inventory and pricing at distributors suggest the steel market is approaching a "near-term bottom" in pricing. If second-half 2013 non-residential construction projections hold up, this could be good news for Nucor.

This is, however, a big "if." Last week, the Steel Market Update newsletter reported that market giant U.S. Steel (NYSE: X  ) has raised its base prices for all flat-rolled steel by at least $50 a short ton. According to SMU, the last time USX made a move like this, it "marked the bottom, and list prices moved higher almost immediately." AK Steel (NYSE: AKS  ) quickly followed USX's lead, announcing its prices for carbon flat-rolled steel are going up "at least" $50 a ton.

Needless to say, price hikes at competitors bode well for Nucor, offering breathing room for the company to raise its own prices, and offering the prospect of fatter profit margins for all concerned. That said, if projections don't bear out -- if the revival in steel pricing should turn out to be a mirage -- then a rally in Nucor's share price could turn into a rout.

Already, the stock looks overpriced at a P/E ratio of nearly 29, but only 8% long-term earnings growth projected. Meanwhile, free cash flow at Nucor is exceedingly weak -- barely $0.50 in FCF for every $1 the company reports as net income. Suffice it to say that a price-to-free cash flow ratio of more than 57, I'm not optimistic about Longbow's first pick.

Steel Dynamics (NASDAQ: STLD  )
Moving on then to the analyst's second recommendation, we find Nucor twin Steel Dynamics -- again, a mini-mill operator, albeit smaller in both market cap and apparent overvaluation.

Steel-D costs only about 20.8 times earnings. What's more, the company's producing much healthier cash profits than its larger rival. Free cash flow for the past 12 months came to $222 million -- 35% ahead of its $164 million in reported income. At 15 times free cash flow, growing (faster than Nucor) at 15%, and paying a 2.7% dividend yield, I'm inclined to favor Steel Dynamics.

My main reservation here is that while Steel Dynamics carries a lighter debt load than Nucor ($1.8 billion net of cash, versus Nucor's $2.5 billion net debt position), Steel-D's debt load is bigger relative to its small market cap of just $3.3 billion. So while on the surface, this stock pick looks more attractive, beware: If interest rates start rising, it could be even riskier than Nucor.

Commercial Metals Corp (NYSE: CMC  )
Riskiest of all Longbow's bets is Commercial Metals Corporation. Smaller than either Nucor or Steel Dynamics at a market cap of only $1.9 billion, the company shares Steel-D's debt "issues" as it carries more than $1 billion of debt net of cash. CMC's akin to Nucor, meanwhile, in that it's not generating nearly as much cash as you might think from reading its income statement. Free cash flow for the past year was a paltry $15 million -- barely a tenth of the company's near-$150 million in reported earnings.

Result: If Commercial Metals Corporation looks like the cheapest of the three stocks discussed so far, with a P/E ratio of less than 13, well... the stock's cheap for a reason. Between high debt and low cash production, CMC is actually the worst of the three options Longbow has recommended so far.

And U.S. Steel
Finally, and more of a side note than a recommendation, we learned from StreetInsider.com yesterday that at the same time it was upgrading its peers to full-blown buy status, Longbow upped its rating on USX to only neutral.

Why? No mystery here: Unprofitable on a trailing-12-month basis, and carrying a net-debt load fully 10% greater than its own market cap, USX looks riskier than any of the stocks Longbow actually recommended this week. That said, there are factors weighing in USX's favor.

For example, while technically "unprofitable," USX did generate $412 million in free cash flow last year. That's more than anyone else discussed so far. It's enough cash profit to give this stock a 15.3 enterprise value-to-free cash flow ratio and, if you're willing to ignore the debt (hint: Don't ignore the debt), a price-to-free cash flow ratio of only 7.1. At 8% projected growth, this latter number looks good. But honestly, while I'm not sure USX deserves to be singled out as the only steel stock Longbow doesn't absolutely love... it's still not cheap enough to deserve your hard-earned investing dollars.

Foolish final thought
If you were wondering why I gave AK Steel only passing mention in this column, don't. Alone among the five steel majors discussed so far, it's the one that's actually burning cash -- "producing" $335 million in negative free cash flow last year alone. And alone among the five, it's the only one I'd actually consider shorting.

Worried about the steelmakers yet? Want to diversify your bets? To learn more about a few ETFs that have great promise for delivering profits to shareholders in a recovering global economy, check out The Motley Fool's special free report "3 ETFs Set to Soar During the Recovery." Just click here to access it now.


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