Friday's Top Upgrades (and Downgrades)

This series, brought to you by Yahoo! Finance, looks at which upgrades and downgrades make sense, and which ones investors should act on. Today, our headlines feature new buy ratings for two of the biggest steelmakers in the world -- U.S. Steel (NYSE: X  ) and ArcelorMittal (NYSE: MT  ) . But before we get to those two, let's take a quick look at...

Who's downgrading United Technologies now?
As you may have heard by now, industrial conglomerate United Technologies (NYSE: UTX  ) released its earnings forecast for the rest of this year last night -- and the news wasn't great. While United Technologies is pretty sure it can top out its previous earnings guidance of $6.10-$6.15 per year, analysts were apparently expecting a "beat by a penny" performance, and looking for $6.16 a share. United Technologies says that isn't going to happen -- and one analyst at least is not pleased.

This morning, banker William Blair pulled its outperform rating on the stock and downgraded to market perform. Sadly, it's probably right to do so.

Don't get me wrong -- as a business, I think United Technologies is in fine fettle. The problem here, quite simply, is that the stock costs too much for the earnings it's likely to produce. Currently, United Technologies shares cost 15.6 times earnings. Analysts are expecting earnings to grow at 13.2% annually over the next five years, and management appears to believe it can come close to that target, if perhaps not actually exceed it.

However, United Technologies' "earnings" aren't quite all they're cracked up to be. Free cash flow at the firm fell short of $4.6 billion over the past 12 months -- a far cry from the firm's reported $6.3 billion GAAP profit. Factor in a sizable debt load of $16.6 billion (net of cash), and viewed conservatively, what we're looking at here is less of a 15.6 P/E "stock" than an "enterprise" valued at more than 25 times free cash flow.

To me, that seems too high a price to pay for 13% growth. And that's if United Technologies can even grow that fast... which apparently, it doesn't think it can. Therefore, I agree that William Blair is right to downgrade it.

But that's where my agreement with Wall Street ends.

Finding faults in steel
Turning now to the day's "good" news, we find investment banker Cowen & Co. issuing upgrades both left and right to rival giants U.S. Steel and ArcelorMittal. As described today on Barron's website, the basic theory here is that the economies of both Europe and the U.S. are "accelerating," a trend which will increase both demand for steel products (revenue growth) and the prices that steel companies can charge for these products (profit margins).

Granted, greater demand for steel equals greater demand for the inputs needed to manufacture steel (cost of goods sold). But Cowen thinks investors can mitigate this risk by sticking to buying shares of companies that are "vertically integrated." As the analyst explains: "[We] prefer mills with greater flat rolled operating leverage and those with vertical integration. Strengthening demand and an accelerating global economic recovery should enable producers with excess capacity to capture latent earnings. On the other hand, non-vertically integrated mills will likely face a margin squeeze from elevated iron ore prices ... [and] rising scrap prices in the near-term."

Which sounds good in theory. But before following Cowen's advice and buying these companies, consider the price tags.

U.S. Steel
Unprofitable today, and priced at close to 25 times what analysts think the company might conceivably earn next year, U.S. Steel shares look overpriced relative to S&P Capital IQ estimates of 6.5% long-term-earnings growth.

Worse still, U.S. Steel is lugging around $3.2 billion in net debt. Factor this debt load into the picture, and the shares really cost something closer to 45 times next year's putative earnings. Finally, if you value the company on the free cash flow that it actually does produce today ($83 million over the past 12 months), rather than the earnings that it may or may not produce tomorrow, you end up with an enterprise value to free cash flow ratio of 86 -- which is even more out of whack with the growth rate.

Long story short, I'd rather be short this one than long.

Arcelor
But what about ArcelorMittal, U.S. Steel's European archrival? Here, the situation's both better... and worse.

On the better front, analysts expect Arcelor to grow a whole lot faster than U.S. Steel over the next five years, averaging an annual growth clip of better than 31%. Arcelor also already generates a whole lot more free cash than does U.S. Steel. Free cash flow at the Luxembourger steel giant approximated $929 million over the past year.

Unfortunately, with great free cash flow comes a great big pile of debt at Arcelor -- even more debt than U.S. Steel can boast. Net of cash, Arcelor is up to its hips in $17.6 billion of debt. Divide current free cash flow into the firm's $47.9 billion enterprise value, therefore, and you end up with an enterprise value to free cash flow ratio nearly as bad as U.S. Steel's -- 51.5.

Result: While Arcelor's superior projected growth rate suggests it's probably a safer bet than U.S. Steel, I really don't think either of these stocks offers a whole lot of value for investors' money. If it were me doing the picking, I think I'd prefer a minimill operator like Steel Dynamics (NASDAQ: STLD  ) over either of these integrated firms. With $241 million in trailing free cash flow, it's a better cash producer than U.S. Steel. And with a growth rate projected at 25%, it's growing nearly as fast as Arcelor. Combine these facts with a dividend yield superior to both U.S. Steel's and Arcelor's, and I think Steel Dynamics is the stock to beat.

Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 


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