Wednesday'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 upgrades for two of the world's largest steelmakers Steel Dynamics (NASDAQ: STLD  ) and ArcelorMittal (NYSE: MT  ) . Elsewhere in the industrial sphere, though...

Eaton is going down...
Proving that no good deed goes unpunished, we begin the day with a downgrade for industrial electrical products producer Eaton Corp. (NYSE: ETN  ) . Eaton reported an earnings beat yesterday, topping analyst expectations of $1.06 per share by a couple of pennies. Its reward this morning, though, is to get hit by a downgrade to neutral from MKM Partners.

Why?

Part of the reason, one suspects, is the fact that Eaton guided investors to expect only about $1 per share in earnings this current fiscal Q1 2014 -- and predicted full-year earnings will range around the $4.70 level. Compared to analyst expectations of $1.03 and $4.88, respectively, Eaton thus looks likely to "miss" earnings over the course of this year. That along is probably sufficient to justify the downgrade.

But there are even more reasons to avoid the stock, other than just the fact that one analyst no longer likes it. Valuation, for example. Eaton currently trades for roughly 20 times earnings, which would be expensive even if the company succeeded in hitting analyst targets for 12% long-term earnings growth. Now, Eaton is telling us that it expects to grow slower than the analysts were hoping for. As a result, this already expensive stock is looking even pricier. MKM is right to downgrade it.

... but Steel Dynamics is going up?
Next up: Steel Dynamics. This time, shareholders are treated to what seems, at first glance, to be better news. To wit, analysts at Jefferies & Co. have come out with a late-breaking upgrade in response to Steel D's Q4 earnings report featuring better-than-expected revenues ($1.9 billion) that produced merely the anticipated level of earnings ($0.24 per share).

When Steel Dynamics reported these numbers last week, CEO Mark D. Millett boasted that his company "continued to perform at the top of our industry during 2013, both financially and operationally," growing pre-tax income "29%" in 2013. Jefferies seems to agree: "The recent -18% pullback in STLD's valuations [since mid-January] offers investors an attractive entry point into one of the more favorable stories in N.A. steel," confides Jefferies. And the analyst especially likes the company's record of producing what it calls "consistently strong FCF."

But I disagree.

The problem with Steel Dynamics is that it does not in fact produce "strong FCF," either consistently or otherwise. Free cash flow at the company was only $125 million over the past year. That number is down significantly from 2012 FCF production, and down even further from 2011 levels. The $125 million in cash profit that Steel Dynamics produces today represents a level of profitability only 66% of what is reflected in the company's GAAP income statement.

Accordingly, the stock's 19 P/E ratio overstates the company's true profitability -- which is better described by its enterprise value-to-free cash flow ratio: 43. That's too rich a valuation, even if the analysts are right about Steel Dynamics being able to grow its profits at 27% annually over the next five years. The stock's expensive, and Jefferies is wrong to recommend buying it.

... and ArcelorMittal is going up, too?
And finally, we come to perhaps the strangest analysts move of the day: HSBC's decision to upgrade shares of world's biggest steelmaker ArcelorMittal. This morning, HSBC moved Arcelor up one notch to overweight. Investors are responding to the news by bidding up Arcelor shares strongly -- more than 1.1% on a day when many other stocks are still tumbling.

Problem is, I'm not at all certain they're right to do so.

Unprofitable Arcelor lost more than $3 billion in 2012. At last report, it wasn't doing much better in 2013, with losses for the past three reported quarters exceeding $1.3 billion. Free cash flow was nearly as bad, with Arcelor running $833 million in the red over the first nine months of 2013.

Granted, most analysts agree that things are looking up for Arcelor. Yahoo! Finance consensus estimates have the company growing its profits at 52% annually over the next five years. S&P Capital IQ backs up this seemingly wild claim with an estimate of 51% long-term growth. All that being said, though, the company isn't actually producing any profits right now. And it's hard to know what to make of predictions of strong growth in profits that a company isn't actually earning yet.

For the time being, I'm going to have to disagree with this upgrade as well. While Arcelor stock might be worth a small speculative position, it's not at all clear yet that it is a buy.

Rich Smith has no position in any stocks mentioned, and neither does The Motley Fool.


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