Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

Lithium miner Livent (NYSE:LTHM) beat earnings by a bit last week, sending its shares soaring 34%. Now that the initial enthusiasm has worn off, however, Wall Street is taking a closer look at what Livent reported -- and what it said about guidance -- and at least one analyst doesn't much like what it sees.  

In fact, investment banker Merrill Lynch dislikes Livent so much that this morning, it downgraded Livent stock to underperform (the equivalent of a sell rating) and cut its price target from $10 a share to just $7.

Here's what you need to know.

Lithium spodumene rock

Image source: Getty Images.

What Livent said

Livent reported profits of $0.11 per diluted share for its fiscal second quarter 2019 last week, and adjusted earnings of $0.12 per share, which was $0.01 better than Wall Street had expected.  

Revenue came in at $114 million, which was up 6% year over year. Though earnings beat estimates, they were down dramatically. From $0.31 a year ago to $0.11 earned in Q2, Livent suffered a staggering 65% decline in net profitability. How did that happen?

The income statement tells the tale. Despite revenue rising gradually, Livent's "cost of sales" exploded 48% higher as the company's commitments to supply lithium to its customers far outran its ability to mine the stuff, and Livent was forced to buy lithium from third parties to fulfill its supply commitments. That pricey necessity was the prime factor causing profits to crash last quarter.

What Merrill Lynch said about that

And yet, judging from investors' reaction to the news, you'd almost think they're feeling this is a good problem to have: So much demand for Livent's product that it can't mine the stuff fast enough? Hurray! Let's bid it up 34%!

Not so fast, though, says Merrill Lynch. While demand for lithium may look robust today, and Livent management has promised to "debottleneck" its Argentine operations to produce "as much as 1,000 incremental tons of [lithium carbonate equivalents] on an annual basis," supply isn't the major concern for lithium miners. Instead, Merrill worries about demand.

Livent (and others) are working hard to ramp up production. Indeed, the company's cash flow statement shows that capital spending in the first half of this year nearly tripled over money spent in the first half of last year -- $74.2 million in capital investment, versus just $41.3 million in cash generated from operations.

But with Livent (and its peers) spending so much to try to ramp up production, they may end up producing more lithium than the market can absorb. Ultimately, explains TheFly.com in a note covering Merrill's report, the problem is that "the lithium hydroxide market for electric vehicles may not have enough growth to absorb the new capacity coming over the next 6-12 months."

The upshot for lithium investors

And that right there is the issue in a nutshell. To alleviate a situation of not being able to produce enough lithium on its own today, Livent is spending itself into a hole, generating negative free cash flow, and all in furtherance of ensuring that it can produce...more lithium than the market will want to buy in a year or so.

As a result, after three straight years of careful financial stewardship that saw Livent at least generate positive free cash flow from rising sales (if not quite so much free cash flow as it was claiming for its net profit "earnings"), data from S&P Global Market Intelligence now confirms that Livent is in a position where it's still growing sales, but burning cash to do so.

So what does this mean for investors?

Livent's guidance for the rest of this year shows that management still believes it can hit its target of generating between $0.56 and $0.66 per share in adjusted profit on sales of between $435 million and $475 million. Investors seem to like this news.

However, management made no promises about generating positive free cash flow from these sales. To the contrary, CEO Paul Graves warned that "the average realized price that we see in those contracts for hydroxide and in our forecasts will be down ... at least double-digit percent in our guidance expectations," which suggests that Merrill Lynch may be onto something when it warns of waning demand. (Because if demand were to remain strong, you'd expect customers would have to pay more.)

This is why, in contrast to other investors who found Livent's forecast reassuring last week, I think you're better off watching the trend in the company's actual free cash flow, and spend less time worrying about whether Livent beats or misses guidance for making sales that only serve to burn more cash.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.