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 UBS upgraded shares of Alcatel-Lucent (NYSE: ALU) yesterday, investors shrugged -- but they're not shrugging anymore. Already today, Alcatel shares were up as much as 2%, and significantly ahead of the broader market. So who was right? Investors yesterday, who ignored UBS's bullish comments on the company, or investors today, who seem to be taking them to heart?

According to UBS, Alcatel is all set to report its "highest-ever post merger margin in Q4." Granted, much of this owes to the firm's "high-margin CDMA business," which UBS expects will suffer a slow "eventual decline." There's also the risk that Alcatel fails to deliver on "cost savings." But UBS doesn't care about any of that: "Our checks and mix analysis provides comfort in the near-term."

"Near term"?
So much for Wall Street's focus on long-term investing. At UBS, it seems that investing is all about tomorrow. If things fall apart a week from Tuesday, so be it. (Actually, UBS says Alcatel's probably safe through 2012, but you get the point.)

For now, UBS is focusing on Alcatel's 10% decline in stock price since early May. UBS blames it on "cautious comments from Juniper (Nasdaq: JNPR), Finisar (Nasdaq: FNSR), and Ciena (Nasdaq: CIEN)" -- and, one presumes, from Cisco as well. Yet UBS thinks Alcatel's price is cheap enough to justify buying, based on "improving margins and robust growth trends" in the short term.

Let's go to the tape
Is that really the right way to play Alcatel, though? I'm all for grabbing quick profits when they're offered. But UBS's record in the Communications Equipment industry doesn't really support its ability to successfully time the market:

In the CommEquip industry, UBS has established a record of getting nearly twice as many picks wrong as it does right. The analyst underperformed the S&P 500 by a combined 104 percentage points in the process. Not exactly inspiring.

End on an up note
Speaking of uninspiring, I can't help but note that despite UBS's optimism about improving GAAP profit margins, at last report Alcatel was still frantically burning cash. For the 12 months ending in March, the company had annualized cash burn of approximately $470 million. Of the rivals named above, only Ciena is in a similar cash-burning state -- everyone else is currently generating at least some free cash flow from their operations. Everyone but Alcatel (and Ciena).

Personally, I have no intention of investing in Alcatel until the company proves it can generate sustainable free cash flow from its business. For that reason, I cannot support UBS's short-term, bottom-calling recommendation of the stock today. Braver Fools than I, however, may want to rush into the stock based on a couple of optimistic data points:

• First, while still burning cash, Alcatel is at least burning less cash than it did in 2010 and 2009. There's an upwards trend in its business, and if UBS turns out to be right about the stock, I suspect it will be because free cash flow turns the corner.
• Second, contributing to the better FCF picture, Alcatel generated significant cash from operating in Q4 of last year -- even better than it did in Q4 2009, the last quarter in which operating cash flow was positive. So long as capex remains more or less stable, as it appears to be in most years, rising cash from ops will slowly by surely move Alcatel in the right direction.

Now, is that a full-throated "buy" thesis for Alcatel? No. But for now, it's about the best I can muster in support of the stock. Here's hoping that next quarter, Alcatel can give me something more to work with.