Is Portugal Telecom Destined for Greatness?

Every investor can appreciate a stock that consistently beats the Street without getting ahead of its fundamentals and risking a meltdown. The best stocks offer sustainable market-beating gains, with improving financial metrics that support strong price growth. Let's take a look at what Portugal Telecom's (NYSE: PT) recent results tell us about its potential for future gains.

What the numbers tell you
The graphs you're about to see tell Portugal Telecom's story, and we'll be grading the quality of that story in several ways.

Growth is important on both top and bottom lines, and an improving profit margin is a great sign that a company's become more efficient over time. Since profits may not always be reported at a steady rate, we'll also look at how much Portugal Telecom's free cash flow has grown in comparison to its net income.

A company that generates more earnings per share over time, regardless of the number of shares outstanding, is heading in the right direction. If Portugal Telecom's share price has kept pace with its earnings growth, that's another good sign that its stock can move higher.

Is Portugal Telecom managing its resources well? A company's return on equity should be improving, and its debt-to-equity ratio declining, if it's to earn our approval.

Healthy dividends are always welcome, so we'll also make sure that Portugal Telecom's dividend payouts are increasing but at a level that can be sustained by its free cash flow.

By the numbers
Now, let's take a look at Portugal Telecom's key statistics:

Source: PT Total Return Price data by YCharts.

Source: YCharts. * Period begins at end of Q3 2009.

Source: PT Return on Equity data by YCharts.

Source: YCharts and Morningstar . * Period begins at end of Q3 2009.

How we got here and where we're going
This is one of the worst scores any stock can get, and Portugal Telecom is saved from earning a complete goose egg only because of its lower debt levels relative to its equity. Nothing else is moving in the right direction. The company even failed to earn a passing grade by sustaining higher levels of free cash flow than net income -- something that should be easy for a telecom.

Contrarians might point to Portugal Telecom's position in Brazil and China, but thus far, that hasn't been enough to offset the slow but unstoppable decline in Portugal itself. In the company's third-quarter earnings call , it was revealed that Portugal-sourced revenue had fallen 6.7% year over year, notwithstanding a 4.1% increase in residential revenue.

Portugal Telecom would seem to be the ideal company to move into Brazil, what with the shared culture and language, but according to a Brazilian telecom analysis, the current market share breakdown looks like this:

Sources: Teleco Brazil and corporate sites.

Portugal Telecom owns a fifth of the fourth-place telecom. More importantly, it has a weaker position from which to compete. Here's a breakdown of these four competitors on a cash flow and capital expenditure basis:

Source: Morningstar. Numbers are for trailing 12 months.

The only telecom that's even close to Portugal Telecom's spending is Telecom Italia, and it generates over 14 times as much in free cash flow. Diversification is good if a company can diversify defensibly, but with this sort of competition, Portugal Telecom is going to have its work cut out for it in Brazil.

Putting the pieces together
Today, Portugal Telecom has very few of the qualities that make up a great stock, but no stock is truly perfect. Digging deeper can help you uncover the answers you need to make a great buy -- or to stay away from a stock that's going nowhere.