This Just In: Upgrades and Downgrades

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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.

Is U.S. Steel a rust bucket?
Last week, I called steel mini-mill operator Nucor (NYS: NUE) "the only steel stock I'd even consider owning at today's prices." Yesterday, at least one analyst agreed with me. Initiating coverage on a quartet of steel stocks, ace investment banker Wells Fargo praised Nucor for its strong dividend yield, which pays investors to be patient as they await a turnaround in steel pricing. Meanwhile, the analyst argues that Nucor's strong "balance sheet ... lean cost structure, and product diversification" will enable it to weather the storm and reward investors on the other side.

Wells quickly rejected the other steel stocks it examined as unsuitable for investment today.

  • AK Steel (NYS: AKS) faces competitors with "lower cost structures and cleaner balance sheets."
  • Steel Dynamics (NAS: STLD) is in "a challenging pricing environment which we expect to pressure margin and earnings through 2012."
  • Meanwhile, U.S. Steel (NYS: X) is burdened with "a high cost structure, direct exposure to Europe, and weak balance sheet."

Accordingly, Wells rated these three stocks only "market perform." At the same time as Wells was saying this, another brand-name banker on Wall Street was going even further. On Tuesday, Goldman Sachs argued that not only should you not buy U.S. Steel today. You should give serious consideration to selling the shares (if you own them), and perhaps even selling them short (if you don't).

Goldman versus U.S. Steel
Goldman thinks U.S. Steel will fumble badly when it reports earnings next week. According to the analyst, "2H-2011 consensus estimates for X are too high and company's qualitative guidance for 4Q will disappoint the market, driving the stock down." Nor will U.S. Steel bounce back anytime soon. Steel supply continues to exceed steel demand, which in Goldman's opinion means steel prices will remain depressed for some time. Consequently, not just 2011 estimates, but 2012 estimates as well, are probably "too optimistic."

Is Goldman right?
I don't know. Really, I don't. I mean, it's clear that things are rough out there for the steel industry. (And not just steel -- Alcoa's (NYS: AA) report last week was pretty scary, too.) Just this morning, TheWall Street Journal ran an article discussing a global slowdown in steel demand, and production cutbacks by the steelmakers, which it blamed in large part for the sagging stock prices at met-coal producers Cliffs Natural Resources (NYS: CLF) and Alpha Natural Resources (NYS: ANR) .

That sure sounds bad, but it's hard to say exactly how bad, or how badly the slump in steel demand will hurt USX's profits in the second half of 2011 -- much less 2012. What I do know, is that the numbers U.S. Steel is currently putting up don't justify the stock's price.

Low expectations, lower prospects
Yahoo! Finance currently puts U.S. Steel at about 6.2 times forward earnings. And yes, that's a cheaper valuation than you'll find at AK Steel, Steel Dynamics, or Nucor. But I still don't think it's cheap enough.

Why not? Well, Wall Street analysts on average predict that U.S. Steel will grow its earnings at 8% per year for the next five years. (How you "grow" earnings that are currently negative is a trick I still haven't figured out.) But even if we take this prediction at face value, it may not hold water. Consider: According to the World Steel Association, global steel demand is expected to rise only 6.5% this year, then decelerate further to 5.4% in 2012.

Now, if you think U.S. Steel is a superior quality steel company, it's possible to envision a scenario in which U.S. Steel grows at 8% when the rest of the world doesn't. Problem is, U.S. Steel earns gross profit margins less than one-third that of the average steelmaker in this industry. To me, this means U.S. Steel is an inferior steel company, rather than a superior example of the industry. It means the 8% growth projection is unlikely. And it means Goldman Sachs is right to recommend selling the stock.

Looking for ways to diversify and hedge your bets beyond a single-industry steel focus? Read our free report on3 ETFs Set to Soar During the Recovery.

At the time this article was published Fool contributorRich Smithdoes not own shares of any company named above.You can find him on CAPS, publicly pontificating under the handleTMFDitty, where he's currently ranked No. 324 out of more than 180,000 members. The Motley Foolhas adisclosure policy.The Motley Fool owns shares of Nucor.Motley Fool newsletter serviceshave recommended buying shares of Nucor.We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors.

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