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 best ...
I'm afraid I have bad news for investors in AboveNet (NAS: ABVT) . Bad news, too, for owners of Level 3 Communications (NAS: LVLT) and its new BFF, Global Crossing (NAS: GLBC) . All of your stocks just got downgraded -- and that's not even the worst news.
The worst news is that the analyst doing the downgrading is none other than DA Davidson. And when it comes to picking diversified telecommunications services stocks, DA Davidson is one of the savviest stock pickers in the business -- and it thinks none of your stocks are worth buying anymore. Let's get right to why not.
Starting from the "top," Davidson worries that bullish sentiment for AboveNet is no longer warranted because IT budgets are about to get cut in 2012. According to the analyst, telecom service companies tend to lag the economic cycle. As a result, the analyst can't yet point to a specific warning sign portending doom for this sector. Call it more gut instinct -- but instinct based on fact. Davidson notes, for example, that AboveNet gets one-third of its revenue from the financial services industry. Considering the well-publicized difficulties companies such as Goldman Sachs (NYS: GS) and Bank of America (NYS: BAC) are experiencing these days, this could pressure their IT budgets, and accordingly, AboveNet's income.
The worries are similar, but in a different location for Global Crossing. Here, Davidson fears economic weakness in Latin America and the U.K. That's not as worrisome for Global Crossing today as it was before Level 3 offered to buy it. But it's still not good news.
Speaking of Level 3, Davidson warns that as IT budgets contract, so too will the "multiples" investors are willing to pay for telecom industry earnings. While I personally am more worried about the effect Netflix's (NAS: NFLX) pricing plan revamp will have on data traffic flowing through Level 3, it's simple overvaluation in the industry that Davidson is focusing on at Level 3. The analyst agrees that the company's merger with Global Crossing will create $300 million in cost "synergies," yet Davidson still feels that Level 3's 7.7-times EBITDA valuation is too high for the economic times we're entering, and believes a 5.6-times EBITDA ratio is more appropriate.
Let's go to the tape
Should this worry you? In a word: Yes. You see, when I called Davidson one of the savviest stock pickers in the business, I wasn't just whistling Dixie. We've been tracking this analyst's performance for well over three years here on CAPS. And, according to our data, DA Davidson isn't just a "good" stock picker, outperforming 85% of the investors we track. It's darn near infallible when it comes to diversified telecom services stocks like AboveNet, Global Crossing, and Level 3.
Since 2008, this analyst has made six picks in the industry, gotten five of them right -- and outperformed the S&P 500 (and the Dow Jones Industrial Average (INDEX: ^DJI), for that matter) on each and every company it's ventured an opinion on: PAETEC? Beat the market by 66 percentage points. TW Telecom? Beat it by 63 points. For that matter, Davidson scored a 93-point margin of victory on Global Crossing itself!
Foolish final thoughts
With a record such as the one Davidson boasts, I suspect investors already have more than enough reason to avoid Level 3, Global Crossing, and AboveNet today. But just in case you're not willing to listen to Davidson's say-so (and good for you for showing some healthy skepticism), here are a few final facts to consider.
Level 3 has lost money for five years straight, and burned cash in four of those five years. Global Crossing has done better, and will now be folded into Level 3, improving the business. Still, Global Crossing costs nearly 100 times free cash flow today. That's a high price to pay for incremental improvement.
For its part, AboveNet's profitable, but it's still burned cash in three out of the last five years, generates less free cash flow today than it claims as "net income," and sells for 28 times its free cash flow. Even if Davidson is wrong about AboveNet's growth rate coming down, the 18% long-term growth most analysts expect still isn't enough to justify the stock price.
My advice: Take DA Davidson's advice. Stay away from these stocks.
At the time thisarticle 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. 437 out of more than 180,000 members. The Motley Fool has adisclosure policy.The Motley Fool owns shares of Bank of America.Motley Fool newsletter serviceshave recommended buying shares of Netflix.Motley Fool newsletter serviceshave recommended buying puts in Netflix.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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