This Just In: Upgrades and Downgrades

Editor's note: A previous version of this article stated that Cliffs Natural Resources had already cut its dividend. The Fool regrets the error.

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.

Trouble in steeltown
The natural resources rout continues. Last week, two separate analysts -- first Davenport, then RBC -- announced downgrades of Cliffs Natural Resources. A third analyst, BMO Capital Markets this time, declared the mining stock a "high-risk iron play" and warned that Cliffs' current level of dividend payments is "not sustainable," predicting that a cut in the payout from $0.625 per share to perhaps $0.28 a share could be in the offing.

This week, pessimism is swimming farther downstream, and infecting the users of iron ore. Specifically, steelmakers. More specifically, U.S. Steel .

Yesterday, Longbow Research announced that it's cutting America's premier steelmaker to "underperform" -- analyst talk for "sell." According to the analyst, demand for steel products (and consequently, for iron ore) is looking to be "flat-to-lower" in the near term. This has Longbow thinking that U.S. Steel shares should be selling for closer to $17, than the $21 and change they currently fetch.

Is Longbow right about that?

Survey says...
Not to hear The Wall Street Journal tell it. In an article last week, the Journal noted that steelmakers have recently been instituting increases in spot prices for their product. And while buyers aren't paying the full 15% price hike (on average) demanded, they are paying about 10% more than pre-hike prices -- about $644 per ton.

As the Journal tells it, this marks "a modest recovery for a battered industry," which has seen ArcelorMittal post "a larger-than-expected $709 million loss" in Q3, smaller AK Steel a disheartening $60.9 million loss, and Nucor a positive profit, but one down nearly 40% from what it was earning a year ago.

In contrast, U.S. Steel is actually looking relatively healthy, according to the Journal, having just reported a $44 million quarter, in which profits were double what it earned in last year's Q3. Is that the kind of performance, an investor might ask, that deserves a sell rating from Longbow?

Actually, yes. It is.

Valuation matters
Here's why, in a nutshell. U.S. Steel doesn't operate in a vacuum. If rival steelmakers are struggling to make a living, they're likely to be quite flexible on price, and willing to accept lower (read: "worse") profit margins in order to keep their factories operating. That won't be good news for U.S. Steel, which will have trouble keeping its own prices, and profits, rising in the face of industry prices moving the other way.

And U.S. Steel doesn't have a lot of room to maneuver here. While it's true that it is generating cash again (and for the first time in four years), the company's not really as cheap as its 12.1 price-to-free cash flow ratio might suggest. You see, four years of continuously burning cash have left U.S. Steel mired in debt -- $3.4 billion net of what little cash it has on hand. Speaking of which, the company is probably more properly valued with this debt in mind, as an "enterprise" with a value more than 25 times the $260 million in cash it generated over the past year.

That would be fine, of course, if the economy were booming, steel customers buying, and steelmakers like U.S. Steel growing their profits at a strong, double-digit clip. Problem is, most analysts agree that the fastest we can expect USX to grow over the next five years is about 6.5% annually -- a rate far too slow to justify the stock's 25 EV/FCF ratio. (Not to mention its infinity-times-earnings P/E ratio).

Foolish takeaway
In short, there's a big difference between the "modest recovery" and the "stopped slide" in steel prices that the Journal says it sees, and the kind of gangbusters growth that's needed to justify U.S. Steel's share price. Absent faster growth, Longbow is right: U.S. Steel's share price must fall.

With the U.S. relying on the rest of the world for such a large percentage of our goods, many investors are ready for the end of the "made in China" era. Well, it's arrived, and with the balance of manufacturing power shifting yet again, you can profit with the "3 Stocks to Own for the New Industrial Revolution." They're the biggest industry disruptors we've seen since the personal computer, and you can read more about them in our free analyst report. Click here to learn more.

The article This Just In: Upgrades and Downgrades originally appeared on Fool.com.

You can find Rich on CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 274 out of more than 180,000 members. The Motley Fool owns shares of ArcelorMittal. Motley Fool newsletter services recommend Nucor. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.