Tuesday's Top Upgrades (and Downgrades)

Motley Fool

This series, brought to you by Yahoo! Finance, looks at which upgrades and downgrades make sense, and which ones investors should act on. Today, our headlines feature a pair of diverging ratings -- one up, one down -- for copper miners Freeport-McMoRan (FCX) and Southern Copper (SCCO) . Also, a downgrade just got delivered to topsy-turvy trucker YRC Worldwide (YRCW) . In fact, let's start with that one...

Horizons shrink for YRC Worldwide
Trucker YRC Worldwide has been on a pretty wild ride these past 12 months, soaring from below $7 levels to pass $35 a share on hopes that the company would soon restructure its debt and return to financial health. Then it plunged down close to $7 in November, before bouncing back on (renewed) hopes for a pay down of debt and a resurgence in profit earlier this month.

News that the company's Teamsters union rejected an extension of its depressed-wages contract last week, however, has shaved away a lot of the gains that YRC had recently enjoyed, and according to the bankers at BB&T Capital, the stock's become a lot less attractive in consequence. This morning, BB&T announced that it has downgraded the stock to hold, and stripped away its previous price target of $20.

As of today, BB&T has no official opinion on what the stock should cost -- but investors do. Responding to the downgrade, they've decided YRC is worth 3.4% less than it was before BB&T removed its price target. Are they right?

It's hard to say. As I explained last month, a "successful" union vote does have the potential to save YRC. By converting $300 million of debt into equity, YRC could conceivably cut its annual interest expense by enough to turn the company free-cash-flow positive -- giving it the ability to "snowball" its debt, paying it down at an accelerating rate as free cash flow improves. Unless and until the Teamsters approve their contract, however, the stock remains unprofitable, free cash flow negative, deeply mired in debt, and... not a great stock to buy.

Value at Freeport: All mined out?
A second stock getting the old heave-ho from Wall Street today is copper miner (and gold miner, and oil producer) Freeport-McMoRan, just downgraded to market perform at FBR Capital. According to FBR, there was a "valuation gap" at Freeport after the company got hit with negative sentiment from its purchase of oil producers Plains Exploration and Production and McMoRan Exploration in December 2012. As the stock regained $10 from its June 2013 lows around $26, however, that gap has closed, and FBR sees the stock as less attractive today.

I agree. Sure, priced at only 13 times earnings today, Freeport certainly looks cheap enough, but looks can be deceiving. For one thing, Freeport's P/E doesn't reflect the size of its $18.9 billion net debt load. Valued as an "enterprise" rather than on its market cap, the stock's EV ratio to earnings would be closer to 22. Worse, because Freeport generates so much less real free cash flow ($409 million) than it claims as net income ($2.7 billion), the company's enterprise value to free cash flow ratio is a staggering 147.8.

With most analysts agreeing that Freeport will be hard-pressed to grow its profits much faster than 11% per year over the next five years, neither of these valuations looks defensible to me. I think Freeport's share price is headed for a fall -- and I think FBR is right to warn investors away from the stock before that happens.

Southern Copper: Heading north?
At the same time as it panned Freeport-McMoRan, FBR praised its rival Southern Copper, arguing that the company is poised to nearly double copper production to 1,145 kilotons from 2013 levels through 2017, while the stock's valuation has become "attractive."

StreetInsider.com quotes the analyst worrying about "production growth/dividend cut risk," but arguing that this risk has been fully priced into the stock already. With Southern Copper today selling for a P/E ratio nearly as low as that at Freeport (13.8), but growing a bit faster (11.4% annualized), and sporting a much lower debt load (about $2 billion, net of cash), FBR seems to think the company offers a better bet on copper demand than what we find at Freeport.

To an extent, I agree with this thesis as well -- but not entirely. You see, whereas Freeport-McMoRan currently generates far less real free cash flow than it reports as net profit, Southern Copper generates ... no free cash flow at all. To the contrary, despite reporting profits of $1.7 billion over the past 12 months, Southern Copper has actually burned about $2.1 million in cash -- essentially breakeven results.

Were this a momentary aberration, I'd be more inclined to give the company the benefit of the doubt. But in fact, Southern Copper's cash flow statements show that over the past five years at least, the company has consistently reported higher "accounting profit" than it's collected in actual cash profit. For this reason, and despite FBR's endorsement, I cannot recommend the stock. Southern Copper is no buy. It might even be a sell.

Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool owns shares of Freeport-McMoRan Copper & Gold.

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