This Just In: Upgrades and Downgrades

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.

Introducing: a quartet of "Capital" oil stock ideas
So far this year, Kodiak Oil & Gas (NYSE: KOG  ) has lost 21% of its value -- or, to look at it another way, has become 21% cheaper to own. Despite the lower price, though, most investors looking at the stock earlier this week shrugged off the discount and wandered off across the oil patch in search of better bargains.

Most -- but not all.

Yesterday, analysts at oil and gas specialist Capital One Southcoast decided -- with a hearty cry of "Yukon, ho!" -- that Kodiak was finally too cheap to resist. Upgrading it to "add," alongside fellow oil plays Noble Energy (NYSE: NBL  ) , Comstock (NYSE: CRK  ) , and Rosetta Resources (Nasdaq: ROSE  ) , it's apparent the folks at Southcoast believe there's oil in them thar hills and now is the time to go drilling for it. Are they right?

A question for the ages
I actually looked at a similar situation with respect to Kodiak toward the end of last year -- and came to the conclusion that no, the analysts who sang Kodiak's praises then were not right at all. The stock was too expensive even under the rosiest of circumstances and downright dangerous, should all have gone other than perfectly well. (And yes, I put my reputation on the line and publicly gave Kodiak the big ol' red thumbs-down on Motley Fool CAPS.)

It turns out I was right to do so. Priced at $9.66 on the day that article ran, shares of Kodiak can today be had for the much more modest sum of $8 -- and that's after the stock enjoyed a 6% bounce on news of Southcoast's endorsement. Still, it's been nearly six months. Perhaps something has changed? Perhaps now, 14% cheaper than it was when I last panned it, Kodiak has finally become a bargain.

I'm a reasonable Fool. I'm willing to give Kodiak another chance. So let's look at the numbers as they stand today and find out what they're telling us.

Kodiak Oil & Gas by the numbers
Right off the bat, Kodiak presents us with a quandary. The stock sells for 136 times trailing earnings but only 7.4 times next year's "forward," or estimated, earnings. This stark contrast in P/E ratios allows Kodiak bulls to argue that the stock's a screaming buy, because analysts say it will grow earnings 50% per year over the next five years, and, that means the PEG ratio is only 0.25.

To which I reply: Sounds too good to be true! (And it is.)

Kodiak will take a dive
So here's the most important thing you need to know about five-year earnings estimates, folks: You know that first year? The one where Kodiak is supposed to earn so darn much profit that its P/E is going to drop down to seven? Well, that first year is part of the "five years." And Kodiak's move from $0.06 in trailing earnings toward $1.05 in (projected) fiscal earnings will cannibalize the 50% annual growth investors are counting on over the next half-decade.

This is the reason why you have to be so careful when investing based on PEG ratios. If you use the wrong P/E, you may think you're getting an incredible bargain PEG of 0.25 (which Kodiak isn't), but instead wind up owning a god-awful PEG of 2.7 -- which Kodiak is.

Kodiak and the rest
The reasons outlined above, I think, explain why I'm still bearish on Kodiak's prospects. But the fact that Kodiak burned $1.1 billion in negative free cash flow last year and has never produced positive free cash flow for a full fiscal year certainly makes me no more confident in the company's chances.

Incidentally, that's why I'm no more sanguine about the prospects for Comstock, Rosetta, or even Noble Energy. Sure, Rosetta and Noble at least sport low P/E ratios of around 20 and strong growth rates. But none of these stocks is currently generating the kind of cash flow needed to fund its own operations. Each and every one of them is burning cash.

Foolish final thought
If you want to help these companies out of this jam they're in and send them a bit of your cash to tide them over, it's a free country, and nobody's stopping you. (But I would advise against it.) A better idea might be to check out a few of the companies singled out in our recent report, "3 Stocks for $100 Oil." This report is free for download today, but it won't be for long. If you'd like to see the picks, make sure to click quick.

Fool contributor Rich Smith does not own shares of, or short, any company named above. You can find him on CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 325 out of more than 180,000 members. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.


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