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.

SandRidge gets drilled
It's turning into a pretty bad week to be a shareholder of SandRidge Energy (NYSE: SD  ) -- or anything named "SandRidge," for that matter. On Monday, analysts at Ladenburg Thalmann announced they were downgrading shares of SandRidge to neutral, and cutting their price target to $7 a share. Yesterday, a second analyst -- JPMorgan this time -- added its vote of no-confidence in the stock, and downgraded SandRidge even further, all the way to underweight, and with a $5 price target.

Sentiment looks similarly low for one of SandRidge's recent spinoffs, SandRidge Mississippian Trust II (NYSE: SDR  ) , which found its own price target cut Monday by Wunderlich Securities. Wunderlich cut SMT2 from a $22 price target to $18, based on the disappointing announcement Friday that SMT2 will be paying out only $0.533 per share in profit distributions this month, rather than the $0.71 distribution analysts had been hoping for. This news sent a fourth investment banker, Raymond James, into a full-scale reversal on SMT2, downgrading the shares from outperform to underperform.

In each case, analysts appear to be reacting to a report that SandRidge's hydrocarbon assets are turning out to contain more natural gas than oil. And with nat-gas prices remaining depressed, that's not a good proportion for a driller to have on its balance sheet. But is it possible these analysts are overreacting to the bad news?

After all, just this morning, two major players in the nat-gas downstream market -- Cummins (NYSE: CMI  ) and Westport Innovations (NASDAQ: WPRT  ) -- announced a pair of contracts to provide natural-gas engines for buses being purchased by the transportation authorities in Los Angeles and San Diego. Together, the sales promise to outfit as many as 1,368 buses in the two cities with Cummins-Westport nat-gas engines. Combined, the orders represent a 20% increase in the size of the bus fleet running on nat-gas in North America, and could portend a major shift in energy usage for transportation on the continent, an increase in demand for natural gas -- and greater profits for its producers.

SandRidge Mississippian Trust II
Given this announcement, does it make sense to sell shares of SandRidge Mississippian Trust II (SMT2)?

Perhaps not. After all, even after cutting its payout to $0.53-and-a-fraction-of-a-penny, SMT2 still pays a tidy $2.13 annualized -- a 13.4% yield. That certainly seems like enough to justify a 13.3 P/E ratio -- if SMT2 can maintain the payout.

On the other hand, the smaller distribution at SMT2 is directly tied to the revenues it gets from the oil and gas it produces. SMT2 only earned about $1.19 per share over the past year, so, naturally, its distributions are falling in tandem. Granted, if the news out of Cummins and Westport does portend an increase in gas demand, and gas prices, this should result in higher distributions from SandRidge going forward. But for now, the distributions are heading the other way... and the stock price is following along.

SandRidge Energy
Now for SandRidge proper. Ladenburg says it's only neutral on this stock today, but to my Foolish eye, JP Morgan has the better of this argument, and the stock looks more like a sell than a neutral.

Why? Well, let's start with the obvious. The company reported earning $60 million over the past year. On SandRidge's $3 billion market cap, that works out to a P/E ratio of 50 -- which is quite a lot of money to pay for a company that most analysts think will be stuck at 7% annual growth for the next five years. Worse, if you factor SandRidge's $3.6 billion net debt into the equation, the company is actually trading for an enterprise value to earnings ratio more than twice its apparent P/E -- 110.

And that's the good news. The bad news is that SandRidge is intensely free cash flow negative. Over the past 12 months, it burned through $1.3 billion. Indeed, if you examine the company's history, while it's often reported "profits" under GAAP, there's literally never been a year in which SandRidge generated positive free cash flow.

Never. Not one.

Foolish final thought
But what if you're the kind of nat-gas bull who believes prices must turn around, and that deals like the one Westport and Cummins announced Tuesday will increase in frequency in years to come? Actually, that still isn't much of an argument in favor of SandRidge, which of late has been directing most of its capital spending toward efforts to discover and extract oil rather than gas.

A lot of investors think all we need for these stocks to turn around, is a turnaround in the price of natural gas. They will likely see yesterday's news about Cummins and Westport as a positive for SandRidge, and maybe for SMT2 as well. To that argument, I respond that 10 years of SandRidge financial statements beg to differ. In good times and bad times for nat-gas prices, SandRidge has never generated one red cent in real cash profits for its shareholders. To me, that sounds like a great reason to sell it.

If you are unsure about the future of this emerging oil and gas junior, and are looking to find out more about its strengths and weaknesses, you should view this brand-new premium report detailing SandRidge's game plan and what to expect from the company going forward. To get started -- click here!


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