Thursday's Top Upgrades (and Downgrades)

This series, brought to you by Yahoo! Finance, looks at which upgrades and downgrades make sense, and which ones investors should act on. Today, we're looking at one segment of the market in particular -- airlines -- and one analyst in particular that's decided to go shopping there: UBS.

Christmas shopping for airline stocks
UBS initiated coverage of the airline sector this morning, recommending that investors buy three names -- Alaska Air (ALK -1.51%), Delta Air Lines (DAL 0.46%), and Southwest Airlines (LUV -9.37%) -- but leave American Airlines (AAL 0.11%) and United Continental (UAL -0.67%) in the hangar. Why?

With none of the major media outlets providing details on UBS's recommendations this morning, it may seem this is a mystery we cannot solve. But not so. In fact, to figure out why UBS is recommending three airline stocks, and dismissing the others, all you really need to do is take a look at the numbers:

P/E, growth rates, and dividend yield data courtesy of Yahoo! Finance. Free cash flow data from S&P Capital IQ. "Dashes" indicate negative profits, free cash flow, and/or dividend, as appropriate.

No cash? No recommendation
Let's begin with the day's two losers -- newly merged American Airlines and recently merged United Continental. While they sport the highest projected profits growth rates of the group, it's hard to tell how much such growth is worth -- or even what, precisely, they'll be growing.

At last report, both American and United were burning cash, while neither one was paying a dividend. American, at 21.6 times earnings, boasted the highest real price to earnings ratio of the bunch. Profitless United Continental had no P/E ratio at all.

So... if you're an analyst like UBS, and just coming to the airline industry, taking a look at your options, and looking to cull out likely losers from potential winners -- American Airlines and United Continental are two stocks that it's very easy to toss aside.

Cash is king
In contrast, there's quite a bit to like about the three airline stocks that UBS does recommend. For one thing, each of Alaska Air, Delta, and Southwest pays a dividend -- even if the dividends are at present fairly small. Each company boasts positive GAAP profits, and positive free cash flow to boot. For valuation purposes, this gives each of UBS's three recommendations an attractive PEG ratio and price to free cash flow ratio as well.

Which of the three is the best bet, though? In order from least to greatest, I think I'd rank them Delta, Alaska, and Southwest. All three stocks sell for P/E and P/FCF ratios at or below their projected growth rates. Southwest, however, while on the surface the most expensive with its 21.5 P/E, generates so much more free cash flow than its rivals, and is projected to grow so much faster than any other (cash-profitable) airline out there, that it's the clear winner in this race.

Long story short, I like all three of UBS's recommendations today. But I like Southwest best.

Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned.