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." So you might think we'd be the last people to give virtual ink to such "news." And we would be -- if that were all we were doing.

But in "This Just In," we don't simply tell you what the analysts said. We'll also show you whether they know what they're talking about. To help, we've enlisted Motley Fool CAPS, our tool for rating stocks and analysts alike. With CAPS, we track the long-term performance of Wall Street's best and brightest -- and its worst and sorriest, too.

And speaking of the best ...
Stock market investors rejoiced as markets turned green again yesterday, and Halliburton (NYSE:HAL) owners were even happier than most. For this, they can thank Wells Fargo, which yesterday declared Halliburton "the most attractive risk-reward of the Big 4" oil servicers, and initiated coverage on the company with an "outperform" rating. Buoyed by the megabanker's encouraging words, Hal's stock went on a 4% tear.

But should it have?

Let's go to the tape
The question is a bit more complicated than it ought to be today, but let me walk you through it. Once upon a time, there was a bank named Wachovia. It made some "poor choices," however -- as my mother might put it -- and wound up getting 'et by a bigger, smarter bank by the name of Wells Fargo.

But Wells Fargo wasn't just smarter than Wachovia. It was also more reticent about reporting its stock guesses to Briefing.com. Hence, it hasn't amassed much of a paper trail on CAPS yet. Worse, what record it does have on Oil, Gas and Consumable Fuels (OGC) stocks is less than impressive. Several months of picks in the sector have left Wells Fargo with an anemic record of 30% accuracy in the oil field, based on a very small sample size.

To get a better picture of the analytical team that now inhabits Wells Fargo, though, I traveled back in time (did I mention that CAPS has a time machine?) to examine how "Wachovia" used to fare in the oil patch. The news was both bad and good. Good, in that Wachovia scored a respectable 55% for accuracy in OGC stocks ...

... and bad in that Halliburton is not technically an OGC stock -- it's a servicer of such stocks. And when you drill down to Wachovia's record in this sector, termed Energy Equipment and Services, it appears that Wachovia historically has about a 46% accuracy in this sector:

But enough about Wachovia's record. Let's turn now to Wells Fargo's reasons for telling us to buy Halliburton (with analyst-to-English translation):

• "HAL ... consensus 2010-11 EPS growth expectations are second only to WFT's, but it's trading in line with the mean of the other 3." (Translation -- Hal's got a good PEG ratio.)
• "Since 2002, HAL has made infrastructure and technology investments, and employed strategies in international land and shelf, North American unconventional land, and global deepwater markets ..." (Hal's spending a lot on capital expenditures.)
• Last but not least: "HAL's ongoing interest in M&A and robust balance sheet suggest deals are probable and its returns record that any such deals should be accretive." (The company has cash to burn, it is likely to overpay for acquisitions in the near future, and Wells Fargo doesn't know how to read a cash flow statement.)

Ouch!
I'm sorry. Was that mean? Allow me to explain. Wells Fargo seems utterly impressed with Halliburton's strong double-digit returns on both capital and equity. What it seems to have missed, however, is that over the last five years, Halliburton has reported $8.8 billion in aggregate earnings -- but generated only $5.5 billion in actual free cash flow from its business. In other words, the "returns record" that has Wells Fargo smiling actually overstates the company's free cash flow profitability by about 60%.

Nor is Wells Fargo's other valuation argument exactly airtight. If you take the long view of growth, and not limit yourself to just what these companies are expected to earn next year, you'll find Schlumberger trading for a PEG ratio of 3.4, Halliburton for 2.8, BJ Services at 4.2, and its soon-to-be-new-owner, Baker Hughes, at 1.14. Far from "the most attractive" play in the oil patch. Therefore, Halliburton can just as fairly be described as stuck in the middle!

Foolish takeaway
Whether you value it on its free cash flow or its GAAP earnings, either way, Halliburton looks frightfully expensive to me. (And no, just because other companies carry equally scary price tags doesn't change the fact.) That being the case, it's going to take more than a middling-to-mediocre analyst to change my mind on this one.

Wells Fargo, Wachovia -- whatever your name is this week -- sorry, but you don't make the cut.