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.

On beavers, bankers, and ... oil drillers
Well isn't UBS just the busy little beaver this week? Yesterday, we discussed the Swiss banker's latest "experiment" with drug companies, as it reinitiated coverage of large-caps Bristol-Myers and Lilly, Pfizer and Merck. But these weren't UBS's only forays into new territory this week. Today, we'll be discussing UBS's move in a completely different direction ...

Down
On Thursday, UBS established new buy ratings for a trio of deepwater oil drillers: Transocean (NYSE:RIG), Pride International (NYSE:PDE), and Diamond Offshore (NYSE:DO). UBS posits a "positive long-term view of the Ultradeepwater and deepwater markets," and praises all three firms for locking down long-term contracts to drill in the deep end of the pool -- $32 billion in backlog at Transocean, "nearly $7 billion" at Pride, and $8.6 billion at Diamond Offshore.

Additional pluses, in UBS's view, include:

• Transocean's "size, scale, and deepwater reputation/experience, which place Transocean in a class of its own."
• "[F]our newbuild drillships currently under construction" at Pride, which should aid expansion in this market.
• At Diamond, investors find "an attractive 8% dividend yield." (Foolish investors should note, though, that this yield depends on Diamond's policy of paying special dividends which may or may not be forthcoming. The firm's regular dividend suggests a dependable yield of barely 0.5%.)

Drill, baby, drill?
Should you follow UBS's advice, and buy these three drillers? I wish I could give you a definite answer. Sadly, this banker's record in the oil patch is about as clear as tar. Among actual "oil companies," UBS does all right, achieving nearly 53% accuracy across some seven dozen recommendations, including high-profile names like:

But within the specific subsector of the oil industry where drillers dwell -- Energy Equipment and Services -- UBS has dug itself a pretty dry hole. With nearly three dozen picks to its name, the banker is scoring under 30% accuracy, guessing wrong more than twice as often as right. Notable goofs include:

Sadly, I fear that it will fare no better with this week's three oil drilling picks.

Oh, I know that on the surface, each of these three companies looks like a no-brainer -- guaranteed winners one and all. Transocean sells for just eight times earnings, despite consensus estimates calling for 16% long-term growth. Pride's numbers look similar: a 10 P/E, versus 22% projected growth. Likewise Diamond, at 10 times earnings and 20% growth. Any PEG enthusiast would drool over numbers like these. Not me.

Dig deeper
In the course of recommending Transocean, UBS let slip the fatal flaw in its bull arguments on all three companies: "Our rating reflects ... significant free cash flow ... equating to a free cash flow yield of 12%." Problem is, even Transocean's $2.9 billion in trailing free cash flow falls short of its reported "net income" under GAAP. And careful study of the other firms' cash flow statements shows similar -- but worse -- problems. Pride generated almost no free cash flow at all in the last 12 reported months; Diamond, less than $300 million.

Foolish takeaway
Weak cash generation at Pride and Diamond tells me that neither company is anywhere near the kind of top prospect that UBS seems to think it is. Investors should be advised that cash flows can vary wildly in this field as drillers build rigs and acquire others, but I'm still a bit leery of their prospects relative to my favorite of the bunch: Transocean. While it's not as profitable as meets the eye, its free cash flow is still considerable. And even after factoring a sizeable debt load into the picture, the company looks attractively priced at an enterprise value-to-free cash flow ratio of 13. That's a bargain if the company can live up to Wall Street's growth expectations.

Long story short, my guess is that UBS will once again go one-for-three on oil picks this week. But there's no need to you to do as poorly. My advice: Take a closer look at Transocean, but leave Diamond in the rough, and remember that Pride goeth before a fall.