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 ...
On Tuesday, Transocean's (NYSE:RIG) board of directors announced its intent to repurchase $3.2 billion worth of its own shares. As is the nature of such things, the dividend buyback is subject to change, can be "suspended or discontinued at any time," and will likely be implemented only at prices management deems attractive. And guess what?

Those prices just got a whole lot more attractive.

Thanks, Dahlman!
For this, thanks is owed to the Wall Street Wizards at Dahlman Rose, who yesterday downgraded both Transocean and rival deepwater driller Diamond Offshore (NYSE:DO). Now, Dahlman didn't disclose why it did the downgrades (at least not publicly) -- but the secondary downgrade of Diamond is at least suggestive of Dahlman's reasoning. Diamond recently warned investors that rig downtime will rise sharply in 2010, you see, lending credence to growing worries about a glut in global drilling capacity. If Dahlman's buying into these fears, it would explain the analyst's negative take on Transocean.

And it would be wrong.

Let's go to the tape
Now, at first you might think the contrary. After all, Dahlman ranks among the best investors tracked by CAPS, scoring inside the 80th percentile across the breadth of its many stock recommendations. Problem is, there's one specific subsector of the market where Dahlman is struggling -- and it's the exact same place that Transocean sets up its rigs:

Within the Energy Equipment and Services sector, Dahlman's getting only about one pick in five correct. Over the course of the past two years, its recommendations in this sector have netted investors who followed Dahlman's advice a combined 90 points of market underperformance. So when Dahlman now tells you to avoid Transocean ... well, its record suggests you might consider doing the exact opposite.

Incidentally, Transocean's numbers suggest the same thing. A few months ago, you see, I examined three key picks in the drilling sector, recommended by rival banker UBS. Reviewing the numbers at Transocean, Diamond, and Pride International (NYSE:PDE), I concluded that Transocean is clearly the best of the bunch.

Buy the numbers
Despite consensus expectations that it will grow faster than 15% per year over the next five years, Transocean currently sells for less than eight times earnings. More importantly, Transocean boasts free cash flow far superior to its rivals -- $2.9 billion generated over the past 12 months -- giving us a bargain-basement price of just 9.2 times free cash flow on this stock (or 12.9 times enterprise value).

As far as overcapacity concerns go, Transocean boasts a host of long-term contracts for its rigs, and a backlog of $32 billion in work to be performed. This positions the company well to ride out any downturn in demand across the industry.

Foolish takeaway
Now, I'm not saying the deepwater drilling industry isn't in for some turbulence. To the contrary, fellow Fool Toby Shute argued as much just yesterday. But Toby also argued that the downturn is already "priced into the shares to some degree," temporary in nature, and provides forward-looking investors "a very interesting long-term opportunity" should these shares slide further.

Dahlman's downgrade gave us just this opportunity. My advice: Don't let it slip away.