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.

A most remarkable day
After writing about Wall Street's daily upgrade/downgrade moves for nearly four years now, it's not often I come across a news flash that totally throws me for a loop. By now, I know most of the big names on Wall Street by heart, the upgrad-ers and the upgrad-ees alike. Not so, yesterday.

Midday yesterday, the news came down: Johnson Rice was upgrading National Oilwell Varco (NYSE: NOV) to "overweight." The stock, already up along with everybody else in the market yesterday, was certainly not hurt by the upgrade, as investors bid it up more than 5% by the time the closing bell rang.

Hooray! ... Wait. Who?
Yeah, that's basically the reaction I had. I mean, National Oilwell Varco -- of course I've heard of it. (It's a Motley Fool Stock Advisor recommendation, after all.) Why, I've even written about NOV, praising the stock as a great, cheap way to play the long-term trend of rising energy prices. (Of course, that was before BP went and upset the oil cart, making all energy companies anathema.)

But the fact that Johnson Rice ever had NOV on its radar -- or that there was even an analyst out there by the name of "Johnson Rice" -- was news to me. But for good reason. As it turns out, JR is a most laconic fellow.

Let's go to the tape
Over the entire history of CAPS, a service now entering its fifth year of operation, Johnson Rice had published a grand total of four stock picks reported to Briefing.com (and so showing up on our CAPS scorecard). Of these four, three resembled yesterday's NOV upgrade, inasmuch as they concerned members of the oil and gas industry: Energy XXI (Nasdaq: EXXI) and GMX Resources (Nasdaq: GMXR) drill and produce the stuff, while Holly Corp. (NYSE: HOC) refines it.

JR's fourth recommendation was for PetSmart, a big-box retailer of dog food, cat litter, and a wide range of similar products. Care to guess which of the four Johnson Rice was right about?

Don't tell me
Sorry to break the bad news, but I suspect you've already guessed it. The one pick we've got on record as outperforming the market for JR, is PetSmart. As for the rest, they've bombed pretty badly:

Now to be fair, this may not be a completely accurate compilation of the analyst's performance. As it turns out, the NOV pick hasn't shown up on Briefing.com yet, either. I just happened to stumble across it while scanning the news Monday on StreetInsider.com -- a one-line release that confirmed the upgrade happened, but didn't tell us why it happened. So let's give JR the benefit of the doubt. Assume the analyst does make the odd successful oil and gas pick from time to time. What are the chances that National Oilwell Varco will turn out to be one of the good 'uns?

Drilling for dollars
Well, let's see here. To start with, we've got the stock's 10.7 price-to-earnings ratio. That certainly doesn't sound expensive. Not with oil service peers like Halliburton (NYSE: HAL) and Schlumberger (NYSE: SLB) trading in the mid-20s for P/E, and not with rival Weatherford International (NYSE: WFT) so devoid of profits that it has no trailing P/E at all. (A handicap under which past JR calls GMX and Holly both labor, I might add.)

That said, Fools know that a low P/E isn't necessarily a bargain -- only possibly. In addition to a low price, you also want to see the company generating free cash flow to back up its earnings, and growing these earnings over time; it's here that the bull case for National Oilwell Varco begins drilling into murky waters.

Because, as it turns out, NOV fails both tests. While the company hasn't disclosed cash flow for its most recent quarter, the four quarters preceding last week's earnings showed free cash flow lagging reported GAAP earnings by approximately $200 million. Again, that's not necessarily dispositive (free cash flow can come in lumpy from time to time). The real kicker, though, is that most analysts who follow the stock expect NOV's earnings will also shrink over time. And I don't mean any "Honey, I left your sweater in the dryer too long" shrinkage, either. I'm talking average expectations that earnings will drop 13.8% a year ... every year ... for the next five years.

Foolish final thought
Between the upgrade from an analyst of questionable reliability, the company's suspect quality of recent earnings, and the very real risk that these earnings will decline over time, I see "three strikes" against National Oilwell Varco today and very little reason to own the stock.

But hey, that's just my opinion. If you think I'm wrong, feel free to correct me in the comments section below, and vote your conviction (be it to buy the stock or sell it) on NOV's CAPS page right here.