This series, brought to you by Yahoo! Finance, looks at which upgrades and downgrades make sense, and which ones investors should act on. Today, our headlines focus on the oil & gas sector, where analysts are handing upgrades out to the likes of Valero Energy (NYSE:VLO), Marathon Petroleum (NYSE:MPC), and HollyFrontier (NYSE:HFC). On the other hand, we've got a downgrade for Transocean (NYSE:RIG). Let's start with that one.
Is Transocean drowning?
It's been nearly a month since Wall Street started expressing misgivings about the prospects for deepwater oil driller Transocean. Around mid-September, analysts -- first at Bernstein, then at Swedbank -- began assigning various flavors of "neutral" ratings to the stock. Now, a negative sentiment appears to be picking up steam. This morning, Argus Research joined the chorus of analysts declaiming Transocean, cutting to "hold" a stock it had formerly endorsed.
If you ask me, however, the analysts may be dealing too harshly with this stock.
Sure, I understand that there are things to dislike about Transocean. For one thing, the stock's badly underperformed the rest of the S&P 500 over the past year. It's got a heavy debt load (about $7.5 billion net of cash), and weak free cash flow to boot ($533 million in cash profits over the past year -- just 76% of reported net income).
But, if you ask me, there are just as many things to like about this stock. Its P/E, 23 times earnings, seems fully supported by the 23% annual earnings growth that Wall Street says it will produce over the next five years. Transocean pays a generous 5% dividend yield, and, according to Yahoo! Finance figures, this equates to only about 29% of its net income -- leaving room for the company to actually expand the dividend if it chooses to do so.
Meanwhile, the stock's been throwing off cash at the rate of about $1.6 billion annually over the past three years. Assuming it can get back to those levels of free cash flow production sometime soon, that would work out to a price-to-free cash flow ratio of about 10x on the stock.
My take: Transocean stock looks cheap, and I can't help but think that Wall Street is missing out on a good thing by downgrading it.
Refining more ratings
As pessimistic as Wall Street appears to be on driller Transocean this morning, it seems to be taking a real liking to some of the nation's bigger oil refiners. For example, bright and early Tuesday, we learned that analysts at Howard Weil upgraded not one, not two, but three separate refiners: HollyFrontier, Marathon Petroleum, and Valero Energy as well.
As summarized by flyonthewall.com, the analyst's thesis was in each case the same: "improving 2014 crude differentials, declining RIN costs and utilization, and a potential shift back to contango." Translated into English, this means the analyst thinks the refiners will pay less to blend biofuels such as ethanol into their refined production next year, even as investors become more willing to pay a premium for their product. All this is supposed to help boost profitability and lift the stock prices at these refiners.
According to the analyst, Valero will soon vault to $43 a share (from $36 and change presently), HollyFrontier will hit $47, and Marathon move to $80. But is Howard Weil right about this?
Quite possibly, yes.
Based on trailing 12-month profits, all three stocks look surprisingly cheap today, boasting low P/E ratios in the single digits. True, many industry watchers fear that earnings could continue dropping over the short term, but even so next year's "forward" P/E ratios on the stocks predict that all three will remain firmly profitable. Marathon and Valero, at least, should continue to sell for single-digit multiples to earnings, while HollyFrontier costs not much more than that -- 11 times forward earnings.
Free cash flow at these refiners also looks remarkably strong, with Marathon in particular generating significantly more cash profit (about $4.4 billion) than it's able to report as "net income" under GAAP accounting standards ($3.3 billion). Marathon boasts the additional advantage of almost no net-debt on its balance sheet. And its dividend yield of 2.5% lags HollyFrontier's by only 30 basis points, and is equal to Valero's payout.
Long story short, Howard Weil has good reason to name Marathon its "focus stock" in this sector. It's an excellent place to start digging in your own search for a bargain -- but HollyFrontier and Valero? Those two look pretty good to me, too.
Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool owns shares of Transocean.