This Just In: Upgrades and Downgrades

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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." Today, we'll show you whether those bigwigs actually know what they're talking about. To help, we've enlisted Motley Fool CAPS to track the long-term performance of Wall Street's best and worst.

Flotek and the Machine
I have to say that when I saw the headline on Friday's announcement of the new initiation at Global Hunter Securities, my heart sort of skipped a beat. According to the upgrades-watchers at StreetInsider.com, Global Hunter thinks investors should rush right out and buy Flotek Industries (NYS: FTK) because it's -- and I quote -- "a free cash flow generating machine." And if there are six words in the dictionary better calculated to attract a value investor's attention, I don't know 'em.

Let's go to the tape
This is especially high praise coming from an analyst of Global Hunter's caliber. You see, GH may not be the highest-ranked investor we track on CAPS (actually, it's ranked in the bottom 40%), but there is one thing this analyst focuses on: picking winning oil stocks.

A dedicated oil & gas investor, GH spends more time researching oil companies than anything else in the equities markets. Its second-largest area of coverage is also on point for Flotek: energy equipment and services companies. In this industry, GH has racked up a record of 63% accuracy on its picks, including such name-brand winners as Schlumberger (NYS: SLB) , Noble (NYS: NE) , and Cameron International (NYS: CAM) :

Company

Global Hunter Rating

CAPS Rating
(out of 5)

Global Hunter's Picks Beating S&P by

SchlumbergerOutperform*****1 point
NobleOutperform*****3 points
Cameron InternationalOutperform*****13 points

Source: Motley Fool CAPS.

Like Flotek, each of these firms operates in the oil services sector. Unlike Flotek, each has lagged the Dow Jones Industrial Average (INDEX: ^DJI) slightly in performance this past year. In contrast, Flotek itself has more than doubled since last December. This of course raises the question of why Global Hunter would choose to recommend the stock now, after Flotek's remarkable run-up, rather than -- oh, I don't know -- a year ago, maybe?

What goes up...
Even though Flotek has a market cap well over twice what it was a year ago thanks to newly issued common shares, Global Hunter nonetheless argues that it's a stock "overlooked, undervalued, and underappreciated" by investors. And I guess I agree with the analyst on one of these points. Most bankers are overlooking Flotek -- because right now, Global Hunter is the only Wall Street analyst of any size covering the stock. But should they bother?

I don't think so, and I'll tell you why not. Beginning with the obvious, Global Hunter tells us that this oil services firm is underappreciated by investors. I believe Flotek's run-up in price argues otherwise. More important, though, is the analyst's contention that Flotek is "undervalued" and a "free cash flow generator with substantial growth opportunities." I don't believe it is.

Now don't get me wrong -- Flotek is free cash flow-positive. Indeed, it's generated more free cash flow than GAAP "net income" over the past 12 months -- $9.3 million to be precise. But to my Foolish eye, this is both an aberration from Flotek's usual practice and woefully insufficient to justify the stock price. Historically, Flotek has more generally averaged about $2 million or so a year in FCF. And while $9 million is certainly an improvement on that weak performance, it still leaves the company with a price-to-free cash flow ratio of 51.

Foolish takeaway
If you're an investor focused on finding stocks that are real "free cash flow machines" -- as I am -- Global Hunter's announcement that it has found one in Flotek was clearly cause for excitement. Sadly, it turns out to have been a false alarm. Paying 51 times free cash is too high a price even if Flotek does manage to achieve the 18% long-term earnings growth it's pegged for.

On the other hand, if you're a traditional P/E investor, and perhaps intrigued by Flotek's more reasonable-seeming 15 times forward P/E ratio...again I don't see anything to get excited about in this stock. Cameron International, noted above, sells just as cheaply, and carries a more manageable debt load. Schlumberger costs only a little bit more, and is a much more stable operation. Meanwhile, other giants of this industry -- Halliburton (NYS: HAL) , National Oilwell Varco (NYS: NOV) , and even Noble -- all sell for forward P/E ratios significantly cheaper than what's on offer at Flotek.

My advice: Don't go with the "Flo" on this one. There are better ideas out there.

And in fact, we've just come up with one of our own. Read all about it -- for free! -- in the Fool's new report: "The Only Energy Stock You'll Ever Need."

At the time this article was published Fool contributorRich Smithdoes not own (or short) shares of any company named above.You can find him on CAPS, publicly pontificating under the handleTMFDitty, where he's currently ranked No. 326 out of more than 180,000 members. The Motley Foolhas adisclosure policy.The Motley Fool owns shares of National Oilwell Varco and Noble.Motley Fool newsletter serviceshave recommended buying shares of National Oilwell Varco. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors.

Copyright © 1995 - 2011 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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