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." 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.

And speaking of the best...
It's Dec. 29, and as trading for 2011 winds down to a close, one analyst is closing out its buy recommendation on Kodiak Oil & Gas (NYS: KOG) -- and booking a big win in the process. Yesterday, ace oil analyst Northland Securities announced that because of valuation concerns, it was downgrading shares of the Coloradan oil company to "market perform."

Investors weren't pleased with the news, selling off Kodiak shares by more than 5%. But should they have? After all, it wasn't as if Kodiak did anything wrong to inspire the downgrade -- quite the contrary. When Northland told investors to buy Kodiak back in July, it had assigned the stock a $10 "price target." On Tuesday, Kodiak shares hit that target. So really, all Northland did on Wednesday was declare "mission accomplished," take its winnings, and start tallying up its profits. So there's nothing to see here, folks, move along -- right?

Actually, no. I personally think there's a very strong argument -- three of them, in fact -- for going a step further than Northland did yesterday. For not just downgrading the stock to "market perform," but actually going out and selling Kodiak Oil & Gas. And now I'll tell you why...

Kodiak: The bear argument(s)
Right off the bat, Kodiak looks like a poor choice for a profitable investment. The company sells for 53 times earnings today, versus long-term earnings growth expectations of about 20% annualized. True, analysts on average expect to see Kodiak's P/E drop to 10 next year as earnings rebound strongly in 2012. But assuming this stellar one-year growth is built into the long-term 20% growth rate (as is logical), I still see Kodiak as a stock selling for a 2.6 PEG ratio -- and not the 0.5 PEG that its fans may cite.

Additionally, there's the problem of cash flow. While currently profitable on a trailing basis, as GAAP accountants figure such things, Kodiak is in fact a notorious burner of cash. Over the five-year period running from 2006 through 2010, the company burned through $311 million in cash. And over the past 12 months alone, free cash flow ran to -$333 million. Simply put, Kodiak's not nearly as profitable an operation as its boosters believe. Quite the contrary.

Give the bulls their due
Now admittedly, some oil bulls argue that GAAP earnings -- and perhaps even free cash flow -- aren't the best metrics to use when valuing an oil company. Rather, they say, you should price an oil stock based on the amount of assets it possesses -- assets that, in the fullness of time, the company can convert to revenue, and profit.

They may be right about that. I may be wrong. (It's happened before. In fact, if you take a look at my record on CAPS, I've been wrong about a whopping 29% of the recommendations I've made over the last five years.) So let's give the bulls their do, and see how Kodiak stacks up when valued not on its anemic earnings, but on its assets.

According to Kodiak's SEC filings, this company is currently sitting on some 10 million barrels worth of proven oil reserves and an additional 9 billion cubic feet of proven natural gas reserves. Impressive numbers, but what do they mean?

The 10 million barrels of proven reserves, at today's Brent spot price of $107 and change, should be worth $1.07 billion in asset value. Add in the company's natural gas reserves (9 billion cubic feet of proven reserves times 1,030 BTUs per cubic foot, divided by 1 million, times a spot price of $3.08 per million BTUs, equals $28.6 million in asset value on the natural gas) and what you wind up with is a company whose combined assets should be worth roughly $1.1 billion.

Yet Kodiak is itself selling for $2 billion today -- nearly twice the value of its assets. Is this reasonable?

One word: no
Or if I may expand on that answer: not a chance. Consider a few comparisons for context. ExxonMobil, the biggest 800-pound gorilla in the oil zoo, boasts proven reserves of oil alone -- as in, not even counting its natural gas assets -- of 11.7 billion barrels. Valued at their spot price, these oil reserves should be worth $1.2 trillion. But what is Exxon's market cap? $406 billion. Not twice the value of its assets, but a mere fraction thereof. The situation's similar with...

  • BP (NYS: BP) -- $1.1 billion worth of oil assets, $134 billion market cap.

  • Chevron (NYS: CVX) -- $695 billion worth of oil, $96 billion in market capitalization.

  • ConocoPhillips (NYS: COP) -- $502 billion worth of oil assets and a $96 billion market cap.

In fact, most everywhere you look, major oil companies are valued at a fraction of the value of their assets. (Which is only logical. Those assets may be worth $107 a barrel when extracted and ready for refining, but getting them out of the ground in the first place is a pricey proposition.) Yet somehow, tiny Kodiak's supposed to be worth more than its assets? I don't think so.

And that, Fools, is why right now I'm heading over to Motley Fool CAPS to give a big red thumbs-down on Kodiak Oil & Gas -- an overvalued oil play that's doomed to go down. If you like, feel free to follow along and see how the pick works out for me (and jeer loudly if it turns out I'm wrong.)

Meanwhile, if you're looking for a better energy stock idea than Kodiak, take a look at the new energy industry report that our Fool analyst team has prepared. It will tell you all about "The Only Energy Stock You'll Ever Need." And as far as bargain's go ... this report is completely free!

At the time thisarticle was published Motley Fool newsletter services have recommended buying shares of Chevron, but Fool contributor Rich Smith does not own (or short) shares of any company named above. You can find him on CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 333 out of more than 180,000 members. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

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