Friday's Top Upgrades (and Downgrades)

This series, brought to you by Yahoo! Finance, looks at which upgrades and downgrades make sense and which ones investors should act on. Today, some of the most interesting action on Wall Street concerns oil companies, and one analyst in particular, England's HSBC, is taking a stroll through the oil patch, handing out buy and sell ratings left and right.

Companies winning HSBC's favor this morning include two firms local to the banker, French Total and local British heavyweight BP . In contrast, HSBC takes a dim view of the prospects for American champion ExxonMobil . But is this just a case of "familiarity bias," where HSBC favors the companies it knows best over those farther away -- or are Total and BP really better places to drill for oil profits?

Let's dig into the news and find out, beginning with ...

An "overweight" rating for Total ...
Total announced yesterday that it's decided to partner with upstart oil concern InterOil on a project to develop the Elk-Antelope gas fields in the Gulf Province of Papua New Guinea, taking a gross 61.3% interest in Petroleum Retention License 15 that covers the fields. The news seems to be helping to lift Total stock this morning (InterOil isn't fairing as well). But considering the time HSBC must have needed to prepare its recommendations, the InterOil deal alone probably doesn't explain why the banker picked Total as one of its top recommendations.

So, what does?

Starting with the basics, Total shares sell for about 11.1 times earnings today. The stock's not expected to grow its earnings much at all over the next five years -- just 2.1% annualized growth being the consensus estimate. Even with Total paying a 5.5% dividend yield (according to S&P Capital IQ), that slow growth rate doesn't bode well for Total's chances of outperforming the market.

Even worse, if you take a look at the company's cash-flow statements, you'll see that Total is spending considerably more cash on its capital improvements than it takes in from operations. As a result, after more than five years of generating at least some free cash flow from its business, Total is currently operating at a cash loss.

That may not worry all investors. Oil companies are, after all, notorious for spending great piles of cash on capital expenditures, and rarely generate free cash flow in excess of reported income. Still, the negative free-cash-flow number at Total is a strike against the stock in my book. If there are any better choices out there, I'd be inclined to pass on this one.

... another overweight for BP
So, let's move right along to BP and see if that choice looks any better. As with Total, HSBC is assigning an overweight rating to the British oil giant. And this time, the surface level view of the stock looks a bit more appealing. The stock is priced cheaper and growing faster than Total, albeit it pays a slightly smaller dividend (4.9%).

BP stock costs just 6.1 times earnings. Its growth rate will burn no barns at 2.6% annually over the next five years, but it does at least outpace the growth rate at Total. Meanwhile, its 4.9% dividend yield probably holds some attraction for income investors -- but not for me.

The problem with BP, as with Total, is that while the company has often generated decent free cash flow, it's currently not generating any free cash flow at all. In fact, it's burning cash even faster than Total. FCF ran negative to the tune of $2.6 billion over the past 12 months at BP, which was nearly twice the $1.4 billion cash-burn rate at Total. So, once again, I see little reason to follow HSBC's advice.

But for ExxonMobil, and underweight
In contrast, the highest-profile negative pick HSBC made today, ExxonMobil, actually does generate free cash flow. Not as much as it claims to be "earning," of course, but some: $12.6 billion.

Exxon's ability to consistently throw off cash from its business probably helps to explain why its shares command a higher P/E ratio than do its Euro rivals. But at 12.4 times earnings, the stock is the priciest we've looked at so far. It's also the slowest growing (0.8% annual growth projected over the next five years) and the stingiest with its dividend payouts (just 2.6%).

These three factors -- apparent high price, slow growth, and low dividend -- seem to constitute "three strikes" in HSBC's book. And to be honest, they don't exactly float my boat, either. Plus, Exxon's "earnings multiple" would look even more expensive if we valued it on free cash flow rather than earnings, which would make for a price-to-free-cash-flow ratio of nearly 33!

Nonetheless, the fact remains that with real free cash flow coming in the door -- a fact of which neither Total nor BP can boast -- Exxon is probably the safest "oil stock" of the three. If you feel you absolutely have to own a big oil company, and if price -- or rather, overpricedness -- is no object to you, I suspect ExxonMobil is the first stock you should consider.

The article Friday's Top Upgrades (and Downgrades) originally appeared on Fool.com.

Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool recommends Total SA. (ADR).

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