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.

Crow: It's not just for breakfast anymore
You know, they say confession is good for the soul. But I have to wonder whether Citigroup is rethinking that maxim. Last week, as you may recall, the megabanker made two separate 180-degree turns in sentiment, first upgrading Amazon.com (Nasdaq: AMZN  ) after downgrading the stock in November, then reversing course on Research In Motion (Nasdaq: RIMM  ) as well, contradicting a September downgrade.

Citi prefaced its U-turn-on-the-Amazon with the following dinner of crow: "This call should be treated skeptically" -- a rare mea culpa on Wall Street. But Citi admitted no such wrongdoing when it upgraded RIM last week... or when it upgraded Netflix (Nasdaq: NFLX  ) just yesterday.

Well? Why should it?
Because as recently as Friday, Citi had argued that the price wasn't yet right. In a reiteration of its previous hold on the stock, Citi professed its love for Netflix's "pristine balance sheet," its anticipated "3-year 20%+ compound EPS growth," and its "differentiated/unique DVD & Digital Delivery hybrid model." Regardless, Citi looked at the stock's opening price of $43.53 and pronounced it too high, saying: "we are still looking for a more attractive valuation entry point and/or the dissipation of overly aggressive market expectations."

Patience is a virtue... that Citi lacks
Three days later, Netflix opened $0.41 a share higher -- but Citi had lost patience. Fearing the bull was escaping the barnyard, it slapped the "buy" button -- and quickly moved into full-scale self-justification mode. Suddenly, Citi noticed that:

  • Hey! The "shares have corrected 15% in the last two weeks."
  • "[Netflix's] valuation relative to growth [is] very reasonable."
  • "[W]e believe this creates an attractive entry point" (but apparently not as attractive as one that was 41 cents cheaper on Friday.)

Piti Citi
Citi's hit a run of bad luck these past few months, as bullish bets turned against it at Goldman Sachs (NYSE: GS  ) -- down two points since Citi recommended the stock two weeks ago -- and ExxonMobil (NYSE: XOM  ) -- down 13 points over the past month plus. Worst of all, the surge in financial stocks like Bank of Ireland (NYSE: IRE  ) has left Citi badly burned -- that one doubled after Citi panned it in late February. So I guess I can understand if Citi's starting to feel nervous.

Still, defending the indefensible is never easy, and I fear Citi's got its work cut out for it on Netflix.

As I've pointed out previously, Netflix is a tricky beast to value, because of the way it accounts for the costs of building out, and gradually selling off, its DVD library. Still, through what has gradually become the "accepted" means of crunching the numbers, we can say with some conviction that the firm generated about $106 million in free cash flow (FCF) over the past 12 months. And working from this figure, we can tentatively peg the stock's current valuation at about 25 times trailing FCF.

Granted, there's a chance that Netflix will improve its profits faster than anyone expects, as it expands distribution through DVD-less channels such as TiVo, Roku, and Microsoft's (Nasdaq: MSFT  ) Xbox Live. But I think it equally likely that the high cost of building out a Blu-ray disc library will instead depress free cash flow.

Foolish takeaway
Balancing the potential risks and rewards, I have to say that an FCF multiple of 25 seems to me a high price to pay for the 17% growth that Wall Street now expects of Netflix. With no margin of safety to fall back on, I greatly fear that the next time this company stumbles, it won't be Citi we pity -- but the Netflix investors who followed Citi's advice.

Amazon and Netflix are Stock Advisor picks. Microsoft is an Inside Value selection. To find out what the Fool is saying about these companies today, try a free 30-day trial.

Fool contributor Rich Smith does not own shares of any company named above. You can find him on CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 298 out of more than 130,000 members. The Fool has a disclosure policy.


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