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.

And speaking of the best ...
Pity Electronic Arts (NASDAQ:ERTS). It wasn't enough that the game maker had to suffer the injury of a 9% stock drop yesterday; it also bore the brunt of an insult from Needham & Co., which pulled its buy rating on the stock.

Arguing that there's insufficient "upside in the shares over the next year to warrant recommending purchase," Needham downgraded EA to "hold" post-earnings yesterday. The analyst predicted $0.50 per share in profits for fiscal 2011, and $0.75 in fiscal 2012. Yet as Needham reasoned: "Assuming that a year from now the shares sell at a P/E even as high as 20x those EPS, that implies a valuation of only about $15."

Nice timing, Needham
To which I can only reply: "Thanks for the advice, Needham. But next time, would you mind giving us the warning before the massive earnings miss, rather than after?"

I mean, these Wall Street folks are paid to be smarter than the rest of us, right? To know what's going to happen before it happens? But if the best Needham can manage is to warn us after the fact, then some poor investor who's paying for this advice got a pretty raw deal.

I come not to bury Needham, or to praise 'em
I don't mean to set off on a Needham-bashing spree here. There's a lot of blame to spread around Wall Street in the bungled calls department. Fact also is Needham's not a half-bad software analyst. Well, most of the time:

And yes, to be perfectly honest, when I look at the numbers Needham cites, the stock does seem a mite expensive today. Not as lofty as it was back when I panned EA in October 2005, tagging the stock with the dreaded "great quality, lousy price" label. (But that was nearly five years, and 70% of destroyed market cap ago.) But expensive nonetheless.

It's just that saying EA has no future today seems just a little too easy. Now that investor sentiment's turned against the stock, it's a little too obvious to look at the GAAP numbers alone and say they don't add up to a "buy" thesis (kind of like downgrading a stock after the bad news is already out.)

Times change
I mean, sure, despite selling $2.7 billion worth of electronic happiness over the past nine months, EA hasn't managed to earn a dime's worth of profit, and it's actually burned through $384 million in free cash flow. But that's just one year's miserable news. Over the five-year period stretching from 2005 through 2009, in contrast, this company generated $1.4 billion in free cash flow, averaging $271 million per year. If you pull back your focus from the present year's results, it quickly becomes apparent that this business can produce cash when it sets its mind to it.

Here in the U.S., EA products regularly retail for $50 a pop, with each incremental sale costing essentially nothing after the software has been developed. And in the space of just a few years, EA went from being top dog of the industry to runner-up-to-Activision -- yet EA could drastically flip the situation around any time it wants, just by buying Take-Two Interactive (NASDAQ:TTWO) and adding its revenue streams to the EA pot.

Foolish takeaway
So let's see: a popular-verging-on-addictive product, vast potential profit margins, and a fluid competitive landscape in which "who's on top" changes at the drop of a hat. I don't know about you, but to me this is a situation tailor made to surprise us -- and not well-suited to obvious, pat answers like the one Needham gave us yesterday.

So while I'm not totally convinced that Electronic Arts is a buy, I wouldn't count 'em out just yet.