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 ...
What do you do when one of the best analysts in the business trashes your stock... and everyone on Wall Street, it seems, agrees with 'em? Personally, I listen up. And from what I hear, Canaccord Genuity (formerly Canaccord Adams) thinks it's time to downgrade your Netflix (Nasdaq: NFLX) subscription to "hold."

The reasons won't surprise you -- not if you read fellow Fool Rick Munarriz's write-up on Netflix's quarter yesterday, at least. Citing "pricing pressure to drive activations," which reduced average revenue per user (ARPU) at Netflix, "higher churn rates," and  "higher SAC" (subscriber acquisition costs), Canaccord made the logical conclusion that Netflix should be priced lower than where it's been. 

I agree. 

Let's go to the tape
Now, if Canaccord has proven itself an absolute ace of an Internet-stock-picker over the years, scoring wins on everything from Amazon.com (Nasdaq: AMZN) to drugstore.com (Nasdaq: DSCM) to Orbitz Worldwide (NYSE: OWW) -- and Netflix itself, then we have a right to be concerned. 

Over the course of four years of tracking the Canaccord's performance, we've found it to be right on the money with Internet stocks about twice as often as it's wrong -- a record even better than the its overall record of 51% success in stock-picking, and one that's helped lift it into the elite ranks of the top 10% of investors we track.

Canaccord and discord
Now mind you -- I don't agree with Wall Street's objections to Netflix entirely. In fact, a few of 'em seem just plain misguided to me. Take Canaccord's worry over the higher churn at Netflix. As Rick pointed out yesterday, churn may be up in the short-term, but if you take the longer-term view, churn is actually "down dramatically over the past year." 

Or consider the worry implicit in Canaccord's complaint about lower ARPU, a worry made explicit by other commentators, who argue Netflix made a wrong turn when it enabled free streaming of videos to anyone anteing up a mere $9-per-month for Netflix's lowest-tier of DVD-by-mail-plus-free-streaming service. 

Did this cost Netflix some subscribers who otherwise would have paid in the low-to-mid-teens for DVD-only service? I'm certain it did. I know -- because I'm one of 'em. But in downgrading from Netflix's "3-out" plan to its cheapest-plus-free-streaming option, I also made a mental commitment to remain a Netflix subscriber year-round, to maintain access to the service. At $9 a month, it's simply not worth the effort to continue my historical pattern of signing up for the service in the summer, and suspending it when the networks introduce new programming in the fall. Over time, I think we're going to see churn rates continue to drop at Netflix, while customer loyalty soars (and Netflix, not incidentally, sidesteps the USPS's now annual rate hikes on the postage it pays to ship DVDs hither-and-yon.) 

And yet ...
So why do I agree with Canaccord 's downgrade even as I dispute the reasons that caused it? There's no great secret here: Two months ago, I argued that Netflix stock was overpriced relative to its growth prospects at $110 a share. The fact the stock is now trading a coupla bucks cheaper than that doesn't change the picture. To the contrary, the numbers I'm seeing at Netflix now have me more convinced than ever that the stock is doomed to fall farther.

Consider: Selling for 41-times trailing earnings, and projected to grow its profits at about 27% per year over the next five years, Netflix seems obviously overpriced on the surface. From a cash flow view, the situation is about the same, trading at 42-times free cash flow. But, if we look a little deeper, it's not as clean cut. In contrast to last quarter, where we saw Netflix's reported earnings and actual free cash flow pretty much even, the latest quarter's numbers showed Netflix reporting earnings fully 27% higher than the amount of free cash flow generated.

By way of comparison, Amazon -- named alongside Microsoft (Nasdaq: MSFT) as a possible suitor for Netflix in a UBS report two months ago -- and Coinstar (Nasdaq: CSTR), the company most often considered a Netflix rival now that Blockbuster has pretty much gone the way of the dodo -- both sell for much less than the valuation of Netflix.

Foolish takeaway
I know this conclusion won't go over well with Netflix shareholders who are just beginning to hope that today's bounce is actually the beginning of a return to health for their shares -- and believe me, I feel your pain. But the fact remains: Even after losing nearly 14% of its market cap yesterday, Netflix shares remain vastly overpriced relative to the alternatives.

For that reason alone, I'm in complete accord with Canaccord 's decision to downgrade. In fact, I'd go a step farther than the analyst on this one. If I owned shares of Netflix today, I'd make darn sure I didn't own 'em anymore by 10 days from now, after waiting out the mandated silent period of the Fool's disclosure policy.