This Just In: More Upgrades and Downgrades

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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...
Like being forced to listen to stories of Bret Favre's misbehavior, or watching George Foreman shill for electric grills on TV, it's never enjoyable to see a onetime champion brought low by the inexorable march of time. Sadly, that's exactly what's happening to Microsoft (Nasdaq: MSFT  ) -- at least according to two of Wall Street's top analysts this week.

Issuing twin downgrades to the equivalent of "hold," FBR Capital and Pacific Crest chastised Microsoft for failing to keep pace with the evolution of high tech. As consumers eschew PCs in favor of BlackBerrys, iPads, and Android clones, Microsoft is becoming obsolete, the analysts say. Rapidly evolving tablet PCs, which could have been a growth driver for the Redmond regent, are instead turning into a "net negative." Mr. Softy is failing to "catch up and be relevant." As a result, FBR says it's now no longer enthused with the company's "inexpensive" stock price. Instead, it's "less optimistic" than it once was.

Not so fast, Tex
That's disappointing news, but it's nothing Microsoft shareholders haven't heard before. The real question is whether investors today should be listening to the analysts criticizing Microsoft. Alas, the analysts in question this week have vastly different records when picking winners in the techno-sphere.

On one hand, Pacific Crest ranks among the very worst investors we track here on CAPS, languishing in the sub-20% basement. On the other hand, FBR's record is not nearly so bad. The latter analyst handily thumps the market on picks devoted both to software ...



FBR Says:

CAPS says:

FBR's Picks Beating S&P By:

Oracle (Nasdaq: ORCL  ) Outperform **** 66 points
Nuance Communications (Nasdaq: NUAN  ) Outperform **** 15 points

... and hardware:


FBR Says:

CAPS says:

FBR's Picks Beating S&P By:

EMC (NYSE: EMC  ) Outperform ***** 50 points
NetApp (Nasdaq: NTAP  ) Outperform ** 42 points

Yet FBR's success in picking winning tech stocks notwithstanding, I can't support its decision to downgrade Microsoft today. The numbers just plain won't allow it.

Generating a staggering $22 billion in free cash flow per year, Microsoft sells for an astoundingly low price-to-free cash flow ratio for a company of its quality -- just more than 10.

I won't dispute analysts' assertion that the company faces slower growth as the PC replacement cycle stretches out, and consumers "make do" with the computers they have longer and longer between upgrades. Still, it seems to me that the slower growth expectations at Microsoft are already factored into consensus growth rates for the company. Everybody knows that Research In Motion (Nasdaq: RIMM  ) puts out a new BlackBerry model or three every year, while Apple refreshes its iOfferings seemingly every other Thursday. That's precisely why Wall Street has RIM pegged for 13% long-term earnings, growth, Apple for 19%, and Microsoft for a relatively dawdling 10%.

Foolish takeaway
In contrast, I consider 10% growth perfectly adequate to support Microsoft's 10-times price-to-free cash flow ratio. Plus, remember that:

  • Microsoft possesses more than $30 billion net cash on its balance sheet, a fact that pushes its enterprise value-to-FCF ratio down all the way to 8.5.
  • Competition in the tablet space from devices incorporating Microsoft-ware, such as Hewlett-Packard's (NYSE: HPQ  ) new "Slate" tablet, could accelerate the upgrade cycle for Microsoft, as it has for Apple.
  • Unlike Apple or RiM, Microsoft pays a generous 2.5% dividend.

Foolish final thought
Age notwithstanding, I wouldn't want to get in a ring with Mr. Foreman today (or Mr. Favre, for that matter). And I wouldn't discount Microsoft as an investment.

For value investors at least, this one's a contender.

Microsoft is a Motley Fool Inside Value pick. Apple and Nuance Communications are Motley Fool Stock Advisor selections. Nuance Communications is a Motley Fool Hidden Gems choice. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of Apple, Microsoft, and Oracle.

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. 587 out of more than 170,000 members. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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