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." Today, we'll show you whether those bigwigs actually know what they're talking about. To help, we've enlisted Motley Fool CAPS to track the long-term performance of Wall Street's best and worst.

And speaking of the best...
What do you do when one of the best stock pickers in the business takes a shine to the biggest name in computer software? Personally, I listen up. And from what I hear, ace software analyst Davenport has fallen back in love with Microsoft (Nasdaq: MSFT  ) -- upgrading its shares to buy on Friday.

Long regarded as one of Wall Street's best analysts on CAPS, Davenport also has a particular fondness for unloved underdog stocks. I think most PC users will agree that there aren't many companies that generate fewer fond feelings than Microsoft. (And even fewer investors. Witness how the shares barely budged after Thursday's blowout earnings report.) But don't reject Davenport's advice to buy Microsoft just because you hate it. There's real logic to this upgrade.

PCs: Down but not out
Crunching the numbers from Microsoft's earnings report, Davenport argues that "strong enterprise demand for its PC and server applications should more than offset lower consumer PC revenue" at the company. In the June-ended quarter, PC units sold to consumers slipped 2% as people preferred to spend their cash on Apple (Nasdaq: AAPL  ) iPads and the slew of "me-too" tablets from Hewlett-Packard (NYSE: HPQ  ) , Motorola Mobility (NYSE: MMI  ) , and Research In Motion (Nasdaq: RIMM  ) . Business demand for PCs, however, remains strong -- rising 8% by unit volume.

Put it all together, and Davenport believes Microsoft will earn perhaps $2.91 per share next year on 7% revenue growth -- numbers well ahead of consensus estimates. Then, toward the end of 2012, Microsoft's results could be turbocharged by the release of Windows 8 for tablet PCs.

Microsoft's secret weapon(s)
Meanwhile, back in the here and now, Microsoft is quietly generating unnoticed piles of cash from its entertainment and devices division (read: "Xbox"). Sales in the games unit leapt 44.5% last year, to $8.9 billion, while operating income more than doubled to $1.32 billion. (Put down your calculators. That's a 14.6% operating margin; not software-like margins, I admit, but pretty nice for a hardware unit. HP, for example, gets only 10.5% operating margins from its hardware, while Motorola is still losing money on an operating basis.)

Even further behind the scenes, Mr. Softie is reaping continuing benefits from its 2009 tie-up with Yahoo! (Nasdaq: YHOO  ) . Its Bing search engine expanded its market share by nearly a third, leaping to 14.4% in online search. (Watch your backs, Google (Nasdaq: GOOG  ) and Facebook.)

Of course, the question remains: Does all this good news add up to a buy thesis for Microsoft?

Let's go to the tape
I think it does, but don't take my word for it. Take Davenport's. According to our CAPS super-computer, this top-ranked analyst's recommendations outperform the stock market fully 60% of the time. Davenport is especially savvy in software, getting more than 69% of its picks right in Mr. Softie's home industry. If there's anyone you want to take software advice from, it's Davenport.

In addition to the arguments mentioned above, Davenport also points to a few of Microsoft's key accomplishments from fiscal 2011. Microsoft stunned the skeptics with a fourth-quarter earnings report showing GAAP net income up 30% from last year. That was even faster than its full-year figure of 23%. Free cash flow rose 9.4% for the quarter (11.5% for the year). With all this free cash pouring through its doors, Microsoft now sits on a cash pile $40.9 billion high, even after returning $16.8 billion to shareholders in the form of share buybacks and dividend payments last year.

Final point
Speaking of cash, I can't help but notice that Microsoft's cash (and free cash flow) is selling at a very low price point today, Davenport's endorsement notwithstanding. Already cheap-seeming at 11 times earnings, Microsoft actually costs only 9.4 times FCF when valued on its $24.6 billion in trailing cash profits. Net out the company's treasure chest, and the valuation falls even further -- to a drool-inducing 8.0 enterprise value-to-free cash flow ratio. Indeed, if you factor in Mr. Softie's generous 2.4% dividend payout, Microsoft really only needs to grow 5% or 6% per year for its stock to be a bargain.

Wall Street says Microsoft will grow about 10% per year over the next five years, and Davenport's predicting 15% growth this year alone. The math here is obvious, folks: Microsoft is a buy.

Fool contributor Rich Smith owns shares of Google. You can find him on CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 593 out of more than 180,000 members. The Motley Fool has a disclosure policy.

The Motley Fool owns shares of Google, Apple, Yahoo!, and Microsoft. Motley Fool newsletter services have recommended buying shares of Microsoft, Apple, Yahoo!, and Google. Motley Fool newsletter services have recommended creating a modified collar position in Microsoft. Motley Fool newsletter services have recommended creating a bull call spread position in Apple.

We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.


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