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.

Is it time to buy telecoms?
Shareholders of twin telecom titans AT&T (NYSE: T  ) and Verizon (NYSE: VZ  ) have been enjoying an absolute embarrassment of riches these past few days. On Friday, Swiss megabanker Credit Suisse announced upgrades for both of America's major telcos, recommending investors buy them both. This morning, Canadian banker Canaccord Genuity -- which had already recommended buying the stocks -- echoed CS's optimism by raising its price targets even higher: $35 for AT&T, and $41 for Verizon.

What's behind all the optimism? Actually, quite a few things. To begin with, in the wake of last year's failed attempt to merge with T-Mobile, word began leaking out last week that AT&T is in talks to buy Leap Wireless (Nasdaq: LEAP  ) . Consolidation is in the air again for the telecom industry, and as the big fish eat the little fish, competition will wane and pricing power will improve -- both for those that do the consolidating (AT&T) and for those that don't (Verizon).

So long, and thanks for all the subsidies
More broadly, however, what's really getting the analysts interested in Big Telco is the prospect for greater pricing power -- versus their suppliers.

Pointing to moves by AT&T and Verizon to discourage phone upgrades and slow down cell-phone manufacturers' product cycles, CS believes the big telcos could succeed in cutting the cost of subsidizing new smartphone sales. If the companies succeed, this could be bad news for a certain smartphone maker whose name rhymes with "Snapple." It would also hurt sales among key smartphone chip suppliers such as Qualcomm (Nasdaq: QCOM  ) -- and accordingly, CS cut its earnings estimates for Qualcomm last week. On the other hand, lowering smartphone subsidy costs would do wonders for the  profitability of AT&T and Verizon.

Granted, there's the risk that smartphone makers will respond by declining to offer their wares to recalcitrant telcos. But again, the more this industry consolidates, the fewer companies smartphone makers have to choose from when offering exclusive deals.

There's also the risk that fickle consumers will get bored with their current phones and demand upgrades at reasonable prices. To address this concern, though, AT&T is spreading around its risk with a $150 million marketing campaign to support the adoption of Nokia's (NYSE: NOK  ) new Lumia smartphones. Verizon seems to like this idea, too, and is likewise said to be looking into Lumia.

Foolish takeaway
What's all this mean to investors? Well, consider: Both of these companies pay hefty dividends to their shareholders. (In fact, one of them won a place in the Fool's recent report on 9 Rock-Solid Dividend Stocks -- see which one it was.) But despite the generous dividend yields, at first glance, neither AT&T nor Verizon looks like an obvious candidate for upgrades. One trades for 48 times trailing earnings, the other for 44. With both stocks pegged for roughly 10% long-term earnings growth, this suggests neither telco is much of a bargain.

On the other hand, both AT&T and Verizon are arguably a whole lot cheaper than they look. Each generates free cash flow at rates several times what it reports as net income under GAAP. As a result, AT&T, when valued on its free cash flow, sells for less than a 14 multiple. Verizon's arguably even cheaper than that, sporting a price-to-free cash flow ratio of less than 8.

If the companies can succeed in strangling their smartphone subsidies and keep a bit more of that cash in their bank accounts, rather than remitting it to their phone suppliers, we could see profits add up a whole lot faster than the 10% annually that Wall Street currently expects. Good news for both companies -- and for their shareholders as well.