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 ...
As markets across the globe flatlined this morning, one group of shareholders was left smiling: Investors in Motley Fool Rule Breakers recommendation Rackspace Hosting (NYSE: RAX  ) . For this, you can thank the friendly bankers at Wells Fargo, who initiated coverage on the stock today, arguing that trends of "managed hosting and cloud computing" will propel the stock to new heights.

Calling Rackspace a "pure play" on these "high growth markets," Wells urges investors to buy the shares and "benefit as the economy recovers." And there's good reason to expect that Wells is right.

Let's go to the tape
Wells may be best known for its high-profile (and generally successful) picks in the oil & gas sector:

Companies

Wells Says:

CAPS says:

Wells Picks Beating S&P By:

XTO Energy  (NYSE: XTO  )

Outperform

*****

60 points

Chesapeake Energy (NYSE: CHK  )

Outperform

*****

(16) points (two picks)

Devon Energy (NYSE: DVN  )

Outperform

*****

2 points

EOG Resources (NYSE: EOG  )

Outperform

***

60 points

But Wells boasts an even better record in the field of Internet Software and Services stocks (such as Rackspace). According to our records here at CAPS, Wells is actually twice as likely to be right as it is wrong about such companies. Wells has done particularly well with its circa-2008 recommendations of Switch & Data Facilities and Equinix (Nasdaq: EQIX  ) , which are beating the market by a combined 175 percentage points. It's hard to argue with such a record of success.

And yet ...
That's exactly what I'm going to do today. Not because I enjoy arguing against our Rule Breakers recommendations, of course, but because the numbers here just don't provide a compelling buy thesis anymore. That's the downside of picking a good stock. Rackspace has more than doubled since we picked it back in June ... but as a result, the stock's now somewhat more expensive.

How much more expensive? The P/E is sitting just short of 100 on a trailing-12-month basis. It also sells for nearly 58 times this year's estimated earnings, and about 52 times trailing free cash flow -- shockingly high numbers, and reminiscent of fellow cloud-computer salesforce.com (NYSE: CRM  ) , another stock I've argued recently has gotten a bit ahead of itself.

Forget the racks -- where's the scaffolding?
Even worse, Rackspace appears to lack salesforce's stellar growth prospects in support of its valuation. Whereas analysts have salesforce pegged for something very near to 40% annual growth over the next five years, estimations of Rackspace's growth prospects, while optimistic, are a somewhat-less-thrilling 22%.

Yet despite positing revenue and EBITDA numbers not far from what the rest of Wall Street is expecting ($759 million versus $754 million, and $252 million versus $240 million, respectively), Wells Fargo still believes this stock is a buy, arguing that an improving economy could "drive upside to our revenue and EBITDA estimates."

Foolish takeaway
Now I'm not disagreeing with Wells' prediction. The banker's record speaks to its ability to see things that the rest of us miss. All I'm saying is that in order to justify the kinds of multiples-to-earnings that Rackspace currently sports, the company will have to post growth rates far in excess of what either Wells, or the investment banking community in general, currently consider feasible.

Personally, I'm skeptical that Rackspace is up to the task -- but hey, feel free to disagree. Motley Fool Rule Breakers members have already profited mightily from this recommendation, but if you believe there's room for still more profits at Rackspace, here's your chance to tell us why: Sound off here.

Chesapeake Energy is a Motley Fool Inside Value recommendation. Rackspace Hosting and salesforce.com are Motley Fool Rule Breakers selections. The Fool owns shares of Chesapeake Energy and XTO Energy.

Fool contributor Rich Smith has no position in any of the stocks named above. You can find him on CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 1174 out of more than 145,000 members. The Motley Fool has a disclosure policy.


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