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'll be tracking the long-term performance of Wall Street's best and brightest -- and its worst and sorriest, too.

And speaking of the worst ...

Roses are red.
Violets are blue.
Morgan's schizophrenic...
and Keegan is, too.

On Tuesday, Memphis-based investment banker Morgan Keegan twisted logic into a pretzel with a pair of new ratings, upgrading the shares of both Visa (NYSE:V) and Mastercard (NYSE:MA) ... while downgrading its earnings estimates for each.

Citing a "deteriorating economic market" in which bankers are hesitant to lend, and consumers reluctant to spend, Morgan Keegan pulled a penny off the top of its estimates for Visa's fiscal 2008 earnings, while slicing seven cents from its guess at Mastercard's annual haul. Regardless, considering the stocks' considerable fall from grace since their recent highs in May, the analyst made a "valuation call" that lower stock prices trump lower earnings -- and both stocks are now buys.

So ... OK. In retrospect, I can actually buy that argument. What Morgan Keegan's saying here is that even if neither Visa nor Mastercard earns as much as we previously thought, the market has overreacted to the current economic trauma. Enough so that what the companies will earn is overshadowed by their falling stock prices.

Of course, the question still remains: Will these companies earn as much as Morgan Keegan thinks they will? Is this analyst as smart as it thinks it is? Only one way to find out. You know the drill by now, so let's not pass "Go", skip collecting $200, and proceed directly to ...

Reviewing the tape
According to our CAPS stats, Morgan Keegan is neither the worst analyst in the investing universe, nor the best. With a record of 46% accuracy on its picks, the analyst is more often wrong than right -- still, it does better than seven out of ten other investors.

Over the course of the two years we've been monitoring the analyst's ratings, it has made picks both brilliant ...

... and less-than-enlightened:

All of which adds up to a record I can only describe as mixed. On the one hand, Morgan Keegan called Wachovia -- a big loaner of money -- right. On the other, its good guess was more than wiped out by a very wrong call on Moneygram which specializes in the transfer of money.

And while the banker made some good calls on retailers Wal-Mart and Bed, Bath & Beyond -- whose revenue streams flow through both Visa and MC -- what's the deal with Lowe's and Home Depot? They're retailers, too, right? Yet it seems Morgan Keegan was actually too pessimistic on their prospects.

What will the future hold?
Personally, I've no special insight into the behavior of the American consumer on the cusp of a recession. I'm certainly not as confident an analyst as Morgan Keegan, which based on yesterday's upgrades, seems (to think itself) capable of calling Visa's earnings to the penny, and Mastercard's to the nearest seven cents.

But I do know a thing or two about valuation, and what I see here still doesn't appeal to me. Yes, Mastercard has been cut nearly in half over the past few months, and Visa is down by a third, but from where I sit, both stocks still cost too dang much.

You see, over the past 12 months, Mastercard has generated $717 million in free cash flow (FCF). At its current price, the stock sells for 31 times trailing FCF, which to me, seems a bit rich for what analysts expect to be a 21% grower going forward. And Visa -- that one attracts me even less. The company's been FCF negative all year long. However, if we adjust for litigation costs, then they've cleared about $1B in FCF over the first nine months of this year. The problem with this is that Visa's valuation (market cap) is twice that of Mastercard. Analysts' posited 22% growth rate leaves me unenthused.

Foolish takeaway
Long-term , will Visa and Mastercard be successful companies, dominate global commerce, and impose an oligopolic stranglehold on the international payments system? Indubitably. But there's such a thing as paying too much for even the strongest of stocks. At their current prices, both Mastercard and Visa are simply too expensive for their profits.

So my advice: Put both these in the icebox for now, and wait for an even bigger sale before thawing 'em out.

In the coming weeks, Fool co-founder David Gardner and his Motley Fool Pro team will invest $1 million in a portfolio designed to help you make money in any market. The service, which just launched, will rely heavily on proprietary CAPS "community intelligence" data to establish long and short positions in a broad range of securities, including common stocks, publicly traded put and call options, and exchange-traded funds (ETFs). To learn more about Motley Fool Pro and to receive a private invitation to join, simply enter your email address in the box below.