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 best...
Sharpening up the old saw that "no good deed goes unpunished," Netflix (NASDAQ:NFLX) reported beaucoup earnings last week ... and found itself promptly downgraded by Wall Street.

Worse still, the downgrade came from one of the Street's smarter analysts as tracked by CAPS: Baltimore-based Stifel Nicolaus & Co. Here's what Stifel has to say Friday: "Netflix is a good company that treats its customer well. ... Netflix is also well-managed and has been positioned well for an eventual transition to digital."

Huh? That's a downgrade?
Hold up a sec. There's more: "That said, Netflix shares are now expensive at 23x 2009 cash earnings. " Stifel also pointed out that five insiders have sold shares since the company reported earnings. "[T]he shares now overly reflect positive near-term fundamentals."

In other words, "great company, lousy price." Stifel's pronouncement hasn't really fazed investors, though. After slipping 2% when Stifel called it a "sell," Netflix bounced right back this morning, and it once again trades above its pre-downgrade, post-earnings-blowout stock price. But should it?

Let's go to the tape
I have to say I'm gratified to see Netflix shares holding up so well -- the stock is, after all, a Motley Fool Stock Advisor recommendation. At the same time, I worry that Stifel may be on to something here. Precious few Wall Street analysts have a record like Stifel's, and it's especially interesting to see the number of times that Stifel cribbed ideas from our own stock picks -- and profited in the process:

Source: CAPS.
*Total over three picks.

On the other hand, Stifel has also stuck with a number of Fool picks that we've since dismissed from our own portfolio -- for good reason:

* From two different picks.

But we can't really fault them for that, now can we? (Hope springs eternal.) And I must say that despite sharing a few Foolish missteps, overall, Stifel's done a fine job for its clients. The banker's outperforming the broader stock market by better than five points per pick, and ranks in the top 10% of investors tracked by CAPS.

Which is why I've decided to take a closer look at Stifel's valuation work today. Now, as I've written in the past, Netflix is a tricky beast to value. Depending on what you consider a "capital expense," the firm's either generating $77 million a year in free cash flow, or $96 million, or ... $240 million! My hunch, looking at Stifel's math, is that the analyst is taking a middle-of-the-road approach on Netflix, charging the firm for the cost of building out its DVD library, but crediting Netflix for cash generated from the sale of used DVDs -- a fair approach, in my opinion.

Taking that approach, Netflix currently trades for 22-times its trailing free cash flow, which seems a bit steep based on consensus expectations of 14% long-term profits growth.

Foolish takeaway
Now, it's entirely possible that Netflix will exceed that growth estimate. Q4 certainly turned out well for the company, and as it expands film offerings via such DVD-less channels as TiVo, Roku, and Microsoft's (NASDAQ:MSFT) Xbox Live, we could see capital spending undershoot projections -- and profits exceed those expectations.

Still, in this Fool's view, Stifel is more likely right than wrong about Netflix: The risk inherent in today's stock price now outweighs the reward. The way I crunch the numbers, the stock no longer carries the same margin of safety it bore when I recommended the shares on CAPS myself nearly two years ago.

So personally, I intend to take my CAPS winnings (up 116 points in two years), and close out my position on Netflix today. If you disagree, here's the place to tell us why.