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 ...
Electronic Arts (NASDAQ:ERTS) owners got a big boost yesterday, courtesy of FBR Capital Markets. Hearing that the banker was bullish on their stock, investors bid up the shares a whopping 4.4%. But closer examination of the upgrade suggests they might want to curb their enthusiasm.

Let's go to the tape
Let's begin a quick glance at FBR's record. Generally speaking, FBR is a passable stock picker on software stocks. A bit more than 53% of the time it predicts a stock's trajectory, FBR guesses right:

So roughly 50/50 in stocks that go "010010101011 ..." But notice that within the Software Kingdom, the FBR picks named above all tend toward the office side of things. Now let's see how FBR does with entertainment software:

First impressions
Better accuracy here, but considerably less coverage, and the margin by which the firm outperforms the market is a bit underwhelming. So far, I'm not exactly frightened to follow FBR's advice on EA ... but I'm not yet convinced, either. So let's look at the firm's reasoning.

And then let's look again
According to FBR, you should buy EA because of the "weakness in EA's football business, near-term costs [and] the likelihood of the company [missing] its $1.00 FY10 pro forma EPS guidance." All of which reduce EA's value from FBR's previously estimated $23 to about " the $20-$22 level by year-end."

No, wait. I got that backwards. Turns out, this banker is actually saying you should buy EA in spite of these negatives, because they're already reflected in the stock price. And maybe they are.

After all, EA has seen its stock chopped in half and then some over the past year as the broader S&P 500 lost less than 12% of its value. This leaves the stock trading for about 21 times FBR's estimate of $0.91 per share in 2010 pro forma (which is Latin for "when you wish upon a star ...") earnings. Considering consensus predictions of 21% long-term earnings growth at EA, that's not too crazy a price to pay -- at least, so long as FBR isn't wishing away too many real costs in arriving at its pro forma profits number.

Look farther back ... and forward
At the same time as FBR believes the company's minuses are well discounted, it's also suggesting that investors are missing a few pluses to EA. For example, EA's stock has lagged the Nasdaq badly in recent months, the company boasts $7 a share in cash, and the outlook for gaming in general looks to be strengthening.

And I see some merit to those arguments. Consider that while currently losing money and burning cash, EA's historical performance shows the company capable of producing both free cash flow and GAAP profits. Look back over the last five years, for example, and you'll find that EA averaged about $222 million in annual free cash flow from its business. Back out the "$7 a share" that FBR says it's got, and that values EA's actual business at just 17 times its average longer-term free cash flow.

Foolish takeaway
Now, whether you consider that a fair price to pay for EA depends a lot on how confident you are in everybody else's predictions of 21% long-term growth at EA. Me, I think the number's a bit optimistic. Then again, it doesn't have to pan out at the full 21% in order to justify a multiple to free cash flow of 17. My guess is that EA can fall considerably short of the hurdles it's been set, yet still reward investors today.

Long story short, EA looks like a buy to me, too -- but in spite of FBR's recommendation, rather than because of it.