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 worst ...
Earnings season is a scary time. (Especially around Halloween.) If you own a bad stock, and it reports worse news, your investment could blow up in an instant. Conversely, if you're short a great stock, as Collins Stewart has been the past few months, and it performs excellently, not only are you due for some losses, but the sky's the limit on how bad things can get.

With just a day remaining before Dolby Labs (NYSE:DLB) reports Q3 earnings, Collins lost its nerve Friday, removing its sell rating on the stock and "upgrading DLB to HOLD ahead of the company's FQ4 (Sep) report."

Collins still believes Dolby is in for a rough fiscal 2010, as the company struggles to "replace $40-$50M in one-time revenues" booked in 2009, and overcome "declining attach rates of third-party DVD playback software beginning with the launch of Windows 7."

Collins figures these factors will weigh on Dolby's earnings in 2010. However, recent "strong shipment trends in DVD, Notebook PCs, and LCD TVs" have the analyst worrying that Dolby might earn $0.35 per share in Q4 2009 ($0.02 more than predicted) and guide even higher in the near term. With the prospect of an "earnings beat" imminent, Collins quickly pulled its sell rating. But is that reason for the rest of us to become optimistic about the stock?

Let's go to the tape
Not necessarily. First, consider Collins' less-than-spectacular record in the field of electronic equipment, instruments, and components stocks. Collins' previous sell rating on Dolby was deeply in the red before being withdrawn -- and it's not the only one:

In fact, only 15% of the 13 recommendations Collins has made in this sector have beat the market over the past three years. But perhaps Collins has had better luck with the PC equipment makers? After all, their strong sales performance has Collins fearing for the safety of its sell rating on Dolby ...

Collins does have a better record when rating computers and peripherals stocks, though the three named above are not entirely representative. In fact, Collins gets fewer than half its picks right in this sector as well. All in all, I think Collins isn't getting off to a particularly good start as we examine its Dolby upgrade.

Worse yet, we've actually heard this song before. About a month ago, if you recall, we discussed FBR Capital's decision to downgrade AMD (NYSE:AMD). Like Dolby, AMD was looking pretty good at the time, as surging PC production drove demand for the company's chips. But digging deep into the supply stream, FBR discovered several factors that seem to be artificially pumping up PC production, namely:

• "The October launch of Windows 7 has motivated some finished goods stockpiling"
• "Component tightness ... caused suppliers to build early to guard against shortages"
• An upcoming weeklong holiday in China may have convinced some PC manufacturers to build comps ahead of schedule.

AMD turns up the volume on Dolby
What's all this have to do with Collins' Dolby upgrade? On the one hand, I think Collins is right: There's a good chance that Dolby will "beat earnings" tomorrow. Even if the ramp in PC production is temporary, it's real today -- and it may do good things for Dolby's numbers tomorrow. That being the case, I sympathize with Collins' fear of being short the stock going into earnings.

Foolish takeaway
That said, after the news comes out ... well, it will depend on what Dolby tells us tomorrow, of course. But for now, with the numbers we've got to work with today, I remain unconvinced of the need to own Dolby.

Selling for 17 times free cash flow and 20 times earnings, yet expected to grow at only 14% per year going forward, Dolby is not the most wildly overpriced equity I've ever seen -- but it's not an obvious bargain, either. Maybe this will change when we see tomorrow's numbers, but for now, I'm agreeing with Collins Stewart's stance: Stay neutral until you're convinced it's safe to do otherwise.