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 ...
Markets are bleeding red again this morning, but shareholders of one company should still be grinning. Why? This morning marked Wells Fargo's advance further into the e-gaming sector as it initiated coverage on three stocks -- Activision Blizzard (NASDAQ:ATVI), Electronic Arts (NASDAQ:ERTS), and THQ. The latter two only got "market perform" ratings, but Activision won the coveted "outperform."

According to Wells, Activision's "Modern Warfare 2" videogame is off to a gangbusters start, and with "an impressive game slate for 2010 we think Activision represents a strong way to play the interactive entertainment sector." Citing its own pro forma estimates for the coming year, Wells says Activision deserves an "18-21x forward P/E multiple to our CY2010 EPS estimate of $0.77."

But with the stock selling for 46 times what it earned in the past year, and predicted to grow these earnings at less than 16% per year for the next five years, should Wells' vote of confidence convince you to buy the stock?

Let's go to the tape
At first glance, you might not think so. Wells Fargo isn't much of a software analyst (and never has been.) Since it began reporting ratings through Briefing.com, the banker has mainly focused on Oil & Gas stocks, and Big Media (albeit it's done fairly well in these sectors, booking gains on Williams Companies (NYSE:WMB) in the former, and Time Warner (NYSE:TWX) in the latter.)

As for its historical performance ... well, I've laid out Wells Fargo's history and described how it absorbed Wachovia's analysts several times already, so let me cut right to the chase here: Wachovia was never very good at picking stocks, and Wells Fargo hasn't proven itself much better -- at least in software:

Now, here's why you should buy Activision anyway
According to Wells Fargo, Activision is likely to book $5.07 billion in sales next year, and earn $0.77 in pro forma profit thereon. But even if you discount this analyst's projections based on its poor record, the rest of the analysts tracking the company still think Activision can manage to break above the $5 billion mark -- and that's the number to focus on.

Why? Well consider: I've crunched Activision's numbers for the past almost-five years (2005 through 2008, plus the first three quarters of this year), and figured out that Activision has generated $1.3 billion in free cash flow over the period. That's nearly $600 million dollars more than Activision reported as "net earnings" under the GAAP accounting rules. It also works out to a free cash flow margin of nearly 15% that Activision earned on its $8.9 billion in sales in the period.

If you plug that figure into the consensus estimate, therefore, we can probably expect to see Activision generate roughly $738 million in actual free cash this year. To me, the company's current enterprise value of $11.7 billion looks like a perfectly reasonable price to pay for that kind of free cash flow, at the consensus rate of growth.

So worst case, Activision is fairly priced today. But consider a possible catalyst that could make the stock look under-valued in very short order. Wells argues: "We model 13MM units and $681MM in sales for [Modern Warfare 2] during Q4, which... assumes a 20% attach rate on the current PS3 and XBOX360 installed base of about 59MM units. However, considering the 35% attach rate experienced by [Grand Theft Auto IV], coupled with Modern Warfare 2's impressive first week sales of $550MM, we see the potential for upside to our estimates for this game." Plus, Activision Blizzard looks set to unleash other potential blockbusters next year, such as the long-awaited Starcraft 2.

Foolish takeaway
Summing up: If Modern Warfare is only half as popular as Take Two's Grand Theft Auto franchise, Activision looks fairly priced today. If, on the other hand, it proves as popular as GTA, or even somewhat less-popular-than, then Activision will generate more free cash flow than anyone is currently projecting -- and the stock is a bargain.

Should you bet the farm on Wells Fargo being right about this catalyst? No. But even a stopped clock is right twice a day, and my hunch is that today's the day to bet on Wells Fargo -- and Activision.