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 ...
In recent days, we've seen titans of the investing world such as Citigroup, JPMorgan Chase, and UBS return to their former glory as well-respected analysts in CAPS -- or at least, stop flailing around like so many proverbial monkeys, throwing darts at the Wall Street Journal stock tables. Not all analysts have been so lucky, though.

Needham & Co., for example, remains a broker in serious need of a clue. As its peers return to breakeven on their recommendations, Needham still occupies a barstool, tossing darts at the newsprint, and missing three times for every two hits. With less than 40% accuracy on its picks, and a record of underperforming the S&P 500 by about three points per pick, Needham lags more than 80% of the investors tracked by CAPS.

But this Fool wonders: Was yesterday's downgrade of Yahoo! (NASDAQ:YHOO) to a "hold" just the thing necessary to pull the underperformance monkey off of Needham's back?

In a word, no
While Needham was right to downgrade Yahoo! yesterday, the analyst just didn't go far enough. Consider: According to Needham, Yahoo!'s "core ad market" is falling apart. IAC/Interactive (NASDAQ:IACI) just warned that its display advertising revenue could be cut in half in the first quarter. Time Warner (NYSE:TWX) subsidiary AOL is guiding toward a "35%-45% decline in display" ad revenue. Yet Yahoo! is predicting only a 10% decline. If Yahoo!'s wrong, and everybody else is right (which seems likely), that means that Wall Street estimates assembled in reliance on Yahoo!'s guidance are probably too optimistic.

This, accordingly, has Needham feeling pess-imistic. The analyst doubts we'll see any "transformational deal" with Microsoft (NASDAQ:MSFT) or AOL in the near future that might save Yahoo! from its possible fate. And barring such an unlikely event, Needham says it won't become bullish on the stock again until Yahoo! hits $10 a share, or thereabouts.

Um, but wasn't Yahoo! selling for $14 Monday?
Indeed, it was. So by Needham's own logic, the stock was overpriced at the start of the week. Seems to me that this calls for a downgrade all the way to "sell" -- not the half-measure of a "hold" rating that Needham gave Yahoo! yesterday.

And really, folks, Needham should have more confidence in its analysis than that. Sure, this banker has made its share of backward calls in the hardware-tech sector:

But Needham appears to have a firm grasp on Ether-tech. Since recommending that investors buy Yahoo! back in November, the stock is up 50%, and has outperformed the market by a good 41 points. Needham's also up a good 13 points on its two-year-old recommendation of Google (NASDAQ:GOOG).

To sum up:

• Needham's got a pretty miserable record as an analyst.
• But the one place where it's really shown its chops is in Internet search stocks.
• Its logic on Yahoo! is sound.

And here's the kicker: Yahoo! appears to be priced to fall.

Foolish final thoughts
Right now, the stock sells for a 41 P/E and an enterprise value-to-free cash flow multiple of 12. The first valuation seems a mite high to me. The second looks about right for the 15%-a-year grower that Wall Street believes Yahoo! to be. But if Needham is correct in its prognostications, Yahoo! is not going to live up to those growth estimates -- in which case, it's overvalued.

Between the stock's questionable valuation, Needham's demonstrated skill in picking "search" stocks, and Needham's own reasoning as regards the looming gap in Yahoo!'s growth plans, everything here adds up to only one conclusion: Needham should have stuck to its guns and gone all the way with its downgrade. It should have rated Yahoo! a "sell."