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 ...
"Success is its own reward," goes the old saw. But if that's true, then can someone please explain Deutsche Bank's latest downgrade? To me it seems like NetEase just got punished for its success.

The past year has seen Net-easily outperform the S&P 500 -- it's up 87.8%, while the itsy-bitsy SPY-der has gone 19.7% down the waterspout. Yet on Wednesday, the Teutonic megabanker pulled its buy rating on NetEase.com (NASDAQ:NTES), citing the very run-up in price that has made NetEase such a successful stock for its shareholders.

Deutsche explains that with NetEase's launch of Activision Blizzard's (NASDAQ:ATVI) World of Warcraft delayed, it no longer expects the game to contribute revenue before "late August." This has Deutsche reducing its 2009 third-quarter WoW revenue contribution estimate "slightly" (by 25%!)

Which would indeed seem to justify a downgrade. But how accurate has Deutsche been in making such calls in the past?

Let's go to the tape
Not super-accurate, as it turns out. Oh, Deutsche's no analytical laggard -- to the contrary, it gets about 56% of its recommendations right in the Internet Software and Services sector:

And in fact, Deutsche has been right on NetEase itself so far -- beating the market by about 27 percentage points through when it closed its recommendation yesterday.

Fact is, Deutsche could very well be right about NetEase. And with earnings due out just the other side of the weekend, adopting a neutral stance on the stock pending updated information probably is the prudent course to take. But what if Deutsche is being too cautious?

Reason for optimism
Great was the rejoicing among NetEase shareholders when Activision stripped the WoW license from rival The9 and handed it to NetEase. As well they might. The terms of the license guarantee NetEase three years of access to one of the biggest sources of online gaming revenue.

And looking out over a similarly long timespan, Deutsche admits that NetEase's Fantasy Westward Journey game remains "very popular in China," and that NetEase's gross margin will probably remain "stable at around 82.5%," with operating margins north of 60%. (For reference, that's way more than Activision nets on its own games. It's better than Microsoft (NASDAQ:MSFT).) And despite walking back its near-term revenue assumptions on the WoW delay, Deutsche has left its "estimates for 2010 onwards unchanged," suggesting it sees no long-term threat to the firm's growth.

Speaking of which, most Wall Street analysts expect this growth to be "only" 16% this year, but to accelerate to nearly 19% per year over the next five years.

Foolish takeaway
NetEase faces some short-term difficulties, no doubt. Ultra-short term, it could disappoint investors on Wednesday and lose its investors some of their gains. But the long-term investment thesis here remains intact -- yes, even after an 87% run-up. $285 million in trailing free cash flow divided into a $5.7 billion market cap means that this stock is selling for 20 times its annual cash production.

That price would be more than fair if NetEase only matches consensus expectations for its growth. But considering that NetEase also has $880 million in cash on its balance sheet, and no debt to speak of, this stock is actually cheaper than it looks. Deutsche could well rue the day it lost sight of this.

Discretion may be the better part of valor, but patience is the better way to make a profit.