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.
The game's the thing
When Brean Murray downgraded Electronic Arts (Nasdaq: ERTS) yesterday, you might have expected the shares to fall. They didn't. The question is why not? The answer is: It really wasn't that bad of a downgrade.
Sure, Brean knocked the stock down a notch (from "buy" to "hold"), but it wasn't for the reason you might think. Brean doesn't seem concerned about Activision Blizzard (Nasdaq: ATVI) adding Electronic Arts to its Infinity Ward lawsuit, alleging its rival lured the Call of Duty creators away from Activision. (That was probably a foregone conclusion.) Rather, Brean worries about a possible delay in release of EA's Star Wars: The Old Republic. According to the analyst, the game is taking a little longer to develop than anticipated, and will probably be released in Q4 2011 -- crimping earnings in the next fiscal year.
This delay has Brean "moderating" its optimism about the stock. But this implies the analyst remains at least somewhat optimistic. "Near-term upside potential" may have been capped, but the analyst doesn't really see risk of the stock falling from current levels. Is Brean right or, as the famous-yet-anonymous Imperial officer from Star Wars IV might have put it: There is a danger that EA will "pull a Death Star" and explode in a billion points of light?
Let's go to the tape
From what I see, the danger to EA is real -- more real than even Brean seems to realize. Let's begin with the analyst's record in the software space, which is anything but inspiring:
|
Company
|
Brean Says |
CAPS Rating |
Brean's Picks Beating (Lagging) S&P by |
|---|---|---|---|
| Perfect World (Nasdaq: PWRD) | Outperform | *** | 12 points |
| The9 Limited (Nasdaq: NCTY) | Outperform | *** | 8 points |
| Take-Two (Nasdaq: TTWO) | Outperform | **** | (40 points) |
| Activision | Outperform | ***** | (42 points) |
Despite possessing a pretty impressive CAPS record overall (the analyst ranks in the top 15% of investors we track), Brean's record in the software sphere is anything but. The analyst scores a "perfect" 50% rating for accuracy, meaning that for every right guess it's made in the software sphere, the analyst has negated its win with a wrong guess.
Interestingly, I think Brean has accomplished the neat feat of doing both at once this week: It's right to be downgrading EA, but it's wrong in that it didn't downgrade the stock far enough. Fact is, EA actually has quite a bit further to fall.
The Force is weak with this one
The stock has already underperformed the S&P 500 by more than 28 percentage points over the past year, so why do I think it has further to fall? Because that's what the numbers tell me.
Now don't get me wrong, I don't put too much faith in EA's GAAP-unprofitable valuation today. In fact, when I examine the firm's free cash flow, I find EA is in fact a decently profit-making venture.
The company generated in excess of $130 million in free cash flow over the past year, but even that wasn't enough to pull EA's valuation down much below 40 times free cash flow. Even if you trust analyst estimates and agree that EA is likely to expand its cash production at roughly 17.5% per year over the next five years, that still leaves the stock more than twice-overpriced, by my calculations. On the other hand, if you buy Brean's concerns about The Old Republic timetable, then this suggests EA's growth could be even slower -- and the stock even more expensive than it looks.
Foolish takeaway
Any way you look at it -- or rather, any way I look at it (you're certainly free to disagree) -- EA still looks vastly overpriced relative to its prospects. If you absolutely, positively feel you must own a gaming stock … might I suggest Xbox star Microsoft (Nasdaq: MSFT)? With a price-to-free cash flow ratio of less than 10, 11% long-term growth, and more than $43 billion in the bank -- and to top it all off, a tidy 2.3% dividend -- you could do a lot worse.
