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." The pinstripe-and-wingtip crowd is entitled to its opinions, but we have some pretty sharp stock pickers down here on Main Street, too. And we're not always impressed with how Wall Street does its job.
So perhaps we shouldn't be giving virtual ink to "news" of analyst upgrades and downgrades. And we wouldn't -- if that were all we were doing. Fortunately, in "This Just In," we don't simply tell you what the analysts said. We also show you whether they know what they're talking about.
Calm before the storm
I won't say I told you so -- but I did. Earlier this month, in a column discussing multiple upgrades and downgrades in the credit-card industry -- MasterCard
This week, that latter worry became actual, when, in the course of reporting mostly in-line earnings, Visa confirmed that debit-card use dropped 2% sequentially from Q2 into Q3. Worryingly, Visa noted that this decline both reversed a trend of rising card use from earlier in the year and "occurred sooner and was of greater magnitude than we forecast."
And now the downgrades have begun.
Cry havoc! And let loose the dogs of the Dow
So far this year, Visa shares have vastly outperformed the majority of Dow Jones Industrial Average (INDEX: ^DJI) stocks and beat the S&P 500 by a factor of 5. But perhaps not for much longer. Yesterday, ace banking analyst FBR Capital Markets -- an analyst ranked in the top quintile of investors we track, and sporting a 60% record for accuracy in Visa's industry sector -- removed its "outperform" rating from Visa stock.
Why? FBR blamed the decline in debit-card transactions in part. More importantly, though, FBR pointed to Visa's increased use of "incentives" to attract merchants to its transaction routing system. These price breaks, says FBR, amounted to 19.5% of Visa's gross revenue for the quarter -- significantly ahead of what Visa had been telling investors to expect. This is even more worrisome than the decline in debit-card use, because, according to FBR, he "incentives" in question apparently cost Visa about 2.5% of potential revenue growth. Worse, "Incentives could further detract from results in upcoming quarters."
Why is this bad news? Well, right now, Visa shares look fairly priced at 18.5 times earnings and about 18.7 times free cash flow. Whichever number you choose to focus on, they both look about right -- or maybe even cheap -- for the 19.3% long-term growth that analysts expect to see out of Visa over the next five years.
But what if that growth doesn't happen? What if FBR is right about the "incentives" continuing, and Visa winds up with only, say, 17% growth or so? In that case, the 18.5 P/E ratio starts too look not "maybe even cheap," but instead looks "possibly a bit expensive."
That doesn't sound like much of a distinction, but consider: At last report, 29 out of the 36 analysts covering Visa had "buy" ratings on the stock. That's not surprising, when you combine Wall Street's usual bias toward optimism with the apparent slight undervaluation of the shares. Slow the growth rate just a bit, though, and get Visa shares starting to look overvalued -- and I'll bet you start to see more and more of those "buy" ratings slip down toward "hold" -- just like FBR just did.
My prediction: FBR's downgrade was just the beginning. Expect more bad news to follow.
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Fool contributor Rich Smith owns no shares of, nor is he short, any company named above.You can find him on CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 364 out of more than 180,000 members.
The Motley Fool owns shares of MasterCard and Bank of America. Motley Fool newsletter services have recommended buying shares of Visa. Motley Fool newsletter services have recommended creating a write covered strangle position in American Express. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.