A Detour Into Upgrades and Downgrades

FAN Editor

In this Market Foolery podcast segment, host Mac Greer, Total Income‘s Ron Gross, and Motley Fool Pro and Options‘ Jeff Fischer take a detour into an area The Motley Fool usually shuns — the realm of analysts’ upgrades and downgrades. Why do we avoid covering them? Because for the most part, they don’t mean as much as people want them to, and the team will explain why. That said, just this once, there are a few things worth discussing about a downgrade of Disney (NYSE: DIS) related to its under-construction streaming service, and an upgrade to outperform on not-yet-GAAP-profitable payment processor Square (NYSE: SQ).

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A full transcript follows the video.

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This video was recorded on Oct. 12, 2017.

Mac Greer: OK, guys, I want to do something that we don’t do very often on Market Foolery, and it’s talking about Wall Street analyst upgrades and downgrades. Jeff, we don’t do that because upgrades and downgrades are not great indicators of future performance. True statement?

Jeff Fischer: True statement. In the past, actually, they’ve actually been a good country indicator. That said, to the extent that most analysts, most sell-side analysts, are bullish and put out buy recommendations, they are right over the long term on good companies.

Ron Gross: One of the main reasons I think they’re not good indicators is, they’re typically based on 12-month price targets, rather than long-term outlooks for companies, which is what we focus on here at the Fool. So it’s very hard to get it right within 12 months. And I think we see it show up in the data that these companies aren’t — you can get a downgrade of a company even though the analyst loves that company long-term; they just think the stock might pull back within the next six months. That’s not really investing as we practice it.

Greer: OK, so, we’ve given it some context here, we’ve qualified it, and we’ve said we don’t really believe in these upgrades and downgrades. But they can tell us where some interesting areas of concern are, right?

Fischer: Yeah. It’s good to see what analysts are thinking about, and what trends they’re watching and why they make like the business or have concerns about it, definitely. But as Ron said, especially new investors should generally ignore upgrades, and definitely downgrades. I’ve seen new, younger investors, their stock gets downgraded and falls 5% and they get concerned and think, “I’d better sell it; it’s been downgraded.” Really, it may mean nothing at all, and it typically doesn’t.

Gross: A little inside baseball: Institutional investors don’t focus on it that much, either, even though you probably think they do. Buy-side, mutual funds, hedge funds, those guys, they have their own analysts to decide whether or not a stock is a buy. The sell-side guys, who we’re talking about now, who put the headline on sell/buy/neutral, those guys are used mostly for their industry knowledge, not for whether they think a stock is a buy or a sell.

Greer: OK. So in that spirit, let’s talk about a couple of upgrades and downgrades. Buyer beware here. Guggenheim, Ron, a big Wall Street firm, downgrading Disney. And here’s the interesting part of the story to me — on concerns over rising costs at Disney as it tries to compete with Netflix (NASDAQ: NFLX) with its streaming service. Disney, in August, announcing plans to introduce a streaming service in 2019. So, what do we think of this idea that Disney is less attractive because it’s going to have to spend more to compete with Netflix — which, by the way, I think is spending a lot?

Gross: I think this is a perfect example of the short term versus the long term. I think the analyst is right about the costs in the short term and the lead time it’s going to take Disney to ramp this up. But even this particular analyst admits that long-term, he likes the company, and things look a little better. It’s just that over the next 12 months, we might see costs spike, and the stock will pull back as a result. Again, if you want to start playing games like that, where you’re going to sell the stock and then buy it back and then sell the stock and buy it back, you certainly can. But if you believe in the long term of Disney, let’s call it five years from now, then there’s nothing wrong with just buying it now and holding it and letting the volatility of the stock take care of itself.

Fischer: Yeah. I think it’s right on of them to, after the August announcement from Disney, which said they’re going to put all their content from Netflix and do their own streaming service, it takes some time to digest what that’s going to cost or what it may cost and how it may affect the business. And by now, it’s a good time to come out and say, “We have new concerns because of these costs.” So I think, in that spirit, it’s good to put these concerns out there. And as Ron said, longer-term they’re optimistic. What’s funny, though, and why you have to read downgrades completely as well — anyone who’s concerned about them, the stock is in the high 90s right now. Their target is still $105 per share. So they’re still looking for the shares to go higher than where they are right now. And yet, they’re downgrading it. So context is important. So Netflix has committed nearly $16 billion to content in the next few years.

Greer: Which seems like a lot.

Fischer: It’s a fair amount. [laughs] Six billion this year alone. The cable business for Disney is one of its most profitable. Of its four divisions, it’s usually second or third most profitable. It fluctuates between movies and the cable business. As we know, ESPN, the cable business in general, is under pressure as streaming grows. Disney is up against not only Netflix but Amazon and Hulu and, to some extent, YouTube. And they’re going to have to spend a lot of money to, indeed, capture the zeitgeist of a change in how we view content that’s already well out of the gate.

Greer: But they’ve got a bit of a head start with that content, right?

Fischer: Their content, some of it is the most valuable in the world. The Star Wars franchise, for one. But …

Gross: The delivery mechanism is yet to be decided. And, specific to Disney, I’m not actually sure yet if this works for them or not.

Greer: Really?

Gross: Yeah, I’m unclear.

Greer: Oh, I think it is a slam dunk.

Gross: I’m unclear. But at 17, 18 times earnings, you’re not paying up too much, actually, at this point, for Disney. Even 10 times cash flow or EBITDA, not that expensive. So even if you’re someone like me who’s not sure, you could probably still be a buyer of Disney and not get hurt at this level.

Fischer: At this price, I agree. I was looking at that as well this morning, Ron. The shares have come down some 20% in the past several months, and now it’s 16 times expected earnings. It’s near its average low.

Greer: Let’s talk about one more upgrade. If you haven’t figured it out now, this is just a cheap excuse. We wanted to talk Disney and Netflix, and now we want to talk Square. Jeff, Oppenheimer put an “outperform” rating on Square. I love that, “outperform.” Square is a payment processing company that hooks up to those credit card readers. Guys, we were talking before the show about how we all love Square, like, I love seeing the little square come out. I don’t own this stock.

Gross: Neither do I. Jeff does.

Greer: But I’m always happy when I see it. Jeff, what’s going on with Square?

Gross: Well, there you go. That’s a buy right there.

Fischer: You know, you’re not the only one. For some reason, they’re aesthetically pleasing to see, and it feels futuristic. So yeah, two out of three here in the studio feel that way, and that’s the only reason I bought the stock. No, that’s a joke that fell flat.

Greer: [laughs] No, I like it.

Fischer: A square joke.

Gross: Before the show, I was saying, it’s a $12 billion company — $11 billion is based on the shape, and $1 billion is based on the business prospect.

Fischer: [laughs] It’s a recommendation in Pro this year. Fintech, as it’s called, and digital payment services have done well across the board. Visa, Mastercard, PayPal, Square. And the reason for that is, more money is being transacted digitally. Cash is becoming an anomaly, almost. Square, where it fits in is, it’s disrupting the traditional system of, if you’re a merchant, a retailer, and you want to use credit cards, you have to pay thousands of dollars to get a machine, and sign these agreements and hook into the network. Square has made a point-of-sale system that basically offers you free of charge. And most of us have probably seen them at a coffee shop or some other place. It’s basically an iPad screen, or it looks like one, and all the transactions go through there.

But it’s not only the point of sale that they offer, and the easy hookup — you can be up and running within an hour with their system for almost no cost. It’s the software behind the scenes that you pay for that helps you manage their business better. It’s the lending services that Square offers to small businesses. They’re disintermediating banks as well. They have, I don’t have the numbers in front of me, but they loaned more than $300 million last quarter to 49,000 different companies. The average loan is $6,000. I remember the numbers. So that’s a small loan, and it’s a short-term loan, and they know the company’s finances and cash flow very well because they see the money going through the business, so they can make the loans more safely. Square is using mobile payments, AI, and machine learning as well, to build a new financial technology.

Gross: So we’ve said we’ve liked the shape, and the business model seems to make sense. I get that — $12 billion company, not profitable, cash flow negative. Why would I be an owner of this stock?

Greer: And there’s some competition, right? In fairness, when you look at that space, broadly defined, I see names like Apple and PayPal.

Gross: I’ve heard of them

Greer: They’re not small fish.

Fischer: No, they’re not. What’s funny though is, they’re all joining the leaders instead of trying to buck the leaders, meaning they’re all allowing you to take Mastercard and Visa and whatnot. So as a shareholder in those, of course I’m happy to see that as well. But why buy Square? Their losses have grown smaller and smaller quarter by quarter, Ron. The business model lends itself to higher and higher margins over time. They’re expected to — they just recorded non-GAAP profits this year the last two quarters, and that’s if you take out, mainly, stock-based compensation. They should be, including all costs, GAAP-profitable or GAAP-breakeven next year in 2018. Then the profits grow from there.

Gross: I would imagine the growth built in is pretty significant — $12 billion is not the biggest company in the world, obviously, but those are real dollars, so obviously folks are thinking significant growth over the next five to 10 years.

Fischer: The cash flow dynamics should be very strong, and the leverage in the business should really make itself shown as the business keeps growing. The other benefit is, they’re gaining larger and larger customers, no longer just a single person with the little square plugged into their phone. They’re dealing with more and more retailers who have $500,000 in sales a year and up. So they’re growing. And their software sales are growing as well.

Greer: OK. Well, my completely arbitrary exit question — over the next five years, on a desert island, Disney, Domino’s, or Square?

Fischer: I’d rather have Domino’s, because you need food on a desert island. Is that what you meant?

Greer: How about the stock?

Gross: You know what? I’m going to give you a counterintuitive answer for me. I think I would say Square, because that’s much more a bet on the future of where this fintech is going. And I think it seems like a more exciting investment than the other two.

Fischer: I would say Square as well, because they’re still young and small-ish in the United States, and they’re just entering the U.K. and Australia and other countries overseas. So they have a lot of room to grow. I think Ron made a key point. I find Wall Street and investing right now as interesting as I’ve ever seen it, because the changes are arriving so rapidly, and they’re so connected to us, the consumers, that we can really see them, and see how they might play out. That’s why Disney is under pressure, that’s why Square is gaining some market share, that’s why so many things have done well in recent years, from Facebook to Netflix to you name it. But Square looks like a company that’s future minded, and Disney looks like it’s trying to catch up.

Gross: How about you, Mac? I think you’re a Disney guy, aren’t you?

Greer: You know, I am a Disney guy. It’s funny — over the last few years, it’s been one of my worst-performing stocks. So you never know in the short term.

Gross: It’s one of my longest-term holdings. I bought it for my kids when they were born.

Greer: And Crocs. Crocs have just been on fire. I finally bought Crocs a while back because of you.

Gross: That’s a little bit of a different thing, because that’s a value investment.

Greer: It’s like a dead Crocs bounce. [laughs]

Fischer: I wouldn’t bet against Disney, either. To produce great content is not easy, as easy is Netflix may make it seem. I am a little bit concerned — can anyone burn out the Star Warsfranchise? Will we ever tire of it?

Greer: I don’t know.

Fischer: I don’t think so. But I want to take the contrary view: What happens if we do?

Greer: Yeah, it’s a good question. I’ll tell you, my focus group, consisting of my oldest son, is all about Stranger Things. He’s all about Stranger Things and Netflix now. He likes Star Wars, but I don’t think near as much. I have underestimated Netflix for far too long.

Gross: Stranger Things figurines in the local Toys R Us anytime soon?

Greer: No, but he’s dressing up for Halloween. And I may throw my Stranger Things costume in.

Fischer: That’s a great picture. Already at Mac’s house, they’re wearing Halloween costumes. They’re ready.

Greer: That’s right. Is that wrong?

Fischer: Not at all. [laughs]

Jeff Fischer owns shares of Amazon, Apple, Facebook, Mastercard, Netflix, Square, and Visa and has the following options: short October 2017 $27 puts on Square. Mac Greer owns shares of Amazon, Apple, Crocs, Facebook, Netflix, and Walt Disney. Ron Gross owns shares of Amazon, Apple, Crocs, Facebook, Mastercard, and Walt Disney. The Motley Fool owns shares of and recommends Amazon, Apple, Facebook, Mastercard, Netflix, PayPal Holdings, Visa, and Walt Disney. The Motley Fool owns shares of Square and has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool recommends Crocs. The Motley Fool has a disclosure policy.

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