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." Today, we'll show you whether those bigwigs actually know what they're talking about. To help, we've enlisted Motley Fool CAPS to track the long-term performance of Wall Street's best and worst.

Speak of the devil
And speaking of the best, two analysts have just come out with reports arguing that speech-to-text specialist Nuance Communications (NAS: NUAN) is one of the best buys out there today. In twin buy recommendations, first Japan's Mizuho Securities initiated coverage of Nuance with a buy rating and a $28 price target. Within minutes, Canaccord Genuity -- already positive on the stock -- reiterated its support and went Mizuho one better, upping its $28 price target on the stock by $2, to an even $30.

Nuance has been in the news a lot lately, thanks to the supporting role its technology plays in Apple's (NAS: AAPL) new Siri "virtual assistant" on the iPhone 4S. Stealing a march on Google (NAS: GOOG) and its "Voice Actions" software, Apple took the mobile search game to a new level with its voice-activated Internet search feature. And analysts are already saying Google will need to respond with further advances, that Microsoft (NAS: MSFT) (and its partner in smartphones Nokia (NYS: NOK) ) must improve as well, and that unless Research In Motion (NAS: RIMM) wants to rename itself "Irrelevance at a Standstill," it will need to come up with a similar product. All of this opens the possibility of additional licensing deals for Nuance, if not an outright acquisition.

Indeed, I've argued myself that a logical move for IBM (NYS: IBM) might be to roll up Nuance into its "Watson" supercomputer and grab a commanding lead in this market for itself.

So clearly -- it's exciting times for Nuance these days. Still, at around 200 times earnings, the stock price does give one pause. Can even the multitude of possibilities opening up for Nuance today justify the stock's nosebleed valuation?

Future's so bright that Nuance should wear shades
Canaccord believes it does. As the analyst explains: "investors sometimes forget that SIRI is still in beta, so better functionality is yet to come [and] ... there is a literal scramble by competitors to catch up." Meanwhile, Canaccord reminds us that there's still the "'other' 70%" of Nuance's business, aside from Siri, to consider -- its health care, enterprise, and imaging businesses. These other facets of Nuance are "performing at least in line with consensus forecasts" -- and possibly better. But is even that enough to make the stock a buy?

Perhaps 200 times earnings is too much to pay for a 13% grower (the consensus forecast for Nuance). But according to Canaccord, superior performance from Siri, plus strong performance at its other businesses, could help Nuance grow organic revenues by as much as 18% and earnings by up to 20% in the 2012 to 2013 period. This, Canaccord says, justifies paying 20 times Nuance's forward earnings estimates.

Postulating $2.15 to $2.25 per share in earnings for fiscal 2014, the analyst argues Nuance could hit not just the $30 "price target" it's set for the stock, but perhaps as much as $44 per share within 18 months! And remember -- all this is just if Nuance continues to fly solo, with no need for an acquisition bid by IBM, Google, Apple, or anyone else to push up the stock price.

Can you believe Canaccord?
Could Canaccord be right? Yes. We've been tracking Canaccord's performance for more than five years now here at CAPS. And according to our records, this analyst does in fact get about 65% of its software recommendations right. Nuance could be another one of those times.

Consider: Buying a stock with a 200 P/E is a scary prospect. But if you dig deeper into Nuance's finances, the company looks cheaper than that. Run a traditional free cash flow calculation on Nuance, and its $357 million in trailing cash flow, minus capital expenditures of $35 million, gives the stock $322 million in trailing free cash flow -- and a price-to-free-cash-flow ratio of just 23. That's almost reasonable if Canaccord's right, and Nuance grows at 20% or thereabouts over the next five years.

My main worry here is that traditional FCF calculations don't capture the cost of Nuance's acquisition spree -- the vast sums this company spends to keep its growth going: $99 million in fiscal 2009, $204 million in 2010, $402 million this year. If we assume these cash outlays are integral to Nuance's business (as I believe they are), and not "one-time" in nature (as they clearly are not), then I'd argue they should be counted against Nuance's FCF. In which case, Nuance becomes free cash flow negative -- in the blink of an eye.

Foolish takeaway
Between Nuance's past success, Siri's future prospects, and the record of the analyst recommending it, I see many reasons to buy Nuance today. Regardless, the company's ceaseless acquisitions keep me from buying it.

I may not yet be convinced that the company is a dog. But I'm not brave enough to buy it, either.

Do the nuances of a triple-digit P/E and potential cash burn worry you? Fair enough. Maybe you'd prefer buying a few steady-eddy dividend payers instead? If so, read the Fool's new -- and free! -- report: "13 High-Yielding Stocks to Buy Today."

At the time thisarticle was published Fool contributor Rich Smith owns shares of Google. You can find him on CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 335 out of more than 180,000 members. The Motley Fool has a disclosure policy.The Motley Fool owns shares of International Business Machines, Apple, Google, and Microsoft. Motley Fool newsletter services have recommended buying shares of Microsoft, Google, Nuance Communications, and Apple, as well as creating bull call spread positions in Apple and Microsoft.We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

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