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.

Citi tunes in to Sirius
Friday was a pretty fantastic day for most investors on Wall Street, as the Dow reversed its dive from the previous day, and the Nasdaq soared nearly 2%. And on that happy day, Sirius XM (NAS: SIRI) shareholders had even bigger smiles on their faces, as their shares notched a 2.5% gain. For this, you can thank the friendly analysts at Citigroup.

On Friday, Citi managed to sneak out one last buy report before the trading week was done. Predicting many years of subscriber growth lie ahead for Sirius, Citi argued Sirius could ultimately end up charging monthly subscription fees to about 1 in 10 Americans -- 34 million customers, sending in their payments of $12.95 and up every 30 days. What's more, Citi sees all these new customers as incredibly profitable for the satellite radio operator, generating perhaps $0.75 in cash flow for every $1 in revenue Sirius collects. According to the analyst, the combination of strong, sustained revenue growth and high profit margins on that revenue is enough to make the shares worth $2.20 today.

But is Citi right about that?

Let's go to the tape
I've little doubt Citi is right about the revenue opportunity here. As the analyst points out, automakers like Ford (NYS: F) , General Motors (NYS: GM) , and Toyota install Sirius hardware in roughly two-thirds of the new cars they sell in America every year, often giving away the service initially. That's about 9 million potential new customers annually, in addition to the 23 million car-based Sirius accounts already in existence.

Sure, there are alternatives to Sirius. Free terrestrial radio from stations owned by CBS (NYS: CBS) . Free Internet and mobile radio from Pandora (NYS: P) , Spotify, and the like. Portable music devices like SanDisk's (NAS: SNDK) MP3 players, and of course the ubiquitous Apple (NAS: AAPL) iPods, iPads, and iPhones. But post-merger with XM, Sirius is today the satellite radio monopolist in America. With no other providers out there offering quite the same service it provides, I can see a path leading toward 10% market penetration for Sirius pretty easily.

That's not the question, though. (And it never was.) The question is whether Sirius can capture the revenue streams and convert them into enough profit to justify its stock price. The question, in a word, is "valuation."

Valuation matters
Fortunately, this is not a question Citigroup skips over lightly (as it did, for example, when recommending Pandora this past summer). To the contrary, Citi makes an entirely defensible argument (I think) in favor of Sirius being worth $2.20.

Consider: I mentioned above the amount of cash flow that Citi expects Sirius to generate. But here's where the story gets really good. Citi points out that actual free cash flow is also coming a gusher at Sirius. The analyst predicts we will see this satellite radio monopolist nearly double its FCF to about $740 million in 2012. If Citi's right about that, it implies a forward price-to-free cash flow ratio of less than nine times for Sirius -- much cheaper than the stock's apparent 44 times trailing P/E.

But in fact, you don't even have to buy Citi's guess as to 2012 FCF to see why this stock is starting to look attractive. Based solely on the free cash Sirius has already generated -- about $381 million for the past 12 months -- the stock only costs about 17 times trailing FCF today. That's already a much more attractive multiple than Sirius' 44 P/E. And if you ask me, it's plenty cheap to justify the stock's price based on consensus projections of 30% long-term annual profits growth at the company -- let alone a one-year 94% spike in FCF.

Foolish takeaway
I've personally decided to publicly endorse Sirius as an outperformer in my public CAPS portfolio. (Feel free to follow along and see how this works out). Why? Running a quick back-of-the-envelope valuation on Sirius -- taking into account trailing free cash flow, future growth prospects, and the company's $2.5 billion net debt load -- I see about 25% upside in Sirius stock today. Meanwhile, approaching the valuation from a different direction entirely, Citi is telling us it expects the stock to rise from $1.75 per share today to $2.20 per share a year from now, which coincidentally works out to about a 26% profit.

And hey -- far be it from me to argue with one of the biggest names in investment banking...when it comes to the same conclusion I've worked out for myself.

Is investing in the volatile Sirius XM a bit too "exciting" a stock idea for you? Why not try a few steady-eddy dividend payers instead? Read the Fool's new, and free, report: "13 High-Yielding Stocks to Buy Today."

At the time thisarticle was published Fool contributorRich Smithowns shares of SanDisk.You can find him on CAPS, publicly pontificating under the handleTMFDitty, where he's currently ranked No. 327 out of more than 180,000 members. The Motley Foolhas adisclosure policy.The Motley Fool owns shares of Ford Motor and Apple.Motley Fool newsletter serviceshave recommended buying shares of Apple, Ford, and General Motors, as well as creating a bull call spread position in Apple.We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors.

Copyright © 1995 - 2011 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.