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." 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'll be tracking the long-term performance of Wall Street's best and brightest -- and its worst and sorriest, too.

And speaking of the mediocre ...
Wait -- we weren't speaking of mediocre analysts at all, were we? But that's what we've got to work with today. A pair of Wall Street's not-quite-finest firms started off the trading week with a pair of conflicting ratings on Motley Fool Stock Advisor recommendation Quality Systems (NASDAQ:QSII). One likes Quality; the other doesn't.

On the sunny side, Piper Jaffray piped up with the following thoughts on President Obama's stimulus plan and the upside it creates for Quality Systems: 

We believe [Quality Systems] is well positioned to benefit from the stimulus package [which provides rebates for doctors installing electronic medical records systems] ... We estimate as many as 200,000 physicians will take advantage of the incentives, equal to $4 billion in spending. ... The challenge for entire industry will be how to install this many physicians in a reasonable timeframe. We believe [mergers and acquisitions] will be likely in 2009 to give small companies (such as [Quality Systems]) the access to capital needed to execute on such a large opportunity.

On the other side, Caris & Co. downgraded the shares to "average." Caris didn't say why (or, at least no major news outlet thought the reasoning worth mentioning), but a Fool could infer that there was something in last week's earnings release that Caris didn't like.

So basically, what we're looking at here is one banker betting the stimulus plan will benefit Quality Systems -- either directly (in the form of more business) or indirectly (in the form of Quality Systems getting bought out at a premium by a bigger player who wants the extra business). The other banker doesn't say much either way about the stimulus plan -- but isn't too hot on Quality Systems itself. Whom to believe?

Let's go to the tape
As I suggested above, I'm not particularly impressed by either analyst's overall record. According to our scorecard (and we've been tracking both bankers for two-years-plus), neither one performs better than the 70th percentile among investors we track. Nor indeed does either one outperform a coin flip -- Caris gets only 47% of its stock picks right; Piper, 44%. Within the medical sphere in particular, their records are quite mixed:

Meanwhile, Caris' performance looks something like this:

Focus, focus, focus
But there are significant differences. Most striking is Caris' record on Quality Systems itself. Since recommending the stock just eight months ago, Caris has already outperformed the S&P 500 by nearly 60 points. That fact speaks to the analyst's understanding of the stock.

And I have to admit that, the more I look at the numbers, the more I agree with Caris’ opinion -- and the less I'm inclined to follow Piper's lead and take a gamble on a broad macro thesis that, you know, Obama likes health care, and Quality Systems does health care, therefore Quality Systems is a good investment. Seems a bit too conclusory, given the number of big ifs.

Especially so, given that I don't see much of a margin of safety in the stock at these prices. And I'm not just talking about the price-to-earnings ratio at a healthy 24. The way I look at it, Quality Systems doesn't generate enough free cash flow to justify even this valuation. Management still hasn't yet shown us its cash flow statement for the last quarter (even though it released GAAP numbers four days ago), but at last report, Quality was generating about $37.4 million in annual free cash flow -- 15% less than its reported net income.

Foolish takeaway
Unless the company grew a bumper crop of cash last quarter, its enterprise value-to-free cash flow ratio now stands at 27. To my mind, that's simply too high a price to pay for 18% growth.

Could Obama salvage the valuation with an infusion of taxpayer-funded growth? Sure. Anything's possible. But am I willing to bet my hard-earned money on a too-expensive stock being saved by a presidential Hail Mary? Not when there's dependable bargains aplenty out there. Not a chance.