Portfolio Review

5/21/2012


Upgrades and downgrades

Express Scripts ($54; ESRX), the largest pharmacy-benefit manager (PBM) in the U.S., manages more than one billion prescriptions annually. PBMs administer drug plans for employers and insurers. The company, which completed a $29.1 billion acquisition of rival Medco Health Solutions in April, should be able to leverage its massive scale to gain market share.

March-quarter operating earnings per share increased 11% and revenue rose 9%. Total adjusted claims, which include prescriptions filled at pharmacies and via mail order, rose 3.6% to 193 million. Walgreen ($33; WAG) left Express Scripts' network late last year after the companies failed to renew a contract. Nevertheless, Express Scripts said that more than 95% of prescription volume moved into 2012 with minimal disruption.

For 2012, Express Scripts targets per-share earnings of $3.36 to $3.66. The company earned $2.97 per share in 2011, which did not include contributions from Medco. Shares trade at less than 15 times the 2012 consensus of $3.66 — a reasonable multiple given the projected profit growth of at least 23% this year and next. Express Scripts is being added to the Buy List and Long-Term Buy List.


Universal Health Services ($39; UHS) shares have fallen 11% since the company announced disappointing March-quarter results. Per-share profits declined 2% and missed the consensus, but that wasn't the only worrisome development. Sales growth decelerated below 4%. Operating profit margins declined year-over-year, reversing a six-quarter upward trend. Operating cash flow fell after five quarters of improvement. And consensus profit estimates for 2012 and 2013 have begun to fall.

Universal's Quadrix Overall score has fallen to 88, hurt by weaker Momentum. Admittedly, the stock looks cheap relative to both its history and its peer group. But Universal could remain under pressure until its fundamentals improve. And the March quarter's combination of weak admissions growth and poor pricing at acute-care hospitals suggests the problems won't clear up right away. Universal Health is being dropped from the Buy List, and from coverage.


AutoZone ($382; AZO) is being dropped from the Buy and Long-Term Buy lists. The stock has rallied 18% this year, nearly triple the gain of the S&P 1500 Index. That surge leaves the shares looking expensive at 18 times trailing earnings, an 18% premium to their three-year average and 10% above the median for S&P 1500 automotive-retail stocks. The stock's Value score has slumped to 36, pulling the Overall score down to 83 from 94 at the start of the year.

Stock buybacks have carved 20% from the share count in the past two years, aiding per-share profit growth. But long-term debt now stands at 161% of total capital, up from 118% two years ago, which could eventually limit AutoZone's ability to repurchase its shares. Initiated as a Buy and Long-Term Buy in April 2011 at $276 per share, AutoZone should be sold. The stock is now rated B (average).


Cisco Systems ($17; CSCO) is being removed from the Focus List but remains a Buy and a Long-Term Buy. Despite posting solid March-quarter results, shares plunged more than 10% on management's outlook. Cisco's July-quarter guidance calls for 10% to 15% higher per-share profits, below the consensus of 23% growth at the time of the announcement. CEO John Chambers described a cautious business-spending environment.

The world's largest supplier of networking equipment, Cisco's expansive reach makes it highly correlated to global growth, suggesting a worldwide economic slowdown could hit Cisco before other tech companies. But the shares are deeply discounted, trading at less than 10 times trailing earnings, 46% below the stock's five-year average and 38% below the median for communications-equipment stocks in the S&P 1500 Index.

Earnings update

Agilent Technologies' ($41; A) per-share profits rose 5% to $0.78 per share excluding special items in the April quarter, topping the consensus by a nickel. Sales rose 3% to $1.73 billion, while orders rose 8% to $1.84 billion. For the July quarter, the midpoint of Agilent's per-share profit guidance (calling for 9% growth) topped the consensus at the time of the announcement. Shares rallied on the results. Agilent is a Focus List Buy and a Long-Term Buy.


Excluding special items, CA ($26; CA) earned $0.56 per share from continuing operations in the March quarter, up 17% and $0.04 above the consensus. Revenue advanced 5% to $1.19 billion, and cash provided by continuing operations surged 22% to $776 million. The midpoint of CA's guidance range for the fiscal year ending March 2013 is slightly below the consensus profit estimate. CA is a Buy and a Long-Term Buy.

Intel's rosy picture

Intel ($27; INTC) said 2012 is unfolding as expected and, unlike Cisco Systems, it has seen no slowdown in Europe. CEO Paul Otellini envisions a "golden age" in which companies such as Intel that fabricate their own semiconductors will enjoy cost advantages. He also sees many consumers returning to PCs, as laptops will soon feature touchscreens and Windows 8. Intel added that 2013 gross profit margins should hover near the high end of the company's historic range. The last time Intel shares traded at the levels experienced this month was March 2004. Intel is a Focus List Buy and a Long-Term Buy.

Stick with J.P. Morgan

J.P. Morgan Chase ($36; JPM) said its chief investment office has lost more than $2 billion on trades so far this quarter. Previously viewed as relatively conservative with its risk, J.P. Morgan had avoided many of the pitfalls that caught other large U.S. banks. But this year, J.P. Morgan's London office built a large synthetic derivatives portfolio intended to hedge exposure to U.S. loans and other credit risks — and ultimately found itself on the wrong end of the trade. Just last month, J.P. Morgan addressed analysts' concerns about outsized positions taken by a trader dubbed the "London Whale." At the time, CFO Doug Braunstein said the bank was "very comfortable with the positions we have."

The U.S. Justice Department has opened an investigation into the trades, while the Securities and Exchange Commission is conducting its own review. The $2 billion in losses are offset by about $1 billion in gains, and company targets for the unit's quarterly loss account for about 5% of the profits analysts expect for 2012. Consensus profit estimates are likely to decline, but a strong balance sheet should absorb the losses and protect J.P. Morgan's dividend. J.P. Morgan Chase, still the strongest of the big banks, remains a Buy and a Long-Term Buy.

Rank Changes

Express Scripts ($54; ESRX) is being added to the Buy List and Long-Term Buy List. AutoZone ($382; AZO) is being dropped from the Buy List and Long-Term Buy List. Universal Health Services ($39; UHS) is being dropped from the Buy List. Cisco Systems ($17; CSCO) is being dropped from the Focus List but remains a Buy and a Long-Term Buy. Vanguard Short-Term Investment-Grade ($10.76; VFSTX) now accounts for 13.6% of the Buy List and 15.3% of the Long-Term Buy List.


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