Portfolio Review

8/13/2012


Two up, two down and a new retailer

Shoe-store chain Foot Locker ($34; FL) fits us well. We look for growth at a good price, and Foot Locker delivers. Over the last four quarters, sales rose 10%, per-share profits 50%, and operating cash flow 24%. Despite a rise in spending on new stores and renovations in recent quarters, free cash flow also managed 11% growth in the 12 months ended April. Aggressive cost controls have helped boost Foot Locker's profit margins, which have trended upward steadily over the last three years. Operating margins over the last four quarters reached their highest level in 14 years.

Subscribers need not pay up for Foot Locker's growth. The shares trade at less than 17 times trailing earnings, 34% below the three-year average P/E and 4% below the median apparel retailer despite Foot Locker's superior operating momentum. Foot Locker, slated to declare July-quarter results Aug. 17, is being initiated as a Buy and a Long-Term Buy.


We are adding Express Scripts ($61; ESRX) to the Focus List. Shares rallied after the pharmacy-benefit manager topped June-quarter estimates and raised its full-year guidance. Express Scripts earned $0.88 per share, up 24%, and $0.06 above the consensus. Sales more than doubled to $27.69 billion, bolstered by the $29.1 billion acquisition of Medco Health Solutions in April. Express Scripts is already seeing cost savings from the deal and expects to eventually realize $1 billion in annual savings.

Express Scripts shares have risen 18% since we added the stock to the Buy and Long-Term Buy lists in May. Its July pact with Walgreen ($36; WAG) cleared up some uncertainty. In addition, the large number of drugs losing patent protection bodes well for Express Scripts, which enjoys higher profit margins on generic drugs. Earlier this month, the U.S. approved generic versions of Singulair, Merck's ($44; MRK) asthma medication with $5.48 billion in revenue last year. For 2012, Express Scripts sees per-share profits of $3.60 to $3.75, above the $3.53 consensus at the time of the announcement. Merck and Walgreen are rated A (above average).


Google ($641; GOOG), already a Buy and a Long-Term Buy, is being added to the Focus List. The company posted an outstanding June quarter, with earnings per share growing 16% on a 35% surge in sales and a 21% jump in operating cash flow. Google's core advertising business remains strong, driven by growth in mobile and emerging markets. And Android, its mobile operating system, captured 59% of global smartphone shipments in the March quarter.

Of course, there is no shortage of overhanging concerns to distract investors, such as competitive pressures, ongoing disputes with regulators, the integration of Motorola Mobility Holdings, and weakness in Europe. Moreover, Google sometimes indulges in flights of fancy that leave investors scratching their heads. Self-driving cars? Asteroid mining? While these distractions may have weighed on the stock, investors shouldn't shy away. The consensus projects per-share-profit growth of 18% this year and 16% next year. And at 15 times the 2012 estimate, Google trades at an 18% discount to its peer group.


Intel ($27; INTC) is being dropped from the Buy List and Focus List, though it remains a Long-Term Buy. The Quadrix Overall rank has dipped to 74 from 89 at the end of June and 97 at the end of April. Blame weak operating momentum and earnings estimates for the lower Overall score. Intel's per-share profits were flat or lower in the last two quarters, and the consensus projects another earnings decline in the September quarter. However, Intel seems capable of returning to profit growth in the December quarter.

At less than 11 times trailing earnings, Intel trades at a 19% discount to its three-year average P/E ratio and 42% below its peer group. Intel no longer qualifies as a top pick for the year ahead, but we will monitor operating results closely in coming quarters. A pickup in momentum — most likely hinging on personal-computer sales in the wake of the new version of Microsoft ($30; MSFT) Windows — could vault Intel back onto the Buy List.


Qualcomm ($61; QCOM) is coming off the Focus List. However, it retains its place on the Buy and Long-Term Buy lists. The stock's Quadrix Overall score has dipped to 63, hurt by weak cash-flow growth and poor earnings-estimate trends. In the wake of lower-than-expected June-quarter earnings and disappointing company guidance for the September quarter, consensus estimates for the fiscal years ending September 2012 and 2013 have declined. Still, Wall Street expects per-share profits to rise 14% this year and 13% next year. In addition, the profit warning reflects problems with supply, not demand. Qualcomm has struck supply deals and should catch up later this year.

While Qualcomm's Value score has fallen to 43, we still consider the stock fairly cheap, particularly versus historical norms. Qualcom trades at least 23% below its three-year average based on trailing price/earnings and price/operating cash flow ratios.

Earnings roundup

DirecTV's ($50; DTV) earnings per share jumped 20% to $1.09 in the June quarter but missed the consensus by $0.04. Sales rose 9% to $7.22 billion, as the U.S. business grew 7% and Latin America 20%. DirecTV is a Focus List Buy and a Long-Term Buy.


Macy's ($37; M) shares rallied after the retailer said it grew per-share profits 22% to $0.67 in the July quarter, $0.02 above the consensus. Both same-store sales and total revenue climbed 3% in the quarter, powered by a 36% jump in online sales. Macy's is a Focus List Buy and a Long-Term Buy.


Apache ($88; APA) earned $2.07 excluding special items in the June quarter, down 36% and $0.46 below the consensus estimate. Revenue slumped 8% to $3.97 billion as 3.5% higher production couldn't offset lower energy prices. Apache is a Long-Term Buy.

Corporate report

Investors are snacking on morsels in internal documents uncovered during the ongoing patent trial between Apple ($621; AAPL) and Samsung. For instance, an internal Samsung document concluded that its mobile products would be better if they more closely resembled the iPhone. Meanwhile, a senior Apple executive wrote that former CEO Steve Jobs may have supported a smaller version of an iPad, fueling speculation about a mini iPad in the works. Apple seeks $2.5 billion in damages from Samsung. Apple is a Focus List Buy and a Long-Term Buy.


Wells Fargo ($34; WFC) said potential losses caused from the repurchase of soured mortgages could exceed its current reserve by $2.6 billion. Wells Fargo is a Focus List Buy and a Long-Term Buy.

Rank Changes

Foot Locker ($34; FL) is being initiated as a Buy and a Long-Term Buy. Intel ($27; INTC) is coming off the Buy List and Focus List but remaining a Long-Term Buy. Qualcomm ($61; QCOM) is coming off the Focus List but remaining a Buy and a Long-Term Buy. Express Scripts ($61; ESRX) and Google ($641; GOOG) are being added to the Focus List. Vanguard Short-Term Investment-Grade ($10.80; VFSTX) now accounts for 9.9% of the Buy List and 14.6% of the Long-Term Buy List.


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