Portfolio Review

8/27/2012


Upgrades & downgrades

Two new additions

We are upgrading CVS Caremark ($46; CVS) to a Buy and a Long-Term Buy. CVS has delivered five straight quarters of double-digit sales growth, driven by strong operating momentum at both the retail pharmacy and the pharmacy-benefits-management business. Same-store sales grew 7.0% in the first half of 2012, while free cash flow rose 37% to $2.78 billion. CVS hiked its quarterly dividend by 30% to $0.1625 per share in March and now yields 1.4%.

The stock isn't especially cheap, trading at nearly 14 times estimated 2012 earnings, in line with other drug retailers and 10% below the median for S&P 1500 health-care stocks. But CVS continues to impress investors with its outlook. It has increased its full-year guidance three times this year, estimating that it can retain half of the customers it gained from Walgreen's ($36; WAG) dispute with Express Scripts ($61; ESRX). Rising analyst estimates for CVS target per-share earnings growth of 20% in both the September and December quarters.


U.S. Bancorp ($33; USB) is being added to the Long-Term Buy List. With businesses including wholesale and consumer banking and wealth management, U.S. Bancorp managed to remain profitable throughout the financial crisis. In the first half of 2012, robust growth in mortgage and commercial loans more than offset softness in credit and debit cards.

U.S. Bancorp yields 2.4% after hiking its dividend 56% in March. The bank said during the first half of the year it returned 62% of earnings to shareholders through dividends and stock buybacks; it targets a long-term ratio of 60% to 80%, split fairly evenly between distributions and repurchases. At 12 times trailing earnings, shares look cheap relative to their 10-year average of 14.

Three new Focus List picks

Aflac ($47; AFL) shares still quiver at Europe's every sneeze, even though the insurer continues to shift its investment portfolio away from European debt and toward U.S. corporate bonds. As result, investors seem to have neglected Aflac's impressive operating momentum. Growth in operating cash flow has topped 20% in nine straight quarters, and analyst profit expectations for 2012 and 2013 seem conservative. While Europe's situation remains unresolved, the threat of a worst-case scenario has receded, and Aflac has the capital to absorb some defaults. Aflac, already rated a Buy and a Long-Term Buy, is being added to the Focus List.


Fifth Third Bancorp's ($14; FITB) shares enjoy strong price action, up 7% since the end of June, versus a 3% gain for the S&P 1500 Financial Sector Index. Profit estimates for the September and December quarters have risen more than 5% over the last two months. On Aug. 21, the Federal Reserve approved the bank's proposal to raise the quarterly dividend 25% to $0.10 per share — Fifth Third will consider the hike In September. The company also authorized the repurchase of up to 100 million shares, more than 4% of the total outstanding. Fifth Third, a Long-Term Buy, joins the Buy and Focus lists this week.


UnitedHealth Group ($53; UNH) shares have fallen 9% since the end of June on concerns about rising health costs. The selloff seems overdone considering the insurer's strong execution and market-share gains in the June quarter. Shares trade at 11 times trailing earnings, a 31% discount to their 10-year average. If the insurer becomes more aggressive in returning cash to shareholders, we can see the P/E ratio rising above 12. With both sector-specific ranks exceeding 90, UnitedHealth is being added to the Focus List. The stock is already a Buy and a Long-Term Buy.

Three to sell

In the wake of a weaker-than-expected July quarter, Agilent Technologies ($37; A) is being dropped from the Focus List, Buy List, and Long-Term Buy List. Sales growth of less than 2% was the weakest in 11 quarters, hurt by a slowdown in the testing business. Since the earnings release, the consensus profit estimate for the fiscal year ending in October has fallen 5%, while the fiscal 2013 estimate is down 7%. We had hoped for a bounce in a stock that trades at 12 times trailing earnings, but Agilent has given us no reason for optimism. The stock is now rated B (average).


We've been waiting for St. Jude Medical ($38; STJ) to shake off its malaise, but the medical-device maker's symptoms won't go away. News of defects in the company's Riata defibrillator leads broke in late March. While St. Jude has maintained that its next-generation Durata leads are safe, earlier this month the Food and Drug Administration asked for tests on patients using Durata. One study published Aug. 21 said Durata's design changes did not solve the problems. St. Jude, already plagued by weak operating momentum and profit-estimate erosion, could remain depressed for some time. The stock is being dropped from the Long-Term Buy List and is now rated B (average).


KLA-Tencor ($54; KLAC) has risen 58% over the last year. But we see clouds on the horizon and advise selling on strength. The Quadrix Overall score has dipped to 76, dragged down by a 22 in Momentum and 14 in Earnings Estimates. Operating profits declined in each of the last three quarters, and consensus estimates for the fiscal year ending in June 2013 (sales up 1%, per-share profits down 8%) don't inspire confidence that things will improve any time soon. KLA-Tencor is being dropped from the Buy List, and from coverage.

Aetna buying Coventry

The latest to stake its claim in the Medicaid plan grab, Aetna ($40; AET) agreed to acquire Coventry Health Care ($42; CVH) for $7.3 billion, including the assumption of $1.6 billion in debt. Aetna plans to issue about $2.1 billion in new shares and $2.5 billion in new debt. That price tag amounts to a 20% premium to Coventry's stock price prior to the announcement. Last month, WellPoint ($57; WLP) agreed to pay $4.9 billion for Amerigroup ($90; AGP), a 43% premium.

Following the Supreme Court ruling on health reform, Medicaid providers, once shunned for their relatively low profit margins, appear positioned for strong growth. Aetna shares rose on news of the deal. Medicaid accounts for just 5% of Aetna's health-care revenue but generated 19% of Coventry's revenue in the first half of 2012. Aetna is a Buy and a Long-Term Buy.

Corporate roundup

Wal-Mart Stores ($71; WMT) earned $1.18 per share in the July quarter, up 8% and a penny above the consensus. Total revenue advanced 5%, and U.S. same-store sales ticked 2.4% higher. The midpoint of the company's full-year profit guidance fell short of the consensus, and the shares dipped on the news. Wal-Mart remains a Long-Term Buy.


In a patent complaint filed with the U.S. International Trade Commission, Google ($670; GOOG) accused Apple ($656; AAPL) of infringing on seven patents held by Motorola Mobility. The fate of a separate patent dispute between Apple and Samsung now rests in the hands of a federal jury. Apple seeks more than $2.5 billion in damages. Both Apple and Google are a Focus List Buys and Long-Term Buys.


Rank Changes

Fifth Third Bancorp ($14; FITB) is being added to the Buy and Focus lists. Aflac ($47; AFL) and UnitedHealth Group ($53; UNH) are being added to the Focus List. CVS Caremark ($46; CVS) is being upgraded to Buy and Long-Term Buy. U.S. Bancorp ($33; USB) is being upgraded to Long-Term Buy. Agilent Technologies ($37; A) is being dropped from the Focus List, Buy List, and Long-Term Buy List. St. Jude Medical ($38; STJ) is being dropped from the Long-Term Buy List. KLA-Tencor ($54; KLAC) is being dropped from the Buy List, and from coverage.


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