Portfolio Review

9/17/2012


Upgrades & downgrades

With a Quadrix Overall score of 95, Foot Locker ($37; FL) ranks near the top 5% of our research universe and No. 2 among the 43 apparel retailers. A strong shoe and clothing product cycle bodes well for growth. In addition, cost controls and improved inventory management have reduced markdowns and boosted profit margins in recent quarters. Over the last 12 months, Foot Locker grew per-share profits 40% on 9% higher revenue. A 40% rise in free cash flow over the same period suggests earnings quality is high.

In the July quarter, revenue rose 7% on impressive same-store-sales growth of 10%. Per-share earnings surged 58%, beating the consensus for the 10th consecutive quarter. For the fiscal year ending January 2013, consensus estimates project per-share profits of $2.45, implying 35% growth. The consensus was $2.38 a month ago. Despite that growth, the shares trade at less than 17 times trailing earnings — a 13% discount to apparel retailers in the S&P 1500 Index and 32% below the stock's five-year average P/E of nearly 25. Foot Locker, already rated a Buy and a Long-Term Buy, is being added to the Focus List.


U.S. Bancorp ($34; USB), already a Long-Term Buy, is being added to the Buy List. See our review in Analysts' Choice.


Operationally, AGCO ($44; AGCO) has shined, delivering sales growth of 20% and per-share-profit growth of 41% over the last four quarters. But we see some clouds on the horizon, and subscribers should sell before the storm hits. Why so nervous about a stock with strong operating momentum and high Quadrix scores?

First, rivals Deere ($78; DE) and Titan Machinery ($20; TITN) missed July-quarter profit expectations, Titan blaming its woes on the drought.

Second, consensus profit estimates for the September and December quarters are falling, and we fear AGCO's operating momentum could peter out over the next year.

Third, operating cash flow has declined in each of the last two quarters, a trend that makes us less confident in the earnings outlook.

Fourth, the shares are roughly flat over the last four months, unable to build on the bounce after June-quarter results.

AGCO is being dropped from the Focus and Buy lists and from coverage.


Wyndham Worldwide ($54; WYN) has trended mostly higher over the last year and may not be done yet. But in the wake of an 84% return over the last 12 months, the shares have become somewhat expensive for our tastes. To be clear, valuation was never Wyndham's most appealing attribute — we were drawn to its growth. Over the last four quarters, Wyndham's per-share profits jumped 31%, with operating cash flow up 23%.

The consensus projects profit growth of 27% this year and 13% next year. Given strong occupancy and pricing trends in the hotel business and aggressive share buybacks (share count down 14% over the last year), the profit targets seem reachable, and a move to $60 in the next six months would not surprise us. In fact, the hospitality concern remains among our favorite 25 or so stocks, and we still expect market-beating performance over the next year.

But the valuation takes some of the edge off Wyndham. At 17 times expected 2012 earnings, the stock still trades at a discount of 26% to its peer-group median. But it looks expensive relative to its own historical norms for price/earnings, price/sales, and price/operating cash flow. Wyndham no longer ranks among our favorite 15 and is losing its place on the Focus List; the stock remains a Buy and a Long-Term Buy.

September-quarter guidance

Intel ($23; INTC) slashed its sales target for the September quarter to a range with a midpoint of $13.2 billion, versus a prior estimate of $14.3 billion. While the warning was not a shock given weakness at Dell ($11; DELL) and Hewlett-Packard ($18; HPQ), the degree of the cut surprised investors. Intel also withdrew its full-year guidance; the consensus estimate for 2012 has fallen 8% over the last week and now projects a profit decline of 9%. At this time of year, makers of personal computers usually build up inventory for the holidays. But Intel said its customers have trimmed inventories because of weak end-market demand, including a slowdown in emerging markets. Intel may be choppy in the near term. But the stock, modestly valued at 11 times the lowest Wall Street estimate for 2012 earnings, remains a Long-Term Buy based on its two- to three-year rebound prospects.


Southwest Airlines ($9; LUV) said it anticipates 2% growth in unit revenue — what airlines collect for each mile flown by a passenger — in the September quarter. The airline reported an increase in the load factor (percentage of seats filled) in August, a trend partly offset by lower-than-expected growth in fares. Southwest Airlines is a Long-Term Buy.


Wells Fargo ($34; WFC) CFO Tim Sloan said the bank will likely report a decline in net interest margin for the September quarter versus the June quarter, hurt by strong deposit inflows and the expiration of higher-yielding loans. Still, Wells Fargo is seeing robust mortgage volumes so far this quarter. Wells Fargo is a Focus List Buy and a Long-Term Buy.

Military waves off Walgreen

Walgreen ($35; WAG) failed to renew a contract with Tricare, a medical-benefits provider for the U.S. military. Tricare accounted for 15 million Walgreen prescriptions last year, roughly 17% of those filled at Walgreen by Express Scripts ($62; ESRX) customers and nearly 2% of the drugstore chain's total scripts. The Tricare announcement illustrates how Walgreen could struggle to recover its footing after ending a seven-month contract dispute with Express Scripts. It also appears to support Express' strategy of narrowing its network of participating pharmacies in order to lower costs for plan participants and fatten its own profit margins. The news also bodes well for customer-retention rates at CVS Caremark ($46; CVS). Express Scripts is a Focus List Buy and a Long-Term Buy. CVS Caremark is a Buy and a Long-Term Buy. Walgreen is rated A (above average).

Technology review

Amazon.com ($256; AMZN) has refreshed its line of Kindle Fire tablets, including a larger model it hopes will compete with Apple's ($661; AAPL) iPad. Given Apple's launch of a new iPhone and growing speculation about an iPad mini, Amazon's timing sounds excellent. Unlike Apple, Amazon is willing to sell its devices near cost in hopes of generating profits from games, books, and videos. Amazon.com is rated C (below average).


As Samsung tries to lift the U.S. ban on the sale of its tablets, Apple reportedly seeks to reduce its reliance on the company by buying components from other Asian suppliers. Apple is a Focus List Buy and a Long-Term Buy.


The European Union said Microsoft ($31; MSFT) is working on a strategy to comply with demands to protect consumer choice for web browsers. Several companies have complained that Microsoft failed to meet this requirement, which stems from an antitrust deal three years ago. Microsoft is a Buy and a Long-Term Buy.


Rank Changes

Foot Locker ($37; FL) has been added to the Focus List. U.S. Bancorp ($34; USB) is being added to the Buy List. Wyndham Worldwide ($54; WYN) is being dropped from the Focus List but remains a Buy and a Long-Term Buy. AGCO ($44; AGCO) is being dropped from the Focus List and the Buy List, and from coverage.


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