Portfolio Review

11/17/2014


Shire up, Dover and Capital One down

We removed Shire ($201; SHPG) from our Buy and Long-Term Buy lists in the July 21 issue, when the Ireland-based drug maker embraced a $53 billion takeover bid from AbbVie ($64; ABBV). Last month, however, Shire shares plunged 30% after AbbVie reneged on the deal in response to new rules aimed at curbing foreign acquisitions that allow U.S. companies to lower their tax bills. Shire's stock has recovered some ground since the deal's collapse, though it remains down 24% from its high.

Shire may now be a less-appealing acquisition target, but its business prospects — the reason we recommended it in the first place — remain attractive. Shire makes drugs that treat so-called "orphan diseases," or illnesses that affect fewer than 200,000 patients. The stock's Quadrix Overall score of 95 is bolstered by four category ranks that exceed 90.

For the 12 months ended September, Shire delivered 51% growth in per-share profits on 20% higher sales. Despite its superior operating momentum, Shire trades at 20 times trailing earnings, a 14% discount to its peer-group average. Shire is being initiated as a Long-Term Buy. AbbVie is rated B (average).


Capital One Financial ($82; COF) is being dropped from the Long-Term Buy List. The Overall score has slumped to 73, with the Momentum score down to 42 after a somewhat disappointing September-quarter report. Also, the Value score has dropped to 70, partly because the stock has rallied to within 4% of the six-year high reached in July. Capital One, a leader in credit cards and auto loans, reported solid loan growth in the September quarter. But loan-loss provisions jumped, and management expects loan charge-offs to rise over the next two years. Capital One, which will remain on our Monitored List with a B (average) rating, should be sold.


Dover ($81; DOV) is being removed from the Long-Term Buy list. Dover shares have surged 13% since the company posted September-quarter results, presenting an opportunity to sell a stock with eroding Quadrix scores. The Overall score has slipped to 58 from 82 at the end of August, hurt by weaker operating momentum. Dover's operating cash flow and free cash flow have now declined in four straight quarters. Exposure to capital spending from the energy sector could begin to weigh on Dover's operations and trigger more downward profit revisions. The stock is now rated A (above average); subscribers who track our recommended lists should sell.

Operational updates

Macy's ($62; M) grew earnings per share 30% to $0.61 in the October quarter, well ahead of the consensus of $0.50. Revenue slipped 1% to $6.20 billion, missing the consensus. Same-store sales dipped 0.7%. Management lowered its full-year profit guidance, which now implies per-share earnings of $2.24 to $2.34 in the January quarter, compared to $2.31 earned in the year-ago quarter and the consensus of $2.54 at the time of the announcement. A heavy dose of pessimism already seemed priced into Macy's shares, down since the end of August. Despite the disappointing outlook, Macy's shares rallied 5%. Macy's remains a Long-Term Buy.


For fiscal 2015 ending September, UGI ($38; UGI) expects per-share profits of $1.88 to $1.98, implying a decline of 1% to 6%. The profit consensus was $1.95 per share at the time of the announcement. UGI is a Buy and a Long-Term Buy.


Southwest Airlines ($39; LUV) shares rallied after management called December-quarter sales trends "encouraging." For October, traffic rose 4%, despite capacity remaining essentially flat. Southwest plans to boost capacity 6% in 2015, primarily by adding more seats to existing planes and flying longer routes. Southwest says its average cost for a gallon of fuel is projected to fall 7% to 12% in 2015. Southwest Airlines is a Long-Term Buy.


Alaska Air Group ($56; ALK) said traffic surged 10% on 11% higher capacity in October. Shares rose on the report. Alaska Air is a Focus List Buy and a Long-Term Buy.

Net neutrality could neuter Comcast deal

President Obama called on the Federal Communications Commission to tighten internet rules to prevent cable companies from allowing online content providers such as Netflix ($384; NFLX) to pay extra for faster delivery. Obama's strict stance addresses concerns that cable companies could become gatekeepers in a pay-for-speed environment that would favor well-funded websites over start-ups.

Following Obama's remarks, FCC Chairman Tom Wheeler, a former lobbyist for the cable industry, said he seeks a more balanced approach between cable companies and websites. Some investors have suggested that by starting down this path, the government could eventually move to regulate broadband prices.

Shares of Comcast ($54; CMCSa), AT&T ($35; T), and Verizon Communications ($51; VZ) fell on Obama's statement. Cable operators claim heavy regulations similar to those imposed on phone operators and utilities would discourage investment. Stricter rules would also reduce the financial benefits of Comcast's pending $45 billion acquisition of Time Warner Cable ($136; TWC).

A former FCC chairman said regulators could impose price controls as a condition of approving Comcast's acquisition of Time Warner. The deal, which has no breakup fee, will collapse if Comcast finds the terms too burdensome. Time Warner shares trade at their largest discount to the takeover price since before the deal was announced in February. Comcast is a Buy and a Long-Term Buy. Verizon is rated A (above average). AT&T is rated B (average).

New challenges, goals for ACA

The U.S. Supreme Court agreed to hear a legal challenge on whether subsidies can be used in the 36 states that do not run their own health exchanges under the Affordable Care Act. Without the subsidies, health premiums would likely surge. The court plans to announce its decision by the end of June. Shares of both health providers and insurers slumped on the news.

U.S. health officials now expect to have 9.0 million to 9.9 million Americans enrolled on health exchanges by the end of 2015; they had previously targeted 13 million. The Obama administration says 7.1 million people have obtained coverage through ACA exchanges, down from an August estimate of 7.3 million and 8.0 million in the spring. The reduced forecast reflects weaker renewal rates and fewer employers dropping their existing health plans than previously anticipated.


Rank Changes

Shire ($201; SHPG) is being added to the Long-Term Buy List, while Capital One Financial ($82; COF) and Dover ($81; DOV) are being sold from the list.


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