Portfolio Review

12/1/2014


Keep riding the rails

Our railroad stocks keep chugging along, with Union Pacific ($123; UNP) shares advancing 46% on the year and Norfolk Southern ($117; NSC) up 26%. By comparison, the S&P 500 has risen 12%.

Railroad shares got a jolt from merger speculation in October, when Canadian Pacific Railway ($208; CP) briefly discussed acquiring CSX ($38; CSX). Although CSX (market value of $37.8 billion) balked at the deal, Canadian Pacific says it will consider other targets. Norfolk Southern (market value of $36.6 billion) could become a target, though regulatory scrutiny could derail a deal. In a move that may dim the chances of a merger, Norfolk agreed this month to pay Canadian Pacific $217 million to acquire more than 280 miles of rail line in Pennsylvania and New York.

Merger speculation notwithstanding, our rail stocks enjoy solid operating momentum. Union Pacific's volume rose 7% in the first nine months of 2014, while Norfolk has grown volume 8% in each of the past two quarters after posting a 1% decline in the March quarter. Reports of congestion on railway networks in the past month suggest volumes remain healthy.

So far, slumping oil prices have probably had a minor effect on railroads. It would likely take a sustained decline in oil prices for clients to begin sending more business to truckers. Moreover, the boom in shale drilling still represents a small part of railroads' overall business. Major railroads generated $2.15 billion from transporting crude oil in 2013, reported The Wall Street Journal, up from $25.8 million in 2008. The five U.S. railroad companies in the S&P 1500 Index combined for $51.77 billion in sales over the last 12 months, while Canada's two largest railroads totaled $15.99 billion.

Shale drilling accounted for 4.5% of Union Pacific's 2013 volume, primarily from hauling sand to oilfields, and then transporting crude oil to refiners. This year, drilling in U.S. shale fields has driven growth for Union Pacific's industrial-products (sales up 15% for the first nine months of 2014) and chemicals (up 4%) segments.

Norfolk transports sand and crude oil in the Eastern U.S. In September, management said carloads of crude oil should jump 33% to 100,000 this year. Crude oil represented 1% to 2% of Norfolk's total volume last year.

Neither of our recommended railroads earns a strong Quadrix® Value score, though their shares seem reasonably priced versus peers. Norfolk trades at just 16 times estimated 2015 earnings, while Union Pacific's forward P/E ratio of 19 falls in line with the average for S&P 1500 railroads.

Norfolk is projected to grow 2015 per-share profits 13% and Union Pacific 15%. The ratio of forward P/E to estimated long-term growth (PEG) is 1.5 for Union Pacific
and 1.6 for Norfolk, compared to their peer-group average of 1.7. Norfolk Southern is a Long-Term Buy. Union Pacific is a Focus List Buy and a Long-Term Buy. CSX is rated A (above average).

Technology update

A U.S. judge approved Apple's ($118; AAPL) proposed settlement for a case in which it was found guilty of colluding with publishers to set e-book prices. If Apple fails to get the ruling overturned, it will pay $400 million to up to 23 million customers and an additional $50 million in lawyer fees. In other news, BB&T ($38; BBT) CEO Kelly King said Apple Pay and other mobile-payment systems should face the same regulations as banks for protecting customer information from hackers. Apple is a Focus List Buy and a Long-Term Buy.


EU lawmakers are expected to vote on Nov. 27, after our deadline, on a proposal for Google ($549; GOOGL) and other internet companies to be broken up. The proposal essentially calls for web-search businesses to be unbundled from commercial services. This initiative comes in response to complaints that Google has abused its dominant position in online search by prioritizing the visibility of its own websites over rival sites. Google's share of the online-search market exceeds 90% in many European countries, compared to 67% in the U.S.

The vote is solely symbolic — the parliament has no legal authority to follow through with the measure — but it would up the political pressure on antitrust authorities, who are continuing their own probe of the company. The U.S. has responded by urging the EU to avoid politicizing the antitrust investigation.

Google has faced additional criticism from regulators for not fully complying with the EU's new privacy rules, dubbed as the "right to be forgotten." European officials will reportedly ask Google to honor privacy requests by EU residents on its U.S. search site, a measure Google has resisted so far. Google is a Buy and a Long-Term Buy.

Foot Locker shares retreat on results

For the October quarter, Foot Locker's ($57; FL) per-share profits jumped 22% to $0.83 excluding special items, topping the consensus by $0.04. Foot Locker has now exceeded consensus profit estimates in five straight quarters. Total revenue increased 7% to $1.73 billion, while same-store sales advanced 6.9%. Same-store sales have risen in 19 consecutive quarters — and exceeded 5% growth in 15 of those quarters.

Shares fell on the results but have mostly recovered since then. Investors may have been concerned that price increases — not volumes — drove growth. Moreover, sales momentum decelerated through the October quarter, partly due to the timing of new footwear launches. Profit-taking may have also played a factor, considering the stock has delivered a 40% total return so far this year.

However, a strong roster of footwear releases leading up to Christmas should boost January-quarter results. Foot Locker says same-store sales rose by a low-double-digit rate in first few weeks of November and should be up by the mid-single-digit rate for the quarter. Gross profit margin has risen in each of the past three quarters, and management expects that trend to continue in the current quarter.

At 17 times trailing earnings, the stock trades 16% below both its five-year average and the median for S&P 1500 apparel retailers. Foot Locker remains a Focus List Buy and a Long-Term Buy.

Corporate roundup

Aetna ($87; AET) raised its quarterly dividend 11% to $0.25 per share, payable Jan. 30. The managed-care provider also approved $1 billion more in stock buybacks, on top of the existing plan with $464 million remaining. In all, Aetna is authorized to repurchase 5% of outstanding stock at its current price. Buybacks have lowered the share count by 5% over the past year and 20% over the past five years. Aetna is a Buy and a Long-Term Buy.


France negotiated with Gilead Sciences ($101; GILD) to obtain the lowest price in Europe for hepatitis C drug Sovaldi. A 12-week regimen will cost $51,400, compared to $84,000 in the U.S. Gilead is already selling Sovaldi at a deep discount in several developing countries and has reached licensing deals with generic-drug makers in several others. Gilead is a Long-Term Buy.


Rank Changes

No changes were made this week in Dow Theory Forecasts.


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