Portfolio Review

12/8/2014


Portfolio Review

When the facts change, we change our opinion. This week, responding to shifting Quadrix scores and profit expectations, we are downgrading two stocks and upgrading four. In Analysts' Choice, we add Mylan ($58; MYL) to the Buy List. Below we explain the other rank changes, along with some changes we're not making.

Energy review

Whiting Petroleum ($41; WLL) is being dropped from the Buy and Long-Term Buy lists, as profits are likely to be hit hard by the collapse in oil prices. The stock appears modestly valued at less than 11 times the consensus profit estimate of $3.83 per share for 2015. But the consensus has yet to catch up to the latest drop in oil prices, and the most recent estimates have been below $3.30 per share.

More important, Whiting has negative free cash flow and may be forced to cut spending sharply, meaning expectations for production growth beyond 2015 are in doubt. Long-term debt represents 39% of total capital — still decent relative to peers but up from 34% at year-end 2012. The stock's Overall Quadrix score has dropped to 72, hurt by poor marks for Momentum, Earnings Estimates, and Performance. Whiting, also being dropped from the Monitored List, should be sold.


Schlumberger ($87; SLB) remains our top pick in the energy sector. But the stock is being dropped from the Focus List, as it no longer ranks among our favorite 12 to 18 stocks. The drop in oil prices is likely to dampen revenue growth and hurt pricing for even the strongest players in oilfield services. U.S. drillers have responded quickly to lower oil prices, with November permits for oil and gas wells falling 37% from October.

The Overall score has dropped to 86, down from 92 on July 31, because of poor scores for Earnings Estimates and Performance. But the Value score has jumped to 87, and Schlumberger appears attractively valued even based on fairly pessimistic profit estimates.

For 2015, the most recent estimates call for per-share earnings of $6.00 to $6.30. Even assuming Schlumberger earns $5.00, the stock would sell for $105 in early 2016 if the trailing P/E returns to the 10-year median of 21. The company plans to take an $800 million charge this quarter as part of a plan to reduce its marine seismic fleet, but the write-down is not expected to impact cash flow. Schlumberger, yielding 1.8%, remains a Buy and a Long-Term Buy.


Halliburton ($41; HAL) seems capable of a rebound to $46 or $50 over the next six to 12 months, so the stock is being maintained as a Buy and a Long-Term Buy. Consensus estimates still call for per-share earnings of $4.63 for 2015, up from the $4.03 expected for 2014. But expectations of $3.75 to $4.35 seem more realistic for 2015, reflecting the oilfield giant's heavy exposure to North American drilling.

Assuming Halliburton earns $3.75 and the trailing P/E returns to the 10-year norm of 17, the stock would trade at nearly $64 in early 2016. While that target seems optimistic, Halliburton is unusually cheap relative to its peers and to its own history, partly because of its unpopular decision to pay a massive takeover premium for rival Baker Hughes ($58; BHI). While we agree that Halliburton is overpaying and risking a protracted antitrust-review process, we like the long-term strategic merits of the merger. Halliburton will be watched closely but remains a Buy and a Long-Term Buy.

Upgrades

F5 Networks ($131; FFIV), a Buy and a Long-Term Buy, is being added to the Focus List. The company, a provider of networking software, has delivered three straight quarters with year-to-year growth of at least 17% in sales and 15% in operating profits. Encouragingly, cash from operations and free cash flow have also been moving higher.

The stock is not cheap at 21 times the fiscal 2015 consensus profit estimate. But F5 seems reasonably valued versus peers considering its superior growth rate, and the stock is cheap compared to its own five- and 10-year norms. Recent order trends reflect a healthy competitive position, particularly in products that help optimize cloud-based applications. F5, well positioned to capitalize on surging spending on network security, is a top year-ahead pick.


Shire ($215; SHPG) is being added to the Focus List. The Irish drugmaker, already on the Buy and Long-Term Buy lists, appears positioned for 13% to 20% year-to-year growth in per-share earnings in the next two quarters. The consensus calls for 8.5% growth for full-year 2015, but Shire seems capable of exceeding that target.

Even using the 2015 consensus, Shire trades at a discount to peers despite superior long-term growth prospects. The stock also trades at a discount to its own historical norms, and a move to $250 seems achievable by early 2016 if Shire returns to its 10-year norm of 22 for trailing P/E.

On Dec. 10, Shire plans to provide an update of its research and development pipeline. Surging free cash flow and a rock-solid balance sheet should allow the company to fill out its pipeline with niche acquisitions. Shire, with an Overall score of 92, is our top pick in the health-care sector.


Lincoln National ($56; LNC), a provider of annuities and life insurance, is being initiated as a Long-Term Buy. The stock's main appeal is its modest valuation. Lincoln is cheap versus peers based on price/earnings and price/book value ratios, and it trades at a 9% discount to its own 10-year median trailing P/E. The Value score is 88, helped by a strong score for price/free-cash-flow ratio.

We also like Lincoln's recent improvement in sales growth and free cash flow, strong balance sheet, and impressive profit-estimate trends. Favorable inflows bode well for near-term annuity results. The stock, yielding 1.4%, offers superior two- to three-year potential.

Stocks in the news

Alaska Air ($57; ALK) shares have been volatile, surging on the drop in oil prices before slumping on a brokerage downgrade that pointed to rising competitive pressures in its home market of Seattle. But Delta Air Lines ($45; DAL), the rival responsible for much of the increased competition, cited strong pricing in Seattle in its November results. Alaska Air said November traffic rose 9.4% on an 8.7% increase in capacity. Alaska Air remains a Focus List Buy and a Long-Term Buy.


B/E Aerospace ($79; BEAV) announced details for its pending split into two separate companies. Shares of KLX, which provides distribution services in select aerospace and energy markets, will be distributed on Dec. 16, with investors receiving one share for every two shares of B/E. The new stock will begin trading on Dec. 17 using the ticker KLXI. The core aerospace business will use the legacy B/E Aerospace name and ticker.

With roughly $1.7 billion in 12-month sales, KLX's aerospace unit (76% of revenue) provides fasteners and consumable products to more than 4,700 customers. An expanding oil and gas unit (24%) should help diversify sales and sustain growth. Through 2017, management says, per-share earnings are expected to grow at least 20% annually.

With roughly $2.7 billion in annual sales, the "new" B/E Aerospace is the largest global supplier of aircraft interiors. Product launches and contract wins should help drive results. In addition, a backlog totaling $7.9 billion and healthy cash flow bode well for growth. For 2015, B/E sees per-share earnings of $3.00 and sales growth of 10%. Over the next three years, management targets yearly profit growth of 18% to 20%. The company plans to initiate an annual per-share dividend of $0.76, with the payout projected to grow roughly 10% per year.

B/E enjoys solid operating momentum, reflecting healthy demand for commercial aircraft and increased production at Boeing ($132; BA) and Airbus. In our view, the near-term outlook for KLX is not as bright, partly reflecting likely weakness in the energy sector. For now, we suggest that investors hold both stocks when trading begins later this month. B/E Aerospace is a Buy and a Long-Term Buy.


Rank Changes

F5 Networks ($131; FFIV) and Shire ($215; SHPG) are being added to the Focus List. Schlumberger ($87; SLB) is coming off the list, but remains a Buy and a Long-Term Buy. Mylan ($58; MYL) is joining the Buy List, while Lincoln National ($56; LNC) is being initiated as a Long-Term Buy. Whiting Petroleum ($41; WLL) is being dropped from the Buy List, Long-Term Buy List, and from coverage. Vanguard Short-Term Corporate Bond ($80; VCSH) now accounts for 2.8% of the Buy List and 8.1% of the Long-Term Buy List.


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