Portfolio Review: December 5, 2016

12/5/2016


An upgrade and a new pick

We are adding Carnival ($51; CCL) to the Buy List. In the week since we initiated Carnival as a Long-Term Buy, the stock's Quadrix scores have improved, including two categories that tend to be especially timely: Earnings Estimates and Performance.

In the last days of November, shares broke out to their highest level since January, helped by a brokerage upgrade and the strongest monthly reading in 10 years for U.S. consumer confidence by the Conference Board. The stock has returned 8% including dividends in the past three months.

Robust operating momentum makes the stock look cheap, even after those recent gains. Carnival has delivered record 12-month operating cash flow in each of the past five rolling quarterly periods. Shares trade at 7.5 times trailing operating cash flow, well below their five-year median of 9.3 and the industry median of 14.4. The stock's trailing P/E ratio of 16 offers a 26% discount to its five-year median. Carnival is also a Long-Term Buy.


With a Quadrix Overall rank of 94, CBS ($61; CBS) joins the Long-Term Buy List. CBS is a conglomerate that spans nearly every form of media: local TV and radio stations, cable networks, book publishing, online, and film and TV production. Each of its five segments delivered higher sales and operating income in the September quarter, leading to companywide growth of 4% for revenue and 19% for earnings per share.

CBS has a choppy track record, and there is some risk that management may overpay to acquire Viacom ($37; VIAb). CBS split off from Viacom in 2006, but the two companies have discussed reuniting.

Free cash flow and operating cash flow rose more than 25% in the 12 months ended September. In fact, operating cash flow has grown to surpass net income, a signal of improving earnings quality. Returns on equity and investment are also trending higher. The shares look cheap, earning a Value rank of 82 and trading at 15 times trailing earnings, below the five-year average of 17. Viacom is rated B (average).

Apple battles for smartphone supremacy

With the iPhone approaching its 10th anniversary next June, Apple ($111; AAPL) continues to take nearly all of the smartphone industry's profits. But it also faces increased competition in China and questions about the long-term future of its flagship device.

Apple's sales in Greater China slumped 17% in fiscal 2016 ended September. A pair of upstart Chinese smartphone makers, Oppo and Vivo, played a large role in that decline. They combined for a 34% share of China's smartphone market last quarter, causing Apple's slice to shrink to 7%, its lowest level in nearly three years. Oppo and Vivo make low-priced devices that have become popular in rural China. Their local-marketing efforts have proved successful.

The iPhone posted 12% lower sales in fiscal 2016 and could see limited growth opportunities in the coming decade, say some analysts, citing slowing innovation and a narrowing gap in performance compared to rival devices. For now, Apple appears focused on designing its next iPhone, rumored to feature an organic light-emitting display. OLEDs tend to be thinner than traditional screens and flexible enough to be shaped into a curve. The forthcoming device could face some competition from Alphabet's ($776; GOOGL) Pixel smartphone, which has received positive reviews and is projected to generate $3.8 billion in sales next year. The iPhone posted $136.70 billion in sales for fiscal 2016.

Plenty of risk already appears baked into Apple's share price. The stock trades at 12 times estimated fiscal 2017 earnings, ranking among the cheapest 20% of stocks in our research universe. Its PEG ratio (forward P/E ratio divided by projected long-term profit growth) is 1.4, versus the S&P 1500 technology sector's median of 1.7. Alphabet is a Focus List Buy and a Long-Term Buy. Apple is a Buy and a Long-Term Buy.

New pact strengthens CVS retail-pharmacy business

Hoping to breathe fresh life into its retail unit, CVS Health ($77; CVS) formed a partnership with OptumRx, a pharmacy-benefits manager (PBM) owned by UnitedHealth Group ($158; UNH). Terms of the agreement include allowing OptumRX customers to fill their 90-day prescriptions at home-delivery prices at all CVS stores, starting July 1. The deal could modestly boost CVS' prescription volumes in 2017, with stronger growth possible in 2018. The agreement also eases some concerns that the CVS retail-pharmacy business could face more defections after announcing in November the loss of multiple contracts to Walgreens Boots Alliance ($85; WBA).

CVS shares rose on the announcement but remain down 18% since the company's September-quarter report. Its initial per-share-profit outlook of $5.77 to $5.93 for 2017 fell well short of analyst expectations. However, the stock trades at just 13 times the lowest analyst profit estimate of $5.81, compared to the median P/E ratio of 19 for S&P 1500 consumer-staples stocks. At 14 times trailing earnings, CVS also trades near its lowest level since 2010. CVS is a Long-Term Buy. UnitedHealth and Walgreens are rated A (above average).

Corporate roundup

Disney ($99; DIS) raised its semiannual dividend 10% to $0.78 per share, payable Jan. 11. Disney is a Long-Term Buy.


Alphabet ($776; GOOGL) is reportedly negotiating a tax settlement with Indonesia. Indonesian officials had previously said Alphabet's tax bill could exceed $400 million for 2015 alone. A settlement could inspire more countries to seek back taxes from internet companies. Alphabet is a Focus List Buy and a Long-Term Buy.


Southwest Airlines ($47; LUV) said its appearance technicians approved a new four-year contract, the latest in a series of new labor contracts reached by the airline. Southwest Airlines is a Focus List Buy and a Long-Term Buy.


Shares of WGL Holdings ($73; WGL) rallied after Bloomberg reported that the company held preliminary talks to possibly sell itself to Iberdrola ($24; IBDRY), an electricity company based in Spain. Natural-gas utilities such as WGL have become attractive takeover targets for large electric companies seeking to diversify their operations and stoke growth as electricity demand stalls. For now, WGL remains a member of our Top 15 Utilities portfolio.


Rank Changes

CBS ($61; CBS) is being added to the Long-Term Buy List. Carnival ($51; CCL), already a Long-Term Buy, is being added to the Buy List. Vanguard Short-Term Corporate Bond ($79; VCSH) exchange-traded fund now accounts for 8.8% of the Buy List and 10.8% of the Long-Term Buy List.


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