Capital-Gains Favorites For 2010

12/21/2009


In the search for our 2010 capital-gains favorites, we looked for the qualities we seek in all members of our Buy List:

An Overall Quadrix® score above 80, and preferably above 90.

Above-average scores for most Quadrix categories, with no particularly low scores for Value, Earnings Estimates, or Performance.

An attractive valuation relative to other stocks and relative to a stock’s own history.

A solid track record and bright growth prospects, with the potential to exceed consensus expectations.

A catalyst, or a reason to think a stock’s strong fundamentals will draw attention over the next 12 months.

For a variety of reasons, the six Buys reviewed below seem particularly well positioned for 2010. All six are solid growers with attractively valued stocks, all of which seem capable of delivering at least 20% to 25% returns over the next year.

Aflac’s ($47; AFL) per-share earnings are projected to jump 21% this year and 10% in 2010. Although the stock has more than doubled since February, it still carries a low PEG ratio (forward P/E divided by expected annualized five-year earnings growth) of 0.78.

Investors still worry about Aflac’s investment portfolio, particularly the hybrid European securities that sent shares tumbling earlier this year. The hybrids, many issued by banks hit hard by the credit crisis, combine features of debt and equity. While further write-downs seem likely, a worst-case scenario involving massive defaults and bank nationalizations seems unlikely.

Most of the insurer’s growth opportunities lie in Japan, where the deregulation of insurance sales at banks has opened a new channel for Aflac to promote its cancer and medical insurance products. Sales through banks now generate about 7% of Aflac’s total revenue, a percentage likely to rise. Banks are training more employees to sell the products, and additional restrictions could lift in 2011 to allow Aflac to offer more coverage to clients. New customers account for 80% of bank-channel sales, so the strategy diverts little revenue from Aflac’s established agencies. Yielding 2.4%, Aflac is a Focus List Buy and a Long-Term Buy.


BMC Software ($39; BMC) develops products that run corporate data centers, which house critical computer systems. BMC’s long-term contracts sustained stable profits during the downturn. Over the next 12 months, results should benefit as clients resume spending on technology. Consensus estimates project per-share profits will advance 15% in fiscal 2010 ending March — and grow 14% annually over the next five years.

Recent acquisitions have bolstered BMC’s promising segment for automating data-center activities. Fortune 500 companies comprise more than 85% of BMC’s client list, and it is unlikely such companies will abandon cost-cutting initiatives once the environment improves. Reflecting this optimism and better-than-expected results for the September quarter, BMC in October raised profit guidance for fiscal 2010.

With a trailing price/earnings ratio of 15, BMC trades at a discount to its three-year average P/E of 22 and five-year average of 27. If the P/E returned to the three-year average and BMC matched consensus profit estimates, the stock would trade at $58 next year. While that target seems a stretch, BMC seems fully capable of reaching $45 to $50. BMC is a Focus List Buy and a Long-Term Buy.


As the largest U.S. satellite-television operator, DirecTV ($33; DTV) owns more than $2 billion worth of satellites orbiting the earth. But it is the assets on the ground — including an enviable nationwide customer base, licensing agreements to air exclusive content, and a solid balance sheet — that separates DirecTV from its competitors.

DirecTV typically targets wealthier, less risky consumers. Earlier this year, DirecTV grew its subscriber base through heavy promotions, but it has used discounts more sparingly in recent months to retain its best customers.

The Nov. 19 merger with Liberty Entertainment simplified DirecTV’s ownership structure, and many expect one of its telecom-industry partners to bid for DirecTV. The CEO of Verizon Communications ($33; VZ) said Dec. 11 that he did not see the strategic need for a takeover, as the partnership is working nicely. Verizon may or may not be posturing. What does seem clear is that Verizon would hate to see DirecTV bought by AT&T ($28; T), and vice versa.

Rising free cash flow has helped DirecTV trim its share count by more than 11% over the past year, and many expect buybacks to accelerate in the absence of any takeover deal. DirecTV — trading at 15 times estimated year-ahead earnings, a 12% discount to the three-year average — is a Focus List Buy and a Long-Term Buy.


Hewitt Associates ($44; HEW) delivers many of the services of a human-resources department. The outsourcing segment, which administers health and pension plans, accounts for two-thirds of Hewitt’s sales. But management sees 2010 growth coming from the consulting business, which lays out strategies for designing benefit plans, training employees, and adjusting to mergers. Hewitt says any health-care legislation should help its health-management business.

For fiscal 2010 ending September, per-share earnings are projected to advance 10% on 2% higher sales. At 15 times expected fiscal 2010 earnings, Hewitt trades in line with the data-processing group despite superior long-term growth potential.

Hewitt’s returns on equity have risen sequentially in the past five quarters. Cash of $6.87 per share accounts for 16% of the stock price and exceeds long-term debt. Hewitt, with strong Momentum and Quality scores and an Overall Quadrix score of 98, is being upgraded to a Focus List Buy.


Hospira ($49; HSP) produces medical devices and specialty injectable pharmaceuticals, but its best growth prospects rest in biosimilar drugs — generic versions of complex biological drugs. Legislation to allow biosimilar drugs in the U.S. is likely to be part of any national health-care bill. With some biological drugs costing $100,000 a year per patient, generics would curb government expenses.

Hospira is the only U.S. company producing biosimilars. Anemia treatment Retacrit is available in 15 countries, and a second biosimilar is scheduled to launch in Europe next year. Two deals made in the past four months have bolstered Hospira’s biosimilar pipeline, described by management as one of the biggest in the world. A third deal, announced in December, bolsters Hospira’s core business — generic injectable drugs. Hospira will pay $400 million to Orchid Chemicals & Pharmaceuticals for its generic injectable drug portfolio and facilities in India.

The stock has jumped 84% this year. Yet, at 16 times trailing earnings, the P/E is 13% below the five-year average. Wall Street expects profits to climb 12% next year to $3.27 per share. If Hospira hits that target and the P/E returns to the five-year average, the stock would trade at $62. Hospira is a Focus List Buy and a Long-Term Buy.


The global recession slowed some traditional businesses for IBM ($128; IBM), leaving the technology giant to pursue new growth drivers. Some ideas — a computer that emulates the human brain, for instance — seem farfetched. The impact of other initiatives could be more immediate.

One such business is cloud computing, in which computing services are delivered over the Internet from remote data centers. Another opportunity is business-analytics software, a market projected to grow 4% this year to $25 billion, according to research firm IDC. In December, IBM boosted its portfolio of business-analytics software with the acquisition of two companies, including $225 million for Guardium, whose technology monitors for fraudulent database activity and automates tasks related to regulatory compliance.

Shares trade at 13 times trailing earnings, a 12% discount to the five-year average. IBM says it plans to generate per-share earnings of $10 to $11 next year. Even at IBM’s minimum earnings target, the stock would reach $150 by the end of 2010 if the P/E reverts to the five-year historical average. IBM, yielding 1.7%, is a Focus List Buy and a Long-Term Buy.

 

SIX PICKS TO CLICK
All six of our 2010 capital-gains favorites are likely to deliver solid profit growth in 2010. Relative to historical median P/E ratios over the past three and five years, all six seem attractively valued.
Earnings
–— Per Share —–
Median
— Trailing P/E —
Company
(Price; Ticker)
Year-
End
2009
Est.
($)
2010
Est.
($)
P/E on
2010
Est.
36
Mos.
60
Mos.
Quadrix
Overall
Aflac’s
($47; AFL)
Dec.
4.82
5.31
8.8
16.0
16.1
95
BMC Software
($39; BMC)
Mar.
2.26 *
2.61
14.9
21.5
25.8
93
DirecTV
($33; DTV) 
Dec.
1.38
2.20
15.1
20.2
20.7
92
Hewitt Assoc.
($44; HEW)
Sep.
2.67 *
2.93
14.9
13.7
19.1
98
Hospira
($49; HSP)
Dec.
2.91
3.27
15.1
19.1
19.6
91
IBM
($128; IBM)
Dec.
9.89
10.90
11.8
15.2
15.4
88
Quadrix scores are percentile ranks, with 100 the best.      * Actual results.

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