Portfolio Review

4/11/2011


List review

Our Buy List is limited to our best 25 to 30 ideas for year-ahead gains, while our Focus List represents our top 12 to 15 names from the Buy List. As part of our never-ending drive to limit both lists to our true favorites, we are making several rank changes this week. As always, you can find more information on all our recommendations at www.DowTheory.com.

New additions

AutoZone ($277; AZO) is being added to the Buy List and Long-Term Buy List. The retailer of automotive parts has compiled an impressive track record, with nine straight years of higher per-share earnings and sales. Growth has accelerated in recent periods, reflecting a push into the market of supplying automotive-repair shops. Per-share-earnings growth exceeded 30% for both the November and February quarters, while sales growth exceeded 10%. Encouragingly, cash flow and free cash flow have climbed with earnings. Free cash flow topped $20 per share in the 12 months ended February.

AutoZone earns an Overall Quadrix score of 95, reflecting above-average scores in all six category scores. Per-share earnings are expected to rise 25% to $18.69 for the year ending August. At less than 15 times the consensus, the stock trades at a 13% discount to the auto-parts group. AutoZone, showing encouraging share-price action, seems capable of reaching $335 over the next 12 to 18 months.


Walter Energy ($141; WLT), a leading provider of metallurgical coal, is being added to the Buy List. Volume growth and higher coal prices have triggered much-improved results, with revenue up more than 65% and operating earnings up more than threefold in the September and December quarters. Cash flow and free cash flow have also surged, allowing Walter to strengthen its balance sheet. Long-term debt represented 21% of total capital on Dec. 31, down from 71% at year-end 2008.

Walter is leveraging its improved financial strength, expanding its mines in Alabama and buying Western Coal for more than $3 billion in cash and stock. The April 1 purchase of Western, with operations in British Columbia, should improve Walter's ability to sell into Asian markets. Over the next several years, Walter expects the deal and other measures to nearly double its production capacity. At 11 times expected 2011 earnings of $12.74 per share, the stock trades at a discount to its peer group and its own five- and 10-year norms. Walter, with an Overall Quadrix score of 98, seems capable of reaching $175 over the next 12 months.

Upgrades

Fresh off an impressive February quarter, Oracle ($34; ORCL) is being added to the Buy List and Focus List. Oracle reported strong momentum in software, and though hardware revenue was somewhat disappointing, the unit's gross margin expanded — and its plan of attack still seems valid. Cash provided by operations jumped 50%, marking the fourth gain in as many quarters.

Analysts responded to Oracle's earnings announcement by hiking May-quarter profit estimates to $0.71 per share, the midpoint of Oracle's raised guidance, implying 18% growth. Shares also rose on the news, but at 16 times trailing earnings still trade 21% below their five-year average and 10% below the average systems-software stock in the S&P 1500 Index. Oracle was already a Long-Term Buy.


Hess ($86; HES) is being upgraded to a Focus List Buy. The shares have rallied 13% so far this year but still seems cheap, especially considering the recent rise in oil prices (oil trades at $108 per barrel, its highest price since September 2008) and the likelihood that per-share-profit estimates will rise. Hess, with its production unhedged, is more sensitive to oil prices than most of its peers.

With merger-and-acquisition activity heating up, Hess might find a buyer for its aging refinery located in the U.S. Virgin Islands. Rising analyst estimates target March-quarter profits of $1.73 per share, up 16%. Hess was already a Buy and a Long-Term Buy.

Downgrades

Ameriprise Financial ($62; AMP) is being removed from the Focus List. We still like the stock, but it no long ranks among our top 12 to 15 favorites, partly because of recent share-price action and partly because of a legal dispute. Ameriprise and subsidiary Securities America tentatively agreed to settle a class-action lawsuit by paying up to 48% of up to $400 million in claims related to the sale of notes of companies later charged with fraud. A judge rejected a previous offer to pay just 20% of claims. Ameriprise has the liquidity to absorb the hit, considering it produced $2.04 billion in cash from operations last year. Ameriprise remains a Buy and a Long-Term Buy.


We are dropping Ross Stores ($72; ROST), a retailer for off-price apparel and home goods, from the Focus List, Buy List, and Long-Term Buy List. In the last four quarters, cash provided by operations (down 24%) and per-share profits (up 31%) have drifted in different directions, suggesting a poorer quality of earnings. Moreover, Ross's price chart has turned choppy. Ross, first recommended in February 2010 at $47, is being dropped from the Monitored List and should be sold.


Travelers ($59; TRV) is being dropped from the Buy List. The property-casualty insurer's Quadrix Overall score has slipped to 77 on fading operating momentum. Revenue fell 2% in the December quarter, and operating cash flow declined for a fourth consecutive quarter. But Travelers remains a decent pick for patient investors seeking three- to four-year total returns. And at nine times trailing earnings, Travelers trades 16% below the peer-group average. Travelers is still a Long-Term Buy.


We are dropping Varian Medical Systems ($69; VAR) from the Buy List. Projected to grow per-share profits 17% in fiscal 2011 ending September, Varian offers excellent growth prospects. But the shares seem expensive, trading at 18 times the fiscal 2011 estimate, a 12% premium to the group average. Varian has been under pressure since reporting December-quarter results, and recent price action suggests a near-term move to $73 is not as likely as we had previously hoped. Varian is still a Long-Term Buy.

Mergers and deals

In a highly anticipated move, NASDAQ OMX Group ($28; NDAQ) and partner IntercontinentalExchange ($120; ICE), offered about $11.3 billion in cash and stock for NYSE Euronext ($39; NYX). That's a 19% premium to the all-stock deal Deutsche Boerse proposed in February. ICE seeks control of NYSE's futures and derivatives unit, while NASDAQ wants NYSE's stock and options business, which would essentially create a monopoly on U.S. listings. Deutsche Boerse has not yet indicated whether it will raise its offer, though at least one published report says it will not, and NYSE Euronext plans to consider the proposal at a board meeting by April 14. Either deal would face close regulatory scrutiny. NASDAQ has rallied 8% since the announcement. NASDAQ is a Buy and a Long-Term Buy.


Seeking to expand its presence in the analog-semiconductor market, Texas Instruments ($35; TXN) agreed to purchase National Semiconductor ($24; NSM) for $6.5 billion in cash, or $25 per share, a 78% premium to National's price before the news broke. TI's balance sheet contains $3.07 billion in cash and no long-term debt, and the company will borrow some of the funds needed. The combined company would control a 17% stake in the fragmented $42 billion analog-semiconductor market. TI sees the deal providing $100 million in annual cost savings. Shares of TI rose on the news, and the stock remains a Focus List Buy and a Long-Term Buy.

Rank Changes

AutoZone ($277; AZO) and Walter Energy ($141; WLT) are being initiated as Buys, with AutoZone also a Long-Term Buy. Oracle ($34; ORCL) is being added to the Buy List and Focus List. MasterCard ($263; MA) and Hess ($86; HES) are being added to the Focus List. Ameriprise Financial ($62; AMP) is being dropped from the Focus List but remains a Buy and a Long-Term Buy. Varian Medical Systems ($69; VAR) and Travelers ($59; TRV) are being dropped from the Buy List but remain Long-Term Buys. Ross Stores ($72; ROST) is being dropped from coverage.


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