Portfolio Review


Two new Buys

Macy's ($34; M) operates about 850 department stores under its namesake or Bloomingdale's brands. During the holiday season (combining November and December) same-store sales climbed 5.7%, while online sales jumped 40%. As a result, the retailer raised its guidance for the January quarter. Also in January, Macy's doubled its quarterly dividend to $0.20 per share, payable April 2.

The shares have advanced 5% so far this year but trade at just 12 times trailing earnings, at least 21% below their own five-year average and the median for department-stores stocks in the S&P 1500 Index. Macy's shares seem capable of reaching $42 over the next year. Scoring at least 88 in both of our sector-specific ranks, Macy's is being initiated as a Buy and a Long-Term Buy.

KLA-Tencor ($51; KLAC), a maker of test and inspection equipment for semiconductors, is being initiated as a Buy. The company's fortunes hinge on capital-spending trends in the cyclical semiconductor industry, and foundries are currently scrambling to boost capacity to keep up with demand for chips used in mobile devices. In the December quarter, KLA-Tencor's per-share profits fell 35% to $0.72 but exceeded the consensus by $0.06. Orders soared to $950 million, up 95% from September-quarter bookings, well above management's target of 25% to 45% growth.

KLA-Tencor guided projected March-quarter sales and earnings well above the consensus. The company raised its dividend 40% in August, and the stock now yields 2.7%. Shares rallied on the December-quarter results, but they still trade at less than 10 times trailing earnings. KLA-Tencor is being initiated as a Buy.

Upgrades and downgrades

Aetna ($44; AET), already a Buy and Long-Term Buy, is being added to the Focus List. The company said operating earnings surged 54% to $0.97 per share in the December quarter on virtually flat revenue. Operating results for Aetna, a managed-care provider, continue to benefit from low utilization rates as customers forego doctor and hospital visits.

Aetna's medical-benefits ratio — the percentage of collected premiums paid out to cover medical costs — slipped below 81% from 83% in the year-ago quarter. That ratio will likely creep upward in 2012. The company expects to have more than $1.35 billion available this year that could help grow the dividend (raised 17% in December), trim the share count (down 10% in the past year), or make niche acquisitions. Aetna is now a Focus List Buy and a Long-Term Buy.

Qualcomm ($59; QCOM), already a Buy and a Long-Term Buy, is joining the Focus List. Benefiting from the burgeoning smartphone market, Qualcomm said earnings per share for the December quarter rose 18% to $0.97 excluding special items, topping the consensus by $0.07. Sales jumped 40% to $4.68 billion, also above the consensus. For the March quarter, management sees revenue rising 19% to 29% and per-share profits up 6% to 13%, both targets exceeding market expectations.

Qualcomm sells wireless semiconductors and software, and also licenses its technology used in wireless devices. Operating cash flow jumped 130% to $6.63 billion in the 12 months ended December. An investment in fourth-generation connections is paying off as mobile-device makers adopt technologies with faster speeds.

In the wake of Google's ($580; GOOG) disappointing profit report and decline in Quadrix scores, we are removing it from the Focus List. But while Google is no longer among our very top picks, it retains its Buy and Long-Term Buy ratings. Despite 25% sales growth, Google's per-share profits rose just 9% in the December quarter, the lowest growth in nearly three years.

However, the consensus still projects per-share-profit growth of 17% in both 2012 and 2013, and Google trades at just 14 times the 2012 estimate. A failure to deliver the operating momentum implied by the consensus could cost the stock its place on the Buy List. But the shares seem to have found support, and stabilization of profit estimates should drive the Overall score back above 80.

We are removing Exxon Mobil ($84; XOM) from the Focus List, but it remains a Buy and a Long-Term Buy. Exxon's Overall score is 76, and its Earnings Estimates score has fallen to 9. Exxon grew earnings per share 6% to $1.97 on 16% revenue growth in the December quarter. Profits from the upstream business jumped 18% despite a 9% decline in production, while downstream profits plunged 63% and chemical earnings fell 49%.

Based on Exxon's historical valuations, we believe the stock can move to $95 or $100 in the next year. But we think some other Buys have a bit more upside potential. Exxon's fellow supermajor Chevron ($103; CVX) is our top energy selection.

IBM ($193; IBM) has fallen prey to its own success. In the wake of strong December-quarter results, the stock has bounced back near all-time highs. Since we added IBM to the Buy List in January 2007, the shares have risen 96%. But the Value score has fallen to 51 and the Overall score to 73. The 12-Factor Sector score, which considers a dozen statistics that work particularly well for technology stocks, has dipped to 7.

We still like the company's business strategy and its efficient execution of that strategy. But given IBM's valuation and Quadrix scores, we prefer other technology names — such as Apple ($456; AAPL) and Intel ($26; INTC) — for the year ahead. IBM is being dropped from the Buy List, though it remains a Long-Term Buy.

Earnings update

Chevron ($103; CVX) earned $2.58 per share in the December quarter, down 2% and $0.26 below the consensus. Chevron's upstream business grew profits 18% to $5.74 billion, as higher energy prices offset a 5% decline in production. The downstream business posted a $61 million loss versus a $742 million profit in the year-earlier quarter. In other news, a Brazilian prosecutor plans to file criminal charges against Chevron workers in connection with an oil spill, though such environmental cases rarely lead to convictions in Brazil. Chevron is a Focus List Buy and a Long-Term Buy.

In the December quarter, Aflac ($48; AFL) reported operating profits of $1.48 per share, up 11% but $0.03 short of the consensus. Those results exclude net realized investment losses of $0.31 per share. Revenue increased 13% to $5.98 billion. For 2012, Aflac expects U.S. sales to grow 3% to 8%, though the larger Japanese business will likely contract 2% to 5%. Per-share profits are projected to rise 2% to 5%, versus the consensus estimate of 5% at the time of the announcement. Aflac, trading at just seven times the 2012 profit target, remains a Buy and a Long-Term Buy.

BMC Software ($36; BMC) earned $0.93 per share excluding special items in the December quarter, up 18% and $0.11 above the consensus on 2% revenue growth. The company raised its projection for per-share earnings for the fiscal year ending March 2012; but given the outperformance in the December quarter, the midpoint of the 2012 guidance is below consensus expectations for the March quarter. Operating cash flow fell 9%, while bookings declined 12%. For now, BMC remains a Buy and a Long-Term Buy.

Energen ($48; EGN) earned $0.98 per share excluding mark-to-market losses in the December quarter, down 12% and matching the consensus. Revenue slumped 23% as 11% higher production could not offset weaker natural-gas prices. The company also raised its quarterly dividend 4% to $0.14 per share, payable March 1, marking its 30th consecutive annual increase. Energen is a component of our Top 15 Utilities Portfolio. Be sure to read the Feb. 13 issue, in which we will review the Top 15 Utilities Portfolio.

Rank Changes

KLA-Tencor ($51; KLAC) is being initiated as a Buy. Macy's ($34; M) is being initiated as a Buy and a Long-Term Buy. Exxon Mobil ($84; XOM) and Google ($580; GOOG) are being dropped from the Focus List but remain Buys and Long-Term Buys. Aetna ($44; AET) and Qualcomm ($59; QCOM) are being added to the Focus List. IBM ($193; IBM) is being dropped from the Buy List but remains a Long-Term Buy. The Vanguard Short-Term Investment-Grade ($10.73; VFSTX) bond fund now accounts for 9.9% of the Buy List and 12.4% of the Long-Term Buy List.

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