Portfolio Review


Two new buys

Below we review two new recommendations. Other changes to our buy lists are outlined in the Market Commentary.

Thermo Fisher Scientific ($60; TMO) is being initiated as a Buy and a Long-Term Buy. The company provides diagnostic instruments, laboratory equipment, and bioscience reagents, products designed to test food safety, research new drugs, and analyze compliance with environmental regulations. Sales grew 11% to $6.16 billion in the first half of 2012, while fatter operating profit margins contributed to a 30% surge in operating cash flow to $900 million.

Spending in the government and academic markets, roughly one-quarter of Thermo Fisher's sales, has been sluggish. But shares appear to reflect that slowdown, trading at 13 times trailing earnings, 41% below their five-year average. Relative to five-year norms, the stock's price/sales ratio is discounted 8% and price/operating cash flow ratio 28%.

BB&T ($33; BBT), a regional bank, is being added as a Long-Term Buy. BB&T has scooped up the assets of several distressed banks in the past five years, expanding its presence in the Southeast. Rising regulatory costs and low interest rates could pressure the bank's profit margins in coming quarters, but robust loan growth drove revenue up 10% in the six months ended June. The consensus calls for per-share profits of $0.70 in the September quarter, up 35%. BB&T plans to post quarterly results Oct. 18.

Shares trade at less than 14 times trailing earnings, a 13% discount to their five-year average and 5% below the median for regional banks in the S&P 1500 Index. Yielding 2.4%, BB&T raised its quarterly dividend 25% in the March quarter.

Microsoft set up for Windows Pain?

Investors once looked to Microsoft's ($30; MSFT) Windows 8, due out Oct. 26, as the best hope to revive the personal-computer market. But sentiment has turned increasingly negative in the past month.

The Windows operating system runs 90% of all personal computers, though tablets keep pecking away at that market, posing a risk to Microsoft. Windows generated 25% of company sales and 41% of operating profits in the fiscal year ended June 2012. In July, Microsoft said it expects to defer $1.0 billion to $1.2 billion in revenue in the September quarter for Windows updates and presales of Windows 8. Three years earlier, Microsoft had forecasted deferred revenue of $1.1 billion to $1.3 billion as it headed into the Windows 7 launch. Windows 7, released in October 2009, sold more than 60 million licenses in its initial quarter, the best launch of an operating system in Microsoft's history.

Last month, Intel ($23; INTC) showed off a new batch of semiconductors powerful enough to showcase Windows 8. The program allows tablet users to stream high-definition video and run popular software such as Word and Excel — without draining devices' batteries too quickly. But Intel has yet to deliver the requisite software to manufacturers, crimping the time device makers have to fine-tune their products for the holiday season.

Businesses can be slow to adopt new technology, and many companies won't consider upgrading to Windows 8 right away. Initial demand for Windows 7 was driven by consumers — not businesses, which had clamped down on spending during the downturn. Nearly three years later, more than 50% of corporate desktop computers run Windows 7.

Establishing Windows 8's place in the consumer market looks like Microsoft's biggest challenge for the next few quarters. As Apple ($661; AAPL) has demonstrated, winning the hearts of consumers can help win the wallets of their employers — at least in the case of mobile devices. Microsoft is a Buy and a Long-Term Buy. Apple is a Focus List Buy and a Long-Term Buy. Intel is a Long-Term Buy.

Corporate roundup

Abbott Laboratories ($69; ABT) said it incorrectly reported in regulatory fillings from 2002 to 2007 the credentials of Richard Gonzalez, named as CEO of AbbVie, the drug unit to be spun off by the end of the year. In other news, Abbott won approval from U.S. regulators to expand the usage of Humira to treat ulcerative colitis, a bowel disease that affects 700,000 Americans. Abbott is a Long-Term Buy.

American Express ($57; AXP) agreed to pay $113 million to settle charges it violated consumer-protection laws. Amex is a Focus List Buy and a Long-Term Buy.

The New York attorney general sued J.P. Morgan Chase ($41; JPM) for allegedly deceiving investors about the quality of loans underlying mortgage-backed securities sold by its Bear Stearns unit. Investors reportedly lost at least $22.5 billion on securities issued by Bear Stearns from 2006 to 2007; J.P. Morgan bought Bear Stearns in March 2008. J.P. Morgan is a Long-Term Buy.

Express Scripts' growth makes it a value play

Pharmacy-benefits provider Express Scripts ($64; ESRX) is not your classic value stock. At 20 times trailing earnings, the shares trade at a 13% premium to the median health-care distributor and service stock in the S&P 1500 Index. But the company, which administers drug plans for employers and insurers, has superior growth potential. Wall Street expects Express Scripts to earn $3.70 per share this year, up 25%. For 2013, the consensus projects 21% growth. Factoring in expected growth, Express Scripts looks more like a value play. Shares trade at 17 times estimated current-year earnings, versus 18 for its peers — a group that on average is expected to increase per-share profits 11% this year and 15% in 2013.

Importantly, profit estimates for Express Scripts could prove too low. The April acquisition of Medco is expected to generate at least $1 billion in annual savings. In addition, the company is eschewing higher-cost retail pharmacies, which should trim expenses and boost profit margins. Express Scripts' ability to keep drug costs low is winning new customers, and the company is positioned to leverage its estimated 30% market share in the fast-growing market for specialty pharmacy services.

Aided by contributions from Medco, Express Scripts' June-quarter earnings per share hit $0.88, up 24% and $0.06 above the consensus. That momentum should carry over to the September quarter, as estimates have risen in recent months. Express Scripts is a Focus List Buy and a Long-Term Buy.

Rank Changes

Bed Bath & Beyond ($62; BBBY) is being dropped from the Focus List but remains a Buy and a Long-Term Buy. CVS Caremark ($48; CVS) is being added to the Focus List. McKesson ($86; MCK) is being dropped from the Buy List but remains a Long-Term Buy. Thermo Fisher Scientific ($60; TMO) is being initiated as a Buy and a Long-Term Buy. BB&T ($33; BBT) is being initiated as a Long-Term Buy. CSX ($21; CSX) and Apache ($87; APA) are being dropped from the Long-Term Buy List.

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