Portfolio Review


So far, profits don't look good

While we had low expectations for September-quarter earnings, results released so far suggest we were still too optimistic. About 59% of S&P 500 Index companies have exceeded consensus profit estimates, but only 38% have topped consensus revenue estimates. Both earnings and revenue are expected to be down from year-earlier levels, the first such decline for either metric since 2009.

Even worse, guidance for the December quarter has been overwhelmingly negative, with more than 80% of those issuing guidance lowering expectations. Consensus estimates still project profit growth of 9% for the S&P 500 Index in the December quarter, followed by 6% growth in the March quarter. But those growth rates are falling, and the forecast for growth of more than 11% in full-year 2013 seems very optimistic.

While you cannot expect to avoid disappointments entirely in such an environment, you can put the odds in your favor by emphasizing stocks with sales momentum, improving profit margins, rising profit estimates, and reasonable valuations. As a partial hedge, hold approximately 10% to 15% of equity portfolios in a short-term bond fund. With a breakdown below the June lows of 12,101.46 in the Dow Industrials and 4,847.73 in the Dow Transports, our stock-market exposure will be reduced.

Not all the news is bad. Some of our recommended companies have posted strong quarters and seen their stocks rise on the news. Here are just two:

Alliance Data Systems ($143; ADS) said core earnings per share advanced 10% to $2.37 in the September quarter, $0.14 ahead of the consensus estimate. Revenue also topped the consensus. Peeking ahead to 2013, management sees core per-share earnings of $9.50, implying 10% growth, on 8% higher sales. While the 2013 profit guidance is below the consensus, Alliance Data is known for its conservatism. Alliance Data is a Focus List Buy and a Long-Term Buy.

In the September quarter, Thermo Fisher Scientific ($58; TMO) grew earnings per share 11% to $1.19 excluding special items, topping the consensus by $0.03. Sales advanced 5% to $3.09 billion, powered by 15% growth in specialty diagnostics, Thermo Fisher's most profitable business. The company also raised its full-year profit target to a range with a midpoint of $4.85 per share (up 16%), versus its prior target of $4.79 and the consensus of $4.82. Thermo Fisher is a Buy and a Long-Term Buy.

Southwest shares grounded

In the wake of lackluster September-quarter results, we are dropping Southwest Airlines ($9; LUV) from the Long-Term Buy List. Southwest earned $0.13 per share excluding special items, easing past the consensus by a penny, on flat revenue of $4.39 billion. The listless quarter failed to revive Southwest shares, down 4% since the end of July, or halt the slide in analyst estimates for upcoming quarters. Quadrix ranks have also deteriorated, with the Overall score sinking to 66. The stock looks cheap, earning a Value rank of 93, but could get cheaper over the next year or two. Southwest should be sold.

Earnings roll call

American Express ($55; AXP) earned $1.09 per share in the September quarter, up 6% to match the consensus. Total revenue net of interest expense rose 4% to $7.86 billion. Spending by U.S. cardmembers rose 8%, ending a streak of nine straight quarters of double-digit growth. Heading into the holiday season, U.S. consumer spending appears to be gaining momentum, as surveys describe an uptick in consumer confidence. The consensus calls for Amex to deliver 5% growth in sales and profits in the December quarter. Amex is a Focus List Buy and a Long-Term Buy.

In the September quarter, Fifth Third Bancorp ($15; FITB) earned $0.40 per share excluding special items, flat with year-ago profits but $0.02 above the consensus. Loan growth slowed in the quarter, but the residential-mortgage portfolio still grew 16% from the year-earlier period, while commercial and industrial loans advanced 15%. The consensus projects per-share-earnings growth of 21% in the December quarter and a 2% decline for full-year 2013. Trading at just 10 times trailing earnings, Fifth Third is a Focus List Buy and a Long-Term Buy.

Wyndham Worldwide ($53; WYN) reported adjusted per-share earnings of $1.13 for the September quarter, up 20% from year-earlier levels and slightly above consensus estimates. Adjusted net income rose 6% on a 4% sales gain, but buybacks reduced the average share count by 11%. The company raised the lower end of its 2012 guidance for both sales and earnings. For 2013, the company says it expects growth of 7% to 12% for sales, 7% to 10% for operating earnings, and 9% to 14% for per-share earnings. The stock, not cheap but reasonably valued at 15 times expected 2013 earnings, remains a Buy and a Long-Term Buy.

EMC ($25; EMC) shares dipped on weak September-quarter results. Per-share earnings were $0.40, up 8% but $0.02 below the consensus. Revenue increased 6% to $5.3 billion but also fell short of expectations. For 2012, EMC projected sales and profits slightly below analyst expectations. On the bright side, management said the company continued to grow faster than overall tech spending and gain market share. EMC is a Buy and a Long-Term Buy.

Corporate roundup

Apple ($613; AAPL) took the covers off its long-awaited iPad mini, priced at $329 — well above the $199 cost of similar-sized tablets made by Amazon.com ($234; AMZN) and Google ($680; GOOG). While some analysts worry about the price, Apple has had success selling products at a premium to rivals' offerings. Both Apple and Google are Focus List Buys and Long-Term Buys. Amazon.com is rated C (below average).

Reata Pharmaceuticals, a research partner of Abbott Laboratories ($65; ABT), ended a late-stage trial of an experimental kidney treatment because of safety concerns. Abbott's stock fell on the news but remains a Long-Term Buy.

Visa ($137; V) raised its quarterly dividend 50% to $0.33 per share, payable Dec. 4. Visa is a Buy and a Long-Term Buy.

Tech giants stumble

Google ($680; GOOG) shares have slumped 10% since the internet-search giant reported disappointing September-quarter results, with revenue excluding recently acquired Motorola up 19% from year-earlier levels. That growth rate fell short of consensus expectations, largely because currency headwinds and the shift toward mobile internet usage lowered Google's cost-per-click (the price it receives per ad served on its sites) 15%, or 8% excluding currency translation. Paid clicks (the number of ads served on its sites) jumped 33%. Overall, per-share earnings excluding items fell 7% on a 45% sales gain.

Google does not provide guidance, and the company has a history of surprising investors. While the stock could remain in Wall Street's doghouse in the near term, the core franchise in internet ads remains healthy. The shift toward mobile internet usage will weigh on per-ad pricing but bodes well for long-term revenue growth. Excluding $119 in cash per share, the stock trades at roughly 12 times lowered 2013 profit estimates. Google remains a Focus List Buy and a Long-Term Buy.

In the September quarter, Microsoft ($28; MSFT) deferred $1.36 billion in revenue related to preorders for the Windows 8 operating system and discount offers for Windows and Office business software. Including that revenue — a safe bet since Microsoft has already collected much of it — sales were flat and profits down 4%, both well above expectations.

Shares fell on the news, reflecting uncertainty about the personal-computer business, higher costs, and Microsoft's lack of optimistic guidance. With the launch of Windows 8 and the Surface tablet, both on Oct. 26, Microsoft hopes to make a big splash in the mobile market.

In other news, European Union regulators threatened a fine of potentially more than $1 billion in connection with a failure to offer browser choice in an earlier version of Windows. While the concerns about Microsoft are genuine, at less than 10 times expected profits in the year ending June 2013, shares of the Buy and Long-Term Buy already reflect a lot of bad news.

Rank Changes

Southwest Airlines ($9; LUV) is being dropped from the Long-Term Buy List. The Vanguard Short-Term Investment-Grade ($10.88; VFSTX) bond fund now accounts for 15.4% of the Long-Term Buy List.

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