Portfolio Review: September 21, 2015


Kroger bags another big quarter

Kroger's ($37; KR) per-share profits jumped 26% to $0.44 in the July quarter, topping the consensus by $0.04. Revenue increased 1% to $25.54 billion, while operating cash flow advanced 3% to $1.00 billion. Same-store sales excluding fuel increased 5.3% and management raised its full-year target for the second time this year. Kroger also raised its guidance for per-share profits for fiscal 2016 ending January, now expected to rise 9% to 13%. Shares rallied on the results.

The stock's Quadrix Overall rank has slipped to 81, hurt by its middling Value rank of 52. At 19 times trailing earnings, the shares carry a 34% premium to their 10-year average but trade in line with other S&P 1500 food retailers. The stock's valuation still seems reasonable given its solid operating momentum. The grocer grew its market share nearly 1% last year and continues to see healthy store traffic and rising volumes. Kroger is expanding its online-ordering program, a strategy made easier by last year's $287 million acquisition of Vitacost.com. Kroger has increased same-store sales in 47 straight quarters — and recent growth is the strongest in four or five years excluding inflation. Kroger is a Buy and a Long-Term Buy.

Oil producers get drilled

Investors drilling for optimism in the U.S. oil patch are coming up dry. The value of asset write-downs taken by U.S. energy producers totaled $59.8 billion through June — about $11 billion more than the industry has ever seen for an entire year, reported The Wall Street Journal.

The sector could get a lift in the coming weeks if the U.S. House approves a proposal to end the ban on crude-oil exports. The White House would likely veto the bill; it wants the Commerce Department to decide export policy. Earlier this month Goldman Sachs ($189; GS) cut its 2016 price target on Brent crude, the benchmark for international oil, to $49.50 a barrel, roughly in line with today's levels. It also described a scenario in which a global glut could push oil down to $20 a barrel.

Continental Resources ($30; CLR) is among the rash of U.S. shale drillers to cut 2016 projections for capital spending. Several more, including Anadarko Petroleum ($69; APC) and Apache ($43; APA), suggested they may follow suit. The energy sector has also experienced a surge in dividend cuts in the past 12 months, as detailed in our Sept. 7 issue. Concerns about dividend sustainability may soon spread to stalwarts Chevron ($79; CVX) and Exxon Mobil ($74; XOM), given that their expected year-ahead dividends now exceed 50% of trailing 12-month income, versus 30% in December 2012.

Exxon continues to promise investors reliable dividend growth, illustrated by its 6% hike in April. But troubling trends are emerging. Exxon's operating cash flow declined in four straight quarters, free cash flow turned negative in four of the past five quarters, and net debt surged 90% to $29.46 billion over the past year.

Chevron raised its dividend in the June quarter in each of the past five years but held off in 2015. Chevron says growing its dividend is "our absolutely number one objective." But the company focuses on total dividends paid out each year rather than on a per-share basis. It could keep the per-share payout stable this year, yet the total dividend would still be larger than last year's, which included one quarter with a lower payout. Moreover, Chevron vows that free cash flow for 2017 will cover its dividend. That may be a challenge, considering the company last generated positive free cash flow in the December 2012 quarter. Chevron now yields 5.4% (versus its 10-year average of 3.3%) and Exxon 3.9% (2.3%). Both Continental and Goldman are rated B (average). Anadarko, Apache, Chevron, and Exxon are rated C (below average).

Health-care review

Gilead Sciences ($111; GILD) announced plans to issue $10 billion of debt, inviting speculation it may be preparing for a big acquisition. Gilead agreed in May to pay $65 million for EpiTherapeutics to expand its portfolio of cancer drugs, and more deals could be in the pipeline. Free cash flow surged 150% to $17.19 billion in the 12 months ending June. Gilead spent part of that cash on a new dividend, launched last quarter, yet its balance sheet still contained $8.61 billion in cash at the end of June, versus $11.92 billion in long-term debt.

Management has expressed a willingness to explore more deals, both big and small, though Gilead appears cautious about overpaying, given the high valuations for drugmakers. S&P 1500 drug and biotech stocks have averaged a 5% decline in the past month, yet still trade at 29 times trailing earnings, well in excess of the broader index as well as Gilead's trailing P/E ratio of 11. Yielding 1.5%, Gilead is a Focus List Buy and a Long-Term Buy.

Shire ($223; SHPG) is exploring ways to sweeten its takeover offer for Baxalta ($37; BXLT), a company that makes drugs for rare blood disorders, reported The Wall Street Journal. In July, Baxalta spun off from Baxter International ($36; BAX) in a deal that minimized taxes for U.S. shareholders. To preserve those tax savings, Shire's bid is all stock — plus the promise of a $10 billion share buyback once the deal is done. Shire is reportedly exploring ways to accelerate the return of cash to Baxalta shareholders without running afoul of tax laws.

Complicating matters, Shire's original bid valued Baxalta at roughly $30 billion. Shire has sold off 17% since the announcement, reducing the value of the deal. Shire may also need to increase the value of its bid even more to win over Baxalta's management, which has repeatedly called the original offer too low. Shire is a Focus List Buy and a Long-Term Buy. Baxter International is rated B (average).

Mylan ($49; MYL) launched a hostile takeover of Perrigo ($182; PRGO) after failing to win over the company's management. The stock-and-cash deal is worth roughly $27 billion, down from its original value of about $35 billion because of a decline in Mylan's share price. Mylan is rated B (average).

Corporate roundup

Russia's antitrust regulator found Google ($666; GOOGL) guilty of abusing its market position by forcing manufacturers to preinstall applications on devices that run its Android mobile operating system. Russia will release its full ruling before the end of the month. In other news, Google and Samsung are separately launching mobile-payment systems this month. Google has rolled out Android Pay to more than a million U.S. locations, while Samsung Pay hits the U.S. market Sept. 28. Apple ($116; AAPL) expects its Apple Pay service to reach 1.5 million U.S. locations by the end of the year. The mobile-payment market could more than double over the next two years to $1 trillion globally, says researcher IDC. Separately, Google is considering expanding its high-speed internet service Google Fiber to three more cities. Google and Apple are rated Focus List Buy and Long-Term Buy.

Jones Lang LaSalle ($152; JLL) CEO Colin Dyer said "robust demand" continues to drive up commercial-property prices. He predicted the upturn in the commercial-property cycle could last two more years. His comments lifted Jones Lang shares, which are still down 15% since the end of July. Jones Lang LaSalle is a Focus List Buy and a Long-Term Buy.

Comcast ($58; CMCSa) announced plans to begin selling phone and internet services to large businesses throughout the U.S. in an attempt to challenge traditional telecommunications providers. Comcast already offers these services to smaller companies. Comcast is a Focus List Buy and a Long-Term Buy.

Rank Changes

No changes were made this week in Dow Theory Forecasts.

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