Portfolio Review: August 22, 2016


Top 15 Utilities portfolio changes

With an Overall rank of 82 and both sector-specific ranks above 95, SJW ($39; SJW) is one of the top scorers in the utility sector. The company provides water service to 229,000 customers in California and 12,000 in Texas. Like many water utilities, SJW must spend heavily to maintain and upgrade its network. However, in June regulators approved a rate increase and a $318 million capital-improvement program.

In the June quarter, earnings topped expectations by 78%. The one-analyst consensus now projects profit declines of 2% in the September quarter and 7% next year, targets that seem overly conservative. Given its historical growth and current expansion projects, SJW seems capable of double-digit long-term profit growth; we can't say that about many utilities. The stock trades at 18 times trailing earnings, 9% below the median utility and 30% below the median water utility.

Vectren ($50; VVC), which provides electricity or natural-gas service to 1.1 million customers in Indiana and Ohio, has delivered choppy growth recently. We blame that in part on the company's nonregulated infrastructure-services business, which should see results improve in the year ahead. Other companies are stepping up their investment in oil and natural-gas pipeline systems, a trend that should benefit Vectren's infrastructure unit.

In the June quarter, Vectren's regulated utilities delivered 8% profit growth. The well-run businesses should continue to provide steady, if unexciting, growth going forward. Vectren appeals to us not because of its home-run potential, but because it offers appealing consistency, augmented by a potential kicker from higher-growth nonregulated businesses. The consensus projects profit growth of 16% in the second half of this year and 8% next year. Vectren yields 3.2%.

NextEra Energy ($126; NEE) has the distinction of earning the lowest Quadrix Momentum and sector-specific scores in our Top 15 Utilities Portfolio. Despite the company's weak recent operating growth, the stock was performing fairly well until it issued weaker-than-expected profit guidance last month. NextEra looks expensive relative to its peers, while consensus growth targets seem aggressive, a combination that translates into downside risk. Subscribers should sell NextEra, which is being downgraded to B (average) in our Utility Update.

CMS Energy ($43; CMS) has delivered six straight years of increases in net income and operating cash flow, and its long-term growth potential is among the best in the sector, based on its portfolio of production assets and projects. However, CMS has been dangling that potential in front of us for years, never delivering the hoped-for outsized growth. These shares trade at 22 times trailing earnings, 9% above the average diversified utility. While CMS topped consensus profit targets in the June quarter, its guidance equated to a warning for the second half of 2016. Given CMS' valuation and its long history of running on hype, this company seems particularly vulnerable should it or the utility sector run into some bad news. CMS Energy is being downgraded to B (average) in our Utility Update and should be sold.

Chips fall into place for Nvidia

Nvidia's ($61; NVDA) July-quarter earnings per share soared 56% to $0.53 excluding special items. The consensus stood at $0.37. Revenue jumped 24% to $1.43 billion on robust demand for high-end semiconductors used in data centers (up 110% to $151 million) and gaming computers (up 18% to $781 million). Nvidia also continues to gain ground with carmakers, with sales up 68% to $119 million for automotive infotainment modules and product-development contracts. The midpoint of management's October-quarter outlook calls for sales of $1.68 billion, up 29% and above the consensus of $1.45 billion at the time of the announcement.

Cash from operations rose 13% to $184 million, marking the eighth straight quarter of double-digit growth, and recent product launches should support operating momentum. Management also credits growth in the data-center market to rising demand for "deep learning," a branch of artificial intelligence.

Nvidia remains a compelling story, though expectations may eventually run ahead of the stock. Shares rallied on the quarterly report and are now up 86% in 2016, versus a 7% gain for the S&P 1500 Technology Sector Index. The stock trades at a trailing P/E ratio of 31, well above the median of 23 for S&P 1500 semiconductor stocks. Even after backing out net cash of about $5.50 per share, the stock's P/E ratio looks elevated at 28. For now, Nvidia, earning a Value score of 11 and Overall score of 68, remains a Long-Term Buy.

Corporate roundup

Aetna ($121; AET) said it plans to pull out of 11 of the 15 states where it sells health insurance to individuals through government-run exchanges under the Affordable Care Act. Like other insurers, Aetna faces mounting losses from the exchanges. It has reported losses of $430 million since the exchanges' 2014 launch, including $200 million in the June quarter alone. Aetna covers about 838,000 of the 11.1 million individuals signed up through the exchanges.

UnitedHealth Group ($142; UNH) and Humana ($179; HUM) have also announced plans to reduce exposure to the exchanges due to heavy losses. However, insurers that focus on Medicaid plans, such as Centene ($68; CNC), are faring better. Last month Centene called its experience on the exchanges "favorable," adding that profit margins hover near the top of its target range. Centene is a Focus List Buy and a Long-Term Buy. UnitedHealth and Aetna are rated A (above average).

Comcast's ($68; CMCSa) NBCUniversal unit averaged 27.9 million viewers for the first nine days of the 2016 Summer Olympics, down about 15% from the 2012 Olympics and down 18% from the 2008 Olympics. The number of viewers age 18 to 34 has slumped 30% from four years ago, a sign that even major events aren't immune to changing viewership habits. Still, NBCUniversal CEO Steve Burke says the Rio Olympics will "make a lot more" than the $120 million profit generated by the 2012 London Games. Comcast is a Focus List Buy and a Long-Term Buy.

The technical glitch that forced Southwest Airlines ($37; LUV) to cancel or postpone more than 2,000 flights in July will cost the airline at least $54 million in lost revenue. Southwest Airlines is a Focus List Buy and a Long-Term Buy.

South Korea said it has opened an antitrust probe into Alphabet's ($805; GOOGL) Google search business. Alphabet faces multiple antitrust investigations in Europe and was fined $6.75 million by Russia for breaching competition rules. Alphabet remains a Focus List Buy and Long-Term Buy.

Rank Changes

We are making no changes to our buy lists this week. In the Top 15 Utilities portfolio, we are dropping NextEra Energy ($126; NEE) and CMS Energy ($43; CMS) and replacing them with SJW ($39; SJW) and Vectren ($50; VVC).

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