Portfolio Review: November 7, 2016


Upgrades & downgrades

On Oct. 28 we dropped McKesson ($136; MCK) from the Buy and Long-Term Buy lists after the drug distributor posted disappointing September-quarter results and slashed its full-year guidance. McKesson's per-share profits fell 7% to $2.94 excluding special items, missing the consensus estimate of $3.05. Revenue crept 2% higher to $49.96 billion but also fell short of the consensus. The company blamed its weak outlook on intensifying competition. McKesson also noted slowing price inflation for branded drugs, a recurring theme in the conference calls for many drugmakers in recent weeks. McKesson has been dropped from coverage and should be sold.

We are adding Applied Materials ($29; AMAT), the largest semiconductor-equipment maker, to the Long-Term Buy List. Applied Materials' growth can be volatile, given the cyclical nature of the industry. But the company appears to be gaining momentum, posting 13% higher sales in the July quarter — its strongest growth since the three months ended October 2014. Both free cash flow and operating cash flow have grown more than 15% in each of the past four quarters.  The shares trade at just 12 times estimated year-ahead earnings, a 25% discount to their S&P 1500 industry median. The company expects to report October-quarter results on Nov. 17. Rising analyst estimates project per-share profits of $0.65, up 124%, on 40% revenue growth. Applied Materials had been rated A (above average).

VMware ($78; VMW) is being added to the Buy and Long-Term Buy lists. The company designs software and support services used by data centers. The stock scores above 60 for all six Quadrix categories, contributing to an Overall rank of 98. Analyst estimates are rising after the company raised its 2016 guidance last month.

VMware generates consistent sales growth, though operating profit has eroded in three straight quarters. For the 12 months ended September, cash from operations rose 32% and free cash flow surged 54%. The stock's trailing P/E ratio of 19 lags its five-year median of 41. Excluding net cash of nearly $16 per share, VMware's P/E ratio falls below 15. VMware was previously rated A (above average).

Earnings reviews

Health care

For the September quarter, AbbVie ($57; ABBV) reported per-share profits of $1.21 excluding special items, up 7% and a penny above the consensus. Revenue increased 8% to $6.43 billion. But the results did nothing to ease concerns over slowing growth for blockbuster arthritis drug Humira, which posted 11% higher sales, down from gains of 15% in the June quarter and 17% in the March quarter. AbbVie says per-share profits should climb 13% to 15% in 2017, below analyst expectations. Humira generated 63% of AbbVie's revenue in the first nine months of 2016. AbbVie hiked its quarterly dividend 12% to $0.64 per share, payable Feb. 2017. Shares fell on the news but retain their Long-Term Buy rating.

Amgen ($139; AMGN) grew adjusted earnings per share 11% to $3.02 on sales of $5.81 billion, up 2%. Both metrics surpassed consensus estimates, as price increases supported growth amid sluggish drug volumes. Although Amgen raised its 2016 guidance for the third straight quarter, its implied December-quarter outlook for both earnings per share and revenue missed analyst expectations. Amgen braced investors for lower sales next year for for its top-selling drug, rheumatiod-arthritis treatment Enbrel, which is also facing biosimilar competition. The company also said patent lawsuits could postpone the launch of its biosimilar version of AbbVie's Humira until 2018. Amgen shares slumped on the report but remain rated Buy and Long-Term Buy.

QuintilesIMS ($72; Q) reported adjusted per-share profits of $1.00 in the September quarter, up 6% and a penny above the consensus. Quintiles, a contract-research organization (CRO), said revenue excluding reimbursed expenses rose 4% to $1.14 billion. Looking ahead to the December quarter, the midpoint of management's guidance calls for per-share profits of $1.06, up 18%, on revenue of $1.97 billion, up 74% and above the consensus. Growth will benefit from the $8.75 billion acquisition of IMS Health, completed on Oct. 3. Shares rallied on the report. Quintiles is a Buy and a Long-Term Buy.

Shire ($167; SHPG) said September-quarter earnings per share slipped 2% to $3.24 excluding special items, missing the consensus by $0.03. Total revenue surged 109% to $3.45 billion but also fell short of analyst expectations. Shire's $32 billion Baxalta acquisition, completed in June, drove the majority of its growth. Excluding the deal, drug revenue increased 12%, led by Vyvanse, a treatment for attention deficit hyperactivity disorder, up 20%. Shire is a Long-Term Buy.


Alphabet's ($788; GOOGL) per-share profits jumped 23% to $9.06 excluding special items in the September quarter, comfortably ahead of the consensus of $8.63. Revenue, up 20% to $22.45 billion, also exceeded the consensus estimate. Operating cash flow climbed 64%, while free cash flow doubled to $7.26 billion. Clicks on Alphabet's online ads surged 33%, its fastest growth in four years. Average cost per click fell 11%. The company announced plans to repurchase up to $7 billion of stock, roughly 1% of outstanding shares. Alphabet is a Focus List Buy and a Long-Term Buy.

CDW ($44; CDW) grew September-quarter earnings per share 16% to $0.97 excluding special items, topping the consensus by $0.07. Sales advanced 6% to $3.71 billion, as 11% growth from public-sector customers more than offset a 2% decline for large and midsize corporate clients. Management sees a sluggish environment for technology spending. CDW hiked its quarterly dividend 49% to $0.16, payable Dec. 12. CDW is a Focus List Buy and a Long-Term Buy.

More earnings reports

EQT Midstream Partners ($71; EQM) reported net income of $1.23 per limited partnership unit, up 10%, exceeding the consensus of $1.18. Operating revenue advanced 15% to $171 million. Management raised its 2016 guidance for operating earnings and distributable cash flow, prompting analysts to hike their profit estimates. EQT Midstream also said it will pay a quarterly distribution of $0.815 per unit on Nov. 14, up 4% from last quarter and up 21% from the year-ago quarter. The company said its president, Steven Schlotterbeck, would replace CEO David L. Porges when he retires in the March quarter. EQT Midstream is a Buy and a Long-Term Buy.

LKQ ($32; LKQ) said adjusted earnings per share climbed 25% to $0.45 in the September quarter, matching the consensus. Sales grew 30% to $2.39 billion, lifted by a combination of acquisitions and 4% organic growth from its parts and services business. LKQ trimmed its 2016 profit guidance to a range with a midpoint of $1.81, a penny below the previous midpoint, citing currency headwinds and lower scrap prices. Management also lowered its full-year outlook for organic growth and operating cash flow. The stock fell on the soft guidance. For now, LKQ remains a Focus List Buy and a Long-Term Buy. 

Kroger ($32; KR) shares rallied after management reaffirmed its profit guidance for the current fiscal year. Kroger's guidance-range midpoint of $2.15 implies 4% growth and exceeds the consensus of $2.13. Kroger is a Buy and a Long-Term Buy.

Airlines update

Southwest Airlines ($40; LUV) shares rallied after the carrier matched American Airlines' ($40; AAL) $5 price hike on one-way domestic flights. The fare hikes will help offset higher labor costs. Southwest's flight attendants approved a new contract that will boost wages 6% immediately, followed by 3% raises in 2017 and 2018. Separately, a U.S. judge refused to dismiss an antitrust lawsuit against Southwest and three other U.S. airlines. A group of passengers has accused the largest carriers of colluding to keep seating capacity low in order to raise fares. Southwest Airlines is a Focus List Buy and a Long-Term Buy.

Alaska Air Group ($71; ALK) is nearing regulatory clearance to complete its long-awaited $2.7 billion acquisition of Virgin America ($54; VA), reported the New York Post. Alaska Air, which yields 1.6%, is a Buy and a Long-Term Buy.

Rank Changes

VMware ($78; VMW) is being added to the Buy and Long-Term Buy lists. Applied Materials ($29; AMAT) is being added to the Long-Term Buy List. On Friday, McKesson ($136; MCK) was sold and dropped from coverage. Vanguard Short-Term Corporate Bond ($80; VCSH) ETF now accounts for 12.4% of the Buy List and 13.8% of the Long-Term Buy List.

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