Portfolio Review: August 21, 2017


Corporate roundup

Amid slowing iPhone growth, Apple ($161; AAPL) is increasingly relying on its often-overlooked services unit, which contains application sales, music subscriptions, and payment transactions. Benefiting from the iPhone's huge user base, the services business now represents 16% of Apple's total revenue, up from 10% two years ago.

The services unit alone generated $27.80 billion in revenue over the past 12 months; more than four-fifths of companies in the S&P 500 Index posted less revenue. Apple's services business grew sales 20% over the last 12 months, a faster pace than nearly nine-tenths of S&P 500 companies. Apple's total sales have risen 1% in the past year.

Rumors about production delays for the upcoming iPhone 8 abound, with some analysts pushing the launch out to November, rather than Apple's traditional September release. However, such news often circulates around Apple, and the stock's strong performance (up 12% over the last six weeks) suggests investors aren't overly worried. Apple is a Buy and a Long-Term Buy.

After clearing the last of the regulatory hurdles, Dow Chemical ($64; DOW) and DuPont ($82; DD) said they will merge on Aug. 31. Following the deal's completion, DowDuPont will trade under the ticker DWDP. With a market value of nearly $150 billion, DowDuPont will be the world's largest chemical company. Dow and DuPont are rated B (average).

FedEx ($210; FDX) said it plans to avoid extra fees for most home deliveries this holiday season, when daily volumes can double, straining the shipper's network. The company will add surcharges on the largest packages delivered from Nov. 20 to Dec. 24. Rival United Parcel Service ($115; UPS) announced in June that it would add charges to most packages during peak holiday periods. Online sales are projected to rise 17% to $107 billion this holiday season, estimates researcher eMarketer. FedEx is a Long-Term Buy. UPS is rated C (below average).

Alphabet review: the search for answers

Alphabet's ($944; GOOGL) Google search engine has always been the default for Apple's ($161; AAPL) Safari browser, including the version used on iPhones and iPads. While Apple doesn't say how much it charges Google for that privilege, court documents showed the fee at $1 billion in 2014. Analysis by Bernstein researchers suggests that payment is now closer to $3 billion, which is interesting for two reasons.

First, while $3 billion sounds like a lot on the surface, Alphabet wouldn't pay unless it felt the value was worth it. Given iPhone's roughly 15% global market share and 45% U.S. market share at the end of March — and that fact that Google's mobile revenue has tripled since 2014 — we can't fault Alphabet for staking out that turf.

Second, Bernstein says licensing revenue makes up either the largest or second-largest contributor to Apple's services unit (see the top of this page for more on services), providing another growing revenue stream and boosting our confidence in future expansion of Apple's profit margins.

In unrelated news, Alphabet has taken a lot of heat in the media over the last two weeks. A male engineer at Google was terminated Aug. 7 after he fired off a memo suggesting women were biologically less suited for high-stress technology jobs. Since then, the engineer threatened a lawsuit and began a high-profile defense of his conduct via social and traditional media; a group of current and former employees threatened to sue Alphabet over alleged gender-related discrimination; the company planned a town-hall meeting on diversity to include all employees; and the company later canceled the meeting citing safety concerns after some employees received online threats.

While the Google firestorm makes for good headlines, Alphabet shares have already recovered most of the ground they lost in the week after the firing. Regardless of how this story plays out, it shouldn't affect Alphabet's operating results, and as such shouldn't have more than a short-term effect on the share price. Alphabet is a Focus List Buy and a Long-Term Buy.

Generic woes haven't spread to biotechs

In response to longstanding criticism of drug prices, the U.S. Food and Drug Administration continues to push for development of more generics. The FDA has approved 633 drugs in the last 10 months, on pace to beat last year's record of 651 approvals.

However, the generic craze has been slower to affect biotech drugs. Biotechnology medications are based on biologics, which are harder to replicate because they are complex and living cells. Since 2010, the FDA has approved five biotech copycats, of which just two are on the market. As of mid-February, the latest data available, firms had approached the FDA for meetings regarding just 23 biotech drugs, a number that seems surprisingly small until you consider the development process is more complicated than that of traditional drugs.

The feds' broad initiative is working, with pricing of generic drugs on the decline. Of course, such success doesn't feel like progress for makers of traditional generic drugs, such as Mylan ($30; MYL) and Teva Pharmaceutical Industries ($17; TEVA), which feel the pricing pressure.

However, while generic competition has long been a major factor in the growth of traditional branded drugmakers, biotechs haven't felt the same pain. Biotechnology enjoys this insulation from generic competition in part because of the slow pace of biosimilar research, and in part because major players such as Amgen ($171; AMGN) are developing their own biosimilars. Over the last three months, the S&P 1500 Biotechnology Industry Index has gained 9%, versus just 2% for the pharmaceutical index.

Celgene ($131; CELG), our top biotech pick, is a Focus List Buy and a Long-Term Buy. Amgen is rated Long-Term Buy. Mylan is rated B (average).

Centene jumps in when rivals leave

Centene ($83; CNC) has positioned itself to profit from other managed-care companies' decision to de-emphasize Obamacare. Earlier this month, Anthem ($193; ANTM) announced it would reduce its exposure to public insurance exchanges in Virginia, building on earlier plans to scale back in other states. This is just the latest in a string of announcements from major insurers citing weak enrollment, shifting membership rolls, and lower-than-expected profit margins.

In June, Centene made a bold move, offering coverage in three new states and expanding its presence in four others. Unlike its rivals, Centene has reported strong profits from the exchanges. Earlier this month, the company agreed to provide coverage in 14 Nevada counties that would otherwise have had no coverage next year.

Centene's success in squeezing profits out of the insurance exchanges suggests the company can handle the extra exposure. And while a cutback in subsidy payments would represent a big hit to Centene, a Congressional Budget Office report suggests ending subsidies would deny coverage to about 5% of Americans. In a midterm election year, such a move would face heavy resistance. Centene is a Focus List Buy and a Long-Term Buy. Anthem is rated A (above average).

Rank Changes

No changes were made this week in Dow Theory Forecasts.

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