S&P Downgrades PETCO to Buy

Analyst Michael Souers is concerned that the retailer's high-low pricing strategy may not be appropriate in this economic climate. Plus: analysts' opinions on Merck, Novell, and more

PETCO Animal Supplies (PETC ): Downgrades to 4 STARS (buy) from 5 STARS (strong buy)

Analyst: Michael Souers

July-quarter earnings per share of 31 cents, vs. 33 cents, is a penny below our estimate. Also, PETCO revises its EPS guidance significantly lower for the back half of fiscal year 2006 (January). Gasoline prices were blamed for the decline in traffic, and we are concerned that PETCO's high-low pricing strategy may not be appropriate in the current economic climate. We are reducing our fiscal year 2006 and fiscal year 2007 EPS estimates to $1.42 and $1.67, from $1.69 and $2.02, and are cutting our discounted cash flow-based 12-month target price by $6 to $32. However, with its shares priced now at about 15 times our fiscal year 2007 Core EPS estimate of $1.53, we would buy PETCO.

Merck (MRK ): Reiterates 3 STARS (hold)

Analyst: Herman Saftlas

With the number of lawsuits mounting (now over 5,000), Merck says it may now consider settling cases by persons who took Vioxx for 18 months and had no other risk factors, according to The Wall Street Journal. We see the company using revised tactics, such as delaying actions, settlements, and more jury-friendly arguments. Barring much worse than expected outcomes, we think Merck's $14 billion in cash and investments, plus $15 billion in repatriated funds, should enable it to manage Vioxx and fund its $1.52 dividend. Our 12-month target of $28 applies a discount to peers' p-e of 11.5 to our EPS estimate for 2006.

Costco Wholesale (COST ): Reiterates 4 STARS (buy)

Analyst: Joseph Agnese

We are raising our August-quarter earnings per share estimate by a penny to 66 cents, based on our expectation of 7% comp-store sales growth, at the top of 5%-7% company guidance. However, poor gas-margin visibility remains a risk to our near-term EPS estimate. Nevertheless, we believe the company remains better positioned than peers because of its higher-income customer base, despite an environment of rising gas prices. A balance sheet we view as strong positions Costco well, in our view, to accelerate new openings in fiscal year 2006 (August). As a result, our 12-month target price remains $54, on discounted cash flow and p-e analyses.

Seagate Technology (STX ): Reiterates 5 STARS (strong buy)

Analyst: Richard Stice, CFA

We believe the shares are lower today on unconfirmed reports suggesting that Apple Computer (AAPL ) is in the process of converting its iPod mini product line from a hard drive version to a flash memory-based format. Even if these reports prove correct, we think the negative impact on Seagate will be relatively modest. The company's focus on the consumer electronics market encompasses a variety of products, including mobile PC's, digital video recorders and gaming devices. We view today's sell-off as an enhanced purchasing opportunity. Our 12-month target price is $27.

Novell (NOVL ): Reiterates 3 STARS (hold)

Analyst: Jonathan Rudy, CFA

July-quarter operating earnings per share of 3 cents, vs. 3 cents, is 1 cent below our estimate. Revenues of $290 million were below our estimate of $308 million. Novell notes particular weakness in the Europe/Middle East/Africa region. We are lowering our fiscal year 2005 (October) operating earnings per share estimate to 10 cents from 11 cents, and see 14 cents in fiscal year 2006. With a balance sheet we view as solid, and trading at a discount to peers on ratio of enterprise value to sales, we would hold Novell shares, despite our view of its inconsistent execution. Our 12-month target price remains $6.50 based primarily on relative valuation analyses.

Hewlett-Packard (HPQ ): Reiterates 3 STARS (hold)

Analyst: Megan Graham-Hackett

Hewlett-Packard announces an additional $4 billion share buyback program. The buyback authorization was largely expected and follows H-P's prior $3 billion authorization, which had $0.8 billion left. The company had acknowledged that it was considering such a further buyback authorization, and we expected the buyback due to H-P's improving cash flow generation. Our fiscal year 2005 (October) EPS estimate remains $1.53 and our S&P Core EPS forecast stays $1.19, reflecting our estimates of stock option and pension expenses. With shares trading at a price/sales of 0.9, below the peer average, we view H-P as worth holding.

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