Investment Strategy

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Investment Strategy
What is the goal of the Tortoise Portfolio? The Tortoise Portfolio aims to outperform the S&P 500 index over time. Companies in this portfolio tend to be mature, relatively slow-growing, and with moderate to low risk. New purchases must have an economic moat, preferably wide. We attempt to tilt the portfolio toward companies with at least stable competitive advantages (stable moat trends).

What is the goal of the Hare Portfolio? The Hare Portfolio aims to outperform the S&P 500 index over time. Companies in this portfolio tend to be faster-growing, with both higher risk and higher return potential than those in the Tortoise. New purchases must have an economic moat, preferably wide. We attempt to tilt the portfolio toward companies with growing competitive advantages (positive moat trends).

Investment Strategy
Morningstar StockInvestor invests in companies with established competitive advantages and generous free cash flows, trading at discounts to their intrinsic values. These are core holdings, with more conservative ideas appearing in the Tortoise Portfolio and more aggressive ideas in the Hare Portfolio. We expect both portfolios to beat broad U.S. stock index benchmarks, such as the S&P 500, over rolling three-year periods.
About the Editor
As editor of Morningstar's StockInvestor newsletter, Matthew Coffina manages the publication's two real-money, market-beating model portfolios — the Tortoise and the Hare. Matt was previously a senior healthcare analyst, covering managed care and pharmaceutical services companies. Matt also developed the discounted cash flow model used by Morningstar analysts to assign fair value estimates to most of the companies in its global coverage universe.

Matt joined Morningstar in 2007. He holds a bachelor's degree in economics from Oberlin College and also holds the Chartered Financial Analyst (CFA) designation.

Jul 31, 2014
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Matthew Coffina, CFA
Morningstar StockInvestor
As editor of Morningstar's StockInvestor newsletter, Matthew Coffina manages the publication's two real-money, market-beating model portfolios -- the Tortoise and the Hare. Matt was previously a senior healthcare analyst, covering managed care and
Featured Posts
Roundup, 7/25/14 -- Baidu Delivers Rapid Revenue and Earnings Growth
We're more than half way through earnings season, and so far there haven't been any major surprises from our holdings--which is always a good thing. My take on the week's reports is below.

Coca-Cola KO
Revenue Growth: 3%
Operating Income Growth: 5%
EPS Growth: 6%

Considering Coca-Cola's 3.0% dividend yield, all I ask for is mid-single-digit earnings per share growth, which should enable annual total returns in the high-single-digits over the long run (assuming a stable price/earnings ratio). Adjusting for currency movements and other non-recurring items, the company delivered this in the second quarter. Worldwide sparkling beverage volumes returned to growth--up 2% versus a slight decline last quarter. Still beverage volumes were up 5% despite a headwind from lower juice volumes as the company raised juice prices to offset higher input costs. Company-wide pricing increased a respectable 2%. Between currency headwinds, adverse regulatory changes, and increasingly health-conscious consumers, this remains a difficult time for Coca-Cola. However, even in this challenging environment, Coke's constant-currency revenue, operating income, and earnings per share have continued to expand at an acceptable pace. I think it's likely that results will gradually improve from here, and I plan to hold.

PepsiCo PEP
Revenue Growth: 4%
Operating Income Growth: 6%
EPS Growth: 9%

While PepsiCo's beverage business continues to lag behind Coca-Cola, the company's overall results were slightly better than Coke's thanks to price increases for snacks, ongoing cost-cutting, and more effective share repurchases. Currency headwinds are also less severe for PepsiCo than Coke because of the former's lower exposure to emerging markets. Both PepsiCo's snack and beverage volumes were up just 1% from the prior year. However, strong pricing enabled constant-currency snacks revenue to expand 5%, while beverage revenues improved 2%. Relative to Coca-Cola, PepsiCo seems more willing to let cost cuts fall to the bottom line (Coke would rather reinvest productivity improvements in marketing and other growth initiatives). PepsiCo's share count (down 2.2% year-over-year) is also declining slightly faster than Coke's (down 1.6%). PepsiCo increased its forecast for full-year adjusted earnings per share growth to 8% (from 7%), and I will be very happy if the company can sustain a similar rate of growth going forward. I expect to hold.

General Dynamics GD
Revenue Growth: -5%
Operating Income Growth: -1%
EPS Growth: 4%

General Dynamics' second-quarter results were uninspiring, but expense discipline and a very strong backlog hold promise for brighter days ahead. Overall revenue declined 4.6% on weakness in every segment other than marine systems. Combat systems stabilized, with revenue down just 0.5% compared to double-digit declines in previous quarters. However, business aviation sales were down almost 3% from the prior year--a major deceleration from the double-digit growth seen previously. Information systems and technology was the biggest drag on revenue, down a little over 15%. On the plus side, marine system sales were up 5%, while margins improved in all of the segments other than marine systems. The company's overall operating margin was up 40 basis points to 12.7%. A lower tax rate and share repurchases also facilitated earnings per share growth.

General Dynamics' backlog was the highlight of the quarter. The backlog rose to $71.1 billion--up 55% from the beginning of the year and representing well over two years' worth of revenue. The most significant addition was a huge $18 billion contract from the U.S. Navy for 10 submarines, but the company also saw healthy order flow across its other segments. While government budget pressures remain a headwind to defense spending, General Dynamics' backlog reassures investors that the company will post steady results for the foreseeable future. We raised our fair value estimate to $109 from $105 to account for cash earned since our last update, and I plan to hold.

Unilever UL
Revenue Growth: 4%
Operating Income Growth: 7%
EPS Growth: 14%

The growth rates above refer to Unilever's first half, since the company only reports full results twice per year. Adjusting for currency headwinds and other items, Unilever delivered underlying sales growth of 3.7% in the first six months of 2014, split roughly evenly between pricing and volume gains. Growth was powered by emerging markets (sales up 6.6%), as revenue in developed markets was barely changed from the prior year. This demonstrates why I prefer consumer staples names with significant emerging markets exposure--for example, Unilever over Procter & Gamble PG, Philip Morris International PM over Altria MO--despite their elevated foreign exchange risk. Demand for many consumer products in developed markets is likely to remain stagnant for the foreseeable future, while emerging markets promise decades of growth. Unilever's operating margin was flat in the quarter, but would have improved 30 basis points from the prior year if not for currency headwinds. Earnings per share advanced a very robust 14% in constant-currency terms, but only 2% in euros. If foreign exchange rates stabilize from here, the currency headwind should ease in the second half. I plan to hold.

Visa V
Revenue Growth: 7%
Operating Income Growth: 11%
EPS Growth: 15%

Visa's stock--the latest addition to the Tortoise--was down almost 4% after the company reported slowing revenue growth in its fiscal third quarter. The shares are once again trading roughly in line with our purchase price from earlier this month. Constant-currency revenue growth was 7% (5% in dollar terms), down from 9% in the second quarter and 13% in the first. I believe slower growth reflects difficult global macroeconomic conditions rather than anything fundamentally wrong with Visa's business. Cross-border transaction fees were the most notable source of weakness, which was attributed to a temporary reduction in currency volatility. However, geopolitical tensions in Eastern Europe, the Middle East, South America, and China certainly aren't helping international travel either. Management lowered its full-year constant-currency revenue growth outlook by a percentage point, to 9%-10%, but reiterated its commitment to double-digit revenue growth over the long run. On the other hand, robust 15% earnings per share growth speaks to the power of Visa's financial model. Total operating expenses fell more than 3%, allowing the operating margin to expand to 64%. Share repurchases enabled a 3.5% reduction in the Class A share count. Management predicted roughly 18% earnings per share growth for the full year, and I continue to believe that Visa is capable of mid-teens annual EPS growth for the foreseeable future. Overall, I would love to see both Visa and MasterCard MA trade lower so that we can increase our stakes--indirectly through ongoing share buybacks and directly through potential add-on purchases.

Discover Financial Services DFS
Revenue Growth: 6%
Net Income Growth: 7%
EPS Growth: 13%

Discover continues to distinguish itself as a highly capable consumer lender with shareholder-friendly management. In the most recent quarter, credit card loans increased 6% from the prior year--handily outpacing industry loan volumes, which are roughly flat. So far, there's little evidence that Discover is taking on excess risk to achieve this result, as net interest margins, net charge-off rates, and delinquency rates all remain healthy. The company is also very well capitalized, with a Tier 1 Common Ratio in the mid-teens. Discover easily passed the Federal Reserve's stress tests earlier this year, which cleared the way for the recent 20% dividend increase and aggressive share repurchases. The share count was down 4.7% from the prior year, which was a significant contributor to earnings per share growth. Our analyst raised his fair value estimate to $68 from $57 on improved expectations for long-term balance sheet expansion. Discover is trading at a modest discount to our new fair value estimate, in contrast to the past few years when it has generally traded at a premium. This illustrates why I am often willing to hold stocks even when they appreciate above our fair value estimates: High-quality companies tend to compound their intrinsic values over time, and we may just need to wait patiently until intrinsic value catches up to the stock price. Discover is a possible destination for new money.

PotashCorp POT
Revenue Growth: -12%
Operating Income Growth: -26%
EPS Growth: -23%

While earnings were still down sharply from the prior year--reflecting the fallout from the breakup of the Eastern European potash cartel--PotashCorp is on the mend. Potash prices appear to have found a bottom; at $263 per metric ton in the quarter, PotashCorp's average realized price for potash was down 26% from the prior year but up 5% from the first quarter. I expect continued gradual price improvements under the status quo, or perhaps more significant improvements if the partnership between Russian miner Uralkali and Belarusian miner Belaruskali is renewed. Potash volumes were roughly flat with the prior year thanks to recovering demand in North America. As I've said in the past, farmers can't delay potash application indefinitely without compromising the health of their soil. The nitrogen segment delivered solid results on higher volumes, partly offset by weaker pricing. PotashCorp's smallest segment--phosphate--turned in markedly lower gross profit due to short-term weather and technical mining challenges. Management raised its outlook for full-year earnings per share to a range of $1.70-$1.90, up 20 cents on the low end and 10 cents on the high end. We increased our fair value estimate to $41 from $39 based on the improving near-term outlook, and I expect to hold.

Baidu BIDU
Revenue Growth: 59%
Operating Income Growth: 23%
EPS Growth: 34%

Baidu delivered another quarter of exceptional revenue growth, but this time it was accompanied by accelerating earnings growth. With earnings per share up nearly 30% through the first six months of 2014, management also seemed to back away from its previous forecast that full-year earnings would be flat because of aggressive investments in mobile. Baidu continues to make a successful transition to mobile--a theme that is common to other leading Internet advertising companies such as Google GOOG and Facebook FB. Mobile accounted for 30% of Baidu's revenue in the quarter, and any lingering doubts about whether Baidu would maintain its position as China's dominant search engine are fading into the background. While a variety of competitors have ambitions in search, none can match Baidu's strong network effect, brand recognition in search, and strategic focus. We raised our fair value estimate to $220 from $206. I continue to see a very long growth runway for Baidu, and I plan to hold. However, I would caution investors not to become complacent about Baidu's risks just because of the recent success of this investment. The stock remains highly volatile, and is only appropriate for investors willing to hold through thick and thin.


In other news, we raised our fair value estimate for Abbott ABT to $44 from $40 to account for recently-announced acquisitions and divestitures in the generic drugs segment. In light of our latest appraisal, I expect to hold.

Lastly, it was reported that PetSmart PETM has hired JPMorgan Chase's JPM investment bank to explore strategic alternatives--including issuing debt to repurchase shares or selling the company to a private equity firm--in response to recent pressure from an activist investor. The discussions are still in the early stages, and it remains to be seen if anything will come of this. PetSmart is now trading right around our $71 fair value estimate, but I plan to hold to see how this plays out.


Matt Coffina, CFA
Editor, Morningstar StockInvestor


Disclosure: I own all of the stocks in the Tortoise and Hare in my personal portfolio.


Morningstar Stock Analyst Notes

Baidu BIDU  |  Yue Yao

Rapid mobile monetization and disciplined cost control has led to another strong quarterly performance for Baidu. Second-quarter online marketing revenue achieved 57% year-on-year growth, which was in line with management guidance. Mobile search revenue accounted for approximately 30% of total revenue. This compares to around 20% in the previous quarter. The firm had around 488,000 online marketing customers this quarter, representing a 4.3% year-over-year growth. Advertiser base expansion and increasing adopting of online search as an important marketing tool among SMEs in China resulted in a 50.3% growth in average revenue per online marketing customer.

Gross margin clocked in at 62.1%, 1.1% above the market estimate, due to lower-than-expected traffic acquisition and bandwidth costs. At 29.7%, operating margin beat the market estimate by 1.3%, and our own by 1.9%, as selling, general and administrative expenses (SG&A) came in below projections. Still, SG&A expenses almost doubled from the year-ago period, and accounted for 17.9% of total revenue. Management expected total revenue to achieve 51% to 54% year-over-year growth in the third quarter, but maintained the flat profit growth guidance for full-year 2014, as more investments in the mobile business are in the cards.

Given the stronger-than-expected mobile monetization and revenue guidance, we're raising our 2014 revenue growth forecast to 54.1% from 45.4%, and our five-year average growth rate to 35.1% from 32.7%. However, we're holding steady on our operating margin projection, as we expect investments to accelerate for the rest of this year. Our updated fair value estimate of USD 220 per share implies a 2015 price/earnings of 32.0 times, enterprise value/EBITDA of 21.8 times, and a free cash flow yield of 3.6%. After a strong rally, we believe the current share price has largely incorporated the earnings growth potential for Baidu. Our narrow economic moat and positive moat trend ratings are unchanged.


Visa V  |  Jim Sinegal

Wide-moat Visa continued to keep a tight lid on expenses in its fiscal third quarter, reducing personnel expenses 6%, marketing expense 9%, and professional fees 20%. Combined with a 5% increase in net operating revenue, these reductions increased the operating margin to 64% from 61%. However, pressure from customers continued, with client incentives consuming about 17% of gross revenue during the quarter. Deals closing in the final quarter will probably result in a higher level to finish the year, according to management, and overall spending is likely to rise from third-quarter levels. Aside from adjustments for the time value of money, we don't intend to significantly alter our valuation model or fair value estimate. We expect the company to achieve management's goal of high-single-digit revenue growth.

Geopolitical instability affected revenue to some extent, with a reduction in cross-border volume in areas like Russia, the Ukraine, Venezuela, and the Middle East. However, the company did not benefit from currency volatility, as might be expected in such an environment. We have no reason to believe these situations will be permanent, and we expect an eventual resumption of cross-border spending and normal exchange rate volatility.

We think Visa is making the right moves in the digital world, offering its capabilities to parties beyond issuers and acquirers and protecting--if not expanding--its competitive advantages resulting from network effects. We view the company's rebranding of as Visa Checkout as a way to ensure that customers can continue to choose Visa's brand and security features online, rather than a digital wallet provided by a competitor. While it's still in the early innings, we think this is a preferable strategy to providing yet another commodity digital wallet.

We also like the company's continued efforts to return cash to shareholders--returning a majority of free cash flow through dividends and buybacks.


Coca-Cola KO  |  Adam Fleck, CFA

We're keeping our $44 fair value estimate and wide moat rating for Coca-Cola following second-quarter results. The firm continued to see revenue decline year over year, but this was due entirely to currency headwinds and structural changes in the business (largely the firm's refranchised bottling operations); concentrate volume grew 2% and price and mix added 2% to the top line.

Although the shifting Easter holiday benefited the second quarter this year versus last, recent marketing efforts also seem to be taking hold, as systemwide unit case volume increased 2% during the first half of 2014. This figure falls at the low end of our long-run forecast, but we're encouraged that Coke seems to be making a concerted effort to drive better pricing in the North American market. As evidence, the core carbonated soft drink business saw price/mix increase 3%--following a 2% increase in the first quarter--alongside market share gains, and the region's weakness in juice stemmed from major price hikes to offset increased commodity costs. Volume growth was relatively solid in other geographies, with share gains in Eurasia and Africa, stabilized performance in Europe, and 9% volume growth in China.

With improved volume and pricing, gross margins rose to 61.7% from 60.9% a year ago. Some of this increase was reinvested in marketing, but adjusted operating income still increased 5% year over year, outpacing sales gains. We project operating profit climbing at a 6%-7% clip over the long run as volume and pricing growth continues.

Management offered a slightly weaker outlook for the second half of 2014 as a result of issues in Venezuela (where the government has limited corporate profitability), partially offset by lessened currency translation headwinds and a lower tax rate. Still, at an estimated negative earnings per share hit of just $0.02 (versus our current full-year EPS forecast of $2.10), we see minimal impact to our valuation.

In the second half of 2014, the firm plans to launch its naturally sweetened Coca-Cola Life product in the United Kingdom and the United States, following the initial offering in Argentina and Chile. Management noted this quarter that Diet Coke sales in North America were soft--a continued trend from last year given consumers' backlash against artificial sweeteners such as aspartame. Coke Life uses sugar and Stevia, a plant-based sweetener, to achieve its "natural" description and lower calorie count than a regular soda. We expect marketing efforts to support this product in the near term, and if recent other innovative products (such as Dr Pepper Snapple's 10 lineup) are any indication, there is potential to recapture lapsed soda drinkers. That said, we don't expect this product to completely stem declining per capita carbonated soft drink consumption in developed markets, given continued concerns about high amounts of sugar and calories and the likelihood that Coca-Cola Life could partially cannibalize other offerings.

Nonetheless, we remain encouraged by Coke's cash flow and share-repurchase plans. Free cash flow through the first six months of 2014 stands at about $3.4 billion, up from $2.9 billion over the same period a year ago. Management noted that it remains on track for full-year net share repurchases of $2.5 billion-$3.0 billion; at the current market quote, we believe these investments are attractive.


PepsiCo PEP  |  Adam Fleck, CFA

PepsiCo’s second-quarter results reflected continued emerging-market gains, positive net pricing, and solid profitability. Given the firm’s strong results over the first half of the year, management raised its estimated full-year earnings per share growth rate to 8% (on an adjusted basis) from 7%; including a forecast 4% negative impact from currency effects, this implies EPS of $4.55, in line with our $4.53 estimate. We continue to believe Pepsi’s wide economic moat will support further pricing power and profitability expansion, and we plan to maintain our $89 per share fair value estimate.

Net of negative currency effects, Pepsi enjoyed 8% year-over-year gains in developing and emerging markets, following 9% growth in the first quarter. The firm’s snacks business in the Asia, Middle East, and Africa segment was again the top-performing segment, with 7% volume growth from a year ago; the company noted that organic revenue in China increased low double-digits, led by snacks. Although Latin American foods saw a 2% volume decline, results were again hurt by Mexican taxes. We remain encouraged that other countries in the region saw further gains, and that the company’s strong market position enabled price increases that helped to offset inflationary effects. Importantly, Pepsi also noted that its revenue in Russia climbed at a mid-single-digit rate; although geopolitical concerns remain a critical risk, management believes the underlying core food and beverage demand remains solid.

In North America, the company saw continued year-over-year volume declines in carbonated soft drinks, but increased pricing and a 1% gain in non-carbonated drinks helped to offset this effect. In fact, Pepsi outlined that it was able to increase pricing at retail at a greater rate than Coca-Cola during the quarter; we believe a continued rational pricing environment in the U.S. will benefit both companies in the long run.

Frito-Lay North America saw volume gains slow to 2.5% from 3% in the prior quarter amid continued economic sluggishness, but we’re encouraged that operating margins climbed to nearly 28% from 27% a year ago. During the quarter, the segment was PepsiCo’s highest-margin business and the largest by operating income, contributing 30% of operating profit before corporate costs. We expect this leadership to continue for the foreseeable future, stemming from Frito-Lay’s strong end-market position and management’s focus on supporting the business with advertising efforts.

While Pepsi increased its EPS forecast for the year, it didn’t alter its free cash flow projection (estimated at north of $7 billion), or its planned share repurchases. The company also didn’t comment on renewed rumors that an activist investor is still looking to split apart the business; we believe the firm’s recent results (which reflect better pricing discipline, increased marketing spend, and improved volume growth), combined with a share price ahead of our fair value estimate, prevents a substantial amount of value accretion from a potential breakup.


Discover Financial Services DFS  |  Jim Sinegal

Discover reported $631 million, or $1.31 per diluted share, for the first quarter. The results support our thesis that Discover is well-positioned to continue gaining market share in consumer lending, with the company’s network providing potential—but not guaranteed—upside. We do not intend to significantly alter our fair value estimate.

Discover was able to grow deposits by a healthy 6% during the last 12 months. We think that the company’s low-cost online model will support continued growth and profitability of its deposit base, even if the company must pay a more competitive rate than peers, as the bank can leverage the operating cost advantage created by its online presence.

At the same time, Discover is deploying its funds into high-yielding assets, diversifying its loan portfolio. Personal loans, in particular, grew by 27% over the last 12 months, while internally generated student loans also expanded at a healthy rate. We think Discover’s focus on higher-risk assets makes sense given its expertise in unsecured lending, but caution that risk is growing along with the portfolio.

Discover’s network business was a low point during the quarter, with slow growth and rising expenses contributing to a small increase in pretax segment income during the quarter, but a 40% drop from the previous year. In our view, investors should not depend on Discover’s narrow-moat network to drive growth given the wide economic moats of larger peers such as Visa and MasterCard. Instead, the network adds potential upside if the company can maintain or grow its share of a growing payment pie.

Finally, we like that management is committed to returning capital to shareholders. In our view, Discover has done an excellent job allocating capital to acquisitions, dividends, and repurchases. Discover repurchases $305 million in shares during the quarter and increased its dividend from $0.20 to $0.24 per share.


PotashCorp POT  |  Jeffrey Stafford, CFA

We’re raising our fair value estimates for PotashCorp to $41 and CAD 44 per share from $39 and CAD 43 after the release of the company’s second-quarter results. PotashCorp holds an attractive position on the potash industry cost curve, and our wide moat rating remains intact.

North American potash demand was particularly strong in the first half of the year, and PotashCorp raised the midpoint of its sales volume guidance 4.7% to 8.9 million metric tons from 8.5 million metric tons. We have raised our near-term volume forecast. Management cited a strong order book for the second half of the year and noted that producer inventories in North America ended the first half at their lowest level since 2011. Demand in Latin America and China has also been robust in the first half of the year.

Over the long run, we think the company’s potash sales volumes will increase markedly as recently added capacity is filled. We forecast that PotashCorp will eventually sell roughly 15 million metric tons of potash per year.

Potash prices were down considerably year over year, about 25%. But we think prices have bottomed, and we expect moderate annual increases going forward. Further, recent comments by Uralkali add support to long-term potash prices. Uralkali announced that it will cut its potash production this year by approximately 8% in an effort to support prices. Consistent with our thinking that it was more likely than not that Uralkali would eventually move back to a price-over-volume strategy. We think Uralkali will eventually make amends with former-partner Belaruskali, further solidifying Uralkali’s commitment to support potash prices by pulling back production during periods of weaker demand. “Market share is important for us, but we don’t want prices to fall,” new CEO Dmitry Osipov said in June interview. We’re sticking with our long-term potash price target of $350 per metric ton.


General Dynamics
GD  |  Neal Dihora, CFA

General Dynamics posted a 4.6% decline in sales for the second quarter but expanded operating margins by 40 basis points as the firm drove expenses down by more than 5%. Sales were softer than our model resulting from weakness in all segments except marine. Margins expanded in all segments except marine. Earnings per share of $1.88 were higher by 4% than last year, as the company repurchased 26.7 million shares over the last 12 months. Overall, General Dynamics continues to show the power of its economic moat. General Dynamics' guidance for 2014 includes sales of $30.2 billion, operating margin of 12.5%, and EPS of $7.40-$7.45 (versus $7.05-$7.10 provided last quarter). Our fair value estimate goes to $109 from $105 due to time value of money and fine-tuning of our estimates.

Aerospace declined 3% and posted operating margins of 19.2%, with deliveries of 33 green and 38 outfitted aircraft, versus 35 and 36, respectively, in the year-ago period. Combat sales were down less than 1% and margins were about flat at 15%. The long-cycle marine segment saw sales rise by 5%, but margins moved down by 70 basis points to 9.4%. Marine signed a massive $17.8 billion order for 10 Virginia-class submarines during the quarter. Information systems and technology experienced weakness as sales fell 15.2%, but margins improved 90 basis points to 8.7%. While this is much better than the forecast for the year, General Dynamics continues to have limited visibility for the segment.

Backlog grew strongly to $71 billion from $46 billion at year-end 2013 and $56 billion in the prior quarter. Orders of more than $22.5 billion in the quarter reflect a book/bill of 3 during the quarter. This was the highest total backlog level since 2008. With the benefit of incumbency and a highly relevant product lineup, General Dynamics is in a strong position to endure and drive shareholder value.


Unilever UL  |  Erin Lash, CFA

Unilever is not immune to the pressures of unfavorable foreign currency movements, which hurt reported sales by more than 8%, and slowing growth in emerging markets. However, we contend that second-quarter results show that strategic efforts to realign the firm's business away from slower-growing food brands and toward faster growing personal-care brands and reinvest behind core brands are gaining traction. Underlying sales jumped nearly 4%, equally split between higher prices and volume. We think this balanced growth is evidence of the strength of Unilever's product set, supporting the intangible asset source of the firm's wide moat.

The dichotomy of faster-growing emerging markets and more-mature developed markets was pronounced, as emerging markets (57% of sales) jumped 6.6% (which although favorable was a marked slowdown from the 10% recorded in the year-ago period), while developed markets (43%) edged up just 0.3%. Management highlighted that while conditions in Europe remain challenging (down 0.8% in the quarter), the firm realized improved pricing in several Southern European countries, including Spain, Greece, and Italy, pointing to further stabilization in the region.

Through the first half of 2014, underlying operating margins popped 30 basis points to 14.3%, which is notable, considering Unilever's brand investments. We think this signals the firm is leveraging its global scale and subsequent cost advantage (which also contributes to our thinking regarding Unilever's competitive positioning) to generate enhanced profitability. Results through the first half of the year are tracking in line with our expectations, and we don’t anticipate a material change to our EUR 33, GBX 2,748, and $44 fair value estimates. Although the stock strikes us as fairly valued, we'd probably recommend investment if it traded down on concerns surrounding unfavorable foreign currency movements or slowing emerging-market growth, similar to late last year.

From a category perspective, Unilever delivered fairly robust growth across home care (up 6.2%), personal care (4.5%), and refreshments (4.5%); food was the only laggard, posting underlying sales growth of just 0.7%. While this is far from a positive, we recognize that 60% of the firm's food sales are derived through slower-growing developed markets, which is probably hindering the top-line growth of this segment. Further, we expect that Unilever will continue to actively manage its brand portfolio in line with actions taken over the past six years, during which the firm shed EUR 2.5 billion in sales (mostly food brands), while completing nearly EUR 3 billion in acquisitions (primarily in personal care). Given Unilever's vast portfolio, we think it's essential that its resources--both financial and personnel--are focused on the highest-return opportunities, and we applaud these strategic actions.


PetSmart PETM  |  Liang Feng

Reuters has reported that PetSmart has hired JPMorgan's investment banking arm to evaluate a number of strategic alternatives, including a leveraged share buyback and a potential deal with private equity. According to the unnamed sources, the discussions are in the very early stages, and management currently favors a leveraged buyback.

We do not expect to change our $71 fair value estimate as a result of this update and will wait for more concrete details before we do so. Additionally, at current market prices (with shares less than 3% below our fair value estimate), we believe a leveraged buyback would be largely neutral to our valuation, assuming business conditions do not change. Consequently, we believe management should remain focused on improving core operations over temporary capital structure changes. Depending on the size of the premium, however, a private equity deal could be the most attractive option, so we believe management should continue to explore its private market value.

While a combination would carry significant regulatory risk, in our view, it would be prudent to test the waters regarding a potential transaction with Petco. If management does decide to follow through with the leveraged buyback, we suspect that activist investor Jana Partners and longtime shareholder Longview Asset Management, which own 9.9% and 9% of shares, respectively, could push back against management if an attractive private market option were available.


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