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.

Oct 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
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Roundup, 10/31/14 -- Payment Networks Charge Higher

What sell-off? The stock market's mid-October slide proved short-lived. The S&P 500 rallied another 2.7% this week, ending at an all-time closing high. Unfortunately, this has left us with few prospects for new money and a growing list of potential sources of funds among existing holdings. On the plus side, the Hare recovered most of its underperformance from early October, while the Tortoise remained meaningfully ahead of its benchmark for the month.

It was another busy week of earnings; we heard from 11 more portfolio holdings. In contrast to last week, the positive reports significantly outweighed the negative ones this time around.

Novartis NVS
Revenue Growth: 5%
Operating Income Growth: 11%
EPS Growth: 13%

Novartis reported impressive third-quarter results, especially in light of the ongoing headwind from patent expirations and increasing generic competition. Big Pharma peers such as Eli Lilly LLY, AstraZeneca AZN, GlaxoSmithKline GSK, and Pfizer PFE are experiencing falling sales and earnings as they work through their respective patent cliffs, but Novartis' robust pipeline and disciplined cost control have enabled it to sustain growth during this challenging time. We expect more of the same going forward, as patent expirations on older drugs like Gleevec are offset by new potential blockbusters such as LCZ696 for heart failure. Novartis is also helped by its Alcon eye care division (sales up 6%, operating income up 12%) and Sandoz generic drug segment (sales up 7%, operating income up 14%), which help to balance out the highs and lows in the drug business. I plan to hold.

Visa V
Revenue Growth: 10% (10%)
Net Income Growth: 14% (15%)
EPS Growth: 17% (19%)

The growth rates in parentheses reflect Visa's full-year results. After a sluggish fiscal third quarter, Visa's revenue and earnings growth re-accelerated in the fourth quarter, sending shares more than 10% higher on the day of the company's earnings release. The results reinforce our bullish long-term view of traditional payment networks. Visa enjoys a very wide moat and multiple growth drivers, including rising global personal consumption expenditures, the shift toward electronic forms of payment, operating leverage, and share repurchases funded by robust cash flows. For fiscal 2015, management predicted low-double-digit revenue growth in constant currencies and midteens earnings per share growth, consistent with my long-run expectations. In other news, it was reported that China is considering opening its domestic payment processing business to foreign companies, weakening the monopoly currently enjoyed by China UnionPay. The potential for greater electronic payments adoption in China is huge, although it remains to be seen how well Visa and MasterCard MA can navigate China's complex political and regulatory landscape. Visa is a core long-term holding for the Tortoise.

ITC Holdings ITC
Revenue Growth: 13%
Net Income Growth: 11%
EPS Growth: 12%

ITC isn't big on surprises, and third-quarter results were no exception. While growth slowed again (it's harder to grow off a larger base), ITC continues to expand earnings per share far faster than its regulated-utility peers. I expect growth to decelerate further over the next five years, as the Federal Energy Regulatory Commission will likely implement a modest reduction to ITC's allowed return on equity. Even so, I think ITC's stock is capable of delivering total returns to investors in the neighborhood of 8%-10% per year, with risk that is well below average. ITC is another core long-term holding.

Enterprise Products Partners EPD
Revenue Growth: 2%
Distributable Cash Flow Growth: 14%
Distributable Cash Flow per Unit Growth: 11%

Enterprise's current distribution rate of $0.365 per unit is up 5.8% year-over-year, and the distribution continues to be easily covered (1.4 times over, to be exact) by distributable cash flow. While Enterprise's quarter-to-quarter results can be lumpy depending on the impact of asset sales, commodity price movements, and other factors, I believe the underlying growth trajectory remains strong. The company continues to invest in midstream energy infrastructure that is crucial to the domestic energy boom--particularly in natural gas liquids and onshore crude oil. Enterprise completed nearly $5 billion in capital spending projects over the past 12 months and is working on more than $6 billion of projects scheduled to enter service over the next two years. While growth will inevitably slow as the energy boom matures--perhaps compounded by weaker oil and gas prices--I expect Enterprise's low cost of capital and diverse, integrated asset network to create plenty of investment opportunities. I plan to hold.

Compass Minerals CMP
Revenue Growth: 30%
Adjusted EBITDA Growth: 45%
EPS Growth: 76%

The benefits of a cold and snowy winter were apparent in Compass' third-quarter results, as municipalities began to rebuild salt inventories in anticipation of the upcoming highway deicing season. Average selling prices for highway deicing salt jumped 20% from the prior year thanks to an improved supply and demand balance, while volumes advanced 5%. Overall, adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization) in the salt segment was up 25%. Further improvements are expected over the next several quarters, especially if the weather cooperates. The plant nutrition segment also enjoyed a rebound in demand for fertilizer after last year's disruption caused by the Uralkali/Belaruskali dispute. Average selling prices for sulfate of potash were up nearly 4% year-over-year to $670 per ton, and remain well above our long-run forecast. If sulfate of potash prices stay at current levels, it could add as much as $15 per share to our $90 fair value estimate. EBITDA in the plant nutrition segment was 69% higher than the prior year. I expect to hold.

Express Scripts
Revenue Growth: -1%
Adjusted EBITDA Growth: 8%
EPS Growth: 24%

Express Scripts continues to enhance profitability and aggressively repurchase shares, but declining prescription volumes are still a major headwind. Excluding the lost UnitedHealth UNH contract, adjusted prescription volumes fell 4% in the third quarter and are projected to be down 4%-10% in the fourth quarter. Management plans to step up its investment in selling, general, and administrative functions to respond to recent client service issues. The company also reiterated its outlook for adjusted prescription volumes to fall less than 1.5% in 2015, as new business wins and growth of existing clients largely offset client losses. We're still counting on improved client retention and accelerated prescription drug utilization for our Express Scripts investment to work in the long run. In the meantime, robust third-quarter earnings per share growth was driven by a 13% improvement in EBITDA per adjusted prescription, a lower tax rate, and a 9% reduction in the share count. Express Scripts' robust cash flow remains its most attractive quality, and at the current price the stock offers a roughly 7.6% free cash flow yield. I intend to hold.

Baidu BIDU
Revenue Growth: 52%
Operating Income Growth: 17%
EPS Growth: 27%

Baidu is the fastest-growing company in the Hare by far. Third-quarter revenue was up 52% from the prior year, while earnings per share advanced 27%. Earnings growth, while healthy, continues to lag revenue growth because of Baidu's aggressive investments in research and development, marketing its mobile applications, and content for its online video platforms. Baidu has successfully made the transition from desktops to mobile, with the latter now accounting for 36% of revenue and more than half of user traffic. Baidu is believed to have roughly 80% market share in mobile search--greater than its market share on PCs, where the company has faced increased competition from Qihoo 360 QIHU and others. I believe Baidu's recent investments were both wise and necessary: Without them, Baidu's narrow moat and positive moat trend could have been in jeopardy. However, I doubt expenses will grow so much faster than revenue indefinitely. Assuming the company's operating margins begin to stabilize, I think we can expect materially faster earnings growth in 2015 and beyond. Baidu's remarkable outperformance of the past six months has caused the Hare's weighting toward the stock to increase to 10.6%. While I plan to hold the vast majority of our shares, Baidu is still one of the Hare's riskiest picks, and I'm not comfortable letting our position size get too far above 10%. As such, Baidu is a possible candidate to be trimmed.

Revenue Growth: 7%
Operating Income Growth: 7%
EPS Growth: 12%

Derivatives trading volume is the key to CME's short-term results, and trading activity has been picking up substantially since the summer lull. October is on track for the highest monthly trading volume in CME's history, but even third-quarter volumes were up 12% from the prior year (compared with a 12% decline last quarter). Interest rate derivatives have been especially strong as traders speculate on the direction of Federal Reserve policy. CME plans to hold operating expenses flat in 2015, partly through a 5% reduction to its workforce, which sets the stage for meaningful operating leverage if volumes continue to improve (though operating leverage cuts both ways if volumes decline). I plan to hold.

MasterCard MA
Revenue Growth: 13%
Net Income Growth: 15%
EPS Growth: 19%

MasterCard posted slightly faster revenue and earnings growth than Visa in the latest quarter. This was partly due to acquisitions, though I expect MasterCard to sustain faster growth in the long run thanks to its greater exposure to international markets (where penetration of electronic payments is lower), more room to expand operating margins, and certain technological advantages. MasterCard's nearly 20% earnings per share growth is especially impressive in light of current macroeconomic and geopolitical challenges; the company would probably be growing even faster with more robust global economic growth. The stock was up close to 10% on the day of its earnings release and now trades roughly in line with our $82 fair value estimate. Still, I view MasterCard as a core long-term holding for the Hare.

National Oilwell Varco NOV
Revenue Growth: 17%
Adjusted EBITDA Growth: 23%
EPS Growth: 28%

National Oilwell Varco reported robust third-quarter results, but the downturn in offshore drilling is starting to show up in backlog. The company's rig systems backlog ended the third quarter at $14.3 billion, down from $15.4 billion last quarter. NOV should be able to sustain earnings through a year or two of depressed oil prices by working through backlog. However, a longer period of low oil prices would make deepwater drilling uneconomic for many operators, eroding demand for NOV's rig equipment. In light of recent commodity price moves, we lowered our near-term outlook for NOV's orders and operating margins and cut our fair value estimate to $89 per share from $93. On the plus side, we still expect earnings per share to grow in 2015, and NOV is already trading at a modest price/earnings multiple. I believe NOV offers an acceptable risk/reward tradeoff at the current price, and I plan to hold.

Novo Nordisk NVO
Revenue Growth: 8%
Operating Income Growth: 11%
EPS Growth: 7%

The growth rates above refer to Novo Nordisk's results for the first nine months of the year. This remains a challenging time for Novo because of the exclusion of key diabetes drugs from Express Scripts' national formulary, regulatory delays to ultra-long-acting insulin Tresiba in the U.S., intensifying competition among diabetes treatments, and a variety of other factors. Even so, the company has managed to sustain double-digit operating income growth, and longer-term growth opportunities are progressing. Tresiba has enjoyed a successful launch outside of the U.S., regulators recently approved Xultophy (a combination of Tresiba and GLP-1 analog Victoza) for sale in Europe, and obesity treatment Saxenda received a favorable opinion from an FDA advisory committee.

Before Novo's earnings report, Sanofi SNY had set investors on edge by predicting that its own diabetes division would see flat sales in 2015, largely due to increased discounting on long-acting insulin Lantus in the U.S. The next day, Sanofi also announced the abrupt dismissal of its CEO, claiming that he hadn't been communicating adequately with the board. We lowered our fair value estimate for Sanofi to $59 from $64 after cutting our forecasts for Lantus. I have occasionally mentioned Sanofi as a potential candidate for the Tortoise, and with the stock at a 22% discount to our new fair value estimate, I will be devoting more research time to the company in the coming weeks.

As for Novo, investors were reassured by management's outlook for 10% constant-currency operating income growth in 2015. Novo's long-acting insulin Levemir was already priced meaningfully below Lantus, and Levemir's recent market share gains in the U.S. were probably one of the reasons Sanofi found it necessary to discount Lantus so much. (Sanofi may also be trying to head off competition from biosimilar versions of Lantus, particularly a product from Eli Lilly working its way through the regulatory process.) On the other hand, increased price-based competition isn't good for the industry, and implies that our investment thesis--an important part of which is that insulin manufacturing is a rational oligopoly--may be breaking down. In light of these concerns, and since Novo is trading roughly in line with our $46 fair value estimate while carrying an above-average 7.1% weighting in the Hare, I am considering trimming our position.


Aside from the week's earnings news, it was reported that PetSmart PETM is conducting an auction for itself. According to The Wall Street Journal, the company has attracted interest from several private equity firms, and a winner should be announced in mid-December. The presence of multiple suitors indicates that a bidding war is possible, though I wouldn't count on PetSmart investors receiving much of a premium from the current stock price. After all, the stock is already up more than 20% since speculation about a buyout began with the involvement of activist investor Jana Partners. I plan to hold for now, but our PetSmart investment may be nearing its conclusion.

Charles Schwab SCHW announced a new "robo-advisor" offering--a free, technology-enabled investment advice solution called Schwab Intelligent Portfolios. The program is primarily intended for beginning investors with relatively simple investment needs, and provides more evidence of Schwab's intention to disrupt the traditional asset management industry with inexpensive, easy-to-use solutions. While the service itself will be free--and probably won't have much financial impact in the near term--Schwab will presumably use it as a platform to distribute its proprietary funds. There could also be future cross-selling opportunities as investors mature and their investment needs become more complex, requiring more sophisticated advice from Schwab or a third-party advisor in its network. Charles Schwab was the subject of a favorable cover story in Barron's last weekend, which I thought did a nice job of summarizing the opportunity in front of the company as well as the operational improvements management has implemented over the past five years (which have been largely masked by the unfavorable interest rate environment). I plan to hold.

Lastly, we raised our fair value estimate for Berkshire Hathaway BRK.B to $157 from $150 after adjusting a variety of assumptions about the company's diverse operations.

Boo! Happy Halloween!


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

Visa V  |  Jim Sinegal

We are maintaining our $223 per share fair value estimate for Visa following the company's fourth-quarter fiscal 2014 results. The company continued to generate double-digit growth in nominal payment volume, both in debit (up 10%) and credit (up 10%) with transaction volume expanding by 9% during the year, supporting our thesis that the dual tailwinds of spending growth and a shift to electronic payment methods will continue to support the growth of the company's business. However, we expect modest pressure on pricing to temper the company's net revenue growth. Indeed, client incentives expanded by 13% during the year and management reiterated that these costs will maintain an upward trajectory over time. Furthermore, we think competition is likely to increase in the coming years, especially in international markets as China UnionPay matures.

We're pleased to see that the company continues to return a large portion of capital generated to shareholders. Visa spent only $149 million on acquisitions during the year, and of the $5.4 billion in net income the company produced during the 12 months ended Sept. 30, Visa paid out $1 billion in dividends and repurchased $4.1 billion in shares. We think the average price paid--approximately $209 per share--was fair relative to our fair value estimate.

Expenses were flat overall in the final quarter of the fiscal year, with the exception of a $453 million litigation provision, thanks to a significant decline in professional fees. However, an increase general and administrative expenses offset much of the benefit. Personnel and marketing expenses--the largest expense categories for Visa--were essentially unchanged from the previous year, reinforcing our belief that there is still quite a bit of operating leverage remaining in the business.


MasterCard MA  |  Jim Sinegal

MasterCard’s third-quarter results supported our thesis on the company--namely, that double-digit growth will continue for the foreseeable future, offset by slightly weaker bargaining power as a result of both regulations and consolidation of the company’s customer base. We are therefore maintaining our $82 per share fair value estimate.

MasterCard generated 12% growth in nominal payment volume processed, and cross-border volume rose a healthy 15% in a quarter marked by rising global turmoil. This supports our view that MasterCard’s international exposure will be a long-term positive for spending volume over the network, though the company may experience some short-term volatility in results.

Expense control was somewhat concerning, as operating expenses rose 12% as well. However, we think this is reasonable given the need to invest in the business as mobile payments replace the traditional card model. Furthermore, we believe MasterCard is laying the foundation for future growth as it aggressively targets new markets. China UnionPay, for instance, is likely to be a much stronger competitor internationally in the years to come, so we think higher spending is justified as the company attempts to maintain its competitive positioning.

Finally, we like that MasterCard continues to return capital to shareholders while investing in the business. The company reported $2.8 billion in income for the first nine months of the year but repurchased $3.2 billion in shares during the quarter and paid out $388 million in dividends over the same period. In summary, we think MasterCard--and peer Visa--offer a rare combination of high growth, wide moats, and solid management, and see both stocks as attractive long-term holdings.


Novo Nordisk NVO  |  Karen Andersen, CFA

Novo Nordisk reported strong third-quarter results that put it on track to meet our estimates for the year, and most important, management's preliminary guidance for high-single-digit revenue growth and similar operating profit growth in 2015 is also in line with our forecast. We don't expect to make any significant changes to our $46 fair value estimate, and the shares once again look fairly valued after a volatile week. We continue to think that Novo's scale and innovation contribute to its wide moat and a strong pipeline will keep this moat stable despite regulatory and pricing headwinds.

Novo's 2015 outlook reassures us about pricing in the long-acting insulin space, as it doesn't appear to incorporate extreme discounting for Levemir in the U.S. market. Management was quiet regarding specific pricing decisions for 2015, noting that U.S. pricing overall should still be flat to a slight positive for the firm's gross margin in 2015. Our long-term forecast points to gross margins approaching 85% (from 83% in 2013), due to manufacturing improvements and increased sales from higher-margin products like Victoza, Tresiba, and Xultophy. Novo's growth benefits from underlying demand for Levemir, as market share has steadily grown to almost one fourth of the basal market in the U.S. versus Sanofi's Lantus.

Tresiba's U.S. launch remains key to valuation, and we still expect a filing in the first half of 2015. For the first nine months, Novo saw 8% growth, with half of sales (and two thirds of growth) coming from North America. Given increased pricing pressure in the long-acting market as Lilly's biosimilar Lantus approaches the U.S. market (launch likely in the second half of 2016), Novo needs to be able to market Tresiba in the U.S. to hang on to its pricing power. While we won't see the interim data, we will find out whether Novo's designated team and the FDA have decided that data warrant a submission, or whether the final analysis (likely in 2017) will be needed.

Novo's third-quarter sales growth was particularly strong at 10% in local currencies, as the effect of generic Prandin is starting to annualize, Tresiba continues to launch outside the U.S., and Victoza gains share. Tresiba's launch is also going strong in Japan, boosting Novo's overall insulin market share in the country. We note that Victoza's share is also improving both globally and in the U.S. market, despite the Express Scripts formulary exclusion; U.S. share of the GLP-1 market has improved from 66% to 69% over the past year.

We still see strong growth prospects in the modern insulins and GLP-1 markets, and Saxenda in obesity could begin to become a significant contributor. While Lilly's Trulicity (dulaglutide) was just approved by the FDA in September, we think Victoza and next-generation product semaglutide will see combined sales growth in the high single digits in the long run, as GLP-1 products overall still have a relatively small 7% share of the overall diabetes market. In the long run, we expect that once-daily Tresiba and Xultophy (Tresiba plus Victoza) could be key to Novo's ability to continue to improve diabetes control while minimizing side effects, allowing for at least stable global pricing. Saxenda's positive FDA advisory committee vote in September could lead to FDA approval shortly, and we incorporate $1 billion in sales from the product by the end of our 10-year forecast.


Baidu BIDU  |  Yue Yao

Mobile search continued to drive rapid business growth for Baidu during the third-quarter of fiscal 2014. Total revenue achieved 52% year-on-year growth, largely in line with our 54% estimate, and market consensus of 53%. The strong growth was fueled by rapid increase in mobile search traffic and improved monetization. During this quarter, mobile traffic surpass PC traffic for the first time, and mobile revenue accounted for 36% of total revenue, growing from 33% in the previous quarter. Management guided to 45% to 50% year-on-year revenue growth for the fourth quarter, which was slightly higher than our expectation.

Gross margin reached 63% this quarter, 2% higher than our estimate as a result of lower-than-expected bandwidth, depreciation and content expenses. Product development expenses accounted for 14% of revenue this quarter, which is 1% lower than our forecast but negatively offset by rapidly growing selling, general and administrative expenses. Operating margin stood at 29%, off by 1% from the previous quarter and 2% higher than our estimate. We do not plan to change our fair value estimate of USD 220 per ADR since the third-quarter results and fourth-quarter guidance are broadly in line with our projections.

We expect Baidu to continue its heavy investment in certain strategically important areas, including mobile search, online-to-offline services and location-based services. These investments will ensure long-term sustainable business growth for Baidu but will also weigh on overall profitability for the firm. Therefore, we do not anticipate noticeable margin recovery for Baidu in the near-term and believe the shares are fully valued for now.


Express Scripts ESRX  |  Vishnu Lekraj

Express Scripts reported third-quarter results that were largely in line with our expectations, and we are reiterating our $89 fair value estimate. The firm also narrowed its 2014 adjusted full-year earnings per share outlook to $4.86-$ 4.90 from $4.84-$ 4.92 (maintaining a midpoint estimate of $4.88). The shares remain materially undervalued and continue to be one of the better opportunities in the market, in our view. We believe the cost-containment services Express provides its clients will grow more critical as payers look for ways to materially curb the cost of pharmaceuticals. From our perspective, this dynamic will be a major driver of long-term outsize returns on capital for the pharmacy benefit manager.

Revenue decreased 4.8% year over year while operating margins increased a decent 44 basis points to 3.82%. These metrics include the runoff of the UnitedHealth Group contract and are not unexpected. Excluding the effect of the UnitedHealth claims volume, adjusted EBITDA increased 8.4% from year-ago levels.

The subpar integration of the Medco acquisition has been a major headwind throughout most of 2014; however, Express seems to be on track with correcting these issues. For the quarter, gross and operating margins increased materially, expanding 35 basis points to 8.04% and 44 basis points to 3.82%, respectively. This positive expansion in both profit lines is highly encouraging and we believe points to increasing pricing leverage with suppliers, excellent generic program execution, and better Medco integration.

However, the firm did make material infrastructure investments during the third quarter with adjusted selling, general, and administrative expense increasing 2%, factoring out UnitedHealth claims. Management will also make incremental client service infrastructure investments during the fourth quarter. We believe these investments are necessary and will correct for certain client servicing issues the firm is facing. As the firm moves past 2014 and into 2015, these investments should help drive long-term client retention and new client sales.

All metrics on a per-adjusted-claim basis also improved at a healthy clip during the quarter. This included gross profit rising a robust 13.4%, operating profit increasing a solid 22.6%, and adjusted EBITDA up a strong 14.5%. We believe the increase in both revenue and profitability per adjusted claim points to Express' ability to drive increased services and savings to clients. Ultimately, this dynamic will also lead to more value growth for investors. Express was able to increase its generic fill rate 240 basis points to 84%.

We believe the stock remains significantly undervalued and a strong potential buying opportunity. We strongly believe the firm's command of the pharmaceutical supply chain is unparalleled, given its 30% market share. The PBM's recent exclusion of certain branded drugs from its national formulary and its Medicare Part D partnership with Walgreens highlight its advantages. Given these factors, we believe Express will produce robust economic profits over the long term, and we are reiterating its place on our Best Ideas list, given its wide economic moat, solid growth potential, dominant market position, and undervalued stock.


National Oilwell Varco NOV  |  Robert Bellinski, CFA

National Oilwell Varco's third quarter was in line with our revenue forecast but ahead of our earnings estimates. While we're encouraged with the better-than-expected profitability, rig systems orders fell considerably in the quarter. As such, we're adjusting our forecast for much lower order volumes for the remainder of 2014 and 2015, and trimming our fair value estimate from $93 to $89. Our wide moat rating is unchanged.

Rig systems revenue hit $2.66 billion for the quarter, slightly ahead of our $2.57 billion forecast. While we were not expecting a book/bill ratio of 1/1, orders still came in lower than expected at $1.34 billion. Backlog is $14.3 billion, which, combined with capital orders from aftermarket work, will sustain activity levels. Still, we have elected to cut our 2015 order forecast to about $6.2 billion, from $9.3 billion. Operating profit fell to 20%, down about 100 basis points sequentially. In addition to the lower order volumes we've also adjusted our rig systems margin assumption to 20% for 2015.

NOV's remaining segments fared better. Rig aftermarket revenue increased more than 6% sequentially and operating margins were over 27%. Wellbore Technologies revenue grew slightly less than expected, but margin expanded to 18.9%, versus our 18% assumption. Completion and production solutions beat both our revenue and margin estimates, with revenue growth of 5.6% and 153 basis points of margin expansion, sequentially. We're very encouraged by this margin expansion, as management commented on this morning's earnings call that margin is heavily influenced by product mix--increased sales of completion related equipment is accretive to margins. Our read is that this confirms continued improvement in the pressure pumping market, and North American unconventional activity through the end of the year. While lower oil prices still remain a threat to NOV and the sector at large, we do not yet see a direct signal of activity receding.


ITC Holdings ITC  |  Charles Fishman, CFA

We are reaffirming our wide economic moat, stable moat trend rating and $37 per share fair value estimate after ITC Holdings reported solid third-quarter earnings and narrowed its 2014 capital expenditure guidance. In addition, management's upbeat comments on potential development projects in the Southwest Power Pool and the Lake Erie Connector give us increased confidence in our long-term earnings growth rate assumptions.

ITC reaffirmed its 2014 operating earnings guidance of $1.83 to $1.90 per share and our EPS estimate of $1.89 is unchanged. ITC reported 2014 third-quarter operating earnings of $0.47 per share versus $0.42 per share in the same period last year. The increase was primarily attributable to higher income associated with the increase in the rate base.

ITC narrowed its 2014 capital expenditure guidance to a range of $785 million to $835 million from the previous range of $730 million to $840 million. Management indicated that the increase in the lower end of the range was not the result of accelerating 2015 planned projects into 2014. We expect management will increase its $4.5 billion, five-year capital expenditure guidance when it rolls guidance forward to the five-year period ending 2019.

In SPP, although the formal review will not occur until early 2015, the RTO was overwhelmed by approximately 1,200 transmission project proposals of which ITC submitted roughly 25%. These comments confirm our thinking that once the ISOs and RTOs establish procedures for incorporating FERC Order 1000 in their bid processes, there will likely be an acceleration in transmission spending.

The HVDC 1,000 MW capacity Lake Erie Connector would run approximately 60 miles under Lake Erie and, although the project is in the early stages of development, it would result in a significant increase in ITC's consolidated rate base. However, the Lake Erie Connector would likely not contribute to earnings until 2018 and beyond.


Novartis NVS  |  Damien Conover, CFA

Novartis overcame generic competition and reported solid growth in the third quarter, slightly exceeding our and consensus expectations, but we don't expect any changes to our wide moat rating or $91 fair value estimate due to the minor outperformance. At the current market price, we believe the market recognizes the company's excellent pipeline, which is partly offset by major patent losses over the next two years.

Despite the solid quarter, patent losses will weigh on growth over the next several quarters, but new product launches should offset generic competition. In the quarter, the patent loss on cardiovascular Diovan shaved off $415 million of high-margin sales (3% of total sales), and this headwind should continue into 2015. However, recently launched drugs are offsetting the generic competition. While the 2016 patent loss on cancer drug Gleevec (8% of sales) will create another hurdle for growth, we believe the pipeline is strong enough to increase total sales through the generic competition to Gleevec.

Novartis' industry-leading speed in product development is quickly creating the next generation of blockbusters, which should reinvigorate growth and support the company's wide moat. We expect hypertension drug LCZ696 (skipped Phase II) will posted peak sales of more than $6 billion due to the strong efficacy data reported during the quarter. We expect accelerated development programs for cancer treatments LEE011 and CTL019 will also lead to blockbusters.

On the expense side, Novartis' major restructurings are expanding margins. We believe the divestiture of the low-margin diagnostic unit (completed in January) helped the quarter's solid earnings growth (up 13% year over year). Further, the announced sale of the animal health and vaccine units along with the formation of a consumer health joint venture with Glaxo should strengthen Novartis' operating margins (restructurings expected to be finalized in early 2015).


Compass Minerals CMP  |  Jeffrey Stafford, CFA

We're holding steady on our fair value estimate of $90 per share for Compass Minerals following the release of third-quarter results. Our wide moat rating, based on cost advantages in both salt and fertilizers, is unchanged.

Higher highway deicing salt prices (up 20% year over year) helped boost sales and profits for Compass in the third quarter. Results were also solid in plant nutrition, where sulfate of potash prices continue to track well above muriate of potash prices. Companywide adjusted EBITDA rose to $59.7 million from $41.1 million in the third quarter of 2013.

Salt sales increased 23% year over year as higher average selling prices and volume both contributed to revenue gains. Highway deicing prices were up 20%, while consumer and industrial salt prices climbed 8%. Healthy preseason restocking following a snowy North American winter in 2013 supported both prices and volume. Salt results were partially dented by reduced demand in the United Kingdom following a very mild winter there. Salt adjusted EBITDA margins held relatively steady around 26% year over year. Potential EBITDA margin expansion was held in check by much higher logistics costs and the impact of imported salt. Compass has chosen to import some salt to meet demand this season, as its mines are running at full capacity. We expect Compass' salt profitability will expand over the long run as the company undertakes projects to lower its mining costs and expand capacity.

The Wolf Trax acquisition pumped up plant nutrition results (sales up 60%), but the legacy sulfate of potash portion of the business also performed well. The spread between SOP and MOP continues to widen. We think the spread has expanded to unsustainable levels and will eventually contract. Our view is that SOP prices will sink closer to marginal costs of production, which are based on MOP prices. If SOP prices remain elevated, our current fair value estimate will prove too conservative. If we assume the firm's fertilizer prices remain flat from the third quarter to 2018, our fair value estimate would increase by roughly $15 per share.

During the quarter, the firm finally put the tornado at Goderich behind it, collecting a pretax insurance settlement gain of $83.3 million. This settlement marks a full recovery of the insurable losses the company incurred.


Enterprise Products Partners EPD  |  Jason Stevens

Enterprise delivered another solid quarter, in line with our estimates for the partnership, and we are reiterating our $43 per unit fair value estimate and wide economic moat rating. Gross operating margin for the quarter increased to $1.34 billion, up $181 million, or 16%, year over year and just ahead of our $1.33 billion estimate. The largest contributor was a $73 million increase at Enterprise's petrochemical services unit, driven by higher propylene sales, lower expenses, and lower maintenance expenses for pipeline integrity compared with last year. The partnership's core natural gas liquids services segment saw an 11% increase to $640 million in gross operating margin, with contributions from the ATEX pipeline responsible for about half the gain year over year.

Distributable cash flow for the quarter came in at $975 million, up 7% year over year, and Enterprise raised distributions by 5.8%. Distribution coverage of 1.4 times provides Enterprise with plenty of running room to continue its methodical quarterly distribution increases. The large excess coverage also provides a cheap source of funding for the partnership's growth projects, helping propel consistent cash flow growth. In our view, Enterprise continues hitting on all cylinders.


CME Group CME  |  Gaston F. Ceron

CME Group reported solid third-quarter earnings, and we believe the company is on track to beat our expectations for the year. We aren’t planning to make any large changes to our $72 fair value estimate on this wide-moat name.

Trading volume has been very high in October, and we believe this sets CME up for a strong finish to the year. Through Oct. 29, volume is averaging nearly 17.9 million contracts per day, up 17% from September's pace and 61% higher than the volume in October 2013. We feel that the robust activity in interest-rate derivatives helping to drive the volume surge has some legs and that speculation on the path of rates and the U.S. economy will keep rate futures volumes at healthy levels for some time. The higher volumes should be very beneficial to the company's profits, since exchanges possess a good dose of operating leverage as the cost of incremental trades isn't large. Indeed, CME's operating income captures $0.80-$0.90 of every new revenue dollar.

Given the revenue headwinds the firm has faced the past few years, we believe CME took the right step by cutting 5% of its staff. Compensation makes up 42% of operating expenses so it was a natural place to look for savings. We expect the savings from headcount reduction to offset cost increases in other parts of the company, including salary increases for continuing employees and spending on professional services, rather than drive a big absolute decrease in the firm's expense base. CME is projecting adjusted operating expenses to remain flat in 2015 (at about $1.3 billion) relative to this year's results.

Although we believe CME has the ability to sweeten its $4.55-per-share offer for GFI Group, we don’t think the company is likely to overstretch itself to beat BGC Partners' rival $5.25-per-share offer. The deal certainly has benefits to CME, such as helping the company expand its presence in Europe and Asia, but we perceive the financial benefits as limited in the near term.


PetSmart PETM  |  Liang Feng

Dow Jones reported on Oct. 29 that several large private-equity firms (including Apollo, Hellman and Friedman, and KKR) are interested in acquiring PetSmart and will soon release their initial bids (consistent with the New York Post’s report that first-round bids are due by the end of October).

Given the number of prospective buyers, it is possible that a bidding war could generate a higher offer than our $71 stand-alone fair value estimate. However, the stock has already moved up significantly after Jana Partners' previously disclosed strategic initiatives (from a price of $59.80, before Jana announced its involvement on July 3), and speculation has floated that private-equity firms were not interested in bidding above the current price (by justifying the bid as higher than the pre-activist price). The situation remains highly uncertain since the process is still in its very early stages, so we do not expect to change our fair value estimate right now. From our view, management has made mistakes by underinvesting in its e-commerce/omnichannel program, but we believe these errors are fixable, as the firm continues to benefit from meaningful intangible asset and cost advantages, supporting a narrow economic moat.

Taking a step back, we continue to believe that management would prefer to operate PetSmart independently and hopes that its recent slate of initiatives (both operationally and with the capital structure) will keep the company out of private equity’s reach. However, if a meaningfully superior offer does emerge, we think it will be difficult for management to resist, since even its large, long-time shareholder (Longview Asset Management, which owns about 9% of shares) has supported the bidding process and has said that it would be willing to roll its holdings into the private-equity bid (reducing the amount of capital that needs to be raised), if a suitable offer/bidder emerges.


Charles Schwab SCHW  |  Gaston F. Ceron

We believe Charles Schwab's new "robo-advisor" platform offers an opportunity for the firm to make inroads into a growing market.  Given Schwab's plans to not levy fees such as commissions on the service--one way for the firm to make money is through its own exchange-traded funds that make it into client portfolios--and the lack of more-detailed information on its long-term strategy, we don't now expect this effort to materially contribute to near-term earnings. Thus, we aren't making changes to our $25 fair value estimate for this narrow-moat name.

In our view, Schwab Intelligent Portfolios, planned for the first quarter of 2015, will give the company a potentially powerful lure to court investors, many of them younger, who prefer a cheaper and more technology-driven approach to managing their money. The robo-advisor marketplace already has plenty of competition, but we believe Schwab's brand, reputation, scale, and investing know-how will make it into a strong player. For instance, we believe Schwab will be able to offer more-robust customer service than smaller rivals. We also think the Schwab name will help the Intelligent Portfolios offering stand out in the market.

There are risks. We see cannibalization is a potential danger, as the offering could siphon away current Schwab clients. Ultimately, we suspect that many of the robo-advisor clients are likely to be new to Schwab and that this will be an opportunity for the firm to attract assets that otherwise would go to rival firms.


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