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.

Jan 31, 2015
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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, 1/30/15 -- Nine Decent Earnings Reports

It was a busy week of earnings, as we heard from nine more Tortoise and Hare holdings. I'll get right to it.

Novartis NVS
Revenue Growth: 4% (3%)
Operating Income Growth: 9% (8%)
EPS Growth: 12% (10%)

Amid intensifying generic competition and a comprehensive restructuring program, Novartis delivered solid results in 2014. Healthy 6%-7% constant-currency growth in the eye-care and generics divisions helped to offset patent expirations in the pharmaceutical segment. Novartis and Johnson & Johnson JNJ are similar in that both have meaningful operations outside of branded pharmaceuticals, but lately Novartis' other segments have been contributing a lot more growth than J&J's consumer products and medical devices. Patent headwinds will persist over the next couple of years, but I'm optimistic that Novartis can keep sales growing at a mid-single-digit pace, helped by innovative new drug launches in cancer, heart failure, psoriasis, and other indications. Disciplined cost control should also result in continued margin expansion. Novartis will feel a modest negative impact from the recent rise in the Swiss franc since 13% of operating expenses are in Switzerland versus only 2% of sales. However, the bigger foreign exchange headwind (from the perspective of a U.S. shareholder) comes from the strength of the U.S. dollar against most other currencies, similar to most global companies. I expect to hold.

General Dynamics GD
Revenue Growth: 4% (0%)
Operating Income Growth: 16% (5%)
EPS Growth: 24% (11%)

General Dynamics' fourth-quarter and full-year results demonstrated continued strong execution despite a difficult defense spending environment. Full-year earnings per share advanced 11% on margin expansion and share repurchases even though revenue was down slightly from the prior year. The backlog ended 2014 at $72.4 billion, up 58% year-over-year. Looking forward, management's guidance calls for 2015 revenue and EPS to only be up about 2% and 3%, respectively. However, management doesn't include share repurchases in its guidance, and there may also be upside to margins. In all, General Dynamics should be capable of delivering at least mid-single-digit EPS growth this year, which is consistent with an 8%-10% long-run total return profile (in line with my objectives for the Tortoise). Furthermore, General Dynamics' sales growth may accelerate in 2016 and beyond as the government reconsiders defense spending cuts, the Department of Defense adapts to emerging threats, and new business jet models enter service. We raised our fair value estimate to $124 from $121 to account for cash earned since our last update. As we move past the trough of the defense spending cycle, I am increasingly inclined to view General Dynamics as a core long-term holding.

Enterprise Products Partners EPD
Gross Profit Growth: 5% (10%)
Distributable Cash Flow Growth: 4% (9%)
Distributable Cash Flow Per Unit Growth: 0% (6%)

Few midstream energy companies are as well positioned for a downturn as Enterprise Products, and I expect management's conservatism to pay dividends (literally) in the current environment. Natural gas liquids prices have collapsed alongside crude oil prices, which could weigh on Enterprise's commodity-price-sensitive activities such as NGL marketing and equity NGL production. If sustained, lower NGL prices could also hurt capacity utilization for Enterprise's pipelines, processing plants, fractionators, and export terminals. However, for at least the next few years, cash flows should be well insulated by long-term contracts, fee-based pricing, strong customer relationships, and Enterprise's diverse, integrated, and flexible asset base, which enables it to capitalize on whatever opportunities present themselves. The company also has more than $6 billion of growth capital projects currently under construction that should generate incremental cash flow over the next two years. Perhaps most importantly, Enterprise is entering this downturn with significant excess distribution coverage: Distributable cash flow was sufficient to cover the distribution approximately 1.5 times, both in the fourth quarter and for the full year. If cash flows stagnate or decline moderately, Enterprise can always dip into its excess distribution coverage--which it built up for just such an occasion--to sustain distribution growth. The 2014 distribution was up 5.8% from the prior year, and I think it's likely that a similar pace can be maintained for at least the next few years, almost regardless of commodity prices. I consider Enterprise a possible destination for new money.

Abbott Laboratories ABT
Revenue Growth: 7% (5%)
Pre-Tax Income Growth: 20% (15%)
EPS Growth: 22% (13%)

Abbott finished the year on a strong note, with robust growth in three of its four business segments. International nutrition sales continued to bounce back from the prior year's infant formula recalls, diagnostics sales expanded at a high-single-digit rate, and the branded generic drugs business benefited from Abbott's new focus on emerging markets. Only the medical devices segment is lagging behind due to intense reimbursement and competitive pressure. Abbott's adjusted operating margin expanded 200 basis points for the full year, which I attribute to management paying more attention to controlling costs since the AbbVie ABBV spinoff. Adjusted EPS growth is likely to pause in 2015 because of asset divestitures, but management projects the core business to produce EPS growth in the 6%-11% range. Our analyst indicated that a modest increase to our $44 fair value estimate may be in order, and I expect to hold.

Visa V
Revenue Growth: 9%
Net Income Growth: 11%
EPS Growth: 15%

I'm not sure why investors are surprised when Visa reports solid results; you would think the company's super-wide moat and strong secular tailwinds would be common knowledge by now. In any case, Visa's fiscal first-quarter earnings were a few cents ahead of consensus expectations, which sent the stock higher on Friday. Midteens earnings per share growth was achieved despite a challenging global economic backdrop, and I expect a similar level of EPS growth to be sustainable for the foreseeable future (barring a major economic downturn). The company also announced a four-for-one stock split effective March 19. We raised our fair value estimate to $234 from $223 to account for cash earned since our last update. With the share price up roughly 19% since we initiated our position last July, Visa now looks fully valued, but I consider the stock a core long-term holding for the Tortoise.

PotashCorp POT
Revenue Growth: 23% (-3%)
Operating Income Growth: 66% (-10%)
EPS Growth: 88% (-11%)

What a difference a year makes! In mid-2013, Russian potash miner Uralkali decided to prioritize volumes over prices, which created significant uncertainty in the fertilizer market and depressed demand for potash as customers held out for lower prices. Since then, Uralkali turned over its ownership and management and seems to be backing away from the volume-over-price strategy. An important Uralkali mine has also been flooded, which could improve the global supply/demand balance for potash and open the door for PotashCorp to gain market share. The collapse in the price of other commodities such as crude oil and iron ore raises questions about the desirability of BHP Billiton BBL moving forward with its proposed potash mine at Jansen, Saskatchewan. BHP may need to preserve cash for other priorities like its dividend. At the same time, PotashCorp is winding down its major capacity expansion program, which should result in improved free cash flow and lower operating costs. Despite headwinds from lower crop prices, potash prices and PotashCorp's volumes should gradually improve from here. Management predicted 2015 earnings per share of $1.90-$2.20, which would represent 12.6% growth at the midpoint. The company recently increased its dividend by 9%, providing a yield of 4.2%. Overall, I'm glad we stuck with PotashCorp, and I may even be willing to add to our position.

Google GOOG
Revenue Growth: 15% (19%)
Operating Income Growth: 6% (14%)
EPS Growth: 3% (10%)

Google's fourth-quarter report--including slowing revenue growth and continued operating margin contraction--was initially met by investor disappointment. However, the stock rose almost 5% on Friday as investors took comfort in management comments suggesting more discipline around its investment and capital allocation decisions. Chief Financial Officer Patrick Pichette said things like "we manage these a prudent manner," "we're driving to make sure we don't waste our shareholder's money," and "the share price does matter." I've long made the case that much of Google's spending is discretionary and that management could easily increase margins if it wanted to. There are plenty of things I don't like about Google's stewardship, especially its refusal to return cash to shareholders and the steady erosion of our ownership interest due to stock-based compensation. However, on the whole I'm inclined to give management the benefit of the doubt, particularly since the core business continues to generate robust cash flows and grow at a very healthy pace. Prior to the earnings release, we increased our fair value estimate to $600 per share from $545 to account for the time value of money and modestly higher revenue growth forecasts. I still view Google as a core long-term holding and a favorite for new money.

MasterCard MA
Revenue Growth: 17% (14%)
Operating Income Growth: 3% (11%)
EPS Growth: 25% (19%)

MasterCard is my favorite company in the world, and not just because it's made me (and the Hare) a lot of money over the years. In my view, MasterCard has an impenetrable economic moat, strong secular growth tailwinds, and shareholder-friendly management. The company also has a more favorable business mix than Visa and superior technological infrastructure, which should lead to at least a few extra percentage points of revenue and earnings per share growth over the long run. MasterCard did a lot better than that in its most recent quarter, delivering 17% constant-currency revenue growth. Expense growth outpaced revenue growth as the company invested in a variety of strategic initiatives and acquisitions, but I expect positive operating leverage to return over the long run. Management continues to align the tax structure to MasterCard's global footprint, which resulted in a dramatically lower tax rate in the fourth quarter--this was the main reason for 25% earnings per share growth. MasterCard continues to pay a much higher tax rate than most global businesses (28.8% for the full year). I'm not counting on lower taxes to drive future EPS growth, but this could be a nice bonus. We raised our fair value estimate to $88 per share from $82 to account for cash earned since our last update. MasterCard is another core long-term holding and a favorite for new money in the Hare.

Novo Nordisk NVO
Revenue Growth: 10% (8%)
Operating Income Growth: -- (13%)
EPS Growth: 11% (8%)

Considering all of the challenges it faced in 2014--including the exclusion of key drugs from Express Scripts' ESRX national formulary, regulatory delays to next-generation insulins, and intensifying competition within its core diabetes niche--Novo Nordisk delivered pretty solid results. Local-currency operating income advanced 13% for the full year and is projected to grow another 10% in 2015. While reimbursement, regulatory, and competitive pressures won't go away any time soon, Novo's long-term growth is supported by a top-notch salesforce and one of the best pipelines in the industry. Among the drugs in development that could accelerate Novo's earnings growth in 2016 and beyond are ultra-long-acting insulin Tresiba, combination insulin/GLP-1 Xultophy, once-weekly GLP-1 Semaglutide, obesity treatment Saxenda, a faster-acting mealtime insulin, once-weekly human growth hormone, and new hemophilia therapies.

Novo's currency exposure is a bit different than most of our other holdings. The company reports in Danish krone, and a significant portion of manufacturing and research & development is in Denmark. However sales are derived globally, with about half coming from North America. The Danish krone is tightly linked to the euro through the European Exchange Rate Mechanism (ERM II). There has been some speculation recently that Denmark could abandon the krone-euro peg, similar to the recent move by the Swiss National Bank. I can't say it's impossible, but ERM II is a more formal arrangement than Switzerland had, with deep historical and political support. It seems very likely that the krone-euro relationship will be defended by the Danish central bank. There isn't much practical limitation to Denmark's ability to maintain the peg, since this basically involves printing krone to buy euros (and a country can print as much of its own currency as it wants--the limiting factor being the potential for inflation).

In any case, the recent weakness in the euro should be a boon to Novo Nordisk. If exchange rates stay at current levels, currency is projected to be a 12 percentage point tailwind to reported revenue and a 19 percentage point tailwind to operating profit in 2015. Much of the foreign currency exposure is hedged in the short term, but the hedges roll off within a year. Of course, U.S.-based investors will lose most of this benefit when translating earnings back into dollars, but not all of it because of the mismatch between revenue and expenses. Our analyst indicated that currency movements could result in a modest increase to our $44 fair value estimate--welcome news, considering most multinationals' fair value estimates are being cut because of currency.

In recent updates, I've mentioned Novo Nordisk as a possible candidate to be trimmed or sold. I still consider the stock fully valued, especially relative to its pharmaceutical peers. However, I am very hesitant to sell an otherwise high-quality company purely for valuation reasons, especially when we already have a 12.1% cash position in the Hare and few better places to put our money. Considering that the company is still delivering respectable growth and has the promise of brighter days ahead, I plan to hold for now.


In other news, the U.K. government is moving forward with plain packaging legislation for cigarettes. Because of restrictions on advertising, packaging is one of the only ways for tobacco companies to reinforce their brands with consumers. Similar legislation in Australia resulted in trading down to lower-priced cigarettes, though it didn't necessarily reduce overall smoking rates. The U.K. is a relatively small market for Philip Morris International PM, so the direct effect of the legislation should be limited. However, if plain packaging rules spread to other countries, it could have serious implications for Philip Morris' pricing power and economic moat, especially because the company is strongest in the premium end of the market (Marlboro). I plan to watch this situation closely, but considering that Philip Morris has been confronting similar regulatory challenges for decades, I'm not in a rush to sell.

Lastly, the U.S. Senate passed legislation authorizing TransCanada TRP to proceed with construction of its Keystone XL pipeline. President Obama has threatened to veto the legislation, and it appears unlikely that either the House or Senate would have enough votes to overcome a presidential veto. If that happens, Congressional Republicans have indicated that they will attach the Keystone provision to other critical legislation--such as a spending bill--to try to force the President's hand. Considering the State Department already concluded that the pipeline wouldn't contribute to climate change--without it, the oil will just move by rail, which is more dangerous and less efficient--I'm not sure this is a fight worth having. Regardless of the outcome, this project is no longer crucial to TransCanada's growth plans, as the company is working on a variety of alternative projects. I consider TransCanada a possible destination for new money in the Tortoise, along with Enterprise Products, Magellan Midstream Partners MMP, or a new midstream energy name like Spectra Energy SE.


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

MasterCard MA  |  Jim Sinegal

MasterCard suffered from heightened competitive pressures and rising expenses in the fourth quarter, but it was still able to achieve reported earnings per share growth of 21% during 2014. We think this demonstrates the resiliency of the wide-moat firm's business model to competitive threats, slowing global economies, and regulatory changes, and we are raising our fair value estimate to $88 per share as we incorporate these results and the time value of money since our last update. We believe the company is fairly valued at 23 times our 2015 earnings per share estimate.

In our view, escalating expenses across the board should be the biggest concern for investors. Management at both MasterCard and Visa guided toward higher rebate and incentive spending in 2015. We think this indicates decreased bargaining power relative to both merchants and issuers, and think this trend will continue over our forecast period. That said, currency-adjusted rebate and incentive spending rose only 3% during the year, despite a healthy increase in gross revenue. At the same time, operating expenses rose dramatically over the past 12 months. General and administrative expenses in particular grew by a reported 36% due in part to acquisition and restructuring spending. We would not be surprised to see moderately higher spending as the industry enters a major transition from plastic cards to online and mobile methods. We think MasterCard will remain a dominant firm thanks to its brand and connections to financial institutions around the world, but keeping ahead of the technological curve will not be without cost. Management has acknowledged as much, and we therefore don't expect major increases in near-term operating margin.

We're not reading too much into near-term hiccups in growth and currency movements. MasterCard's efforts in emerging markets should pay off, but the price of this growth could be paid in short-term volatility.


Visa V  |  Jim Sinegal

Visa's momentum slowed in the first quarter of its 2015 fiscal year, as weakness in global economies and pressure from clients had an impact on results. We've long expected rebate and incentive spending to increase as Visa deals with harsher regulation and consolidation among its customers--both the banks that issue its branded cards and the merchants that accept them. That said, we don't see many obstacles to the company achieving its double-digit earnings per share growth goals over the next several years. We are therefore increasing our fair value modestly to $234 per share, based mainly on the time value of money since our last update. We still view the company's shares as priced for perfection at more than 25 times our 2015 earnings estimate, though the wide moat business is certainly capable of achieving exceptional results.

Strength in the U.S. dollar affected cross-border volumes, and we don't see any reason to believe this trend will reverse in 2015 given mounting economic and political tribulations around the world. Similarly, falling gas prices reduced spending particularly on Visa-branded debit cards--another factor that could provide a slight headwind. We don't think these factors affect the long-run outlook for volume and revenue growth, though, as electronic payment volumes are virtually sure to be much higher by the end of our five-year forecast period. Growing amounts of online and mobile commerce present enormous opportunities for the firm, and will further speed a global shift away from cash.

We continue to see new technologies--whether tokenization, Apple Pay, or other advances--as evolutionary rather than revolutionary. Much as the networks once shifted from paper and telephone connections to computers, Visa's advances in the tech arena should make its connections between banks, merchants, and customers more secure and convenient, rather than making it easier for new players to disrupt the status quo.


Google GOOG  |  Rick Summer, CFA, CPA

Google announced fourth-quarter results that were modestly ahead of our forecast for revenue and earnings and exited 2014 continuing to invest heavily in its employee base (through salary and stock compensation), data center capacity, real estate, and general research and development. We are sticking with our $600 fair value estimate and consider the shares modestly undervalued as of the earnings call. Our wide moat rating is unchanged.

Revenue grew 10.5% versus 2013 to $18.1 billion, although foreign currency had a negative impact of approximately 3.4%, excluding the contribution of the company's hedging program. Management called out particular strength in its mobile and programmatic advertising businesses, although it shared very little in the way of metrics for either segment. Google sites (which includes company-owned and -managed websites such as Google Search and YouTube) continue to be the engine, growing 18% versus 2014 excluding traffic acquisition costs. Even as Google's business matures, we expect the company to benefit as the digital advertising sector grows in the double digits over the next five years, according to our estimates.

Operating margins showed slight improvement versus the prior year, rising 100 basis points to 24.3%. The firm continues to invest heavily in compensation and head count, as the employee count has grown by nearly 6,000 over the past year, or 12%. Management also addressed an increase in compensation expense (for example, research and development expense grew 33%) caused by a one-time bonus payment, increased head count, and a reclassification of stock-based compensation.

Eventually, we expect growth in head count (and related expenses) to lag revenue growth, leading to higher operating margins. Presently, however, we expect 2015 to be another year of investment, and we are more focused on Google's growth and competitive positioning for purposes of our investment thesis and valuation. On these metrics, we continue to have a positive view and believe the stock is attractive at these levels.


Novo Nordisk NVO  |  Karen Andersen, CFA

Novo Nordisk reported 2014 results and 2015 guidance ahead of our projections, as currency headwinds turned to dramatic tailwinds in the fourth quarter. 2015 guidance includes a 19-percentage-point boost to operating profit growth from foreign exchange (partly offset by expected hedging losses). We expect to raise our fair value estimate slightly, with a larger increase for local shares, to account for these currency moves, as the firm looks to be on target with our assumptions operationally. Novo's innovative and increasingly diversified diabetes portfolio has secured a wide moat around the firm, and we think cost advantages give the firm a stable moat trend.

In 2014, Novo's local currency sales growth was 8% (6% as reported), with continued double-digit growth for modern insulins and Victoza. North America remains the driver for half of sales and the majority (61%) of growth, and on a product level, long-acting insulin Levemir (42% of growth) and once-daily GLP-1 product Victoza (27% of growth) are the key drivers for the firm. Novo continues to see steady market share gains (2 percentage points in 2014) for Levemir in the U.S. market against Sanofi's market leader Lantus, and price increases in the U.S. also helped support 25% local currency Levemir growth. While Victoza had a difficult first quarter due to the exclusion from the Express Scripts formulary, market share has remained strong overall, and GLP-1 demand (which the entrance of Lilly's Trulicity and Glaxo's Tanzeum partly boosted) as well as positive U.S. pricing helped drive 16% local currency growth. Operating profit grew 13% in local currencies, as gross margins slightly improved and the firm significantly lowered promotional spending.

Novo forecasts slightly lower growth for 2015 on a constant currency basis, with 6%-9% top-line growth and 10% operating profit growth. Novo continues to expect single-digit price increases in the U.S. market for all of its modern insulins, but this is a step down from prior double-digit increases for Levemir due to the more competitive contracting environment. However, the impact from currency is expected to be very strongly positive this year, at 12 percentage points on the top line and 19 percentage points in operating profit. In addition, product launches are poised to continue. Beyond new insulin products (Tresiba and related products Ryzodeg and Xultophy), the firm is launching obesity drug Saxenda this year in the U.S. and likely also in Europe, and appears to be on track to extend NovoEight's launch (in hemophilia A) to the U.S. market by midyear. Novo is also moving forward with late-stage development of several programs to supplement long-term growth, including once-weekly GLP-1 semaglutide, a faster-acting insulin analog, and a once-weekly version of growth hormone Norditropin.

Tresiba remains central to Novo's upcoming U.S. launches. The DEVOTE cardiovascular outcomes study for Tresiba (compared with Lantus) has now hit the number of events necessary for the interim analysis, and a team from Novo will decide in the first half of the year whether to file on this analysis or wait for final data (trial will complete in the second half of 2016). We assume a U.S. launch for Tresiba in 2016, followed by a 2017 launch of Xultophy. Outside the United States, Tresiba continues to gain traction, and Xultophy is just beginning to launch in select European markets. We think both products remain multi-billion-dollar opportunities, and the recent DUAL V data for Xultophy could help differentiate the combination product--which includes both Tresiba and Victoza--from basal insulin treatment (such as Sanofi's Lantus or Novo's Levemir).


Novartis NVS  |  Damien Conover, CFA

We don't expect any changes to our CHF 84 (local) and $95 (ADR) fair value estimates for Novartis, as fourth-quarter results fell slightly below our projections but 2015 guidance was better than expected. The company's strong progress with its pipeline reinforces our wide moat rating. Following the corporate restructuring (sales of animal health and vaccine businesses and the creation of the consumer joint venture), we expect Novartis will post stronger margins and have the scale to be in a stronger competitive position with its remaining business lines of drugs, eye-care products, and generics.

On the drug side, new products are helping to mitigate generic competition. We expect the generic headwinds will continue over the next two years as the patent losses on cardiovascular drug Diovan (ongoing) and cancer drug Gleevec (2016) represent close to 10% of the company's total sales. However, new drug launches should continue to offset these pressures. We expect blockbuster potential for heart failure drug LCZ696, cancer treatment CTL019, and psoriasis drug Cosentyx. Also, the push of wet age-related macular degeneration drug ESBA1008 into Phase III studies could help Novartis defend its multi-billion-dollar Lucentis franchise.

Turning to the eye-care business, we are slightly skeptical of Novartis' 2015 guidance of mid- to high-single-digit growth, which is ahead of our expectations. On a normalized basis, we believe Novartis' eye-care business can achieve this growth, but the likely patent losses on several midsize ophthalmology drugs could weigh on the division's growth. However, the complexity of creating generic ophthalmology drugs may keep generic competitors at bay.

For the generic business, Novartis remains on track for steady growth, buoyed by the opportunity for biosimilars. The recent U.S. approval of Zarxio (generic Neupogen) reinforces our view that Novartis is one of the best-positioned firms to lead in the complex field of biosimilars.


General Dynamics GD  |  Neal Dihora, CFA

We are raising our fair value estimate for General Dynamics to $124 per share from $121 due to the time value of money in our discount cash flow methodology. The company continues to show the power of its economic moat with sales growth of 3.1% for the fourth quarter and margin improvement of 130 basis points to 12.8%. Sales were stronger than our estimates, resulting from strength in aerospace and marine. The margin improvement was broad-based, revealing that CEO Phebe Novakovic has instilled her operations focus through the organization. Earnings per share of $2.19 were 24% higher than last year. The company reduced share count 6% from last year. General Dynamics provided an outlook for 2015 EPS of $8.05-$8.10 and sales of $31.3 billion-$31.5 billion, increases of 3% and 1%, respectively.

Aerospace sales increased 5% and posted an 18.4% operating margin, with deliveries of 38 green and 42 outfitted aircraft, versus 40 and 41, respectively, in the year-ago period. Orders remained strong across all platforms and should accelerate as new platforms G500 and G600 near entry into service dates in 2018 and 2019. Combat sales were up 1%, and margins were up 110 basis points to 16.8%. Combat's backlog represents more than three years of work and will show sales increase starting in 2016. Sales in the long-cycle marine segment rose 25%, but margins declined 30 basis points to 9.5%. Marine is transitioning to the next Virginia-class submarine block and starting work on commercial ships, damping margins. Sales in information systems and technology fell 8%, but margins improved 130 basis points to 8.6%.

Backlog stands at $72 billion, up strongly from $46 billion at year-end 2013. Orders of $57 billion in 2014 establishes a line of sight for growth in 2016 and beyond. With the benefit of incumbency and a highly relevant product lineup, General Dynamics is in a strong position to endure and drive shareholder value.


Abbott Laboratories ABT  |  Debbie S. Wang

Despite foreign exchange headwinds, Abbott posted strong fourth-quarter performance thanks to robust underlying growth in some of its key markets. We plan to modestly raise our fair value estimate to reflect more optimistic projections for nutrition, diagnostic, and diabetes sales growth over the next few years. Narrow-moat Abbott demonstrated some of the margin improvement we have assumed in our valuation. Over 2014, the firm has made gradual progress expanding its operating margin, and we expect this to continue as new manufacturing facilities in the emerging markets enter the picture.

We were pleased to see solid demand drive in pediatric nutritionals, diagnostics, and the newly remodeled established pharmaceuticals segments during the fourth quarter.  Compared with competitors, Abbott remains very well-positioned to take advantage of growth in consumer and health care spending in the emerging markets with its new alliance with dairy supplier Fonterra in China and an expanded footprint in Latin America for branded generics. Even though the diabetes business saw major revenue declines in the fourth quarter as it works through domestic reimbursement issues, we remain eager to see how well the new Freestyle Libre diabetes monitor is adopted in Europe. This technology is truly differentiated and can make life substantially easier for diabetic patients.

Finally, we note that the medical devices unit is still an area of weakness for Abbott. The drug-coated stent business is vulnerable to very quick market share shifts, and Abbott's Absorb resorbable stent is far from establishing itself as the standard of care. It remains a niche product and is unlikely to become a major growth driver. With the recent acquisition of Topera, Abbott seeks to enter the fast-growing atrial fibrillation ablation market. However, St. Jude Medical, Boston Scientific, and Johnson & Johnson are firmly entrenched in that market and Abbott will be playing catch-up.


PotashCorp POT  |  Jeffrey Stafford, CFA

We're holding steady on our fair value estimate of $41 per share for Potash Corporation of Saskatchewan after the company released fourth-quarter and full-year results. However, we're increasing our Canadian-dollar-denominated fair value estimate to CAD 52 per share from CAD 46 because of fluctuations in the USD/CAD exchange rate. Our wide moat rating, based on cost advantage, remains intact.

Quarterly potash volumes roared back compared with last year, increasing more than 40%. Global buying patterns returned to more normal levels after 2013 demand that was severely dented as the market adjusted to Uralkali's strategy shift. In addition to normal buying levels, we believe fourth-quarter volumes were inflated by many customers and dealers refilling inventory to more sustainable levels. Helped by this inventory restocking boost, global potash shipments grew to more than 61 million metric tons compared with about 55 million in 2013. We expect global potash volumes to take a small step back in 2015 without the positive inventory effect seen in 2014. Our 2015 potash volume forecast for PotashCorp remains at about 9.5 million metric tons.

Over the long run, we expect volumes to expand significantly as the company fills capacity that it has built over the last few years. In the meantime, this extra capacity serves as deterrent to expansion projects from other potential players, most notably BHP Billiton and its Jansen project in Saskatchewan.

Potash prices were essentially flat year over year. We think prices bottomed in 2014, and we expect modest pricing growth from here, based on our outlook for supply and demand. With Uralkali looking like it will revert back to a price-over-volume strategy over the long run, we expect potash prices to remain above marginal costs of production, due to the cartel-like structure of the industry.


Philip Morris International PM  |  Philip Gorham, CFA, FRM

We believe the announcement by the U.K. government that it will press ahead with legislation to introduce plain cigarette packs in England will have limited impact on the names under our coverage. However, we regard the spread of plain pack legislation as a significant negative for the industry, and we would probably revise our pricing assumptions for the global players if similar legislation spreads to other markets. Until we gain more visibility into governments' strategies, however, we are retaining our wide moat and stable moat trend ratings for the tobacco multinationals we cover.

Following around two years of consultation, culminating in last year's Chantler report that recommended the introduction of plain packs, the U.K. government has announced that it will put legislation to Parliament by May that will propose the introduction of standardized packaging on tobacco products in England. We believe the bill has a strong chance of passing. A poll by Cancer Research UK (admittedly an organization with a vested interest) indicates that 72% of U.K. voters favor such legislation. The largest opposition party also takes a firmly anti-tobacco stance, which should tip the balance toward enactment.

We believe plain packs would be a significant negative for the industry because the legislation could cause trading down by smokers and/or erode the pricing power of premium brands over lower-priced competitors. In an industry that already has limited opportunities to communicate with its core consumer, plain packs would eliminate trademarks and packaging branding, some of the few remaining marketing tools available to cigarette manufacturers. In turn, we believe this could lead to trading down to cheaper brands by consumers less able to differentiate among brands. Differences in taste and perceived quality are likely to offset trading down, however, particularly at the higher end where smokers tend to be more brand loyal.

Evidence on the impact of standardized packaging from Australia, the only other market to have introduced the legislation, is mixed. Retail World supermarket sales data showed that volume of mainstream and premium brands fell 8%-9% in 2013, but value brands increased 12.9%, indicating that trading down is occurring. Plain packs were introduced in 2012, along with a large excise tax increases of 12.5% every year for four years. This has muddied the waters for measuring the impact of plain packs, as Australia is already one of the highest-price-point cigarette markets in the world, and the change in consumption patterns could be driven by the increasing price points rather than economizing.

In the United Kingdom, the major manufacturers have well-laddered product portfolios, and all have lower-priced brands that could capture market share in the event of trading down. However, we think the migration of consumers to lower price points represents a risk for those with the largest market share. Imperial Tobacco is the market leader in the U.K., with a volume share of around 45%. Its product portfolio ranges from Davidoff and Embassy at the high end of the pricing spectrum to Lambert & Butler and JPS at below-average price points. Japan Tobacco (not covered) has a share of around 40% and could have the most to lose. Through Benson & Hedges and Silk Cut, the firm has a heavy presence in premium price categories. For British American Tobacco and Philip Morris International, however, the U.K. is a relatively small market. Both firms possess volume shares in the high single digits and will be less affected than Imperial and Japan Tobacco. Nevertheless, the Marlboro brand is positioned at the premium end in the U.K. and Philip Morris International could suffer share losses as a result.


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