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 24, 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, 10/17/14 -- Strong Results from BLK, SLB; Investors Overreact to EBAY, GOOG
Third-quarter earnings season is underway, and this week we heard from 10 portfolio holdings. As always, the growth rates below reflect adjusted, constant-currency figures where available.

Wells Fargo WFC
Revenue Growth: 4%
Net Income Growth: 3%
EPS Growth: 3%

I bought Wells Fargo partly for its positive exposure to higher short-term interest rates, which is an especially helpful hedge given the interest rate sensitivity of many of our other Tortoise holdings. Unfortunately for Wells--but to the benefit of the Tortoise as a whole--the prospect of a hike to short-term rates in the near future may be dimming. Longer-term interest rates have fallen precipitously in the past few weeks, indicating that investors believe concerns about global economic growth and deflation risk in Europe will prevent the Federal Reserve from raising short-term rates as quickly or aggressively as previously expected.

Wells' exposure to interest rates is evident in its net interest margin--the difference between interest income earned on loans and securities and interest expense paid on deposits and other liabilities, as a percentage of interest-earning assets. Wells' third-quarter net interest margin fell to 3.06% from last year's 3.39%. However, other fundamental performance metrics were strong across the board, including loan growth, deposit gathering, lower operating expenses as a percentage of revenue, improving credit quality, a strong capital position, and healthy returns on equity. Earnings growth probably won't accelerate until the economy picks up steam and short-term interest rates start to rise, but Wells Fargo remains my favorite bank for the long run.

Johnson & Johnson JNJ
Revenue Growth: 8%
Pre-Tax Income Growth: 13%
EPS Growth: 10%

It was another solid quarter for Johnson & Johnson, and management bumped up its outlook for full-year earnings per share by about 1% to a range of $5.92-$5.97. However, J&J remains highly dependent on the drug division for growth. Sales of consumer products were only about 2% higher (excluding a business divestiture), indicating that last quarter's relatively strong consumer segment growth may have been an aberration. Medical device and diagnostic sales advanced even more slowly, up 1.6% (also excluding a divestiture), and this segment continues to face relatively severe reimbursement and competitive pressure. Pharmaceutical sales were once again the highlight, soaring nearly 19%. Unfortunately, hepatitis C drug Olysio--which accounted for 63% of the pharmaceutical division's sales growth in the quarter--will face stiff competition from Gilead's GILD recently approved all-in-one hepatitis C treatment Harvoni. J&J is also getting closer to a few key patent expirations. Overall, I expect J&J's growth rate to slow from here, but I still consider the company a worthwhile holding for the Tortoise.

American Express AXP
Revenue Growth: 5%
Net Income Growth: 8%
EPS Growth: 12%

American Express reported healthy third-quarter results. Adjusted revenue net of interest expense improved 5% from the prior year while operating expenses were only up 1%. I've been impressed by management's disciplined control over expenses the past few years. Credit quality is still extremely high, with only 1.1% of loans 30 days or more past due. Our valuation model continues to assume a pronounced deterioration in credit quality in the long run, creating upside potential if credit losses remain subdued. The company's return on equity came in at 29%, demonstrating significant shareholder value creation. Despite a bounce on Friday, AmEx's share price has been weak over the past few months, and now trades roughly in line with our $82 fair value estimate. I plan to hold.

Philip Morris International PM
Revenue Growth: 4%
Operating Income Growth: 4%
EPS Growth: 10%

The currency headwinds facing Philip Morris International are getting worse due to the strong U.S. dollar, but underlying results have steadily improved. Cigarette volumes only fell by 0.4% in the third quarter compared to a 2.7% decline in the second quarter and a 4.4% drop in the first. I expect long-run volume declines to be manageable, with growth in emerging markets largely offsetting declines in developed markets. Meanwhile, price increases continue to drive revenue growth, and disciplined cost control and share repurchases contribute to higher earnings per share. Philip Morris recently raised its dividend by 6.4% to an annualized rate of $4 per share, providing a yield of 4.7%. The stock's above-average yield and below-average price/earnings multiple remain the primary draws relative to other consumer staples firms. I consider Philip Morris a favorite for new money in the Tortoise.

Kinder Morgan Management KMR
Revenue Growth: 16%
Distributable Cash Flow Growth: 10%
Distributable Cash Flow Per Unit Growth: 3%

It feels like a lame-duck session for Kinder Morgan Management as we wait for the company to be acquired by general partner Kinder Morgan, Inc. KMI. That deal is expected to close by the end of the year, at which point we will receive 2.4849 shares of KMI for each share of KMR we own. KMI plans to pay a dividend of $2/share in 2015. Applying the exchange ratio and assuming we get one more quarterly share dividend before the deal closes, that means KMR shareholders will soon be receiving cash dividends equivalent to about $5.05 per current KMR share, for a forward dividend yield of 5.6%. Additionally, Kinder plans to raise the dividend 10% per year through the end of the decade.

Kinder Morgan comes with a fair bit of risk--especially by pipeline company standards--stemming from its high degree of leverage, modest excess dividend coverage, and long-run production declines and commodity price sensitivity in the CO2 segment. However, I believe we are being more than adequately compensated for taking on these risks. After all, the company only needs to sustain a dividend growth rate of 4.4% per year--less than half of management's target--to justify its current valuation and deliver a 10% annual total return. Trading in midstream energy firms has been especially volatile in the past two weeks, and I'm on the lookout for an opportunity to add to our KMR stake. I'm also open to adding to our stake in Enterprise Products Partners EPD or starting a position in Magellan Midstream Partners MMP.

BlackRock BLK
Revenue Growth: 15%
Operating Income Growth: 24%
EPS Growth: 34%

Among our holdings, BlackRock's intrinsic value is uniquely sensitive to the level of asset prices, so I can't say I'm surprised to see the recent stock market volatility trim $10 per share from our fair value estimate (now $350). Even so, BlackRock reported outstanding third-quarter results. Assets under management advanced 10% thanks to both investor inflows and market appreciation versus the prior year. In contrast to the first half, revenue growth of 15% outpaced AUM growth, indicating that fee pressure was overcome by favorable business mix shifts. The adjusted operating margin expanded 300 basis points to a remarkable 44.2%, demonstrating BlackRock's inherent operating leverage. Lastly, a lower tax rate and share repurchases propelled adjusted earnings per share growth north of 30%. I view BlackRock as a core long-term holding for the Hare. If the stock sells off in conjunction with a broad market decline, I would gladly add to our position.

Charles Schwab SCHW
Revenue Growth: 13%
Net Income Growth: 11%
EPS Growth: 9%

We're counting on an eventual rise in short-term interest rates to drive earnings growth at Charles Schwab and justify an otherwise rich valuation. No doubt the recent drop in interest rates is one of the reasons for Schwab's poor stock price performance the past few weeks. In the most recent quarter, Schwab's net interest revenue expanded 13% as the net interest margin rose 13 basis points to 1.64%. However, further gains will be difficult without higher short-term rates, and if rates stay this low I wouldn't be surprised to see Schwab's net interest margin turn back into a headwind over the next several quarters. Schwab also waived $190 million in money market fees in the third quarter to ensure a positive return for investors.

Schwab remains ahead of the pack when it comes to asset gathering with another $34.7 billion in asset inflows in the most recent quarter--an annualized organic growth rate of 6%. At the heart of Schwab's positive moat trend is its ability to bring assets in the door and then cross-sell banking and investment advisory services that increase customer stickiness. I view the company as exceptionally well positioned to meet investor demand for quality, cost-effective financial help. Total client assets were up 12% from the prior year--aided by market appreciation--while assets receiving some form of ongoing advice were up 15%. Asset management revenue improved 11% despite the money market fee waivers.

Lastly, Schwab's trading revenue was down almost 7% as trading activity was subdued through most of the quarter. The recent spike in volatility may reverse this trend, though trading revenue remains a relatively small contributor to Schwab's overall results (less than 15% of year-to-date net revenue). On the margin side, the operating leverage witnessed in the past few quarters wasn't present in Schwab's most recent results. This was partly due to some non-recurring charges, without which earnings per share would have been up about 14%. I continue to expect significant operating margin expansion if and when short-term interest rates return to more normal levels. I plan to hold.

Revenue Growth: 10%
Net Income Growth: 1%
EPS Growth: 6%

EBay's shares were down about 5% on the day of its earnings release, but I don't think investors are putting the numbers in the proper context. Considering that eBay has been simultaneously dealing with a data security breach and a change to Google's search algorithm that eroded organic search traffic, results could have been a lot worse. Marketplaces revenue increased 5% from the prior year. While the segment margin was down due to costs required to react to the recent challenges--especially increased marketing expense--I suspect many of these costs are temporary. PayPal's revenue growth rate accelerated slightly to 21%, though this segment's margin was also down due to business mix shifts and investments in marketing and product development. EBay plans to separate its two businesses in the second half of 2015, and I continue to believe that this split may help shareholders realize eBay's intrinsic value. While management's execution has been disappointing, I don't think eBay's current valuation--at 16.2 times 2014 earnings estimates and a 24% discount to our $63 fair value estimate--adequately accounts for the secular tailwinds benefiting both e-commerce and digital payments. EBay has continued to deliver relatively attractive growth, almost in spite of itself. I plan to hold at least through the split, and eBay is also a potential destination for new money.

Schlumberger SLB
Revenue Growth: 9%
Operating Income Growth: 12%
EPS Growth: 16%

Schlumberger's stock bounced higher in the second half of this week (after we added to our position on Wednesday), but the company certainly isn't out of the woods. Exploration and production firms set their capital spending plans months or years in advance, so the recent drop in oil prices wasn't reflected in Schlumberger's strong third-quarter results. The effect of lower oil prices will depend on how long they last and the extent to which oil producers respond by curtailing drilling or demanding lower prices from services providers. Even so, Schlumberger's third-quarter results--including high-single-digit revenue growth, margin expansion, and 16% earnings per share growth--hint at Schlumberger's long-run potential. Investors in Schlumberger should be prepared to ride out some major cyclical ups and downs, but I still find the risk/reward tradeoff attractive at the current price.

Google GOOG
Revenue Growth: 20%
Operating Income Growth: 16%
EPS Growth: 13%

Google's free-spending ways were back in focus with third-quarter results. Revenue growth remains healthy at 20%. Google's growth will inevitably slow as the company becomes larger and more mature, but I believe double-digit top-line growth can be sustained for at least the next few years thanks to the secular shift toward digital advertising. On the other hand, third-quarter costs once again expanded faster than revenue, in contrast to last quarter but consistent with the trend of the past few years. Most notably, research and development expense soared nearly 46% and consumed 16% of revenue. I am willing to give Google's management an unusual degree of latitude when it comes to such lavish spending because of (1) the tremendous success of past investments such as Android, YouTube, Google Docs, and Gmail, which more than make up for the failures along the way; (2) Google's huge cash balance and fat margins in the core business, which provide significant financial flexibility; and (3) the likelihood that various investments could be wound down if unsuccessful, resulting in some wasted spending but a return to higher operating margins in the long run. Even so, Google's capital allocation and stewardship are key risks. After declining on Friday, Google's shares are now trading at a modest discount to our fair value estimate--especially the Class C shares with ticker GOOG--for the first time since early 2013. I consider this a fair price for a super-wide-moat core holding, and I'm open to adding to our position.


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

eBay EBAY  |  R.J. Hottovy, CFA  

With eBay recently announcing its intent to spin off PayPal, its third-quarter update provided an opportunity to reassess the moat sources underlying each business. Our view on PayPal is largely unchanged, as active users (up 14% to 157 million), payments per active user (up 7%), and mobile payments (up 72% to $12 billion, or 20% of total payment volume) suggest that its network effect is intact. PayPal's segment margin decline (down 180 basis points to 20.9% due to Braintree's lower take rate and mobile investments) raises questions, but we still believe longer-term margin opportunities exist as current investments wind down. Management didn't provide much color about PayPal's potential as a funding source on Apple Pay or future NFC integration, though we continue to believe PayPal's versatility, security features, and convenience make it a natural partner for mobile payment platforms.

Marketplaces presents more of a mixed picture, as the segment is still feeling the effects of May's data breach and Google search algorithm changes. Active buyers increased 13% to 152 million, but gross merchandise volume growth slowed to 9% (versus a 12% run rate year to date). Management is attempting to counter slowing volume with increased marketing, driving segment margins down 300 basis points to 35.9%. Although we view some of these marketing investments as prudent ahead of the holidays and believe eBay is taking measures to adjust to search engine changes, we have concerns that new user acquisition may become more costly in the periods to come, but will wait to assess holiday traffic before adjusting our margin assumptions.

There is no change to our $63 fair value estimate. Embedded in this are stand-alone valuations of $31 per share for PayPal (midteens revenue growth and margins improving to 25% the next five years), $27 per share for Marketplaces/eBay Enterprise (high-single-digit revenue growth and margins in the high 30s), and more than $5 per share in net cash.

Management anticipates that the slower-than-expected recovery in Marketplaces segment volume, coupled with the negative impact of a strengthening dollar relative to the company's other key currencies, will result in a $300 million reduction to its previous full-year revenue outlook and a $0.07 reduction in adjusted earnings per share, though part of the EPS impact will be offset by tighter cost controls (some of which will redeployed as the aforementioned marketing investments) and a reduction in the company's effective tax rate stemming from U.S. research and development tax credits. We believe these guidance adjustments are realistic, given the pace of eBay's Marketplaces recovery, and we plan to align our full-year estimates with the updated guidance (including revenue of $17.85 billion-$17.95 billion, operating profit of $3.5 billion, and adjusted EPS at the low end of the previous range of $2.95-$3.00). Looking forward to 2015, we believe EPS growth will continue to trend at a high-single-digit clip (excluding any incremental costs tied with to the separation of PayPal), as we expect marketing investments will be required to stimulate Marketplaces volume growth and new mobile technologies are developed during the first half of the year. However, we anticipate sequential improvement in Marketplaces GMV as the year progresses.

Details were sparse, but the company provided some additional color around the planned separation of PayPal. Management expects to file the necessary registration statements for a stand-alone PayPal in the first half of 2015, with the transaction expected to take place during the second half. The company's $7.6 billion debt balance is expected to stay with eBay unit, though management noted that PayPal will be allocated sufficient cash to fund its PayPal Credit portfolio (presumably a sizable portion will be cash held overseas, which currently funds 73% of PayPal Credit's principal loan portfolio). Additionally, management emphasized that it plans to structure the "arm's length" operational agreements between the stand-alone eBay and PayPal units so that Marketplaces continues to be a source for new PayPal users and data sharing opportunities between the entities still exist. Assuming these operational agreement are successfully implemented, we believe it will preserve the synergies between the businesses while allowing the continuing leadership of each segment (Dan Schulman at PayPal, who comes from American Express, and Devin Wenig at eBay) to accelerate relationships that enhance their respective network effects.


Schlumberger SLB  |  Robert Bellinski, CFA

Schlumberger’s third-quarter earnings didn’t reflect the drop in oil prices over the past few months--revenue growth was strong and margins expanded, leading to a $0.03 earnings beat versus our estimate. We continue to believe that Schlumberger’s wide moat is safe even if oil stays at current levels. We see greater threat to our $145 fair value estimate the longer that oil stays near $80/bbl. We are not changing it at this time, but we are closely monitoring producers’ 2015 capital budgets to gauge whether a cut will be appropriate.

Revenue growth in North America was robust, while international activity varied by location. Sequential revenue in North America was up 9% as the firm continued to benefit from higher stage counts on unconventional wells, as well as recent acquisitions' artificial lift. International revenue growth was 3% versus the second quarter, with Latin America leading at 10% sequential growth. Project delays in Russia, as producers exercised caution in the wake of sanctions, held back growth in the Europe/CIS/Africa region. Unrest in Kurdistan caused a slowdown in Iraq that kept the Middle East and Asia segment’s revenue sequentially flat.

Margins were resilient, despite obstacles in international activity. Overall pretax operating income reached $2.8 billion for the quarter, up 7% sequentially and 12% year over year. International operating margins expanded by 55 basis points to reach nearly 25%, continuing their steady ascent from ~15% over the past five years. In North America, operating margin increased 137 bps to hit 19.4%--not the high-water mark we saw in 2011, but still an improvement. We are unsure to what degree unconventional activity might decrease in the near term. A sharp reduction in new wells would likely kill services companies’ hopes for continued recovery in pressure pumping pricing, and North American revenue growth and margins would clearly suffer. Early indications are that 2014 remains stable, but 2015 is still uncertain.

Even facing near-term headwinds, Schlumberger still sees oil supply and demand as balanced over the long term. The company acknowledged the threat of lower economic growth in Europe and China cutting the global oil demand outlook, as well as OPEC’s unwillingness to support oil at $100/bbl. However, during today’s earnings call CEO Paal Kibsgaard noted he expects oil production will still need to increase 1.1 million barrels per day to meet demand in 2015 while non-OPEC international production growth has struggled to increase, and he was skeptical of the sustainability of spare production capacity from OPEC. Where production growth would come from (i.e., deep-water versus unconventional versus lower-cost production in currently unstable regions) is more dependent on where oil prices eventually settle. Fortunately, Schlumberger's unparalleled international scale provides it considerable opportunity to capitalize on any of these outcomes, and consequently the firm remains our favorite pick among the oilfield services sector.


BlackRock BLK  |  Greggory Warren, CFA

We've lowered our fair value estimate for wide-moat BlackRock to $350 per share following the firm's release of third-quarter earnings. Much like we saw with the other asset managers that have reported September AUM data, BlackRock was affected by the falloff in global equity and currency markets near the end of the third quarter. This led to a 2% decline in its managed assets to $4.525 trillion, below our forecast for $4.625 trillion in total AUM. As a result, we have reduced our full-year forecast for the firm's managed assets to $4.350 trillion-$4.650 trillion from $4.650 trillion-$4.950 trillion.

We also expect BlackRock to generate revenue growth at the lower end of our 10%-12% full-year forecast (having believed previously that the firm would end up at the upper end of the range), as 12% growth in average AUM year over year is diminished slightly by a lower fee realization rate. Unlike most of the other asset managers, BlackRock has a portfolio capable of generating organic growth in the near term (even with the market expected to be a bit more volatile), with both its ETF and fixed-income platforms firing on all cylinders right now. This is the main reason why we continue to project mid- to high-single-digit annual revenue growth for BlackRock over the remainder of our five-year forecast.

Given the positive operating leverage that exists in the business, we don't expect the weaker top-line results this year to suppress BlackRock's ability to close out 2014 with full-year operating margins in excess of 40%. We also continue to believe that the company's operating profitability will increase to more than 42% of revenue by the end of our five-year projection period. While we acknowledge that asset managers can see a meaningful improvement in their margins as the size and scale of their operations increase, we expect the impact for BlackRock to be a bit muted in the near to medium term, as the firm commits greater resources to sales and distribution efforts.


Wells Fargo WFC  |  Jim Sinegal

Interest rates continued to weigh on Wells Fargo's results in the third quarter, even as net interest income rose to $10.9 billion from $10.8 billion thanks to higher deposit and loan balances. Low-cost core deposits--the key source of Wells Fargo's narrow moat--grew at an 8% annualized rate during the quarter, an indication that the company's competitive advantage continues to grow. Yields continue to pressure results, though, and net interest margin was 3.06% during the quarter, down from 3.39% in the third quarter of 2013 and 4.79% five years ago. We're still reluctant to incorporate a rebound of similar magnitude, as the timing and extent of rate increases are difficult to predict. Our current valuation forecast incorporates net interest income growth averaging 5% annually over our five-year forecast period, stemming from both loan growth and an increase in net interest margin. However, current futures data from CME Group implies a 43% probability that the target fed funds rate will not exceed 0.25% by September 2015, supporting our cautious outlook. We don't expect to alter our $50 fair value estimate.

While Wells Fargo is poised to benefit from rising interest rates in years to come, part of this benefit is likely to be offset by rising credit losses. The bank charged off only 0.32% of loans in the third quarter, well below our long-term forecast of 0.55%. We note that the bank experienced recoveries in both its commercial real estate and construction lines of business and charged off less than 3% of credit card loans, results we believe are not sustainable.

Finally, management confirmed that an increasing regulatory burden is likely to continue weighing on costs. Salaries and incentive compensation both reached their highest levels in five quarters--offset by declining employee benefits--and litigation accruals and outside professional costs again ticked up, consistent with our thesis and forecasts.


Philip Morris International
PM  |  Philip Gorham, CFA, FRM

Philip Morris International, our pick in the global tobacco space--on both valuation and business quality--reported strong third-quarter results that beat consensus estimates on both the top and the bottom lines for the second consecutive quarter.

Although unfavorable foreign exchange movements remain a near-term headwind, we think this was a good quarter for Philip Morris and one which supports our long-term thesis that the firm has the strongest competitive positioning in the global tobacco industry.  Management has tightened full-year guidance slightly, and as we were at the high end of previous guidance, we may lower our 2014 EPS estimate very modestly. This is unlikely to affect our $90 fair value estimate, which is based on the discounted future cash flows of the business. We are reiterating our wide economic moat rating in light of a decent underlying performance in which currency-adjusted profitability improved despite a drop in volumes.

In our second-quarter earnings note, we suggested that an improvement in Europe and Asia would be catalysts for Philip Morris' stock. In the third quarter, there were signs of both beginning to occur, but the challenges in these segments are ongoing. In the EU, volume grew by 0.5%, despite an industry volume decline of around 4.0%. Some favorable trade inventory movements provided a temporary boost to volumes, but Philip Morris took share in several key markets across the EU. However, conditions remain quite fragile and currency-neutral revenue growth 0.5% was sequentially lower than the first half of the year as European smokers continued to trade down. Most of Philip Morris' volume gains came from Chesterfield, a brand positioned at the lower end of the price spectrum. Although industry volumes appear to have stabilized to a level we believe is a reasonable assumption for long-term declines, we would prefer to see a more balanced profile of price increases and trading up before becoming more optimistic on Europe.

In Asia, the news was a little better. In the Philippines, where Philip Morris' dominant market share position has been modestly eroded for several quarters as a result of some predatory pricing strategies by a local competitor, market share grew by 1.3 percentage points. Indonesia, the world's fourth-largest cigarette market by volume, continued its recovery. Industry volumes grew by almost 5.0%, but Philip Morris again lost share due to the shift from hand-rolled to machine-made kretek products. We expect the sequential market share performance in the third quarter (Philip Morris' share fell by 0.9%) to continue, particularly as the firm will cycle the elimination of some low-priced products in that market next year.

With the exception of Indonesia, we regard Philip Morris' operational problems--namely a strong U.S. dollar, macroeconomic weakness in parts of Europe, and the share loss in the Philippines--as mostly temporary in nature. We still regard the firm as the best-positioned business in the global tobacco industry, as we believe it possesses a wide economic moat through a cost advantage over local manufacturers and strong brand loyalty to Marlboro in developed markets. With the stock trading at around a 10% discount to our fair value estimate, we suggest that investors who can accept the risk of standardized packaging and exposure to volatile currencies should take a close look at Philip Morris.

Kinder Morgan Management KMR  |  Jason Stevens

Kinder Morgan Energy Partners' third-quarter results largely met our expectations, and we are reiterating our fair value estimates of $98.50 for KMP and $99.40 for KMR. These fair value estimates reflect the terms of the proposed consolidation of the Kinder entities into KMI, under which unitholders of KMP would receive $10.77 cash and 2.1931 shares of KMI for each unit owned, valuing KMP at $98.50 at our $40 fair value for KMI, and shareholders of KMR would receive 2.4849 shares of KMI for each share of KMR, equating to $99.40 at our $40 fair value of KMI. We continue to expect a KMP/KMR unitholder vote on the proposed merger by year-end, and we also believe that it's likely KMP will receive the 51% vote needed to approve the deal. Should the deal not go through, our stand-alone fair value would revert to $90 per unit.

For the quarter, declared distributions of $1.40 per unit are up 4% year over year, while distributable cash flow increased to $607 million, or $1.31 per unit, up from $554 million, or $1.27 per unit, last year. Coverage for the quarter was 0.94 times as expected due to seasonality. We continue to expect full-year coverage to be just above 1.0 times. KMP remains on track to declare full-year distributions of $5.59 per unit, a 5% year-over-year increase.

Looking at segment results, natural gas, CO2, and product pipelines all put up close to 10% earnings growth, while Kinder's terminals business grew 25% year over year to $247 million. Combined segment earnings increased 10% to $1.54 billion. Kinder's project backlog increased $900 million, to $16.3 billion, after placing $1.1 billion in projects into service during the quarter. We believe this backlog provides clear support for Kinder's growth plans over the next several years and continues to support its wide economic moat.


Kinder Morgan, Inc. KMI  |  Jason Stevens

Kinder Morgan's third-quarter results look good, in line with our estimates, and we are reiterating our $40 per share fair value estimate and wide economic moat rating. Cash inflows to KMI were flat year over year, at $728 million for the quarter. This is somewhat distorted by the impact of drop-downs, as cash inflows from KMP were up 8%, inflows from EPB up 5%, but cash generated from assets held at KMI (which included Gulf LNG, Ruby and Young Gas Storage, all of which were dropped down to EPB this year) declined 45% or $47 million. A slight decline in corporate expenses and taxes resulted in cash available for dividends to increase $11 million to $435 million, or $0.42 per share.

Kinder Morgan declared a $0.44 per share dividend on the quarter, a 7% increase, and still plans on boosting its 2015 dividend to $2.00 per share following the close of the proposed consolidation of Kinder Morgan, Kinder Morgan Energy Partners, and El Paso Pipeline Partners. We continue to expect this merger to be approved by shareholders this quarter. Kinder Morgan Management estimates that committed institutional shareholders and insiders add up to about 30% of total votes needed for approval. Of the remaining units, the company would only require affirmative votes from one in three shareholders to approve the transaction. Given institutional ownership of KMP, we think this is likely.


Google GOOG  |  Rick Summer, CFA, CPA

Google's third-quarter results showed robust demand by digital advertisers as the firm's growth continues to outpace the market. Despite higher-than-expected operating expenses (particularly research and development), we did not see anything in the quarter that would cause a structural change in our financial model. We are sticking with our $545 fair value estimate and our wide moat rating.

Overall revenue excluding traffic acquisition costs (excluding payments made to partners) grew 25% versus 2013, a slight deceleration from last quarter but still faster than rates the firm was posting in 2012. Google showed particular strength in its websites segment (which includes the core search business and YouTube, among other owned and operated websites), posting 23% growth, faster than our estimate for overall market growth in the midteens. We are modeling for continued deceleration as the industry and company go through a normal maturation cycle.

On the expense side, several items led to a dramatic uptick in costs, although we expect revenue growth to outpace these expenses in the coming quarters. In particular, management pointed to a third-quarter hiring cycle for new college graduates as well as annual equity compensations "refreshes" driving research and development to 16.1% of quarterly revenue, a 210-basis-point increase from the prior quarter and a 260-basis-point increase over 2013. The company remains in a heavy investment period, investing beyond its core business in areas such as cloud computing, YouTube, and a recently relaunched Google Express same-day delivery service.

Regarding Google Express, management shared very little about the company's rollout plans or its competitive differentiation versus Amazon. We believe this initiative is likely to drive lower returns on capital, particularly compared with the company's core search business. Furthermore, we are skeptical that the firm will be able to achieve material customer adoption for the next several years. Still, we anticipate Google's investment rates to remain high as the firm continues to pursue large end markets, even if the payback is not immediately apparent.


Johnson & Johnson JNJ  |  Damien Conover, CFA

Led by strength in the drug unit, Johnson & Johnson posted solid third-quarter results, slightly exceeding our expectations and those of consensus. While both the device and consumer segments continue to generate tepid growth, new drug launches are buoying overall results, leading to 6% overall top-line growth and a faster 10% earnings growth rate as the drug division carries stronger margins.

However, we don't expect any changes to our $99 fair value estimate or wide moat rating. Part of the outperformance was attributable to strong sales of hepatitis C drug Olysio (4% of the quarter's sales), which will likely decline significantly in late 2014, since Gilead's Harvoni was recently approved in the U.S. and carries a best-in-class profile. Nevertheless, J&J has several other recently launched drugs that should support solid drug division growth in 2015, albeit decelerating growth. Potential risks to growth in 2015 are sales declines for Risperdal Consta and Invega Sustenna because of generic competition, but we don't project generics until 2016 and 2018, respectively, because of the complexity in manufacturing the drugs.

The brand power in the consumer business and power of switching costs in the device segment showed signs of weakness in the quarter. While product divestitures and manufacturing issues make comparisons more complex, we believe the flat growth in these divisions in the first nine months of the year is signaling a minor deterioration in the competitive positioning of J&J. This is more acute within the hip business, where prices fell 5% in the quarter.

J&J's strong drug sales boosted overall margins. While the company reinvested some of the gains, a good portion fell to the bottom line as shown by operating costs as a percentage of sales falling 180 basis points year over year. We expect margins to fall slightly in 2015 as the drug division's sales growth decelerates and the high-margin U.S. sales from Olysio decline rapidly.


Charles Schwab SCHW  |  Gaston F. Ceron

Charles Schwab's third-quarter earnings were close to our views, and we don't plan big changes to our fair value estimate. Generally, the improvement in net interest margin, a key revenue driver, is a nice hint at stronger eventual earnings power. Further, Schwab's success with its advice-solutions products underscores its ability to sow sticky client relationships, which we think helps its narrow economic moat. Indeed, the combination of higher interest revenue and asset-management fees more than offsets lower trading revenue, lifting overall revenue by 13% year over year to $1.55 billion.

Schwab's asset growth is stronger than we expected, with client assets just north of $2.4 trillion in September, up from $2.25 trillion in December. This helps Schwab drive higher revenue from its asset-management fees, even though it is still hobbled by fee waivers on money-market funds to the tune of $190 million in the quarter. We continue to expect that the eventual end of these waivers will boost Schwab's revenue. Overall, asset-management and administration fees rose 11% to $649 million, lifted by a 17% increase in revenue from advice solutions.

While net interest margins are still far from the 3%-plus that we view as achievable over time, Schwab improved on this front. The firm's second-largest revenue source, net interest revenue, rose 13% to $573 million as NIM widened by 13 basis points to 1.64% amid higher yields on securities held to maturity. In addition, trading revenue fell 7% to $209 million amid lower activity, though we suspect that the recent market turmoil is inspiring more trading.

Costs rose more than we expected, but it was due to $68 million in one-time severance items. Thus, we aren’t too alarmed by a 23% increase in compensation costs that helped drive the pretax margin down to 33.4% from 33.8%. Overall, profits rose 11% to $312 million.


American Express AXP  |  Jim Sinegal

American Express’ third-quarter results, including $1.40 in diluted earnings per share—up 12% from the third quarter of 2013 and a 28.8% return on average equity—support our thesis that the wide-moat company can achieve low-double-digit earnings growth for years to come. We are therefore maintaining our $82 fair value estimate.

American Express continues to manage operating expenses exceptionally well, offsetting the impact of a relatively weak global economy. However, rewards and services expenses grew by 5% and 4% over the course of the year, supporting our belief that competition for the firm’s “spend-centric” customers is sure to increase as card issuers and new players such as Apple and Google attempt to receive a larger slice of the payment pie. Similarly, while marketing expenses fell slightly from the third quarter of 2013, we think American Express’ target of 9% of revenue is reasonable given the need to maintain its intangible asset value in a more competitive environment.

In any case, the company’s base of free-spending customers remains a key differentiating factor, and this advantage is growing. Cardholders spent an average of $4,223 in the third quarter—up from $4,037 in the September 2013 quarter. Cards-in-force and billed business grew both within and outside the United States. In our view, American Express is particularly well-positioned to succeed in an environment of higher inflation, as spending-related revenue would grow faster, with very little in the way of additional costs.

Credit quality remains nearly pristine. American Express charged off only 1.6% of principal during the quarter. We have no reason to believe that underwriting standards have changed dramatically in the last 12 months, and if the U.S. economy continues to improve, we think losses could remain low for quite some time. Over the long run, though, we expect considerably higher charge-off rates—around 4% of loan balances.


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