Before getting into the week's portfolio news, I'd like to share some final thoughts on Apple AAPL. You can read my earlier comments here and here.

Apple's stock has been on a bit of ride since I first wrote about it last month, falling from around $420 to as low as $385, recovering to as high as $465 (more than a 20% swing from low to high), and then settling back to about where it started. There has been some news of varying significance--most importantly management's announcement of an aggressive share repurchase program and a 15% dividend increase. Apple also raised $17 billion of debt on very attractive terms to help fund the return of capital to shareholders without paying taxes on repatriated foreign cash. Reports of various hedge funds either buying or selling Apple shares also pushed the stock price around, which I take as a sign that Apple's investors are driven as much by emotion as by fundamentals.

Apple's fiscal second-quarter results were nothing to write home about. Revenue improved 11.3% from the prior year. Apple's two key growth drivers, iPhones and iPads, showed unit volume growth of 6.6% and 65.3%, respectively. Average selling prices for both products were down about 4%, with consumers showing a preference for lower-priced older iPhone models and iPad Minis. Business mix shifts resulted in severe margin contraction, with the operating margin falling to 28.8% from 39.3%. While we knew that 2012 margin levels were unsustainable, I would not underestimate just how quickly margins can contract in the consumer electronics business.

Earnings per share of $10.09 were down 18% from the prior year. Management is predicting fiscal third-quarter earnings per share of around $7, which would be some 25% below the prior year. While Apple had earned a reputation for giving excessively conservative guidance, I believe the company is trying harder to be accurate now, and I wouldn't count on them exceeding this forecast.

Analyst estimates have come down significantly since I first wrote about Apple, and consensus now calls for earnings per share of about $40 for 2013. That would give Apple a P/E multiple of 10.8, or 7.0 if you exclude $153 in cash per share. Depending on what the stock price does, the share repurchase program could become a meaningful contributor to earnings per share growth, with $60 billion of authorized repurchases through 2015 amounting to about 15% of the current market capitalization. The new dividend rate of $12.20 per year gives Apple a yield of 2.7%.

I still think Apple looks cheap. However, I also think there is a lot of uncertainty here, and given Apple's past success and $400 billion market cap, I have the distinct impression that there is more uncertainty on the downside than the upside. Furthermore, the moat is on the narrow end of narrow--despite the positive moat trend, it's relatively difficult to see Apple crossing the threshold into "wide moat" territory. Most of all, Apple has its work cut out for it to remain on top--with the fierce competition and rapid innovation in consumer electronics, management can't afford to rest on its laurels for even a few quarters.

In conclusion, there is a price at which I would buy Apple, but I don't think it starts with a "4". I will be keeping an eye on both the company and the stock--hoping that the intrinsic value goes up and the stock price goes down. If the market offers us a price that I feel includes an adequate margin of safety, Apple remains a possible addition to the Hare.

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I had been hoping to add to our small Cisco CSCO position--I included the stock among May's "Favorites for New Money"--but I may have waited too long. The stock was up 15% this week following the release of solid third-quarter results. Revenue improved 5.4% and adjusted earnings per share advanced 6.3%. Gross margins were especially strong, suggesting a rational competitive environment and disciplined hardware pricing, combined with a shift toward higher-margin software and service revenue. I am a fan of Cisco's strategy, which should result in deeper customer relationships and higher switching costs. We raised our fair value estimate by $2 per share to $26. I expect to hold the Hare's shares, and would take a pullback as an opportunity to add more.

Autodesk's ADSK first-quarter results were not so encouraging, with flat revenue on a constant-currency basis (down 3% including exchange rate headwinds), 60 basis points of adjusted operating margin contraction, and adjusted earnings per share down 10.6%. A weak global construction environment appears to be mostly to blame. However, management still expects 3% revenue growth and meaningful operating margin improvement for the full year. Subscription revenue was a bright spot, up 5.8%, which indicates Autodesk is successfully navigating the transition to cloud computing. Subscriptions accounted for 43% of revenue in the quarter. I'm comfortable that Autodesk's struggles are more cyclical than secular, and that the moat remains wide and stable. Despite a 6.7% sell-off in the stock on Friday, Autodesk is trading close to our reaffirmed $38 fair value estimate, and I expect to hold.

Wal-Mart's WMT first-quarter results were relatively weak, which was not unexpected given macro headwinds like the increase in the payroll tax and delayed income tax refund checks which disproportionately affected Wal-Mart's core customers. U.S. same-store sales declined 1.4% in the first quarter, although same-store sales are expected to return to minimal growth in Q2. Wal-Mart claims to be gaining market share in its most important markets. The company also continues to gain traction with its smaller store formats, Neighborhood Market and Walmart Express, which could help neutralize the competitive threat from dollar stores. The operating margin was flat at about 5.65%, and earnings per share were up 4.6%. I expect to hold.

Google's GOOG stock hit an all-time high this week just shy of $920 per share on investor enthusiasm surrounding the Google I/O developer conference. Google announced a number of improvements to its software products--new tools for app developers, enhancements to Google Maps and Google+, greater integration between Android tablets and smartphones, and so on--as well as a new subscription music streaming service. While the direct revenue and margin impact of these announcements is likely to be immaterial, they do tend to reinforce Google's already super-wide moat--making users stickier and leveraging the company's scale and data into unique capabilities. I like Google's ambitious, risk-taking approach, which is exceedingly rare among companies that are already so large and successful. Many of Google's "big bets" will fail, but if even a couple work out, the payoff could be huge. In a worst-case scenario, I think Google has a lot of discretionary expenses in its cost structure that could be scaled back to keep earnings growing. While the stock is now trading for an 18% premium to our $770 fair value estimate, I have no intention of selling.

Finally, there were a few other small tweaks to our analysts' valuations this week. We raised our fair value estimate for CarMax KMX by $1 per share to $40 on improved expectations for new store sales productivity. We lowered our fair value estimate for Potash Corporation of Saskatchewan POT by $2 per share to $49 on a lower long-term outlook for realized selling prices for potash. I expect to hold both stocks. We also increased our fair value estimate for PepsiCo to $88 from $75 after lowering our cost of equity assumption to 8% from 10%. The lower cost of equity strikes me as appropriate given the stable and non-economically-sensitive nature of PepsiCo's business. With so few opportunities available in the Tortoise, I wouldn't mind adding to PepsiCo, although I'd prefer a slightly larger discount to our new fair value estimate.

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Earnings season is finally winding down, and Lowe's LOW is the only portfolio holding scheduled to report next week. I'm just getting started on my cover story for June, the topic of which I think you will find highly relevant right now: "When to Sell." Lowe's is one of several companies we own that has had a strong run recently, and the stock is trading at a 15% premium to Morningstar's $37 fair value estimate. Even so, I'm in no rush to sell, as I think there could be significant room for margin expansion in a more robust housing recovery and with an improved merchandising strategy. Lowe's operating margin remains far below both the housing-boom peak and levels at competitor Home Depot HD. With a 7.9% weighting, Lowe's is our second-largest holding in the Tortoise, and I will be watching the results with interest.

Regards,

Matt Coffina, CFA
Editor, Morningstar StockInvestor

Email: matthew.coffina@morningstar.com

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

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Morningstar Stock Analyst Notes

Cisco Systems CSCO  |  Grady Burkett, CFA

Cisco Systems' third-quarter results were solid, particularly against the backdrop of fairly sluggish results from many of its peers. Management is leveraging Cisco's entrenched position in data networking to steadily shift its portfolio toward services and software without making outsize acquisitions or disrupting important revenue streams. We are moderately increasing our long-run operating margin forecast, which in turn increases our fair value estimate by $2 per share to $26. We are maintaining our wide economic moat rating.

Third-quarter revenue grew 5.4% year over year to $12.2 billion, with product revenue growing 5.0% from the year-ago quarter despite a slight decline in routing and switching revenue. GAAP gross margin improved sequentially by 80 basis points to 61.5%, and stability in product gross margin suggests to us that management is maintaining good pricing discipline and seeing early benefits from its shift toward software revenue. GAAP operating margin improved sequentially by 100 basis points to 24.1%, its highest level in more than three years. Interestingly, research and development expense came in at an all-time high this quarter, while management has kept a lid on sales and marketing expense over the past seven quarters. We believe that the firm's evolving product strategy and customer base is resulting in a temporary shift in investment toward engineering from marketing and distribution.

Free cash flow came in at $2.8 billion, compared with $2.7 billion in the year-ago quarter. Cisco's net cash balance grew $1.0 billion sequentially to $31.1 billion, as dividends and net share repurchases consumed roughly $1.3 billion in cash, while the firm spent about $340 million on acquisitions in the quarter.

Management expects 4%-7% year-over-year revenue growth in its fiscal fourth quarter, which implies total revenue of $12.3 billion at the midpoint. Additionally, management guided for 27.5%-28.5% non-GAAP operating margins, a bit above the range it provided (and achieved) this quarter. The fact that management raised its year-over-year growth and profitability guidance ranges slightly suggests to us that the firm expects relatively benign pricing and macroeconomic environments next quarter.

In all, Cisco posted a solid if somewhat uneventful quarter. We expect this to increasingly be the case as management continues to add higher-margin software revenue to its portfolio, increases the size of its services business, and remains focused on expense control throughout the business cycle. We remain confident in our assessment of Cisco's economic moat and management's ability to execute, and we think Cisco's recent dividend increase is a harbinger of long-term dividend growth.

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Autodesk ADSK  |  Andrew Lange

Autodesk reported weaker-than-expected first-quarter results, owing largely to an uneven macroeconomic climate. As a result, management lowered its full-year revenue and earnings expectations. Revenue growth for fiscal 14 has been lowered to 3% from 6%, while the non-GAAP operating margin is expected to grow 50-100 basis points, down from 125 to 150 basis points. Although Autodesk’s short-term outlook is mediocre, over the long-term, we believe Autodesk remains well positioned given its significant competitive advantage in computer-aided design (CAD) software. Therefore, we maintain our wide economic moat and fair value of $38.

For the quarter, revenue decreased 3% year over year to $570 million, the non-GAAP operating margin fell 60 basis points to 24%, and non-GAAP diluted earnings per share slipped 11% to $0.42. The most significant factor during the quarter was macroeconomic uncertainty, which lead to mixed results across all geographies. Notably, Emerging Economies revenue dropped 8% to $75 million, reflecting lower suite product penetration (“stickier” product) and higher piracy, which management attributed to "tougher" economic times. While the challenging macro environment was an overhang during the quarter, foreign exchange headwinds and an unsatisfactory performance in the company’s major account program also added to the weakness. The major account weakness is a hangover from recent sales channel restructuring and the company will focus on improving this performance over the second-half of the year.

Importantly, subscription revenue grew 6% to $247 million and deferred revenue rose 17% to a record $851 million, which reflected good subscription adoption and supports our view that the firm's quarterly slip is likely cyclical and not structural. Despite its lowered full-year guidance, management expects a stronger back end of the year given its current pipeline, and the sale of AutoCAD LT and Suites should provide the majority of growth. Overall, we continue to think Autodesk will successfully navigate the shift to an increasingly cloud-based operating model and retain its market leading position in the process; however, with shares trading near our fair value estimate, we would wait for a larger margin of safety before investing in the firm.

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Wal-Mart WMT  |  Morningstar Equity Analysts

Wal-Mart shares traded lower in premarket trading after the company reported weaker-than-expected first-quarter comparable-store sales growth in the U.S. A weak comp wasn’t altogether unexpected as management previously guided for flat comps, but the 1.4% decline in same-store-sales at Wal-Mart U.S. stores was slightly lower than we expected. Still, we had anticipated that delayed income tax refund checks, a 2% increase in the payroll tax, and lower food inflation could weigh on top-line growth during the first quarter, and we are encouraged that comps have improved with management guiding for second-quarter comp growth of 0%-2% and 1%-3% for Wal-Mart U.S. and Sam’s Club, respectively. We think this guidance is achievable, especially as warmer weather should improve demand for summer apparel and outdoor items across the U.S.

Wal-Mart’s operating margin remained flat at around 5.6% despite weak sales growth, and we continue to believe that the company's sizeable cost advantage over smaller players will allow the firm to leverage its existing footprint and continue generating excess returns on capital. As a result, our wide economic moat rating remains unchanged; however, we think other lower cost operators such as Amazon AMZN and Costco COST will present Wal-Mart with a healthy level of competition in the years to come. With shares trading at a premium to our $74 fair value estimate (which we don’t expect to change materially), we’d recommend investors wait to purchase Wal-Mart shares at a greater margin of safety.

Despite a weak comp, Wal-Mart’s small store formats performed quite well, and we continue to think management’s decision to allocate more capital to these stores will leave the firm better positioned to compete head-to-head with the dollar stores, which have been aggressively adding square footage. Neighborhood market (which average between 35,000-50,000 square feet) comparable-store-sales increased in the low-single-digits, while Wal-Mart Express (10,000-15,000) comps increased in the double-digits. E-commerce sales also increased by over 30%, and management intends to begin piloting its store lockers in the second quarter. It’s still too early to determine the impact that this strategy could have on Wal-Mart’s overall business, but we think it’s an intriguing proposal that has the potential to bolster the firm’s e-commerce platform.

Wal-Mart’s international segment also performed well, reporting a 5.4% sales increase (constant currency), although higher expenses weighed on profit growth. While margins in the international business remain below those in the U.S., we recognize that building out a global store network can take years, and we believe that Wal-Mart’s current investments should leave the firm better positioned to leverage its global scale (which should support margins) over the long term. An area of positive performance in the first-quarter was Wal-Mart’s Asda banner in the U.K. Asda sales increased by 2.6% (3.0% excluding currency, and comp-store sales increased by around 1.3%, which compares favorably to the 0.5% like-for-like sales decline reported by narrow moat rival Tesco TSCO. Overall, operating conditions remainder challenging the U.K., as inflationary pressures for essential items have outpaced income growth, but these results suggest that Wal-Mart’s price investments appear to be working.

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TransCanada TRP  |  David McColl

TransCanada announced the sale of a 45% interest in two of its natural gas pipelines, the Gas Transmission Northwest Pipeline, or GTN, and Bison Pipeline, to TC Pipelines LP TCP. TransCanada has a 33% interest in the LP and will retain a 30% interest in both pipelines following the asset sale. There are a few key items we would like to raise.

First of all, TransCanada has previously indicated the possibility of utilizing the LP more than it has in the past as a financing lever. In this regard, the sale of an asset is not alarming, although it has been several years since TransCanada pursued this route. For those who follow Enbridge ENB, this method of financing should not be unfamiliar. In general we find this type of asset sale to the LP beneficial for the parent company as it generates cash without the need for additional debt, or equity.

Second, in exchange for the 45% interest in the pipelines, TransCanada will receive $1.05 billion, with the sale expected to close in July 2013. We estimate $150 million in 2013 EBTIDA from these two pipelines, implying a reduction of $67.5 million in annual EBITDA with a $33.7 million impact in 2013. Going forward, we would expect EBITDA from these two pipelines around USD 82 million in 2014 and beyond.

Third, we look for the cash from the sale to pay down $146 million in debt (associated with GTN), with the remaining USD 904 million going toward TransCanada’s $26 billion capital program.

Finally, given the small size of the sale at $67.5 million EBITDA versus TransCanada's $4.4 billion in 2012 EBITDA, we do not expect it to have a material impact on our $50/CAD 50 per share fair value estimate or our narrow moat rating.

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PepsiCo PEP  |  Thomas Mullarkey, CFA

Given Coca-Cola's KO and PepsiCo's wide economic moats and consistency of cash flows, along with the persistent environment of low interest rates, we have reduced our assumptions for firms' cost of equity to 8% from 10%. Each firm has a bevy of billion-dollar brands, with Coca-Cola dominating the global non-alcoholic beverage market and PepsiCo being a worldwide leader in the snack category. Both firms also carry a modest amount of financial leverage (Coca Cola's net debt/EBITDA is around 1.6 times, and Pepsi's net debt/EBITDA is about 1.7 times), supporting our view that these names possess below average systemic risk. We are not making any adjustments to our sales growth, profitability, or cash flow assumptions, and the lower COE is the predominant reason we are increasing our fair value estimate for Coca-Cola to $45 from $41, and our PepsiCo fair value estimate to $88 from $75. Following these changes, both firms trade slightly below our new fair value estimates, though with our low uncertainty ratings, we would not require much margin of safety before taking a position. Our new valuations imply a value of roughly 20 times 2014 earnings for Coca-Cola, and 19 times for PepsiCo.

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Berkshire Hathaway BRK.B  |  Greggory Warren, CFA

Wide-moat-rated Berkshire Hathaway's first-quarter 13-F filing, which details the firm's equity holdings at the end of the March quarter, veered somewhat from the theme we've seen the past couple of years, when the firm was selling off big chunks of some of its legacy positions to fund the portfolios that Ted Weschler and Todd Combs were running, with only a few minor sales popping up during the most recent period.

That said, Berkshire continues to view Kraft Foods KRFT as a source of cash, selling off another 4% of its stake in the packaged foods giant (raising around $3 million in the process). The insurer also dipped into Mondelez International MDLZ, which was spun off from Kraft in the fourth quarter of last year, eliminating close to half of its holdings (raising around $160 million). Warren Buffett also recently noted that Berkshire had sold a small part of its stake in Moody's MCO, which won't show up until the firm's second-quarter 13-F is filed in August.

As for the other sales during the March quarter, Berkshire sold off 4% of its stake in Bank of New York Mellon BK, and completely eliminated its holdings in General Dynamics GD and Archer-Daniels Midland ADM, raising at least $450 million from the transactions. Based on our records, and given Weschler's heavier preference for media names and Combs' penchant for trading in and out of names, we believe that each of these holdings was in Combs' portfolio.

Looking at the purchases, Buffett committed another $650 million to Wells Fargo WFC, which continues to be Berkshire's largest holding (at 20% of its $85 billion equity portfolio). The second-largest purchase during the quarter was 6.5 million shares of Chicago Bridge & Iron Company CBI, which we believe were purchased by Combs' with the proceeds from his asset sales.

In addition to those transactions, Berkshire put additional capital to work in VeriSign VRSN, DIRECTTV DTV, DaVita DVA, National Oilwell Varco NOV, Wal-Mart Stores WMT, U.S. Bancorp USB, International Business Machines IBM, and Wabco Holdings WBC. The total cost for those purchases was in the neighborhood of $900 million (based on our estimates). The company also received 5.6 million shares of Starz STRZA, which was spun off from Liberty Media in early January.

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Google GOOG  |  Rick Summer, CFA, CPA

Google opened its three-day Google I/O conference for developers Wednesday, unveiling several notable features for Android developers that distribute their applications through the Google Play store. We believe most of these enhancements reinforce the firm's wide moat around its smartphone assets. In a move we are comparatively more neutral about, the company announced a new music streaming service for $9.99 a month after striking licensing deals with Universal Music Group, Sony Music Entertainment, and Warner Music Group. On balance, we believe these moves further support our wide moat rating. Still, as these changes do not alter our cash flow forecast, we are sticking with our fair value estimate of $770.

Although the Android smartphone operating system is based on free and open-source software, Google Play has become a necessary and dominant platform for developers who are distributing their applications to Android users, in our view. (Google announced that there have been more than 900 million Android devices activated thus far.) Apple's AAPL iOS platform is equally compelling, and we believe all roads to mobile subscribers lead through both Google and Apple. Major announcements included an enhanced development environment for richer applications, better session management for games (allowing users to stop playing and resume on another Android device), and more location-awareness functions exposed to applications. Rightfully, Google is investing in the Google Play store to prevent an alternative option (for example, Samsung Hub) from becoming the primary Android app store.

On the application front, the headline announcement was a new music streaming service, Google Play Music All Access. We are skeptical that a subscription service on its own, even if it achieves profitability, would have a material impact on our valuation (which exceeds $250 billion at our fair value). For example, one of the leading music streaming companies, Pandora P, is currently valued at less than $3 billion. Furthermore, we believe that content costs are likely to depress margins in the music business, even if the company is able to deliver profitability across a large user base.

We believe Google's entree into the music streaming business is largely a defensive maneuver. In our view, the company is trying to broaden adoption of Google content services, which are more proprietary to Android than applications. For example, Apple users who have deep content libraries are unlikely to switch to Android devices, as the content would not be usable. Furthermore, cloud application companies such as Netflix NFLX, Spotify, and Pandora are platform agnostic--customers of these services can consume content on both Android and iOS devices. We think Google's patience will serve it well, but we do not expect the firm's music service will move the needle on our valuation.

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Potash Corporation of Saskatchewan POT  |  Jeffrey Stafford, CFA

With China and India back to buying potash after an extended hiatus in 2012 (global shipments were down 9% in 2012 from 2011), we expect demand growth of close to 10% in 2013. Potash prices should firm up from prevailing Saskatchewan spot levels around $420 per metric ton as the year progresses, although we don't expect a return to the heady levels of late 2011 ($550 per metric ton). Over the next five years, we still expect supply will grow faster than demand, but the gap between the two has shrunk, given our expectation for strong near-term demand growth and some modifications to our supply forecast (projects shelved, longer ramp-up times, and so on).

Our long-term price forecast remains $375 per metric ton at the typical plant gate in Saskatchewan. Despite our expectation that prices will drop further, wide-moat Potash Corporation of Saskatchewan, which benefits from low-cost assets, looks moderately undervalued. PotashCorp's position on the cost curve delivers some downside protection if our price thesis turns out to be too bullish. Narrow-moat Intrepid Potash IPI, which has a geographic cost advantage, is the most undervalued producer, in our opinion. We think producers' stock prices could have more room to advance now that potash prices have dipped closer to what we see as a more sustainable level.

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Exelon EXC  |  Travis Miller

We are reaffirming our wide moat rating for Exelon after our discussions with utilities industry managers at the Electric Power Conference in Rosemont, Ill. Some have challenged the economics of existing and new nuclear generation as gas prices have fallen below $4 per thousand cubic feet and renewable generation has boomed. But we think these analyses fail to consider the value of nuclear plants' ability to produce low-cost, reliable, emissions-free generation, something no other generation source can match. In the long run, we think power buyers will pay premiums for nuclear power because of these attributes, allowing nuclear to maintain its low-cost competitive advantage.

More wind generation and the drop in price for competing coal and gas generation fuels are the primary reasons Exelon's realized generation unit margins fell to $27.23 per megawatt hour in the first quarter of 2013 from $32.57 per megawatt hour in the first quarter of 2012 and $44.30 per megawatt hour in the first quarter of 2011. This is especially true in Illinois, where 11 of Exelon's 17 nuclear reactors are located and developers have built 2.7 gigawatts of wind generation in the past decade. We expect this trend to continue for the rest of 2013 before margins stabilize and start climbing again in 2015 and beyond.

Despite the near-term earnings challenges, we continue to believe Exelon's nuclear fleet gives the company the most valuable long-term economic options in the industry. Exelon's 2012 merger with Constellation could help it monetize that value through full-requirements retail supply contracts. We think the combination with Constellation's retail business can help Exelon's generation unit add 5%-10% to its margins starting this year.

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