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.

Feb 14, 2016
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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, 2/12/16 -- HCP, VTR, TWX, CMP on Sale

It's said that the stock market is the only kind of market where merchandise is put on sale and all the shoppers run for the exits. It's not my favorite analogy, because I think investing is a bit more complex than that: If stocks are on sale, there's usually a reason. But in today's increasingly panic-prone and irrational market, I'm starting to get more excited about discounted stocks than I have been in some time.

Exhibit A this week came from healthcare REIT HCP HCP. Don't get me wrong, HCP's Tuesday earnings report included some very bad news: Fixed charge coverage for its largest tenant (HCR ManorCare) dipped back below 1 in the second half of 2015, even though HCP reduced ManorCare's rent earlier in the year. At the time of that rent cut, HCP had projected that ManorCare would achieve a fixed-charge coverage ratio of 1.28-1.30; ManorCare's financial health has deteriorated much faster than I or HCP's management anticipated. This is partly due to Medicare reimbursement headwinds in the troubled skilled nursing business, but it also implies some fairly significant operational problems at ManorCare.

HCP has engaged a financial advisor to help it explore all alternatives for ManorCare, but there are no easy fixes in sight. Management denied that another rent cut is coming, but that may be its only option unless it wants to force ManorCare into bankruptcy. HCP's management has lost most of its credibility at this point, given its earlier faulty predictions. HCP should be entitled to substantially all of the cash flow that ManorCare generates, but it seems increasingly unlikely that this will cover its contractual rent obligations. HCP can also try to sell or lease facilities to new operators, but probably not on the same terms it is receiving from ManorCare.

It is entirely appropriate that HCP's stock sold off on this news, but what doesn't make sense to me is the magnitude of the sell-off. After completing the already-announced sales of some ManorCare properties, this tenant will account for about 25% of HCP's run-rate cash flow. Yet HCP's stock was down 26% this week. If all of the buildings had burned to the ground, I'm not sure the stock price reaction would have been much different.

The other major question is about the sustainability of HCP's dividend. The board recently raised the dividend by 1.8%, keeping alive a 31-year streak of consecutive annual dividend increases. That streak has overcome many serious challenges over the past three decades, including the 2008-09 financial crisis. Management's 2016 guidance implies a payout ratio on funds available for distribution of 87%, which still leaves a decent cushion--as recently as a few years ago, HCP's FAD payout ratio was close to 100%, and it could operate there again if it needed to. However, a couple of the major agencies put HCP's BBB+ credit rating on negative watch. Given the sensitivity of the REIT business model to the cost of capital, an investment-grade rating is important for HCP. With a dividend yield of 8.8%, investors are clearly worried about a dividend cut. But since dividends aren't central to our strategy, I'm more interested in HCP's overall valuation, which still looks favorable despite a cut to our fair value estimate to $43 per share from $54. I plan to hold.


Ventas VTR sold off in sympathy with HCP, but fortunately Ventas is in much better shape: The company has less tenant concentration; none of its tenants are in as poor financial health as HCR ManorCare; and, best of all, Ventas already divested most of its skilled nursing facilities through the Care Capital Properties CCP spin-off (which occurred prior to the Hare's investment). That transaction is looking smarter and smarter, reinforcing our positive view of Ventas' management.

Ventas also reported 2015 results this week. Same-property net operating income grew 4% for the year, while funds available for distribution per share advanced 9% (adjusting for the CCP spin-off, related expenses, and various non-cash charges). Less than 6% of Ventas' net operating income comes from triple-net tenants with fixed charge coverage below 1.2, and almost no tenants have coverage below 1. Probably the biggest negative in the earnings report was slowing growth for Ventas' senior housing operating portfolio, which reflects increasing supply of senior housing. However, the portfolio is still growing modestly, with expectations for more of the same in 2016. For the overall company, management projects 3%-4% growth in FAD/share this year assuming no major acquisitions. The current dividend rate of $0.73 per quarter provides a 6.0% yield and implies a 79% payout ratio on funds available for distribution. While Ventas' yield is well below that of HCP, this seems like a fair tradeoff for Ventas' superior financial health, management, and tenant base. I consider Ventas a favorite for new money.


Time Warner's TWX fourth quarter was somewhat weak, though I wouldn't read much into quarterly results given volatility around the timing of film releases, licensing deals, sporting events, and so on. I found the company's full-year 2015 performance to be highly satisfactory, including 3% revenue growth (7% in constant currencies) and 14% adjusted earnings per share growth (27% in constant currencies). Management forecasts roughly 12.5% adjusted EPS growth in 2016, which would have been north of 20% if not for the strong U.S. dollar. Cord-cutting remains a headwind to subscriber counts in the Turner segment, but I continue to believe that investors are overestimating the extent and pace of cord cutting. To be frank, Time Warner is growing EPS faster than the vast majority of Hare holdings in this environment, yet the stock trades for only 13.1 times 2015 earnings and just 11.6 times the midpoint of management's guidance for 2016.

Of course it's possible that cord-cutting will accelerate over the next five years as TV viewers get more and better over-the-top options. Netflix NFLX is an especially capable competitor that is getting stronger every day. However, traditional distributors and media companies recognize the cord-cutting threat, and are working hard to evolve their video offerings. I don't think cord-cutting is a foregone conclusion; for example, Comcast CMCSA recently reported its best fourth quarter for net TV subscriber additions in almost a decade, helped by the rollout of its innovative X1 platform. Watching television is most people's primary leisure activity, and as much as they may grumble about their cable bills, there is a strong desire to access a large selection of high-quality content--including live sports, news, events, and other kinds of programming that generally aren't available through Netflix.

I also continue to believe that Time Warner is in one of the best positions among media companies. Turner's business is concentrated in its four core networks--TNT, TBS, Cartoon Network/Adult Swim, and CNN. The company doesn't have a lot of marginal channels that could easily be cut out of narrow channel bundles, in contrast to some peers like Viacom VIAB. Turner has completed contract renewals with all of its top 10 domestic distributors that include significant rate increases, which management expects to drive an acceleration in domestic subscription revenue growth to the low teens in 2016 and 2017. The company also has a lot of room to improve monetization of HBO by adjusting the terms of its agreements with distributors. While some investors were disappointed that HBO NOW has only attracted 800,000 subscribers so far, it's still early days, with the service yet to be added on devices like PlayStation and Xbox and plans for a 50% increase in original programming this year. The Warner Bros. film studio is also on track for improved performance after a relatively poor 2015, with a greater focus on hit franchises like Harry Potter, DC Comics, and LEGO movies over the next several years. Even Time Warner's advertising revenue is holding up remarkably well despite the secular shift to digital advertising.

Our analyst cut his fair value estimate to $85 per share from $94. However, all things considered, I think Time Warner is performing as well as could be expected in a challenging environment, and I plan to hold.


Coca-Cola KO and PepsiCo PEP delivered fourth-quarter results that were consistent with our expectations. They project high-single-digit organic EPS growth in 2016, though reported results will once again be pressured by currency headwinds and certain structural changes. While I think these two stocks are decent holdings in an absolute sense, they are trading right in line with our fair value estimates, and the sell-off in the broader market has created better opportunities. As a result, I'm considering selling the Tortoise's position in both names.

Compass Minerals' CMP fourth-quarter results were predictably poor as mild winter weather in its service territory reduced salt revenue 34% year-over-year. The company counted only 17 snow events in the fourth quarter, compared to 35 last year and a 10-year average of 47. The plant nutrition segment is also under pressure due to the broader farming downturn and the collapse in prices for standard potash, which can be a substitute for Compass' specialty fertilizers in some cases. Given all of the external challenges, I'm pleased that Compass was able to hold full-year 2015 earnings per share to a 2% decline, helped by lower fuel costs and improved mining efficiency. Management's outlook for 2016 calls for a further 15% decline in EPS to around $4 per share. However, management still believes $500 million in adjusted EBITDA is possible by 2018--assuming normal weather and an upturn in the agriculture cycle--which would represent close to 19% compound annual growth from the 2015 level. We trimmed our fair value estimate to $89 per share from $92, but I think investors who buy Compass today and wait at least until the next snowy winter to sell will be well rewarded.


Aside from the week's earnings reports, ITC Holdings ITC announced that it has agreed to sell itself to Canadian utility Fortis, which has been aggressively building its U.S. utility exposure. The deal was initially valued at $44.90 per ITC share, which is right around what I was expecting. However, ITC shareholders will be paid with $22.57 in cash and 0.752 Fortis shares per ITC share. (Fortis is currently listed in Toronto, but it plans to apply for a listing on the New York Stock Exchange prior to closing.) Unfortunately, Fortis' stock price was down sharply on the acquisition announcement, which lowered the effective deal price to around $42 per ITC share. Our fair value estimate for Fortis is CAD 38, implying a $43 deal price.

I doubt I will want to own Fortis over the long run, not least because of the currency risk associated with its Canadian operations. Avoiding currency risk is a major attraction of investing in domestic utilities. Additionally, while owning ITC's assets will contribute to Fortis' above-average growth prospects, the combined company won't be as attractive as stand-alone ITC in terms of its returns on capital, growth rate, and overall risk profile. Finally, there is some risk that the deal could be rejected by regulators; it will require approval from four separate federal agencies and at least five states. On the plus side, only the Federal Energy Regulatory Commission has jurisdiction over ITC's customer rates, which should make for a smoother regulatory path than other deals in the utility sector (such as ITC's failed bid for Entergy's ETR transmission system). Our analysts believe there is a 75% chance that the deal will close. If it is rejected, ITC's stock could presumably trade back into the low $30s--where it was prior to the acquisition speculation--at which price I would be very interested in being a shareholder again.

But what should we do with the shares we own now? That's always a tricky question to answer in these situations. I see the following arguments in favor of holding: (1) There is 8% upside between ITC's current share price and the implied deal price. If the deal closes, these values will converge. (2) By holding, we can also continue to collect ITC's dividend. We can probably expect at least 3-4 more payments, adding another 1.5-2.0 percentage points of total return. (3) Fortis is now trading at a modest discount to our fair value estimate, and we think investors are misunderstanding the opportunity from the ITC purchase. If Fortis shares rebound, it would increase the value of the deal. (4) In today's volatile market, a low-risk, roughly 10% total return in less than a year would be quite attractive. (5) If the deal fails, ITC's share price would likely decline in the short run, but I would still be happy to hold (or buy more) at the lower price. There's also a possibility that a different suitor could emerge, perhaps with a superior bid. (6) The Hare's shares were purchased on 10/29/15. If we can wait until a year from that date, we will have a long-term capital gain instead of a short-term gain.

On the other hand, here are the arguments against holding: (1) The fact that ITC couldn't secure an all-cash bid from a domestic suitor indicates that interest in the company wasn't as high as I had hoped. If the deal fails, especially for regulatory reasons, ITC may not be acquired at all. (2) We're suddenly exposed to the Canadian dollar, which has depreciated sharply over the past couple of years due to lower oil prices and the commodity sensitivity of Canada's economy. (3) ITC is also waiting to hear the result of FERC's review of its allowed returns on equity, expected later this year. A negative outcome could diminish ITC's earnings power and intrinsic value. (4) With so much volatility elsewhere in the market, we have a number of potentially better uses for our capital. If we need the funds, especially in the Tortoise where ITC is a nearly 10% position, this is an easy place to find them.

At this point, I think the risk/reward tradeoff favors holding our ITC shares. I don't expect any material regulatory news--either on allowed returns or merger approval--for at least several months. I'd also like to give Fortis' shareholders some time to get more comfortable with the (very attractive) assets they're acquiring. And I'm not exactly desperate for funds at the moment, with excess cash in both portfolios and a number of other fully valued stocks in the Tortoise that could be sold. However, I'd say it's unlikely that I will hold ITC all the way through closing: If we can get another couple of dollars per share and perhaps collect a dividend payment or two, I will probably move on to the next opportunity.


Baidu BIDU announced that two executives, including CEO Robin Li, have offered to buy its stake in online video company iQiyi at a valuation of $2.8 billion. Baidu's stock was up on this news, presumably because iQiyi is unprofitable and had been a drag on Baidu's reported earnings. Following the decision to sell Baidu's stake in Qunar QUNR to Ctrip CTRP, this latest move may signal that management is prioritizing near-term profitability. The biggest cost center has been Baidu's online-to-offline initiative, and any decision to divest or partner that business would likely be viewed positively as well.

However, as a long-term investor, I was willing to accept Baidu's near-term losses on online travel, online video, and online-to-offline in exchange for the tremendous long-run potential of these businesses. I liked the Ctrip/Qunar deal because it promised significant synergies while allowing Baidu to retain a large ownership stake in the combined company. It's hard to see a similar long-term benefit for Baidu shareholders in the iQiyi deal, and I'm uneasy with management's self-dealing. The divestiture will boost short-term margins and earnings, but it could mean we end up missing out on China's version of Netflix.

The transaction will be reviewed by a special committee of three independent directors, but I'm skeptical of their willingness to cross Robin Li given his majority voting control of Baidu. Although I believe Baidu has better corporate stewardship than most of its Chinese peers--my distrust of Alibaba's BABA management is the main reason I haven't bought that stock yet--I count this as a strike against Baidu and Robin Li (unless, of course, the independent directors reject the deal, in which case I will be surprised and impressed). That's not to say that $2.8 billion might not be a fair price for iQiyi; there has been too little disclosure to really value the asset. But the whole situation just makes me uncomfortable. Since our investment thesis mostly revolves around Baidu's core search business, I plan to hold, but I'll be interested to hear what management has to say about this deal when the company reports earnings on Feb. 25.  

Lastly, we downgraded PotashCorp's POT moat rating from wide to narrow. While the Canadian dollar has depreciated relative to the U.S. dollar, currencies in Russia and Belarus have dropped even faster, which has hurt PotashCorp's position on the global cost curve for fertilizer. Furthermore, the breakdown of the Eastern European potash cartel has caused producers to abandon their pricing discipline, sending potash prices closer to marginal costs of production. While PotashCorp continues to trade at a steep discount to our $24 fair value estimate, there is a very high degree of uncertainty surrounding that appraisal. We also have a large unrealized capital loss on our position, which has potential tax benefits for investors who own the stock in taxable accounts. Most importantly, I've concluded that PotashCorp falls outside our circle of competence, since its intrinsic value is so closely tied to unpredictable commodity prices. For these reasons, I'm inclined to sell the Hare's small 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

HCP HCP  |  Edward Mui

HCP reported fourth-quarter and full-year 2015 results that saw modest progress in parts of its business, including significant new or renewed leases in its medical office building and life science portfolio, robust same-store net operating income growth in HCP's RIDEA operating portfolio during fourth quarter, and continued development activity. However, any potential positive aspects were overshadowed by news of advancing deterioration in HCP's post-acute/skilled nursing portfolio and HCR ManorCare. We are lowering our fair value estimate for HCP to $43 and increasing our uncertainty rating to high in response to our updated outlook for the company and the various actions management might explore.

HCR ManorCare is HCP's largest single tenant, representing approximately a quarter of the company's annualized revenue and cash NOI, of which nearly $100 million is attributable to post-acute/skilled nursing facilities. Performance of these properties continued to weaken in the second half of 2015 through a combination of pressured reimbursements and shorter patient stays, even as overall admissions increased marginally. Facility-level EBITDAR coverage stayed under 1 times, ending the quarter at 0.86 times, while ManorCare's operating company, which guarantees its master lease with HCP, experienced 1.05 times fixed charge coverage, even taking into account its early-2015 rent reduction. This reflects our overall long-term view of skilled nursing facilities: Rent increases of 2%-3% are unsustainable in an especially scrutinized and heavily regulated industry with flat (and potentially negative) income and medium-term growth prospects due to Medicare reform. HCP management is exploring options to reduce its exposure to ManorCare and figure out a long-term solution. At this point it is unclear whether that will be through another rent reduction or ManorCare asset sales, but we expect a significant action within the next six to 12 months.

Our updated fair value estimate is based on a lowered outlook of organic income growth for HCP's portfolio of skilled nursing facilities. However, other parts of its business remain relatively healthy, while new developments add the potential for income growth. We believe the company has ample room to maintain and increase its annualized $2.30 per share dividend, which implies an 8.1% dividend yield. At current pricing, long-term investors who can stomach the next 12-24 months could find it an attractive opportunity, even without income growth in skilled nursing facilities.


Time Warner TWX  |   Neil Macker, CFA

Time Warner reported fourth-quarter results below expectations as foreign exchange continued to negatively affect top- and bottom-line results. Despite the weak results, management did raise its earnings per share guidance for 2016 to $5.30-$5.40 from $5.25. We are maintaining our wide moat rating but lowering our fair value estimate to $85 per share from $94 to account for lowered ad and HBO subscription revenue expectations. Now trading in deep 4-star territory, the stock may offer an attractive entry point for investors with a longer-term investment horizon.

Revenue at Turner increased 2% to $2.7 billion as ad revenue improved 5%, offsetting flat quarters for the other segments. Advertising revenue was driven by additional MLB playoff games and improved ratings at CNN due to the primaries. However, this growth was more than offset by higher programming costs including the MLB rights. HBO growth of 6% was driven by a 20% increase in content revenue due to international library licensing. Warner Bros. revenue declined 15% as the division suffered from tough theatrical comps with The Hobbit and Interstellar in theaters a year ago. Adjusted operating margin fell 160 basis points to 19.6% as the decline at WB offset selling, general, and administrative expense improvements from last year's restructuring plan.

Management released the first subscriber numbers for HBO Now, its stand-alone subscription video on demand offering. The reported level of 800,000 subscribers appears weak despite the service only being on the market for 10 months. The slow rollout for supporting platforms appears to have limited the potential market, and HBO Now is still not available on Xbox One or PS4, two major streaming platforms. HBO plans to increase the number of hours of original programming by 50% to enhance the attractiveness of the service. We expect the next season of Game of Thrones to help improve new sub adds as the service launched with the premiere of the last season.


Coca-Cola KO  |  Adam Fleck, CFA

We don’t expect much change to our $43 per share fair value estimate for Coca-Cola after examining the firm’s fourth-quarter results and plans to accelerate its bottling divestitures. Unit case volume growth finished the year strong, with 3% year-over-year gains in the second half of the year versus 1% to 2% in the first half; non-carbonated beverages continued to lead this improvement, climbing 6% in the quarter and 5% for the year. Shipment timing issues and fewer calendar days in this year’s fourth quarter led to Coke’s reported volume falling about 3% in the period, but we believe case volume is a better indicator of underlying demand. That said, the firm’s total reported volume grew 1% in the year, in line with our expectations.

We believe this volume growth, combined with positive pricing, supports our wide-moat rating for Coca-Cola. Price and mix lifted sales about 2% in the quarter and the full year, the strongest annual performance since 2011. We expect continued contribution from this metric at roughly 3% per year, owing to a further push in reduced package sizes (which drive up price per ounce), increased marketing spending, and rising consumer incomes in developing markets.

In addition, adjusted full-year operating margins of 23.4% were in line with our expectations, as the firm maintained or improved profitability in each segment. Total margins fell primarily due to the mix impact of lower-margin North America (a function of Coke owning its bottling and distribution assets in the U.S.) posting the strongest full-year growth. Nonetheless, we expect cost-savings programs, improved pricing, and bottling divestitures to drive near- and long-term margin expansion, and management’s target for 2016 operating earnings growth to outpace organic revenue gains buoys this thinking.

Coke also announced plans to complete the divesture of its U.S. bottling assets by the end of 2017, several years ahead of its original timeline. Moreover, the firm will also sell its sparkling-beverage production facilities, driving a return for Coke to being largely a concentrate producer rather than manufacturing finished goods in this segment (the firm will keep production of its juice, sports drinks, and several other non-carbonated beverages).

Ultimately, while Coke's accelerated transactions will drive lower reported revenue but higher profitability on its income statement, this doesn't alter our long-term view of the business' underlying drivers. We continue to believe that demand growth for carbonated beverages will significantly trail that of non-carbonated drinks in the U.S. and other developed economies, but volume gains in emerging markets and continued positive pricing actions in North America will offset this issue. Following the completion of these divestitures, we still expect revenue growth in a mid-single-digit range (excluding currency impacts), with solid operating leverage leading to earnings growing at a high single digit pace.

Encouragingly, management targets similar organic figures for 2016, with 4% to 6% revenue growth, 6% to 8% gains in earnings before taxes, and 7% to 9% earnings per share, and also maintained its $3 billion productivity plan, despite losing a substantial amount of targetable costs in the revised divestiture plan; in other words, the company increased its expected long-run cost savings by about $500 million. Still, while the firm’s organic performance next year is forecast to be in line with our long-run estimates, the structural changes to the business, along with continued currency exchange headwinds, look to reduce revenue about 8 to 9 percentage points and earnings before taxes roughly 12 to 13 points, which will lead us to reduce our 2016 forecasts.

We also note that although the Pacific segment was particularly strong (climbing 5% on the back of balanced sparkling and non-carbonated gains), China’s growth slowed to about 1% from mid-single-digit performance the past two quarters. Coke gained value share in the country but mentioned that the macroeconomic environment led to slowing overall. While China is not yet as important a driver as the U.S., Mexico, or Europe for the firm, we expect outsized long-run growth for the geography given rising per-capita consumption rates over time. Nonetheless, we’re encouraged that Coke also plans to refranchise its ownership in this region as well (the company currently owns about a third of the bottling and distribution in the country), which we believe is evidence of its two bottling partners’ commitment to future growth investments.


PepsiCo PEP  |  Adam Fleck, CFA

PepsiCo’s fourth-quarter results were in line with our expectations, and we don’t plan major changes to our $99 fair value estimate. Volume growth across its portfolio continued to grow slowly, but pricing and profitability improved solidly. The firm’s early read into 2016 suggests continued organic margin expansion, but a bit slimmer free cash flow generation as the firm laps strong performance in 2015. Nonetheless, this outlook follows our own assumptions.

For the full year, reported revenue fell about 5.4%, in line with our target. Slightly higher effective pricing (5% versus our 3% assumption, as the firm mitigated foreign-exchange headwinds) was offset by a higher currency effect and negative impact from deconsolidating Venezuelan operations. That said, we’re encouraged by solid pricing in North America; Frito-Lay, for instance, posted a 2% contribution from price, while North American beverages enjoyed 3% gains (with acceleration as the year progressed). We think this strong pricing alongside slight volume growth highlights PepsiCo’s brand intangible asset and supports our wide moat rating.

We’re also encouraged by Pepsi’s continued profitability expansion. During the year, the company’s productivity initiatives, positive pricing, and increased volume drove adjusted operating margins of 15.8%, up from 15.5% in 2014 and mirroring our estimate. The company outlined an additional $1 billion of productivity gains expected for 2016, and although some of this will be reinvested back into the business (similar to 2015, when advertising and marketing expenses climbed 40 basis points as a percentage of sales), we nonetheless remain comfortable with our outlook for 30 to 50 basis points of annual margin improvement over the next several years. We will incorporate stronger currency headwinds in our 2016 estimates, but management’s overall forecast for earnings per share to climb 8% before these impacts and Venezuela-related costs broadly tracks our assumption.

Free cash flow looks to dip to about $7 billion this year from $8 billion in 2015, but this outlook still suggests a net income conversion ratio above 100% (including 2015, this metric has averaged about 99% over the past five years). The company also plans to return a more appropriate amount of cash to shareholders in 2016 (roughly $4 billion in dividends and $3 billion in buybacks) after two years of using excess cash and debt to drive combined dividends and repurchase activity above free cash flow.

Finally, a large part of our long-term growth outlook assumes above-average gains in developing and emerging markets, and despite consumer spending headwinds in many of these regions throughout the quarter, PepsiCo reported underlying revenue growth of about 6% in these geographies in the quarter. We continue to expect that as consumers’ incomes rise in these regions, PepsiCo should see mid- to high-single-digit volume gains plus a bit of price increase. In all, we remain confident in our long-term outlook for mid-single-digit revenue growth, continued operating leverage, and earnings per share growing of 6% to 7%.


Compass Minerals CMP  |  Jeffrey Stafford, CFA

Compass Minerals struggled with industry headwinds in 2015 but still managed to keep adjusted EBITDA relatively flat year over year. Cost measures and better production rates at the Goderich salt mine led to 2015 adjusted EBITDA of $300 million compared with $306 million in 2014, despite a 14% decline in sales.

Even so, we've still trimmed our fair value estimate to $89 per share from $92 after the release of 2015 results and 2016 guidance. Tough market conditions in both salt and fertilizer haven't relented, and we've cut our 2016 profit forecast accordingly. In addition to a reduction in near-term profits, a higher effective tax rate, lower long-run salt volumes (based on updated long-run annual averages), and lower consumer and industrial salt pricing weigh on our fair value. Better progress on salt unit costs and a reduction in management's capital spending plan partially offset these factors. Our wide moat rating is intact.

A mild winter dented Compass' 2015 salt profits. The company saw only 17 fourth-quarter snow events compared with a 10-year average of 47 days. Quarterly highway deicing volumes dipped 32% year over year as a result. The company was able to offset volume pressure with lower unit costs driven by better mine production rates and less of a need for higher-cost imported salt to meet demand. Lower fuel prices also helped on the cost side. Over the long run, we expect improvement in salt margins as prices grow and costs are held in check because of mine modifications at Goderich.

On the fertilizer side, a number of factors contributed to weaker results. Lower farm incomes, a strong dollar, and weak muriate of potash pricing all weighed on Compass' plant nutrition business. Full-year Plant Nutrition EBITDA declined 14%. Looking ahead, it seems the spread between sulfate of potash and muriate is finally starting to come down. We have long held that SOP pricing would deteriorate. Based on the company's guidance for the first quarter of 2016, management expects plant nutrition pricing to drop considerably this year. Our long-run pricing for this segment remains intact, and we're expecting weak results in the plant nutrition business going forward.


ITC Holdings ITC  |  Andrew Bischof, CFA

We are increasing our fair value estimate for Fortis to CAD 38 per share from CAD 37 after the firm announced the acquisition of ITC Holdings at an equivalent $44.90 per share: $22.57 in cash and 0.7520 Fortis share. The total equity purchase price is $6.9 billion, with an $11.3 billion enterprise value. We are maintaining our narrow moat and stable moat trend ratings for Fortis.

We assign a 75% probability of deal completion, with significant regulatory approvals needed from the Federal Energy Regulatory Commission, Justice Department, Committee on Foreign Investment in the U.S., and state regulators (Illinois, Kansas, Missouri, Oklahoma, and Wisconsin).

We've taken a negative view of Fortis' previous acquisitions, given the premiums paid, but we applaud the ITC purchase, which is just a 6.5% premium to our $42 fair value estimate. We think management can more than offset any dilution from transaction synergies and issuing shares above our stand-alone Fortis fair value estimate. On a stand-alone basis, we project ITC's adjusted earnings growth at approximately 8%, above our stand-alone 5.5% Fortis earnings growth forecast. The transaction also supports our 6% dividend growth forecast.

Strategically, the acquisition gives Fortis an opportunity to benefit from moaty transmission investments to support coal plant retirements, renewable expansion, and transmission upgrades. We view FERC regulation more favorably as investments are provided higher allowed returns of equity with minimal regulatory lag, the crux of our wide moat rating for ITC. Fortis management has historically allowed its subsidiaries to operate independently, and we like that the strong ITC management bench remains in place.

We believe the transaction is an excellent outcome for ITC shareholders, representing a 33% premium to the stock price before ITC announced a strategic review. Based on a 75% probability of the deal being completed, our $42 fair value estimate for ITC is unchanged.


PotashCorp POT  |  Jeffrey Stafford, CFA

We've lowered Potash Corporation of Saskatchewan's moat rating to narrow from wide. PotashCorp is on the low half of the potash cost curve, but steep currency depreciation has eroded the firm's previously stellar cost position relative to peers in Russia and Belarus; essentially moving PotashCorp's Canadian mines up the global cost curve. Over the last two years, the ruble has depreciated more than 50% versus the U.S. dollar, while the Canadian dollar only depreciated about 20% versus the U.S. dollar over the same time period. Not only does the relative depreciation harm Canadian producers' cost position, but we also think currency movements have increased price competition in potash markets.

On the pricing side, our lower outlook for long-term potash prices will crimp PotashCorp's future profits. The company has seen some cost relief to compensate, but it will likely not be enough to fully offset the price decline. As such, we think PotashCorp's returns on invested capital will suffer. We expect potash supply growth to exceed demand up to 2020. As a result, we anticipate prices will slide in real terms until that time, which won't allow PotashCorp to again reach the lofty ROIC heights that it achieved in years past.

Even so, we think the concentrated nature of the potash industry and several large price-first producers will cause potash to be priced at a premium to marginal costs. And while PotashCorp's solid asset base should allow it to pump out profits even if potash prices should approach marginal costs of production in the future, we are no longer comfortable enough with the firm's relative cost position to award the company a wide moat.


Defense  |  Chris Higgins

The U.S. Department of Defense unveiled its fiscal 2017 budget request on Feb. 9, and the top-line figures came in accordance with the bipartisan budget agreement struck at the end of last year. We see the budget outlook as broadly positive for defense names like Raytheon, General Dynamics, Northrop, Boeing, and Lockheed.  That said, the department needed to find $16.8 billion in savings, which required about $11 billion of cuts to modernization investments. Among the names we cover, we believe these cuts disproportionately affect Lockheed. However, we maintain our fair value estimate of $193, noting that our valuation is still 12% below where Lockheed is currently trading.

The fiscal 2017 request came in at $523.9 billion for the base budget, which excludes overseas operations, and $58.8 billion for overseas contingency operations. Our initial take on the 2017 budget and related projections is that the defense budget is finally set to return to growth after the total budget--base funding and overseas contingency operations--fell nearly 20% from fiscal 2010 to fiscal 2015. Even if the current budget control act caps came down from fiscal 2018-21, the base budget would grow at an average per annual rate of 2% during this period. Since Congress and the White House have demonstrated a willingness to raise these caps and allocate overseas operations funding as well, we expect faster budget growth than this regardless of how the elections play out.

Aircraft procurement took a big hit year over year and compared with previous spending plans for fiscal 2017. This was primarily driven by lower UH-60 procurement quantities, the end of the MH-60’s multiyear procurement, and fewer F-35s. Lockheed is the prime contractor on all of these programs. For fiscal 2017-20, the Department of Defense deferred 37 F-35 aircraft to after 2020, which represents $4.3 billion less funding over the period.

This delay is not very significant when viewed across the entire program, which includes the procurement of 2,457 aircraft. Indeed, our base case for the F-35 generates a $21.50 per share value for the program and completely removing these 37 aircraft would translate to only a $0.50 decrease in the program’s value to Lockheed. However, this could signal the first of many procurement delays for the F-35 and, given the other budget priorities the aircraft competes with, these delays could turn into larger de facto quantity reductions in our view.

Northrop’s Long Range Strike Bomber program, which is still under protest by a competing Boeing-Lockheed team, was fully funded in the aircraft accounts. Boeing’s aircraft programs also emerged relatively unscathed with Army AH-64 helicopters serving as bill payers for other programs, but the Air Force fully funded the larger tanker program. We also view the delays in F-35 as a potential positive for Boeing given its role on legacy fighters like the F-18.

In contrast to aircraft, munitions and missiles investment (research plus procurement) is slated to grow in 2017 by 1.2%. Procurement in this category was up even more at 3% year over year, based on our analysis. This was not a major surprise given Defense Secretary Ashton Carter telegraphing an increase in munitions spending before the budget release plus ongoing air operations in the Middle East. Raytheon’s significant exposure to demand for missiles and munitions means it should benefit from the funding increases here and we currently rate Raytheon’s stock as 3-stars. Within munitions spending, Boeing should also benefit from a fully funded tanker program in 2017 and in the later years plus $571 million of overseas contingency funding in 2017 for small-diameter bombs and joint direct attack munitions.


Oracle ORCL  |  Rick Summer, CFA, CPA

We are reaffirming our thesis, $44 fair value estimate, wide moat rating, and overall positive view of Oracle. The investment case for Oracle remains the same and hinges on our belief that the firm's switching costs around its database and applications businesses remains, supporting a wide economic moat and an ability to earn excess returns on capital. Still, investors should be mindful of valuation; Oracle is unlikely to increase its market share, at least organically, so massive upside surprises to our midrange forecast are unlikely, in our view.

Our valuation assumes that maintenance revenue provides significant ballast to Oracle's revenue base and profitability. Even with currency headwinds, maintenance revenue has grown at a 5% annualized rate over the past two years and closer to 8% on a constant-currency basis. We believe this growth provides reasonable evidence, at least today, that Oracle's customers face significant switching costs even as they consider cloud alternatives from competitors. Maintenance revenue is approximately 50% of total revenue and closer to 80% of overall operating profits.

As cloud revenue continues to grow in importance to Oracle's financial results, we expect growth in revenue and operating income to reaccelerate to the midsingle digits within the next three years. Cloud revenue grew 26% in the most recent quarter (on an annual basis) and currently represents 7% of the total revenue base. As this revenue mix begins to tilt more toward the ratable cloud business, overall results should demonstrate stronger revenue growth and less overhang from the company's past investments in cloud computing. We expect that patient investors will be rewarded and today's concerns over cloud disruption will prove to be overstated.


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