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May 23, 2017
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David Harrell
Editor, Morningstar StockInvestor
David Harrell is the editor of the Morningstar StockInvestor, a monthly newsletter that focuses on a wide-moat stock investing strategy. For illustration purposes, issues highlight activities pertaining to Morningstar, Inc. portfolios
Featured Posts
Roundup 5/19/2017 -- Positive Developments for McKesson

StockInvestorSM focuses on the activities of portfolios of Morningstar, Inc. that are invested in accordance with the Tortoise and Hare strategies. These portfolios are managed by Morningstar Investment Management LLC, a registered investment adviser, which manages other client portfolios using these strategies.

Please see new Morningstar analyst notes below for Alphabet GOOG/GOOGL, Berkshire Hathaway BRK.B, Lowe's LOW, and McKesson MCK. And General Dynamics GD was tagged in a general note about business jet deliveries.

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David Harrell,
Editor, Morningstar StockInvestor

Pricing Environment Stabilizes for McKesson, Reports Solid Fiscal 4Q Results
by Vishnu Lekraj | Morningstar Research Services LLC | 05-18-17

The operating environment seems to have stabilized for McKesson as the firm reported a solid fiscal fourth quarter. Importantly, both branded and generic pricing have both stabilized during the quarter and management guided a continuation of this trend into the next fiscal year. From our perspective, these developments are highly positive and highlight our long-term outlook for the firm. McKesson will be a major pharmaceutical supply chain player as the firm's scale remains largely intact and gives it key competitive advantages. The drug distributor also plays a critical role in the pharmaceutical industry, as many supply chain participants depend on its services for streamlined product distribution and procurement. Even with the recent issues McKesson faced over the last several quarters, its long-term fundamentals have not changed and should lead to outsize economic profits in the future. Accordingly, we are reiterating our $200 fair value estimate and wide moat rating for the drug distributor.

While McKesson had a solid quarter, we still believe its stock remains deeply undervalued and is an attractive opportunity for investors seeking exposure to a high-quality healthcare name. From our perspective, certain market participants extrapolated near-term headwinds during fiscal 2016 and 2017 into the long term. As the firm's fiscal fourth-quarter results indicate, these headwinds have started to abate and have not impaired the long-term outlook for McKesson. The firm is still positioned to take advantage of the secular tailwinds blowing through the pharmaceutical space.

Highlighting the positive quarterly developments was management's outlook regarding fading competition within the small/independent client segment. McKesson was forced to match lower generic drug pricing during the last few quarters in order to preserve volume among this client subset. However, this dynamic has stabilized as management stated generic pricing concessions to independent clients has moderated. Additionally, management also guided branded inflation to be in the low- to mid-single digits for fiscal 2018. We believe this is a prudent outlook as management was too aggressive with its initial fiscal 2017 branded pricing assumptions that assumed high-single-digit to double-digit pricing increases for certain branded products. Given the recent scrutiny drug manufacturers have faced over their pricing strategies, a conservative branded pricing outlook is the correct course for McKesson, from our perspective.

Berkshire Clips Delta's Wings to Add to Southwest and American, Sells One Third of IBM Stake
by Greggory Warren, CFA | Morningstar Research Services LLC | 05-19-17

Berkshire Hathaway reshuffled its holdings in the four major domestic airlines--Delta Air Lines, Southwest Airlines, American Airlines, and United Continental Holdings--during the first quarter of 2017, selling 5.0 million shares of Delta and using the proceeds to fund the purchase of 4.5 million additional shares of Southwest and another 3.7 million shares of American Airlines. At the end of the first quarter, the four airline stocks accounted for 5.7% of Berkshire's reported equity holdings, down from 6.3% at the end of last year.

We continue to view the airline holdings as more of a trade than a buy-and-hold position for Berkshire; despite Warren Buffett's belief that they've gotten a "bad century out of the way," we continue to have reservations about the industry. Its long history of value destruction, a business model that is not conducive to rational pricing, a lack of high entry barriers, the commodification of air travel, and the presence of low switching costs coupled with price transparency make the airlines less attractive as long-term investment ideas, in our view.

Looking more closely at the other first-quarter purchases, Berkshire more than doubled its stake in Apple, picking up 72 million shares for an estimated $9.3 billion, making it the insurer's third-largest holding--accounting for 11.5% of its equity portfolio--at the end of March. The company also put more capital to work in Bank of New York Mellon and Sirius XM Radio.

All told, Berkshire spent an estimated $10.3 billion on stock purchases during the first quarter, funding about a third of that total with the proceeds of stock sales--including the elimination of its stake in Twenty-First Century Fox, as well as sales of IBM and Wabco Holdings. While the 13-F filing revealed a 20% reduction in Berkshire's IBM stake, Buffett noted ahead of the company's annual meeting that the firm had sold about a third of its stake in the technology giant.

Artificial Intelligence Is the Main Theme at the Google I/O
by Ali Mogharabi | Morningstar Research Services LLC | 05-18-17

Alphabet's Google launched its annual three-day developer conference, or I/O, on May 17. Some attention-grabbing announcements included the availability of Google Assistant, the firm's virtual assistant based on machine learning, on Apple's iPhones, along with the Android operating system now operating 2 billion mobile devices. We were not surprised to see Google's continuing focus on using artificial intelligence, or AI, to strengthen its ecosystem. The firm is adding a variety of vision- and voice-based functionalities that utilize machine-learning algorithms to attract not only more users, but also possibly more digital ad dollars. In addition, Google's advantage in faster and more efficient computing on the cloud side was evident, in our view. We think the highlighted features during the first day of the I/O conference and the continuously improving open platform could help Alphabet strengthen its network effect and data moat sources going forward. While we viewed the first day of the Google I/O as positive, we maintain our $860 fair value estimate and see this wide-moat-rated name as fairly valued.

Google kicked off the conference by emphasizing that it is including machine learning in all of its products, which we think could increase dependency on the products and drive more user adoption, supporting the firm's already-strong network effect moat source. Google's focus has shifted from "mobile first" to "AI first." Some of the machine-learning features that Google is rolling out include SmartReply, which makes automated email responses within Gmail more conversational over time as the Gmail app becomes more familiar with the way its user replies to emails. The firm is also improving the vision- and voice-based functionalities on many of its apps and devices.

On the vision side, the camera on the Pixel will help users remove objects that block the main image in a photo. Further, utilizing its machine-learning technology, Google has added the Google Lens to its photo app, which over time can automatically identify people and objects throughout a user's photo library. By utilizing Google's practically unlimited search data, Google Lens can also help a user understand what he or she is viewing. For example, Google Lens can tap into Google Maps data to find more information about a restaurant that the user is standing in front of. Simply put, Google Lens helps users have a visual-based conversation or interaction with different Google apps. We view this as another type of search that Google can monetize in the future.

As for its voice-based features, Google highlighted that its Google Home, powered by Google Assistant, can now identify different speech due to improvement in the machine-learning technology behind it. Google Home's word error rate has also declined significantly since it was first launched in mid-2016. According to Google, its smart home product will be able to interact with TVs, responding to user requests not only by voice, but also by displaying the response on the TV screen. The firm also demoed how Google Home can help users conduct a voice-based search for a restaurant and order for a delivery right away, which we view as not-so-good news for companies such as Grubhub. As mentioned earlier, the company also announced that Google Assistant will be available for download on iPhonesa if widely used, this could strengthen Google's network effect and the value of its consistently growing intangible asset: data.

In our view, the firm is also distancing itself from others in machine learning as it continues to improve the performance of its own tensor processing unit, or TPU, which will not only speed up computations in Google's data centers, but may also allow the learning (or, as Google said, "training") of the technology to be processed more efficiently. While Google's TPU works only on the TensorFlow software library, the open-source TensorFlow remains a very popular machine-learning software library for developers. This, along with more aggressive data center additions, may help Google gain some traction on the cloud front.

On the smartphone operating system side, Android is now on 2 billion devices, according to Google. The firm is also focusing on improving the operating system's battery life, security, and performance. Google also announced Android Go, a lighter version of Android, as it is attempting to tap further into emerging markets, which have a much higher level of demand for low-cost mobile devices. In our view, this could increase the user base of the Android operating system and Google apps, possibly strengthening Google's network effect in the long run. Google also announced that Android will fully support the Kotlin programming language, which has gained popularity among developers. We believe this decision could strengthen Google's network effect among app developers, which may bode well for the Google Play app store.

Finally, regarding virtual reality, or VR, and augmented reality, or AR, Google is making headway, as its VR platform Daydream will become available on Samsung's Galaxy S8 and S8+ mobile devices. The firm is also working on stand-alone VR headsets with HTC and Lenovo. On the AR side, Google demoed its visual positioning service, or VPS, which works with Google Maps, but provides indoors positioning information. For example, VPS can help a user find products within stores using a smartphone. As the company said, "GPS can get you to the door, and VPS can get you to the exact item that you're looking for." In our view, increase in usage of VPS can represent another user monetization opportunity (via ad dollars) for Google.

Lowe's Steps Into Building Management Sales With Acquisition of Maintenance Supply Headquarters
by Jaime M. Katz, CFA | Morningstar Research Services LLC | 05-18-17

Following in the footsteps of closest peer Home Depot, wide-moat Lowe's has entered the maintenance, repair, and operations business more meaningfully with its acquisition of Maintenance Supply Headquarters, tapping into additional professional consumers in the Western and Southern United States. Focused on products sold to apartment managers and owners, Lowe's also noted its tie-up with Central Wholesalers in November 2016, offering the company exposure to MRO sales in the Mid-Atlantic and Northeast regions. The transaction with Maintenance Supply Headquarters is anticipated to cost $512 million, be accretive to earnings in 2017, and close in the second quarter.

With the professional business growing faster than the do-it-yourself business for home improvement retailers in recent periods, we think this helps Lowe's tap into a revenue stream that is a bit less cyclical than the traditional core customer, with easier access to market share growth. Home Depot has pegged the MRO market at $50 billion, and Lowe's anticipates its MRO business will be able to generate more than $400 million in annual sales supported by 16 distribution centers upon close of the transaction, implying the opportunity for significant market share gains. We think Maintenance Supply was generating above $100 million in revenue in recent years, and given that Home Depot paid $1.625 billion for Interline's $1.6 billion in revenue in 2015, we believe Lowe's paid a higher multiple for the deal. We assume operating margins at Maintenance Supply are significantly lower than at Lowe's, as Interline was delivering around 3% operating margins on a larger sales base before its acquisition. With Lowe's forecast to generate $68 billion in revenue, we don't expect this acquisition to change our $87 fair value estimate, but we plan to re-evaluate the growth potential surrounding the segment and its impact on total growth longer term after the firm's quarterly conference call next week.

The outlay for this purchase is likely to keep Lowe's anticipated share repurchases within its guided range in 2017, with the company calling for $3.5 billion in buybacks and $2 billion in free cash flow and the issuance of $3 billion in notes in April (to retire $1.6 billion in outstanding debt). However, we anticipate share repurchases will continue at a healthy clip in years ahead, given the current state of the housing market.

Business Jet Deliveries Will Bottom Out This Year, but a Sustained Recovery Won't Happen Until 2019
by Chris Higgins | Morningstar Research Services LLC | 05-17-17

We attended market data provider Flight Ascend's business jet update on May 16. The presentation confirmed our view that deliveries this year will not grow, and Flight Ascend forecasts a 3.7% decrease in deliveries for 2017. However, the business jet market appears to be stabilizing with most aircraft values recently coming in flat on a year-over-year basis. The latest market data, demand for new models, and recent manufacturer comments indicating they will hold the line on pricing, gives us some hope that we're finding a bottom. Still, we believe the market remains oversupplied. Among the manufacturers we cover, we believe Gulfstream (General Dynamics), which enjoys industry-leading margins, remains the best positioned thanks to its dominant position in large cabin jets coupled with the introduction of its new G500 (late 2017) and G600 (2018) models.  

In 2016, there were 661 business jets delivered, which was the lowest delivery figure since 2004 and represented a 7.9% drop versus 2015. Although growing corporate profits should be stimulating demand, overproduction from 2005-20, corporate cost-cutting, and more recently soft emerging market demand, have placed downward pressure on sales and deliveries. These trends have kept inventory above 10% for many models and pressured residual values, which dampens new aircraft demand. Most manufacturers are sitting on backlogs comparable to 2010-11.

For 2017, we had been forecasting a slight decrease year over year in deliveries to around 655 aircraft, but Flight Ascend is a bit more bearish, expecting deliveries to come in below 650. Business confidence, particularly in the U.S., seems to be improving the outlook for manufacturers. The Trump effect on business jets--primarily business optimism centered around deregulation and lower tax rates--isn't translating into delivery growth yet, and we think concrete legislation around corporate tax reform is required to push demand higher.

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David Harrell may own stocks from the Tortoise and Hare Portfolios in his personal accounts.

 
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