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.

Apr 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, 4/17/14 -- Few Surprises in First Big Week of Earnings

This week's roundup comes a day early due to the Good Friday holiday.

On Tuesday, ITC Holdings ITC held an investor day at which it detailed a new five-year investment plan covering the years 2014-18. The plan calls for $4.5 billion of net capital expenditures and 11%-13% annual earnings per share growth. While this is slower growth than investors had become accustomed to in recent years--an inevitable consequence of growing from a larger base--ITC's outlook remains far better than that of most regulated utilities. The company's ability to achieve or exceed its 11%-13% EPS growth target will largely depend on (1) identifying and executing on worthwhile electricity transmission projects and (2) the Federal Energy Regulatory Commission maintaining attractive allowed returns on equity. On the first point, ITC has an exceptional track record and is very well positioned to compete for projects. On the second point, regulators' intentions remain inscrutable, but I still believe that the FERC has little incentive to reduce transmission ROEs materially. We should know more soon, as a FERC decision on transmission rates in New England is expected later this year. We raised our fair value estimate by $1 to $35 per share, and ITC remains a core long-term holding for the Tortoise.


--Late last week, Automatic Data Processing ADP announced a plan to spin off its Dealer Services segment, which sells software and services to automobile retailers. Our analyst estimates that the Dealer Services segment accounts for around 15% of ADP's fair value. There are few if any synergies with the core human resources outsourcing business, so I think a spinoff makes sense. The transaction is expected to be completed in the fourth quarter. I plan to hold.

--Strict emissions regulations by the Environmental Protection Agency survived what looks to be their final legal challenge, making it likely that utilities will move forward with plans to close older, less-efficient coal plants. This is bullish for electricity prices, and supports our investment thesis for Exelon EXC. Exelon has been among our best-performing holdings thus far in 2014, but I'm not enthusiastic about the company's exposure to volatile commodity prices. If the stock trades much closer to Morningstar's $42 fair value estimate, I will be very tempted to sell.

--Wal-Mart WMT announced a plan to offer domestic money transfers, displacing a partnership it previously had with MoneyGram International MGI. I see this as yet another sign of increasing competition within the money transfer business, which reinforces my decision to sell Western Union WU last year. (For what it's worth, Western Union's stock is down 17% since we sold.)

--We raised our fair value estimate for HCP HCP by $1 per share to $51, reflecting a routine adjustment for the time value of money. I expect to hold.

--We raised our fair value estimate for TransCanada TRP by $1 per share to $48. TransCanada remains a potential source of funds.


Earnings season is in full swing, with 10 of our 38 holdings reporting this week. Growth rates below reflect adjusted, constant-currency numbers where available.

Johnson & Johnson JNJ
Revenue Growth: 5%
Pre-Tax Income Growth: 10%
EPS Growth: 7%

Johnson & Johnson reported another strong quarter, and we raised our fair value estimate by another $2 to $99 per share. I've lost count of how many times we've increased J&J's fair value estimate in the past year and a half. While sales in the consumer and medical device segments were relatively flat, the pharmaceutical segment remains on fire with 12% constant-currency revenue growth. J&J's robust portfolio of recently-launched drugs and modest exposure to patent expirations distinguish it from its Big Pharma peers. The company increased its full-year earnings per share outlook to $5.80-$5.90 per share, reflecting growth of 6% at the midpoint, which it should have little trouble achieving. I plan to hold.

Coca-Cola KO
Revenue Growth: 2%
Operating Income Growth: 7%
EPS Growth: 5%

Coke's stock jumped after the company released first-quarter results, which I attribute to low expectations. Volumes and prices both improved 2% from the prior year, reflecting the benefits of diversification as well as Coke's enduring brand power. While sparkling beverage volume was down 1%--the first such decline in 15 years--still beverage volume was up 8%. As long as consumers don't switch from packaged beverages to tap water, I think Coca-Cola will capture its fair share of drink sales: Juices, teas, bottled water, sports drinks, and energy drinks should pick up the slack for soda. The stronger dollar weighed on reported figures, but adjusted constant-currency earnings per share were up 5%. In light of Coke's 3.0% dividend yield, that's about all we need to achieve an 8% annual total return, which is my minimum return hurdle for the Tortoise. However, I still believe high-single-digit annual earnings per share growth is achievable over the long run, in which case total returns should be closer to 10% per year. I plan to hold.

Abbott Laboratories ABT
Revenue Growth: 1%
Pre-Tax Income Growth: -7%
EPS Growth: -2%

Abbott's first-quarter results were uninspiring, but growth should pick up later in the year as the company faces easier prior-year comparisons. Currency headwinds, last summer's recall in the China infant formula business, and downtime at a manufacturing plant to enable capacity expansions all weighed on first-quarter revenue, which was barely changed from the prior year. Diagnostics was the only segment to post respectable growth, with sales up 5%. Management still expects roughly 10% earnings per share growth for the full year, which seems attainable in light of cost cutting opportunities. However, I remain skeptical of Abbott's long-term competitive position; the company participates in markets characterized by slow growth, a high degree of competition, limited innovation, and ongoing reimbursement pressure. The stock is a likely source of funds for the Tortoise.

Kinder Morgan Management KMR
Revenue Growth: 37%
Distributable Cash Flow Growth: 26%
Distributable Cash Flow Per Unit Growth: 6%

It was another steady quarter for Kinder Morgan Energy Partners KMP, which increased its distribution to $1.38, up 6.2% from the prior year (we receive our distributions in the form of additional KMR shares). Distributable cash flow per share increased at the same 6.2% pace and covered the distribution 1.12 times. There is some seasonality to Kinder's cash flows that is likely to result in coverage closer to 1 for the full year. The project backlog increased to $14.9 billion from $13.5 billion, which provides a fairly high degree of visibility into Kinder's near-term growth outlook. That buys management time to alleviate some of the longer-term concerns, including a lack of excess distribution coverage, the inevitable decline in oil production, and the severe general partner burden. I expect to hold for now, but if Kinder trades close to our $90 fair value estimate it would be a likely candidate for sale.

American Express AXP
Revenue Growth: 5%
Net Income Growth: 12%
EPS Growth: 16%

I continue to be impressed by American Express' disciplined cost control, respectable loan growth, and modest credit losses. Card member loans advanced 3% in the first quarter and yielded a net interest margin of 9.5%. Discount revenue rose 5% thanks to increased consumer spending on American Express cards. Operating expenses declined 4% from the prior year, and net write-offs remained exceptionally low at just 1.7% of loans. The combination of rising revenue and falling costs is powerful, enabling American Express to achieve a return on equity north of 28%. At the same time, American Express maintains a very strong balance sheet, which allows it to easily pass the Federal Reserve's stress tests and continue returning capital to shareholders through both dividends and share repurchases. I plan to hold.

PepsiCo PEP
Revenue Growth: 4%
Operating Income Growth: 7%
EPS Growth: 10%

PepsiCo posted solid first-quarter results and is on track to meet management's target of 7% constant-currency earnings per share growth for the full year. Pricing was a bright spot, as Pepsi was able to push through 3% price increases across its portfolio. Beverage volume was flat, with growth in non-carbonated drinks just offsetting declining soda volumes; I continue to believe that Coca-Cola has a much stronger competitive position in beverages than Pepsi. However, the snacks business remains PepsiCo's primary growth driver, with revenue up 5% on 2% higher volumes. The operating margin also improved thanks to ongoing productivity initiatives. I expect to hold.

Charles Schwab SCHW
Revenue Growth: 15%
Net Income Growth: 58%
EPS Growth: 60%

Charles Schwab's earnings power is like a coiled spring that is only now beginning to unfurl. All three of the company's major revenue sources--asset management, net interest revenue, and trading revenue--were up by double-digit percentages in the latest quarter. Schwab remains a prolific asset gatherer, with $34.2 billion of net asset inflows (a 6% annualized organic growth rate). The company is also making steady progress cross-selling banking and investment advisory services to existing brokerage clients. Operating leverage is now apparent to all, with Schwab's pre-tax margin expanding 960 basis points to 35.3% in the quarter.

I think Schwab still has a long way to go to demonstrate its long-term earnings potential. The net interest margin improved by 13 basis points to 1.64%, but remains at barely half the level we think Schwab is capable of in a more normal short-term interest rate environment. Similarly, fee waivers in money market funds (to ensure a positive return for investors) totaled $185 million in the latest quarter. Those two factors alone--a higher net interest margin and ending the fee waivers, which would come with little incremental cost--should be enough to more than double Schwab's current earnings. Schwab's valuation looks rich on the surface, at around 28 times consensus earnings per share estimates for 2014. However, our analyst believes the company could be earning more than $2.50 per share by 2017, assuming the Fed follows through on its plan to raise short-term rates. If Schwab then trades at a reasonable 15-20 times price/earnings multiple, we could be on track for an annual total return in the range of 12%-24% from the current price over the next few years. I intend to hold.

Google GOOG
Revenue Growth: 19%
Operating Income Growth: 13%
EPS Growth: 5%

Google's first-quarter revenue growth was robust, but operating costs rose even faster. Combined with higher income taxes and ongoing share count dilution, earnings per share growth was a disappointment. I continue to believe that Google's aggressive investments are largely discretionary. It seems there are few areas of technology that management isn't willing to experiment with; recent projects and acquisitions run the gamut from cloud infrastructure to drones, robots, smart thermostats, high-speed home Internet, self-driving cars, and new forms of hardware straight out of a science fiction movie. In an age where few companies are willing to bet on such "moon shots," I actually find Google's approach refreshing. Since 2007, the S&P 500's sales per share are only up 9%, while earnings per share are up 30%--in other words, the modest earnings growth we've seen from the market as a whole has been primarily driven by cost cutting and share repurchases. I agree with the cliché: We can't cut our way to prosperity in the long run. While I have no doubt that many of Google's projects will fail to deliver an adequate return to shareholders, I'm optimistic that there will be at least a few big winners that more than offset the losers. We raised our fair value estimate by $20 per share to $520 on an improved revenue outlook, and I intend to hold.

Philip Morris International PM
Revenue Growth: -2%
Operating Income Growth: -3%
EPS Growth: 5%

It was a challenging start to the year for Philip Morris International. Currency headwinds sent reported net revenue (excluding excise taxes) down almost 9% and operating income down nearly 13%. However, even without the stronger dollar, revenue and operating income would have been down modestly as price increases weren't enough to offset a 4.4% decline in cigarette volumes. Volumes were hurt by inventory de-stocking, without which the decline would have been a more manageable 2.0%. The Asia region was the primary weak spot in terms of revenue, while the European Union showed signs of stabilizing volumes. Philip Morris indicated that its market share declined following Australia's implementation of a plain-packaging law, which makes it harder to differentiate premium cigarette brands. While Australia accounts for an immaterial share of Philip Morris' revenue, similar laws are under consideration in other key markets, especially in Europe. Plain-packaging legislation poses one of the few serious threats to Philip Morris' economic moat, and this is a trend I'll be watching closely. For the full year, management reiterated its projection of 6%-8% constant-currency EPS growth, which should turn into roughly a 4% adjusted EPS decline after accounting for currency headwinds. I expect to hold.

BlackRock BLK
Revenue Growth: 9%
Operating Income Growth: 15%
EPS Growth: 21%

BlackRock--the newest addition to the Hare--started the year on a high note. Assets under management were up 12% from the prior year thanks to rising equity markets and continued asset inflows ($26.7 billion in the quarter for an annualized organic growth rate of about 2.7%). Revenue growth trailed AUM growth by 3 percentage points due to mix shifts and ongoing pressure on fees. However, adjusted operating income advanced 6 percentage points faster than revenue (3 percentage points faster than AUM) thanks to the significant operating leverage inherent in BlackRock's business model. Adjusted earnings per share growth was even better at 21%--9 percentage points ahead of AUM growth--helped by some non-operating items and a 1.5% reduction in the share count. Relative to the investment thesis I laid out in my trade alert last week, the quarter's results were basically consistent with my long-term expectations for factors #1, 3, 5, and 6, weaker than expected for factor #2, and significantly better than expected for factor #4. Altogether, I think BlackRock's shares remain on track to meaningfully outperform the S&P 500 over the long run. I will be on the lookout for an opportunity to add to our stake, especially if the overall market declines.

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

BlackRock BLK  |  Greggory Warren, CFA   

Despite the volatility in emerging and developing markets during the first quarter, which had a negative impact on flows for one of BlackRock's largest ETF offerings--iShares MSCI Emerging Markets (EEM)--the company closed out the period a record $4.4 trillion in total AUM (right in line with our projections). While total equity inflows of $3.8 billion were below our forecast of $13.9 billion, BlackRock more than made up for it with stronger inflows into fixed income products, especially institutional index funds and ETFs (with iShares' $6.6 billion in net inflows representing the lion's share of total fixed-income ETF flows during the first quarter). Management continues to view fixed income as a growth area, especially in its ETF business, and we agree, having forecasted stronger flows for BlackRock's fixed-income operations over the near- to medium term than we're willing to afford other fixed-income heavy firms like Franklin Resources, Legg Mason, and AllianceBernstein.

With total AUM increasing 12% year over year, and average AUM up 12% as well, BlackRock was able to post a 9% increase in revenue when compared with the first quarter of 2013. An ongoing mix shift in the firm's portfolio toward lower fee generating products, along with the ongoing trend of declining fee rates for the industry overall, diminished the impact that BlackRock's AUM growth had on revenue. With top-line results during the first quarter slightly lower than our forecast, we've adjusted our full-year projections for revenue growth from 10% to a high-single digit rate. BlackRock is, however, seeing much stronger operating leverage from its business than we were projecting, with operating margins exceeding 39% during the first quarter. This leaves the firm on pace to close out the year with margins about 50 basis points higher than our forecast. With full-year cash flows likely to end up about where we expected them to be, we see no reason to alter our $340 per share fair value estimate.


Google GOOG  |  Rick Summer, CFA, CPA   

Google's first-quarter results showed another solid quarter of revenue growth, but aggressive investment in data center capacity led to a decline in free cash flows. Still, we believe these investments are critical to supporting Google's wide economic moat and may create additional avenues for growth beyond advertising. We are increasing our fair value estimate to $520 per share to account for a modestly higher revenue forecast; our wide moat rating remains intact.

Overall company revenue grew 19% versus 2012, buoyed by advertising placed on Google properties, particularly Google Search and YouTube. Excluding traffic acquisition costs, this direct advertising revenue grew 27%, while Google Network revenue (for ads placed on other companies' Web properties) declined 1.2% on an ex-TAC basis.  Google's Web traffic continues to command the bulk of digital advertising budgets, and we expect the company's ad revenue growth to continue to outpace the overall market for the foreseeable future.

From a free cash flow perspective, the company continues to invest heavily in data center capacity, and free cash flows declined 16% to $2 billion. While we believe these investments are prudent in protecting its competitive advantages in search and advertising markets, we believe the returns on capital in new businesses such as hardware (Nest) and cloud computing will ultimately be lower than the legacy business. As a result, we are sensitive to valuation and expect that the company's returns on invested capitals are unlikely to expand dramatically from current levels. Still, we believe the shares are fairly valued, and given the relative overvaluation of other names in the sector such as Facebook and Twitter, Google represents of the most attractive names to consider as a core holding in the Internet sector.


Philip Morris International PM  |  Philip Gorham, CFA, FRM

Unfavorable currency and trade inventory movements caused noise in Philip Morris International's first-quarter 2014 earnings report, masking the structural advantages that we think should allow the firm to earn excess returns on capital in the long term. The company is on track to meet our full year forecasts, and we do not intend to adjust our $90 fair value estimate. We also reiterate our wide moat rating, although we remain concerned that plain packaging is a threat to Philip Morris' competitive advantages.

Reported revenue fell 4.0% largely due to unfavorable foreign exchange movements, slightly ahead of our full-year estimate of a 4.4% revenue decline. Even excluding currency, however, both revenue (-1.6%) and operating income (-3.1%) declined as Philip Morris failed to offset lower volumes with higher prices. We do not think this is indicative of the long term, and we believe Philip Morris' wide economic moat, particularly through its brand strength, should allow it to grow revenue at a mid-single-digit rate in the long term.

In the first quarter, unfavorable inventory movements in Japan affected volumes and cyclical macroeconomic factors continued to weigh on pricing. We were encouraged to see, however, some stability in the European Union segment, with volume down 3% (in line with long-term trends and a sequential improvement from the 6.5% decline in 2013), and revenue essentially flat in the first quarter. Management raised its 2014 EPS guidance by $0.07 to a range of $5.09 to $5.19, putting our estimate of $5.11 at the lower end. We may raise our near-term estimates slightly to account for the improving visibility in Europe, but we do not expect this to make any impact on our fair value estimate, which is driven by the long-term earnings power of the business.

While we remain confident in our wide moat rating, we are concerned by Philip Morris' first-quarter share decline in Australia, to date the only market to have implemented plain packaging legislation. We think this lends support to our thesis that plain packaging is one of the few legitimate threats to economic moats in tobacco. We believe that the erosion of brand identity is likely to cause trading down, which should lead to premium brands (such as Philip Morris' Marlboro) losing share. Pricing power would be at risk if cigarette makers defend market share by competing more aggressively on price. While it is still too early to draw any definitive conclusions from Australia, this data point may suggest that smokers are trading down. Australia is a small market (we estimate it represents just 0.8% of Philip Morris' volumes) so we do not believe this share loss affects the firm's economic moat. However, if plain pack legislation were to spread to larger markets, we would review our moat ratings for the tobacco space.


Kinder Morgan Management KMR  |  Jason Stevens   

Kinder Morgan Energy Partners' first-quarter results were in line with our expectations, and we are maintaining our $90 per unit fair value estimates and wide moat ratings for KMP and KMR. Declared distributions of $1.38 per unit are up 6% year over year and 1.5% sequentially, and imply distribution coverage of 1.1 times for the quarter. Distributable cash flow increased to $693 million, or $1.55 per unit, up from $550 million or $1.46 per unit last year. Segment earnings increased $92 million to $1.6 billion for the quarter, driven by large gains in the natural gas pipeline business.

During the analyst call Wednesday, Rich Kinder addressed growth concerns head-on, citing a new study that expects midstream infrastructure spending through 2035 to exceed $600 billion, or about $30 billion a year. As the largest operator of natural gas pipelines and terminals in the United States, he argues, Kinder Morgan is well positioned to claim its share of these opportunities. In other words, there's plenty of room out there for KMP to keep growing.

While we share Kinder's optimism on gas demand moving significantly higher over the next decade, we're less certain about the required levels of industry spend and continue to believe that midstream is moving into its middle phase. Certainly, Kinder Morgan will play a meaningful role in plumbing the Marcellus, meeting Mexican gas demand, and building the infrastructure needed to export LNG. We think most of these projects are visible within the next five years or so, and once these bottlenecks are addressed, it is less obvious as to what drives future investment growth.

Nonetheless, this quarter Kinder Morgan brought $800 million of new projects on line, while increasing its project backlog to $16.4 billion, adding $2.4 billion in projects into backlog this quarter. This creates a very significant tailwind for the partnership as the majority of these projects will sustain and prolong excess returns, supporting our wide moat rating.


ITC Holdings ITC  |  Charles Fishman, CFA

We attended the ITC Holdings investor day meeting at the company’s headquarters in Novi, Mich., on April 15. ITC updated its five-year capital spending forecast with plans to invest $4.5 billion from 2014-18. After incorporating the updated capital investment plan and other updates from management, we expect to raise our fair value estimate to $35 per share from $34. We are reaffirming our wide Morningstar Economic Moat rating and our stable moat trend.

As part of ITC's investment plan, the company will bid on upcoming competitive transmission projects in the PJM Interconnection and the California Independent System Operator regions. In addition, ITC plans to repurchase $250 million of its shares by the end of 2015. We have increased our operating earnings estimates to account for the stock buyback.

For the most part, the updated capital expenditure plan was in line with our estimate, especially investments in the MISO and SPP regions where ITC already has a presence. ITC management spent a considerable amount of time detailing their logic for entering the PJM and CAISO regions. Roughly 25% of the $4.5 billion of planned investments is for as-yet-unspecified projects in these regions. ITC management likes the way PJM is going about implementing FERC Order 1000, as they believe it rewards planning expertise. In addition, since PJM is contiguous with ITC’s existing footprint they can leverage their existing facilities and personnel. PJM will solicit solutions to identified concerns rather than bids for defined projects. RFPs are expected as early as the second quarter of this year.

ITC will also focus on California transmission. CASIO projects to date have been awarded to incumbent utilities, but ITC believes the large number of projects and FERC Order 1000 will create opportunities for non-incumbents. Since ITC has no experience operating in California, it intends to partner with an existing utility.


Charles Schwab
SCHW  |  Gaston F. Ceron

Charles Schwab reported a solid first quarter. Revenue and profits are tracking well relative to our targets and we may move some of our near-term estimates higher. Our long-run views for key earnings drivers, though, are unlikely to move dramatically and thus our fair value estimate will not change substantially. We continue to believe Schwab has a narrow economic moat.

We see Schwab's higher interest revenue--up 18% to $553 million--as starting to foretell its true earnings power, to be gradually unmasked by improving interest rates. Net interest margin rose 13 basis points year over year to 1.64%, helped by higher yields on securities and as assets grew. This is well short of the 3% margin that we believe Schwab can eventually earn, but it is trending better than what we had thought. Asset-management fees are still checked by steep fee waivers on money market funds, but here, too, we continue to expect eventual relief from higher rates. We believe growth in fees from other offerings, such as advice products, will help mitigate the near-term damage from the waivers. Indeed, this helped produce an 11% jump in the asset-management segment's overall revenue this past quarter.

We were pleased with the improvement in trading revenue, fed by revenue-producing trades that are tracking ahead of our views, though we caution this could still slow if the recent market dip turns into a rout that damages investor sentiment and offsets volatility-inspired trading. At $247 million, this was the highest quarterly level for trading revenue in over two years. We view Schwab's income from selling order flow, which we estimate to be below $100 million, as vulnerable to criticisms of this practice, though we don't think its loss would substantially hurt revenue.

Schwab's costs are close to our views and were nearly unchanged at $956 million. Altogether, the firm earned $318 million, or $0.24 per share, up from $198 million, or $0.15 per share, with net revenue up 15% at $1.48 billion.


American Express AXP  |  Jim Sinegal

We're generally pleased with American Express' quarterly results. The firm reported net income of $1.4 billion, or $1.33 per share, for the quarter ended March 31. Total revenues increased only 4% over the course of the last year, but tight control of expenses and share repurchases led to a 16% increase over the $1.15 in earnings per share recorded in the same quarter of 2013. We do not intend to significantly increase our fair value estimate, aside from time value adjustments.

The quarter's results support our thesis on the company in several ways. First, American Express is continuing to benefit from global transaction growth, though its relative focus on the United States and its exposure to lending as well as spending may reduce growth rates relative to peers with more exposure to developing markets. Loans and receivables balances each grew by only 3% during the year. That said, billed business grew at a 6% pace in both domestic and international markets during the year and basic cards in force grew by 9% internationally.

We were also interested to see that average discount fees are remaining steady, despite increasingly cheaper options due to interchange regulations and an increasing number of new merchant solutions. Rewards spending also grew in line with revenue, potentially indicating that competitive pressures are waning.

Overall, the company was able to generate a 28% return on equity, while immediately returning a vast majority of capital generated to shareholders. Of its $1.4 billion in net income, American Express spent more than $900 million buying back shares and returned another $0.23 per share via dividends. We expect the combination of growing wealth, increasing consumer spending, high returns on equity, and shareholder-friendly capital allocation practices to continue benefiting owners of American Express shares for the foreseeable future, though we think the stock is richly valued compared to our $77 per share fair value estimate.


Johnson & Johnson JNJ  |  Damien Conover, CFA

Johnson & Johnson reported first-quarter results that exceeded our and consensus expectations. We attribute the outperformance largely to strong high-margin drug sales. Based on the solid results, we plan to raise our fair value estimate by $2, to $99 per share, which would put the current stock price close to our estimate. The strength in J&J's most competitive division--pharmaceuticals--reinforces our conviction in the company's wide moat. Based on the strong quarterly results, J&J slightly increased its full-year earnings per share outlook to $5.80-$5.90, which we expect it to easily meet.

New product launches are driving the solid growth in the drug division (up 12% year over year). We expect this trend to continue for at least the reminder of the year. However, in 2015, we expect growth to decelerate as new hepatitis C drugs enter the market, slowing the growth of J&J's hepatitis C drug Olysio, which represented 500 basis points of this quarter's growth. Nevertheless, other recent drug launches (immunology drug Stelara and cardiovascular drug Xarelto) are likely to continue to drive solid growth for J&J's drug division over the next three years. The relatively high margins of the drug unit should continue to provide an amplified impact on the bottom line over the next several years.

Turning to the other key divisions, both medical devices and consumer health care posted largely flat growth in the quarter. Poor health-care utilization and increased competition led to the stagnant performance in the period. While we expect these divisions to return to mid-single-digit growth as a result of new innovative product launches and strong brand power, we anticipate they will remain a drag on overall company growth for the remainder of the year.


Coca-Cola KO  |  Adam Fleck, CFA

We plan to maintain our $44 fair value estimate for wide-moat Coca-Cola following the company's first-quarter results. Continued volume and value share gains, with stronger gains in the latter, indicate that pricing power remains solid. Moreover, recent marketing efforts seem to be taking hold in developing and emerging markets, which enjoyed 3% volume growth from a year ago. China saw total beverage volume jump 12%, while Brazilian volume ticked up 4%--both sequentially improved. In all, revenue fell 4% year over year, though the entirety of this decline stemmed from negative currency headwinds, which is not surprising given management's prior comments on the issue.

However, sparkling case volume declined about 1% year over year. Still drink volume increased 8%, reflecting continued success in nonsoda products, but sparkling beverages represented a larger 74% of total cases in 2013. Management attributed the weakness to a shift in the Easter holiday this year and price discipline in Great Britain at the expense of volume, given new packaging; the company expects the absence of these issues and stepped-up marketing to drive volume growth in line with long-term targets in the low single digits for the full year. Such advertising activities will probably erode the selling, general, and administrative expense leverage enjoyed in the first quarter.

We plan to maintain our Exemplary Stewardship Rating for Coke, as we believe recent investor criticism surrounding the potential dilutive effects of the proposed management incentive plan largely ignores offsetting factors such as proceeds garnered from options transactions, performance standards that still need to be met, and the company's sizable repurchase program. Admittedly, dilution under the new plan may still be slightly higher, but it improves the ownership mentality of more than 6,000 Coke employees, easing our qualms about the mathematics of the equation.


PepsiCo PEP  |  Adam Fleck, CFA

PepsiCo’s first-quarter results highlighted the company’s strong snack portfolio and pricing power in the beverage arena, and we plan to maintain our $88 per share fair value estimate and wide moat rating.

Frito-Lay North America enjoyed 4% organic revenue growth, led by mid-single-digit gains in U.S. salty snacks and price increases across the portfolio. Similarly, Pepsi Americas Beverages‘ positive price actions and growth in non-carbonated drinks helped to offset further volume declines in North American soda and difficult performance in Mexico. For PepsiCo in sum, price increases added three percentage points of growth in the quarter. In our opinion, this disciplined price performance highlights the company’s solid brand intangible assets, and we continue to believe that management’s long-run mid-single-digit revenue growth target is appropriate.

The firm also provided further details on its productivity goals, noting that the $1 billion of annual savings (roughly 1.5% of 2013 revenue) planned for the next five years is meant to offset labor cost inflation, negative mix impacts from emerging market sales growth, and rising marketing expenses. In all, management remained committed to increasing operating margin roughly 30 basis points per year, an outlook we largely share. We were also encouraged that the company considers advertising and research spending to be protected costs; we think a core tenet of Pepsi’s competitive advantages centers around continued brand penetration and product innovation, particular in emerging economies.

The company continued to gain traction in these markets during the quarter, with developing and emerging economy organic revenue growth of 9%. While China was a bit disappointing given difficult comparisons from a year ago and subsequent bottler restructuring, the company expects this market to return to a normal trajectory over the course of the year, and double-digit growth in non-Mexican snacks provided offsetting gains.


Abbott Laboratories ABT  |  Debbie S. Wang

Abbott Laboratories posted first-quarter results that fell short of our expectations on the top line, but made up for it on the bottom line. We're holding our $40 fair value estimate steady, and leaving the firm's narrow economic moat unchanged. Abbott's quarterly revenue grew an anemic 50 basis points in constant currency, compared with the prior-year period. In particular, ongoing weakness in the established pharmaceuticals segment was exacerbated when Abbott took one manufacturing facility off line in order to expand capacity. We expect this slowdown should resolve itself once the newly outfitted plant returns to service next quarter. Ripple effects from last summer's recall of Abbott's infant formulas in China also continue to dog the nutritionals segment. However, those challenging comparisons from last year should ease after the second quarter, and the firm's investment in new manufacturing facilities in China and India should help the firm solidify its competitive position in these important emerging markets.

Two bright spots turned out to be diagnostics, where several large customers purchased Abbott's instrument systems in the first quarter, and optical care, which benefits from growing demand for cataract surgery. However, this growth was offset by declines in the diabetes franchise due to Medicare's competitive bidding program, and weakness in the vascular business. Thanks to favorable timing on some expenses and some progress with efficiencies, quarterly adjusted operating margin remained on par with last year's improved margin. Nonetheless, we still see opportunities for Abbott to increase profitability, as it continues to lag behind key competitors.   

We were surprised to learn that Abbott's bioresorbable stent, ABSORB, now accounts for 20% of total stent sales in markets where it is available. We have long considered ABSORB a niche product, mainly because practitioners have been cautious about switching over to it, and the clinical data on vessel remodeling has not been entirely clear. We thought ABSORB would likely be used primarily in patients who cannot tolerate the anticoagulation therapy that accompanies traditional drug-eluting stents. However, we may get a peek at the ABSORB II trial data in fall. If the data demonstrate an advantage over the conventional Xience stent, we will reassess the potential for the bioresorbable stent.

Finally, we look forward to Abbott's launch of the Supera stent for peripheral use, and think it could drive gains in the endovascular product line. As with other vascular device-makers, Abbott has seen its larger coronary business slow down as concerns about stent overuse have cast a pall on procedure volume. On the other hand, the endovascular market continues to see steady, midsingle-digit growth. Even though stents for peripheral artery disease are not ideal--they are still prone to fracture--there is growing appetite for new solutions, and we expect Abbott's Supera stent can ride this wave. Although the endovascular franchise is currently too small to move the needle for Abbott, we still think it is an attractive market with opportunities for innovation.


Exelon EXC  |  Travis Miller

Tough regulations restricting certain U.S. coal plant emissions cleared what appears to be a final legal challenge with an affirmative D.C. Circuit Court of Appeals ruling April 15. Although most utilities have been preparing for the April 2015 implementation of the Environmental Protection Agency's proposed Mercury and Air Toxics Standards, we expect that the court ruling ensures utilities will go forward with their plans to close smaller, older coal plants and invest substantial capital in emissions controls equipment.

We believe power and gas markets have yet to fully price in the tightening supply-demand conditions we expect from additional coal plant closures. The Energy Information Administration reports 18.7 gigawatts of coal plant capacity have closed since 2011, representing 5% of total U.S. coal plant capacity. We count another 38 GW of capacity that prior to the April 15 ruling utilities had already announced they will close within the next five years.

Key winners are utilities with nuclear, natural gas or renewable energy generation, notably Exelon, Calpine, and NextEra Energy. We already incorporate higher future power prices in our fair value estimates for most U.S. utilities, so we are reaffirming all of our fair value estimates, moat ratings and moat trend ratings.

Large coal plant owners such as American Electric Power, NRG Energy, FirstEnergy, and Southern Company have been planning for tighter emissions regulations for several years. We already incorporate coal plant closures and capital investment for environmental controls in our analyses, so we are reaffirming our fair value estimates, moat ratings, and moat trend ratings. For all regulated utilities with large coal fleets, tighter regulations raise regulatory risk but shouldn't have any direct impact on earnings or shareholder value in the long run since they should be able to recover higher costs through customer rate increases.


Exelon EXC  |  Travis Miller

Exelon's year-to-date run from $27 per share to nearly $36 appears to reflect the market's turn away from an overwhelmingly bearish view of future power and natural gas markets. We are reaffirming our $42 per share fair value estimate and financial forecasts. We see no material changes in market power prices or Exelon's earnings outlook since our last update in mid-February. We are reaffirming Exelon's wide moat and stable moat trend.

We are reaffirming our 2014 EPS estimate of $2.32, in line with management's $2.25 to $2.55 EPS guidance range and the $2.37 consensus estimate as of April 14. All are virtually unchanged since the beginning of the year. This suggests Exelon's 2014 forward price-to-earnings multiple has expanded to 16 from 12 in January. During that period, Exelon has returned 30%, including a $0.31 per share dividend paid in mid-February. The S&P 500 is flat, including dividends, and the Morningstar Utilities Index is up 10%, including dividends.

We attribute most of that multiple expansion to the market's shifting view on long-term power market fundamentals in Exelon's core Midwest and mid-Atlantic power markets. Forward 2015-16 power prices in those regions are up 10% since the beginning of January, according to EOX Live data. Forward 2015-16 natural gas prices in the Mid-Atlantic are up 20%. However, Exelon can't take full advantage of the recent rally since it already had hedged 65% of its expected 2015 generation and 33% of its expected 2016 generation as of year-end 2013. Our primary long-term earnings driver continues to be based on our view that midcycle power prices are 20% higher than current forwards prices.


CME Group CME  |  Gaston F. Ceron

A key European markets reform package took another step forward, as the European Parliament approved the updated Markets in Financial Instruments Directive (known as MiFID II, a sequel to an earlier reform package). The rules are still some time away from hitting the markets, as technical details still have to be worked out, and implementation is expected around 2016, though transition periods will probably delay full application beyond that. Our view is that one of the package's key provisions, regarding open access to futures clearinghouses, risks upsetting the vertically integrated clearing and trading model that helps protect the economic returns of exchange companies such as Deutsche Boerse and IntercontinentalExchange Group. Furthermore, MiFID ushers in curbs on high-frequency trading, such as limits on the size of security pricing increments, and mandatory tests for trading algorithms, which we believe will add to the continuing volatility in the U.S. debate of this practice.

Separately, we also note the scrutiny of the role of clearinghouses in the U.S., by operators such as BlackRock and Pimco. According to the Wall Street Journal, both want the clearinghouses owned by the major exchanges to share more of the financial burden if a trading party fails to deliver. BlackRock suggested that the exchanges hold a backstop of 8%-12% of the guarantee fund versus relying more on the trading parties to provide the needed funds. Industry players are generally worried that since the crisis, too many risky trades have been concentrated in too few clearinghouses. Currently, CME has more than $350 million committed as a backstop, while ICE has more than $200 million in funds, but both clearinghouses handle trillions of dollars worth of derivatives. We view this discussion as far from over and expect that concerns about market structure will continue to surface. We are not changing our fair value estimates for the affected exchanges or our economic moat ratings.


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