Investment Strategy

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Investment Strategy
What is the goal of the Tortoise Portfolio? The Tortoise Portfolio aims to outperform the S&P 500 index over time. Companies in this portfolio tend to be mature, relatively slow-growing, and with moderate to low risk. New purchases must have an economic moat, preferably wide. We attempt to tilt the portfolio toward companies with at least stable competitive advantages (stable moat trends).

What is the goal of the Hare Portfolio? The Hare Portfolio aims to outperform the S&P 500 index over time. Companies in this portfolio tend to be faster-growing, with both higher risk and higher return potential than those in the Tortoise. New purchases must have an economic moat, preferably wide. We attempt to tilt the portfolio toward companies with growing competitive advantages (positive moat trends).

Investment Strategy
Morningstar StockInvestor invests in companies with established competitive advantages and generous free cash flows, trading at discounts to their intrinsic values. These are core holdings, with more conservative ideas appearing in the Tortoise Portfolio and more aggressive ideas in the Hare Portfolio. We expect both portfolios to beat broad U.S. stock index benchmarks, such as the S&P 500, over rolling three-year periods.
About the Editor
As editor of Morningstar's StockInvestor newsletter, Matthew Coffina manages the publication's two real-money, market-beating model portfolios — the Tortoise and the Hare. Matt was previously a senior healthcare analyst, covering managed care and pharmaceutical services companies. Matt also developed the discounted cash flow model used by Morningstar analysts to assign fair value estimates to most of the companies in its global coverage universe.

Matt joined Morningstar in 2007. He holds a bachelor's degree in economics from Oberlin College and also holds the Chartered Financial Analyst (CFA) designation.

Oct 30, 2014
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Matthew Coffina, CFA
Morningstar StockInvestor
As editor of Morningstar's StockInvestor newsletter, Matthew Coffina manages the publication's two real-money, market-beating model portfolios -- the Tortoise and the Hare. Matt was previously a senior healthcare analyst, covering managed care and
Featured Posts
Roundup, 10/24/14 -- Weak Demand Hurts Consumer Staples Firms
The "buy the dip" crowd came out in force this week, sending the S&P 500 up more than 4%. Frankly, I'm a little disappointed--I'm in no rush to sell any of our current holdings, and we have some cash on hand (5.9% in the Tortoise, 5.0% in the Hare) that I was hoping to put to work. If you plan to be a net buyer of common stocks, it's only rational to wish for lower prices in the near term. Instead, our opportunity set is starting to thin out again.

In any case, six more Tortoise and Hare holdings reported earnings this week, with mixed results.

Coca-Cola KO
Revenue Growth: 1%
Operating Income Growth: 5%
EPS Growth: 6%

Coca-Cola's third-quarter results were disappointing on a number of fronts. Year-over-year volume growth decelerated to just 1%, compared to 3% last quarter. Pricing was also up only 1%, compared to 2% last quarter. Slowing volume and revenue growth seemed to be a common theme across a number of consumer staples firms in the third quarter, indicating that weak consumer spending is primarily to blame, especially in Europe and emerging markets. However, investors are also wary of secular threats to Coke's volumes--such as increasing health-consciousness among consumers and regulatory actions to counteract obesity--as well as continuing severe currency headwinds. Coke's shares were down 6% on the day of the earnings release, and we trimmed our fair value estimate by $2 per share to $42 based on weaker near-term revenue expectations.

Management also backed away from its long-term revenue growth target while promising more aggressive cost cutting. These two factors offset each other such that constant-currency earnings per share growth is still projected to be in the high-single digits over the long run. However, Coke expects to come in below this target in both 2014 and 2015. Worse, currency headwinds have wiped out most of the recent earnings growth, such that 2015 adjusted earnings per share will probably only be about 5% higher in dollar terms than they were in 2012. Even mid-single-digit annual EPS growth should be enough for Coke to deliver a satisfactory total return to investors, but we need currency headwinds to subside for our investment to work in the long run. Furthermore, we're counting on Coke's elevated price/earnings ratio being sustainable, which is far from guaranteed if investors lose faith in the company's ability to consistently grow revenue and earnings. I plan to hold for now, but I'm starting to question whether Coke's upside potential justifies its expanding set of risks.

General Dynamics
Revenue Growth: 0%
Operating Income Growth: 4%
EPS Growth: 11%

Compared to last quarter's mid-single-digit revenue decline, General Dynamics' flat revenue in the third quarter looks like a victory. Strong revenue growth in aerospace, combat systems, and marine systems was offset by another double-digit decline for information systems and technology. General Dynamics' revenue can be lumpy from quarter to quarter, but I expect more robust top-line growth to remain elusive in the near term as the company battles government spending pressures. On the other hand, growing political instability around the world could cause Congress to rethink the desirability of cuts to the U.S. defense budget. At the very least, the worst of the defense spending headwinds are probably behind us. Furthermore, General Dynamics' expenses remain under control, the backlog is healthy, and the company continues to generate significant cash flow. Management also indicated that it anticipates strong aerospace orders in the fourth quarter as the company will introduce two new jets. We raised our fair value estimate to $121 from $109, which accounts for cash earned since our last update as well as higher long-run revenue and margin expectations. I have occasionally mentioned General Dynamics as a potential source of funds, but after numerous increases to our fair value estimate over the past two years, I'm currently inclined to hold.

Abbott Laboratories ABT
Revenue Growth: 7%
Pre-Tax Income Growth: 24%
EPS Growth: 23%

It was a solid quarter for Abbott, with accelerating revenue and earnings growth due in part to the planned divestiture of the company's developed-market generic-drug business (growth rates above reflect continuing operations). The remaining generics business--with a focus on emerging markets that have more favorable competitive dynamics--should be a solid contributor going forward. The nutrition segment also continues to bounce back from last year's infant formula recalls in China, while diagnostics sales are expanding at a healthy mid-single-digit pace. The only weak spot in the quarter was medical devices, where sales declined slightly because of intense competition, especially in drug-eluting stents. Moving down the income statement, Abbott continues to make progress cutting costs and enhancing its operating margin, which we viewed as one of the firm's biggest opportunities following the spin-off of AbbVie ABBV. Overall, I'm satisfied with the progress Abbott is making, and I plan to hold.

Unilever UL
Revenue Growth: 2%

Unilever only releases full financial results twice per year; after the first and third quarters all we get is a sales update. Unfortunately, the latest sales weren't so hot--constant-currency revenue growth slowed to 2.1% (compared to 3.8% growth last quarter), with volume up just 0.3% and pricing up 1.8%. Similar to Coca-Cola, I believe this reflects an industry-wide slowdown in demand for consumer products--especially in Europe and emerging markets--rather than anything wrong with Unilever itself. China was especially challenging as retailers cut back on inventory in anticipation of weaker consumer demand, leading to a 20% sales decline for that market. The little bit of underlying sales growth that Unilever was able to capture was fully erased by adverse currency movements. On the plus side, management reaffirmed that it expects to gain market share and expand operating margins this year despite the industry headwinds. Furthermore, while international exposure is clearly a liability for consumer staples firms in the current environment, I continue to view it as an advantage in the very long run thanks to superior volume growth prospects. We trimmed our fair value estimate for Unilever by $2 per share to $44 to account for the slowing sales. However, unlike Coke, Unilever is trading at a respectable 11% discount to our latest fair value estimate. As a result, I now consider Unilever my top pick among consumer staples firms, and I'm considering adding to our stake.

Discover Financial Services DFS
Revenue Growth: 6%
Net Income Growth: 9%
EPS Growth: 14%

Discover's stock was down a little more than 5% in the wake of its earnings release, apparently because of concerns about competitive pressure and rising costs next year. However, I was pleased with the third-quarter results. Total loans expanded 7.4% from the prior year--well ahead of the industry average. Discover continues to make progress expanding beyond its core credit card business, with personal loans up 21%.  While net charge-offs deteriorated slightly from the prior year, credit quality remains very strong by historical standards. A handful of operating expense categories rose more quickly than revenue, but this didn't prevent the overall net income margin from improving. Management hinted at modest margin contraction in 2015 due to additional spending on marketing, regulatory compliance, and technology investments. However, I believe Discover's modest price/earnings ratio and strong loan growth leaves room for margins to contract over the next few years, whether through greater credit losses or higher operating expenses. Discover is a possible destination for new money.

PotashCorp POT
Revenue Growth: 8%
Operating Income Growth: 3%
EPS Growth: -7%

PotashCorp continues its gradual recovery from the damage inflicted by the break-up of the Eastern European potash cartel. This was the first quarter in a year that PotashCorp posted positive revenue and operating income growth. Potash volumes were up nearly 29% from the prior year; as expected, farmers can only go so long without applying potash or they risk compromising soil quality and hurting crop yields. While average realized selling prices for potash were still down year-over-year, they once again improved quarter-over-quarter, reaffirming that pricing discipline is returning to the market. Outside of potash, strong performance by the nitrogen segment more than offset weakness in phosphate. PotashCorp's stock has been weighed down in recent weeks by concerns about favorable weather and declining crop prices, which could hurt demand for fertilizer in the next growing season. I view this as a short-term risk; the more important consideration for long-term investors is that potash suppliers are beginning to act rationally again. I plan to hold.


In non-earnings news, the Federal Energy Regulatory Commission called for a hearing to determine a reasonable allowed return on equity for electricity transmission owners in the MISO region. The outcome of this hearing will have a significant effect on ITC Holdings ITC, and we continue to believe that a modest reduction to ITC's allowed returns is likely; this is already incorporated in our $37 fair value estimate. At the same time, FERC rejected a few proposed changes that would have been especially negative for ITC, such as restricting the use of equity in its regulated subsidiaries' capital structures (ITC issues debt at the parent-company level that becomes equity at the regulated-subsidiary level, which boosts parent-company returns on equity considerably) or eliminating certain ROE incentives (ITC is entitled to incentives for being an independent transmission company and for participating in regional transmission organizations). On the whole, FERC's ruling was consistent with our expectations and greatly reduces the risk of a major adverse regulatory outcome for ITC. ITC remains a core long-term holding for the Tortoise.

A new analyst took a fresh look at Compass Minerals CMP and raised our fair value estimate to $90 per share from $87. I continue to believe that the sell-off in Compass' shares since the seasonally-weak second-quarter earnings report was unfounded. Improved pricing in the most recent bidding season for highway deicing salt sets the stage for significant earnings growth in the upcoming winter. Weather remains the primary source of uncertainty for Compass, so shareholders should be rooting for another cold, snowy winter in the Midwest. Although weather is unpredictable, this risk factor has little correlation (or even a negative correlation) with our other holdings, which makes Compass a valuable diversification tool. I plan to hold.


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

Coca-Cola KO  |  Adam Fleck, CFA

We are likely to trim our $44 fair value estimate for wide-moat Coca-Cola about $1 or $2 to reflect near-term concerns, but overall we believe the company’s revisions to its 2020 vision only delay rather than prevent the long-term high-single-digit earnings growth potential of the business.

The firm reported top-line challenges in its third quarter, with adjusted 1% year-over-year revenue growth reflecting slowing price/mix and volume growth and further foreign currency headwinds. We're encouraged that the company continued to enjoy positive, rational pricing in the core North American sparkling beverage market, and that profitability again improved, but we caution that further top-line headwinds look to threaten this year-over-year margin improvement in the fourth quarter. As such, we continue to forecast Coke’s adjusted earnings per share (including negative currency translation) to be roughly flat versus 2013. Similarly, management estimates that currency-neutral 2015 EPS growth will also be in a mid-single-digit range.

That said, the company reiterated its long-run high-single-digit EPS growth target, which is in line with our own forecast, though the structure has changed slightly. The firm now expects net revenue growth in the mid-single-digit range (versus about 6% previously). Although we believe our current long-run 5.5% forecast captures the new guided midpoint, we will probably lower our projections given continued top-line uncertainty.

Mitigating this factor, management also extended its annual savings target to $3 billion by 2019 (and $2 billion by 2017) from a prior expectation of $1 billion by the end of 2016. These updated initiatives include restructuring the firm’s North American manufacturing footprint and streamlining operations for additional back-office cost savings. While some of these savings will be reinvested into the business, we nonetheless expect slightly higher long-term operating margins than we previously forecast.

In all, we think management is working to control what it's able given the low-growth environment of nonalcoholic beverages, but we’re also encouraged that the firm will install revenue growth targets as a measurable goal for incentive pay. Local managers will be measured on both a volume and price basis, depending on geography (skewed more toward price for developed markets and more toward volume for emerging ones). While growing at a profitable rate will remain Coke's ultimate goal, we believe setting up top-line goals also incentivizes the company’s management to be proactive with bottling partners, and to spend marketing dollars more effectively (an area of recent focus).

Beyond focusing on owned operations, Coke also moved its 6%-8% long-term earnings growth goal to focus on earnings before taxes rather than operating income. While some critics may surmise that this alteration implies interest expense engineering will drive much of the growth, we believe instead that the move is meant to capture increasing equity income, which is slated to climb materially as the firm increases its partnership with Monster Beverage (which will remove energy drinks from Coke's consolidated operations); in fact, we wouldn't be surprised to see additional similar partnerships struck over the coming years.

In the near term, however, Coca-Cola noted that cash flow is likely to be a bit softer than originally expected at the beginning of the year largely because of negative currency translation, and the company now targets repurchasing approximately $2.5 billion of shares--at the low end of its prior guidance. Because we view shares as currently undervalued, we'd prefer to see increasing levels of buybacks.


Unilever UL  |  Erin Lash, CFA

While Unilever’s third-quarter trading update marked a retreat for a fairly consistent operator, we don’t suspect this indicates a deterioration in the firm’s brand intangible asset (which in combination with its cost advantage form the basis of our wide moat). We’re modestly adjusting our fair value estimates for the firm’s shares to EUR 33 per share (from EUR 34), $44 per ADR (from $46), and GBX 2,863 (from GBX 2,758) to reflect a slight pullback in our expectations for the firm’s fiscal 2014 top-line performance; however, we’re holding the line on our long-term forecast (which calls for nearly 5% annual sales growth and operating margins just shy of 16%). With shares trading at a modest discount to our valuation, we’d suggest investors keep this wide-moat name on their radar.

Organic sales ticked up just 2.1%, almost entirely driven by price (up 1.8%) as volumes were lackluster (up just 0.3%). Despite this, we don’t believe Unilever has wavered from its commitment to bring value-added new products to market. Rather, a portion of this pronounced slowdown reflects trade destocking in Chinese hypermarkets, driving sales in the country (which represents about EUR 2 billion in annual sales or 4% of its total) down a whopping 20%. While this is far from a positive, management stressed this wasn't reflective of consumer demand. However, we note emerging markets (57% of sales) have decelerated over the past few quarters (increasing just 5.6% in the past three months, down from 9% in 2013). As we've highlighted, emerging-market consumers spend a disproportionate amount of their income on food (in some case close to half, where prices have trended higher partly because of increased protein and dairy costs), leaving them less to spend in other categories. Further, developed markets (down 2.5% in the quarter) are likely to remain challenging, as price competition (among retailers and manufacturers) persists in both Europe (down 4.3%) and North America (up a mere 0.6%).

Personal care (up 3%) and home care (up 5.7%) drove the bulk of Unilever’s sales in the quarter, as food (down 0.5%) and refreshments (up 0.5%) were again muted. The majority of this weakness reflects declining margarine category sales and soft ice cream performance in Europe, as the summer weather was particularly cool. Improving its spread brands has been a focus for Unilever’s management group for the past 18 months, and while the firm cites improving category share as evidence its investments are working, we ultimately question whether Unilever could look to shed this underperforming business given its penchant to trim its food portfolio in order to focus its resources on the highest return opportunities. Ultimately, we expect Unilever will continue to actively manage its brand portfolio in line with actions taken over the past six years, during which the firm shed EUR 2.5 billion in sales (mostly food brands), while completing nearly EUR 3 billion in acquisitions (primarily in personal care).


Discover Financial Services DFS  |  Jim Sinegal

Discover’s third-quarter results--including annual loan growth of 7.4%--support our thesis that the company is well-positioned to take share in the online banking market, and we are maintaining our fair value estimate. However, increasing costs due to two previously identified trends in the card and banking industries overshadowed positive developments.

First, rewards competition continued to increase, with reward costs up 11% during the year to $304 million, exceeding a 9% increase in interchange revenue. Management mentioned that competitors are offering uneconomic levels of rewards in order to gain customer loyalty, and Discover plans to take a charge of up to $185 million in the fourth quarter as it essentially eliminates forfeiture mechanisms in its rewards program. We expect this trend to continue as card issuers fight for both spending volume and customer relationships.

Second, an increasing compliance and regulatory burden is taking a toll on the company's ability to limit the growth of expenses--a trend witnessed at most of the banks we cover. Discover is simultaneously investing for growth to a larger extent than some peers--compensation expenses rose by $28 million during the year to $320 million and marketing expenses grew by $8 million to $182 million.   

In addition to healthy card balance growth, personal and private student loan balances expanded at a 20.9% and 23.1% pace, respectively, over the past 12 months. In our view, the private student loan business is a source of risk--student loans now make up the second-largest component of U.S. household debt. However, exposure is limited at 12% of Discover's loan portfolio.

Deposit growth totaled 5% during the year, although brokered deposits accounted for most of the growth with direct-to-consumer deposits remaining flat. Management attributed the change to an active repositioning of the customer base in anticipation of higher interest rates--a reasonable explanation, in our view.


General Dynamics GD  |  Neal Dihora, CFA

We are raising our fair value estimate for General Dynamics to $121 per share from $109 because of the time value of money and higher future sales and margin estimates. The firm posted flat sales for the third quarter but expanded operating margins by 50 basis points to 12.9%. Sales were stronger than our model, resulting from strength in all segments except IS&T. The margin improvement was driven by aerospace and IS&T. Earnings per share of $2.05 were higher by 11% than last year. The company repurchased around 28.9 million shares in 2014, or more than 8% of year-end 2013 share count. General Dynamics continues to show the power of its economic moat. General Dynamics raised its 2014 EPS to $7.60-$7.70 (versus $7.40-$7.45 provided last quarter).

Aerospace sales increased 6% and posted an 18% operating margin, with deliveries of 38 green and 31 outfitted aircraft, versus 34 and 38, respectively, in the year-ago period. Combat sales were up 7%, and margins were down 90 basis points to 16.6%. Sales in the long-cycle marine segment rose by 7%, but margins declined by 70 basis points to 9.3%. Marine is transitioning production to the next Virginia-class submarines block and starting work on commercial ships, dampening margins. Sales in information systems and technology fell 12.9%, but margins improved 60 basis points to 9.0%.

General Dynamics likely hit a bottom for defense sales during the third quarter. Backlog grew strongly to $74 billion from $46 billion at year-end 2013. Orders of nearly $51 billion so far in 2014 establishes a base of work for the future and a potential bottom of its defense business. This was the highest total backlog ever at General Dynamics. With the benefit of incumbency and a highly relevant product lineup, General Dynamics is in a strong position to endure and drive shareholder value.


Abbott Laboratories ABT  |  Debbie S. Wang

We were heartened to see Abbott make progress on profitability in the third quarter; the firm is on track to meet our full-year projections, and we are leaving our $44 fair value estimate and narrow moat rating in place. By wringing out roughly 400 basis points in manufacturing and operational costs, Abbott pushed its quarterly operating margin up to 14%, offsetting weaker earnings growth from earlier this year.

Abbott delivered respectable growth across most of its businesses, but vascular devices stood out as a weakness. In particular, we like how Abbott has been recovering from its pediatric nutritional recall in China last year, and expect further expansion of manufacturing facilities in Asia to help Abbott take advantage of increasing demand in that part of the world. Additionally, we were impressed with the double-digit growth of the reconfigured established pharmaceuticals segment. Now that the branded generics business in mature developed markets is being sold to Mylan, Abbott is set for robust growth focused on the emerging markets. While we do not expect that 13% growth is sustainable over the longer haul, we have projected 8% steady-state growth for this segment.

Finally, Abbott's vascular segment was the evident black eye in the third quarter, and looks to be set for a third consecutive year of decline. Although the market for drug-eluting stents (DES) has been lackluster for several years thanks to more clinical evidence suggesting overstated clinical benefits, competitors such as Boston Scientific and Medtronic have been better able to navigate choppy waters with new innovation.  Indeed, Boston's third-quarter DES sales rose 8% on the strength of its new Promus Premier. It is not clear how Abbott will restart growth in this segment since earlier hopes for the adoption of MitraClip and ABSORB have not yet panned out. We would not be surprised if Abbott acquired new vascular technology to shore up its DES franchise.


PotashCorp POT  |  Jeffrey Stafford, CFA

Our U.S. dollar fair value estimate for PotashCorp remains unchanged at $41 per share after the company released its third-quart results. Our Canadian dollar fair value has increased to CAD 46 per share from CAD 44 on currency fluctuations since our last update. Our wide moat rating, based on cost advantages, remains intact.

With a return to normal buying patterns (Uralkali's temporary strategy shift weighed on volumes last year), potash volume jumped 28.5% compared with the prior-year period. This brings volume growth to 8.1% through the first nine months of the year. We forecast annual 2014 potash volume growth of 11.5%. Over the long run, we expect volumes to expand significantly as the company fills capacity that it has built over the past few years. In the meantime, this extra capacity serves as deterrent to expansion projects from other potential players, most notably BHP Billiton and its Jansen project in Saskatchewan. Our outlook for the eventual filling of PotashCorp's new capacity is influenced heavily by our forecast for emerging-market food consumption. In particular, we expect strong caloric intake growth in India and sub-Saharan Africa over the next decade.

Potash pricing was down 8.4% year over year, but up 6.7% sequentially from the second quarter. We think potash prices bottomed earlier this year, and we expect modest pricing growth from here, based on our outlook for supply and demand. With Uralkali looking like it will revert back to a price-over-volume strategy over the long run, we expect potash prices to remain above marginal costs of production, due to the cartel-like structure of the industry.


ITC Holdings ITC  |  Charles Fishman, CFA

The Federal Energy Regulatory Commission's decision to reject certain aspects of a Section 206 complaint in the Midcontinent Independent System Operator region is a positive development for wide-moat ITC Holdings. In November 2013, an industrial group asked FERC to cut the MISO region’s base ROE to 9.15% from 12.38%. We reiterate our assumption that FERC will reduce ITC's allowed ROE, but not to the level requested.

We are reaffirming our stable moat trend and $37 per share fair value estimate, which assumes ITC's weighted-average consolidated ROE falls to approximately 12% in 2018 from an estimated 13.1% in 2013. The FERC order increases our confidence that ITC can achieve this level of return.

The FERC order allows ITC to continue using higher equity at its operating subsidiaries and holding company leverage, which boosts consolidated ROE. The complaint asked FERC to lower the assumed equity component of operating subsidiaries to a maximum of 50%.

The FERC decision also upheld the 50-basis-point ROE adder ITC receives for being a member of MISO and the 100-basis-point adder for being an independent transmission company. We expect the final decision or settlement will be similar to the June ISO New England FERC initial order (recently finalized) and will cap the total ROE at the upper end of the zone of reasonableness. In the New England decision the upper end of the zone was 11.74%.


Compass Minerals CMP  |  Jeffrey Stafford, CFA

We’re transferring coverage of Compass Minerals and raising our fair value estimate to $90 per share from $87. Our wide moat rating and stable trend remain intact.

Compass Minerals is undervalued but not trading at a steep discount. Opportunities could arise with a mild winter. For now, shares offer a place of refuge in a materials sector that we expect to remain under pressure as China's investment-led growth model falters. Durable cost advantages in salt and specialty fertilizers afford Compass Minerals a wide economic moat, a rarity in the commoditized basic materials sector. The firm not only controls world-class geologic assets, but they are also close to key markets--a prerequisite for outsize returns in salt, which is a very regional market because of its low value/weight ratio. In fertilizer, Compass controls one of three salt brines in the world that currently produces sulfate of potash, a specialty fertilizer used on high-value crops. More importantly, the firm's brine-based production method is low-cost.


PepsiCo PEP  |  Adam Fleck, CFA

We plan to maintain our $90 per share fair value estimate for PepsiCo after reports that it will partner with SodaStream in the U.S. to test the potential for in-home versions of Pepsi’s products. The magnitude of such an offering would probably be minimal in the near term; SodaStream’s installed base in the U.S. is only about 1 million-2 million households, with revenue of about $200 million in 2013—only half a percent of PepsiCo’s U.S. sales last year.

Nonetheless, we think investment in this area makes strategic sense. We view the target consumer base as preferring convenience over price, as the upfront costs of a SodaStream product, combined with required carbonation cartridges and flavor additives, compare unfavorably to alternatives such as 2-liter bottles of soda. As such, we believe Pepsi can capture outsized pricing, which should be a high-margin opportunity.

We also partly attribute SodaStream’s minimal penetration to a lack of notable brand partners. Keurig Green Mountain reports an installed base of a much-higher 23 million hot-brew systems and has partnered with a wide variety of major-label providers. Given the brand strength that we think powers Pepsi’s wide economic moat, we anticipate the availability of its products on SodaStream’s platform could help to reinvigorate the in-home category.

Finally, we believe Pepsi (and Coca-Cola, which has partnered with Keurig on an in-home system for launch in 2015) views the in-home market as a potential runway for growth that won’t cannibalize its existing customer base. Health concerns have been a major driver behind declining U.S. soda consumption, and SodaStream often cites the health benefits of in-home brewing; we believe consumers already using the product are probably not also purchasing high-calorie branded sodas. As such, to target this market, Pepsi will launch flavors such as Pepsi Homemade, which will be naturally sweetened and not available in other retail forms, according to Beverage Digest.


CME Group CME  |  Michael Wong, CFA, CPA

We see BGC Partners' $5.25 all-cash tender offer for GFI Group shares as a win-win situation for each company. We also continue to believe that the expense and capacity rationalization after a merger of the two companies should be positive for others in the interdealer-broker industry, such as ICAP. That said, while the other party in this drama, CME Group, has ample capacity to increase its prior $4.55 per share offer for GFI Group, CME’s management would have to be able to see greater upside optionality in expanding its reach into Asia and European energy markets than BGC Partners perceives in the more concrete benefits associated with merging two similar businesses. We don’t anticipate making any material changes to our fair value estimates or moat ratings for these companies.

The outcome for BGC Partners is positive whether it ultimately acquires GFI Group or not. If an acquisition occurs, operational synergies should either make the deal value accretive to BGC or at least buffer the downside if it turns out BGC overpaid. In the event that CME increases its bid, BGC Partners already owns 13.5% of GFI Group, so BGC will be able to book a nice gain on its investment.

As our stand-alone fair value estimate for GFI Group of $3.80 per share is below both CME Group's and BGC Partners’ offers, we believe either deal is desirable from a GFI Group shareholder perspective.


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