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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 invested in accordance with a strategy that seeks to focus on companies with stable or growing competitive advantages. David served in several senior research and product development roles and was part of the editorial team that created and launched He was the co-inventor of Morningstar's first investment advice software.

David joined Morningstar in 1994. He holds a bachelor's degree in biology from Skidmore College and a master's degree in biology from the University of Illinois at Springfield.

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Mar 17, 2018
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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
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Roundup 3/16/2018 -- MLPs Get FERCed Around

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.

Yesterday, the Federal Energy Regulation Commission announced that it would no longer allow master limited partnerships to recover a specific income tax allowance. It was subsequently a rough trading day for MLPs, though many did recover somewhat from their intra-day lows. However, Morningstar believes that Thursday's market reaction was somewhat overblown. Stephen Ellis, a sector strategist for Morningstar Research Services, wrote:

Despite the elimination of the double-recovery benefit, the MLP model remains sound, as taxes are still passed through to unitholders. FERC's action merely eliminates a loophole that allowed MLPs to benefit twice from taxes. This has been debated in FERC filings and court cases going back more than a decade. Given the considerable number of pipelines that appear to be underearning their allowed rates, we think pipeline owners might already have anticipated FERC's move.

His full analyst note is included below, along with a new analyst note about Enbridge ENB and the MLPs under its corporate umbrella.

The MLPs held in the Tortoise portfolio -- Enterprise Products Partners EPD and Magellan Midstream Partners MMP -- both gained ground today, although both closed below their opening prices from Thursday. Their two-day losses, however, were modest: Enterprise is down 1.4% for the past two days while Magellan lost 2.2%.

While Enbridge, a Hare portfolio holding, is not an MLP, it is the corporate parent of Spectra Energy Partners SEP and Enbridge Energy Partners EEP and it was also hit hard on Thursday. Today's closing price represents a 5% decline for the past two trading days. In Enbridge's case, however, the negative impact on its U.S. operations due to the new FERC policy would likely be mostly offset by positive implications for its Canadian operations.

All three firms quickly issued reactions to the FERC decision.

From Enterprise Products Partners: "We do not expect the revisions to the FERC's policy on the recovery of income taxes to materially impact our earnings and cash flow."

From Magellan: "Although Magellan is organized as an MLP, it does not have cost-of-service rates that would be directly impacted by this policy change."

From Enbridge: "does not expect a material impact to its previously disclosed financial guidance over the 2018-2020 horizon as a result of the Federal Energy Regulatory Commission (FERC) revised policy statement on interstate pipeline tax allowance recovery in Master Limited Partnerships (MLPs) nor from FERC's Notice of Proposed Rule-Making (NOPR)." Enbridge also plans to challenge the proposed policy change.

While Morningstar believes the market overreacted to this policy change, Morningstar analysts are reviewing their valuation models for each of the affected firms, with an eye toward potential small changes to their fair value estimates.

Also below are new Morningstar analyst notes for Sanofi SNY and Unilever UL.

Best wishes,

David Harrell,
Editor, Morningstar StockInvestor

Policy Changes Won't Dent Midstream Moats
by Stephen Ellis | Morningstar Research Services LLC | 03-16-18

A D.C. Circuit Court decision prompted the Federal Energy Regulation Commission, or FERC, to propose policy changes on Thursday that could have a negative impact on our midstream coverage. The policy changes could eliminate MLPs' ability to recover a tax allowance, potentially leading to lower tariffs, revenue, and earnings.

We are reviewing Williams Partners, Enbridge, Enbridge Partners, Energy Transfer, and Spectra Energy Partners for potential modest fair value estimate cuts. The relative winners here are corporations and market-based pipelines, primarily NGLs and refined products partnerships where the agreements are negotiated between child and parent. However, we don't plan any moat changes for the industry. We reiterate that investors should be purchasing the highest-quality midstream firms that are deeply undervalued, including Enterprise Product Partners, Spectra Energy Partners, Enbridge, and Plains All American Pipelines and its general partner.

For natural gas pipelines that charge cost-of-service rates at maximum allowed levels, we expect a drop in EBITDA approximating 1%-5%. We expect a similar potential impact for oil pipelines operating under an index rate methodology. However, with the exception of Williams Partners, we believe many pipelines are actually underearning their allowed rates, meaning there will not be a material impact. Many pipelines charge negotiated or settled rates that also would not be impacted.

Despite the elimination of the double-recovery benefit, the MLP model remains sound, as taxes are still passed through to unitholders. FERC's action merely eliminates a loophole that allowed MLPs to benefit twice from taxes. This has been debated in FERC filings and court cases going back more than a decade. Given the considerable number of pipelines that appear to be underearning their allowed rates, we think pipeline owners might already have anticipated FERC's move.

The circuit court ruled FERC's discounted cash flow methodology used to set MLPs' pipeline tariffs is a pretax return, thus MLPs should not receive an additional tax allowance since they don't pay corporate taxes. In the proposal, FERC is requiring pipelines to file updated costs, self-implemented rate reductions, or justification for maintaining current tariffs after accounting for lower tax allowances.

Companies with the most potential exposure such as Energy Transfer and Spectra Energy Partners have said the impact will be limited because they have negotiated rates or are underearning their allowed returns for most of their portfolios. We expect them to challenge the FERC proposal and submit financials that show their cost-of-service rates are underearning allowed returns.

Given the effective elimination of the tax allowance for MLPs, down from the already lowered 21% in 2018, we anticipate the potential for material earnings charges this year. The potential offset that could lower the charges substantially would be the pipeline owner's estimate of costs that would be recovered (the underearning portion of the formula), which would differ by pipeline and operator and could lead to a elimination of the charges, or an potential modest boost in EBITDA. Given the moaty nature of the pipelines involved as well as the negotiated and black box nature of some rate settlements, it is also very likely that pipelines will be able to retain a portion of the tax allowance.

For Williams in particular, as it charges the highest allowable tariffs across its natural gas pipelines, we anticipate the greatest impact. Williams disclosed a $713 million charge or $36 million annually if we assume a 20-year amortization period with the initial reduction in the tax rate to 21%. Doubling the impact to $72 million as a conservative estimate would only still be around 1.6% of our 2018 $4.5 billion EBITDA forecast.

FERC has also ordered that this policy will be reflected for oil pipelines on indexed rates (which are a separate rate methodology than cost of service) via an index pricing change beginning in 2020. This would primarily affect Magellan Midstream Partners, as 40% of its refined product pipelines operate under indexed rates. However, Magellan has indicated that even if the tax allowance is reduced to 0%, its pipelines are still underearning. For pipelines that are not underearning, we estimate a potential 14% fee reduction holding all else equal that would have to be offset by higher industry costs and the moat of the pipelines involved. This suggests a range of a decline in the 5%-10% range, in our view.

The relative winners here are corporations and market-based pipelines, primarily NGLs and refined products partnerships where the agreements are negotiated between child and parent. Corporations (primarily general partners) won't see a tax benefit with this change but will see a reduction in cash flows from its child MLP. However, we don't anticipate the tax allowance would impact the tax-free periods the corporate general partners such as Oneok, Williams, Targa, and Plains have already outlined, which can be more than a decade in some cases. This also supports our view that most MLPs are unlikely to consider a switch to a corporate model.

Pipelines that operate under a market-based pricing model would not be directly affected though market rates would likely naturally adjust over time to balance out any impact. This would primarily include NGL pipelines. On a relative basis, this would favor NGL-oriented partnerships such as Oneok and Enterprise Product Partners, and refined product MLPs that operate under market-based rates such as Valero Energy Partners and Phillip 66 Partners.

FERC Rate Proposal Hits the Enbridge Family but Market Reaction Overblown
by Joe Gemino, CPA | Morningstar Research Services LLC | 03-15-18

The Federal Energy Regulation Commission on Thursday proposed policy changes that could eliminate energy master limited partnerships', or MLPs', double recovery of income taxes, causing Enbridge and its family of MLPs to drop sharply. The proposed changes could lead to lower earnings and cash flows for Enbridge Energy Partners and Spectra Energy Partners. We expect to cut our fair value estimates modestly for all three entities.

However, we believe the negative impact will be limited. Some of the partnerships' pipelines are underearning their FERC allowed returns based on current tariffs or have negotiated rates that likely would not change. We expect Enbridge Energy Partners and Spectra Energy Partners to make rate filings later this year that will show which tariffs are most at risk. We believe wide moat pipelines companies like Enbridge and SEP should feel the least impact because of the high demand for capacity.

The impact on the liquids pipeline will be minimal for parent Enbridge but could be large for EEP. Half of the Lakehead system operates under a cost-of-service arrangement and could face significantly lower tolls. The lower toll will result in an equal and offsetting increase to the Canadian Mainline as part of the International Joint Tariff on the Mainline.

For SEP, half of its gas pipeline revenue is based on negotiated tariffs that likely would not change. The other half of revenue could drop due to rate cuts under the revised FERC policy. However, we estimate some of those pipelines with cost-of-service rates are underearning their allowed returns and tariffs would not change even with the tax allowance eliminations.

Enbridge plans to challenge the proposed FERC policy. If Enbridge's challenges fail, we think it would convert SEP and EEP to C-corporations so that they could continue collecting tax allowances in their cost-of-service rates. As C-corps, FERC's proposed policy would have no impact on cash flows for any of the entities.

Sanofi and Regeneron Report Strong Praluent Data, Supporting Our Above-Consensus Projections
by Damien Conover, CFA | Morningstar Research Services LLC | 03-12-18

Sanofi and Regeneron announced positive outcome data for their partnered cardiovascular drug Praluent, supporting our above-consensus sales estimate for the drug and undervalued stock call for Sanofi and slightly undervalued stock call for Regeneron. We had expected the positive data, so we don’t expect any major changes to our fair value estimates for the companies. Further, the solid data reinforces both companies' moats by strengthening the value of a key drug in their portfolios.

In the large Odyssey study, Praluent statistically significantly reduced the risk of MACE (the primary endpoint based on a composite of heart attack, ischemic stroke, death from coronary heart disease, or unstable angina requiring hospitalization) by 15% (similar to the benefit seen from Amgen’s Repatha in a different outcomes study of slightly less sick patients) with a strong p-value of 0.0003. The study also showed that Praluent caused a reduction in all-cause death. In the patient population with LDL cholesterol above 100 mg/dL, the reduction in all-cause death was an impressive 29%. Importantly, no significant safety signals were seen across the study of almost 19,000 patients. At the American College of Cardiology meeting, where the data was presented, 62% of the doctors surveyed stated they would change their prescribing habits because of the data.

Unilever's Corporate Restructuring Neutral to Valuation; We Remain Constructive on Margin Expansion
by Philip Gorham, CFA, FRM | Morningstar Research Services LLC | 03-15-18

We do not believe Unilever's decision to rationalize its equity structure into a single legal entity, to be based in the Netherlands, is material to the company's valuation, and we are reiterating our EUR 52 fair value estimate of the Amsterdam-traded shares. Unilever's beauty and personal care and home care divisions will remain located in London, and the firm will maintain its listings in the U.K. and the U.S.

There are several reasons why the decision to locate the single headquarters in the Netherlands is not surprising. First, the Dutch share class is more liquid and represents a higher proportion (around 55%) of the total share capital. Second, Brexit makes access to the European common market for U.K. companies uncertain. Third, Britain has taken a relatively laissez-faire attitude to foreign takeovers in recent years, and the acquisition of Cadbury by Kraft in 2010 is an example of one of Britain's consumer product crown jewels falling into the hands of foreign ownership. Having itself been a target for the now enlarged Kraft Heinz last year, we suspect Unilever likely regards the relocation of the legal entity away from Britain as an added bonus in its takeover defenses.

Overall, however, we regard this as essentially a nonevent from a valuation perspective, and we remain constructive on Unilever. The company's restructuring of the business to allow resources to flow more freely to local markets gives us conviction that management is making the right steps to reignite growth in an environment of sluggish real wage growth and increasing consumer apathy to consumer product brands. Unilever's wide moat is intact because it has the resources to defend its shelf space and its position as a preferred vendor in mainstream channels. With around 20% upside to our fair value estimate, we believe the shares are approaching an attractive margin of safety.


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All Morningstar Stock Analyst Notes were published by Morningstar, Inc. The Weekly Roundup contains all Analyst Notes that relate to holdings in Morningstar, Inc.'s Tortoise and Hare Portfolios. Morningstar's analysts are employed by Morningstar, Inc. or its subsidiaries.  In the United States, that subsidiary is Morningstar Research Services LLC, which is registered with and governed by the U.S. Securities and Exchange Commission.

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

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