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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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Matthew Coffina, CFA, is the portfolio manager for Morningstar Investment Management LLC’s Hare strategy. 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.

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Prior to joining Morningstar in 2004, Michael worked at a public accounting firm and in the business lending arm of a major commercial bank. He has an undergraduate accounting degree from Loyola Marymount University, an MBA from Cornell University and is a CFA charterholder.

Jun 27, 2017
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David Harrell
Editor, Morningstar StockInvestor
David Harrell is the editor of the Morningstar StockInvestor, a monthly newsletter that focuses on a wide-moat stock investing strategy. For illustration purposes, issues highlight activities pertaining to Morningstar, Inc. portfolios
Featured Posts
Roundup 6/23/2017 -- Strong Quarters for CarMax and Oracle

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

Please see new Morningstar analyst notes below for CarMax KMX, Oracle ORCL, and Visa V. In addition, several Tortoise and Hare holdings were tagged in general notes on bank stress tests, interest rates and banks, defense firms, the U.S. Senate's healthcare bill, and new home construction. These notes are also included below.

Best wishes,

David Harrell,
Editor, Morningstar StockInvestor

CarMax Starts Fiscal 2018 Off With Robust Comps
by David Whiston, CFA, CPA, CFE | Morningstar Research Services LLC | 06-21-17

CarMax reported a strong start to fiscal 2018 in its first quarter numbers, but we do not see any reason to change our moat rating or fair value estimate at this time. Diluted EPS grew by 26% year over year to $1.13, easily beating consensus of $0.98. Comparable store revenue grew 6.1%, while comparable store unit volume rose by a healthy 8.2%. Management cited strong conversion rates of in-store traffic as well as payoffs from search engine optimization work bringing customers in who are more likely to buy as reasons for the growth. It also cited the delay in federal tax refunds likely moving some business to fiscal first quarter from fiscal 2017's fourth quarter.

The auto investing world has had much concern this year over falling used vehicle prices and discounting of new vehicles, but we are not seeing a severe negative impact from either of these factors on CarMax's results. Management went out of its way on the earnings call to stress that a mix shift to younger vehicles seeing price declines at retail is being offset by lower acquisition costs for these vehicles at auction and via offers to consumers in CarMax stores. Average selling prices for vehicles retailed fell by 1.9% year over year, and CarMax's auction business saw a 2.9% decrease. The company's advantage in big data helps it price more efficiently than other used vehicle retailers (one reason we give the firm a moat), and once again management kept used vehicle gross profit per unit at a healthy rate and more than offset the decline in selling price. Used vehicle gross profit per unit increased by only $10 year over year to $2,212, but used vehicle gross margin increased by 20 basis points to 11.2%.

The key metric, however, is volume because it helps the company increase its scale. Total unit volume rose 14.1%, which, along with lower stock compensation, enabled it to lower its SG&A as a percentage of revenue by 30 basis points to 8.9% and lower SG&A per used vehicle sold by 7% to $2,066.

CarMax Auto Finance continues to see small declines in its interest margin, which fell 10 basis points to 5.8%. Average managed receivables growing 11.1% to $10.83 billion helped offset the margin compression and a 7.5% increase in the loan loss provision. The allowance for loan losses reached 1.18% on May 31, which isn't drastically higher than 1.05% in fiscal first-quarter 2017. First quarter originations rose 7.1% to $1.5 billion, and total CAF income increased 8.5% to $109.4 million. Management did buyback 3,000,000 CarMax shares in the quarter (for $182.1 million) and has $1.4 billion remaining under an authorization that does not expire. We model $400 million of buyback spending for fiscal 2018.

Oracle Keeps it SaaS-y in Fourth Quarter, but We Still Have Questions About IaaS Strategy
by Rodney Nelson | Morningstar Research Services LLC | 06-21-17

Oracle closed its fiscal 2017 on a high note as the company continues to execute on its transition to the cloud. Software-as-a-service revenue continues to grow at a meteoric pace, aided in part by the recent NetSuite acquisition. Still, Oracle's limited capital expenditure profile gives us pause about the legitimacy of their public cloud offering for infrastructure-as-a-service, or IaaS. We are maintaining our wide economic moat rating, and after incorporating management's guidance and a modestly lower tax rate, we are raising our fair value estimate to $46 per share, from $40 previously. Shares are rallying more than 10% on the back of these results, and we would wait for a better entry point before investing in the name.

Fourth-quarter GAAP revenue rose 2% year over year to $37.7 billion, driven primarily by SaaS growth. SaaS revenue continues to grow at an elevated clip, rising 67% versus the prior-year period to $964 million. Although the contributions from SaaS remain relatively minimal compared with the broader Oracle business, we are encouraged to see this segment working to offset long-term declines in software license sales and, eventually, maintenance revenue from those licenses. Although we do not expect Oracle to return to the 40%-plus operating margins it once enjoyed as a solely on-premise vendor, the company saw minimal margin contraction in the fourth quarter (roughly 10 basis points).

Although Oracle has visions of competing with the likes of Amazon and Microsoft in IaaS, we have a hard time reconciling the firm's modest capital investment profile that we deem a prerequisite for scaled competition. While these firms pour billions of dollars into building out global infrastructure, Oracle expects its total capital investments to shrink next year well below the $2.2 billion spent in fiscal 2017. We ultimately believe Oracle will struggle to compete effectively in this market, limiting the amount of revenue scale the firm can achieve.

Visa's Plans to Propagate Payments and Serve Sellers Support Our Bullish Thesis
by Jim Sinegal | Morningstar Research Services LLC | 06-22-17

Visa's 2017 investor day supported our bullish thesis on the company. In our view, the company's wide economic moat remains intact. The combination of a massive global network of financial institutions, merchants, and customers is extremely difficult to replicate, and the intangible asset associated with the company's brand is as strong as ever--security and ubiquity arguably become even more valuable as digital payment methods proliferate. At the same time, the firm has a long growth runway ahead as electronic spending grows. We view the company's stock as attractive relative to our $108 fair value estimate.

We have three main reasons for increased optimism regarding Visa's future following the company's investor day. First, Visa is addressing merchant needs by investing in new value-additive services in the realms of marketing, loyalty, and analytics. Second, Visa is skillfully partnering with potential competitors from Android to Amazon to maintain its position in the payment value chain. Third, we believe the company is more aggressively using its scale to compete, leveraging the numerous fixed costs of the network business across double the payment volume of its largest competitor.

The themes of this year's investor day also reinforced our bearish thesis on payment hardware providers. Visa is intent on extending payment capability to any connected device in the Internet of Things, which will render traditional payment hardware obsolete.  The company is planning to digitize the point-of-sale in both developed and emerging markets, eventually eliminating cards and point-of-sale devices.

Long-term growth prospects for digital payments remain bright. Global consumer spending growth and the decline of cash (including the relative growth of e-commerce) ensure that the market for the company's services will grow at a healthy rate for years to come. In fact, Visa's new efforts in the business-to-business and government-to-consumer markets may eventually open trillions of dollars in potential processing volume. The digital transition will also add millions of nodes to the network as any connected device will eventually be able to both send and accept payments. On a related note, both Visa and its major competitors are focused on attacking cash rather than competing for share of electronic payments. Visa now processes roughly $7 trillion in payment volume annually--management identified an additional $17 trillion in cash and check spending and $30 trillion in new customer segments as potential drivers of future growth.

Visa was owned by issuers for much of its history, but its relationship with merchants has often been tumultuous. We think the company is addressing these issues by helping merchants acquire and maintain relationships with customers. Visa is expanding its range of merchant and issuer services--some of which utilize the massive amounts of data the company gathers -- to both grow revenue and increase its attractiveness relative to competitors. Some efforts have helped to build the Visa network as well as increase merchant sales -- the company's investment in Square and its mVisa terminal-free acceptance technology in India are good examples. The Visa Commerce Network enables rewards, while its advertising solutions also help merchants reach customers. The company is also using its ability to provide ancillary services to offset price competition in routing. We think Visa's efforts in this realm are aligned well with merchants' desire to connect more closely with customers and add value to the payment process.

Interest in payments from firms outside the financial sector has grown in recent years, creating new competitive threats. On this front, too, we think Visa is skillfully working to maintain its position as a key intermediary. We note that potential competitors continue to utilize Visa's services rather than go it alone. Apple Pay uses network rails and both Android Pay and Samsung Pay are adopting Visa Checkout. PayPal has agreed to effectively stop competing with Visa by steering customers to ACH or other payment methods. Visa's token technology can also enable payments through a variety of merchant applications. These partnerships -- and Visa's open business model -- have muted the threat of competition to some extent.

Finally, we think Visa's scale is becoming a more important source of competitive advantage. The company's network is most relevant on a global scale and for cross-border transactions, while competition can be fierce at a local level. However, few domestic networks can rival Visa's spending on technology. As customers focus more on cost, Visa can also leverage its scale -- extremely price-conscious customers like Costco and Amazon may find that Visa is the most cost-effective processing choice.

We Prefer Banks With Individual Issues to Rate-Sensitive Names
by Jim Sinegal | Morningstar Research Services LLC | 06-23-17

We believe the time is right for investors to rotate away from rate-sensitive banks into the stocks of companies that depend less on slow macroeconomic changes and more on factors under their own control. We believe Wells Fargo will eventually benefit from both lower expenses and -- perhaps surprisingly -- more effective sales practices as a result of more thoughtful incentive programs. We think capital return at Citigroup will improve returns on equity. As the U.S. economy strengthens, concerns over potential credit losses at Capital One should be assuaged as solid underwriting manifests in results.

Valuation is our main concern for the most rate-sensitive banks. Our fair value estimates depend primarily on long-term yield curve expectations -- we expect the 10-year Treasury rate to reach 4.5% over the next five years, with a commensurate increase in short-term rates. Many regional banks, including Comerica, M&T Bank, and Regions Financial, are now valued at levels that are difficult to support even as we incorporate much higher long-term rate expectations.

Our shorter-term rate outlook is another cause for concern. Our interest-rate thesis rests on slow-changing demographic, borrowing, and technological trends. We believe evidence of a turning tide will show up first in the housing market. Aging millennials should soon boost household formation, demand for labor is growing along with construction activity, and mortgage credit supply seems finally set to increase in a less stringent regulatory environment. Over time, these factors should increase both economic growth and interest rates, but we don’t expect dramatic change in the next 12 months. In fact, long-term rates have actually fallen year to date, potentially indicating that the bond market shares our somewhat more pessimistic view. Low inflation also supports our view that current interest-rate policy is not excessively accommodating, and as a result, there is no rush to tighten it.

2017 Stress Test Results Affirm Bank Capital Strength and Capital Return Plans Should Come Next Week
by Michael Wong, CFA, CPA | Morningstar Research Services LLC | 06-22-17

The Fed released the 2017 results from the supervisory stress tests conducted as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The tests serve to inform regulators, financial markets, and the general public how institutions' capital would withstand a hypothetical set of adverse economic conditions. All 34 of the banks subject to the stress test performed well on the most commonly watched measure, the common equity Tier 1 capital ratio, with even the two lowest performing banks -- Ally Financial and KeyCorp -- being 2-percentage points or more above the 4.5% regulatory minimum. These solid results are not all that surprising given that banks have been adding capital -- over $750 billion since 2009 -- to strengthen their balance sheets.

The Fed used two scenarios, adverse and severely adverse, as part of its stress tests. Highlights of the severely adverse scenario include a severe global recession with U.S. GDP declining about 6.5%, the U.S. unemployment rate rising to 10%, equity prices falling 50%, and commercial real estate prices falling 35%. Cumulatively, the stress tests under the severely adverse scenario projected loan losses of $383 billion over the nine-quarter planning horizon, with total losses of $493 billion when including other losses, such as trading and counterparty losses. The total losses of $493 billion were less than the $526 billion calculated for last year's stress tests due primarily to changes in balance sheets and risk characteristics. On average, the aggregate common equity Tier 1 capital ratio would decrease to 9.2% from 12.5% in the fourth quarter of 2016 in the severely adverse scenario.

Despite Full Valuations for U.S. Defense Majors, It's Time to Hold 'Em, Not Fold 'Em

by Chris Higgins | Morningstar Research Services LLC | 06-22-17

It's a strange time for the U.S. defense majors we cover: We're sitting at peak historical multiples, but the industry is only two years into what we forecast as a six-year upcycle in U.S. defense spending. Although defense budgets are headed higher, we're skeptical when we hear claims of historic defense spending increases; we only anticipate average annual growth of roughly 3% through 2021. Moreover, our detailed assessment of the Trump administration's fiscal 2017 and 2018 budgets indicates that spending increases are tilting toward segments of the budget that contractors can only partially address.

Still, thanks to defense budget increases, defense companies will increase their revenue after several years of shrinking top lines. Post-2020, we think defense spending will likely be squeezed due to growth in mandatory government spending. On the one hand, we're broadly neutral on the firms we cover, finding stocks are fairly valued to slightly overvalued. And we are reaching this conclusion even after embedding historically high midcycle operating margins, a 25% U.S. effective corporate tax rate, and steady revenue growth in our valuations. On the other hand, these are moaty businesses that consistently earn returns above their cost of capital even during tough market conditions.

We don't recommend investors blindly jump in with both feet, but current holders shouldn't be too quick to sell such high-quality names. We still like General Dynamics, which garners a wide moat and an Exemplary stewardship rating, but its price/fair value ratio stands at 1.10. From a valuation standpoint, Raytheon is the most attractive, but it's trading at only a slight discount to our fair value estimate. Finally, we think investors underappreciate Boeing's defense unit, particularly in light of F/A-18 funding increases and ongoing efficiency initiatives at the company, and we have raised our fair value estimate to $189 from $180, but shares are still slightly overvalued.

Senate's Healthcare Bill Shares Great Similarity With the AHCA, but Passage Is Still Uncertain
by Debbie S. Wang | Morningstar Research Services LLC | 06-22-17

While there are challenges to translating the Senate's healthcare bill into law, if successful, we think it would be largely positive for pharmaceutical and devices firms while having a mixed impact on hospitals and managed care firms.

After taking great pains to keep their healthcare proposals under wraps to bypass the normal committee consideration process and limit floor debate, Senate Republicans finally revealed their bill on June 22. Despite earlier comments by some senators that their bill would be substantially different from the House's American Health Care Act, the Senate's bill actually shares many similarities, including elimination of all mandates, high-risk pools, wider community rating bands, the option for states to redefine essential benefits, and a move toward capping Medicaid spending.

Considering the overlap between the House and Senate bills, we would be surprised if the Congressional Budget Office's anticipated scoring is significantly different from that of the House's AHCA, which is projected to result in 23 million Americans losing healthcare coverage over a 10-year period. The question remains whether grassroots outcry can gain enough steam before the vote, which is expected to be held next week.

On one hand, the similarities between the House and Senate bills make it more likely that the two bodies can work out their differences if the Senate votes in favor of its bill. On the other, there are considerable challenges to securing that vote in the Senate. The Republicans must thread a very fine needle in the Senate, given its control of 52 seats and the vice president's tie-breaking vote. In particular, senators from states that have expanded Medicaid face difficult choices, because those governors generally oppose capping Medicaid, despite a more gradual transition. The Senate's effort to maintain coverage for pre-existing conditions is generally rendered meaningless because of the large loophole for states to redefine benefits.

New Home Construction Hits a Snag Due to Near-Term Constraints; Long-Term Outlook Unchanged
by Charles Gross | Morningstar Research Services LLC | 06-19-17

Following strong year-over-year growth in home construction during the first quarter, building activity has slowed meaningfully in the past two months, in contrast with largely positive macroeconomic data in the United States. As a result, we've reduced our residential construction forecast to 1.26 million units, down from 1.31 million, largely to account for a slower-than-anticipated pace of single-family home construction. Given our bullish long-term view for residential construction, this adjustment remains immaterial to our wood product, home-building, and home improvement valuations.

May construction activity proved considerably weaker than we had expected, falling 2.4% from the prior year, to a 1.09-million-unit pace. While the bulk of May's weakness is explained by falling multifamily activity, we were more concerned by single-family starts in the U.S. South remaining roughly flat over the prior year. Even so, we expect this slowdown will prove transitory as headwinds ease during the second half of the year.

Most key housing drivers remain positive. Demand has remained robust, with the U.S. Home Vacancy Survey implying household growth exceeding 1.2 million through the first quarter, and leading indicators such as the Atlanta Fed's Wage Growth Tracker at roughly 3.5%. New home supply, however, appears more constrained. Reviewing the Fed's most recent Beige Book, many districts highlight the constrained supply of skilled construction labor, while the Federal Reserve Bank of Atlanta pointed to rising construction loan oversight.

Although we've tempered our outlook for the year, we've left our long-term forecast unchanged. We expect U.S. housing starts to peak at roughly 1.9 million units in 2021, before fading to a demographically sustainable 1.5-million-unit pace beyond 2025.


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

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