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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.

Michael Corty, CFA, is the portfolio manager for Morningstar Investment Management LLC’s Tortoise strategy. Before focusing his attention on the Tortoise, Michael co-managed five equity strategies offered by Morningstar Investment Management LLC and Morningstar Investment Services LLC since December 2013. Michael was previously a senior equity analyst on Morningstar Inc.’s equity research team covering companies in the media, business services, and consumer industries. Michael also spent several years on Morningstar’s moat committee, which assigns economic moat and moat trend ratings to their global coverage.

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.

About the Editor David Photo
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 9/25/20 -- An Acquisition for Microsoft and a Fair Value Trim for Tencent

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 analyst notes and updates below from Morningstar Research Services for CarMax KMX, Facebook FB, Microsoft MSFT, and Tencent TCEHY. Several holdings were tagged in two general notes -- one on healthcare policy and one on how the death of Supreme Court Justice Ruth Bader Ginsburg might affect court rulings on healthcare. Both are included below.

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Editor, Morningstar StockInvestor

Inventory Rebuild Hurts CarMax's Second-Quarter Cash Flow, but We Like Its Competitive Position
by David Whiston, CFA, CPA, CFE | Morningstar Research Services LLC | 09-24-20

CarMax reported second-quarter fiscal 2021 results that showed good recovery from the pandemic. No employees are furloughed, and same-store unit sales for the quarter increased by 1.2% year over year. This is a low number and below management's targeted growth level of 5%-8% to leverage SG&A costs, but it was skewed downward by the virus causing a high-single-digit negative number in June. CarMax's data advantage helps it procure vehicles to maintain a consistent level of gross profit dollars per used vehicle sold. This quarter that metric grew 1.4% to $2,214 and total gross profit increased by 8.5%. That increase along with good SG&A discipline and a 29% increase in CarMax Auto Finance income led to record second-quarter results. Diluted EPS rose by 27.9% to $1.79, easily beating the Refinitiv consensus of $1.08, while revenue grew 3.3%.

We calculate adjusted free cash flow, however, was negative $181.5 million, versus a burn in the prior-year quarter of $13.1 million, due to a large inventory rebuild that reduced operating cash flow by about $926 million by our math. This free cash burn along with small comparable store unit growth and many auto retail names in our coverage selling off on Sept. 24, may explain CarMax's stock falling by over 10% the morning of earnings. We feel the ongoing high level of vehicles coming off-lease in calendar 2020 and 2021 combined with CarMax's omnichannel rollout now completed and a healthy CAF business sets the company up for good results long term. We are raising our fair value estimate to $89 from $80 based on the time value of money, higher CAF earnings as a percent of revenue, and higher revenue growth across our five-year forecast period than previously modeled due to fiscal 2021 trending better than our expectations. Management also announced that it is resuming new store openings, with 8-10 stores planned for fiscal 2022. Four stores opened in fiscal 2021 before the pandemic, but there was no mention of fiscal 2021 plans.

CAF earnings growth of 29% did benefit from a $19.5 million year-over-year reduction in the loan loss provision. We calculate the 29% growth would have been 11.9% excluding this benefit. Management cited actual loan loss performance being better than expected at the end of the first quarter, which we can understand because estimating loan performance in the midst of a crisis is not easy. We calculate diluted EPS would still have far exceeded the Refinitiv consensus ignoring the improved loss provision. The allowance for loan losses at Aug. 31 was 3.23% of ending managed receivables, down 9 basis points from May 31. CAF also enjoyed a 6.0% interest margin before the loan loss provision, which was its highest level since the second half of fiscal 2016. CAF tends to benefit when interest rates go down as the benefit of lower funding costs is not wiped out by lowering rates to consumers. Management cited no need to remain competitive via offering a lower annual percentage rate in fiscal second quarter, but we don't expect this lag benefit to remain long term.

President Trump OKs the Possible TikTok Deal; We Do Not Expect Much Impact on Facebook or Snap
by Ali Mogharabi | Morningstar Research Services LLC | 09-20-20

On Sept. 19, President Donald Trump said that “in concept” he approved a possible TikTok deal with Oracle and Walmart, which increases the probability TikTok will continue to be available in the U.S. This does not change our views on wide-moat Facebook and no-moat Snap. As we wrote Aug. 2, a deal that will allow TikTok to continue operating in the U.S. could benefit Facebook (including Instagram) a bit but slightly hurt Snap. We continue to value Facebook at $265 and Snap at $18.

With partial ownership by Oracle and Walmart, TikTok likely will continue to compete fiercely for users with Facebook, Snap, and other social network apps. We think the presence of such a formidable competitor may somewhat lessen antitrust pressure on Facebook, allowing the firm to make more aggressive acquisitions in the future.

In addition, Facebook's Reels (which is basically copying TikTok features) is already available on Instagram. With Reels, TikTok users, which are also the content creators, could set up shop on Instagram to further increase consumption of their content. This could attract more viewers to Instagram, increase time spent on the app, minimize users leaving the app for TikTok, or all of the above. Plus, as we mentioned in our previous note, the virtuous cycle that we have seen on the Facebook and Instagram platforms has proven difficult to reverse.

TikTok may slow Snap user growth and take some ad dollars away from the platform. Snap has been the most popular social app for younger users (13- to 24-year-olds) in the U.S. At the same time, advertisers are attracted to the fact that many of those users remain on Snap as they get slightly older (25- to 34-year-olds), generating higher returns on investment on ads. TikTok may interrupt this process as it clearly targets and attracts younger users. With a weaker network effect, it may be a bit more difficult for Snap to attract users away from or keep its users from migrating to TikTok.

The structure of the deal between Oracle, Walmart, TikTok, and ByteDance (the parent company of TikTok) remains unclear. According to a statement tweeted by TikTok on Sept. 19, Oracle will become a “trusted technology provider” (or a cloud provider, according to Oracle) for user data storage and security, while Walmart will become a commercial partner. We are assuming that ByteDance will continue to run TikTok's algorithms (considered as the firm's valuable intangible assets), but managed and overseen on Oracle's cloud platform.

Oracle and Walmart could have up to a combined 20% ownership of TikTok, which will be referred to as TikTok Global after the deal. Oracle and Walmart stated that their stakes in TikTok Global will be 12.5% and 7.5%, respectively. The Wall Street Journal stated that its sources said ByteDance (of which 40% is owned by U.S. investors) could keep 80% of TikTok.

Microsoft Bolsters Gaming Portfolio with ZeniMax Media Acquisition; FVE Unchanged
by Dan Romanoff, CPA | Morningstar Research Services LLC | 09-21-20

Microsoft announced the acquisition of ZeniMax Media, owner of Bethesda Softworks, one of the largest privately held game developers and publishers in the world. The all-cash deal for $7.5 billion is expected to close between January and June 2021. While no financial metrics were provided for ZeniMax, Microsoft expects the deal to have "minimal impact" on non-GAAP operating income in fiscal 2021 and 2022. Bringing ZeniMax's various studios into the fold ups Microsoft's internal studio count from 15 to 23. To the gaming world, we think this deal, combined with recent Xbox introductions, emphatically underscores that the gaming segment is important to Microsoft and the company expects to remain a leader for years to come. Overall, we think adding content to the gaming platform is strategically important, so we view the deal as strategically sound. Our $228 fair value estimate and wide moat rating are unchanged.

We believe Bethesda's titles, including The Elder Scrolls, Fallout, Doom, Quake, and Wolfenstein, are iconic and will be important additions to the GamePass catalog, which now boasts 15 million subscribers. Ultimately, a $7.5 billion transaction is immaterial to Microsoft. For comparison, Epic Games' June 2020 financing valued it at about $17 billion based on an estimated $5 billion in revenue, which implies a price/sales multiple of 3.4 times for that deal, while publicly traded analogs such as Activision, Electronic Arts, and TakeTwo, among others, trade at a median price/sales of 5.9 times. Using these multiples as guardrails suggests ZeniMax's revenue could be in a range of $1.3 billion-$2.2 billion for calendar 2020. At the midpoint, this represents about 1% of Microsoft's revenue, which, when coupled with a cash hoard of $136.5 billion, demonstrates that the transaction is clearly not material to the financial operations of Microsoft. We do, however, think it suggests gaming is becoming more important internally.

Trimming Tencent's FVE by 4% to Account for Rising Geopolitical Tension
by Chelsey Tam | Morningstar Research Services LLC | 09-20-20

The Department of Commerce in the U.S. has announced prohibitions on transactions relating to the WeChat mobile app on national security grounds. Separately, the Committee on Foreign Investment in the U.S., or CFIUS, has inquired Tencent's investees, including Epic, Riot and others, about their security policies in handling U.S. users' personal data. Given the rising tension, we now think there is more than a 50% chance that Tencent's U.S. revenue is at risk, and therefore shaved off 2% of Tencent's revenue in our base case. We estimate higher revenue impact on gaming, followed by advertising. According to our check, the contribution from the U.S. to the revenue of WeChat Pay or Weixin Pay and the cloud business--both of them having lower margins--is very small. Sale of the U.S. gaming assets is not baked into our base case.

Tencent's fair value estimate has been trimmed by 3.8% to HKD 600 or USD 77, mainly due to the loss of U.S. revenue and to a small extent model fine-tuning. We believe the shares are fairly valued. Near-term downside risks to the share price include further escalation leading to the ban of all Tencent apps in the U.S. and CFIUS' requirement of a forced sale of Tencent's major U.S. gaming assets. Upside could come from better-than-expected key game launches.

President Trump's Updated Healthcare Policy Targets Drug Costs, but Implementation Looks Tough
by Damien Conover, CFA | Morningstar Research Services LLC | 09-25-20

President Donald Trump updated the administration's healthcare policy to include new drug benefit cards for seniors and executive orders supporting insurance protection for pre-existing conditions and increased clarity around medical billing. We don't expect any major changes to our fair value estimates or moat ratings based on the announcements, but the updates slightly increase uncertainty within the drug industry. The updates add to executive orders issued over the past two months, including international drug importation, Medicare drug price setting based on international prices, elimination of drug rebates in the supply channel, and the minor expansion of 340b drug discounts (targeting low-income patients) for certain drugs.

We largely view the updated announcements as political and see significant challenges with the implementation of the initiatives, especially without Congressional approval. The cost for the new drug benefit cards would surpass $5 billion, and the funding source is less clear but could come from savings generated by other initiatives. International reference pricing for Medicare would generate savings and likely be the largest headwind for the drug group. We estimate that industry sales would fall by over 20% if international drug reference pricing were used by Medicare and followed by private insurance. However, this seems highly unlikely due to the likely need for Congressional approval and the complexities and ambiguities around international pricing. The administration may lean on the demonstration policies within the Affordable Care Act to push forward the healthcare policies, but the initiatives seem to go beyond the scope intended in the ACA. Trump is also still hoping to repeal the ACA, putting the strategy into question longer term. We expect several delays to the administration's healthcare plans that will likely mean minimal healthcare policy changes until after the presidential election.

Supreme Court Shakeup Adds Another Layer of Complexity to Election Year for Healthcare Industry
by Julie Utterback, CFA | Morningstar Research Services LLC | 09-20-20

With Justice Ruth Bader Ginsburg's death on Sept. 18, another layer of complexity has been added to this election year for the healthcare industry. The Supreme Court is scheduled to hear oral arguments on the Affordable Care Act on Nov. 10, a week after the U.S. election. Prior to Ginsburg's death, the court looked likely to uphold the ACA at least along the previous voting lines (5-4), but without her vote, the path to upholding the law just got more complicated, creating the potential for the millions of Americans who gained access to insurance through the ACA to lose that coverage. For now, we are not changing our views on any moats or valuations in the industry, but investors should be aware of the various scenarios that could influence the U.S. healthcare system over the next several weeks.

Importantly, the Supreme Court has a couple of options related to hearing oral arguments on the ACA. First, the court could decide to hear the arguments with only eight justices. In the event of a 4-4 tie, the court could turn the case back to the original district court to decide which parts of the law could be upheld without the individual mandate that is in question. In that case, further appeals of that court's decision-making process could be possible while the ACA remains the law of the land. To avoid such uncertainty related to a potential tie vote, though, the Supreme Court could wait to hear oral arguments until another justice is named to the court, which would lead to a definitive vote.

Despite previous precedent from Republican leadership in the Senate that delayed voting on an Obama nominee in 2016 because it was an election year, President Trump and Senate leadership appear intent on voting on a new justice before the end of the year. If that is the case, there is a chance that a 5-4 vote upholding the ACA could turn to a 5-4 vote against the law, assuming the new justice votes in line with most of the other conservative jurists.

One notable exception last time was Chief Justice John Roberts, who previously cast the deciding vote for the ACA based on Congress' right to tax through the individual mandate. There is a chance that he will change his view on the law given the elimination of the individual mandate in the 2017 tax reform act. However, some legal experts believe that Roberts and other conservative jurists (such as new Justice Brett Kavanaugh) could rule that the individual mandate is severable from the other aspects of the ACA, meaning that the other parts of the law were able to stand despite the individual mandate being dropped to $0 with the tax reform act in late 2017.

Overall, though, considering all of these potential changes to the Supreme Court and the ACA in the near future, we think there is an increased probability that Democrats may decide to go "nuclear" in a Democratic sweep scenario to remedy any potential actions that are not supported by the upcoming election result. By going nuclear, Senate voting requirements could decline to a simple majority from a supermajority for legislative bills. That decision to reduce the voting requirement would only need a simple majority vote in the Senate, and Democrats could pursue a number of new initiatives from healthcare reform to expanding the Supreme Court to alleviate the perceived imbalance on the court.

In general, we think going nuclear to reduce voting requirements in the Senate on major legislation could create more risk for healthcare industry players in the long run. As Senate majorities whip back and forth after each election, significant changes to the U.S. healthcare system could be possible after each election. While we still believe the public-private partnerships that the U.S. system has been built on will likely remain in place, the uncertainty surrounding the managed care, service provider, and pharmaceutical sectors may rise in the long run in a nuclear scenario. During this election cycle, Democrats have outlined their healthcare strategy that looks likely to build on the existing system, rather than changing it completely, like a "Medicare for All" plan would have.


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

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