Please see new analyst notes and updates below from Morningstar Research Services for Amazon AMZN, Berkshire BRK.B, CarMax KMX, and Mastercard MA.
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Peggy Seemann
Publisher, Morningstar StockInvestor
Amazon: We Doubt Amazon Is Broken Up by the FTC and Instead See a Relatively Minor Fine
by Dan Romanoff, CPA | Morningstar Research Services LLC | 09-27-23
We are maintaining our fair value estimate of $150 per share for wide-moat Amazon as the U.S. Federal Trade Commission, or FTC, was joined by 17 state attorneys general in filing a lawsuit against the company for a variety of alleged anticompetitive practices. Our initial opinion is that a settlement is the most likely outcome, with a fine being levied and possibly some minor changes in business practices, and we are highly skeptical that Amazon will be broken up. Shares still appear modestly undervalued to us.
The legal filing seeks unspecified remedies but appears to skew toward structural changes, rather than fines, and may seek to break up Amazon. We struggle to come up with a recent relevant precedent for doing so, as U.S. courts have been applying a framework that revolves around consumer welfare for more than four decades. In this case, it is difficult to see how an Amazon breakup would clearly benefit U.S. consumers. Regardless, we think this legal matter will take years to wind its way through the courts.
In the highly unlikely event of a breakup, it is possible that new investors may focus on certain parts of the business (like AWS), and the sum of the parts might be greater than the whole. However, our wide moat rating around the retail business is based on cost advantages, intangible assets, and network effects, and would clearly be threatened depending on the exact nature of a theoretical breakup.
Nonetheless, we think the most likely outcome of this legal matter is a settlement that involves Amazon paying a relatively small fine and ceasing certain business practices. The largest fine ever levied by the FTC was for $5 billion on Facebook in 2019. A $5 billion fine would be less than 1% of the firm's market cap. To date, we have seen various governments around the world attacking mega-cap tech companies without achieving a win that materially affects any of these businesses, so we are skeptical this action against Amazon will be meaningfully different.
Overall, we view the claims contained in the lawsuit as spurious. The FTC alleges Amazon employs antidiscounting practices, forces third-party sellers to use fulfilment by Amazon in order to be included in Prime filtering, degrades customer experience, bias' search results to favor Amazon's products over other sellers, forces sellers to use Amazon advertising, and charges excessive fees, among other anticompetitive practices. Unsurprisingly, Amazon believes the prosecutors are wrong on the facts, misunderstand the basics of competition, and are misleading within their claims. Further, a variety of practices the firm is accused of are no longer executed.
Acquisitions, Higher Short-Term Rates, and Improved Equity Markets Have Lifted Berkshire's Value
by Greggory Warren| Morningstar Research Services LLC | 09-29-23
We continue to believe that Berkshire, owing to its diversification and its lower overall risk profile, offers one of the better risk-adjusted return profiles in the financial-services sector (and remains a generally solid candidate for downside protection during market selloffs). We remain impressed by Berkshire's ability in most years to generate high-single- to double-digit growth in book value per share, comfortably above our estimate of its cost of capital. We also believe it will take some time before the firm finally succumbs to the impediments created by the sheer size and scale of its operations, and that the ultimate departure of Warren Buffett and Charles Munger will have less of an impact on future operating results than many investors believe. We view Berkshire's decentralized business model, broad business diversification, high cash-generation capabilities, and unmatched balance sheet strength as true differentiators for the firm.
While these advantages have been overshadowed during much of the past decade by the company's ever expanding cash balances—which earned next to nothing in a near-zero short-term interest rate environment—we believe the company has finally hit a nexus where it is focused on reducing its cash hoard through a mixture of stock investments and share repurchases. Over the past 12 calendar quarters, the company has repurchased close to $60 billion worth of its common stock, equivalent to $4.9 billion per quarter on average, which has eliminated just over 10% of the company's total shares outstanding. The company has also pursued higher dividend yielding securities when purchasing equity securities and is benefiting from higher short-term rates on its cash balances. With the firm closing out June 2023 with an estimated $107 billion in dry powder and valuations not quite where they need to be for many of the types of quality assets Buffett would prefer to acquire outright, we expect the bulk of the company's excess capital allocation to be focused on stock and bond investments and share repurchases.
CarMax Earnings: Some Improvements Visible but Recovery Has a Long Way To Go
by David Whiston, CFA, CPA, CFE | Morningstar Research Services LLC | 09-28-23
CarMax's stock declined by over 11% on Sept. 28 after reporting fiscal 2024 second-quarter diluted EPS of $0.75 that fell 5.1% year over year and missed the Refinitiv consensus of $0.78. We see no reason to change our fair value estimate because we continue to expect CarMax's profit to improve from recent levels once used vehicle affordability improves. Vehicle affordability will improve gradually over a long time due to poor late model used vehicle supply following the pandemic and chip shortage and from some less affluent customers unable or unwilling to pay higher interest rates than a few years ago.
We believe management is doing the best it can to control expenses and how much inventory to buy when pricing declines rapidly, as it did in June and July. For example, inventory reductions from the fiscal first quarter, by our calculations, helped adjusted free cash flow more than triple year over year and rise seven-fold from the fiscal first quarter to $686.6 million. Other improvements, although still headwinds, include comparable store unit sales down 9%, which was the first single-digit decline in three straight quarters, and average retail selling price down 4% year over year to $27,500. This level is still causing consumer affordability problems—which is understandable given prepandemic ASPs of around $20,000.
Management said that over 25% of inventory is priced below $20,000, but we suspect those vehicles are not that desirable. The company also says it has strong demand across all consumer credit spectrums but many midtier to subprime consumers often don't close the deal once they see the high monthly payment offered. We don't see that problem abating until interest rates fall or stop rising, and we have more years of robust new vehicle sales to create future used vehicle supply. We are glad to see the company announce it intends to resume share repurchases in the fiscal third quarter. We believe CarMax's stock is rarely undervalued, and the chip shortage has disrupted used vehicle pricing enough to make the stock cheap for an extended period of time, so management should take advantage of these times when able. Buybacks have not occurred since a small amount was repurchased during fiscal 2023's third quarter. CFO Enrique Mayor-Mora said on the call that buybacks will initially be at around $50 million a quarter rather than the prior quarterly rate of about $150 million to offset annual dilution. We assume he means dilution from stock-based compensation.
CarMax Auto Finance income fell by 26.2% on a 120-basis-point decline in interest margin before loan losses to 6.1% and the loan loss provision as a percent of average managed receivables rising by 20 basis points to 2.1%. The impact of recent Federal Reserve rate increases bleeds into CAF's portfolio over time rather than abruptly due to interest income on loan assets recognized across roughly five years, with 70% of the recognition in Years 2 and 3, so we don't expect interest margin expansion in near-term future results. However, 6.1% is level from the fiscal first quarter and was in the high 5% range just before the pandemic started. CAF's collateral spread, which is the difference between CAF's funding costs and rates charged to customers, was 4.9% in the most recent asset back securities deal, known as 2023-3. This is a 60-basis-point improvement from the prior ABS deal (2023-2) and the third straight deal that the spread increased after bottoming at 3.17% for 2022-4. The spread in calendar 2019 ranged between 5.26% and 6.53% and was in the high 7% range in 2021 before the Fed started raising rates. Although the loan loss provision increased by 18.9% year over year due to unfavorable credit performance, earlier CAF standard tightening has enabled the allowance for loan losses at Aug. 31 to be 3.08%, down from 3.11% at May 31, so we are not concerned about the quarter's results indicating a major credit quality problem starting to emerge.
Mastercard Enjoys a Wide Moat and Good Growth Prospects
by Brett Horn | Morningstar Research Services LLC | 09-28-23
Mastercard has multiple characteristics that should draw investors' attention. First, despite the evolution in the payment space, we think a wide moat surrounds the business and view Mastercard's position in the current global electronic payment infrastructure as essentially unassailable. Second, Mastercard benefits from the ongoing shift toward electronic payments, which provides plenty of opportunities to utilize its wide moat to create value over the long term. Digital payments, on a global basis, surpassed cash payments just a few years ago, suggesting that this trend still has a lot of room to run, and we think emerging markets could offer a further leg of growth even as growth in developed markets starts to slow. Finally, Mastercard is something of a tollbooth business, and the company is relatively agnostic to smaller shifts in the electronic payment space, as it earns fees regardless of whether payment is credit, debit, or mobile.
Mastercard has not been without issues recently. Cross-border transactions, which are particularly lucrative for the networks, came under heavy pressure due to the fallout from the pandemic and a reduction in global travel. We expected a full recovery, and that has largely played out, although the ongoing bounceback remains a tailwind. From a longer-term point of view, we think it is likely that smaller and more regional networks are building out capacity for cross-border transactions, which could eat into growth a bit in the coming years, but we haven't seen a material effect yet.
In the near term, we see the state of the economy as Mastercard's biggest risk. A downturn in the economy would slow overall growth, as Mastercard's revenue is sensitive to the volume and dollar amount of consumer transactions. The company saw growth decline significantly during the early stages of the pandemic. But we don't see any industry trends that will impede Mastercard's ability to maintain double-digit growth in the coming years, and the company looks poised to continue to modestly outperform its larger peer, Visa.
We are increasing our fair value estimate for Mastercard to $406 per share from $389, due mainly to time value since our last update. Our new fair value estimate equates to 28.1 times projected 2024 earnings, adjusted for one-time expenses. While revenue declined in 2020 due to the coronavirus and that issue bled into the start of 2021, growth has since bounced back quickly. We think secular trends and improving share should allow Mastercard to maintain strong growth rates over the next five years. We project net revenue to grow at a 12% compound annual growth rate. In part, this growth rate hinges on the bounceback that we expect to occur over time in cross-border volumes. But we believe Mastercard can maintain low-double-digit growth even in the back half of our projection period. We think growth will be increasingly fueled by international markets, and Mastercard's mix leaves it relatively well positioned. While margins have held roughly level recently and were pressured in 2020, we think the company can achieve some modest margin expansion over time, and we project operating margins (based on net revenue) to improve from 57% in 2022 to 60% by 2027. We assume the increase in client incentives as a percentage over revenue slows a bit, following fairly strong increases in recent years. Given the company's history of fines and one-time charges, we include ongoing one-time costs roughly in line with historical averages in our projections, but these costs are excluded from the margin levels above. We use a cost of equity of 9%.
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Peggy Seemann does not own stocks from the Tortoise and Hare Portfolios in her personal accounts.
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