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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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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.

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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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Fair Value Increases for Alphabet, Facebook, and Amazon

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 Alphabet GOOG/GOOGL and Facebook FB (a single note), AMZN, Berkshire Hathaway BRK.B, Charles Schwab SCHW, Enbridge ENB, and Uber Technologies UBER.

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Pandemic Not as Severe on Digital Ads; Raising Alphabet, Facebook, Pinterest, Snap, and Twitter FVEs
by Ali Mogharabi | Morningstar Research Services LLC | 07-08-20

We have increased our estimates for Alphabet, Facebook, Pinterest, Snap, and Twitter, as the coronavirus-related hit to digital advertising looks softer than we initially anticipated. We think advertisers will continue to allocate more of their ad dollars toward direct-response campaigns after the pandemic. The main beneficiary of what may become a lasting change is likely to be Facebook. Investments by Pinterest and Snap to enhance their direct-response offerings will probably partially offset the impact of lower spending on broad-based campaigns. The same could be true of Twitter, but to a lesser extent. At Google, we expect search to attract more advertisers, given the overall decline in ad prices. Plus, assuming no significant lockdowns by the second half of 2021, we expect Google and Snap to more effectively monetize their map apps. The adjustments to our projections lift our fair value estimates for Alphabet 9% to $1,520, Facebook 14% to $245, Pinterest 4% to $27, Snap 6% to $18, and Twitter 7% to $32.

Digital ad spending in the second half of this year is likely to be higher than the same period of 2019. According to a survey of advertisers conducted by the Interactive Advertising Bureau in mid-June, more ad buyers said they plan to increase ad spending on social media and paid search than to not change or decrease their spending during the next six months compared with last year. The survey also showed that the increase will likely come at the expense of cutting spending on traditional advertising. The survey also indicates that advertisers may increase their social media and paid search spending by at least 25% and 20%, respectively, from the second half of 2019. Earlier this month, eMarketer also published its latest estimates for 2020 digital ad spending, which it now believes will increase 2% year over year, well above our initial projection in March of a 5%-10% decline.

In our view, most of the higher spending over the next six months will be on direct-response ads, which make campaign results more measurable in real time and have historically generated higher returns on investment. The continuing shift toward e-commerce, which the pandemic has accelerated, has also pushed advertisers to spend more on these bottom-of-the-funnel campaigns. EMarketer estimates that retail e-commerce will grow 18% in 2020, while overall retail sales will decline 10.5% from last year. Increased adoption of e-commerce should further increase direct-response ROIs.

We think the coronavirus has also pushed businesses of all sizes to more rapidly start and complete their digital transformation. More enterprises have been transitioning to the cloud, while many small and midsize businesses have begun to focus more on creating or improving their e-commerce sales channels. In addition, while the current downturn has had a devastating effect on SMBs, forcing many to shut down, many more are likely to be created during a recovery; those new firms will likely focus initially more on e-commerce, which will require more digital ad spending. Further growth in e-commerce will also create opportunities for the direct-response ad inventory providers to also get a piece of the transactions conducted on their platforms. Plus, we think it is safe to assume that spending on broad-based campaigns will increase during a recovery. However, we still think advertisers will steadily shift focus toward direct-response types of marketing in the long run.

Facebook will be the main beneficiary of higher direct-response ad spending and the accelerated shift toward e-commerce. In addition, the increase in users and user engagement during the pandemic on Facebook and Instagram has created more ad inventory, which admittedly is currently being sold at lower prices. In our view, SMBs depend heavily on Facebook for their marketing, and we think this will remain during a recovery. We expect Facebook's recent launch of Facebook Shops will not only retain many SMBs that are advertising on the platform but will also attract many new ones. The firm's Instagram and Facebook checkout features also position it to benefit from growth in e-commerce.

We have increased our 2020 top-line growth estimate for Facebook to 3% from a decline of 3% and are now modeling a 21% five-year revenue compound annual growth rate, higher than our previous 16%. We continue to expect operating margins to be lower than historical levels, mainly due to additional costs of content quality management, which again has come to the forefront as some large brands and advertisers are suspending ad spending on Facebook and Instagram and demanding the firm to more effectively limit hate speech and misinformation.

While we don't think the impact of such a boycott by advertisers on Facebook revenue will be significant (as we indicated in our June 29 note), we remain concerned about the long-term risk of increased regulations. Facebook's reaction to the boycott movement could lead to various organizations and politicians demanding changes to Section 230 of the Communications Decency Act, which provides liability protection for online firms.

Increased COVID-19-Related Demand Should Amplify Amazon's Retail and Cloud Competitive Positioning
by R.J. Hottovy, CFA | Morningstar Research Services LLC | 07-07-20

Since bottoming out around $1,600 in mid-March during the market's early coronavirus fears, wide-moat Amazon's stock has roared back the past several months and closed above $3,000 per share for the first time on July 6. There are several reasons to explain the stock's meteoric rise, including heightened Prime member engagement (especially for online grocery services), strong AWS usage rates (particularly among customers less impacted by COVID-19 disruptions), and a shortage of high-quality growth investments. Amazon is likely to put up impressive growth when it reports second-quarter results in late July, and we expect it to exceed the high-end of its quarterly revenue outlook of $75 billion-81 billion. Based on this near-term revenue upside, we're raising our FVE to $2,750 per share from $2,500. Nevertheless, we believe investors should be asking whether the current stock price has outpaced Amazon's longer-term cash flow potential?

Admittedly, betting against Amazon has been a risky proposition in the past, and we believe the longer-term positives (international growth potential, AWS upselling potential, expanded advertising services, technology licensing) still outweigh the negatives (online sales growth from competing mass merchants like Walmart and Target, potential regulatory risk) from an investment story perspective. We believe the market has moved back to a "growth-over-profitability" mindset with respect to Amazon, and expect the market to overlook what could be an expensive quarter (including at least $4 billion in COVID-19-related expenses, which will make it difficult to exceed the high-end of management's operating profit outlook of $1.5 billion). However, to justify the market price of $3,000 we'd have to assume at least high 20s average annual top-line growth and operating margins reaching 10% over the next five years (compared with high 20s revenue growth and 4% operating margins over the past three years), which we find moderately aggressive.

We're planning to raise our full-year revenue growth outlook to around 28% (up from 26%), but we'll maintain our operating margin forecast of 4% (versus 5.2% last year). We're also planning a modest increase in our medium-term revenue outlook, which will bring our five-year average annual revenue growth outlook to 19% from 17% due to greater engagement among Amazon Prime members, increased third-party sales from its suppliers, digital content sales, international expansion, and emergent business segments like advertising and technology licensing. With respect to Amazon's sales mix, we now forecast online retail revenue to grow 17% annually over the next five years, with smaller segments like physical stores, third-party seller services, subscription services, AWS, and advertising growing 5%, 19%, 20%, 26%, and 30%, respectively, over the same period.

We forecast gross margins will approach 42%-43% over the next five years, compared with 41% in 2019. Amazon's growing clout with suppliers and advertisers, the higher proportion of third-party units in the sales mix, increased usage and service adoption among AWS customers, and new advertising service offerings should allow for higher gross margins. We also forecast operating margin expansion through increasing expense leverage (particularly in the marketing and general and administrative expense line items), contribution from AWS, and accelerating third-party unit sales. Our model calls for Amazon to reach 8% GAAP operating margins over the next five years, based on its strong competitive positions in AWS and North American e-commerce, as well as early indications of success in some international markets.

Berkshire Hathaway Adds to Energy Assets With $9.7 Billion Deal for Dominion Energy's Gas Operations
by Greggory Warren, CFA | Morningstar Research Services LLC | 07-06-20

We do not expect to alter our fair value estimate of $342,500 ($228) per Class A (B) share for wide-moat-rated Berkshire Hathaway following news that the firm has agreed to acquire nearly all of wide-moat-rated Dominion Energy's natural gas transmission and storage operations for $4 billion, or $9.7 billion when including assumed debt. Berkshire closed the March quarter with a record $137 billion in cash and cash equivalents and likely has even more cash on hand coming into the current quarter (it's expected to generate more than $20 billion in free cash flow annually the next several years), so this deal represents only a small reduction in its substantial cash hoard, which continues to serve as a drag on overall returns, especially with short-term interest rates dropping to near zero.

That said, we are encouraged to see Berkshire finally putting some capital to work following CEO Warren Buffett's hesitance to jump into the fray following the COVID-19 shutdown. While the deal may not move the needle all that much from a balance sheet perspective, it should produce around $1 billion in net income annually, based on results for Dominion's gas distribution and gas transmission and storage operations the past several years. As we've noted for a number of years, we believe Berkshire's primary area of focus for future deals will be in the utilities and energy parts of its portfolio, an area that Greg Abel (vice chairman in charge of Berkshire's noninsurance business operations and our lead candidate to eventually succeed Buffett) is intimately involved in.

Absent other deals or lucrative internal investments, we still believe the best use of capital for Berkshire in the near term would be repurchasing its own common stock, which continues to trade at around a 20% discount to our fair value estimate and 1.2 times and 1.1 times our projected book value per share for the end of 2020 and 2021, respectively.

Realization of Merger Synergies in Coming Years Provides Upside to Charles Schwab-TD Ameritrade
by Michael Wong, CFA, CPA | Morningstar Research Services LLC | 07-07-20

We believe the market is undervaluing the medium- to long-term value creation from wide-moat Charles Schwab and narrow-moat TD Ameritrade's merger synergies. There are clearly near-term headwinds to earnings from lower interest rates and uncertainty over the valuation of the stock market and client asset levels, which we project will lead to earnings being around 40% lower in 2021 compared with 2019 for Charles Schwab on an organic basis. However, we also believe that there are clear medium- to long-term tailwinds, primarily from the $3.5 billion to $4 billion of merger synergies. The expense synergies should be fully realized by the beginning of year four of the merger, while the revenue synergies will phase in over the next decade, providing a persistent earnings tailwind. After gaining more confidence in the valuation of their merger synergies, we recently increased our fair value estimate for Charles Schwab to $45.50 and for TD Ameritrade to $49. We assess shares of both firms are undervalued and trading at an attractive discount to many companies in the financial sector.

After earnings reset lower in 2021 from the low interest rate environment, we expect Charles Schwab-TD Ameritrade to have a persistent earnings tailwind. Realization of merger synergies will start to materially increase earnings, even if interest rates remain low, though we should be near the bottom for both short- and long-term interest rates. We forecast that the combined firms should generate around an additional $0.84 per share of earnings in 2024 (mainly from the realization of expense synergies) and an additional $1.55 per share in 2031 (half from expense synergies and half from revenue synergies). Using a 15-times price/earnings multiple, the additional earnings could add $12.50 to the stock price in the next four years and $23 in the next 11 years. On a discounted free cash flow basis, we value the synergies at around $6.75 per share.

Michigan Judge Approves Partial Restart of Enbridge's Line 5
by Joe Gemino, CPA | Morningstar Research Services LLC | 07-06-20

On July 1, the Ingham County Circuit Court of Michigan lifted its temporary restraining order on the west leg of Enbridge's Line 5 segment that runs under the straits of Mackinac. Conversely, the east leg will remain shut down as Enbridge continues to work with the pipeline safety regulator on the process of collecting data and restarting the line. As we wrote in our June 26 note, we expected this decision by the Michigan court. We continue to expect Enbridge to work with the pipeline safety regulator to fix the anchor support on the east leg. It's likely that the issue is resolved within a few weeks to months, and it shouldn't have a material impact on the company's financial results given that the Mainline system is running at reduced rates as a result of lower crude oil demand across North America. We are maintaining our $40 (CAD 57) fair value estimate and wide moat rating. Since the market sell-off in May, Enbridge's stock has remained under pressure. The stock is down nearly 20%, while most of the market has experienced vast recoveries. Despite the poor performance, we see an attractive entry point for long-term investors. Enbridge remains one of our top picks in the energy sector. We think the market is mistaken to price Enbridge like oil prices will remain weak forever. However, we don't expect the market's concerns will be fully addressed for some time, which can lead to volatile swings in the stock. We advise investors to stay the course while getting paid a handsome 7.8% dividend. In the end, we believe Enbridge's long and winding road will lead to 35% upside.

Acquisition of Postmates to Strengthen Uber's Presence in Online Food Delivery; Maintaining FVE
by Ali Mogharabi | Morningstar Research Services LLC | 07-06-20

On July 6, Uber announced its acquisition of the online delivery service provider, Postmates, for $2.65 billion in an all-stock deal that will likely close in first-quarter 2021. We applaud this move as it will further consolidate the online food delivery market which could lead to pricing stabilization in the long run. In addition, with Postmates, Uber will increase its lead over Grubhub as the number two player in the space, trailing only DoorDash. Plus, we think this deal could strengthen the firm's network effect moat source, especially as the ride hailing segment returns to growth after the pandemic. We have not made significant changes to our model and continue to value 4-star Uber at $48 per share.

After the acquisition of Postmates closes, the U.S. online food delivery space will consist of only three major players -- DoorDash, Uber Eats, and Grubhub. We think with fewer competitors, more rational pricing will emerge, similar to what was taking place in the ride hailing market prior to the pandemic. With less aggressive pricing, profitability for Uber Eats will become more likely. We continue to expect Uber to become GAAP profitable in 2024.

Based on numbers from Second Measure and Edison Trends, we expect the addition of Postmates to increase Uber Eats' U.S. market share to over 30%, behind DoorDash's nearly 45%, and ahead of Grubhub's 20%-plus. With a larger market share, the supply and demand sides of Uber's network effect moat source are likely to strengthen and help create synergies which Uber management estimates will result in around $200 million in annual cost savings beginning in 2022.

As mentioned in our July 1 note, this acquisition will lower Uber Eats' costs of bringing restaurants onboard. The deal will also increase utilization of all Uber drivers, driven by more food delivery requests. Management discussed that the integration of Postmates into Uber's overall platform will likely lead to more efficiently assigning deliverers to requests, and better routing and pricing. According to both companies, Postmates has been one of the most efficient delivery service providers as its technology-driven batching and chaining capabilities have helped its deliverers average three deliveries per hour in various markets.

Regarding diners, Postmates will make Uber Eats the number one or number two online food delivery service provider in most of the top 12 cities in the U.S. (based on population). Using data from Second Measure, we estimate that Uber Eats will either become the market leader or maintain its number one position in Los Angeles (50% market share), Miami (78% market share), Atlanta (47% market share), and Phoenix (43% market share along with DoorDash). It will be the number two player in New York City, behind Grubhub. The firm will trail DoorDash as number two in Dallas, Houston, Washington D.C., and San Francisco. With such presence across the country, we expect requests placed on Uber Eats to further increase, attracting more restaurants and drivers to Uber's platform, which can attract more diners to the platform, resulting in lower diner acquisition costs. Uber Eats' growing presence will also help Uber more effectively cross-sell the two businesses (Uber ride hailing and Uber Eats) to a larger user base, especially after the pandemic.

The $2.65 billion that Uber is paying for Postmates represents a 10% premium to Postmates' last valuation of $2.4 billion (according to PitchBook), after its last round of funding in late September 2019. Based on Postmates' first- and second-quarter numbers (as provided by both companies during the call), we think that Uber will be paying between 4 and 5 times our estimate of Postmates' 2020 net revenue. We view this as a bit high for two reasons. First, Postmates has been slightly losing market share, mainly to Uber Eats and DoorDash (according to data from Second Measure and Edison Trends). And second, the multiple is much higher than what our fair value estimate of Grubhub represents, or slightly above three times 2020 revenue. However, it is in line with where Grubhub, which we consider as overvalued, is currently trading. Overall, we still view the acquisition as a positive and necessary strategic move given that such consolidation will increase the likelihood of pricing stabilization in this market and that it could strengthen Uber's overall network effect moat source, thereby creating operating leverage in the long-run.


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